Public Information Notice No. 04/31

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Spain

April 2, 2004

On March 19, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Spain.¹

Background

While not escaping the global slowdown, the Spanish economy has weathered it relatively well thanks to the strength of domestic demand. After several years of growth in excess of 4 percent, partly propelled by the tailwinds of EMU participation, the expansion lost steam in 2001 and growth slowed to 2½ percent in 2003. The slowdown reflected euro area weakness and the worldwide slump in tourism. But domestic demand held up well, buoyed by private consumption, public infrastructure spending, and booming construction activity. Output growth thus remained well above the euro-area average, ensuring further real income convergence. In addition, as labor market flexibility improved, employment continued expanding. These developments contrast with previous slowdowns, when growth would fall well below the euro-area average with sizable job losses. Productivity performance, however, has remained lackluster, partly reflecting the success in drawing new, lower-skilled entrants into employment. Concurrently, household indebtedness rose rapidly, amidst a continued housing price boom.

Inflation and its margin over the euro area have declined since late 2002, but the cumulative inflation differential with the euro area, transmitted to labor costs via widespread indexation mechanisms, has eroded competitiveness. While overall export market shares have held up well, export margins have come under increasing pressure.

Gains in fiscal consolidation were maintained in 2003, with the general government recording a small surplus (0.3 percent of GDP) and helping to counter very easy monetary conditions. For 2004, the budget target of a "zero deficit"—formulated when that was the expected outcome for 2003—would imply some fiscal loosening. For its part, monetary policy from Spain's perspective is clearly accommodative, with short-term real interest rates in negative territory for over two years.

Despite the uncertainty generated by the recent terrorist attacks, the prevailing prospect is that of a moderate but sustained recovery, with growth projected slightly below 3 percent in 2004. Such a performance—predicated to be largely driven by the strength of domestic demand, with a continued, albeit smaller, drag from net exports—would again appreciably outstrip that expected for the euro area. Inflation is projected to remain in the order of 2.7 percent, implying a differential of around 1 percentage point with respect to euro area inflation forecasts.

After a trying two years—with substantial declines in profits associated with investments in Latin America—the banking sector staged a come back in 2003, and exhibits comparatively strong key indicators. Market participants generally view domestic risks from the sector's exposure to the housing market as manageable.

On the structural front, following reform of the unemployment benefits system at end-2002, main measures in 2003 concerned the full liberalization of the electricity and gas markets, initiatives to improve corporate governance and modernize the business environment, and new steps to counter money laundering and the financing of terrorism. Some other long-standing issues, however, including pension reform, the wage negotiating framework, and the land supply process, remain to be addressed.

Executive Board Assessment

Executive Directors expressed their profound sympathy and solidarity with the Spanish people and authorities in the face of the terrorist attacks of March 11 in Madrid.

Directors commended Spain's pursuit of stability-oriented macroeconomic policies and structural reforms which have secured a continued rise in per capita income, sustained job creation, and strengthened economic resilience. This performance is particularly noteworthy at a time of economic weakness elsewhere in Europe, and, in general, in the world economy. The exemplary pursuit of fiscal adjustment, in observance of Spain's Budgetary Stability Law and of the EU's Stability and Growth Pact, has appropriately focused on structural expenditure reductions. Against this background, Spain's short-term growth prospects remain favorable, despite the uncertainty caused by recent events.

To sustain this strong economic performance in the period ahead, Directors saw as priorities for the new government to take timely action to contain some emerging domestic risks and to pursue the structural reform agenda with determination. On the domestic front, there was general agreement that the boom in housing prices and rising household indebtedness—although driven by structural factors and not posing an imminent risk—cannot continue unabated without increasing the potential for an adverse fallout. To minimize this risk and facilitate a soft landing will require continued fiscal restraint and firm financial sector oversight. Decisive efforts will also be needed to press ahead with structural reforms in product and labor markets, as this will be key to address Spain's continued price differential with the euro area, enhance the economy's flexibility and supply-side response, and ensure competitiveness in an enlarged European Union.

With euro area monetary conditions being easy from Spain's perspective, Directors stressed that fiscal policy will need to remain appropriately restrictive. They welcomed the achievement of a small general government surplus in 2003, but noted that, in light of this result, the budgeted "zero deficit" for 2004 would imply a small fiscal stimulus. Most Directors encouraged the new government to aim for a better-than-budgeted result, availing itself of the useful framework provided by the Budgetary Stability Law. This should be achieved by keeping central government spending below the budget ceiling, carefully safeguarding the contingency fund for truly exceptional circumstances, and strengthening the monitoring of regional budget execution. Efforts to ensure the timely reporting of regional fiscal data will be important in this regard.

Directors welcomed the positive role that public infrastructure spending has played in supporting economic activity and growth potential, within the general context of fiscal consolidation. The widening range of financing modalities, with a growing share of investment carried out by public enterprises and through public-private partnerships, however, calls for strengthened monitoring and transparent quantification of the potential fiscal implications of these operations. Directors welcomed the expanded information in budget documents on investment carried out by state-owned nonfinancial enterprises and entities. They encouraged further steps toward closer tracking and fuller disclosure of all public contingent liabilities associated with public investment activities. The fiscal transparency ROSC, requested by the Spanish authorities, should provide timely guidance in this respect.

While welcoming the reduction in public sector debt and the strengthening of the social security reserve fund, Directors stressed that long-term fiscal sustainability will also need to be supported by comprehensive pension reform. They encouraged the new government to place pension reform high on its policy agenda with a view to translating the renewed Pacto de Toledo into a specific set of measures. These measures should be centered on gradually raising the effective retirement age and strengthening the link between contributions and benefits.

Directors noted that safeguarding external competitiveness, further improving the productivity and employment outlook, and reducing remaining price and cost differentials with the euro area will require sustained further reform efforts in labor and product markets. In particular, they highlighted the importance of moving toward a wage-setting process that is more attentive to productivity developments, including by scaling back the current widespread recourse to wage indexation clauses. In the process of social dialogue on this issue, Directors also encouraged the authorities to pursue steps to reduce the rigidity of open-ended employment contracts, noting that this rigidity has contributed to the high incidence of fixed-term employment. Directors also encouraged efforts to strengthen human capital and research and development.

In goods and services markets, Directors encouraged the authorities to build on the progress achieved to date through a vigorous enforcement of competition policy. In key network industries, much progress has already been made in strengthening competition, although in some sectors there remains scope for further improvements. In retail trade and distribution, Directors called for the removal of restrictive barriers on the part of regional governments, noting that this will ultimately be in the best interest of local consumers and the regions' own economic performance. Directors also encouraged the authorities to take steps to alleviate the long-standing constraints on the supply of developable land and promote greater transparency in the urban zoning process. They also called for a revision of the generous tax relief favoring home ownership, to help dampen the booming housing market.

Directors commended the prudent supervisory approach, which has allowed the banking sector to weather adverse external developments in 2001-02 and record a strong comeback in 2003, with high levels of solvency, profitability, and efficiency. Nonetheless, continued vigilance is needed in the face of the rapid expansion of credit and household indebtedness. Directors welcomed the steps to reduce the cost of mortgage refinancing and the authorities' efforts to raise the public's awareness of potential interest rate risks, as well as Spain's recent request for a Financial Sector Assessment Program (FSAP). They commended Spain's commitment to counter money laundering and the financing of terrorism, including the new comprehensive legislation in this area.

Directors welcomed the recent increase in Spain's official development assistance, and looked forward to further increases in the years ahead. They welcomed Spain's support for trade liberalization vis-à-vis the least developed countries, and encouraged the authorities to work actively toward the success of the Doha round.