IMF warns Spain over uncertain economic future

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      Spain—2007 Article IV Consultation, Preliminary Conclusions of the IMF Mission
      March 26, 2007

      1. The Spanish economy enjoyed another year of remarkable growth in 2006, further extending its prolonged expansion. The year was marked by a gathering pace of output growth; brisk job creation which absorbed further large immigration flows; a revival in productivity; and a gradual moderation of inflation. Not only did Spain grow more, it also began to grow better, with signs of an economic rebalancing. Higher interest rates and indebtedness appear to be reining in consumption and cooling the housing market. In turn, strong corporate profitability is supporting equipment investment and net exports are exercising a lesser—though still sizeable—drag on growth. In the policy arena, buoyant fiscal revenues were commendably set aside to raise the 2006 general government surplus to a record 1.8 percent of GDP.

      2. For 2007 and beyond, the central scenario is for a gradual deceleration of growth, with however a continued large current account deficit. Our projection is broadly similar to that of the government’s updated Stability Program. Growth is expected to slow gradually in 2007-08 to some 3½ percent, in line with estimated potential growth. Both projections however also foresee a further widening in the already very large current account deficit—in our case, to 9½ percent of GDP this year and close to 10 percent of GDP going forward, due inter alia to higher interest payments on the accumulated external debt.

      3. The large external deficit and related high private sector indebtedness constitute the major risk to the projected “soft landing.” Given the elimination of currency risk within EMU and the overall strength of Spain’s financial sector, external financing of the deficit is not a concern. But while EMU participation changes the nature of the external constraint, it does not eliminate it: the accumulation of net external liabilities cannot continue indefinitely. The counterparts to Spain’s large external deficit lie in the private sector, in the form of high household and, more recently, corporate indebtedness, both of which have risen to among the highest in the main advanced economies. The key question—to which there is no ready empirical answer—is that of the critical level of indebtedness that might induce the private sector to pull in its oars and embark on a pronounced balance-sheet retrenchment, heralding a possibly protracted period of slow growth. The continued steady losses in Spain’s competitiveness—given remaining differentials in inflation and labor cost growth—and its marked domestic market rigidities do not augur well for the slack to be quickly reabsorbed via a quick shift of resources toward export sectors. It is the task of economic policy to ensure the sustainability of continued growth in the medium term, forestalling such adverse scenarios, even if uncertain in their timing and intensity. To this end, there are three broad priorities: safeguarding budgetary stability while tempering demand; raising the economy’s supply capacity and improving its competitiveness; and keeping the financial sector strong.

      Safeguarding budgetary stability while tempering demand

      4. The further strengthening of public finances in 2006 is highly welcome, though it was eminently revenue-based. The appreciable surplus recorded in 2006, the further accumulation of assets in the Social Security Reserve Fund, and the reduction of public debt to below 40 percent of GDP are all commendable achievements. Indeed, relative to 2005, the surplus improved even in excess of the ½ percentage point of GDP that we had recommended last year. In contrast to that recommendation, however, the improvement stemmed totally from revenue overperformance, while primary (i.e., non-interest) spending increased by a further 0.4 percentage points of GDP, for the second year in a row. This rising trend has been partly driven by intermediate consumption and social transfers, but also by successive budgets’ emphasis on the expansion of “productive expenditure” (R&D, infrastructure investment, etc.). Given Spain’s shortfall in this area, this emphasis is understandable, but there needs to be greater assurance that such spending is truly productive. Thus the use of public money and government sponsorship of activities need to be subject to a scrupulous cost-benefit and efficiency analysis, ensuring value-for-money. The creation of the new agency to assess public policies1 is a step forward but—with its in-house character (within a Ministry) and its focus on ex-post evaluations—it falls well short of requirements. Similarly, there is a need for a rigorous evaluation of territorial governments’ expenditures, which now account for over 75 percent of total public spending (excluding social security).

      5. The recent revenue bonanza is unlikely to persist, highlighting the importance of expenditure restraint during “good times.” There are a number of reasons to view the 2005-06 revenue performance as extraordinary: part of the outcome has clearly a cyclical component, evident throughout Europe; international experience suggests that asset boom-driven revenues can rapidly fade; the full-year effect of the regularization of immigrants has now played out; and the yield from the fight against tax fraud cannot be replicated each year. In addition, the tax reform and the tax-cutting proclivity of several territorial governments will also depress receipts. While budgeted revenues are conservatively estimated, the extent of any positive surprise is likely to be more limited than in the recent past. Against this background, it is important to act now, in “good times,” to avoid an entrenchment of primary spending dynamics which are notoriously difficult to reverse when fortunes turn. Without greater spending restraint, the fiscal surplus could well decline in 2007-08 (as indeed officially envisaged), imparting an untimely procyclical stimulus, in contrast with the underlying logic of the new budgetary stability law.

      6. Implementation of the Ley de Estabilidad Presupuestaria (LEP) should be exemplary in 2008, its first year of application. First, and in line with the considerations above, the State budget should set the example via a sufficiently tight expenditure ceiling, keeping primary spending constant in relation to GDP. Second, reflecting the present cyclical position, the Autonomous Communities should aim for a surplus, mirroring their share of the permissible deficit in the low-growth scenario: indeed, if not now, when? Third, the definition of excluded capital spending should be tight, closing avenues for circumvention. In this regard, the recourse to various means of off-budget capital spending and alternative financing arrangements (through public enterprises and entities, and private-public partnerships), including at the territorial level, remain a source of concern. The IMF has long recommended to improve the monitoring, quantification, and public reporting of the longer-term fiscal impact of such operations, as well as the potential fiscal risks arising from loans, capital injections, and guarantees to public entities outside the general government; these recommendations remain to be adopted. Fourth, and most importantly, successful implementation of the LEP requires far greater progress in fiscal transparency of the territorial governments, with timely reporting and publication of comparable, national accounts-based fiscal data. Given the key role of peer pressure in a highly decentralized system, we continue to see a useful function for independent assessments of fiscal policy plans and outturns at the various levels of government, and of their consistency with the LEP. We would encourage reflection on how best to strengthen fiscal governance mechanisms, within Spain’s constitutional reality, to allow early identification of profligate fiscal behavior, elicit public censure, and stimulate corrective action.

      7. Preserving Spain’s budgetary stability is also key to longer-term sustainability, and will need to be supplemented by further pension reform. The latest agreement on Social Security reform is welcome, though—as the Stability Program itself recognizes—it is but a “step forward” and a “first package of measures.” Accordingly, more will be needed for the system’s long-term viability. The Toledo Pact process, while helpful in generating the needed consensus in this area, has since its inception been slow-paced and overly gradual. The next legislature should impart a brisker pace and greater ambition to the reform process, as the passing of time will narrow the scope for gradualism. The work of the envisaged Comisión de Seguimiento y Evaluación could act as stimulus in this regard, and we look forward to an early first evaluation. Careful attention will also need to be paid to the implementation details of the Ley de Dependencia, where—despite some safeguards in terms of cost-sharing between the State and the regions—there is the risk of an underfunded mandate and rising cost pressures over time.

      Raising the economy’s supply capacity and improving competitiveness

      8. Placing the economy on a sustainable medium-term growth path requires stepping up structural reforms. As noted above, a combination of market rigidities and weak competitiveness may lead to a prolonged period of difficult slow-growth adjustment. Averting this scenario, and regaining competitiveness within EMU, will require the implementation of a bold supply-oriented reform agenda, with an emphasis on enhancing product market competition and labor market flexibility.

      9. The priorities for the remainder of this legislature are to persist in a firm implementation of the National Reform Plan and ensure passage of pending legislation. The National Reform Plan has received positive plaudits from the organizations—the EU Commission and the OECD—entrusted with the evaluation of the wide range of microeconomic measures it envisages. We encourage its continued implementation, with a particular emphasis on fostering competition in sheltered domestic markets, whose rigidities are a major contributor to inflation and cost differentials with trading partners and stunt innovation and productivity growth. At the same time, it is important that various positive pending measures (including notably the abolition of energy tariffs and the Competition Law) not be held hostage to the electoral calendar and be implemented in this legislature. Work on transposing the EU Services Directive should be accelerated, as it holds the potential to open up protected sectors throughout Spain.

      10. Against the background of still highly sheltered domestic markets, the efficacy of competition enforcement is key. In this regard, the draft Competition Law has several positive features that will need to be fully exploited. Among these are, first, the increased independence accorded to the future Comisión Nacional de Competencia. To promote such independence, Parliament will need to exercise its new consultative role in the appointment of the Commission’s members in a strong and effective manner, via open public hearings focused on the appointee’s expertise. Second, the new Commission’s strengthened advocacy role is a potentially powerful instrument, that should be wielded proactively and forcefully. And third, international experience suggests that the new leniency policy can also be a highly effective instrument if well-designed, and we would thus encourage close attention to best practices in defining its details. As regards mergers, the draft law, while listing a set of criteria, still allows a fair amount of discretion for the government to over-ride the Commission’s prohibition of an operation. While some drafting ambiguities could usefully be avoided, the success of any competition policy ultimately depends on a credible political commitment of the government to promote open and contestable markets—a stance encouraged throughout the IMF membership. In addition, the independence of sectoral regulators should also be enhanced, with an extension of Parliamentary oversight to the nomination of all their members (i.e., beyond their Presidents), and the establishment of an arm’s length relationship with the relevant sectoral ministries.

      11. Unprecedented large immigration flows have imparted the flexibility to labor markets that, to be durable, needs to be consolidated by reforms. The immigration phenomenon—whose scale and duration has surpassed most expectations—has endowed the Spanish economy with a de facto flexibility that has contributed to its strong performance to date. But this flexibility is bound to be transitory. Eventually, many immigrants will become “insiders” in Spain’s highly dual labor market, and this market’s regulatory rigidity—among the highest in the OECD—will again be evident. Here too, while steps forward have been taken, the pace and ambition of reform has fallen short of requirements. The latest agreement’s approach relies largely on providing public money to attenuate the effects of the restrictiveness of permanent contracts and the consequent high incidence of temporary employment. But this approach is only a palliative, weighing on the public purse. Spain’s labor market duality and its related problems are destined to persist as long as the rigidity and high dismissal costs of regular contracts are not directly addressed. In our discussions, we also found universal dissatisfaction with the effectiveness of current active labor market policies, which should be subject to an in-depth reassessment and overhaul.

      Keeping the financial sector strong

      12. The financial system has recorded another excellent year, but the Bank of Spain’s continued vigilance is well-placed in the face of continued strong credit growth. The solidity and dynamism of Spain’s financial system, and its strong prudential supervision and regulation, remain a major forte of the economy. The main risk continues to be related to rapid credit growth and the heavy concentration of loans in the real estate sector. We however view this risk as relating to the outlook for continued strong output growth rather than to financial stability, given very low levels of non-performing loans and high provisions. Indeed, stress tests conducted under last year’s Financial Sector Assessment Program (FSAP) indicated the financial system’s robust resilience to a range of large adverse shocks. In this context, parallels drawn by some analysts between the U.S. sub-prime market and Spain’s mortgage market are ill-founded: there is no comparable phenomenon in Spain. Nonetheless, continued Bank of Spain vigilance and the strength of its reporting and provisioning requirements are well-advised in the current environment.

      13. In the financial sector as well, a range of pending measures should be passed in this legislature; it is regrettable that the transfer of insurance supervision might be delayed. Spain’s support for the process of European financial integration should be reflected in a more timely implementation of all related Directives. Among these, delays incurred in the process of adopting the Markets in Financial Instruments Directive (MiFID) will need to be rapidly made up to observe the November 2007 deadline. We welcome the extensive preparatory work being undertaken to encourage banks and cajas to undertake the steps needed to ensure the Directive’s effectiveness on the ground. The new mortgage market law, the takeover law, and Basel II legislation should also all proceed forthwith. With respect to the latter, we welcome the intended application of the most conservative approaches to the treatment of credit institutions’ industrial participations under Basel II. As regards the supervisory framework, it is regrettable that the transfer of insurance supervision from the Ministry of Economy and Finance to the central bank (for solvency issues) and the securities commission (for consumer protection) appears to have stalled. It is to be hoped that the proposal will soon be revived. Finally, we welcome the ongoing debate on the governance of cajas. We have long advocated improvements in this area, supporting the shielding of cajas from external interference and their exposure instead to market discipline. A new legislature should seek to secure progress in this respect.

      14. On balance, the Spanish economy has performed well and its short-term prospects remain bright, but there are gathering clouds stemming from accumulated imbalances. In this setting, it is important that the achievements to date not lead to complacency, fed by expectations of a benign continuation of past trends, and that the political calendar not act as an obstacle to the passage of economic and financial legislation that is worthwhile in its own right.

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