Statement by Mr. Ramon Guzmán, Executive Director for Spain

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.


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.

We thank the staff for the work put into the Report. While we broadly share the staff’s analysis, most of the policy recommendations have somehow been overtaken by the response of my authorities to the crisis, with bold and ambitious measures that had been under preparation for months and were adopted within weeks of the consultations. These measures aim at returning to a sound fiscal position and at unlocking potential growth through structural measures in both the factor and product markets. Financial sector restructuring and the labor market reform are crucial steps already adopted, but also products and services markets have been under thorough reform. We would call the attention of the Board towards the Update Supplement and to Section 2 below.

1. Background

For more than a decade, Spain experienced a period of strong growth during which the economy developed substantial imbalances; namely, the overall level of debt of households and corporate sectors (linked to a large extent to the real estate boom) and persistent large current account deficits. Euro adoption in 1999 eliminated the currency risk and brought unprecedented low levels of real interest rates. European savings joined domestic savings to finance a buoyant private demand, also fueled by higher disposable income, intense job creation and consumer and business confidence.

It is relevant to underline that the increase in the indebtedness of the Spanish economy was essentially a private sector phenomenon. Spain adhered strictly to the European (SGP) public deficit and debt limits. By 2007 public debt was 36.1% GDP (well below EU average) and Spain presented a 2.2% GDP surplus.

Banks tapped European savings to finance credit growth through the securities markets. However, a sound regulatory framework kept risks at bay; provisions—including a countercyclical generic buffer—were roughly four times higher than in other EU banking systems; off-balance sheet vehicles were banned out of the banking landscape and lending standards did not universally relax (NPL in mortgages are still today below 3 percent).

The correction of the imbalances started in 2006–07, albeit in a gradual manner, induced by the combination of rising interest rates and stronger European demand. When the central scenario was that of a soft landing, the international financial crisis triggered a credit squeeze and delivered a shock to private sector confidence that accelerated the correction and caused a severe economic downturn. The economy adjusted mainly in quantities. Construction sector activity plummeted. The inefficiency of the Spanish labor market produced unemployment at the same speed as it produced employment during the boom. The downturn hit especially those under fixed-term contracts and those involved in the construction industry. Consumption and investment also adjusted severely. However, inflation also turned negative for a brief period, for the first time in decades.

Banks resisted the first impact of the crisis without government support (with the exception of some liquidity and funding facilities put in place during the first stages of the turmoil) although uncertainty about the length and depth of the downturn compelled the Government to initiate the restructuring of the sector. Some weaknesses gradually appeared, mainly linked to the Cajas. The Spanish savings banks suffered from a relatively high exposure to Real Estate and, given its legal nature, a more limited access to capital markets.

The sound initial fiscal position also helped the economy weather the initial phase of the crisis. However, the fall in tax receipts and the increase in transfers via unemployment benefits took the deficit to unexpectedly high levels (11.2 percent of GDP at end 2009). Part of the deficit originated in the stimulus measures adopted to mitigate the impact of the crisis as part of the EU/G20 coordinated response.

The management of the Greek crisis failed to prevent contagion to other European countries. In January 2010, Spain announced fiscal measures redoubling efforts to consolidate, already within the restrictive envelope of the 2010 Budget. Also, in January, the Government launched the pension reform debate and challenged unions and business federations to reach agreement on a reform of the labor market in six months. Tensions in financial markets continued to increase. Ultimately, in the weeks immediately after the European Council Decisions of May 9th (creation of the EFSF in the wake of the approval of the Greek package) my authorities multiplied their efforts to stabilize market perceptions and to support the incipient recovery.

2. Recent Policy Measures

Fiscal measures. The first priority was to reassure markets on the commitment of the Government to fiscal sustainability. On May 20th Parliament approved a package of fiscal measures to guarantee the accomplishment of the 3 percent deficit target by 2013. The measures reverse the stimulus package put in place during 2009 and deliver further structural adjustment, altogether adding 1.5 cumulative percentage points in 2010 and 2011, to the initial consolidation plan. The measures are bold; they imply significant cuts in wages (applicable to all levels of Government), pensions, public investment and other current expenditures. The deficit is projected to fall from 11.2 percent to 9.3 percent of GDP by end 2010, and to 6 percent of GDP by end 2011. The package effectively frontloads 60 percent of the total adjustment in the first two years of the consolidation period (2010-2013).

On June 15th the Fiscal and Financial Policy Council—that coordinates fiscal matters with the regions—unanimously agreed on the fiscal targets for the regional governments for the period 2010-2013. Moreover, the agreement with the Regions contemplates a significant tightening of the budgetary discipline framework, with bi-annual evaluations linked to the adoption of additional measures and/or to debt authorizations. An explicit prohibition to municipalities to raise debt in 2011 has also been introduced. Finally, on June 16th the Government approved the expenditure ceilings for 2011 (with a 7 percent reduction on preceding budget ceilings).

The fiscal policy is designed around its deficit targets and is independent of the macro scenario. Monitoring will detect slippages due to lower growth and additional measures are prepared and will be implemented if the 6 percent or the 3 percent targets were at risk. Any excess receipts will not be used to increase expenditure.

Last but not least, a comprehensive pension reform is underway in the context of a special parliamentary Commission. The Government has tabled a proposal based on a gradual increase of the retirement age (to 67 years), on strengthening the relationship between contributions and benefits, and possibly including an adjustment of other parameters of the current system. This reform will be finalized in the next few months and will constitute a decisive step to guarantee the sustainability of the pension system and a significant improvement of the long-term fiscal outlook.

Labor market reform. The second challenge was to reform the labor market in order to unlock growth potential. Again, the staff report and update describe the main issues. Let me emphasize that the two key objectives are a) to foster the flexibility of firms, both in terms of wages (effectively allowing for the opt out clauses to function) and working conditions and, b) to reduce the duality in the labor market by generalizing the use of an indefinite contract with 33 days wages per year of service as termination payment (currently 45) and by providing legal certainty and a less burdensome process for the firing of workers on economic grounds.

The measures approved represent a significant break with years of inaction and point in the right direction as staff highlights. As with any structural change, its effects will be felt only over a period of time, but my authorities are confident that the newly awarded flexibility will serve the companies well in adjusting to competition, ultimately facilitating the shift of resources towards the tradable sector from less productive activities.

Financial sector. Finally, the consolidation process of the financial sector under the FROB (Fund for the Orderly Restructuring of the Banking sector, launched in June 2009) was finalized. The FROB avoided a widespread recapitalization and addressed the problems of banks individually and minimizing costs for the taxpayer. The process has ended with 92 percent of the Cajas sector assets (39 out of 45 Cajas) involved in merger operations. This process will imply a 15 percent reduction in personnel and a 25 percent reduction in terms of branches, significantly reducing capacity and triggering synergies that will help get credit flowing back into the economy.

As the consolidation process went on, lingering doubts about the health of the sector centered on bank’s exposure to Commercial Real Estate (CRE). In April 2010, GFSR and BoS stress tests took into account this exposure and concluded that, even in the most severe scenarios, losses would be contained and FROB resources would comfortably cover them. My authorities have since promoted the publication of stress tests, on a bank by bank basis, in order to restore the credibility of the robustness of our financial system. Pending details on common assumptions and methodologies, the BoS has already committed to this publication in the context of the European wide stress tests, probably on July 23rd.

Looking beyond the short term, the Government approved the Reform of the regulatory regime of Cajas, on July 9th. Basically, this reform aims at facilitating the transformation of Cajas into banks (by delinking the banking business from the consolidated and merged Cajas) with total independence from the former governing bodies, professional management and subject to capital markets discipline. A number of small, vocationally local, Cajas might be allowed to retain their legal statute, but the regulatory burden will be tailored to carefully balance their capitalization capabilities and business models.

3. Outlook

While we agree on the thrust of Report, our analysis is more optimistic on the pace of the recovery. Differences of view merely qualify the challenges facing the economy and impact on the speed and specific shape of the adjustment looking forward, but do not imply differences on the broad diagnosis, neither on the policy mix necessary to facilitate recovery:

Real Estate Sector downsizing. The necessary price correction in housing might be overestimated. Demand for housing services or for housing as a store of value has proven a consistently sound investment; NPLs in mortgages are below 3 percent which hints at non-speculative factors behind demand (population dynamics, size reduction of households). However, supply outgrew demand in 2006 and 2007 and the stock of unsold houses, estimated at 700,000, will start to shrink in 2010, but still limits residential investment that will remain negative in 2010 and 2011. The length and speed of this adjustment is crucial for the economy; my authorities estimate that within two years trend demand will absorb the accumulated inventory.

Speed of deleveraging. A close up picture of the Spanish private sector’s indebtedness reveals important facts concealed beneath the averages. In the corporate sector, leverage is essentially a problem linked to the Real Estate boom. Credit to Gross Value Added for the Construction and Real Estate sector reached 439 percent in 2009, while it is a mere 62 percent for the rest of the non-financial corporations, not far away from the 53 percent average in the Euro Area. All in all, gross savings rates and net borrowing to GDP rates of non- financial corporations prove that the deleveraging process of Spanish firms is well underway.

Also household deleveraging might prove faster than what staff anticipates. Households financed their housing investment with bank debt and in doing so increased their real wealth and reduced their housing expenses. If residential rent payments are taken into account, debt service relative to income is moderate, while interest rates remain at historically low levels (96 percent of mortgages at variable rates). Moreover, as the staff points out, households’ savings ratio has jumped to unprecedented levels making deleveraging compatible with moderate consumption growth [especially non-durables and services].

Competitiveness of the Spanish economy. Over half of the investment that took place in the run-up to the crisis did not go into construction, or into real estate. ‘’Asian’’ rates of investment helped modernize the capital stock and the infrastructures of the economy. Price competitiveness indicators tend to overestimate cost and inflation factors as the engines behind our current account deficit, and conceal the well-known dual inflation problem in the Spanish economy (export prices do not rise as those of non tradable). If it is probably true that the ongoing reduction of costs vis-à-vis the rest of the world would contribute to the rebalancing of our growth model, it is easy to exaggerate the degree to which it is necessary in the overall adjustment of the economy. My authorities do not foresee a drastic deflationary process looking forward.

To sum up, my authorities have embarked in an ambitious package of measures to put in place the necessary conditions to facilitate the rebalancing of our growth and to trigger the recovery. However, progress will not be possible unless financial market conditions stabilize. While the measures adopted, per se, should have a positive impact on consumer and investor confidence, and increase aggregate demand, we are also fully aware of the importance of the recovery within the EMU and the EU more broadly, and of the importance of fiscal consolidation and banking sector recovery at the European level.

Spain: 2010 Article IV Consultation: Staff Statement; Staff Supplement; Staff Report; Statement by the Executive Director for Spain; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund