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Spain: 2008 Article IV Consultation - Concluding Statement of the Mission
December 9, 2008
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.
After 15 years of impressive growth led by a housing boom, a gradual correction of accumulated imbalances got underway. In mid-2007, the global financial crisis accelerated Spain's slowdown when funding for the excessive external deficit dried up. The authorities' response has been forceful and earlier than EU partners with market-based banking policies and substantial fiscal measures. Embedding these short-run fiscal measures into a long-run consolidation plan could increase effectiveness and boost confidence. The medium-term recovery also crucially depends on progress with implementing comprehensive structural reforms. In their absence, Spain could get stuck in a low-competitiveness, slow-growth, extended-deleveraging, and high-unemployment equilibrium, from which returning to lower public debt would be difficult.
The Outlook is challenging
1. The near term prospects are somber and uncertain. Indicators suggest a bleak end to 2008, with continued slow activity in 2009. The mission expects output to drop by (at least) 1 percent in 2009. Private sector deleveraging is in full swing with households cutting consumption and firms reluctant to invest. Moreover, external demand is weak just when Spain needs higher exports. Despite some upside potential, with oil prices falling, a lower euribor, and large fiscal packages, the balance of risks remains on the downside. Confidence could improve if a comprehensive forward-looking strategy were better defined, linking fiscal support with structural reform, while banking policies remain firmly market-based.
2. Without deeper reforms, the medium-term risks showing protracted weak growth (L-shape) and high unemployment. The recovery is likely to be tepid if productivity remains sub-par, inflation above trading partners, and reforms tentative. High private debt and weak external competitiveness make for long adjustments. Spain cannot devalue the currency to reset relative prices, so reforms that cut costs and improve flexibility and productivity are key. Impaired bank loans and unemployment are tightly correlated, thus connecting the health of the labor market with that of banks.
The housing sector is in full correction
3. Housing sector adjustment takes time. Many new homes will still come onto the market, pressuring home prices. However, building permits and housing starts are falling quickly-presaging far less construction activity in the medium run.
4. By limiting the inventory of vacant homes, housing policies can facilitate adjustment:
Banking assistance policies are market based with appropriate exit strategies
5. Banks have held up well so far owing to sound prudential regulation and supervision and the strong traditional retail banking model. Countercyclical provisioning and rigorous treatment of off-balance sheet vehicles placed the banking sector on a sounder footing than in many other countries. Moreover, banks are conservatively managed with virtually no toxic paper on their balance sheets. While nonperforming loans have increased rapidly, robust provision buffers have allowed Spanish banks to gain valuable time and maintain healthy profit and capital ratios. Asset and capital management have remained fully market based without government intervention nor a single bank failure, despite the sharp slowdown.
6. In conjunction with EU partners, Spanish authorities have reacted promptly to mitigate the effects of the financial turmoil while preserving a market-oriented system. High reliance on wholesale markets makes funding the Achilles' heel of the Spanish banking system. As a result, the authorities have taken pointed measures to shore up market confidence and assist funding:
It is reassuring that the FAAF and government guarantees have been designed to disappear automatically in the medium run (exit strategy). Banks need to allocate loans, even if funded by the FAAF or government guarantees, without political distortions.
7. Looking ahead, banks' operating environment will remain extremely challenging, and the authorities need to remain highly vigilant and prepare to act should consolidation become necessary. Persistent dislocation of wholesale markets, higher funding costs, deteriorating asset quality, and slowing lending growth weigh on banks' outlook. Some consolidation may thus occur, which should take place on market terms without political interference, but with willingness to act if systemic pressures arise.
8. We welcome the progress by cajas in seeking market testing with the emission of cuotas participativas. Cajas are encouraged to issue again as conditions permit. Simplifying payout rules of cuotas will make them more attractive to investors.
9. Given challenging global conditions, continued cooperation in supervisory colleges for Spain's largest and globally active banks is crucial. The authorities have close cross-border supervisory cooperation with EU and Latin-American colleagues and in other markets where the big Spanish banks are active.
Fiscal policies have been bold but should seek bigger reform leverage
10. The fiscal response has been swift and large. The government has taken 4 percent of GDP in structural measures for 2008-09 to assist the economy-bigger than many EU partners and ahead in timing. Together with automatic stabilizers, this results in deficits of 3 percent of GDP in 2008 and over 5 percent in 2009-a swing of more than 7 percent of GDP in the headline balance (compared with an end-November 2008 estimate of 1¾ percent for the euro area as a whole). While the mission notes the focus in the 2009 package on spending for labor-intensive local public works, the authorities need to ensure that this is channeled to its most productive use. The mission sees this fiscal effort (with built-in unwinding as the exit strategy) as temporarily boosting demand.
11. The main shortcoming of the measures is that they have not been used to achieve structural reforms that will increase medium-term growth potential. If the L-shaped path materializes, big deficits will recur in coming years, essentially cancelling Spain's long and hard-won fiscal turnaround through 2007. If the public loses confidence in the quality of fiscal measures, these will become less effective as households and businesses turn Ricardian and markets increase spreads.
12. As a result, any further fiscal impulse-only if necessary, and in cooperation with EU partners-should be linked to overdue structural reforms, to minimize their social costs. Assistance to the poor and liquidity constrained and a boost to infrastructure are likely to be most effective in stimulating demand. With relatively modest tax ratios, Spain is correct to resist further tax cuts at this time.
13. Short-run fiscal policies need to be embedded in a long-run context to explain how the debt can be lowered once the economy stabilizes. Public debt, while still manageable, is poised to jump. To boost confidence in light of high aging costs, the authorities should present a plan how to lower the debt again once activity stabilizes, including with pension reform. The mission encourages the authorities to develop an intertemporal public sector balance sheet for publication in the annual budget. It would show the debt already incurred, and also the present value of the projected stream of future deficits (a forward-looking debt) under unchanged policies. This provides perspective on long-run fiscal sustainability.
Structural reforms are vital to reset prices and help obtain a new growth model
14. More significant reforms than currently contemplated are needed to achieve a vigorous medium-term recovery and avoid a potential L-shaped outlook. Labor reforms need to be taken simultaneously with product and service market reforms to raise productivity and cut costs. Focusing on one side of the reform agenda could disturb income distribution and therefore run into stiff opposition. A persistent inflation differential with euro partners reflecting both high margins (returns to employers) and high unit labor costs (returns to workers) has resulted in a significant competitiveness gap. Inflation cannot remain above partner countries in a currency union.
15. Product and service market reforms require strong and full implementation to deflate margins and bolster productivity. Intentions in this respect are welcome:
16. Labor market reform is the most important missing policy issue. The highest cost of the crisis is paid by workers because the labor market is adjusting through volumes (unemployment), not prices. Spain needs extended strong wage moderation to regain competitiveness. The government is working on valuable microeconomic aspects of the labor market, including job-matching and active labor market programs. The mission sees a more immediate need to focus on three crucial macroeconomic issues:
The mission is grateful to the authorities for their hospitality and assistance, and appreciates the high quality of the discussions with all interlocutors.
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