Mission Concluding Statement 

Spain: Staff Concluding Statement of the 2021 Article IV Mission

December 22, 2021

Washington DC:

Economic Outlook

The Spanish economy is recovering from the deep recession caused by the COVID pandemic. Timely and decisive policy support has helped protect jobs, household incomes, and firm balance sheets. A highly successful vaccination campaign, with almost 90 percent of the target population now fully vaccinated, helped limit the impact of infections on hospitalizations, mobility, and economic activity in 2021. Employment has rebounded robustly and is already above pre-crisis levels. After falling by 10.8 percent in 2020, economic growth resumed in the second quarter of this year, although output remains well below its pre-pandemic level, in part due to the lingering impact of the pandemic on contact-intensive sectors and persistent global supply bottlenecks.

Economic activity is projected to grow at 4.6 percent in 2021 and 5.8 percent in 2022. Private consumption would remain the main driver of growth in the near term, underpinned by a strong labor market recovery and a continued normalization of households’ savings. Investment is expected to strengthen in 2022, reflecting robust demand, continued favorable financing conditions, a gradual easing of global supply bottlenecks, and a higher pace of deployment of Next Generation EU (NGEU) funds. The cumulative impact of the NGEU funds on output could reach 1½ to 2 percent by the end of 2022. External demand, particularly international tourism, is also expected to recover further in next year as vaccination rates increase globally. Headline inflation is likely to remain elevated in early 2022 due to high energy prices and supply-chain disruptions but should moderate in the second half of the year as these factors dissipate.

Uncertainty around the outlook is high, with the evolution of the pandemic remaining a key risk. The ongoing wave of infections highlights the continued risks that the pandemic poses to activity, especially if new variants reduce the effectiveness of vaccines. The pace of recovery will also depend on the duration and magnitude of supply disruptions. On the upside, a faster unwinding of households’ accumulated savings could lead to a stronger recovery of domestic demand. The pace of absorption of EU funds and how effectively they are used will shape the path of growth in the coming years. Finally, it is important that wage-setting negotiations continue to internalize the transitory nature of the current drivers of inflation and avoid a vicious cycle of higher wages leading to higher inflation.

Fiscal Policies

Unprecedented public support measures played a major role in limiting the economic fallout from the Covid crisis but have inevitably taken a toll on public finances. The swift response of the Spanish government and the ECB cushioned the impact of the economic shock by providing income and liquidity support and ensuring favorable financing conditions. The successful short-time work scheme (ERTE), along with support for the self-employed,

covered about 25 percent of total employment at the peak of the crisis, facilitating adjustment via working hours and limiting job losses. The number of firms benefitting from state-backed loan guarantees was the highest in Europe. Solvency support for the corporate sector aimed to prevent liquidity issues from morphing into solvency problems. Some key support measures have been extended into 2022 and made more targeted. The ECB’s highly accommodative stance has so far has helped keep long-term bond yields low and the public debt maturity has been extended. Nonetheless, the high level of public debt (at 120 percent of GDP in 2021) is a source of vulnerability.

Fiscal policy should remain supportive until the recovery is firmly entrenched, while becoming more targeted and focused on supporting the most vulnerable. With economic slack persisting and activity projected to return to pre-crisis levels only in late 2022 or early 2023, fiscal policy should remain broadly supportive next year, in line with the authorities’ 2022 draft budgetary plans. While the fiscal deficit is expected to decline in 2021 and 2022, this is mainly driven by the economic recovery and automatic stabilizers, and by the downscaling of the Covid-related emergency measures. The high weight of investment in government spending, facilitated by the use of EU funds, is most welcome. Any positive surprises to the fiscal balance from faster-than-expected recovery next year should be saved. Conversely, judicious use of the limited available fiscal space would be needed if downside risks materialize. The policy response should remain agile and, depending on the evolution of the pandemic, some support measures may need to continue to be flexibly extended, while becoming increasingly targeted to facilitate resource reallocation.

Over time, Spain will need to bring debt levels down to more prudent levels and create space for responding to future shocks. In the absence of discretionary measures, the fiscal deficit is expected to remain above pre-crisis levels over the medium term. A sustained gradual fiscal consolidation process should be initiated once the output gap is closed, and the economy is on a sustained growth path. Under the baseline scenario, these conditions would be met by 2023. The fiscal adjustment should be growth-friendly, which will require preserving space for public investment and education spending, and accompanying the process with growth-enhancing structural reforms. At the EU level, it would be desirable to complete the reform of the fiscal framework prior to the deactivation of the general escape clause, or to have a transitional arrangement until a reform becomes effective.

An early formulation of credible medium-term plans could help build the necessary social consensus and support investor confidence. Such plans would need to include both revenue measures and greater spending efficiency, while creating room for continued investment in key areas, including climate mitigation and adaptation. Possible revenue measures—which could bring the tax-to-GDP ratio closer to regional peers—include a broadening of tax bases and an increase in environmental taxes. The ongoing expert review of Spain’s tax system will provide valuable input in these areas. Expenditure rationalization should include efficiency improvements, informed by spending reviews. The recent creation of a permanent division within the fiscal responsibility authority (AIREF) to provide continuity to the spending review exercises is welcome.

The initial phase of the pension reform has prioritized social acceptability and sufficiency, but sustainability concerns remain in the absence of additional measures. Under the current reform proposal, pension payments will be permanently indexed to CPI inflation and the sustainability factor will be repealed starting in 2021. This would raise annual pension outlays by 3½ percent of GDP by 2050, compared to a full implementation of the previous pension legislation. Part of the increase is expected to be offset by other measures proposed in the first phase of the reform, such as the introduction of incentives to increase the effective retirement age and the temporary increase in social security contributions. Preserving the sustainability of public finances requires additional efforts to counterbalance pension spending pressures, which would also help signal the authorities’ commitment to fiscal responsibility. Possible additional measures include the introduction of mechanisms to restrain expenditure (for example, further extending work lives) and to raise revenues (such as by increasing the maximum earnings subject to contributions). Some of these measures are expected to be incorporated in the second phase of reforms in 2022.

Financial Policies

Public support has played a key role in cushioning the effect of the pandemic shock on private sector balance sheets. The crisis impact on labor markets and households’ income was partly offset by social transfers, including unemployment benefits, the ERTE program, and the minimum vital income scheme. Temporary debt payment moratoria also helped ease financial pressures. Household leverage and debt service ratios increased only moderately. The non-financial corporate sector experienced a significant drop in earnings in 2020 and has taken on greater debt to cover short-term liquidity needs. The state-backed loan guarantee support program provided critical support, accounting for about a third of new lending to non-financial corporates. While profitability improved in aggregate in 2021, the recovery has been uneven across sectors, and vulnerabilities have increased due to larger debt positions particularly in the most affected sectors.

Recent stress testing exercises suggest that banking sector capital buffers are broadly adequate, but close monitoring is needed to ensure continued resilience. Aggregate asset quality indicators have remained stable so far. Nonetheless, banks should maintain prudent levels of forward-looking provisions since borrower distress may come with a lag as support measures are phased out. Dividend payouts and share buybacks should continue to be assessed on a case-by-case basis, taking into account the uncertainty over the ultimate economic impact of the pandemic. In case downside risks materialize, banks should be encouraged to use their buffers to avoid undue tightening of lending conditions. At the EU level, completing the banking union with a common deposit insurance scheme would foster resilience. Strengthening Spain’s private debt resolution frameworks and ensuring sufficient court capacity to handle insolvency procedures is essential, including through the ongoing work to transpose the EU Directive on restructuring and insolvency, increase opportunities for a “fresh start” and introduce a special procedure for micro enterprises.

The planned expansion of the Bank of Spain’s macroprudential toolkit is timely. Residential transactions have picked up in 2021, reflecting pent-up demand, and residential prices have accelerated. While there is no evidence of significant misalignment in housing prices, close monitoring is warranted. Work is underway to expand the Bank of Spain’s macroprudential toolkit, which includes sectoral countercyclical capital buffers, sectoral concentration limits, and other tools. These instruments to mitigate sector-specific pressures could be useful, for example, if risks in the real estate sector become more pronounced.

Structural Policies

NGEU funds provide an exceptional opportunity to raise potential growth and make it more inclusive and sustainable by supporting strategic investments and facilitating needed structural reforms. Spain, one of the largest beneficiaries of the NGEU funds, is set to receive €69.5 billion in grants as part of the recovery and resilience mechanism. The European Commission endorsed Spain’s recovery plan and the first disbursement request, and now the emphasis is on implementation. The selection of projects with high social returns, efficient coordination, and a focus on transparency and accountability are critical to ensure effective use of the investment funds. The planned comprehensive structural reforms—if well designed and implemented—will amplify the positive impact of planned investments. It will be important to establish a framework for regular data-based evaluation of the effectiveness of these reforms. The success of the recovery plans across European countries, including Spain, could help build political support for future fiscal collaboration at the EU level.

The government has already made progress in a number of areas which would help boost productivity . Long-standing structural issues targeted by the reforms include low education completion rates, skills mismatches in the labor market, limited adoption of digital technologies by SMEs, and low investment in research and development. The education reforms aim to raise human capital by modernizing the education system, expanding vocational training and building up digital skills. Significant expansion of investment is planned in connectivity and in digitalization of the public administration and SMEs. Greater efforts to strengthen the collaboration between public and private sectors, including in research and development, would help increase the effectiveness of public investments.

Spain’s labor market reform plans identify the right priorities, but specific policies are still being discussed by the government and the social partners. Spain’s unemployment rate has historically been among the highest in the EU, with particularly elevated youth and long-term unemployment. Moreover, the country has one of the highest shares of temporary and involuntary part-time employment in Europe, which reduces incentives for training and the accumulation of human capital. Top policy priorities include addressing labor market duality, enhancing flexibility and job mobility, and improving the effectiveness of active labor market policies. These reforms should also help support the needed reallocation of workers related to pandemic-induced changes in consumer preferences and firm behavior, and to long-term structural shifts such as rising automation and the adoption of new technologies to address and adapt to climate change.

• Recent reforms to boost inclusion in the labor market, aiming to reduce gender wage gaps and promote the development of gender equality plans by large firms, are welcome. Moreover, the new laws that regulate work based on digital platforms and teleworking will help the Spanish labor market adapt to new practices triggered by the pandemic.

• The proposed measures in the new Employment Law aim to modernize active labor market policies. Key actions include the development of a national digital job market platform to facilitate labor matching and the provision of individualized employment services to the unemployed. An effective implementation and regular ex-post evaluation of these reforms, as well as close collaboration with the private sector, will be critical for their success.

• To help reduce duality, the use of temporary contracts for permanent work needs should be discouraged. In parallel, it would be important to make open-ended contracts more attractive to firms, including by reducing the cost of legal uncertainty associated with the dismissal of permanent workers. The use of well-designed short-time work schemes could provide firms with the ability to cushion temporary shocks. However, it would be important to ensure that such schemes do not put a burden on public finances. In case of structural shocks, a reallocation of workers across firms or sectors should be supported through more effective active labor market policies. The reforms to the collective bargaining system should aim to preserve flexibility, including by allowing firm-level agreements within broad parameters set at the sectoral level.

Continued efforts to address housing affordability would support growth, facilitate labor mobility across regions and reduce inequality. The draft housing law and national housing plan introduce a set of measures to improve housing affordability, including welcome targeted rent support programs for vulnerable groups. The proposed supply-side measures, such as an increase in taxes on empty properties and an expansion of the social housing stock, should help ease pressures on the rental market. However, some measures, such as rent caps for stressed areas, may introduce inefficiencies and restrict the availability of properties for future renters. Further evaluation of the measures would be useful to gauge their impact. Additional policies to increase housing supply could include simplifying land use regulations and accelerating licensing processes at the regional government level.

Significant effort will be needed to reach Spain’s new more ambitious climate mitigation objectives, as reflected in the authorities’ plans. Spain’s Law on Climate Change and the Energy Transition establishes the goal of carbon neutrality by 2050, together with an intermediate requirement to reduce emissions by 23 percent relative to 1990 levels by 2030 (about a one third reduction compared to 2018 levels). Carbon price coverage in Spain is comprehensive, but the effective tax rates are low relative to estimates of emission damages, and also tend to be lower than in other euro area economies. Carbon price increases should be gradual, predictable, and complemented with distributive policies to protect vulnerable households. Complementary policies will be essential to address sector-specific obstacles to reducing emissions. Across all sectors, public investment and financial support will be vital where market failures constrain private investment. The authorities’ plans to leverage the NGEU funds to support green investments, prioritizing clean energy, sustainable mobility and building efficiency renovations, are most welcome.