Spain: Staff Report for the 2015 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
14 Aug 2015
eISBN:
9781513560069
Language:
English
Keywords:
balance sheet constraint; firm commitment; high-productivity firm; house wealth; savings ratio
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Context. The recovery has strengthened and employment is increasing, driven by the rebound in consumption and investment. Reforms and strong policy implementation have supported the return of confidence, and significant external tailwinds are helping. However, the level of unemployment remains very high and without further reforms the growth momentum is expected to slow in the medium-term. This reflects still sizable public and private debt overhangs and persistent structural problems, including remaining impediments in the labor market and the low productivity of Spain’s many small firms. Policies. Sustaining the current high levels of growth and job creation over the medium term and further reducing vulnerabilities will require additional policy efforts. Key priorities include the following: Enhancing labor market performance. Maintaining wage growth in line with developments in productivity and external competitiveness, ensuring wages adequately reflect differing business conditions across firms, lowering duality, and enhancing the skills of the long-term unemployed will improve prospects for higher and more inclusive growth also in the medium term. Supporting growth of small firms. Removing obstacles for Spain’s many small firms to grow will allow them to benefit from economies of scale both in domestic and external markets and raise productivity. Facilitating private deleveraging. Continuing to reduce firm and, especially, household debt will foster investment and growth. Further strengthening the banking system will ensure that banks can support growth as credit demand recovers. Anchoring confidence. Sustaining a gradual and growth-friendly fiscal consolidation, well coordinated across all levels of governments, will help maintain strong market confidence and put public debt on a firmly declining path.

Abstract

Context. The recovery has strengthened and employment is increasing, driven by the rebound in consumption and investment. Reforms and strong policy implementation have supported the return of confidence, and significant external tailwinds are helping. However, the level of unemployment remains very high and without further reforms the growth momentum is expected to slow in the medium-term. This reflects still sizable public and private debt overhangs and persistent structural problems, including remaining impediments in the labor market and the low productivity of Spain’s many small firms. Policies. Sustaining the current high levels of growth and job creation over the medium term and further reducing vulnerabilities will require additional policy efforts. Key priorities include the following: Enhancing labor market performance. Maintaining wage growth in line with developments in productivity and external competitiveness, ensuring wages adequately reflect differing business conditions across firms, lowering duality, and enhancing the skills of the long-term unemployed will improve prospects for higher and more inclusive growth also in the medium term. Supporting growth of small firms. Removing obstacles for Spain’s many small firms to grow will allow them to benefit from economies of scale both in domestic and external markets and raise productivity. Facilitating private deleveraging. Continuing to reduce firm and, especially, household debt will foster investment and growth. Further strengthening the banking system will ensure that banks can support growth as credit demand recovers. Anchoring confidence. Sustaining a gradual and growth-friendly fiscal consolidation, well coordinated across all levels of governments, will help maintain strong market confidence and put public debt on a firmly declining path.

Context and Outlook

1. Spain’s recovery has gathered speed, but unemployment is still high. The economy expanded at 1.4 percent in 2014, and growth accelerated significantly in the first half of this year. This reflects the continued rebound in business investment and private consumption, which came on the back of rising confidence supported by strong policies (Figure 1). Significant external tailwinds are helping, including from lower oil prices, the depreciation of the euro, and the European Central Bank’s (ECB) expansionary monetary policy. Financial conditions remain supportive, with sovereign bond yields about 5¼ percentage points below their 2012 peak, despite some recent rise. Borrowing costs of Spanish corporates and households have fallen as well, although the decline came later. Employment has increased with the rebound in demand and moderate wage growth. At the same time, a significant share of the jobs created still takes the form of temporary and part-time contracts. More than 5 million Spaniards, over 23 percent of the labor force, remain unemployed, many of them young.

Figure 1.
Figure 1.

The Recovery Has Gathered Speed

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: INE; Bankof Spain; Eurostat Bloomberg; and IMF staff estimates.
A01ufig1

Rebounding growth

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: WEO, IMF staff calculations.
A01ufig2

Declining lending rates to SMEs since mid-2014

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Bank of Spain; ECB; IMF staff calculations.1/ Small loans up to 1-year maturity and up to €1million.
A01ufig3

Increasing Confidence

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Haver Analytics.

2. The reforms are making a difference. Labor market reforms and moderate wage growth have supported job creation and helped Spain regain competitiveness lost during the pre-crisis boom. The Market Unity Law has begun to address some of the obstacles for firms to grow and raise productivity. The progress achieved by financial sector reform, supported by the European Stability Mechanism, has been confirmed by the positive outcome of the ECB’s comprehensive assessment. Together with continued fiscal consolidation, these reforms have reassured markets, consumers, and investors alike.

3. Deleveraging is slowing and new credit is being extended, especially to firms with strong financial positions. New credit to households is also growing. This comes on the back of improving banking sector performance, with increased capital and earnings, improved asset quality and provisioning, and more favorable funding conditions. There are also signs that the real estate sector might have begun to turn the corner. After a long period of decline, housing prices started to increase moderately in the second half of 2014—albeit unevenly across regions—and investment and employment in construction have started to recover (Figure 2).

Figure 2.
Figure 2.

The Housing Sector Appears to Have Bottomed Out

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: INE, Haver, IMF staff calculations.

4. The current account maintains a small surplus, but external vulnerabilities remain. As in past recoveries, imports accelerated with the strong rebound in domestic demand. However, the external current account registered a 0.8 percent of GDP surplus in 2014. This reflects, in part, healthy export growth supported by regained competiveness from price and wage moderation. Employment in the tradables sector has been relatively resilient throughout the crisis as more firms turned towards external markets. However, Spain’s negative net international investment position (NIIP), while expected to improve in the medium term, is still among the highest in Europe at 93 percent of GDP in 2014 (Figure 3).1 Given the need to improve the NIIP, the cyclically adjusted current account remained ½ to 2½ percent of GDP weaker than what would be consistent with medium-term fundamentals and desirable policy settings, and staff assesses that the real effective exchange rate (REER) is still about 5–10 percent overvalued (see Appendix I for the External Stability Report, ESR).

Figure 3.
Figure 3.

Despite the Current Account Surplus, Net External Liabilities Remain High

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

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

5. Against this background, the growth momentum is expected to carry on this year and next. The forces driving private consumption and corporate investment are expected to weaken only gradually, while construction investment should continue its moderate recovery. Net exports will profit from the gradual pickup in euro area activity and the expected continuation of improvements in competitiveness, helped by moderate wage growth. Overall, real GDP growth is expected at 3.1 percent in 2015 and 2½ percent in 2016, well above the euro area average.

6. However, deep structural problems remain and vulnerabilities persist, limiting Spain’s growth potential in the medium term. As the recovery matures and tailwinds dissipate, growth is bound to decline to levels closer to Spain’s still very low rate of potential growth of less than 1½ percent. Absent further reforms, this will leave unemployment at its estimated structural level of about 16½ percent even as the output gap closes. Moreover, a strong link between domestic demand and imports is expected to persist and will continue to curb the scope for current account improvement as growth strengthens. Multiple factors are holding back the prospect for well balanced growth in the medium-term:

A01ufig4

Spain’s unemployment has historically been high

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: IMF WEO, IMF staff calculations.

  • Labor market challenges. Structural unemployment is persistently high and the crisis has lengthened unemployment spells and aggravated skill deficits, especially for the young. Moreover, duality is still pervasive, and labor market participation is declining. A lack of differentiation in wage dynamics across firms slows the reallocation of labor toward more productive sectors.

  • Low productivity. Spanish firms tend to be smaller, less productive, and less export-oriented than their European peers. A number of obstacles prevent them from generating economies of scale domestically as well as externally, which would allow them to compete more successfully in global markets and against imports.

  • Continuing deleveraging. Private and public debt levels remain high, at 235 and 98 percent of GDP, respectively. Household debt, in particular, is still significantly above its pre-crisis levels (Figures 4 and 8). Hence, deleveraging is likely to proceed, continuing to weigh on domestic demand (Box 1).

Figure 4.
Figure 4.

The Crisis’ Legacy and Structural Problems Limit Medium-Term Growth

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: INE; Bank of Spain; Eurostat Bloomberg; and IMF staff estimates.x
Figure 5.
Figure 5.

Labor Market Reforms Are Helping, but Further Efforts Needed

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: INE, Quarterly Labor Force Survey, IMF Staff calculations1/ Residuals from a regression of log nominal hourly wages on lagged unemployment, lagged log CPI, linear and quadratic trend.2/ Prediction based on pre-2012 estimated wage-employment dynamics.
Figure 6.
Figure 6.

Structural Obstacles to Firm Growth

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: EC (based on WB Governance Indicator), OECD, INE, Ministry of Finance.1 2012 data on MFP for DNK, NDL, PRT, CHE and GBR is extrapolated using 2011 growth rates.2 Region names are abbreviated as follows: AD- Andalusia, AR-Aragon, AS-Asturias, CH-Castile-La Mancha, CN- Canarias, CS-Castile-Leon, CT-Cantabria, CY-Catalonia, EX-Extremadura, GA-Galicia, MA-Madrid, OJ-La Rioja, RC-Murcia, RL- Balearic Islands, SC- Basque Community, VR-Navarre, VV-Valencian Community.3 The recent corporate tax reform is reducing the effect of firm size on effective tax rates, but size continues to play a role in taxation and regulation.
Figure 7.
Figure 7.

Financial Sector Performance Has Improved

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: BdE; Haver Analytics; Bankscope; IMF FSI; SNL;and IMF staff estimates.
Figure 8.
Figure 8.

Fiscal Consolidation Continues, but Challenges Remain

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Spain Ministry of Finance; Bank of Spain; and IMF staff estimates.

7. Vulnerabilities amplify risks on the downside. Risks of contagion from developments in Greece remain significant. Although the initial market reaction from the recent breakdown in negotiations with official creditors and the Greek referendum have been contained, there is still substantial uncertainty about potential spillovers. Depending on the final outcome, heightened uncertainty could weigh on market sentiment and renew sovereign and financial sector stress in Spain. These risks, however, would be mitigated if timely and effective policy measures are implemented at the euro area level, including—if necessary—an expansion of the asset purchase program and additional longer-term liquidity support for banks. Domestically, a firm commitment to complete the reform agenda and to reduce the level of sovereign debt through continued fiscal consolidation would help anchor market confidence.

Risks: Still High Vulerabilities Exacerbate Downside Risks1

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The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). See Risk Assessment Matrix (Table 3) for further discussion of risks and methodology.

8. In this context, a key risk is a reversal of past reforms. Such a reversal would create uncertainty and could hamper the recovery, especially if the external environment were to deteriorate significantly. On the external side, other important risks are weaker than expected demand and inflation in the euro area and a sharp asset price adjustment and decompression of credit spreads (see Appendix II for the full Risk Assessment Matrix).

Authorities’ view

9. The authorities have higher forecasts for medium-term growth while agreeing that remaining vulnerabilities and structural issues require attention. They broadly shared staff’s view about the short-term outlook and risks and stressed that high growth and progress achieved in the correction of imbalances offered important protection against a possible deterioration of the external environment. In this context, they emphasized the role played by past reforms in explaining the strong economic rebound and the progress already made in reducing domestic imbalances, especially with regard to public finances, private sector deleveraging, the financial sector, and employment. They expect higher growth in the medium term as the output gap is still large, but agreed that there was still significant scope to improve Spain’s long-term growth potential. They considered that external imbalances have already been reduced amid structural competitiveness improvements, and pointed out that, unlike in previous recoveries, higher GDP growth rates have been accompanied by current account surpluses. At the same time, they recognized the need for further competitiveness gains.

Policy Agenda

10. Sustaining the current high levels of growth over the medium term and reducing vulnerabilities requires additional policy efforts. Spain has rebounded strongly and employment is increasing. However, the level of unemployment is still painfully high and domestic and external vulnerabilities remain. Sustaining job-rich, inclusive growth at the current pace, transitioning to a more balanced and export-oriented growth model, further reducing public and private indebtedness, and maintaining confidence call for additional structural reforms and gradual but sustained fiscal consolidation (Box 2). Acting while economic activity is strong and monetary policy is very supportive will make these measures easier to implement and add to their effectiveness. The main priorities are:

  • Improving labor market performance. Keeping wage growth aligned with productivity and external competitiveness developments, ensuring wages reflect differing business conditions across firms, and strengthening the skills of the long-term unemployed will enhance prospects for higher and more inclusive growth.

  • Enhancing small firm growth. Removing obstacles for Spain’s many small firms to grow will allow them to scale up both domestically and externally, and raise productivity.

  • Facilitating private debt reduction. Further reducing firm and household debt will support investment and growth going forward. Continued strengthening of banks will ensure they support growth as credit demand recovers.

  • Anchoring confidence. Continued gradual and growth-friendly fiscal consolidation, well coordinated across all levels of governments, will help maintain strong market confidence.

A01ufig5

Reforms benefit from macroeconomic support

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Decressin and others (forthcoming), Staff Discussion Note.1/ Model-simulated impact of wage moderation relative to the rest of the euro area, QE support at the ZLB, and implementation of the G20 growth strategy commitments.

A. Further Strengthening Labor Market Performance

11. The labor market reforms are helping, but unemployment remains very high. The 2012 reforms increased room for workers and firms to adjust wages and hours worked, and staff analysis suggests that this helped protect employment during the recession and promoted job creation during the recovery (Figure 5).2 In 2014, average real wages increased very moderately and employment growth strengthened considerably, reaching over 3 percent by end-2014—a pace not seen since 2007—and exceeding output growth. The unemployment rate has come down, but remains too high. As of the first quarter of 2015, more than 23 percent of the active labor force and more than half of those under 24 years old were looking for a job. Moreover, about 60 percent of the unemployed have been jobless for over a year, many of them low-skilled, and risks of poverty and social exclusion have been rising with the level of unemployment since the crisis.

A01ufig6

Social indicators tightly linked to unemployment

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Eurostat.

12. Despite the reforms, wage dynamics still do not adequately reflect differences in business conditions across firms. Not enough firms are yet making use of the flexibility clauses introduced by the reforms to deviate from sector-level wage agreements. This reflects, among other things, administrative and legal costs to firm-level wage agreements, and uncertainties over the abolishment of the automatic extension of expiring collective wage agreements (ultra-activity), where recent court decision could limit firm-level adjustment going forward. As a result, it remains difficult for the labor market to adjust to variations in sectoral or regional demand. This also reduces the incentives for workers and capital to move from low- to high-productivity firms, including in the tradables sector, which slows Spain’s much needed adjustment towards a model of faster and more export-oriented growth.

13. Labor market duality remains high. Measures to reduce duality, including statutory limitations on the use of temporary contracts and hiring subsidies for new permanent workers—which were modified earlier this year to benefit low-income earners more—appear to have contributed to a pickup in employment based on permanent contracts. However, after dropping sharply during the recession, the share of temporary jobs in overall employment has remained fairly steady at around 25 percent, still among the highest among European peers. Such high duality in the labor market exacerbates downward wage rigidity, lowers workers’ productivity, and concentrates the burden of market adjustment on those temporarily employed.

14. This suggests there is still significant scope for measures that will foster high-quality job creation. Further action in this direction will help reduce unemployment and, thereby, raise Spain’s longer-term potential for inclusive growth. Steps toward this goal include the following:

  • Setting the right labor market conditions. Keeping wage growth in line with developments in productivity and external competitiveness is key for promoting strong and sustainable employment growth in the medium-term.

  • Promoting firm-level adjustment. Making sure that wage dynamics reflect differences in firm- and sector-specific conditions will boost aggregate productivity and income. To this end, it is important that the existing options for firm-level adjustment are used as needed, and that remaining obstacles to firm-level wage bargaining and opt-out, particularly for small firms, are removed.

  • Lowering duality. The new incentives for permanent hires are better targeted but temporary in nature. At the same time, the cost of dismissing a permanent worker is still materially higher than that for a temporary one. This gap should be closed, for example by introducing a single contract with tenure-based dismissal costs in sectors without high seasonal turnover. Alternatively, other approaches could be considered—for example, uniformly financing dismissal costs through regular employer contributions to a common fund so that workers are adequately protected and employers’ hiring decision are not distorted toward excessive reliance on temporary contracts. Finally, reducing legal and administrative uncertainties in collective dismissals and streamlining the application of objective criteria for fair dismissals would also help support permanent hiring.

  • Making Active Labor Market Policies count. The recent measures to improve the skills of the long-term unemployed and low-skill youth are important. However, to be effective these programs need to be closely monitored, evaluated, and, if needed, fine-tuned, starting with the more transparent use of regional coverage and enforcement data. Steps to increase the effectiveness of public and private job-placement agencies also deserve consideration.

Authorities’ view

15. The authorities broadly agreed with the assessment of the impact of labor market reforms and most of the remaining challenges. They stressed that the reforms have been a crucial driver of the Spanish recovery and the pickup in employment. They shared the view that firm and sector-level adjustment should improve further and suggested that, given the significant scope of recent reforms, more time is needed for the social partners to adapt to the new rules before considering additional measures. The authorities recognized that duality is still a problem but noted that the solutions to address it are complex.

B. Boosting Small Firm Growth

16. Productivity growth is fundamentally weak, partly reflecting the dominance of small firms. Spanish firms tend to be more numerous, smaller, less productive, innovative, and export-oriented than those of most European peers. Firms with fewer than 50 workers employ nearly two thirds of the labor force while generating only about half of the value added in the economy. At the same time, the productivity gap between small and large companies is wider than in many other European countries. Staff analysis suggests that, for example, lowering the share of small firms to match that of Germany and closing the productivity gap between small and large firms to German levels could raise the level of aggregate total factor productivity (TFP) by as much as 9 percent, with most of the improvement coming from the reallocation of employment between firms.3

17. A number of obstacles prevent firms from expanding to exploit economies of scale. Staff analysis shows substantial variation of TFP across firms’ size, sector, and region. This regional heterogeneity could point to market fragmentation from the proliferation of regulatory requirements and practices (such as permits and standards) at the regional and local level, which constitute barriers to entry and inhibit competition. Other obstacles to growth include size-dependent thresholds in regulation (e.g., in reporting, auditing, and labor-related regulation) and taxation, as well as limited financing access (Figure 6).

18. Creating the conditions for small- and medium-size enterprises (SME) to grow is critical. A number of measures can help generate crucial economies of scale, both in domestic and external markets. Exploiting these would increase productivity, long-term growth, and employment.

  • Fostering competition. Fast and effective implementation of the Market Unity Law and moving ahead with the long-delayed liberalization of professional services would facilitate market entry and allocation of resources to their most productive uses.

  • Lowering constraints. The recent corporate tax reform is set to reduce fiscal disincentives for companies to expand. However, a careful review and assessment of all size-related rules and regulations is needed to identify and eliminate other unwarranted obstacles to growth.

  • Supporting exports. While the number of exporting firms has increased significantly since the crisis, the degree of internationalization of SMEs is still relatively low. Against this background, the government strategy for boosting internationalization could do more to help SMEs enter export markets and remain competitive, for example by helping reduce the high fixed costs of exporting—including market penetration and other trade costs, and fostering innovation.

A01ufig7

Relatively low export-to-GDP ratio

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: WEO, IMF staffcalculations

19. In this context, efforts to strengthen smaller firms’ access to finance are still important. While bank lending will remain dominant, efforts to increase market-based financing for SMEs, including via alternative exchanges, venture capital, and securitization should continue. The accuracy of financial reporting and transparency could be increased, for example by incorporating consolidated financial information of SMEs in the centralized database and register. For the financing of new firms, the ongoing program providing guarantees and direct financing through ICO, a state-owned financial institution, remains highly relevant and could be complemented by European efforts (including by guarantees extended under the Juncker plan), while making sure they support all SMEs lacking market access.

Authorities’ view

20. The authorities agreed on the need to help firms grow and stressed recent progress in this area. They noted that the implementation of the Market Unity Law is ongoing and that differences in regulatory norms and practices across Spain, which among other factors limit firm growth, are being addressed. They emphasized the link between firm size and export orientation, pointing out that, despite recent advances, additional efforts are necessary to support the internationalization of Spanish SMEs.

C. Further Strengthening Banks While Reducing Debt

21. Banking system indicators have improved in the last year:

  • Banks’ asset quality and specific provisioning have strengthened. The domestic non-performing loans (NPL) ratio fell to 12.1 percent at end-March 2015 from 13.4 percent one year earlier, while provisions rose to 57 percent of NPLs—significantly above the euro area average (Figure 7).

  • Banks have increased nominal capital, mostly through reinvested earnings and equity issuance. The phased-in Basel III CET1 capital ratio of the system has increased, reaching 11.8 percent (ranging between 9.7 and 12.7 in the case of the 10 largest banks), comfortably above the minimum regulatory levels. Spain’s large banks are on track to complete the fully-loaded Basel III capital schedule on schedule—or ahead of time in case of the two systemically important financial institutions (SIFIs), which are benefiting from globally-diversified earnings.

  • Funding conditions have become more favorable, supported by the ECB’s Targeted Longer-Term Refinancing Operations (TLTROs) and lower market financing costs, although resident deposits declined moderately mainly due to a shift to higher yielding instruments.

  • Liquidity has also improved, with Spanish banks now fully complying with the phased-in requirement of 60 percent for the liquidity coverage ratio (LCR).

  • The profitability of the banking system has increased reflecting lower provisioning costs due to improved asset quality, stronger net interest margins, as deposit rates declined more rapidly than lending rates, and mark-to-market gains on holdings of government bonds linked to the ECB’s purchase program.

  • Banking sector efficiency has continued to strengthen. Spanish banks lowered operating costs-to-income by 1.5 percentage points (to 49 percent) at end-2014, which compares favorably with peers in large euro area economies. Efficiency gains have followed significant consolidation of the banking sector during 2012–14, with the number of commercial banks falling from 50 to 15.

A01ufig8

Banks’ capital ratios have strengthened

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Bankscope, IMF staff calculations
A01ufig9

Banks’ earnings have been recovering

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Bankscope, IMF staff estimates.

22. Progress towards the banking union continues. The Single Supervisory Mechanism (SSM) now directly supervises Spain’s larger banks, representing more than 90 percent of the assets in the banking system. The transposition of the Bank Recovery and Resolution Directive (BRRD) in Spain, approved in June 2015, constitutes an important step in implementing an effective European resolution framework. The law established a two-tier setup, with the Bank of Spain being responsible for pre-resolution tasks and the national bank resolution fund (FROB) responsible for all resolution functions in the execution phase. The European Systemic Risk Board (ESRB) has noted that further progress is needed to bring the macroprudential framework in line with its recommendations.

23. Against this background and with the outlook improving, the ongoing deleveraging process has become more selective. The overall level of credit in the economy is still declining but the pace has slowed from around -10 percent at end-2013 to -5 percent year-on-year in April 2015, and it is expected to turn positive by the end of this year. Meanwhile, new credit is being extended, especially to non-financial corporations outside real estate and construction with healthy financial positions. New household credit is also growing. The improved credit outlook is mostly demand driven. In the meantime, the process of dealing with the public legacy of the financial crisis continues (see Box 3).

24. However, banks still face challenging operating conditions. Upcoming international regulations on fully-loaded Basel III capital, total loss-absorbing capital (TLAC), and minimum requirements for own funds and eligible liabilities (MREL) will likely demand additional loss-absorbing capacity, including capital, for most banks. A change in the treatment of deferred tax assets (DTAs) might require additional capital buffers for some banks. A prolonged low-interest rate environment in the euro area could compress lending margins, while some banks continue to face significant costs from foreclosed assets and high levels of NPLs. In this context, pressures to cut operational costs are likely to persist.

25. Continued strengthening of the Spanish banking sector will support growth as credit demand picks up. It remains important to further encourage banks to increase high-quality capital (e.g., through equity and restraint on dividends and bonuses) and reduce the carrying costs (e.g., for administration, capital, and funding charges) associated with high levels of NPLs. This will ensure more favorable credit conditions for financially-sound households and corporates, and make it less likely that credit growth will be constrained by supply as the recovery matures.

26. The recent insolvency reforms are significant steps to help facilitate private sector deleveraging. Consistent with previous staff recommendations, in early 2015 Spain introduced a “fresh start” for individual entrepreneurs and consumers. The new mechanism allows for a conditional discharge of individuals’ residual debt after liquidation of assets in bankruptcy. This could encourage liquidation of nonviable businesses whose debt is inseparable from that of individuals (e.g., sole proprietorships) and help households reduce debt to sustainable levels. Other reforms include amendments to the out-of-court restructuring mechanism for SMEs and the restructuring and liquidation procedures within insolvency to facilitate restructuring of viable firms and the sale of businesses as going concerns.

27. Implemented effectively, the “fresh start” can encourage demand and entrepreneurial activity in the formal sector, while preserving Spain’s strong payment culture. Staff analysis suggests that this could potentially reduce the stock of household debt by around 3–4 percent and the level of corporate debt by about 1–2 percent relative to the baseline, which would contribute to higher private consumption and investment (Box 1).4 At the same time, the negative effects on bank earnings are estimated to be limited. Correspondingly, banks are unlikely to face significant impact on their ability to extend credit.

28. However, there are critical challenges related to implementation, including:

  • Achieving the greatest possible clarity regarding the post-liquidation payment plan and conditions that would lead to a revocation of the fresh start would reduce uncertainty for debtors and limit potential for abuse, ultimately maximizing the positive effects of the reform.

  • The inclusion of public creditors—fully involving them in all restructuring processes of the insolvency regime and making at least those public claims considered ordinary (i.e., 50 percent of tax and social security claims) subject to discharge after liquidation—would increase the effectiveness of the system and avoid creating incentives for debtors to strategically prioritize payments to public creditors at the expense of private ones, with negative effect on payment culture.

  • Staff estimates that the possible immediate impact on the public sector will likely be small, and it could be positive in the longer term if formal-sector activity increases.

Authorities’ view

29. There was broad agreement on the assessment of banks. The authorities stressed the progress made in dealing with crisis legacies and the continued strengthening of the banking system in terms of capital ratios, profitability, asset quality, funding and liquidity conditions, while acknowledging the challenges coming from a prolonged low interest rate environment and new regulatory issues, including the prospects for higher international loss-absorbency requirements in the coming years.

30. The authorities also generally concurred with staff’s views on the reforms to the insolvency regime. They agreed with the need to clarify certain key elements in the “fresh start” reform, and pointed out that Parliament has already approved amendments to do so. While taking note of staff’s concerns regarding the exclusion of public creditors, they did not consider that this would limit the reform’s effect, and pointed to potential fiscal repercussions of excusing even bankrupt firms from their obligations to the public sector and the harmful impact on the current tax deferment policy. The authorities broadly agreed that the short-term impact of the recent insolvency reforms on banks’ earnings was likely to be limited while stressing that the effects on Spain’s strong payment culture deserved careful monitoring.

D. Ensuring a Coordinated and Credible Fiscal Consolidation

31. Deficit reduction is continuing, supported by higher growth and lower interest rates, but public debt is close to 100 percent of GDP and still increasing. Deficit reduction over the last four years has been critical for underpinning confidence. However, the pace of consolidation has slowed and is stalling this year in structural terms, although significant tailwinds from higher than expected nominal growth and relatively low interest rates are helping to meet the 2015 deficit target of 4.2 percent (Figure 8). Bringing the headline deficit below 3 percent to exit the Excessive Deficit Procedure (EDP) in 2016 and reaching structural balance in 2020 in line with European Union and national rules will be challenging. One reason is that measures specified so far fall short of the required structural adjustment.

32. Fiscal risks at the regional level are particularly high.5 The contribution of regional governments to post-crisis consolidation has been significant, helped by reforms in fiscal governance—in particular the adoption of Spain’s Budget Stability Law (BSL) in 2012 and subsequent improvements in regional budget practices and fiscal transparency. However, fiscal efforts have been uneven across regions and the overall regional target has been systematically missed, threatening to undermine the credibility of the overall consolidation effort going forward (Figure 9). Regional liquidity mechanisms in the form of conditional loans at low interest rates from the central government have helped regions but also raised moral hazard risks.

Figure 9.
Figure 9.

Regional Fiscal Framework

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Ministry of Finance; IGAE; European Comission, Fiscal Rules Database; Bank o f Spain; and Bloomberg.Note: AND = Andalusia; ARA = Aragón; AST = Asturias; BaC = Basque Country; BAL = Baleares; CaL = Castilla y León; CAN = Canarias; CAB = Cantabria; CAT = Catalonia; CCAA = Total CCAA; CLM = Castilla-La Mancha; EXT = Extremadura; GAL = Galicia; LaR = La Rioja; MAD = Madrid; MUR = Murcia; NAV = Navarra; PaV = País Vasco; VAL = Valencia.1/ Positive deviations: under-compliance. Negative deviations: over-compliance.2/ Savings estimates from lower interest obtained under the FLA and FFPP.3/ Yellow bars represent the total debt burden of regions benefitting from RLM (FLA) between 2012-14.

33. Continued coordinated and credible fiscal consolidation will help protect confidence and reduce vulnerabilities to potential adverse shocks.6 Any windfalls from higher nominal growth and lower borrowing costs should be used to bring the deficit down further. A pace of structural adjustment of around ½ percent of GDP per year would ensure debt is put firmly on a downward path. This will require a concerted effort across all government levels through more ambitious and better-specified measures than currently envisaged, while protecting the most vulnerable. Specifically:

  • Raising excise duties and environmental levies, and gradually phasing out value added tax (VAT) preferential treatments would bring Spain’s collection efforts more in line with those of other European countries. It would also support a growth-friendly fiscal consolidation by completing the tax shift from direct to indirect taxes initiated with the recent tax reform. In this context, it remains important to protect vulnerable groups by strengthening the support provided by the transfer and tax system.

  • At the regional level, there is scope for additional efficiency gains and fiscal savings—for example, by reducing the costs of providing public health and education services and, as recommended by the Tax Reform Expert Committee last year, by increasing the regions’ regulatory power to establish copayments for these services. To maintain access and affordability of public education and health services, copayments could be reduced or eliminated for vulnerable groups on the basis of means testing as well as for specific health services (e.g., chronic diseases, preventive care, and immunization).

A01ufig10

Stronger consolidation would accelerate public debt reduction

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Haver, Ministry of Finance, Bank of Spain, and IMF Staff calculations. Note: Baseline scenario based on July 2015 WEO projections. Scenario 1 assumes windfalls from higher growth rate, comparing forecasts in July vs. April WEO vintages and from saving the lower interest rates. Scenario 2 assumes a structural primary balance adjustment of 1/2 percent per annum over the projection period.
A01ufig11

Spain’s collection from VAT is relatively small

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Eurostat.

34. Further improving the regional fiscal framework would help with these efforts. While post-crisis reforms have strengthened regional fiscal autonomy and governance, there is scope for further advances:

  • The monitoring and enforcement of regional fiscal targets, rules, and access to regional liquidity mechanisms under the BSL and related instruments could be enhanced. This could be achieved, for example, by introducing pre-agreed intra-year targets and corrective measures, stressing regional best budgeting practices, and improving the responsiveness to the independent fiscal council’s recommendations.

  • Risk sharing and discipline could be rebalanced. Consideration could be given to strengthening the conditionality of existing regional liquidity mechanisms (for example, by making access to all mechanisms conditional to the approval of an adjustment plan and disbursements to compliance with intra-year fiscal targets under this plan) or by adding new conditional credit facilities to help finance regions in bad times (e.g., tax-based rainy day funds).

  • Fiscal equalization and settlement procedures under the current regional finance system could be improved. A more effective way of equalizing the regions’ resources to meet their spending needs would increase their capacity to reach their fiscal targets. Reviewing the rules determining how intergovernmental transfers are advanced and settled would reinforce their incentives to follow through with fiscal adjustment.

  • Consideration could also be given to allowing regions’ fiscal targets to differ—in a rules-based and transparent fashion—taking into account structural differences in adjustment needs and capacity.

Authorities’ view

35. The authorities are confident that they can achieve the deficit targets. The planned reduction in the headline deficit this year and next is supported by the strong economic recovery, lower interest rates, and the measures envisaged under the Stability Program. They stressed that the BSL and, in particular, the expenditure rule should help ensure regional fiscal targets are met. They saw public debt on a clear downward path and argued that historical sustainability scenarios based on an extraordinary difficult period including the recent crisis period could be misleading.

36. The authorities broadly agreed with the need to strengthen the regional financing system. They saw merit in a review of the financing system of the regions pointing out the complexity of the issue. They felt that monitoring and enforcement rules under the BSL have supported achieving general government deficit targets and that the conditionality requirements under existing regional financing mechanisms are sufficient to mitigate moral hazard risks.

Staff Appraisal

37. Spain’s recovery has accelerated. Stronger confidence is supporting the rebound of domestic demand, aided by the ECB’s expansionary policies and external tailwinds. Employment is growing, even though, at more than 5 million people, unemployment remains painfully high.

38. Past reforms and strong policy implementation are contributing to the recovery. Labor market reforms and moderate wage growth, the Market Unity Law, financial sector reform, and continued fiscal consolidation have reassured financial markets and underpinned confidence.

39. However, it will take additional efforts to sustain growth at current levels. In the medium term, the expansion is constrained by still sizable public and private debt overhangs that are weighing on consumption and investment and deep structural problems, including high structural unemployment and the notoriously low productivity of Spain’s many small firms.

40. There is still significant room for improving labor market performance. Keeping aggregate wage increases in line with productivity and competitiveness while allowing firm-level wages to better reflect business conditions will promote job-rich growth and encourage resources to move to more productive and export oriented sectors. Reducing duality and implementing more effective active labor market policies would improve skills and help the long-term unemployed find work.

41. Reducing obstacles for small firms to grow can unlock productivity. Accelerating the implementation of the Market Unity Law and opening up professional services would foster market entry and competition. A careful review of size-related rules and regulations, supporting SME internationalization, and further developing access to finance would allow firms to scale up and significantly improve Spain’s growth potential.

42. Further strengthening banks will support growth as credit demand recovers. The ECB’s comprehensive assessment confirmed the much stronger position of the banking system, but operating conditions remain challenging. This calls for continuing to build high-quality capital and reducing the carrying costs of high NPLs.

43. The “fresh start” reform facilitates private sector deleveraging. Implemented effectively, it can boost demand and future entrepreneurial activity while protecting Spain’s strong payment culture. Fully involving public creditors would add to the impact of the reform.

44. Credible, coordinated, and growth-friendly fiscal consolidation needs to continue. The deficit has been declining, but consolidation efforts have slowed. A pace of structural adjustment of around ½ percent of GDP per year should be ensured to put debt on a firmly declining path. Any windfalls from lower interest rates and higher-than-expected growth should be saved. Additional measures will be required at all government levels to achieve EDP and Medium-Term Budgetary Objective (MTO) targets. These should be implemented in such a manner as to protect the vulnerable.

45. The regional fiscal framework can be strengthened further. Regions contributed significantly but unevenly to post-crisis consolidation. To reduce implementation risks, monitoring and enforcement of fiscal targets and access to regional liquidity mechanisms could be improved and design drawbacks in the regional finance system addressed, including by allowing fiscal targets to vary in line with adjustment needs and capacities.

46. It is recommended that Spain remain on the standard 12-month Article IV consultation cycle.

Household Deleveraging and Growth

What are the implications of household debt deleveraging for private savings and consumption dynamics? Private consumption has rebounded recently and there is much upside potential. The level of consumption is still 11 percent below its 2007 peak and lagging GDP, which has recovered to about 7½ percent below the pre-crisis peak. The household savings ratio has declined to 9.7 percent in 2014 and could, in principle, fall further. However, the savings rate is already well below its 2000–14 average of 10.6 percent and, at 109 percent of disposable income, Spanish household debt is still high—both in historical and international comparison.

A01ufig12

Private consumption is back to 2000 levels

(Constant prices, per capita, 2000=100)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: INE.
A01ufig13

Households Debt

(Percent of gross disposable income)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Bbk, BdE, BdF, BdI, ONS, Haver Analytics.

Household savings decisions will also be affected by the need to rebuild assets and wealth. Household wealth has declined substantially since the pre-crisis peak. While the household debt-to-disposable income ratio dropped by 25 percentage points since 2007, household wealth-to-disposable income fell by nearly 30 percent, with house wealth, the bulk of household assets, losing about a third of its value since 2007. Empirical evidence suggests that households’ debt and asset position have had a major influence on consumption in Spain and elsewhere since the crisis.

A01ufig14

Household Wealth

(In percent of GDI)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Bank of Spain, Haver and IMF Staff calculations.
A01ufig15

Consumption Growth: Underlying Determinants

(Cumulative change 2008Q1-2011Q4, in real logs)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Source: Jaramillo and Chailloux (forthcoming), IMF Working Paper.Note: For Canada, right panel corresponds to change 2008Q1-2010Q4.

Simulations illustrate the link between deleveraging, asset accumulation, and household savings. In a baseline scenario, households reduce their gross debt/GDI ratio to its 2004 level within 20 years while house prices are assumed to rise such that the gross asset/GDI ratio improves by 3¼ percent by 2020. With GDI growing at 3½ percent per annum over 2015–20, on average, this would require an increase in household saving ratio from current levels to slightly below the long run historical average. However, achieving the same deleveraging target in just 10 years would require higher savings of ½ percentage point of GDI per year, on average, compared to the baseline (scenario 1). An even more ambitious strategy to rebuild household net wealth by achieving the same deleveraging target in 10 years, while maintaining a constant share of financial assets-to-GDI would require higher savings of 1¼ percentage points of GDI per year, on average, compared to the baseline (scenario 2). If implemented effectively, the recent insolvency reforms, allowing for a “fresh start” for individual entrepreneurs and consumers, could facilitate a decline in household debt and reduce savings. Depending on the speed at which the reform’s effects unfold, it could lower savings by up to a ½ to a third of a percentage point of GDI per year, on average, over a 10 to 20 year period, respectively. This, for example, would at least partially offset the hypothetical increase in the savings ratio vis-à-vis the baseline modeled in scenario 1.

The alternative scenarios would imply lower household consumption than under the baseline, but the effects on aggregate demand depend on the circumstances. For example, aggregate demand would remain unchanged if the higher household savings would finance higher net-exports or be channeled into higher investment, with possible benefits for potential growth going forward. Conversely, to the extent that these additional savings would be used to pay down existing external debt and to lower the very high negative NIIP (see fifth chapter of Selected Issues Papers), aggregate demand would be lower.

A01ufig16

Deleveraging impacts savings and consumption

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: Haver and IMF staff calculations.Note: Baseline assumes a return of the gross debt to gross domestic income (GDI) ratio to its 2004 level within 20 years; and an improvement in house prices of 3 percent of GDI by 2020. Scenario 1 achieves the same debt deleveraging in only 10 years, while Scenario 2, in addition, assumes that the financial asset to GDI ratio is brought back to its 2006 level in 6 years.

Potential Output Growth in Spain: What Is the Scope for Improvement?

Potential growth slowed significantly since the global financial crisis. Multivariate filter-based estimates suggest a drop from about 3 percent in 1995–2007 to around ¾ percent since 2008.1 The crisis led to a sharp fall in investment, with balance sheets effects aggravating the impact of weak demand.2 Unemployment rose rapidly, leading to an increase in long-term and structural unemployment. Empirical measures of TFP have shown some improvement relative to the very low levels in the past, and this has been linked mostly to the exit of low-productivity firms and the drastic labor shedding, especially of relatively lower-skilled temporary workers, during the crisis.

A01ufig17

Spain: Contributions to Potential Growth

(Percent)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: INE, IMF staff calculations.

Absent additional reforms, potential growth is expected to remain low. Staff estimates place potential growth at well under 1½ percent per year on average 2015–20. This reflects the expectation that capital accumulation is likely to remain subdued as firm balance sheet constraints would still weigh on investment, adverse population dynamics, and persistent structural unemployment at around 16 percent. In addition, TFP growth is expected to remain low, reflecting the continued dominance of small firms and labor market duality, which lowers incentives to invest in workers’ skills.

How much higher could potential output growth be in the medium term? Staff analysis suggests that addressing Spain’s structural problem could have a significant impact on potential output. For example, a counterfactual exercise simulating a reform that would lower the share of small firms to match that of Germany and close the productivity gap between small and large firms to German levels could possibly raise TFP (and the corresponding level of potential output) by as much as 7 and 2 percent above the baseline, respectively.3 Tackling duality, addressing skills deficiencies, and other reforms that would lower structural unemployment to about 10 percent would lift potential output by an estimated additional 4 percent. Joint implementation within a 10 year time frame would result in potential annual growth of about 2½ percent, almost double the rate currently expected under the baseline.

A01ufig18

Total Factor Productivity

(Log change, percent)

Citation: IMF Staff Country Reports 2015, 232; 10.5089/9781513560069.002.A001

Sources: INE, IMF Staff Calculations.
1 See third chapter of Selected Issues Papers.2 See second chapter in Italy—Selected Issues Papers (IMF Country Report 15/167).3 See second chapter of Selected Issues Papers.

Public Stakes in the Financial Sector

Spain’s bank resolution fund, FROB, is making progress in the sale of public stakes in the financial sector, but remaining divestments appear more challenging in the near term. Since 2009, FROB provided €53.5 billion of public support to banks in the form of equity stakes. In 2014, the fund sold its holdings in NCG Banco and Catalunya Banc, as well as a 7.5 percent stake in Bankia, resulting in about €3.5 billion of revenue over a number of years as payments are being received in installments. Buyers of banking stakes have been mainly domestic banks, while portfolios have been acquired by private equity funds. Selling the two remaining stakes (in Bankia and BMN), worth about €11 billion, ahead of the end-2017 and early-2018 deadlines could be more difficult. Although these banks’ earnings have increased, their share price valuations remain below target sale prices, in part due to potential concerns about a large share of deferred tax assets (DTAs) in capital. The FROB also maintains a 45 percent equity stake in SAREB, Spain’s Asset Management Company, amounting to approximately €½ billion, which is expected to be divested by 2027.

SAREB has continued to face losses. Losses amounted to €0.3 billion in 2013 and €0.6 billion in 2014, mainly owing to optimistic valuations of the assets transferred—even though the real estate market has now stabilized after a roughly 40 percent decline. The original portfolio (€50.7 billion) has been reduced by almost 15 percent, broadly in line with the targeted 15-year unwinding schedule. The business plan has recently been updated to reflect more realistic assumptions and SAREB has also hired 4 investment companies, including distressed debt funds, as servicing companies, to manage the cash flow and sales of the bulk of its portfolio assets.

Table 1.

Main Economic Indicators, 2011–20

(Percent change unless otherwise indicated)

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

Excludes loans transferred to SAREB.

Output per worker.

The headline deficit for Spain excludes financial sector support measures equal to 0.5 percent of GDP for 2011 and 2013, 3¾ percent of GDP for 2012, and 0.1 percent of GDP for 2014.

Table 2.

General Government Operations, 2012–20

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Sources: Ministry of Finance; Eurostat; and IMF staff estimates and projections.
Table 3.

General Government Balance Sheet, 2009–14

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Sources: Bank of Spain, IMF Staff estimates.
Table 4.

Selected Financial Soundness Indicators, 2006–14

(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.

Refers to domestic operations.

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.

Table 5.

Balance of Payments, 2011–20

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Sources: Bank of Spain; and IMF staff projections.