Mission Concluding Statements
Spain and the IMF
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International Monetary Fund
1. The Spanish economy has weathered the difficulties posed by the world economic slowdown of the last three years remarkably well. While European economies languished, growth in Spain proved resilient and unprecedently rich in job creation, and real convergence progressed further—in marked contrast to previous slowdowns. As a global recovery emerges, Spain stands out as the major euro area country where the pickup is most evident. This overall performance is a tribute to the two pillars guiding economic policy: a stability-oriented fiscal policy, in observance of the EU's Stability and Growth Pact and of Spain's own Ley de Estabilidad Presupuestaria, and the pursuit of structural reforms. While EMU participation and the related decline in interest rates also played a key role in supporting growth, Spain's experience stands as testimony of the rewards of policy rectitude.
2. In an adverse international environment, Spain's growth necessarily had to rely on domestic sources. Within the overall framework of budgetary stability, policies were addressed to ensuring that this would happen, with tax cuts and targeted social security rebates supporting household demand and employment, and the public sector boosting infrastructure investment. Combined with historically easy monetary conditions, this policy setting secured a rapid pace of domestic demand growth, based primarily on private consumption and construction activity.
3. This pattern of growth—while welcome in the circumstances—now needs to become better balanced, to ensure the durability of the expansion and counter the risks inherent in a prolonged reliance on a subset of internal demand components as the main engines of growth. Such risks are of a dual nature. First, the strength of domestic demand, along with insufficient competition in certain markets, has sustained a persistent inflation differential vis-à-vis the euro area. In turn, shortcomings in the wage-setting process have transmitted this differential to labor costs, gradually eroding competitiveness. Second, recent growth has been accompanied by a rapid rise in household indebtedness. While there are several reassuring factors (elaborated further below), a level of indebtedness now surpassing the EU average, still rising briskly, and contracted predominantly at variable interest rates heightens the economy's vulnerability to adverse shocks. Though these risks do not appear to be imminent, their severity would intensify if trends in the underlying determinants were to continue unabated.
4. Re-balancing growth away from private consumption and construction and toward exports and investment in machinery and equipment, while reducing Spain's inflation differential, will—in the presence of continued easy monetary conditions—require the concerted effort of a range of policies. The main requirements are: continued fiscal restraint; the containment of unit labor cost growth; improvements in the land supply process; the strengthening of competition in sheltered sectors; and continued strict oversight of the activities of financial intermediaries.
5. In our discussions, we found an encouraging convergence of views on the prospects for a moderate but sustained recovery going forward. We project that real GDP growth this year could slightly exceed the official budget forecast of 2.3 percent, while remaining marginally below the 3 percent posted for 2004. Such a performance—projected to be still largely driven by the strength of domestic demand with a continued, albeit smaller, drag from net exports—would again appreciably outstrip that expected for the euro area. At the same time, in both our and the official projections, inflation would remain in the order of 2.7 percent (as measured by the private consumption deflator in the latter case)—implying a differential of between ¾ and 1 percentage point on the basis of prevailing forecasts for euro area inflation.
6. Our policy recommendations are cognizant of the electoral calendar. This implies that, over the coming months, fiscal policy, flanked by firm financial sector oversight, will likely be the primary policy tool. For their part, the structural reforms recommended below are offered as items that ought to be at the top of the next government's economic policy agenda, so as to ensure that the positive performance to date will persist—and in several areas be improved upon—in the future. This future is marked by the accession to the EU of new competitors, a development that in our analysis provides appreciably more opportunities than risks, and all the more so the more flexible and competitive the Spanish economy is made to be.
7. Fiscal policy: We view Spain's sustained fiscal adjustment following EMU qualification as a cornerstone of its current performance. While this adjustment was aided by the EMU-related decline in interest rates, it also met the broader requirements of successful, growth-enhancing consolidations. It was based largely on cuts in current spending which paved the way for credible tax relief, and an ensuing virtuous circle of economic growth and buoyant revenue performance. This year, this process has led to a surplus of the central administration (State and social security), officially estimated at ½ percent of GDP. The general government result will depend on the still unknown outcome for territorial governments, though the official expectation is that the latter will be in broad balance, as required under the Ley de Estabilidad Presupuestaria.
8. In a context of overly easy monetary conditions for Spain, fiscal policy has usefully acted to rebalance the policy mix; this stance should be maintained in 2004. Attainment of a "zero deficit" next year would be unduly lax, implying in our calculations a structural primary deterioration of about ½ percentage point of GDP, and imparting an untimely demand stimulus. We would thus recommend the maintenance in 2004 of the currently projected 2003 surplus, or a larger one if the automatic stabilizers so determine. This would combine short-term requirements with the advisable longer-term objective of a small structural surplus; the end-year update of the Stability Program should build on the improved starting position of 2003. We advise the following for fiscal policy in 2004:
9. Household indebtedness and the housing market: Clearly, there are various fundamental factors (demographics, immigration flows, non-resident demand, etc.) driving the strong demand for housing, the boom in housing prices, the expansion in mortgage lending, and the related rise in household indebtedness. From this perspective, the process may be viewed as a natural shift to a new environment. There are also several reassuring factors: low mortgage rates and a lengthening of maturities have limited the related debt servicing burden for households; the rise in employment and in the number of double-income households has acted similarly; and the acquisition of an appreciating asset has had a counterbalancing effect on household wealth. Nonetheless, the longer the process continues at its current rapid pace—and there is little sign of it abating—the more severe the potential repercussions from adjustments in either housing prices or interest rates. While the consensus view is that the adjustment will, as in the early 1990's, be gradual and that most plausible shocks are unlikely to be of a problematic magnitude, it is the task of policy to minimize any such risks and facilitate a soft landing.
10. There is a patent and long-recognized need to improve the functioning of the housing market. On the supply side, despite strong house-building activity, the constraints arising from the Ley del Suelo and its links to municipality financing are widely acknowledged. Indeed, at the time of our visit last year, there was recognition of the need for a non-partisan pact on this issue, with however regretfully no follow-up. This approach should be decisively resumed in the new legislature, with a view also to promoting greater transparency and reducing uncertainty in the urban zoning process. In the rental market, various stimulatory measures have been taken, but they are unlikely to have much impact in the face of the very generous tax relief favoring home ownership. This latter provision is distortionary, weighs on the budget, and merits revision.
11. We welcome the Bank of Spain's careful prudential control over mortgage lending and share its call for greater moderation, including in lending to construction and property development. While the level of non-performing loans (NPLs) has remained low, the overwhelming predominance of variable rate mortgages (at a time when interest rates may well have bottomed out) is a source of potential vulnerability—though banks' stress tests suggest that NPLs would remain contained except under rather dire circumstances. In this context, the authorities' efforts to raise the public's awareness of potential interest rate risks and reduce the costs of mortgage refinancing are well-placed. While market views differed on this matter, we would suggest further technical examination of whether there are any regulatory features that may act to increase the cost of offering fixed-rate mortgages and thus contribute to a wider-than-otherwise differential vis-à-vis variable rate loans.
12. Inflation and the wage negotiating process: Following its pronounced widening in 2002, the inflation differential with the euro area has been narrowing for most of this year, to only about ½ percentage point in October. This is most welcome, as is the steady decline in core inflation. Nonetheless, the cumulative inflation differential over several years is appreciable, and its effects—via the impact on labor costs—are beginning to be apparent. In the face of euro appreciation, Spanish exporters have been reducing their prices sharply, while the sector's unit labor costs and value added deflators have risen steadily. The preservation of market shares has thus been at the cost of a reduction in exporters' profit margins. To counter these developments, we see a need to act on a root cause of the growth in unit labor costs: a wage-setting process that is excessively focused on an inflation reference value-a feature reinforced by the extensive use of safeguard clauses-and insufficiently attentive to productivity developments. We would thus reiterate the need for a reform of Spain's collective bargaining system, with the aim of ensuring greater, productivity-based, wage differentiation. In the related process of social concertation, it would be useful to address other issues, taking further steps to reduce the rigidities of open-ended contracts, which lie behind the high incidence of fixed-term employment, and to further improve female labor market performance.
13. Inflation and competition in selected markets: As well-illustrated in the report by the Tribunal de Defensa de la Competencia, competition in the retail distribution sector is being adversely affected by a host of restrictive norms taken by regional and local authorities. We would stress that such measures are ultimately harmful to the local communities themselves, undermining their relative attractiveness for investors and adversely affecting local consumers' welfare. We would encourage steps to safeguard the unity of the national market and the overall consistency of competition policy, possibly in the form of a national pact. In this regard, we were reassured by the positive experience to date of the Consejo de Defensa de la Competencia in coordinating competition policy across regions. With the scope of regional competition tribunals properly circumscribed and their activities coordinated, they should be in a position to contribute to enhancing competition by dealing with local cases that would otherwise likely be overlooked. We also encourage continued strengthening of competition in network industries, where results in terms of price declines—to generally below EU levels—constitute an evident pay-off of steps to date.
14. Another key structural reform that will need to be a priority of the incoming government in 2004 concerns the pension system. Although there is considerable uncertainty regarding long-term population projections, available studies consistently indicate that, while the Spanish demographic shock occurs later than elsewhere in Europe, it is relatively more pronounced. In this context, a gradual approach to reform is feasible only if it starts early, progresses continuously, and is sufficiently ambitious. However, after initial measures in 1997, the reform process has suffered repeated delays. While increased allocations to the Fondo de Reserva are welcome, the achievement of long-term fiscal sustainability requires substantive pension reform. This should be centered on gradually raising the effective retirement age, via stronger incentives to forego early retirement, and a strengthening of the link between contributions and benefits.
15. The resilience shown by the Spanish banking system to the difficulties in Latin America deserves to be highlighted. Indeed, the speed and extent of the turnaround in 2003 has been pronounced, with major banks' results surpassing market expectations. The Spanish banking system continues to show high levels of solvency, profitability, and efficiency, supported by a firm and proactive supervisory stance of the Bank of Spain. In this light, we believe that both Spain and the international community could derive useful indications from the conduct of a Financial Sector Assessment Program (FSAP). We would therefore encourage the translation of the authorities' previously stated interest in a FSAP into a formal request. With respect to the savings banks, Spain's experience also stands out, with the highly competitive cajas being an element of both stability and dynamism in the system. We welcome the improvements in their governing bodies and other aspects foreseen in the Ley Financiera and other provisions, including the requirement to publish an annual "good governance" report. Given the cajas' particular structure and goals as not-for-profit foundations, vigilance will need to be maintained to avoid all appearances—whether perceived or real—of external influence in the formation and role of the cajas' bodies. In a similar vein, the regulations for the cuotas participativas should aim to ensure that this new instrument acquire a significant role and act as an effective tool of market discipline over the management of individual cajas.
16. Finally, in the data area, we look forward to the availability of revised national accounts, which will be helpful in advancing economic analysis in various areas. We would also encourage the extension of the best practice of pre-announced release calendars for all key data (including, for example, the fiscal accounts and external trade statistics).
IMF EXTERNAL RELATIONS DEPARTMENT