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Spain -- 2001 IMF Article IV Consultation
1. Among the larger euro area economies, Spain has shown the most sustained dynamism over the past five years. And even in the current adverse global setting, output and employment have continued to expand more rapidly than the euro area average. This performance is due, first and foremost, to strong policies-oriented toward medium-term goals of macroeconomic stability and structural reform. The challenge now is to build on this success, with policies that will carry the economy forward to an extended period of strong growth and job creation.
The short-term outlook
2. The September 11 shock-to a slowing global economy-heightens the challenge. Growth in the euro area should be less affected than in the United States. Given the unfolding nature of events, it is difficult to develop a firm projection for the Spanish economy, but it should maintain a margin of growth well above the euro area average. Even so, growth may be only some 2.3 percent in 2002. Consumer price inflation should fall to under 2½ percent by end-2002, and the unemployment rate should decline slightly further-developments that testify to labor market reforms, and the prudence of the labor unions in prioritizing job creation, in the setting of a credible monetary framework. There are some upside possibilities to the outlook. Confidence could prove more resilient than expected. And there may be a stronger-than-anticipated impact of lower energy prices and interest rates-with monetary conditions, certainly, remaining somewhat easy for the Spanish economy. But this is not to deny the serious downside risks. Transmitted through the global economy, there could be a deeper or longer shock to confidence; and there are some specific risks that could affect the economy-notably, in tourism, despite likely gains from diversion of business away from riskier markets.
3. The key, in a setting of some uncertainty, remains a firm medium-term orientation in policies-sustaining consumer and business confidence, and fostering growth. The next few years should see continuing real convergence, both with Spain's most advanced EU partners, and among its own regions. Achieving this, in a setting of macroeconomic stability, is a crucial challenge for policy. Rightly framed, fiscal and structural policies can assure a smooth and fast-paced transition, as some influences that have been boosting growth and job creation are felt less forcefully-such as the steep fall in interest rates triggered by policy credibility during Spain's advance to euro area membership.
4. It is also worth recalling that, before the downtrend in the world economy set in, the concern in Spain was about risks of overheating, and supply-side constraints on growth-at a time when unemployment was well in double digits. Policies responding to the current situation need to be anchored on the need to raise the medium-term ceiling on growth. This suggests two key priorities. First, to continue enhancing efficiency in the use of public and private resources: while statistics are probably imperfect, the rise in productivity appears disappointing in recent years. The second, at least as important, is to raise Spain's still low employment level, which will involve further reducing imbalances in the labor market-particularly among regions.
5. These priorities need to be pursued in a global environment where the transmission of shocks is evolving. Recent shocks to Spain's economy have been of a traditional nature-higher oil prices, slowing export markets. But the underlying changes in the world economy need to be kept in mind. Change in the information and telecommunications sector, and the continuing globalization of financial markets, are strengthening and accelerating financial linkages.
6. How can policy best respond, in cooperation with the territorial authorities and social partners, in order to foster strong growth, while buffering the economy against real and financial shocks?
Priorities in fiscal policy
7. To promote stability, the government has rightly given priority to a renewal of Spain's budgetary framework. Fiscal consolidation has been a cornerstone of the strong and stable expansion of recent years. These fiscal gains need to be locked in. The draft Budgetary Stability Law addresses these issues squarely. Together with the far-reaching changes in the financing of the Autonomous Communities, it can facilitate the efficiency gains possible in a decentralized fiscal system.
8. Four aspects of the Budgetary Stability Law appear particularly important, and will be influenced by the details of design and implementation. Some specific points are as follows:
· Transparency. To foster public accountability, the prompt reporting of fiscal performance, in line with ESA 95 standards, needs to be ensured at all levels of government. The details of regional financing arrangements also need to be wholly transparent. So, too, do the transitional arrangements for non-contributory pensions and for the linked treatment of the state and social security balances.
· Fiscal co-responsibility, within the setting of the EU Stability and Growth Pact. With the Autonomous Communities now having revenues that match their expanded role in public spending, and assuming the associated risks, they will need to manage expenditure in ways that sustain sound public finances, within the framework of the Stability and Growth Pact. An essential priority is that medium-term financial goals at each level of government be consistent with the overall objectives of Spain's Stability Program-balance or a modest surplus. Hence it is indeed important that negative deviations in any year from medium-term targets, at any level of government, be explained and accompanied by a viable adjustment program demonstrating how these will be eliminated.
· Ceilings on central government spending. By introducing such ceilings Spain is joining the leaders in the field. This framework facilitates strategic expenditure restraint, helping to reconcile deficit and tax reduction objectives and, crucially, protect the investment program-one of the keys to rapid growth and regional convergence. One lesson of experience elsewhere is to set firm nominal or real ceilings on expenditure over the multi-year period, avoiding risks of an upward drift. Another is achieving upfront consensus on strategic priorities, ministry by ministry-and on the structural reforms in current primary spending that are needed to make room for expanded public investment and lower taxes. The contingency fund should help cope with, and limit, the inherent risks in budgeting.
· Fiscal discipline. Strict control of spending by the central government and territorial administrations must be the bedrock of economic policy. The law, however, should not operate in a way that triggers procyclical actions at any level of government-such as investment cuts or tax increases when the economy is weakening. Under monetary union, and with the nature of global shocks evolving, this is important. Winning the battles of the past in fiscal management has created room to accommodate cyclical fluctuations, in line with the rules of the game of the EU Stability and Growth Pact. But Spain's fiscal credibility is of recent date. Policy-makers can declare victory-but they cannot afford to give up hard-won ground. Accommodating cyclical fluctuations must not open the door to a loss of fiscal discipline.
9. In line with this medium-term approach, the government was well-advised in aiming, in 2002, for overall balance for the public administrations, rather than the originally-planned surplus, given its most recent forecast of economic growth on the order of 2.9 percent of GDP. After allowing for the effects of the cycle, this is consistent with the path of consolidation underlying Spain's Stability Program. Moreover, if growth should turn out closer to 2.3 percent, then a modest and purely cyclical decline in revenues (likely some 1/4 percent of GDP) should be tolerated, in line with the philosophy of the Stability and Growth Pact. Notable also in the budget is the composition of spending, with a well-judged emphasis on investment and education, which are favorable for future economic growth. Reforms of the corporate income tax will also provide some boost for investment as a by-product. Absent a major change in the economic outlook, spending should be strictly limited to budgeted levels.
10. The question how far fiscal policy should aim for a move into surplus at the general government level will need to be kept under review. This will depend critically on the impact of pension reforms, as part of an integrated approach to the demographic shock. With low fertility and high life expectancy, Spain faces a larger, if later, pension shock than many other countries. On the favorable side, it is notable that immigration recently has been running at higher levels than assumed a few years ago. On the other hand, healthcare spending for an ageing population will add significantly to the fiscal shock. Higher productivity and employment can soften the shock, however; and continued fiscal consolidation would reduce its impact.
11. A satisfactory demographic strategy thus needs to draw on a range of elements. A surplus in the social security fund can contribute, but is not a full solution in itself. And sizable fiscal surpluses have opportunity costs-potentially including investment. Reforms to the pension system, therefore, are also needed. Recent changes include important elements, such as the plan to allow pensioners to work. And the evolving plans to develop a viable second pillar to the pension system, with widespread company-based pension plans-and workable arrangements for small- and medium-sized firms-are highly welcome. But there remains a need to align contributions and benefits more closely, thus improving incentives, and contributing also to the functioning of the labor market.
The role of structural policies
12. Sound macroeconomic policies, fostering robust growth, have helped to stimulate a strong expansion of employment. In addition, economic growth, since the late 1990s, has been richer in job creation: reforms in the labor and product markets, combined with sustained wage moderation, have been crucial. Still, the activity ratio remains low, especially among women; there are wide and enduring regional disparities in the labor market; and the exceptionally high, if gradually declining, ratio of temporary workers suggests that some underlying distortions remain in the cost of regular contracts. Moreover, productivity appears to be growing only fairly slowly, and the "new economy," while beginning to make itself felt, has lagged several other advanced countries. Building on the important reforms already in place, labor and product market performance still needs to be improved.
13. Recent labor market measures promise further progress. Especially welcome is the extension of permanent contracts with low firing costs indefinitely, and to more groups. Restrictions on part-time work have been relaxed. Cuts in social contributions have been extended-including to promote the hiring of women. But hiring and firing costs remain complex; reintegration policies, including the unemployment benefit, need to be more efficient; and a further scaling back of early retirement is needed, with a timely review how this year's changes in fact influence firms and employees' behavior.
14. Continuing progress is needed. And, most fundamentally, wide regional imbalances in unemployment signal the need for a forceful attack by the government and the social partners on potential barriers to stronger employment growth throughout Spain. In addition to improvements in infrastructure, there are two key issues in this regard. One is to address inefficiencies in the housing market, including rigidities in the rental sector and the availability of municipal land-which will entail a reform of local government financing. Facilitating mobility, this will help relieve bottlenecks, as growth reaccelerates. The other, more fundamental, is to enhance both wage differentiation and training, thus improving labor market entry and the matching of skills. As practices in wage formation evolve, it will be critical to ensure an effective link between wages and productivity, with one aspect of this being freedom for variation among regions and localities. It also important to avoid a "cascading" of salary reference levels. Finding cooperative, workable solutions in such areas would raise medium-term potential and reduce overall national unemployment.
15. Tax reform can also play a role. Recent years have seen a major modernization: reducing compliance costs; improving neutrality; enhancing incentives for work, saving, risk-taking, and investment; and removing obstacles to international activity. But over time, the effect of taxation on the labor market will remain critical. The next round of personal income tax reform needs to give priority to promoting the incentive to work, including through a cut in tax rates. An increase in the earned income allowance also appears desirable. And it is important, in the structure of taxes over the medium term, there is not undue reliance on social contributions, which fall directly on labor.
16. In the product markets, the government acted boldly last year to attack several key constraints on competition in telecoms, electricity, gas, pharmaceuticals and retail sales. The privatizations of Iberia and Aerolineas Argentinas have now been completed. And, among other reforms, a number of restrictions on competition-from text books to practices in the liberal professions-have been lifted this year. The recent strengthening of the resources of the competition agency is very welcome. A key priority ahead is continuing progress in the network industries, where Spain has made great strides, and where the opening of the local loop in telecoms has been a crucial recent step; it is particularly important not to lose pace in electricity distribution. Also, the further real reduction in central government subsidies to public enterprises effected in the 2002 budget needs to be extended forcefully in the future. But there is also an important challenge in developing cooperative approaches with the territorial administrations to enhance competition: in this respect, priorities include reversing a trend toward new public enterprises at the regional and local level, and increasing competition in retail sales.
17. The banking sector in Spain has undergone a profitable expansion, including in international markets. Supervisors had already, in 2000, introduced a forward-looking, and path-breaking, provisioning system to ensure a more adequate building of bank reserves over the business cycle. They are continuing to pay particular attention to the risks associated with the development of bank investments in Latin America, given the uncertainties concerning economic developments in that region. They have ensured a conservative accounting treatment of investments, forged working links with overseas supervisors, and strengthened their own capacity for monitoring risk. Among the cajas, supervisors have also stressed that the development of non-traditional business must move ahead only hand-in-hand with the broadening of skills. Overall, levels of capital in the financial system are high.
18. With global activity slowing and risks rising, vigilance remains essential. Some institutions, in this setting, may lean toward more caution in lending: but, with the respective roles of the banks and the cajas, Spain's financial system remains competitive and broad-based, and serious credit constraints do not appear likely. The system is evolving, and all categories of institutions need to continue adapting to a fast-paced change in global financial markets. And in this market setting, supervisory coordination will remain crucial. Between banking and securities supervision, it is already well-developed. In the period ahead, a growth in private pensions may well call for a strengthening of the institutional basis of their supervision, and a deepening of supervisory coordination in this field also. Plans for a new financial services law are welcome: among other things, this will clear the way for future EU directives.
19. These structural issues, from the labor market to financial supervision, are crucial. The question is often asked: is the Spanish economy competitive? In the narrow sense of relative costs, the answer is yes-though profit margins in traded goods may have tightened somewhat, and are likely to come under pressure if the euro, over time, moves toward a higher level, consistent with longer run fundamentals. But in a deeper sense, the competitiveness of the economy is best understood in terms of its capacity for renewal and medium-term growth-and this will depend on the approach of policy makers, firms, and labor unions. Meanwhile, in key branches of policy-fiscal, labor market, and product markets-the regional dimension will remain important. And as tax bases become more decentralized, and fiscal relations more durably defined, the Autonomous Communities have a deeper stake than ever in the success of such reforms.
20. The key lies in pressing ahead with carefully designed fiscal and structural reforms. And there could be no stronger assurance about the future than Spain's experience with economic reform in recent years: it is an impressive record to build on.
21. The mission would like to thank the authorities for their warm cooperation.