Investing in Spain: PEST Analysis and Economic Assessment

Introduction

As of late 2010, rumors in the financial community persist that Spain will be the next Eurozone nation to suffer an economic crisis. Spain's high unemployment rate, coupled with a lack of economic recovery and an inability to adjust interest rates due to its participation in the euro, has resulted in a rapid appreciation of interest rates on Spanish sovereign debt amid speculation in the bond markets that Spain will be unable to meet its obligations (Krugman, 2010; Krause, 2010). The Spanish economy, it would seem, has been suffering in recent years, and that suffering is not expected to end any time soon.

For a company looking to do business in Spain, the current situation is certainly cause for alarm. The economic fundamentals of the country look troubling, and there are significant structural reasons why Spain will not be a good place in which to invest any time soon. However, in order to truly assess the situation, one must move beyond the headlines and engage in a deeper analysis of the country and its economic circumstances.

This paper analyzes Spain in terms of both the big picture and its current economic situation. The claim that Spain is overpriced as a place to invest will be addressed, as will a number of other concerns. The perspective for this report is that of an American firm seeking to invest in Spain. Economic, cultural, and political elements of Spain and its society will be considered so that an American firm can gain the full knowledge required to make the right decision for its business. At the core of the report is a PEST analysis, in which four specific components are examined: the political environment, the economic environment, the social environment, and the technological environment. Each of these plays an important role in the decision of whether or not to invest in Spain at present.

The components of this paper, in order, are the history of Spain, its government, the current climate, its culture, its employment and labor conditions, education, taxes, foreign investment climate, business practices and freedoms, and the corruption climate. Lastly, the paper brings all of this knowledge and insight together to reach a conclusion with respect to investing in Spain.

History and Government

History

After emerging from Muslim rule in 1492, the Kingdom of Spain immediately became a colonial power with the Columbus expedition. This period saw Spain as one of the world's leading economic powers, a position it occupied for several hundred years through a series of dynasties, culminating in the first republic in the late nineteenth century. Just before the Second World War, Spain's republic fell and the country became a dictatorship under Francisco Franco. After Franco died, the country began a transition to democracy that ushered in its modern age. Spain joined the European Union in 1986 and was one of the founding adopters of the euro in 1999, setting the stage for the country's current economic climate.

Today Spain is one of the largest and most important countries in Europe, with a total population of 46 million people. Of these, 74% are the majority Castilian ethnic group, 17% are Catalan, 7% are Galician, and 2% are Basque. Among the Castilians there are further subgroups such as Asturian, Aragonese, and Andalusian, each with distinct regional culture and dialect (CIA World Factbook, 2010).

Government

The current structure of the Spanish government is a parliamentary monarchy. The royal family holds only nominal control of the country; it is run by elected officials in a parliamentary system. The country is governed by the National Assembly, which consists of a 264-seat Senate, of which 208 are elected, and a 350-seat Congress. The Congress consists of 248 representatives elected under a proportional representation system and a further 2 members from each of the fifty provinces, plus a single member each from the African enclaves of Ceuta and Melilla. A number of political parties participate in Spanish government, including regional parties representing Basque Country, Catalonia, the Canary Islands, and various parties representing the Castilian population across the political spectrum. There are a significant number of socialist and communist parties represented. The head of state is King Juan Carlos I, but the head of government is José Zapatero, a member of the Spanish Socialist Workers' Party (CIA World Factbook, 2010).

Despite having a socialist leader, Spain's political climate in recent years has generally been favorable to investment interests. Spanish law remained unchanged following the election of the Socialists in 2004. Foreign investment is permitted up to 100% equity and capital movements are completely liberalized (Dimireva, 2009). As a result, Spain has seen significant capital inflows, which were in part responsible for the country's current economic situation, as these inflows led to a real estate bubble that has since burst.

Current Economic Climate

The bursting of that real estate bubble has led to considerable difficulty in Spain's current economic climate. Unemployment stood at 18.1% in 2009, up from 11.4% in 2008. Spain has the worst unemployment rate in the EU by far and the second-worst in Europe after Bosnia-Herzegovina. To put Spain's unemployment rate in perspective, it ranks between Kyrgyzstan and Sudan — two landlocked, developing nations with considerable civil strife (CIA World Factbook, 2010). Spanish GDP declined 3.7% in 2009 and appeared to have continued to decline in 2010.

There is intense speculation that the European Union will need to bail out the Spanish economy. Such a bailout could cost upwards of $1 trillion, severely depleting Europe's contingency reserves, which in turn could trigger a crisis in the euro. Any reduction in the value of the euro would have a dual effect on Spain: it would make Spanish exports more competitive, but it would also increase the real value of Spain's sovereign debt. The overall impact of such a scenario is expected to be negative.

At present, Spain is not yet in full crisis, but interest rates on its sovereign debt have increased significantly. While this increase is largely speculative, it has real consequences for the cost of Spanish borrowing, making such speculation a self-fulfilling prophecy of sorts. Spain is currently considered the second-riskiest country in Europe after Portugal, so depending on the reaction of major EU powers, Spain's situation could either stabilize or worsen dramatically in the near term (Faiola, 2010).

At the heart of this crisis was Spain's real estate bubble. When the euro was formed, it enabled money from across the continent to flow more freely, encouraging investment in what were then marginal economies like Ireland, Portugal, and Spain. As early as 2004, there were signs that Spain was experiencing a real estate bubble prone to bursting; the OECD warned of this likelihood at the time, with real estate prices growing at 17% annually. A number of perverse incentives in the economy fueled the real estate boom, but when global credit markets began to dry up, the bubble burst. This crippled Spain's GDP and threw millions of Spaniards out of work. Whatever measures are undertaken in terms of government response and European bailout assistance, there is little in the fundamentals of Spain's economy to indicate that demand will be restored any time soon, so the bleak outlook will continue for the foreseeable future (Knowledge @ Wharton, 2004).

Working in Spain's favor thus far has been its relative reluctance to implement austerity measures, having passed a small package by only a single vote and taking its time in implementing it (Dowsett, 2010). Austerity measures — which have proven entirely ineffective in aiding Ireland's economy or lowering its cost of debt — essentially cripple any hope of economic recovery and cause dramatic civil unrest. If Spain were to implement tougher austerity measures, its economic situation would deteriorate further, so it is hoped that the country's current strategy is sufficient to pull it through the crisis.

One of the most important considerations of the current crisis is that it is unlikely any measures can restore the country's economic health in the near term. In essence, the real estate bubble left Spain with an overpriced economy, characterized by prices and wages above equilibrium levels. This problem persists, making Spain generally uncompetitive at present. The primary skill set in the workforce is in construction, an industry that is now dormant. Spain's solvency issues mean it is not well-positioned to provide fiscal stimulus, and it cannot devalue its currency as a means of bringing real prices and wages down. Without the devaluation option, and with no prospect of either fiscal or monetary stimulus, Spain faces a long and painful period of deflation in order to bring the economy back to equilibrium — and during this process, internal devaluation only makes the country's debt problems worse (Krugman, 2010).

Beyond the immediate crisis, Spain's current rate of inflation is -0.3%. While deflation is generally negative in that it increases the real cost of debt, it is also necessary in the Spanish economy to bring prices into equilibrium. The deflationary environment is therefore expected to continue, especially with respect to wages and real estate. This implies that any investment in Spain should be delayed, as it will be cheaper in the future than it is today, should internal disinflation hold.

Conclusion

The most important consideration with respect to investing in Spain today is the current state of the country's economy. The country is facing an economic crisis characterized by crippling debt, slumping GDP, high unemployment, and high asset prices. There is opportunity in the large pool of available workers, but the underlying fundamentals of the Spanish economy are generally poor, and there is real risk that the economy could deteriorate further. The euro is the biggest constraint to Spanish economic recovery; barring an extended depreciation of the euro, Spain will remain an overpriced place to invest.

Even absent an economic crisis, Spain offers only a moderately positive investment climate. The country has a fairly open investment framework that attracts a substantial amount of FDI, but labor laws are highly restrictive. In addition, there are significant cultural differences that affect how business is conducted. Managers setting up a subsidiary in Spain should be aware of these cultural differences, preferably through experience with similar cultures. Spain has a reasonable corruption index, but on the whole it lags northern Europe in areas such as corruption and technology.

The political climate is difficult, not least because of the socialist government and the threat of heavy external intervention from bodies such as the European Commission. The political environment is therefore only moderately favorable and could easily deteriorate in the near term.

All in all, the economy remains the overriding factor in any decision about investing in Spain. There is considerable uncertainty surrounding the Spanish economy and the political and social landscape, creating a real likelihood that the economy will continue to deteriorate. In particular, if Europe were to "bail out" Spain in the manner it did Ireland and demand austerity measures in return, this would not only cripple any growth the Spanish economy might otherwise achieve but would also trigger significant social unrest. The high degree of uncertainty surrounding Spain right now makes the country a risky investment destination. Unfortunately, the opportunities in the Spanish market do not offset this risk. Therefore, it is not recommended that a company invest in Spain at present. There are more stable economies, better political landscapes, fewer social barriers, and better opportunities to be found elsewhere.

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