Concluding Remarks of 1999 Article IV Consultation--Spain

March 30, 1999

At the conclusion of annual Article IV bilateral discussions with the authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a statement of its preliminary findings.
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Spain—1999 Article IV Consultation Mission

Concluding Remarks
March 30, 1999

The expectation that Spain would be among the countries to benefit most from EMU has been confirmed by recent developments. Prudent monetary and fiscal policies over the last few years made possible the adjustment of the public finances to meet the Maastricht criteria. Together with wage moderation and structural reforms, this has resulted in a lowering of inflation, an even sharper reduction in interest rates, and declining public debt as a share of GDP. This in turn has triggered a virtuous circle of rapid economic growth and job creation. It is difficult to overstate the importance for Spain of becoming a founding member of the euro, and the authorities deserve ample credit for this major success, which has also enjoyed widespread support among Spanish society at large.

Now that stability has been achieved and Spain is inside the monetary union, the key policy challenge is to ensure that the opportunities offered by the new regime are fully grasped. Today's favorable macroeconomic position should be viewed as an opportunity to extend the ongoing implementation of ambitious and comprehensive policies that are necessary to promote rapid convergence of Spain's per capita income level to the EU average, to reduce unemployment from 18 percent at present to single digits, and to prepare for the consequences of the aging of the population. This will require shifts in the structure of taxation and expenditure, and far-reaching liberalization of the goods and factor markets, as well as prudent macro policies.

Prospects for 1999

Domestic demand is likely to continue expanding very strongly in 1999, but exports have slowed sharply as a result of the crisis in emerging markets and lower growth in some of Spain's main trading partners in Europe. This in turn is likely to dampen overall GDP growth, which we project at 3¼–3½ percent in 1999, as against close to 4 percent in 1998. With continued strong growth in relatively labor intensive sectors such as construction and services, employment is expected to remain buoyant. The rapid recovery in employment since 1995 has reflected not only favorable cyclical developments, but also the trade unions' responsible behavior in preserving a climate of social peace and keeping wage demands moderate, as well as the positive impact of the labor market reforms of 1994 and 1997.

With wage settlements running at about 2 percent, and continued moderation in import prices, the strong growth of domestic demand is not expected to give rise to inflationary pressures. Hence, despite the reversal of some one-time factors that reduced the inflation rate in 1998, inflation is nevertheless likely to remain at about 2 percent in 1999, consistent with the Government's forecast. This level of inflation is not a cause of concern in itself. However, the existence of a differential of ½–¾ of a percentage point vis-à-vis the rest of the euro area should not be viewed with complacency, because relatively low productivity growth has contributed to a more rapid increase in unit labor costs in Spanish industry than in the rest of the euro area in recent years. Given the absence of scope for nominal exchange rate adjustment now that Spain is in the common currency area, preserving competitiveness should be given the highest priority. To that end, it will be necessary to continue the process of consolidating and reforming the public finances and implementing supply-side structural reforms in the product and labor markets to raise productivity and growth.

Fiscal Policy

The Spanish authorities' Stability Program envisages achievement of balance in the public finances by 2002. That objective seems appropriate: once attained, from thenceforward it should be possible to remain within the 3 percent deficit limit set by the Stability and Growth Pact without having to take contractionary measures in case of an economic downturn. The 1999 budget targets a deficit of 1.6 percent of GDP—a rather modest reduction compared with the (admittedly, much better than expected) outturn of 1.8 percent of GDP in 1998. Given the need to reach structural balance by 2002, the 1999 budget could have moved more forcefully toward fiscal balance. Accordingly, to the extent that revenues are greater than anticipated in the budget, we would suggest that the authorities overperform on the deficit. A weakening of the target should only be considered if growth falls well short of current projections, which seems unlikely. Ambition in implementing the 1999 budget is appropriate in view of the inflation differential and the relatively lax monetary conditions in Spain. In any case, disciplined implementation of the expenditure budget will be of great importance.

The Role of Automatic Stabilizers

Looking ahead to next year, the Stability Program's target of a fiscal deficit of 1.0 percent of GDP in 2000 seems broadly appropriate under current macroeconomic projections. Nevertheless, now that Spain is in the EMU and is well below the 3 percent deficit limit under the Stability and Growth Pact, the need to meet specific nominal deficit targets has become less over-riding, and more attention can be paid to the prevailing cyclical conditions when determining annual fiscal targets. When setting the budget targets for 2000 in the late summer of 1999, the authorities should be more ambitious in case growth is very strong and inflationary pressures appear likely to emerge, especially if monetary policy in the euro area is eased later this year. Conversely, if the outlook for growth changes considerably for the worse—which seems unlikely—the authorities should be willing to set a less ambitious nominal deficit target. This is because, under monetary union, fiscal policy has become the only instrument to dampen the economic cycle, and a willingness to let the automatic stabilizers operate in a symmetric manner—compatible with, but also in the spirit of, the Stability and Growth Pact—has now become more important than in the past. Adherence to the nominal deficit targets in the Stability Program even in the face of large deviations from the expected macroeconomic environment would run the risk of accentuating the cycle in both good times and bad. Instead, discipline should be maintained on the expenditure side, with cyclical fluctuations in revenue playing the stabilizing role.

Cuts in Primary Current Outlays

To eliminate the fiscal deficit by 2002, the Stability Program envisages a cut in primary current expenditures by 2 percentage points of GDP between 1998 and 2002. This is an objective that we support, as it would make room for increased investment as well as lower taxation. In this vein, we support the reform of the IRPF undertaken this year as it will reduce the tax wedge on labor and eliminate distortions in the taxation of capital income. However, the current expenditure targets will be attained only through forceful reforms that have not been fully identified. Possible areas of saving include a decline in the number of civil servants, including by reducing the duplication of responsibilities between the central and the regional and local governments; reforms and improved efficiency in the health care system; and lower transfers through greater discipline on social spending.

Using the Ensuing Margin to Foment Employment

If primary current expenditures are indeed reduced as planned, and if the assumptions in the Stability Program on revenue buoyancy and the interest bill turn out to be conservative, margins could be generated relative to the Program targets. Over the long run, it could be argued that structural balance in the overall public sector is not enough, and that any margins should be saved to prepare for the aging of the population. In our view, the best course would be to use any such margins as part of a concerted set of reforms aimed at accelerating growth and generating greater employment, including via reductions in social security tax rates. The tax burden on labor is very high in Spain, particularly compared with countries with low unemployment. Cuts in social security contributions, however, would have to be combined with other measures to preserve the long-run sustainability of the pension system.

Reforms to the Pension System

Even though the contributive pension system is projected to be in balance or to run small surpluses during the next ten years, major changes are needed to prepare for the consequences of the expected sharp increase in the ratio of pensioners to people of working age-from one to four today to one to two in 2040. Measures are already being undertaken in the framework of the Pacto de Toledo to strengthen the finances of the system. However, further measures will clearly be needed, and their impact will be less disruptive the earlier they are taken. Possibilities include increasing the role of private complementary pensions; a further reduction in the ratio of pensions to lifetime wages (the replacement ratio) for future retirees; and further gradual increases in the retirement age. The next round of discussions on the Pacto de Toledo will be of great importance for addressing these issues.

The Health System

In health care, progress has been made in keeping the growth of expenditures in line with GDP through improvement in the administration of the system and measures to curb fraud. These efforts need to be pursued further, and additional savings from continued application of the current strategy may be considerable. However, rising incomes and the aging of the population will put increasing strain on the health budget in coming years. Thus, there is still a need to contain costs through enhanced incentives to consumers, including more widely applied user fees; and continued implementation of reforms providing greater autonomy and productivity incentives to hospitals and health care centers. One potentially significant source for savings would be through liberalization of the market for pharmaceuticals (which currently absorb about 20 percent of health care expenditure) and greater use of generic drugs. The cost of pharmaceuticals more generally could be reduced by providing permits for the opening of new pharmacies more liberally, widening the range of products that can be sold by other types of retail outlets, and removing restrictions on the ability of large chains to hire pharmacists and sell pharmaceuticals.

Regional and Local Government Finances

The regional and local authorities have, taken together, played an important role in reducing their deficits and achieving the Maastricht targets in recent years, and they have committed themselves to continued discipline in the framework of a domestic stability pact. The ongoing transfer of responsibilities over health and education, as well as of increased powers over taxation, heightens the importance of financial discipline in the regional and local authorities in securing the achievement of the goals of the national Stability Program. The financing system put in place in 1997 recognizes that divorcing the ability to spend revenues from the responsibility to raise them generates incentives to overspend, and that regional and local governments that choose to provide more expensive services should bear the political costs of their financing. In order for the system to be fully effective, however, the devolution of expenditure responsibilities must be accompanied by hard budget constraints at the level of the regional and local governments.

One way of ensuring that regional governments continue to fulfill their commitments under the program would be to publish the targets and the outturns of fiscal deficits of each regional government in a timely and transparent manner. Scrutiny by the public at large would provide a powerful incentive for compliance with the agreed targets. Also, the trend toward the creation of new public entities by the regional and local governments should be monitored closely. Even though these entities are outside the general government, and their debts are small at present, over the medium term they could cause significant problems.

The Need for Greater Flexibility in the Economy

Under monetary union, the ability to respond to shocks and to preserve the country's competitiveness will be ensured only through greater flexibility throughout the economy. To be fair, many of the rigidities that are present in Spain still exist also in other European countries, and are producing similar results in terms of unacceptably high unemployment. Thus, this is not the model that Spain should compare itself to if it wishes to outdo its neighbors. To promote faster growth and job creation, and achieve real convergence with the rest of the euro area, wide ranging reforms are needed in many areas. This is clearly recognized by the authorities and reflected in the large number of measures that are already being introduced or contemplated.

The Labor Market

Despite the recent rapid growth of employment, the unemployment rate and the share of temporary employment in Spain are still the highest among industrial countries, and the participation rate remains relatively low. The excessive share of temporary contracts carries high social and economic costs. The reforms of 1994 and 1997, by and large, have been steps in the right direction, but their effects in terms of reducing the ratio of temporary to permanent workers are still moderate. The reforms therefore need to be deepened in the direction of a further lowering of dismissal costs, which are doubtless the root cause of the high share of temporary employment; and greater decentralization of the wage bargaining system. In addition, the duration of unemployment benefits should be reduced to provide stronger incentives to search for jobs early on, before workers begin to lose their skills. The resulting savings could be used for transfers to the truly needy, among them the many unemployed who do not qualify for any benefits at present.

Building on the approach adopted in 1997, a new attempt should be made to clarify the definition of "justified" dismissals; to reduce compensation for "unjustified" dismissals, and thus the great difference in compensation between the two and the associated strong incentive to litigation; and to place the burden of proof that the dismissal was "unjustified" on the employee. Such steps could perhaps be allied to an additional reduction of social security contributions for new permanent contracts incorporating these changes and applying to all categories of workers. The advantage of extending the duration of reduced employer social security contributions for workers that have already been hired, however, is not clear, and runs the risk of becoming a mere subsidy to employers.

The authorities aim to increase the number of part-time (as opposed to temporary) jobs through the recent introduction of the new type of part-time permanent contract. While it is too early to tell whether the new contract will have a large impact, there is obviously considerable scope for job creation through this channel.

A striking feature of the Spanish labor market is the large and persistent differences in regional unemployment rates. This suggests that the wage bargaining system is de facto excessively centralized, and that wages in high-unemployment areas do not fall sufficiently to attract firms there. To improve the situation, the social partners should seek greater wage bargaining decentralization, as foreseen by their 1997 agreement. One possibility would be for the social partners to agree that all firms above a certain size should have a firm-level round of wage negotiations, and to ensure that higher-level negotiations do not impose a binding minimum on lower-level settlements.

Additional measures in the labor market might well include scaling down the Plan de Empleo Rural, which artificially encourages underemployed workers to remain in a declining sector, and replacing it with general unemployment protection and retraining programs. Active labor market policies are being stepped up, as foreseen in the Stability Program. Experience suggests that these policies must be well targeted (for example, to training programs for the unskilled) and closely monitored to ensure that they do not just become a generalized subsidy to employers.

Liberalization in Other Markets

The authorities should be given great credit for the wide range of structural reforms already implemented in recent years, notably in electricity and telecommunications, as well as in privatization, where the progress has been particularly impressive during the past two years. The plan essentially to complete the privatization process by next year is laudable. Steps have been taken to improve the efficiency of public enterprises such as RENFE that are not slated for privatization, but more will be needed to prevent them from accumulating further debts that will eventually be covered by the government. The independent regulatory agency for the energy sector contemplated in the new Energy Law should be set up as soon as possible. Once this is done, it should become possible to accelerate the liberalization of the natural gas sector. In this vein, we also strongly support the efforts underway to enhance the powers and resources of the Tribunal de Defensa de la Competencia.

Despite the progress that has been made, widespread rigidities and distortions in goods and other factor markets are contributing to unemployment in Spain. Priority areas for further action seem to be the land, retail trade, and rental housing markets. In the market for land, recent legislation goes in the right direction, by establishing that all land can be used for construction unless it is explicitly protected. Nevertheless, local authorities apparently are still restricting supply to sustain prices and the related revenues, which account for a considerable share of their total revenues. A new approach to urban zoning seems to be needed to avoid piecemeal actions and cumbersome processes.

In the area of retail trade, the regional and local governments are unduly restricting permits for the establishment of new large outlets. Opening hours in retail trade should be liberalized. This would boost part-time employment and provide many benefits for employers, employees and consumers in general. This could be particularly helpful in increasing female employment.

With respect to rental housing, a liberalization of the legislation on contracts is needed. Minimum contract lengths and other restrictions constrain supply, making it difficult for unemployed workers to move, particularly in a situation where the vast majority of employment vacancies are, at least initially, for temporary jobs.

The regional and local governments need to assume major responsibility in the reform effort that is vital to allow Spain to reap the full benefit of membership in EMU. We would urge them to cooperate with liberalizing initiatives. Liberalization measures will require tackling a wide range of vested interests. But, there are large constituencies that draw benefits from liberalization: every citizen is a consumer and the high level of unemployment has pervasive, negative ramifications throughout Spanish life. Businesses will locate and thrive in those regions and cities where regulations are less cumbersome and permits are provided more liberally. Ultimately, the benefits to all members of society that would accrue from greater liberalization will far outweigh the costs to vested interests.

Financial Sector Issues

With the achievement of monetary union, the banking system is facing new challenges. At the same time, the crisis in Latin America will impose costs on some banks, but the prudent provisioning undertaken over the past years should enable them to face these without much difficulty. The introduction of the euro will have deep and long-lasting implications. Increased competition and declining margins have already prompted considerable merger activity in Spain and other countries. Privatizing the cajas de ahorro, which would require a change in their legal status, would allow market forces to determine the new structure of the Spanish banking system independently of institutional constraints. This approach has been adopted successfully by other countries that had similar systems.

Recent efforts to foster the development of the stock market, which is still underutilized compared with other countries, are welcome. Growth of the domestic equity market would make it easier for entrepreneurs to raise financing, would increase the transparency of companies' accounts, and would reduce the need for close relations between the large banks and industry.

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Dramatic changes have occurred in Spain's economy in recent years, culminating in membership in EMU. The fruits of these efforts are now being enjoyed in the form of high growth, low inflation, and rising employment. Nevertheless, per capita incomes remain below the European average and unemployment—despite recent declines—is still extremely high. EMU membership presents Spain with the opportunity for sustained rapid growth of output and employment, but only to the extent that the economy is freed from the widespread structural rigidities that continue to fetter its productive capacity. It is to be hoped that the national consensus that enabled Spain to adopt the reforms necessary to join EMU can be maintained to see the process of adaptation to this new international reality through to a successful conclusion.