We thank staff for their work and their comprehensive set of papers. This Article IV, together with the recent FSAP, comes at a decisive moment for Spain. Authorities are fully aware of this situation and are acting decisively to reduce the uncertainty in the financial sector, strengthen the fiscal accounts, boost growth, and fight unemployment. Consequently, most of the recommendations in the Article IV report are already being implemented, as noted in the staff’s supplement (SM/12/183 sup.2) that describes the most recent measures and significantly alters the staff’s appraisal. This notwithstanding, authorities will stand ready to adopt additional measures as necessary. Moreover, they are working hand in hand with their European partners to face both domestic and Euro Area challenges.

The imbalances of the Spanish economy—mainly the debt overhang of the household and corporate sectors associated to the real estate bubble—accumulated over a long period of high domestic demand and credit growth, were crudely exposed by the crisis. Throughout the last months, the Spanish government has embarked on a comprehensive plan that encompasses a very intense fiscal adjustment program and bold financial and structural reform processes.

The outlook is certainly challenging, as the correction of imbalances is hindered by an economic context defined by global economic risks and uncertainties, acute market stress, and widespread lack of growth. Nevertheless, the current strategy, together with appropriate actions at the European level, has the potential to rebuild trust and get the Spanish economy back on a sustainable growth path—supported by the dynamism of the external sector.

The strategy mentioned above relies on three main areas: financial sector, fiscal accounts, and structural reforms. To address one of the main sources of uncertainty, the government has acted decisively to reform and reinforce the financial sector. Over the last five months, two Royal Decree Laws were enacted raising regulatory demands on banks’ provisions and capital buffers. Beyond that, the measures included in the recently signed Memorandum of Understanding on Financial Sector Policy Conditionality (MoU), in the context of the financial assistance granted to Spain by its European partners, will constitute the backbone of the Spanish financial sector reform program until its completion (as explained in the supplement). Fully in line with the recommendations of the recent FSAP and the Art. IV report, the policies contained in the MoU have the overarching goal of restoring confidence in the financial sector by strengthening the resilience of individual institutions and the soundness of the general framework.

In dealing with institutions, the first step is the evaluation of their individual capital needs to be finalized in September. This stress test assessment, together with an asset quality review, is being conducted by independent consultants—whose work is being monitored by the Spanish authorities, the European Commission, the ECB, the EBA and the IMF. All entities in need of more capital will have to present recapitalization plans to be jointly approved by the Spanish authorities and the EC. In the case of banks requiring public funds, this approval—and the launching of the subsequent recapitalization or resolution processes—will have to be ready by year-end. Banks that do not need public support will have, as a maximum deadline, until June 30, 2013 to raise the necessary capital from private sources. All institutions requiring public funds will have to (i) remove impaired assets from their balance sheets by transferring them to an external Asset Management Company that will be operational by November, and (ii) require burden sharing from hybrid capital and subordinated debt holders after allocating losses to shareholders.

In order to increase the soundness of the regulatory framework, Spanish authorities will request, from December 31, 2012 onwards, a minimum Common Equity Tier 1 ratio of 9 percent for all credit institutions. At the same time, the regulatory framework will be reviewed and improved in the areas of loan-loss provisioning, credit concentration, governance (mainly of former saving banks and the commercial banks controlled by them), and transparency. Regarding the supervisory framework, the internal procedures and operational independence of BdE will be strengthened by acquiring the sanctioning and licensing powers currently held by the Ministry of Economy.

The above description of tasks, to which the Spanish authorities are fully committed, is not exhaustive but provides an idea of its comprehensiveness and the importance attached to the culmination of the financial sector clean-up process. The latter will not only contribute to regaining confidence, but will also facilitate the restoration of the normal flow of credit to profitable enterprises and, therefore, contribute to the return to growth and the reduction of unemployment.

Turning to the fiscal area, last December authorities reacted to the 2011 slippage by announcing a package aimed at yielding a 1.5 percent of GDP consolidation—8.9 billion euros in expenditure reductions, and 6.2 billion euros from increased revenues. However, as for the financial sector, last few weeks have witnessed the adoption of very important measures in the fiscal front that have altered staff’s original appraisal. First, on July 10^th, the Council of the European Union issued a set of recommendations to which Spain is fully committed. Again along the lines of the IMF’s advice, the essential elements of the current fiscal strategy are the new extended deadline (2014) for the correction of the excessive deficit and the corresponding smoother deficit reduction path—expressed both in overall targets (6.3 percent of GDP in 2012, 4.5 in 2013, and 2.8 in 2014) and in terms of structural yearly improvements (2.7, 2.5, and 1.9). In order to achieve these targets, Spain will also adopt a detailed multi-annual budget plan for the foreseen period.

Second, the government has recently adopted a substantial set of additional fiscal consolidation measures. Once again in line with the suggestions included in the report, the main building blocks are (i) the increase in VAT—by substantially raising rates and widening the basket of goods to which the highest rates are applicable—and the tobacco excise tax; (ii) the elimination of the mortgage income tax deduction; and, (iii) the reduction in the public sector wage bill. Additional measures include a further cut in ministerial spending of one billion euros, a 20 percent additional reduction in the financing of political parties, unions, and business organizations, the streamlining of active labor market policies, and steps aimed at guaranteeing the sustainability of the social security and dependency long-term care systems. Moreover, the Budget Stability Law enacted in February enshrines the principle of budget balance and sustainability at all levels of government. This normative instrument contains new powerful instruments to control budgets and its forceful implementation will be crucial. In applying this Law, the Ministry of Finance has recently set in motion the warning procedure for those regions in risk of breaching annual targets. At the same time, the Council of Ministers approved, on July 13^th, a centralized fund to support the financing of regions, subject to reinforced fiscal conditionality.

The reform of the public sector is also being boosted by a large number of measures that are already being carried out. Their goal is to increase the efficiency and to streamline the range of services provided. The main lines of action include the elimination of overlaps and duplicities, clear definition of responsibilities and allocation of functions among government levels, budget control, reduction in the number of elected public officials and capping of their wages.

All these fiscal initiatives will have a significant impact on public debt trajectory, as analyzed in the supplement. The public debt level will stabilize within the forecast period, even if the total amount of the European assistance for the financial sector is included, as staff conservatively assumes.

The Spanish authorities are also very aware of the need and importance of structural measures. They will play a key role in fostering sustainable growth, correcting internal and external imbalances, and boosting the competitiveness and flexibility of the economy. We broadly share the staff´s analysis of the well documented problems of the Spanish labor market. We also concur with the positive assessment of the February labor reform and its potential to reduce the excessively high rate of unemployment. This will be done by addressing the two main factors that make this market dysfunctional: duality and rigidity in wages and employment conditions. Implementation is of the essence. Preliminary data on the latter is positive: collective agreements signed in 2012 have led to wage moderation, opt-out clauses are increasingly being used, and severance payments for collective dismissals have decreased.

On other structural fields, authorities are also introducing improvements. The recently announced measures include, beyond labor market reform, a number of actions that will contribute to making the Spanish economy more flexible and competitive. Among others, reforms are focused on the energy sector, the service sector—particularly professional services—shopping hours, commercial distribution, and the transport sector.

All in all, the Spanish authorities have been proactive in the adoption of measures throughout the crisis, with a significant intensification in recent months. The actions already taken and the ones to be adopted in the future will decisively contribute to the improvement of the economic situation. The Spanish authorities remain committed to their forceful implementation. Nevertheless, ultimate success will hinge also on continued progress at the European level in strengthening the currency union and in reducing stress in sovereign debt markets.