Jaime Caruana: Overview of the Spanish economy in 2005
Address by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, to the Governing Council of the Bank of Spain on the occasion of the
presentation of the Annual Report 2005, Madrid, 15 June 2006.
* * *
Ladies and gentlemen,
The vigour of the world economy in 2005 confirmed that the current expansionary phase is proving
one of the most dynamic of recent decades. In the past few years, average growth rates not seen
since the late seventies have been attained. There are two particularly notable facets to this
expansion. First, unlike in previous booms, the world economy has benefited from the salient
contribution of the emerging economies. And further, this high growth rate has been accompanied by
very moderate inflation rates, a most significant development in the light of their concurrence with a
marked and persistent rise in oil prices.
The vagaries of oil prices have, indeed, been central to international economic developments in recent
years. The momentum of worldwide demand for energy, combined with its slowly expanding supply
which is, moreover, fairly volatile owing to geopolitical tensions and climate-related shocks, pushed oil
prices up throughout 2005 and the opening months of 2006 to an all-time high in early May. In turn,
other commodities, including most notably industrial metals, have risen substantially. Although the
world economy has so far been able to absorb the impact of higher oil and commodity prices, they are
a primary factor of risk, and economic policies should remain duly vigilant.
Along with dearer energy, increasing global external imbalances (which, far from being corrected,
continued to widen in 2005) are another characteristic feature of the international economic situation.
The US external deficit reached a new high, the counterpart of which was the bigger surplus of the
emerging Asian economies and, most notably, of the oil exporting countries. This build-up of
imbalances reflects the insufficiency of the economic policies geared to their correction in the main
economies involved, a point to which I shall return later.
How can we explain the resilience of the world economy in the face of the adverse impact of dearer
oil? We must acknowledge that our understanding of some of the features of this upturn is as yet
limited, owing among other reasons to the far-reaching structural changes taking place in the world
economy, which hamper the diagnosis and interpretation of certain features of the recent expansion.
As the main determinants of this resilience, however, we can identify the confluence of expansionary
macroeconomic policies, generous financial conditions and strong rises in real-estate and financial
assets, against a background of price stability. I shall now address these factors to examine their
distinctive features.
As stated, macroeconomic policies remained expansionary in 2005. This needs qualifying, however.
Whereas the expansionary stance of fiscal policies scarcely altered in the main developed countries,
where public debt continued on a rising trend, the accommodative stance of monetary policies
(though, overall, they also helped sustain growth in 2005) was gradually toned down. The main central
banks - especially in the United States and, to a lesser extent, in the euro area - progressively raised
interest rates and withdrew the unusual monetary stimulus of the previous years. This pattern will
possibly also extend to Japan this year, making it likely that, for the first time in 15 years, there will be
a phase of monetary policy tightening in the three major developed areas.
In this respect, I should stress that the gradualness of the decisions adopted and central banks' clarity
in transmitting them have steered financial market expectations, which has been conducive to their
stability and has cushioned the impact of these measures on world growth.
But beyond the generally still-expansionary stance of macroeconomic policies, I believe a significant
factor that helps explain the buoyancy of the world economy in recent years is the broadly generous
financial conditions that most countries have faced. Real and nominal interest rates at various terms,
financial and real-estate asset prices and risk premia have, in general, held at very favourable levels
for consumption and investment. In turn, the favourable expectations of economic growth, in a setting
of abundant liquidity, fed into rising stock market trends and the reduction in risk premia on corporate
and emerging-market debt. The increases in official interest rates scarcely fed through in 2005 to
longterm interest rates, which led to the forceful flattening of the yield curve, an unusual occurrence at this
stage of the cycle, although the rise in long-term yields in the opening months of 2006 is contributing
to lessening the scale of this discrepancy. Finally, the increase in household wealth, stemming from
the rise in the value of financial and real-estate assets, eased the drag on real income arising from
dearer energy products in the oil-importing countries.
Yet there has been a significant contrast between this optimism on financial markets and the wariness
of companies, mirrored by slack investment in the real sector which is particularly striking if regard is
had to the favourable trend of corporate profits. Several explanations have been offered for the muted
performance of business investment in recent years, such as the difficulties in valuing investment in
intangible assets appropriately, over-investment in the second half of the nineties (which caused
surplus capacity in recent years), the ongoing reduction in corporations' financial leverage, the
uncertainty generated by globalisation and companies' caution following the recent changes in the
legislative and accounting framework in the wake of the corporate scandals in some countries. Insofar
as some of these factors are probably transitory, greater investment momentum may be expected in
the coming years.
The buoyant global demand for commodities and the attendant rise in their prices were conducive to
the economic growth of the commodities-exporting countries, while widening the room for manoeuvre
of their economic policies. The Latin American countries benefited from this positive effect on their
terms of trade, enabling them to reconcile relatively high growth rates with current-account surpluses.
In this respect, a clearly contrasting use was made of this greater flexibility by the Latin American
countries: while some have sought to strengthen their macroeconomic fundamentals and reduce their
vulnerability by limiting and improving the terms of their debt, others have given an interventionist bias
to their policies which seriously undermines the maintenance of legal security and dents their
mediumterm investment and growth prospects.
As stated, an essential ingredient in the stability of the world economy has been the maintenance of
moderate inflation, despite the rise in energy and other commodities prices. Admittedly, the dynamism
of China and other emerging Asian economies has contributed to this increase in commodities prices;
but their penetration in the international markets for manufactures has also helped contain wage and
price pressures. The greater anti-inflationary credibility of monetary policies is, in any event,
responsible for anchoring inflation expectations at moderate levels, having prevented the so-called
"second-round effects" - via prices and wages - that prompted a global inflationary spiral in the
eighties in the wake of dearer energy. This diagnosis, far from making us complacent, should be a
reminder that such credibility cannot be taken for granted; rather, it has been attained thanks to
policies clearly geared to safeguarding price stability, policies which we are bound as central banks to
persevere with.
What does the immediate future hold for us? The prospects for the current year point to continuing
strong economic growth rates, with a more balanced geographical distribution (owing to the firming of
the expansion in the euro area and Japan) and with inflation contained. As I indicated earlier, there are
two main risks to this central forecast.
The first is related to the possibility of a further hike in oil and industrial commodities prices. Unlike in
the past two years, in which price increases have been prompted by the buoyancy of the demand for
energy, dearer oil might be linked on this occasion to supply constraints, which would exert a sharper
effect on activity and prices and might bear adversely on agents' confidence. To ward off this
possibility, steps must be taken to reduce the world economy's dependence on oil in the medium term,
without prejudice to promoting an expansion in production and refining capacity. Moreover,
progressive constraints on production globally may generate a greater response by wages and prices
to an increase in energy prices. In the face of these risks, and with monetary policies in the main areas
closer to a neutral stance (which also entails greater uncertainty about their future course), central
banks must persevere with those decisions that bolster the credibility of these policies, since price
stability is the best contribution we can make to economic growth.
A second main factor of risk is that continuing world growth might be jeopardised by the presence of
growing global imbalances. These could trigger or amplify significant adjustments on international
financial markets, such as sharp increases in interest rates and in risk premia.
Correcting the imbalances requires the adoption of appropriate economic policies in each of the main
economic zones, policies which will, fortunately, also shore up the foundations for growth in each of
these areas in the long run. A clear instance of this complementarity can be found in US fiscal policy,
whose moderation would contribute to reducing its external imbalance and would improve its
mediumterm growth prospects. As to the emerging Asian economies, further steps towards making their
exchange-rate regimes more flexible will be needed, especially in China. This will not only contribute
to more harmonious and sustainable world growth, but will be an essential ingredient for entrenching
progress in China towards higher levels of well-being. Finally, Japan and the euro area should
continue on the path of structural reforms geared to increasing their flexibility and adaptability and,
ultimately, their potential growth rates, giving particular priority to reforms bearing on the services
sector.
Turning to the international financial system, banks have gained in soundness and are now in a
position to face a correction of the global imbalances, even if this were accompanied by some
adjustment of financial conditions and a moderate increase in volatility. However, further headway
must be made in improving the measurement of the risks implicit in the complex financial linkages
present in some segments of the international financial system.
Although they provide for greater risk diversification, greater financial integration, new participants on
the markets and the emergence of new financial instruments all make it more difficult to determine on
which agents and sectors the risks finally fall. It is also more complicated to evaluate, where
necessary, the risks of excessive concentration in segments where supervision by regulatory bodies is
lighter. It is thus important to foster awareness in companies, and in households too, of the risks they
assume, and for regulators to exercise effective surveillance of financial intermediaries and markets.
All the more so given that the uncertainty over the effects arising from future bouts of turbulence on
the markets will be exacerbated by the fact that this relatively new financial structure has not so far
been tested in less favourable phases of the business cycle. In this respect, the volatility seen on
international financial markets in recent weeks serves as a reminder of the need for prudent risk
assessment and for the right resources to adapt to a broader and more demanding financial
environment.
But it is not only the conduct of national authorities that must rise to the challenges entailed by the
ever-increasing complexity of our financial systems. At the international level, growing economic and
financial integration requires reconsideration of the guiding principles of the multilateral financial
institutions, which have hitherto remained perhaps too anchored in the bilateral supervision of national
policies, without paying sufficient heed to the increasingly complex links globally. The strengthening of
multilateral surveillance, especially in the financial realm, would thereby provide for a more effective
contribution by these agencies to embedding international monetary and financial stability.
The European environment
in 2005 the euro area economy posted a modest average increase in GDP, and one lower than in
2004 and than in the other developed economic areas. Nonetheless, year-on-year growth was on a
rising profile throughout 2005, attaining a rate of increase in line with potential in 2006 Q1. The
economic performance differed, in fact, from the first to the second half of 2005. In the first six months
output was markedly sluggish, the result among other factors of the temporary easing in the
momentum of world trade, the strong increase in oil prices and the effects stemming from the
appreciation, in the previous years, of the effective exchange rate of the euro. After the summer, and
although high oil prices persisted, the euro area economy gathered greater steam, driven externally by
more robust world demand and some correction in the euro exchange rate, and internally by the
progressive thrust of investment. However, and although stock market gains and house price
increases generated a positive wealth effect, consumption remained lacklustre, weighed down by the
local growth rate of disposable income, against a background of scant job creation and continuing
wage restraint.
The inflation rate was influenced throughout the year by the swings in oil prices. Nonetheless,
underlying inflation tended to slow, reflecting the scant buoyancy of aggregate demand and of the
labour market, and the downward effects on final costs and prices of globalisation and the vigorous
emergence on the world trade scene of the developing countries. Early this year, further oil price rises
were manifest in a fresh increase in inflation in the area, and also made themselves felt in the
underlying component, which may denote a growing rootedness of upward pressures.
In 2005, demand policies in the euro area retained, overall, an expansionary stance geared to reviving
private spending in the economy. But in the second half of the year, monetary policy, in keeping with
its aim to preserve price stability, adopted an increasingly watchful attitude in the light of the increase
in inflationary risks. That led in December 2005, and in March and June 2006, to respective
quarterpoint rises in official interest rates from the historically low level of 2% at which they had held since
June 2003. Despite these rises in official rates, the Eurosystem's monetary policy stance has
remained propitious to the firming of the pick-up in activity and job creation. Nonetheless, the ECB is
closely monitoring developments in the euro area to ensure inflation expectations remain in line with
price stability over the medium term.
Budgetary policies adopted a moderately contractionary stance in the area as a whole, although the
persistent fiscal imbalances in several Member States continued. Consequently, the current firming of
higher growth rates should drive more resolute action to correct these imbalances, the persistence of
which may, in some Member States, have dented agents' confidence and may thus affect their
spending decisions. The reform of the Stability Pact appears to have successfully concluded a phase
of uncertainty over the application of regulations relating to the fiscal policy discipline of the euro area
countries. However, preserving the credibility of the new framework requires an unequivocal and
ongoing commitment by the national authorities to strict compliance with the Pact.
The recent persistence of sluggish growth rates, despite highly favourable financial conditions,
highlights the pressing need to see through the European structural reform agenda with firmer resolve.
The revision of the Lisbon strategy in 2005 may contribute to driving this process. Nonetheless, as in
the case of budgetary policies, a common framework for action is only effective if accompanied by the
sufficient political resolve to adopt the measures that enable programmed objectives to be met. In the
case of structural policies, these are chiefly oriented to stepping up the use of the labour factor and to
increasing the pace of productivity through the promotion of knowledge, innovation and the
incorporation of new technologies.
As earlier mentioned, the phase of more dynamic economic growth initiated around mid-2005
continued in the opening months of 2006. The main international organisations have forecast a rate of
increase in GDP in the euro area of slightly over 2% in 2006, i.e. around potential. This recovery will
foreseeably be underpinned by the strength of domestic demand, among whose components
investment is expected to post a high rate, while private consumption will probably trend more
moderately, albeit at a somewhat higher rate than in recent years, in step with the gradual
improvement expected in the labour market.
However, there are some factors of risk clouding this outlook. In the external environment, such
factors comprise the existing global imbalances and the persistence of high oil prices. On the domestic
front, employment and consumption are the factors subject to most uncertainty.
The inflationary outlook for 2006 and 2007 indicates that the rate of change of the HICP may be close
to the price stability benchmark of 2%, or might even exceed it again. Yet upside risks persist here,
stemming mainly from the possibility of further increases in oil prices - given the instability of the
market - and from the potential emergence of second-round affects in a more buoyant economic
setting. But the fact that the level of output is still below potential provides leeway for the recovery to
continue for some time without generating excessive inflationary pressures. In any event, the
European Central bank will remain watchful so as to prevent risks to price stability in the medium term
from materialising.
The Spanish economy
Throughout last year and in early 2006, the expansionary cycle of the Spanish economy continued
and intensified, in contrast to the difficulties experienced in the euro area as a whole in emerging from
the phase of low growth currently in train. Spanish GDP increased by 3.4% in 2005, while employment
advanced at an equally high rate of 3.1%. In both cases, these rates were several tenths of a point up
on the previous year's figures. Moreover, 2005 saw the publication of the new Spanish National
Accounts base 2000 figures, which meant a considerable upward revision of economic growth since
1995 and, especially, since 2000. These new estimates reflect more appropriately the dynamism of
the population and of employment these past few years, and they show a more buoyant economy
more closely in step with the expansionary behaviour seen in other economic variables such as credit
or tax revenue.
As a result of this trajectory, there has been fresh headway in Spain's real convergence with the EU
and with the euro area. On the latest provisional estimates available, Spanish per capita GDP stood in
2005 at over 98% of the EU average, more than five percentage point up on its level in 2000. There
were also significant improvements in the form of greater labour market participation and a lower
unemployment rate, aspects where the traditional differences with the core European countries have
narrowed substantially. The decline in the unemployment rate is particularly noteworthy. It now stands
at a similar level to that observed in the main European countries, following several decades in which
a high unemployment rate was singled out as the most characteristic problem of the Spanish
economy, even in cyclical upturns.
The performance of the Spanish economy in 2005 and early 2006 reflects the continuity of the
expansionary impulses operating on the growth rate and on job creation. Monetary and financial
conditions have remained markedly loose in the light of the economy's domestic situation, having been
determined by the prevailing price stability and sluggishness of activity in the euro area as a whole.
The low levels of interest rates have continued to combine in Spain with the significant rises in
financial and real-estate asset prices (although in the latter case they have tended to ease off), which
has reinforced their impulse to spending. In these circumstances the gradual withdrawal of the
Eurosystem's expansionary monetary policy stance, begun in late 2005, has only partly reduced the
looseness of financial conditions.
Immigration flows, which remained very high in 2005 according to the information available, were a
further factor behind the dynamism of economic activity and employment. They also added some
flexibility to production and working arrangements. On one hand, the increase in the immigrant
population has sustained the thrust of domestic spending, while on the other, the resulting greater
supply of labour has increased the Spanish economy's productive capacity, enabling increases in
output more closely tailored to the buoyancy of demand to be attained. Furthermore, the presence of
this additional labour - which has a comparatively higher degree of mobility - has contributed to
restricting potential sectoral bottlenecks and the wage pressures that usually characterise situations of
notably vigorous expenditure, such as that seen in recent years.
The composition of growth in 2005 evidenced few changes in relation to previous years, in step with
the continuity of the impulses received by the economy. Indeed, the growth pattern became slightly
more unbalanced, as national demand grew by 5.1%, outpacing the related increase in 2004, while
foreign trade gave rise once again to a substantial negative contribution to GDP growth. Household
consumption and housing-related spending continued to be the main underpinning of the increase in
demand, supported in turn by the sound growth of disposable income and of employment, and by the
generosity of financial conditions in the economy. As a result, households continued to reduce their
saving ratio and to increase their net demand for financing.
The principal new development in 2005 was the marked recovery in corporate productive investment
expenditure, which focused particularly on the acquisition of capital goods. This pick-up was
accompanied by a strong increase in credit, favoured by accessible financing conditions. Credit was
directed especially at small - and in principle more dynamic - companies, and it spread to all sectors
of the economy, including manufacturing industry. Public-sector demand also quickened last year,
driven by the rise in investment that characterises the initial years of a legislature and by the increase
in government consumption.
As stated, the unbalanced features of this growth pattern were manifest again in 2005, especially in
the behaviour of the external sector. Flat goods exports, despite the burgeoning growth of foreign
markets, combined with a fresh and significant increase in imports to give rise to a further deterioration
in the negative contribution of net external demand, which had already been very marked in 2004. A
mix of factors was involved here: first, the increase in the energy bill and the greater buoyancy of
demand in Spain compared with its EU neighbours, which partly reflects Spain's different cyclical
position; and further, the losses in competitiveness that have built up in recent years (and to whose
source and consequences I shall refer later), along with other structural factors relating to the sectoral
and trade composition of our economy.
In annual average terms, the discrepancies between the behaviour of domestic spending and of net
external demand were further accentuated in 2005; however, throughout the year there were incipient
signs of a change in the composition of growth, as national demand embarked on a slight slowdown
and as a likewise modest correction was seen in the contractionary contribution of the external sector.
Nonetheless, initial estimates for the opening months of 2006 would suggest that this rebalancing of
the composition of expenditure has come to a halt, against a background in which activity has
continued to grow sharply.
In the absence of sufficiently appreciable changes in the drivers of the expansion and of significant
corrections in the pattern of growth, the imbalances already building up in the Spanish economy have
become bigger and certain factors of vulnerability to potential future shocks have been accentuated.
The high growth rates of domestic demand have combined with the inertia persisting in cost and price
determination and have continued fuelling the inflationary pressures that have been eroding the
economy's competitiveness. In turn, the fact that private-sector spending has outpaced
incomegenerating capacity has made for fresh increases in corporate and, above all, household debt, and for
a growing resort to external saving. Both factors resulted in an ongoing deterioration in the nation's
borrowing requirements, despite the fact that the public sector has appreciably increased its saving
capacity. The Annual Report I present today analyses closely the different factors bearing on this
diagnosis, and I shall now refer briefly to them.
Spanish inflation has continued trending at a high rate, above that of the euro area, with the differential
between the two widening. Although the Spanish economy is more dependent on oil imports than
other countries in the area, the inflationary performance cannot be attributed to the direct impact of the
strong hike in oil prices in 2005 and early 2006. Indeed, the underlying inflation (excluding energy and
unprocessed food prices) differential with the euro area has widened more than that of the overall
index, a pattern that has been exacerbated in the opening months of this year in which industrial
goods prices have accelerated.
Looking at the determinants of the inflation differential on the costs side, it can be seen that, unlike in
previous stages, the relative increase in margins has contributed more to the deterioration than the
rise in unit labour costs. The widening of margins behind this behaviour has been more marked in the
activities less exposed to competition, such as construction and services, which is also where demand
pressures have been sharpest.
Wage increases agreed under collective bargaining have not diminished and the impact of the
indexation clauses is proving considerable both in 2005 and in 2006. However, average labour costs
have grown at relatively moderate rates as a result of the rise in employment in industries with
comparatively lower wages, which are those where the influx of immigrants is proving greater. In this
respect, the sizeable immigrant inflows are acting as a factor of wage flexibility in certain labour market
segments. In any event, while this behaviour of wages may be considered moderate, compared with
their historical, upward pattern, growth has remained higher than that of wages in other euro area
countries. Moreover, these developments have taken place against a background of very low
productivity gains, meaning that the cost growth differential with the euro area has remained wide.
This differential is proving particularly harmful for manufacturing industry, which has continued under
increasingly sharp pressure from foreign competition.
It should be borne in mind that, in the euro area, the consequences of losses in competitiveness
induced by continuing demand pressure may be difficult to reverse. This is because they require a
direct adjustment of relative prices and costs based on the effective moderation and the sufficiently
flexible behaviour of wages. In Spain's case, moreover, given the specialisation of the productive
structure in industries where demand is more sensitive to relative prices and in which the pressure
exerted by products from the emerging economies is very high, companies may find themselves
having to make a sharper adjustment to make up for lost ground on international markets and on the
domestic market. That all shows how important it is for the economy to have flexible price- and
wagesetting mechanisms. And there is a general need to reinforce the capacity of the productive system to
compete, through improvements in specialisation, efficiency and higher productivity gains.
As earlier indicated, the growing mismatch between household and corporate expenditure and income
last year has been accompanied by fresh increases in these sectors' debt. What has proven
conducive to this has been the maintenance of financial conditions which have continued to be
markedly loose for the situation of strong demand pressure in the economy. This growth in household
and corporate liabilities is naturally bearing on the financial position and burden of both sectors.
The financial pressure borne by households has, however, been alleviated by the increase in their net
wealth, sustained by the growth of stock market prices and, above all, of house prices. In the case of
companies, the notable increase in profits has strengthened the sector's capacity to withstand the
increase in their financial commitments. Accordingly, the financial position of both sectors, considered
overall, remains sound and does not therefore pose a serious obstacle to the continuity of the
economic upturn currently in train.
The foregoing should not, however, conceal the evident fact that the expansion of domestic spending,
particularly in the case of households, will not be able to base itself for much longer on growth in debt
at rates such as those currently seen. Moreover, the ongoing rise in indebtedness levels and the
prevalence of debt incurred at variable interest rates entails a greater sensitivity of the Spanish
economy to monetary policy decisions, against a background in which the present generosity of
monetary conditions may be expected to move to a more normal footing. The influence of interest
rates on expenditure is undoubtedly sharper in the case of relatively more indebted households, which
are in the lower strata of the income distribution.
Along these same lines, the strong concentration of household wealth in property and the relative
weight of productive activities related to the residential sector are resulting in a greater exposure of the
economy as a whole to the changes in property-market activity and prices. Regarding the latter, 2005
appears to have marked the start of a slowdown in house prices, raising (all the more so the more
firmly the deceleration becomes entrenched) the likelihood of the current overvaluation of housing
being progressively reabsorbed, as in previous booms. Let me remind you, however, that some
element of risk is always present in all scenarios involving the absorption of a phase of overvaluation.
This is a consideration that all agents should bear in mind when deciding where to place their
investments.
Any assessment of the consequences arising from the greater exposure of the Spanish economy to
changes in house prices and in interest rates would be incomplete were it not also to allude to the
parallel developments reinforcing the economy's capacity to face potentially adverse shocks in any of
these variables. In this respect, it should be underscored that the behaviour seen in recent years in the
main indicators of the activity, profitability and solvency of domestic credit institutions is helping
mitigate the financial risks bearing on the course of our economy in the medium term. These
institutions are therefore well positioned to absorb the potential impact of shocks such as those
indicated without seeing their capacity to ensure the financing of economic growth affected.
Undoubtedly, the prolongation of the phase of robust demand has contributed to widening the
economy's external imbalance, increasing the need to resort to foreign saving to finance private-sector
spending. Overall, the e