Staff Report for the 2012 Article IV Consultation

The Spanish economy suffered an unprecedented double-dip recession with the rising unemployment and public debt situation. Spain also suffered a reversal of private external financing flows in 2011 and 2012. To counter this situation, major policy actions have been taken in the banking sector. The fiscal framework has been improved, and a scheme for clearing subnational arrears has been established. The Executive Board emphasized the need for sustained efforts and a medium-term strategy for structural reforms and financial sector restructuring.


The Spanish economy suffered an unprecedented double-dip recession with the rising unemployment and public debt situation. Spain also suffered a reversal of private external financing flows in 2011 and 2012. To counter this situation, major policy actions have been taken in the banking sector. The fiscal framework has been improved, and a scheme for clearing subnational arrears has been established. The Executive Board emphasized the need for sustained efforts and a medium-term strategy for structural reforms and financial sector restructuring.

Context and Outlook

1. Imbalances accumulated over the long boom years are gradually being unwound while the economy faces considerable stress. Spain is facing mounting market pressure and costly market access, with possibly negative repercussions for the rest of the Europe, amid the longer-term challenge of unwinding imbalances that built up during several years of excess private sector spending. This unwinding is occurring as the economy enters an unprecedented double-dip recession with unemployment already unacceptably high, public debt increasing rapidly, and segments of the financial sector lacking capital and market access. The center-right Popular Party won an overall majority in the November general election and took office in late December with a strong mandate for consolidation and reform.

2. The new government has taken prompt action on a range of fronts. Facing an intensification of the euro area debt crisis, the economy falling back into recession, unemployment rising even further, bank wholesale funding drying up, and the news that the fiscal deficit for 2011 would be at least 8 percent of GDP rather than the 6 percent of GDP targeted, the government responded with a number of major policy actions:

  • Banks. Provisions and capital requirements have been raised, independent valuations commissioned, the fourth largest bank is being restructured, and a credible backstop provided with support from Spain’s European partners. The government adopted a pro active approach to the FSAP and committed to draw on its findings rapidly.

  • Fiscal. A package of measures was introduced in December, an ambitious 2012 budget was introduced, the fiscal framework significantly improved, and sub-national arrears are being cleared.

  • Labor. A profound labor reform was enacted in February.

3. After an LTRO-led respite, market tensions re-emerged in the Spring and the government sought euro area financial support:

  • Successive 3-year refinancing operations by the ECB in December and February saw a particularly large take up by Spanish banks, which helped relieve concerns about bank funding and allowed them to increase their purchases of government bonds. However, banks access to capital markets remained virtually shut and gross ECB borrowing rose to €343 billion (around 9 percent of total assets) as of end May. Including staff estimates of SMP purchases, the Eurosystem held claims on Spain of close to 40 percent of Spanish GDP as of end May.

  • Spain has suffered a sharp reversal of private external financing flows in the second half of 2011 and early 2012 (Box 1). Once the LTRO effects subsided, this pressure was reflected in spread over German bunds hit euro era highs. The 10-year bond yield differential with Italy also reversed, moving from a peak of almost 200 bps in December in Spain’s favor above 90 bps in Italy’s favor as of early July, although correlations remained high. The sovereign and banks also have suffered multiple-notch downgrades from rating agencies and LCH Clearnet has increased the margin requirements on banks using Spanish government debt as collateral in repo operations. Downgrades and increased spreads have also led to much costlier market access for large corporates.


Spain: Uses of 3-Year LTROs

(Billions of euro; Absolute change: November 2011 - March 2012)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Banco de España; Ministerio de Economia y Competitividad; J. P. Morgan; and IMF staff estimates.

In early June, the government announced its intention to request European financing for bank recapitalization, which was welcomed by the Eurogroup, for up to €100 billion, with further strengthening of the planned financial assistance at the Euro area summit of June 29 (Box 2).

Spain’s External Financing

Over the past decade, Spain’s current account deficits had been financed by private capital inflows: this came to a sudden stop in 2011. While recent years had witnessed increased reliance on Eurosystem refinancing, private flows had remained the dominant source of funding. Even in 2010, the spike in ECB borrowing had been mostly temporary, and portfolio repatriation by residents had played a key role. By contrast, in the second half of 2011 and early 2012, net private capital outflows have been persistent. The resulting financing needs, which greatly surpass current account financing needs, have been covered for a limited part by ECB intervention in the bond market (through the SMP), and to a larger extent by a surge in bank refinancing with the Eurosystem.


2011 Current Account Deficit and Private Outflows Financed by Eurosystem Borrowing

(percent of GDP)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Source: Bank of Spain.

At the end of 2011, both gross external debt and the net IIP were broadly unchanged in magnitude compared to a year before. However their composition had shifted significantly toward less portfolio assets and liabilities, and increased Bank of Spain liabilities to the Eurosystem.

Staff projects a gradual decline in reliance on ECB financing. In the central scenario, ECB financing would not drop markedly before maturity of the 3 year LTROs and would still amount in 2015 to about half current levels. A moderate decline in private sector reliance on external financing would be compensated by external asset drawdown. Alternative scenarios include:

  • A resumption of private capital inflows combined with continued foreign asset drawdown, would allow ECB refinancing to be paid down by 2015.

  • If foreign investors were not to rollover any of their portfolio holdings of Spanish government and bank debt as they mature, reliance on ECB financing would increase and foreign asset drawdown would accelerate.

  • If private capital outflows were to continue at the same pace that was seen over the second half of 2011, non-resident holdings of Spanish government debt could soon drop to zero. ECB refinancing would further rise.

Spain’s request for Euro Area Financial Assistance to Recapitalize the Banking Sector

Purpose. On June 25, the Spanish Government formally requested financing from euro-area Member States for the recapitalization of its weakest financial institutions. The Eurogroup has welcomed the request. Financial assistance will be provided by the EFSF until the ESM becomes available, and would then be transferred to the ESM without gaining seniority status. The assistance is intended to backstop all possible capital needs estimated by the diagnostic exercise commissioned by the Spanish authorities from external evaluators. The envelope of up to €100 billion defined by the Eurogroup is intended to cover currently estimated capital requirements with an additional safety margin.

Process. Following the formal request, an assessment that eligibility conditions for access to an EFSF/ESM financial assistance for the re-capitalisation of financial institutions were satisfied was provided by the European Commission. In liaison with the ECB, EBA and the IMF, the Commission has also prepared proposals for financial sector policy conditionality that will accompany the assistance. Once agreed, a MoU will be signed by the Spanish Government.

  • Amount: The specific amount will be determined based on the ongoing bottom-up assessment of individual institutions.

  • Conditionality: The Eurogroup considers that the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector.

  • Commitments: Spain’s European commitments under the excessive deficit procedure and with regard to structural reforms, with a view to correcting any macroeconomic imbalances as identified within the framework of the European semester. Progress in these areas will be closely and regularly reviewed in parallel with financial assistance.

  • Disbursement: The FROB, acting as agent of the Spanish government, would receive the funds and use them to recapitalize the financial institutions concerned. The Spanish Government will retain the full responsibility of the financial assistance. Assistance provided as a loan, as opposed to direct equity stakes, will increase Spain’s general government debt in gross terms. When a single supervisory mechanism for banks in the euro area, involving the ECB, is established, the ESM could have the possibility to recapitalise the banks directly via a new instrument.

Role of the Fund. As indicated by the Eurogroup, the Commission will continue to liaise with IMF (as well as the ECB and EBA) for the preparation of the forthcoming assessment of capital needs. The Eurogroup has also invited the IMF to support the monitoring of the financial assistance with regular reporting. To that effect, Spain will request technical assistance from the IMF.

4. The economy has entered an unprecedented double-dip recession with unemployment surging over 24 percent. The modest recovery from the 2008–09 crisis gave way to a new slowdown in the second half of 2011 as financial tensions rose. By the end of the first quarter of 2012, real output was some 3 percent below its 2008 peak, similar to Italy. Unlike France and especially Germany, output has not recovered its pre-crisis level (though it has when excluding construction). Private consumption and investment led the downturn and domestic demand is almost 13 percent below its 2007 peak. Recent wage moderation proved insufficient to arrest the pace of job losses, and Spain has net emigration for the first time since the early 1990s. Credit is declining and house prices are falling at an increasing rate. An inflation differential with the euro area has opened up while net exports are cushioning the fall in activity.


Real GDP for Selected European Countries


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: IMF, World Economic Outlook.

Net Migration Flows in Spain, 1960-2011


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: FEDEA.

Wage Costs and Unemployment


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Source: Ministry of Labor and Immigration: Eurostat: and INE.

Unemployment Rates


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

5. Income inequality and poverty are on the rise, especially among the young, reflecting labor market developments. Spain suffered one of the worst absolute deteriorations in income distributions since the crisis, mainly due to unemployment, though additional income support provided by informal occupations may have provided a limited buffer. In a dual labor market, the income gap between workers with permanent and temporary contracts further widened, with now close to three quarters of temporary workers in the bottom half of the income distribution. Around half of all youth are unemployed, a third has dropped out of school, and those who have jobs are largely on temporary contracts.


Impact of Financial Crisis on Income Inequality, 2007-2010

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: INE, Eurostat, and IMF staff estimates.

Share of Workers in Lower Half of Income Distribution by Type of Contract


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

6. Private sector imbalances are large but diminishing with deleveraging underway. The trade balance was a bright spot. In 2011, exports were higher than their pre-crisis level at 30 percent above trough. Imports fell more than domestic demand, helping the current account deficit narrow to 3 ½ percent of GDP. The household savings ratio declined back towards pre-crisis levels in 2011 amidst weakening disposable income and housing investment. Nonfinancial corporate sector balance sheets continued to strengthen and the sector is now a net lender to the economy. However, this also reflects the lack of investment and access to finance of many businesses. Large corporations that had access to the financial markets now find it increasingly difficult and SMEs are constrained in their access to bank finance. House prices have fallen by some 30 percent since the peak and construction investment is back to its 2000 level, representing 10 percent of total value added.


Real GDP and Construction


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Source: Eurostat; IMF, World Economic Outlook.

Exports of Goods and Services

(Index of Volumes, 2005=100)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

7. But stock problems are little improved. While the current account deficit has narrowed sharply, the net external position has only stabilized at a very high level. Private sector debt remains high. House prices are still overvalued, potentially by a significant margin. The large stock of unsold housing has little diminished, which suggest that while investment in construction may be at historical norms, a substantial period of “undershooting” may be necessary, as inventory effects are poorly captured by traditional models of overvaluation.

Spain: Estimates of House Price Overvaluation 1/


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Average of house price measures, i.e. house price-to-rent ratio, house price-to-income ratio, affordability index, etc.

A. Outlook2

8. The outlook is very difficult. Large fiscal consolidation is planned and unavoidable. Coupled with high unemployment and household and corporate deleveraging, this will continuously drag domestic demand and dampen underlying inflation. Output will likely decline this year and next, and over the medium term the effects of fiscal consolidation will have to be fully factored in. Potential output growth is also projected to turn negative reflecting high structural unemployment and a permanent decline in capital accumulation. But with an assumed gradual easing in financial conditions and an eventual improvement in the labor market (aided by the labor market reform), employment, private consumption and fixed investment are likely to recover modestly. Net exports are expected to continue to contribute positively to growth, with exports projected to maintain their world market share and the current account moving into surplus over the medium term. By 2017, however, real GDP would have only just surpassed its 2007 level (real domestic demand would be some 9 percent lower) and unemployment only have fallen to 20 percent.

Spain: Real GDP Growth Projections


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Spain: Staff Medium Term Outlook--Baseline Scenario

(percent, unless otherwise indicated)

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Sources: Eurostat; and IMF staff projections.

Contribution to growth.

As percent of potential GDP.

9. Private sector credit will likely contract further for the next few years. Although ECB liquidity support has alleviated bank funding pressure, private sector credit is expected to shrink by about 5 percent in 2012 and continue to decline until 2014. By 2017, the deleveraging process would bring down private sector credit to about 140 percent of GDP. Deposits would decline gradually in 2012–13, in the wake of a weak economy. The loan-to-deposit ratio would be lower-decreasing only marginally wholesale financing needs—but at a high level while it converges to the euro area average.

10. Structural reforms could lead to a much improved medium-term scenario (Box 3). If properly implemented and accompanied by other measures, the recent labor market reform could lead to a substantial reallocation of resources towards more dynamic sectors. This could boost the level of potential output by 4–5 percent by 2017 and bring unemployment down by an additional 3–4 percentage points by 2017 (though at above 15 percent would remain high). New jobs would center in more knowledge-based and tradable sectors.

Structural Reforms and Medium-term Growth

Structural reforms focusing on the supply side and leading to labor reallocation could boost potential growth and employment by 4 percent over 4 years. This upside scenario builds on the announced reforms (centered on the recent labor market reform) for 2014 and beyond. Reallocation towards more productive and profitable sectors is assumed to bring about a moderate increase in the capital-labor ratios of the targeted sectors and the entire economy, boosting growth potential even without any additional positive contribution from TFP.

The upside scenario for employment reverts price misalignments accumulated during the boom years. Construction, real estate activities, and the housing-related part of financial intermediation contributed over a third of 2001–07 growth but their contribution will shrink or disappear in 2014–17. The upside scenario mimics a sectoral pattern of recovery after the early 1990s recession resuming the pre-crisis long-term trends in agriculture and business services. Estimates from the literature on the degree of reallocation and frictionless (or intrinsic) employment are used to project sectoral growth. The sectors that would make the largest contribution to employment growth would be business services, wholesale and retail trade, and transport and communications.


Employment growth and sectoral contribution: Baseline and Upside Scenarios


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Eurostat; and IMF staff calculations.

To support job creation and bridge the gap between the baseline and the upside scenarios, policies should support the expansion of the tradable sector. Policies needed for this necessary reallocation include wage moderation, improved job search assistance and incentives, better integrated employment services, and more competitive domestic markets. Further reforms at the European level would increase even more Spain’s potential (IMF SDN/12/07 “Fostering Growth in Europe”).

11. But downside risks greatly dominate the outlook. Macroeconomic risks include a faster than expected private sector deleveraging and fiscal consolidation having greater than envisaged output costs. Tail risks are significant and potentially extremely costly both for Spain and Europe (Table 9).

  • Immediate homegrown risks primarily relate to a repetition of a large fiscal slippage and debt accumulation, accelerated by the recognition of contingent liabilities and higher than expected capital needs in the banking sector, and intensified funding pressure on weak banks.

  • External risks are dominated by the threat of continued capital outflows amid renewed financial market stress, focusing on sovereign/bank spillovers. Direct recapitalization of banks as envisaged by the euro area summit could mitigate these adverse effects.

  • Although both the sovereign and banks have significant buffers, materialization of these risks could threaten sovereign market access. Financing needs of the sovereign are large at 11 percent of GDP for the remainder of this year and 23 percent of GDP for next year. Given Spain’s size, financing needs and external indebtedness, potential spillovers can be large. German and French banks have considerable exposures while market correlations suggest other southern European countries could be affected.


Spanish Treasury and Bank Debt Amortization

(billions of euro)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Tesoro; and Bloomberg.

B. Authorities' Views

12. The authorities viewed the renewed market tensions as reflecting the imbalances of the Spanish economy but also flaws in Euro area frameworks. They emphasized the extent and depth of reforms adopted since the beginning of the year, their comprehensive approach to government finances and noted that although the economy has been adjusting, unwinding the accumulated imbalances would take time. They noted that the Spanish economy is becoming more competitive. The authorities saw the market risks faced by Spain as having a major Euro-area dimension and thus requiring, along with national policy actions, a Euro-area response to mitigate. They stressed that the solution to current tensions is more Europe, and that although Spain is ready to play an active part and will continue on its reform path, additional measures by Spain in isolation risk losing traction in the short term if significant Euro area-wide measures are not forthcoming.

13. The authorities broadly shared the assessment of the ongoing adjustment of macroeconomic imbalances, near-term prospects, and medium-term potential of the recent reforms. The authorities also concurred with the analysis of the challenges facing the economy over the medium-term. However, the government saw a stronger recovery starting from mid-2013 with much lower output costs of fiscal consolidation. Even in the absence of any immediate growth employment gains from reforms, the government reiterated its strong commitment to maintaining the reform momentum.

The Policy Agenda

14. Continued strong implementation of a comprehensive strategy is needed to restore confidence so that imbalances can be unwound smoothly and jobs and growth fostered. This strategy should include strengthening the finances of the government and finalizing the banking reform. The financial sector backstop allows the financing of the clean-up, restructuring, and recapitalization of the weak segments of Spain’s banking sector once and for all. But the policy plan also should include better functioning labor and product markets to support household incomes, fiscal consolidation, banks’ asset quality, and social backing for reform. The recent labor market reform offers a good stepping stone to intensify the ongoing reversal of the large misalignment in prices and wages. Gains in employment and external competitiveness will be gradual but should also be at the center of this agenda. It will be important to communicate such a package clearly and cohesively.

15. It is critical that Spain’s prospects be helped by decisive progress at the European level. There is an immediate need at the euro area level to ensure adequate bank funding and mitigate contagion. But a lasting resolution to the Euro area crisis will require a convincing and concerted move toward a complete and robust EMU, as discussed in the Euro area Article IV staff report. At their summit meeting on June 28–29, European leaders agreed upon significant positive steps to address the immediate crisis. The agreement, if implemented in full, will help break the adverse links between sovereigns and banks. These initiatives are in the right direction and will need to be complemented, as envisaged, by more progress toward deeper fiscal integration and a full-fledged banking union. A clear commitment to implement steps in this direction, in particular through an area-wide deposit insurance and resolution authority, and greater fiscal integration, with risk sharing supported by stronger governance, is essential to chart a credible path ahead.

A. Financial3

16. Spanish banks remain under pressure, though the 3-year LTROs provided some temporary relief. Bank issuance virtually stopped since mid-2011, spreads soared, and interbank tension rose. Against this backdrop, Spanish banks drew heavily from the ECB 3-year LTRO operations. Following an ECB Council decision in December 2011, the BdE, like other euro-area national banks, widened the range of collateral eligible for repo-operations; to date the use of this additional collateral remains marginal. Domestic retail deposits have somewhat declined reflecting, besides macroeconomic factors, portfolio reallocation towards more remunerative banks’ commercial papers and government securities.


Spain: Banks' ECB Borrowing and Sovereign Bond Holdings

(Percent of MFI total assets)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: European Central Bank; Bundesbank; Banco de España; Banco de Portugal; Central Bank and Financial Services Authority of Ireland; and Banca d'Italia.

17. Amid continuing asset deterioration and declining profitability, banks have strengthened capital and provisioning buffers. Nonperforming loans reached 8.7 percent of gross loans in April. Including assets repossessed from developers and households, impaired loans amount to about 12 percent of gross loans. Declining net interest income and rising cost of risk curbed banks’ profitability, despite cost-reducing policies. Spanish banks buttressed their core capital ratio from less than 7 percent in mid-2008 to about 9 percent (including state support). Most of the recapitalization has been achieved through retained profits, conversion into equity of hybrid instruments, and below-par debt pre-payments. Some de-risking of banks’ total assets has also taken place, partially reflecting the decline in credit to the private sector. Provision and specific capital buffer requirements against real estate were further increased in February and May, amounting to about 7 percent of GDP. This would bring the coverage of the total problematic portfolio to about 70 percent. In addition, banks were required to transfer real estate foreclosed assets into asset management subsidiaries.


Spain: Nonperforming Loans; Breakdown by Activity

(billions of euro; quartely data)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Banco de España; R.R. de Acuña & Asociados; and IMF staff estimates.

18. The restructuring of the banking sector has continued apace. By end-2012, ten institutions will have been resolved since 2008, with most of the costs borne by the banking industry, and the number of former savings banks reduced to 8 (from 45 at the beginning of the crisis). The number of bank employees has been reduced by 11 percent and branches by 13 percent. The authorities and the industry (via the Deposit Guarantee Fund) have outstanding funding and capital support amounting to about 9 percent of GDP. In early May, the FROB intervened the holding company of the fourth largest bank, thereby taking a 46 percent ownership in the latter.

Spain: Financial Sector Support Measures

(As of March 2012)

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Includes EUR 2.5 billion granted for the takeover of CCM and 80 percent of total ring-fenced portfolio net of accumulated provisions granted for the takeover of CAM and Unnim (maximum possible disbursement).

Bridge loan granted for the takeover of CCM.

19. The outlook for banks remains highly challenging. Further significant deterioration in asset quality is likely given the projected recession and further rises in unemployment. Deleveraging and low credit demand will sustain margin pressure, despite the benefits of LTRO related carry-trade, while the need to increase loan loss provisioning will absorb a very large share of banks’ pre-provision income. These factors will significantly reduce banks’ capacity to internally generate capital, while regulatory and especially market solvency pressure has intensified. The inter-reliance of banks and the sovereign has increased. Assuming the stability of domestic deposits, liquidity buffers appear sufficient at the system level, but collateral posted at the ECB for repo purposes is vulnerable to ratings downgrades and margin calls while asset encumbrance for some banks is high and the capacity to generate new collateral is weakening. Spanish banks also face €158 billion (medium- and long-term) debt redemption in 2012–13. Although the LTROs have provided a sizeable cushion, the phasing-out of ECB funding will likely prove problematic if market access does not improve and reliance on wholesale funding is not reduced. Indeed, liquidity stress tests in the context of the FSAP show that liquidity risk can potentially become the biggest risk should ECB support not be renewed.

20. Stress tests in the context of the recent FSAP show that while the core of the system appears resilient, vulnerabilities remain in some segments. Under the adverse scenario, the largest banks would be sufficiently capitalized to withstand further deterioration of economic conditions, while several banks would need to increase capital buffers by about 4 percent of GDP to comply with the Basel III transition schedule (core tier 1 capital of 7 percent). Important caveats are attached to these stress test results. In particular, feedbacks between banking system distress and economic performance cannot be fully captured and capital needs in these banks would be larger than this, as they would also include restructuring costs and reclassification of loans that may be identified in the recently launched independent valuations of assets. For a core tier 1 of 10 percent in the baseline scenario, the recapitalization needs would be around 5 percent of GDP. Stress tests by independent consultants hired by the authorities reported in June a potential capital need under an adverse scenario of around 5–6 percentage points of GDP. A more definitive estimate will need to await the results of the independent valuations.4

21. Recent reforms need to be followed through by a comprehensive strategy to decisively clean up the system taking advantage of the European backstop. Reforms to date, while substantial and increasingly well-designed and comprehensive, have yet to decisively clean up the system and to convince markets. The recent FSAP identifies some key reform areas, many of which are along the lines envisaged by the government. A final phase of the reforms should involve:

  • Independent valuation. The quality and transparency of the independent valuations and stress tests should be assured (the inclusion of staff of independent institutions to advise on the process is encouraging).

  • Triage. Banks should quickly be required to meet any resulting additional need for higher provisions and capital, drawing on the backstop as needed. Banks should be triaged into: (1) those that do not need support (2) viable banks that need government support, which will be provided subject to tightly-monitored restructuring plans, and (3) non-viable banks.

  • Dealing with intervened banks. The new management of the fourth largest bank should quickly present their detailed restructuring strategy and timetable. The strategy for the other intervened banks should be announced, including their restructuring plans and estimated cost of government support. Consideration should also be given to strengthening the state’s ability to manage its large stakes in a substantial share of the banking system, and to enhance its ability to eventually exit, and ideally benefit, from the sale of such stakes.

  • Using the backstop. The exact cost to the government will depend on many factors, including the results of the valuation exercise, the costs of restructuring intervened banks, and the specific strategy adopted. Even if the cost were to reach the full Eurogroup commitment of €100 billion, this would remain manageable from a debt sustainability perspective, provided the envisaged fiscal adjustment is undertaken.

  • Legacy assets. A goal of dealing comprehensively with legacy real estate assets should be announced, with options to be finalized after the independent valuations.

  • Liquidity. Banks should take full advantage of the new rules widening the range of collateral eligible for repo-operations. The BdE should streamline and expedite current procedures to facilitate the prepositioning of collateral by banks.

22. In this context, an upgrade of the banking supervision and crisis management resolution frameworks is key (Box 4). The BdE’s gradual approach in taking corrective action has allowed weak banks to continue to operate and requires, inter alia, measures to improve the timeliness and cost-effectiveness of remedial action. To this end, amendments should be introduced to allow overriding shareholders rights, the partial transfer of assets and liabilities, the allocation of losses to (left behind) creditors, the conversion of some categories of bank debt into equities, and special administrative bank insolvency and liquidation procedures. In addition, FROB should be allowed to use mechanisms more rapid and flexible than the current auction procedures to dispose of an intervened bank if systemic considerations arise.

Authorities’ views

23. The authorities largely concurred with staff’s analysis. They shared staff's view that the Euro area backstop is a unique opportunity to clean up Spain's financial sector once and for all. However, they expressed their preference, shared by staff, for direct recapitalization with European funds to help break the adverse feedback loops between sovereign and banking stress at the national level. In this respect, in follow up discussions after the mission, they strongly welcomed the Euro area summit statement and the possibility of direct recapitalizations once a single supervisory mechanism is in place. Regarding the practical implications of greater bail-in, while this would be in line with the burden sharing principles outlined in the recent European Commission directive, the authorities observed that since in Spain a high share of hybrid capital is held by retail customers, a too strict bail-in could risk triggering undesirable reactions. A large bail in program could undermine banks’ market access, including for larger institutions. The authorities also argued that ECB collateral policies are more important than Bank of Spain procedures in alleviating eventual needs for greater pools of collateral.

FSAP Main Recommendations

The economic environment increases the risks to corporate and household balance sheets and consequently, the soundness of the banking sector. However, vulnerabilities are unevenly distributed across credit institutions. Most banks appear resilient and the results of the stress test and the diagnostic analysis confirm the need to address segments of the system

Spain’s financial oversight framework is largely compliant with international standards. However, it needs to be further enhanced in some aspects; in particular, by:

  • strengthening remedial actions and sanctioning powers of the banking and securities regulators—currently shared with the Ministry of the Economy—so as to address preemptively the build-up of risks in the system;

  • providing operational and regulatory independence to the banking and securities regulators and financial-budgetary independence to the insurance and securities regulators; establishing a risk-based regulatory framework for the insurance sector and monitoring potential risk build-up in the system;

  • developing regular testing and contingency plans to further strengthening the resilience of financial market infrastructures to liquidity shocks.

Although the BdE has flexible powers to deal with weak banks, the framework should be further strengthened by putting in place a more forward-looking approach. The crisis management framework should be buttressed by widening the array of resolution tools, in line with recent international practices. And while significant progress have been made in reforming and consolidating the savings bank sector, a clear long-term strategy on governance structures needs to be designed to transform of savings banks into minority institutional investors over the medium-term.

B. Fiscal Policy5

24. The 2011 fiscal slippage was much worse than expected, underlining the challenges of fiscal consolidation at all levels of government. The 6 percent of GDP target was missed by almost 3 percent of GDP and the adjustment in 2011 was only 0.4 percent of GDP—even less adjustment than in 2010 and not due to worse macro conditions. The slippage is mainly (two-thirds) at the regional level, which did not adjust at all in 2011. But the central government and social security systems also slipped substantially. The slippage was largely revenue related, pointing to a rapid deterioration of the tax base and higher than usual elasticities, in particular for indirect taxes.

Fiscal Performance by Level of Government 1/

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Source: MHAP.

These data do not include the effect of the financing system settlement.

25. The government reacted by announcing at the end of December a package of measures of about 1½ percent of GDP. This was an emergency package effective immediately while the 2011 budget was prolonged and until the full 2012 budget was presented to Parliament in April. The package was two-thirds expenditure based with a broad-based freeze on expenditure authorizations and wages, and one-third revenue based, with marginal tax rates on personal and capital income and real estate raised progressively. New revenue measures for 0.8 percent of GDP are predominantly from corporate taxation and temporary increases in personal income tax rates. However, the package was closer to 1 percent of GDP when considering offsetting measures (such as a reinstated mortgage deduction for housing, the extension of a lower VAT rate on housing transactions and a small pension increase). Some of the measures are temporary, covering the first two years of the legislature—such as the increase in personal income tax and a revaluation of property taxes.

General Government Revenues and Expenditures

(percent of GDP)

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Source: Ministry of Finance.

26. These emergency measures were included in the draft 2012 budget, which aims for very ambitious consolidation. The initial target in the 2011 SGP for 2012 was set at 4.4 percent of GDP, but rested on unrealistic growth forecasts and the assumption of no slippage in 2011. The revised target of 5.3 percent of GDP remains highly ambitious (involving a structural improvement of some 4 percent of GDP) and could have accommodated more fully the effects of the cycle. A tax regularization program was introduced and expected to bring 0.2 percent of GDP. The expenditure adjustment entailed ministerial cuts of 17 percent on average, and is designed to be achieved through lower capital expenditures, and goods and services. In addition, the government introduced measures to cut health and education expenditures by about 1 percent of GDP, and with an impact mostly at the subnational level. The clearing of arrears at the subnational government level through the creation of a special fund, financed by bank borrowing, implies a debt increase of around 3½ percent of GDP.

27. Further substantial slippage is likely in 2012, though the adjustment could still be significant.

  • The macroeconomic framework is largely in line with staff’s, but underlying revenue weakness could be stronger than expected. Items such as social security contributions, pensions or unemployment are likely to respond more negatively to the economic outlook. Tax revenues over the first five months have been weak, in particular for VAT. The timeframe for the adjustment is short: though some measures have been implemented at the beginning of 2012, the rest of the adjustment rests on just seven months. The adjustment is very dependent on relatively large expenditure cuts at the central government level, resting essentially on capital expenditures and goods and services, with the underlying measures not fully specified. The international experience with tax repatriation programs in particular suggests significant risks of underperformance. The adjustment at the regional level seems optimistic given the very high deficits in some regions, the difficulty of adjusting their expenditure (mainly health and education) and their poor track record.

  • Staff expects an overall deficit of around 7 percent of GDP, a deviation with respect to target of around 1 ½ percent of GDP. Structural slippage should be resisted, but given the weak growth outlook, it should not be made up in a compressed timeframe. This could imply, for example, immediately taking additional measures of at least 1 percent of GDP on a full year basis to reach a 2012 deficit of about 6 ¼ to 6 ½ percent of GDP. The additional measures could usefully include eliminating some VAT exemptions, raising VAT rates (especially reduced rates) and other indirect taxes, taxing the thirteenth salary, and cutting fourth quarter capital expenditure.


Comparison: Fiscal Projections 2012-17

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

28. Achieving the medium term fiscal targets will also be very challenging, but critical for debt sustainability. Reaching a primary surplus of about 2-3 percent of GDP should allow maintaining debt at manageable levels. However, the bulk of the planned consolidation from 2013 is based on expenditure savings, many of which are yet to be specified.

  • The revenue to GDP ratio is projected in the SGP to barely rise over the period, though indirect taxes are projected to grow and social security contributions to fall after an initial increase in 2012.

  • Primary spending is projected to fall by almost 4 percent of GDP. Only a part of this reduction has been linked to specific measures (such as raising co-payments on prescription drugs and increasing class size); the bulk is to come from reviews of current spending at all levels of government and rationalization of spending responsibilities across different levels of government. The evolution of the wage bill in particular is underpinned only in part by measures that would allow a significant nominal decline over time.

  • Interest expenditure is projected to fall by 2015 as the yield on 10-year Spanish government debt is projected by the government to decline gradually to 3.7 percent. Under staff’s framework, growth would also be significantly lower than the government’s were the deficit targets to be achieved.

  • Under staff’s baseline, deficits remain high. Given the lack of detailed measures, staff projects the deficit to substantially overshoot targets and to fall gradually to only about 4 percent of GDP in the medium term. This, plus debt from bank recapitalization and financing regional arrears, would lead to debt surpassing 100 percent of GDP in the medium term.

29. Staff believes that the medium-term fiscal plan should be strengthened around three dimensions:

  • Path. The deficit path envisaged in the SGP should be less front-loaded, in agreement with European partners. The medium-term targets are broadly appropriate, but a smoother path would be more desirable during a period of extreme weakness, when multipliers are likely to be particularly large and the tax base soft, to reduce the risk of creating a negative feedback loop with growth and NPLs, which may also undermine market confidence, especially if targets are missed (Box 5). Such a smoother path should also be embedded in a prudent macroeconomic framework.

  • Composition. Given the size of the needed consolidation, no options should be ruled out. Revenue measures should play a larger role. In particular, there is considerable scope to reduce tax expenditures and increase indirect tax revenue by broadening the base and raising and unifying rates, especially on VAT and excises—actions that should be taken now. Reducing social security contributions to induce an internal devaluation is desirable, but should be contingent on first reducing the deficit (to, say, below 3 percent of GDP). The reintroduced deduction for mortgage payments should be eliminated. It is also important that the measures deliver permanent and not one-off gains (for example, there should be no further amnesties or transitory rate increases). Spending on the most vulnerable should be protected.

  • Certainty. Spending reductions are planned for the right areas. But they will take time to identify, be difficult to implement, and their yields uncertain. To give assurance that the envisaged savings will materialize, future public wage cuts to reduce the wage bill and VAT/excise increases could be legislated now and only cancelled if the revised targets are hit. Spain has privatized extensively in the past, but privatization on remaining assets should be more aggressively pursued to give upside risk to debt projections.

What is the Right Deficit Path?

The needed medium-term consolidation can either be achieved by a front-loaded adjustment or a smoother reduction over time (a third approach of a back-loaded adjustment would very likely not be considered credible by the market). Both have pros and cons. On balance, staff recommends a less front-loaded strategy than envisaged in the government’s Stability Program.

  • Front-loaded adjustment. The medium-term targets under the Stability Program imply a front-loaded adjustment path, as the deficit target for 2011 was significantly overshot, and despite the loosening of the target in 2012 to 5.3 percent of GDP (in both scenarios a slippage of 1 percent of GDP to a 6.3 percent deficit in 2012 is assumed). Based on Staff’s macroeconomic assumptions, the total improvement of the primary balance from 2011 to 2015 would be almost 10 percent of GDP, of which over 3 percentage points would be achieved in 2012. Debt would peak at 94 percent of GDP in 2014.

  • Smoother adjustment. Spreading the same primary balance adjustment more smoothly would imply higher deficits in the near term and higher debt. To stabilize debt from 2014 onwards, some degree of frontloading would still be needed, but the target of a 3 percent deficit would be pushed back by one year (a completely smooth adjustment towards the primary balance of 1 percent of GDP/year by 2014 would not allow for a stabilization of the debt). A strong adjustment of the structural primary balance of more than 2 percent in 2013 (instead of 4 percent), 2 percent in 2014 and then ¾ percent every year until 2017 would allow a smoother profile, while still ensuring debt stabilization. Debt would peak in 2014, at about 96 percent of GDP and would fall back to 93 percent of GDP in 2017. In both scenarios, and although staff made a conservative assumption to include the Eurogroup’s commitment up to €100 billion that includes an additional safety margin, there are downside risks to the debt path, through for instance the recognition of contingent liabilities.

Pros and cons. Compared to a smooth adjustment, the front-loaded strategy has the advantages of: (1) improving the deficit and debt faster, which should boost market confidence and reduce borrowing needs; and (2) possibly being more politically feasible as adjustment measures, especially if permanent, could be more easily introduced early in the legislature. The main disadvantage is that the front-loaded strategy would imply most contraction when the economy is weakest, compounding the headwinds of de-leveraging and labor market adjustment. This would likely lower significantly growth compared to the baseline (using a multiplier of ½ in the first year and ¼ in the second) and raise unemployment and non-performing loans. This could create a negative feedback loop with adjustment. This would likely lower significantly growth compared to the baseline (using a multiplier of ½ in the first year and ¼ in the second) and raise unemployment and non-performing loans. This could create a negative feedback loop with fiscal consolidation, especially if multipliers are even larger and tax bases weaker than envisaged. The benefits of a front-loaded strategy would also be lost if the targets are missed by significant margins. The smooth path could also be compatible with establishing credibility by: (1) pre-announcing fiscal measures and with the path still being front-loaded in structural terms; (2) strong action in other areas, such as labor markets (already undertaken) and banks that would allow to compensate for the drag on growth in outer years; and (3) the implementation of institutional fiscal reforms.

Fiscal paths

(percent of GDP, unless otherwise indicated)

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Source: IMF Staff estimates.

30. The fiscal framework has been significantly strengthened. A constitutional balanced budget amendment was passed in September, supported by the Budget Stability Law in February and a draft Transparency, Access to Public Information and Good Governance Law. The laws apply to all levels of government and stipulate a structural balanced budget and a debt ratio of 60 percent of GDP by 2020, with transitional requirements in the interim, and limits expenditure growth to below that of GDP. Monitoring and transparency requirements on subnational governments are enhanced, as are tools to sanction non-compliance. For example, fines can be levied, transfers withheld and, ultimately, sub-national financial autonomy removed (see Annex I). Public officials that deliberately fail to comply with the fiscal targets in the organic law can also be directly sanctioned, including removal and ineligibility for public office and loss of pensions. The center is also giving financing to sub-national governments, in return for greater conditionality (Box 6).

31. While the recent legislation has many promising elements, implementation will be key and further improvements in the fiscal framework are still necessary. It is important that the new provisions in the Budget Stability Law be fully implemented (for example, immediately warning some regions and quickly intervening if they fail to respond promptly). But the framework could benefit from further improvement, and the stronger the framework, the more likely markets would accept a smoother consolidation path.

  • While significant progress has been made in recent months, including publishing quarterly regional government outturns in national accounting terms for the first time, greater fiscal transparency is essential. For example, providing monthly consolidated general government accounts on a cash basis within six weeks. Regional budgets, fiscal plans and reporting should be made more homogenous and user-friendly. A durable framework for funding regional governments also needs to be established.

  • Moving to a fully-fledged medium-term budget framework with expenditure ceilings and detailing measures covering at least 2013 and 2014, alongside measures that would aid sub-national consolidation (for example by introducing savings in health spending).

  • Creating an independent fiscal council. This could, for example, analyze budgets and provide their key macroeconomic assumptions, develop comparative regional performance indicators, and conduct nationwide expenditure reviews of major programs.

The Challenge of Regional Fiscal Adjustment

Spain’s regions have recently failed to meet their fiscal targets. Poor fiscal reporting and transparency have made taking timely corrective measures difficult. Before 2012, enforcement of agreed fiscal targets was non-credible and penalties for regions that violated agreed targets or flaunted procedure went unused. Cyclical revenues (including linked to real estate) have failed since the crisis but expenditure, which is over two-thirds related to structural social categories (e.g. education and health), is yet to be significantly consolidated.


Deficit in 2011 and Target for 2012

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Even with strong efforts at the regional level and help from the central government, achieving the 1.5 percent of GDP regional 2012 deficit target is challenging. Regions began 2012 with a weighted average consolidation need of 2 percent of GDP (and some much more). Rebalancing plans were finished only in May, leaving little time for execution. Moreover, the adjustment is tilted towards current expenditure consolidation, which may be difficult given the structural nature of regional public spending. Some regions showed difficulties already in Q1 2012, for example, Navarra and Murcia reported Q1 outturns close to the 1.5 percent of GDP full-year target while Asturias had not agreed on a rebalancing plan as of mid June.

The central government is reducing structural expenditure mandates on health, education and other areas, to improve the likelihood of consolidation through two Royal Decree Laws. In health, pharmaceutical copayment has been linked to income, and a raft of rationalization measures have been introduced, e.g. requiring generics or limiting prescriptions. In education, class sizes and tuition have increased, and in both sectors, working weeks have been extended, replacement rates limited, and benefits reduced. Other measures, such as changing the public television requirements or eliminating duplicate public services and entities are in progress.

The central government has also introduced and used a number of “carrots” to induce fiscal cooperation, increase monitoring, and reach consensus on fiscal targets. The central government has taken action on its declaration that no region would default, and raised the possibility of mutualizing issuance via, for example, “hispanobonos” (central-government guaranteed debt to cover regional amortizations). Liquidity pressures were reduced by advancing transfers and extending the repayment of past revenue overpayment from five to ten years. Two financing facilities were created with favorable terms, also to be used for repaying suppliers and rolling over maturing debt. The deficit target was also relaxed from 1.3 percent in 2011 (and 2012) to 1.5 percent of GDP under the 2012 SGP.

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Check mark indicates the envisioned measure has been utilized.

But the government has also range of “sticks” which it has used less actively. The Constitutional Amendment passed in September of 2011, the Organic Law for Fiscal Sustainability and Financial Stability, and the Transparency and Good Governance Law provide several tools to increase fiscal discipline. Expenditure and debt ceilings are extended to the regions and fiscal reporting is greatly increased (including rebalancing plans, the standardization and increased content of budgets, and improved reporting fiscal outturn, including in national accounting). Deviating regions must adjust within one year instead of three and monitoring by the central government is quarterly. Warnings, penalties and the possibility for taking a region into national administration are envisioned in the law as progressive penalties for persistently deviating regions. Officials proven to have intentionally failed to comply with mandates or disregarded implementation of measures face penalties including dismissal, ineligibility for public service and loss of pension.

These sticks need to be used. In the short-run, establishing the legal mechanisms which ensure transparency and deliver consolidations is critical to ensuring success. The rebalancing plans were reportedly reviewed more stringently in 2012, which is promising. The functionality and credibility of new tools, such as warnings, non-disposition of credit decrees, and dismissal of public officials should be quickly and convincingly established. Stronger measures, such as imposing the recommendations of a delegation of experts and taking a region into national administration, should also be executed as promptly as the law permits. Ultimately, all options must be tabled to ensure the fiscal sustainability of the regions, which are now more intertwined than ever with each other and the sovereign.

Authorities' views

32. The government recognized that the envisaged fiscal consolidation is very ambitious and challenging. They concurred with staff that a smoother path of consolidation would have been preferable given the rapid deterioration of the economy. They assessed that a traditional approach to fiscal multipliers might not be warranted, as the inter-temporal effects of fiscal consolidation might differ between time periods. They concurred with the view that Spain has a low level of tax revenue and the need to take revenue measures along the path of fiscal consolidation, although they considered that legislating measures for the medium term was difficult in the current constitutional framework of Spain.

33. The authorities pointed to the significant changes in their fiscal framework and underscored their willingness to take additional measures as needed. The authorities agreed with the pressing need to bring greater certainty and transparency to fiscal outcomes at all levels of government, and particularly at the regional level. They viewed initiatives including the Fund to Pay Suppliers, the Organic Budget Stability Law and the Fiscal Transparency and Good Governance Law as strengthening transparency and fiscal control in all levels of government. The authorities, however, did not agree that an independent fiscal council would be useful, noting for example, the risk of undermining existing institutions.

C. Structural reforms

34. Spain urgently needs job-rich growth and further gains in competitiveness. Domestic demand is likely to be structurally weak for the foreseeable future and the current account deficit needs to improve further. This means focusing on policies to expand the tradable sector, raise productivity and lower costs by addressing wage-price misalignments that have developed with a decade long, credit-fuelled, boom. Though product markets require significant improvement, Spain’s main structural problems are its labor market rigidities and high unemployment, with adverse effects both on aggregate demand and potential output.

35. Spain’s labor market rigidities have resulted in highly cyclical and volatile employment. Spain suffered one of the largest falls in employment in the OECD, even though its GDP loss was mild. The negative performance of the Spanish labor market can be attributed to the following structural rigidities (Box 7):

  • Wage rigidity: Wages react little to unemployment and are more correlated to past inflation than in other OECD economies. Spain’s wage rigidity is due to collective wage agreements that are automatically extended to the whole province/industry, with very restrictive opt-out clauses and widespread wage indexation.

  • Insufficient flexibility of working conditions: Industry or region wide collective agreements restrict the ability of firms to modify working arrangements to adjust to shocks. For example, Spain’s hours worked per employee increased since 2007, when unemployment was rising, while they fell in most OECD countries.

  • High labor market duality: Spain has the largest share of temporary workers in the OECD. Workers on open-ended contracts enjoy high protection and job stability, while workers on temporary contracts have low protection and face job instability. Given the rigidity of wages and working conditions, and the high dismissal costs of workers on open-ended contracts, Spanish firms keep a large share of temporary workers and adjust to negative shocks by dismissing them. For example, temporary employment has fallen by 34 percent since end-2007 while employment in open-ended contracts has fallen only by 6 percent.


Change in GDP and Employment, 2007-11

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Source: INE.

Unemployment Volatility and Labor Market Rigidities

Empirical analysis indicates that Spain’s labor market rigidities play a large role in explaining the cyclical behavior of unemployment. A wage Phillips curve vector autocorrection equation with five variables (labor compensation, prices, labor productivity, unemployment and work hours), is used with the G7 economies as a benchmark. In comparison to the G7 economies, Spain’s labor compensation stands out for its high inertia (high responsiveness of labor compensation to a 1 percent increase in labor compensation), high responsiveness to inflation (a high increase of labor compensation in response to a 1 percent increase in inflation), and low sensitivity to unemployment (labor compensation does not fall when the unemployment rate increases by 1 percent). In addition, Spain’s work hours react little to labor market shocks. These rigidities result in large increases in unemployment in response to shocks to wages or inflation.

The recent labor market reform can significantly improve the performance of Spain’s labor market over the medium-term. This reform aims at reducing wage and working time rigidity, and if properly implemented, can substantially increase the sensitivity of labor costs to economic conditions.

36. The recent reform promises a significant improvement in the functioning of the labor market. This reform, enacted as a decree on February 2012, introduced measures that can importantly reduce labor market duality, wage rigidity and firms’ internal inflexibility. These should boost job creation over time by making wages more responsive to economic conditions, allowing firms to agree wages and working conditions according to their needs, and making firms more willing to offer open-ended contracts and step up in-job training. Most Spanish labor market academics shared the view that this is a potentially major reform. The main elements of the reform are:

  • Duality is reduced by lowering the dismissal costs of permanent workers for unfair dismissals. More importantly, the reform eases and clarifies the use of fair dismissals for firms in distress (those firms facing current or prospective losses, or a persistent decline in sales). It also reduces procedural costs and eliminates the need for prior administrative approval for fair dismissals. The goal is to make fair dismissals the regular channel to dismiss workers with permanent contracts in distressed firms, thus significantly reducing dismissal costs.

  • Wage rigidity and firms’ internal inflexibility are reduced by giving priority to firm level agreements over wider collective agreements. The reform also allows distressed firms to change working conditions, temporarily suspend contracts, and reduce working time. The goal is to allow distressed firms to adjust wages and working time instead of dismissing workers. In addition, the reform limits the automatic extension of expired collective agreements to one year.

37. The reform also introduces more targeted measures to foster employment and training, although some may have potentially limited effectiveness. The reform includes a number of measures aimed at fostering job creation for the youth and long-term unemployed, and in-job training. However, some of these measures are based on subsidies and tax breaks, which have been used in the past with little success. The measures that do seem more likely to foster job creation are the authorization for temporary employment agencies to act as private placement agencies, and the enhanced flexibility of part-time work and telework.

38. The reform’s success hinges on its implementation and further strengthening labor policies should be considered. Previous reforms have not been successful, largely as the changes were marginal and not widely used, in part, due to interpretation by the courts. The reform could also be strengthened, for example, by reducing the difference between protection for open-ended and temporary contracts to make the labor market more inclusive and by eliminating the practice of indexation and “ultra-activity”. The new flexibility options could also be better communicated to firms. And if sufficient firm-level flexibility is not quickly forthcoming (which should be transparently monitored), policymakers should prepare contingency plans, for example, by moving to an opt-in system for collective bargaining. The planned review of active employment policies is welcome and should carefully consider whether the unemployed are being given sufficient training and incentive to secure employment and whether the use of subsidies (that has proven inefficient and expensive in the past) offers the best alternative. Recent measures on fighting fraud, including on unemployment benefits, should also contribute to decreasing the size of the grey economy and strengthening labor policies.

39. Further improvement in labor productivity will be needed to increase trend growth. Since the beginning of the crisis, productivity per employee rose by 11 percent, largely reflecting labor shedding, and the working week increased by almost 3 percent. Wage growth slowed helping deflate unit labor costs. Yet, more progress will be needed for Spain to fully regain competitiveness lost during the boom years and to sustain the needed export-led recovery. Further improvement in labor productivity will have to be achieved not by means of additional layoffs but rather through the better use of resources.

40. The external position remains considerably weaker than would be consistent with medium term fundamentals and appropriate policy settings. The current account has improved significantly on the back of resilient export market shares, and Spain now has a trade surplus with the euro area. Yet because the ongoing improvement partly reflects domestic demand compression, a sizeable output gap, and labor shedding attaining full employment and strong and sustainable growth would require a significantly weaker real effective exchange rate.

  • Competitiveness indicators based on either consumption prices or unit labor costs show that the large gaps that opened up vis-à-vis trading partners since euro entry (when the current account deficit was already 3 percent of GDP) have only partly corrected since 2008. EBA and CGER model estimates still point to REER overvaluation of 10 to 15 percent (Annex V). Recent competitiveness improvements significantly reflect cyclical productivity gains from labor shedding, and a change in relative prices is the primary way to improve the external balance while closing the output gap.

  • Further structural improvement bringing about a persistent current account surplus would be appropriate to help improve the net IIP position, which would still remain very negative for many years. External debt is also too high, and is to be further increased in gross terms to the extent that the European financial assistance to bank recapitalization would take the form of a loan rather than direct equity stakes. Although projected to gradually decline over time, external debt remains a major source of external vulnerability as it generates large financing needs.

  • To improve the external position, an effective implementation of the labor market reform should bring down labor costs, while financial sector restructuring should help banks reduce reliance on the ECB. Delivering fiscal consolidation will also contribute significantly to external adjustment.


Spanish Competitiveness based on Manuf. ULC


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Source: Bank of Spain.

Spanish Competitiveness based on CPI


Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

41. Other structural reforms are necessary to support the labor reform with decisive changes in the product and service markets. The growth challenge is such that Spain should be aiming to be have one of the most business-friendly internal markets in the world. Reforms to the goods and service markets not only would help Spain to raise its growth potential, but also to accelerate its employment recovery. Reforms aimed at increasing overall competitiveness in the economy can help strengthen labor demand across all sectors, but may not be sufficient to absorb the workers shed by the labor-intensive construction sector since 2007. A cooperative solution, where workers accept greater wage moderation, employers pass on the cost savings to prices and hire, and banks recapitalize, could result in a faster reallocation of resources to dynamic sectors and a better outcome for all.

42. The government’s reform agenda is promising and needs to be rapidly implemented. Retail licensing has already been eased and the government’s reform agenda appropriately targets a common regulatory framework in all regions, boosting the rental market, liberalizing retail hours and professional services, and eliminating the tariff deficit. It would be important that these reforms are rapidly and effectively implemented – a detailed and ambitious timetable would help structure and communicate the efforts. Further reforms, such as policies to help small firms grow, deregulating the fuel sector and postal services and supporting intellectual property rights, also seem necessary to foster inclusive and job-rich growth. Establishing a clear goal, such as getting Spain into the “Top 10” list of global indices of competitiveness and business environment could help focus policy and popular understanding.

Authorities’ views

43. The government argued that the labor market reform is profound, introducing significant flexibility. They acknowledged that the reform needs time to take effect and it is too soon to assess whether it is working as planned. Still, they noted that there are some early indications that the reform is producing results. Notably, partial data for the first 3–4 months of 2012 show that wage increases in collective agreements signed during 2012 are low, the number of opt outs from industry or sectoral level collective agreements has increased, and the severance payments for collective dismissals has fallen. The authorities viewed their structural reform agenda as comprehensive, already underway, and helping to revive growth in the medium-term. They already enacted a reform removing the license requirement to start small retail businesses, a process which previously took more than six months. The authorities agreed that ongoing competitiveness gains were not sufficient, and that persistent current account surpluses would be needed to reduce external vulnerabilities.

Staff Appraisal6

44. Faced with great challenges on several fronts, the government reform momentum has been strong, with many major actions initiated in recent months. In the financial sector, provisions and capital requirements have been raised, independent valuations commissioned, and a large backstop provided with support from Spain’s European partners. In the fiscal sector, a package of measures was introduced in December, the 2012 budget is ambitious and the new organic budget and transparency laws provide for greater transparency and control over regional finances. A profound labor reform was also introduced.

45. The outlook is very difficult. The economy is falling into an unprecedented double-dip recession, with unemployment already at 24 percent, persistent capital outflows and risks of losing market access. Large-scale fiscal consolidation is beginning, private sector de-leveraging has far to go, credit is contracting, and banks rely heavily on the ECB. On the positive side, imbalances are unwinding, especially the current account deficit, inflation and unit labor costs. Wage and price realignment should be supported by the recent labor market reform. While upside risk exists, especially related to a successful implementation of the labor reform, downside risks largely dominate at this juncture. In particular, while the Euro area financial backstop and the end June Euro area summit decisions help mitigate short-term risks, market tensions could further intensify. Private sector deleveraging could also be faster than envisaged, and the fiscal consolidation may have larger than envisaged output costs.

46. Continued strong reform momentum and a clear medium-term vision are critical to restore confidence so that imbalances can be unwound smoothly and jobs and growth fostered. This strategy should be based around concrete measures to deliver the needed medium-term fiscal consolidation, and a clear roadmap for restructuring the weak segments of the financial sector. It also means better functioning labor and product markets to support household incomes, fiscal consolidation, banks’ asset quality, and social backing for reform. Intensifying the ongoing reversal of the large misalignment in prices and wages should be at the center of this agenda. A cooperative approach, where workers accept greater wage moderation, employers pass on the cost savings to prices and hire, and banks recapitalize, could result in a faster reallocation of resources to dynamic sectors and a better outcome for all. The prospective Euro area financial sector support is an important plank in this comprehensive strategy, and the recent Euro area summit decisions rightly aim to address market concerns on the implication of bank sector losses for the sovereign balance sheet, Spain’s prospects for lowering borrowing costs would be critically helped by a timely implementation of the summit decisions and continued progress towards a banking and fiscal union at the European level, and actions to support and revive growth.

47. The recent progress in the financial sector needs to be built upon to complete the restructuring. The recent FSAP helps identify some key reform areas, which include ensuring the quality of the independent valuations, supporting viable but weak banks while resolving the non-viable, and developing a comprehensive strategy to deal with legacy real estate assets. Banking supervision and the crisis management and resolution framework also needs to be upgraded in key areas. The government is to be commended for ensuring a backstop for the financial sector, which is an opportunity to help complete this task.

48. Significant consolidation efforts are in train for this year. Despite the considerable effort, the very ambitious deficit target for 2012 will likely be missed by a substantial margin. Given the weak growth outlook, however, slippage should not be made up in a compressed timeframe. Given also the lack of detailed measures after 2012, the deficit will likely fall only gradually over the medium term. This, plus debt from bank recapitalization and financing regional arrears, requires achieving the medium-term targets to maintain debt at manageable levels.

49. The medium-term fiscal plan should be strengthened. The deficit reduction path envisaged should be made less front loaded and contain specific measures. Revenue should play a larger role in the adjustment, especially indirect taxes—action in this area should be taken immediately. Greater certainty could be given to the plans by legislating now measures to take effect in the future, though the application of some could be contingent.

50. An improved fiscal framework would facilitate the envisaged adjustment. Full and proactive use should be made of new provisions to control regional government finances and the transparency of their accounts greatly improved. The budget should also become more medium-term oriented and an independent fiscal council considered.

51. Spain urgently needs job-rich growth and further gains in competitiveness. This means focusing policies to facilitate reallocation of resources towards the tradable sector and lower costs. The recent labor reform is most welcome as it has the potential to substantially improve the functioning of the labor market. The reform’s success hinges on its implementation and it could usefully be strengthened, including by improving active labor market policies. Labor reform should be complemented by delivering on the structural reform agenda in other areas—a detailed and ambitious timetable would help structure and communicate the efforts.

52. It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

Figure 1.
Figure 1.
Figure 1.
Figure 1.

Spain: Activity

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Bank of Spain; Eurostat; WEO; and IMF staff calculations.
Figure 2.
Figure 2.
Figure 2.

Spain: Inflation

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

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Eurostat; IMF staff projections based on data provided by the authorities; and WEO.1/ Excludes nonprocessed foods and energy products.
Figure 3.
Figure 3.
Figure 3.
Figure 3.

Spain: High Frequency Indicators

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

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Eurostat; and IMF staff calculations based on data provided by the authorities.
Figure 4.
Figure 4.
Figure 4.

Spain: Competitiveness

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Direction of Trade; Eurostat; and WEO.
Figure 5.
Figure 5.
Figure 5.
Figure 5.

Spain: Imbalances and Adjustments

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Banco de España; Instituto Nacional de Estadistica; MVIV; CSO; WEO; and IMF staff calculations.1/ For each country, the left column refers to 2008, and the right column to 2011.
Figure 6.
Figure 6.
Figure 6.
Figure 6.

Spain: Financial Market Indicators, 2010-11

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: Bank of Spain; Bloomberg; and IMF staff estimates.1/ Peers include Unicredit, Intesa-San Paolo, Commerzbank, Deutsche Bank, HSBC, Barclays, UBS, Credit Suisse, Societe Generale, BNP, and ING.2/ Includes Banco Popular, Bankinter, Banco Sabadell, and Banco Pastor.
Figure 7.
Figure 7.
Figure 7.
Figure 7.

Spain: Labor Markets, 1990-2011

Citation: IMF Staff Country Reports 2012, 202; 10.5089/9781475505818.002.A001

Sources: OECD; and IMF staff estimates.
Table 1.

Spain: Main Economic Indicators 1/

(Percent change unless otherwise indicated)

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

Significant policy developments occurred after this Staff Report had been issued to the Board, which are discussed in the attached Staff Supplement.

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

Based on data from IMF, International Financial Statistics. Data for 2012 refer to April 2012.

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.

Starting 2008, solvency ratios are calculated according to CBE 3/2008 transposing EU Directives 2006/48/EC and 2006/49/EC (based on Basel II). In particular, the Tier 1 ratio takes into account the deductions from Tier 1 and the part of the new general deductions from total own funds which are attributable to Tier 1.

Including real estate developers.

Sum of main and long-term refinancing operations and marginal facility.

Ratio between loans to and deposits from other resident sectors.

Senior 5 years in euro.