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What to do About Inflation?

The Case of Spain

by José Moisés Martín Carretero  |  30th November, 2022

At the time Russia invaded Ukraine in 2022 and the war broke out, Spain was the EU country with the weakest economic recovery since the Covid-19 crisis. With growth prospects still high and the labour market performing well, however, Spain does not have a particularly high strategic exposure to Russia, which provides only 9 per cent of its natural gas. As of 2022, the energy mix for power generation is dominated by renewables, accounting for a total of 43.9 per cent of total generation, while gas – including co-generation and combined cycle power – accounts for 28.5 per cent. The remainder is provided by nuclear (20.4 per cent) and other technologies.

 

Most Spanish gas imports are from NGL vessels from the United States (16 per cent), or from Algeria (30 per cent). Changes in relations with Algeria have led to a drop in gas imports during 2022, thus increasing the use of NGL gas. Spain maintains 25 per cent of Europe's entire liquefied natural gas management capacity, but has poor interconnection with the gas infrastructures of the rest of the continent. This situation has led Spain, together with Portugal, to be considered ‘energy islands’ in the context of the European Union.

 

Inflation in Spain has been remarkably high, however, above the Eurozone and EU averages, because of poorly functioning markets. The government's economic policy has been aimed at both alleviating the social and business effects of the price crisis, while focusing on correcting some of the inefficiencies in electricity generation markets.

 

Recent Inflation Developments in Spain

Recent inflation trends in Spain point to a significant acceleration in the past 12 months, after a long period of inflation contained by low economic growth and successive economic crises. In the summer of 2021, prices began a rise that ended in August 2022, with a year-on-year growth of 10.5 per cent, the highest in Spain for three decades. This recent price growth is due mainly to energy: energy prices rose by almost 20 per cent year-on-year after a peak of 35 per cent in March 2022, although over the course of 2022 this price increase has spilled over into other sectors, such as food prices, but also other goods and services. The result of this process is a marked increase in core inflation (which does not incorporate food and energy prices), which stood at a decades-long high of 6.4 per cent in August 2022.

 

Reasons for this inflationary growth are twofold. First, growth in gas and oil prices, which started to accelerate in 2021, has negatively affected the final energy price, with a significant rise throughout 2021 and 2022. On average, the price of electricity grew by 600 per cent between February 2021 and March 2022, when it peaked, and before the Spanish government took the necessary measures to moderate its growth.

 

By product, and taking into account the most recent data, the energy sector is indeed the sector with the highest price growth, while other goods and services maintain lower growth rates, although price rises in transport, food and hotel and catering services also stand out.

 

In this way, Spain is experiencing its highest inflation in 40 years. At the same time, it is also one of the European countries most affected by the Covid-19 crisis in 2020. GDP has still not yet reached the level of 2019, while public debt grew by 20 percentage points – from 97 to 117 per cent of GDP – between 2019 and 2021, and the public deficit is projected to end 2022 at around 5.4 per cent of GDP. On the other hand, growth is expected to be strong in 2022 and 2023, and employment has reached a 15-year record, with 20 million in employment, despite signs of deceleration at the end of summer 2022.

 

Impact on the Economy and Social Cohesion

Main Affected Sectors

The impact of price increases, and particularly the price of electricity, gas and oil, has largely affected the economic sectors most dependent on these markets, such as electricity-intensive industries, agriculture and transport. While energy prices in general account for around 9.39 per cent of production costs (apart from wages), in some sectors they are 18 to 20 per cent of production costs.

 

In economic terms, rising prices have significantly affected business margins in some sectors. The most affected sectors are hotels and catering, construction, agriculture and transport. More than 20 per cent of the total labour force works in these sectors.

 

The price shock has directly affected these sectors with no reaction time. These are sectors in which energy demand is very rigid and in which it is difficult to pass on the energy price shock to prices of goods and services, so that their margins have been significantly reduced. The most affected industries include transport, manufacturing and agriculture.

 

In addition to the rise in energy prices, some industries have encountered supply difficulties, due to the ramification of the crisis through international supply chains. This is particularly relevant for the car industry, one of Spain’s main export sectors. Bottlenecks in the chip industry in 2021 affected some car manufacturers. In 2022, other industries, such as ceramics, ran short of raw materials coming from Ukraine.

 

Social Effects: Wages and Inequality

In social terms, the impact has been significant, though uneven. During the adjustment years between 2010 and 2014, wages in Spain lost 8 percentage points of purchasing power, which has partially been recovered in recent years. However, the differential between the price level and wages has widened again during 2022, in line with average inflation forecasts for the year and the agreed increase in wages through collective bargaining. The result is that, as of today, wages are again losing significant purchasing power, thus affecting consumption and household welfare. It is expected that, by December 2022, wages will have lost more than 10 per cent of their purchasing power, compared with 2009. Despite the intensive employment creation, wages are suffering an adjustment sharper than during and after the great recession of 2008/2009.

 

This is particularly relevant for lower wages. Between 2009 and 2017, the minimum wage was frozen. In 2018, the new progressive government committed itself to raise the minimum wage to 60 per cent of the median wage, in accordance with the European Social Charter. Despite this effort, the purchasing power of low wages will be strongly reduced due to inflation.

 

On the other hand, the effects of price rises on inequality are also remarkable. According to Oxfam, lower incomes experienced a 30 per cent greater loss of purchasing power than higher incomes, given the higher percentage of income spent on the consumption of goods affected by price rises.

 

In conclusion, the effects of the price crisis have increased inequality and have mainly affected lower wages, which have not recovered their purchasing power since the 2008 crisis. Thus, social cohesion is being weakened, with a negative impact on production conditions in many industries.

 

Spain and the ECB Policy

Spain is part of the Eurozone and as such is subject to the monetary policy of the European Central Bank (ECB). Measures taken by the ECB to mitigate the effects of inflation over 2022 include the following:

 

  • end of the asset purchasing programme linked to the pandemic. The ECB decided to stop its pandemic emergency purchase programme in July 2022, thus ending a quantitative easing policy lasting nearly eight years, with some interruptions in 2018 and 2019. Spain has been one of the major beneficiaries of this purchasing programme;
  • interest rate hike to 2.0 per cent and announcement of further rate hikes in the coming months;
  • launch of the Transmission Protection Instrument (TPI), a programme of selective purchases of public sector assets aimed at avoiding excessive risk premia, which would mean less effective monetary policy transmission mechanisms. The programme, still in the implementation phase, would buy public debt from countries with higher risk premia in exchange for conditionality based on compliance with the European Union's Stability and Growth Pact and the milestones related to the European Union's Transformation and Resilience Mechanism.

 

Spain is one of the countries that have benefited most from recent ECB monetary policy and therefore one of the countries most likely to be affected by monetary policy tightening. However, the new TPI programme is an important guarantee to avoid negative effects on the evolution of the cost of Spanish public debt, which stands at 117 per cent of GDP in 2022. Despite this high level of debt, risk spread remains stable and below 120 basis points.

 

Main Government Measures

The Spanish government approved the first package of measures to alleviate the economic and social burdens generated by the price crisis in March and June 2022; further measures were announced in July 2022. These packages comprise three types of measures:

 

  • measures targeting households and consumers, particularly the most vulnerable;
  • measures targeted at the hardest hit companies and sectors;
  • measures targeting energy markets.

 

Measures Aimed at Families and Consumers

The main measures for households and consumers include the following:

 

  • rebates on the purchase price of fuel for vehicles, with a discount of 25 cents per litre, 20 cents being borne by the government and 5 cents by the supply companies (budget of 1.43 billion euros);
  • an increase in social benefits: the minimum subsistence income and non-contributory pensions are to be increased by 15 per cent until December 2022;
  • a social bond on electricity and heat: the number of beneficiaries of the electricity and heating price protection system for the most vulnerable households is to be increased to 1.9 million families (75 million euros);
  • a guarantee of basic supplies: people at risk of social exclusion will not have their water, gas, electricity or telecommunications services cut off;
  • direct support is to be provided in the form of a one-off payment of 200 euros for unemployed persons and workers with an annual income of less than 14.000 euros (540 million euros);
  • a suspension of eviction orders for vulnerable households without housing alternatives. Limits on the updating of housing rents;
  • a 100 per cent discount on multiple tickets on the national rail network, including short-distance services and services offered by the central government (221 million euros);
  • a reduction of the value added tax rate to 5 per cent for electricity and gas (estimated fiscal cost: 600 million euros).

 

Measures Targeting Economic Sectors

As regards measures targeting economic sectors, the following should be mentioned:

 

  • an 80 per cent reduction in grid access costs for energy intensive sectors (225 million euros);
  • direct aid for gas-intensive industries, such as paper, man-made fibres, glass and ceramics (125 million euros);
  • support for the chemical, iron and steel products and cement sectors (250 million euros);
  • aid to the transport sector to mitigate the impact of the rise in fuel prices and to encourage the use of public transport, including aid to bus lines, taxis, passenger transport vehicles and ambulances, in the amount of 1.04 billion euros;
  • direct aid to regional and local authorities for urban and interurban transport services, for a 30 per cent reduction in monthly ticket prices (200 million euros);
  • aid and loans to the primary sector, including the milk production sectors, livestock operators and farmers, as well as fishing enterprises, both as grants and loans (430 million euros);
  • ban on employee dismissals for reasons linked to the war in Ukraine.

 

Energy Measures

Among the most noteworthy energy policy measures are the following:

 

  • speeding up the processing of renewable energy projects:
  • an increase in natural gas reserve requirements from 20 to 27 days;
  • ‘Decoupling’ or ‘gas cap’ mechanism. The system, negotiated with the European Commission, involves a cap on the electricity price in the wholesale market by setting a ceiling on the marginal cost of electricity production using gas. The cap has been established at 40 euros MW/h, and it will be increased to 70 euros MW/h in 2023. Power companies will receive compensation for this cap and thus may set a lower marginal price than that established under market conditions. While preserving the functioning of the marginal market, the marginal price is capped at 40/70 euros plus the compensation for the real gas market price. This compensation is included in the monthly bill. In this way, users pay only the price difference between the real and the capped gas price, while other sources will be paid according to the maximum capped price. This system will reduce the consumer price by 30 per cent, on average;
  • revised calculation of the regulated electricity price, with the aim of incorporating long-term market prices and a reduced VAT rate for electricity;
  • energy saving plan. Approved in August 2022, and in line with the Conclusions of the Council of the European Union of 26 July 2022, it focuses on the objective of achieving a 7 per cent reduction in natural gas consumption in Spain, through the establishment of new temperature limits for public and commercial centres, reduction of commercial lighting hours, promotion of teleworking and other measures.

 

In total, Spain is investing around 5 billion euros in direct support to firms and families and 3.5 billion euros through reduced public prices and taxes. This represents a total amount of 8.5 billion euros to support the price crisis, around 0.6 per cent of GDP. In order to compensate for this expenditure, Spain has introduced a temporary windfall tax on energy companies and the banking system. In September 2022, the government announced a new wealth tax to be implemented in 2023.

 

Income Policy and the Role of the Social Partners

All in all, the main problem affecting the Spanish population is the differential between prices and wages which, as we have pointed out, poses a major challenge in the medium term. Aware of this situation, the government has shown an interest in promoting an agreement between employers and workers that would allow them to agree a path to recover purchasing power that does not accelerate inflation in the medium term. To date, however, the social partners have not been able to find the right framework for the development of such an income pact, which poses a significant risk of social conflict in the coming months.

 

Pensions are another important topic. The government is committed to raising pensions in order to avoid a reduction in purchasing power at the end of 2022. This represents a nominal increase of 8.9 per cent in the public pension budget. Over the years the European Commission has expressed concerns about the sustainability of the Spanish public pension system and, according to calculations, this increase might affect negatively the future of the system. Employers and trade unions have not reached an agreement on this increase.

 

While negotiations in the private sector are stagnant, there have been recent developments in the public sector. The government has offered a wage rise of 3.5 per cent for public servants. Conversations are now under way.

 

Evaluation of Government Policies

In the context of rising prices, the measures taken by the Spanish government represent an ambitious programme aimed at alleviating the social and economic consequences of the crisis. It should be noted, however, that these public policies are transitional in nature, so they have a limited timeframe. Originally approved for three months, they have been extended to the end of 2022, which will put pressure on public finances this year and next, if the price crisis does not abate quickly. While public revenue has been increased by 10 per cent due to inflation, prolongation of the crisis would lead to an increase in the fiscal cost of the measures to be implemented. This is particularly relevant for the pension system, which accounts for 10.3 per cent of GDP. If pensions are to maintain their purchasing power, this could mean an increase of 1 per cent of GDP in 2022 and could generate a negative effect on the future evolution of pension expenditure. In fact, this is the main object of discussion with regard to the sustainability of the public finances in the near future, as Spain continues to have a high public deficit.

 

On the other hand, regional governments, which will have regional elections in 2023, have started a race to the bottom regarding personal income taxes. This policy, not recommended by the international economic institutions, is endangering regional governments’ capacity to generate enough policy space for the next few years.

 

A large proportion of public policies are aimed at supporting the most vulnerable households, in an effort to preserve social cohesion. On the other hand, other policies, such as fuel subsidies for vehicles, are regressive in nature, do not adequately adjust demand to new supply conditions, and run counter to climate change objectives. The same could be said of some measures to support productive sectors, which have not incorporated energy saving and efficiency targets. According to preliminary estimations from CaixaBank Research, fuel consumption has increased for wealthy families (by 20 per cent since 2019), while poor households have reduced fuel consumption by 10 per cent since 2019.

 

Despite these measures, the middle class is also being affected by the falling purchasing power of wages, while most policy actions are not aimed at them. According to Oxfam estimates, the middle class has lost any capacity to save. This is important for young people in particular, who have suffered three crises in 15 years. This is now a very important socio-economic issue. The absence of an institutional framework for an income pact makes it difficult for the middle classes to improve their situation in the face of rising prices. The government is preparing measures to facilitate such a pact, but at the end of the summer of 2022, uncertainty was still high.

 

The Author

José Moisés Martín Carretero is a Spanish economist and consultant. He is a lecturer at the Camilo José Cela University and a member of the Council of Economic Advisors of the Spanish Ministry of Economic Affairs.

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