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One knee-jerk reaction to Italy's shock election was to worry about contagion to Spain. As Rome's bond yields shot up last Tuesday, Madrid's were dragged up in sympathy. These are the two troubled big beasts of the euro zone periphery and an explosion in either of them could destroy the single currency.
But Spain, where I spent part of last week, probably won't catch Italian flu. True, the risk of Madrid being thrown off its reform path has risen since Italy's inconclusive election. But Prime Minister Mariano Rajoy doesn't have to face the voters for nearly three years. What's more, the Italian vote may make euro zone policymakers less keen on austerity and so give Spain a better chance of returning to growth.
Indeed, investors have already started having second thoughts. By Friday, Madrid's 10-year bond yield had fallen back to 5.1 per cent from 5.4 per cent on Tuesday. The spread between Spanish and Italian yields has shrunk to 0.3 percentage points. There's even a chance that Madrid could enjoy lower borrowing costs than Rome in the coming weeks if Italy's political paralysis shows no sign of resolution.
There is, of course, no cause for Schadenfreude in Madrid. The same factors that led to a stunning breakthrough in the Italian elections for the populist Beppe Grillo could eventually play out in Spain, albeit in a different way. Spain's traditional ruling parties – Rajoy's centre-right People's Party and the Socialists – are discredited by a mixture of recession, 26 per cent unemployment and corruption allegations. They each enjoy support of around 25 per cent in the opinion polls, while the electorate's trust in politicians has continued to plummet.
Spain doesn't have a Grillo. But it does have radical left and centrist parties, each with roughly 15 per cent support, as well as strong nationalist movements in Catalonia and the Basque Country. Unless there is an economic turnaround, nobody will have a majority in Spain's next parliament and the country could be hard to govern.
But the good news is that there is no need for an election until late 2015. What's more, Rajoy – for all his faults as a poor communicator and a slow decision-maker – is a dogged reformer. Even the latest corruption allegations don't seem to have diverted him from his path.
It's still too early to talk about green shoots of economic recovery. Spain's GDP shrank by 1.4 per cent last year and the European Commission thinks it will fall a similar amount this year. But the reform efforts are beginning to have an impact. This is most visible in the labour market, where unit labour costs fell another 3.6 per cent last year.
Cheaper labour has encouraged car companies to boost their production in Spain and offshore call centres to repatriate their operations from places like Latin American and Morocco. The current account deficit, which was a staggering 10 per cent of GDP in 2008, was virtually wiped out last year.
The cleanup of the banking system is also positive. Both Rajoy and his predecessor denied the problems for too long. But bust banks are now well on the way to being recapitalised. Dud real estate assets are also being shifted into a bad bank. One can quibble about the financial engineering that has been used to keep this highly-leveraged vehicle off the government's balance sheet and may yet return to bite it. But the economy is no longer haunted by zombie banks diverting their limited funding to zombie property companies. The challenge now is to get credit flowing to healthy parts of the economy.
The government is also pressing ahead with a new raft of reforms. The most important are: measures to deter early retirement and make pensions more affordable; the creation of a single market within Spain by getting rid of the barriers between the country's 17 regions that gum up trade; and a crackdown on duplication between different levels of government.
The country's Achilles' heel is the poor state of its public finances. The fiscal deficit has fallen, but it was still 6.7 per cent of GDP last year. The European Commission thinks it will be roughly the same this year before rising to 7.2 per cent next year as supposedly temporary tax rises wear off. Debt, meanwhile, is forecast to reach 101 per cent of GDP by the end of next year.
The government itself is more optimistic than this. Even so, it faces a challenge reconciling the need to put its finances on a sustainable footing with the need to get its economy growing. This is where the Italian election may help. Spain's European partners may be so worried about austerity fuelling populism elsewhere in the euro zone that they cut Madrid extra slack in achieving its budget targets.
At present, Spain is supposed to bring its deficit below 3 per cent of GDP next year. That is impossible. It is hoping to negotiate a deal allowing the deficit to drop to, say, 4.7 per cent next year and 3.4 per cent the year after – with a sub-3 per cent figure only being reached in 2016. Even to achieve that, the bulk of the temporary tax rises would have to be made permanent and there would have to be some further belt-tightening. But at least the hope of growth wouldn't be stamped out.
Provided Madrid sticks with its ambitious programme of structural reforms, its partners should agree to such a path. Spain would then see a silver lining from the Italian cloud.