Spain--2010 Article IV Consultation, Concluding Statement of the Mission

IMF News, May 24, 2010

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Published: May 24, 2010

Context and executive summary

Madrid, May 24, 2010.
Spain faces multiple severe challenges: a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness.
Ambitious fiscal consolidation is underway, recently reinforced and front-loaded. This needs to be complemented with growth-enhancing structural reforms (particularly a labor market overhaul), a bold pension reform along government proposals, and accelerated banking consolidation and reform.
Broad political and social support is essential and time is of the essence.

The outlook: a weak and fragile recovery

Recent developments and near-term status:
- Imbalances accumulated during the boom have begun to unwind; the current account deficit has halved as private savings surged and housing investment fell.
- Competitiveness has begun to improve as productivity rose and the core inflation differential turned negative.
- Output rose slightly in the first quarter, ending the long and deep recession.
- Unemployment has soared as firms adjusted employment rather than wages or working hours.
Staff projection (central scenario):
- Growth rising gradually to 1½-2 percent in the medium term.
- Domestic demand recovers only slowly due to continued uncertainty, high unemployment, and the need to reduce indebtedness; public demand constrained by large-scale consolidation.
- Stronger export growth should support the recovery; inflation would remain subdued despite rebounding energy prices and the VAT increase.
- Slowing population growth, high unemployment, and weak investment weigh on potential growth.
Uncertainty and risks:
- Upside: faster household consumption recovery, firmer global recovery, weaker euro boosting exports.
- Downside: possible stagnation if private demand weakness and fiscal consolidation interact, especially if competitiveness and growth reforms are timid.
- Financial market deterioration could raise borrowing costs for government and private sector.

Policy agenda: rebalancing the economy and boosting confidence

Core policy priorities:
- Make the labor market more flexible to promote employment and reallocation across sectors.
- Pursue fiscal consolidation to put public finances on a sustainable footing.
- Accelerate banking sector consolidation and reform to cement soundness and efficiency.
Synergies:
- Labor market reform coupled with further liberalization of product and service markets would boost investment and employment, reduce prices, ease fiscal consolidation, and strengthen banks.
Implementation:
- Reforms should be proactive to boost financial market sentiment and underpin credibility.

Structural reforms to spur growth through increased competitiveness and employment

Labor market findings:
- Unemployment is structurally high and excessively cyclical due to high labor market duality.
- The wage bargaining system limits wage and firms’ flexibility and is ill-suited to currency union membership.
- The government provided broad guidelines for reform to be negotiated by social partners with an agreement expected by the end of May.
Recommended labor market reforms (radical overhaul urged):
- Reduce duality and encourage permanent hires by lowering severance payments to at least EU average levels and preventing excessive use of unfair dismissals.
- Boost wage flexibility and employment by coupling reduced protection of permanent contracts with decentralizing wage setting (for example by moving to an “opt-in” rather than “opt-out” system for collective bargaining) and eliminating indexation.
- Care: ensure reforms do not increase fiscal cost or make temporary employment more difficult in the near term.
- If social partners fail to agree quickly, the government should act, including on collective bargaining.
Product and service markets:
- Commendable recent progress (including transposing the EU Services Directive and housing sector measures), but implementation is critical.
- Priority: further reduce restrictions on retail trade, professional services, and the rental market to boost growth and competitiveness.

Fiscal policy: restoring sustainability

Consolidation targets and measures:
- Ambitious fiscal consolidation underway to reach the three percent of GDP deficit target by 2013.
- Achieving the implied 10 percent of GDP improvement in the primary balance from 2009 to 2013 requires a wide range of measures; staff fully support the recent fiscal package approved by the Cabinet.
- The new path implies cutting the deficit by more than five percentage points of GDP in 2010 and 2011 and would put the government debt ratio onto a downward path in a reasonable timeframe.
Risks and recommended safeguards:
- Any slippage should be aggressively pre-empted; risks arise from implementation and from underlying projections of a fairly rapid recovery.
- Supporting structural reforms must be implemented quickly; additional high-quality adjustment measures should be prepared in advance to allow pre-emptive correction of slippages.
- Measures should protect the most vulnerable and could include further reducing spending, and raising revenue by reducing tax benefits and further increasing relatively low VAT and excise rates.
Pension reform:
- Bold pension reform (including raising the retirement age to 67 and an automatic link to life expectancy) should be implemented soon to strengthen long-term sustainability.
Fiscal institutions:
- Stronger fiscal frameworks are needed, given bulk spending occurs in Autonomous Communities.
- Institutionalize spending review processes to improve quality and durability of spending reductions.
- Consider options to bolster credibility, for example establishing an independent fiscal council.

Banks: accelerating consolidation and reform

Current banking sector assessment:
- The banking sector is sound but under pressure; impaired assets have increased, though banks report robust capital and provision buffers supported by a strong supervisory framework.
- Risks are elevated and unevenly distributed, focused mainly on savings banks.
- Repossessed real assets are largely land, difficult to value.
- Market liquidity conditions remain difficult and access limited; further strains may arise from unwinding of exceptional ECB liquidity measures, ending of the funding guarantee scheme, and intense deposit competition.
- Funding difficulties, weaker credit growth, provisioning for troubled assets, and system overcapacity will likely pressure profitability.
Consolidation and diagnostics:
- Consolidation needs to accelerate to reduce overcapacity and produce more robust institutions.
- Progress under the Fund for Orderly Bank Restructuring (FROB) has been too slow; much more progress is needed before the FROB deadline of end-June 2010.
- The Bank of Spain should be prepared to intervene promptly where pockets of weakness remain.
- A comprehensive and transparent bank-by-bank “diagnostic” based on conservative assumptions on asset valuation and prospects should be carried out to enhance investor confidence.
Savings banks legal framework:
- The current legal structure is ill-suited to future needs: cross-region mergers require regional approval, the sector is closed to external investors, and capacity to raise external capital is limited.
- Legislative and policy priorities:

1. Reduce political influence in savings banks. 2. Enhance their ability to raise external capital. 3. Offer an opportunity to transform into stock-holding companies, and require this for systemically important savings banks.

Prompt implementation is necessary so savings banks can access the full range of options to raise capital as soon as possible.

Concluding Statement of the Mission, Spain—2010 Article IV Consultation, May 24, 2010 (IMF staff).