## _cr11215

## Source details

**Canonical URL:** [_cr11215](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11215.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11215.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11215.pdf.json)

---

### 1. Savings Bank Reform
- Reconfiguration and consolidation of the savings bank sector
  - Number of institutions reduced from 45 to 18.
  - Two small ailing savings banks were intervened and resolved.
  - By mid-2010, the BdE approved seven mergers or takeovers and the creation of five institutional protection systems (“SIPs”), one of which subsequently broke up.
  - Seven consolidation operations benefited from capital support in the form of convertible preference shares from the state bank support vehicle (“FROB”) for a total of €9.7 billion, equivalent to an average of 2 percent of total risk-weighted assets or 25 percent of Tier 1 capital of the seven.
  - Associated restructuring plans envisage reductions in the number of branches and staff ranging between 10–25 percent, and 12–18 percent, respectively.
  - Progress already achieved: number of branches down 14 percent since the peak in 2008 and employees down 7 percent for the system as a whole.
- New capital and regulatory requirements
  - February 2011 law: required by end-September an 8 percent minimum core capital ratio for all banks, but 10 percent for those that rely heavily on wholesale borrowing and without significant private shareholdings (in practice, savings banks).
  - In March, the BdE notified that 12 banks, 8 of which were savings banks, must increase their capital by a total of €15 billion, with equity injections by the FROB as a backstop.
  - Following the break-up of one SIP, the potential capital needs for savings banks to reach a 10-percent threshold rose to €16 billion.
  - Five of the new commercial banks, including the two largest, intend to raise capital from private sources. If these five processes go through, the potential demand for FROB capital would be about €8 billion.
- Measures to ensure valuation, oversight, and market discipline
  - FROB recapitalization approach: approval of recapitalization plan; financial and business due diligence; assessment by three independent investment firms.
  - Process subject to EC state aid oversight.
  - Enhanced bank-by-bank disclosure of exposure to troubled assets implemented.
  - Bank bond debt guarantee scheme extended until end-2011; increased deposit guarantee fund contributions on above-normal yield deposits.
- Interaction with broader financial-sector reforms
  - Law: increase of core capital to 8 percent and to 10 percent for institutions reliant on wholesale funding and with limited private shareholding; individual recapitalization plans requested and approved by Bank of Spain; extended FROB support through purchase of common equity.
  - Reform of provisioning rules: tightened allowances for repossessed real estate; unified and accelerated provisioning calendars; valuation haircuts for collateral (accounted as mitigating factor).
- Observed outcomes and remaining vulnerabilities
  - Commercial banks increased market share at the expense of savings banks.
  - Since January 2008, the banking sector has recognized losses of nearly 9 percent of GDP.
  - Tier 1 capital ratio for Spanish banks rose from 8.4 percent in 2008 to 9.6 percent in 2010.
  - Banks face rising nonperforming loans, lower lending activity, shrinking profits (particularly for savings banks), and rising funding costs since end-2010.
  - Potential further capital needs and the success of private recapitalizations remain material to reduce reliance on FROB support.

### 9. Ambitious fiscal consolidation and 2010 outcomes
- Fiscal consolidation and 2010 outcomes
  - Deficit improved by about 2 percentage points of GDP from 2009 to 9.2 percent of GDP in 2010.
  - Revenue pick-up driven notably by VAT and changes to monthly VAT refund system that had a one-off effect in 2009.
  - Measures contributing to revenue and expenditure changes: withdrawal of stimulus measures; increase in VAT and excise rates; reversal of 2008–09 anti-crisis measures; extraordinary measures reduced primary expenditure.
- Fiscal adjustment composition (Measures 2010; Percent of GDP)
  - Total 1.9
  - Measures 2.4
  - Revenue measures 0.6
    - Revenue 0.6
    - Suspension of 400 euro PIT deduction 0.3
    - Increases in VAT rates 0.2
    - Increases in excise tax 0.1
  - Expenditure measures 1.8
    - Expenditure 1.8
    - Reversal of stimulus program 0.2
    - Budget 2010 - current spending cuts 0.8
    - Immediate Action Plan (January 2010) 0.5
    - May 20, 2010 measures 0.5
      - 5 percent wage cut 0.2
      - Investment cuts 0.2
      - Others (ODA, transfers, medicine costs) 0.1
  - Other -0.3
  - Cyclical factors -0.3
  - Increase in interest payments -0.1
- Consolidation masked regional problems: about half of regions missed their targets; regions’ deviation 0.3 percent of GDP was offset by central government over-performance.
- General government debt increased to 60.1 percent of GDP.
- Financial net worth deteriorated and payment delays increased.
- External sector and current account
  - Current account deficit narrowed to 4½ percent of GDP in 2010.
  - Most current account improvement in 2010 driven by reduction in the income deficit on the back of FDI income.
  - Spain’s net IIP close to 90 percent of GDP.
  - Bank liabilities account for close to half of external debt.
- Competitiveness and adjustment needs
  - External sustainability approach implies running a balanced current account on average over 20 years (vs. a 4½ percent of GDP deficit in 2010) to halve the net foreign asset position; achieving this via real effective exchange rate could require a real depreciation of some 18 percent.
  - Estimates of competitiveness gap (Percent):
    - Macroeconomic balance approach 1/5
    - External sustainability approach 2/18
    - Equilibrium real exchange rate approach 21
- Medium-term projections (percent unless otherwise indicated)
  - Real GDP: 2007 3.6; 2008 0.9; 2009 -3.7; 2010 -0.1; 2011 0.8; 2012 1.6; 2013 1.8; 2014 1.9; 2015 1.8; 2016 1.7
  - Exports: 2007 6.7; 2008 -1.1; 2009 -11.6; 2010 10.3; 2011 11.0; 2012 5.0; 2013 5.2; 2014 5.4; 2015 5.5; 2016 5.5
  - Imports: 2007 8.0; 2008 -5.3; 2009 -17.8; 2010 5.4; 2011 5.6; 2012 3.1; 2013 3.6; 2014 4.2; 2015 4.8; 2016 4.7
  - CPI inflation, pa: 2007 2.8; 2008 4.1; 2009 -0.2; 2010 2.0; 2011 3.0; 2012 1.7; 2013 1.5; 2014 1.6; 2015 1.8; 2016 1.8
  - Unemployment rate, pa: 2007 8.3; 2008 11.3; 2009 18.0; 2010 20.1; 2011 20.1; 2012 18.6; 2013 17.2; 2014 16.2; 2015 15.5; 2016 14.8
  - Potential growth: 2007 2.7; 2008 2.4; 2009 1.4; 2010 0.5; 2011 0.4; 2012 0.6; 2013 0.9; 2014 1.2; 2015 1.5; 2016 1.7
  - Output gap: 2007 3.9; 2008 2.4; 2009 -2.8; 2010 -3.4; 2011 -2.9; 2012 -2.0; 2013 -1.1; 2014 -0.4; 2015 -0.1; 2016 0.0
  - Current account balance (%GDP): 2007 -10.0; 2008 -9.6; 2009 -5.2; 2010 -4.5; 2011 -4.2; 2012 -3.7; 2013 -3.2; 2014 -2.9; 2015 -2.7; 2016 -2.5
- Outlook and risks
  - Medium-term average growth: overall growth should average 1½ to 2 percent.
  - Private consumption unlikely to rebound strongly; household saving rate returned to below the euro area average and unemployment remains very high.
  - Risks tilted to the downside and potentially severe, including deterioration in financial conditions from rising sovereign risk perceptions in the euro area and a protracted slow recovery with stubbornly high unemployment.
- Policy priorities
  - Fully address banking and fiscal sustainability to reduce borrowing costs and allow reallocation of credit.
  - Boldly strengthen labor market reforms to substantially reduce unemployment.
  - Foster greater competition in domestic markets to raise productivity and reduce mark-ups.
  - Follow through on measures already adopted and continue reform momentum.

### 22. Funding, liquidity, and financial sector recommendations
- Funding and liquidity outlook
  - Banks refinanced much of maturing debt; amount falling due in remainder of this year is relatively limited (less than €40 billion).
  - Banks maintain access to the repo market and hold substantial ECB repo-able assets.
  - Indicators pointing to continued funding pressure: lack of bond issuance by smaller Spanish banks; steady downward trend in share of domestic deposits held by savings banks; higher refinancing needs in 2012 (about €115 billion, with a peak in the first half).
  - Conclusion: funding and liquidity pressure could remain elevated in the near term.
- Capitalization and market concerns
  - Moderate decline in house prices compared to previous increase and excess supply of housing.
  - Rolling-over of loans to, or taking equity stakes in, troubled real estate borrowers.
  - Limited reduction in loans to the real estate sector.
  - Wide range of market estimates of potential capitalization needs; funding spreads generally higher than peers.
  - Staff view: extent of potential capital needs is limited and affects only a few institutions.
  - Even if FROB’s entire borrowing limits were used in 2011, public debt would still remain relatively low in Spain compared with other euro area countries.
- Recommended measures for the financial sector
  - Weak banks
    - Carefully assess viability of weak banks with little prospect of tapping the capital market on deliberately conservative assumptions.
    - If FROB holds a majority equity stake in a bank, presume the institution is swiftly resolved.
    - Strengthen conditionality on FROB equity (for example, prohibit profit distribution until FROB equity stakes are repurchased unless a rapid exit is guaranteed).
  - Buffers
    - Encourage banks, via pillar II, to achieve capital buffers above the minimum requirements revised in February 2011, especially those with more uncertain asset quality.
    - Example target: a core Tier 1 ratio of at least 10 percent by the end of 2012.
    - Strengthen provisioning buffers.
    - Spain’s SIFIs should build capital (and liquidity) buffers in line with emerging international consensus.
  - Stress testing
    - Europe-wide stress tests should underpin confidence; coverage of Spanish banks to be much wider than in the rest of Europe.
    - Fully disclose underlying data and specific methodology; consider independent review of loan-loss estimates.
  - Transparency
    - Make enhanced transparency permanent; improve scope, granularity, and comparability of bank-by-bank information, especially on troubled real estate exposure and prudential indicators, and publish under the Bank of Spain.
  - Savings bank reform
    - Transfer banking business to newly-created commercial banks to be listed on the stock exchange, done promptly.
    - Savings banks to become arms-length minority interest institutional investors, likely requiring conversion into foundations as envisaged by law.
    - Consider a special law for foundations with substantial bank interests.
    - Immediate governance improvements: further reduce public sector representation and increase independent board members; apply robust fit-and-proper criteria; ensure separation of managerial positions in controlled and controlling entities.
- Authorities’ views
  - Authorities reiterated commitment to completing financial sector strengthening.
  - New provisioning and capital requirements viewed as sufficient to ensure soundness even in stressed conditions; FROB capital injections to be at market price and temporary.
  - Strategy for savings banks is a historic transformation; further legislative changes on foundations not viewed as a priority.

### Fiscal policy targets, risks, and reforms
- 2011 consolidation aim: deficit target of 6 percent of GDP (from 9.2 percent of GDP in 2010).
  - Staff project a deficit of 6.2 percent of GDP without additional measures.
  - Medium-term government aim: cut deficit to 2.1 percent of GDP by 2014 (from 9.2 percent of GDP in 2010), implying a deficit reduction of 7.1 percentage points of GDP.
  - About 40 percent of the total consolidation envisaged in 2011.
  - Financing requirements: Spain’s annual financing requirements projected to remain around 20 percent of GDP in the next few years.
  - To achieve government targets, additional measures of about 2 percent of GDP (cumulative through 2014) would be required, according to staff.
  - General government debt would increase to about 74 percent of GDP absent further measures.
- Pension reform
  - Draft approved by Lower House end-June 2011: raise statutory retirement age from 65 to 67 phased 2013–27; increase years to calculate earnings base from 15 to 25 years and contribution years for full pension from 35 to 38.5 years; tighten eligibility for early retirement: minimum retirement age raised from 61 to 63 years (at least 33 years of contribution) and increase penalty rate; introduce a sustainability factor to reassess parameters every 5 years starting in 2027.
  - Estimated impacts: staff estimates reform would reduce pension expenditure by about 2 percent of GDP by 2050; including full impact of sustainability factor, savings could be about 3½ percent of GDP.
  - IMF GIMF model estimates reform could increase potential growth by 0.2–0.3 percent in the long-run.
  - Additional options: shorten transition period; further reduce incentives for early retirement; make sustainability factor automatic; extend reference period to life-time earnings.
- Improving fiscal frameworks
  - Recommendations: enhance sub-national transparency (quarterly reporting on national accounts basis); accelerate CPFF approval of regional fiscal adjustment plans and publish them; strictly apply debt authorization restrictions to regions that miss targets; consider independent fiscal council; institutionalize periodic public-sector-wide reviews of major spending programs; enact spending control mechanisms including expenditure rules at all levels.

### 33. Government stance, labor market, and structural reforms
- Government emphasized commitment to deficit targets and viewed staff’s macroeconomic scenario as pessimistic.
- Government confident debt authorization mechanism and rebalancing plans sufficient to deliver required consolidation at regional level; pledged readiness to take additional actions if needed.
- Labor market: structural flaws contributed to unemployment above 20 percent; 2010 reform increased hiring incentives by easing dismissal costs and criteria and by granting firms greater flexibility to opt out of collective agreements.
- June 2011 collective bargaining reform measures:
  - Establish prevalence of firm-level agreements, especially over provincial ones.
  - Reduce possibility of indefinite extension of previous agreements when social partners cannot agree.
  - Further ease opt-outs of collective agreements; give firms more internal flexibility.
- Need for bolder labor reforms (staff recommendations)
  - Fully decentralize collective bargaining to firm level; move away from inflation indexation; reduce severance payments to at least EU average levels; improve retraining and youth employment support; ensure incentives to return to work are sufficient.
- Structural reforms for productivity and competition
  - Factors limiting productivity: policy and regulatory rigidities; preponderance of SMEs (only 24 percent of businesses have more than 250 employees versus 57 percent in Germany and 46 percent in France); limited R&D and innovation; inefficient human and technological capital accumulation.
  - Recommended reforms: fully implement EU Services Directive and Sustainable Economy law; open up regulated professions; increase competition in energy sector; foster housing rental market; reduce restrictions on retail opening hours; reform bankruptcy law; ensure reduction of payment delays.
- Staff appraisal and outlook
  - Policy response over the last year was strong and wide-ranging; recovery gradual and export-led; unemployment projected to fall only moderately and remain well above the euro area average; inflation forecast to decline to around two percent.
  - Financial sector guidance: banks needing capital should raise it promptly from the market; those without market prospects should be rapidly restructured or resolved; FROB support a last resort at market terms and strictly temporary.
  - Fiscal consolidation: additional measures may be necessary if near-term risks materialize; under staff’s less optimistic macro projections, additional fiscal measures of about 2 percent of GDP required through 2014; government should commit early to achieving the MTO of a balanced budget and proactively manage below-the-line operations.

### 54. Scheduling and sustainability assessments
- Scheduling
  - Proposed to hold next Article IV consultation on the regular 12-month cycle.
- Fiscal and external sustainability — summary findings and projections
  - Spain has large public sector and external funding needs for the next few years. External funding needs largely driven by bank debt. Government funding pressure arises largely from amortization payments.
  - Central government raised roughly half of net funding needs for 2011 on a year-to-date basis.
  - Relative to European peers public sector debt-to-GDP ratio is relatively low; average maturity lengthened to 6.7 years.
  - Baseline public DSA projects further increase in debt-to-GDP ratio over the medium term under unchanged policies; expected additional measures would contribute to stabilize the debt-to-GDP ratio, but stress scenarios could result in further increases.
  - Baseline for fiscal sustainability: gross financing need-to-GDP ratio projected to fall gradually from 30.4 percent in 2011, though it is expected to remain large by historical standards.
- Key macroeconomic and fiscal statistics (selected, preserved exactly)
  - Real GDP growth: 2006: 4.0; 2007: 3.6; 2008: 0.9; 2009: -3.7; 2010: -0.1; 2011: 0.8; 2012: 1.6.
  - Unemployment rate (percent): 2006: 8.5; 2007: 8.3; 2008: 11.3; 2009: 18.0; 2010: 20.1; 2011: 20.1; 2012: 18.6.
  - HICP (average): 2006: 3.6; 2007: 2.8; 2008: 4.1; 2009: -0.2; 2010: 2.0; 2011: 3.0; 2012: 1.7.
  - General government balance (percent of GDP): 2006: 2.0; 2007: 1.9; 2008: -4.2; 2009: -11.1; 2010: -9.2; 2011: -6.2; 2012: -5.1.
  - General government debt (percent of GDP): 2006: 39.6; 2007: 36.1; 2008: 39.8; 2009: 53.3; 2010: 60.1; 2011: 67.5; 2012: 69.7.
- Banking sector and financial soundness indicators (selected exact figures)
  - Non-performing loans (billions of euro): 2005: 9.6; 2006: 10.9; 2007: 16.3; 2008: 63.1; 2009: 93.3; 2010: 107.2.
  - Non-performing to total loans (percent): 2005: 0.8; 2006: 0.7; 2007: 0.9; 2008: 3.4; 2009: 5.1; 2010: 5.8.
  - Provisions to non-performing loans (percent): 2005: 255.5; 2006: 272.2; 2007: 214.6; 2008: 70.8; 2009: 58.6; 2010: 67.2.
  - Exposure to construction sector (billions of euro): 2005: 262.8; 2006: 378.4; 2007: 457.0; 2008: 469.9; 2009: 453.4; 2010: 430.3.
    - of which: Non-performing (construction, billions): 2005: 0.5; 2006: 0.3; 2007: 0.6; 2008: 5.7; 2009: 9.6; 2010: 13.5.
  - Households - House purchase (billions of euro): 2005: 427.0; 2006: 523.6; 2007: 595.9; 2008: 626.6; 2009: 624.8; 2010: 632.4.
    - of which: Non-performing (house purchase, billions): 2005: 0.4; 2006: 0.4; 2007: 0.7; 2008: 2.4; 2009: 2.9; 2010: 2.4.
  - Use of ECB refinancing (billions of euro): 2005: 30.3; 2006: 21.2; 2007: 52.3; 2008: 92.8; 2009: 81.4; 2010: 69.7.
    - in percent of total ECB refin. operations: 2005: 7.7; 2006: 4.9; 2007: 11.6; 2008: 11.6; 2009: 12.1; 2010: 10.8.
    - in percent of total assets of Spanish MFI: 2005: 1.4; 2006: 0.8; 2007: 1.7; 2008: 2.7; 2009: 2.4; 2010: 2.0.
  - Loan-to-deposit ratio: 2005: 161.0; 2006: 165.0; 2007: 168.2; 2008: 158.0; 2009: 151.5; 2010: 149.2.
- Illustrative policy-relevant observations
  - Large near-term funding needs for public sector and banks imply continued market scrutiny and vulnerability to stress scenarios.
  - Reducing gross financing needs and stabilizing debt require fiscal consolidation measures; expected measures would help stabilize but stress scenarios can reverse improvements.
  - Progress in narrowing the current account deficit and consolidation of external liabilities should help put gross external debt on a downward path in the baseline.
  - Bank balance-sheet repair is critical given the sharp rise in non-performing loans and waning provision buffers observed up to 2010.

### Public debt sustainability baseline and shocks
- Baseline public debt trajectory example: Baseline: 76.2 percent of GDP (figure example).
- Impact of a real interest rate shock
  - Historical average real interest rate: 1.3 percent.
  - Scenario: real interest rates reach 3.4 percent (representing a ½ standard deviation shock).
  - Result: debt would increase to 78.7 percent of GDP by 2016, about 2½ percentage points of GDP above the baseline.
- Role of debt maturity
  - Average maturity of central government debt rose from 5.6 years in 2000 to 6.6 years in 2010.
  - Debt rollover over the forecasting period expected to be modest.
- Sensitivity to growth shocks
  - If growth falls by a little over 1 percentage point over the forecasting period, the debt-to-GDP ratio could reach 91.8 percent by 2016, about 16 percentage points higher relative to the baseline.
- Euro depreciation and contingent liabilities
  - A 30 percent nominal depreciation of the euro (after adjusting for domestic inflation) combined with a contingent liability shock of 10 percent of GDP would raise the debt-to-GDP trajectory to 86½ percent.
  - Foreign-currency denominated government liabilities: less than 2 percent.
- Alternative scenarios for external sustainability (external debt in percent of GDP)
  - Interest rate shock: 40 basis point increase → increases external debt by roughly 7 percentage points of GDP by 2016.
  - Growth shock: prolonged anemic growth of 0.6 percent on average → increases external debt by roughly 14 percentage points of GDP by 2016.
  - Standard combined shock: permanent ¼ standard deviation shock to interest rate, real growth rate, and current account balance → increases external debt by about 13 percentage points of GDP by 2016.
  - Country-specific combined (tail-risk) shock: permanent one standard deviation shock to interest rate (80 basis points above baseline) and ½ standard deviation shock to growth rate → by 2016 external debt would surge by about 21 percentage points of GDP compared to baseline.
- Executive Board/Staff summary recommendations
  - Continue decisive implementation of financial sector reform; strengthen provisioning and capital buffers and maintain transparency on real estate exposures and funding profiles.
  - Steadfast fiscal adjustment is key; additional measures may be needed if near-term risks materialize.
  - Urge all levels of government, including sub-national, to deliver on fiscal commitments.
  - Continue labor market reforms to reduce unemployment: promote decentralized wage bargaining, less indexation, and further lower severance payments.
  - Complement labor adjustments with structural reforms in the non-tradable sector: more efficient regulatory environment and further opening up regulated professions and services.

### EBA stress tests, Bankia IPO, and fiscal rule
- EBA stress test results (Spain)
  - Coverage of the Spanish system: 93 percent.
  - Number of Spanish institutions participating: 25.
  - Under the adverse scenario: 5 out of the 25 institutions below the benchmark, representing 9 percent of total banking assets; combined shortfall €1.6 billion (less than 0.2 percent of GDP).
  - Country-specific balance sheet elements (generic provisions and mandatory convertible bonds in Spain) were not taken into account as loss-absorbing instruments for comparability; Spanish authorities indicate that if they are counted, no additional capital is required.
  - Staff view: results underscore importance of FROB backstop and decisive implementation of reforms.
- Bankia IPO
  - IPO concluded on July 18.
  - Amount raised: slightly more than €3 billion.
  - Amount and price lowered compared to initial target ranges, implying substantial discount to book value.
  - Share of institutional investors: 40 percent (reportedly mainly domestic).
  - Ownership: half of Bankia’s capital would be held by private investors.
- Fiscal rule and budget framework
  - Royal Decree (effective July 1) modifies budget stability law to include an expenditure rule: central and local governments must keep increase in nominal public expenditure (excluding interest and unemployment benefits) below growth in nominal GDP.
  - Nominal GDP growth defined as average of past 5 years, estimate for current year, and projections for next 3 years from the SGP.
  - Staff view: expenditure rule is a useful complement to the deficit rule and should be applied to all levels of government.

_Italic: IMF staff report content unit _cr11215 — Staff Report for the 2011 Article IV Consultation and related chapter summaries._

### 1. Savings Bank Reform .................................................................................................

### 1. Savings Bank Reform

### Reconfiguration and consolidation of the savings bank sector
- The number of institutions has been reduced from 45 to 18.
- Two small ailing savings banks were intervened and resolved.
- By mid-2010, the BdE approved seven mergers or takeovers and the creation of five institutional protection systems (“SIPs”), one of which subsequently broke up.
- Seven of the consolidation operations benefited from capital support in the form of convertible preference shares from the state bank support vehicle (“FROB”) for a total of €9.7 billion, equivalent to an average of 2 percent of total risk-weighted assets or 25 percent of Tier 1 capital of the seven.
- Associated restructuring plans envisage reductions in the number of branches and staff ranging between 10–25 percent, and 12–18 percent, respectively.
- Progress already achieved: number of branches down 14 percent since the peak in 2008 and employees down 7 percent for the system as a whole.

### New capital and regulatory requirements
- February 2011 law: required by end-September an 8 percent minimum core capital ratio for all banks, but 10 percent for those that rely heavily on wholesale borrowing and without significant private shareholdings (in practice, savings banks).
- In March, the BdE notified that 12 banks, 8 of which were savings banks, must increase their capital by a total of €15 billion, with equity injections by the FROB as a backstop.
- Following the break-up of one SIP, the potential capital needs for savings banks to reach a 10-percent threshold rose to €16 billion.
- To facilitate private capital participation, most savings banks are reconfiguring corporate structure by spinning off banking operations into newly created commercial banks, and in some cases segregating impaired real-estate assets in a separate company.
- Five of these new commercial banks, including the two largest, intend to raise capital from private sources. If these five processes to raise capital from private sources go through, the potential demand for FROB capital would be about €8 billion.

### Measures to ensure valuation, oversight, and market discipline
- The FROB has established a comprehensive approach for recapitalizations based upon:
  - approval of a recapitalization plan;
  - carrying-out of financial and business due diligence;
  - assessment by three independent investment firms.
- The process will be subject to EC state aid oversight.
- Enhanced bank-by-bank disclosure of exposure to troubled assets was implemented.
- The authorities extended, with EC approval, the bank bond debt guarantee scheme until end-2011 and increased banks’ deposit guarantee fund contributions on above-normal yield deposits.

### Interaction with broader financial-sector reforms
- Law to further strengthen the financial sector includes:
  - increase of core capital to 8 percent and to 10 percent for institutions reliant on wholesale funding and with limited private shareholding;
  - individual recapitalization plans requested and approved by Bank of Spain;
  - extended support of the FROB through the purchase of common equity.
- Reform of provisioning rules introduced:
  - tightened allowances for repossessed real estate;
  - unified and accelerated provisioning calendars;
  - valuation haircuts for collateral (accounted for as mitigating factor).

### Observed outcomes and remaining vulnerabilities
- Commercial banks increased market share at the expense of savings banks, possibly reflecting flight to quality and savings banks’ restructuring.
- Since January 2008, the banking sector has recognized losses of nearly 9 percent of GDP.
- Tier 1 capital ratio for Spanish banks rose from 8.4 percent in 2008 to 9.6 percent in 2010, but capitalization remains somewhat on the low side compared to peers.
- Banks face rising nonperforming loans, lower lending activity, shrinking profits (particularly for savings banks), and rising funding costs since end-2010.
- Potential further capital needs and the success of private recapitalizations remain material to reduce reliance on FROB support.

*Source: IMF staff summary of chapter “1. Savings Bank Reform.”*

### 9.      Ambitious fiscal consolidation is underway and the 2010 deficit target was hit

### 9.      Ambitious fiscal consolidation is underway and the 2010 deficit target was hit

### Fiscal consolidation and 2010 outcomes
- Deficit improved by about 2 percentage points of GDP from 2009 to 9.2 percent of GDP in 2010.
- Revenue pick-up driven notably by VAT and changes to monthly VAT refund system that had a one-off effect in 2009.
- Measures contributing to revenue and expenditure changes:
  - Withdrawal of stimulus measures and increase in VAT and excise rates.
  - Reversal of the 2008–09 anti-crisis measures and extraordinary measures adopted during the year reduced primary expenditure.
- Fiscal adjustment composition (Measures 2010; Percent of GDP):
  - Total1.9
  - Measures2.4
  - Revenue measures0.6
    - Revenue0.6
    - Suspension of 400 euro PIT deduction0.3
    - Increases in VAT rates0.2
    - Increases in excise tax0.1
  - Expenditure measures1.8
    - Expenditure1.8
    - Reversal of stimulus program0.2
    - Budget 2010 - current spending cuts0.8
    - Immediate Action Plan (January 2010)0.5
    - May 20, 2010 measures0.5
      - 5 percent wage cut0.2
      - Investment cuts0.2
      - Others (ODA, transfers, medicine costs)0.1
  - Other-0.3
  - Cyclical factors-0.3
  - Increase in interest payments-0.1
- Consolidation masked regional problems: about half of regions missed their targets; regions’ deviation0.3 percent of GDP was offset by central government over-performance.
- General government debt increased to 60.1 percent of GDP.
- Financial net worth deteriorated and payment delays increased.

*Sources: SNL; J.P. Morgan; and IMF staff estimates.*

### External sector and current account
- Trade and current account:
  - Strong export growth helped stabilize the trade deficit in 2010 while the current account deficit narrowed to 4½ percent of GDP.
  - Trade deficit little changed as import growth picked up reflecting higher oil prices.
  - Most current account improvement in 2010 driven by reduction in the income deficit on the back of FDI income.
  - Current account deficit was mainly financed by unwinding portfolio investments abroad.
- Net international investment position (IIP):
  - Large negative net IIP stabilized through temporarily higher Euro system refinancing which smoothed volatility in other investment flows.
  - Box 3: Spain’s net IIP close to 90 percent of GDP, reflecting accumulation of large current account deficits over the last decade.
  - Bank liabilities account for close to half of external debt.

### Competitiveness and adjustment needs
- Inflation and unit labor costs:
  - During the recession headline and core inflation declined significantly as unit labor costs moderated; inflation differential turned slightly negative but reversed in early 2010 as energy prices rose and tax increases kicked in.
- Competitiveness gap and required adjustment:
  - External sustainability approach implies running a balanced current account on average over 20 years (vs. a 4½ percent of GDP deficit in 2010) to halve the net foreign asset position; achieving this via real effective exchange rate could require a real depreciation of some 18 percent.
  - Estimates of competitiveness gap (Percent):
    - Macroeconomic balance approach 1/5
    - External sustainability approach 2/18
    - Equilibrium real exchange rate approach21
  - Despite indicators, Spanish exports broadly held global market share and performed strongly, reflecting productivity of larger Spanish firms.

### Outlook: medium-term projections
- Staff projection: modest export-led recovery, reflecting need to unwind imbalances, high unemployment, fiscal consolidation, and tight financial conditions.
- Key projections and levels (percent, unless otherwise indicated):
  - Real GDP: 2007 3.6; 2008 0.9; 2009 -3.7; 2010 -0.1; 2011 0.8; 2012 1.6; 2013 1.8; 2014 1.9; 2015 1.8; 2016 1.7
  - Exports: 2007 6.7; 2008 -1.1; 2009 -11.6; 2010 10.3; 2011 11.0; 2012 5.0; 2013 5.2; 2014 5.4; 2015 5.5; 2016 5.5
  - Imports: 2007 8.0; 2008 -5.3; 2009 -17.8; 2010 5.4; 2011 5.6; 2012 3.1; 2013 3.6; 2014 4.2; 2015 4.8; 2016 4.7
  - CPI inflation, pa: 2007 2.8; 2008 4.1; 2009 -0.2; 2010 2.0; 2011 3.0; 2012 1.7; 2013 1.5; 2014 1.6; 2015 1.8; 2016 1.8
  - Unemployment rate, pa: 2007 8.3; 2008 11.3; 2009 18.0; 2010 20.1; 2011 20.1; 2012 18.6; 2013 17.2; 2014 16.2; 2015 15.5; 2016 14.8
  - Potential growth: 2007 2.7; 2008 2.4; 2009 1.4; 2010 0.5; 2011 0.4; 2012 0.6; 2013 0.9; 2014 1.2; 2015 1.5; 2016 1.7
  - Output gap: 2007 3.9; 2008 2.4; 2009 -2.8; 2010 -3.4; 2011 -2.9; 2012 -2.0; 2013 -1.1; 2014 -0.4; 2015 -0.1; 2016 0.0
  - Current account balance (%GDP): 2007 -10.0; 2008 -9.6; 2009 -5.2; 2010 -4.5; 2011 -4.2; 2012 -3.7; 2013 -3.2; 2014 -2.9; 2015 -2.7; 2016 -2.5
- Medium-term average growth: overall growth should average 1½ to 2 percent.
- Private consumption unlikely to rebound strongly; household saving rate returned to below the euro area average and unemployment remains very high.
- Unemployment projected to fall only moderately and remain well above the euro area average.
- Inflation forecast to decline to around two percent as transitory factors fade.
- Government projection: growth reaching 2.6 percent by 2014; unemployment projected at 16 percent in 2014.

### Risks and spillovers
- Risks tilted to the downside and potentially severe:
  - Near-term: deterioration in financial conditions from rising sovereign risk perceptions in the euro area; contagion via confidence effects; significant exposure of Spanish banks to their sovereign could pressure sovereign and bank funding costs; Spain’s financing needs remain significant for the public sector in coming months and for banks in early 2012.
  - Medium-term: protracted slow recovery with stubbornly high unemployment could trigger negative cycle—greater-than-expected house price falls, delays in bank balance sheet repair, faster household and corporate deleveraging, and potential undermining of employment growth if labor costs are unresponsive.
- Scenarios of negative spillovers from Spain indicate substantial impact on the rest of Europe and globally given Spain’s systemic importance (Box 4).
- Box 4 highlights channels of spillovers:
  - International bank exposures concentrated in German and French banks (respectively a quarter and a fifth of foreign claims at end 2010); U.S. bank exposures including derivatives also significant.
  - Spain’s consolidated bank claims focused on Europe (half total; two-thirds on the U.K.), significant also in U.S., Brazil, Mexico, Poland, Turkey.
  - Foreign portfolio assets held by Spain focused on Europe (France, Italy, Benelux, Germany together close to half).

### Political and authorities’ views
- Political context: governing socialist party in minority, reliant on alliance with two small regional parties; opposition called for early general election due by March 2012.
- Authorities view risks from euro-area sovereign concerns as significant but manageable; emphasized strong fundamentals, policy responsiveness, structural reforms, and delivery on policy commitments.
- Authorities argued appropriate response should be at system level and expressed confidence in a sufficiently strong European response.
- Authorities project stronger recovery and higher potential growth than staff, attributing this to strong effects of recent reforms and resilient labor force participation.

### Policy agenda and reforms
- Long-term unwinding of imbalances and crisis legacy will take years; “flow” imbalances improving but “stock” problems remain (stretched private and external balance sheets, high unemployment, overvalued housing market, stock of unsold units).
- Need for a new growth model more balanced between tradable and non-tradable sectors, boosting the supply side.
- Policy priorities:
  - Fully address banking and fiscal sustainability to reduce borrowing costs and allow reallocation of credit.
  - Boldly strengthen labor market reforms to substantially reduce unemployment.
  - Foster greater competition in domestic markets to raise productivity and reduce mark-ups.
  - Follow through on measures already adopted and continue reform momentum.
- Sector-specific challenges and aims:
  - Tradable sector: encourage firms to expand and hire while maintaining or improving productivity; strengthen business environment; moderate price of labor and reduce price pressure from non-tradable sector.
  - Non-tradable sector: boost productivity, spur employment outside construction and public administration, contain price pressures; foster competition; moderate labor costs near-term to spur employment.
- Authorities emphasized implementation of structural measures and saw some deleveraging as necessary while considering pre-euro equilibrium debt levels contextually appropriate.

### Financial sector: completing reforms
- Outlook for banking industry remains challenging:
  - Net interest income likely under pressure due to depressed lending activity and elevated funding costs despite some relief from rising lending rates.
  - Weak economic activity and high unemployment expected to increase non-performing assets and loan loss provisions.
  - One-off income sources may include divestment of industrial holdings and non-core activities.
  - Cost rationalization and ongoing mergers could provide gains, though some smaller mergers might need substantial restructuring.
  - Large international Spanish banks may rely on geographic and business diversification; domestically-oriented banks face weak profitability outlook that could affect capital buffers.

*Italic: IMF staff report content unit _cr11215 — 9. Ambitious fiscal consolidation is underway and the 2010 deficit target was hit.*

### 22.      Funding and liquidity pressure are likely to remain elevated in the near term.

### 22.      Funding and liquidity pressure are likely to remain elevated in the near term.

### Funding and liquidity outlook
- Spanish banks have been able to refinance much of their maturing debt; the amount falling due in the remainder of this year is relatively limited (less than €40 billion).
- Banks maintain access to the repo market and hold substantial ECB repo-able assets.
- Indicators pointing to continued funding pressure:
  - Lack of bond issuance by smaller Spanish banks.
  - Steady downward trend in the share of domestic deposits held by savings banks.
  - Higher refinancing needs in 2012 (about €115 billion, with a peak in the first half).
- Conclusion: funding and liquidity pressure could remain elevated in the near term.

### Capitalization and market concerns
- Despite strong reforms and balance sheet repair, market concerns that some banks are undercapitalized linger.
- Contributing factors to uncertainty:
  - Moderate decline in house prices compared to the previous increase and the excess supply of housing.
  - Rolling-over of loans to, or taking of equity stakes in, troubled real estate borrowers.
  - Limited reduction in loans to the real estate sector.
- Manifestations of uncertainty:
  - Wide range of market estimates of potential capitalization needs.
  - Funding spreads generally higher than peers.
- Staff view: the extent of potential capital needs is limited and affects only a few institutions.
  - Even if in the extreme the FROB’s entire borrowing limits were used in 2011, the level of public debt would still remain relatively low in Spain compared with other euro area countries.
  - Potential needs would be greatly reduced if the largest savings banks raise needed capital from the market.
- High valuation uncertainty around many assets persists.

### Recommended measures for the financial sector
- Decisive restructuring of the financial sector, combined with robust capital and liquidity buffers, would:
  - Reduce uncertainty.
  - Protect against tail risks.
  - Foster a faster reallocation of credit across sectors.
- Specific recommendations:
  - Weak banks
    - Carefully assess the viability of weak banks with little prospect of tapping the capital market on deliberately conservative assumptions.
    - If FROB ends up holding a majority equity stake in a bank, presume the institution is swiftly resolved.
    - Strengthen conditionality on FROB equity: for example, prohibit profit distribution until FROB equity stakes are repurchased (unless a significant portion of equity is sold to private investors and a rapid exit from FROB is guaranteed).
  - Buffers
    - Encourage banks, via pillar II, to achieve capital buffers above the minimum requirements revised in February 2011, especially those with more uncertain asset quality.
    - Example target: a core Tier 1 ratio of at least 10 percent by the end of 2012.
    - Strengthen provisioning buffers.
    - Spain’s global and domestic systemically important financial institutions (SIFIs) should build capital (and liquidity) buffers in line with emerging international consensus.
  - Stress testing
    - Europe-wide stress tests should underpin confidence about potential capital needs.
    - Coverage of Spanish banks to be much wider than in the rest of Europe.
    - Fully disclose underlying data and specific methodology behind stress test results.
    - Consider complementing future stress tests with a review of estimates of loan losses (especially real-estate related) by a leading independent firm and make results public.
  - Transparency
    - Make enhanced transparency a permanent feature of the Spanish system.
    - Improve scope, granularity, and comparability of bank-by-bank information, especially on troubled real estate exposure and prudential indicators, and publish under the aegis of the Bank of Spain.
  - Savings bank reform
    - Transfer banking business to newly-created commercial banks to be listed on the stock exchange, done promptly.
    - Savings banks will retain majority ownership in many newly-created entities; going forward they should become arms-length minority interest institutional investors, likely requiring conversion into foundations as envisaged by law.
    - Consider preparing a special law for foundations with substantial bank interests to provide a sound legal and regulatory framework.
    - Immediate governance improvements for savings banks:
      1. Further reduce public sector representation and increase independent members of executive boards.
      2. Apply robust fit-and-proper criteria to all managers and directors.
      3. Ensure separation of managerial positions in the controlled and controlling entities.

### Authorities’ views on financial sector measures
- Authorities reiterated commitment to completing the ongoing financial sector strengthening.
- They view new provisioning and capital requirements as sufficient to ensure soundness even in stressed conditions and intend to address any shortfalls that emerge.
- Authorities concur that transparency has been useful to allay market sentiment and will consider ways to enhance disclosure, while asserting Spain is already at the forefront.
- On savings banks:
  - Strategy is not confined to mere recapitalization but a historic, far-reaching, and lasting transformation of the sector.
  - Further legislative changes, including regarding foundations, were not viewed as a priority; strengthening corporate governance is considered an ineluctable consequence of the transformation.
  - FROB capital injections will be at market price and temporary; FROB representatives will oversee strict implementation of agreed recapitalization plans.

### Fiscal policy: consolidation targets and risks
- 2011 consolidation aim: deficit target of 6 percent of GDP (from 9.2 percent of GDP in 2010).
  - Full impact of revenue measures in 2010, wage and pension freeze, hiring restraint, and 2011 spending cuts should help lower the deficit.
  - Staff project a deficit of 6.2 percent of GDP without additional measures.
  - Larger risk: some regional governments may again miss their targets.
- Medium-term government aim: cut deficit to 2.1 percent of GDP by 2014 (from 9.2 percent of GDP in 2010), implying a deficit reduction of 7.1 percentage points of GDP.
  - About 40 percent of the total consolidation envisaged in 2011 (2010 May package front-loaded the adjustment).
  - Expenditure restraint is the main contributing factor in outer years; about half of required adjustment envisaged by sub-national governments.
- Challenges to achieving targets:
  - Adjustment based on relatively optimistic macroeconomic projections and regions hitting targets.
  - Preliminary data suggest regions could miss their target by a similar magnitude as last year.
  - Some spending restraint measures not fully identified; implementing containment requires a decisive break with the past (for example, the public sector wage bill is projected to decline by ½ percent of GDP a year).
- Financing requirements and contingency
  - Spain’s annual financing requirements are projected to remain substantial in the next few years, around 20 percent of GDP, underscoring the need for maintaining market confidence.
  - Staff projects the deficit to decline to about 4 percent of GDP in 2014.
  - To achieve the government’s targets, additional measures of about 2 percent of GDP (cumulative through 2014) would be required, according to staff.
  - General government debt would continue to increase to about 74 percent of GDP absent further measures.
  - Pro-active management of below-the-line operations (such as privatization) is warranted to ensure the debt ratio is on a firmly declining path and to anchor market expectations.
- Suggested areas for additional measures:
  - Further reducing current spending (for example, the wage bill remains higher than the euro area average).
  - Cutting investment (which has been well above EU average).
  - Raising VAT and excise rates, especially on petroleum products.

### Pension reform and long-term sustainability
- The pension reform draft (approved by the Lower House end-June 2011) key elements:
  - Raise statutory retirement age from 65 to 67, phased in gradually between 2013–27.
  - Increase years to calculate earnings base from 15 to 25 years and contribution years for full pension from 35 to 38.5 years.
  - Tighten eligibility for early retirement: minimum retirement age raised from 61 to 63 years (at least 33 years of contribution) and increase penalty rate.
  - Introduce a sustainability factor to reassess parameters every 5 years starting in 2027 to factor higher life expectancy.
- Estimated impacts of the reform:
  - Staff estimates reform would reduce pension expenditure by about 2 percent of GDP by 2050.
  - Including full impact of the sustainability factor, savings could be about 3½ percent of GDP.
  - IMF GIMF model estimates the reform could increase potential growth by 0.2–0.3 percent in the long-run.
- Additional options to strengthen the reform during parliamentary approval:
  - Shorten the transition period.
  - Further reduce incentives for early retirement.
  - Make the sustainability factor automatic.
  - Extend reference period to life-time earnings.
- Recommendation: government should commit to achieving early its MTO of a balanced budget by no later than 2016.

### Improving fiscal frameworks
- Spain’s fiscal framework is strong in some areas but needs improvement, especially for subnational governments.
- Recommendations:
  - Enhance transparency: sub-national accounts should be available at same frequency and coverage as central government; aim for quarterly reporting on a national accounts basis.
  - Fiscal and Financial Policy Council (CPFF) should accelerate approving regional fiscal adjustment plans and publish them alongside Ministry of Finance assessments.
  - Strengthen mechanisms to ensure subnational compliance with deficit targets:
    - Strictly apply debt authorization restrictions to regions that miss agreed targets.
    - Consider increasing frequency of CPFF monitoring, widen scope for cutting joint investment and discretionary transfers, and secure voluntary commitments by regions missing targets to implement concrete consolidation measures.
  - Establish an independent fiscal council to provide macroeconomic parameters for the budget, estimate cost of proposed legislation, and provide long-term fiscal projections including social security sustainability adjustments.
  - Institutionalize periodic public-sector-wide reviews of major spending programs and integrate budgeting processes into a medium-term budget framework.
  - Enact spending control mechanisms, including expenditure rules at all levels of government, to complement the deficit rule.

_Italic: Source: IMF staff report section titled "22.      Funding and liquidity pressure are likely to remain elevated in the near term."_

### 33.      The government emphasized its commitment to the deficit targets. They viewed

### _cr11215 - 33.      The government emphasized its commitment to the deficit targets. They viewed

### Fiscal policy stance and commitments
- The government emphasized its commitment to the deficit targets and viewed staff’s macroeconomic scenario as pessimistic, noting that their growth forecast projections for 2010 had proven more correct than staff’s.
- The government was confident that the debt authorization mechanism and rebalancing plans were sufficient to deliver the required consolidation at the regional level and that any possible overshooting by some regions would be limited in size and likely offset by over-performance in others.
- The government stressed they stand ready and committed to taking additional actions required to meet the general government target, which was unconditional.
- They agreed the importance of aiming for the MTO beyond 2014 to ensure fiscal sustainability.
- The pension reform has already gone through Congress and is expected to be passed into law shortly.
- While considering existing fiscal frameworks sufficient, the government saw scope for improvement over the medium term, including further subnational fiscal transparency and spending control mechanisms at all levels of government.
- The government did not view an independent fiscal council or a full-fledged medium-term budgeting framework as playing a major supporting role in Spain.

### Labor market: assessment and reforms to date
- Structural flaws in Spain’s labor market contributed to unemployment soaring to above 20 percent, despite an output loss broadly in line with the euro area, as most of the adjustment was pushed onto employment.
- Wage bargaining system constraints cited: inflation indexation and protection of permanent contracts; automatic extension of industry/province agreements to entire provinces and industries with limited firm- or worker-level opt-outs.
- The 2010 reform increased hiring incentives by easing dismissal costs and criteria and by granting firms greater flexibility to opt out of collective agreements.
- June 2011 collective bargaining reform measures included:
  - establishing the prevalence of firm-level agreements, especially over provincial ones;
  - reducing the possibility of indefinite extension of previous agreements when social partners cannot agree on a new agreement;
  - further easing opt-outs of collective agreements; and
  - giving firms more internal flexibility.
- Interlocutors (social partners, ILO, academics) broadly agreed reforms were in the right direction but incomplete; reforms did not directly address inflation indexation and allowed sectoral agreements to potentially prevail over firm-level agreements if social partners agreed.
- Success of reforms depends on implementation by social partners and courts.

### Need for bolder labor reforms (policy recommendations)
- A bold strengthening of reforms is needed to substantially reduce unemployment and labor market duality; policy should err on the side of boldness rather than gradualism.
- Specific recommendations:
  - Collective bargaining needs to be effectively decentralized to the firm level to allow wages to adjust to firm-specific conditions and foster employment and the reallocation of labor. The scope for firm-level flexibility offered by the June 2011 reform should be actively pursued by social partners and ideally strengthened during the Parliamentary approval process. If there are not clear and immediate signs the reform is delivering necessary firm-level flexibility, a more radical reform should be introduced.
  - Social partners should move away from inflation indexation, which is endemic compared with other countries and is inconsistent with the functioning of a currency union. Reference could be made to guidelines based on productivity and regaining competitiveness with main trading partner countries. Elimination of indexation should be accompanied by stronger competition in the nontradable sector to keep price increases moderate.
  - Severance payments should be further lowered to at least EU average levels and should be better designed to make permanent hires more attractive. Despite the 2010 reform, severance payments remain high and likely constitute a significant deterrent to the use of permanent contracts once employment growth strengthens.
  - Support measures: further improve retraining of workers with mismatched skills, support youth employment, ensure incentives to return to work are sufficient. Recent improvements in active labor market policies, such as allowing private placement firms, should be useful.

### Authorities’ views on labor reforms
- The government argued that the labor market reforms have been strong and acknowledged limited evidence so far that the 2010 reform is improving employment prospects and reducing labor market duality, but expected the impact to strengthen over time as the recovery continues.
- The recent collective bargaining reform is seen by the government as a major step forward; success will depend on implementation by social partners.
- The government stressed inflation indexation is considered a prerogative of social partners and cannot be legislated against.
- The BdE also saw the need for bold strengthening of reforms, though it saw significant potential in the recent collective bargaining reform.

### Structural reforms for productivity and competition
- Achieving strong and sustainable growth requires strong productivity gains; more than half of the productivity differential with the rest of the EU is not explained by sectoral composition, and weak productivity growth is prevalent in almost all sectors.
- Factors attributed to weak productivity growth:
  - policy and regulatory rigidities limiting competition (e.g., high firm startup costs);
  - low efficiency linked to the preponderance of SMEs (only 24 percent of businesses have more than 250 employees versus 57 percent in Germany and 46 percent in France);
  - limited R&D and innovation (spending on R&D is well below the EU average and Spain has one of the lowest numbers of patents per capita);
  - inefficient accumulation of human and technological capital (high proportion of university graduates but high dropout rates, long completion times, low return to education), worsened by labor market duality and barriers to mobility from the under-developed housing rental market.
- Spain has taken productivity-enhancing measures (implementation of the Services Directive, measures to lower start up costs, removal of the mortgage deduction for income tax), but significant entry barriers remain.
- Key reforms recommended to boost competition and productivity:
  - fully implement the EU Services Directive and Sustainable Economy law;
  - open up regulated professions;
  - increase competition in the energy sector;
  - foster growth of the under-developed housing rental market;
  - reduce restrictions on retail opening hours;
  - reform the bankruptcy law;
  - ensure reduction of payment delays (as per recent legislation).

### Staff appraisal, outlook, and fiscal/financial recommendations
- The policy response over the last year was strong and wide-ranging, helping strengthen market confidence; the economy showed resilience and policymakers were responsive.
- Recovery is gradual and export-led; export growth projected to remain strong while domestic demand improves gradually. Unemployment projected to fall only moderately and remain well above the euro area average. Inflation forecast to decline to around two percent as transitory factors fade.
- Downside risks dominate: upside risk of stronger-than-expected export growth and reform impacts; downside risk of intensification of domestic headwinds and near-term sovereign risk concerns in the euro area.
- Financial sector guidance:
  - Banks needing capital should raise it promptly from the market; those without market prospects should be rapidly restructured or resolved.
  - FROB support should be a last resort, provided at market terms and strictly temporary.
  - Staff sees merit in further building capital, liquidity and provisioning buffers over time.
  - Continued improvements in transparency and corporate governance in the savings bank sector are recommended.
- Fiscal consolidation:
  - Ambitious fiscal consolidation is underway; if near-term risks materialize, additional measures may be necessary.
  - Larger risk to the 2011 target is regional governments missing targets; the general government fiscal target should remain the overarching objective.
  - Achieving medium-term fiscal targets will likely require further action:
    - targets are based on strong spending restraint;
    - under staff’s less optimistic macro projections, additional fiscal measures of about two percent of GDP will be required through 2014;
    - build strong buffers in the 2012 and future budgets;
    - government should commit early to achieve the MTO of a balanced budget and proactively manage below-the-line operations (such as privatization);
    - draft pension reform should be quickly passed and implemented, and ideally strengthened in some areas.
  - Improving fiscal frameworks:
    - short-term focus on sub-national finances: improve transparency of subnational accounts and strictly apply existing policy levers to ensure compliance with deficit targets;
    - medium-term: institutionalize a nationwide comprehensive review of major spending programs to identify high-quality expenditure savings; an independent fiscal council could bolster credibility; implement spending control mechanisms, including spending rules, at all government levels.

*Source: _cr11215 - 33.*

### 54.      It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

### _cr11215 - 54.      It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

### Scheduling
- It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

### Fiscal and external sustainability — summary findings and projections
- Spain has large public sector and external funding needs for the next few years. External funding needs are largely driven by bank debt. The government’s funding pressure arises largely from amortization payments.
- On a year-to-date basis, the central government has raised roughly half of net funding needs for 2011.
- Relative to European peers the public sector debt-to-GDP ratio is relatively low, and debt rollover is a limited portion of central government debt; the average maturity has lengthened to 6.7 years.
- Market scrutiny is high and interest costs on newly-issued debt have risen.

Baseline fiscal and external outlook
- Under unchanged policies, the public DSA projects further increase in the debt-to-GDP ratio over the medium term.
- Expected additional measures would contribute to stabilize the debt-to-GDP ratio, but stress scenarios could result in further increases.
- The external DSA projects gross external debt to start declining over the medium term, supported by consolidation of external liabilities in 2010 and a projected narrowing of the current account deficit; however, stress scenarios could result in further increases.
- In the baseline scenario for the fiscal sustainability assessment, the gross financing need-to-GDP ratio is projected to fall gradually from 30.4 percent in 2011, though it is expected to remain large by historical standards.

### Key macroeconomic and fiscal statistics (selected, preserved exactly as in source tables)
- Real GDP growth: 2006: 4.0; 2007: 3.6; 2008: 0.9; 2009: -3.7; 2010: -0.1; 2011: 0.8; 2012: 1.6 (percent change).
- Unemployment rate (in percent): 2006: 8.5; 2007: 8.3; 2008: 11.3; 2009: 18.0; 2010: 20.1; 2011: 20.1; 2012: 18.6.
- HICP (average): 2006: 3.6; 2007: 2.8; 2008: 4.1; 2009: -0.2; 2010: 2.0; 2011: 3.0; 2012: 1.7 (percent).
- General government balance (percent of GDP): 2006: 2.0; 2007: 1.9; 2008: -4.2; 2009: -11.1; 2010: -9.2; 2011: -6.2; 2012: -5.1.
- Primary balance (percent of GDP): 2006: 3.7; 2007: 3.5; 2008: -2.6; 2009: -9.4; 2010: -7.3; 2011: -4.1; 2012: -2.6.
- Structural balance (percent of potential GDP): 2006: -1.2; 2007: -1.1; 2008: -4.9; 2009: -9.2; 2010: -7.4; 2011: -4.7; 2012: -4.1.
- General government debt (percent of GDP): 2006: 39.6; 2007: 36.1; 2008: 39.8; 2009: 53.3; 2010: 60.1; 2011: 67.5; 2012: 69.7.
- Current account balance (percent of GDP): 2006: -9.0; 2007: -10.0; 2008: -9.6; 2009: -5.2; 2010: -4.5; 2011: -4.2; 2012: -3.7.
- Net international investment position: 2006: -65.9; 2007: -78.1; 2008: -79.3; 2009: -91.1; 2010: -87.1; 2011: -88.6; 2012: -88.9 (percent of GDP).

### Banking sector and financial soundness indicators (selected exact figures)
- Non-performing loans (billions of euro): 2005: 9.6; 2006: 10.9; 2007: 16.3; 2008: 63.1; 2009: 93.3; 2010: 107.2.
- Non-performing to total loans (percent): 2005: 0.8; 2006: 0.7; 2007: 0.9; 2008: 3.4; 2009: 5.1; 2010: 5.8.
- Provisions to non-performing loans (percent): 2005: 255.5; 2006: 272.2; 2007: 214.6; 2008: 70.8; 2009: 58.6; 2010: 67.2.
- Exposure to construction sector (billions of euro): 2005: 262.8; 2006: 378.4; 2007: 457.0; 2008: 469.9; 2009: 453.4; 2010: 430.3.
  - of which: Non-performing (construction, billions): 2005: 0.5; 2006: 0.3; 2007: 0.6; 2008: 5.7; 2009: 9.6; 2010: 13.5.
- Households - House purchase (billions of euro): 2005: 427.0; 2006: 523.6; 2007: 595.9; 2008: 626.6; 2009: 624.8; 2010: 632.4.
  - of which: Non-performing (house purchase, billions): 2005: 0.4; 2006: 0.4; 2007: 0.7; 2008: 2.4; 2009: 2.9; 2010: 2.4.
- Use of ECB refinancing (billions of euro): 2005: 30.3; 2006: 21.2; 2007: 52.3; 2008: 92.8; 2009: 81.4; 2010: 69.7.
  - in percent of total ECB refin. operations: 2005: 7.7; 2006: 4.9; 2007: 11.6; 2008: 11.6; 2009: 12.1; 2010: 10.8.
  - in percent of total assets of Spanish MFI: 2005: 1.4; 2006: 0.8; 2007: 1.7; 2008: 2.7; 2009: 2.4; 2010: 2.0.
- Loan-to-deposit ratio: 2005: 161.0; 2006: 165.0; 2007: 168.2; 2008: 158.0; 2009: 151.5; 2010: 149.2.

### Illustrative policy-relevant observations (drawn from source analysis)
- Large near-term funding needs for public sector and banks imply continued market scrutiny and vulnerability to stress scenarios.
- Reducing gross financing needs and stabilizing debt require fiscal consolidation measures; expected measures would help stabilize but stress scenarios can reverse improvements.
- Progress in narrowing the current account deficit and consolidation of external liabilities should help put gross external debt on a downward path in the baseline.
- Bank balance-sheet repair is critical given the sharp rise in non-performing loans and waning provision buffers observed up to 2010.

_Italic: Source: _cr11215 - 54.      It is proposed to hold the next Article IV consultation on the regular 12-month cycle.

### 2.4 percent over the projection period. The impact of an increase in interest rate is not

### _cr11215 - 2.4 percent over the projection period. The impact of an increase in interest rate is not

### Public debt sustainability: baseline and shocks
- Baseline public debt trajectory: baseline values shown in figures (example box: Baseline: 76.2 percent of GDP).
- Impact of a real interest rate shock:
  - Historical average real interest rate: 1.3 percent.
  - Scenario: real interest rates reach 3.4 percent (representing a ½ standard deviation shock).
  - Result: debt would increase to 78.7 percent of GDP by 2016, about 2½ percentage points of GDP above the baseline.
- Role of debt maturity:
  - Average maturity of central government debt rose from 5.6 years in 2000 to 6.6 years in 2010.
  - As a result, debt rollover over the forecasting period is expected to be modest.
- Sensitivity to growth shocks:
  - If growth falls by a little over 1 percentage point over the forecasting period, the debt-to-GDP ratio could reach 91.8 percent by 2016, about 16 percentage points higher relative to the baseline.
- Euro depreciation and contingent liabilities:
  - A 30 percent nominal depreciation of the euro (after adjusting for domestic inflation) combined with a contingent liability shock of 10 percent of GDP would raise the debt-to-GDP trajectory to 86½ percent.
  - Foreign-currency denominated government liabilities: less than 2 percent.

### Alternative scenarios for external sustainability (external debt in percent of GDP)
- Interest rate shock:
  - Permanent ½ standard deviation shock to the interest rate for all outstanding external debt = 40 basis point increase from the baseline.
  - Effect: increases external debt compared to baseline by roughly 7 percentage points of GDP by 2016.
- Growth shock:
  - Permanent ½ standard deviation shock to projected real growth rate → prolonged anemic growth of 0.6 percent on average.
  - Effect: increases external debt compared to baseline by roughly 14 percentage points of GDP at the projection horizon.
- Standard combined shock:
  - Permanent ¼ standard deviation shock applied to projected interest rate, real growth rate, and current account balance.
  - Effect: increases external debt compared to baseline by about 13 percentage points of GDP by 2016.
- Country-specific combined (tail-risk) shock:
  - Permanent one standard deviation shock to the interest rate (80 basis points above the baseline) and ½ standard deviation shock to the growth rate.
  - Effect: by 2016 external debt would surge compared to the baseline by about 21 percentage points of GDP.

### Fiscal and macroeconomic context and policy implications
- Fiscal consolidation:
  - Deficit target: 3 percent of GDP in 2013.
  - The fiscal deficit improved by about 2 percentage points of GDP from 2009 to 9.2 percent of GDP in 2010.
- Banking sector developments:
  - Tier 1 capital ratio increased from 8.4 percent in 2008 to 9.6 percent in 2010.
  - Number of savings banks fell from 45 to 18 following reshaping.
  - Decree in February 2011 prompted savings banks to transfer banking activities to commercial bank entities and prepare recapitalization plans (IPOs or FROB participation).
- Executive Board assessment and policy recommendations (summarized):
  - Continue decisive implementation of financial sector reform; strengthen provisioning and capital buffers and maintain transparency on real estate exposures and funding profiles.
  - Steadfast fiscal adjustment is key; additional measures may be needed if near-term risks materialize.
  - Urge all levels of government, including sub-national, to deliver on fiscal commitments.
  - Continue labor market reforms to reduce unemployment: promote decentralized wage bargaining, less indexation, and further lower severance payments.
  - Complement labor adjustments with structural reforms in the non-tradable sector: more efficient regulatory environment and further opening up regulated professions and services.

### Key indicators and selected statistics (2006–11 and related data)
- GDP and demand (percent change):
  - Gross domestic product: 2006: 4.0; 2007: 3.6; 2008: 0.9; 2009: -3.7; 2010: -0.1; 2011: 0.8.
  - Private consumption: 3.8; 3.7; -0.6; -4.2; 1.2; 0.7.
  - Gross fixed investment: 7.2; 4.5; -4.8; -16.0; -7.6; -2.8.
  - Construction investment: 6.0; 3.2; -5.9; -11.9; -11.1; -8.0.
- Potential output growth and output gap:
  - Potential output growth (long run HP-filter): 2.7; 2.7; 2.4; 1.4; 0.5; 0.4.
  - Output gap (percent of potential): 3.0; 3.9; 2.4; -2.8; -3.4; -2.9.
- Prices and labor:
  - GDP deflator: 4.1; 3.3; 2.4; 0.6; 1.0; 1.6.
  - HICP (average): 3.6; 2.8; 4.1; -0.2; 2.0; 3.0.
  - Unemployment rate (percent): 8.5; 8.3; 11.3; 18.0; 20.1; 20.1.
  - Unit labor cost in manufacturing: 2.8; 4.1; 6.9; 2.8; -4.6; -1.2.
- External sector (percent of GDP):
  - Trade balance (goods): -8.5; -8.6; -7.9; -4.0; -4.4; -4.5.
  - Current account balance: -9.0; -10.0; -9.6; -5.2; -4.5; -4.2.
  - Net international investment position: -65.9; -78.1; -79.3; -91.1; -87.1; -88.6.
- Public finances:
  - General government balance: 2.0; 1.9; -4.2; -11.1; -9.2; -6.2.
  - Primary balance: 3.7; 3.5; -2.6; -9.4; -7.3; -4.1.
  - Structural balance: -1.2; -1.1; -4.9; -9.2; -7.4; -4.7.
  - General government debt: 39.6; 36.1; 39.8; 53.3; 60.1; 67.5.
- Fund relations and data specifics:
  - Quota: 4,023.40 (SDR Million), 100.00 percent of quota.
  - Fund holdings of currency: 2,912.78 (SDR Million), 72.40 percent of quota.
  - Reserve position in Fund: 1,110.65 (SDR Million), 27.60 percent of quota.
  - SDR net cumulative allocation: 2827.56 (SDR Million), 100.00 percent of allocation.
  - SDR holdings: 2951.89 (SDR Million), 104.4 percent of allocation.
  - Projected payments to Fund (Charges/Interest) forthcoming: 2011: 0.48 (SDR Million); 2012: 0.99; 2013: 0.99; 2014: 0.99; 2015: 0.99.
  - Fund position (June 30, 2011): Holdings of currency (percent of quota): 72.4; Holdings of SDRs (percent of allocation): 93.8; Quota (millions of SDRs): 4,023.4.

*Source: INTERNATIONAL MONETARY FUND—SPAIN: Staff Report for the 2011 Article IV Consultation—Informational Annex and Supplementary Information (July 6, 2011; July 19, 2011), and Public Information Notice No. 11/102 (July 29, 2011).*

### 1.      The European Banking Authority (EBA) released the results of the EU-wide

### The European Banking Authority (EBA) released the results of the EU-wide

### EBA stress test results (Spain)
- Coverage of the Spanish system: 93 percent (EBA requirement: at least 50 percent).
- Number of Spanish institutions participating: 25.
- Analysis incorporates measures through April 2011, including existing and committed FROB support for weaker institutions.
- Results under the adverse scenario:
  - Institutions below the benchmark: 5 out of the 25.
  - These represent 9 percent of total banking assets.
  - Combined shortfall: €1.6 billion (less than 0.2 percent of GDP).
- Country-specific balance sheet elements (e.g., generic provisions and mandatory convertible bonds in Spain) were not taken into account as loss-absorbing instruments for comparability; Spanish authorities indicate that if they are counted, no additional capital is required as a result of the exercise.
- Staff view: results underscore the importance of:
  - the FROB capital backstop;
  - decisively implementing envisaged financial sector reforms, in particular swiftly addressing the few small weak banks;
  - further strengthening capital buffers in light of current market tension.

### Bankia IPO
- IPO concluded on July 18.
- Amount and price were lowered compared to initial target ranges, implying a substantial discount to book value.
- Amount raised: slightly more than €3 billion.
  - Implication: no need to resort to FROB resources to meet minimum capital standards.
- Share of institutional investors: 40 percent (reportedly mainly domestic).
- Ownership: half of Bankia’s capital would be held by private investors.

### Fiscal rule and budget framework
- A Royal Decree (effective July 1) modifies the budget stability law to include an expenditure rule:
  - Central and local governments must keep the increase in nominal public expenditure (excluding interest and unemployment benefits) below the growth in nominal GDP.
  - Nominal GDP growth defined as the average of the past 5 years, the estimate for the current year, and projections for the next 3 years from the SGP.
- Use by regional governments to be discussed at the Fiscal and Financial Policy Council meeting scheduled for July 27.
- Staff view: an expenditure rule is a useful complement to the deficit rule and should be applied to all levels of government.

### Pension reform
- Draft pension reform scheduled for final approval by Congress on Thursday, July 21.
- Main pillars of the reform:
  - Increase of the statutory age of retirement to 67.
  - Tightening of conditions for access to partial and early retirement.
  - Extension of the period for calculating pension entitlement from the last 15 years to the last 25.
  - Introduction of a sustainability factor to update system parameters every five years according to changes in life expectancy.
- Impact estimates:
  - Could cut pension expenditures up to 3 and a half percent of GDP by 2050.
  - Could raise potential output by 0.2–0.3 percent.

### Authorities’ macroeconomic assessment and outlook
- Spain stabilized in 2010; authorities expect growth to reach 1.3 percent in 2011.
- Exports driving recovery; export base widened with the number of companies exporting goods increasing by 12.6 percent over the last three years.
- Authorities estimate structural reforms could raise potential GDP by one percent by 2014 onwards.
- Balance of risks:
  - Downside: ongoing financial market spillovers and funding pressures from European sovereign debt market uncertainties.
  - Upside: substantial if financial markets normalize and spreads converge to fundamentals.

### Fiscal performance and targets
- General Government deficit in 2010 ended 0.1 percentage points below the Government's initial commitment (9.2 percent of GDP).
- Public debt: 60.1 percent of GDP (25 percentage points below the euro area average).
- Structural fiscal adjustment for 2011: 2.7 points of GDP (largest among major advanced economies, per the report).
- Authorities committed to SGP targets:
  - Deficit of 3 percent of GDP in 2013.
  - 2.1 percent of GDP and a structural primary surplus of 1 percent of GDP in 2014.
- Under staff’s macro projections, government debt to GDP stabilizes at 70 percent in 2013.
- Sub-national compliance: Autonomous Communities and local governments committed via Fiscal and Financial Policies Council resolutions; Royal Decree Law issued on July 1 reinforces fiscal discipline and introduces the spending rule on Budgetary Stability Laws.

### Financial sector restructuring and recapitalization
- First-phase outcomes:
  - FROB funds used to strengthen solvency: €10.1 billion.
  - Write-downs and provisions increased: additional €22 billion provisions by entities that requested FROB support.
  - Number of entities reduced from 45 to 18 through mergers and acquisitions.
  - Cost and capacity adjustments: on average 25 percent of branches cut and 15 percent of staff reduced.
- Second-phase objectives:
  - Improve governance, increase transparency, reinforce solvency and capital quality.
  - New regulation requires a capital principal ratio of at least 8 percent of risk-weighted-assets by end-September.
    - For entities considered heavily dependent on wholesale markets (20 percent threshold) this ratio is increased to 10 percent.
  - FROB will subscribe shares if necessary to allow compliance; interventions to be temporary, market-based, and backed by demanding restructuring plans approved by Banco de España, the EC and the FROB, with independent audits by renowned international firms.
  - Expected FROB support: only four savings banks—representing eight percent of total assets of the Spanish banking system—will require this support.
- Note on capital principal definition:
  - Capital principal = core capital + convertible preference shares subscribed by FROB + debt instruments mandatorily convertible into common shares before end-2014.

### Labor market and other structural reforms
- Labor market:
  - Staff describes traditional problems of duality and inflexibility; reforms pursued to foster permanent and training contracts, clarify grounds for objective dismissal, and reform collective bargaining to incentivize company-level bargaining, link agreements to economic conditions, encourage prompt renegotiation, and expand opt-out clauses.
  - Authorities acknowledge more work remains but view reforms to date as important steps to improve potential growth.
- Other structural measures:
  - Full transposition of the European Service Directive to boost productivity and reduce administrative burdens.
  - Sustainable Economy Law (enacted last March) introduces improvements in competitiveness-related areas: economic environment, innovation, education, and energy mix.
  - Revamps to airport management and state lotteries through modern regulatory frameworks, private management systems, and partial privatization.
  - Telecommunications regulation improvements to achieve more efficient spectrum use via reallocation and auctioning.

### Concluding assessment by authorities
- Spain has laid the ground for a new growth model aimed at being more sustainable and higher productivity within a monetary union.
- Authorities stress no room for complacency and the need to maintain reform momentum with overarching goals of fostering growth and creating employment.

*Sources: European Banking Authority; Bank of Spain; and IMF staff estimates.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11215.pdf_