2012 Article IV Consultation with Spain
Concluding Statement of IMF Mission
Madrid, June, 14, 2012
Many major policy actions have been taken in recent months on several fronts. But market confidence remains weak and the outlook is very difficult. The economy is in the midst of an unprecedented double-dip recession with unemployment already unacceptably high, public debt increasing rapidly, and segments of the financial sector needing recapitalization. This calls for a commensurately ambitious policy response and communicating it within a comprehensive medium-term strategy. This strategy should be based around concrete measures to deliver the needed medium-term fiscal consolidation, a roadmap for restructuring the weak segments of the financial sector, and structural reforms to boost growth. The prospective Euro area financial sector support is an important opportunity to implement such a strategy. Spain’s prospects will also be helped by further progress at the European level.
1. Faced with great challenges on several fronts, the government reform momentum has been strong, with many major actions initiated in recent months:
- Banks. Provisions and capital requirements have been raised, independent valuations commissioned, the fourth largest bank is being restructured, and a credible backstop provided with support from Spain’s European partners.
- Fiscal. A package of measures was introduced in December, the 2012 budget is ambitious, the new budget stability and transparency laws provide for greater transparency and control over regional finances, and sub-national arrears are being cleared.
- Labor. A profound labor reform was introduced in February.
2. Despite these reforms and efforts, market confidence is weak. After a brief LTRO-induced respite, market tensions re-emerged in the spring. By mid-June, yields and spreads on Spanish government bonds were around their previous highs. Banks remain unable to tap private unsecured financing. And despite the announcement of the European backstop, market conditions remain weak.
3. The outlook is very difficult. The recession is deepening and unemployment is 24 percent (above 50 percent for the young) and rising. Headwinds from household and corporate deleveraging, combined with unavoidable fiscal consolidation, will likely translate into output contractions this year and next. But with an assumed stabilization in financing conditions and a better functioning labor market as the reform kicks in, private consumption and investment should recover modestly. Net exports are expected to continue to contribute strongly to growth. Downside risks dominate, in particular:
- Financial: while the Euro area financial backstop helps to mitigate short-term risks, market tensions could intensify, particularly if policies fail to stem capital outflows or due to further stress elsewhere in the Euro area.
- Macroeconomic: private sector deleveraging could be faster than envisaged, and the fiscal consolation may have larger than envisaged output costs.
4. But there is also upside potential. Reforms, including the successful implementation of the recent labor reform, the strengthening of the financial sector supported by the Euro area backstop, and faster competitiveness gains, could lead to a significantly better medium-term outlook.
The policy agenda: restoring confidence
5. Continued strong reform momentum and a clear medium-term vision are needed to restore confidence so that imbalances can be unwound smoothly and jobs and growth fostered. This means strengthening the finances of the government and finalizing the banking reform. But it also means better functioning labor and product markets to support incomes, fiscal consolidation, banks’ asset quality, and social backing for reform. Intensifying the ongoing reversal of the large misalignment in prices and wages should be at the center of this agenda. A cooperative solution, where workers accept greater wage moderation, employers pass on the cost savings to prices and hire, and banks recapitalize, could result in a faster reallocation of resources to dynamic sectors and a better outcome for all.
6. The Euro area support for the financial sector backstop is an opportunity to complete the task. The government is to be commended for ensuring a credible backstop for the financial sector. This backstop will ease the financing of the clean-up, restructuring, and recapitalization of the weak segments of Spain’s banking sector once and for all. Doing this thoroughly and accompanied by a comprehensive package of reforms in other areas should help restore confidence and put the economy back on a path of growth and employment. It will be critical to communicate such a package clearly and cohesively.
7. Spain’s prospects will also be helped by further progress at the European level. There is an immediate need at the euro area level to ensure adequate bank funding and mitigate contagion. But a lasting resolution to the Euro area crisis will require a convincing and concerted move toward a complete and robust EMU. This requires a roadmap toward a banking union and fiscal integration. A clear commitment in this direction, in particular on area-wide deposit insurance and a bank resolution framework with common backstops, is essential to chart a credible path ahead.
Financial sector: a roadmap for restructuring the weak segments
8. The recent progress needs to be built upon to complete the restructuring. The IMF’s Financial Sector Stability Assessment identifies some key reform areas, many of which are along the lines envisaged by the government:
- Independent valuation. The quality and transparency of the independent valuations and stress tests should be assured (the inclusion of staff of independent institutions to advise on the process is encouraging).
- Triage. Banks should quickly be required to meet any resulting additional need for higher provisions and capital, drawing on the backstop as needed. Banks should be triaged into: (1) those that do not need support (2) viable banks that need government support, which will be provided subject to tightly-monitored restructuring plans, and (3) non-viable banks.
- Dealing with intervened banks. The new management of the fourth largest bank should quickly present their detailed restructuring strategy and timetable. The strategy for the other intervened banks should be announced, including their restructuring plans and estimated cost of government support. Consideration should also be given to strengthening the state’s ability to manage its large stakes in a substantial share of the banking system and to enhance its ability to eventually exit, and ideally profit, from such stakes.
- Using the backstop. The exact cost to the government will depend on many factors, including the results of the valuation exercise, the costs of restructuring intervened banks, and the specific strategy adopted. Even if the cost were to reach the full Eurogroup commitment of €100 billion, this would remain manageable from a debt sustainability perspective, provided the envisaged fiscal adjustment is undertaken.
- Legacy assets. A goal of dealing comprehensively with legacy real estate assets should be announced, with options to be developed and finalized after the independent valuations.
9. Banking supervision and the crisis management and resolution framework needs to be upgraded in key areas.The gradual approach in taking corrective action since the bursting of the real estate bubble has not been conducive to financial stability and requires, inter alia, measures to improve the timeliness and cost-effectiveness of remedial action. This improvement should include, for example, special tools to resolve banks, such as prompt recapitalizations and bridge banks.
Fiscal policy: implementing a robust medium-term consolidation strategy
10. The fiscal slippage in 2011 greatly undermined the credibility of Spain to deliver fiscal consolidation and increased the needed fiscal adjustment for 2012. The impact of the large overrun (almost 3 percent of GDP) was exacerbated by maintaining the message, until almost the end of the year, that the deficit was on track, and by the lack of timely and reliable data.
11. A large consolidation is in train for this year. Despite the considerable effort, the very ambitious 5.3 percent of GDP deficit target for 2012 will likely be missed. Revenue could be weaker than expected and the timeframe is short (in part because the budget was delayed). The envisaged adjustment would require deep structural changes for many of the regions. Given the weak growth outlook, however, slippage should not be made up in a compressed timeframe.
12. The bulk of the planned consolidation in 2013-15 is based on expenditure savings, many of which are yet to be specified. The revenue to GDP ratio is projected in the Stability Program to barely rise over the period. Primary spending is projected to fall by almost 4 percent of GDP, with only a part linked to specific measures, and interest spending is also projected to fall in the medium-term. Growth projections are in line with ours, but incorporating the fiscal consolidation envisaged in the Stability Program would entail lower growth under staff’s framework.
13. Further action needs to be taken to stabilize public debt and bring it down over time. Given the lack of detailed measures after 2012, staff projects the deficit to significantly overshoot targets and to fall only gradually over the medium term. This, plus debt from bank recapitalization and financing regional arrears, requires achieving the medium-term fiscal targets to maintain debt at manageable levels.
14. The medium-term fiscal plan should be strengthened around three dimensions.
- Path. The deficit path envisaged in the Stability Program should be less front-loaded (in agreement with European partners). The medium-term targets are broadly appropriate, but a smoother path would be appropriate during a period of extreme weakness, when multipliers are likely to be particularly large and the tax base soft, to reduce the risk of creating a negative feedback loop with growth and NPLs, which may also undermine market confidence, especially if targets are missed. Such a smoother path should also be embedded in a prudent macroeconomic framework.
- Composition. Given the size of the needed consolidation, no options should be ruled out. Revenue measures should play a larger role. In particular, there is considerable scope to reduce tax expenditures and increase indirect tax revenue by broadening the base and raising and unifying rates, especially on VAT and excises—actions that should be taken now. Reducing social security contributions is desirable, but should be contingent on first reducing the deficit (to, say, below 3 percent of GDP). The reintroduced deduction for mortgage payments should be eliminated. It is also critical that the measures deliver permanent and not one-off gains (for example, there should be no further amnesties or transitory rate increases). Spending on the most vulnerable should be protected.
- Certainty. Spending reductions are planned for the right areas. But they will take time to identify, be difficult to implement, and their yields uncertain. To give assurance that the envisaged savings will materialize, future public wage cuts and VAT/excise increases could be legislated now and only cancelled if the targets are hit. Privatization should be more aggressively pursued to give upside risk to debt projections.
15. An improved fiscal framework would facilitate the envisaged adjustment. It is important that the new provisions in the Budget Stability Law be fully implemented (for example, immediately warning some regions and quickly intervening if they fail to respond promptly). But the framework still needs improvement, and the stronger the framework, the more likely markets would accept a smoother consolidation path.
- While significant progress has been made in recent months, including publishing quarterly regional government outturns in national accounting terms for the first time, greater fiscal transparency is essential. For example, providing monthly consolidated general government accounts on a cash basis within six weeks. Regional budgets, fiscal plans and reporting should be made more homogenous and user-friendly. A durable framework for funding regional governments also needs to be established.
- Moving to a fully-fledged medium-term budget framework with expenditure ceilings and detailing measures covering at least 2013 and 2014, alongside measures that would aid sub-national consolidation (for example by introducing savings in health spending).
- We continue to recommend an independent fiscal council. This could, for example, analyze budgets and provide their key macroeconomic assumptions, develop comparative regional performance indicators, and conduct nationwide expenditure reviews of major programs.
Structural policies: going for growth
16. Spain urgently needs job-rich growth and further gains in competitiveness. Domestic demand is likely to be weak for quite some time and the external current account needs to improve further. This means focusing on policies to facilitate the expansion of the tradable sector, raise productivity and lower costs. These are inherently complex and difficult reforms but critical if growth is to be inclusive and job-rich. Establishing a clear goal, such as getting Spain into the “Top 10” list of global indices of competitiveness and business environment could help focus policy and popular understanding.
17. The recent labor reform is most welcome as it has the potential to substantially improve the functioning of the labor market. Spain’s labor market stands out for its high unemployment, segmentation, wage rigidity, and inflexible working conditions. The recent labor reform should allow firms to adapt more nimbly to market conditions, for example, by adjusting wages and hours rather than employment. The reform needs time to take effect and it is too soon to tell if the reform is working: while there are some tentative positive signs, wages are still insufficiently sensitive to the very high level of unemployment.
18. The reform’s success hinges on its implementation. The reform could, however, be strengthened, for example, by reducing the difference between protection for permanent and temporary contracts to make the labor market more inclusive and eliminating the practice of indexation and “ultra-activity”. The new flexibility options could also be better communicated to firms. And if sufficient firm-level flexibility is not quickly forthcoming, policymakers should prepare contingency plans, for example, moving to an opt-in system for collective bargaining. The planned review of active employment policies is welcome. It should carefully consider whether the unemployed are being given sufficient training and incentive to secure employment and whether the use of subsides offers best value for money.
19. Delivering the envisaged other structural reforms will be important to complement the labor reform. Retail licensing has already been eased and the government’s reform agenda appropriately targets a common regulatory framework in all regions, boosting the rental market, liberalizing retail hours and professional services, and eliminating the tariff deficit. It would be important that these reforms are rapidly and effectively implemented – a detailed and ambitious timetable would help structure and communicate the efforts. Further reforms, such as policies to help small firms grow, also seem necessary to foster inclusive and job-rich growth.
Thanks Dannielle: All your comments will be welcome.
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