Jan von Gerich Spain: Hung parliament to spell disaster? Nordea Research, 15 December 2015 Spain will hold general elections on Sunday, which are almost certain to lead to the ruling People’s Party losing its majority. As two of the main three opposition parties have been campaigning for the reversal of some of the labour market reforms that have boosted the Spanish recovery, a lot is at stake. With difficult coalition government negotiations ahead in almost all scenarios, caution towards Spanish bonds is warranted. In the worst case, markets well beyond Spain will be affected. Two-party system long gone The two strong forces in Spanish politics have traditionally been the currently ruling right-wing People’s Party (PP) and the Spanish Socialist Workers’ Party (PSOE). In the current lower house of parliament (by far the most important chamber in the Spanish bicameral parliament), these two parties hold 295 of the total 350 seats, while the largest opposition party currently holds only 16 seats. That division of power will change markedly in the current elections. The break-up of the two-party system that has prevailed in Spain for a long time is not a bad thing itself. After all, it will bring some fresh thinking into old policies, and that way even has the potential to lead to really beneficial reforms. However, the emergence of new parties makes building a new government much harder, especially as the newer parties are somewhat reluctant to work with the more traditional parties, not helped e.g. by the corruption scandals that have troubled the ruling PP. In Spain, the two-party system has become a four-party system after the emergence of the left-wing Podemos and the centrist Citizens or Ciudadanos (C’s). nexus.nordea.com/research The recent polls have been rather volatile, but they do confirm that the PP has remained the largest party with support of more than 20%. The PSOE, C’s and Podemos have been polling on both sides of 20%, depending on the poll, with the PSOE in the second place in many polls. The share of the popular vote does not turn directly into parliamentary seats, but gives a rough indication. Still, barring a major swing compared to the polls, the PP will fall well short of the 176 seats needed for a majority, so a coalition or a minority government supported by a major opposition group will be needed. PP still ahead in the polls, but far from being able to secure a majority Reforms vs rollbacks What makes the Spanish elections especially interesting is that the different parties have very different policy plans. As far as economic policies are concerned, the PP and C’s offer policies that would offer more stability from a market perspective, while the policy proposals of the PSOE and especially Podemos would create considerable uncertainty about the future course of Spain and thus also spur market worries. The C’s are probably the most reform-minded party of the four, and are e.g. campaigning for clearly deeper labour market reforms than implemented so far. The PP would continue a gradual implementation of labour market reforms, while both Podemos and the PSOE actually plan to roll nexus.nordea.com/research back the reforms already implemented. The PP and the C’s also appear to put more focus on sustainable government finances, while the PSOE and especially Podemos would create a larger public sector and boost government spending and social security. The Spanish labour market recovery has been aided by the reforms implemented that have sought to make the labour market more flexible. In fact, they have helped turn Spain into one of the fastest growing Euro-area economies. Still, the reforms have not gone far enough and more is definitely needed. A rollback of the reforms could easily hit confidence and undermine the entire economic recovery. Spanish recovery still with a long way to go Government formation harder than it looks Ideologically then, the PP and the C’s do not appear to be that far from each other. Further, recent polls suggest they may reach majority together, though this is far from certain. The problem is that especially the C’s appear reluctant to join a government in a junior role, especially if it is led by a traditional party like the PP that the C’s see as corrupt. Still, assuming the election result warrants, a PP-led minority government supported by the C’s looks very possible. It would likely also be the best perceivable outcome from a stability point of view, even if such a government would be more fragile compared to the current one. Further, such nexus.nordea.com/research a government would probably offer very little leeway to Catalonia in the region’s quest towards independence. The PP could also ally with the PSOE in a grand coalition, but only if it were the only option left. Co-operation between the PP and Podemos is hard to imagine, while the PSOE and Podemos (or the C’s) could probably work together. Too early to go long Spanish bonds Spanish bonds have felt pressure for most of this year on the back of political uncertainty. In addition to national politics, the Catalan issue has been creating uncertainty. This issue remains unresolved, and is one of the hard issues awaiting the new national government. In the past month, Spanish bonds have posted a partial rebound, as many polls seem to have weakened the prospects of an anti-reform government emerging, while there has not been that much progress in the Catalan independence plans. Still, a lot of uncertainty remains, and especially in light of the rebound already seen, a cautious stance towards Spanish assets remains warranted. As described above, the government formation is not going to be easy, so not all of the uncertainty will be removed even after the election result is known. However, if the election outcome supported the formation of a government consisting of the PP and C’s, i.e. a reform-minded one, the prospects for the Spanish economy – and thus also Spanish assets – would be relatively favourable. Spanish bond spreads rebounded vs Italy after underperformance earlier in the year nexus.nordea.com/research Watch out for surprises Spain is the fourth largest Euro-area economy, and political uncertainty in a country of this size would have consequences well beyond its borders. The emergence of an anti-reform government (e.g. one in which Podemos would have a strong role) would lead to fears about the direction of Spain going forward. It could easily create worries about the commitment of Spain to sustainable public finances and the Euro area in general. In many countries, parties with more radical views have already made it into government. So far, no big policy surprises have followed, but the situation in Portugal looks quite fragile, while radical political forces have considerable support in countries ranging from France to Italy. Political risks thus remain real – the next test case will be in Spain on Sunday. nexus.nordea.com/research Disclaimer and legal disclosures Disclaimer Origin of the publication or report This publication or report originates from: Nordea Bank AB (publ), Nordea Bank Danmark A/S, Nordea Bank Finland Plc and Nordea Bank Norge ASA (together the “Group Companies” or “Nordea Group”) acting through their unit Nordea Markets. The Group Companies are supervised by the Financial Supervisory Authority of their respective home countries. 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