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2013 Article IV Consultation with Spain- Concluding Statement of the Mission
June 18, 2013
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.
Strong reform progress is helping stabilize the economy and external and fiscal imbalances are correcting rapidly. But unemployment remains unacceptably high and the outlook difficult. This calls for urgent action to generate growth and jobs, both by Spain and Europe.
Important reform progress is supporting the economy amid strong headwinds
1. Strong progress has been made on critical and difficult reforms since last year’s consultation. A major labor reform was instituted in July. Decisive action was taken to help clean up banks in the context of the ESM-supported financial sector program. A wide range of fiscal measures were enacted, at all levels of government, and transparency was sharply upgraded. Product and service market reform advanced. European policies were also strengthened, in particular, via the ECB’s OMT program and steps to banking union.
2. Helped by these policy actions, key imbalances are correcting rapidly and sovereign spreads have fallen sharply. Sovereign spreads have halved since last summer as financial market confidence strengthened. Wage growth has moderated and unit labor costs have decreased. This has improved competitiveness, exports have performed strongly (among the best in the euro area), and the current account has swung rapidly into surplus, thus reducing vulnerabilities. Equally remarkably, the fiscal deficit fell sharply despite the recession, with every region contributing. Private debt is also falling.
3. But strong headwinds have kept the economy in recession amid unacceptable levels of unemployment. Lower sovereign borrowing costs are not feeding through to the real economy: credit is contracting sharply and lending rates remain too high. Hampered by private sector deleveraging and fiscal consolidation, and compounded by labor market rigidities, output has contracted for seven quarters and unemployment has reached 27%.
4. While there are signs the economic contraction may end soon, the outlook remains difficult. In our baseline scenario, we expect growth to start to turn positive later this year and to gradually pick up to around one percent in the medium term, with limited gains in employment. The external sector will likely continue to be the bright spot, but probably not enough to generate sufficiently strong growth given weak domestic demand. An upside scenario similar to the government’s is certainly possible, especially in the medium term if the envisaged reforms are fully implemented by Spain and Europe. But there are also downside risks: private sector deleveraging could weigh more heavily on growth or financial market pressures intensify.
The policy imperative: generating jobs and growth
5. This outlook calls for raising the reform effort to the level of the challenge. Euro-area policies need to be much more supportive, but Spain needs to deliver on its announced program, and indeed go further in some areas. The focus should be on a pro-jobs strategy that allows the economy to grow and hire. This means building on existing progress in making prices bear more of the adjustment than quantities, helping the private sector delever, making sure banks can extend credit to healthy businesses, and minimizing the drag from the inevitable fiscal consolidation. It also means avoiding any tendency to take the prospective economic stabilization as a reason to slow the reform effort.
Making the labor market more job-friendly and inclusive
6. Labor reform needs to go further to generate jobs. Last year’s reform made substantial improvements and is gaining traction. But labor market dynamics need to improve to reduce unemployment sufficiently.
7. Faster progress in boosting competition and the business environment would complement the labor reform by reducing prices and spurring employment. The government targets an appropriate range of reforms—it now needs to deliver. Priorities include implementing a strong Market Unity law, reducing regulatory barriers that keep firms from growing, de-indexing public pricing, and finding a lasting solution to the electricity tariff deficit. The plan to open up professional services is also important and should avoid being undermined by vested interests and further delayed. To identify future priorities and build consensus, an independent “growth commission” could help.
8. A mechanism should be explored to bring forward the employment gains from structural reforms. This would augment ongoing efforts to help guide Spain’s economy to a better outcome and could comprise two elements: (1) employers committing to significant employment increases in return for unions agreeing to significant further wage moderation and (2) some fiscal incentives in the form of immediate cuts in social security contributions offset by indirect revenue increases in the medium term. A significant increase in employment and reduction in inflation will be critical so that household purchasing power in the aggregate does not suffer. The challenges for all involved are enormous, and it will be crucial to avoid that the approach is watered down or needed structural reforms delayed.
Helping the private sector delever
9. Private sector deleveraging is underway, but there is scope to smooth the adjustment process. While any change must not compromise financial stability, there is scope to continue to improve the insolvency regime:
10. Banks, the other side of the deleveraging coin, also need to play their part. Losses need to be promptly recognized and distressed assets sold to avoid tying up resources that could flow to more productive uses. And while it is only to be expected that aggregate credit contracts in a recession following a credit boom, a slower pace would benefit the economy as a whole.
Supporting credit while safeguarding financial stability
11. The banking system is now significantly stronger but risks remain. While the ESM-supported program1 is helping tackle legacy risk from the real estate boom-bust, the macro downsides could trigger a negative feedback loop between credit and the economy, with deteriorating loan books and pressure on profits.
12. This calls for proactive vigilance to protect the hard-won solvency of the system and to support credit. Priorities include continuing to: (1) reinforce the quality and quantity of capital, including by being very prudent on cash dividends; (2) clean up loan books and encourage prompt disposal of distressed assets, including by following up on the welcome initiative to clarify the classification of refinanced loans; and (3) remove any supply constraints, for example, by developing well-designed guarantee and risk-sharing schemes targeted at SMEs, following through on plans to enhance non-bank financing, lowering deposit rates, and clearing public sector arrears. These actions could be incentivized by swapping deferred tax assets for tax credits. Rigorous and regular forward-looking scenario exercises on bank resilience should guide supervisory action.
Minimizing the drag on growth from the inevitable fiscal consolidation
13. The required fiscal consolidation needs to be as gradual and growth-friendly as possible. Despite the substantial adjustment in 2012, the deficit is still very large and needs to be reduced further to ensure debt sustainability. But reducing it too quickly would hurt growth. The government’s new medium-term structural deficit reduction targets strike a reasonable balance between reducing the deficit and supporting growth. It will be crucial to detail how these targets will be achieved and to ensure the measures are permanent and as growth-friendly as possible. The nominal (and, if necessary, structural) targets should be flexible in the event growth falls short of the government’s projections—the more credible the consolidation plans, the more scope for flexibility on targets. Given the need to stabilize the economy and assuming the structural consolidation in train for 2013 is delivered, significant additional measures for 2013 are undesirable.
14. Encouraging progress on structural fiscal reforms needs to be followed through with ambitious legislation and rigorous implementation.
Europe should do more
15. Last, but certainly not least: more should be done at the European level to ease Spain’s adjustment. Recent euro-area actions have reduced tail-risks and financial market stress. Nevertheless, these initiatives have not been sufficient to reverse financial fragmentation, fix the broken transmission mechanism, and deliver higher growth and employment, neither for the euro-area nor Spain. Of particular importance to Spain would be moving faster to full banking union, which would help break the sovereign/bank loop by allowing Spanish firms to compete for funds on their own merits rather than on their country of residence. Further ECB measures to reduce the much higher borrowing costs facing Spain’s private sector would also be important. Spain and the euro-area should keep the option of an OMT-eligible program open to help cement market confidence and lower yields.
1 For more detail, see our quarterly financial sector monitoring reports.
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