Mission Concluding Statements
Spain and the IMF
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Spain—2004 Article IV Consultation
November 8, 2004
1. The overall performance of the Spanish economy has been distinctly positive: output growth and employment creation have been brisk, enterprises and banks have strengthened their balance sheets, and the fiscal accounts are in good health. A key feature of this performance is the shared recognition—across party lines and through society—of the benefits of fiscal stability, wage moderation, and growth-enhancing structural reforms, and the pursuit of policies consistent with these goals. The new government thus faces a propitious environment to pursue its announced priorities: fiscal stability, transparency, and productivity enhancement. We support these priorities and look forward to their expression in concrete measures to deal with both immediate and longer-term challenges.
2. Such challenges are not lacking. On the domestic front, the persistence, over several years, of the real estate boom and of an inflation differential with the euro area is of particular concern. The unrelenting rise in house prices and household indebtedness—while undoubtedly driven by a number of fundamental factors—has engendered an overvaluation in the housing sector and raised the economy's vulnerability to adverse developments. At the same time, the inflation differential has remained stubbornly high, and cannot be attributed solely to different cyclical positions or to a structural catch-up process. It also stems from insufficient competition in sheltered sectors, stunting the supply response to strong demand pressures. In addition, the widespread use of wage safeguard clauses stands to perpetuate second-round effects from current oil price rises. The cumulative erosion of competitiveness, while not yet reflected in export market shares, is evident in the unbalanced pattern of growth. Last year, we noted—with respect to both housing prices and competitiveness—that, although related "risks do not appear to be imminent, their severity would intensify if trends... were to continue unabated." This has indeed been the case.
3. The external environment, while remaining generally supportive, has been clouded by the rise in oil prices. Though this rise has been recently mitigated by the renewed surge of the euro, the latter poses risks of its own. The effects of the oil price rise are unlikely to be appreciable in 2004, and indeed current indicators suggest still buoyant domestic demand, albeit in the midst of higher inflation. We consequently do not expect real GDP growth in 2004 to deviate significantly from the official forecast, averaging some 2.6 percent for the year. Going forward, there is much uncertainty about oil prices, exchange rates, and interest rates, with both upside and downside risks. Under our current central assumption for oil prices (some $11 a barrel above the budget figure), we expect real GDP growth to stabilize in 2005 at around its present rate of 2.6 percent. Nominal GDP growth is however likely to be in line with, or even slightly above, budget assumptions, given the prospect of higher inflation. Thus, while nominal growth may well be sufficient to safeguard the fiscal targets, the composition of growth between output and inflation will tilt unfavorably.
4. In responding to the oil price rise, policy will need to be guided by the awareness that the current oil shock appears to contain a possibly significant permanent component. Domestic oil prices should thus be allowed to adjust freely, so as to shape users' incentives in favor of much-needed energy efficiency and conservation, given Spain's relatively high oil-dependence. While there may be a need, for equity reasons, to mitigate some distributive consequences of the price shock, any measures should be contained in size, limited in time, well-targeted to truly vulnerable sectors, and neutral in terms of relative prices.
5. In what follows, the authorities' three key priorities—fiscal stability, transparency, and productivity enhancement—are taken in turn to assess how best they can be realized, covering both the macroeconomic stance and structural reforms in key sectors.
A. Fiscal stability
6. Fiscal stability is a cornerstone of Spain's strong performance to date. It needs to be resolutely safeguarded, and we welcome the government's emphasis in this sense. Its preservation has three dimensions: the pursuit of an appropriate cyclical stance, the attainment of long-term fiscal sustainability, and the adherence to a robust fiscal framework that consistently delivers on both counts.
7. As regards the advisable cyclical stance in current circumstances, the persistent inflation differential, the house price boom, the risks associated with an extended period of domestic demand-led economic growth, and the presence of overly easy monetary conditions for Spain, all militate in favor of fiscal restraint. Such restraint is unlikely to be observed in 2004: we anticipate that, after correcting for the one-off accounting adjustments, the fiscal stance will impart a mild—but nonetheless untimely—stimulus.
8. Following on this, the 2005 budget target of a general government surplus of 0.1 percent of GDP would imply a broadly neutral stance. A better outcome is both possible and desirable, and should be pursued proactively. At the central government level, the advocated restrictive stance would require containing spending below the budget ceiling, avoiding parliamentary amendments that complicate this task, and safeguarding the contingency fund for truly exceptional circumstances. In social security, the expected surplus—likely further boosted by the effects of the Ley de Extranjería—should be fully saved, resisting pressures for generalized cuts in social security contributions or increases in social spending. Finally, regional governments will need to abide by the commitments made in the Consejo de Política Fiscal y Financiera, including firm adherence to the adjustment plans by the communities concerned. In the event of higher-than-budgeted transferred resources, the regions should contribute to fiscal restraint by containing spending.
9. Moving to a larger-than-targeted fiscal surplus in 2005 would also help toward constituting the buffer required to deal with the fiscal consequences of aging and enhance long-term fiscal sustainability. We encourage the authorities, in their first update of the Stability Program later this year, to spell out their view on the desirable medium-term fiscal target for Spain, demonstrating its consistency with addressing the fiscal impact of aging. In our view, running a small medium-term surplus is required to reverse an otherwise sharp increase in public debt as the demographic shock unfolds. But fiscal restraint, and the related build-up of the Fondo de Reserva, cannot be the sole instrument toward long-term fiscal sustainability, and pension reform will also be required.
10. The Pacto de Toledo has been an effective instrument to build consensus on an agenda for pension reform, but—after partial measures in 1997—progress has been disappointingly slow. Still, at present reform measures could be phased in gradually, with relatively muted immediate effects, avoiding the need for more radical action as the demographic shock nears. For while it is true that this shock is further removed in time in Spain than in other countries, it stands to be considerable, even under favorable population and immigration assumptions. Pension reform thus needs to be placed upfront on the policy agenda, aiming for a gradual increase in the effective retirement age and an improved alignment of benefits and contributions. In particular, features of the pension calculation mechanism which now perversely encourage early retirement need to be corrected, with a potentially powerful growth effect. Aside from broader reform, early measures should be taken to address the overly generous provisions governing surviving spouses' pensions (viudedad) and abuses of disability benefits and sick leave.
11. A disciplining fiscal framework is crucial to the maintenance of hard-earned fiscal stability. The Ley de Estabilidad Presupuestaria (LEP) represented an important advance in setting such a framework, legally enshrining the objective of fiscal stability. Nonetheless, in its first year of application (2003), eleven out of seventeen regions recorded a deficit—even though, in most cases, the shortfall was relatively small. In addition, the absence of explicit countercyclical provisions in the LEP constituted a potential constraint in dealing with cyclical fluctuations. In this light, the authorities see benefits to modifications to the LEP with a view to providing scope for countercyclical action, strengthening the framework's persuasive element, and increasing ownership and observance by the regions.
12. Fiscal discipline at lower levels of government is crucial in as highly a decentralized system as that of Spain. Following a major devolution of spending responsibilities in recent years, territorial entities now account for almost 50 percent of total public expenditure, and over 70 percent of expenditure excluding social security. Within such a system, there are no easy solutions to ensuring overall fiscal discipline. Changes to the LEP should be pondered carefully, shielded from political pressures, and guided by the following general principles.
13. A model fiscal framework needs to be well-defined, transparent, and adequate with respect to the central goal of maintaining fiscal stability. In this respect, it should be governed by pre-specified, clear rules covering: (a) the desirable medium-term target; (b) the cyclical adjustment to this target; and (c) how to deal with cyclical revenue shortfalls for subnational levels of government, avoiding "unfunded mandates" in key areas. These three aspects are taken up in turn below.
14. Finally, any fiscal framework in Spain needs to take account of a constitutional and political reality in which hard enforcement mechanisms appear largely unavailable. All admissible means to contain risks of fiscal laxity in this setting will thus need to be drawn upon, and based on a good degree of ownership by the regions. Among such means, the regions could usefully arm themselves with the budgetary instruments that have proven their worth at the central government level, notably the use of an expenditure ceiling and of a contingency fund. The latter notion could be extended to include the build-up—perhaps through the provision of appropriate incentives—of budget stabilization reserves (so-called "rainy day funds") to provide savings for unexpected revenue shortfalls. It would also be useful to increase regional revenue-raising powers, enhancing local accountability for autonomous decisions on additional spending. There is furthermore a role for a more effective use of borrowing authorizations and the introduction of an explicit "no bail-out" clause. Finally, determination of the need for corrective adjustment programs should be based on fiscal outturns measured in relation to regional GDP, rather than national GDP as at present—a method that clearly favors smaller regions.
15. Ultimately, however, enforcement will need to rely largely on the exercise of peer and public pressure. Such dissuasive pressure requires early identification of unsound fiscal behavior, so as to promote awareness of profligate policies, increase public censure and reputational costs, and stimulate appropriate action. A rationale for decentralization is that proximity breeds greater efficiency and accountability: this holds only if the public is adequately informed and aware of the soundness (or otherwise) of local fiscal policy.
16. In light of the above, a critical ingredient—indeed a sine qua non—of any change to the fiscal framework embodied in the LEP must be increased transparency of the subnational governments' fiscal accounts. This includes prompt publication of monthly data on regional budget execution and release of the information submitted to the Intervención General de la Administración del Estado (IGAE). The regions should also pursue a degree of transparency similar to that being sought at the central government level in other areas (e.g., public enterprises, contingent liabilities, etc.).
17. The central administration has, in line with the recommendations of the recent IMF mission on fiscal transparency, taken steps in this direction. These have included the recording of a number of liabilities in the 2004 accounts and the inclusion in the 2005 budget documents of information on potential risks emanating from some public enterprises. Such risks should be resolutely addressed through restructuring, privatization, or liquidation as needed, so as to avoid new debt assumptions in the future. In this vein, we view with concern the announcement of large investment projects, such as those for national roadworks, outside of the budget process. We would reiterate the importance that the assumption of contingent liabilities via public investment and/or public-private partnerships (PPPs) be subject to an orderly process and captured in the budget documents, with full disclosure of the operations' terms and conditions so as to allow informed assessments of related fiscal risks. It is vital that the central government set the example in this area, where risks at the subnational level appear to be increasing. More generally, we welcome steps toward greater data transparency, including the extension of pre-announced release calendars.
C. Productivity enhancement
18. The authorities have assigned a high priority to enhancing productivity. This emphasis is well-placed given Spain's lackluster performance in this area. The role of public policy in this domain is primarily that of creating an economic environment that is supportive of private entrepreneurship, through structural reforms and a liberalized regulatory framework. In addition to improving productivity, there also remains a need—as testified by still comparatively high unemployment and low female employment rates—to increase labor utilization in Spain.
19. The housing sector is important not only for its repercussions on the short-term outlook, but also for its potential role in inhibiting much-needed geographic labor mobility in the face of high regional dispersion in unemployment rates. The Plan de Choque de la Vivienda strengthens the social housing program and introduces some measures to promote the critically underdeveloped rental market (mainly via fiscal subsidies). But the plan fails to tackle the fundamental problems in the housing market, whose resolution would require: (a) phasing out the unequal fiscal treatment arising from generous tax relief that favors home ownership and weighs heavily on the budget; (b) changing a legal framework that is prejudicial to rental activity and smothers the supply of rental units; and (c) reforming the laws and regulations governing developable land (Ley del Suelo) that, along with insufficient transparency in the urban zoning process, limit its supply. Until and unless these key issues are dealt with resolutely, other measures will likely be palliatives with limited effect.
20. In the labor market, earlier reforms are bearing fruit, both in terms of rising female employment rates and a declining share of temporary contracts, particularly in the private sector. But performance remains far from Lisbon objectives, highlighting the need for further action. Last July's Declaración para el Diálogo Social identifies a number of key areas, and we look forward to progress in ongoing negotiations. We would note that the intense immigration being experienced by Spain, that has contributed to the strong growth performance of recent years, requires a flexible and adaptive labor market for its smooth and efficient absorption. The outcome of the diálogo social should be unequivocally in this direction. It would otherwise risk swelling the ranks of the shadow economy, rendering immigration a fiscal burden without a fiscal counterpart.
21. Spain's uncommonly high rate of temporary employment contracts has understandably focused attention on this issue, given its social costs. Temporalidad is heavily concentrated in certain sectors (notably in construction and local authorities), where such recourse has some fundamental determinants. In the private sector excluding construction, its incidence has been declining steadily, also as a result of the creation, in 1997, of open-ended contracts with reduced social security contributions and lower dismissal costs (contratos de fomento). Consideration could be given to widening the scope of application of such contracts, though the net fiscal impact of higher employment and lower social security contributions would need to be assessed carefully. More generally, the guiding principle in tackling this issue has to be that of increasing, not decreasing, labor market flexibility, with the primary avenue thus being a reduction in the rigidity of standard open-ended contracts.
22. In other labor market areas, there remains a need for changes in a collective wage bargaining system that generates a high homogeneity of wage increases across sectors, skills, and regions. A greater attention to relative productivity is indeed key to the government's interest in improving performance in this area. Though reforms of the wage bargaining framework have been proposed periodically, social partners' negotiations have regularly foundered, and—despite the agreed bipartite nature of these negotiations—a more proactive government role may in due course be helpful. In the present context, we are also concerned by the potential second-round effects of the oil price rise due to the triggering of wage safeguard clauses at end-2004. While such clauses appear to be firmly radicated in Spain's wage formation process and thus not easily phased out, consideration should be given to linking their operation to developments in core, rather than headline, inflation, so as not to entrench price shocks in the future.
23. In product markets, the emphasis on increased competition in various areas is well-placed and we look forward to its pursuit with the intended new Competition Law, the strengthening of competition and of regulatory agencies in key sectors (notably network industries and energy), the liberalization of professional services, and further progress in corporate governance. A continued sore point remains that of the various restrictions to effective competition in retail distribution imposed by the subnational authorities who have competence in the matter. As previously observed, such barriers and obstacles to freedom of establishment in other areas have costs for the regions themselves, in terms of their relative attractiveness for investors, consumer welfare, and economic performance. The opportunity provided by the EU Directive on Services in the Internal Market should be actively pursued to remove entry barriers throughout Spain. At the same time, it is regrettable that, in the face also of legal impediments, the recent decision on opening hours runs counter to earlier liberalizing efforts. The provision however does not prevent regions from adopting more liberal regimes than the minimum indicated, and we would encourage movement in this direction as having positive effects on competition and productivity.
24. In the financial system, commercial banks and cajas are recording increasingly positive results, boosted by strong domestic earnings and the rebound of activity in Latin America. Foreign risk exposures have been contained by strong provisioning, active risk management, and a strategy of asset relocation toward higher investment grade countries. Key financial soundness indicators remain strong. But the continued expansion of residential mortgages (virtually all at variable interest rates) and of lending to real state developers (with a history of cyclical nonperformance) have raised related vulnerabilities. The Bank of Spain's continued vigilance in this area is well-placed. Also important are the steps to ensure that the system is in a position to flexibly offer financial products that could facilitate the response to a prospective rise in interest rates, including through refinancing at fixed rates. In other areas, Spain is commendably well-advanced in defining new accounting rules for deposit-taking financial institutions, compatible with International Accounting Standards. Progress in implementing the Ley Financiera stands to strengthen governance in the cajas, with improvements in their governing bodies and the requirement to publish an annual "good governance" report serving to increase the protection against unwarranted political interference. Finally, we welcome preparations under way for the conduct of a Financial Sector Assessment Program (FSAP) in 2005, which will provide an appraisal of the strengths and vulnerabilities of the financial system, with likely useful lessons for both Spain and the international community from an overall positive experience.
25. Spain's support for the success of the Doha trade round and the increase of official development assistance (ODA) in the 2005 budget are warmly welcome.
Madrid, November 8, 2004
IMF EXTERNAL RELATIONS DEPARTMENT