Spain
2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion

This 2008 Article IV Consultation highlights that after 15 years of impressive growth led by a housing boom, the Spanish economy has entered a sharp downturn in the wake of the global liquidity squeeze since mid-2007. Executive Directors have commended the authorities for their timely and substantial fiscal and financial sector responses to help cushion the downturn. They have emphasized that these efforts need to be complemented by reforms to bolster competitiveness and to avoid a prolonged period of slow growth and high unemployment.

Abstract

This 2008 Article IV Consultation highlights that after 15 years of impressive growth led by a housing boom, the Spanish economy has entered a sharp downturn in the wake of the global liquidity squeeze since mid-2007. Executive Directors have commended the authorities for their timely and substantial fiscal and financial sector responses to help cushion the downturn. They have emphasized that these efforts need to be complemented by reforms to bolster competitiveness and to avoid a prolonged period of slow growth and high unemployment.

I. Context and Recent Developments

1. Spain was a growth leader for nearly 15 years until 2008. Contributing factors were peseta devaluations in the early 1990s, EU integration, euro adoption, swelling immigration, rising incomes, and easy funding that permitted a housing boom.

Macroeconomic Indicators (average 1993-2007)

(Percent, unless otherwise indicated)

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Source: WEO.

Excluding Spain.

2. Sustainability weakened as growth became increasingly dependent on importing labor and capital. Inflation exceeded the euro average. Productivity growth weakened as structural reforms lagged during the upswing. The expansion centered on nontradables. Households and companies became highly indebted. The current account deficit reached 10 percent of GDP by 2007 (Figure). With consistently negative external balances, the international investment position (IIP) steadily weakened.1

Figure 1.
Figure 1.

Spain: International Comparison

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

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

3. What started as a soft landing turned into an abrupt unwinding of imbalances with the global liquidity squeeze in mid-2007, posing a major macroeconomic challenge. Following a gradual slowing in activity beginning in 2006, the financial crisis has reduced funding for the external deficit and triggered a major bust in the housing market. With construction activity collapsing, banks under pressure, foreign demand faltering, and competitiveness weak, the economy now needs both cyclical support and deep structural reform. The authorities’ challenge is to achieve this adjustment, and bolster competitiveness to avoid getting stuck in a long stagnation, while guarding fiscal sustainability.

4. The Socialist Party won reelection for a second term in March 2008. To address the crisis, the government has opted for increasing fiscal spending, assisting bank funding, initiating product market reforms, and improving job matching and active labor market policies. The main opposition conservative party would prefer tax cuts and increased financing for small and medium-sized companies. Both parties focus on short-term stabilization without an overarching intertemporal strategy.

* * *

5. At end-2008, as the global economic downturn accelerated, downside risks accumulated. Monthly indicators turned worse than expected with housing, industrial activity, and durable goods (vehicle sales) bearing the brunt of adjustment. Unemployment is rising fast, reaching 12.3 percent in November (Eurostat; Figures 2, 3). Bank funding tightened up again after the collapse of Lehman Brothers and continued losses in some large European banks. Many economies, including Spain, are deleveraging, with fiscal balances weakening as governments seek to soften the downturn.

Figure 2.
Figure 2.

Spain--Cyclical Indicators Suggest a Sharp Slowdown

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: IMF staff calculations based on data provided by the authorities.
Figure 3.
Figure 3.

Spain--Labor Market Indicators Show that Unemployment Remains a Key Vulnerability

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Sources: INE; WEO; and IMF staff calculations based on data provided by the authorities.

6. A combination of slumping credit demand and tightening bank lending is slowing consumption and investment. With 98 percent of mortgages indexed to the 12-month euribor debt servicing costs first increased after the onset of the crisis in mid-2007, before easing sharply in late 2008. The spike in food and energy inflation further sapped disposable incomes and confidence. Construction investment slumped and machinery and equipment outlays fell with the weakening sales outlook (Figures 4, 5).

Figure 4.
Figure 4.

Spain--Confidence Indicators

(Percent Balance, seasonally adjusted)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: Eurostat; indicators are rebased to average 1985=100.
Figure 5.
Figure 5.

Spain--Quarterly National Accounts Reveal the Expenditure Switch from Domestic Demand toward Net Exports

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: IMF staff calculations based on data provided by the authorities.

7. Spain’s external current account deficit has started to improve. The process so far has been led by falling imports as domestic demand contracts. Net factor payments continue to worsen with the lower IIP (Figure 6).

Figure 6.
Figure 6.

Spain--Balance of Payments and International Investment Position

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: Bank of Spain.

8. Despite the slowdown, wage increases have outpaced the euro average, while headline inflation converged from above to the euro average in December 2008. Spain’s high energy intensity made the oil shock especially painful. Indexation transferred price shocks to wages. Collective bargaining wages were rising at 3½ percent, but many contracts then added retroactive compensation when prices rose above a limit. Hourly labor cost growth is approaching 6 percent, compared with 3½ percent for the euro area as a whole (Figure 7). Weakly contested output markets, segmented labor markets, and low productivity raise costs and lower competitiveness. Inflation is now declining sharply with the drop in oil prices and indexation is expected to be less onerous in 2009.

Figure 7.
Figure 7.

Spain--Inflation and Wages

(Annual percent change)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Sources: Eurostat; IMF staff projections based on data provided by the authorities; and WEO.1/ Excludes nonprocessed foods and energy products.

9. The housing downturn, growing unemployment, and funding tightness have put banks under pressure. Asset quality is weakening as building companies are failing, house prices are declining, and unemployment is rising. Banks have used prudential cushions to absorb shocks, but lower asset returns and higher funding costs are beginning to reduce profitability. With banks, nonfinancial companies, and households all deleveraging, credit growth has slowed sharply from 25 percent y/y in early 2007 to 7 percent in late 2008.

10. The general government balance has switched from moderate surpluses to sizeable deficits. The soft economy slowed revenue, while spending outpaced output. The interest bonus from EU integration, lowering costs by over 3 percent of GDP, is no longer helping. The debt ratio has bottomed out. The central government is relatively small with subnational governments accounting for 2/3s of spending. Social security accounts have a current surplus but actuarial deficit (Figure 8).

Figure 8.
Figure 8.

Spain--Fiscal Indicators Suggest There Are Risks Ahead

(Percent of GDP)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: IMF staff projections based on data provided by the authorities.

II. The Outlook

11. There was agreement that the outlook is somber. However, while deleveraging and global economic events exert downward pressure on growth, there were also upside developments. These include the recent sharp drop in oil prices and euribor rates, and the authorities’ large fiscal efforts.2 Consequently, staff and the authorities preferred to analyze the outlook as a range around a baseline scenario.

12. The staff has lowered its 2009 growth scenario further to a range between -1 and -2½ percent with a baseline of -1.7 percent. During the mission, the staff had presented a baseline of (at least) -1 percent, but subsequent data indicate that conditions have worsened with a rebalancing from domestic demand to net exports at a time when foreign demand is also weak. Staff projects inflation to drop to 0.8 percent in 2009, which could be temporarily below EU partners because of Spain’s high oil intensity. Unemployment would peak around 17 percent in 2010. Given labor market rigidities, lower demand results in job shedding rather than wage moderation.

Spain: Real GDP Growth

(Percent)

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Stability and Convergence Program 2008-2011.

Spain: Staff Medium Term Outlook--Baseline Scenario 1/

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In percent.

Contribution to growth.

Spain: Staff Quarterly Baseline Scenario 1/

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In percent.

Contribution to growth.

13. The balance of risks around the staff baseline is on the downside, and the forecast range is wide. The drop in oil prices and euribor are supporting disposable income, but it is unclear how much finds its way into spending versus saving to restructure private balance sheets—i.e. how long and deep deleveraging will be. The upside range assumes a smaller increase in household saving than 2¼ percentage points assumed in the baseline; the downside range assumes saving rates jumping by 3¾ percentage points. Further, downward risks could materialize as external demand from the EU continues to weaken (2009 import volumes from euro-area partners are currently projected to drop between 1.5–2 percent). Furthermore, the slowdown in Latin America and other markets may feed back through the significant interlinkages of Spain’s large banks (¶30), thus worsening domestic credit conditions. Finally, high unemployment and extended slow growth would continue to put pressure on Spain’s domestic banks as well, which could slow credit growth yet further.

14. Without more reforms to increase flexibility, staff is concerned that Spain could get stuck in a low-growth extended-adjustment (L-shaped) equilibrium. Such a scenario has been experienced by Portugal, Germany, and Japan. If the structural inflation premium over euro partners persists and deleveraging requires time, immigration could subside and actual and potential growth remains weak. The cumulative loss of competitiveness and high private sector indebtedness thus restrain growth. Construction, which has been the engine of growth, is unlikely to rebound soon. The switch to higher productivity will likely be slow with timid product and labor market reforms, as assumed in the staff’s medium-term outlook.

15. The authorities expect a more V-shaped recovery. They note the higher population dynamics in Spain relative to trading partners (immigration would still contribute to growth). Spain’s attractiveness as a residential destination for many Europeans would support the housing market to some extent, which could lead to a gradual recovery from 2010. So far, Spanish export market share has held up relatively well—seen to reflect better competitiveness than relative prices may indicate. The authorities view some of the inflation differentials as catching up with trading partners (Balassa-Samuelson effects), but agree that competitiveness should be improved. They prefer to focus on output market reforms to assist productivity, with less emphasis on labor market reform.

III. Policy Discussions

16. The discussions centered on the deteriorating outlook on the back of the housing correction and its implications for banking, fiscal policy, and structural reforms. Interlocutors agreed that the housing market needs to stabilize to bolster the quality of bank assets. Banks need funding access and sufficient capital to manage the effects of the crisis. Fiscal policy is providing liquidity to the economy and propping up activity and employment to the extent possible. Staff stressed the need to calibrate these measures in a long run sustainability framework to assure a return to lower debt and boost confidence. In this vein, structural reforms need to complement cyclical-support policies by lowering costs and increasing productivity to raise growth potential. Several interlocutors remarked that the political system was not interested in the long-run at this moment. Support for reforms was said to be uneven, especially for labor reforms.

A. Housing3

17. Spain has achieved a major upgrade of its housing stock. The renewal in the Spanish housing market reached a crescendo in 2006 when Spain started nearly 800,000 homes—more than Germany, France, Italy, and the UK combined. Construction value-added reached 17 percent of GDP, more than double in other countries. Construction employment was also very high, including using immigrant labor.

18. However, the 2007 funding crunch brought the boom to a halt, and adjustment will take time given a large inventory (Figure 9). Estimates differ. The authorities estimate a stock of at least 600,000 unsold homes, to increase somewhat as new units are being finished. The private sector estimates a stock of 1 million, compared with demographically sustainable sales of some 400,000 homes a year. With peak housing starts nearing completion, inventories will likely expand throughout 2009.

Figure 9.
Figure 9.

Spain: Housing Market Indicators

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: Staff calculations and projections based on data provided by the authorities, and Fotocasa.1/ These are flows of newly built houses; does not take into account existing excess inventory.2/ Assessed house prices represent the official house price series deflated by the CPI. This indicator has been lagging market house prices recently. Market house prices are from Fotocasa, a private firm.3/ Initial annual payments on a typical new mortgage, defined as an 80 percent loan-to-value mortgage on a home priced at 149,000 euros in 2007.

19. House price data diverge—predictions of future house prices more so. Official statistics on assessed value per square meter suggest that prices are now slightly down y/y. A new official series on home prices per dwelling has started to show more substantial nominal declines. Home prices by private assessors or average market asking prices suggest that nominal home prices are already falling over 10 percent y/y. The staff is positing a scenario of house prices falling by 30 percent in real terms over four years (peak/trough), and construction activity to bottom out at the earliest in 2010. The authorities feel that this price drop is too high due to housing market segmentation and downward price stickiness. However, banks’ contingency plans closely match staff assumptions—an extended correction with significant price declines.

20. The implications are important:

  • Higher unemployment. Slowing construction may release 1 million workers (5 percent of total employment in the economy).

  • Pressure on banks. Mortgage credit is 35 percent of loans; construction and real estate company credit another 25 percent. Deteriorating asset quality is affecting the banks’ profitability, and funding, which depends heavily on mortgage-backed securities.

  • Weaker public finances. Escalating asset prices and transactions lifted revenue. Estimates of sustainable revenues and the structural fiscal position have been too optimistic, in staff’s view.

21. The authorities have taken several measures to assist the construction sector. They aim at creating jobs (including through public infrastructure), facilitating mortgage refinancing, limiting foreclosures,4 promoting the rental market, and expanding subsidized housing. Many interlocutors among banks and analysts felt that these measures were useful and timely.

22. Staff agrees that the housing measures have been valuable, and sees some further room for improvement. While home-ownership is (overly) subsidized through tax deductions, the market for rentals is underdeveloped, hindering labor mobility, and there is potential to absorb vacant housing stock. In this context, restrictions need to be relaxed, such as the landlord’s obligation to automatically renew the lease during the initial five years (the tenant can quit, but not the landlord), and capping of rent increases at CPI indexation. Eviction rules are being clarified to protect homeowners while mediation is being revamped to safeguard consumer rights. Staff cautioned against constructing more subsidized housing at this time, which adds to supply, and does not always reach the vulnerable groups intended. The authorities said that this keeps employment up and were in a market segment that did not interfere with the free housing sector.

B. The Banking Sector

23. The banking sector has weathered well the initial impact of the global crisis thanks to prudent regulation, sound supervision, and cautious retail-oriented business models. On the asset side, Spain’s dynamic loan-loss provisioning helped build cushions during good times (Box 1). Also, rigorous consolidation rules reduced incentives for off-balance-sheet vehicles and banks avoided investing in opaque structured products. On the funding side, banks used their extensive branch networks to gather deposits, but also issued large amounts of asset-backed securities, mainly covered bonds.5 It is estimated that the dynamic provisions have “bought” banks about two years worth of cushion (€24 billion), which are now starting to run low. Banks continued to record healthy profits in 2008, maintained moderate leverage and sound capital adequacy, and no bank was closed or intervened (Tables 2 and 3, and Figures 10, 11).

Table 1.

Spain: Main Economic Indicators

(Percent change unless otherwise indicated)

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

Data for 2008 as of September.

Based on national definition (i.e., the labor force is defined as people older than 16 and younger than 65).

Table 2.

Spain: Selected Financial Soundness Indicators

(Percent or otherwise indicated)

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Sources: Bank of Spain; ECB; WEO; Bloomberg; and IMF staff estimates.

Consolidated groups of credit institutions.

As of end-June.

As of end-August.

Liquid assets include cash and holdings of securities different from equity shares and participations.

Sum of main and long-term refinancing operations; end of period.

As of October 28, 2008.

Senior 5 years in euro.

Table 3.

Spain: Financial Soundness Indicators of the Non-banking Sectors

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Sources: Data received from the authorities and staff estimates.

As of end-June.

Available solvency marging over required solvency margin.

Earnings before interest and tax as a percentage of interest and principal expenses.

Assessed housing prices per square meter in the free housing market as published by the Ministry of Housing. 2008 data cover the entire year.

Figure 10.
Figure 10.

Spain--Financial Sector Indicators (I)

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Sources: Bank of Spain; ECB; and data provided by the authorities.1/ Simple average of asset swap spreads on covered bonds by Santander, BBVA, Caja Madrid, and Caixa Barcelona.
Figure 11.
Figure 11.

Spain: Financial Sector Indicators (II)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Sources: Data provided by the authorities; Bank of Spain; ECB; and Bloomberg.

Spain: Banking Indicators

(percent)

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Source: Bank of Spain.

Latest data available, mostly June-November.

Unweighted bookvalue capital/asset ratio.

24. Nevertheless, financial market disruption has severely affected banks’ operating models. The banks are restructuring their balance sheets. On the liability side, they have intensified competition for deposits, stepped up recourse to the ECB (with another run-up at end-2008), and availed of government funding assistance (below). On the asset side, they slowed lending to the euro-area average growth rate, sold industrial participations, and tightened credit standards while seeking workouts with distressed property developers.

25. The authorities have taken measures to assist bank funding, rather than purchasing bank assets or injecting capital (Box 2). Bank assets are mainly loans, which are granular and less volatile than exotic products held in other banking systems. This provides Spanish banks some time to adjust. At this stage, the authorities prefer not to intervene directly by purchasing assets, because banks are best placed to manage these. For contingency purposes, the authorities have adopted legal provisions for potential capital support. They have refrained from capital injections so far and will continue to do so to the extent possible to promote private sector market-based solutions first, and to avoid distorting competition. Staff agrees. Indeed, the authorities expressed concern that government-led recapitalization of weak institutions elsewhere had already created significant distortions in the EU. In their view, Spanish vulnerability is on the funding side—especially wholesale funding with forthcoming debt amortizations of about €170 billion in the next two years. Thus, the authorities have put in place facilities to help banks cope with funding tightness and increased deposit insurance together with EU partners to assist confidence.

The Spanish Prudential Framework

Dynamic loan-loss provisioning has built buffers before the current stress materialized; and rigorous consolidation rules have reduced incentives for off-balance-sheet vehicles. Both features are attracting international attention.

Dynamic loan loss provisions–The Bank of Spain (BdE) has pioneered the use of dynamic provisions since 2000 to mitigate credit procyclicality.1/ The principle recognizes that potential loan losses may exist from the moment a loan is granted—and this requires a provision. Hence, Spanish banks are required to create two provisions: specific, against identified losses or doubtful assets, and general, against potential losses. For the latter, banks’ standard loans are subdivided into six risk categories with corresponding provisioning coefficients, determined by historical experience of impairment and loss given default. In each quarter, banks are required to set aside general provisions equal to the difference between a notional amount of provisions and the amount of specific provisions accumulated during the period (notional provisions being a function of the flow and stock of banks’ exposure in each risk category multiplied by the respective provisioning coefficient). The total stock of general provisions is required to remain within predetermined limits.2/ Dynamic provisioning helps build cushions during expansions, which partially smooth bank profits and solvency over the business cycle. The estimated €24 billion in provisioning cushions in banks resulted in nonperforming loan (NPL)-coverage ratios of over 200 percent at the peak, compared with the EU average equivalent of just over 60 percent.

uA01bx01fig01

Credit Institutions’ Loan-Loss Provisions, 1999-2008Q3

(Billions of euro)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: Banco de España, Statistical Bulletin.
uA01bx01fig02

Credit Growth, NPLs and Loan-Loss Provisions

(12-moth growth rate; percent of total credit)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Securitization and consolidation practices–Securitization began in 1982 with initiatives to develop the mortgage markets and has grown strongly since 1992. Before adopting IFRS in 2005, it was normal for banks to effectively remove securitized loans from their books. In adopting IFRS, the BdE extended to individual institutions the application of accounting criteria for the consolidated level. In addition, risk transfer and control of special purpose entities were defined in strict terms. Both steps reduced incentives for off-balance sheet securitization and capital relief.

1/The framework was reformed in 2005 to comply with IFRS (Circular 4/2004).2/Currently the limits are 0 and 125 percent of bank exposures multiplied by their respective provisioning coefficients (Circular 6/2008). The BdE maintains an indicative minimum level of 10 percent (Actualizado Circular 6/2008).

Bank Support Measures

Spain is assisting the banking system in line with the common framework agreed by euro-area countries:

  • The limit on deposit insurance was raised from €20,000 to €100,000. Moreover, the deposit information system was strengthened to allow a timely response in emergencies.

  • A €30–50 billion fund was established to purchase high-quality securities issued by credit institutions (FAAF). The auctions are modeled after, and complement, the ECB liquidity facilities, but with longer maturities up to 3 years. Up to 25 percent of a tender may be allocated through noncompetitive bids to credit institutions in proportion to their contribution to credit growth. Limits have been envisaged to safeguard sufficient diversification in allocation among institutions. Four auctions have been carried out with positive results in allocated amounts and spreads.

  • Government guarantees are provided for credit institutions’ new debt issues. The amount approved is €100 billion to be used by mid-December 2009. A possible additional €100 billion might be allotted in 2009 if market conditions do not improve. Pricing is agreed with EU partners as a minimum of 50 basis points plus a factor that depends on the CDS spreads and/or the rating of the originator. Many banks will participate in this program.

  • If necessary, credit institutions’ recapitalization may be carried out through the government’s acquisition of nondiluting instruments such as preferred shares.

26. Turning to 2009, it was agreed that Spanish banks face a very difficult year, likely leading to bank consolidation. Balance sheet restructuring is contributing to the slowdown. Several large real-estate developers have filed for bankruptcy. Impaired loans have jumped, although from a very low base, eroding prudential cushions. CDS spreads have widened (sometimes a thinly traded indicator) and bank share prices have dropped, reflecting prospects of continued economic weakness and in property markets.

27. Staff stress tests based on published data suggest that banks may face capital needs—Bank of Spain’s results, using detailed internal data, are more benign, but the authorities are not complacent.6 The staff assumes that significant pressures will still build on profits and asset quality in 2009 as the housing and growth downturn unfold. Staff noted that there is a need for (fiscal) contingency plans to assist banks with capital. The authorities viewed the severe scenario by staff as too pessimistic, especially regarding the assumption of loan impairments rising rapidly to double digit NPL-ratios. This was in part because the authorities envisage a somewhat smaller downturn and housing price decline than staff, and because regulations for loan impairment have been tightened relative to the early 1990s, which results in higher NPL statistics for any given economic scenario today relative to the early 1990s. Also, they thought the staff assumptions on loss given default (LGDs) too high in comparison with historical experience for some loan categories; and that staff had depressed the interest margin for bank earnings too much (it had remained stable so far). In addition, the authorities emphasized that average loan-to-value ratios in mortgage lending were moderate, and households were responsible for the debt not just with the property but also with their income. Thus, the loss experience in home lending had always been moderate, and more closely tied to unemployment than falling home prices.

28. The Bank of Spain has stepped up its surveillance and the authorities are prepared to act as needed to forestall systemic disruptions. Both off-site analysis (stress testing and liquidity monitoring) and on-site examinations have been reinforced as the authorities agreed that increased pressures will still come. In particular, supervisors share staff concern about property developers. In anticipation, they have followed a conservative approach to banks’ debt-to-equity (property) swaps with ailing real estate companies, requiring the buildup of adequate capital and provision buffers.

29. Savings banks (cajas) have regional concentration and particular exposure to construction. NPLs in cajas are higher than for commercial banks, with some cajas in better shape than others—the staff believes that some consolidation is inevitable to keep the caja system functioning robustly, and to avoid large fiscal costs down the line. Further, and following staff’s previous recommendations for more market exposure, cajas have made progress with one institution issuing participation shares in mid-2008. The downturn in the stock market has hindered further issuance, but staff recommended that they continue attempts to bolster capital, as market conditions permit. Regulations of participation shares should be simplified to make them more attractive to investors—especially regarding overly complex dividend payout rules. Further, the 2006 FSAP had recommended allowing cajas to issue capital instruments with voting rights, and eliminating the requirement for regional governments to approve mergers of cajas (Table 4). The authorities said that they do not perceive these elements as major stumbling blocks today, and would focus on immediate needs. They noted that discussions on consolidation were indeed underway and this would continue as the operating environment weakened, thus facilitating interregional mergers. Representatives of cajas explained that these had never caused a systemic disturbance and that no caja has ever failed, even though weaker ones have been absorbed through mergers.

Table 4.

Spain: Status of Implementation of Main FSAP Recommendations

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30. Santander and BBVA are international players and could face some risks from abroad. Their profits have remained high so far, and they noted that their global diversification, focused on relatively safe traditional retail banking, has been an element of strength, rather than weakness. Still, bank representatives said that Mexico, Brazil, and Chile are key markets for them, each with their own pressure points, to which they were responding with dedicated adjustments. Santander has taken advantage of the crisis to expand its retail banking model in the US and UK—it is now cutting costs in these ventures to improve profitability and reduce risks. In November, at the height of the crisis, Santander placed €7.2 billion in new shares to bolster its Tier 1 capital base, without government assistance. Likewise, BBVA, which has been less aggressive in expanding its capacity, has placed over €1 billion in preferred shares in December, and a similar amount in bonds in early January, also without government assistance. Both banks were hit by the Madoff scandal, but direct exposures are small. The authorities said that they were closely monitoring potential spillovers from foreign markets into Spain via the large banks through close cross-border cooperation with EU, US, and Latin-American supervisors (Figure 12).

Figure 12.
Figure 12.

Spain: Santander and BBVA

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Sources: Bloomberg; National authorities; Bank of Spain; and ECB.1/ Average of Unicredito, Commerzbank, HSBC, ING, BNP Paribas.

C. Fiscal Policy

Short run

31. The fiscal accounts have weakened sharply with several factors contributing—hitherto overestimating the structural balance is among them. Since 2001, primary spending has outpaced potential growth. Moreover, the housing boom created the impression of a permanent strong tax base. With falling house prices and less homebuilding, revenues will drop, including for local governments. Also, the ongoing rebalancing from domestic to export demand will moderate the tax base.

32. For 2008–09, the authorities have taken measures of 4 percent of GDP so far. The last package, designed as part of the joint EU stimulus for 2009, is valued at 1.1 percent of GDP. It focuses on labor-intensive local public works, assistance to the automobile industry, and smaller measures. This impulse adds to the elimination of the wealth tax (0.2 percent of GDP) effective from 2009. In staff’s view, the measures have been largely cyclical (supporting demand), without being used as a lever to reform labor and product markets, or to ease long-run structural fiscal pressures to anchor better expectations (¶ 38–39; Section D). Adding discretionary fiscal measures and automatic stabilizers, the staff projects the fiscal surplus of 2.2 percent of GDP in 2007 to turn to a headline deficit of 6.1 percent, and a structural deficit of 5.2 percent, in 2009 (Table 5).

Table 5.

Spain: General Government Operations

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

Includes the FAAF.

Includes government guarantees and ICO credit lines assuming their full use.

Spain: Main Fiscal Measures

(Percent of GDP)

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33. The authorities estimate a smaller structural deficit than staff, partly because they have higher potential growth.7 They pointed out that measures had been designed to drop out of spending once the recession fades—an exit-strategy. Staff agreed that the structural balance would decline again in the medium run if the spending boost is temporary and no follow-up (maintenance) is required. In 2007, Spain legislated a fiscal rule that requires a surplus if growth exceeds 3 percent and permits a small deficit when growth is below 2 percent. Under current conditions, however, the authorities agreed that the fiscal balance would swing into large deficits, exceeding the SGP limits. Both domestic and SGP rules would require lowering the fiscal deficit in the future.

34. There was considerable soul-searching how to proceed with fiscal policy in 2009 if growth were to deteriorate further. There are three sets of views, including among the authorities. First, those that express puzzlement at further pressure, including from the Fund, for even larger deficits. They note that Spain has been living beyond its means and adjustment is necessary. Second, those considering that supporting the economy was appropriate but that Spain has done enough. Third, those supporting additional measures if the downturn worsens. Staff said that the circumstances were unusual and the large response by Spain had been warranted so far to avoid a standstill.

35. Proceeding, the authorities would first give the approved measures a chance to generate their full impact. If more measures were necessary, they would consider transfers to poor and liquidity-constrained families with high spending propensities (such as extending unemployment support, welfare) and labor-intensive infrastructure spending to protect employment. Fiscal multipliers so far had been low with resources (tax cuts) used by the private sector for deleveraging, instead of spending. The authorities would endeavor to keep measures timely and targeted, within a coordinated response with EU partners. Staff agreed that while allowing automatic stabilizers to operate fully, fiscal policy needed to remain cautious given that some fiscal powder also should be kept dry, as a contingency, to assist banks with capital, if needed. If still lower growth materializes and the authorities decided that further fiscal support were needed, staff stressed that this should be combined with long-run fiscal, labor (such as agreeing with social partners on a program of wage moderation and labor market liberalization), and product market reforms. This would help start a new growth cycle with improved competitiveness and higher productivity to avoid a potential L-shaped stagnation.

36. In addition to the above-the-line measures, the authorities have taken below-the-line measures to support housing, SMEs, and banks. The fully government-guaranteed Official Credit Institute (ICO) and the Treasury have granted credit lines and guarantees providing up to 4.9 percent of GDP in liquidity support through end-2009 (additional to the deficit). The many extensions to its programs are challenging ICO, which is small. Room to do more is limited if implementation is to remain of high quality. Funding assistance to banks (FAAF and debt guarantees) is potentially large at 22.8 percent of GDP, if fully employed.

Spain: ICO Credit Lines -- 2008 and 2009

(Percent of GDP)

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Spain: ICO and Government Guarantees

(Percent of GDP)

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Spain: Government Banking Assistance 2008-09 1/

(Percent of GDP)

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Cumulative. Euro area is GDP weighted and excludes Finland and Luxembourg.

37. The debt implications of the fiscal measures, credit lines, and guarantees are large. The deficit is likely to stay elevated in the medium-term, with some improvement as spending measures drop out in future years. Nevertheless, if all support is fully used, gross debt and guaranteed debt would increase by €395 billion (34 percent of GDP) in 2007–09, and the debt ratio could rise to 74 percent of GDP. The assets backing some debts are rated AAA and AA, so potential losses were deemed small. Further, sunset clauses imply that the guaranteed debt will fall quickly once the programs end, but staff felt that risk exposure, given the weak economy, should not be downplayed. The sovereign spread over 10 year Bunds has already increased from 7 to over 100 bp, and Spain’s long-run AAA sovereign debt rating has been downgraded one notch by one rating agency, so caution is warranted.

Long run

38. The authorities agreed that current economic policies do not secure long-run fiscal sustainability. The authorities’ medium-term potential growth projections (around 3 percent a year) are higher than those of staff (2 percent a year), but similar beyond the next decade. Spain faces growing dependency ratios, lower labor input, and slowing output growth rates in the future. Immigration is more buoyant in the authorities’ medium-term projections, which would push out into the future the effects of aging on growth and the fiscal position—a delay, not a solution of eventual pressure. In the staff’s long-run framework (Figure 13), and assuming a productivity recovery from low levels, potential growth could remain around 2 percent for some time before demographic slowing kicks in. Spain has one of the highest aging costs among advanced countries and those in the EU Aging Working Group. Using these data, the staff’s long-run projections find unsustainable debt dynamics with current policies (Figure 14).8

Figure 13.
Figure 13.

Spain--Demographic Indicators and Assumptions

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: IMF staff projections based on data provided by the authorities.
Figure 14.
Figure 14.

Spain--Long-Run Macroeconomic Scenario and Public Debt Sustainability

(Annual percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 128; 10.5089/9781451812282.002.A001

Source: IMF staff calculations.1/ Assumes real interest rate = real GDP growth + 100 bp.

Spain: Staff Baseline Scenario for Long-Run Potential Real GDP 1/

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Percent.

Spain: Aging Costs 1/

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Source: Ministry of Economy and Finance.

Increase in age-related spending through 2050.

Spain: Cross-Country Comparison of Aging Burden 1/

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Source: IMF, Fiscal Affairs Department.

Net present value of long-run age-related spending.

39. Staff recommended publishing an intertemporal public sector balance sheet as part of the annual budget document to frame policies in a long run context. The balance sheet would reflect current assets and liabilities and the NPV of future primary balances, including aging costs, based on current policies. Staff calculations suggest that in 2007 Spain’s public sector net worth was -40 percent of GDP. However, with the large downshift in the structural primary balance, the path of future primary balances significantly worsened, leading net worth to drop to -147 percent of GDP in 2009 (even after clawing back some expenditures in the medium term) (Table 6). Seen in this context, Spain has no fiscal space for expansion, unless the authorities can commit to adjustments (parametric pension and health reforms; extending retirement ages; limiting benefit indexation for the wealthiest; a combination of progressive income tax increases and expenditure cuts in the non-aging related budgets, including phasing out the mortgage interest deduction) that bolster the public balance sheet. The authorities agreed that further steps in pension reform were necessary and that plans to this effect were being developed in cooperation with social partners. Staff felt that this effort might require a firmer push by the authorities.

Table 6.

Spain: Public Sector Balance Sheet

(Preliminary)

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Sources: Bank of Spain; and IMF staff estimates.

Net present value of 50-year future primary balance projections in the baseline scenario of unchanged policies. The discount rate is equal to the average interest rate on the public debt. Over the long-run the real interest rate = real GDP growth + 100 bp.

Excludes fixed assets as these may not be marketable.

Includes the FAAF.

Includes government guarantees and ICO credit lines assuming their full use.