Spain -- 2002 Article IV Consultation, Preliminary Conclusions of the IMF Mission
November 11, 2002
1. Spain's economic performance during the latest cycle stands as eloquent testimony to the pay-off of sound policies. A stability-oriented fiscal policy, structural reforms, and wage moderation engendered remarkably high output and employment growth during the 1997-2000 upswing. Despite the recent deceleration, GDP growth, at some 2 percent, is set to be about double that of the euro area in 2002, continuing the process of real convergence. More telling still, employment has continued to expand even as the economy has cooled. This experience stands in marked contrast to earlier slowdowns, when growth would fall below the EU average amidst sizeable job destruction.
2. These positive results provide the best motivation for continued resolute action and a sustained structural reform effort, essential to future prospects. Despite the notable progress achieved, performance in a number of key areas remains unfavorable, reflecting a comparatively weak starting position. In particular, the rate of unemployment is still high, with a wide regional dispersion, and the employment rate of certain groups remains low. In addition, the cumulative effect of a persistent inflation differential is steadily eroding competitiveness. As the stimulus of EMU-related lower interest rates fades, and with enlargement due to bring new competitors and reduce EU transfers, continued real convergence with the euro area depends critically on strengthening the economy's sources of growth. Placing growth prospects on a firmer medium-term footing will require, in particular, lifting remaining obstacles to strong employment growth throughout Spain and increasing competition in key sectors, in concert with the territorial authorities.
3. Looking forward, Spain's short-term growth prospects remain relatively favorable. With monetary conditions that are clearly supportive, and the boost to disposable income provided by the planned income tax cut, we place GDP growth in 2003 at around 2½ percent. This would imply a continued positive growth differential with the euro area. Nonetheless, apart from the currently highly uncertain international environment, Spain faces a number of country-specific downside risks: notably, consumers' possibly heightened caution in the face of increased indebtedness, a potential correction in housing market prices, and the fall-out from the difficulties in some Latin American countries. In these areas, there are, on current prospects, grounds for reasonable confidence that the likelihood of adverse developments with significant economic repercussions for Spain remains low. Of greater concern, albeit for the medium term, is the fact that 2003 will see a continued inflation differential with the euro area, further affecting competitiveness.
4. While there are varying views on the underlying causes of Spain's persistently higher inflation, our assessment is that a good part of this differential cannot be attributed either to a benign equilibrating adjustment within monetary union (there is scant evidence of a productivity catch-up in the tradable goods sector) or to demand pressures over time (with the differential even widening in concomitance with the economic slowdown). Liberalization has advanced significantly in various key sectors, yielding clear benefits, but in some areas--most notably in retail distribution, where competencies have been devolved to the territorial authorities--competition remains inadequate. Indeed, the stubbornness of inflation would appear largely attributable to supply rigidities in these sectors, whose pricing behavior has accordingly been characterized by increasing mark-ups. Thus, with inflation persistence associated with such structural factors, a further widening of the output gap, and the prevalence of downside risks to growth, we would see the appropriate policy response as lying in a strengthened pursuit of the structural reform agenda within an overall supportive stance of macroeconomic policies, with fiscal policy assuming a broadly neutral posture.
5. The latter orientation of fiscal policy is made possible by Spain's noteworthy fiscal achievements. By making judicious use of the recent expansion to strengthen its underlying fiscal position, Spain--alone among the larger euro area countries--brought its fiscal accounts in compliance with the Stability and Growth Pact (SGP) commitments as from 2001, a performance which appears set to be repeated in 2002. This contribution to the smooth workings of EMU is most welcome, but it is key also to Spain's own welfare, creating the scope for fiscal policy to play a role in attenuating cyclical fluctuations.
6. It is in this context that we would reiterate our advice that fiscal policy allow the full play of automatic stabilizers. At the same time, we recognize that allowing cyclical fluctuations to be reflected in the fiscal accounts may be misconstrued as permitting fiscal laxity or discretionary activism--hence the official emphasis on an unwavering "zero deficit" target, as a disciplining factor in a transitional phase. We would nonetheless note, as evidenced by the vicissitudes of the Stability and Growth Pact, that an undue focus on nominal targets that are not contingent on growth outcomes is not a cyclically robust framework over time. In the specific case of Spain, it is also important to prepare policy-makers at all levels to the notion that, once growth resumes with greater vigor and output rises above potential, a small nominal surplus will be required. Failing this, the improved underlying position achieved through several years' efforts would be eroded. In sum, well-considered flexibility in the conduct of fiscal policy would provide the best guarantee to ensure the continuance of fiscal co-responsibility, the cornerstone of the regional agreement.
7. The year 2003 will mark a historic step in the evolution of Spain's fiscal framework, with the first budget drawn up under the Ley de Estabilidad Presupuestaria, the completion of the transition to the permanent financing arrangement for autonomous communities, the full decentralization of health services, and the introduction of a new financing system for local authorities. Given this series of innovations, careful monitoring and transparency are of the essence, and we thus welcome the readiness to consider the possibility of conducting a fiscal transparency ROSC in the coming period. As a first priority, we see a pressing need to address the lack of timely information on the execution of the budgets of the autonomous communities. While the debt figures published by the Bank of Spain are helpful, with some disciplining impact, effective monitoring requires a fuller set of information, covering all of the main budget items. We would thus urge that current efforts to strengthen reporting requirements come to rapid fruition. Second, given the growing proportion of public investment being carried out by public entities outside the general government definition, it is important to ensure--even though such operations meet Eurostat standards--that the transactions and accounts of all entities involved are fully transparent and available on a timely basis, so as to rapidly reveal any risk of future debt liabilities. This holds also for the various similar entities that have been created at the territorial level.
8. As regards the 2003 budget itself, an important feature is the further reform of the personal income tax, which goes beyond a cut in rates and provides welcome supply-side incentives, affecting, for example, female labor market participation and geographical labor mobility. With respect to budget execution, under our growth projections--less sanguine than those of the budget--the emergence of a small general government deficit (around ¼ percent of GDP) would be consistent with the recommended neutral stance. We would note however that the assessment of the budget, besides being affected by the inherently difficult comparability problems arising from the shifts in financing and competencies, is complicated also by the considerable prudence exercised in the estimation of revenues. While this can help to contain expenditure pressures and is seen as cautious budgeting, enhancing budgetary transparency ultimately requires closer consistency between the budget's underlying economic assumptions and its estimates of revenue and expenditure items.
9. In a broader perspective, the issue is that of defining an appropriate medium-term fiscal objective for Spain, in light also of the pressures from population aging. Mindful of the difficulties of such projections, compounded in Spain by the uncertainty of immigration flows, there is broad agreement that Spain's demographic shock exhibits two special features: it starts unusually late (after 2020), but it is--given low fertility rates and high life expectancy--set to be unusually deep. The former feature allows for a gradual approach to social security reform, but the latter points also to the need for an ambitious reform process that is continuous and uninterrupted, based on changes that are phased in over time so as to avoid more painful changes later. Following on the 2001 reforms, we would urge further advancement in this process in 2003, as was then envisaged. We would note in particular the powerful impact that could be had from a gradual increase in the effective retirement age, via stronger incentives to forego early retirement and a strengthening of the link between contributions and benefits. Provided social security reform is sufficiently ambitious, a small general government surplus (in the order of ½ percentage point of GDP over the cycle) would appear to be an adequate medium-term fiscal objective for Spain, both to contribute to addressing aging pressures and to provide some cushion for cyclical fluctuations while abiding by the letter of the Ley de Estabilidad Presupuestaria. It would be useful if such longer-term reflections, with associated goals and scenarios, were included in the next Stability Program.
10. The improved performance of the labor market has been among the most heartening features of recent years. At the same time, it remains true that Spain still lags the rest of Europe in key indicators of labor market performance. We thus welcome the government's continued attention to labor market issues, expressed most recently in the reform of the unemployment benefits system. The return-to-work emphasis of this reform is well-placed. Experience elsewhere suggests that the success of such reforms lies in their practical implementation, i.e., in the capability of the public employment services both to assist active job search and effectively apply, when needed, the suspension of benefits. It will be accordingly important to monitor experience, and make adaptations as needed, as the new system is implemented. The reform also serves to reduce the uncertainty surrounding the amount of dismissal costs, although their relatively high level remains largely unaffected. A final important element of the reform, designed to help much-needed labor mobility, is the phasing out of the Plan de Empleo Rural.
11. We believe that the most significant labor market issue that the social partners and the government should now address in concertation is that of the organization of Spain's collective bargaining system. There are three features of this system that merit revision:
•; The first is the practice whereby, in the absence of negotiations or agreement, a contract's provisions remain in effect indefinitely (ultra actividad). This has been a serious disincentive to broader discussions and served to focus the negotiations almost exclusively on the salary increase, at the expense of other critical issues (e.g., the flexibility of work organization, productivity improvements, training, enterprise pension schemes, etc). This impoverishment of the content of collective bargaining is a serious handicap.
•; Second, and another long-standing issue, is the need to ensure greater wage differentiation, as one element in addressing the marked regional disparity in unemployment.
•; Third, the continued and widespread existence of backward-looking wage safeguard clauses is a heritage of a high-inflation past and does not sit well with the requirements of a competitive economy in monetary union. In our discussions, we found a widespread recognition of the benefits of wage moderation, which however risk being undone by such clauses. Readiness to phase them out will, however, likely be contingent on a reference value for wage negotiations that is seen as a reasonably realistic projection of expected inflation. In this context, given its leadership role, we have some concern that the signal coming from the civil service agreement--albeit following earlier rigorous moderation in this sector--may feed into high wage demands elsewhere. We would encourage the social partners to pursue a new, moderate collective wage agreement for 2003 (which, to this end, will need to recognize the transitory nature, due to a base effect, of the inflation uptick that is in store for the closing months of the year) and to enlarge their discussions to embrace the issues noted above.
12. In goods and services markets, as elsewhere, there is an increasing territorial dimension. It is nonetheless evident that a nationally coherent and well-coordinated policy affecting such markets is crucial to enhancing Spain's overall economic performance, and to avoiding that what is done at the central level be undone at other levels. We would thus see great benefit in extending to goods and services markets the same model of co-responsibility that imbued the fiscal agreement. All levels of government should engage in a partnership to place Spain among the most competitive and efficient economies in Europe. As a priority, in light also of our earlier-stated concerns regarding the supply rigidities behind the persistent inflation differential, we would urge the lifting of the numerous barriers to more effective competition in retail distribution and trade (be they outright prohibitions for super or hypermarkets, complex regulations, or overlapping and discretionary licensing requirements) and a liberalization of opening hours. In a similar vein, the new regional competition tribunals and services will need to coordinate closely with their national counterparts, to ensure the overall coherence of competition policy. Finally, the difficult but crucial issue of land supply needs to be revisited, to alleviate upward pressures on housing prices and address obstacles to internal labor mobility.
13. In network services, liberalization has advanced and measures are being taken to stimulate competition in key sectors, some of which remain dominated by incumbents. Further progress here is partly dependent on greater liberalization throughout Europe, but Spain can continue to play a useful leadership role, in keeping with its excellent record in transposing internal market legislation. Spain also knows well, from its own experience, the benefits of opening up to trade, and we welcome its strong support for trade liberalization vis-à-vis the least developed countries, its commitment to the success of the Doha round, and its related readiness to consider needed reforms of the Common Agricultural Policy (CAP). While in pure budgetary terms Spain is a net beneficiary of the CAP, the welfare costs to consumers are likely to be appreciable, in Spain as in the rest of Europe, and the burden for developing countries is well-established.
14. Spain is well-advanced in its reflections on corporate governance and transparency, accounting rules and principles, and investor protection. The wealth of initiatives in these areas is welcome, as are the concrete measures already taken, as in the Ley Financiera. The new bankruptcy law (Ley Concursal) under preparation constitutes another important element, that should help in particular the resolution of difficulties in small- and medium-sized enterprises. Given the range of initiatives, it will of course be important to ensure their overall consistency, as well as to guard against the risk of excessive interference as a reaction to recent corporate problems in some countries. This issue is indeed well-recognized in the draft Ley de Nueva Empresa, which helpfully reduces the administrative burden in the setting up of new enterprises. Finally, we welcome Spain's advanced implementation of measures to counter money laundering and combat terrorist financing.
15. In the banking sector, the salient feature is the resilience it has shown during an undoubtedly difficult period. Despite developments in Argentina that have in several respects been more severe than anticipated, notably as regards the adoption of measures affecting the banking system (such as the pesificación asimétrica), the banks concerned have been able to endure and indeed fully absorb the effects of the crisis, with complete provisioning of both credit risks and investments. And this has been done through a reduction in profits--the banks' first line of defense--with profit growth nonetheless remaining positive and in line with the banks' timely reassessment of prospects for the year. This outcome reflects the banking sector's strong starting position in terms of capitalization, provisioning, efficiency, and profitability, based on a vibrant domestic franchise, but is also the result of the Bank of Spain's proactive role in promoting conservative risk management practices (through, for example, forward-looking provisioning and accelerated amortization of goodwill). A similar approach is governing both the banks' and supervisors' reaction to developments elsewhere in Latin America. Although risks remain, especially in the event of more extreme scenarios, the banking system's overall sound position and the continuation of a vigilant supervisory approach provide reasonable assurance--reflected also in analysts' assessments--that such risks will remain manageable. This holds also for potential domestic risks, where however some deceleration from the currently very rapid rate of mortgage lending would be desirable. Finally, we would note the innovations introduced by the Ley Financiera in the savings banks (cajas de ahorro) sector, and in particular the role to be assumed by participation certificates (cuotas participativas) in the savings banks' capital structure. As the market for these instruments develops, it will be important to ensure that they effectively provide a market-based assessment of the relative performance of individual savings banks. With regard to the financial sector more generally, we warmly welcome Spain's readiness to undergo a Financial Sector Assessment Program (FSAP) in the coming year.
16. Spain emerges from the latest cycle as a more resilient economy with sounder fundamentals, thanks to the series of reforms undertaken over the years. The best assurance that the impressive performance recorded to date will persist in the future can be provided by resolutely maintaining the reform effort through the upcoming electoral period and beyond.
Madrid, November 11, 2002