Introduction
Spain’s economy needs far-reaching and comprehensive reforms. The challenges
are severe: a dysfunctional labor market, the deflating property bubble, a
large fiscal deficit, heavy private sector and external indebtedness,
anaemic 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, building on the progress made on
product markets and the housing sector, especially overhauling the labour
market. A bold pension reform, along the lines proposed by the government,
should be quickly adopted. Consolidation and reform of the banking system
needs to be accelerated. Such a comprehensive strategy would be helped by
broad political and social support, and time is of the essence.
The outlook: a weak and fragile recovery
1. The necessary adjustment is underway and output has stabilised.
Imbalances accumulated during the long boom have begun to unwind, with the
current account deficit halving as private savings surged and housing
investment fell. Competitiveness has begun to improve as productivity rose
and the core inflation differential turned negative. The large fiscal
deficit is beginning to fall. Output rose slightly in the first quarter,
ending the long and deep recession. But unemployment has soared as firms
adjusted employment rather than wages or working hours.
2. We project the nascent recovery to be weak and fragile. Our central
scenario is one of continued adjustment of the various imbalances with
growth rising gradually to 1½-2 percent in the medium term. Domestic demand
recovers only slowly, with private demand weighed down by continued
uncertainty, high unemployment, and the need to reduce indebtedness, and
public demand by large-scale consolidation. Stronger export growth, however,
should support the recovery. Despite rebounding energy prices and the VAT
increase, inflation would remain subdued, helping regain competitiveness.
Slowing population growth, high unemployment, and weak investment all weigh
on potential growth, underlining the importance of growth-enhancing
structural reforms.
3. The uncertainty around this outlook is large. On the upside, household
consumption could grow more rapidly as confidence firms, and the global
recovery and the weaker euro may induce faster export growth. On the
downside, the economy may stagnate as the weakness in private demand and
fiscal consolidation interact, especially if reforms to boost
competitiveness and growth are timid. Financial market conditions may also
deteriorate further, raising borrowing costs for both the government and the
private sector.
The policy agenda: rebalancing the economy and boosting confidence
4. Policy should focus on fostering the smooth rebalancing of the economy.
This calls for urgent and decisive action on:
• making the labour market more flexible to promote employment and its
reallocation across sectors;
• fiscal consolidation to put public finances on a sustainable footing; and
• banking sector consolidation and reform to cement the soundness and
efficiency of the system.
Such broad reforms in many sectors simultaneously would produce synergies.
For example, labour market reform coupled with further liberalisation of
product and service markets would boost investment and employment and reduce
prices, making fiscal consolidation easier and strengthening banks. Such
reforms would also support Spain’s long-term convergence with higher-income
peers. These reforms should be implemented pro-actively to boost financial
market sentiment and underpin credibility.
Structural reforms to spur growth through increased competitiveness and
employment
5. The labour market is not working. Unemployment is structurally high and
excessively cyclical, reflecting the high degree of duality in labor
markets. The wage bargaining system, which hamstrings wage and firms’
flexibility, is ill-suited to membership of a currency union. The government
has provided some broad guidelines for reforming the labor market to be
negotiated by the social partners. An agreement is expected by the end of
May.
6. A radical overhaul of the labour market is urgent. The reform will need
to be ambitious and comprehensive if it is to significantly change labor
market dynamics and to avoid missing an historic opportunity. In particular:
• reducing duality and encouraging permanent hires requires lowering
severance payments to at least EU average levels and preventing excessive
use of unfair dismissals;
• boosting wage flexibility and employment requires coupling this reduced
protection of permanent contracts with decentralising wage setting (for
example by moving to an opt-in rather than opt-out system for collective
bargaining) and eliminating indexation.
Care should be taken that any reform does not increase the fiscal cost of
the system or make temporary employment more difficult in the near term.
Ideally the social partners will quickly deliver such an overhaul, but if
not, the government will need to follow through on its commitment to take
action itself, including on collective bargaining.
7. Commendable progress in recent years on product and service market reform
needs to continue. Many important measures have been taken recently,
especially in transposing the EU Services Directive (though implementation
will be critical), and in the housing sector in which incentives for buying
homes have been partially eliminated and the rental sector is being
promoted. Given the pressing need to boost growth and competitiveness,
however, Spain should aim to be among the top performers in terms of product
and service market liberalisation. The priority should be to further reduce
restrictions on retail trade, professional services, and the rental market.
Fiscal policy: restoring sustainability
8. Ambitious fiscal consolidation is underway to reach the three percent of
GDP deficit target by 2013. To achieve the implied 10% of GDP improvement in
the primary balance from 2009 to 2013, the government has taken a wide range
of measures, including the fiscal package approved by the Cabinet last week.
We fully support this package. It significantly strengthens and front loads
the envisaged adjustment and enhances credibility by taking concrete and
bold measures, such as cutting public sector wages. The new path for the
deficit is also appropriate. This path implies cutting the deficit by more
than five percentage points of GDP in 2010 and 2011 and would put the
government debt ratio (which would still be lower than the euro area
average) onto a downward path in a reasonable timeframe.
9. Achieving these targets will be critical and any slippage should be
aggressively pre-empted. Risks to achieving the targets come from both the
implementation of the measures and the underlying projections of a fairly
rapid recovery. Any slippage in attaining fiscal targets will make it
difficult to put government debt on a firm downward path in a reasonable
timeframe and undermine credibility. It is thus critical that the supporting
structural reforms are quickly implemented and additional high-quality
adjustment measures are prepared in advance to allow pre-emptive correction
of any prospective slippages and avoid surprises. Such measures should
protect the most vulnerable segments of society and could include further
reducing spending (which has increased sharply over the last decade), and
raising revenue by reducing tax benefits and further increasing relatively
low VAT and excise rates.
10. Bold pension reform should also be implemented soon. Spain faces strong
spending pressures over the longer term due to ageing and slower population
growth. The government has outlined possible reforms, including raising the
retirement age to 67. These measures, together with others (in particular,
an automatic link to life expectancy) would strengthen the sustainability of
the system and bring Spain closer in line with European peers that have
already reformed their pension systems. As such reforms would boost fiscal
sustainability without undermining growth, they should be quickly adopted.
11. Stronger fiscal frameworks could help. As the bulk of spending occurs in
Autonomous Communities, their role is critical, underscoring the need for
strong mechanisms to ensure they deliver the needed adjustment.
Institutionalising spending review processes could also help improve the
quality and durability of spending reductions. It might also be useful to
consider options to bolster the credibility of fiscal policy, for example,
by establishing an independent fiscal council (like Sweden’s or Belgium’s)
to provide objective analysis of fiscal developments and long-term
sustainability issues.
Banks: accelerating consolidation and reform
12. The banking sector is sound but remains under pressure. Although
impaired assets have increased with the downturn, Spanish banks overall
report robust capital and provision buffers, supported by a strong
supervisory framework. But the risks remain elevated and unevenly
distributed across institutions, focused mainly on the savings banks. The
situation is also complicated in that much of banks’ repossessed real assets
is land, which is particularly difficult to value. On the liquidity side,
although funding is generally of good duration, market conditions remains
difficult and access limited. Further strains may arise from the unwinding
of the exceptional liquidity measures by the ECB, the ending of the funding
guarantee scheme, and from the intense competition for deposits. These
funding difficulties, coupled with lower earnings due to weak credit growth,
provisioning for troubled assets and the system’s overcapacity, will likely
lead to pressure on profitability.
13. Consolidation needs to accelerate to reduce overcapacity and produce
more robust institutions. Progress, under the aegis of the Fund for Orderly
Bank Restructuring (FROB), has been too slow, though the recent agreement
between the two main political parties in this regard is encouraging. Much
more progress needs to happen before the FROB deadline of end-June 2010. The
Bank of Spain should be prepared to intervene promptly if pockets of
weakness remain. To this end and to enhance investor confidence, a
comprehensive and transparent bank-by-bank “diagnostic” based on
conservative assumptions on asset valuation and prospects could usefully be
carried out.
14. The legal framework of savings banks should be updated for the new
economic context. Performance among savings banks is highly diverse and the
sector has an important role to play, but the current legal structure is not
well suited to Spain’s needs going forward. Under the current framework,
cross-region mergers still need to be approved by regional governments, the
sector remains closed to external investors, and savings banks’ capacity to
raise external capital remains limited, putting public funds are at risk.
The legislative and policy priority should be to: (1) reduce political
influence in savings banks; (2) enhance their ability to raise external
capital, and (3) offer an opportunity to transform into stock-holding
companies, and, indeed, requiring this for systemically important savings
banks. This reform should be implemented promptly so savings banks can have
the full range of options to raise capital as soon as possible.