Spain’s auto industry is attracting billions in new investments from car makers world-wide, a bright spot for an economy still recovering from years of recession and high unemployment.

Germany’s Volkswagen AG and Daimler AG have recently ramped up their production capacity in the country, encouraged by relatively flexible labor laws and a vast network of local parts suppliers.

“Spain cannot compete with Eastern Europe, but it’s still cheaper than France or Germany and equally competitive,” said Joachim Hinz, financial planning director of SEAT, a brand that Volkswagen bought from the Spanish government in 1986.

The country may not have a domestic-owned car maker, but it has become Europe’s second-largest producer of vehicles behind Germany, and the eighth-biggest in the world.

Spain’s appeal comes largely from labor reforms enacted in 2012, during the euro-zone crisis, after the conservative Popular Party came to power. The reforms made it easier for employers to lay off longtime employees and weakened collective bargaining agreements.

“The labor reform helped us to improve our future expectations,” SEAT’s Mr. Hinz said.

Volkswagen said last year it would invest €1 billion ($1.11 billion) in its plant in Pamplona, where it will build its next generation of Polo models, adding 500 employees to a workforce of 4,500 people. Workers agreed to reduce their hourly wage by 50 European cents and work one extra day annually, said Eugenio Duque, general secretary of the union representative committee.

German companies poured €4.8 billion into Spain last year, making the country the second-largest destination for German foreign direct investment behind only the U.S., according to fDi Markets, a publication specialized in international investment. The lion’s share of that investment—€4 billion—went to the country’s auto industry.

The car sector accounted for 8.7% of Spain’s gross domestic product last year, up from 5.2% in 2005, according to ANFAC, the country’s association of car manufacturers. It employs 9% of Spain’s labor force and produced a record 2.7 million vehicles last year, 80% exported.

Eduardo González, general director in Spain of German car-component manufacturer Continental AG , praises the country’s “highly specialized suppliers,” as well as “a qualified labor force and flexible labor relations to react to swift changes in demand without resorting to layoffs.”

When Ford in 2014 chose to close its plant in Genk, Belgium, to move its production of Mondeo, Galaxy and S-Max models to Valencia, local suppliers were an important factor. Ford plans to invest €2.3 billion in the Valencia plant by 2020. The plant has become the U.S. car maker’s biggest in Europe. “Suppliers are a major contributor to the success of our operations in Valencia,” said Linda Cash, Ford Europe’s vice president of manufacturing.

Gestamp is the biggest Spanish producer of car components—making bumpers, pedal boxes, chassis and other products in 20 countries. It expects to post 7% growth in 2016. Working alongside diverse companies “makes our productive network very versatile and has favored the investments in R&D in production techniques,” said Francisco José Riberas Mera, the company’s CEO.

In Vitoria, northern Spain, lies Daimler’s second-largest van plant world-wide, where the German car maker produces the Mercedes Vito and V-Class midsize vans. Daimler has invested €1 billion in the plant since 2012. Detroit’s General Motors Co. , Renault SA and PSA Peugeot Citroën of France have also built an important presence in Spain.

But a political deadlock is putting the labor reforms’ future in doubt. Spanish voters went to the polls twice in six months, with no party able to win an outright majority. If the center-left Socialist Party and centrist Ciudadanos Party decide to block the Popular Party from forming a minority government, Spain would face its third general elections in a year. Spain’s two biggest opposition forces, the Socialists and the far-left coalition Unidos Podemos, campaigned on rescinding the labor reforms, which they say undermined workers’ rights.

Spain is still reeling from a housing bubble that unleashed a double-dip recession, bringing the unemployment rate from 8% in 2008 to 26% in 2013. The construction sector, once the country’s economic engine, lost about two-thirds of its workers. It accounted for 5% of Spain’s gross domestic product last year, half its precrisis level of 10%.

The country’s GDP grew 3.2% in 2015, but remains smaller than it was eight years ago. Unemployment is hovering around 20%, and part-time workers have grown from 12% to 15% of the workforce.

Sergi Basco, an economics professor at Universidad Carlos III in Madrid, says cheap labor has attracted investment and drawn jobs from more expensive countries further north. But it isn’t a long-term solution, he noted.

Spain needs to “reach a national consensus on how to increase the skills of its workers,” said Prof. Basco. The task, he added, “won’t be easy.”