## _cr06211

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### Executive summary — recent performance and imbalances
- Output growth, 2005: 3.4 percent.
- Employment creation: Spain created more than 60 percent of all new jobs in the euro area in 2005.
- Unemployment reduction: unemployment rate reduced by 12½ percentage points since 1996.
- Public finances, 2005:
  - General government surplus: 1.1 percent of GDP.
  - Public debt: declined from 67 to 43 percent of GDP over the 1990s into 2005 (noted in Introduction).
- Domestic demand: has driven growth since mid-2002 and outpaced GDP.
- External and competitiveness indicators:
  - Current account deficit, 2005: 7½ percent of GDP.
  - Net external liabilities, 2005: 46 percent of GDP.
  - Inflation differential with the euro area (2006:Q1): 1¾ percentage points.
- Household sector and credit:
  - Household indebtedness: over 110 percent of disposable income (2005).
  - Mortgage credit growth, 2005: 25 percent.
  - Household and corporate credit growth: over 20 percent in the year to January 2006.
- Financial intermediation and external financing:
  - Financial institutions’ financial assets: about 220 percent of GDP in 1996 to 330 percent in 2005.
  - Net external borrowing by credit institutions and other financial intermediaries, 2005: 14 percent of GDP (mainly via mortgage-backed securities).
- Sectoral and price dynamics:
  - Growth concentrated in services, construction, and energy; sectors exposed to external competition experienced little growth.
  - Real house price growth: peak 15½ percent in 2003:Q2; 8¼ percent in 2006:Q1 (seasonally adjusted, q-o-q annualized).
  - Core inflation margin (2006:Q1): 1.6 percentage points (core inflation over euro area average).
  - Hourly labor costs decelerating; wages and unit labor costs still increased faster than the euro area average.
- Liquidity and lending rates:
  - Real lending rates are negative or close to zero.
  - Little housing equity withdrawal; nontraditional mortgages relatively rare but developing.

### Immediate growth outlook (short-term projections and near-term indicators)
- Staff and official projections:
  - Growth projected to moderate to some 3.3 percent in 2006 and to 3.2 percent in 2007.
  - Inflation forecast for 2006: close to 3½ percent.
- Near-term domestic demand signals:
  - Slowdown in retail sales, consumer durables, house prices, and other leading indicators.
  - Consumption and residential investment expected to decelerate in 2006; housing market gradually cooling.
  - Business investment expected to plateau in response to higher capital costs.
- External sector outlook:
  - Gathering euro-area recovery expected to reduce external drag; authorities noted firming euro-area interest rates and strengthening external demand as favorable, while staff judged euro-area interest rates unlikely to rise sufficiently from Spain’s standpoint.

### External imbalances and competitiveness
- Historical/current patterns:
  - Current account deficit widened from an average close to 2½ percent of GDP since EU accession in 1986 to 7½ percent of GDP in 2005.
  - Trade-weighted export market share: increased until about 1998, stagnated thereafter, and declined from 2003.
  - Import volume penetration has risen continuously.
- Cost and productivity differentials:
  - Manufacturing unit labor cost differential with the euro area widened by 16 percentage points since 1995.
  - Indicators of Spain’s export margins exhibited the weakest evolution among other large euro-area economies since 1995, with some recovery since 2003.
- Staff decomposition (1980–2005) of current account variation:
  - About 33 percent attributable to oil prices.
  - About 37 percent attributable to the cyclical position.
  - Residual (~30 percent) increasingly negative, amounted to 2½ percentage points of GDP in 2005, reflecting in part underlying competitiveness losses.
- Methodological assessment:
  - Staff estimated required real effective exchange rate improvement in a range of 23–30 percent (results subject to considerable caution and estimation error).
- Projected financing needs:
  - Financing needs projected to rise to above 8 percent of GDP by 2008 due to further net export deterioration, increased interest payments and immigrant remittances, and envisaged decline in EU transfers.

### Main risks, scenarios, and financial sector resilience
- Principal downside risk:
  - Continuation of unsustainably rapid domestic spending leading to pronounced household balance-sheet and real estate valuation adjustments, and a protracted period of depressed employment and activity.
- Stress scenarios highlighted:
  - Balance-sheet and real estate valuation adjustments triggered by high household indebtedness (110 percent of disposable income) could produce pronounced corrections.
  - Protracted depressed employment and activity in severe adjustments.
- Sectoral exposure:
  - Construction accounts for 10½ percent of output and 14 percent of employment.
- FSAP and Bank of Spain stress-test examples indicating financial system resilience to plausible shocks:
  - Hypothetical fall in real house prices of slightly over 17 percent in the first year and of 4½ percent in the subsequent year.
  - A 30 percent drop in equity prices.
  - An abrupt depreciation of the US dollar.
- Staff vs. authorities:
  - Staff remained more concerned than the authorities about risks and urged a more vigorous structural and countercyclical policy response.

### Fiscal policy stance, recommendations, and the Budget Stability Law (BSL)
- Fiscal outcomes and stance:
  - 2005 general government surplus: 1.1 percent of GDP; buoyant tax collections.
  - Conventional cyclically adjusted balance estimates indicate a fiscal withdrawal of about a ¼ percentage point of GDP in 2005; staff judged fiscal stance in 2005 inadequate due to excessive growth in public spending.
  - General government non-interest spending rose by 0.3 percentage points of GDP in 2005 (adjusted for one-time 2004 balance-sheet operations).
- Authorities’ 2006–07 outlook:
  - Authorities expected an appreciable fiscal surplus in 2006 and strong performance in 2007; 2006 revenues set to exceed budget projections by a wide margin.
  - Central government consumption budgeted to rise in real terms by 4.1 percent in 2006.
- Staff short-term fiscal recommendations (dampen demand):
  - Advocate greater expenditure-based fiscal restraint.
  - Aim to improve the 2006 general government surplus by at least ½ percentage point of GDP (relative to 2005), based on expenditure control.
  - Central government should keep spending appreciably below current ceilings and safeguard the budget’s contingency fund for truly exceptional events.
  - Regions should move to balance in 2006 and surplus by 2007—consistent with the new Budget Stability Law.
- Draft Budget Stability Law (highlights and staff concerns):
  - Targets a fiscal balance over the cycle for the general government, excluding the social security system.
  - Establishes targets for three states of the economy to avoid defining cyclical position:
    - Normal growth: fiscal balance set at between 2 and 3 percent for the 2007–09 period.
    - Low growth: a small public deficit.
    - High growth: a surplus (of underdetermined size).
  - Excluded capital expenditure: up to 0.5 percent of GDP, of which half is allocated to the regions.
  - Allocation table (tabled numerical allocations as presented in the source):
    - Normal growth (between 2 and 3 percent)
      - Central: Balance 0.20 percent of GDP; Excluded capital expenditure -0.20 percent of GDP
      - Regional: Balance 0.25 percent of GDP; Excluded capital expenditure -0.25 percent of GDP
      - Local: Balance 0.05 percent of GDP; Excluded capital expenditure -0.05 percent of GDP
    - Low growth (less than 2 percent)
      - Central: -0.20 0.20 percent of GDP; Excluded capital expenditure -0.4 percent of GDP
      - Regional: -0.75 0.25 percent of GDP; Excluded capital expenditure -1.0 percent of GDP
      - Local: -0.05 0.05 percent of GDP; Excluded capital expenditure -0.1 percent of GDP
    - High growth (greater than 3 percent)
      - Central: Surplus 0.20 percent of GDP; Surplus - 0.20 percent of GDP
      - Regional: Surplus 0.25 percent of GDP; Surplus - 0.25 percent of GDP
      - Local: Surplus 0.05 percent of GDP; Surplus - 0.05 percent of GDP
  - Staff concerns:
    - Asymmetry: deficit limit specified in low growth but no commensurate surplus requirement in high growth, risking insufficiently ambitious targets in good times.
    - Exclusion of part of capital spending judged insufficiently precise, raising off-budget capital spending concerns.
    - Ambiguity whether surplus requirement in good times applies to Autonomous Communities as a whole or to each Community individually.
    - Implementation clarity and precision needed to avoid circumvention and divergent interpretations.
  - Enforcement features:
    - Three-year corrective plans for any level of government failing to reach the balance over-the-cycle target.
    - Enforcement relies on increased transparency and timeliness of subnational data, and an explicit barring of regional government bail-outs.

### Territorial financing, healthcare, pensions, and tax reform
- Territorial financing and taxation:
  - Territorial financing arrangements under review in parallel with the BSL.
  - Reform of the Statute of Autonomy for Catalonia foresees transfer of a higher share of taxes and some greater taxing autonomy; could act as a blueprint.
  - Authorities indicate greater taxing autonomy—particularly with respect to the personal income tax; corporate income tax to remain uniform nationwide.
  - Staff: unless central transfers are cut back, current framework provides little incentive for regional governments to use enhanced tax powers.
- Healthcare financing:
  - Public spending on healthcare: 6 percent of GDP and growing rapidly.
  - Healthcare-related transfers increased by 0.2 percent of GDP over budgeted levels in 2005; health appropriations raised in 2006 until new cost-sharing in 2007.
  - Staff recommendation: broader reform likely required, including forms of private participation and cost-sharing (user co-payments).
  - Caution: commitments under a new disability law (Ley de Dependencia) should be costed carefully and beneficiaries targeted closely.
- Pension reform and long-term fiscal risks:
  - Recent agreement: incentives to prolong effective working life; marginally extends effective minimum contribution period (from 12.8 to 15 years); consolidates agricultural and self-employed regimes; extends coverage of widowers’ pensions; increases pensions of those retired early due to dismissal; base period to compute pensions left untouched.
  - Staff: helpful move but long-term sustainability will require further action, including changes to key parameters and timely broad-ranging reform.
  - Social security reserve fund reached 3½ percent of GDP, postponing funding shortfalls by five years.
- Recent tax reform (entering into effect in 2007):
  - Reduces marginal personal income tax rate and the number of brackets.
  - Introduces a uniform rate on savings of 18 percent.
  - Phased-in reduction of corporate tax rate by 5 percentage points.
  - Eliminates a range of tax deductions; does not eliminate the mortgage deduction.
  - Staff concerns: reduction in tax-exempt contributions to private pensions may deter pension provision; employers viewed rate cut as insufficient after deduction eliminations.

### Structural reform agenda — product and labor markets
- Authorities’ programs:
  - Dynamization Plan (February 2005, updated March 2006) and National Reform Program (NRP, October 2005) aimed at increasing productivity and employment rate.
  - Emphasis on public goods provision (infrastructure, education) and sponsorship (R&D, start-ups).
- Staff emphasis:
  - Urged early focus on deregulating and opening sheltered sectors to competition (energy, utilities, telecommunications, transportation, professional services).
  - Competition-based incentives preferred to subsidy-based R&D measures.
- Productivity diagnosis:
  - Spain experienced catch-up in labor productivity through mid-1980s but fell behind thereafter.
  - Productivity gap with a 23-industrial country sample increased from 9 percent in 1985 to 30 percent in 2004 (or to 23 percent if measured at current prices).
  - Low ICT capital, low R&D spending, and human capital shortfalls; barriers to competition and labor market rigidities impede dynamism.
- Labor market specifics:
  - Temporary contracts account for 34 percent of total contracts (versus 5–10 percent in most other EU countries).
  - Recent limited reform (early May) focuses on reducing incidence of temporary contracts via legal provisions and fiscal incentives; allows contratos de fomento to be applied more broadly through end-2007.
  - Staff: reform does not address permanently reducing rigidity and high dismissal costs of regular contracts nor reforming centralized collective wage bargaining.

### Financial sector — FSAP findings and recommended follow-up
- FSAP overall assessment:
  - Financial system is highly dynamic and competitive under strong prudential supervision and regulation.
  - Sector strengths include high intermediation, low margins, well-capitalized institutions, and a robust prudential framework.
  - Stress tests indicate banks and insurance companies could withstand large adverse shocks without systemic distress.
- Main risks and supervisory recommendations:
  - Rapid credit growth and potential housing downturn, with increased nontraditional mortgage products.
  - Marginal LTVs rising; average LTV relatively low.
  - FSAP recommendations (selected):
    - Tighten prudential requirements for nontraditional real estate loans (ST).
    - Adopt most conservative approaches under Basel II for industrial participations (ST/MT).
    - Strengthen independence of financial sector supervisors; separate insurance supervision from Ministry of Economy (MT).
    - Improve governance and market discipline of savings banks; allow mergers; promote high-quality capital instruments (cuotas participativas); reduce public sector representation ceilings (MT).
    - Introduce regulations to prevent credit institution representatives serving on nonfinancial company boards from participating in related decisions (MT).
  - Authorities broadly receptive; Bank of Spain increased vigilance via disclosure guidelines and consumer awareness initiatives.
- Noted nonregulated event:
  - Discovery of large-scale fraud by two nonfinancial investment companies specialized in stamp trading—reported €4–5 billion (about ½ percent of GDP); these activities fall outside financial sector regulators.

### Staff appraisal — macro assessment and policy priorities (summary)
- Recent performance:
  - Decade-long expansion: robust growth, job creation, and record fiscal revenues producing an appreciable surplus.
  - Expansion supported by reforms since early 1990s and EMU membership with low interest rates.
- Key concerns:
  - Intensifying macroeconomic imbalances: record current account deficit driven by unsustainable domestic demand and widening cost/productivity differentials; buoyant demand and pricing power in sheltered markets keep inflation above euro-area average.
  - High oil prices and rising gross and net external liabilities heighten exposure to interest rate risk.
- Policy priorities recommended by staff:
  - Implement bold supply-oriented reforms emphasizing product market competition and labor market flexibility.
  - Fiscal policy to rein in domestic demand via greater expenditure-based restraint in 2006 and 2007—use the high-growth period to implement reforms.
  - Early pension and healthcare reforms for long-term fiscal sustainability.
  - Strengthen fiscal framework, fiscal transparency, and fiscal co-responsibility across levels of government.
  - Financial sector follow-up: increase independence of supervisors, strengthen savings banks governance, adopt conservative Basel II treatment of industrial participations, and monitor nonconventional mortgages.
  - External policy: continue raising ODA toward the 0.7 percent of GNP UN target (from 0.29 percent in 2005) and contribute to liberalization in Doha round.

### Key statistics and projections (selected series and highlights)
- Growth and demand:
  - Real GDP growth (2001–07): 3.5, 2.7, 3.0, 3.1, 3.4, 3.3, 3.2
  - Total domestic demand (real growth, 2001–07): 3.6, 3.3, 3.8, 5.0, 5.3, 4.5, 3.8
  - Private credit growth: 11.8, 12.3, 14.2, 17.9, 27.2, ...... (series truncated)
- Prices and labor market:
  - HICP (average, year-on-year, 2001–07): 2.8, 3.6, 3.1, 3.1, 3.4, 3.4, 3.1
  - HICP differential with euro area average: 0.5, 1.4, 1.0, 0.9, 1.2, ...... (series truncated)
  - Unemployment rate (percent, 2001–07): 10.6, 11.5, 11.5, 11.0, 9.2, 8.6, 8.5
- External sector and balance of payments:
  - Trade balance (percent of GDP, 2001–07): -5.7, -5.0, -5.1, -6.4, -7.6, -8.3, -8.6
  - Current account balance (percent of GDP, 2001–07): -3.9, -3.3, -3.6, -5.3, -7.4, -8.1, -8.5
  - Current Account (billions of euros, 2004–11 projections): -44.2 (2004), -66.6 (2005), -78.4 (2006), -87.7 (2007), -95.6 (2008), -101.0 (2009), -106.4 (2010), -114.8 (2011)
  - Net International Investment Position (percent of GDP): -42.9, -46.1, -50.3, -55.1, -60.1, -65.2, -70.0, -74.8
- Public finance (selected):
  - General government balance (2001–07, percent of GDP): -0.5, -0.3, 0.0, -0.1, 1.1, 0.9, 0.7
  - Primary balance (2001–07, percent of GDP): 2.1, 2.1, 2.1, 1.7, 2.7, 2.5, 2.1
  - General government debt (2001–07, percent of GDP): 55.6, 52.7, 48.9, 46.4, 43.2, 39.4, 36.3
- Financial and vulnerability indicators:
  - Gross liabilities (percent of GDP, 2000–05): 124.2, 129.1, 133.4, 141.6, 153.2, 170.6
  - Gross assets (percent of GDP, 2000–05): 99.1, 101.7, 101.4, 104.0, 110.1, 124.5
  - Nonperforming credit to total gross credit (2000–05): 1.0, 0.9, 1.0, 0.9, 0.7, 0.6

### Recommendation and procedural note
- It is recommended that the next consultation be held on the standard 12-month cycle.

*Source: Executive Summary and selected sections of IMF staff report _cr06211._*

### Executive Summary ......................................................................................................

### _cr06211 - Executive Summary

### Background: recent performance and imbalances
- Output growth in 2005: 3.4 percent.
- Employment creation: Spain created more than 60 percent of all new jobs in the euro area in 2005.
- Unemployment reduction: unemployment rate reduced by 12½ percentage points since 1996.
- Public finances in 2005:
  - General government surplus: 1.1 percent of GDP.
  - Public debt: low (noted decline from 67 to 43 percent of GDP over the 1990s into 2005 in the Introduction).
- Domestic demand: has driven growth since mid-2002 and outpaced GDP.
- Current account and competitiveness:
  - Current account deficit in 2005: 7½ percent of GDP.
  - Inflation differential with the euro area: rose to 1¾ percentage points (noted as 1¾ percentage points in 2006:Q1).
  - Net external liabilities in 2005: 46 percent of GDP.
- Household sector:
  - Household indebtedness reached over 110 percent of disposable income (2005).
  - Mortgage credit growth in 2005: 25 percent.
- Financial intermediation and external financing:
  - Spanish financial institutions’ financial assets increased from about 220 percent of GDP in 1996 to 330 percent in 2005.
  - Net external borrowing by credit institutions and other financial intermediaries amounted to 14 percent of GDP in 2005 (mainly through mortgage-backed securities).
- Sectoral and price dynamics:
  - Growth concentrated in services, construction, and energy; sectors exposed to external competition experienced little growth.
  - Real house price growth decelerated from a peak of 15½ percent in 2003:Q2 to 8¼ percent in 2006:Q1 (seasonally adjusted, q-o-q annualized).
  - Core inflation exceeded the euro area average by 1.6 percentage points in 2006:Q1.
  - Hourly labor costs decelerating despite employment gains; wages still increased faster than the euro area average, as did unit labor costs.
- Liquidity and credit:
  - Real lending rates are negative or close to zero.
  - Household and corporate credit grew at over 20 percent in the year to January 2006.
  - Little housing equity withdrawal; nontraditional mortgages relatively rare but developing.

### Policy discussions: central themes and authorities’ stance
- Near-term outlook:
  - Short-term growth prospects viewed as good: 3.3 percent in 2006 (official and staff central projections).
- Medium-term risks:
  - Main adverse risk: continuation of unsustainably rapid domestic spending leading to pronounced household balance-sheet and real estate valuation adjustments, and a protracted period of depressed employment and activity.
  - Other risks: high net external liabilities, heavy household indebtedness, and competitiveness losses.
- Fiscal policy:
  - 2005 fiscal outcome: general government surplus of 1.1 percent of GDP, buoyed by revenues.
  - Authorities confident that appreciable fiscal surpluses would continue into 2006–07.
  - Authorities saw limited scope for countercyclical spending cuts beyond tight implementation of current plans; staff advocated firmer dampening of demand.
  - Revisions to the fiscal framework planned to introduce cyclical flexibility and provide greater leeway to regional governments (the new Budget Stability Law is noted in the text).
  - In the absence of effective enforcement mechanisms, transparency at the subnational level emphasized as key.
  - Regional financing arrangements under review; healthcare and pension reform remain on the agenda.
- Structural reform agenda:
  - Authorities have an ambitious, detailed National Reform Program to improve productivity and dynamism.
  - Early focus recommended on deregulating and opening sheltered sectors to competition, including sensitive areas such as energy.
  - Labor market: protracted negotiations led to an agreement aiming to reduce extensive use of temporary employment while leaving regular-contract provisions unchanged.
  - Productivity concerns: trend described as lackluster productivity growth and significant rigidities in product and labor markets.
- Policy engagement and consensus constraints:
  - Authorities emphasized a consensual approach and faced a minority position in Parliament; viewed “good times” as diminishing perceived need for change.
  - Staff intensified outreach to parliamentarians, trade unions, employers, regional representatives, and academics to impart greater policy urgency.

### Outlook: projections and scenarios
- Central projection: smooth rebalancing underlies official and staff central projections, helped by firmer euro-area activity and rising interest rates.
- External deficit: expected to remain large under central scenarios.
- Stress scenarios highlighted:
  - Balance-sheet and real estate valuation adjustments triggered by high household indebtedness (110 percent of disposable income) could produce pronounced corrections.
  - Protracted depressed employment and activity could result if adjustments are severe.
- Sources of competitiveness loss: cyclical real exchange rate appreciation, strength of domestic demand, and structural factors (weak productivity, product and labor market rigidities) noted in the authorities’ National Reform Program.

### Financial sector: FSAP findings and staff recommendations
- FSAP overall assessment: highly dynamic and competitive financial sector under strong prudential supervision and regulation.
- Main FSAP recommendations reflected in discussions:
  - Exercise vigilance with respect to developments in the mortgage market.
  - Bolster the independence of financial sector supervisors.
  - Improve governance and market discipline of savings banks.
  - Adopt a conservative treatment of financial institutions’ industrial participations under Basel II.
- Authorities’ reception: broadly receptive to FSAP recommendations.

### Key statistics and indicators (preserved from source)
- Output growth, 2005: 3.4 percent.
- Projected growth, 2006: 3.3 percent.
- General government surplus, 2005: 1.1 percent of GDP.
- Current account deficit, 2005: 7½ percent of GDP.
- Inflation differential with euro area (2006:Q1): 1¾ percentage points.
- Core inflation margin (2006:Q1): 1.6 percentage points (core inflation over euro area average).
- Net external liabilities, 2005: 46 percent of GDP.
- Household indebtedness: over 110 percent of disposable income.
- Mortgage credit growth, 2005: 25 percent.
- Financial institutions’ financial assets: about 220 percent of GDP in 1996 to 330 percent in 2005.
- Net external borrowing by credit institutions and other financial intermediaries, 2005: 14 percent of GDP.
- Real house price growth: peak 15½ percent in 2003:Q2; 8¼ percent in 2006:Q1 (seasonally adjusted, q-o-q annualized).

*Source: Executive Summary of IMF staff report _cr06211.*

### 9.      Immediate growth prospects remain upbeat. Staff and official projections broadly

### _cr06211 - 9.      Immediate growth prospects remain upbeat. Staff and official projections broadly

### Immediate growth outlook
- Growth is projected to moderate to some 3.3 percent in 2006 and to 3.2 percent in 2007.
- Inflation forecast for 2006 remains close to 3½ percent, well in excess of the euro area average.
- Near-term domestic demand indicators point to softening:
  - Slowdown in retail sales, consumer durables, house prices, and other leading indicators.
  - Consumption and residential investment expected to decelerate in 2006, with the housing market gradually cooling off.
  - Business investment should plateau in response to higher capital costs.
- External sector: a gathering euro-area recovery is expected to reduce the drag from the external sector; authorities noted firming euro-area interest rates and strengthening external demand as favorable for rebalancing, while staff judged euro-area interest rates unlikely to rise sufficiently from Spain’s standpoint.

### External imbalances and competitiveness
- The authorities’ Stability Program and staff project large external imbalances over the medium term.
- Financing needs projected to rise to above 8 percent of GDP by 2008 due to:
  - Further net export deterioration (high elasticity of imports and projected growth in final demand).
  - Increased interest payments and immigrant remittances.
  - Envisaged decline in EU transfers.
- Current account deterioration and competitiveness evidence:
  - Current account deficit widened from an average close to 2½ percent of GDP since EU accession in 1986 to one of 7½ percent of GDP in 2005.
  - Staff decomposition (1980–2005) attributes about 33 percent of current account variation to oil prices and about 37 percent to the cyclical position; the remaining residual (~30 percent) became increasingly negative and amounted to 2½ percentage points of GDP in 2005, reflecting in part underlying competitiveness losses.
  - Trade-weighted export market share increased until about 1998, stagnated thereafter, and declined from 2003.
  - Import volume penetration has risen continuously.
  - Manufacturing unit labor cost differential with the euro area widened by 16 percentage points since 1995.
  - Indicators of Spain’s export margins exhibited the weakest evolution among other large euro-area economies since 1995, albeit recovering somewhat since 2003.
- Staff methodological assessments of required competitiveness improvement (real effective exchange rate) indicate appreciable weakness in a range of 23–30 percent (results subject to considerable caution and estimation error).
- Authorities argued part of the deficit may reflect an intertemporal saving-investment decision and that EMU membership expanded capacity to finance external deficits by eliminating currency risk.

### Risks, financial sector resilience, and structural reform
- Main downside risks: real estate overvaluation and associated household indebtedness.
- Sectoral exposure: construction accounts for 10½ percent of output and 14 percent of employment.
- FSAP and Bank of Spain analyses indicate financial system resilience to plausible shocks, including:
  - Hypothetical fall in real house prices of slightly over 17 percent in the first year and of 4½ percent in the subsequent year.
  - A 30 percent drop in equity prices.
  - An abrupt depreciation of the US dollar.
- Staff remained more concerned than the authorities about risks and urged a more vigorous structural and countercyclical policy response.
- Consensus: solution to productivity and competitiveness problems lies primarily in structural reforms; however, these take time, and fiscal policy should attenuate imbalances in the interim.
- Staff warned that, without sufficiently flexible product and labor markets, regaining competitiveness could be a long and difficult process with adverse effects on output and employment.

### Fiscal stance and short-term fiscal policy recommendations (dampening demand)
- Fiscal outcomes and stance:
  - Buoyant tax collections produced a fiscal surplus of 1.1 percent of GDP in 2005.
  - From a cyclical standpoint, staff judged the fiscal stance in 2005 to have been inadequate owing to excessive growth in public spending.
  - Conventional cyclically adjusted balance estimates indicate a fiscal withdrawal of about a ¼ percentage point of GDP in 2005; staff analysis suggests public spending increases had a significantly larger expansionary impact on demand and the current account than equivalent revenue gains.
  - General government non-interest spending rose by 0.3 percentage points of GDP in 2005 (adjusted for one-time 2004 balance-sheet operations).
- Authorities’ 2006–07 fiscal outlook:
  - Authorities expected another appreciable fiscal surplus in 2006 and a strong performance in 2007.
  - 2006 revenues set to exceed budget projections by a wide margin (partly due to the regularization of immigrants).
  - Authorities intended to allow the full play of automatic stabilizers and expected a significant general government surplus, possibly above the 0.9 percent of GDP projected in the updated Stability Program.
  - Central government consumption was budgeted to rise in real terms by 4.1 percent in 2006.
- Staff recommendations to dampen demand:
  - Advocate greater expenditure-based fiscal restraint.
  - Aim to improve the 2006 general government surplus by at least ½ percentage point of GDP (relative to 2005), based on expenditure control.
  - Central government should keep spending appreciably below current ceilings and safeguard the budget’s contingency fund for truly exceptional events.
  - Regions should move to balance in 2006 and surplus by 2007—consistent with the new Budget Stability Law due to take effect that year.
- Authorities’ constraints:
  - Authorities saw limited scope for reining in already budgeted spending and highlighted political-economy difficulties of explicitly aiming for rising fiscal surpluses.
  - Immigration generated warranted expenditure needs for infrastructure, social services, education, and the judiciary.
  - Government emphasis on improving productivity and raising R&D spending entails public effort.

### Fiscal framework and medium-term stability
- A new Budget Stability Law (BSL) is before Parliament and expected to take effect in 2007.
  - Draft BSL seeks to allow automatic stabilizers by making budget targets contingent on the cyclical position and aims for fiscal balance over the cycle.
  - The new “balance over-the-cycle” target will apply to the general government with exclusion of the social security system (currently running a 1 percent of GDP surplus).
  - Draft law bars state bail-outs for lower government levels.
  - The new framework envisages strengthened reporting requirements to increase fiscal transparency of territorial governments.
- Staff view:
  - Welcomed positive features of the draft law but judged the information flow still insufficient for early identification of profligate fiscal behavior and for eliciting corrective action.
  - Recommended using fiscal policy to attenuate imbalances while structural reforms take effect.

*Source: _cr06211 - 9. Immediate growth prospects remain upbeat. Staff and official projections broadly (IMF staff report).*

### 18.      The mission pointed to several features of the draft law that, in providing

### _cr06211 - 18.      The mission pointed to several features of the draft law that, in providing

### Concerns about the Draft Budget Stability Law (BSL)
- Staff noted three main concerns with the draft law:
  - Asymmetry in specifying a deficit limit in the case of low growth but not a commensurate surplus requirement in the high-growth scenario, risking insufficiently ambitious targets in good times.
  - The exclusion of part of capital spending was judged insufficiently precise and raised concerns about off-budget capital spending by regional and municipal governments.
  - The draft BSL did not clearly specify whether, in good times, the surplus requirement would apply to the Autonomous Communities as a whole or to each individual Community, creating potential for conflicting interpretations and implementation difficulties.
- Authorities’ view:
  - Much would depend on implementation.
  - Saw drawbacks in setting a minimum surplus target for the high-growth scenario (it could become a ceiling).
  - Considered ambiguity in surplus allocation as potentially constructive to address coordination challenges across decentralized governments.
- Staff emphasis:
  - Implementation clarity and precision were needed to avoid circumvention and divergent interpretations.
  - Concern about growing recourse to off-budget capital spending by regional and municipal governments.

### Details of the Proposed Budgetary Stability Law (Box 4)
- Fiscal targets:
  - Targets a fiscal balance over the cycle for the general government, excluding the social security system.
  - Establishes targets for three states of the economy to avoid defining cyclical position:
    - Normal growth: fiscal balance set at between 2 and 3 percent for the 2007–09 period.
    - Low growth: a small public deficit.
    - High growth: a surplus (of underdetermined size).
  - Social security system: envisaged to have a separate target set to ensure its financial sustainability.
- Allocation of targets:
  - Low-growth deficit (up to 1 percent of GDP) is allocated predominantly (0.75 percent of GDP) at the regional government level.
  - No indication provided about the level and allocation of the high-growth surplus.
- Individual targets:
  - Targets for each region will be determined by bilateral negotiations.
  - If inconsistent with the overall target, the Ministry of Economy can set individual targets.
- Excluded capital expenditure:
  - Proposed exclusion of capital (and some other) expenditure aimed at improving productivity and competitiveness, in an amount up to 0.5 percent of GDP, of which half is allocated to the regions.
  - Thus, the total low-growth deficit for the central and territorial governments is 1.5 percent of GDP.
- Enforcement:
  - Three-year corrective plans for any level of government failing to reach the balance over-the-cycle target.
  - Enforcement relies on increased transparency and timeliness of subnational data, and an explicit barring of regional government bail-outs.
- Tabled numerical allocations (as presented in the source):
  - Normal growth (between 2 and 3 percent)
    - Central: Balance 0.20 percent of GDP; Excluded capital expenditure -0.20 percent of GDP
    - Regional: Balance 0.25 percent of GDP; Excluded capital expenditure -0.25 percent of GDP
    - Local: Balance 0.05 percent of GDP; Excluded capital expenditure -0.05 percent of GDP
  - Low growth (less than 2 percent)
    - Central: -0.20 0.20 percent of GDP; Excluded capital expenditure -0.4 percent of GDP
    - Regional: -0.75 0.25 percent of GDP; Excluded capital expenditure -1.0 percent of GDP
    - Local: -0.05 0.05 percent of GDP; Excluded capital expenditure -0.1 percent of GDP
  - High growth (greater than 3 percent)
    - Central: Surplus 0.20 percent of GDP; Surplus - 0.20 percent of GDP
    - Regional: Surplus 0.25 percent of GDP; Surplus - 0.25 percent of GDP
    - Local: Surplus 0.05 percent of GDP; Surplus - 0.05 percent of GDP
  - /1 The proposal excludes the social security system, which is envisaged to be in balance in the long-run. It also proposes to calculate percentages in terms of the relevant GDP, i.e., national (regional) GDP for the central (regional) government.
- Additional staff observation:
  - At last year’s consultation, staff and many Directors “advised that the regions should consistently aim at budget balance, avoiding a build-up in subnational debt.” In contrast, the new BSL would, in a low-growth scenario, allow territorial governments to incur a deficit of up to 1.1 percent of GDP.

### Authorities’ Position on Fiscal Framework and Enforcement
- Authorities saw the new fiscal framework as promoting co-responsibility while respecting constitutional autonomy of regions.
- Framework provides for an articulated system of annual negotiations, agreements, and monitoring among central and regional governments to secure buy-in.
- Authorities intended to prioritize transparency and accountability and to strengthen:
  - State Administration’s General Audit Office (IGAE).
  - Regional coordinating council, Consejo de Politica Fiscal y Financiera.
- Authorities were open to, but not committed to immediately adopting, independent assessments of subnational fiscal policies and their consistency with the BSL.
- Noted recent progress in implementing recommendations of the 2005 fiscal ROSC.

### Territorial Financing and Taxation Issues
- Territorial financing arrangements are under review in parallel with the BSL.
- A reform of the Statute of Autonomy for Catalonia:
  - Foresees transfer of a higher share of taxes from central government and some greater taxing autonomy.
  - Could act as a blueprint for more general reform.
- Staff argument:
  - Key feature of successful decentralization is significant powers for territorial governments to set their own taxes.
- Authorities’ indications:
  - New arrangements would grant greater taxing autonomy—particularly with respect to the personal income tax.
  - They view regional sales tax options favorably but flagged EU compatibility issues.
  - Strong view that corporate income tax should remain uniform nationwide to avoid undue tax competition.
- Staff caveat:
  - Unless central government transfers were cut back, the current institutional framework provides little incentive for regional and municipal governments to use enhanced tax powers.

### Healthcare Financing and Reform Considerations
- Public spending on healthcare (a decentralized competency) has reached 6 percent of GDP and is growing rapidly.
- Given regional governments’ spending overruns:
  - Healthcare-related transfers from the central government had to be increased by 0.2 percent of GDP over budgeted levels in 2005.
  - Health appropriations were raised in 2006 until a new cost-sharing arrangement between levels of government is established in 2007.
- Authorities expect new financing arrangements to provide incentives for regional budgets to contain costs and are introducing stricter controls and rationalizing procurement.
- Staff recommendation:
  - Broader reform likely required, with effective cost containment probably needing forms of private participation and cost-sharing, such as user co-payments to rationalize demand.
  - Cautioned that commitments under a new disability law (Ley de Dependencia) be costed carefully and beneficiaries targeted closely to avoid another potential source of spending pressure.

### Recent Limited Tax Reform (to enter into effect in 2007)
- Reform features:
  - Reduces the marginal personal income tax rate and the number of brackets.
  - Introduces a uniform rate on savings of 18 percent.
  - Foresees a phased-in reduction of the corporate tax rate by 5 percentage points.
  - Eliminates a range of tax deductions.
- Reaction and staff observations:
  - Employers considered the rate cut insufficient and more than offset by elimination of deductions; authorities disputed this for small- and medium-sized enterprises.
  - Uniform tax on savings seen positively for enhancing competition among financial instruments.
  - Concern that reduction in tax-exempt contributions to private pension plans may deter pension provision and increase uncertainty about future tax treatment.
  - Reform did not eliminate the mortgage deduction—a longstanding staff recommendation.
- Authorities’ caution:
  - Deliberate caution in reducing tax burden was based on concerns about impact on current demand pressures; staff noted that concerns could have been eased and tax reduction larger if accompanied by greater spending restraint.

### Long-Term Fiscal Risks: Pensions and Age-Related Spending
- Long-term fiscal outlook clouded by lack of progress on pension and age-related cost reforms.
- Long-term projections by authorities and the EC’s Aging Working Group place Spain among EU countries with the largest age-related spending increase over the next 25–50 years despite:
  - Upward revisions in population growth reflecting current immigration trends.
  - Rather sanguine assumptions on future labor utilization and productivity.
- Authorities’ interim response:
  - Accumulation of social security surpluses in a special reserve fund, which has reached 3½ percent of GDP, postponing funding shortfalls by five years.
- Staff view on required reforms:
  - A definitive solution will require reform of entitlements.
  - With social security deficits expected within the next decade, reform initiatives need to be timely and broad-ranging, potentially including:
    - Actuarially fair incentives to prolong effective working life.
    - Extension of the base period to compute pensions.
    - Further expansion of private provision.
- At the time of the mission, focus was mainly on reducing early retirement schemes and possibly raising the minimum contribution period by a marginal amount.

### Creating a More Competitive Spain — Product and Labor Market Reforms
- Authorities’ reform agenda:
  - Dynamization Plan (February 2005, updated March 2006) and National Reform Program (NRP, October 2005) aimed at increasing productivity and employment rate.
  - Emphasis on government provision of public goods (infrastructure, education) and sponsorship (R&D, start-ups); less emphasis on competition-based incentives.
- Staff emphasis:
  - Central role for fostering competition and deregulating sheltered sectors to regain competitiveness.
  - Sheltered sectors (energy, utilities, telecommunications, transportation, professional services) are major contributors to the widening price and cost differential with trading partners.
  - Lack of competition and pricing power shown by differential evolution of markups between tradables and nontradables.
- Productivity diagnosis (Box 5, summarized):
  - Spain experienced catch-up in labor productivity through mid-1980s but fell behind thereafter.
  - Productivity gap with a 23-industrial country sample increased from 9 percent in 1985 to 30 percent in 2004 (or to 23 percent if measured at current prices).
  - Productivity underperformance predates recent employment expansion and is not primarily due to low capital stock; residual (total factor productivity) shows same decelerating pattern.
  - Key factors: low ICT capital, low R&D spending, and human capital shortfalls; barriers to competition, restrictive regulations, and labor market rigidities impede dynamism.
- Regulatory and competition developments:
  - Ongoing reform of the anti-trust system to strengthen competition authorities and limit executive override.
  - Plan announced to restructure loss-making public broadcasting company (RTVE).
  - Regional and municipal regulations (licensing, zoning, opening times) have restricted entry in retail distribution, protecting incumbents and limiting contestability.
  - Authorities hopeful the new EU Services Directive could provide opportunity to review constraints; staff urged full exploitation of this opportunity.
- Concerns over regulatory independence and use of takeover powers:
  - Elimination of the “golden share” option noted positively.
  - In March 2006 the National Energy Commission was accorded broad powers over takeovers in the sector; this was seen as a move to stymie a foreign bid and the EC opened an infringement procedure.
  - Staff urged authorities to refrain from using newly granted powers in a discriminatory manner and expressed concerns about appointment procedures to sectoral regulatory agencies not fully guaranteeing independence.

*Source: _cr06211 - 18.      The mission pointed to several features of the draft law that, in providing (PDF chapter/section).*

### 27.      Although reforms implemented since the last decade are bearing fruit, most

### _cr06211 - 27.      Although reforms implemented since the last decade are bearing fruit, most

### Labor Market Flexibility and Temporary Employment
- Reforms since the early 1990s are producing positive outcomes, but most indicators still lag well behind Lisbon objectives and labor markets remain among the most rigid in the OECD.
- Rising employment rates for female and older workers, large immigration flows, and declines in structural and long-term unemployment point to growth-enhancing potential from increased labor market flexibility.
- Temporary labor contracts account for 34 percent of total contracts (versus 5–10 percent in most other EU countries).
- The high share of temporary contracts may partly reflect the employment weight of construction, tourism, and agriculture—highly seasonal activities.
- Staff view prevalence of temporary contracts as mainly reflecting excessive rigidity of regular contracts; temporary contracts themselves are also among the most restrictive in the OECD.
- The collective wage bargaining system is characterized as excessively rigid and centralized, preventing labor costs from matching productivity developments and hindering geographical and sectoral labor mobility.
- A limited reform reached in early May focuses on reducing incidence of temporary contracts via legal provisions and fiscal incentives.
  - Positive feature: possibility of applying indefinite contracts with lower firing costs (contratos de fomento, introduced in 1997) to any worker currently on a temporary contract—but only during a limited period (through end-2007).
  - The reform strengthens legal provisions against consecutive temporary contracts and introduces other limits to their use.
  - The reform does not address the key requirement identified by staff: permanently reducing the rigidity and high dismissal costs of regular contracts.

### Financial Sector (FSAP findings and recommendations)
- FSAP findings:
  - The financial system is highly dynamic and competitive under strong prudential supervision and regulation.
  - Sector strengths: high degree of financial intermediation; low intermediation margins; well-capitalized and professionally managed institutions; and a robust and well-developed prudential framework.
  - Stress tests indicated banks and insurance companies could withstand large adverse shocks without systemic distress, reflecting strong capitalization, risk management, and sizeable loan-loss cushions.
- Main risks:
  - Rapid credit growth and a potential downturn in the housing market, particularly if combined with an adverse macroeconomic scenario.
  - Recent increase in nontraditional lending products (interest-only, very long-term, and adjustable amortization mortgages) raised concerns about borrower and lender financial sophistication.
  - Although average loan-to-value ratio (LTV) of banks’ portfolios was relatively low, marginal LTVs had been rising.
  - Authorities (Bank of Spain) have stepped up vigilance via disclosure guidelines and consumer awareness initiatives and indicated readiness to consider additional prudential action if necessary.
- Noted event: discovery of large-scale fraud by two nonfinancial investment companies specializing in stamp trading—reports indicated €4–5 billion (about ½ percent of GDP); these activities fall outside financial sector regulators and are subject to consumer protection provisions.
- Box 6. FSAP—Selected Main Recommendations:
  - A. Macrorelevant Recommendations
    - Tighten prudential requirements for nontraditional real estate loans to discourage excessive risk-taking.
    - Adopt most conservative approaches under Basel II to contain credit institutions’ industrial participations.
  - B. Financial Sector Supervision
    - Strengthen independence of financial sector supervisors by delegating more broadly the authority to issue norms and sanction violations to the respective agencies (ST 1/); separate insurance supervision from the Ministry of Economy (MT 2/).
    - Clearly maintain the state-level supervisors’ sole responsibility and powers regarding prudential supervision and regulation in the ongoing revisions of Autonomous Communities’ Statutes. ST
    - Introduce regulations to prevent a credit institution representative serving on the board of a nonfinancial company from taking part in the institution’s decisions regarding that company. MT
  - C. Issues Related to Savings Banks
    - Allow savings banks to merge freely, provided favorable ruling by the Bank of Spain on the viability of the merged institution. MT
    - Promote means to raise high-quality capital, such as cuotas participativas. MT
    - Reduce over time the public sector representation ceiling on savings banks’ boards. MT
  - Timing notation: ST (short term), or 6–12 months. MT (medium term), or 1–3 years.
- Supervisory and governance issues:
  - FSAP recommended enhancing statutory independence of financial regulators by delegating norm-setting and sanction powers more broadly from the Ministry of Economy and Council of Ministers to agencies.
  - Formal independence of the insurance regulator is particularly constrained because it is directly part of the Ministry of Economy.
  - Importance stressed that revisions of regional Statutes of Autonomy preserve the sole role of State-level supervisors in prudential oversight to minimize conflicts.
  - Savings banks (cajas) account for about one third and one half of credit institutions’ assets and deposits respectively; their ownership structure (no private shareholders and substantial political representation on boards) requires stronger governance frameworks.
  - Staff proposals for savings banks include reducing public sector representation ceilings, promoting high-quality capital instruments (cuotas participativas), and removing restrictions on mergers.
  - Large industrial participations by some credit institutions raise concentration and corporate governance risks; staff supported adopting the most conservative Basel II approaches to industrial participations and recommended regulations preventing conflicts of interest for credit institution representatives on nonfinancial company boards.

### Staff Appraisal — Macroeconomic assessment and policy priorities
- Recent performance and imbalances:
  - The decade-long expansion continues: robust economic growth raised average incomes, boosted job creation, and generated record fiscal revenues that swung the general government balance into an appreciable surplus.
  - Positive performance attributed to reforms since early 1990s, EMU membership, and related low interest rates.
  - Macroeconomic imbalances are intensifying: a record current account deficit driven by unsustainable domestic demand growth and widening cost and productivity differentials with trading partners, plus high oil prices.
  - Buoyant demand and pricing power in sheltered markets keep inflation significantly above the euro-area average.
  - Lackluster productivity growth weighs on competitiveness.
  - Rising savings-investment imbalance of the nonfinancial private sector has been financed within EMU, but gross and net external liabilities have reached high levels, increasing exposure to interest rate risk.
- Outlook and risks:
  - Immediate growth outlook is buoyant; growth expected to remain strong in 2006, although decelerating toward trend over the medium term.
  - External deficit remains high.
  - Continuation of brisk domestic demand growth and further competitiveness losses risk a pronounced private sector balance-sheet consolidation as households reduce high indebtedness.
  - Market rigidities and weak competitiveness may lead to a prolonged period of difficult, slow-growth adjustment.
- Policy priorities and recommendations:
  - Implement a bold supply-oriented reform agenda emphasizing product market competition and labor market flexibility to regain competitiveness within EMU.
  - Fiscal policy should contribute by reining in domestic demand; in absence of monetary policy, fiscal policy is the only countercyclical tool available.
  - Early reform of pension and healthcare systems is required for long-term public finance sustainability.
  - The current high-growth environment is the best opportunity to implement these policies, minimizing potential short-term costs.
  - Government reform agenda to improve productivity and competitiveness deserves highest priority; emphasis should be on competition-based incentives rather than subsidy-based R&D measures.
  - Key focus: further deregulating sheltered sectors; maintain openness and ensure recent changes to takeover procedures in the energy sector are implemented in a nondiscriminatory manner; review appointment procedures to sectoral regulatory agencies to fully guarantee independence.
  - Labor market: further reform needed despite recent agreement; permanently reduce rigidity and high dismissal costs of regular contracts; social partners should discuss modifications to collective wage bargaining to better reflect relative productivity developments and encourage regional mobility.
  - Fiscal stance:
    - Greater expenditure-based fiscal restraint needed in 2006 and 2007.
    - 2005 general government surplus—the first since the 1970s—is notable, but public spending has been growing excessively rapidly, adding to demand pressures.
    - Authorities’ intention to allow full play of automatic revenue stabilizers is welcome, but must be accompanied by spending restraint at all government levels.
    - Spending policies should increase the central government surplus and restore balanced positions in regional and municipal governments in 2006, moving to a slight surplus in 2007—in keeping with the new BSL.
  - Decentralization and fiscal framework:
    - Spain’s highly decentralized system needs a robust budgetary framework to promote fiscal discipline at all levels.
    - Planned revisions to the BSL include greater countercyclical flexibility, safeguarding social security surpluses, and proscription of state bail-outs for other government levels; ambiguous wording and insufficiently precise specifications risk allowing leeway and circumvention.
    - Territorial financing review should augment fiscal co-responsibility by granting territorial governments powers to set taxes and incentives to use them, rather than relying on higher transfers from the central government.
    - Increased fiscal transparency is necessary: improve timeliness and standardization of regional fiscal data, especially budget execution, quasi-fiscal activities, and contingent liabilities.
  - Pension and healthcare reform:
    - Reforms are required to ensure long-run fiscal sustainability given rising costs of aging, which are only a decade or so away.
    - Delays in reform increase the eventual size of measures needed.
    - Measures should include extension of the base period used to compute pensions and further development of private pension plans with stable and predictable tax treatment.
    - Containing healthcare spending will require reforms, including a larger role for private provision and user co-payments.
  - Financial sector follow-up:
    - Bank of Spain vigilance regarding nonconventional mortgages and rapidly growing credit vehicles is well advised.
    - Increase independence of the three financial sector supervisors, particularly the insurance supervisor.
    - Strengthen governance of savings banks via issuance of market-accountability instruments, reducing government-nominated board directors ceiling, and removing obstacles to mergers.
    - Adopt the most restrictive interpretation regarding industrial participations under Basel II and introduce clear separation between credit institutions’ management and board directors of nonfinancial companies in which they have a significant stake.
  - External and development policy:
    - Authorities encouraged to continue raising ODA toward the 0.7 percent of GNP UN target (from 0.29 percent in 2005).
    - Encourage active EU-level contribution to a significant liberalization of international trade in the Doha round, including in agriculture and other sensitive areas.
  - Statistical recommendations:
    - Statistical data provision is appropriate for surveillance, but improvements in timeliness and standardization of regional fiscal data should be a priority (Appendix III).

*Source: _cr06211 - 27.      Although reforms implemented since the last decade are bearing fruit, most*

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

### _cr06211 - 47.      It is recommended that the next consultation be held on the standard 12-month cycle.

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

### Main macroeconomic indicators and projections (selected series, 2001–07)
- Gross domestic product (real growth): 3.5, 2.7, 3.0, 3.1, 3.4, 3.3, 3.2
- Private consumption (real growth): 3.2, 2.9, 2.6, 4.4, 4.4, 3.7, 3.6
- Public consumption (real growth): 3.9, 4.5, 4.8, 6.0, 4.5, 5.1, 3.8
- Gross fixed investment (real growth): 4.5, 3.3, 5.6, 4.9, 7.3, 5.8, 4.4
- Total domestic demand (real growth): 3.6, 3.3, 3.8, 5.0, 5.3, 4.5, 3.8
- Net exports (contribution to growth): -0.2, -0.7, -0.9, -2.2, -2.2, -1.5, -1.0
- Potential output growth: 3.9, 3.6, 3.4, 3.2, 3.2, 3.1, 3.1
- Output gap (percent of potential): 1.0, 0.1, -0.3, -0.4, -0.2, 0.0, 0.1
- Private credit growth: 11.8, 12.3, 14.2, 17.9, 27.2, ...... (series truncated in source)

### Prices and labor market (selected series)
- GDP deflator (year-on-year): 4.2, 4.4, 4.0, 4.1, 4.4, 3.6, 3.1
- HICP (average, year-on-year) 2/: 2.8, 3.6, 3.1, 3.1, 3.4, 3.4, 3.1
- HICP differential with euro area average: 0.5, 1.4, 1.0, 0.9, 1.2, ...... (series truncated)
- Unemployment rate (in percent): 10.6, 11.5, 11.5, 11.0, 9.2, 8.6, 8.5
- Unit labor cost in manufacturing (growth rate): 2.5, 1.8, 2.3, 2.5, 2.5, 2.5, 2.5
- Employment growth: 3.2, 2.4, 2.6, 2.6, 3.6, 3.2, 2.7
- Household savings (percent of disposable income): 12.3, 12.5, 12.8, 12.7, 11.0, ......

### External sector (selected indicators)
- Trade balance (percent of GDP): -5.7, -5.0, -5.1, -6.4, -7.6, -8.3, -8.6
- Current account balance (percent of GDP): -3.9, -3.3, -3.6, -5.3, -7.4, -8.1, -8.5
- Official reserves excl. gold (US$ billions): 30.3, 35.3, 20.7, 13.3, 7.7, 1.9, -4.3
- Nominal effective rate (1990=100): 72.5, 74.2, 76.8, 77.6, 76.3, ......
- Real effective rate (1990=100): 85.2, 88.8, 92.6, 94.4, 94.3, ......

### Public finance and fiscal accounts (selected series, percent of GDP)
- General government balance: -0.5, -0.3, 0.0, -0.1, 1.1, 0.9, 0.7
- Primary balance: 2.1, 2.1, 2.1, 1.7, 2.7, 2.5, 2.1
- Structural balance 5/: -1.2, -0.3, 0.1, 0.8, 1.1, 0.9, 0.7
- Structural primary balance 5/: 1.5, 2.0, 2.3, 2.6, 2.7, 2.5, 2.0
- General government debt: 55.6, 52.7, 48.9, 46.4, 43.2, 39.4, 36.3

Selected line items from Table 2 (2001–07, percent of GDP)
- Current revenues: 37.4, 37.7, 37.6, 37.9, 38.7, 38.6, 38.4
- Current expenditures: 33.9, 33.8, 33.7, 33.7, 33.3, 33.6, 33.5
- Interest payments: 3.1, 2.7, 2.4, 2.1, 1.8, 1.7, 1.5
- Current balance: 3.5, 3.9, 3.9, 4.2, 5.3, 5.0, 4.9
- Capital balance: -4.1, -4.2, -4.0, -4.3, -4.3, -4.0, -4.1
- Overall balance: -0.5, -0.3, 0.0, -0.1, 1.1, 0.9, 0.7
- Government debt (percent of GDP): 55.6, 52.7, 48.9, 46.4, 43.2, 39.4, 36.3

### Public Sector Debt Sustainability Framework (selected outcomes and assumptions)
- Public debt/revenues (1/): 146.3, 137.2, 128.1, 120.6, 109.4, 100.2, 92.9, 86.2, 83.2, 78.4, 82.0, 147.3, 252.1, 366.8 (years: 2001–2050 as in table)
- Public debt/GDP (1/): 55.6, 52.7, 48.9, 46.4, 43.2, 39.4, 36.3, 33.5, 31.3, 29.1, 30.0, 54.4, 96.8, 144.8
- Change in public debt/GDP (2/): -3.7, -2.9, -3.8, -2.5, -3.2, -3.8, -3.1, -2.8, -2.3, -2.1, 1.2, 2.8, 4.7, 4.9
- Net debt-creating flows/GDP (5+6): -3.4, -3.1, -3.2, -2.9, -5.2, -3.6, -2.9, -2.7, -2.2, -2.0, 1.2, 2.8, 4.7, 4.9
- Overall deficit, excluding net interest payments/GDP (=primary deficit): -2.1, -2.1, -2.1, -1.7, -2.7, -2.5, -2.1, -1.9, -1.7, -1.6, 1.3, 2.8, 4.7, 4.8
- Revenue and grants/GDP: 38.0, 38.4, 38.3, 38.7, 39.4, 39.3, 39.1, 38.9, 37.6, 37.2, 36.6, 37.0, 38.4, 39.5
- Noninterest expenditure/GDP 3/: 35.5, 36.0, 36.0, 36.8, 36.6, 36.7, 36.9, 36.9, 35.8, 35.5, 37.9, 39.7, 43.1, 44.3
- Average interest rate on public debt (percent per year): 5.6, 5.2, 4.8, 4.5, 4.2, 4.2, 4.0, 4.1, 4.7, 4.7, 4.7, 4.7, 4.7, 4.7
- Average real interest rate (percent): 1.4, 0.8, 0.9, 0.5, -2.2, 0.6, 1.0, 1.2, 1.9, 1.9, 2.2, 2.3, 2.3, 2.3
- Real GDP growth (percent per year, memorandum): 3.5, 2.7, 3.0, 3.1, 3.4, 3.3, 3.2, 3.2, 3.2, 3.2, 2.5, 2.2, 2.2, 2.2
- Consumer price index (change, percent per year, memorandum): 2.8, 3.6, 3.1, 3.1, 3.4, 3.4, 3.1, 2.8, 2.7, 2.7, 2.5, 2.4, 2.4, 2.4

### Debt sustainability stress tests (summary outcomes reported)
- Baseline public debt/GDP (selected years shown in stress table): 39.3, 37.4, 35.5, 33.7, 29.1, 32.2, 56.6, 98.9, 147.0 (stress test row 1 aggregate presentation in table)
- Variant stresses produce higher projected debt ratios, examples (selected outcomes for stress scenarios):
  - Scenario 2 (real interest rate shock): 39.3, 38.6, 38.0, 35.7, 31.0, 34.0, 58.4, 100.7, 148.8
  - Scenario 3 (real GDP growth shock): 39.3, 37.0, 34.8, 32.5, 30.4, 31.3, 55.5, 97.9, 146.0
  - Scenario 4 (primary balance shock): 39.3, 39.5, 39.8, 37.5, 35.3, 35.8, 59.9, 102.3, 150.4
  - Scenario 6 (one-time 30 percent real depreciation in 2005): 39.3, 36.9, 34.2, 31.9, 29.8, 30.7, 55.0, 97.3, 145.4
  - Scenario 7 (debt ratio in 2005 rises by additional 10 percent of GDP): 39.3, 46.3, 43.4, 40.9, 38.7, 39.0, 63.1, 105.4, 153.6

Memorandum assumptions used in stress tests (selected)
- Primary deficit (percent of GDP, average of past 10 years): -1.4 (average); standard deviation: 1.3
- Real interest rate (average of past 10 years): 2.4; standard deviation: 2.4
- Nominal interest rate (average of past 10 years): 6.2; standard deviation: 1.6
- Real GDP growth rate (average of past 10 years): 3.5; standard deviation: 1.0
- GDP deflator (average of past 10 years): 3.8; standard deviation: 1.1

### External and financial vulnerability indicators (selected, 2000–05 and related series)
- Exports (annual percent change, U.S. dollars): 2.4, 3.0, 8.3, 23.8, 15.8, 6.0 (series for 2000–2005)
- Imports (annual percent change, U.S. dollars): 6.1, 0.9, 7.1, 24.9, 22.4, 11.5
- Current account balance (settlements basis, percent of GDP): -4.0, -3.9, -3.3, -3.6, -5.3, -7.4 (2000–2005)
- Official reserves (US$ billions, end-of-period): 31.8, 30.3, 35.3, 20.7, 13.3, 7.7
- Net international investment position: -25.2, -27.4, -31.9, -37.7, -43.1, -46.1
- Gross liabilities (in percent of GDP): 124.2, 129.1, 133.4, 141.6, 153.2, 170.6
- Gross assets (in percent of GDP): 99.1, 101.7, 101.4, 104.0, 110.1, 124.5
- Public sector debt (Maastricht definition): 59.3, 55.6, 52.7, 48.9, 46.4, 43.2
- 3-month T-bill yield: 4.6, 3.9, 3.3, 2.2, 2.2, 2.2
- Stock market index (General): 994.8, 853.4, 723.6, 706.4, 863.3, 1066.1
- Regulatory capital to risk-weighted assets: 12.4, 12.9, 12.5, 12.6, 12.3, 12.2
- Nonperforming credit to total gross credit: 1.0, 0.9, 1.0, 0.9, 0.7, 0.6

### Balance of payments (1999–2005, selected levels and percent of GDP)
- Current account balance (billions of euros): -16.9, -25.1, -26.3, -23.8, -27.9, -44.2, -66.6 (1999–2005)
- Trade balance (billions of euros): -10.8, -19.2, -15.6, -13.9, -16.5, -31.9, -46.3
- Exports of goods (billions of euros): 106.0, 125.6, 131.2, 134.8, 139.8, 149.0, 156.4
- Imports of goods (billions of euros): 135.9, 165.8, 169.8, 171.3, 179.6, 202.6, 225.3
- Current account balance (percent of GDP): -2.9, -4.0, -3.9, -3.3, -3.6, -5.3, -7.4
- Trade balance (percent of GDP): -1.9, -3.0, -2.3, -1.9, -2.1, -3.8, -5.1
- Balance of factor income (percent of GDP): -1.5, -1.2, -1.8, -1.7, -1.5, -1.4, -1.9

### Medium-term projections of the balance of payments (2004–11, selected series)
- Current Account (billions of euros): -44.2 (2004), -66.6 (2005), -78.4 (2006), -87.7 (2007), -95.6 (2008), -101.0 (2009), -106.4 (2010), -114.8 (2011)
- Trade Balance of Goods and Services (billions of euros): -31.9, -46.3, -56.1, -64.0, -70.4, -76.7, -83.1, -90.1
- Exports of Goods and Services (billions of euros): 218.3, 231.8, 244.1, 256.5, 271.5, 287.5, 304.6, 322.5
  - Exports of Goods: 149.0, 156.4, 162.1, 170.3, 180.3, 190.9, 202.3, 214.1
  - Exports of Services: 69.4, 75.4, 82.0, 86.2, 91.2, 96.6, 102.3, 108.3
- Imports of Goods and Services (billions of euros): -250.2, -278.1, -300.2, -320.5, -341.9, -364.3, -387.8, -412.6
  - Imports of Goods: -202.6, -225.3, -242.2, -258.6, -275.8, -293.9, -312.8, -332.9
  - Imports of Services: -47.6, -52.8, -58.0, -61.9, -66.1, -70.4, -74.9, -79.7
- Balance of Factor Income (billions of euros): -12.1, -17.2, -18.4, -19.6, -20.8, -20.8, -20.8, -22.1
- Capital Account (billions of euros): 8.4, 8.0, 8.7, 7.2, 5.5, 3.5, 2.5, 2.6
- Financial Account (billions of euros): 34.9, 59.6, 69.6, 80.5, 90.1, 97.6, 104.0, 112.2
- Net International Investment Position (billions of euros): -359.5, -416.7, -486.4, -566.9, -657.0, -754.5, -858.5, -970.7
- Current Account (percent of GDP, 2004–11): -5.3, -7.4, -8.1, -8.5, -8.7, -8.7, -8.7, -8.8
- Exports of Goods and Services (percent of GDP): 26.1, 25.6, 25.2, 24.9, 24.8, 24.8, 24.8, 24.8
- Imports of Goods and Services (percent of GDP): -29.9, -30.8, -31.0, -31.1, -31.3, -31.5, -31.6, -31.8
- Net International Investment Position (percent of GDP, implied by levels in table): large negative positions rising through projection horizon.

*Source: IMF staff tables and projections as presented in the source PDF.*

### 4.   Net International Investment Position-42.9-46.1-50.3-55.1-60.1-65.2-70.0-74.8

### 4.   Net International Investment Position-42.9-46.1-50.3-55.1-60.1-65.2-70.0-74.8

### Net international investment position and trade balance
- Net International Investment Position (percent of GDP): -42.9, -46.1, -50.3, -55.1, -60.1, -65.2, -70.0, -74.8
- Memorandum — Trade Balance of Goods (percent of GDP): -6.4, -7.6, -8.3, -8.6, -8.7, -8.9, -9.0, -9.1
- Sources cited: Bank of Spain; and IMF Staff Projections.

### Recent external sector developments
- Current account: widened by €3.2 billion (0.35 percent of 2005 GDP) in the first two months of 2006 relative to the same period of 2005.
- Exports and imports: both export and import growth rose in Q1 2006 (Q1 noted as a period of pickup in exports).
- Net financial transactions with the rest of the world and sectoral financing (percent of GDP) shown for 1990–2005 across Government, Non-Financial Corporations, Households, Financial Institutions, and National Economy (figures are presented in source charts).

### Macroeconomic performance and inflation
- Output growth: "Output grew by 3½ percent in the year to 2006:Q1" (with 3.1 percent quarter-on-quarter annualized and seasonally adjusted).
- Private spending and investment: data show a quarter-on-quarter deceleration in private consumption and, less markedly, investment in Q1 2006.
- Headline inflation: May headline inflation recorded as 4.1 percent.
- Inflation differential: inflation differential with the euro area of 1.6 percentage points (as of May).
- Real GDP, consumption, and investment: charts show annualized quarterly changes and trends (2000–2006 period highlighted in source charts).

### Housing, credit, and financial indicators (high-level observations from figures)
- Mortgage and housing credit: series and ratios displayed including mortgage payments in the first year as percent of household disposable income (assumes initial down payment of 20 percent, loan-to-value ratio of 80 percent), mortgage credit as percent of GDP, housing credit (in balance and securitized), and construction (housing units) for 1980–2005.
- Financial markets: bank and stock indices (2000–06 and 1996–06), and government bond spreads (10-year and 3-year) are provided in figure form.

### Fiscal policy developments and government targets
- Government announced medium-term fiscal targets through 2009 and the central government’s expenditure ceiling for 2007 (announced in early June).
- Official estimate for 2006 general government outcome: a surplus of 0.9 percent of GDP (set in the December 2005 Stability Program); fiscal data so far in 2006 "confirm the likelihood of a better outcome."
- Fiscal stance for 2007: announced target for 2007, if implemented as announced, would imply a moderately expansionary stance; central government spending growth intended to be contained at 6.7 percent, "in line with nominal GDP."
- Territorial governments: continuation of territorial governments’ deficit through 2007; deficits ascribed to a number of regions and municipalities being addressed under phased adjustment plans.
- Staff assessment: announced targets "fall short of the expenditure-based fiscal restraint recommended in the Staff Report (¶40) to help curb excess domestic demand in the short term." Staff anticipates budget execution may exceed announced targets through automatic revenue stabilizers.

### Fund relations, membership, and financial position (Appendix I)
- Membership: Spain became a member of the Fund on September 15, 1958.
- Article VIII obligations: accepted on July 15, 1986 (Article VIII Sections 2, 3, and 4).
- Quota and holdings:
  - Quota: 3,048.90 SDR Million (100.00 percent of quota)
  - Fund holdings of currency: 2,709.07 SDR Million (88.85 percent)
  - Reserve position: 339.84 SDR Million (11.15 percent)
- SDR Department:
  - Net cumulative allocation: 298.81 SDR Million (100.00 percent)
  - Holdings: 216.32 SDR Million (72.39 percent)
- Outstanding purchases and loans: None
- Latest financial arrangements: None
- Projected payments to Fund (Charges/Interest and Total, SDR Million):
  - 2006: 2.13
  - 2007: 2.91
  - 2008: 2.92
  - 2009: 2.91
  - 2010: 2.91
- Exchange rate arrangement: Spain entered the final stage of European Economic and Monetary Union on January 1, 1999, at a rate of 166.386 Spanish pesetas per euro.
- Exchange system: Spain maintains an exchange system free of restrictions on payments and transfers for current international transactions, except for exchange restrictions imposed solely for preservation of national or international security (notified pursuant to Executive Board Decision No. 144-(52/51)).
- Article IV consultations: last Article IV consultation concluded on February 9, 2005; Spain is on the standard 12-month consultation cycle.

### Statistical issues and data reporting (Appendix II)
- General government:
  - Need for making historical revisions, preliminary estimates, and planned fiscal accounts data publicly available shortly after being sent to Eurostat in March and September.
  - Major revisions should be fully documented.
  - Reconciliation of cash and accrual general government data is unclear; details of these calculations would enhance monitoring at higher frequencies.
- Territorial governments:
  - Reporting and transparency improved following 2005 fiscal ROSC recommendations, but expenditure and revenue details remain wanting and timeliness is still an issue—regional fiscal outcomes for 2004 are now available, but 2005 outcomes were yet to be published at the time of the report.
  - Reporting of PPP-related operations at all levels of government should be improved.
  - Monitoring fiscal developments at the territorial level is essential given recent deviations from fiscal targets and the Budgetary Stability Law.
- Labor market:
  - Two different measures of unemployment reported by authorities ("registered" and "survey" unemployment) that vary substantially.
  - Employment growth data are distorted by flows from the informal to the formal labor force, complicating productivity growth and unit labor cost calculations.
- National accounts:
  - Revised in line with the 1995 version of the European System of Accounts.
  - Chain-linked national accounts in base year 2000 published since May 2005, but pre-1995 data have not been revised yet.

*Source: Spain — Staff Report for the 2006 Article IV Consultation; Supplementary Information. Prepared by the European Department. Approved June 7, 2006.*

### 4.      The social partners and the government have reached agreement on a limited

### 4.      The social partners and the government have reached agreement on a limited pension reform

### Pension reform: components and assessment
- Reform components:
  - Incentives to prolong the effective working life.
  - Marginally extends the effective minimum contribution period (from 12.8 to 15 years).
  - Consolidates the agricultural and self-employed regimes into the general system.
  - Extends the coverage of widowers’ pensions.
  - Increases pensions of those retired early as a consequence of dismissal.
  - Leaves the base period to compute pensions untouched.
- Staff assessment:
  - The agreement represents a helpful move in the direction advocated by staff.
  - The long-term sustainability of the social security accounts will require further action.
  - Placing the pension system on a long-term sustainable path will require further steps, including changes to key parameters such as the pension computation period.

### Fiscal projections for 2005–09 (In percent of GDP)
- General government balance: 1.1 0.9 0.7 0.8 0.8
- Central government: 0.4 0.1 0.2 0.2 0.2
- Social security: 1.1 0.9 0.7 0.6 0.6
- Territorial governments: -0.4 -0.1 -0.2 0.0 0.0
- Sources: Ministry of Finance and Economy, and authorities' projections.
- Note: 1/ Actual for 2005; Stability Program (December, 2005) for 2006; and Council of Ministers (June 2, 2006) for 2007-09. Official Fiscal Projections 1/

### Background: macroeconomic context and risks
- 2005 performance and drivers:
  - Growth of 3.4 percent in 2005.
  - Over the last year, the economy created more than 60 percent of all new jobs in the euro area.
  - Domestic demand (consumption and investment in construction, and more recently equipment) remained the main pull on activity.
  - Net exports increased their negative growth contribution to some 2 percentage points.
  - Growth concentrated in nontradables; sectors exposed to foreign competition experienced little gain.
- Financial and credit conditions:
  - Despite recent interest rate hikes, liquidity and credit conditions remain expansionary.
  - Private sector credit grew at over 20 percent, spearheaded by real estate lending.
  - Household indebtedness rose to over 110 percent of disposable income by end-2005.
  - Headline and core inflation differentials with the euro area widened to 1.8 and 1.6 percent respectively in the first quarter of 2006.
  - Unit labor cost growth, while slowing down, remained above the euro area average.
- External position:
  - Current account deficit reached 7½ percent of GDP in 2005.
  - Net external liabilities reached 46 percent of GDP.
  - Financial institutions intermediate external savings, mainly through issuance of mortgage-backed securities in euro-area markets.
- Fiscal stance and institutions:
  - Buoyant revenue drove the 2005 general government budget into a surplus of 1.1 percent of GDP.
  - Non-interest spending rose by 0.3 percentage points of GDP (adjusted for one-time operations recorded in 2004).
  - Budget and spending plans for 2006–07 imply a moderately expansionary stance.
  - The Budget Stability Law and financing arrangements with the regions are undergoing reform to increase cyclical flexibility and regions’ ownership and co-responsibility.
- Long-term challenges:
  - Age-related fiscal costs are set to rise considerably over the longer term, with the onset of pension system deficits starting during the next decade.
  - Containing rising healthcare spending will also require reform measures.

### Executive Board assessment: opportunities and policy recommendations
- Overall appraisal:
  - Welcomed continued strong growth and robust job creation accommodating large immigrant flows.
  - Commended reforms since the early 1990s that opened the economy, enhanced flexibility, and established stability-oriented policy frameworks.
- Short- and medium-term outlook:
  - Short-term growth prospects remain buoyant and well above the euro area average.
  - Projected widening of the already large current account deficit noted as a concern.
  - Risk of a more pronounced domestic demand slowdown from private sector balance sheet consolidation and real estate valuation correction.
- Policy priorities and recommendations:
  - Support for the authorities’ National Reform Program (NRP) to improve productivity, market flexibility, and competitiveness.
  - Call for bold supply-oriented structural reforms to regain competitiveness within EMU.
  - Emphasize competition-based incentives for private sector R&D and further deregulation of sheltered sectors (distribution, energy, transport, and other services).
  - Strengthen the competition authority and ensure full independence of sectoral regulatory agencies.
  - Encourage continued labor market flexibility reforms; review collective wage bargaining to better link wage and productivity increases, and promote greater labor mobility.
  - Fiscal policy:
    - Welcome appreciable fiscal surplus, accumulation in the Pension Reserve Fund, and reduced public debt.
    - Recommend allowing full play of revenue stabilizers accompanied by greater spending restraint at all levels of government.
    - Support the greater flexibility and cyclical sensitivity of the new Budget Stability Law (BSL), while stressing the need for a robust budgetary framework and improved public reporting and transparency, particularly at the territorial government level.
    - Review regional financing arrangements to strengthen fiscal co-responsibility by matching decentralization of competencies with greater taxing powers for territorial authorities.
  - Financial sector:
    - Welcome FSAP assessment that the financial sector is dynamic, profitable, professionally managed, and under strong supervision.
    - Main risks: rapid credit growth connected with the housing market boom.
    - Recommend monitoring credit quality, vigilance on rapidly growing new credit vehicles (such as nonconventional mortgages), and steps to strengthen independence of financial regulators—most particularly the insurance supervisor.
    - Emphasize preserving the centralized prudential supervision and regulation system.
    - Encourage stronger governance of savings banks, issuance of instruments that enhance market accountability, and reducing the ceiling on government representation on their boards.
    - Recommend applying the most conservative approaches under Basel II to industrial participations in some credit institutions’ portfolios.
- External policy:
  - Commended Spain’s commitment to double official development assistance allocation by 2008, aiming to reach the UN target.
  - Urged contribution within the EU to a successful completion of the Doha round.

### Selected economic indicators and key statistics (2001–06)
- Real economy (change in percent):
  - Real GDP: 3.5 2.7 3.0 3.1 3.4 3.3
  - Domestic demand: 3.6 3.3 3.8 5.0 5.3 4.5
  - HICP (average): 2.8 3.6 3.1 3.1 3.4 3.4
  - Unemployment rate (in percent): 10.6 11.5 11.5 11.0 9.2 8.6
- Public finance (general government; in percent of GDP):
  - Overall balance: -0.5 -0.3 0.0 -0.1 1.1 0.9
  - Primary balance: 2.1 2.1 2.1 1.7 2.7 2.5
- Interest rates:
  - Money market rate: 4.4 3.3 2.3 2.0 2.1 ...
  - Government bond yield: 4.9 4.6 3.5 3.6 3.1 ...
- Balance of payments (in percent of GDP):
  - Trade balance: -5.7 -5.0 -5.1 -6.4 -7.6 -8.3
  - Current account: -3.9 -3.3 -3.6 -5.3 -7.4 -8.1
- Fund position (as of March 31, 2006):
  - Holdings of currency (in percent of quota): 88.85
  - Holdings of SDRs (in percent of allocation): 72.40
  - Quota (in millions of SDR): 3,048.90
- Exchange rate:
  - Exchange rate regime: Euro Area Member
  - Present rate (May 12, 2006): US$ 1.29140 per euro
  - Nominal effective rate (2000 = 100): 72.5 74.2 76.8 77.6 76.3 ...
  - Real effective rate (2000 = 100): 85.2 88.8 92.6 94.4 94.3 ...

*Source: IMF Public Information Notice (PIN) No. 06/65 — IMF Executive Board Concludes 2006 Article IV Consultation with Spain (June 14, 2006).*

### 28.7 percent for 04-05, while the Euro area average has decreased (from 20.7 percent to

### 28.7 percent for 04-05, while the Euro area average has decreased (from 20.7 percent to

### Macroeconomic context and external position
- Current account and savings
  - “28.7 percent for 04-05”
  - Euro area average decreased “from 20.7 percent to 20.4 percent” for the same period.
  - Savings-to-GDP ratio in Spain: “22.4 percent” vs. Euro area average “20.9 percent”.
  - Public sector surplus reduces the economy’s borrowing requirement.
  - Spain’s deficit represents “0.3 percent of the GDP of the Euro area” and “6 percent of its savings”.
- Inflation and prices
  - Authorities expect inflation in 2006 to remain within the range of the Consensus Forecast “[3.0, 3.5]”.
  - Prices in early 2006 show “worrying dynamics”, especially due to oil price developments.
  - Real salaries in Spain “have decreased in 2005, for a second year in a row, in an amount comparable to that of Germany”.
- Exchange rate and Euro area membership
  - Membership in the Euro area mitigates exchange rate risk for individual members and facilitates capital movements within the monetary union, easing financing of current account deficits.

### Fiscal policy
- 2005 outturn and stance
  - 2005 general government budget closed with a surplus of “1.1 percent of GDP”.
  - First public administration surplus in the past three decades of democracy.
  - Spain is one of only three Euro-area countries with a surplus in 2005.
  - Authorities dispute staff’s assessment of pro-cyclicality in 2005; OECD qualified the fiscal stance in 2005 as “moderately restrictive”.
- Medium-term objectives and policy measures
  - Government approved medium-term objectives of budgetary stability targeting a fiscal surplus through 2009, implying “an unprecedented five consecutive years of fiscal surplus” for the public administration.
  - Authorities will attend expenditure needs arising from immigration (population growth “up to 10 percent in only six years”) and needs related to innovation, human capital formation, and infrastructure investment.
  - Authorities argue public expenditure is relatively low: expenditure-to-GDP ratio in Spain is “38.2 percent”, “9 points below the Euro-area average”, making it one of only two countries (together with Ireland) with ratios below “40 percent”.
  - Staff’s Box 3: a “1 percent reduction on real expenditure” would yield only a “0.15-0.16 improvement in the current account”.
  - Authorities announced an expenditure cap: public expenditure growth within the 2007 budget will be limited by nominal GDP growth to ensure a public surplus in 2007 and budgetary leeway thereafter.
- Major fiscal reforms underway
  - New Budget Stability Law (BSL), to enter into effect in 2007:
    - Sets the target of a fiscal balance over the cycle for all levels of government while safeguarding social security on separate accounting.
    - Establishes that Autonomous Communities will hold a balanced or in surplus budget, allowing cyclical deficits when national growth is below the reference level (“2 percent”).
  - Income tax reform (in Parliamentary procedure):
    - Reduction of the corporate tax rate “down to 30 percent and to 25 percent for small and medium companies”.
    - Personal income tax simplification: reducing number of brackets, higher exempt minimum income, a uniform rate on savings, and lowering marginal rates.
  - Pension reform (social dialogue agreement announced mid-May):
    - Measures include prolonging effective working life and extending the minimum affiliation period to compute pensions to reinforce long-term fiscal sustainability.

### Structural reforms
- Reform framework and principles
  - Economic reform structured around the Plan de Dinamización and the National Reform Plan under the EU Lisbon strategy.
  - Principles: predictability, accountability, comprehensiveness (fiscal stabilization, product and labor market liberalization, infrastructure, education, R&D), and continuous review with monitoring and evaluation.
- Key achievements and measures
  - Labor market reform based on social dialogue to reduce high incidence of temporary employment; agreement completed May 9 to reduce temporary employment via greater utilization of the contrato de fomento and reinforcement of active labor market policy services.
  - Plan de Dinamización first-year results: “85 percent success rate” in initiatives focused on product and service markets.
  - Measures: modernization of the competition authority (independent National Commission of Competition to be established in 2007), liberalization of telecommunications services, new licenses for railroad transportation, fast-track judicial procedure for house rental market, start of national registry of rights of emission under the Kyoto protocol.
  - Plan updates in March included the expenditure-cap and a reform on the mortgage law (under public consultation); pipeline measures include liberalization of railroad cargo transportation and increased competition in the energy sector.
- Official Development Aid
  - Authorities committed to duplicate the amount of ODA as a share of GDP to reach “05% of GDP by 2008” and ultimately achieve the UN goal of “0.7% of GDP in the near future”.

### Financial Sector Assessment (FSAP) and supervisory issues
- FSAP assessment and risks
  - FSAP team assesses Spanish financial system as resilient and competitive: high degree of financial intermediation, efficient allocation of savings, high capitalization, reduced risk-profile of institutions, wide access to financial services, well-regulated system, and cutting-edge prudential supervisory framework.
  - Main risks: expansion of credit to housing and construction sectors, housing market developments, and competitiveness of the Spanish economy.
  - Stress-tests indicate strong resilience of the financial system even under extreme scenarios.
- Authorities’ response to FSAP recommendations
  - Delegation of more normative and sanctioning power to supervisory agencies: legal constraints exist because capacity to legislate and to approve/repeal licenses belongs to the public administration; Bank of Spain does not formally belong to the Spanish public administration and therefore cannot legally be invested with such powers. The Ministry of Economy and Finance (ME) elaborates prudential rules; supervisors enforce and develop detail; license revocations are sanctioned by the Ministry after supervisor proposal.
  - ME argued as the institution with a global view of banking, insurance and securities and responsible for negotiating and transposing EU legislation on financial services.
  - Ongoing reform of Estatutos of Autonomous Communities will not affect centralized prudential supervision; constitutional jurisprudence assigns supervision and sanction on solvency matters exclusively to the State.
  - Ministry and supervisors signed a cooperation agreement last February creating a high level Committee on Financial Stability, which will hold its first meeting shortly.
  - Savings banks:
    - Well regulated and supervised; can merge within and across Autonomous Communities.
    - Promotion of new means to raise high-quality capital such as cuotas participativas is supported; 2004 regulation provided legal certainty for these instruments.
    - Corporate governance improvements: irrevocability of the mandate, reduction of ceiling on public sector representation on boards, obligation to publish an annual corporate governance report for savings banks issuing securities admitted to trading in official markets.

*Source: _cr06211 - 28.7 percent for 04-05, while the Euro area average has decreased (from 20.7 percent to*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06211.pdf_