## 1. Policy Recommendations and Implementation

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### Background: recent performance and macro conditions
- GDP growth proceeded at 2.6 percent in 2004 (staff—and now also official—projection for the year as a whole), sustained by private consumption and construction.
- Differential of final domestic demand growth over the euro area remained large (over 3 percentage points in the third quarter of 2004).
- Net exports deducted 2 percentage points from GDP growth in the third quarter of 2004; external current account deficit estimated to have widened to some 4¼ percent of GDP in the first half of 2004.
- Headline and core HICP inflation reached 3.3 percent and 2.9 percent, respectively, at end-year 2004; headline differential vis-à-vis the euro area around 1 percentage point.
- Cumulative headline (core) inflation differential with the euro area since EMU qualification in 1997 amounts to about 7 (8½) percentage points.
- Real appreciation and persistently higher inflation contributed to plateauing of exports to the euro area and continued compression of export margins.
- House prices recorded a sixth consecutive year of double-digit percentage increases in 2004; real house prices have virtually doubled since 1997.
- Mortgage credit—almost exclusively at variable rates—grew at around 25 percent in 2004.
- Household indebtedness exceeded 70 percent of GDP in 2004.
- Real interest rates were in negative territory for some three years, supporting strong credit demand.
- General government is estimated—excluding one-off accounting adjustments amounting to 0.8 percent of GDP—to have recorded a slight surplus in 2004; social security recorded a surplus slightly under 1 percent of GDP, offsetting central and subnational deficits.

### Report on discussions: policy direction and priorities
- Focus: safeguard stability-orientation of fiscal policy, advance transparency, and prioritize productivity enhancement (notably pension reform).
- Implementation to date: broadly followed Fund advice—stability-oriented fiscal policy and structural reforms in labor and product markets.
- Shortcomings: fiscal reporting and monitoring still insufficient—particularly at the subnational level; political/institutional constraints have limited comprehensive pension reform and reforms to land supply and zoning.
- Outlook differences: authorities somewhat more sanguine than staff; both agreed domestic demand would remain robust and net exports would continue to exert a drag.
- Projections: authorities revised 2005 growth projection to 2.9 percent (from 3 percent in the 2005 budget); staff projection is 2.7 percent.

### Cyclical outlook and inflation risks
- Staff assessed greater risk of inflation persistence due to:
  - Backward-looking wage indexation affecting three-quarters of contracts, raising likelihood many revision clauses are triggered.
  - Lack of effective competition in sheltered services sectors and income catch-up pressures.
- Updated Stability Program (end-December) raised official projection for inflation in 2005 to 3.1 percent (private consumption deflator); staff remained less sanguine.
- Oil price sensitivity (authorities’ estimate): a 10 percent increase in oil prices would reduce growth by about 0.1 percentage point in a year at unchanged ECB interest rates; impact would be twice as much if interest rates were to rise by 50 basis points.
- Authorities supported allowing domestic oil prices to adjust freely; introduced limited, temporary income tax rebates for agriculture and fishing to offset cost increases.

### Housing market risks, stress-test findings, and policy responses
- Bank of Spain models (re-estimated through 2004:Q3) suggest house prices may be overvalued by 20 and 30 percent respectively in the most recent period; model caveats noted.
- Illustrative consumption impacts (Bank of Spain quarterly model, macro scenario unchanged):
  - Historic-pattern correction (similar to 1992–96, real house prices fell ~20 percent with more than half in the first year):
    - Model A (20 percent correction; 12 percentage points in the first year): consumption would decline by about 0.3 percent in two years.
    - Model B (30 percent correction; 18 percentage points in the first year): consumption would decline by about 0.5 percent in two years.
  - Smooth-pattern correction (gradual real house price declines of 1.0 and 1.5 percent per quarter for 20 quarters in Model A and B respectively):
    - Model A: consumption declines by about 0.1 percent after two years.
    - Model B: consumption declines by about 0.2 percent after two years.
- Estimates are lower-bound: do not account for macroeconomic effects through income, employment, or the financial sector.
- Additional data points:
  - Home ownership rate: 85 percent.
  - Real estate assets account for more than 80 percent of household wealth.
  - Construction represents 12 percent of employment and 8 percent of GDP.
- Government “shock plan” (July 2004 Plan de Medidas Urgentes) measures:
  - Promote rental market via subsidies for young renters and preferential credit lines to refurbish rental properties.
  - Increase supply of social housing.
  - Establish Agencia Pública de Alquiler and a panel of experts to propose landlord-tenant legal reforms.
- Staff assessment: plan did not address fundamental problems—distortions from arbitrary regulations governing developable land and unequal fiscal treatment favoring home ownership (annual budgetary cost of 0.4 percent of GDP).
- Authorities acknowledged importance of land regulation and tax distortions but noted complexity tied to local authority financing and entrenched tax reliefs.

### Structural and fiscal policy priorities and recommendations
- Structural needs:
  - Comprehensive pension reform (key to long-term fiscal sustainability).
  - Land supply and zoning transparency and responsiveness.
  - Strengthening fiscal reporting and monitoring, especially at subnational levels.
- Authorities signaled possible room to address preferential tax treatment of home ownership in the context of broader personal income tax reform.
- Pension reform recommendations (staff):
  - Move comprehensive pension reform up the agenda.
  - Set a moderate structural fiscal surplus as Spain’s medium- to long-term fiscal target (Stability Program envisages rising surplus to 0.4 percent of GDP in 2007 and extended to 2008).
  - Implement reforms to increase the effective retirement age (primarily by changing provisions governing early retirement) and align contributions and benefits (extend base period used to compute pensions toward life-long earnings).
  - Authorities view gradual increases in minimum contribution period as politically more acceptable.
- Fiscal stance guidance:
  - 2005 budget target: small general government surplus of 0.1 percent of GDP (same as previous government’s Stability Program).
  - Staff judged a larger-than-targeted surplus was possible and desirable; an outcome in the order of 0.3 percent of GDP was considered possible.
  - Directors recommended proactively containing central government spending below the budget ceiling; safeguard contingency fund; fully save expected social security surplus; and ensure regional governments adhere to balanced budgets.

### Budgetary Stability Law (BSL) reform and subnational fiscal issues
- Authorities propose modifying BSL via a Budgetary Stability and Transparency Law to:
  - provide explicit scope for countercyclical action;
  - increase observance by regions in a highly devolved system;
  - enhance fiscal transparency.
- Core elements to be retained: ceiling on central government spending, contingency fund for unforeseen circumstances, dedication of any social security surplus to pension reserve fund.
- Reform options under consideration:
  - shift from annual “balanced budget” target to “balance-over-the-cycle” to avoid procyclicality;
  - adopt pre-established formulae to compute cyclical position and fiscal stance or rely on case-by-case expert panel judgments.
- Staff preference: system governed by pre-specified, clear rules covering (a) medium-term target (small surplus due to fiscal costs of aging) and (b) the cyclical adjustment, with public scrutiny of assessments.
- Strengthening subnational adherence measures considered:
  - increase regional revenue-raising powers;
  - strengthen authorization process for subnational borrowings;
  - introduce explicit no bail-out clause;
  - improve regional budgetary processes (expenditure ceilings and contingency funds).
- Staff cautions: political-economy constraints (national government dependence on small regional parties) complicate BSL changes.
- Transparency requirements emphasized: timely publication of regional budget execution data and high degree of fiscal transparency.

### Banking sector position, vulnerabilities, and policy emphasis
- Banking system: strong financial position supported by favorable macro environment and rebound in Latin America.
- Asset quality: non-performing loans fell to a record low of 0.6 percent of gross loans; provisioning surpassing 250 percent of NPLs.
- Capitalization: Basel ratio remains above 12 percent.
- Funding and margins: credit expansion outpaced deposit growth, raising average funding costs and compressing intermediation margins; banks sheltered profitability via retail activity, commission revenues, and cost containment.
- Mortgage and real estate exposure:
  - loan-to-value ratios typically 80 percent (and far less on average since many mortgages were issued when house prices were lower);
  - authorities judged households could endure interest rate hikes of up to 300 basis points before loan repayment difficulties;
  - bank provisioning in excess of €20 billion provides additional cushion.
- Concerns: continued growth of variable-rate mortgage credit and credit to real estate developers.
- Policy emphasis: continued vigilance, ensure effective credit approval and monitoring, promote wider variety of mortgage products including greater use of fixed rates.
- Note: Financial Sector Assessment Program (FSAP) scheduled for 2005.

### Labor markets, product markets, and other structural reforms
- Labor market:
  - Productivity performance lackluster relative to European average.
  - 2002 unemployment benefits reform aimed to promote active job search and geographical mobility; implementation concerns remain.
  - Female employment: activity rates among university-educated nearly close to male counterparts (3 percentage points lower); for primary education, female activity rate about 30 percentage points lower.
  - Fixed-term contracts account for about 30 percent of total employment (vs. some 5–10 percent in most other EU countries); reducing prevalence is an official priority.
  - Mission recommendation: reduce dismissal costs for open-ended contracts to lower the wedge and address high temporary employment.
  - Wage bargaining system criticized for homogeneous nominal wage increases across sectors, insufficient attention to relative productivity and non-wage factors.
- Product markets:
  - Progress in competition in several markets; full liberalization of electricity and gas advanced.
  - Remaining obstacles: restrictions to effective competition in retail distribution imposed by subnational governments.
  - Authorities intend to modernize Competition Law, strengthen regulatory agencies, and liberalize professional services.
- Energy and Kyoto targets:
  - Goal: increase share of renewable sources of energy to 12 percent by 2012.
  - Energy conservation strategy: reduce projected energy use by 7.5 percent by 2012.
  - Plan consistent with Kyoto Protocol during 2005–07; implies small reduction in greenhouse gas emissions for Spain (0.2 percent from 2002 levels).
  - Medium Term Energy Targets (Share of primary consumption): 2004 / 2012 — Coal: 1 / 2; Oil: 51 / 48; Natural gas: 18 / 23; Nuclear: 11 / 9; Renewable: 8 / 12.
- Agriculture and CAP: authorities support Doha completion and 2003 CAP reform; staff questioned maintaining maximum permissible coupling of aids with production.
- AML/CFT: progress implementing EU AML Directives; strong commitment to CFT noted.

### Staff appraisal: outlook, risks, and policy recommendations
- Assessment: Spain’s economic performance remains remarkably strong—brisk output growth and employment creation, strengthened enterprise and bank balance sheets, and fiscal accounts in good health.
- Outlook: continued economic growth in excess of the euro area average.
- Key near-term risks: inflation persistence and housing market developments; unbalanced, consumption-led recovery; demand pressures in sheltered services with inadequate competition; backward-looking wage indexation; rapid rise in house prices and household indebtedness.
- Fiscal policy recommendations:
  - Given inflation differential and booming housing market with easy monetary conditions for Spain, pursue fiscal restraint.
  - 2005 budget target of 0.1 percent of GDP surplus seen as only mildly restrictive; staff recommend pursuing a better outcome (staff judged a surplus in the order of 0.3 percent of GDP possible and desirable).
  - Specific actions: contain central government spending below budget ceiling; safeguard contingency fund; fully save expected social security surplus; ensure regional governments adhere to balanced budgets.
- Pension reform: not a substitute for fiscal restraint; expedite comprehensive reform to raise effective retirement age and align contributions and benefits; reforms could be phased gradually if enacted promptly.
- Directors’ emphasis: build on better-than-expected 2004 fiscal outcome; press ahead on structural reforms to address inflationary rigidities and improve competitiveness.

### Selected key statistics and projections (as reported)
- GDP growth (2005 projection): 2.7
- Private consumption (2005 projection): 3.4
- Gross fixed investment (2005 projection): 4.9
- Potential output growth (2005 projection): 2.8
- Output gap (percent of potential, 2005): -1.2
- Unemployment rate (2005): 10.4
- HICP (average, 2005): 3.5
- Current account balance (2005): -4.6 (percent of GDP)
- Trade balance (2005): -6.8 (percent of GDP)
- General government balance (2005): 0.3 (percent of GDP)
- Primary balance (2005): 2.3 (percent of GDP)
- Structural balance (2005): 1.1 (percent of GDP)
- General government debt (2005): 45.0 (percent of GDP)
- Current revenues (2005): 39.3 (percent of GDP)
- Current balance (2005): 4.5 (percent of GDP)
- Current expenditures (2005): 34.8 (percent of GDP)

*Source: _cr0556 - 1. Policy Recommendations and Implementation*

### 1. Policy Recommendations and Implementation .....................................................................6

### 1. Policy Recommendations and Implementation

### Background: recent performance and macro conditions
- GDP growth proceeded at 2.6 percent in 2004 (staff—and now also official—projection for the year as a whole), sustained by private consumption and construction.
- The differential of final domestic demand growth over the euro area remained large (over 3 percentage points in the third quarter of 2004).
- Net exports deducted 2 percentage points from GDP growth in the third quarter of 2004; the external current account deficit is estimated to have widened to some 4¼ percent of GDP in the first half of 2004.
- Headline and core HICP inflation reached 3.3 percent and 2.9 percent, respectively, at end-year 2004, with the headline differential vis-à-vis the euro area around 1 percentage point.
- The cumulative headline (core) inflation differential with the euro area since EMU qualification in 1997 amounts to about 7 (8½) percentage points.
- Real appreciation and persistently higher inflation contributed to a plateauing of exports to the euro area and continued compression of export margins.
- House prices recorded a sixth consecutive year of double-digit percentage increases in 2004; real house prices have virtually doubled since 1997.
- Mortgage credit—almost exclusively at variable rates—grew at around 25 percent in 2004.
- Household indebtedness exceeded 70 percent of GDP in 2004.
- Real interest rates were in negative territory for some three years, supporting strong credit demand.
- General government is estimated—excluding one-off accounting adjustments amounting to 0.8 percent of GDP—to have recorded a slight surplus in 2004; social security recorded a surplus slightly under 1 percent of GDP, offsetting central and subnational deficits.

### Report on the discussions: policy direction and priorities
- Discussions focused on safeguarding the stability-orientation of fiscal policy, advancing transparency, and prioritizing productivity enhancement (notably pension reform).
- Policy implementation has broadly followed Fund advice: stability-oriented fiscal policy and structural reforms in labor and product markets.
- Remaining shortcomings: fiscal reporting and monitoring still insufficient—particularly at the subnational level—and political/institutional constraints have limited implementation of comprehensive pension reform and reforms to the land supply and zoning process.
- The authorities were somewhat more sanguine than staff on the outlook; both authorities and staff agreed domestic demand would remain robust and net exports would continue to exert a drag.
- Authorities revised their 2005 growth projection to 2.9 percent (from 3 percent in the 2005 budget); staff projection is 2.7 percent.

### Cyclical outlook and inflation risks
- Staff assessed a greater risk of inflation persistence due to:
  - Backward-looking wage indexation affecting three-quarters of contracts, raising the likelihood that a significant proportion of revision clauses is triggered.
  - Lack of effective competition in sheltered services sectors and income catch-up pressures.
- The updated Stability Program (end-December) raised the official projection for inflation in 2005 to 3.1 percent (private consumption deflator); staff remained less sanguine.
- On oil prices: authorities estimated that a 10 percent increase in oil prices would reduce growth by about 0.1 percentage point in a year at unchanged ECB interest rates; the impact would be twice as much if interest rates were to rise by 50 basis points.
- Authorities supported allowing domestic oil prices to adjust freely to promote energy efficiency and conservation; they introduced limited, temporary income tax rebates for agriculture and fishing to offset cost increases in those sectors.

### House prices overvaluation and impact on consumption (Box 2 findings)
- Bank of Spain models (re-estimated through 2004:Q3) suggest house prices may be overvalued by 20 and 30 percent respectively in the most recent period.
  - Model caveats: the second model may overstate overvaluation where rents are administratively controlled; net present value of consumption might be underestimated due to structural changes.
- Illustrative consumption impacts using the Bank of Spain’s quarterly model (holding the macroeconomic scenario unchanged):
  - Historic-pattern correction (similar to 1992–96, real house prices fell ~20 percent with more than half in the first year):
    - Model A (20 percent correction; 12 percentage points in the first year): consumption would decline by about 0.3 percent in two years.
    - Model B (30 percent correction; 18 percentage points in the first year): consumption would decline by about 0.5 percent in two years.
  - Smooth-pattern correction (gradual real house price declines of 1.0 and 1.5 percent per quarter for 20 quarters in Model A and B respectively):
    - Model A: consumption declines by about 0.1 percent after two years.
    - Model B: consumption declines by about 0.2 percent after two years.
- These estimates are lower-bound: they do not account for macroeconomic effects through income, employment, or the financial sector.
- Additional relevant data points:
  - Spain’s home ownership rate is 85 percent.
  - Real estate assets account for more than 80 percent of household wealth.
  - Construction represents 12 percent of employment and 8 percent of GDP.

### Policy responses and staff assessment on housing
- The government’s July 2004 “shock plan” (Plan de Medidas Urgentes) aimed to:
  - Promote the rental market via subsidies for young renters and preferential credit lines to refurbish rental properties.
  - Increase supply of social housing.
  - Establish an intermediation and information agency (Agencia Pública de Alquiler) and a panel of experts to propose legal reforms to landlord-tenant rules.
- Staff view: the plan did not address fundamental problems, notably distortions from arbitrary regulations governing developable land and unequal fiscal treatment favoring home ownership (annual budgetary cost of 0.4 percent of GDP).
- Authorities acknowledged the importance of addressing land regulation and tax distortions but noted complexity: developable land availability is linked to local authority financing and established tax reliefs are difficult to change or phase out without risking disruptions to construction activity.

### Structural and fiscal policy implications highlighted
- Structural reforms have improved labor and product market functioning but further action is needed on:
  - Comprehensive pension reform (key to long-term fiscal sustainability).
  - Land supply and zoning transparency and responsiveness.
  - Strengthening fiscal reporting and monitoring, especially at subnational levels.
- The authorities signaled possible room to address preferential tax treatment of home ownership in the context of broader personal income tax reform.

*Source: _cr0556 - 1. Policy Recommendations and Implementation*

### 11. The 2005 budget is designed to reflect the new government’s economic priorities

### 11. The 2005 budget is designed to reflect the new government’s economic priorities

### Budget priorities and composition
- Objectives: continued fiscal stability, productivity enhancement, and transparency.
- Fiscal target: a small general government surplus of 0.1 percent of GDP (the same as in the previous government’s Stability Program).
- Revenue measures: no major tax initiatives; adjustment of personal income tax brackets for inflation; small increases in taxes on alcohol and tobacco products.
- Expenditure policy: central government spending ceiling set to maintain a constant expenditure-to-GDP ratio.
- Composition of spending: tilted toward productivity-enhancing initiatives, notably spending on R&D, education, and public infrastructure.
- Other initiatives: measures announced to enhance competition and improve the regulatory framework in product markets.

### Transparency and budget innovations
- Budget documents include innovations to enhance transparency of central government accounts.
- Inclusion in the 2005 budget of:
  - a reconciliation of budget and national accounts presentations;
  - information on potential risks from certain public enterprises;
  - intended close attention to contingent liabilities associated with private-public partnerships (PPPs).
- Fiscal ROSC mission (mid-2004) concluded Spain fully meets or exceeds the Fiscal Transparency Code’s standards in many areas.
- Staff concern: announcement of a large multi-year investment project for national roadworks outside the budget process ran counter to transparency initiatives.

### Fiscal stance and possible outcomes
- The 2005 budget implies a mildly restrictive fiscal stance: target general government surplus of 0.1 percent of GDP equals the estimated outcome for 2004 (excluding one-off adjustments).
- Staff judged a larger-than-targeted surplus was possible and desirable; an outcome in the order of 0.3 percent of GDP was considered possible.
- Factors supporting a larger surplus: continued strength of social security contributions (supported by planned further regularization of illegal immigrants), persistent inflation differential, real estate asset boom, and overly easy monetary conditions.
- Authorities' approach: let automatic stabilizers work toward a better outcome if forthcoming; staff encouraged a proactive approach.

### Personal income tax reform
- Authorities intend to revamp the personal income tax to broaden the base and simplify the framework.
- No decisions made; measures likely only toward the end of the legislature after public debate.
- Considered option: a flat tax with a moderately high exemption and possibly a surcharge for higher income levels.
- Authorities estimate that revenue neutrality with a reduced tax rate would require reassessment of tax deductions.
- Staff: viewed the proposal with interest and awaited further specification.

### Changes to the Budgetary Stability Law (BSL)
- Authorities propose modifying the BSL via a new Budgetary Stability and Transparency Law to:
  - provide explicit scope for countercyclical action;
  - increase observance by the regions in a highly devolved system;
  - enhance fiscal transparency.
- Core elements of the current BSL valued and to be retained: ceiling on central government spending, contingency fund for unforeseen circumstances, dedication of any social security surplus to the pension reserve fund.
- Working groups examining options; no final proposals at the time of the mission.

### Reformulation of fiscal rules and monitoring
- Proposed shift from an annual “balanced budget” target to “balance-over-the-cycle” to avoid procyclicality.
- Alternatives under consideration include:
  - pre-established formulae to compute cyclical position and fiscal stance;
  - a less structured system relying on case-by-case judgments by a panel of experts.
- Staff preference: a system governed by pre-specified, clear rules covering (a) the desirable medium-term target (seen as a small surplus due to fiscal costs of aging) and (b) the cyclical adjustment, with public scrutiny of assessments.
- Staff encouraged setting up an independent, non-partisan agency to monitor budget assumptions and developments.
- Country examples cited as potentially interesting: Chile and Switzerland.

### Strengthening subnational adherence and fiscal decentralization issues
- Context: territorial entities account for over 70 percent of public expenditure excluding social security.
- First-year BSL implementation (2003): 11 of 17 regions recorded a deficit rather than the mandated balanced budget; most deficits were small.
- Political/legal concerns: several regions challenged the BSL’s constitutionality, risking a legislative void if appeals succeed.
- Authorities’ intended measures to strengthen adherence:
  - increase regional revenue-raising powers;
  - strengthen authorization process for subnational borrowings;
  - introduce an explicit no bail-out clause;
  - improve regional budgetary processes (e.g., expenditure ceilings and contingency funds).
- Staff cautions: changes to the BSL should be carefully considered given political-economy forces (national government dependence on small regional parties).

### Transfers, cyclicality, and regional stabilization
- Issue: potential shortfall of transferred national revenues relative to devolved non-discretionary expenditures (education and health).
- Authorities generally unconvinced that mandates are “unfunded”; health financing review committed in 2005.
- Concern: cyclicality of transfers (based on revenue-sharing of national taxes tied to actual GDP) vs. rigidity of regional education and health expenditures.
- Staff suggestion: consider making transfers to regions proportional to trend (or potential) rather than actual GDP to limit cyclical swings in regional revenues and spending.
- If regions are no longer held to a “zero” budget balance, staff saw merit in building regional stabilization reserves (“rainy day funds”).

### Dealing with the fiscal consequences of aging
- Demographic transition: sharp declines in fertility and increases in life expectancy driving an older population.
- Fiscal impact of aging: estimated to amount to some 6 percent of GDP by 2050, excluding healthcare (staff estimates).
- If unaddressed, demographic shock would increase public debt sharply by 2050.
- Pension reserve fund: authorities intend to continue devoting social security surpluses to the pension reserve fund, set to approach 3 percent of GDP in 2005 (equivalent to some four months of benefits).
- Staff recommendations:
  - move comprehensive pension reform up the policy agenda;
  - set a moderate structural fiscal surplus as Spain’s medium- to long-term fiscal target (Stability Program envisages a gradually rising surplus to 0.4 percent of GDP in 2007 and extended to 2008);
  - implement pension reforms to increase the effective retirement age (primarily by changing provisions governing early retirement) and further align contributions and benefits (by extending the base period used to compute pensions toward life-long earnings).
- Authorities’ view: gradually raising the minimum contribution period seen as politically more acceptable than abrupt changes.
- Short-term priorities identified by authorities: address costly aspects of pension and healthcare systems (notably surviving spouses’ pensions, abuses of disability pensions and extended sick leave), and craft a social pact on healthcare reform as part of the 2005 financing review.

### Banking sector developments and risks
- Banking system position: strong financial position supported by favorable macro environment and rebound of activity in Latin America.
- Asset quality: non-performing loans (NPLs) fell to a record low of 0.6 percent of gross loans; provisioning surpassing 250 percent of NPLs.
- Capitalization: Basel ratio remains above 12 percent.
- Funding and margins: strong expansion of credit has outpaced deposit growth, raising average cost of banks’ funds and compressing intermediation margins; banks sheltered profitability via retail activity, commission revenues, and cost containment.
- Mortgage and real estate exposure:
  - loan-to-value ratios typically 80 percent (and far less on average since many mortgages were issued when house prices were lower);
  - authorities judged households could endure interest rate hikes of up to 300 basis points before loan repayment difficulties;
  - bank provisioning in excess of €20 billion provides additional cushion.
- Concerns:
  - continued growth of mortgage credit almost exclusively at variable rates viewed with concern, particularly credit to real estate developers.
  - Bank of Spain has issued repeated calls for prudence; authorities considered prudential controls were operating adequately and saw limited scope for tightening controls for cyclical credit management.
- Policy emphasis: continued vigilance to ensure effective credit approval and monitoring processes; promote a wider variety of mortgage and financial products, including greater use of fixed rates.
- Note: a Financial Sector Assessment Program (FSAP) in 2005 will provide a fuller analysis of the banking sector.

*Source: 11. The 2005 budget is designed to reflect the new government’s economic priorities*

### 25. The governance of the savings banks (cajas) is being strengthened by the

### _cr0556 - 25. The governance of the savings banks (cajas) is being strengthened by the

### Governance of the savings banks (cajas)
- New legislation approved in 2003:
  - Greatly reduced the presence and role of political appointees in the cajas’ governing organs.
  - Mandatory creation of Investment and Compensation Committees entrusted with approval of new strategic investments and remuneration policies and their disclosure.
- From 2004, cajas and all companies issuing publicly traded instruments are required to publish an annual report on corporate governance.
- Staff view:
  - Welcomed these developments.
  - Stressed the need to remain vigilant due to continued proclivity of political parties to attempt to influence cajas’ decisions when important local issues are at stake.

### Accounting and reporting norms for deposit-taking institutions
- Bank of Spain draft circular (for public comment) to revise accounting norms with a view to adoption of the International Financial Reporting Standards (IFRS) as from 2005.
- Circular provisions include new regulations governing:
  - Asset classification and provisioning.
  - Risk measurement.
  - Reporting standards.
  - Rules for consolidating financial conglomerates.
- On provisioning:
  - Circular envisages merging generic and “statistical” provisioning.
  - Authorities emphasized that the countercyclical feature of the system would remain.
  - Adjustment implies some relaxation of provisioning parameters and tightening of classification rules.
  - Authorities expected some initial freeing up of resources for the system as a whole, but judged amounts involved unlikely to have a macroeconomic effect and noted timing was dictated by required IFRS adoption in 2005.
- Context on statistical provisioning:
  - Statistical provisioning introduced by the Bank of Spain in June 2000.
  - Designed to cover expected losses on the basis of long-run experience over the cycle to mitigate cyclical impact on banks’ profit and loss accounts.
- Note in source: “Excludes securitized (off-balance sheet) loans”

### Labor markets: progress, challenges, and policy priorities
- General assessment:
  - Productivity performance has been lackluster, lagging behind the European average.
  - Labor utilization has evolved relatively well but scope for improvement remains given a still high unemployment rate.
  - Authorities emphasize raising productivity, notably by enhancing competition in product markets; government role seen as creating an enabling environment.
- 2002 unemployment benefits reform:
  - Designed to promote active job search and greater geographical mobility.
  - Formal observance of “return-to-work” requirements appears high, but doubts remain about practical implementation (job search assistance and application of sanctions) by the public employment agency.
  - Reform provided possibility to side-step protracted dismissal process, effectively reducing dismissal costs via declaring dismissal unjustified to avoid payment of “procedural” wages (salario de tramitación).
  - Employers view court proceedings as largely ineffectual; roughly three-quarters of all labor rulings favored the employee.
- Female employment:
  - Recent trends provide confidence in gradual improvement in female employment rates.
  - Female activity rates among those holding university degrees are close to male counterparts (only 3 percentage points lower); for workers with only a primary education, female activity rate is about 30 percentage points lower.
- Fixed-term contracts:
  - Reducing prevalence of fixed-term contracts is an official priority.
  - Fixed-term contracts account for about 30 percent of total employment, compared to a range of some 5–10 percent in most other EU countries.
  - Use of fixed-term contracts declined slightly in private sector, increase in public sector (municipal level).
  - Authorities favor extending applicability of contratos de fomento to a wider range of sectors, and addressing abuse of consecutive fixed-term contracts.
  - Mission stressed focusing on the primary cause: considerably higher dismissal costs and rigidities of open-ended contracts; recommended reducing the wedge by lowering dismissal costs for open-ended contracts rather than making fixed-term contracts less attractive.
- Wage bargaining and productivity:
  - Collective bargaining system generates high homogeneity of wage increases across sectors, skills, and regions and is insufficiently attentive to relative productivity developments.
  - System dampens incentives to human capital accumulation and discourages geographical mobility; institutional features focus on nominal wage awards at expense of factors that could raise productivity (work organization flexibility, performance incentives, training).
  - Social dialogue agreement recognizes the issue but leaves it to social partners.
- Immigration:
  - Rough estimates place upper bound of illegal immigrants in the range of 1.2–1.3 million (about 3 percent of the population).
  - Government approved a plan to regularize a large number of immigrants in the course of 2005; actual number likely to be regularized markedly less.
  - Mission stressed importance of creating a flexible and adaptive labor market to absorb immigrants smoothly and efficiently.

### Product markets and competition
- Progress:
  - Strengthened competition in several key product markets has led to notable price declines.
  - Full liberalization of electricity and gas markets has advanced further.
  - Authorities intend to modernize the Competition Law, strengthen regulatory agencies, and liberalize professional services.
- Remaining obstacles:
  - Effective competition in retail distribution persists as a problem; subnational governments have jurisdiction and have erected restrictions that in some instances widened retail margins.
  - Lack of competition in retail distribution is concerning given evidence that distributive trades account for a large share of the productivity differential between the U.S. and EU countries.
- Policy tensions:
  - Central government’s ability constrained by devolution of competencies.
  - EU Directive on Services in the Internal Market seen as an opportunity to address entry barriers.
  - Staff critical of government’s decision to lower minimum opening hours, noting it reversed earlier efforts toward complete liberalization; authorities described the decision as a compromise allowing regions to adopt more liberal regimes.

### Energy, agriculture, and AML/CFT
- Energy and Kyoto:
  - Goal to increase the share of renewable sources of energy to 12 percent by 2012.
  - Energy conservation strategy aims to reduce projected energy use by 7.5 percent by 2012.
  - Plan consistent with Kyoto Protocol requirements during 2005–07; implies a small reduction in greenhouse gas emissions for Spain (0.2 percent from 2002 levels).
  - Medium Term Energy Targets (Share of primary consumption):
    - 2004 / 2012
    - Coal: 1 / 2
    - Oil: 51 / 48
    - Natural gas: 18 / 23
    - Nuclear: 11 / 9
    - Renewable: 8 / 12
- Agriculture and Doha/CAP:
  - Authorities support successful completion of Doha round and supported 2003 reform of the Common Agricultural Policy (CAP).
  - Reform to be implemented in Spain from 2006 while maintaining maximum permissible coupling of aids with production—approach questioned by staff.
  - Authorities expressed reservations about reform initiatives affecting sugar and Mediterranean products; expected conversion of subsidies from production to income support could lead to decline in sugar beet, cotton, and olive oil production and significant change in rural economy.
- Anti–money laundering and counter-financing of terrorism (AML/CFT):
  - Authorities reported progress implementing EU AML Directives: extension of reporting duties (including currency couriers and lotteries) and strengthening of reporting requirements.
  - Emphasized strong commitment to CFT; noted limits given small sums required for devastating terrorism (example: Madrid attacks of March 2004 estimated to have cost under €10,000).

### Staff appraisal: outlook, risks, and policy recommendations
- Economic assessment:
  - Spain’s economic performance remains remarkably strong: brisk output growth and employment creation, strengthened enterprise and bank balance sheets, and fiscal accounts in good health.
  - Outlook: continued economic growth in excess of the euro area average.
- Key risks:
  - Inflation and housing market developments are principal near-term concerns.
  - Recovery is unbalanced and largely consumption-led; demand pressures in services with inadequate competition contribute to persistent inflation.
  - Higher oil prices and backward-looking wage indexation expected to prolong inflation and erode competitiveness.
  - Rapid rise in house prices and household indebtedness increases vulnerability to adverse developments.
- Fiscal policy recommendations:
  - Inflation differential and booming housing market, together with easy monetary conditions for Spain, argue for fiscal restraint.
  - 2005 budget target is a 0.1 percent of GDP surplus; staff view this as only mildly restrictive and recommend pursuing a better outcome.
  - Specific recommendations:
    - Contain central government spending below the budget ceiling.
    - Safeguard the contingency fund for truly exceptional circumstances.
    - Fully save the expected social security surplus.
    - Regional governments should adhere firmly to commitments to balanced budgets.
- Pension reform and longer-run fiscal sustainability:
  - Fiscal restraint alone is not a substitute for comprehensive pension reform.
  - Pacto de Toledo has built consensus on reform agenda but progress has been disappointingly slow.
  - If enacted promptly, reform measures could be phased in gradually with relatively muted immediate effects, avoiding more radical action later.
  - Reforms should aim for a gradual increase in the effective retirement age and improved alignment of benefits and contributions.
  - Features that perversely encourage early retirement need correction and could have a potentially powerful growth-enhancing effect.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 43.      Spain needs a strong budgetary framework, and the prime objective of changes

### Spain needs a strong budgetary framework, and the prime objective of changes to the Budgetary Stability Law must be the promotion of greater overall fiscal discipline

### Fiscal framework: objectives and design
- Prime objective: promotion of greater overall fiscal discipline through changes to the Budgetary Stability Law (BSL).
- Core principles: a model fiscal framework should be well-defined and transparent, governed by pre-specified, clear rules covering:
  - the desirable medium-term target;
  - the methodology used to determine observance “over the cycle”; and
  - fiscal relations with subnational governments.
- Improvements sought by authorities:
  - provide explicit room for countercyclical action;
  - strengthen the framework’s persuasive element; and
  - increase ownership and observance by the regions.
- Caution: changes to the BSL should be pondered carefully, shielded from political pressures, and guided by sound general principles.

### Decentralization, enforcement, and regional fiscal tools
- Constitutional constraint: hard enforcement mechanisms for subnational governments are largely unavailable in Spain.
- Design objective: ensure regions consistently aim at budget balance and avoid build-up in subnational debt; frameworks should be cyclically robust over time.
- Recommended regional fiscal instruments:
  - adoption of an expenditure ceiling;
  - creation of a contingency fund;
  - increased regional revenue-raising powers to enhance local accountability;
  - more effective use of borrowing authorizations.
- Institutional support: independent agencies reporting assessments of budgetary developments and trends to national and regional parliaments could bolster effectiveness.
- Enforcement reliance: largely on dissuasive peer and public pressure, requiring the highest degree of fiscal transparency.

### Transparency requirements
- Transparency is a sine qua non for changes to the BSL:
  - timely publication of data on regional budget execution;
  - pursuit of a degree of transparency for subnational governments similar to that sought at the central government level.
- Rationale: decentralization’s efficiency and accountability benefits depend on the public being adequately informed about local finances.
- Fiscal ROSC recommendation: highest degree of fiscal transparency.

### Housing market: fundamental problems and priority reforms
- Fundamental problems persist and require bolder measures than in the authorities’ plan.
- Priority aims:
  - (i) phase out unequal fiscal treatment from generous tax relief that favors home ownership and weighs heavily on the budget;
  - (ii) change a legal framework prejudicial to rental activity;
  - (iii) reform regulations governing developable land that limit supply.
- Assessment: until these key issues are dealt with resolutely, other measures will likely be only palliative.

### Labor market: progress and further reform needs
- Earlier reforms are bearing fruit, but further action needed to approach Lisbon Objectives.
- Immigration challenge: intense immigration requires an adaptive labor market for smooth and efficient absorption.
- Policy direction:
  - social dialogue should aim to increase labor market flexibility;
  - primary avenue: reduce rigidity and high dismissal costs of standard open-ended contracts to address high temporary employment rates;
  - reform collective wage bargaining with greater attention to relative productivity and non-wage aspects of work organization to improve productivity performance.

### Product markets: competition and removal of barriers
- Emphasis on increased competition is well-placed.
- Major remaining issue: restrictions to effective competition in retail distribution imposed by subnational authorities with competence in the matter.
- Costs of barriers: reduced regional attractiveness for investors, lower consumer welfare, and weaker economic performance.
- Recommendation: actively pursue the opportunity provided by the EU Directive on Services in the Internal Market to remove entry barriers throughout Spain.

### Financial sector: strengths and vulnerabilities
- Commercial banks and cajas: increasingly positive results.
- Vulnerability: continued expansion of real estate-related lending raises risks.
- Supervisory response: Bank of Spain’s ongoing vigilance is appropriate.
- Preparedness: ensure the system can flexibly offer financial products to respond to a prospective rise in interest rates.
- Progress: well-advanced in defining new accounting rules for deposit-taking financial institutions; strengthening of governance in the cajas is proceeding.
- Planned action: conduct of a Financial Sector Assessment Program (FSAP) in 2005 is welcome.

### External policy and development assistance
- Official Development Assistance (ODA): encouraged to build on the increase in 2004 and move closer to the 0.7 percent of GNP benchmark.
- Trade policy: Spain’s support for trade liberalization is welcome; authorities encouraged to actively promote completion of the Doha Round, including supporting needed flexibility on agricultural trade issues.
- Data caveats: Spain’s data are adequate for effective surveillance, but the quality of productivity data and the frequency and timeliness of regional fiscal data need improvement.

### Recommended timing
- It is recommended that the next consultation be held on the standard 12-month cycle.

### Selected key statistics (as reported)
- GDP growth (2005 projection): 2.7
- Private consumption (2005 projection): 3.4
- Gross fixed investment (2005 projection): 4.9
- Potential output growth (2005 projection): 2.8
- Output gap (percent of potential, 2005): -1.2
- Unemployment rate (2005): 10.4
- HICP (average, 2005): 3.5
- Current account balance (2005): -4.6 (percent of GDP)
- Trade balance (2005): -6.8 (percent of GDP)
- General government balance (2005): 0.3 (percent of GDP)
- Primary balance (2005): 2.3 (percent of GDP)
- Structural balance (2005): 1.1 (percent of GDP)
- General government debt (2005): 45.0 (percent of GDP)
- Current revenues (2005): 39.3 (percent of GDP)
- Current balance (2005): 4.5 (percent of GDP)
- Current expenditures (2005): 34.8 (percent of GDP)

*Source: IMF staff report (selected excerpts).*

### 7. If debt ratio in 2005 rises by (additional) 10 percent of GDP, others at baseline

### 7. If debt ratio in 2005 rises by (additional) 10 percent of GDP, others at baseline

### Fiscal projections and debt dynamics (General government, percent of GDP)
- Revenue: 40.0, 39.9, 39.9, 40.0, 40.0, 40.1, 40.2
- Expenditure: 39.6, 40.6, 39.8, 39.8, 39.8, 39.8, 39.8
- Current expenditure: 34.8, 35.1, 34.8, 34.7, 34.6, 34.6, 34.6
- Capital expenditure: 4.8, 5.5, 5.0, 5.1, 5.2, 5.2
- Balance: 0.4, -0.8, 0.1, 0.2, 0.4, 0.4
- Central Government balance: -0.3, -1.8, -0.5, -0.4, -0.3, -0.3
- Social security balance: 1.0, 0.8, 0.7, 0.7, 0.7, 0.7
- Territorial governments balance: -0.3, 0.2, -0.1, -0.1, 0.0, 0.0
- Gross debt: 50.7, 49.1, 46.7, 44.3, 42.0, 40.0
- Primary balance: 2.9, 1.5, 2.2, 2.2, 2.3, 2.3

(Note: Table labeled "Program Table 5. Spain: Updated Stability Program, 2003–08".)

### Macroeconomic scenario (growth rates)
- Real GDP: 2.5, 2.6, 2.9, 3.0, 3.0, 3.0
- Private consumption: 2.9, 3.3, 3.1, 3.0, 2.9, 2.9
- Public consumption: 3.9, 4.2, 3.5, 3.3, 3.3, 3.3
- Gross fixed capital formation: 3.4, 5.3, 5.5, 4.7, 4.2, 4.0
- Domestic demand: 3.2, 4.0, 3.8, 3.5, 3.3, 3.3
- Exports: 2.6, 5.1, 6.4, 6.8, 6.9, 6.9
- Imports: 4.8, 8.9, 8.5, 7.5, 7.0, 6.9

### Other macro variables (deflators, employment)
- GDP deflator: 4.0, 3.8, 3.7, 3.5, 3.2, 2.8
- Private consumption deflator: 3.1, 3.0, 3.1, 2.9, 2.7, 2.4
- Employment: 1.7, 2.1, 2.1, 2.2, 2.1, 2.0

### Authorities' low-growth scenario (selected series)
- Real GDP (growth rate): 2.6, 2.4, 2.5, 2.5, 2.5
- General government balance: -0.8, -0.2, -0.2, -0.2, -0.2
- Gross debt: 49.1, 47.2, 45.5, 43.9, 42.6

### Memorandum items (historical averages and volatilities, exact values preserved)
- Primary deficit (percent of GDP, average of past 10 years): -0.8 (listed repeatedly)
- Primary deficit (percent of GDP, standard deviation of past 10 years): 1.9 (listed repeatedly)
- Real interest rate (nominal rate minus change in GDP deflator, average of past 10 years): 3.3 (listed repeatedly)
- Real interest rate (nominal rate minus change in GDP deflator, standard deviation of past 10 years): 1.8 (listed repeatedly)
- Nominal interest rate (average of past 10 years): 7.0 (listed repeatedly)
- Nominal interest rate (standard deviation of past 10 years): 1.7 (listed repeatedly)
- Real GDP growth rate (average of past 10 years): 2.8 (listed repeatedly)
- Real GDP growth rate (standard deviation of past 10 years): 1.5 (listed repeatedly)
- GDP deflator (average of past 10 years): 3.7 (listed repeatedly)
- GDP deflator (standard deviation of past 10 years): 0.9 (listed repeatedly)

### Selected external and financial vulnerability indicators (Table 6, headline figures)
- Exports (annual percent change, in U.S. dollars): 3.2, 2.3, 3.4, 8.0, 24.0, 12.6 (Latest observation: Jan-Aug)
- Imports (annual percent change, in U.S. dollars): 8.8, 5.1, 0.9, 7.3, 25.3, 20.8 (Latest observation: Jan-Aug)
- Current account balance (settlements basis): -2.3, -3.4, -2.8, -2.4, -2.8, -4.1 (Latest observation: Jun)
- Capital and financial account balance: 3.1, 4.0, 4.0, 3.9, 4.0, 4.5 (Latest observation: Jun)
  - Inward portfolio investment (debt securities, etc.): 6.6, 12.2, 5.8, 5.9, 3.8, 7.3 (Jun)
  - Inward foreign direct investment: 2.3, 7.8, 6.0, 6.1, 2.4, 0.6 (Jun)
  - Other investment liabilities (net): 2.5, 6.9, 8.5, 2.2, 5.3, -0.4 (Jun)
- Official reserves (U.S. dollars, billions, end-of-period): 33.9, 31.8, 30.3, 35.3, 37.8 (data columns include "......")
- Central Bank foreign liabilities (U.S. dollars, billions): 80.9, 86.1, 76.3, 78.1, 67.7, 65.3 (Latest observation: Sep)
- Foreign assets of the financial sector (U.S. dollars, billions): 266.1, 361.8, 395.9, 389.9, 338.6, 339.1 (Sep)
- Foreign liabilities of the financial sector (U.S. dollars, billions): 441.8, 585.2, 648.2, 664.7, 639.6, 658.4 (Sep)
- Official reserves in months of imports: 2.3, 2.1, 2.0, 2.1, 1.8 (data columns include "......")
- Total external debt: 30.6, 29.4, 26.5, 22.4 (remaining entries ".........")
  - Of which: General government debt: 18.9, 23.1, 23.5, 22.8
- Total external debt to exports (ratio): 1.7, 0.9, 0.9, 0.8
- Exchange rate (per U.S. dollars, period average): 0.9, 1.1, 1.1, 1.1, 0.9, 0.8 (Latest observation: Sep)

### Financial market and soundness indicators (selected)
- Public sector debt (Maastricht definition): 63.1, 61.3, 57.8, 54.4, 50.7 (data columns include "......")
- 3-month T-bill yield: 3.0, 4.6, 3.9, 3.3, 2.2, 2.2 (Latest observation: Sep)
- 3-month T-bill yield (real): 0.7, 1.7, 1.3, -0.3, -0.7, -0.3 (Sep)
- Stock market index (general): 894.4, 994.8, 853.4, 723.6, 706.4, 917.7 (Latest observation: Nov)
- Spread of 3-month T-bills with Germany (percentage points, end-of-period): 0.1, 0.3, 0.3, 0.4, 0.2, 0.1 (Sep)

Selected banking soundness ratios (consolidated domestic deposit takers; ratios):
- Regulatory capital to risk-weighted assets: 12.6, 12.4, 12.9, 12.5, 12.5, 12.1 (Jun)
- Regulatory Tier I capital to risk-weighted assets: 9.4, 9.0, 8.9, 8.6, 8.5, 8.2 (Jun)
- Nonperforming loans net of provisions to Tier I capital: 15.3, -2.2, 1.0, 3.9, 4.3, 2.9 (Jun)
- Nonperforming loans net of provisions to total capital: -3.6, -9.3, -8.5, -7.6, -8.9, -10.9 (Jun)
- Sectoral distribution of loans to resident total: 72.7, 65.7, 67.7, 73.2, 75.7, 75.4 (Jun)
  - Interbank and central bank: 10.9, 8.1, 7.8, 7.1, 7.0, 6.0 (Jun)
  - General government: 13.8, 11.3, 11.2, 11.4, 11.2, 10.1 (Jun)
  - Other sectors: 48.0, 46.3, 48.6, 54.7, 57.5, 59.4 (Jun)
- Liquid assets to total assets (liquid asset ratio): 39.2, 37.2, 35.5, 33.0, 32.3, 31.4 (Jun)
- Liquid assets to short-term liabilities: 75.4, 78.0, 76.0, 71.5, 69.5, 68.2 (Jun)
- Net open position in foreign exchange to Tier I capital: 22.1, 23.5, 23.1, 12.9, 8.3, 8.5 (Jun)
- Return on assets: 0.99, 1.04, 0.97, 0.87, 0.94, 1.03 (Jun)
- Return on equity: 15.87, 15.52, 13.87, 12.3, 13.7, 15.75 (Jun)
- Interest margin to gross income: 70.23, 68.77, 70.57, 71.20, 69.03, 69.29 (Jun)
- Noninterest expense to gross income: 64.76, 62.97, 60.31, 59.10, 57.09, 55.21 (Jun)

### Figures and longer-term considerations (as presented)
- Charts and figures provided include: Real GDP growth (2000–04), Per capita income as a share of Euro Area average, Contributions to GDP growth by investment/private consumption/public consumption/net exports (2000Q1–2004Q3), HICP headline and core inflation (1997–2004), Competitiveness and exports series (1990–2004) including Unit Labor Cost in Manufacturing (1995=100), Real Effective Exchange Rate (CPI-based, 1995=100), Export Market Share (1989=100), demographic indicators and health spending projections, and productivity/utilization convergence (1970–2003).
- Appendix I provides Fund relations as of December 31, 2004, including quota (3,048.90 SDR Million), Fund holdings of currency (2,034.64 SDR Million), reserve position (1,014.29 SDR Million), SDR Department allocation (298.81 SDR Million), holdings (213.96 SDR Million), projected charges/interest for 2005–2009 (1.67, 1.91, 1.91, 1.91, 1.91 SDR Million), and exchange rate arrangement details (entry to EMU on January 1,1999 at a rate of 166.386 Spanish pesetas per euro) along with listed Council Regulations imposing specific restrictive measures.

*Source: _cr0556 - 7. If debt ratio in 2005 rises by (additional) 10 percent of GDP, others at baseline*

### 2004. Spain is on the standard 12-month consultation cycle.

### _cr0556 - 2004. Spain is on the standard 12-month consultation cycle.

### Appendix II — 2004 Adjustments to Fiscal Accounts
- Three main changes:
  - RENFE debt: To comply with new railway legislation coming into effect in December 2004—whereby the construction and operation of railways are to be managed by distinct entities—capital transfers will be used to pay off 80 percent of the operator’s (RENFE) debt.
  - RTVE debt: To recognize the debt of the heavily indebted public radio and television corporation (RTVE).
  - Argentina loan: To write-off partially the 2001 bilateral loan to Argentina was charged in 2004; smaller charges are envisaged in 2005–06.
- Additional action: The central government settled Andalucia’s disputed debt from the subnational financing agreement in place before 2001. This affects the composition of the deficits but not the general government balance.
- 2004 Fiscal Accounts: One-Time Adjustments (Billion Euros / Percent of GDP)
  - Headline General Government Balance: -6.0 / -0.8
  - Central Government: -1.8
  - Social Security: 0.8
  - Sub-National Government: 0.2
  - Expenditure Adjustments to the Central Government: 9.0 / 1.1
    - RENFE: 5.6 / 0.7
    - RTVE: 0.6 / 0.1
    - Argentina Loan: 0.3 / 0.0
    - Andalucia Debt: 2.5 / 0.3
  - Revenue Adjustment to the Sub-National Government — Andalucia Debt: -2.5 / -0.3
  - General Government Balance (excluding adjustments): 0.5 / 0.1
    - Central Government 1/: -0.7
    - Social Security: 0.8
    - Sub-National Government: -0.1
- Sources: Ministry of Economy, and staff estimates.
- Note 1/: Corresponds to -0.4 percent of GDP on a cash basis.

### Appendix III — Statistical Issues and Core Indicators
- Areas for improvement:
  - General government: Make historical revisions, preliminary estimates, and planned fiscal accounts data public shortly after submission to Eurostat in March and September; fully document major revisions; add details to reconciliation between budget and national accounts; reflect statistical nature and impact of a large multi-year national roads investment project appropriately.
  - Territorial governments: Improve expenditure and revenue detail timeliness and content; monitor fiscal developments at the territorial level to implement the Budgetary Stability Law.
  - Labor market: Two measures of unemployment ("registered" and "survey") vary substantially; employment growth data distorted by flow from informal to formal sector, complicating productivity and unit labor cost calculations.
  - National Accounts: Revised in line with ESA-95, but pre-1995 data have not been revised yet.
- Spain: Core Statistical Indicators (As of January 18, 2005)
  - Date of latest observation entries include: 1/18/05; 11/04; 12/04; 11/04; 1/18/05; 12/04; 11/04; 10/04; 2003; Q3/2004; Q3/2004.
  - Frequency and mode of reporting: Daily, Monthly, Annual, Quarterly as appropriate; sources include central bank, National Institute of Statistics, Ministry of Finance, Reuters.
  - Confidentiality: Public for listed indicators.
  - Footnotes:
    - 1/ Central government balance is released to the press monthly, about three weeks after the end of the month, and published by the Ministry of Finance.
    - 2/ Spanish government debt held by nonresidents is released to the press weekly by the central bank and drawn by staff from Reuters.

### Statement by Moises Schwartz and Pablo Moreno — Economic Prospects
- 2004 performance and labor market:
  - GDP growth in 2004: around 2.6 percent.
  - Unemployment rate: 10.38 percent (lowest since 2001).
- 2005 projections:
  - Authorities project GDP growth: 2.9 percent (slightly higher than staff’s estimate).
  - Staff/IMF projection cited elsewhere: 2.7 percent for 2005.
  - Drivers: larger contribution from investment, lesser drag from external sector, sustained equipment investment from second half of 2004.
- Inflation:
  - Consensus Forecast for 2005: range of [2.5, 3.0]; authorities expect CPI inflation at the lower limit.
  - January HICP inflation reflects a downward trend; wage indexation indicates more moderation than expected.
  - Factors moderating inflation: better-balanced growth, mitigated impact of higher oil prices, appreciation of the euro.

### Policy Framework (new government priorities)
- Triple-axed framework:
  - Budgetary stability:
    - Commitment to short- and medium-term budget consolidation.
    - Strengthen Budgetary Stability Law (to be renamed Budget Stability and Transparency Law, BSTL) by: (i) applying the principle of stability over the cycle; (ii) strengthening transparency and anchoring observance across all levels of government.
  - Boost to productivity:
    - Strategy includes increasing public spending in education, R&D and technological innovation; reinforcing product market competitiveness; labor market reform; improving investment climate; modernizing the Competition Authority.
  - Transparency and regulatory quality:
    - Apply transparency to budget, economic data (on-line availability per predetermined calendars), good-governance practices (new Code of Good Governance), and regulatory procedures with economic rationale and budgetary impact assessments.
- Decentralization context:
  - Territorial authorities control many competences, including education and health, over 70 percent of the general government budget (excluding social security), taxing capacity, labor market active policies, and product/service market regulation.
  - Central government relies on consensus, coordination, transparency, and peer pressure; institutional measures include creation of a Summit of Presidents of Comunidades Autónomas and planned Senate reform.

### Fiscal Policy (government stance and measures)
- 2004 outcome:
  - Final 2004 budget (including ESA-95 adjustments and RENFE debt) brings general government deficit to 0.8 percent.
  - Excluding one-offs, 2004 general government position would have been close to balance (broadly neutral fiscal policy).
- 2005–2008 outlook:
  - 2005 budget projects a surplus of 0.1 percent of GDP, rising to 0.4 percent of GDP by 2008 (see Stability Program Update).
  - In cyclically-adjusted terms: restrictive stance in 2005; broadly neutral in 2006–2008.
  - Expenditure readjusted in favor of R&D (to be doubled in four years), education, and infrastructure.
- Transparency measures:
  - 2005 budget includes reconciliation of budget with national accounts and information on potential risks from public enterprises.
  - BSTL will further enhance transparency; fiscal ROSC finds Spain to fully meet or exceed transparency standards.
- BSTL reform considerations:
  - Reform will be undertaken through permanent dialogue with territorial authorities.
  - Law will preserve objective of budget equilibrium and/or surplus; deficits must be justified by cyclical considerations.
  - BSTL will enable regional authorities to operate cycle-sensitive budgets.
- Pensions and aging:
  - Selected Issues paper analyzes approaches to fiscal costs of aging.
  - New data on national accounts and productivity and immigration effects warrant review of magnitude of costs; updated population estimates for 2050 increased from 41 to 53 million people.
  - Economic Policy Committee working on new projections of expenditure related to population aging, available mid-2005.
  - Government strategy to safeguard long-term fiscal sustainability:
    - (i) Budgetary discipline, with social security surplus to be allocated to the Social Security Reserve Fund (which will reach a 3 percent of GDP on 2005).
    - (ii) Sustained growth in GDP and employment.
    - (iii) Structural actions on pensions in line with Pacto de Toledo recommendations.

### Structural Issues — Financial System, Labor, Product Markets, Housing
- Financial sector:
  - Strong banking position due to prudent management and supportive regulatory/supervisory framework.
  - New bill on financial conglomerates (effective next April) to update distribution of competences and create a coordinator figure.
  - Bank of Spain circular in force since January 1, 2005, adopting IFRS: generic and “statistical” provisions merged; slight decrease in current level of provisions, which will nonetheless remain among the highest in Europe.
  - Real estate lending vulnerabilities monitored: loan-to-value ratios typically 80 percent (and far less on average); authorities estimate households could withstand interest rate increases up to 300 basis points before repayment difficulties.
  - Authorities focus on transparency of market options and diversification of mortgage risk via greater use of fixed or semi-fixed rate loans.
  - Authorities expect FSAP findings scheduled for 2005.
- Labor market reforms:
  - 2004 Social Dialogue Declaration defines thirteen priority areas: reducing prevalence of fixed-term contracts, improving female employability, adapting collective bargaining to productivity, increasing minimum wage, enhancing active labor market policies.
- Product and capital markets:
  - 2004 Progress Report on Economic Reform of Product and Capital Markets under way.
  - Competition Plan: create by end-2005 an independent and better funded National Commission of Competition integrating instruction and resolution bodies.
  - Territorial authorities play key role in product market reform (e.g., retail distribution).
- Housing market:
  - Housing reform a key priority; creation of new Housing Ministry.
  - Despite boom risks, price increases backed by fundamentals; supply at historical records but not keeping up with demand.
  - 2004 construction record: an estimated 675,000 new homes built.
  - Housing prices in 2004 show signs of deceleration; authorities expect orderly stabilization with limited economic impact (staff Box 2 stress-test shows limited impact even in worse scenarios of absolute price declines).
  - 2005 urgent measures: promote rental market and increase supply of social housing; comprehensive strategy to consider fiscal measures and reform to law on land use.

### IMF Public Information Notice (PIN) No. 05/22 — Executive Board Conclusion
- Executive Board concluded the 2004 Article IV consultation with Spain on February 9, 2005.
- Background and IMF assessment highlights:
  - 2004 growth: 2.6 percent; Spain outperformed euro-area average due to strong domestic demand (private consumption and construction); net exports strongly dragged growth.
  - Inflation differential: about 1 percentage point above euro-area average.
  - Household indebtedness continued rising amid a real estate boom; house prices experienced double-digit increases for the sixth consecutive year.
  - Erosion in competitiveness noted; export market shares held up reasonably but export margins compressed.
  - External current account estimated to have widened to some 4¼ percent of GDP in the first half of 2004.
  - Outlook: gradual, sustained recovery with GDP growth projected at 2.7 percent in 2005; domestic demand remains the driver, net exports negative contributor; inflation projected to remain comparatively higher.
  - Policy stance: accommodative; real short-term interest rates negative for three years, spurring strong credit demand.
  - General government estimated—excluding one-time adjustments—to have recorded a slight surplus in 2004, implying a mildly stimulatory stance.

*IMF staff report and country authorities’ statement contained in the PDF chapter.*

### 0.1 percent of GDP general government surplus implies a slightly restrictive fiscal stance.

### 0.1 percent of GDP general government surplus implies a slightly restrictive fiscal stance

### Fiscal stance and framework
- General government surplus: 0.1 percent of GDP implies a slightly restrictive fiscal stance.
- Authorities intend to modify the Budgetary Stability Law to:
  - provide explicit scope for cyclical swings; and
  - increase observance by subnational governments in a highly devolved system.
- Directors’ fiscal guidance and recommendations:
  - pursue a better-than-budgeted surplus in 2005 by:
    - proactively containing central government spending below the budget ceiling;
    - safeguarding the contingency fund; and
    - fully saving the expected social security surplus.
  - regional governments (which account for a large share of expenditure) should adhere firmly to commitments to balanced budgets.
  - regions should consistently aim at budget balance, avoiding a build-up in subnational debt.
  - regions could adopt budgetary instruments effective at the central level, such as an expenditure ceiling and a contingency fund.
  - consider increasing regional revenue-raising powers and establishing independent agencies to assess budgetary developments and trends.
  - changes to the Budgetary Stability Law should promote greater overall fiscal discipline with well-defined and transparent rules covering:
    - the desirable medium-term target;
    - the methodology used to determine observance over the cycle; and
    - fiscal relations with subnational governments.
  - fiscal discipline at lower levels will need reliance on dissuasive peer and public pressure, requiring high fiscal transparency.
  - significant improvement needed in the timeliness and publication of subnational budgetary data; improved fiscal transparency should be integral to any changes to the Budgetary Stability Law.

### Banking and financial sector
- Banking sector position and risks:
  - The banking sector has maintained a strong financial position, helped by the favorable macroeconomic environment, the rebound of economic activity in Latin America, and vigilant prudential oversight.
  - Rapidly rising real estate lending has heightened credit risk, but stress tests remain reassuring.
  - The Bank of Spain’s continued vigilance is welcomed.
  - A Financial Sector Assessment Program (FSAP) is scheduled for 2005.
- Directors welcomed Spain’s commitment to counter money laundering and the financing of terrorism.

### Structural reforms, labor, and product markets
- Progress and remaining issues:
  - Earlier reforms in labor and product markets have improved flexibility.
  - Long-standing issues to be addressed include:
    - pension reform;
    - the wage negotiating framework;
    - the land supply process; and
    - competition in retail distribution.
- Pension reform recommendations:
  - Assign higher priority to comprehensive pension reform; progress under the Pacto de Toledo has been slow.
  - Fiscal costs of aging will be considerable despite arising later in Spain than in other EU countries.
  - The build-up of the pension reserve fund is welcome but pre-funding alone cannot ensure longer-run sustainability.
  - Reforms needed to raise effective retirement age and strengthen the link between contributions and benefits.
  - If decided promptly, reform measures could be phased in gradually.
- Labor market recommendations:
  - Despite appreciable progress, Spain continues to lag significantly behind key Lisbon objectives.
  - Social dialogue should promote labor market flexibility to absorb large immigration flows.
  - Reducing the rigidity and costs of standard open-ended contracts is suggested as the best way to reduce the uncommonly high rate of fixed-term contracts.
  - Reform the collective wage bargaining system to assign greater attention to relative productivity developments and move away from indexation clauses.
- Goods and services markets:
  - Support for increased competition, including modernization of the Competition Law.
  - Concern about impediments to competition in retail trade and distribution enacted by subnational authorities.
  - Urgent need to address fundamental problems affecting the housing market by:
    - phasing out generous tax relief favoring home ownership;
    - changing the legal framework that discourages rental activity; and
    - reforming regulations constraining the supply of developable land.
- Policy emphasis:
  - Some Directors noted that structural policies would be more effective in stemming inflationary pressures given underlying rigidities.
  - Support for shifting composition of spending in favor of research, development, and education to enhance productivity and competitiveness over the medium term.

### Risks, outlook, and Executive Board assessment
- Executive Board commended:
  - skillful macroeconomic management and the economy’s remarkably strong performance;
  - continued rapid rise in per capita incomes, vigorous job creation, and comparatively strong fiscal position.
  - sound policies rooted in fiscal discipline, wage moderation, and growth-enhancing structural reforms.
  - government priorities of fiscal stability, transparency, and productivity enhancement.
- Key domestic risks highlighted by Directors:
  - persisting real estate boom;
  - rising household indebtedness;
  - an appreciable inflation differential with the euro area.
- Directors’ cautions and priorities:
  - While some house price rises reflect fundamental factors, prolonged increases raise potential for overshooting and adverse fallout.
  - Unbalanced consumption-led growth, backward-looking wage indexation clauses, and lack of sufficient competition in sheltered sectors risk prolonging inflation and eroding competitiveness.
  - Given very accommodative monetary conditions for Spain, Directors stressed the importance of firm fiscal restraint.
  - Encouraged building on better-than-expected fiscal outcome in 2004, boosted by strength of tax revenues and social security contributions.
  - Encouraged building upon increase in Spain’s official development assistance in 2004, and to progress further toward the U.N. target.
  - Urged active promotion of completion of the Doha round, including supporting flexibility needed on agricultural issues.
  - Welcomed Spain’s progress in increasing energy efficiency.

### Selected economic indicators (2000–2005) — key figures
- Real economy (change in percent):
  - Real GDP: 4.4, 2.8, 2.2, 2.5, 2.6, 2.7 (years 2000–2005)
  - Domestic demand: 4.6, 2.9, 2.8, 3.2, 3.9, 3.9 (years 2000–2005)
  - HICP (average): 3.5, 2.8, 3.6, 3.1, 3.0, 3.5 (years 2000–2005)
  - Unemployment rate (in percent): 13.9, 10.5, 11.4, 11.3, 10.8, 10.4 (years 2000–2005)
- Public finances (general government; in percent of GDP) 2/:
  - Overall balance: -0.8, -0.3, 0.1, 0.4, -0.8, 0.3 (years 2000–2005)
  - Primary balance: 2.3, 2.6, 2.6, 2.7, 1.3, 2.3 (years 2000–2005)
- Interest rates:
  - Money market rate: 4.4, 4.3, 3.3, 2.3, 2.1, ...
  - Government bond yield: 5.5, 5.1, 5.0, 4.1, 4.4, ...
- Balance of payments (in percent of GDP):
  - Trade balance: -6.2, -5.6, -5.0, -5.1, -6.1, 6.8 (years 2000–2005)
  - Current account: -3.4, -2.8, -2.4, -2.8, -4.0, 4.6 (years 2000–2005)
- Fund position (as of December 31, 2004):
  - Holdings of currency (in percent of quota): 66.73
  - Holdings of SDRs (in percent of allocation): 71.61
  - Quota (in millions of SDR): 3,048.90
- Exchange rate:
  - Exchange rate regime: Euro Area Member
  - Present rate (January 18, 2005): US$ 1.3060 per euro
  - Nominal effective exchange rate (1990=100): 71.9, 72.3, 74.2, 75.9
  - Real effective exchange rate (1990=100): 82.1, 83.6, 87.6, 89.9

*IMF Public Information Notice summarizing Executive Board discussion and staff commentary.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0556.pdf_