Growing political uncertainty and the fragmentation of the exiting political order among some of the developed countries of Europe appears to be here to stay. No more is this true than in the case of Spain where, in fact, there has been the absence of a functional government for almost a year now. Here's how we think the situation may ultimately play out in the country.

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2. Special Report | September 20162
All in all, the election result reveals that the established parties, PP and PSOE, did better than
expected while the newcomers, UP and Ciudadanos, underperformed relative to both the ballot
held last December and polling trends. Polling errors aside, this lends some weight to the view
that, within the context of the UK Brexit vote result, there was a desire on the part of the
Spanish electorate to opt for stability and safety offered by the established political parties.
Having said that, the result does not negate the fragmentation of Spain’s two-party political
system, which initially became evident during last December’s election. Indeed, the joint share
of the vote of the two traditional parties during June’s election stood at around 55%, a figure
which was well below the circa 75% level seen in December 2011. If this trend is to persist
going forward, there is a fear, in our minds, that Spanish politics may undergo an “Italianisation”
process, with frequent changes of government and little prospects of stable majorities.
Coalition scenarios
As with the previous election held last December, the fact that no one party has an absolute
majority, means that the Socialist PSOE – by virtue of being the second largest party – will
retain the balance of power for any realistic government formation in Spain. In fact, the only
feasible cross-party coalitions projected to gather enough seats for a parliamentary majority
are likely to include:
 A PP/PSOE/Ciudadanos grand coalition;
 An “All-But-PP” alliance by PSOE/Ciudadanos/UP alliance;
 A left-wing pact by PSOE/UP supported by regional parties such as the Catalan pro-
independence forces.
Of these potential tie-ups, the one that would be most favoured by the markets is the first one,
given the fact that it would give the combined parties a clear working majority (see Chart 3) on
the back of which they would conceivably be able to push through some of the outstanding
reforms the country still needs to adopt (see “Futures Challenges” section below). But, in
reality, the bitter rivalry between the respective leaders of the PP and PSOE parties means
that such a combination does not seem to be plausible. More likely, in our mind, is the prospect
123
90
71
40
26
137
85
71
32
25
0
25
50
75
100
125
150
175
200
PP PSOE UP Ciudadanos Others
December 2015
June 2016
Outright majority (176 seats)
.
Chart 1: Spain Election Result Versus Previous Poll
(Seats)
(Source) Spanish Electoral Commission
29.6
21.4
24.6
14.4
33.0
22.7
21.1
13.1
0
5
10
15
20
25
30
35
PP PSOE UP Ciudadanos
Polling average
Election result
(Votes, %)
Chart 2: Spain - Actual Election Result Versus
Poll Predictions
(Note) "Polling average": the average of poll predictions a week before the
election.
(Source) Spanish Electoral Commission, various polls

3. Special Report | September 20163
of a minority PP government allied with Ciudadanos (see Table 1), especially in the wake of
the fact that the leader of Ciudadanos, Albert Rivera, on 28 August formally pledged his
support for a PP-led government headed by Mariano Rajoy. Indeed, from an ideological stand-
point, the two parties make a good fit, in particular given their shared belief in liberal market
economics and their willingness to embrace structural reforms. But given that such a
combination would fall short of an absolute majority (by some 7 seats) it would be contingent
on, at the very least, implicit support from the PSOE, especially when it concerns key votes of
confidence in parliament, as we saw during the week commencing 29 August when Rajoy
formally made his unsuccessful case to parliament for a second term in office. We are of the
view that such support will not be forthcoming in the immediate-term and may well require
some intermediation by the King – who has traditionally played an important role in arbitrating
over issues of major constitutional importance in Spain – if the country is to avoid having to
hold a third round of elections. That said, what could accelerate any comprise with the PSOE –
and, in the process, avoid another repeat election from having to take place – is if Rajoy could
be persuaded to steps down form the helm of the PP, a prospect which, as things stand, we
don’t see happening, in part, because Mr. Rajoy thinks that by increasing his tally of seats at
the June election (i.e. by 14) and securing first place, he has a mandated to continue to lead
his party and, indeed, the country.
Our overall sense is that while the prospect of a minority government, with question marks
hanging over its likely durability, is not ideal for Spain at this juncture, it is still more preferable
than not having a functional government. That said, a minority government may not be able to
pass material and/or contentious reforms, as they would require unlikely support from a
0
40
80
120
160
200
240
280
Grand coalition "All but PP" Left-wing pact PP/Cuidanos PSOE/Cuidanos
PP PSOE UP Ciudadanos Regional
Chart 3: Seat Distribution Under Different Coalition Scenarios
(Seats)
(Souce) Spanish Electoral Commission
Threshold for an outright majority (176 seats)
Fiscal policy
Structural
reforms
Agreement with
Catalonia
Minority PP-led govt.
allied with Ciudadanos
Centre-right Baseline Modest tightening Modest/limited Low
PP/PSOE Grand coalition Unlikely Modest loosening Limited Low
PSOE/Ciudadanos/UP Centre-left Unlikely Loosening Limited Low
PSOE/UP Left Unlikely
Significant
loosening
Limited High
(Source) Bank of Tokyo-Mitsubishi UFJ
Prospects for:
Table 1: Main scenarios for cross-party alliances
Coalition Orientation Our view

4. Special Report | September 20164
fragmented parliament. In our view, such a scenario would hurt Spanish medium-term growth
prospects, though as we note in the section below, the country’s growth has continued to hold
up well so far.
…But the economy has so far weathered this uncertainty
In light of Spain’s fragmented political backdrop and ongoing political uncertainty, one would
have expected the country’s real economy to have come under some adverse pressure.
However, with the Spanish economy seemingly going into “auto-pilot” mode recently, this fear
appears to have had little, or no, impact on the country’s economy thus far, at least if its
headline growth is anything to go by. Indeed, the country’s GDP growth since the beginning of
2015 – when the country’s current electoral cycle more or less started – has averaged 0.8% on
a quarterly basis (3.4% y/y), well above that of its broader Eurozone peers (see Chart 4).
Going forward, while our sense is that the country’s GDP growth is set to moderate gradually
as we move through the remainder of this year and into next – in part because of unfavourable
base effects – the fact that the country’s composite PMI is still standing well above the neutral
level of 50 (see Chart 5), suggests to us that Spain should be able to achieve growth at, or
near, the 3% mark on an annual basis for the remainder of this year, a level which, if realised,
should enable it to continue to outperform its Eurozone partners.
Aside from the structural reforms that the preceding two Spanish governments have adopted –
which has helped to improve the prospects of the banking system, the labour market and more
generally the competitiveness of the Spanish economy – in our mind other, more recent,
factors have also been at play in enabling Spain to weather the recent political noise in the
country, including the following:
 The role of the ECB – the ECB embarked on buying government bonds in March last year,
with a view to kick-starting the Eurozone recovery and tacking the problem of deflation.
While there were some doubts about the effectiveness of such policies at the outset, the
fact that the ECB has been willing to extend the scope and duration of its asset purchase
programme has started to bear some fruit with, for example, the cheaper funding costs for
0.0
0.2
0.4
0.6
0.8
1.0
Q12014
Q22014
Q32014
Q42014
Q12015
Q22015
Q32015
Q42015
Q12015
Q22015
Euro Area Spain
Chart 4: Spain's GDP Growth Has Been Easily
Outpacing Its Eurozone Peers...
(Q/Q, %)
(Source) Macrobond
Eurozone average
Spain average
40.0
42.5
45.0
47.5
50.0
52.5
55.0
57.5
60.0
-4
-3
-2
-1
0
1
2
3
4
2010 2011 2012 2013 2014 2015 2016
GDP (RHS)
Composite PMI (3-month average, RHS)
(Y/Y, %)
(Source) Macrobond
Chart 5: ...And This is Set to Continue For Now
Judging by the Evolution of PMI Data

5. Special Report | September 20165
the sovereign also starting to filter through to the private sector as well1
. This, along with
the fact that such policies have helped to supress the value of the euro, has helped to spur
economic activity in countries such as Spain.
 Fiscal support – under Spain’s previous administration of Mariano Rajoy, tax cuts for both
the household and corporate sector were implemented during 2015. Such a move, in
conjunction with Spain’s improving labour market dynamics, has helped to support the
buoyancy of private consumption in Spain, with the result that it has now overtaken net
exports as the most important contributor to the country’s growth.
 The booming tourism sector – with key Middle Eastern destinations, such as Egypt and
Turkey, out of favour with western tourists, due to domestic political strife and/or terrorist
related activity, there has been a noticeable substitution effect in favour of Southern
European destinations, such as Spain. Indeed, after welcoming some 68m tourist arrivals
last year, expectations are that Spain’s tourist numbers are set to top 70m this year.
 Falling oil prices – as a net commodity importer, falling oil prices and the deflationary bias
that this has created, has helped Spain in a number of ways. Aside from helping to boost
private sector spending power, this phenomenon has also helped to keep in check one of
Spain’s key former vulnerability – its high current account deficit – which, at its peak,
topped 10% of GDP.
While the resilience of the Spanish economy in the face of the country’s domestic political
woes gives us some comfort, it must not be taken for granted going forward. Indeed, as we
have alluded to above, if the current political logjam continues to persist for a protracted period,
there is a danger that it could start to undermine the country’s economy through two key
channels:
 First, it could undermine both consumer and corporate confidence and, hence, their
willingness to spend;
 Second, in the absence of a formal government, the prospect of any meaningful reforms
are likely to be adversely affected which, in turn, may over time undermine the market’s
confidence in the country.
Future challenges & what to watch?
Looking ahead, while the fragmentation of Spain’s political system and challenges of forming a
coalition remains the main focus of concern, the economic agenda should not be forgotten. On
the contrary, whatever the political leanings of the next government, major challenges await it
in terms of public finances, labour market and territorial reforms.
Fiscal consolidation – a poor scorecard
On paper, the fiscal adjustment that Spain has undertaken in the aftermath of the financial
crisis appears to be pretty impressive, with the country’s budget deficit falling from some 11%
1
Lending rates of new loans (of up to €1m) with a maturity of 1-5 years have fallen from >6% during the height of the Eurozone debt crisis to a
figure ~3% today.

6. Special Report | September 20166
of GDP at its peak to last year’s figure of 5.1%, a cumulative adjustment which equates to
almost 6 percentage points of GDP. However, this masks the fact that the country has in
recent years repeatedly missed its fiscal deficit target that is has agreed with the European
Commission under the latter’s Stability and Growth Pact rules (see Chart 6). Central to this
problem is the autonomous nature of Spain which, with its 17 autonomous regions, makes the
task of containing spending at the regional level extremely difficult (see Chart 7).
While the government does have the fiscal and legal tools (enshrined in the constitution with
the Budgetary Stability Law) to control regional budgets, it appears to have exercised leniency
in 2015, possibly as result of regional elections of May 2015 and the general election of
December 2015. The government announced new measures to mitigate the risk of 2016
slippages by the regions, including the creation of an expert committee on regional funding and
the need for non-compliant regions to submit an economic and financial plan ensuring
compliance with the deficit objective. But, our thinking is that given the unresolved demand
from Catalonia with respect to its wish for greater autonomy/independence and the fact that
many regions repeatedly deviated from their fiscal targets over the past five years, we think
that changes to regional administrative and fiscal responsibilities are critical for whoever forms
the next government.
Separately, another way of improving fiscal performance is to revamp the tax system, with the
aim of increasing tax revenues. Spain’s VAT revenue as share of GDP is lower than most
other Eurozone countries, even though its standard VAT rate is in line with its major European
peers (see Chart 8). Similar to other euro area countries, tax avoidance/evasion is partly to
blame for weak tax receipts. However, we believe that Spain’s comparatively weak tax receipts
are largely due to super-reduced and reduced VAT rates of 4% and 10%, respectively, applied
to some goods and services, with a view to helping the poor. Such an arrangement, at first
glance, seems a socially fair policy, but we are of the opinion that rather than offering
concessionary VAT rates which are poorly targeted and ultimately detrimental to tax receipts, a
more efficient way of helping the poor would be to provide higher transfers/credits to such
individuals through the personal income tax system.
0
2
4
6
8
10
12
2011 2012 2013 2014 2015
Actual
Target
(% of GDP)
(Source) Minhap
Chart 6: Spain has Repeatedly Failed to Meet Its
Deficit Targets....
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Autonomous
communities
Social security Central
government
Local
government
(Source) Minhap
(Deviation by administration, percentage point of GDP, 2015)
Chart 7: ...With the Autonomous Communities a
Major Factor Behind this Deviation

7. Special Report | September 20167
Labour market – in search of quality
A stronger labour market recovery than expected has been a key feature of the Spanish
recovery, with employment growth accelerating from 1.2% y/y in 2014 to 3% in 2015. Indeed,
within the Eurozone context, Spain has generated over 35% of all the employment created in
the region since 2014 (see Chart 9). While this is certainly welcome news, this achievement
needs to be put to some perspective. Indeed, overall unemployment – while it has come down
substantially from its peak of around 25% – is still high and, at 20%, is well above that of its
Eurozone peers (see Chart 10). More significantly perhaps, of the jobs that have been created,
the majority have been in the form of fixed-term contracts rather than permanent ones (see
Chart 11), raising questions about the quality of the jobs being created.
0
5
10
15
20
25
30
5
6
7
8
9
10
FIN PRT AUT LUX DEU BEL FRA NDL ESP ITA
VAT revenue (LHS)
VAT rate (RHS)
(Source) Eurostat, VATlive.com
(% of GDP) (%)
Chart 8: Spain's VAT Revenues Lag Those of Its Peers
35.8
31.6
22.7
11.4
2.7
0
5
10
15
20
25
30
35
40
Spain Other
Eurozone
Germany Italy Ireland
(%)
(Source) OECD
Chart 9: Spain Has Been the Main Generator of
Employment Since the Start of 2014...
0
5
10
15
20
25
30
07 08 09 10 11 12 13 14 15 16
Spain
Euro Area
(Unemployment rate, %)
(Source) Macrobond
(Year)
Chart 10: ...But the Country's Jobless Rate is
Well Above That of Its Peers

8. Special Report | September 20168
The Spanish labour market, therefore, remains highly dualistic despite the significant reforms
that have been undertaken since 2008 onwards. Some of the rigidities that were endemic in
the country’s labour market have actually been reduced: the de-indexation of wages, the
reduction in redundancy costs and the more flexible/decentralised wage bargaining process
has actually paved the way for a situation where the labour market adjustments are based on a
wider range of variables (wages, working hours, partial unemployment) rather than what
existed before (hiring versus redundancy). Nevertheless, given the persistence of high
unemployment in Spain – with long-term unemployment in the country running at almost
double the level of its Eurozone peers as whole (10.2% vs. 5.2%) – more comprehensive
reforms will be necessary, particularly in terms of active labour market policies which will
through, for example, better vocational training of the existing workforce, aim to improve the
prospects of the labour market. However, as things stand, this is an area where Spain lags
behind most of its EU peers (see Chart 12).
Territorial reforms
Spain’s territorial structure is based on the 1978 constitution, under which neighbouring
territorial entities with common historical, cultural and economic characteristics could form
autonomous communities with their own government within the limit of power laid down by the
732
511
221
0 100 200 300 400 500 600 700 800
Total employment
O/W*: fixed contracts
Permanent
(Thousands)
(Note) *Data as from start 2014 until end-2015
(Source) OECD
Chart 11: Of the Jobs Created in Spain, the Majority Have Been in the
Form of Fixed Term Contracts
0
2
4
6
8
10
12
0.0
0.4
0.8
1.2
1.6
2.0
DNK SWE FIN IRL FRA NDL BEL DEU LUX ESP PRT ITA
Public spending on an active labour market policies (LHS)
Long-term unemployment (RHS)
(Source) OECD, Macrobond
(% of GDP) (%)
Chart 12: Spain's Spending on Active Labour Market Policies
Lags Most of Its EU Peers

9. Special Report | September 20169
constitution. While this appears to have worked fairly satisfactorily for most of the autonomous
regions, some grievances have been aired, in particular with regard to the equity of the current
centralised financing system for the regions. Of particular note here is Catalonia, which has
long argued that it contributes more to Spain’s public finances than it gets back. While this
assertion appears to be true (see Chart 13), the point to note is that other regions, such as
Madrid, actually contribute more in terms of net taxation than Catalonia. Having said that,
some form of reforms aimed at modernising the current regional financing structure and giving
the likes of Catalonia greater control over their finances will, in our minds, be crucial in
stemming the current secessionist tendencies that have been building up in that and, to a
lesser extent, other regions of Spain.
Conclusion
At the European level, the result of the June election held in Spain was hailed as a rejection of
the anti-establishment wave that has been sweeping throughout Europe recently. That may be
true, but for Spain, the result, in our mind, does not leave it in a much better position than in
the aftermath of last December’s election. For one thing, the torturous task of cobbling together
a functioning government among political parties that don’t see eye to eye still lies ahead and,
if this process fails, repeat election may still be in the offing. But, that said, the economy has,
thus far, continued to hold up. While we take some comfort from this, a functional government
will have to be formed – preferably sooner rather than later – to ensure that the one thing that
Spain still has going for it – its strong economy – doesn’t also take a turn for the worst.
23.315.5
14.7
14.1
12.3
12.0
11.0
9.4
7.2
6.8
6.6
5.5
4.3
3.0
-0.3
-1.2
-5.4
-10 -5 0 5 10 15 20 25
Extremadura
Asturias
Canarias
Castilla y Leon
Galicia
Castilla-La Mancha
Andalusia
Cantabria
Pais vasco
Aragon
Murcia
La Rioja
Valencia
Navara
Catalonia
Baleares
Madrid
(Net contributors/recipients of Spanish public finances by region, % of GDP)
Net recipientsNet contributors
(Source) Ministry of Finance
Chart 13: Catalonia Does Not Rank as One of the Regions That is a Net
Recipient of Spanish Public Finances

10. Special Report | September 201610
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