Coping with external shocks and removing domestic distortions. The successful Spanish experience
The early 1980s found the Spanish economy in the midst of a severe economic crisis, both in terms of the magnitude of the underlying imbalances and their persistence. By end-1982, when the present Government came to power, rapidly rising social security expenditures and transfers to ailing public enterprises had pushed the fiscal deficit to unprecedented levels. That and the accompanying sharp deterioration in the terms of trade in the late 1970s, resulting from higher oil prices, had produced persistent current account deficits and a rapid rise in external debt Inflation remained in double digits—at more than twice the average rate for members of the Organization for Economic Cooperation and Development; output growth had come to a virtual standstill; and employment continued on the downward trend begun in the mid-1970s.
From the outset the Government saw the need for a medium-term economic strategy to reduce these serious imbalances. It formulated an adjustment program in 1983, establishing key economic targets through 1987, and acknowledged that noninflationary growth could not be resumed by expansionary demand policies. The program included structural reforms to help modernize key productive sectors and improve the supply response of the economy by reducing distortions in resource allocation and use. These measures affected, inter alia, the industrial and energy sectors, the labor market, the social security system, the management of public enterprises, and the financial system.
The program succeeded in meeting its principal objectives by 1987. The imbalances which had jeopardized sustainable economic growth were largely corrected and the crisis atmosphere of the early 1980s was replaced by a climate of confidence. Spain had joined the European Community in 1986, and the Spanish economy responded positively to the opportunities provided by membership in the Community. A credible and well-timed set of economic policies, with an important element of outward orientation, laid the foundation for macroeconomic stability and for Spain’s emergence as one of the fastest-growing economies in the industrial world.
This article reviews Spain’s adjustment experience, discusses some of the challenges facing the economy over the medium term, and draws lessons from the Spanish experience with stabilization measures and structural reform.
Spain’s economy performed remarkably well in the period between the implementation in 1959 of a stabilization plan, supported by the Fund and the OECD, and the oil price shock of 1973–74. This success was largely the result of a reorientation of its economic policies away from import-substituting industrialization characterized by high protection and official intervention in the economy. The emphasis on self-sufficiency during the post-World War II period had introduced a number of rigidities in the economy that were later to hamper severely the development process. The 1959 plan sought to restore financial and price stability, and to improve Spain’s external accounts through demand management policies and a substantial liberalization of trade and capital flows, particularly of foreign direct investment. This early adjustment effort is now regarded as an important turning point in Spain’s recent economic history as it signaled a permanent break with the inward-oriented policy stance of the previous decade. The Spanish economy responded vigorously to the liberalization. Real GDP grew at an annual average rate above 10 percent in the three-year period following the program while the external accounts recovered swiftly under the impetus of strong export growth and the expansion of the tourist sector.
The transformation of Spain into an industrial economy was hastened by the diversification and growth of imports, which permitted a much needed renovation of capital equipment. The financing of such imports was helped by sharp increases in receipts from tourism, emigrants’ remittances, and foreign investment. The eight-fold increase in tourists over 1959–74 (to 35 million in 1974) generated sufficient foreign exchange to finance the entire trade deficit in the early 1970s, then averaging about 5 percent of GDP.
Despite the initial success of the program, the pace of reform slackened by the mid-1960s, as the authorities embarked upon a series of development plans modeled after the French system of indicative planning. Targets for production, employment, workers’ benefits, or some other indicative variable were set by the State and supported through fiscal incentives and subsidized credit. Resource allocation was largely guided by the authorities’ desire to strengthen industries perceived to be of strategic importance, for example, steel and shipbuilding. Despite the beneficial impact of the initial moves toward trade liberalization, Spain remained the most closed economy in Western Europe as measured by the ratios of commodity trade flows to GDP. The process of industrialization thus proved unbalanced, with most of output directed to the domestic market.
The first oil shock of 1973–74 confronted the Spanish authorities with difficult choices. Spain’s industrial sector was highly dependent on energy imports that were suddenly much more expensive. At the same time, the country was going through a precarious political transition to democracy. To avert political and social confrontations, there was no adjustment to the first oil shock. Exchange rate policy, for instance, sought to offset the impact of the oil price rise on domestic prices and disposable income. Over 1975–79 the peseta appreciated by over 35 percent in real terms while the stock of external debt more than doubled, albeit from a relatively low level. This weakness was compounded by the rapid growth of real wages after 1974, raising the relative price of labor at a time when the terms of trade loss required a moderation of labor costs. Over 1975–79 industrial employment declined by over 20 percent.
By the early 1980s the Spanish economy was in deep crisis. Terms of trade losses stemming from the second oil shock of 1979–80 and the ensuing international recession, a leveling off in the growth of tourism, and the delayed impact of the appreciation of the peseta all contributed to the emergence of current account deficits on the order of 2.5 percent of GDP per year during 1980–82 (see table). As the recession deepened—with GDP growing by less than 1 percent on average over the three-year period, 1980–82—the public sector deficit rose sharply, reaching the equivalent of 5.5 percent of GDP, five times the level of the late 1970s. The differences in inflation rates of Spain and its industrial country trade partners also widened sharply.
Adjustment and recovery
Against this backdrop of growing imbalances, the authorities embarked upon an adjustment effort to improve the external situation and control inflation. Monetary policy was tightened in 1983 and remained restrictive throughout most of 1984, with real interest rates rising to historically high levels. An exchange rate policy which preserved, through 1985, most of the gains in competitiveness achieved with a 12.5 percent real depreciation of the peseta during 1983 sharply improved the performance of Spanish exports. An incomes policy was also framed, to achieve a significant deceleration of wage increases, within the framework of national agreements between government, labor unions, and entrepreneurs. Progress in improving the fiscal balance was initially less successful, partly as a result of the budgetary cost associated with structural reforms and efforts to improve the balance sheets of public enterprises through, inter alia, subsidies and the assumption of their debt.
The new policy stance contributed to a marked turnaround in the external accounts and a sharp slowing of inflation: the current account of the balance of payments shifted from a deficit of 1.7 percent of GDP in 1983 to a surplus of 1.7 percent of GDP in 1985 and the rate of inflation fell to under 9 percent by end-1985. The recovery of the external sector more than offset the decline in domestic demand, and GDP growth averaged 2 percent in 1983–85. Employment, however, continued to fall. The sharp increase in interest rates had an adverse impact on the level of fixed investment, which fell by a cumulative 8 percent during 1983–84.
|(Annual percentage change)|
|Interest rate (percent per annum)2||16.5||16.2||16.3||20.0||14.9||12.2||11.7||15.8||12.6||3|
|Total liquid assets||…||…||16.6||16.0||13.3||12.9||12.0||14.2||10.7||3|
|Terms of trade||−12.1||−9.4||−0.4||−2.1||2.2||4.8||16.9||2.3||2.7|
|Real effective exchange rate||−3.3||−5.7||−0.2||−12.3||2.9||1.8||6.5||4.1||3.7|
|(In billions of U.S dollars)|
|Current account balance||−9.9||−4.5||−4.1||−2.3||2.3||2.9||4.3||0.4||−3.1|
|(In percent of GDP)|
Three-month interbank deposit rate.
Three-month interbank deposit rate.
The recovery of the external accounts and concern over conditions in the labor market prompted the authorities to ease the financial policy stance during 1985–86. Some fiscal stimulus to private consumption was provided through cuts in personal income taxes. Monetary policy permitted an increase in credit to the private sector which had fallen in real terms during the initial phase of the adjustment.
At the same time the authorities began to implement a series of structural reforms. These reforms, and the impact of terms of trade gains associated with the fall in oil prices, contributed to a marked recovery of domestic demand, output, and employment in 1985. Fixed investment expanded by 50 percent in real terms in the period 1985–88, helped in part by the pressures of foreign competition brought about by accession to the European Community and substantial direct investment flows from EC partners.
The performance of the economy during 1987–88 was particularly strong, when real GDP grew by a cumulative 11 percent (the highest rate of growth in the OECD), and inflation decelerated to 5 percent on average. Medium- and long-term capital inflows—mainly direct and portfolio investment—had pushed foreign exchange reserves to $39 billion by end-1988, equivalent to ten months of imports. Employment continued to expand—at 3 percent per year, or four times the European average. The fiscal deficit was reduced to 2.7 percent of GDP as a result of both stronger domestic activity and improved revenue collection, helped in large measure by the successful introduction of a value-added tax in early 1986 and the concomitant expansion of the tax base. Real disposable income over the period rose by 10 percent.
Industrial restructuring. Heavy investment in energy-intensive industries, the rapid growth of real labor costs, inadequate pricing policies, and delays in the modernization of the capital stock all contributed to a sharp deceleration of industrial activity in the late 1970s. Spanish industry turned out to be so heavily concentrated in sectors affected by worldwide excess capacity that, by the early 1980s, the need for some form of retrenchment became apparent. The Law on Reconversion and Reindustrialization, approved in 1984, attempted to lend budgetary support, through transfers, loan guarantees, and subsidized credits, to a restructuring of enterprises. It allowed enterprises to reduce employment, restore their balance sheets, and undertake a massive program of investment for modernization. The reconversion program also sent a powerful signal to the industrial sector, namely, that the budget would not provide unrestrained support to nonviable enterprises and that efficiency considerations would increasingly have to underpin management.
This shift in the role of the public sector was particularly evident in the overhaul of enterprises under the control of INI, the state holding company. By 1983 INI, accounting for some 15 percent of total industrial production, was registering annual losses equivalent to 1 percent of GDP. As a result of the privatization of several enterprises under its control and other improvements in efficiency, INI’s losses had been virtually eliminated by 1987. (Privatization was effected either through direct sales of a controlling interest to private investors or through sales of minority holdings via the stock market) The remaining losses were heavily concentrated in a few sectors (steel and shipbuilding).
Energy policy. Despite Spain’s heavy dependence on imported oil, energy consumption continued to rise after the first oil shock since domestic energy prices were not raised to reflect higher import costs. As a result, by the early 1980s, energy imports accounted for some 40 percent of merchandise imports. A National Energy Plan, first conceived in 1979, updated in 1983, and approved by Parliament in 1984, called for reductions in consumption through a pricing policy which reflected, more rapidly, changes in international prices. This plan also included conservation measures, tax incentives and concessionary loans to the industrial sector for oil-substitution projects, and a substantial expansion of the use of hydropower and coal. Although the plan’s targets extend to 1992, substantial progress has been achieved already: in the four-year period ending 1986 energy consumption rose by 2.3 percent against real GDP growth of 9.5 percent while the share of energy needs covered by domestic sources had risen from 34 percent to 42 percent.
Labor market. In the eight-year period ending 1982, the Spanish economy had suffered the largest employment reduction in the OECD and consequently had the highest rate of unemployment. Up to 1974, Spanish growth had been led by the rapid rise of the industrial sector, producing a concomitant reduction in agricultural employment. But the impact on the unemployment rate was minimized because the rapidly expanding economy and demand for migrant workers in other European countries absorbed much of the excess supply of labor. The oil crisis and the ensuing slowing down of growth in those countries brought a reversal of these migratory flows. The oil crisis coincided with the country’s return to democracy and the emergence of free trade unions bargaining for better wages and benefits. The real cost of labor in the industrial sector rose on average by 9 percent per year during 1975–79, by far the highest growth rate in Europe. The rise in employers’ social security contributions from 19.5 percent of gross pay in 1975 to 24 percent by 1979 brought contribution rates to the highest level in the OECD.
In most European countries increased wage rigidity led to an increase in part-time employment, with a corresponding reduction in the average number of hours worked per employee. In Spain, by the early 1980s, the share of part-time workers in total employment was far lower (one-tenth the EC average). Moreover, the reduction in the average number of hours worked in Spain was achieved through legal measures that shortened the working week and increased labor costs for overtime work.
Aware that such rigidities were preventing a recovery of employment the authorities introduced, in 1984–85, a number of measures to make the labor market more flexible. These included: encouragement of fixed-term contracts and part-time employment, fiscal incentives to reduce firms’ labor costs (e.g., reductions in social security contribution rates or the granting of direct subsidies for the hiring of youth), an earlier retirement age with full pension, and relaxation of the rules governing layoffs. These changes played an important role in the impressive recovery of employment since 1985 and the subsequent increase in female labor force participation that was linked to more part-time job opportunities.
Social security. Improvements in the level and coverage of social security benefits without adequate increases in contributions had produced a steady deterioration in the finances of the social security system and increased their burden on the budget. Demographic changes and some abuse of the pension scheme, such as the artificial inflation of salaries in the two years prior to retirement had induced a marked drop in the ratio of active to passive population within the system. In mid-1985, the government embarked upon a comprehensive reform of the pension system by tightening eligibility requirements and lengthening from two to eight years of employment the period to be used as the basis for determining the size of pensions. These measures slowed the growth of disability pensions and stabilized the ratio of contributors to pensioners.
The pace of growth registered over the recent past has made an important contribution to the recovery of employment. Nearly a million jobs were created in the three years to 1988 as nonagricultural employment rose by close to 15 percent. The growth of the labor force, however, is unlikely to permit a substantial reduction in the currently high level of total unemployment. Employment prospects over the medium term should be enhanced by the maintenance of a favorable investment climate and continued moderation of wage costs. To the extent that. Spain’s unemployment problem seems to stem more from structural features (segmentation of labor markets, adverse demographic factors, and other rigidities) than demand-related factors, a case can be made for the introduction of further measures to make the labor market more market oriented. Efforts to remove obstacles to labor mobility, substantially expanding part-time and other forms of flexible employment, and giving increased weight to productivity considerations in the wage bargaining process are all expected to favor employment creation.
The Government’s medium-term economic strategy is to consolidate the recent gains by maintaining the economy on a path of noninflationary growth. The processes of integration of the Spanish economy into the EC will continue. The need to keep the economy on a path of convergence with the EC is linked to the intention of eventually joining the exchange rate mechanism of the European Monetary System. The EC’s renewed commitment to the cause of economic integration, as manifested in efforts currently underway to create a single market by 1992, poses additional challenges for the Spanish economy and underscores the need for policies geared toward balanced growth and a stable financial environment.
Lessons of experience
As the Spanish economy enters 1989, its fourth year of sustained expansion, it is appropriate to ask: what are the lessons to be drawn from its experience with stabilization policies and structural reform?
Consistency in policy implementation. Policymakers are increasingly recognizing the importance of consistency in the design and implementation of adjustment programs, to generate the credibility required for the effectiveness of economic policies. Economic agents must be able to perceive that the Government’s targets and instruments are mutually compatible and that they will not be subject to unpredictable swings. Appropriate incentives and signals must be in place to guide decision making toward efficient resource allocation.
Two factors contributed significantly to create a credible economic policy environment in Spain. The Government’s prompt rejection of expansionary demand policies as a way of addressing the economic crisis, and its decision to implement rapidly a medium-term program encompassing both demand management and correction of structural deficiencies, coupled with fairly rapid action on both fronts, were key elements of the adjustment strategy. The various policy commitments made to the EC to liberalize the economy also contributed to the credibility of the adjustment effort. While such commitments may have at times constrained the authorities’ policy options, they also reduced the possibility of policy reversals. The strength of the investment drive over 1986–88 provides compelling evidence of the benefits associated with a credible policy environment.
Outward orientation. Recent decades have witnessed diverse manifestations of what Richard Cooper calls the “technological transformation of the world’s economy,” as a result, inter alia, of vast improvements in transportation and telecommunications. Such advances have not only increased the degree of economic interdependence between sovereign states (and thus the need for cooperation among them), but have also led to much higher expectations on the part of the public about the role of economic policies.
A key feature of the Spanish adjustment was the recognition on the part of economic policy makers that Spain’s long-term interests required an acceptance of international economic interdependence. All the outward-oriented policies implemented in the context of accession to the EC reflected this stance. There is a broad consensus that the reduction in tariff protection implied by EC membership and the liberalization of foreign direct investment had clearly beneficial effects. Although the reduction in protection initially contributed to the rapid expansion of imports, it also facilitated the renovation of capital equipment and led to increased investment in export-oriented industries. Indeed, the fivefold increase in foreign investment inflows is expected both to enhance the efficiency of Spanish manufacturing and contribute to the creation of employment.
Timing of liberalization. Recently, there has been much discussion on the appropriate sequence and timing of external trade and capital account liberalization in adjustment programs. The liberalization of the current and capital accounts which took place in Spain as a result of EC accession, plus the measures adopted in early 1987 to deregulate further the financial markets, coincided with a period of strong economic recovery and a comfortable balance of payments position. They had little, if any, destabilizing effects. The stabilization measures implemented by the Spanish authorities beginning in 1983 contributed to a sizable reduction in the rate of inflation, a turnaround in the external accounts, and a recovery of output and employment (above EC averages), thus playing a key role in creating the conditions that permitted the Spanish economy to enter the EC in a position of relative strength. Further, the process of tariff reduction was gradual, giving local industry sufficient time to adjust and preempting protectionist pressures.
Intertemporal choices. The initial phase of the Spanish adjustment program (1983–84) had some adverse short-term effects on employment and output. Although the rate of inflation fell sharply, domestic demand contracted in both years and employment continued to decline. At the same time, wage restraint and a sharp deceleration in the rate of growth of transfer payments contributed to an erosion of real disposable income. But these events were part of a process of economic recovery which had set in by the second half of 1985. The impressive recovery of employment over 1986–88 is evidence that the path chosen—increased flexibility of the labor market—was clearly the appropriate one.
The short-term effects of adjustment efforts on aggregate demand need to be seen in the context of the longer-term supply-side effects of those efforts. For an economy suffering major macroeconomic imbalances and structural rigidities, the demand effects are likely to be offset over the medium term by the supply benefits in the context of a credible, sustained adjustment program. Conversely, in the absence of adjustment, rapid growth today may well be at the expense of slower growth tomorrow.