Competitiveness of the Spanish Economy. Before and After the Crisis (VI).Consequences and Causes of Inflation Differentials

11/03/2015

In the previous instalment we saw how, throughout the period of expansion, Spain had maintained a positive inflation differential with its main trading partners, while it turned negative with the advent of the crisis, especially when energy was eliminated from the inflation calculation. The reason is that our country has a high external dependence as far as energy is concerned, so the evolution of energy prices is highly conditioned by the evolution of international prices.

The evolution of the inflation differential has a direct effect on the international competitiveness of our country and consequently on trade, something we will explain below. As already mentioned, since Spain joined the eurozone, sharing currency with 18 other countries, the traditional competitive devaluations which Spain used in periods of crisis to facilitate economic recovery at the expense of internal impoverishment could be used anymore. However, and in spite of the fact that the exchange rate in nominal terms is not freely modifiable by the Bank of Spain, devaluations are indeed feasible in real terms.

While the nominal exchange rate expresses the price or value of one currency in terms of another, the real exchange rate, as it includes the effect of inflation, shows the price of foreign goods and services in terms of domestic goods and services. And it is precisely the behaviour of the real exchange rate–which is the result not only of changes in the nominal exchange rate, but also in inflation differentials compared to trading partners–that affects the amount of goods and services that can be imported and exported.

The real exchange rate, which is expressed as follows, can be appreciated or depreciated even though the nominal exchange rate remains unchanged, as in the case of countries that share currency. But also in other cases, when the national currency is not unique to the country and the authorities have neither the capacity nor the power to change its value relative to the currency of other countries.

If we now analyse the behaviour of the real exchange rate we can conclude, first and generally, that throughout the period of economic expansion the Spanish currency appreciated in real terms, while it depreciated over the recession period. And second, that the intensity of appreciations and depreciations vary, not only depending on the trading partner, but also on the group of assets to which we are referring to.

 

Annual average rate of real exchange rate in Spain versus the eurozone-12 excluding Spain and variation thereof (January 1997 - December 2014) 

Source: Own calculations based on Eurostat (2015)

 

Thus, when the behaviour of the real exchange rate of Spain regarding the rest of eurozone countries (12) is analysed, we can say, as shown in the graph below, that Spain was slowly losing competitiveness over the entire period of expansion and until mid-2008. This loss of competitiveness was the result of the positive inflation differential typical of Spain throughout the whole expansion phase. On the other hand, in the recession period, the inflation's behaviour seems to have relaxed the growing trend of our real exchange rate. Even though we cannot really say there was a real depreciation of our euro as compared to the euro of the rest of the countries of the eurozone (12), we can say our loss of competitiveness was at a standstill. This is shown by the fact that in specific periods, and as a result of Spain's lower inflation, there was a real depreciation which improved our exports curbing our imports.

 

Average change in the real exchange of Spain against the eurozone-12 excluding Spain, by group of products

Source: Own calculations based on Eurostat (2015)

 

However, the evolution of the real exchange rate has not been identical in all product groups. Thus, in the services sector, the marketing of which is less simple, the appreciations and depreciations have been stronger than in the goods sector. In the latter case, despite the crisis, the appreciation has continued, albeit with less intensity.

In addition to the Member States of the eurozone, Spain has business relationships with, among others, the United States and the United Kingdom. In both cases, as shown in the following graphs, the euro has appreciated in nominal terms during the period of expansion, and has depreciated during the economic crisis, despite the fluctuations experienced especially in the American case. Furthermore, the appreciation was, in both currencies, more intense than their depreciation. However, variations before the dollar have been higher than those experienced before the pound sterling.

 

Evolution of the nominal and real exchange rate (January 1999 - December 2014)

Between the euro and the US dollar

Between the euro and the British pound

   

Source: Own calculations based on Eurostat (2015)

 

On the other hand, if you look at the behaviour of the real exchange rate of the euro before both currencies, it should be noted, first, that the Spanish euro has always been above the nominal exchange rate, but also of the euro in other countries in the eurozone (12).This has made us less competitive compared to our competitors in exports to both countries, that is, compared to other countries in the eurozone, which have seized our loss of competitiveness to increase their exports. Secondly, we should note that the real depreciation has been greater than that experienced in nominal terms, especially in the case of the pound sterling. But not only this should be noted, but also the fact that the depreciation of the Spanish euro was slightly above the overall euro, which has certainly slightly benefited exports.

The trade effects of inflation differentials have been noticeable compared to our trading partners as a whole, as the real depreciation that has come with the nominal one, when the latter was feasible, has generated competitiveness gains that have managed to recover, at least partially, some of the lost competitiveness during the expansion.

Contribution of internal and external factors to the generation of inflation in Spain (1998-2014)

Source: Compiled from AMECO (2015)

 

While there's still a long way to go, given that competitive devaluations are impossible at least in nominal terms, it is essential to know which variables have supported the price differential that has favoured the real depreciation of our currency. To do this we will break inflation factors down into the factors that create it, on the one hand internal factors, and on the other imported factors. Specifically, when we measure inflation with the deflator of final demand, we can say, as shown by the graph below, that with the exception of the years 2000, 2010 and 2011, most of the Spanish inflation comes from domestic factors.

Source: Own calculations based on AMECO (2015)

 

These internal factors, as shown by the table above, are precisely the ones which have supported the positive inflation differential before the eurozone (12) during expansion, and the negative one during the recession. In short, they are the ones that have made us less competitive in the first phase and helped us recover in the second. This is the pattern reproduced in all countries considered, therefore domestic factors are the main cause of inflation in all countries except in Luxembourg, and partly in Belgium, at least during the expansion.

Once we know that the cause of Spanish inflation is primarily internal, we are ready to ask: Which factors essentially influence the behaviour of prices? And then we would proceed to question their behaviour in both the expansionary and recessionary phase. This way we would know which variables are most vulnerable to cycles and thus deserve our attention in order to avoid further loss of competitiveness as that experienced during the 2000-2008 period.

To get to know the elements of domestic inflation it is necessary to measure the behaviour of prices by the GDP deflator, which allows us to disaggregate inflation into four causal factors: wages, productivity, profit margins and taxes. The results of this analysis, shown in the following table, clearly show how in Spain, during the expansion, the growth of wages and the profit margin of businesses became the economic burden of competitiveness. This fact is joined by the low growth of productivity, only slightly exceeding that of Italy, which has barely managed to offset part of the growth of inflation. Meanwhile, the contribution of taxes to the growth of prices has placed itself slightly above the average for the eurozone and also of the US and the UK.

 

Source: Own calculations based on AMECO (2015)

 

In short, during the expansion all factors considered can explain the positive inflation differential registered by Spain, as our country has a worse performance in all of them than its major trading partners, leading to price increases and consequently to an appreciation of the real exchange rate greater than that experienced by the nominal exchange rate.

If we should ask ourselves about what happened during the recession, it should be noted, as shown in the following graph, that the control of the growth of prices which can be seen throughout the entire downturn is the result, first, of improving productivity enough to offset the price increase stemming from the wage and tax behaviour. But also, of the self-control exercised by employers, who were willing to reduce their benefits in exchange for avoiding the closure of their companies.

This behaviour pattern, in particular improvements in productivity, coupled with a restraint in the growth of business profits, is observed only in another country, in France, where nonetheless inflation grows more than in Spain because productivity gains are very small and wage increases are higher than in our country. Only Ireland and Greece show a restraint in the growth of prices higher than that in Spain. However, the reasons behind these cases are different from those in Spain: whereas in the first country, productivity and wages are the cause of deflation, in the second the reasons are a wage and profit margins moderation.

 

Contribution of different economic factors to variation in the GDP deflator (2009-2014)

Source: Own calculations based on AMECO (2015)

 

A simple comparison between the behaviour of different variables before and during the crisis allows us to say that, as far as wages are concerned, moderation has become a fact, to a greater or lesser extent, in all countries, with the exception of Germany and the United States. Both countries used the expansion period to implement economic policies which, even though they did limit the growth of wages, they also generated lower rates of unemployment during the downturn. And this despite the fact that wage growth has been even greater than during the previous expansion phase.

Meanwhile, employers have had quite a similar behaviour in all countries, with large increases during the first phase considered, and very moderate or even negative growths in the recession phase. The exceptions are the United Kingdom and the United States, both countries showing minimal variations in the first phase, and much larger, and even positive, in the second period. Particularly alarming is the case of the United States, where profit margins have soared at this stage.

As far as productivity of labour is concerned, in most countries its contribution was better for the containment of inflation during the boom than during the recession, as almost all of them used the expansion to carry out investments in productive capital rather than to increase employment. Only in the case of Portugal, Ireland and Spain productivity increases more in the recession phase than in the expansion period, achieving better results on inflation.

The behaviour of taxes differs greatly between countries. While in some countries a positive contribution to inflation is greater in the expansion phase than in the recession, in others just the opposite occurs. Only Ireland approved a tax freeze practice during the crisis. However, the low contribution to the increase of prices arising from this variable seems to indicate that, although it may be a good variable to support other measures to contain inflation, thereby achieving improvements in competitiveness, the fact is that it is not a major variable on which to act, therefore we should focus our efforts on the remaining variables considered.

After this general assessment we must focus on the case of Spain, in which, as shown in the following chart, productivity has always contributed favourably to the behaviour of inflation, although it has done so with greater intensity throughout the downturn, especially since 2009. On the other hand, moderation in wage growth, which had soared during the expansion, and also in the profit margins, have helped to increase competitiveness. However, it is necessary to clarify some aspects regarding these two variables. Firstly, wage moderation did not begin until 2010, with some delay that has harmed us in trade relations abroad. Although, when it did appear, it has been a strong incentive to correct inflation. Secondly, with regard to corporate profits, they began their contraction from 2008 onwards, when the contribution of benefits to inflation, although positive, was contained in more than 1.25 percentage points. From that moment the positive and negative contributions of corporate profits have followed each other, subtracting continuity to this variable as a factor improving competitiveness.

 

Contribution of different economic factors to variation in the GDP deflator in Spain (1999-2014)

Source: Own calculations based on AMECO (2015)

 

At this point, one could wonder what conclusions can be drawn for the future? And, what policy recommendations can be made?