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.
After an unprecedented deep and long lasting recession, Spain is now reaping the benefits of a very ambitious policy agenda. Spain is currently among the fastest growing advanced economies, with leading employment creation in the Euro area. These very welcome developments are underpinned by a strong commitment to reforms and fiscal consolidation, which need to be sustained so as to address the still significant challenges ahead. We thank staff for the candid dialogue held during the mission and for its hard work, including the seven high quality and well balanced selected issues papers. We agree with staff’s assessment that “reforms make a difference” and that their reversal would have a negative economic impact. We also agree with their many constructive and useful economic policy recommendations, which are in line with the authorities’ goals.
Correction of macroeconomic imbalances and the improving picture of the Spanish Economy
The Spanish economy is in a much better position now than three years ago. Confidence has been restored, and this includes foreign and domestic investors, consumers and entrepreneurs alike. This improvement stems from the correction of macroeconomic flow imbalances, which has played a major role in the change of perception towards the Spanish economy:
‒ Spain has regained the competitiveness lost after joining the euro vis-à-vis main trading partners through a sizable internal devaluation process. Unit labor costs have come down substantially, and other relative competitiveness indicators, such as CPIs or REERs, are also showing important gains. Alongside with demand compression, there has been a major structural reallocation of production towards the external market: the export sector is thriving, with exports now accounting for 32 percent of GDP vs. 23 percent of GDP in 2009.
‒ The sheer size of the adjustment in the current account surplus, over 11 points in 5 years, is unprecedented by historical standards for an advanced large non-commodity exporting economy, as staff rightly acknowledged in last year’s Art. IV consultation. Spain has been running a current account surplus since 2013; and, more importantly, this surplus is expected to be maintained over the coming years despite a fast growing domestic demand environment, which signals the structural nature of the adjustment. This is no lesser feat: 2015 will be the third consecutive year with current account surplus, which is unprecedented by historical standards.
‒ The deleveraging process is ongoing, with significant progress both in the corporate and household sectors. Private debt has fallen by 38.2 percentage points from its peak, and household debt as a share of net assets stands at 69.9 percent of GDP, a level last seen in 2006, suggesting that consumption growth could be sustained well into the future. The analysis of household debt in terms of net assets is very relevant in the case of Spain, where there is a deep culture of home ownership; the use of this metric should be promoted within the Fund, as has been the case in other European countries’ Art. IV consultations, and for the 2015 WEO.
Economic performance is finally reflecting these corrections: output is growing at an annualized rate of around 4 percent and Spain is profiting from an employment-rich recovery. No analyst or economic institution envisaged this improvement two years ago. As a matter of fact, in 2013 the IMF forecasted 0 percent growth for 2014 and 0.3 percent for 2015, as well as negative potential output, depicting Spain as the example of a stagnant economy saddled by the legacies of the crisis.
A recovery underpinned by a strong policy agenda
An appropriate fiscal consolidation strategy and an ambitious structural reform program have underpinned the turnaround of the Spanish economy.
From its peak, the fiscal deficit is expected to be reduced by 6.6 percentage points of GDP in nominal terms in 2015, against the backdrop of a severe recession, with a sizable structural effort. The authorities remain firmly committed to delivering on fiscal targets, bringing down the fiscal deficit below 3 percent in 2016 and reaching the medium-term objective (MTO) of a balanced budgetary position in structural terms by 2019.
Structural reforms have also been implemented on the fiscal side: the fiscal framework has been strengthened under the Budget Stability Law and a new independent fiscal institution is now operational. Commercial arrears to public sector suppliers have been cleared and efforts have been made to streamline and increase the efficiency of the public sector, with structural reform has also had a positive impact on the fiscal consolidation process, putting the Spanish pension system on a sustainable footing for the future. On the revenue side, progress has been made to rebalance direct and indirect taxation so as to promote an employment rich recovery.
The Spanish authorities have forcefully implemented a comprehensive policy agenda to recover competitiveness and increase the flexibility of the Spanish economy. The 2012 labor market reform has helped firms navigate difficult economic times while at the same time preventing labor shedding in the scale seen before the reform. Now that the economy is growing, the reform has spurred faster job creation and good employment prospects.
Other important reforms include the Market Unity Law, curbing red tape and market fragmentation; an overhaul of insolvency regulations to facilitate deleveraging and encourage ‘fresh start’ while at the same time preserving payment culture; and a broad range of other measures to improve SMEs’ financing, corporate governance and competition.
Financial sector and credit
Over the last few years Spain has completed deep and comprehensive reforms in the financial sector that have included strengthened provisioning requirements and transparency, asset quality reviews, stress tests, recapitalization and transfer of impaired real estate assets to an asset management company. These reforms have also encompassed an overhaul of corporate governance, the savings banks regime, investor protection rules and prudential requirements (such as a narrower definition of capital and stricter forbearance criteria, to name a few).
As a result of all these efforts, the Spanish banking sector has notably strengthened its situation in terms of solvency, profitability, asset quality, provisioning, funding and liquidity, as the staff report acknowledges. Consequently, the Spanish banking system obtained the best result in the asset quality review, and the second best result in the stress test of the Comprehensive Assessment run by the ECB in 2014.
The Spanish economy is already reaping the benefits of a sounder financial system in terms of credit flows and, hence, growth and job creation. Specifically, flows of new credit for SMEs and households have been positive for the last year and a half, and the overall figure for credit to non-financial corporations also turned positive at the beginning of 2015.
Non-financial private sector deleveraging is well advanced and has become compatible with new credit. The aggregate amount of credit is now contracting less sharply than in previous years, both in terms of lending to households and to non-financial corporations, reflecting both net amortization of old loans and dynamic creation of new ones. This aspect is extremely positive, as deleveraging is ongoing while at the same time banks are capable of extending new credit, which is being allocated to more productive and financially solvent borrowers, therefore increasing the quality of banks’ assets.
Stock vs. flow adjustment
Despite the significant correction achieved in terms of flows, the Spanish authorities see no room for complacency, in so far as the adjustment of stocks needs to continue. It should be noted that correction of stock imbalances, particularly coming from high levels, takes time.
Staff’s report rightly focuses on the importance of correcting stock imbalances, but gives less attention to the remarkable and historically exceptional ongoing correction of flows that is taking place in the Spanish economy. As an example, we would have welcomed a mention to employment creation numbers, a major achievement of the Spanish economy that stems from the 2012 labor market reform: according to data from the first quarter of 2015 around 500,000 new jobs were created over last year (on seasonally adjusted terms), reducing unemployment by more than 2 percentage points.
In the same vein, a reference is made to the high level of structural unemployment and the low level of potential growth. Two years ago the estimate for structural unemployment, at 20 percent, was almost 4 percentage points higher and, at the same time, potential growth was deemed to be close to nil, around 1 percentage point both lower than current estimates.
Flow adjustments matter, and they are a precondition for stock adjustments. Lack of attention to the extraordinarily significant flow adjustments can lead to bias in risk assessment. Staff concludes that Greek contagion risks on the Spanish economy “remain significant” and could lead to “renewed sovereign and financial sector stress.” A closer look at the resilience of flow developments (strong growth, employment creation, external surplus, fiscal prudence) would suggest otherwise. We would have also welcomed a stronger mention to the reinforcing of euro institutions, such as the ESM, the banking union or the ECB’s initiatives. Staff’s pessimistic assessment is also at odds with the assessments contained in the Art. IV report for the Eurozone as well as in recent Art. IV reports for other Eurozone countries.
The performance of the external sector has been very positive since the beginning of the crisis. After many years of demand compression and high unemployment, domestic demand started to recover last year without a significant deterioration of the current account, which is still in surplus. Moreover, this recovery of domestic demand has happened in a context of continued credit contraction and deleveraging, which shows that the recovery is not a return to a credit-fuelled absorption boom. Favorable developments of energy prices and the euro have also contributed to a more positive evolution of the current account.
NIIP has worsened substantially since 2000, mainly driven by sustained current account deficits during the boom years—which have now been corrected—and, as staff rightly acknowledges, by substantial valuation effects that are expected to subside. However, there are mitigating factors to the assessment of the net debtor position, correctly considered in the external sector SIP—although not mentioned in the body of the report. The NIIP has a large FDI component (20 percent of GDP), and significant large gross equity liabilities and assets (60 percent of GDP). Debt is in domestic currency in net terms and its maturity is predominantly long term; as for assets, they are diversified. Both authorities and staff expect the NIIP to improve substantially over the coming years.
The prospects for the Spanish economy
The Spanish economy has corrected its flow imbalances and stock imbalances have improved significantly. These corrections attest to the effectiveness of an economic policy agenda based on fiscal discipline and supply side reforms. However, there is no room for complacency. Spain still faces significant challenges ahead. The sizable imbalances accumulated prior to the deep and long lasting recession, together with those created by the economic crisis, cannot be corrected in a couple of years; the Spanish authorities are convinced that fiscal consolidation and reform momentum should continue going forward.