Spain: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Spain
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International Monetary Fund. European Dept.
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Publication Date:
21 Nov 2018
eISBN:
9781484385715
Language:
English
Keywords:
ISCR; CR; liability positions vis-à-vis nonresident; IMF staff calculation; money market rate; IMF staff estimate; government debt-to-GDP ratio; fiscal policy; structural unemployment; unemployment rate; IMF staff projection; Labor markets; output gap
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2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Spain

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Spain

Context

1. Spain continues to make up economic ground lost during the crisis. Real GDP and employment growth are set to exceed that of the euro area average for the fourth year in a row. Repeated upside growth surprises reflect the economy’s improved fundamentals, including a turnaround in productivity growth from its pre-crisis negative trend, and suggest longer-term payoffs from past structural reforms. Growth has been broad-based across demand components, and much of the competitiveness has been restored. Against this background, international rating agencies have upgraded Spain’s sovereign debt ratings.

uA01fig01

Real GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF, World Economic Outlook and IMF staff estimates.1/ Projection for 2018.
uA01fig02

Growth in Total Factor Productivity

(Percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.1/ Euro area average annual growth, GDP-weighted.

2. But efforts to address the remaining structural challenges have stalled. Since the important labor, pension, banking sector, and fiscal governance reforms taken through 2013, little new impetus has followed (Appendix I). Therefore, the steady narrowing of the income gap toward the richer European countries, that has occurred post crisis, is set to slow. The consequences would be felt predominantly by the young generation for which the crisis exacerbated preexisting high youth joblessness that left scarring effects on income and future pensions. Spain’s still low, even though improved, productivity and high structural unemployment are the key obstacles for faster convergence and more inclusive growth. Behind these weaknesses at the economy-wide level are also persistent economic disparities across regions, pointing towards inefficient allocation of resources.

uA01fig03

GDP per Capita Relative to Germany

(Percent; in purchasing power terms)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF, World Economic Outlook and IMF staff estimates.1/ Projection for 2018.

3. The new minority government of the Socialist Party aims to lower inequality and enhance quality of jobs. Its strategy for “fair and inclusive growth” is built on three pillars: (i) fiscal stability; (ii) social cohesion; and (iii) sustainable growth. Proposed policies include more social spending financed by new revenue measures, increases in pension benefits and minimum wages, and changes to the labor market. Some of the envisaged measures would partly reverse past reforms. However, absent a stable parliamentary majority, it will be difficult to advance legislative initiatives.

Recent Economic Developments

4. The Spanish economy maintained its strong momentum but has passed its cyclical peak. After expanding by 3 percent in 2017, growth has eased to 2.6 percent in the first three quarters of 2018. Private consumption growth, while decelerating, remained one of the key growth factors helped by strong job creation. At the same time, investment picked up, particularly in machinery and construction. However, weaker foreign demand has slowed export growth in the first three quarters of 2018. The economic impact from the political uncertainty related to Catalonia has so far been limited and contained to the region. Core inflation hovered around 1 percent in 2017 and through September 2018 (Figure 1). Headline inflation was higher, averaging around 2 percent last year and slightly more than 2 percent during May-October this year, reflecting higher energy prices.

Figure 1.
Figure 1.

Spain: Real Sector and Inflation

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; Eurostat; Haver Analytics; and IMF staff calculations.1/ Ireland is excluded for 2015Q1 due to methodological change and a growth rate of 119 percent.
uA01fig04

Contribution to Growth

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.

5. The labor market has continued to strengthen but significant challenges remain, especially for the young and those long out of work. The unemployment rate fell to 14.6 percent in 2018:Q3, below its long-term average. This helped particularly the long-term unemployed as they accounted for more than half of the total unemployed finding a job in 2017. There was also a notable shift toward more open-ended contracts for new hires (Figure 2). Nevertheless, Spain’s youth joblessness—at 33 percent—, the share of temporary contracts, and involuntary part-time employment remain among the highest in the EU. Wages negotiated in collective bargaining agreements rose moderately by 1.3 percent in 2017, while a much stronger hike (12 percent cumulatively in 2017–18) helped the relatively small number of minimum wage earners. For 2018–20, the guiding principle for wage increases, following the collective bargaining agreement of social partners, suggests annual wage hikes of 2–3 percent.

Figure 2.
Figure 2.

Spain: Labor Market Developments

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat, Haver Analytics, INE, Quarterly Labor Force Survey, Ministry of Employment and Social Security, and IMF staff calculations.1/ 2018Q2 value is used.
uA01fig05

Share of Long-Term Unemployed

(Percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Haver Analytics.
uA01fig06

Collective Bargaining and Minimum Wage

(index, 2000 = 100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.

6. The external position strengthened further but is still moderately weaker than suggested by medium-term fundamentals. The current account surplus declined from 2.3 percent of GDP in 2016 to 1.8 percent of GDP in 2017, recording its fifth consecutive annual surplus. The larger energy trade deficit, due to higher oil prices, was partially offset by a greater services trade surplus, boosted by exceptionally strong tourism (Figure 3). Spain became the world’s second-most visited country in 2017, surpassing the United States. Even though the CPI-based real effective exchange rate (REER) appreciated by nearly 2 percent, export volumes continued to grow robustly (see Box 1). However, export growth decelerated in the first three quarters of 2018, reflecting lower tourist arrivals and a slowdown of goods exports, while imports are rising. The net international investment position (NIIP) remained large and negative at minus 84 percent of GDP, with an adverse valuation effect recorded in 2017 mainly explained by the euro appreciation. Considering Spain’s high net external liabilities, the 2017 current account gap was estimated at -2.5 to -0.5 percent of GDP and the REER overvaluation gap was assessed at 3 to 10 percent (Appendix II). Preliminary 2018 estimates are broadly unchanged. Staff’s assessment of the external position improved from weaker in 2016 to moderately weaker in 2017.

Figure 3.
Figure 3.

Spain: External Sector

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; DataInvex;Eurostat; Haver Analytics; INE; WEO; and IMF staff calculations.1/ Portfolio Investment and Other Investment exclude the Bank of Spain, which is shown separately.
uA01fig07

Trade in Goods

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.
uA01fig08

International Investment Position (IIP) by Institutional Sector

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain, Haver Analytics, and IMF staff calculations.Notes: GG=General Government. BdE=Bank of Spain. Liabilities are shown with negative signs.

7. The private sector continues to deleverage amidst favorable lending conditions. The growth rate of overall (bank and nonbank) credit stayed negative at -1.4 percent in 2018:Q2, after a moderation during 2017. The ongoing correction of the real estate-related loan portfolio explains the still negative net credit dynamics, while in other segments the stock of loans is expanding, especially loans for consumer durables. Firms’ contained demand for bank credit reflects in part increased internal funding, on the back of improved profitability and higher retained earnings, and a greater reliance on corporate debt securities. While some segments of corporates and households are still overly leveraged, the total private sector-debt-to-GDP ratio fell by nearly 10 percentage points in 2017, reaching a similar level to that of the euro area (Figure 4). Financial conditions have remained favorable with 10-year government bond yields below their 2017 average, despite some periods of increased market volatility related to spillovers from policy uncertainty in Italy.

Figure 4.
Figure 4.

Spain: Credit Development and Financial Cycle

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; Haver Analytics; and IMF staff calculations.1/ Positive (negative) values indicate changes consistent with credit expansion (contraction).2/ Bond financing reflects debt securities issued by non-financial corporates.3/ Based on total borrowing and net accounts payable.
uA01fig09

Overall Credit and Bank Credit to Private Sector

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain, Haver Analytics and IMF staff calculations.1/ Excludes write-offs and adjustments.2/ Based on a twelve-month rolling sum.
uA01fig10

Non-Financial Corporates: Saving and Profitability

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: INE and Haver Analytics.

8. Property prices are recovering from a low level, supported by robust demand. After an increase of about 7 percent in 2017, house prices were over 20 percent below their pre-crisis peak in 2018:Q2 (Box 2). However, dynamics differ notably across regions, including for pickup in rents. For example, Madrid and the Balearic Islands experienced a faster recovery, with house prices already at around 85 percent of pre-crisis levels. Several factors explain the strong demand in the property market, including growth in employment and disposable income, low interest rates on mortgage loans, purchases from institutional investors, and tourist demand for online accommodation services.

uA01fig11

House Prices

(Index, 2007 = 100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: INE, Haver Analytics and IMF staff calculations.

9. The health of the banking system continues to steadily strengthen. Asset quality improved as nonperforming loans (NPLs) on a consolidated basis dropped to 4.5 percent of total loans in 2018:Q1, just below the euro area average. The NPL ratio for business in Spain is still more elevated at 6.4 percent in 2018:Q2 with NPLs highest among SMEs, construction and real estate companies. Banks continued to build capital buffers, but progress has been slow and uneven. The common equity tier-1 (CET1) ratio inched up by 0.3 percentage points to 13.4 percent at end-2017 (Figure 5). Banks’ profitability for business in Spain turned negative in 2017, reflecting the large loss (more than €12 billion) posed by Banco Popular after its resolution in June 2017. On a consolidated basis, profitability regained ground after a small dip in 2016. The resolution of Banco Popular through the purchase by Spain’s largest bank, together with the merger of the two state-owned banks have consolidated the banking sector further, with a potential to improve the system efficiency.

Figure 5.
Figure 5.

Spain: Banking System Performance

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; EBA, 2018Q2 Risk Dashboard; ECB, Supervisory Banking Statistics; IMF, Financial Soundness Indicators database; and IMF staff calculations.1/ For banking business in Spain, the aggregate figure of net income in 2011 and 2012 is amplified by the segregation process of saving banks’ business to newly-created banks. See BdE’s Statistical Bulletin (2012) for more details.2/ Data is on consolidated basis, but foreclosed property only reflects business in Spain.3/ Due to data availability, the chart shows semi-annual figures through 2014 and quarterly figures since then.4/ Based on banks reported in the EBA Risk Dashboard.
uA01fig12

Nonperforming Loans in Spain

(Percent of total loans)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; and IMF staff calculations.
uA01fig13

Profitability of Banks in Spain 1/

(Net income in percent of average total assets)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain and IMF staff calculations.1/ For banking business in Spain, the aggregate figure of net income in 2011 and 2012 is amplified by the segregation process of saving banks’ business to newly-created banks. See BdE’s Statistical Bulletin (2012) for more details.

10. Spanish banks maintain significant subsidiary operations in Latin America and Turkey. Their consolidated exposure to these emerging markets, measured by total claims on ultimate risk basis, stood at over US$ 550 billion at end-2017, or 15 percent of Spanish banks’ total claims. Mexico and Brazil alone account for more than 8 percent of total claims. Operations in emerging markets contribute importantly to the profits of Spain’s two global banks. In 2017, such operations generated about 40 and 80 percent of group-wide profits, respectively. Spanish banks largely operate with a subsidiary model, under which there is virtually no intragroup funding. Moreover, parent banks hedge against most exchange rate risk. However, the stock prices of Spain’s global banks recently underperformed as prospects in emerging economies became more uncertain.

uA01fig14

Exposure of Spanish Banks to Latin America and Turkey

(Total claims on ultimate risk basis 1/)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics; BIS, Consolidated Banking Statistics; IMF staff calculations.1/ Claims are defined as financial assets that have a counterpart liability.
uA01fig15

Exposure of Spanish Banks to Emerging Markets, 2017

(Percent of total claims on Latin American countries and Turkey; on ultimate risk basis)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics; BIS, Consolidated Banking Statistics; IMF staff calculations.

11. The fiscal stance was broadly unchanged in 2017 after two years of fiscal easing. The headline fiscal deficit narrowed to 3.1 percent of GDP in 2017—in line with the excessive deficit procedure (EDP) target—nudging down the general government debt-to-GDP ratio (Figure 6). The strong cyclical recovery and lower interest payments were the main drivers for the lower deficit. Tax measures adopted in 2017 yielded only 0.1 percent of GDP additional revenue, 0.4 percentage points less than budgeted, partly due to an overly optimistic inflation assumption. Sub-national governments overperformed as the compliance of regional governments improved further along with the strong economic cycle—contrasting past episodes of weak fiscal discipline and target deviations—and municipalities continued to run a significant surplus.

Figure 6.
Figure 6.

Spain: Public Finances

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Bank of Spain; Fiscal Monitor (October 2018); Spain Ministry of Finance; and IMF staff estimates.1/ For more details, see Debt Sustainability Analysis in Appendix IV.

Authorities’ Views

12. The authorities concurred that the economy has passed its cyclical peak and welcomed staff’s assessment that the external position has improved. They emphasized that external factors, particularly weaker demand from trading partners and higher oil prices, have slowed activity in 2018 more than they had expected. But regained competitiveness should help preserve current account surpluses in the medium term. The authorities also noted that recent strong investment reflects improved growth fundamentals, and they welcomed the continued deleveraging of the economy.

Outlook and Risks

13. After the economy’s impressive growth spell, it is expected to converge to its lower medium-term potential. Reflecting weakening cyclical forces and a less supportive external environment, GDP growth is projected to ease to 2.5 percent in 2018 before gradually slowing to its potential rate, estimated at around 1.75 percent over the medium term (Box 3). Lackluster productivity growth, unfavorable demographics, and high structural unemployment hold back higher potential expansion. The composition of growth is expected to remain broad based, reflecting the healthy change in the structure and competitiveness of the economy. The current account surplus is projected to be close to 1 percent of GDP, gradually reducing the high negative net international investment position. In line with the mature business cycle, core inflation is expected to gradually move to 2 percent in the coming years. Headline inflation is set to decelerate to 1.8 percent in the next few years as the base effect of higher energy prices that propelled inflation to 2 percent in 2017 and parts of 2018 fades away.

14. Risks to the outlook are tilted to the downside. Rising global protectionism and a no-deal Brexit could weigh on trade, potentially hurting Spain’s exports and investment (Appendix III). Renewed market instability related to policy uncertainty in key euro area countries could increase Spain’s bond yields and raise borrowing costs. A sharp tightening of global financial conditions, a perception that national buffers in euro area countries—including Spain—are insufficient, and an abrupt change in global risk appetite could rekindle sovereign and financial sector stress. Profitability of Spanish global banks could suffer from weakening economic conditions in emerging economies. Domestically, prolonged uncertainty related to the political crisis in Catalonia could undermine confidence with negative consequences for investment. A reversal of earlier reform achievements and delay in shoring up public and private sector balance sheets would exacerbate Spain’s existing vulnerabilities. Meanwhile, room for upside surprises remains should Spain’s past structural reforms still deliver higher-than-estimated payoffs or ongoing recovery in investment imply higher potential growth.

Authorities’ Views

15. The authorities broadly shared staff’s assessment of the outlook and the downside balance of risks. They expect GDP growth to moderate but stay above the euro area average. The authorities consider external factors as the main downside risk, while domestic risks are more limited. In particular, they argued that economic activity in the past has proven to be resilient to political uncertainty, and healthier bank and non-bank balance sheets would help withstand shocks. Among external risks, the authorities highlighted an escalation of global trade tensions and the resulting slowdown in trading partners growth, a tightening of financial conditions due to monetary policy normalization, and an increase of oil prices.

Policy Agenda

16. There is a heightened urgency to bolster the resilience and inclusiveness of the economy. With the economic cycle in Spain and the euro area maturing and new external risks rising, policy action should no longer be delayed. Fiscal policy should take full advantage of the good economic conditions to bring down faster the high level of public debt and the large gross financing needs. Otherwise, policy will have little room to proactively counterbalance adverse consequence of future shocks to the economy. Past reforms need to be preserved and enhanced, especially with a view to addressing joblessness and poverty among the young.

A. Fiscal Policy: Creating Needed Fiscal Space

17. The fiscal stance is easing in 2018, amid rising social and political demands. Several measures were adopted to support pensioners and low-income households, including broad increases in pension benefits in 2018–19 (higher than the 0.25 percent implied by the pension formula) and expansions in personal income tax (PIT) deductions for households with specific needs. The budget execution data up to August indicate that revenue performance has been in line with the budget target, whereas expenditure is expected to outrun the budget particularly due to higher-than-expected spending for public employment and pensions. As a result, staff projects the headline deficit to reach 2.8 percent of GDP this year, which is considerably above the 2.2 percent of GDP budget target but would still allow Spain to exit the excessive deficit procedure. In staff’s estimate, the projected 2018 fiscal outcome would imply a worsening of the structural primary balance by about ¼ percent of GDP.

18. Resuming active fiscal consolidation is critical to rebuild fiscal buffers and put debt on a clear downward trajectory. Fiscal consolidation has come to a standstill since 2015 and the structural deficit deteriorated to about 2½ percent of GDP. As a result, Spain’s public debt sustainability remains at risk. With the debt-to-GDP ratio hovering around 100 percent of GDP, Spain would likely be forced to undertake a procyclical tightening when the economy is hit by future shocks unless buffers are swiftly rebuilt. In a scenario in which the economy goes through another recession and does not adjust its deficit immediately, public debt would quickly return to an upward path (see text chart and public debt sustainability analysis in Appendix IV). Moreover, future increases in borrowing cost and pressure from population ageing also pose risks to the fiscal outlook (see Figure 6). Therefore, resuming consolidation of the structural primary deficit by at least 0.5 percent of GDP per year should no longer be delayed. Such an annual adjustment pace should persist until a fiscal structural balance is reached, and debt is on a clear downward path.

uA01fig16

General Government Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Ministry of Finance; and IMF staff calculations.1/ Assuming 0.5 percent of structural primary adjustment annually until structural balance is reached.2/ Assuming one (10-year historical) standard deviation growth shocks in 2019–20 and no fiscal tightening in 2021–23.

19. The 2019 budget needs to include a reliable package of adjustment measures. The government’s draft budgetary plan envisages to bring the headline deficit down to 1.8 percent of GDP in 2019 while creating space for social spending, particuarly targeting the most vulnerable. The implied improvement in the structural deficit of about 0.5 percent of GDP is set to come from a range of revenue measures that target mostly high-income earners, large corporates, and the financial sector. The main revenue proposals include (i) an introduction of a digital sales tax; (ii) an adoption of a financial transaction tax; (iii) an increase in excise on diesel; (iv) changes to the corporate income tax (CIT) system to enhance the collection; (v) a hike in PIT for high-income brackets; and (vi) anti-tax fraud efforts (see text table). Some of these measures have an uncertain yield, in particular those that relate to entirely new taxes and policy actions. Thus, to limit the risk of potential budgetary shortfalls and ensure that the envisaged improvement of the headline and structural balance can be fully met, it is important to add measures in the budget and stand ready to take contingency actions, in case any revenue shortfalls arise. Additional revenue measure would be preferable, but options on the spending side should also be identified.

Revenue Measures in the 2019 Draft Budgetary Plan

(Percent of GDP)

article image
Source: Draft budgetary plan Spain 2019 and IMF staff estimates.

The authorities’ estimation in the 2019 Budgetary Plan.

20. An extension of the 2018 budget or a no-policy-change scenario would not bring the deficit to its targeted level. In case there is no parliamentary majority to pass a budget for 2019 and the budget from 2018 is extended, the deficit is estimated to fall to around 2 percent of GDP. In a no-policy-change scenario, there would be an even bigger gap to the fiscal deficit target as staff projects the deficit to reach only 2.4 percent in 2019. This forecast includes the already legislated pension increase and PIT measures for 2019, as well as the public wage increases agreed with the unions. Thus, to stave off another year without a noticeable improvement in the structural primary balance, it is critical to take additional measures even if no new budget is approved.

Fiscal Balance

(Percent of GDP unless otherwise noted)

article image
Sources: Draft budgetary plan Spain 2019 and IMF staff projections.

Includes 0.1 percent of GDP of contingent liabilities related to the motorways in 2018. IMF staff projections are based on IMF staff macro-economic projections and assume unchanged fiscal policies except for the already legislated measures and the public wage increases agreed with the unions. This explains the difference to the authorities fiscal deficit projections.

21. Measures to lower the fiscal deficit can and should go hand in hand with inequality reduction. Since Spain’s public primary spending, at 38.5 percent of GDP, is already relatively low compared to those of EU peers, the contributions that expenditure rationalization can make to fiscal adjustment are limited. Revenue measures—the preferred adjustment tool by the government—can bring the deficit down and help finance additional spending to achieve social and distributional objectives, as well as protect the most vulnerable, support the employment prospects of the young and those long out of work, as well as foster innovation capacity and environmental protection. But a careful design of tax measures is key to limit distortions and growth implications. Measures that expand VAT collection, raise excise duties and environmental levies, and reduce inefficiencies in the tax system tend to be less distortive to short-term economic activity. Therefore, they are the preferred options to fill any potential revenue shortfalls compared to the 2019 budget and achieve the needed adjustment in the medium term. If implemented gradually they could yield extra revenue of up to 2–3 percent of GDP, though they should be accompanied with targeted spending for the most vulnerable. In contrast, the planned introduction of the digital and financial transaction taxes may yield revenue in the short term but would be more distortive and best embedded in an internationally coordinated framework given the mobility of the tax base (see IMF Country Report No. 18/223, Box 3).

Yield of Potential Revenue Measures

(Percent of GDP)

article image
Source: IMF staff estimates; and Report of the Expert’s Committee for Reform of the Spanish Tax System (2014).

22. Safeguarding the pension system’s financial viability while enhancing the social acceptability is critical. The important 2011/13 pension reforms address the pressure on the Spanish pension system from population ageing, as fewer contributors are funding more and more pensioners. Limiting pension increases to the legislated minimum rate of 0.25 percent per annum over many years would eliminate the structural deficit of social security budget and keep pension spending relative to GDP broadly stable.1 While pensions would rise less than the expected inflation rate and the purchasing power of benefits would fall, Spanish pensioners are nevertheless projected to receive higher pensions, relative to wages, than most other EU countries over the long run. The deviation from the pension formula in 2018–19 and delay in the implementation of the discount factor for changes in life expectancy (“sustainability factor”) from 2019 to 2023 is estimated to cost about 0.3 percent of GDP in the short run. This might appear manageable. But if pensions were to be relinked permanently to inflation, pension spending would be put on a sharp upward trajectory, adding about 3–4 percent of GDP in outlays by 2050 under current demographic and macroeconomic projections. Such a surge in pension spending would move Spain nearly to the top in the EU. While there is room to finance some additional pension spending, the space is rather limited given the already high contribution rates. Therefore, the recent Toledo Pact recommendations of permanently linking pension increases to an indicator of purchasing power should not be taken in isolation but needs to be carefully cogitated as part of a sustainable package.

uA01fig17

Social Security Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Spanish authorities; and IMF staff calculations.

23. A range of reform options could be considered to address the tensions in the pension system. These include efforts to (i) incentivize longer work lives (e.g., extension of the pensionable earnings reference period to a contributor’s full career; automatic indexation of the retirement age to changes in life expectancy); (ii) raise revenues without raising the already high contribution rates (e.g., increase the minimum contribution for self-employed and the maximum earnings subject to contributions); and (iii) encourage supplementary savings (e.g., automatic enrollment in a saving plan with the ability to opt out). At the same time, it is critical to be fully transparent and aim to be equitable in how the needed adjustment will be split between the young and older generation. Future pensioners can then make informed decisions on their work lives and savings (see IMF Country Report No. 17/320, Chapter 1 for more details on pension reform options).

24. Reforms of the regional finance framework should be an integral part of Spain’s overall fiscal adjustment strategy. The application of enforcement tools in 2016 combined with the strong recovery significantly strengthened regional compliance with deficit targets. Further reforms are needed to sustain these achievements and improve the functioning of the regional finance system.

  • Regional finance framework. Reforms to the regional public finances should primarily aim at making the system more transparent and consistent, thereby ensuring also equity. Moreover, it should strengthen the regions’ incentives and capacity to meet their fiscal targets over the medium term. This would, for example, imply providing the regions with greater power to mobilize their own revenues so as to better match the greater expenditure responsibilities they have (see Experts Commission Report on Regional Financing, 2017 and IMF Country Report No. 17/23).

  • Local government financing. To support investment local governments with sound financ al conditions have been allowed to use part of their surplus to fund investments considered financially viable. Proposals have been made to make such exceptions permanent. Experience shows that, even if well intended, such “golden rules” often lead to higher debt when the return of the investment projects do not pay for themselves. Thus, general exemptions should be avoided.

uA01fig18

Regional Governments Fiscal Compliance

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Spanish authorities.

Authorities’ Views

25. The authorities expressed their strong commitment to meet the fiscal targets while preserving growth and fostering social inclusion. They underlined the positive signal from exiting the excessive deficit procedure in 2018. For 2019, the government plans to adopt a structural adjustment of 0.4 percent of GDP. The increase in the revenue-to-GDP ratio by 0.6 percent of GDP would also aim to redistribute welfare, reduce social and gender inequality, and foster sustainable growth by supporting the transition to a low carbon economy. The authorities stressed that yields from new measures would be based on prudent projections. Moreover, the 2019 budgetary process would for the first time include a comprehensive gender perspective. On pension reforms, the authorities underlined the importance of safeguarding the financial sustainability of the system while also protecting the purchasing power of pension benefits. This would be achieved by measures that help lift future wage and GDP growth so as to enable a steady recovery in social security contributions.

B. Labor Market Policy: Moving Toward Greater Inclusion

26. Structural unemployment has been stubbornly high. This reflects both long-standing labor market issues and the impact of the crisis. Especially, high and prolonged youth unemployment and poverty have long-lasting effects on young people’s productivity and incomes, as well as their social prospects (see Box 4). Various estimates, including those by IMF staff, put today’s structural unemployment rate in the range of 12–16 percent, below its long-term average of 18 percent2 Several recent studies find that the 2012 labor markets reforms have supported a reduction in the structural unemployment rate and helped Spain’s export performance (see Box 1 and IMF Country Report No. 17/23, Annex I). This is captured, for example, by a structural change in the empirical relationship between the unemployment rate and the job vacancy rate, known as the “Beveridge curve”. An inward shift in the Beveridge curve suggests an improvement in the labor market matching efficiency. However, such an improvement only recouped part of the deterioration in the structural unemployment during the crisis, as today’s labor market matching efficiency is still far below its pre-crisis level.

uA01fig19

Spain: Beveridge Curve, 2001–2016

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Eurostat.

27. The high structural unemployment is linked to rigidities in the labor market, including a low mobility across regions. Spain’s internal mobility rate has been historically low by international standards. According to Eurostat Labor Force Survey data, the gross flows of internal migration across regions accounted for only 0.3 percent of the overall working age population over the past decade, in contrast to 1.2 percent in Germany and 2.4 percent in the United Kingdom. Limited regional labor mobility has been associated with persistently large disparities in labor market performance across regions, and thereby high unemployment at the national level. During 2008–17, the average gap of the unemployment rate between the top and bottom regions was about 18 percentage points. Staff’s analysis suggests that housing market prices, labor market conditions, and labor market duality are the main factors explaining the low regional labor mobility, besides the standard economic and demographic indicators (Box 5).

uA01fig20

Internal Mobility Rate in Europe

(Average of 2003–16, percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat Labor Force Survey; and IMF staff calculations.
uA01fig21

Internal Mobility Rate vs. Unemployment Rate

(Percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat Labor Force Survey; and IMF staff calculations.

28. Policy actions need to focus on tackling the rigidities in the labor market. The pervasiveness of labor market duality in Spain not only contributes to limited regional mobility, but also has a bearing on structural unemployment and workers’ productivity. Spain has the largest share of temporary employment in the euro area, especially among younger workers. To address this long-standing weakness, narrowing the gap between the costs for firms to hire permanent and temporary workers remains a key policy priority. In this regard, policy measures should focus on enhancing the attractiveness of open-ended contracts for employers, rather than increasing the cost of temporary contracts which would add more rigidities to the labor market. Specific measures could include further reducing the hiring costs and severance payments for permanent workers, creating an employer-based separation fund (“Austrian backpack”), and simplifying the list of possible causes for nullifying a dismissal to mitigate legal uncertainties that add to the cost of permanent contracts. The recently adopted plan to tackle the abuse of temporary contracts is an important effort in complementing the above measures to limit temporary hires.

uA01fig22

Temporary Employment in Euro Area Countries

(Percent of total employment)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat (LFS) and Haver Analytics.

29. Preserving wage flexibility is critical. Future wage increases should follow productivity growth. In view of the important role of wage differentials in explaining regional mobility, ensuring that wage dynamics reflect differences in region- and sector-specific conditions would promote a reallocation of labor toward more productive sectors and regions. It is also critical to continue allowing firms to set wages in line with their business condition, which is particularly relevant to preserve external competitiveness at a time when the economy faces new risks. At the same time, efforts are needed to address shortcomings in the labor legislation. The guideline of the latest collective bargaining agreement as regards general wage increase is welcome. However, the government’s proposed sharp increases in the annual statutory minimum wage by 22 percent to €12,600 in 2019 and €14,000 by 2020 could put at risk employment opportunities for the low-skilled and the young. It would also swiftly lift Spain’s minimum-to-average wage ratio to one of the highest among EU peers. Thus, allowing greater minimum wage differentiation is warranted.

uA01fig23

Minimum Wages in Selected EU Countries, 2017 1/

(Percent of average wage)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat and IMF staff calculations.1/ Bar shows data for 2018 in Spain and 2015 in France.2/ The 2019 proposal corresponds to an annual minimum wage of €12,600; and the 2020 proposal corresponds to €14,000.

30. Policies that enhance employability and incentives for labor mobility remain priorities.

  • The implementation of plans that improve education outcomes and upgrade skills should be expedited (see also Section C below). This includes implementing the multi-year strategy on employment activation. Moreover, more coordinated and better-designed active labor market policies (ALMPs) can foster employability. There is also room to consolidate the vast amount of ALMPs, which often have low participations, receive little funding and are not well-known, and instead expand the most promising programs, such as those involving the support by a personal tutor (see IMF Country Report No. 17/319, Annex I).

  • Policies that provide incentives for people to move could include subsidies for moving expense and temporary and targeted housing assistance. There is also a need to centralize information on social benefits across regions to ensure that these benefits provide sufficient support to unemployed workers but without creating distortions in job search and reallocation.

Authorities’ Views

31. The authorities’ main priority is to improve the quality of jobs with a view to boosting productivity and wage growth. They stressed that the intention is not to reverse the past labor market reforms, but only to fine-tune some aspects that have led to clear imbalances in the bargaining power, whilst maintaining flexibility. The authorities highlighted the need for wages to grow more strongly in the coming years to ensure better social equity. The planned increase in the statutory minimum wage would contribute to that and does not raise substantial concerns regarding negative employment effects, given the low wage level and experience with rapid minimum wage increases in the past that coincided with strong employment growth. In support of wage growth, the government is also working on an action plan that aims to upgrade education outcomes—in particular through more opportunities for vocational training and life-long learning—, lower pervasive labor duality, and confront gender inequality. The government recently adopted a “masterplan for fair and decent jobs” to tackle the abuse of temporary and involuntary part-time contracts as well as improper claim of self-employed status. To strengthen the effectiveness of active labor market policies, the authorities plan to focus on greater coordination between the regions with enhanced profiling tools and information systems, as well as improving the identification of skills required by the labor market.

C. Structural Reforms: Tapping into the Forgone Potential

32. Helped by past structural reforms, productivity has improved but remains notably below some European peers reflecting inefficiencies at the regional level. After total factor productivity (TFP) declined during the pre-crisis decade, the trend has reversed in recent years and TFP growth reached 0.7 percent in 2017. This has allowed Spain to narrow its productivity gap against European peers, but the disparity is still more than 10 percent relative to Germany. Notable productivity variations across regions contribute to Spain’s relatively low level of overall productivity. TFP in the most productive region is about 60 percent higher than in the least productive one. Staff analysis suggests that inefficient use of available technologies, which distances regions from the production frontier—the maximum output that can be produced given the available capital and labor—contributes to the considerable productivity variation across regions (Selected Issues Paper).

uA01fig24

Total Factor Productivity Relative to Germany, 2016

(PPP2011 international dollars)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: PWT, WEO and IMF staff calculations.
uA01fig25

Spain: Production Frontier, 2016

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Instituto Valenciano de Investigaciones Económicas and IMF staff calculations.

33. Efforts to reduce skill mismatch and enhance innovation capacity at the regional level would benefit Spain’s growth potential. Staff analysis suggests that technical inefficiency tends to be higher in regions with considerable skill mismatch and lower in regions with higher foreign direct investment (FDI) and research and development (R&D) spending relative to GDP (Selected Issues Papers). Reducing regions’ distance to the frontier would potentially yield significant long-term gains. For example, if the regions that perform below average improved their efficiency up to the regions’ average, GDP would be 1.4 percent higher. In a scenario in which regions close half of their distance to the production frontier, GDP would be 4 percent higher. Most of the improvement in technical efficiency could come through better skills match and greater reliance on R&D activities.

  • Spain faces a considerable skill mismatch and persistent skills gap among the lower-educated. Skill mismatch has several dimensions and is particularly high for the qualification mismatch. While underqualification is similar to the Euro Area average, overqualification is very high with 25 percent of workers being over-qualified. The mismatch has widened during the post-crisis years, when the share of workers with high-skilled education increased while net employment creation has been concentrated in medium-skill occupations (see IMF Country Report 17/320, Chapter II). At the same time, on the lower end of the skill distribution, skills gaps prevent many people from finding employment. Those with at most lower secondary education make up nearly 40 percent of the labor force—in some regions even over 50 percent—one of the highest shares among Euro Area countries.

  • The quantity and quality of private and public R&D spending lags that of many European peers. Since 2000, Spain spent on average 1.2 percent of GDP annually on R&D—ranging from 0.3 to 1.8 percent of GDP across regions—compared with over 2 percent in Germany and France. Moreover, spending efficiency is low and diverse, as for example measured by the number of new patents per money spent on R&D.

uA01fig26

Spain: Potential Gains in GDP from Lower Skill Mismatch and More R&D Spending

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF staff calculations.
uA01fig27

Share of Low Skilled in Labor Force, 2016

(Share of labor force with at most lower secondary education, percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Eurostat.
uA01fig28
1/ R&D efficiency is measured by the number of new patents per money spent on R&D.

34. New impetus is needed to advance the structural reform agenda. In 2017, few measures were taken that will contribute to lifting productivity growth. Thus, past policy recommendations remain relevant. Reducing regulatory fragmentation and lowering barriers for firms’ growth should be complemented by efforts to encourage labor mobility and better skills-matching, train the low-skilled, and expand firms’ innovation capacity. Narrowing the interregional productivity gaps would also provide a boost to overall productivity. The authorities’ enhanced focus on gender policies should be beneficial to reduce inequality and raise long-term growth.

  • The application of the Market Unity Law, which aims to align regulatory requirements by the central, regional and local authorities, remains slow. While the Constitutional Court has declared the principal of nation-wide effectiveness of licenses null and void, the principle of necessity and proportionality that the Court has endorsed could be used to reduce cross-regional barriers to economic activity. New impetus is also needed to advance the liberalization of professional services.

  • More than 100 size-related regulations have been identified that potentially create incentives for a “small business trap”. However, the 2019 budgetary plan proposes to reintroduce a reduced corporate income tax (CIT) rate for certain SMEs, which could hamper firm growth and productivity as suggested by previous empirical studies (see for example IMF Working Paper WP/17/139). Going forward, modifying or eliminating the identified size-contingent regulations with an aim to eliminate disincentives for firms to grow and enhance their capacity to innovate and cooperate with research institutions is needed to yield tangible results.

  • Governance of research and innovation has been streamlined and made more inclusive. However, coordination between different levels of government remains an area for improvement, including for the design, implementation, and evaluation of research and innovation policies. The government should review what holds back the uptake of R&D incentives and business-science cooperation. Particularly, clarifying and simplifying the eligibility criteria for firms to qualify for R&D incentives could increase demand for these incentives.

  • Active labor market and education policies at the regional level could help address skill mismatches and improve education outcomes. Particularly, the focus on well-targeted training, for which spending has been lower than in other EU countries, could be enhanced. Policies to increase labor market relevance of tertiary education through better cooperation between the private sector and universities and to reduce school drop-out rates will be important. Systematic exchanges of best practices and peer review among regions could help reduce regional differences in education outcomes (see European Commission, Country Report Spain 2018).

uA01fig29

ALMPs: Expenditure on Training, 2016

(PPS per person wanting to work)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Eurostat.1/ 2015 value is used.

Authorities’ Views

35. The authorities appreciated staff’s multifaceted approach to address Spain’s productivity challenge. The government is working on a set of targeted growth-enhancing structural reform initiatives that will fit within the 2019 budget. Nevertheless, they are mindful that broader legislative changes would be difficult to achieve in the fragmented parliament. Thus, they have started a range of consultative processes with social partners and political parties. The authorities highlighted that efforts are underway to strengthen support for SMEs (e.g., provision of financial counseling), implement the Market Unity Law (particularly through strengthened coordination with regions), and enhance innovation (e.g., by preparing a digitalization strategy). The authorities also pointed to some liberalization measures adopted or envisaged in the transport and energy sectors. Addressing obstacles to SME growth will continue to be a priority.

D. Financial Sector: Strengthening Resilience and Upgrading the Financial Architecture

36. Putting legacy issues fully behind and preparing to deal with new challenges remain the priorities for the financial system. Addressing these challenges is crucial to enhance the banking system’s resilience against adverse developments, and support credit intermediation in the medium term. The 2017 Financial Sector Assessment Program (FSAP) identified four priority areas where momentum must endure (IMF Country Report 17/321): (i) accelerated cleanup of legacy bank assets; (ii) further improvement in bank profitability and capitalization; (iii) rigorous management of interest and liquidity risks; and (iv) reform of the institutional framework for financial oversight. Actions taken to address FSAP recommendations so far have been limited in some areas (Appendix V).

37. Implementation of the ECB’s NPL guidance is critical to keep reducing impaired assets. Since August 2017, several major banks have announced plans to dispose of NPLs and foreclosed real estate assets. At least one of these transactions was already completed and the materialization of remaining plans will keep accelerating the decline of impaired assets in the system. However, some banks still need to lower their elevated levels of NPLs and foreclosed assets. The FSAP called for a tough stance on the implementation of the ECB’s NPL guidance, including promoting banks’ disclosure of NPL reduction targets and progress. To secure effectiveness, evaluation of banks’ NPL reduction strategies and targets should be based on a careful analysis of banks’ property price assumptions. Additionally, the recent expansion of consumer lending, a segment where NPLs tend to be relatively high, warrants close monitoring.

uA01fig30

Asset Quality and Profitability, 2016–17H1

(Based on 13 Spanish significant institutions; consolidated operations)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: EBA, 2017 Transparency Exercise; S&P Global Market Intelligence; and IMF staff calculations.

38. Banks would benefit from more capital and need to address low profitability. Common equity tier-1 (CET1) capital on a fully-loaded basis remains lower than that of many European peers even though they are generally less leveraged. Similarly, by some estimates, the Spanish banking system may be among those in Europe facing relatively large shortfalls to comply with the upcoming Minimum Requirements for Own Funds and Eligible Liabilities (MREL) targets. Continuing the buildup of capital buffers and keeping on track the buildup of “bail in-able” debt in the largest banks would help to shield against shocks, especially related to interest rate and sovereign risks, where exposure of the Spanish banking system is relatively high. Larger capital buffers would also help protect banks from potential spillovers related to volatility in emerging markets, as any significant increase in asset impairment at Spanish banks’ large subsidiaries would impact group-wide profitability. To improve bank profitability in a structural manner, the FSAP encouraged further cost cutting and branch consolidation, and an evaluation of the scope for more efficiency gains through mergers, branch reduction, and adjustments in business models, including coping with future challenges from digitalization and Fintech. With the sale of Banco Popular and the merger of Bankia and BMN, the banking system has already consolidated further.

39. Rigorous management of liquidity and interest rate risks is needed, in particular ahead of the ECB’s gradual normalization from accommodative policies. The failure of Banco Popular in 2017 on liquidity grounds and the temporary deposit outflows of banks with large operations in Catalonia during the height of the political crisis highlight the attention that should be paid to liquidity management. Moreover, while gradually rising interest rates might support profitability, stress tests performed during the 2018 Euro Area FSAP and the 2017 Spain FSAP suggest that sharp interest rate increases could erode margins via higher funding costs, and that some banks are vulnerable to interest rate and government bond yield shocks through valuation effects and trading losses, given their significant exposures to long-duration sovereign bonds. Spanish banks also lend most mortgages at variable rates and should carefully manage credit and funding risks that could arise in an environment of rising rates as well as the transition to the new methodology to set the Euribor.

uA01fig31

Sovereign Exposures and Use of ECB Funding, 2017

(Percent of total assets)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: EBA 2017 Transparency Exercise; S&P Global Market Intelligence; IMF, International Financial Statistics; and IMF staff calculations.

40. Several aspects of prudential oversight and resolution warrant attention. The FSAP stressed the need for greater supervisory focus on corporate governance practices across all credit institutions and nonbanks, and particularly the credit cooperative sector. To this end, the draft Mortgage Law presents an important opportunity toward better management of banks’ conduct risk. The resolvability of small banks needs to be improved. Efforts are underway to create a resolution fund for credit cooperatives that could help mutualize potential losses and thereby improve their resolvability. For the asset management company Sareb, which has been loss-making so far, the Bank of Spain should regularly monitor and review its business plan to ensure that it is based on realistic macrofinancial assumptions. Ongoing efforts toward enhancing the Anti-Money Laundering/Combating the Financing of Terrorism regime (AML/CFT) should be advanced, in particular by: amending the AML/CFT Law so as to eliminate any delays in implementing targeted financial sanctions relating to terrorist financing, ensuring the implementation of a risk-based supervisory framework over money and value transfer services, and adding resources to the AML/CFT supervisor (SEPBLAC) beyond the planned increase.

41. The plans to modernize the institutional framework for financial oversight are welcome and should be expedited. Spain’s financial sector oversight follows a strong sectoral approach. With increasing intra-system connectedness, there is an urgent need to establish a mechanism to ensure timely information sharing, monitoring, and action taking among agencies. The FSAP proposed to establish a Systemic Risk Council—chaired by the Bank of Spain and comprising the Treasury and other financial oversight agencies—to bolster systemic risk surveillance and promote interagency coordination. The Spanish authorities are moving in this direction, as they are drafting a proposal for a national macroprudential authority. Focus for institutional upgrades has also been on creating an independent insurance and pension supervisor as well as a financial consumer protection authority, and enhancing the transparency of the appointment process for senior positions at financial oversight agencies.

42. The urgency to enhance the macroprudential toolkit has risen. Even though there is no clear evidence so far of a generalized house price overvaluation (Box 2), it is critical that the Bank of Spain has a comprehensive toolkit at its disposal so that it can act promptly should misalignments emerge. That means that the legal basis should be established for the use of macroprudential tools, such as limits on loan-to-value and debt service-to-income.

Authorities’ Views

43. The authorities emphasized the improvement of banks’ asset quality and the ongoing work to establish a macroprudential authority over the next months. They highlighted that banks’ strategies to reduce NPLs and foreclosed assets have become more ambitious. The authorities agreed on the importance to monitor the growth of consumer credit, which is being mainly used to finance purchases of durable goods. They also concurred that banks should increase further their CET1 capital ratios, since low profitability remains a challenge. The authorities stressed that the Multiple Point of Entry resolution strategy used by Spanish global banks mitigates spillover risks from emerging market volatility. Thus, they expect the impact of those risks to be manageable. The Bank of Spain regularly reviews banks’ funding plans and conducts annual liquidity stress tests since 2017. On the housing market, the authorities did not see signs of overvaluation or financial stability risks stemming from that sector. To tackle rent price pressures in some cities, they are evaluating measures to boost housing supply. The authorities have three near-term priority financial sector projects: setting up of a national macroprudential authority, transposing the EU mortgage directive into national law, and launching a sandbox for facilitating innovation in financial activities within a controlled framework.

Staff Appraisal

44. Spain’s impressive economic recovery is maturing, while downside risks are building. After undergoing important structural changes in the aftermath of the global financial crisis, the economy’s enhanced resilience and flexibility will likely be tested in the coming years. Therefore, it is essential to preserve the thrust of past structural reforms and take full advantage of the still strong economic growth to reinforce the economy further, in particular by accelerating the reduction in public debt and the build-up of capital buffers in the banking system.

45. Now is the time to restart structural fiscal adjustment. With a debt-to-GDP ratio close to 100 percent, public debt sustainability remains at risk. The 2019 budget needs to be the turning point toward persistently rebuilding fiscal buffers, following four years during which the structural fiscal deficit has widened. Thus, it is critical to meet the announced 1.8 percent of GDP deficit target in 2019. This requires adopting a reliable package of structural measures and planning for contingency actions that could promptly compensate any potential revenue shortfalls. A structural fiscal adjustment of at least ½ percent of GDP annually should persist until there is fiscal structural balance and debt is on a clear downward path. Otherwise, Spain would be forced to undertake a procyclical fiscal tightening when the economy is hit by adverse shocks. Restarting structural fiscal consolidation would also help strengthen the external position, which is moderately weaker than suggested by fundamentals and desirable policies.

46. Fiscal deficit reduction is consistent with the goal of lowering inequality. Spain’s revenue-to-GDP ratio is 7 percentage points below that of euro area peers. Narrowing this gap with revenue measures would not only to contribute to a sustained medium-term fiscal adjustment but could also help to finance social and distributional objectives, in particular to create better opportunities for the young. But a careful design of tax measures is key to limit distortions and growth implications. To this end, options such as lowering tax exemptions, increasing environmental taxes, and shifting more items to the standard VAT rate should be seriously considered. Unintended distributional effects can be offset with targeted spending measures.

47. A sustainable and comprehensive package is needed to address the tensions in the pension system. The 2011/13 pension reforms responded with financially appropriate measures to address the pressure from unfavorable demographics. Because the social acceptability of the reforms has been put into question, further adjustments need to be made. It is critical, however, to avoid shifting the burden on to future contributors and pensioners by putting pension spending on a sharp upward trajectory, and to decide already today on a sustainable and equitable solution. It should also be clearly communicated that entirely avoiding a future reduction in real pension benefits will be extremely difficult unless there are fundamental changes to contributions and the labor market.

48. A better-functioning labor market is the core for more inclusion and higher wages. Greater wage flexibility is a critical achievement of the earlier labor market reforms and needs to be preserved, in particular the prevalence of firm-level over sector agreements. But high structural unemployment and pervasive duality are clear signs that the job market is not yet healthy. Additional labor market reforms should address these weaknesses as well as promote social cohesion and wage gains aligned with productivity. Forcefully tackling abuses of temporary contracts is important but by itself cannot be sufficient. Instead, a holistic approach is needed to lower the cost of open-ended contracts, improve training and education outcomes, and raise the low labor mobility across regions. The younger generation needs to be better integrated into the labor market to sustainably enhance their income prospects. However, the planned sharp increases in the statutory minimum wage could put at risk job opportunities of the young and low-skilled.

49. The structural reform agenda requires new impetus to lift productivity. The productivity gap to European peers is large, particularly among small and micro firms. Labor productivity also varies widely across regions. Therefore, policy efforts should focus on eliminating disincentives for firms to grow, improving market access, and expanding firm’s innovation capacity. Since responsibility for regulatory policies, R&D initiatives, and education lies at the regional level, particular efforts are needed to enhance the coordination between the levels of government.

50. The health of the Spanish banking system continues to improve while new risks are emerging. The decline in nonperforming loans and foreclosed assets has accelerated, helping to clean up banks’ balance sheets. But the process is not yet complete. Spanish banks still lag European peers in terms of capital ratios. They would therefore benefit from accelerating the build-up of high-quality capital buffers to protect their business against potential shocks, including from increased volatility in emerging markets and legal risks. Rigorous management of liquidity and interest rate risks is also needed, in particular ahead of the eventual normalization of the ECB’s accommodative policies. Moreover, as consumer lending and housing-related new loans are picking up the Bank of Spain’s macroprudential toolkit should be swiftly expanded to include borrower-based tools, to ensure that it is fully equipped to counter excessive risk-taking in the event of financial stability threats. At the same time, it is critical to complete the setup for systemic risk oversight, including a robust macroprudential framework, and more generally to continue following up on the 2017 FSAP recommendations.

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

The Drivers of Spain’s Export Growth1/

Exports now represent over a third of Spain’s GDP. Key drivers of post-crisis export growth until 2017 included external demand, greater geographic diversification, regained cost competitiveness, and substitution effects triggered by low domestic demand. The impact of the 2010 and 2012 labor markets reforms is estimated to account for nearly one-tenth to above one-quarter of the real export growth rate over 2010–13.

Spain’s export performance strengthened in the wake of the crisis. Exports of goods and services increased from 26 percent of GDP in 2007 to 34 percent in 2017. The average annual real growth rate of goods exports increased from 4.5 percent in 2001–07 to 5.4 percent in 2010–17, while for services, the average annual growth rate surged from 2.9 to 4.3 percent over the same periods. This enhanced export performance was broad-based across the main categories of goods and services. In recent years, Spain has increased its share of world goods exports, outperforming other EU countries.

uA01fig32

Share of World’s Goods Exports

(2000= 100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics, IMF, and IMF staff calculations.

Several factors contributed to strong export growth. A regression analysis indicates that foreign demand was the main driver of export growth. The impulse from foreign demand benefited from increased geographic diversification; particularly, larger exports to non-EU countries, including emerging markets in Asia and Latin America. Meanwhile, the contribution of competitiveness, measured by unit labor costs (ULC) relative to trading partners, switched from negative before the crisis to positive afterwards, partly because of wage moderation. Regained competitiveness supported the greater export orientation of Spanish firms, which was also triggered by depressed domestic demand. As more firms began to internationalize, the number of regular exporters rose by nearly one-third between 2007 and 2017.

uA01fig33

Determinants of Real Exports of Goods and Services

(Average annual growth rates, based on cumulative log changes)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

1/ Includes contribution of a dummy variable that takes the value of 1 in 2008Q4.2/ Excludes contribution of the constant term in the regression.Source: IMF staff calculations.
uA01fig34

Exports of Goods by Destination

(2000=100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics, Eurostat, IMF staff calculations.

New cross-country evidence indicates an important effect of labor market reforms on exports. Labor market flexibility can strengthen export performance, including by enhancing cost competitiveness. Evidence from panel regressions confirm a statistically significant impact on exports of labor market reforms (LMR), as measured by OECD indicators of employment protection. These regressions imply that Spain’s 2010 and 2012 LMR were associated with a faster growth of real exports in the order of 1 to 4 percentage points. This finding suggests that, on average, the LMR accounted for about one-fifth of the growth of real exports in the period from 2010 to 2013.

1/ For more details see Jorge Salas, “Drivers of Spain’s Export Performance and the Role of Labor Market Reforms”, IMF Working Paper (forthcoming).

Developments in the Housing Market: Already a Cause of Concern?

House prices have increased in recent years, although from a low level and without signs of a construction boom. While there is no clear evidence of a significant price misalignment yet, the authorities need to be vigilant. The set of macroprudential tools should be expanded to deal with potential financial stability risks.

The ongoing price recovery is not associated with a construction boom. House prices have increased by around 15 percent between 2014–17, boosted by fast recoveries in cities like Madrid and Barcelona. Registered sales have disproportionately risen among existing dwellings, whereas new-dwelling transactions are still well below their pre-crisis peak. Despite early signs of mild supply-side recovery, such as an increase in new construction approvals from a low level, the housing stock has barely risen so far. In the overall economy, the contribution of value added from the construction sector is nearly half of what it was before the crisis. These trends have been accompanied by a small decline in home ownership (from 80 to 77 percent between 2008–17), while renting activity has strengthened. Against this background, new rent subsidy programs and social home loans were recently introduced. The authorities are also considering expanding the social housing stock.

uA01fig35

Housing Transactions 1/

(2007 = 100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

1/ Based on registered home sales.Sources: Colegio de Registradores, Haver Analytics, IMF staff calculations.
uA01fig36

Housing Supply and Construction Indicators

(2007 = 100)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

1/ Last observation: 2017Q4.Sources: INE, Ministry of Public Works, Haver Analytics, IMF staff calculations.

Although house prices are rising, there is no strong evidence of a clear overvaluation yet. Two approaches are used to assess house price misalignment. The first approach measures deviations from historical averages of the price-to-rent and the price-to-income ratios. As of 2017:Q4, both ratios stand at roughly similar levels as in mid-2003 and less than one standard deviation above their historical averages, thus indicating no overvaluation. The second approach is a regression that includes the growth rates of income per capita, working-age population, interest rates, equity prices, and construction costs, as well as a long-term equilibrium relationship with the price-to-income ratio, which measures housing affordability. This model suggests a slight overvaluation in 2017:Q4. However, this regression-based result should be treated with caution given that the model is particularly limited in capturing supply-side dynamics.

uA01fig37

Price-to-Income and Price-to-Rent Ratios

(Deviations from historical averages, in standard deviations 1/ 2/)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

1/ The historical series start in 1971Q1. They are based on CPI-deflated house prices.2/) The black line indicates the one-standard-deviation threshold, above which prices are considered overvalued.Sources: OECD, IMF staff calculations.

To prevent financial stability risks emerging, the macroprudential toolkit should be expanded and ready to be used. While housing valuation gaps are not significant so far and households’ balance sheets have gradually improved since 2012, persistent demand pressures in the housing market could increase risks to financial stability. As noted in the 2017 FSAP, banks are highly exposed to real estate sector developments, and therefore the macroprudential toolkit should be expanded to deal with risks associated with that exposure (see IMF Country Reports No. 17/321 and 17/336). Other actions would be welcome to: (i) further improve balance sheets in the construction and real estate sectors; (ii) encourage greater use of fixed-rate mortgages; (iii) ensure that eligibility criteria for social home loans and rent subsidies are prudently assessed; and (iv) improve housing development regulation to address supply constraints. Any new measures aimed at reducing rent pressures should avoid causing negative supply-side effects with adverse impact on low-income renters.

Measuring Spain’s Position in the Economic Cycle

Repeated past growth surprises pose the question where the economy stands in the cycle. Considering a range of methods and indicators, the cycle appears to be maturing and the output gap closing soon.

Disentangling the cycle and the trend in economic activity is difficult. Uncertainty owing to measurement errors and challenges in identifying demand shocks complicate the estimation process. The estimation is even more challenging for an economy that experienced structural shifts. These difficulties gave rise to several potential output concepts and methods: (i) the traditional production function approach; (ii) a multivariate filtering approach (developed by Blagrave et al., 2015), which is based on a model that captures links between actual and potential GDP, unemployment, and inflation; and (iii) an extended multivariate filtering approach that accounts also for financial/credit cycles (Berger et al., 2015).

For Spain, traditional and non-traditional measures of output gap estimates range from -1.8 to +2.0 percent of potential GDP for 2018. The range reflects estimates from the European Commission, OECD, and three different estimates by IMF staff using the methods described above. The IMF’s baseline estimate, which uses the multi-variate filter approach, suggests a slightly positive output gap for 2018. Out of five methods three produce a positive output gap for 2018. The differences in output gap estimates reflect the range of potential GDP growth estimates, which vary from 0.9 to 2 percent for 2018. The IMF’s baseline estimates suggest 1.5 percent potential growth for 2018. The lowest level of potential growth estimate is suggested by the OECD, while the highest estimate is produced by the multivariate filter that considers financial frictions.

uA01fig38

Output Gap Estimates

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: AMECO, INE, OECD and IMF staff estimates.

Several other measures of economic slack also point to Spain’s economic cycle being largely completed. The unemployment rate at end-2017 was already slightly below its long-term average, while the ratio of vacancies to the number of unemployed has approached its long-term average. In addition, the negative deviation of hours worked from its long-term average and trend has almost disappeared. Capacity utilization for the overall economy surpassed its long-term average in 2017, while capacity utilization for investment goods has already reached its pre-crisis level. Nevertheless, the share of involuntarily part-time workers in active population has increased somewhat compared to the pre-crisis period pointing to a slack in the labor market.

uA01fig39

Potential Growth Estimates

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: AMECO, INE, OECD and IMF staff estimates.
uA01fig40

Capacity Utilization: Overall Economy

(Long-term average=1)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.
uA01fig41

Capacity Utilization: Investment Goods

(Long-term average=1)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Haver Analytics and IMF staff calculations.

Inequality and Poverty Across Generations1/

A consequence of the global financial crisis in most of Europe was an increase in inequality and poverty across generations. Spain was no exception where its youth was particularly hard hit by economic stagnation, while the older generation was largely protected by the pension system. When deciding on revisions to the pension system going forward, it is important to explicitly take into consideration the impact on intergenerational equity.

Income developments across the younger and older generation have diverged. The median net income ratio of those over age 65 to those between the ages of 18–24 increased in 24 of 28 EU countries following the global financial crisis. Spain experienced the second largest increase. In 2015 those over 65 years earned 20 percent more than those between the ages of 18–24, a reversal of this ratio from the pre-crisis years. The gap has narrowed since then to 10 percent in 2017 helped by the recovery in youth employment. In 2015–17 the older age group saw its mean income increase annually by 1.7 percent on average, while the younger group enjoyed a larger average annual rise of 6 percent.

uA01fig42

Median Net Income Ratio

(Ratio, age 65+ /age 18–24)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: Eurostat and IMF staff calculations.

The risk of youth poverty has surged in Spain over the past decade. During the pre-crisis years, the risk of poverty for Spain’s youth was slightly below the euro area average as many young people were employed in the booming construction sector. When the economy went into recession and job opportunities especially for the young disappeared, poverty for that age group rose rapidly. In 2015, one in three youths was at risk of poverty, defined as the share of persons with equivalized disposable income (after social transfers) of less than 60 percent of the median disposable income. At the same time, compared to all other age groups, the poverty rate for the elderly dropped sharply from 30 percent in 2005 to 12 percent in 2015. Since 2015, the trends have started to reverse with youth poverty on the decline.

uA01fig43

Spain: At-Risk-of-Poverty Rate 1/

(Percent of total)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: Eurostat.1/ Persons at risk of poverty are those living in a household with an equivalised disposable income below the risk-of-poverty threshold, which is set at 60 % of the national median equivalised disposable income (after social transfers).

The pension system helped shield the elderly through the worst of the crisis. While market income inequality in Spain is significantly higher for the elderly, after accounting for fiscal redistribution through taxes and transfers, disposable income inequality for the elderly is lower than for the working age population.

uA01fig44

Spain: Redistributive Impact of Social Spending, 2015

(Gini score)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: OECD.
1/ See also IMF Staff Discussion Note 18/01 Inequality and Poverty Across Generations in the European Union.

Regional Labor Market Mobility1

Spain’s high structural unemployment and persistent regional labor market disparities are often associated with a low labor mobility across regions. Empirical analysis finds that housing prices, labor market conditions and labor market duality are the major factors explaining Spain’s interregional migration flows.

The disparities in regional labor market performance have been large and persistent. Over the last decade, the gap in the unemployment rates between the top (90 percentile) and bottom (10 percentile) regions fluctuated around 15 percentage points. Regions in the Northeast were consistently the best performers with an average unemployment rate of 13 percent, whereas the jobless rates in the Canary Islands and the South (average of 25 percent) were continuously among the highest. The regional dispersion increased notably during the crisis but has declined since 2013 on the back of strong economic recovery.

uA01fig45

Regional Unemployment Dispersion

(Percentage point)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: INE and IMF staff calculations.

The large labor market disparities are linked to a low labor mobility across regions. According to the Residential Variation Statistics data from Spain’s statistical agency INE, about 3 percent of the population changed residence across regions during 1998–2016. The internal mobility rate grew steadily during the economic boom years but declined following the crisis as the overall labor market deteriorated. Much of this underlying trend was driven by labor movement of immigrants, whereas the mobility rate of Spaniards was relatively stable. On average, regional mobility among foreigners was around three times higher than that of Spaniards. In net terms, only a few regions have been consistently a net receiver (Navarra and Balearic Islands) or a net sender (Aragon and Extremadura). The crisis also brought some changes to the pattern of mobility flows, with some regions (e.g. Madrid and Basque Country) switching from net senders before the crisis to net receivers afterwards.

uA01fig46

Internal Mobility Rate 1/

(Percent)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: INE; and IMF staff calculations.1/ Calculated as the number of residential variations within Spain divided by the size of the corresponding population.
uA01fig47

Net Internal Migration Flows

(Absolute value)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: INE; and IMF staff calculations.

Staff’s analysis suggests that housing prices, labor force education, labor market conditions, and labor market duality are the main factors determining Spain’s internal mobility. The regression analysis controls for the standard macroeconomic, demographic, and geographic factors. All else equal, higher housing prices and larger unemployment rates in the destination regions, and greater share of temporary employment in the origin regions have a negative effect on labor mobility. Moreover, regions that have a larger share of low education labor force tend to generate more population outflows particularly after the global financial crisis. The analysis also finds that Spaniards tend to have a strong “home bias”, which could be attributed to culture and unknow institutional factors. In light of this result, there may be a role for policies to provide additional incentives to promote labor movement. Finally, when comparing the behavior of Spaniards and foreigners, the study finds that push factors tend to be more important for foreigners’ mobility, whereas pull factors matter more for Spaniards.

1/ For more details see Lucy Liu, “Regional Labor Market Mobility in Spain”, IMF Working Paper (forthcoming).
Figure 7.
Figure 7.

Spain: Long-Term Growth Prospects

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: AMECO; Bank of Spain; Eurostat; Haver Analytics; INE; ORBIS;WEO; and IMF staff estimates.
Table 1.

Spain: Main Economic Indicators, 2013–23

(Percent change unless otherwise indicated)

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

Output per worker.

The 2019 projections assume unchanged fiscal policies except for the already legislated measures and the public wage increase agreed with the unions.

The headline balance for Spain includes financial sector support measures equal to 3.7 percent of GDP for 2012, 0.3 percent of GDP for 2013, 0.1 percent of GDP for 2014, 0.05 percent of GDP for 2015, 0.2 percent of GDP for 2016, and 0.1 percent of GDP for 2017.

Table 2a.

Spain: General Government Operations, 2013–23 1/

(Billions of euro, unless otherwise noted)

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

Compiled using accrual basis and ESA10 manual, consistent with Eurostat dataset.

The 2019 projections assume unchanged fiscal policies except for the already legislated measures and the public wage increase agreed with the unions.

Table 2b.

Spain: General Government Operations, 2013–23 1/

(Percent of GDP, unless otherwise noted)

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

Compiled using accrual basis and ESA10 manual, consistent with Eurostat dataset.

The projections for 2019 assume unchanged fiscal policies except for the already legislated measures and the public wage increase agreed with the unions.

Including interest income.

Table 3.

Spain: General Government Balance Sheet, 2009–17

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Sources: Haver Analytics, Bank of Spain, and IMF staff estimates.
Table 4.

Spain: Selected Financial Soundness Indicators, 2010–17

(Percent, unless otherwise indicated)

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Sources: Bank of Spain; Haver analytics; FSB, Global Shadow Banking Monitoring Report 2017; IMF, Financial Soundness Indicators database and World Economic Outlook database; and IMF staff estimates.

Based on loans to and deposits from other resident sectors.

Based on main and long-term refinancing operations, and marginal facility.

Include public financial institutions, other financial intermediaries and financial auxiliaries.

Based on FSB’s economic-based shadow banking measure.

Table 5.

Spain: Balance of Payments, 2013–23

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Sources: Bank of Spain; and IMF staff estimates.

Appendix I. Main Recommendations of the 2017 Article IV Consultation and Authorities Actions

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Appendix II. External Sector Assessment

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Appendix III. Risk Assessment Matrix

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Note: The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). 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). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. ST=short term; MT=medium term.

Appendix IV. Debt Sustainability Analysis

A. Public Debt Sustainability Analysis

Spain’s public debt sustainability remains at risk, despite the sizeable reduction of the headline fiscal deficit since 2010. Under the baseline scenario, public debt is projected to decline slowly over the medium term, on the back of a favorable growth-interest rate differential. However, at about 92.5 percent of GDP in 2023, debt would remain at a risky level. A negative growth shock and the realization of contingent liabilities represent the largest risks to public debt sustainability. Returning to a gradual but persistent fiscal consolidation remains a priority. An annual structural adjustment of about 0.5 percent of GDP over the medium term would put debt firmly on a downward path, bringing it to around 87 percent of GDP by 2023—about 5 percentage points lower than under the baseline. Gross financing needs have declined below the 20 percent of GDP early warning benchmark and are projected to continue to fall gradually over the medium term. However, at 17.4 percent of GDP in 2018 it is one of the highest in the euro area.

Background

Definitions and Coverage

1. Public debt comprises Excessive Deficit Procedure (EDP) debt in the hands of the General Government. The General Government includes the Central Government, Regional Governments, Local Governments, and Social Security Funds. It includes only those public enterprises that are defined as part of General Government under European System of Accounts. EDP debt is a subset of General Government consolidated debt (i.e., it does not include trade credits and other accounts payable) and the stocks are recorded at their nominal value.

Developments

2. The public debt-to-GDP ratio increased from 35.5 percent in 2007 to the peak of 100.4 percent in 2014, driven by excessive fiscal deficits (of about 8.3 percent of GDP on average during 2008–14), and a largely unfavorable growth interest rate differential (which contributed an annual average of about 2½ percent of GDP). The support to the banking sector added about 4½ percent of GDP to the public debt stock. Public debt has declined since then, albeit at a slow pace, reaching 98.1 percent of GDP at end-2017.

3. Gross financing needs have dropped to below 20 percent of GDP after peaking at 22 percent in 2012, on the back of an ongoing maturity extension and nominal deficit reduction. The ECB’s quantitative easing has helped bringing yields down, and its sovereign bond purchasing program has mitigated the refinancing risk. As a result, the 10-year bond yield declined from about 6¾ percent in mid-2012 to about 1.5 percent at end-October 2018. The effective interest rate on outstanding debt has also declined, and interest payments are expected to fall below 2½ percent of GDP in 2018.

Other Factors

4. The amortization profile of public debt is tilted towards the long term (93 percent of total debt, on a residual maturity basis). The average life at issuance has increased steadily since 2012, from 5 years to nearly 11 years in 2017, with the average life of outstanding debt increasing from 6.3 to 7 years over the same period. Despite the lengthening of debt maturity, the average cost of outstanding debt has continued to fall, reaching an all-time low of 2.6 percent

in 2017. Holdings of public debt are relatively well diversified. The share of marketable debt held by the Spanish banking system has continued to fall to about 18 percent, while that of the ECB has increased to about 21 percent. The share of public debt held by residents declined by 11 percentage points since 2012 to 56 by end-2017, but remains above the 2007 level (50 percent). The stock of financial assets has gradually declined since 2014 to about 33 percent of GDP in 2017. Nonetheless, the assets are a risk mitigating factor, with net public debt levels amounting to 85 percent of GDP at end-2017.

Baseline

5. Public debt is projected to fall marginally to 97.3 percent of GDP in 2018 and continue declining slowly to 92.5 percent by 2023. Gross financing needs are expected to remain below 20 percent, and gradually decline over the projection period. However, at 16.5 percent of GDP in 2023, they would remain relatively high compared to other euro area countries.

Assumptions

6. The baseline scenario is based on the medium-term projections (Table 1). In particular, (i) growth is projected to be 2.5 percent in 2018 and moderate to 2.2 percent in 2019, as the effect of tailwinds dissipates; (ii) over the medium term, growth is set to converge toward its potential rate of around 1¾ percent; (iii) a structural loosening of around 0.2 percent of GDP is assumed in 2018 and 2019, followed by a broadly neutral fiscal stance over the medium term in structural primary terms; (iv) inflation (based on the GDP deflator) is projected to increase gradually from 1.2 percent in 2017 to 1.9 percent in 2023; and (v) long-term sovereign spreads are assumed to increase slowly in the medium term, with 10-year bond yields increasing moderately to 3.6 percent in line with a gradual normalization of monetary policy.

Realism of Baseline Projections

7. The median forecast error for real GDP growth during 2009–17 is 0.62 percent, suggesting a moderate downward bias in the staff projections. In contrast, the median forecast error is -0.95 percent for the primary balance and -0.31 percent for inflation. Both indicate some degree of upward bias in the staff projections. To assess the realism of projected fiscal adjustment, a comparison with high debt country experience suggests that the projected adjustment and level of the CAPB in Spain are below the thresholds that would question the feasibility of the adjustment.

Stress Tests

8. Public debt levels would either remain broadly flat or increase under a number of standard shock scenarios. Debt dynamics would worsen significantly if contingent liabilities were to materialize or the economy is hit by a combination of negative shocks to GDP growth and the subsequent deterioration in primary balance, with the stock of public debt peaking in 2020 at around 112 percent of GDP and 106 percent of GDP, respectively.

Growth Shock

9. In this scenario, real GDP growth rates are assumed to be lower than in the baseline by one (10-year historical) standard deviation for two consecutive years, in 2019–20. This implies that real GDP would contract by an average of 0.5 percent per year in 2019–20, compared to annual average growth of 2.0 percent under the baseline. Under this recession scenario, inflation would be lower (by an average of 0.6 percentage points per year) and the primary balance weaker (by about 1.9 percent of GDP per year, on average) in the recession years. For 2021–23, the scenario assumes a moderate fiscal tightening as primary expenditure is projected to grow only in line with the new GDP levels which is lower than in the baseline. In this context, the debt-to-GDP ratio would rise to 105 percent of GDP in 2020 before declining slowly to 102 percent in 2023 (almost 10 percentage points higher than the baseline), and gross financing needs would increase slightly above the 20 percent benchmark level reaching 20.8 percent in 2020. If, however, the scenario assumes no fiscal tightening and primary expenditure remains at the same nominal level as in the baseline, higher fiscal deficits in 2021–23 would push public debt into an upward trajectory, reaching 110 percent of GDP in 2023.1

Primary Balance Shock

10. This scenario assumes a relaxation of fiscal policy in 2019–20, with a cumulative deterioration of the primary balance of 1.8 percent of GDP (that is, assuming a shock equal to ½ the 10-year historical standard deviation of the primary balance-to-GDP ratio). Under this scenario, the public debt-to-GDP ratio would continue to increase, peaking at 98.5 percent of GDP in 2020 and then declining gradually to 97.4 percent of GDP in 2023, nearly 5 percentage points higher than in the baseline. The larger primary deficits would also imply more sizable gross financing requirements than in the baseline.

Interest Rate Shock

11. Over the five-year forecast horizon, the debt dynamics could withstand relatively well a real interest rate shock of about 325 basis points during 2019–23, given the relatively long debt maturity and the high share of debt at fixed interest rates. Under such a scenario, the effective interest rate would increase to 4.1 percent by 2023 compared to 2.9 percent in the baseline. The debt-to-GDP ratio would remain broadly stable, amounting to 95.8 percent in 2023. However, a sizeable and sustained increase in interest rates would reduce the (already limited) fiscal space.

Combined Shock

12. A simultaneous combination of the previous three shocks would be particularly adverse for public debt dynamics, mostly due to the impact of lower growth and higher primary deficits. In this scenario, the public debt-to-GDP ratio would increase to 107.7 percent in 2023, about 15 percentage points higher than under the baseline). Gross financing needs would also be significantly higher, rising to 21.4 percent in 2023.

Contingent Liability Shock

13. Large, negative unexpected events could put debt sustainability at risk. A negative financial sector shock scenario, assuming a one-time increase in non-interest public expenditures (in 2019) equivalent to 10 percent of banking sector assets, combined with lower growth and lower inflation in 2019–20 (i.e., growth is reduced by 1 standard deviation) would be particularly adverse for public debt dynamics. The materialization of such contingency liabilities would raise the primary deficit to about 10 percent of GDP in 2019, bringing gross financing needs to 27.5 percent of GDP (about 7 percentage points above standard early warning benchmark levels). Moreover, the debt-to-GDP ratio would continue to increase, peaking at 111.7 percent in 2020, then slowly declining to about 109.8 percent in 2023 (about 17 percentage points higher than the baseline).

Heat Map

14. Risks associated with public debt remain high as the benchmark level (85 percent of GDP) is breached under the baseline scenario as well as in each of the shock scenarios. Gross financing needs would remain below 20 percent of GDP under the baseline, but would surpass that benchmark level in the case of output and primary balance shocks and the materialization of contingent liabilities. Regarding the debt profile, risks stem from the high level of external financing needs and—to a lesser extent—from the share of public debt held by non-residents.

B. External Debt Sustainability Analysis

Under the baseline scenario, external debt is projected to decline over the medium term, from the peak of 168 percent of GDP in 2015 to about 144 percent of GDP in 2023, helped by the accumulation of trade surpluses. Although it will take time to significantly lower Spain’s vulnerability to external shocks, some mitigating factors include the current low cost of debt, the limited share of debt denominated in foreign currency, a favorable maturity structure, and diversified exports.

Methodology

15. The external DSA provides a framework to examine a country’s external sustainability that complements the External Sector Assessment (Appendix II). The external DSA estimates the external debt path under several scenarios. While the assumptions are relatively mechanistic and the estimates do not employ full-fledged alternative macroeconomic scenarios, they can nevertheless provide useful insights on the potential impact of a range of shocks.

Baseline

16. As in the case of the Public DSA, the baseline scenario is based on the medium-term macro projections (Table 1). These projections assume a gradual convergence of real GDP growth to its estimated potential of around 1.75 percent over the medium term. The trade surplus is forecast to gradually improve somewhat and the external current account balance would remain close to 1 percent of GDP. External debt is projected to decline from 167 percent of GDP in 2017 to 144 percent of GDP in 2023. Driven by good export performance in the medium term, the external debt-to-exports ratio is projected to sharply decline during 2018–23. Gross external financing needs will continue to decrease throughout the projection period but are expected to remain high (around 60 percent of GDP in 2023).

Alternative Scenarios

17. Alternative external DSA scenarios, including stress tests, suggest that while Spain’s external debt would remain relatively high, it will gradually decline over the medium term. However, if key macroeconomic variables move closer to their levels observed during the crisis, the external debt would increase. Overall, the level of external debt remains a vulnerability factor given the risks surrounding the economic outlook over the medium term.

Historical Shock Scenario

18. The external debt path would fail to stabilize in a scenario based on historical data properties (2008–17) for real GDP growth, the interest rate on external debt, the GDP deflator in US dollars, and the current account position excluding interest payments. The external debt would increase to 204 percent of GDP by 2023, driven in part by a real GDP growth path of 0.3 percent since 2019 and a lower current account surplus (excluding interest payments).

Interest Rate Shock

19. Following a one-half standard deviation interest rate shock (an increase from 2 percent in the baseline to 2.5 percent), external debt would be higher by about 4 percentage points of GDP than in the baseline scenario at end-2023.

Growth Shock

20. Assuming that real GDP growth averages 0.6 percent between 2019 and 2023, compared with 1.8 percent in the baseline, external debt would reach 154 percent of GDP in 2023.

Non-interest Current Account Shock

21. A stress scenario in which the current account surplus, excluding interest payments, averages 2.3 percent of GDP rather than 3.8 percent of GDP as in the baseline projection, leads to an external debt stock of 151 percent of GDP in 2023.

Combined Shock

22. A combination of ¼ standard deviation shocks to real GDP growth, the external interest rate, and the current account balance is associated with an external debt-to-GDP ratio of 154 percent in 2023.

Real Depreciation Shock

23. Compared to the baseline projection, a 30 percent real depreciation shock would increase the external debt over the medium term, on average, by around 5 percent of GDP per year. In the external DSA, the mechanic transmission channel is via valuation effects, but Spain has a low share of debt denominated in foreign currency.

uA01fig48

Spain Public DSA—Risk Assessment

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 85% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant2/ The cell is highlighted in green if gross financing needs benchmark of 20% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents.4/ Long-term bond spread over German bonds, an average over the last 3 months, 31-Jul-18 through 29-Oct-18.5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.
uA01fig49

Spain Public DSA—Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source : IMF Staff.1/ Plotted distribution includes all countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Not applicable for Spain, as it meets neither the positive output gap criterion nor the private credit growth criterion.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
uA01fig50

Spain Public Sector Debt Sustainability Analysis (DSA)—Baseline Scenario

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ Long-term bond spread over German bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r – π(1 +g) – g + ae(1 +r)]/(1 +g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured byincreasein local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r- π(1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 asae(1+ r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
uA01fig51

Spain Public DSA—Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF staff.
uA01fig52

Spain Public DSA—Stress Tests

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Source: IMF staff.

Spain External Debt Sustainability Framework, 2013–2023

(In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

uA01fig53

Spain External Debt Sustainability—Bound Tests 1/ 2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2018, 330; 10.5089/9781484385715.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-yearhistorical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2019.

Appendix V. Implementation Status FSAP Recommendations1

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BdE=Banco de España; CNMV=Comisión Nacional del Mercado de Valores (National Securities Market Commission); DGSyFP=Directorate General for Insurance and Pension Funds (Dirección General de Seguros y Fondos de Pensiones); EBA=European Banking Authority; ESRB=European Systemic Risk Board; FGD=Deposit Guarantee Fund (Fondos de Garantía de Depósitos); FSB=Financial Stability Board; FROB=Spanish Executive Resolution Authority; LSI=Less Significant Institutions; MoE=Ministry of Economy, Competitiveness, and Industry; SAREB=Management Company for Assets Arising from the Banking Sector Reorganisation (Sociedad de Gestión de Activos Procedentes de la Reestructuración Bancaria); SI=Systemic Institutions; SREP=Supervisory review and evaluation; SSM=Single Supervisory Mechanism.
1

The structural social security deficit is estimated at 1 percent of GDP (see AIReF Report on the Kingdom of Spain’s 2017–2020 Stability Programme Update, May 10, 2017; BBVA Research; Bank of Spain (2017), Occasional Paper 1701).

2

The long-term average covers the period 1980–2017. There was a structural break in the unemployment series in 2001, when the National Statistics Institute (INE) introduced several methodological changes.

1

Alternative assumptions on the growth shock have also been considered, for example, a one standard deviation negative shock in 2019 with persistence parameters estimated using historical GDP data, and a one standard deviation shock in 2019–20 with a gradual recovery to potential growth in 2023. These scenarios generally produce similar results, with a debt-to-GDP ratio reaching the range of 110–15 percent of GDP in 2023, assuming no fiscal tightening in the projection years.

1

In addition to these near-term recommendation, the FSAP also had several other recommendations that are important but could follow after consideration has been given to the near-term recommendations.

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Cover IMF Staff Country Reports
Spain: 2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Spain
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2018: Issue 330
Publisher:
International Monetary Fund
ISBN:
9781484385715
ISSN:
1934-7685
Pages:
82
DOI:
https://doi.org/10.5089/9781484385715.002

Real GDP Growth

(Percent)

Growth in Total Factor Productivity

(Percent)

GDP per Capita Relative to Germany

(Percent; in purchasing power terms)
Figure 1.

Spain: Real Sector and Inflation

Contribution to Growth

(Year-on-year percent change)
Figure 2.

Spain: Labor Market Developments

Share of Long-Term Unemployed

(Percent)

Collective Bargaining and Minimum Wage

(index, 2000 = 100)
Figure 3.

Spain: External Sector

Trade in Goods

(Percent of GDP)

International Investment Position (IIP) by Institutional Sector

(Percent of GDP)
Figure 4.

Spain: Credit Development and Financial Cycle

Overall Credit and Bank Credit to Private Sector

(Year-on-year percent change)

Non-Financial Corporates: Saving and Profitability

(Percent of GDP)

House Prices

(Index, 2007 = 100)
Figure 5.

Spain: Banking System Performance

Nonperforming Loans in Spain

(Percent of total loans)

Profitability of Banks in Spain 1/

(Net income in percent of average total assets)

Exposure of Spanish Banks to Latin America and Turkey

(Total claims on ultimate risk basis 1/)

Exposure of Spanish Banks to Emerging Markets, 2017

(Percent of total claims on Latin American countries and Turkey; on ultimate risk basis)
Figure 6.

Spain: Public Finances

General Government Public Debt

(Percent of GDP)

Social Security Balance

(Percent of GDP)

Regional Governments Fiscal Compliance

(Percent of GDP)

Spain: Beveridge Curve, 2001–2016

Internal Mobility Rate in Europe

(Average of 2003–16, percent)

Internal Mobility Rate vs. Unemployment Rate

(Percent)

Temporary Employment in Euro Area Countries

(Percent of total employment)

Minimum Wages in Selected EU Countries, 2017 1/

(Percent of average wage)

Total Factor Productivity Relative to Germany, 2016

(PPP2011 international dollars)

Spain: Production Frontier, 2016

Spain: Potential Gains in GDP from Lower Skill Mismatch and More R&D Spending

Share of Low Skilled in Labor Force, 2016

(Share of labor force with at most lower secondary education, percent)

ALMPs: Expenditure on Training, 2016

(PPS per person wanting to work)

Asset Quality and Profitability, 2016–17H1

(Based on 13 Spanish significant institutions; consolidated operations)

Sovereign Exposures and Use of ECB Funding, 2017

(Percent of total assets)

Share of World’s Goods Exports

(2000= 100)

Determinants of Real Exports of Goods and Services

(Average annual growth rates, based on cumulative log changes)

Exports of Goods by Destination

(2000=100)

Housing Transactions 1/

(2007 = 100)

Housing Supply and Construction Indicators

(2007 = 100)

Price-to-Income and Price-to-Rent Ratios

(Deviations from historical averages, in standard deviations 1/ 2/)

Output Gap Estimates

Potential Growth Estimates

Capacity Utilization: Overall Economy

(Long-term average=1)

Capacity Utilization: Investment Goods

(Long-term average=1)

Median Net Income Ratio

(Ratio, age 65+ /age 18–24)

Spain: At-Risk-of-Poverty Rate 1/

(Percent of total)

Spain: Redistributive Impact of Social Spending, 2015

(Gini score)

Regional Unemployment Dispersion

(Percentage point)

Internal Mobility Rate 1/

(Percent)

Net Internal Migration Flows

(Absolute value)
Figure 7.

Spain: Long-Term Growth Prospects

Spain Public DSA—Risk Assessment

Spain Public DSA—Realism of Baseline Assumptions

Spain Public Sector Debt Sustainability Analysis (DSA)—Baseline Scenario

(in percent of GDP unless otherwise indicated)

Spain Public DSA—Composition of Public Debt and Alternative Scenarios

Spain Public DSA—Stress Tests

Spain External Debt Sustainability—Bound Tests 1/ 2/

(External debt in percent of GDP)