Spain
2007 Article IV Consultation-Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

Spain’s 2007 Article IV Consultation underlies that immediate growth prospects are bright and the central scenario is for a smooth landing but with appreciable downside risks. The Spanish economy enjoyed another year of remarkable growth in 2006, further extending its prolonged expansion. Output growth gathered pace in the course of 2006 to reach 3.9 percent for the year, and brisk job creation absorbed further increases in female participation and immigration, and inflation moderated appreciably.

Abstract

Spain’s 2007 Article IV Consultation underlies that immediate growth prospects are bright and the central scenario is for a smooth landing but with appreciable downside risks. The Spanish economy enjoyed another year of remarkable growth in 2006, further extending its prolonged expansion. Output growth gathered pace in the course of 2006 to reach 3.9 percent for the year, and brisk job creation absorbed further increases in female participation and immigration, and inflation moderated appreciably.

I. Outlook: A Bright Near Term But Clouds Further Out

1. Following Spain’s remarkably prolonged expansion, the authorities (and staff) project growth to decelerate gradually in 2007–08 toward its estimated potential, but the external deficit will remain large. Under both projections, the impetus from consumption is expected to moderate further—partly offset by firming net exports. Indeed, higher interest rates and indebtedness are already reining in consumption and cooling the housing market (Figure 1). The same forces are projected to curb the growth of investment over 2007–08, whose level will nevertheless remain high. Over the medium term, the rise in nonhousing investment and continued favorable external environment are projected to sustain the productivity gains underway in manufacturing. In sum, both staff and official projections envisage that domestic spending will decelerate gradually, avoiding a pronounced slowdown but keeping the current account deficit high—in staff’s projections at around 9½–10 percent of GDP through the forecast horizon.

Figure 1.
Figure 1.

Spain: Economic Developments

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Sources: INE; Bank of Spain; OECD; Eurostat; WEO; and IMF staff calculations.
uA01fig01

Housing Prices

(4-Q change, in percent)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Source: Bank of Spain.
uA01fig02

Current Account Deficit and Real Effective Exchange Rate (REER)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

uA01fig03

Financial Balances by Sector

(1990-2006)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Source: Bank of Spain.Note: 2006 includes data through Q3 only and is a sum of most recent 12 months.

2. The main risk to this expansion remains high private sector indebtedness and the related large current account deficit. Given Spain’s membership in EMU and the strength of its financial sector, availability of external financing is not a constraint. Nevertheless, the external deficit is symptomatic of the risks to medium-term growth. First, it reflects weak competitiveness stemming from poor productivity performance and resilient price and labor cost differentials with trading partners (Figure 2).1 While there are signs of a manufacturing productivity revival, it has yet to prove its persistence beyond the cyclical upturn. Second, sustained borrowing has raised nonfinancial private sector indebtedness to 187 percent of GDP (mainly at variable rates for households), among the highest in the OECD (Figure 3). Staff illustrated the medium-term implications of the projected external deficits for the country’s private sector indebtedness (text chart) and net external liability position (an increase of about 30 percentage points of GDP over the next five years from the current 58 percent of GDP—(Table 5). In its view, these projections point to significant risks of pronounced balance-sheet retrenchment as low- and middle-income households might be unable or unwilling to continue to accumulate debt. A possible pronounced correction of real estate valuations, spilling over to construction investment (which accounts for one percentage point of GDP growth and 14 percent of employment) would compound such a retrenchment.

Figure 2.
Figure 2.
Figure 2.

Spain: Deteriorating Competitiveness

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Sources: Bank of Spain; INE; Eurostat; IMF WEO, International Financial Statistics, and Global Data Source; and IMF staff estimates.
Figure 3.
Figure 3.

Spain: Private Sector Indebtedness

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Sources: Bank of Spain; Eurostat; U.S. Federal Reserve; and U.S. Bureau of Economic Analysis.
uA01fig04

Private Sector Debt: Medium Term Illustrative Scenario

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

3. Though agreeing on the nature of the underlying risks, the authorities assigned a lesser probability to the risk scenario. While there was no denying that the accumulation of private sector liabilities has an intrinsic limit, determining such a limit within EMU was considered a very uncertain exercise, venturing into “uncharted territory.” Various factors were viewed as working toward a smooth reabsorption of the accumulated imbalances. First, the incipient rebalancing of growth enhanced prospects for a soft landing, and the current combination of rising interest rates and strong demand abroad was seen as optimal for Spain. Second, the recent manufacturing productivity gains, inflation declines, and export pick-up augured well for the environment going forward. Third, Spain had undergone profound structural changes in the recent past (among which a 5 million increase in population), with a strongly positive impact on its supply capacity (Appendix I). Fourth, the overall solvency position of the household sector was viewed as healthy given the comparatively large size of nonfinancial (housing) wealth. Finally, the fact that the process reflected private sector saving and investment decisions was also viewed as reassuring.

4. There was nonetheless agreement that policies needed to address the root causes of the external imbalance and ensure a continuation of growth over the medium term. The discussions (in the context of a streamlined Article IV consultation) centered on the required policy response—containing demand and expanding supply—building on past Fund advice. There was concurrence on the direction and main components of this response, though less so on the pace of implementation, given the different appreciation of the risks and the electoral calendar.2

Implementation of Fund Policy Recommendations

The direction of policies remains broadly consistent with Fund recommendations. The fiscal stance tightened in 2006, as advised by the Fund—albeit based on revenue buoyancy rather than expenditure restraint. The authorities’ structural reform program under the Lisbon agenda is generally well designed, but liberalization of labor and sensitive product markets has lagged. The authorities have consistently maintained strong financial sector prudential policies.

II. Fiscal Policy: Preserving Budgetary Stability While Tempering Demand

5. Revenue buoyancy has strengthened public finances, but primary spending is rising steadily. Higher-than-budgeted revenues (notably corporate and capital gains taxes) have been devoted to raising the surplus (1.8 percent of GDP in 2006), reducing debt (to below 40 percent of GDP), and building up the social security reserve fund (to 4 percent of GDP). However, primary spending (with a higher estimated impact on demand than revenue) rose by about 0.4 percentage points of GDP in both 2005 and 2006, driven by investment and rising regional government spending. Whereas the official forecast of a general government surplus of 1 percent of GDP in 2007 is likely to be 20.0exceeded, as in past years, staff considered that the 18.0combined effect of the 2006 tax reform, regional 16.0tax-cutting initiatives, and planned additional 14.0spending is likely to result in an untimely 12.0procyclical stimulus in 2007–08 (assuming 10.0unchanged policies). The authorities were more 8.0sanguine about structural revenue strength and 6.0thought that spending growth at the territorial level 4.0 might moderate with respect to 2006, as the 2.0electoral spending cycle unwound.

uA01fig05

2006 Central Government Tax Revenue Growth and Elasticity to GDP

(Cash basis)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Source: National authorities and staff estimates.

General Government Fiscal Operations

(In percent of GDP)

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Sources: Authorities and IMF staff estimates.

Calculations exclude one-off expenditure amounting to 0.7 percent of GDP in 2004.

6. For 2008—the first year of application of the new Budget Stability Law—the authorities broadly shared staff’s call for a countercyclical spending stance, but budget preparations have yet to start. With GDP growth projected to exceed 3 percent, the new Law requires the central and territorial governments to be in surplus.3 While the Law does not specify either the level or the allocation of the surplus among the different levels of government, the authorities concurred on the need for all levels of government, including the regions (in balance in 2006, despite buoyant revenues), to contribute to that outcome. In the same vein, they intend to apply strictly the Law’s provisions governing the possible exclusion of certain capital expenditure from the targeted balance. As for the central government, the authorities viewed staff’s call to set the expenditure ceiling so as to keep primary spending constant in relation to GDP as useful encouragement of restraint, but were not in a position to commit at this stage of budget preparations. While it was noted that a minority government might have difficulty in obtaining approval of a tight budget at the end of its term, the wide support for budgetary stability—including from parliamentarians and trade unions—and the absence of calls to “spend” the fiscal surplus provided encouragement.

7. Mechanisms to ensure fiscal discipline in a highly decentralized system need strengthening. With extensive decentralization, strengthened transparency and monitoring (in line with 2005 fiscal ROSC recommendations) remain the most effective means to secure fiscal discipline at the regional and local government levels—who now account for over

75 percent of government spending, excluding social security. Despite progress, disclosure practices remain insufficient to prompt early identification of fiscal profligacy, elicit public censure, and stimulate corrective action. Weak areas include insufficient reporting of off-budget capital spending (via public enterprises and entities, public-private partnerships, etc.) and long lags in the publication of comparable, national accounts-based data for territorial governments. The authorities highlighted continuing efforts in these areas, including an ongoing census of all regional public entities. In a similar vein, given successive budgets’ emphasis on “productive expenditure” (R&D, infrastructure, etc.), staff called for a thorough review of the efficiency of such spending; the authorities noted the creation of a government agency that included that function. Given the key role of peer pressure in a decentralized system, staff also saw a useful role for independent assessments of fiscal policy plans and outturns at the various levels of government. Finally, with the long-term rise in age-related public spending currently estimated at 8½ percentage points of GDP (by 2050), preserving budgetary stability will require further pension reform, beyond that agreed in 2006—a point recognized by the authorities.

III. Raising Supply Capacity and Improving Competitiveness

8. Several key pieces of legislation, including a reform of the competition authority, are pending. The draft Competition Law strengthens the powers and independence of the competition authority and limits the government’s capacity to overrule its merger decisions. It also includes potentially powerful new features such as an advocacy mandate, a leniency (“whistle-blower”) policy, and parliamentary hearings for nominees. Staff welcomed these features but, against the background of a protracted takeover bid in the energy sector that had led the EU Commission to initiate two infringement proceedings against Spain, it emphasized the importance of a clearer political commitment by the government to contestable and open markets, and of greater independence of the sectoral regulators from their relevant ministries. In other areas, the authorities noted as priorities deregulation of energy tariffs and transposition of the EU Takeover Directive. They also saw implementation of the EU Services Directive as offering an opportunity to open sheltered markets and had centered its coordination in the Ministry of the Economy.

Figure 4.
Figure 4.
Figure 4.

Spain: Structural Issues

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Source: INE, National Accounts; OECD; Høj et al. (2007), forthcoming; IMF staff estimates.1. Indicator scale of 0-6 with 6 designating an overall framework least conducive to competition.

9. The authorities’ National Reform Program under the Lisbon agenda is broadly appropriate; determined implementation remains key. Implementation has focused on stepping up government provision of public goods (infrastructure, education) and activities with growth-enhancing externalities (R&D)—areas where there is a broad consensus. In contrast, progress in overcoming special interests, to foster competition in sheltered markets and more flexibility in labor markets, has lagged. The Strictness of employment protection legislation (2003) authorities view the 2006 labor market reform, which staff considered limited, as a step in a continuous process of reforms requiring consensus that, like pension reform, would need to continue in the next legislature.

uA01fig06

Labor Market Flexibility and Temporary Employment

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Sources: Eurostat; OECD.

IV. Keeping the Financial Sector Strong

10. The Bank of Spain has remained vigilant in the face of continued strong credit growth. 2006 was another year of strong profitability and dynamism in the financial sector. Nevertheless, while loan losses remain at very low levels and provisions are high, rapid credit growth and large exposures to the real estate sector warrant continued supervisory attention. There was agreement however that the risks associated with high levels of private indebtedness relate mainly to the growth outlook rather than to financial stability, which the 2006 FSAP showed to be resilient to a range of large adverse shocks. Moreover, there is no parallel to the U.S. subprime market in Spain. Mortgages are predominantly issued by banks subject to tight prudential supervision and strict lending standards. Nondeposit-taking companies (“debt consolidation” companies) represent a tiny fraction of the market and act primarily as brokers between debtors and creditors, raising consumer protection issues—which the authorities intend to address—rather than solvency concerns.

11. Preparations for MiFID and Basel II are advancing. Notwithstanding legislative delays, the authorities expressed confidence that both measures would be effective within their set deadlines. Banks’ large industrial participations would be subject to the strictest Basel II requirements—an FSAP recommendation; this appears to have contributed to significant divestments during 2006. In contrast, the planned transfer of insurance supervision from the Ministry of Economy to the central bank (solvency issues) and the Securities Commission (consumer protection)—in line with FSAP recommendations—has stalled (Table 6). Finally, an active public debate is underway on improving savings banks’ governance, and the authorities saw scope for future progress in this area.

V. Staff Appraisal

12. The Spanish economy again grew strongly in 2006, while showing signs of the awaited rebalancing of growth. Besides strong GDP growth, the performance also comprised rapid employment expansion, a significant deceleration in inflation, a pickup in manufacturing productivity, and a strong fiscal outturn. Welcome signs of a rebalancing of growth compared to the recent past include a slowing in consumption and housing and a strengthening of exports—although the negative contribution of the external sector remains large.

13. These positive developments enhance prospects for a soft landing, but downside risks posed by rising indebtedness remain pronounced. Growth is expected to settle close to potential in 2007–08, but the already very large current account deficit is set to widen further, to 9½–10 percent of GDP. The counterpart to this deficit is growing private sector indebtedness, whose accumulation clearly cannot go on indefinitely. The risk is that agents may adjust their balance sheets more rapidly than foreseen and that regaining competitiveness within EMU—given significant domestic market rigidities that hinder resource reallocation—may entail a protracted period of weak activity.

14. To forestall adverse scenarios and ensure the sustainability of continued growth, three priorities need to orient policies: safeguarding budgetary stability while tempering demand; raising supply capacity and improving competitiveness; and keeping the financial sector strong.

15. A more resolute, expenditure-based countercyclical fiscal stance would be consistent with the new Budget Stability Law and help contain demand. The medium-term orientation of the Law requires acting now, in “good times,” to avoid the entrenchment of difficult-to-reverse primary spending dynamics. The Law’s first year of implementation—2008—should be exemplary. To this end, the central government expenditure ceiling should keep primary spending constant as a share of GDP, and the regional governments should target an ambitious surplus, reflecting their share of the permissible deficit in low-growth periods.

16. Preserving budgetary stability will require substantial strengthening of fiscal accountability as well as further pension reform. Securing fiscal discipline in a highly decentralized system requires far greater progress in fiscal transparency of territorial governments, with timely publication of comparable, national accounts-based data. Improvements in the reporting of off-budget operations are also required at all levels of government. The next legislature should aim for an early revival of reforms to place the pension system on a sustainable long-term path.

17. Competition-promoting efforts should be stepped up and underpinned by a strengthened political commitment to promote contestable markets. The draft Competition Law introduces valuable institutional measures that will need proactive implementation. The independence of sectoral regulators should also be enhanced by an arm’s length relationship with sectoral ministries. Work on transposing the EU Services Directive should be accelerated as it holds the potential to open up still highly sheltered sectors throughout Spain. Finally, while unprecedented large immigration flows have imparted a de facto flexibility to the labor market, this will need to be consolidated by reforms.

18. The financial sector has recorded another strong year, but the Bank of Spain’s continued vigilance is well-placed. The main risks relate to rapid credit growth and loan concentration in the real estate sector. Spain’s support for the process of European financial integration should be reflected in a timely passage of the Markets in Financial Instruments Directive. Basel II legislation—with its welcome application of conservative approaches to banks’ industrial holdings—should similarly proceed forthwith. The proposed spin-off of insurance supervision from the Ministry of Economy has clear merits and should be revived. Finally, with savings banks acquiring an increasingly prominent role, the time is ripe for improvements in their governance, enhancing their exposure to market discipline.

19. It is recommended that the next consultation be held on the 12-month cycle.

Table 1.

Spain: Main Economic Indicators, 2002–08

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Sources: IMF, World Economic Outlook; data provided by the authorites; and IMF staff estimates.

Based on national definition (i.e., the labor force is defined as people older than 16)

Calculations exclude one-off expenditure amounting to 0.7 percent of GDP in 2004.

Table 2.

Spain: Fiscal Accounts, 2003–08

(In percent of GDP)

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Sources: Cuentas Financieras, Bank of Spain; IGAE; and IMF staff projections.

Calculations exclude one-off expenditure amounting to 0.7 percent of GDP in 2004.

Table 3.

Spain: Indicators of External and Financial Vulnerability, 2002–06

(In percent of GDP unless otherwise indicated)

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Sources: Bank of Spain, Economic and Statistical Bulletins; CNMV; data provided by the authorities; and IMF, International Financial Statistics.

Data for 2006 refers to the third quarter.

Deposit-taking institutions comprise commercial, savings, and cooperative banks.

Total gross credit does not include cash and central bank.

Nonperforming credit net of specific provisions and those general and statistical provisions not included in tier 2 capital to total regulatory capital.

Data series starting December 2005 denote the implementation of new accounting rules (IFRS).

Excludes equity investments and fixed income portfolio instruments.

Includes both fixed and variable income portfolio instruments.

Debt excludes non-interest obligations and financing provided by suppliers.

Table 4.

Spain: Balance of Payments, 2000–06

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Source: Bank of Spain.
Table 5.

Spain: Medium-Term Projections of the Balance of Payments

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Sources: Bank of Spain; and IMF staff projections.
Table 6.

Spain: Staus of Implementation of Main FSAP Recommendation

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Appendix I. Authorities’ Study on Immigration

Spain’s economic growth during 2001–06 has been remarkable?3.3 percent annually compared with the euro area’s 1.5 percent. About 60 percent of this performance stems from labor mobilization, with immigrants (2.1 million) in turn accounting for half of the employment growth. A recent report by the authorities4 analyzes the impact of immigration in detail, with the following conclusions:

  • Immigrants are mainly from Latin America (45 percent) and Europe (34 percent); and medium- to high-skilled. Immigrants have on average an educational attainment higher than the native population, although the relationship reverts when comparing similar age cohorts. Job overqualification is more common among immigrants than among natives.

  • Immigration has raised income per capita, fostered employment of natives, and improved labor market flexibility. According to the authorities, immigration accounted directly for one-fourth of the 1.6 percent annual income per capita growth during 2001–05. Indirectly, it also raised occupation rates among natives—including female participation by providing domestic services. It helped labor market flexibility through higher geographical and sectoral mobility, and it possibly slowed real wage growth (controlling for human capital, immigrants earn 7 percent less than the native population).

  • On balance, immigration has improved the fiscal accounts. In 2005, immigrants accounted for 6.6 percent of fiscal revenues and received 5.4 percent of fiscal expenses—with a net effect equivalent to half of the fiscal surplus. Immigrants’ net fiscal contribution is projected to peak in 2012 and become negative by 2030 owing to retirement.

  • The authorities estimate that immigration has had an appreciable negative effect on Spain’s current account. This is attributed to three main factors: (i) immigrants’ remittances; (ii) higher borrowing to purchase durables and housing; and (iii) induced investment through a higher marginal return on capital.

  • There is room for further demographic growth. Despite recent inflows, Spain’s 2005 immigrants-to-population ratio (12 percent) ranked about the middle of OECD countries. The population density is 68 percent of the euro area, and large regions still have low immigration levels.

uA01fig07

Contributions to the Growth of the Occupied Population

(percentage points)

Citation: IMF Staff Country Reports 2007, 175; 10.5089/9781451812275.002.A001

Appendix II. Spain: Fund Relations

(As of February 28, 2007)

Mission: Madrid, March 19–26, 2007. The concluding statement of the mission is available at http://www.imf.org/external/np/ms/2007/032607b.htm.

Staff team: Mr. Leipold (head), Mr. Escolano, Ms. Gutierrez, and Mr. Bennett (all EUR). Mr. Guzmán (Alternate to Executive Director) and Ms. Mira (OED) also participated in most meetings.

Country interlocutors: The mission met with the Second Vice-President of the Government and Minister of Economy and Finance Mr. Pedro Solbes Mira, the Bank of Spain Governor Mr. Miguel Fernández Ordóñez, and other senior officials; Congress’s Economy and Finance Committee; employers and labor unions; representatives of the opposition; and representatives of the private sector.

Data: Spain subscribes to the Fund’s Special Data Dissemination Standard, and economic data are adequate for surveillance.

I. Membership Status: Spain became a member of the Fund on September 15, 1958. On July 15, 1986, Spain accepted the obligations of Article VIII Sections 2, 3, and 4 of the Articles of Agreement.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Latest Financial Arrangements: None

VI. Projected Payments to Fund:

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VII. Exchange Rate Arrangement: Spain entered the final stage of European Economic and Monetary Union on January 1, 1999, at a rate of 166.386 Spanish pesetas per euro.

Spain maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions, except for the exchange restrictions imposed by Spain solely for the preservation of national or international security that have been notified to the Fund pursuant to Executive Board Decision No. 144-(52/51).

VIII. Article IV Consultations: The last Article IV consultation was concluded on June 12, 2006. Spain is on the standard 12-month consultation cycle.

1

Staff’s assessment of Spain’s REER gap (some 20-28 percent), has not materially changed from IMF Country Report No. 06/211. The statistical and methodological uncertainties of such estimates, and the authorities’related strong reservations, noted in that Report, also still hold. Illustratively, annual nominal wage increases would have to be below 1¼ percent to achieve a 20 percent REER depreciation over 10 years with annual manufacturing productivity growth of 1½percent-underscoring the importance of raising productivity.

2

Regional and local elections in May 2007, and parliamentary elections by March 2008.

3

The Law establishes a fiscal balance (for the general government excluding social security) for output growth between 2 and 3 percent; a surplus for growth above 3 percent; and a deficit of up to 1 percent of GDP (three-fourths of which allocated to the regions) for growth below 2 percent. See IMF Country Report No. 06/211.

4

Specifically, by the Economic Office of the President; see http://www.la-moncloa.es/default.htm.

Spain: 2007 Article IV Consultation-Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund