Friday, October 2, 2009

Good news from Spain?

October 1, 2009 2:11pmby Ralph Atkins

Eurozone unemployment is up again and, even if the pace of increase has slackened, the conventional view is that it is only a matter of time before big rises feed through. But that pessimistic take is challenged in an interesting note just published by Jacques Cailloux, European economist at Royal Bank of Scotland.

We knew much of the recent increase had been in Spain. However Cailloux makes the stunning observation that close to 60 per cent of the increase in eurozone unemployment in the current cycle has been due to the ending of short-term contracts in the Spanish construction and manufacturing sector.

He goes on to argue that Spain’s labour market may have reached a turning point, with companies’ hiring intentions improving. “The peak in euro area unemployment could thus happen earlier than we and the ECB currently expect,” he concludes.

Except maybe the ECB has spotted what is going on? Cailloux points out that back in August the ECB cited “unfavourable” labour market developments as a downside risk to growth. But last month it switched to listing better-than-expected unemployment trends as a positive, or “upside” risk. I’ve checked, and he is right.


Euro area unemployment: Spain holds the key

- Since the beginning of the deterioration in euro area labour markets in March 2008, Spain has accounted for 58% of the increase in unemployment in the region

- This is 7 times the GDP weight of the Spanish economy in the euro area, underscoring how asymmetric the shock has been.

- The breakdown of the decline in Spanish employment by sectors and types of contracts shows that almost all jobs lost came from short term contracts not being renewed, mostly in the construction and industrial sectors.

- The implications for the euro area is that the outlook for unemployment is largely
tied to that of Spain.

Early signs of stabilisation there mean euro area unemployment is likely to rise less than expected from here. Also, estimates of the NAIRU and of potential growth at the euro area level are likely meaningless as they are so distorted by one single country. The unemployment rate in the euro area has increased from a low of 7.2% at the beginning of 2008 to 9.6% in August this year. However, the increase in unemployment has been very uneven with countries like Spain and Ireland making a disproportionate contribution to the rise relative to the size of their economies in the region.

This notes focuses on Spain.

In less than a year and a half, the number of unemployed in Spain has risen by a staggering 2.2 millions, which is about 58% of the total increase in unemployment in the euro area: This is more than 7 times the share of Spain in euro area GDP (see chart 1)!.

The deterioration in the Spanish labour market has been unusual and far more acute than suggested by the size of the contraction in output or the build up in slack. Indeed, both chart 2 and 3 show that neither the level of growth nor the level of the output gap explains much about the Spanish labour market situation: the unemployment rate should be much lower than it currently is. Chart 2 displays the short term relationship between GDP and unemployment for a number of euro area countries. This is a graphical representation of the so called Okun’s Law. The Okun’s Law stipulates that there exists a simple statistical relationship between economic growth and the unemployment rate. More specifically, the Okun’s gap model estimation (in the economics literature) suggests that over time, the unemployment rate in the euro area rises by around 1/2 the size of the output gap in the economy. However, there are wide country differences with the coefficient estimates varying between a low of 0.1 in Italy and a high of 0.6 in Spain (see for example: BIS Working Papers, No 111, Output trends and Okun’s law, 2002).

Chart 2 shows that while on average the Okun’s coefficient is around 0.6 for the euro area and thus not too far from where you would expect it to be, wide country differences remain. In particular, Spain stands out with an increase in the unemployment rate 4 times larger than implied by the Okun’s law coefficient.

Chart 3 shows that these results are very similar when looking at GDP growth (instead of the output gap) and changes in the unemployment rate with Spain again the clear outlier.

These very surprising results could suggest that the structure of the Spanish labour market has become much more flexible than in other euro area countries or that the crisis might have pushed corporates to fire en masse, starting what might have been the long awaited and necessary adjustment to rebuild competitiveness. However, the evidence suggests otherwise with the bulk of job losses coming from the industrial and construction sectors which typically have a larger share of short term contracts rather than permanent contracts which typically have a high firing costs attached to them.

At the sectoral level, almost 80% of job losses occurred in either the construction (44%) or the industrial sector (34%). While it is little surprising that the construction and manufacturing sectors were hit hardest, given the nature of the economic crisis, the size of the adjustment has been enormous with employment down 30% in construction since the beginning of 2008 and down close to 20% in the manufacturing sector (with employment down about 12% in the car industry).

The oversized adjustment in the manufacturing and construction sectors can be explained by the fact that these sectors rely predominantly on short term contracts rather than permanent ones. These temporary contracts also have a shorter duration than in other sectors. For example, 75 percent of contracts in the construction sector have a duration of no more than 6 months (Chart 5). The breakdown of the Spanish employment data by types of contracts confirms this assessment. In fact, almost 100% of the decline in employment is due to a collapse in temporary contracts, while employment with permanent contracts hashardly fallen (Chart 6).

In all, labour market developments over the coming months will be at the centre
of the ECB’s analysis on the recovery and its degree of sustainability. The
deterioration in the labour market in this business cycle has been very unusual
with the bulk of the deterioration concentrated geographically and sectorally:
close to 60% of the increase in euro area unemployment in this business cycle
has been due to the end of short term contracts in the Spanish construction and
manufacturing sectors.
The implications for the euro area is mostly twofold:
First, it implies that the outlook for euro area unemployment is very much tied in
to that of Spain. With the pace of contraction in Spanish employment easing
(Chart 7), it is quite likely that the unemployment rate in the euro area has not
only past its inflection point but could actually be much closer to its peak than
most observers including the ECB believe. The peak in euro area unemployment
could thus happen earlier than we and the ECB currently expect. Interestingly,
for the first time in this business cycle, the ECB changed its assessment on
labour markets at the September meeting by shifting labour markets
developments as potential upside risks to the economic outlook from downside
risks previously.

Second, the extent of the asymmetry in the labour market deterioration across
the region suggests that measures of the NAIRU and thus of potential growth at
the euro area level recently published by international organisations and market
participants might not be telling the right story. Indeed, the euro area aggregates
are likely heavily distorted by developments in Spain rather than by an area wide
phenomenon. The NAIRU in Spain has likely shot up which explains most of the
increase in the euro area NAIRU and most of the decline in euro area potential
growth. The decline in potential growth in countries like Germany and France is
likely to have been much less pronounced by the euro area aggregates.

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