Economic Outlook

Growth in 2013 will still be negative, with a government forecasted rate of -1.3. Nevertheless, there are positive signs indicating that the economy will stabilize in the second part of the year. The main leading indicators point in that direction. The June PMI results for the industrial sector and for services have been 50.0 (up 1.9 points) and 47.8 (up 0.5), respectively, a level not seen since 2010. The OECD Composite Leading Indicator was 101.6 in May (up 0.3), an increase not seen since 2008. Retail sale indicators and business values indexes also support this view. According to Bank of Spain’s provisional data, q-o-q GDP growth in 2Q 2013 has been -0.1 percent, which also confirms this trend.

Consistently with this information, the government believes the projected growth rate for 2013 is prudent and within reach, and it is forecasting a positive 0.5 percent in 2014. The 2014 projection is based on a less negative contribution of domestic demand and a significant positive contribution from the external sector, taking also into account that the fiscal drag will be smaller than anticipated. The consensus forecast for 2014, among independent domestic analysts, is 0.7 and 0.3 percent if foreign analysts are included.

Going forward, stronger growth in the world economy, and particularly in the EU, coupled with persistent stability in the financial markets, will go a long way for ensuring a swifter and more solid recovery in Spain.

It is also worth highlighting the improvement in competitiveness and good performance of the external sector. In this sense, the current account adjustment has been very remarkable, with the deficit falling to 0.8 percent of GDP in 2012, from a peak of 10 percent in 2007and it t is expected to turn into a surplus of around 2 percent in 2013. Most of this correction is due to structural factors and cyclically adjusted analysis shows that it is going to continue in the future. The outstanding performance of exports has been the main driver of this improvement. Spanish export-market shares have been very resilient, despite a very difficult international context and strong competition from emerging market countries. Export competitiveness has been strongly driven by non-price competitiveness and geographic and product diversification, together with improving price competitiveness. Spain has now a trade surplus with the EU and some of its more important EU trading partners, while exports have also been diversified towards other dynamic markets.

Unit Labor Costs (ULC) have been falling significantly in past years, with their improvement intensifying in 2012 thanks to productivity gains and wage moderation. In terms of ULC, the loss of competitiveness accumulated since 2004 was already corrected in 2012.

On prices, the inflation rate has been affected by fiscal adjustment, but it is expected to decrease substantially as the effects of the VAT and certain regulated prices increase fades away. Headline inflation stood at 1.7 percent in Q2, but it will decelerate during the second half of the year to end up around 1 percent below EU average.

Confidence has also improved, as reflected in the significant reduction in Treasury yields and the fact that more that 70 percent of funding needs for this year have been already covered.

Fiscal policy

The Government is strongly committed to fiscal consolidation in order to make fiscal finances sustainable in the medium term. As a sign of this commitment, a major coordinated effort within all Public Administrations was made in 2012 to reduce the public deficit. In a year in which activity contracted by 1.4 percent, the deficit (net of one-offs related to the support of financial institutions) was cut 2 percentage points of GDP (from 9 to 7 percent). The intensity of the fiscal effort was among the highest in advanced economies, as highlighted in April 2013 Fiscal Monitor.

A wide number of tax and expenditure measures have been adopted to support fiscal consolidation in 2012 and 2013 amounting to 4.2 percent of GDP in 2012 and 3.5 percent in 2013. Its distribution between the expenditure and revenue sides has been well-balanced, with around 55 percent in expenditure reductions. All public expenditures have declined, except interest payments and social benefits, which have been driven by debt and labor market trends. Public employment has also been reduced by around 375,000 persons between 3Q2011 and 1Q2013. Steps have also been taken to increase indirect tax collection, with measures to increase VAT rates and broaden its base—Spain was the EU country with the highest increase in the average VAT rate in the EU in 2010–13—but also affecting excise duties and environmental taxes. This has led to some shift of the relative tax burden towards indirect taxes. The Government is committed to continue consolidation in the most growth-friendly manner possible.

For the period 2013–16, following the recommendations made by the Council of the European Union and in line with staff’s advice, the targets both for fiscal deficit and public debt have been modified to better adapt the adjustment pace to the current circumstances of the Spanish economy and to mitigate the downdraft of the consolidation measures on growth. The deadline to bring the deficit below 3 percent of GDP has been extended by two years. The deficit target for 2013 has been set at 6.5 percent of GDP (instead of the previous 6.3 percent). Despite the easing of the adjustment path, the fiscal effort will continue to be very significant, requiring a cumulative structural effort of 3.9 percent of GDP in the years 2013–16.

Consolidation efforts continue to yield results. The latest budget execution data published on 15 July 2013 points out that the deficit target will be met, evidenced by significant improvements recorded in all subsectors. In May 2013, the cumulative deficit and primary deficit of the Central Government were 6.5 and 14 percent, respectively, lower than the previous year. In the same period, the Autonomous Regions recorded an aggregated deficit of 0.43 percent of GDP, in line with their annual target of 1.3 percent of GDP.

Different financial mechanisms were established in 2012 to provide liquidity and financial support for the Regions and Local Entities. The Regional Liquidity Fund was created to provide affordable financing to regions under stress, linked to strict conditionality and monitoring. For 2013, this fund has been extended and broadened. A Fund for the Financing of Payments to Suppliers was also set up in 2012 to regularize arrears, influencing similar schemes in other European countries. This fund, which has been extended and is now in phase 3, is being complemented with different measures to combat late payments—over 30 days—in commercial transactions and control commercial debt, with different draft bills in preparation. These financing mechanisms, together with financial operations related to the restructuring and recapitalization of the financial sector, have contributed to the rise in public debt, which reached 84.2 percent in 2012.

Major progress has also been achieved in strengthening the Spanish budgetary institutional framework:

A new Budgetary Stability Organic Law was adopted in April 2012 to develop the constitutional fiscal rule (introduced in September 2011) and further reinforce fiscal discipline, control and transparency. This law has been instrumental in last year’s substantial deficit reduction and marks a fundamental change in the budget culture that should continue to yield fruits in the future.

On fiscal transparency, great improvements have been achieved regarding the content and frequency of budgetary reporting in all layers of government. In particular, monthly data are now published in national accounts terms for the Central Government, the Social Security and the Regions with only one and a half months delay—few other countries with similar degree of decentralization could be found with this timely publication.

An Independent Fiscal Authority is in the process of being created to monitor fiscal rules and provide analysis and advice on fiscal policy issues, including regular assessments of macroeconomic forecasts underlying the budgets and budgetary plans. The bill is currently in parliamentary approval and the authority is expected to be in place before the end of the year.

A thorough revision of the Spanish tax system is already underway to achieve a simpler and more neutral tax system that ensures sufficient revenue. An expert commission was created in early July to make reform proposals and its report should be presented by February 2014. A revision of public expenditures is also planned and is expected to follow the same approach.

In addition to these efforts, a major review of the Spanish Public Administration is ongoing to increase efficiency and avoid overlaps. A Commission on the Reform of the Public Administration presented its report in June 2013 with specific proposals and a clear timetable, and a process has been set up for their timely implementation. A reform of local entities is also in the pipeline. A draft bill has been prepared and will be adopted shortly, after the mandatory opinion of the State Council.

Further to the 2011 pension reform, a second stage of reforms is underway to ensure the long-term sustainability of the pension system. A reform of early and partial retirement was adopted in March 2013, introducing new incentives to extend working life. A revision of the basic parameters of the Social Security system is also taking place to ensure alignment to life expectancy and other demographic and economic factors. To this aim, an independent expert committee was appointed to make proposals on the design of the sustainability factor envisaged in the 2011 pension reform. Its report was issued in June and is currently being analyzed by the Toledo Pact Parliamentary Commission—the tool to reach consensus on pension matters. Based on its conclusion, a legislative proposal will follow.

Financial sector

The Spanish financial system has undergone an unprecedented and profound reform that accelerated with the financial program for bank recapitalization undertaken since July 2012 with the support of the EFSF/ESM. The aim of this reform has been to better capitalize Spain’s banking system, clean up banks’ balance sheets and reinforce the regulation, supervision and resolution framework.

The implementation of the measures contemplated in the reform has been exemplary and the ample majority of them have already been executed. According to the Third Progress Report issued by the IMF—that is providing technical assistance to the Spanish authorities and the European Commission to monitor the implementation of the reform—“the vast majority of measures specified in the program have now been implemented, as envisaged under its frontloaded timetable.” The few remaining measures will be promptly implemented by year end.

The outcome of this reform, that included the identification of capital needs through a rigorous stress test with international participation conducted last year, has been threefold: (i) regulation, supervision and resolution of the financial system has been substantially reinforced; (ii) the number of Spanish banks has been significantly reduced (from 58 to 16, excluding small and rural institutions); and, (iii) banks’ balance sheets have been cleaned up and the remaining institutions are now well capitalized and well prepared to provide credit and to withstand severe shocks.

The authorities fully agree with staff’s view that it is crucial to remain vigilant in order to preserve the hard-won solvency of the system and to preserve the gains of the financial sector reform. Like in other countries, once the main issues regarding the legacy assets have been placed under control, the financial system is exposed to macroeconomic risks. In this regard, buffers have been built in order to endure even very harsh scenarios and additional steps have recently been taken on cash dividends and stricter classification of refinanced loans.

Furthermore, the Bank of Spain is developing, in line with staff’s recommendations, a new supervisory tool to undergo rigorous and regular forward-looking exercises on banks’ resilience to be implemented before the Single Supervisory Mechanism comes into force. This tool will allow to closely monitor individual institutions and it will provide a high-quality basis for deciding whether further corrective actions are needed and what measures would be more appropriate, if deemed necessary.

Within the reform, a broad number of measures have been taken to improve the resilience of the financial sector: the provisioning requirements have been substantially strengthened and the minimum capital requirement has been increased to 9 percent of core tier 1 for all banks; a legislative reform introduced a state-of-the-art recovery and resolution system for banks that includes some features of the future European Directive; a new legal framework for savings banks will soon be in force (the law is currently before Parliament) and the supervisory powers of the Bank of Spain have been strengthened. The creation of a new macroprudential authority is underway and customer protection has been reinforced in all key areas.

In the area of transparency, Spain has been the first country in the EU to require banks to report their exposure to real estate and loan refinancing, and, according to IMF’s Third Progress Report, transparency in Spain is “higher than almost anywhere else in Europe.”

Going forward, the authorities believe that a proper flow of credit to the private sector is of paramount importance to ensure growth. In this regard, despite the strict implementation of the financial sector reform, banks’ balance sheet repair and the reinforcement of banks’ capital ratios, domestic lending rates remain too high and access to credit is still constrained for many companies. Undoubtedly, this situation is affected by the financial fragmentation and the impairment of the monetary policy transmission channel in the euro area. Maintaining progress in improving the European financial architecture, including a timely completion of the Banking Union, and continuing the introduction of targeted measures by ECB and other EU financial institutions will undoubtedly help improve this outcome.

Private sector deleveraging

Private sector deleveraging is progressing, although it needs to be reinforced as much as possible, particularly for households. Corporate debt has fallen by 11.1 percentage points (pp) since the beginning of 2012 to 108.6 percent of GDP. Household debt has been reduced only by 2.5 pp during that period, but its level, at 78.6 percent of GDP, is in line with the EU average.

To a great extent, the financial sector reform has allowed a smooth deleveraging of the real estate and construction sectors and the ensuing pressure on banks’ balance sheets, avoiding a negative loop from the private sector to the banks. The transfer of legacy assets to the SAREB has been a key component of that process.

Regarding the insolvency regime, different measures have been adopted to support the deleveraging of the private sector, with several of them along the lines recommended by staff.

Concerning the mortgage market, a Code of Best Practices was adopted, establishing a set of financial instruments to deal with impaired mortgage debt. Although voluntary, almost all financial entities have subscribed to the code. Compliance with the code is subject to a strict monitoring. Also, a social housing fund has been created for evicted families and a 2-year suspension of evictions granted for families under risk of social exclusion. Other measures include a reduction in default interests and litigation costs in bankruptcy procedures, a mechanism to improve the prices in home auctions and a debt relief mechanism after foreclosure when part of the debt is paid. Further steps affecting bankruptcy proceedings are also underway. Mechanisms have been established to facilitate out-of-court settlements for companies, outside an eviction process, including the creation of a loan mediator. Also, debt relief mechanisms are envisaged for natural persons subject to bankruptcy proceedings.

Additional measures, and in particular the establishment of a special personal insolvency regime to provide a fresh start for debtors, have to be carefully balanced against their impact on the objectives of the policy strategy; i.e. preserving and reinforcing financial stability, and keeping the strong payment culture currently existing in Spain. It is also important to analyze the overall efficiency of those measures from a macroeconomic point of view.

Labor market

The reform introduced by the government in February 2012 is promoting a deep transformation of the Spanish labor market, bringing significant progress in its two main objectives. On the one hand, the reform has increased the internal flexibility of the labor market, promoting an adjustment based on a negotiation around wages and labor conditions (functional and geographical mobility, working hours, work load, etc.) within the companies, and therefore keeping more jobs instead of firings. On the other, the reform is helping to reduce the job-creating GDP growth threshold, which, according to the authorities’ calculations, is being brought down to 1-1.2 percent. Although the positive impact of the reform will be fully visible when economic activity recovers strength, recent years’ insensitivity of wage inflation to cyclical unemployment has started to be addressed. This is confirmed when comparing growth in compensation per employee prior and after the reform (it stood at -0.01 percent in Q2 2012-Q1 2013, while its average growth during 2011 was 1.5 percent).

Other measures of labor reform aimed at reducing duality are also having a positive effect, although more time is needed to see clearer results. The emphasis now is on enhancing active policies and promoting more job opportunities for the youth.

To address the problem of youth unemployment, the Strategy for Youth Entrepreneurship and Employment 2013–16 was adopted in February 2013. It comprises a wide-range of measures to stimulate the hiring of young people and promoting entrepreneurship and self-employment for this group, including incentives for companies, a reduced social security contribution for young entrepreneurs, and allowing compatibility of unemployment benefit with self-employment for a maximum period of 6 months, among others.

The government is now conducting a thorough evaluation of the reform and will issue a report, expected by the end of July, which will be audited by the OECD. Another significant development is that many bargaining agreements are going to be reviewed this summer, as a result of the deadline set up for them in the reform. This will be an important opportunity to see whether the current perception that the legal changes introduced by the reform are generally sufficient.

The government is ready to continue introducing further changes in the labor market, if warranted. However, any further step should to be considered in the light of these aforementioned factors. It would be in any case premature to decide on them without carefully analyzing the outcome of the report and the result of the ongoing negotiations.

Finally, on the agreement proposed in the staff report between unions and employers, the government believes it has difficult practical implications to the extent that it seems barely feasible. It could also be an obstacle for the introduction of future structural reforms, which is a top priority in the policy agenda. In addition, if not completely executed, it could negatively impact households’ consumption and their capacity to repay their debt.

Product and services structural reforms

The authorities are implementing an ambitious structural reform agenda to improve Spain´s medium and long-term growth potential and—as staff highlights—substantial progress has already been made on this area. Apart from structural reforms already mentioned in the financial, fiscal and labor fronts, multiple far-reaching reforms in key areas are underway to improve the business environment, reduce administrative burdens and licensing requirements, enhance competition and promote company growth, as staff advises. These include, but are not limited to, the following measures:

The Law on Market Unity aims at addressing market fragmentation, reducing administrative burdens and streamlining or reducing business licensing requirements. The bill is currently before Parliament. A process was set up to early assess existing laws and regulations to facilitate the adaptation of the regulatory framework to the new law.

The Law on Entrepreneurial Support aims at favoring the creation of companies, promoting their growth, innovation and internationalization via various instruments, including tax measures and funding mechanisms. After public consultation, the law is currently before Parliament under urgent approval process.

The Law on the Liberalization of Professional Services seeks to remove obstacles for the access and provision of these services, including in highly regulated professions, well beyond the requirements imposed by the Service Directive in Europe. Different initiatives have also been implemented to simplify or eliminate activity licensing requirements. Business opening hours had also been further liberalized.

The Law on De-Indexing the Spanish Economy aims at reducing second-round effects in the price formation process of public sector-related activities, replacing the CPI with a more stringent reference index for regular updates of public income, revenue and prices. A draft bill is being drawn and is expected to be in force before January 2014, when major indexation rules apply.

On the energy sector, efforts have been directed to address the electricity tariff deficit (the gap between the regulated cost of the electric system and the revenue stemming from tariffs paid by consumers). Various measures have been adopted since 2012, bringing a substantial reduction of this deficit. Building on those efforts, a comprehensive energy reform was presented in July 2013, with immediate measures to cover the current remaining deficit and a new Draft Bill on the electricity system, establishing a legal framework that prevents tariffs deficits from arising in the future.

The supervisory competition framework has been enhanced with the creation of the National Commission for Markets and Competition in June 2013. The new authority merges the powers of previous sectoral competition bodies, to ensure a consistent application of competition principles across the various economic sectors.

Reforms are also being implemented in other key areas, such as education, innovation, health- care system, transports, social inclusion. A clear road-map has been set up in Spain´s National Reform Plan with a clear schedule for the implementation of pending actions.