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Spain and the IMF
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On February 10, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Spain.1
After a sustained expansion in the late 1990s, Spain experienced a second year of subdued growth in 2002-albeit at a rate still well above the euro area average. This was largely due to the relative resilience of Spain's domestic demand, which in turn was supported by a comparatively stronger showing of investment, sustained by booming construction activity and a continued public infrastructure effort. After having been the mainstay of the earlier upswing, private consumption lost momentum, as households coped with rising inflation and higher indebtedness. The decline in equity values, fueled in some cases by the difficulties in Latin America (which otherwise had a limited direct effect on the Spanish economy), also sapped consumer confidence. Despite the weakening of aggregate demand, inflation (HICP) has climbed steadily since late 2001 to an annual average inflation of over 3.5 percent in 2002-exceeding the euro area average by some 1.5 percentage points, above most estimates of any likely by-product of real convergence.
National accounts data indicate that the slowdown in domestic demand may have bottomed out in the third quarter of 2002, and a slow recovery appears underway. Most projections (including by staff) foresee a gradual pickup in the course of this year-helped by income tax cuts and a continued public investment effort in the 2003 budget-projected to yield an average annual growth of some 2.5 percent (versus a budget assumption of 3 percent). The outlook is, however, characterized by appreciable downside risks.
The sustained gains in fiscal consolidation (with achievement of the Stability and Growth Pact (SGP) requirements already in 2001) were maintained in 2002, despite the economic slowdown. Preliminary estimates point to a small deficit in 2002 due to shortfalls at the regional level. The 2003 budget-the first to be drawn up under the new Budgetary Stability Law (BSL)-again aims for a balanced budget, in keeping with the Law. Under the staff's growth projection, this would imply some further fiscal withdrawal of stimulus countering a monetary policy stance that, from Spain's perspective, is highly accommodative.
In the banking sector, major banks have been able to deal reasonably well with the difficulties stemming from Latin America, with the main casualty being a reduction in profit growth.
Following a series of earlier structural reforms, labor market performance has improved notably, with continued job creation even during the slowdown. The main recent labor market initiative modifies the unemployment benefits system to promote a "return-to-work" orientation and greater geographical mobility. It also includes a phasing out of the rural employment subsidy. However, the level and dispersion of unemployment remain high, wage differentiation is low, and recourse to wage indexation is widespread. Product market reform has advanced, but in key network services effective competition remains low given the still dominant position of a few operators. In retail trade and distribution, a number of regional and local entities have made increasing recourse to a variety of barriers to entry and competition, upholding supply rigidities in a sector subject to comparatively stronger demand pressures as Spain's income levels converge toward the EU average.
Executive Board Assessment
Directors commended Spain's pursuit of sound macroeconomic policies and structural reforms, which has contributed to a significant narrowing of the per capita income differential with the euro area average. A particularly welcome development is the continued growth in employment even during the current economic slowdown. Directors also noted that Spain had made judicious use of the earlier expansion to improve its underlying fiscal position, and has been in compliance with the Stability and Growth Pact (SGP) fiscal balance commitment since 2001. In addition, prudent financial supervision has contributed to the resilience of the banking sector in difficult times. Directors saw these positive results as a powerful incentive for continued resolute action on the structural front to address remaining challenges. This will need to include policies to prepare for population aging, further reduce unemployment, and ensure long-term competitiveness and growth prospects.
Directors considered that, in view of its sound policy setting and improved economic resilience, Spain is comparatively well-placed to weather the current weakness in the world economy, and to register another year of above euro area average growth in 2003. Although a number of country-specific risks-including households' increased indebtedness, the boom in housing prices, and the exposure to Latin America-will warrant the authorities' continued vigilance, Directors generally saw these risks as relatively low and manageable. Barring a deterioration of global economic conditions, they expected the supportive monetary conditions and recent income tax cuts to sustain a gradual pickup in activity during the course of the year.
Directors noted that the persistence of an inflation differential vis-à-vis the rest of the euro area remains a source of concern. While recognizing that a series of one-off factors have contributed to the recent rise in inflation, and that part of the differential may be a by-product of real convergence, Directors nevertheless cautioned that the accumulation of a persistent inflation differential would, over time, weaken the economy's competitiveness. They looked forward to further improvements in economic data that will allow careful analysis of the underlying causes of Spain's comparatively higher inflation. Directors welcomed the assurance that wage moderation will be continued in 2003, and recommended that the authorities explore-in concert with the social partners-the scope for phasing out backward-looking wage indexation, and that they continue to implement structural reforms that will enhance competition and promote the supply response to demand pressures arising in specific sectors.
Directors commended the authorities' exemplary record on fiscal consolidation, which has been a pillar of Spain's successful economic strategy in recent years, and has provided room for a reduction in the income tax burden and an increase in capital spending. They welcomed the new Budgetary Stability Law which, by mandating budget balance at all levels of government, will foster fiscal co-responsibility and consolidate a culture of fiscal discipline throughout Spain. This is essential given the devolution process that has taken place. While the small fiscal withdrawal implied by a balanced budget target in 2003 was not seen as problematic, given very easy monetary conditions, Directors cautioned that, going forward, it will be important to avoid implementing the Budgetary Stability Law in a manner that is unduly procyclical. They welcomed, in this regard, the authorities' assurance to remain vigilant, and urged them to use the flexibility provided under the Law to take appropriate account of cyclical developments. Directors encouraged the authorities to improve fiscal monitoring and transparency, in particular by ensuring timely information on the execution of regional budgets and a closer consistency between the budget's economic assumptions and its revenue estimates.
Directors noted that, even though the demographic shock will occur comparatively late in Spain, it is also set to be deeper. They therefore saw considerable merit in the early formulation of a strategy that will allow needed reforms to be phased in gradually over time. In particular, they highlighted the need for a sufficiently ambitious pension reform to complement the objective of achieving a small fiscal surplus over the medium term, and thereby place the fiscal accounts on a sustainable long-term footing. Directors encouraged the authorities to make strong efforts to mobilize political and social support for substantive pension reforms in their negotiations with the social partners this year. They highlighted, in particular, the importance of reforms that would include further steps toward eliminating incentives for early retirement and strengthening the link between contributions and benefits.
Directors welcomed the resilience shown by the banking sector in the face of the difficulties stemming from their investments in certain Latin American countries. Directors noted that strong starting positions together with strict prudential supervision and the promotion of conservative risk management by the Bank of Spain have contributed to Spanish banks remaining profitable, well-capitalized, and cost-efficient. They also supported efforts to improve the statutory framework of the savings banks. Going forward, Directors stressed the need for continued prudence and vigilance, including with respect to risks stemming from the rapid rise in mortgage lending and household indebtedness. Directors welcomed Spain's decision to participate in the Financial Sector Assessment Program (FSAP). They also commended the authorities' strong commitment to combat money laundering and the financing of terrorism, and looked forward to the implementation of new comprehensive legislation in this area.
Directors were encouraged by Spain's record on labor market reform, which has contributed to strong employment growth in recent years. With unemployment remaining high and exhibiting wide regional variation, the authorities' continued close attention to labor market issues remains nevertheless important. The "return-to-work" emphasis of the recent reform of the unemployment benefits system is well-placed and, as next steps, Directors recommended a revision of Spain's collective bargaining system to promote greater wage dispersion and to broaden the scope of negotiations beyond their almost exclusive focus on the salary increase. Several Directors welcomed the phasing out of the rural employment subsidy.
Directors also viewed favorably the ongoing structural reforms in a wide range of other areas. In product markets, they encouraged the authorities to build on the progress achieved to date by taking further firm action to foster competition in key network services, which are still largely dominated by a few operators. In retail distribution and trade, the priority should be to lift the obstacles to entry and other measures thwarting effective competition, imposed by a number of regional and local entities. The authorities were also encouraged to take steps to remove remaining rigidities in the supply of land and in the housing market. A number of Directors highlighted the importance of preparing for the macroeconomic and structural implications for Spain's medium term outlook and competitiveness that will arise from the enlargement of the European Union.
Directors welcomed Spain's contribution to the Fund's initiatives for its poorest members. They encouraged continued efforts to increase its official development assistance toward the U.N. target. Directors also welcomed Spain's support for trade liberalization and its commitment to the success of the Doha round, and a number of Directors encouraged the authorities, in this context, to work in favor of a substantive reform of the EU's Common Agricultural Policy in the midterm review.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the February 10, 2003 Executive Board discussion based on the staff report.
IMF EXTERNAL RELATIONS DEPARTMENT