Spain -- 2006 Article IV Consultation, Preliminary Conclusions of the IMF Mission
March 21, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. The long expansion of the Spanish economy continued in 2005—a remarkable year in many regards. With GDP growth at 3.4 percent, the past year marked a decade of uninterrupted expansion, during which Spain's average income rose to 98 percent of the EU-25. In parallel, strong employment growth allowed the absorption of exceptionally large immigration flows: the Spanish economy generated more than 60 percent of all new jobs in the euro area in 2005 and unemployment declined to historic lows. This remarkable performance owes much to continued implementation of reforms since the early 1990s that opened the economy, enhanced its flexibility, and improved the macroeconomic policy framework, as well as to EMU membership and related low interest rates. Sustained fiscal consolidation resulted in a general government surplus of over 1 percent of GDP in 2005 and a substantial reduction of the public debt over the past decade.
2. Over the last few years, however, economic growth has become increasingly lopsided and the underlying imbalances intensified in 2005. With output growth continuing to be fueled by domestic spending, the external current account deficit widened to over 7½ percent of GDP in 2005—the second largest in absolute terms in the world. Supported by employment and income gains, wealth effects from the real estate boom, and rapid credit expansion, domestic demand contributed 5¼ percentage points to GDP growth. The external sector, in contrast, depressed growth by almost 2 percentage points, as import penetration and the erosion of export market shares intensified in 2005. No doubt, the widening external deficit reflects in part higher oil prices, weak demand in traditional export markets, and Spain's rising investment. But it also reflects the steady deterioration in Spain's competitive position, in turn driven by price pressures generated by its advanced cyclical position and, more fundamentally, by lackluster productivity growth—as well documented in the government's National Reform Program. Barriers to competition, restrictive regulations, and labor market rigidities all militate against improved productivity performance and a more innovative economic environment. Unsurprisingly, in this setting, growth has been concentrated in construction and the sheltered distribution and services sectors, rather than in tradables.
3. Immediate growth prospects remain good, but the medium-term outlook is clouded by the accumulated imbalances and competitiveness losses. Although decelerating, the strength of domestic demand and firming euro area activity are expected to sustain GDP growth of 3¼ percent in 2006. In our central scenario, consumption growth is set to moderate as housing wealth gains and credit demand slow down, braked by a firming of interest rates. There are risks to this benign scenario, however. One such risk is that a continuation of unsustainable domestic spending growth and rising household indebtedness might then require a subsequent protracted period of balance-sheet adjustment. While some leading indicators point to a cooling of domestic demand, consumption and credit are still posting strong gains. In this context, a correction of real estate prices risks spilling over to the construction sector—which accounts for 9 percent of output and 13 percent of employment—depressing household demand, particularly in an environment of monetary tightening. We do not, however, see this risk as imminent. But we do view with concern a continuation of competitiveness losses stemming from persistent demand pressures and weak productivity performance. If Spanish productivity growth is not improved and its labor and product markets not rendered more flexible, regaining competitiveness within EMU would entail a protracted and costly process weighing on output and employment. As recognized by the authorities, it is the task of economic policy to avert such a scenario.
4. Against this background, economic policy must be directed to moderating domestic demand pressures and setting the stage for a sustainable continuation of growth. This will require resolute policy responses, some of which are already in train, comprising two complementary elements:
• Countercyclical fiscal restraint: reining in the current high rates of growth in public expenditure is essential to address demand pressures and related macroeconomic imbalances. In the absence of monetary policy, it is the only tool to this end.
• Broad-based structural reforms: eliminating rigidities that raise domestic costs, stunt innovation, and restrain competition is essential to creating a more competitive Spain. Here we see three main priorities: concluding the diálogo social with clear liberalizing steps in the labor market; undertaking competition-enhancing product and services market reforms; and launching overdue pension and healthcare reforms.
Containing demand: the role of fiscal policy
5. Public spending is growing at an excessively rapid pace, adding to demand pressures. The 2005 general government surplus is a notable achievement, and one that sets Spain apart from other euro area countries—including, most notably, its larger partners. This outcome implied a mildly restrictive stance as measured by the change in the cyclically-adjusted fiscal balance. But, beyond this indicator and its related measurement difficulties, our analysis points to the prime importance of government spending in determining the demand impact of fiscal policy. Public expenditure has a direct and appreciable multiplier effect on demand and, ultimately, the external current account. Viewed from this angle, fiscal policy was expansionary in 2005. Specifically, non-interest expenditure at the general government level rose by 0.5 percentage points of GDP (after correcting for the RENFE operation in 2004), equivalent to a real growth rate of some 6 percent—a clearly disquieting pace that eroded much of the remarkable increase in revenues. Total expenditure growth was high at all levels of government, even while the State observed its spending ceiling. Most disappointing was the Territorial Authorities' outturn: in a year of vigorous activity and revenue growth, they posted a deficit of 0.4 percent of GDP, driven by the expansion in regional spending (a real growth rate of 7½ percent). Spending plans for 2006 promise a repeat of this pattern, with real expenditures budgeted to outpace real GDP growth by a significant margin at all levels of government. Apart from their demand effect, we are concerned that such expenditure trends can become entrenched and difficult to reverse, while revenue growth will over time return to its trend path.
6. Greater expenditure-based fiscal restraint in 2006 and 2007 is thus called for. A clear countercyclical role for fiscal policy would be in keeping with the approach enshrined in the draft Ley de Estabilidad Presupuestaria (LEP). Specifically, we would advise that fiscal policy be explicitly directed toward the goal of improving the 2006 general government surplus by at least ½ percentage point of GDP (relative to 2005), based on expenditure control. At the State level, this would require containing spending appreciably below the budget ceiling and safeguarding the contingency fund for truly exceptional events. The Autonomous Communities, for their part, should at least aim to be in balance. For 2007, given the current baseline projection that demand will continue to grow strongly (and the current account deficit widen further), the targets of the latest Stability Program have been superseded by events—not only in levels, but also in the planned direction of change (an untimely reduction in the surplus). With GDP growth currently forecast to exceed 3 percent, the State should at least budget an unchanged surplus, and set its spending ceiling accordingly. Territorial governments should also aim for a surplus—in keeping with the new LEP to enter into effect in 2007. Indeed, it is key to the LEP's credibility that implementation be exemplary in its first year of application.
Maintaining fiscal stability in the medium and long term
7. Spain's highly decentralized system needs a robust budgetary framework, able to promote fiscal discipline at all levels of government. We welcome the greater cyclical sensitivity of the draft LEP, with its pursuit of balance over the cycle. The exclusion of the social security system from the law's coverage, and the continued devotion of its surpluses to the Fondo de Reserva, are also well-advised. The strong wording barring state bail-outs for other levels of government is essential in the absence of effective enforcement mechanisms: it will need to be applied rigorously should pressures arise.
8. The greater flexibility provided by the draft LEP requires firm application, unambiguous wording, and the utmost degree of transparency. In this regard, the following features of the draft law raise some concerns:
• First, there is a built-in asymmetry in the proposed approach: while it specifies a deficit limit in the case of low growth, it does not set a commensurate surplus requirement in the high-growth scenario. Though this may be dictated by pragmatic considerations, it runs the risk of insufficiently ambitious targets in good times—such as the present—making balance "over the cycle" an elusive target. It will be important that implementation avert this risk, beginning—as noted above—in 2007.
• Second, the lack of a specific surplus requirement means that its allocation between the different levels of government also remains undetermined. To avoid rising regional debt, the targeted surplus in situations of high growth should be allocated predominantly to the regions, mirroring their share of the permissible deficit in the low-growth scenario.
• Third, the wording of the draft LEP does not clearly specify whether, in good times, the surplus requirement applies to the Autonomous Communities as a whole, or to each individual Community. This ambiguity could give rise to conflicting interpretations, evident during our discussions, and consequent implementation difficulties.
• Fourth, the definition of excluded capital spending should be precise, closing avenues for circumvention. Already, the recourse to various means of off-budget capital spending is a source of concern.
• Last, but far from least: a sine qua non of the greater leeway granted by the revised LEP must be increased fiscal transparency of the territorial governments. Despite some progress, the information flow remains patently insufficient to allow early identification of profligate fiscal behavior, elicit public censure, and stimulate corrective action. Considerable scope remains for more extensive and timely publication of fiscal data, in particular concerning budget execution, quasi-fiscal activities, and contingent liabilities (the State's budget presentation could also be improved in this regard). Adherence to an agreed Code of Fiscal Transparency, drawing from, and enhancing as needed, the existing IMF and Eurostat guidelines, could provide a helpful common benchmark. Given the role of peer pressure in a highly decentralized system, consideration could also usefully be given to the creation of an independent panel of experts to provide, at the behest of Parliament, ex ante and ex post assessments of the fiscal policy plans and outturns of the various levels of government and of their consistency with the LEP.
9. The current review of territorial financing arrangements should aim to augment fiscal co-responsibility. To be successful, the ongoing decentralization of competencies must be accompanied by mechanisms that grant territorial governments significant powers to set their own taxes, and that create incentives to utilize such powers (contrary to the experience to date) and thereby be fiscally responsible and accountable. This, rather than heavy reliance on a higher share of taxes and transfers from the central government which leaves incentives largely unchanged, should be the defining feature of the new system of financiación autonómica (and of local governments). Given the importance of health spending in regional budgets, changes to their financing arrangements should be accompanied by healthcare reform. In this regard, international experience suggests that healthcare costs are difficult to contain without introducing forms of private participation and cost-sharing, such as user co-payments to rationalize demand. In a similar vein, it will be important to cost commitments under the new Ley de Dependencia carefully, and to target its beneficiaries closely, so as to avoid another potential source of spending pressure.
10. The recent tax reform, while limited in size, entails a welcome simplification and reduction of distortions. The deliberate caution exercised in reducing the tax burden is based on concerns about the impact on current demand pressures; while understandable, such concerns could have been eased and the tax reduction been larger if accompanied by greater public spending restraint. A clearly positive feature of the reform is the uniform tax on savings, which stands to enhance transparency and competition among financial instruments. The simplifications in the corporate income tax are also in line with best practices, although the rate remains comparatively high. Finally, the reduction in tax-exempt contributions to private pension plans may send a deterring signal overall, also insofar as such changes per se instill uncertainty about future tax treatment. The private pension pillar is still small in Spain, but its recent growth is encouraging and needs to be nurtured.
11. Pension reform is required to ensure long-run fiscal sustainability. The onset of the rising costs of aging—larger than elsewhere, even taking into account Spain's remarkable immigration phenomenon—is now only ten years away, leaving no room for complacency. The continued reform delays only raise the size of the measures that will eventually be needed. We welcome the submission of the government's proposals last November and would urge that discussions now proceed expeditiously. Reform measures will need to be broad-ranging, encompassing also an extension of the base period used to compute pensions.
Creating a more competitive Spain: labor and product market reforms
12. In the labor market, previous measures are bearing fruit, but remaining rigidities restrain productivity and cost competitiveness, calling for early reform. The rising employment rates of female and older workers, and the decline in structural and long-term unemployment are encouraging, but most indicators still lag well behind key Lisbon objectives. At the same time, employment protection legislation remains among the most restrictive in the OECD and the wage formation process is insufficiently responsive to productivity differentials. Almost two years have passed, without results, since the July 2004 declaration on the diálogo social and, during our visit, we encountered dispiriting doubts about the negotiations' prospects. We would encourage all parties, and in the first instance the government, to find the means to ensure that there be a meaningful labor market reform during this legislature. The response to Spain's uncommonly high rate of temporary employment lies, as shown by earlier reforms, in reducing the rigidity and high dismissal costs of regular contracts. The present environment of declining unemployment and strong labor demand, as well as international experience, should assuage any concerns about increased flexibility. Also, the social partners now need to undertake in earnest discussions on modifications to the collective wage bargaining framework. The objective should be that of devising a system that is attentive to relative productivity developments, encourages regional mobility, and avoids amplifying the inflationary effects of price shocks.
13. The government's ambitious reform agenda to improve competitiveness merits the highest priority, with an emphasis on competition-based incentives. We share the analysis and welcome the quantification of objectives and close inter-ministerial monitoring of the Plan de Dinamización and of the National Reform Program (NRP). As noted in the EU Commission's positive assessment of the NRP, in some areas there is a need for progress—which we would also encourage—in terms of a greater specification of measures, timetables, and budgetary costs. In its broad orientation, the NRP tends to emphasize the government provision of public goods (infrastructure, education) and public sponsorship of activities with positive externalities (R&D, start-up companies). In its further articulation, we would suggest that a larger weight be placed on enhancing incentives stemming from greater competition for the efficient allocation of resources, cost reduction, and innovation.
14. In this vein, a key focus must be on further deregulating sheltered sectors. These sectors are the major contributors to the widening cost and price differential with trading partners. An insufficient degree of competition, pricing power, and the differential evolution of mark-ups between tradables and non-tradables are major factors behind Spain's persistent competitiveness losses. Besides further liberalization of the energy, telecommunications, and transport sectors, we would again press for a lifting of barriers in the retail distribution sector. While this is a decentralized competency, the EU Services Directive could provide the opportunity to review existing constraints (double licensing, zoning restrictions, opening- time regulations, etc.). The attention being given to liberalizing professional services, a key—and highly regulated—sector is well-placed. More generally, we welcome the planned strengthening of the competition authorities under a single, independent Comisión Nacional de Defensa de la Competencia. Finally, the announced restructuring of the national television company (RTVE) is an important step that will need to be implemented firmly.
15. Openness and regulatory independence are key to enhancing competition. We thus warmly welcome the liberal stance taken by the Spanish government in the debate over the EU Services Directive and its recent decision to waive all barriers to immigration from the new member states. We are however concerned about the moves afoot in Europe that risk confining the internal market as it reaches more sensitive areas. In Spain, the recent changes in the competencies of the Comisión Nacional de Energía give the regulator ample leeway for discretion that risks being exercised in a discriminatory manner. We urge close cooperation with the EU Commission and full adherence to the requirements of the single market. More generally, we encourage a review of the existing appointment procedures to sectoral regulatory agencies, so as to fully guarantee their independence.
16. Overall, the recently concluded Financial Sector Assessment Program (FSAP) found the financial sector to be vibrant, highly competitive, and well supervised and regulated. The sector's strengths include a high degree of financial intermediation; low intermediation margins; well-capitalized and professionally managed institutions; and a robust prudential framework. Stress tests showed that banks and insurance companies would be able to withstand large adverse shocks without systemic distress. This reflects strong capitalization and risk management practices of systemically important credit institutions, sizeable loan-loss cushions, and Spain's extended period of strong economic growth.
17. The main risk identified by the FSAP would arise from a potential downturn in the housing market, particularly if combined with an adverse macroeconomic scenario, as that described in paragraph 3 above. The FSAP thus attached high priority to moderating housing-related credit expansion and mitigating credit risk. We would echo the concerns expressed by the Bank of Spain's (BdE) latest Financial Stability Report with regard to non-traditional mortgage products and the maintenance of adequate lending standards. Continued rapid credit growth will require the highest vigilance by the BdE in monitoring credit quality.
18. The FSAP found a high degree of observance of international standards for the supervision of financial institutions and infrastructure, but sought some improvement:
• While no instances of interference were found, there is a need to bolster independence of the three financial sector supervisors. Specifically, the authority to issue norms and to sanction violations should be delegated more broadly from the Ministry of Economy and from the Council of Ministers to the respective agencies.
• Formal independence of the insurance regulator is particularly constrained because it is directly part of the Ministry; we recommend alternative institutional arrangements to increase its independence.
• The BdE in practice has full regulatory and supervisory authority over all credit institutions (as supported also by rulings of the Constitutional Tribunal). Going forward, however, there are some ambiguities about the role of the Autonomous Communities in prudential oversight, notably as regards the applicability of executive actions. It is recommended that state-level supervisors be unambiguously recognized as maintaining their sole responsibility and powers regarding prudential supervision and regulation of financial institutions.
• More regular and continuous collaboration among financial sector regulators would be desirable. The recent establishment of the Committee for Financial Stability is welcome and we look forward to an early start to its work.
19. Recommendations to improve the competitiveness and governance of the savings banks include: reducing further the public sector representation ceiling in governing bodies; promoting means to raise high-quality capital, such as the issuance of cuotas participativas to enhance market discipline; and removing restrictions to savings banks' mergers.
20. Nonfinancial equity investments of credit institutions comprise a sizeable proportion of their capital. Returns on equity are relatively risky and volatile. We thus support consideration by the BdE of adopting the most conservative approaches to the treatment of industrial participations under Basel II. Major participations in a single company also raise the possibility of conflicts of interest and informational asymmetries for credit institutions relative to other investors. The FSAP thus recommends the introduction of regulations to prevent a credit institution representative serving on the board of a nonfinancial company from taking part in the institution's operations with that company.