## _cr10254 ## Source details **Canonical URL:** [_cr10254](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10254.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10254.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10254.pdf.json) --- ### Reform of savings banks — main elements - Allowing “cuotas participativas” to have voting rights and removing the five percent limit on an individual investor’s holding. - Options for savings banks: - (1) maintain their existing structure; - (2) operate through a bank; - (3) become part of a formal group of savings banks (Sistema Institucional de Protección, “SIP”) with a commercial bank as the central entity; or - (4) change legal nature and become a foundation and a (potentially minority) shareholder of the bank to which it transfers its business. - Corporate governance changes: - (1) reducing maximum voting rights for public entities from 50 percent to 40 percent; - (2) prohibiting elected officials from being members of governing bodies; - (3) strengthening reputation and experience criteria. ### Staff preliminary assessment of the reform - Overall view: preliminary positive assessment; full text not published by 12 July. - Achievements: - Enhances ability of savings banks to raise external capital. - Offers opportunity to transform into a stock-holding company. - Reduces political influence. - Remaining limitations: - 50 percent limit on total cuotas participativas a savings bank can issue is maintained. - Capital participation of savings banks in a SIP cannot fall below 50 percent. - Systemically important savings banks are not required to transform into joint-stock companies. - Mitigation noted: transformation into foundations and transferring banking activity would effectively allow these limits to be exceeded. ### Labor market reform (decree-law approved June 16; entered into force June 22) - Main elements: - Reduction of severance pay to 33 days per year of tenure for unfair dismissal (previously 45 days) for almost all new permanent contracts. - Financing 8 days of all severance payments via a fund paid for by firms. - Easing criteria for “fair” dismissal (which would entail 20 days severance payment). - Broadening conditions under which firms can opt-out of collective wage agreements. - Other measures: - Tightening conditions for temporary contracts. - Increasing internal flexibility of firms (e.g., working hours). - Opening labor intermediation more broadly to private firms. - Staff view and recommendations: - Positive aspects but scope for further strengthening. - Severance pay remains above EU average levels. - Effectiveness depends on courts’ interpretation of new provisions. - Effective decentralization of wage setting likely requires change in collective bargaining process. - Government urged to deliver radical overhaul during parliamentary passage and wage bargaining review. ### Banking sector stress tests and transparency - Bank of Spain announced intention on June 16 to publish bank-by-bank stress test results. - Staff welcomes publication; it should enhance transparency and market confidence. - Important conditions: - Stress tests should be based on sufficiently conservative assumptions. - Publication should be accompanied by a clear strategy to recapitalize and restructure institutions with identified capital shortfalls. ### Savings bank consolidation and sector developments (as of mid-June 2010) - Consolidation progress: - 12 merger/integrations underway, involving 38 savings banks. - These comprise 92 percent of the assets of the savings bank sector. - 11 mergers/integrations comprising 34 institutions account for more than a third of the banking sector. - Heterogeneity of impact: - Santander and BBVA preserved reasonable operating profitability due to international diversification and strengthened capital. - Small commercial banks posted still positive profits but face challenging outlook. - Savings banks suffered most due to real estate exposure. - Two small savings banks, comprising a total of 1½ percent of total assets of the banking sector, were intervened by Banco de España in March 2009 and in May 2010. - Some savings banks relied heavily on official liquidity support and government guarantees. ### Context and macroeconomic challenges (Executive Summary highlights) - Adjustment underway; output stabilized but unemployment soared. - Recovery likely weak and fragile with significant downside risks. - Key challenges: - Dysfunctional labor market. - Deflating property bubble. - Large fiscal deficit. - Heavy private sector and external indebtedness. - Anemic productivity growth and weak competitiveness. - Banking sector with pockets of weakness. - Policy priorities: - Ambitious fiscal consolidation (but projections may be optimistic). - Bold pension reform along government’s original plan. - Growth-enhancing structural reforms, especially labor market overhaul. - Accelerate consolidation and reform of banking system. - Need comprehensive strategy with broad political and social support. ### Financial sector measures and regulatory adjustments - Two-stage approach to ease financial stress: - Initial focus on securing funding: Fondo de Adquisición de Activos Financieros—FAAF to purchase high-quality securities; government guarantees for new debt. - Later emphasis on consolidation and recapitalization: Fondo de Reestructuración Ordenada Bancaria—FROB to provide temporary capital assistance to merging credit institutions. - Regulatory/provisioning adjustments: - Fine-tuning conservative provisioning to account for collateral (with haircuts). - Banco de España tightened allowances on repossessed assets to prompt rapid dismissal. - Unified and accelerated provisioning schedule published for consultation on May 26, 2010. ### Fiscal accounts, stimulus, and deterioration - Fiscal swing: surplus of 2 percent of GDP in 2007 to deficit of 11.2 percent of GDP in 2009. - Stimulus measures amounted to some 7 percent of GDP over 2008‒09. - Stimulus focused on temporary measures: broadening social protection and increasing public investment; many tax reductions largely without expiry dates (many later reversed). - Measures to support credit lines to firms and housing, including refinancing facility for mortgages of unemployed or households with financial difficulties. - Impact of fiscal measures (2008‒09, Percent of GDP): - Total (- stimulus): -2.9 (2008), -4.3 (2009), -7.2 (Total) - Revenue (- stimulus): -1.7 (2008), -0.9 (2009), -2.5 (Total) - Expenditure (- stimulus): -1.2 (2008), -3.4 (2009), -4.6 (Total) - Specific items include: €400 PIT deduction -0.4 (2008), -0.2 (2009), -0.6 (Total); Local Investment Fund (Plan E) -0.7 (2008), -0.7 (Total); Total figures reported in source tables. ### Recession severity, sectoral impacts, and macro dynamics - Output fell somewhat less than euro area average but was still very substantial. - Output decline driven by sharp declines in investment, exports, and private consumption; domestic demand contracted much more sharply than in the euro area. - Hardest hit sectors: industry and construction/real estate. - Recession ended in first quarter with quarter-on-quarter growth of 0.1 percent. - Spain: Staff Medium Term Outlook—Baseline Scenario (Real GDP and components, Percent) - Real GDP: 2007 3.6, 2008 0.9, 2009 -3.6, 2010 -0.4, 2011 0.6, 2012 1.7, 2013 1.9, 2014 1.9, 2015 1.8 - Private consumption: 3.6, -0.6, -4.9, 0.4, 0.8, 1.4, 1.4, 1.3, 1.4 - Fixed investment: 4.6, -4.4, -15.3, -8.0, -2.9, 2.8, 4.4, 3.5, 3.3 - CPI inflation, pa: 2.8, 4.1, -0.3, 1.4, 1.3, 1.2, 1.4, 1.6, 1.8 - Unemployment rate, pa: 8.3, 11.3, 18.0, 19.3, 18.7, 18.0, 17.3, 16.6, 16.0 - Current account balance: -10.0, -9.7, -5.4, -4.9, -4.3, -3.9, -3.6, -3.5, -3.5 ### Comparative growth forecasts (2010 onward) - IMF staff: -0.4 (2010), 0.6 (2011), 1.7 (2012), 1.9 (2013) - Ministry of Finance (MoF): -0.3 (2010), 1.3 (2011), 2.5 (2012), 2.7 (2013) - Bank of Spain, EC, OECD, Consensus: differing forecasts for 2011 (generally 0.8–1.0) noted; some forecasts do not include effect of fiscal package announced in May. ### Labor market adjustment and wages - Unemployment rose to 20 percent, affecting mostly temporary workers and youth. - Labor force participation started falling. - Spain has highest sensitivity of unemployment to output growth among advanced economies—partly related to large share of temporary workers. - Productivity improved, narrowing unit labor cost gap. - Wages started moderating recently with conclusion of three-year wage agreement between social partners. ### Property bubble correction and housing market dynamics - Peak overvaluation: at peak in 2007, prices were some 20‒30 percent above long-run equilibrium. - Construction comprised about 9½ percent of GDP in 2007 vs euro area average 5½ percent. - “Official” real prices down about 13 percent since peak, suggesting at least another 10 percent still to fall. - Supply overhang: about 700,000 units; equilibrium demand for property of 400,000 units implies another two to three years before supply conditions normalize. - Annual housing finishes around 425,000 units and new permits at 111,000 units vs 650,000 units in 2007. ### Private sector indebtedness and external adjustment - Household and corporate indebtedness reached about 210 percent of GDP in 2009 (euro area average around 160 percent). - Sharp correction started: households became net lenders and companies substantially reduced net borrowing. - Private saving rate jumped to 25 percent of GDP. - Current account improved significantly as private net savings rose and public savings weakened; trade balance improved largely through declining imports and falling oil prices. ### Outlook: baseline and uncertainty - Baseline: recovery weak and fragile; growth slightly negative in 2010 and weakly positive thereafter, rising gradually to range of 1½ to 2 percent over medium term. - Domestic demand recovers slowly due to uncertainty, high unemployment, deleveraging, and large-scale fiscal consolidation. - Upside risks: faster household consumption growth; stronger partner-country growth and weaker euro. - Downside risks: - Economy may stagnate if regaining competitiveness and deleveraging take many years with negative feedback loops. - Domestic failure to implement fiscal consolidation or an external shock spreading to Spain could have substantial spillovers to Europe and globally. - Empirical note: average conditional probabilities of distress in European sovereign debt markets, given distress in Spanish government debt, are higher than those under Greek distress. ### Political context and authorities’ views - General elections not due until 2012; local elections due in 2011. - Governing socialist party does not have a majority; May fiscal package passed by one vote. Many regions controlled by opposition. - Authorities’ outlook: recovery likely stronger than staff envisage, with growth reaching 2.7 percent by 2013; fiscal policy on track; significant labor market reform and pension reform underway; savings bank consolidation expected to be complete in coming weeks. ### Policy agenda: rebalancing the economy and boosting confidence - Key priorities: - Fiscal consolidation and pension reform to put public finances on sustainable footing. - Making labor market more flexible to promote employment and reallocation. - Banking sector consolidation and reform to cement soundness and confidence. - Reform synergies emphasized; urgency highlighted due to heightened risks and costs. ### Fiscal consolidation measures and near-term stance - Objective: reach 3 percent of GDP deficit target by 2013. - Measures implemented (2010 Budget, Stability Program, May fiscal package): - Increases in VAT rates and personal income tax. - Greatly restricted hiring; cuts in selected transfers and subsidies; reduced public investment. - May package included cutting public sector wages (signaling effect). - Government financing needs: - Central government gross financing needs for 2010: €219 billion (21 percent of GDP). - Gross financing need for 2011: about €226 billion (21 percent of GDP). - Breakdown of Government's Fiscal Plan 2010–13: source tables show composite figures (e.g., "Total8.2Total6.0") and identified measures including Suspension of 400 euro PIT deduction 0.4; Increases in VAT rates and excise tax 0.8; Reversal of stimulus program 2.5; Local Investment Fund 0.8; May 20, 2010 measures 1.5 (including 5 percent wage cut 0.4). ### Staff projections, differences with official plans, and debt outlook - Revised SGP vs Staff overall balance (percent of GDP): - Revised SGP: -11.2 (2009), -9.3 (2010), -6.0 (2011), -4.4 (2012), -3.0 (2013) - Staff: -11.2 (2009), -9.3 (2010), -7.0 (2011), -6.6 (2012), -5.9 (2013) - General government debt (percent of GDP): - Revised SGP: 53.2 (2009), 63.5 (2010), 68.5 (2011), 70.4 (2012), 70.5 (2013) - Staff: 53.2 (2009), 63.3 (2010), 70.6 (2011), 75.8 (2012), 79.8 (2013) - Staff assessment: - Projects deficit decline to 9.3 percent of GDP in 2010 (in line with target), but only to 7 percent of GDP in 2011 (1 percent of GDP above target). - Gap widens to around 2½ -3 percent of GDP in 2013 on announced policies. - Staff projects debt ratio to continue rising to about 85 percent of GDP by 2015 under baseline. - Even under “active” scenario where deficit targets met, debt still increases slightly in 2013; further consolidation in 2014 of about ½ percent of GDP required to start reducing ratio. ### Risks to consolidation and staff recommendations - Risks: - Envisaged adjustment relies on potentially optimistic macroeconomic projections. - Tax base could recover more slowly due to higher household savings and weaker consumption. - Spending restraint challenging given historical primary spending growth about 7.2 percent a year since 1996. - Sub-national governments expected to bear lion’s share of consolidation beyond 2011. - Large financing requirements make market confidence critical. - Near-term recommendations: - Make macroeconomic projections more prudent. - Prepare additional measures to ensure targets are attained. - Protect most vulnerable while reducing current spending and investment and reducing tax benefits. - Consider further raising still relatively low VAT and excise rates. - Support measures with structural reforms. - Institutional recommendations: - Institutionalize spending review processes. - Consider establishing an independent fiscal council. - Increase coordination and monitoring of sub-national government borrowing. ### Longer-term outlook, sustainability, and pensions - Aging costs projected to rise by 9 percent of GDP through 2060 (above EU average), largely from pension expenditure. - Combining long-run projections yields public sector net worth around minus 200 percent of GDP in 2010, deterioration from minus 40 percent in 2007. - Eliminating gap would require upfront permanent improvement in primary balance close to 5 percentage points of GDP in addition to projected turnaround by 2013. - Pension reform recommendations: - Raise retirement age, increase incentives to work in old age, add explicit link between benefits/retirement age and life expectancy. - Government proposal: gradually increase retirement age from 65 to 67 years (Stability Program January 2010). - Adopt mechanism automatically linking key pension parameters to life expectancy. ### Competitiveness and labor market diagnosis - Competitiveness gap: around 14 percent adjustment in real effective exchange rate needed to stabilize international investment position. - Real effective exchange rate appreciated about 20 percent since euro adoption in 1999. - Underlying “structural” unemployment rate about 14 percent. - Labor market highly dual: about a third of labor force in fixed-term contracts. - Wage bargaining system limits wage and firm flexibility; high degree of wage indexation. - Recommended reforms: - Radical overhaul to reduce duality and encourage permanent hires by lowering severance payments to at least EU average levels and having gradual increase in severance in early years. - Boost wage flexibility by decentralizing wage setting and eliminating indexation. ### Progress on product and service market reform (section 35) - Progress achieved reducing state involvement and administrative burdens; reforms in railways, roads, and retail. - EU Services Directive transposed into law; implementation critical. - Sustainable Economy draft bill submitted to partially eliminate incentives for buying houses and promote rental market. - Priority areas: further reduce restrictions on retail trade, professional services, and rental market; review insolvency framework may be warranted. ### Financial sector outlook, vulnerabilities, and scenarios (section 35) - Aggregate: banks report solid capital and provision buffers but risks elevated and uneven. - Adverse scenario projections: - unemployment climbs to 24½ percent by 2011; - house prices fall another 15 percent; - NPLs projected to peak at 7－8 percent in 2011. - Under assumptions including repossessed assets and halving pre-provision income over 2010–12, gross drain on capital could reach: - €5 billion for commercial banks; - €17 billion for savings banks. - These drains correspond to: - some 2 percent of GDP; - 5 and 22 percent of Tier 1 capital respectively. - Comparison: substantially less than the €99 billion maximum potentially available under the FROB. - Funding/profitability/liquidity risks: market conditions difficult, especially for smaller banks and term funding; system has sufficient liquid assets as of end-2009 to cover 2010 maturities but strains may arise from unwinding ECB measures and ending funding guarantees. ### Reform of savings banks — detailed findings and options (Attachment IV and sections 11, 51) - Structure: savings banks (cajas) organized as private foundations with no formal owner; five stakeholder groups in governing bodies. - Reported NPLs may underestimate loan portfolio deterioration: - Staff estimates repossessed or acquired real estate assets by savings banks around €31 billion, equivalent to 38 percent of Tier 1 capital. - If included, NPL ratio for savings banks would increase from 5.3 to 8.6 percent and coverage ratio drop from 56 to 34 percent. - Asset valuation concerns: about 45 percent of repossessed assets is land; BdE increased provisioning for real estate assets and proposed further increases (consultation on May 26, 2010). - Reliance on official support: - Savings banks hold lion share of bonds issued with Spanish government guarantee; almost three-quarters of total amounting to €32.5 billion. - Use of ECB refinancing operations by savings banks estimated between 40 and 70 percent of total Spanish credit institutions’ operations. - Legal/governance constraints impede cross-region mergers and external investor access. - Policy recommendations: - Reduce political influence in savings banks. - Enhance ability to raise external capital (remove limits on cuotas participativas; allow voting rights; consider contingent capital notes). - Offer opportunity to transform into stock-holding companies and require this for systemically important savings banks. - Empower BdE with sole responsibility to approve mergers, considering competition authority’s opinion. - Use FROB resources to incentivize transformation into stock-holding companies and clean balance sheets. ### FROB key features and constraints (Box) - Objective: assist reorganization of banking industry (Royal Decree Law 9/900). - Initial capital: €9 billion (€2.25 billion from Deposit Guarantee Funds, rest by state). - Leverage: up to 10 times (i.e., €99 billion). - Capital-support window for integration expires on June 30, 2010. - Integration beneficiaries: fundamentally sound with core capital ratio at least 6 percent. - FROB instruments: convertible preference shares (non-core Tier 1) with yield rules and conversion/buy-back mechanics; penalties and behavioral safeguards attached. - Example issuance: November 19, 2009, FROB bond €3 billion, five year, 3 percent coupon with unconditional state guarantee. ### Subnational fiscal federalism, risks, and enforcement (sections 8, 11) - Spain’s general government includes central government, 17 Autonomous Communities (ACs), and local governments (50 provinces and 8,112 municipalities). - Subnational spending rose to about half of total public spending in 2008 and nearly 80 percent of public consumption; subnational employees rose to 54 percent of public sector employment in 2009. - New financing system approved December 2009 under common regime increases ceded and shared taxes to roughly 90 percent of total revenue; Fund to Guarantee Public Services (GF) funded partly with about €7.4 billion additional state resources. - Challenges: - Mismatch between revenue and spending outlook; revenue outlook uncertain due to erosion in tax base and higher unemployment. - ACs’ expenditure structural (health and education) and pressure from aging. - Staff concern macro projections underpinning medium-term consolidation may be optimistic. - Recommendations to strengthen compliance: - Introduce credible penalties/enforcement for non-compliance (e.g., withholding transfers). - Link non-compliance with regional tax rates to enhance accountability. - Introduce binding multi-year spending ceilings. - Adopt more cautious macroeconomic projections; consider independent fiscal council. - Change timing of transfers/settlement to link to actual revenue and avoid procyclicality. - Broaden coverage of existing rules (e.g., Golden rule) to larger municipalities. ### Deleveraging of non-financial private sector — risks and dynamics (section 1) - Household and corporate indebtedness about 210 percent of GDP (2009) vs euro area average around 160 percent. - Household debt to gross disposable income: close to 60 percent at start of decade, over 125 percent in 2009. - Variable-rate loans over 90 percent of mortgages; owner-occupied residences rate 86 percent. - Interest burden: over 7.5 percent of gross disposable income in 2008, around 6.2 percent in 2009. - Financial net worth declined from close to 200 percent of gross disposable income in 2000 to about 110 percent at end-2009. - Savings rate spiked to 18.8 percent in 2009 (average 11 percent over decade); households became net lenders (10.3 percent of disposable income in 2009). - Staff baseline: savings rate likely to remain elevated, gradually declining to close to euro area average (14-15 percent); new credit to households negative in 2010 and reverts to positive afterwards at weak growth rates. ### Corporate deleveraging and vulnerabilities (sections 1, 11) - Total corporate debt in 2009 about 125 percent of GDP and over 700 percent of gross operating surplus. - Debt intensity in construction and real-estate: debt to gross operating profit over 1800 percent in 2008. - Debt service burden increased to almost 30 percent of income in 2008, moderated afterwards. - Leverage: total corporate debt to equity peaked over 100 percent in 2009; debt to asset ratio over 70 percent in 2009. - Investment boom: Spain’s average investment rate over last decade 32 percent of gross value added; housing investment peaked at 9½ percent of GDP. - Adjustment: residential investment halved to about 4 percent of GDP; corporate net borrowing reduced substantially. - Baseline: deleveraging continues, especially in construction and real-estate; firms forced to restructure and shed assets; investment remains very weak in medium term. - Risks: upside—higher demand, weak euro; downside—risk-premia shocks increasing interest burden and constraining credit. ### Public debt sensitivity and stress scenarios (section referencing 6.8 years) - Debt rollover: 6.8 years in 2009 (debt rollover over forecasting period expected modest). - Scenario impacts: - Growth shock: growth falls by a little over 1 percentage point → debt-to-GDP could reach 108 percent by 2014/15 (13 percentage points higher relative to baseline). - 30 percent nominal depreciation of euro and contingent liability shock of 10 percent of GDP → debt-to-GDP trajectory increases to 105 percent. - Interest rate shock (permanent ½ standard-deviation, 0.6 percentage point increase) → increases debt by roughly 4 percentage points to 116 percent of GDP in 2015. - One-time 30 percent depreciation in euro in 2010 → increases debt by about 5 percentage points to 112 percent of GDP. - Combined permanent ¼ standard deviation shock to real interest rate, growth and current account → external debt to 121 percent of GDP by 2015 (9 percentage points more than baseline). - Policy measures noted: - May 20 fiscal package to guarantee 3 percent deficit target by 2013 adds 1.5 cumulative percentage points in 2010 and 2011 to consolidation plan; frontloads 60 percent of total adjustment in first two years (2010–2011). - Regional coordination: June 15 fiscal targets for regions agreed; prohibition for municipalities to raise debt in 2011 introduced. - Government approved expenditure ceilings for 2011 with a 7 percent reduction on preceding budget ceilings. *Source: International Monetary Fund — Staff Report for the Article IV Consultation—Supplementary Information (Spain), prepared by the European Department, approved June 29, 2010; excerpts from IMF staff report content unit _cr10254.* ### 1. This statement updates the staff report (SM/10/148) and supplement for the ### This statement updates the staff report (SM/10/148) and supplement for the decree-law reforming the legal and regulatory regime for saving banks approved by the government on July 9. ### Reform of savings banks — main elements - Allowing “cuotas participativas” (equity-like instruments issued by savings banks) to have voting rights and removing the five percent limit on an individual investor’s holding. - Giving savings banks the option to: - (1) maintain their existing structure; - (2) operate through a bank; - (3) become part of a formal group of savings banks (Sistema Institucional de Protección, “SIP”) with a commercial bank as the central entity; or - (4) change their legal nature and become a foundation and a (potentially minority) shareholder of the bank to which it transfers its business. - Altering corporate governance structures, including: - (1) reducing the maximum voting rights for public entities’ from 50 percent to 40 percent; - (2) prohibiting elected officials to be members of governing bodies; and - (3) strengthening reputation and experience criteria. ### Staff preliminary assessment of the reform - Overall view: Staff’s preliminary assessment of the reform is positive, although further enhancement of some aspects would be beneficial. - Basis of assessment: Preliminary because it is based on the summary of the decree-law (the full text had not been published by 12 July). - Achievements relative to staff objectives: - Enhances the ability of savings banks to raise external capital. - Offers an opportunity to transform into a stock-holding company. - Reduces political influence. - Remaining limitations that could reduce investor attractiveness: - The 50 percent limit on the total amount of cuotas participativas a saving bank can issue is maintained. - The capital participation of saving banks in a SIP cannot fall below 50 percent. - Systemically important savings banks are not required to transform into joint-stock companies. - Noted mitigation: The possibility for savings banks to transform into foundations and transfer their banking activity to a bank would effectively allow these limits to be exceeded. ### Labor market reform (decree-law approved June 16; entered into force June 22) - Main elements: - Reduction of severance pay to 33 days per year of tenure for unfair dismissal (previously 45 days was the norm) for almost all new permanent contracts. - Financing 8 days of all severance payments via a fund paid for by firms. - Easing the criteria for “fair” dismissal (which would entail 20 days severance payment). - Broadening the conditions under which firms can opt-out of collective wage agreements. - Other measures: - Tightening conditions for temporary contracts. - Increasing internal flexibility of firms (e.g., working hours). - Opening labor intermediation more broadly to private firms. - Staff view and recommendations: - The reform has many positive aspects that will improve the working of the labor market, but there is scope for further strengthening. - Severance pay remains above EU average levels. - Uncertainty whether easing of criteria for fair dismissal and procedures for opt-outs is sufficient—much depends on how the courts interpret the new provisions. - Effective decentralization of wage setting to firms will likely require a change in the collective bargaining process, currently under review by social partners. - The government should take every opportunity to deliver the required radical overhaul, including during the passage of the decree-law through parliament and the review of the wage bargaining system. ### Banking sector stress tests and transparency - Bank of Spain announced on June 16 intention to publish bank-by-bank results of stress tests. - Staff welcomes publication; it should enhance transparency and underpin market confidence. - Important conditions: - Stress tests should be based on sufficiently conservative assumptions. - Publication should be accompanied by a clear strategy to recapitalize and restructure institutions with capital shortfalls identified by the stress tests. ### Savings bank consolidation and sector developments (as of mid-June 2010) - Consolidation progress: - 12 merger/integrations were underway, involving 38 savings banks. - These comprise 92 percent of the assets of the savings bank sector. - Staff welcomes the accelerated consolidation and emphasizes ensuring it reduces overcapacity and enhances cost efficiency. - Heterogeneity of banking sector impact: - Two largest banks, Santander and BBVA, preserved reasonable operating profitability due to international diversification and strengthened capital. - Small commercial banks posted still positive profits, reflecting an increase in net interest margins, but face a challenging outlook. - Savings banks have suffered the most due to real estate exposure; sector marked by substantial heterogeneity. - Two small savings banks, comprising a total of 1½ percent of total assets of the banking sector, were intervened by Banco de España in March 2009 and in May 2010. - Some savings banks have relied heavily on official liquidity support and government guarantees. - 11 mergers/integrations, comprising 34 institutions and accounting for more than a third of the banking sector, are underway. ### Context and macroeconomic challenges (Executive Summary highlights) - Context: The necessary adjustment is underway and output has stabilized; imbalances accumulated during the long boom have begun to unwind, though unemployment has soared. - Recovery: Likely to be weak and fragile, with significant downside risks. - Key challenges listed: - A dysfunctional labor market. - Deflating property bubble. - A large fiscal deficit. - Heavy private sector and external indebtedness. - Anemic productivity growth and weak competitiveness. - A banking sector with pockets of weakness and difficult financial market conditions. - Policy priorities and staff views: - Ambitious fiscal consolidation is underway but based on potentially optimistic macroeconomic projections; achievement of targets should be made more credible. - A bold pension reform, along the lines originally proposed by the government, should be quickly adopted. - Growth-enhancing structural reforms are needed, especially overhauling the labor market. - Consolidation and reform of the banking system needs to be accelerated. - A comprehensive strategy with broad political and social support would underpin investor confidence; time is of the essence. - Authorities’ stated views: - Recovery likely stronger than staff envisage, boosted by rebounding private consumption and buoyant exports. - Fiscal policy is on track to achieve ambitious targets and any slippage would be promptly met with additional measures. - Significant labor market reform is likely in the coming weeks, and pension reform is underway. - Savings bank consolidation should be complete in the coming weeks and will substantially reduce banking sector pressures. *Source: International Monetary Fund — Staff Report for the Article IV Consultation—Supplementary Information (Spain), prepared by the European Department, approved June 29, 2010.* ### 6. The authorities pursued a two-stage approach to ease financial sector stress. At ### _cr10254 - 6. The authorities pursued a two-stage approach to ease financial sector stress. At ### Financial sector measures and regulatory adjustments - Two-stage approach to ease financial sector stress: - Initial focus on securing funding. - Government established Fondo de Adquisición de Activos Financieros—FAAF to purchase high-quality securities issued by credit institutions. - Government provided guarantees for credit institutions’ new debt issues. - As the operating environment deteriorated and the property market collapsed, emphasis shifted to consolidation and recapitalization. - Government created Fondo de Reestructuración Ordenada Bancaria—FROB to provide temporary capital assistance to merging credit institutions. - Regulatory and provisioning adjustments: - Fine-tuning of conservative provisioning rules to take into account collateral (with haircuts). - Banco de España (BdE) tightened allowances on repossessed assets to prompt their rapid dismissal. - Further revisions, including a unified and accelerated provisioning schedule, were published for consultation on May 26, 2010. ### Fiscal accounts, stimulus, and deterioration - Sharp deterioration in fiscal accounts driven by revenue collapse and stimulus: - General government fiscal position swung from a surplus of 2 percent of GDP in 2007 to a deficit of 11.2 percent of GDP in 2009. - Stimulus measures amounted to some 7 percent of GDP over 2008‒09. - Stimulus expenditure focused mostly on temporary measures: broadening social protection and increasing public investment. - Revenue-side measures: tax reductions largely without expiry dates (many later reversed). - Measures to support credit lines to firms (especially SMEs) and housing, including a facility to refinance mortgages of unemployed or households with financial difficulties. - Impact of fiscal measures (2008‒09, Percent of GDP): - Revenue (- stimulus): -1.7 (2008), -0.9 (2009), -2.5 (Total) - €400 PIT deduction: -0.4 (2008), -0.2 (2009), -0.6 (Total) - Reduction withholding for mortgage payers: -0.2 (2008), -0.2 (Total) - Change in VAT returns and payment 1/: -0.4 (2008), -0.5 (2009), -0.9 (Total) - Child support (cheque bebe): -0.1 (2008), -0.1 (Total) - 2007 PIT reform: -0.3 (2008), -0.3 (Total) - 2007 CIT reform: -0.5 (2008), -0.1 (2009), -0.6 (Total) - Elimination wealth tax: -0.2 (2008), -0.2 (Total) - Increase fuel, tobacco tax and other: 0.2 (2008), 0.2 (Total) - Expenditure (- stimulus): -1.2 (2008), -3.4 (2009), -4.6 (Total) - Local Investment Fund (Plan E): -0.7 (2008), -0.7 (Total) - Other stimulus: -0.3 (2008), -0.3 (Total) - ALMPs and unemployment support: 0.0 (2008), -0.2 (2009), -0.2 (Total) - Public works: -0.2 (2008), -0.2 (Total) - Primary current expenditure pressure: -1.0 (2008), -2.1 (2009), -3.1 (Total) - Total (- stimulus): -2.9 (2008), -4.3 (2009), -7.2 (Total) ### Recession severity, sectoral impacts, and macro dynamics - Recession characteristics: - Output fell somewhat less than the euro area average but was still very substantial. - Output decline driven by sharp declines in investment, exports, and private consumption; weaker imports and rising government demand provided some offset. - Domestic demand contracted much more sharply than in the euro area; net exports improved substantially. - Hardest hit sectors: industry and construction/real estate. - The recession ended in the first quarter, when output grew by 0.1 percent, quarter-on-quarter. - Spain: Staff Medium Term Outlook—Baseline Scenario (Real GDP and components, Percent) - Real GDP: 2007 3.6, 2008 0.9, 2009 -3.6, 2010 -0.4, 2011 0.6, 2012 1.7, 2013 1.9, 2014 1.9, 2015 1.8 - Total domestic demand: 4.2, -0.5, -6.0, -1.5, -0.4, 1.1, 1.5, 1.8, 1.8 - Private consumption: 3.6, -0.6, -4.9, 0.4, 0.8, 1.4, 1.4, 1.3, 1.4 - Public consumption: 5.5, 5.4, 3.8, 0.6, -1.1, -1.3, -1.3, 1.0, 1.3 - Fixed investment: 4.6, -4.4, -15.3, -8.0, -2.9, 2.8, 4.4, 3.5, 3.3 - Net exports (contribution): 2/ -0.9, 1.4, 2.8, 1.1, 0.9, 0.5, 0.4, 0.2, 0.1 - Exports: 6.6, -1.0, -11.5, 7.0, 4.3, 4.6, 4.8, 4.9, 5.1 - Imports: 8.0, -4.9, -17.9, 2.1, 0.6, 2.6, 3.5, 4.3, 4.9 - CPI inflation, pa: 2.8, 4.1, -0.3, 1.4, 1.3, 1.2, 1.4, 1.6, 1.8 - Unemployment rate, pa: 8.3, 11.3, 18.0, 19.3, 18.7, 18.0, 17.3, 16.6, 16.0 - Potential growth: 2.7, 2.4, 1.3, 0.3, 0.3, 0.5, 0.8, 1.1, 1.4 - Output gap: 3.9, 2.3, -2.7, -3.5, -3.2, -2.1, -1.1, -0.4, 0.0 - Current account balance: -10.0, -9.7, -5.4, -4.9, -4.3, -3.9, -3.6, -3.5, -3.5 - Comparative growth forecasts (2010 onward): - IMF staff: -0.4 (2010), 0.6 (2011), 1.7 (2012), 1.9 (2013) - Ministry of Finance (MoF): -0.3 (2010), 1.3 (2011), 2.5 (2012), 2.7 (2013) - Bank of Spain 1/: -0.4 (2010), 0.8 (2011)... - EC 1/: -0.4 (2010), 0.8 (2011)... - OECD: -0.2 (2010), 0.9 (2011)... - Consensus 1/: -0.4 (2010), 1.0 (2011)... - Notes: 1/ Do not include the effect of the fiscal package announced in May. ### Labor market adjustment and wages - Labor market adjusted mainly in quantities; unemployment soared: - Unemployment rose to 20 percent, affecting mostly temporary workers and youth. - Labor force participation started falling. - Spain has the highest sensitivity of unemployment to output growth among advanced economies—partly related to the large share of temporary workers. - Productivity improved, helping narrow the gap in unit labor costs. - Wages started moderating recently with the conclusion of a three-year wage agreement between social partners. - Prior to moderation, labor costs continued to grow strongly due to previously contracted substantial wage increases. ### Property bubble correction and housing market dynamics (Box 1) - Peak and overvaluation: - At their peak in 2007, prices were some 20‒30 percent above their long-run equilibrium. - Construction comprised about 9½ percent of GDP in 2007 compared to a euro area average of 5½ percent. - Price correction and remaining downside: - “Official” real prices down about 13 percent since the peak, suggesting at least another 10 percent still to fall. - Other price series (asking prices, prices of second hand properties) suggest the “true” market price may have fallen by more. - Recent stabilization may be driven by temporary factors: increase in the VAT rate from July and removal of mortgage interest relief for most taxpayers from next year. - Considerable variation in price declines, with coastal areas more heavily affected. - Supply adjustment and overhang: - Annual housing finishes around 425,000 units and new housing permits at 111,000 units compared to 650,000 units for both finishes and permits in 2007. - An “overhang” of property at some 700,000 units and an equilibrium demand for property of 400,000 units would imply another two to three years before supply conditions normalize. ### Private sector indebtedness and external adjustment - High indebtedness and deleveraging: - Household and corporate indebtedness reached about 210 percent of GDP in 2009, significantly higher than the euro area average of around 160 percent. - A sharp correction has started: households became net lenders and companies substantially reduced net borrowing. - Private saving rate jumped to 25 percent of GDP. - Private investment fell markedly. - Corporate deleveraging most intense in construction and real-estate companies, but overall debt levels remain high compared to the euro area. - External imbalances narrowed sharply: - Current account improved significantly as private sector net savings rose and public savings weakened. - Trade balance improved largely through declining imports and falling oil prices. - Adjustment in the current account likely largely structural, reflecting unwinding of the housing boom and return of private saving rates to more sustainable levels. - More recently the current account balance has begun to stabilize as import growth picked up. ### Outlook: baseline and uncertainty - Staff projection (central scenario): - Recovery expected to be weak and fragile; slower and more fragile than the euro area. - Growth remains slightly negative in 2010 and weakly positive thereafter, rising gradually to a range of 1½ to 2 percent over the medium term. - Domestic demand recovers only slowly due to uncertainty, high unemployment, need to reduce indebtedness, and large-scale fiscal consolidation. - Inflation remains subdued despite energy-driven rebound and VAT increase. - Unemployment stays high; potential growth weighed down by slowing population growth, reduced immigration, high unemployment, and moderate investment. - Upside and downside risks: - Upside: household consumption could grow more rapidly; stronger partner-country growth and weaker euro could boost exports. - Downside risks: - Economy may essentially stagnate if regaining competitiveness and private sector deleveraging take many years and negative feedback loops between deleveraging, fiscal consolidation, and confidence are stronger than envisaged. - Domestic failure to implement fiscal consolidation or an external shock (e.g., intensification of market stress for peripheral euro area countries). If distress were to spread to Spain, given its systemic importance, the impact on the rest of Europe and globally could be substantial. - Empirical note: The average conditional probabilities of distress in European sovereign debt markets, given distress in Spanish government debt, are higher than those under Greek distress. ### Political context and authorities’ views - Political constraints: - General elections not due until 2012; local elections due in 2011. - Governing socialist party does not have a majority; May fiscal package passed by one vote. - Many regions are controlled by the opposition. - Authorities’ outlook: - Government sees a significant recovery, especially in outer years, with growth reaching 2.7 percent by 2013 and the output gap closing by 2014. - Government’s rebound driven chiefly by: - Stronger export growth, including expansion to markets outside the euro area. - Stronger household consumption as the savings ratio falls back more quickly and household financial wealth strengthens. - BdE’s forecast for growth in 2011 aligns more with staff, with lower private consumption and export growth than the Ministry of Economy and Finance. ### Policy agenda: rebalancing the economy and boosting confidence - Key policy priorities: - Fiscal consolidation and pension reform to put public finances on a sustainable footing. - Making the labor market more flexible to promote employment and its reallocation across sectors. - Banking sector consolidation and reform to cement soundness and confidence in the financial system. - Reform synergies and urgency: - Broad reforms across sectors would produce synergies (e.g., labor market reform plus product/service market liberalization would boost investment and employment and reduce prices, easing fiscal consolidation and strengthening banks). - Heightened risks and heavy potential costs make reforms especially urgent; imperative to adopt a pro-active, comprehensive, and credible strategy to secure market confidence. - Broad political and social support would greatly help secure confidence. - International precedents and institutional mechanisms: - Other countries have implemented path-breaking fiscal and structural reforms (Canada, Australia, United Kingdom, New Zealand, Ireland, Netherlands). - Examples of institutional mechanisms: independent commissions to set agendas (France’s Attali Commission; Australia’s Productivity Commission), public finance monitors (Sweden’s Fiscal Policy Council), and pacts with social partners (Netherlands’ Wassenaar agreements). *Source: _cr10254 - 6. The authorities pursued a two-stage approach to ease financial sector stress. At* ### 21. Spain has started ambitious fiscal consolidation to reach the 3 percent of GDP ### 21. Spain has started ambitious fiscal consolidation to reach the 3 percent of GDP ### Fiscal consolidation measures and near-term stance - Objective: reach the 3 percent of GDP deficit target by 2013. - Measures implemented (2010 Budget, Stability Program, and May fiscal package): - Increases in VAT rates and personal income tax. - Greatly restricted hiring; cuts in selected transfers and subsidies; reduced public investment. - May package included cutting public sector wages (signaling effect on private sector). - New fiscal package strengthened adjustment and front-loaded the path, with nearly two-thirds of the required adjustment achieved by 2011. - Breakdown of Government's Fiscal Plan 2010–13 (percent of GDP and euro items reported in source tables and text): - Total adjustment figures shown as "Total8.2Total6.0" and "Measures6.0Revenue measures1.3" in source tables. - Specific measures identified in source: Suspension of 400 euro PIT deduction 0.4; Increases in VAT rates and excise tax 0.8; Reversal of stimulus program 2.5; Local Investment Fund 0.8; Stimulus Fund for Economy and Employment 0.3; Extension of €420 unemployment benefit 0.1; Lower CIT-SMEs 0.1; Others (extraordinary deferrals, etc) 1.2; Budget 2010 - current spending cuts 0.8; 2010 Immediate Action Plan 0.5; 2011-13 Expenditure Review Plan 1.9; May 20, 2010 measures 1.5 (including 5 percent wage cut 0.4, No pension adjustment 0.1, Elimination baby-check 0.1, Investment cuts 0.4, Others (ODA, Farm. expenses, Regions) 0.5). - Government financing needs: - Central government gross financing needs for 2010: €219 billion (21 percent of GDP). - Gross financing need for 2011: about €226 billion (21 percent of GDP). ### Staff projections, differences with official plans, and debt outlook - Staff fiscal projections versus Revised SGP 2010-13 projections (selected figures as reported): - Revised SGP revenue (billions of euros): 365.0 (2009), 376.0 (2010), 396.4 (2011), 422.9 (2012), 453.0 (2013). - Staff revenue (billions of euros): 365.0 (2009), 376.0 (2010), 387.5 (2011), 404.1 (2012), 423.7 (2013). - Revised SGP overall balance (billions of euros): -117.6 (2009), -97.9 (2010), -64.7 (2011), -49.7 (2012), -35.0 (2013). - Staff overall balance (billions of euros): -117.6 (2009), -97.9 (2010), -73.9 (2011), -71.9 (2012), -66.8 (2013). - Revised SGP overall balance (percent of GDP): -11.2 (2009), -9.3 (2010), -6.0 (2011), -4.4 (2012), -3.0 (2013). - Staff overall balance (percent of GDP): -11.2 (2009), -9.3 (2010), -7.0 (2011), -6.6 (2012), -5.9 (2013). - General government debt (Revised SGP, percent of GDP): 53.2 (2009), 63.5 (2010), 68.5 (2011), 70.4 (2012), 70.5 (2013). - General government debt (Staff, percent of GDP): 53.2 (2009), 63.3 (2010), 70.6 (2011), 75.8 (2012), 79.8 (2013). - Staff assessment of targets: - Staff projects fiscal deficit to decline to 9.3 percent of GDP in 2010 (in line with target), but only to 7 percent of GDP in 2011 (1 percent of GDP above the target). - Gap widens to around 2½ -3 percent of GDP in 2013 on announced policies. - Staff projects the debt ratio to continue rising to about 85 percent of GDP by 2015 under the baseline scenario. - Even under an “active” scenario where government deficit targets are met, debt ratio still increases slightly in 2013; further consolidation in 2014 of about ½ percent of GDP would be required to start reducing the ratio. ### Risks to consolidation - Macro assumptions and growth risks: - Envisaged adjustment relies on potentially optimistic macroeconomic projections (especially nominal GDP growth); staff uses less buoyant projections and notes significant downside risk. - Tax base and cyclical risks: - Tax base could recover more slowly: household savings may remain higher and consumption weaker given high indebtedness and expected interest rate increases. - Without labor market reforms, employment recovery may be protracted, hurting labor tax base. - Spending restraint challenges: - Government program envisages de facto freeze on primary expenditure between 2009–13. - Historical context: since 1996, primary spending has risen at an average pace of about 7.2 percent a year. - Sub-national government role: - Beyond 2011, the lion’s share of consolidation is expected at the level of sub-national governments, where the bulk of spending occurs. - Market confidence and financing risks: - Spain’s financing requirements are large; retaining market confidence is critical. - Required adjustment would be larger if yields were to rise significantly. ### Policy recommendations and institutional measures - Near-term actions recommended by staff: - Make macroeconomic projections more prudent. - Prepare additional measures to ensure targets are attained. - Protect the most vulnerable while pursuing further reductions in current spending and investment and reducing tax benefits. - Consider further raising still relatively low VAT and excise rates. - Support such measures with structural reforms to support growth. - Institutional recommendations: - Adopt more cautious macroeconomic projections to minimize over-transfers to regions and incentivize local revenue efforts and efficiency. - Institutionalize spending review processes to improve quality and durability of spending reductions. - Consider establishing an independent fiscal council (examples: Sweden, Belgium) to provide objective analysis of fiscal developments and long-term sustainability. - Increase coordination and monitoring of sub-national government borrowing and actions. ### Longer-term outlook, sustainability, and pensions - Aging and long-term fiscal pressure: - Costs associated with aging projected to rise by 9 percent of GDP through 2060 (above EU average), largely reflecting a relatively high increase in pension expenditure. - Combining long-run projections yields a deeply negative public sector net worth of some 200 percent of GDP in 2010, a deterioration from minus 40 percent of GDP in 2007. - Eliminating this gap would require an upfront permanent improvement in the primary balance of close to 5 percentage points of GDP, in addition to the projected turnaround by 2013. - The European Commission classifies Spain as high risk regarding long-term sustainability. - Pension reform recommendations: - Major adjustments needed: raising the retirement age, increasing incentives to work in old age, and adding an explicit link between benefits/retirement age and changes in life expectancy. - Government proposal in Stability Program (January 2010) included gradually increasing retirement age from 65 to 67 years. - Other changes discussed: extending period of earnings history used to calculate benefits and limiting use of early retirements. - Recommendation to adopt mechanism automatically linking key pension parameters to life expectancy, in line with European peers. - Staff view: such reforms would boost fiscal sustainability without undermining growth and should be quickly adopted. ### Competitiveness and real sector: diagnosis and policy - Competitiveness gap and external position: - Competitiveness gap (adjustment in real effective exchange rate needed to stabilize international investment position): around 14 percent. - Real effective exchange rate measures through 2009 indicate an appreciation of about 20 percent since euro adoption in 1999 (about half due to relative price developments, rest driven by nominal effective exchange rate). - Current account deficit remains above the 3 percent level that would stabilize Spain’s international investment position at its highly negative 2008 level. - Export market share has been maintained, but export-to-GDP ratio is low and import penetration is relatively high. - Labor market diagnosis: - Underlying “structural” unemployment rate is about 14 percent. - Labor market is highly dual: about a third of the labor force in fixed-term contracts. - Wage bargaining system limits wage and firms’ flexibility; wage agreements negotiated at industry and province levels and automatically extended without much opt-out scope. - High degree of wage indexation relative to peers causes high wage drift and reduces sensitivity of real wages to labor market conditions. - Severance and dismissal practices: source table shows severance/compensation comparisons across tenures and countries; in discussions the large majority of dismissals are treated as unfair in Spain. - Recommended labor and product market reforms: - Undertake a radical, ambitious, and comprehensive overhaul to change labor market dynamics. - Specific measures: - Reduce duality and encourage permanent hires by lowering severance payments to at least EU average levels, having a more gradual increase in severance in early years of tenure, and preventing excessive use of unfair dismissals. - Boost wage flexibility and employment by coupling reduced protection of permanent contracts with decentralizing wage setting (for example moving to an “opt-in” rather than “opt-out” system for collective bargaining) and eliminating indexation. - Assessment of proposed social partner agreement: - Government proposal includes encouraging permanent hires, flexible working hours, improved labor intermediation, and youth employment measures. - On employment protection, proposal under discussion generalizes 33 days (per year of service) severance pay for unfair dismissals (instead of 45 days) and makes the 20 day cost for fair dismissal more widespread. - Staff view: these reforms are positive but fall short of a necessary “regime change” and do not address the wage bargaining system; further, reforms should not increase fiscal cost nor make temporary employment more difficult in the near term. - Government should follow through with a more fundamental reform, including changes to the wage bargaining system. ### Authorities’ views (as reported) - Authorities emphasized commitment to achieving deficit targets and viewed staff’s macroeconomic scenario as overly pessimistic. - Authorities considered measures adopted sufficient and stood ready to take additional actions if required (May 2010 fiscal package as example). - Authorities believed there was sufficient scope on both revenue and expenditure sides if needed; pension reform had been initiated but cross-party support would require months. - Authorities viewed existing fiscal frameworks as sufficient and were not convinced an independent fiscal council would be useful; they stressed accountability of existing institutions and role of international organizations. - Authorities agreed increased coordination with sub-national governments is key and stressed existing arrangements and newly enhanced monitoring/control mechanisms for regional borrowing should be sufficient. *Source: _cr10254 - 21. Spain has started ambitious fiscal consolidation to reach the 3 percent of GDP* ### 35. Commendable progress on product and service market reform needs to continue. ### 35. Commendable progress on product and service market reform needs to continue. ### Progress on product and service market reform - Much progress achieved recently in reducing the state’s involvement in business operations and administrative burdens, and in reforming railways, roads, and retail (Figure 14). - The authorities have transposed the EU Services Directive into law (though implementation will be critical). - A Sustainable Economy draft bill has been submitted that will, among other reforms, partially eliminate incentives for buying houses and promote the rental market. - Priority areas going forward: - further reduce restrictions on retail trade; - further reduce restrictions on professional services; - further reduce restrictions on the rental market. - Reviewing the insolvency framework may also be warranted. ### Authorities’ views on structural reforms - Authorities agreed with the need for growth-enhancing structural reforms. - Authorities recognized Spain has a competitiveness gap, but judged it smaller than staff estimates, citing: - robustness of Spanish export market shares; - expected continued improvement in the current account following the natural unwinding of the housing boom; - recent improvement in productivity and moderation in wages. - On the labor market, the government emphasized the importance of including the social partners in reform while being ready to act in the absence of agreement. - The BdE’s views were closer to staff on the labor market and saw the need for a more rapid and fundamental reform. ### Financial sector outlook, vulnerabilities, and scenarios - The financial sector outlook remains difficult and vulnerabilities elevated. - Aggregate position: Spanish banks report solid capital and provision buffers, but risks remain elevated and unevenly distributed across institutions. - Adverse scenario projections: - unemployment climbs to 24½ percent by 2011; - house prices fall another 15 percent; - NPLs are projected to peak at 7－8 percent in 2011. - Taking into account repossessed assets, securities investments and prudent loss-given-defaults, and assuming pre-provision income more than halves over the 2010–12 period, the gross drain on capital could reach: - €5 billion for commercial banks; - €17 billion for savings banks. - These drains correspond to: - some 2 percent of GDP; - 5 and 22 percent of Tier 1 capital respectively. - Comparison: substantially less than the €99 billion maximum potentially available under the FROB. - Complication: much of banks’ repossessed real assets is land, which is particularly difficult to value. ### Funding, profitability, and liquidity risks - Despite EU and ECB measures, funding and profitability pressures loom. - Funding: generally medium-term maturity, but market conditions remain difficult and access limited—especially for smaller banks and for term funding. - As of end-2009, the system has sufficient liquid assets, including ECB eligible collateral, to broadly cover debt maturing at least during 2010. - Further strains may arise from: - unwinding of exceptional ECB liquidity measures; - ending of the funding guarantee scheme; - intense competition for deposits. - Consequences: declining private sector deposits, lower earnings due to weak credit growth, higher provisioning for troubled assets, and the system’s overcapacity will likely pressure profitability. ### Consolidation, diagnostics, and policy actions for banks - Consolidation needs to accelerate to reduce overcapacity and produce more robust institutions. - Progress under the aegis of the FROB has been too slow, though recent agreement between the two main political parties and the announcement of additional mergers is encouraging. - Much more progress needed before the FROB deadline of end-June 2010; thereafter mergers/integrations need to deliver envisaged gains (cost reduction, stronger profitability and capital buffers). - The BdE should be prepared to intervene promptly if pockets of weakness remain. - To enhance investor confidence, a comprehensive and transparent bank-by-bank “diagnostic” based on conservative assumptions on asset valuation and prospects could help. - A brief extension of the “capital support” window of the FROB might be warranted in this context. ### Reform of savings banks - The legal framework of savings banks should be updated for the new economic context. - Current framework limitations: - cross-region mergers still need regional government approval; - sector remains closed to external investors; - capacity to raise external capital remains limited, putting public funds at risk. - Legislative and policy priorities: 1. reduce political influence in savings banks; 2. enhance their ability to raise external capital; 3. offer an opportunity to transform into stock-holding companies, and require this for systemically important savings banks. - Reform should be implemented promptly to strengthen consolidation and provide savings banks with full options to raise capital as soon as possible. - Authorities: political consensus to put forward a legal reform by the end of July. ### Staff appraisal and policy recommendations - The necessary adjustment is underway and output has stabilized: current account deficit has halved as private savings surged and housing investment fell; competitiveness has begun to improve; fiscal deficit is beginning to fall; output rose slightly in the first quarter. - Recovery outlook: likely weak and fragile; growth projected to rise gradually to 1½‒2 percent in the medium term. - Factors weighing on domestic demand: continued uncertainty, high unemployment, deleveraging and fiscal consolidation. - Policy should focus on: 1. fiscal consolidation to put public finances on a sustainable footing; 2. making the labor market more flexible to promote employment and its reallocation across sectors; 3. banking sector consolidation and reform to cement the soundness and efficiency of the system. - Fiscal policy: - Ambitious fiscal consolidation is underway. - To achieve the implied 10 percent of GDP improvement in the primary balance from 2009 to 2013, the government has taken a wide range of concrete and bold measures. - The envisaged deficit path implies cutting the deficit by more than five percentage points of GDP in 2010 and 2011 and is appropriately front-loaded. - To make targets more credible, macroeconomic projections should be more prudent and additional measures prepared; these should be supported by a bold pension reform, along the lines proposed by the government in its Stability Program. - Stronger fiscal frameworks could help: mechanisms to enhance incentives for compliance by regions, institutionalizing spending review processes, and an independent fiscal council. - Labor market: - A radical overhaul is urgent and needs to be ambitious and comprehensive. - Specific measures include: - reducing duality and encouraging permanent hires by lowering severance payments to at least EU average levels, having a more gradual increase in severance payments in early years of tenure, and preventing excessive use of unfair dismissals; - boosting wage flexibility and employment by coupling reduced protection of permanent contracts with decentralizing wage setting and eliminating indexation. - Care is needed that reforms do not increase the fiscal cost or make temporary employment more difficult in the near term. - Banking sector: - Banking sector remains sound but under pressure; risks concentrated mainly in savings banks. - Savings bank consolidation needs to accelerate; Bank of Spain should be prepared to intervene promptly if pockets of weakness remain. - A comprehensive and transparent bank-by-bank diagnostic based on conservative assumptions could enhance investor confidence. *Source: IMF staff report content unit _cr10254 - 35. Commendable progress on product and service market reform needs to continue.* ### 51. The legal framework of savings banks should be updated for the new economic ### _cr10254 - 51. The legal framework of savings banks should be updated for the new economic context. ### Findings - Performance among savings banks is highly diverse and the sector has an important role to play, but the current legal structure is not well suited to Spain’s needs going forward. ### Policy recommendations - The legislative and policy priority should be to: - (1) reduce political influence in savings banks; - (2) enhance their ability to raise external capital; and - (3) offer an opportunity to transform into stock-holding companies, and, indeed, requiring this for systemically important savings banks. ### Implementation timing - This reform should be implemented promptly so savings banks can have the full range of options to raise capital as soon as possible. *Source: _cr10254 - 51.* ### 52. It is proposed to hold the next Article IV consultation on the regular 12-month ### _cr10254 - 52. It is proposed to hold the next Article IV consultation on the regular 12-month ### Spain and the global financial crisis — key findings - "Unemployment soared despite an average output fall." - "Spain experienced the largest deficit increase in the euro area." - Housing and construction - "Housing price adjustment has been slow..." - "Construction output and employment contracted sharply." - Figure indicators (selected) - House Prices (Index, 1999q1=100): timeline shown 1999–2009 with Spain, France, Germany, Euro area, Ireland, UK comparison. - Change in Unemployment Rate (percentage points) versus Output Loss 2009q4/2007q3 (percent): cross-country comparisons include AUT, BEL, EA, FIN, FRA, DEU, GRC, IRL, ITA, NLD, PRT, ESP, UK, US. ### Underlying macroeconomic weaknesses - External and sectoral imbalances - "Spain accumulated one of the most negative IIPs among advanced economies." - "Households and corporations are highly indebted." - "Wage increases were high despite very low productivity growth..." - "…leading to sustained large current account deficits, like in other Southern euro area countries." - Bank funding and structure - "Banks have relied significantly on wholesale credit markets to fund their activities." - "Savings banks have become more prominent." - Funding composition, 2008 (percent of total assets) — cross-country bars include LUX, ITA, PRT, AUT, DEU, IRL, ESP, FIN, BEL, GRC, FRA, NLD. - Net IIP, 2008 (Percent of GDP): Portugal, Spain, Greece, Ireland, Italy, Austria, Finland, US, France, Euro Area, UK, Germany, Netherlands, Belgium, Luxembourg shown with Spain among most negative. ### Financial sector indicators and vulnerabilities - Credit and asset quality - "Credit to the private sector plunged and the loan to deposit ratio converged." - "NPLs have increased sharply from a low base and the provision buffers waned..." - "…while funding costs are rising." - Liquidity and market indicators - "Spanish banks went from being below-average to average users of ECB liquidity facilities..." - "…and rapidly rebuilt their government bond portfolio." - Bank-level stress signals - Santander and BBVA: "stock prices outperformed peers ... but their CDS recently increased, reflecting also higher sovereign risk." - "The banks have large amortizations falling due." - Some cajas and private banks show "troubling CDS spreads" and increased "probabilities of default." - Selected quantitative bank indicators (Table 2, years 2005–2009) - Own funds to risk-weighted assets: 11.0, 11.2, 10.6, 11.3, 12.2 - Tier 1 capital to risk-weighted assets: 7.9, 7.2, 7.6, 8.5, 9.7 - Non-performing loans (EUR bn): 9.6, 10.9, 16.3, 63.1, 93.3 - Non-performing to total loans: 0.8, 0.7, 0.9, 3.4, 5.1 - Provisions to non-performing loans: 255.5, 272.2, 214.6, 70.8, 58.7 - Exposure to construction sector (EUR bn): 262.8, 378.4, 457.0, 469.9, 453.7 - Use of ECB refinancing (EUR bn): 30.3, 21.2, 5.2, 2.3, 92.8, 81.4 (sum of operations end of period noted in footnotes) - Loan-to-deposit ratio: 129.7, 131.9, 133.1, 130.6, 129.5 - Macroeconomic context (from same table): Real GDP growth 2005–2009: 3.6, 4.0, 3.6, 0.9, -3.6; Unemployment rate 2005–2009: 9.2, 8.5, 8.3, 11.3, 18.0; Current account (in percent of GDP) 2005–2009: -7.4, -9.0, -10.0, -9.7, -5.4. - Market indicators (end-period, selected) - IBEX 35 % changes: 18.2, 31.8, 21.8, 7.3, -39.4, 29.8 - CDS (spread in basis points) for Spain: 3.1, 2.7, 12.7, 90.8, 103.8 ### Fiscal developments and sustainability concerns - Crisis impact and fiscal deterioration - "The largest deficit increase in the euro area ..." - "Growing concern about the sustainability raised spreads... and resulted in downgrading by rating agencies." - Despite large deficit increase, "…but a low debt ratio." - Fiscal trends 1995–2009 (Figure 6) - Public debt and overall balance: "The fiscal balance turned down sharply and debt rose... in all levels of governments ... as revenue dropped and expenditure surged." - "Housing downturn led to a sharp erosion in the tax base... while primary current expenditure soared.. resulting in a large deterioration in the structural balance." - Table 4 (General Government Operations 2007–15, SGP 2010–13 with May Package; Staff projections) - Revenue (billions of euros), selected years: 2007 432.8; 2008 402.7; 2009 365.0; 2010 376.0; 2011 396.4; 2012 422.9; 2013 453.0 - Primary balance (billions of euros): 2007 37.0; 2008 -27.0; 2009 -98.8; 2010 -74.9; 2011 -37.0; 2012 -17.0; 2013 1.9 - Interest (billions of euros): 16.9, 17.2, 18.9, 23.0, 27.7, 32.7, 36.9 - Overall balance (percent of GDP): 2007 1.9; 2008 -4.1; 2009 -11.2; 2010 -9.3; 2011 -6.0; 2012 -4.4; 2013 -3.0 - Government debt (percent of GDP): 2007 36.1; 2008 39.7; 2009 53.2; 2010 63.5; 2011 68.5; 2012 70.4; 2013 70.6 - Structural balance examples: -1.1 (2007), -4.8 (2008), -9.3 (2009); later projections: -7.8, -5.6, -5.7, -5.4, -5.1, -4.9 - Public consumption (percent of GDP) 2007 18.4; 2008 19.4; 2009 21.1; 2010 21.3; 2011 20.5; 2012 19.6; 2013 18.7 ### National accounts, demand composition, and projections - Table 1 selected projections and historicals (2005–2011, plus later projections) - Real GDP (percent growth): 2005 3.6; 2006 4.0; 2007 3.6; 2008 0.9; 2009 -3.6; 2010 -0.4; 2011 0.6 (further years show modest recovery in projections) - Private consumption: 4.2; 3.8; 3.6; -0.6; -4.9; 0.4; 0.8 - Gross fixed investment: 7.0; 7.2; 4.6; -4.4; -15.3; -8.0; -2.9 - Construction investment: 6.1; 6.0; 3.2; -5.5; -11.2; -11.2; -7.5 - Potential output growth (long run HP-filter): 2.8; 2.7; 2.7; 2.4; 1.3; 0.3; 0.3 - Output gap (percent of potential): 1.8; 3.0; 3.9; 2.3; -2.7; -3.5; -3.2 - Household savings (percent of disposable income): 11.3; 11.2; 10.7; 12.9; 18.8; 16.5; 15.3 - HICP (average) percent growth: 3.4; 3.6; 2.8; 4.1; -0.3; 1.4; 1.3 ### Labor market and inflation dynamics - Labor market stresses - "Labor costs continued to grow strongly... and working hours did not adjust downward like in other countries." - "…leading to one of the biggest declines in employment... and sharpest increase in unemployment." - Selected labor statistics (Table 1 / Figures) - Unemployment rate (selected): 2005 9.2; 2006 8.5; 2007 8.3; 2008 11.3; 2009 18.0; 2010 (projection) 19.3; 2011 18.7 - Unit Labor Cost (Whole economy) shows Spain above euro area in 2000–2008 series. - Labor productivity (Whole economy) shows surge helping narrow ULC gap. - Inflation and bankruptcies - "Inflation fell sharply to negative territory... and core inflation remains below the euro area average." - "Even services inflation, traditionally more resilient, has moderated sharply." - "Bankruptcies have surged reflecting falling prices and increasing labor costs." - Bankruptcies (Number) rising significantly through 2005–2010 period shown. ### External accounts and balance of payments - Current account adjustment - "The current account has narrowed substantially as households and corporations have improved their net savings..." - "…yielding a strong improvement of the trade balance... and adjusting to reduced external financing." - Balance of Payments (Table 5, selected) - Current Account (billions of euros): 2007 -105.3; 2008 -106.0; 2009 -57.2; 2010 -51.5; 2011 -45.2; 2012 -42.0; 2013 -40.2 - Current Account (percent of GDP): 2007 -10.0; 2008 -9.7; 2009 -5.4; 2010 -4.9; 2011 -4.3 - Trade Balance of goods and services (percent of GDP): 2007 -6.5; 2008 -5.6; 2009 -1.8; 2010 -1.3; 2011 -0.6 - Exports of goods and services (percent of GDP): 2007 27.2; 2008 26.7; 2009 23.6; 2010 25.8; 2011 27.1 - Imports of goods and services (percent of GDP): 2007 -33.6; 2008 -32.2; 2009 -25.5; 2010 -27.1; 2011 -27.7 - International Investment Position (Table 6) - Net IIP (billions of euros): 2003 -354.3; 2004 -436.4; 2005 -505.5; 2006 -648.2; 2007 -816.8; 2008 -881.3; 2009 -983.4 - Net IIP (percent of GDP): 2003 -45.2; 2004 -51.9; 2005 -55.6; 2006 -65.9; 2007 -77.6; 2008 -81.0; 2009 -93.6 - Assets and liabilities breakdown by component (Direct Investment, Portfolio Investment, Other Investment) provided. ### Structural labor market and competitiveness issues - Labor market structure - "The unemployment rate is very cyclical around a high structural level." - "The labor market is also highly dual, with a very high share of temporary workers." - "The coordination and centralization of wage bargaining is at an intermediate level... limiting wage flexibility." - "Employers hire temporary workers to avoid the high severance payments on permanent contracts." - Temporary employees share and severance payment metrics shown; Spain exhibits high temporary share. - Competitiveness - "Real effective exchange rates show a strong appreciation since euro adoption." - "The export market share has held up......but trend productivity growth has been weak." - REER indices (HICP and ULC basis) and Market Share in World Exports series 1995–2009 provided. - Product market reform indicators - OECD PMR levels and changes across sectors show "Administrative burdens remain heavy while regulation is still high in rail, post, retail, and professional services." - Spain has "made much progress ... especially in railways, road, and retail." ### Projections, scenarios, and balance-sheet assessments - Macro projections and staff estimates (extracted from tables) - Real GDP growth projections and output gap trajectories shown (Table 1, Table 4). - Public finance projections (Table 4) indicate gradual deficit reduction but high debt ratios through 2015. - Balance of Payments and IIP projections indicate continued external liabilities and need for adjustment. - Public sector balance sheet and intertemporal metrics (Table 7) - Financial assets and liabilities aggregates, financial net worth, nonfinancial fixed assets, current net worth, NPV of future primary balances, and intertemporal net worth series presented for 2000–2009. - Memorandum items: Government debt and Nominal GDP levels provided. ### Policy-relevant observations implied by the analysis - Fiscal policy - Large cyclical and one-off deterioration in balances and a rapid rise in debt underscore fiscal adjustment needs; staff projections indicate primary deficits and high interest burdens must be managed to stabilize debt. - Financial sector - Rising NPL ratios, weakened provision buffers, high exposure to construction, increased reliance on ECB funding, and concentrated amortization profiles imply need for strengthened bank balance sheets and liquidity management. - Labor and product market reform - Dual labor market, high temporary employment share, and administrative/product-market rigidities limit adjustment and competitiveness; reforms to reduce segmentation and administrative burdens would support reallocation and productivity. - External adjustment - Improvements in the current account driven by domestic saving increases and import compression suggest continued adjustment but persistent external liabilities require sustained rebalancing. *Source: _cr10254 - 52. It is proposed to hold the next Article IV consultation on the regular 12-month (PDF content provided).* ### 1. The deleveraging of the non-financial private sector poses significant risks for ### 1. The deleveraging of the non-financial private sector poses significant risks for the economic outlook ### A. Overview: macroeconomic risks from deleveraging - Household and corporate indebtedness reached about 210 percent of GDP, significantly higher than the euro area average of 160 percent and a two-fold increase since the inception of the EMU. - Excessive housing investment and expansion in the construction and real-estate sectors were major drivers. - An abrupt adjustment has taken place: households dramatically adjusted their savings and companies sharply reduced their net borrowing. - The correction of these imbalances to more sustainable levels has further to go and the necessary deleveraging constitutes a source of vulnerability for the macro-economic outlook. ### B. Households — indebtedness, assets, and adjustment - Spanish households became heavily indebted, in particular to finance house purchases. - Debt to gross disposable income: - close to 60 percent at the beginning of the decade (below euro area average), - over 125 percent in 2009. - More than three quarters of the increase in liabilities was used to finance mortgage purchases; the overwhelming majority of mortgages are floating rate. - Owner-occupied residences rate at 86 percent (the highest in the euro area). - Variable-rate loans represent over 90 percent of mortgages (compared to an average of 44 percent in the euro area2). - Interest burden: - more than doubled from the start of the decade, - over 7.5 percent of gross disposable income in 2008, - around 6.2 percent in 2009. - Composition and risk features: - About 75 percent of household debt consists of housing, the majority primary residences. - Riskier products (home equity loans, buy-to-let mortgages) negligible. - Share of mortgages with loan-to-value exceeding 80 percent has been limited. - Distributional vulnerabilities: - Indebtedness increased by 30 percent between 2002 and 2005 for the median indebted household; around 40 percent for low income and 50 percent for medium-high income groups. - For the poorest indebted households, debt payment increased from 30 percent of gross disposable income in 2002 to 38 percent in 2005. - For about a quarter of these poorest indebted households, debt to gross household wealth exceeds 75 percent. - Relatively few low income households have debt: 19 percent in Spain (compared with 53 percent in the US4). - Asset side and net financial worth: - Housing wealth at around 800 percent of disposable income (highest among large OECD countries). - Household financial net worth declined from close to 200 percent of gross disposable income in 2000 to about 110 percent at the end of 2009 (euro area average around 190 percent). - Financial asset allocations dominated by deposits and equity (including mutual funds) – each about 100 percent of gross disposable income – and investments in insurance and technical reserves – about 35 percent of gross disposable income. - Recent adjustment dynamics: - Gross disposable income grew 7 percent per annum before the crisis (compared to less than 4 percent for the euro area), but decelerated sharply after the second half of 2008, including a quarter of outright contraction in 2009:Q3 (and 1 percent increase for the year). - Savings rate: - 11 percent on average over the last decade (compared to 14 percent for the euro area), - spiked to 18.8 percent in 2009 (the largest increase in the EU). - Net borrower position of 3.8 percent of gross disposable income before the crisis reverted to net lender position of 10.3 percent of disposable income in 2009. - During the crisis: shift towards less risky, more liquid financial assets (deposits, increases in mutual funds and insurance technical reserves); liabilities reduced by somewhat less than 1 percent in 2009. - Debt-to-income ratio declined to 125 percent in 2009; debt-to-GDP ratio increased to 86 percent at the end of 2009. - Staff baseline projections and scenarios: - Savings rate likely to remain elevated for the medium-term, gradually declining to a level close to the euro area average (14-15 percent). - As housing investment continues to contract in 2010-11, households’ net lending capacity remains substantial, though gradually declining. - Households will use additional financial capacity partly to build financial assets and partly to reduce debt; portfolio composition to shift towards more liquid and safer investments (currency, deposits, government securities, insurance technical reserves). - New credit to households would remain negative in 2010 and revert to positive afterwards at weak growth rates. - Upside scenario: faster recovery and increased confidence → lower savings rate; if households revert to pre-crisis savings rate of around 11 percent, debt ratios would likely continue to increase (though could be offset by allocating more resources to debt reduction). - Downside scenario: financial market shocks, financial asset price declines, sharper property market adjustment → savings rate remains higher and deleveraging could be significantly more abrupt. ### C. Non-financial Corporations — leverage, investment boom, and adjustment - Corporate leverage and indebtedness grew fast, especially in construction and real-estate sectors. - Total corporate debt in 2009: - about 125 percent of GDP, - over 700 percent of gross operating surplus. - Debt intensity in construction and real-estate: debt to gross operating profit over 1800 percent in this sector in 2008. - Financing structure: - Pre-crisis net borrowing mainly financed by loans and to a lesser extent by issuing new stock; bond finance remained limited. - Bank corporate credit about 90 percent of GDP in 2009 for the entire economy, with approximately half concentrated in construction and real-estate (compared to the average for Germany, France, Italy and UK of 42 and respectively 15 percent5). - Debt service burden: - Increased to almost 30 percent of income in 2008, moderated significantly afterwards. - Construction and real estate: ratio of interest to gross operation profit of 69 percent in 2008 (about double that of other sectors). - Leverage ratios: - Total corporate debt to equity peaked at over 100 percent in 2009. - Debt to asset ratio at over 70 percent in 2009 – 10 percent higher than in the euro area. - Negative net financial worth deteriorated to about 150 percent of GDP at the end of 2009, from about 100 percent at the start of the decade. - Investment boom and sector composition: - Spain’s average investment rate over the last decade of 32 percent of gross value added exceeded the euro area by about 10 percentage points. - At the peak in 2007, Spanish investment rate reached above 30 percent of GDP, roughly equally split between equipment and construction. - Housing investment at its maximum accounted for 9½ percent of GDP. - High investment rates partly reflected catching-up with more capital intensive core European economies and contributed to clusters of diversified, strong companies (IT, aeronautics, energy, chemicals). - Profitability of large listed corporations measured by return on equity and on assets was quite high by euro area standards. - Sharp adjustment during the crisis: - Aggregate net value added average growth rate of 7 percent over the preceding decade (3 percent higher than the euro) contracted by close to 9 percent in 2009 (compared to around 4 percent in the euro area). - Revenue fell; employee compensation and net entrepreneurial income declined significantly; property income receivable provided some mitigation. - Residential investment halved to about 4 percent of GDP; equipment investment declined towards historical average of around 10 percent of GDP. - Net borrowing of Spanish corporate sector deteriorated to over 30 percent of net value added pre-crisis (11 percent of GDP), adjusted to 6 percent of net value added (2.2 percent of GDP) during the recession. - Credit to corporations contracted sharply; loans to non-financial corporations rising at annual rates up to 30 percent by 2007 declined abruptly, causing a reduction in the debt stock in the second half of 2009 (by close to 3 percent). - Companies drew down on stocks of liquid assets (cash and deposits) to mitigate scarcity of bank and market funding. - Corporate vulnerability and defaults: - Contingent claim approach (CCA) analysis indicates increased risk of corporate defaults economy-wide, particularly acute in construction and real-estate. - Based on theoretical BSM default probabilities, Spain ranked slightly above the euro area in 2008. - Using Moody’s KMV, default risk of Spanish listed corporations relatively low compared to Western European peers; however Moody’s KMV shows above average expected default probabilities for construction, real-estate development, tourism and consumer non-durables sectors. - Average one year-ahead BSM default risk in the construction sector exceeded 50 percent in 2008, surpassing the over 30 percent implied default probability in the financial, insurance and real-estate sector. - Actual corporate defaults increased: number of insolvencies in the real estate sector in 2009 was about 9.5 times that registered in 2005, compared with 4.3 times in the non-real estate-related corporate sector8. *Prepared by Adina Popescu (EUR), with contributions from Nikki Sodsriwiboon (MCM). Comments from Dale Gray (MCM), Roberto Blanco and Juan Ayuso (both Bank of Spain) gratefully acknowledged.* ### 11. Going forward, corporate deleveraging to more sustainable levels will require ### 11. Going forward, corporate deleveraging to more sustainable levels will require ### Medium-term baseline scenario and corporate sector trade-offs - Under staff’s baseline scenario for the medium-term, an environment with sluggish growth, weak corporate income and mounting financial debt expenses will force the corporate sector to weigh trade-offs between expanding activity and rebalancing its financial structure. - Deleveraging will continue, in particular in the construction and real-estate sectors, which will substantially shrink their balance sheets, as their contribution to economic growth going forward is going to be modest. - The corporate debt to GDP ratio and other measures of leverage would gradually decline, as the sharp improvement in corporate net borrowing continues and growth starts to gain traction. - Under this scenario: - firms will be forced to deleverage faster, restructure their debts and shed assets; - investment would remain very weak in the medium term. ### Risks to the baseline scenario - Upside risk: - higher demand may boost activity faster, as there is substantial spare capacity; - the construction and real-estate sectors have significantly deleveraged; - a weak euro is boosting international competitiveness. - Downside risk: - risk-premia shocks may increase the interest burden and may constrain the supply of credit. ### Key fiscal and structural targets and context - The government aims to achieve a 3 percent of GDP budget deficit in 2013. - General government deficit amounted to 11.2 percent of GDP in 2009. - Spain’s decentralization and public sector structure: - The current structure of general government includes the central government (incl. social security), 17 Autonomous Communities (ACs, regional governments) at the intermediate level, and the local levels of government (50 provinces and 8,112 municipalities, including 2 Autonomous Cities). - Over 1979-2005 subnational government spending increased significantly, accounting for about a half of total public spending in 2008 and nearly 80 percent of public consumption. - Number of subnational government employees rose from 6 percent of public sector employment in 1983 to 54 percent in 2009. - The ACs are primarily responsible for education and healthcare; local governments are responsible for water and sewerage, waste management, parks, and street lighting. ### Historical fiscal performance of subnational governments - During 1999-2007, real GDP growth exceeded the budget forecast by about ½ percentage point on average. - Despite favorable macro surprises, general government fiscal outturn was only slightly better than budgeted, by 0.1 percent of GDP on average. - The Autonomous Communities (ACs) fiscal outturn was on average 0.3 percent of GDP weaker than budgeted (1999–2007). - With the global financial crisis, subnational underperformance widened to about 2 percent of GDP in 2009. ### Financing system reforms for the Autonomous Communities - The initial funding system based predominantly on a general purposes grant was gradually changed to: - ceded taxes, - revenue sharing in central government taxes, and - a general equalization transfer. - A new financing system approved in December 2009 under the common regime: - increased the share of ceded and shared taxes in total revenue to roughly 90 percent; - allows annual adjustment to reflect any significant demographic changes; - transferred more regulatory powers to the ACs to expand their capacity to decide on the composition and volume of their revenues. - VAT and excise tax revenue are allocated across the regions on the basis of an index of consumption; other taxes are allocated on the basis of several indexes and criteria. - The new funding system specifics: - 75 percent of the tax revenue and about €7.4 billion of the additional resources from the state will fund the Fund to Guarantee Public Services or Guarantee Fund (GF) which will be shared among ACs according to adjusted population. Each ACs will retain the remaining 25 percent of the tax revenue. - The GF ensures that ACs meet their funding needs with the resources assigned under the new model. - ACs will also receive funds from the two Regional Convergence Funds: the Competitive Fund and the Cooperation Fund. - The new funding system will be fully in place in 2011. - Two financing systems coexist: the Basque Country and Navarre have almost full fiscal autonomy, while the other ACs have more limited fiscal autonomy under the “common” regime. ### ACs revenue assignments under the common regime (2009) — selected items (as presented) - Ceded taxes: - Electricity tax: 100 (Admin.: CG; Discretion: No) - Inheritance and gift tax: 100 (Admin.: AC; Discretion: Tax schedule, threshold, and tax credits) - Capital transfer tax: 100 (Admin.: AC; Discretion: Tax rates and tax credits) - Tax on gambling: 100 (Admin.: AC; Discretion: Tax rates, tax base, allowances) - Vehicles registration: 100 (Admin.: AC; Discretion: Tax rates) - Hydrocarbons retail sales: 100 (Admin.: AC; Discretion: Tax rates) - Tax sharing: - VAT: 50 (Admin.: CG; Discretion: No) - Excise taxes: 58 (Admin.: CG; Discretion: No) - PIT 1/: 50 (Admin.: CG; Discretion: Tax schedule, tax credits) - Note: 1/ ACs can set the rate schedule provided the schedule is progressive. Currently, 4 ACs have applied a different rate schedule. ### Local governments: tax assignments (selected) - Owned tax / Admin. / Discretion - Vehicle tax / LG / Tax rates and tax credits - Property tax / LG / Tax rates and tax credits - Economic activities tax / LG / Tax rates and tax credits - Tax on constructions, installations and works / LG / Tax rates and tax credits - Tax on capital gains in urban areas / LG / Tax rates and tax credits - Local governments fund roughly 60 percent of their revenue on municipal taxes, and user fees and charges; the remainder comes from transfers/grants. - Assessment of property values for the main property tax is managed by the central government. ### Fiscal rule and enforcement mechanisms - The Budget Stability Law was approved in 2001 and amended in 2006. - The law was revised to target a fiscal balance over the cycle for the general government, excluding the social security system. - To avoid complexities of defining the cyclical position, the law establishes targets depending on the real growth rate: - a fiscal balance for normal growth between 2 and 3 percent; - a small deficit for low growth; - a surplus (of underdetermined size) for high growth. - For the social security system, it envisages a separate target to ensure its financial sustainability. - Targets for each region are determined by bilateral negotiations; in the event of incompliance, a 3-year financial recovery plan needs to be submitted and approved by the Fiscal and Financial Policy Council (CPFF). - In case of non-compliance, authorization from the central government is required to obtain credit operations abroad or issue public debt. - Additional conditions were introduced to obtain debt authorization and increase transparency by providing the information in a more timely manner. - The CPFF is a consultative body linking the central and regional governments, composed by the Ministries of the central government and representatives of the ACs. The central government has half of the votes of the CPFF. ### Challenges for fiscal federalism and consolidation - Mismatch between revenue and spending growth outlook: - The new financing scheme increased the subnational share of tax revenue, but the revenue outlook is particularly uncertain due to a significant erosion in the tax base (housing market) and higher unemployment. - ACs expenditure is basically structural (health and education) and has rapidly increased; pressure may continue from aging, especially on healthcare. - Optimistic projections risk: - Staff considers the macroeconomic projections underpinning the government’s medium-term fiscal consolidation plans may prove optimistic, especially in outer years when subnational governments are expected to play a larger role. - Recovery in PIT and VAT may only pick up slowly, reflecting permanent erosion in the tax base. - Transfers and grants from the State, linked to the state’s revenue, are also projected to fall. - Need for coordination: - General government budget objectives are set by the central government, while objectives for the subnational governments need to be coordinated in the CPFF and the National Commission of Local Administrations. - Setting individual objectives for each subsector involves negotiation among the sectors. ### International practices on subnational fiscal discipline (summary) - Countries use rule-based approaches focusing on budget balances, debt ceilings or capacity to service debt, and expenditure ceilings. - Many countries use sanctions to foster compliance, including financial sanctions or administrative constraints (e.g., authorization of borrowing operations by the central government). - Effective implementation of such rules requires: - a robust legal basis; - a clear definition of institutional responsibilities; - timely and transparent reporting; - credible enforcement of rules and sanctions. *Source: IMF staff analysis as presented in the provided content.* ### 8. A range of measures could be considered to strengthen the compliance with, and ### _cr10254 - 8. A range of measures could be considered to strengthen the compliance with, and ### Strengthening compliance and credibility of subnational fiscal consolidation plans - Main objective: increase the likelihood that subnational consolidation plans will be adhered to and are credible by increasing the costs (political and economic) of non-compliance. - Emphasis that longer-term fiscal federalism issues (such as the growth rates underpinning the fiscal rule) should be revisited, but the most pressing need is stronger enforcement of existing consolidation plans. ### Policy options and recommendations - Introduce credible penalties/enforcement mechanisms for non-compliance: - Without any penalty for not fulfilling the 3-year financial recovery plan, regions can continue to present new plans every year, postponing adjustment. - Lack of timely information on the ACs’ budget execution has hindered implementing the necessary recovery plan. - Recent decision to tighten the criteria for debt authorization should help, but additional channels for borrowing through ownership and control of local enterprises and banks are difficult to monitor. - Withholding transfers could be an alternative option in case of non-compliance. - Link non-compliance with regional tax rates: - The ACs have not much used their greater regional tax autonomy; discretionary powers for the personal income tax have been only marginally used, although personal income tax accounts for the bulk of their own tax revenues. - To enhance regional accountability, non-compliance with targets could trigger an automatic increase in regional tax rates. - Introduce binding multi-year spending ceilings: - Presently specific constraints exist (for example on personnel—the central government imposes a limit on increases in the number of permanent employees, and sets basic salaries and their annual adjustments for civil servants). - These constraints have been partly circumvented by hiring on temporary contracts. - Adopt more cautious macroeconomic projections: - More prudent projections minimize the risk of excessive transfer to the regions and thus for a “refund” (the difference between the projected and realized taxes) at the settlement after two years. - This would also give more incentive for regions to use their revenue-raising powers to cover required resources or improve efficiency. - An independent fiscal council to set the projections might be helpful. - Change the timing of transfers and settlement: - Consider changing revenue sharing to be directly linked to actual revenue, rather than linking to budget projections for adjustment in two years. - Alternatively, consistent with the recent decision to allow repayment to the central government (negative transfer due to weaker revenue outturn than budgeted) to be distributed in 60 months, any positive transfers should also be conducted in installments; this could prevent fiscal policy being procyclical. - Broadening the coverage of the existing rule: - The Golden rule could be extended to include larger municipalities. ### Notable numeric and procedural details - The excess of taxes allocated to ACs in 2008 amounts to about €6 billion. - Instead of fully paying back in 2010, the ACs will repay in 60 monthly payments from January 2011. - Reference to the existing requirement in one context: total debt service payments (interest and principal) must not exceed 25 percent of current revenue (as noted in the table footnote for certain Autonomous Communities). ### Comparative context (summary of table evidence) - Table 1 summarizes fiscal rules in subnational governments in selected OECD countries, indicating a variety of instruments across countries: budget balance rules, debt rules, expenditure rules, sanctions, monitoring, and enforcement arrangements. - Examples of enforcement/monitoring approaches in the table include fines proportional to shortfalls, committees with regional and central government representation, independent fiscal councils or audit institutions, proposed corrective measures, restrictions on borrowing, and administrative or financial enforcement actions. *Italic: Source — IMF staff text (section 8).* ### 9. An empirical examination finds that the share of temporary workers is boosted ### 9. An empirical examination finds that the share of temporary workers is boosted by high employment protection of permanent workers, high unemployment benefits, a high tax wedge, and low product market regulation ### Empirical findings on temporary employment - High employment protection for permanent workers increases strongly the share of temporary workers, especially the provisions relating to unfair dismissals. - The strictness of regulation of temporary work has an insignificant and not robust impact on the share of temporary workers; simple correlations confirm this. - High unemployment benefits and a high tax wedge presumably operate by reducing labor demand, making it easier for employers to impose flexible contracts. - Lower product market regulation could increase the share of temporary workers for several reasons: - (i) lower product market regulation increases competition and the need for firms to be able to adjust quickly, making it more tempting to hire temporary workers; - (ii) lower product market regulation tends to favor the expansion of services sector, where temporary work is more frequent; - (iii) the lower rents induced by lower product market regulation may prompt firms to reduce labor costs by hiring temporary workers (with lower wages and dismissal costs). - The model explains the share of temporary workers over time in Spain reasonably well (model estimated on a sample of 20 OECD countries during the period 1985-2007 or maximum years available). ### Policy simulations and quantified effects (Spain) - Reform simulations using the estimated model: - Bringing the three components of employment protection of permanent workers to the minimum level observed in the EU15 would reduce the share of temporary workers by respectively 1, 3.5, and 9 percentage points, or a total of 13.5 percentage points. - Table of long-run effects (Average EU15 | Minimum EU15 | Policy Change) — changes in the share of temporary workers (percent): - Unemployment Benefit Replacement Rate: -0.4 | -5.0 | -2.1 - Tax Wedge: 0.0 | -6.9 | -2.2 - Union Density: -1.9 | 0.6 | 0.9 - Product Market Regulation: -0.2 | 0.9 | 1.3 - Subcomponents of EPL (Average EU15 | Minimum EU15 | Policy Change) — changes in the share of temporary workers (percent): - EPL Regular Contracts — Procedural Inconvenience: 0.4 | -1.2 | -1.2 - EPL Regular Contracts — Notice and Severance Pay for Fair Dismissal: -1.3 | -3.5 | -1.7 - EPL Regular Contracts — Difficulty of Dismissal: -1.8 | -8.9 | -4.5 - EPL Temporary Contracts — Fixed Term Contracts: 0.7 | 1.7 | 0.6 - EPL Temporary Contracts — Temporary Work Agency Employment: -0.8 | -1.3 | -0.4 - Policy change definitions: - Policy change is defined as a 10 percentage point reduction for the unemployment benefit replacement rate, the tax wedge and union density, and a one unit reduction for employment protection legislation and product market regulation. ### Relation to unemployment and part-time employment - The unemployment rate and the share of temporary workers are positively correlated: countries with higher shares of temporary workers also have higher unemployment rates. - Regression results: - Most reforms either move unemployment and the share of temporary workers in the same direction (e.g., unemployment benefits and the tax wedge) or affect one without affecting the other (e.g., EPL and the degree of coordination of collective bargaining). - Product market reform is an exception: it seems to reduce the unemployment rate but increase the share of temporary workers, implying product market reform should be accompanied by labor market reform (especially lowering protection of permanent workers). - A higher share of part-time contracts is associated with a lower unemployment rate. Many part-time contracts are voluntary and encourage participation of groups otherwise out of work (e.g., women with children, youth, older workers). Spain has a very low share of part-time contracts, suggesting part-time expansion may be an avenue worth pursuing. ### Policy recommendations and conclusions on labor market reform - Reforms to reduce the share of temporary workers should focus on: - Reducing the employment protection of permanent contracts; and/or - A combination of reductions in the tax wedge and unemployment benefits. - Reducing the tax wedge and the replacement rate of unemployment benefits would also help lower substantially the share of temporary workers. - Different policy mixes can achieve similar results for unemployment and temporary employment: - A fundamental reform toward flexibilization of wage bargaining (collective bargaining decentralization) would substantially reduce unemployment toward the EU15 average. - A combination of reduced unemployment benefits, lower tax wedges, and further product market deregulation would deliver significant unemployment improvements. - Caveats on sequencing and interactions: - Product market deregulation reduces unemployment but increases temporary employment; it should be accompanied by labor market reform, especially lowering employment protection of permanent workers. - Decentralization of collective bargaining and reduction of employment protection on permanent workers likely need to be implemented hand-in-hand; without substantial reduction in employment protection, decentralization may not deliver expected wage flexibility. --- ### Attachment IV. Reforming the Spanish savings banks — selected findings and reform elements ### Overview of the savings banks sector - Spanish savings banks (cajas) are organized as private foundations with no formal owner; five stakeholder groups are identified in governing bodies: depositors, local and regional governments, founders, employees, and other institutions. - Savings banks do not have share capital; equity consists mainly of reserves from retained earnings. - Deregulation since the mid-1970s allowed savings banks to expand activities and geographic presence; branch barriers removed by 1988; compulsory direct lending coefficients abolished in 1992. - Sector heterogeneity: - Two large players (La Caixa and Caja Madrid); - A few medium-sized institutions (Bancaja, Caja del Mediterráneo, Caixa Catalunya) with market share ≥ 2 percent; - 40 small and very small institutions. ### Impact of the global financial crisis on savings banks - Reported NPLs may underestimate loan portfolio deterioration: - Staff estimates repossessed or acquired real estate assets by savings banks amount to around €31 billion, equivalent to 38 percent of Tier 1 capital. - If these problematic assets were included, the NPL ratio for savings banks would increase from 5.3 to 8.6 percent and the coverage ratio would drop from 56 to 34 percent. - Asset valuation concerns: - About 45 percent of repossessed assets is land; the true value of land is particularly uncertain. - BdE increased provisioning applied to real estate assets from 10 to 20 percent if assets are held longer than one year; a proposal to rise the provision to 30 percent after two years (unless an updated appraisal proved it not to be necessary) was issued for public consultation on May 26, 2010. - Profitability pressure: temporary improvement in net interest income was offset by marked contraction of profitability due to provisioning; future pressure from funding costs, lower credit volume, and high loan loss provisioning. - Reliance on official support: - Savings banks hold the lion share of bonds issued with the Spanish government guarantee; almost three-quarters of the total for an amount of € 32.5 billion. - Use of ECB refinancing operations by savings banks estimated to range between 40 and 70 percent of total refinancing operations carried out by Spanish credit institutions. - Restructuring and consolidation developments: - Caja Castilla La Mancha (CCM) intervened by BdE in March 2009 and taken over by Cajastur in November 2009; operation raised market criticisms regarding cost and transparency. - BdE approved merger between Unicaja and Cajasur in June 2009; after negotiations Cajasur rejected the merger and BdE intervened it in May 2010. - A handful of institutions requested financial support from the FROB (subject to EU Commission approval); some cajas launched SIPs and mergers/SIPs have been recently announced. - Legal and governance constraints: - Cross-border mergers still need approval by local authorities; attempts frustrated by political difficulties. - Savings banks remain closed to external investors due to their legal nature, limiting capacity to raise external capital and increasing risk for taxpayer money. - The allocation of regulatory responsibilities between BdE and autonomous communities (ACs) can complicate governance and merger approval. ### Elements of a far-reaching reform - Reform objectives: - Strengthening the oversight and intervention powers of BdE; - Enhancing the ability of savings banks to raise external equity; - Opening savings banks to more dynamic structures of ownership and governance. - Rationale for strengthening BdE oversight: - Opaqueness of ownership and political involvement weakens market disciplinary mechanisms; absence of traded equity and potential takeovers reduces external discipline. - Requirement that mergers and acquisitions between savings banks need AC approval introduces political bargaining that can impede economically advantageous consolidations. - Dual legal framework risks conflicts in supervisory and sanctioning authority; despite cooperation, ambiguity may cause conflicts, particularly in prudential supervision. - Corrective actions affecting shareholders (e.g., calls for cash, suspension of rights) are difficult to apply given stakeholders’ control is not coupled with legal ownership; capacity to raise equity is limited. - BdE has powers to intervene ailing savings banks, but stakeholder control may persist even after intervention; decisions of the board must be validated by the special administrator appointed by BdE. *Source: IMF staff calculations and report content.* ### 11. The attribution of responsibilities between the BdE and ACs needs to be ### 11. The attribution of responsibilities between the BdE and ACs needs to be ### Attribution of supervisory responsibilities - Reform is needed to strengthen the Banco de España’s (BdE) oversight powers over savings banks as consolidation may increase their systemic relevance. - Avoid potential fragmentation of regulatory and supervisory powers by bringing the supervisory framework for savings banks closer to that established for commercial banks. - Recommendation: the legal regime should empower the BdE with the sole responsibility of approving mergers of savings banks, while taking into account the national competition authority’s opinion. ### Enhancing the savings banks’ ability to raise external capital Findings on limitations and implications: - Savings banks’ limitations in raising equity capital have several implications: - (i) they may reduce the scope of these institutions to expand if a particular operation (e.g., a purchase of another institution) requires more capital than what the caja has; - (ii) they seriously limit the capacity to replenish capital if an institution suffers major losses; and - (iii) they deprive savings banks of an instrument (the value of a share) to assess the market’s view on an institution’s performance on a continuous basis. Current capital instruments and market issues: - Savings banks can issue capital instruments but market appetite is limited or their loss-absorption capacity is doubtful. - Capital instruments available: - the cuotas participativas (Tier 1 capital) – equity-like variable income instrument that grants no voting rights to its holder; limits: individual investor’s holding (5 percent) and total amount that an institution can issue (50 percent of capital). In seven years since the legislation was passed, Caja de Ahorro del Mediterraneo has been the only savings bank to have issued cuotas participativas. - Note: The issued cuotas participativas represent 7.5 percent of the equity of Caja del Mediterraneo. - the participaciones preferentes (Tier 1 capital in the case of qualifying preferred participations and Tier 2 capital in the case of non-qualifying preferred participations) – subordinated debt instrument granting fixed dividend rights when issuer obtains profits and no right to dividends when the institution suffers losses. - Events raising doubts about loss-absorption capacity: - securities issued by CCM were bought back at par after the institution was intervened; - Cajasur paid the March 2010 €1.5 million coupon on its €150 million outstanding hybrid capital. Capital requirement pressures: - The forthcoming new Basel agreement is likely to raise the quality, consistency, transparency, and minimum level of bank capital. - Savings banks may find the new regulatory environment more challenging than commercial banks owing to their limited ability to raise external equity capital. Policy options to improve loss-absorbing capital: - Option 1: remove quantitative limits to cuotas participativas and grant representation and voting rights to investors; this would be almost equivalent to issuing equity shares. Caveat: how this form of capital and its remuneration fits with cajas as not profit-distributing organizations is an open question. - Option 2: allow issuance of contingent capital notes (example: Rabobank in the Netherlands), which would probably require defining an appropriate legal framework. ### Strengthening ownership structure and governance Findings on political influence and governance: - Influence of local governments over savings banks has become a macro-financial risk. - Public ownership does not, per se, entail less prudent management if appropriate arms-length arrangements exist; however, political difficulties have delayed consolidation and appointments of top managers at certain systemically important savings banks. - Empirical evidence suggests that chairs of savings banks have not always had sufficient experience in managing and operating credit institutions, contributing to heterogeneity in savings banks’ performance. Policy recommendations to reduce political interference and strengthen governance: - Reduce the number of political representatives in the governing bodies of savings banks as a first step; recognize that political interference can occur through many channels beyond representation on governing bodies. - Enact effective legislation setting out proper and fit criteria to ensure management has appropriate authority and autonomy and that a dividing line is drawn between business/day-to-day decisions and political control. - Ensure a strong, independent supervisory function to enforce fit and proper standards. Legal-structure reform rationale and options: - Rationale: Spain’s economic and financial development has much reduced the rationale for the legal distinction between savings and commercial banks. - Argument: since savings banks behave like commercial banks, offer the same financial services, and can be systemically important, they should probably be commercial banks in all aspects including legal structure. - Advantages of changing legal structure: - clarify ownership structure; - help institutions tap capital markets to raise equity capital; - open consolidation to “outside” investors (Spanish or foreign), reducing the threat to public finances; - increase take-over threat and external shareholder discipline on managers. - Implementation approaches: - voluntary conversion (example: Norway); - mandatory conversion across the board (example: Italy); - conditional mandatory conversion if a savings bank’s market share exceeds a determined threshold. - Empirical note: when savings banks increase in size, economic goals (profit maximization) gain importance over social-oriented ones. Use of FROB resources to incentivize structural change: - The resources of the FROB could be dedicated to savings banks (individual or potential merger) that opt for the stock-holding company option but need additional capital to clean balance sheets from doubtful real estate exposure. - As in the current framework, the FROB would become a shareholder of these “transformed” institutions with the opportunity to sell its participations directly to the market. ### Box: The Fondo de Reestructuración Ordenada Bancaria (FROB) — key features and constraints - Objective: assist and foster reorganization of the Spanish banking industry (Royal Decree Law 9/900). - Initial capital: €9 billion, of which €2.25 billion were contributed by the Deposit Guarantee Funds (Fondos de Garantía de Dépositos, FGDs) and the rest by the state (unused resources from the FAAF). - Leverage capacity: can leverage up to 10 times (i.e. €99 billion). - Two courses of action: integration and restructuring processes. - Capital-support window for integration expires on June 30, 2010. - Integration process: for fundamentally sound institutions needing temporary capital for mergers/takeovers; beneficiaries deemed fundamentally sound when, according to BdE, they do not present weaknesses that can affect viability and have a core capital (capital, reserves, generic provision) ratio of at least 6 percent. - Capital injection form: convertible preference shares cannot exceed 2 percent of risk-weighted assets, except in exceptional circumstances. Subscription by FROB capped to amount necessary to reach a core capital ratio of 8 percent taking into account potential economic losses in a two-year horizon. - FROB securities classification and yield: part of non-core Tier 1; annual yield equal to the minimum between 7.75 percent and the 5-year Treasury bonds plus 500 bp; rate increases by 15 bp each year; interest not cumulative and paid when and to the extent the beneficiary institution has distributable profits. Issuer committed to repurchase preference shares within 5 years. - Conversion trigger: if buy-back period expires and issuer has not repurchased, or if BdE considers buy-back unlikely, FROB will convert securities into ordinary shares and restructuring process will apply. - Behavioral safeguards attached to FROB support: - (i) refrain from non-organic growth (or downsize if FROB subscription exceeds threshold or institution not fundamentally sound); - (ii) align managers’ remuneration to the Commission recommendations; - (iii) enhance cost efficiency; - (iv) cap (or refrain from) dividend distribution. - Penalty: breach of safeguards increases rate of FROB securities by 200 bp. - Restructuring process: for institutions with significant weaknesses; BdE may intervene and appoint a FROB representative as administrator; FROB devises a restructuring plan approved by BdE; possible measures include merger, sale/transfer of assets and liabilities via auction, guarantees, loans at favorable rates, subordinated debt, acquisition of assets, or capital injections. - Legal adjustments to allow FROB operability with savings banks: - law amended to remove current limits on individual holding of cuotas participativas (5 percent) and total amount of cuotas issued (50 percent of capital), and to grant voting power to cuotas issued in favor of the FROB. - Specific transactions to merge credit institutions under restructuring approved by BdE will not require additional administrative authorization other than those required by competition law. - Illustrative facts: - On November 19, 2009, the FROB issued its first bond for €3 billion with a five year bullet maturity and a 3 percent coupon paid annually; issue rated triple-A given unconditional state guarantee. - In exceptional circumstances, the prudential limit of 30 percent of Tier 1 to total issuance of convertible preference shares is waived. - Exceptionally, buy-back period can be extended for two more years at a penalty surcharge of 100 bp per year. *Source: _cr10254 - 11. The attribution of responsibilities between the BdE and ACs needs to be* ### 6.8 years in 2009. As a result, debt rollover over the forecasting period is expected ### _cr10254 - 6.8 years in 2009. As a result, debt rollover over the forecasting period is expected ### Public debt sensitivity and scenario findings - Debt rollover: "6.8 years in 2009." As a result, debt rollover over the forecasting period is expected to be modest. - Growth shock: - "Should growth fall by a little over 1 percentage point over the forecasting period, the debt-to-GDP ratio could reach 108 percent by 2014/15, 13 percentage points higher relative to the baseline." - Euro depreciation and contingent liabilities: - "In the case of a 30 percent nominal depreciation of the euro, after adjusting for domestic inflation, and a contingent liability shock of 10 percent of GDP, the debt-to-GDP trajectory is expected to increase to 105 percent." - "The portion of the government’s liabilities denominated in foreign currencies is small, at less than 2 percent." - Conclusion: "Thus, all else being equal, the impact of a sudden depreciation in the euro exchange rate on the debt profile would be modest." ### Alternative scenarios for external sustainability (summary of impacts) - General statement: - "Despite the large external financing need, growth and current account shocks are expected to have modest impacts on the debt profile, while the impact of higher interest rate is projected to be small." - "Largely as a result of the modest amount of debt denominated in foreign currency – at roughly 5 percent, a sharp depreciation of the currency poses limited risk to the baseline scenario." - Interest rate shock: - "The impact of a permanent ½ standard-deviation shock to the interest rate for all outstanding debt — a 0.6 percentage point increase from the baseline — would increase debt by roughly 4 percentage points to 116 percent of GDP in 2015." - Exchange rate shock: - "A one-time 30 percent depreciation in the euro in 2010 would increase debt by about 5 percentage points to 112 percent of GDP." - Combined shock: - "A permanent ¼ standard deviation shock applied to the real interest rate, growth and the current account balance would increase external debt to 121 percent of GDP by 2015 (9 percentage points more than the baseline)." ### Key numerical projections and comparative boxes (as presented) - Public debt baseline and scenario box numbers (figure annotations): - Growth shock box: "108" (scenario) vs "95" (Baseline) - PB shock box: "105" (scenario) vs "95" (Baseline) - i-rate shock box (public debt figure): "97" (scenario) vs "94.6" (Baseline) - External debt figure annotations: - i-rate shock box: "116" (scenario) vs "112" (Baseline) - Historical / Baseline / Combined shock and other figure boxes repeatedly show baseline "112" for external debt reference in multiple panels. - Combined shock box: "121" (scenario) vs "112" (Baseline) - Currency shock panel: "107" (scenario) vs "112" (Baseline) in one presentation; elsewhere currency shock noted as a "30 % depreciation of euro". - Gross financing need and related labels in figures: - Gross financing need; baseline (right scale); "% of GDP" shown in figures, with baseline and scenarios annotated (no single numeric series summarized in text aside from boxes above). - Selected baseline and scenario averages reported in figure footnotes: - Growth rate: Baseline: "1.5"; Scenario: "0.3"; Historical: "2.6" - Other figure annotations: Baseline: "3.1"; Scenario: "3.7"; Historical: "1.3" (context in figures) ### Policy measures, recommendations, and structural actions described - Fiscal measures: - Parliament approved a fiscal package on "May 20th" to guarantee the "3 percent deficit target by 2013." - The measures "add 1.5 cumulative percentage points in 2010 and 2011, to the initial consolidation plan." - Projected deficits: from "11.2 percent" (end 2009) to "9.3 percent of GDP by end 2010," and to "6 percent of GDP by end 2011." - The package "effectively frontloads 60 percent of the total adjustment in the first two years of the consolidation period (2010-2013)." - Regional coordination: On "June 15th" fiscal targets for regions for 2010-2013 were agreed; "an explicit prohibition to municipalities to raise debt in 2011" introduced. - On "June 16th" the Government approved expenditure ceilings for 2011 with "a 7 percent reduction on preceding budget ceilings." - Monitoring: "Monitoring will detect slippages due to lower growth and additional measures are prepared and will be implemented if the 6 percent or the 3 percent targets were at risk. Any excess receipts will not be used to increase expenditure." - Pension reform: proposal to gradually increase retirement age "to 67 years", strengthen contribution–benefit link, and possibly adjust other parameters. - Labor market reform: - Objectives: a) "to foster the flexibility of firms, both in terms of wages (effectively allowing for the opt out clauses to function) and working conditions" and b) "to reduce the duality in the labor market by generalizing the use of an indefinite contract with 33 days wages per year of service as termination payment (currently 45) and by providing legal certainty and a less burdensome process for the firing of workers on economic grounds." - Financial sector measures: - Consolidation under the FROB (launched in "June 2009") was finalized; "92 percent of the Cajas sector assets (39 out of 45 Cajas) involved in merger operations." - Expected sectoral adjustments: "15 percent reduction in personnel and a 25 percent reduction in terms of branches." - Stress tests: April 2010 GFSR and BoS stress tests "concluded that, even in the most severe scenarios, losses would be contained and FROB resources would comfortably cover them." - Publication commitment: BoS committed to publish bank-by-bank stress tests in the context of the European wide stress tests, "probably on July 23rd." - Regulatory reform: On "July 9th" Government approved reform of the regulatory regime of Cajas to facilitate transformation into banks with professional management and subject to capital markets discipline; some small Cajas may retain legal statute with tailored regulatory burden. *International Monetary Fund, Staff Report for the 2010 Article IV Consultation—Informational Annex (June 30, 2010), excerpts provided in the source content.* ### 3. Outlook ### 3. Outlook ### Overall assessment - The staff and the authorities agree on the broad diagnosis and the policy mix necessary to facilitate recovery, but differ on the pace and specific shape of adjustment; the authorities' analysis is more optimistic on the pace of the recovery. - Progress depends on stabilization of financial market conditions; measures adopted should have a positive impact on consumer and investor confidence and increase aggregate demand, but recovery within the EMU and EU, fiscal consolidation, and banking sector recovery at the European level are important for Spain's prospects. ### Real Estate Sector downsizing - The necessary price correction in housing might be overestimated. - Demand for housing services or for housing as a store of value has been a consistently sound investment. - NPLs in mortgages are below 3 percent, suggesting non-speculative demand factors (population dynamics, size reduction of households). - Supply outgrew demand in 2006 and 2007; the stock of unsold houses, estimated at 700,000, will start to shrink in 2010 but still limits residential investment that will remain negative in 2010 and 2011. - Authorities estimate that within two years trend demand will absorb the accumulated inventory. - The length and speed of the housing adjustment is crucial for the economy. ### Speed of deleveraging - Corporate sector leverage is essentially linked to the Real Estate boom. - Credit to Gross Value Added for the Construction and Real Estate sector reached 439 percent in 2009. - Credit to Gross Value Added for the rest of the non-financial corporations was 62 percent in 2009, compared with a 53 percent average in the Euro Area. - Gross savings rates and net borrowing to GDP rates of non-financial corporations indicate that deleveraging of Spanish firms is well underway. - Household deleveraging might be faster than staff anticipates: - Households financed housing investment with bank debt, increasing real wealth and reducing housing expenses. - If residential rent payments are taken into account, debt service relative to income is moderate. - Interest rates remain at historically low levels: 96 percent of mortgages at variable rates. - Households’ savings ratio has jumped to unprecedented levels, making deleveraging compatible with moderate consumption growth (especially non-durables and services). ### Competitiveness of the Spanish economy - Over half of pre-crisis investment did not go into construction or real estate; high investment helped modernize capital stock and infrastructures. - Price competitiveness indicators tend to overestimate cost and inflation factors as the engines behind the current account deficit and conceal the dual inflation problem (export prices do not rise as those of non tradable). - Ongoing reduction of costs vis-à-vis the rest of the world would contribute to rebalancing, but authorities do not foresee a drastic deflationary process. - It is easy to exaggerate the degree to which cost reduction is necessary in the overall adjustment. ### Authorities' policy response and conditionalities - Authorities have embarked on an ambitious package of measures to facilitate rebalancing and trigger recovery. - Financial market stabilization is required for progress. - Measures are intended to boost confidence and aggregate demand but depend on broader EMU/EU recovery and European-level fiscal consolidation and banking sector recovery. ### Executive Board assessment and recommended policy actions - Directors noted that adjustment is underway and output has stabilized, but growth outlook remains uncertain due to unstable financial markets and weak domestic demand. - Directors welcomed authorities’ decisive policy response and recent reforms to secure market confidence and foster rebalancing. - Continued action recommended on several fronts: - Move ahead with fiscal consolidation and pension reform to put public finances on a sustainable footing. - Strengthen the recent labor market reform to promote employment and its reallocation across sectors. - Follow through on banking sector reform to cement soundness and efficiency of the system. - Directors emphasized that successful implementation requires broad political and social support. - On fiscal policy: - Directors endorsed ambitious fiscal consolidation and welcomed concrete and bold measures; envisaged deficit path considered appropriately front-loaded. - Given uncertainty in macro projections, additional measures should be prepared if needed to make attaining targets more credible. - A bold pension reform and strengthened compliance mechanisms were underscored. - On labor market reform: - Directors welcomed the reform and encouraged further efforts to increase flexibility and competitiveness. - They broadly agreed severance payments should be reduced to at least EU average levels, complemented by clarifying fair dismissal conditions, decentralizing wage setting, and eliminating wage indexation. - On banking sector: - Directors noted that the banking sector remains sound but faces elevated and uneven risks. - They welcomed consolidation of savings banks and reform of their regulatory regime. - They welcomed the authorities’ intention to publish bank-by-bank stress test results, stressing realistic assumptions and a clear strategy to address capital shortfalls. - On product and service market reform: - Directors commended progress and identified priorities: further reduce restrictions on retail trade, professional services, and the rental market. ### Key statistics and projections (selected) - Real GDP (change in percent): 2005 3.6; 2006 4.0; 2007 3.6; 2008 0.9; 2009 -3.6; 2010 -0.4 - Domestic demand (change in percent): 2005 5.1; 2006 5.2; 2007 4.2; 2008 -0.5; 2009 -6.0; 2010 -1.5 - Harmonized index of consumer prices (HICP) (change in percent): 2005 3.4; 2006 3.6; 2007 2.8; 2008 4.1; 2009 -0.3; 2010 1.4 - Unemployment rate (in percent): 2005 9.2; 2006 8.5; 2007 8.3; 2008 11.3; 2009 18.0; 2010 19.3 - General government balance (in percent of GDP): 2005 1.0; 2006 2.0; 2007 1.9; 2008 -4.1; 2009 -11.2; 2010 -9.3 - General government structural balance (in percent of GDP): 2005 -1.6; 2006 -1.2; 2007 -1.1; 2008 -4.8; 2009 -9.3; 2010 -7.8 - Primary balance (in percent of GDP): 2005 2.8; 2006 3.7; 2007 3.5; 2008 -2.5; 2009 -9.4; 2010 -7.1 - General government debt (in percent of GDP): 2005 43.0; 2006 39.6; 2007 36.1; 2008 39.7; 2009 53.2; 2010 63.7 - Money market rate (in percent): 2005 2.2; 2006 3.1; 2007 4.3; 2008 4.6; 2009 1.2; 2010 0.8 - Government bond yield (in percent): 2005 3.4; 2006 3.8; 2007 4.3; 2008 4.4; 2009 4.0; 2010 4.0 - Trade balance (goods and services) (in percent of GDP): 2005 -5.1; 2006 -6.2; 2007 -6.5; 2008 -5.6; 2009 -1.8; 2010 -1.3 - Current account balance (in percent of GDP): 2005 -7.4; 2006 -9.0; 2007 -10.0; 2008 -9.7; 2009 -5.4; 2010 -4.9 - Holdings of currency (percent of quota) (April 30, 2010): 81.4 - Holdings of SDRs (percent of allocation) (April 30, 2010): 104.4 - Quota (millions of SDRs): 3,048.9 - Euro per U.S. dollar (July 14, 2010): 0.79 - Nominal effective rate (2000=100) 2/ 3/: 2005 106.3; 2006 106.5; 2007 108.1; 2008 110.5; 2009 110.7; 2010 108.7 - Real effective rate (2000=100) 2/: 2005 119.1; 2006 122.4; 2007 126.4; 2008 134.7; 2009 135.2; 2010 133.4 *Public Information Notice (PIN) No. 10/106 — IMF Executive Board Concludes 2010 Article IV Consultation with Spain (July 30, 2010).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10254.pdf_