Spain: Staff Report for the 2010 Article IV Consultation

Spain’s economy is facing severe challenges. Financial market tensions increased sharply in the wake of the Greek crisis. Policy should focus on rebalancing of the economy and securing market confidence. Ambitious fiscal consolidation is under way, but achievement of the targets needs to be made more credible and complemented by bold pension reform. A radical overhaul of the labor market is urgent. Progress in recent years on product and service market reform should continue. The banking sector remains sound but is under pressure.

Abstract

Spain’s economy is facing severe challenges. Financial market tensions increased sharply in the wake of the Greek crisis. Policy should focus on rebalancing of the economy and securing market confidence. Ambitious fiscal consolidation is under way, but achievement of the targets needs to be made more credible and complemented by bold pension reform. A radical overhaul of the labor market is urgent. Progress in recent years on product and service market reform should continue. The banking sector remains sound but is under pressure.

I. Spain and the Global Financial Crisis

A. Spain’s Challenges

1. Spain’s economy faces severe challenges. Spain’s economic cycle was already turning and its long-standing imbalances beginning to unwind when the global crisis hit, turning the soft landing hard (Figures 1 and 2):

  • The crisis has taken a heavy toll on the labor market. Despite a similar output fall as elsewhere in the euro area, unemployment soared to 20 percent, double the euro area average. Beyond the heavy social toll, this puts pressure on the fiscal accounts and the banks, and erodes human capital.

  • The deflating property bubble compounds the effects of the global financial crisis. Because the real estate boom involved a large volume increase (unlike in the UK) and housing price adjustment has been slow, construction output and employment have contracted sharply.

  • Spain has exhausted its fiscal space. The combination of a large stimulus and evaporating cyclical and one-off revenues yielded one of the largest deficit increases in the euro area.

  • The economy is highly indebted. During the boom, households and corporations borrowed heavily, resulting in Spain incurring one of the most negative International Investment Positions among advanced countries.

  • Productivity growth and competitiveness are weak. Anemic productivity growth, despite high investment ratios, and rapid wage increases led to substantial rises in unit labor costs and contributed to large current account deficits.

  • Part of the banking sector is fragile. The banking system relied heavily on wholesale borrowing to fund domestic lending to the real estate sector and witnessed a rapid growth of “cajas” – unlisted mutual savings banks without formal owners and share capital and particularly exposed to local property markets – which generated overcapacity in the system.

Figure 1.
Figure 1.

Spain and the Global Financial Crisis

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Eurostat; and WEO.
Figure 2.
Figure 2.

Spain’s underlying weaknesses

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Eurostat; Bank of Spain; European Central Bank; and IMF staff estimates.1/ Monetary financial institutions. Market funding comprises money market funds/shares and debt securities issued. Twelve month change over the stock of total assets at the beginning of the period.

2. Financial market tensions also increased sharply in the wake of the Greek crisis. Following the Greek crisis, financial market conditions became increasingly difficult for many peripheral euro area countries, including Spain. Sovereign spreads over Germany 10-year bunds rose to a post euro peak of about 164 bps in early May, 5-year CDS spreads for the largest Spanish banks widened to about 250 bps, and market access tightened further. The pressure was only eased after the announcement of the European Financial Stabilization Mechanism and the ECB’s Securities Market program to reduce excessive volatility in sovereign debt markets. However, conditions have since then trended negatively and many measures of sovereign risk are back at levels prevailing just before the announcement of the Stabilization Mechanism. This is also reflected in restricted access for Spanish banks to wholesale funding markets. Given Spain’s systemic importance, this underscores that tackling Spain’s economic challenges and strengthening market confidence is critical first and foremost for Spain but also for Europe and the global economy.

uA03fig01

Spain: Sovereign Spreads

(basis points)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Thomson Financial/DataStream; and Bloomberg.

3. The combination of these challenges makes Spain’s recovery from the crisis particularly difficult, though mitigated by some pre-existing strengths. Some of these challenges were masked by the previous boom and the abundant global liquidity. Others are mitigated by strong policy settings and initially healthy starting points, such as the history of fiscal surpluses, relatively low public debt, strong policy credibility, the investment-grade government debt rating, the prudent financial supervision framework, and banks’ high capital and provision buffers. But the underlying structural weaknesses left Spain poorly placed to face the global crisis and now hinder the adjustment process and undermine growth prospects.

B. Global Financial Crisis Impact: Large, Despite a Pro-active Policy Response

4. Despite its retail-oriented business model, the banking system came under pressure. With wholesale funding drying up, Spanish banks scaled up their use of ECB refinancing facilities (now broadly in line with Euroarea average), competed more fiercely for domestic deposits (some banks are offering up to 4 percent), and tightened lending standards (Figure 3 and Table 2). The bursting of the real estate bubble and the sharp downturn in activity further worsened banks’ operating environment (Table 3). Banks increased their holdings of government securities (though exposure to other Southern euro area sovereigns is minor), credit growth collapsed, NPLs soared, and the high pre-crisis provision coverage ratio swiftly declined to that of European peers. Banks managed distressed or potentially problematic exposures actively, including through debt-for-property swaps and debt restructuring, to mitigate the buildup of delinquencies. Banking sector profits contracted markedly and turned negative in the last quarter of 2009 before recovering in the first quarter of 2010. Nonetheless, leading Spanish banks, including the largest savings banks, have expanded overseas into UK, US and Asian markets and through their local subsidiaries were able to support credit in Latin America during the peak of the global financial crisis.

Figure 3.
Figure 3.

Spain--Financial Sector Indicators (I)

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

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Bank of Spain; ECB; and data provided by the authorities.1/ NPL ratio = nonperforming loans in percent of total loans.2/ Coverage ratio = provisions in percent of nonperforming loans.3/ Simple average of asset swap spreads on covered bonds by Santander, BBVA, Caja Madrid, and Caixa Barcelona.
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 2010 refer to March 2010.

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

Capital account not included.

Based on data from IMF, International Financial Statistics. Data for 2010 refer to March 2010.

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.

Including developers.

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.

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 the IMF Corporate Vulnerability Utility.

Available solvency margin over required solvency margin.

Debt includes securities other than shares and loans (excluding inter-company loans). Calculated with information obtained from Financial Accounts of the Spanish Economy and National Accounts.

Calculated using the information in the CBA and CBB databases (derived from the Balance Sheet Data Office’s anual survey and balance sheet information deposited in the Spanish Mercantile Registries).

Earnings before interest and tax over interest expenses.

Since 2004, Bankruptcy Proceedings Statistics replace the Suspensions of Payments and Bankruptcy Declarations Statistic.

Assessed housing prices per square meter in the free housing market as published by the Ministry of Housing. Average year-on-year growth.

Including de-recognised loans.

uA03fig02

Savings banks’ profits contracted more markedly than commercial banks due to higher provisioning.

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Banco de España; and IMF staff estimates.

5. The impact of the crisis differed greatly among banks:

  • The two largest banks, Santander and BBVA, preserved reasonable operating profitability, owing to their international diversification, and were able to strengthen the level and quality of their capital. However, the share price recovery of 2009 had partly corrected by early 2010 and CDS spreads have lately trended upward partially reflecting increasing sovereign risk (Figure 4).

Figure 4.
Figure 4.

Spain: Financial Sector Indicators (II)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Data provided by the authorities; Bank of Spain; ECB; and Bloomberg.
uA03fig03

Tier 1 Capital Ratio Major European Banks

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

uA03fig04

Change in Exposure to Latin America

(consolidated basis; immediate risk; annual change in percent of the stock at the beginning of the period)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: J.P. Morgan; Bank for International Settlements; and IMF staff estimates.
  • Small commercial banks posted still positive profits mainly reflecting an increase in net interest margins. However, the negative economic environment and the expected pressure on margins are weighing on their outlook.

  • Savings banks have suffered the most given their real estate exposure, although the sector is marked by substantial heterogeneity. Two small savings banks, comprising a total of 1½ percent of total assets of the banking sector, were intervened by Banco de España (BdE) in March 2009 and in May 2010. Some savings banks have also relied heavily on official liquidity support and government guarantees. Although at different stages of finalization, 11 mergers/integrations, comprising 34 institutions and accounting for more than a third of the banking sector, are underway.

6. The authorities pursued a two-stage approach to ease financial sector stress. At the start of the crisis, the focus was on securing funding. The government established a fund to purchase high-quality securities issued by credit institutions (Fondo de Adquisición de Activos Financieros—FAAF) and provided guarantees for credit institutions’ new debt issues. As the deteriorating operating environment and the collapse of the property market increased pressure on domestic banks’ capital, the emphasis shifted to consolidation and recapitalization and the government created the Fund for Orderly Bank Restructuring (Fondo de Reestructuración Ordenada Bancaria—FROB), to provide temporary capital assistance to merging credit institutions. While fine-tuning conservative provisioning rules to take into account collateral (with haircuts), the BdE tightened allowances on repossessed assets to prompt their rapid dismissal. Further revisions, including a unified and accelerated provisioning schedule, were published for consultation on May 26, 2010.

7. The fiscal accounts deteriorated sharply, reflecting the large stimulus. With the crisis, the incipient deterioration in the fiscal accounts accelerated as revenue-rich real estate collapsed, automatic stabilizers kicked in, and the large stimulus package took effect. The general government deficit swung from a surplus of 2 percent of GDP in 2007 to a deficit of 11.2 percent of GDP in 2009, sparking widening spreads and ratings downgrades (Figures 5 and 6, and Table 4). Stimulus measures amounted to some 7 percent of GDP over 2008–09, well above other euro area countries. Expenditure measures focused mostly on temporary measures, including broadening social protection and increasing public investment. On the revenue side, tax reductions largely did not have an expiry date, though many were later reversed. In addition, the government has taken measures to support credit lines to firms, especially SMEs, and housing, notably through a facility to refinance mortgages of unemployed or households with financial difficulties.

Figure 5.
Figure 5.

Spain: Fiscal Developments and International Comparison

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Bloomberg; and WEO.
Figure 6.
Figure 6.

Spain: Fiscal Developments 1995–2009

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Ministry of Finance; Eurostat; and IMF staff estimates.
Table 4.

Spain: General Government Operations 2007–15

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

Staff estimates.

SGP figures for other current expenditure includes capital transfers and other.

Impact of Fiscal Measures 2008–09

(Percent of GDP)

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Sources: SGP Budget, European Commission; and IMF staff estimates.

One-off measure.

uA03fig05

Discretionary Measures, 2008-09 1/

(Percent of GDP, relative to 2007 baseline)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: IMF REO, 2009; and IMF staff estimates.1/ Excluding one-off and temporary measures.

8. The recession has been sharp and longer than elsewhere. Cushioned from the full extent of the global financial crisis, the property bust and private sector deleveraging by the strength of the banking sector and the large fiscal response, output fell somewhat less than the euro area average (Figure 7, Table 1). Yet the output decline was still very substantial, and was driven by sharp declines in investment, exports, and private consumption, with weaker imports and rising government demand providing some offset. Imbalances have been correcting, with domestic demand contracting much more sharply than in the euro area, and net exports improving substantially. The hardest hit sectors were industry and construction/real estate (Box 1). The recession ended in the first quarter, when output grew by 0.1 percent, quarter-on-quarter (Figure 8).

Figure 7.
Figure 7.

Spain: National Accounts

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: WEO; Bank of Spain; Eurostat; and IMF staff calculations.
Figure 8.
Figure 8.

Spain: High Frequency Indicators

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

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: IEurostat; and MF staff calculations based on data provided by the authorities.

How Much Further Has The Property Bubble to Deflate?

EMU and euro adoption led to a large property boom, both in prices and supply. At their peak in 2007, prices were some 20–30 percent above their long-run equilibrium. Unlike some other countries with sharp increases in property prices (e.g. the United Kingdom), supply also responded sharply, with construction comprising about 9½ percent of GDP in 2007 compared to a euro area average of 5½ percent. The ensuing correction in prices has been somewhat less rapid than in other countries that had a similar boom, with “official” real prices only down about 13 percent since the peak, suggesting at least another 10 percent still to fall. However, other price series (asking prices, prices of second hand properties) suggest that the “true” market price may have fallen by more, as transactions have been few, banks have been taking over property rather than selling it, and the official index is based on assessments by private appraisal companies, which may be overestimated. Recent stabilization may also be driven by temporary factors, such as the increase in the VAT rate from July and the removal of mortgage interest relief for most taxpayers from next year. There is also considerable variation in price declines, with coastal areas more heavily affected. The new supply of property is however adjusting strongly, with the annual housing finishes running at about 425,000 units and new housing permits at 111,000 units compared to 650,000 units for both finishes and permits in 2007. An “overhang” of property at some 700,000 units and an equilibrium demand for property of 400,000 units, would imply another two to three years before supply conditions normalize.

uA03bx01fig01

Real House Price per Sq. Meter

(2007Q1 = 100)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Bank of Spain; INE; and IMF staff calculations.
uA03bx01fig02

Number of Houses

(Quarterly, thousands)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

9. The labor market has been adjusting in quantities, with unemployment soaring. With the application of previously contracted substantial wage increases, labor costs continued to grow strongly (Figure 9). Wage and working hours rigidities combined with the large share of temporary workers and the real estate bust have led unemployment to soar to 20 percent, affecting mostly temporary workers and youth. Labor force participation started falling. Spain has the highest sensitivity of unemployment to output growth among advanced economies – partly related to the large share of temporary workers. The flip side, however, is that unlike in other euro area countries which have lower employment losses, productivity improved and helped narrow the gap in unit labor costs. Wages have started moderating recently with the conclusion of a three-year wage agreement between social partners.

Figure 9.
Figure 9.

Spain: Labor market indicators

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

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Eurostat; IMF staff projections based on data provided by the authorities; and WEO.
uA03fig06

Unemployment rate

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

uA03fig07

Spain: Employees

(year-on-year percent change)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: INE; and Statistical Office of the European Communities.

10. The product market, in contrast, has been adjusting in prices. Inflation dropped quickly into negative territory and below the euro area average, reflecting the sharp drop in oil prices, Spain’s high energy intensity, and collapsing demand (Figure 10). Although headline inflation has since risen back in line with the euro area, for the first time in many years, core inflation is persistently below the euro area average, even for services. The higher price flexibility may well reflect the strong deregulation of product markets of recent years. With rising labor costs and declining prices however, profit margins have been squeezed and bankruptcies have surged.

Figure 10.
Figure 10.

Spain: Inflation

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

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

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

11. Private sector imbalances have begun to correct, though debt levels remain high. Over the last decade, Spanish household and corporate indebtedness grew at one of the fastest rates in the EU. Household and corporate indebtedness reached about 210 percent of GDP in 2009, significantly higher than the euro area average of around 160 percent. A sharp correction has started, as households became net lenders and companies substantially reduced their net borrowing (see Annex). The private saving rate jumped to 25 percent of GDP, well above the euro area average, and private investment fell markedly (Figure 11). Corporate deleveraging has been most intense in construction and real-estate companies, but overall debt levels remain high compared to the euro area.

Figure 11.
Figure 11.

Spain: Balance of Payments

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Sources: Eurostat; Bank of Spain.
uA03fig08

Private sector indebtedness

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Source: Eurostat.
uA03fig09

Private Savings

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

uA03fig10

Investment

(percent of GDP)

Citation: IMF Staff Country Reports 2010, 254; 10.5089/9781455202836.002.A003

Source: WEO.

12. External imbalances narrowed sharply. As the increase in private sector net savings outweighed weaker public sector savings, the current account improved sharply. This was reflected in the trade balance improving significantly, largely through declining imports and falling oil prices (Tables 5 and 6). The adjustment in the current account is likely to be largely structural, reflecting the unwinding of the housing boom and a return of private saving rates to more sustainable levels (in addition to a strong precautionary component). More recently, however, the current account balance has begun to stabilize, as import growth picked up.

Table 5

Spain: Balance of Payments

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

Spain: International Investment Position, 2003–09

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Source: Bank of Spain.