Miguel Fernández Ordóñez: Overview of the Spanish economy in 2006
Address by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, to the Governing Council
of the Bank of Spain on the occasion of the presentation of the Annual Report 2006, Madrid,
14 June 2007.
* * *
Ladies and gentlemen,
In 2006 the behaviour of the world economy and of the European economy in particular provided a
highly favourable setting for the continuation of the Spanish economy's 13-year-long expansion. The
world economy grew by 5.4% last year, up even on the high rates of the previous two years, this being
the most dynamic three-year period of growth for more than 30 years. The strong increase in oil prices
in the first half of the year and the less expansionary stance of macroeconomic policies did not check
this dynamism, which was moreover compatible with the containment of inflation rates worldwide and
with a more favourable financial market performance.
The geographical distribution of growth was more balanced and more favourable for the Spanish
economy. The notable recovery in the euro area, along with economic firming in Japan, offset the
slowdown in the United States. The contribution of the emerging economies to the global expansion,
with China and India to the fore with growth of around 10%, remained a key factor. Latin America also
grew satisfactorily and its inflation fell to all-time lows, against a backdrop of generally prudent
macroeconomic policies which have contributed to a further reduction in the region's financial
vulnerability. However, the meagre progress in structural reforms and the unorthodox direction taken
by some countries' economic policies may curtail future growth possibilities.
In the short run the world economy can be expected to continue posting high growth, unless the US
slowdown becomes more acute and the rest of the world is unable to continue growing under its own
steam. Further ahead, the continuity of the high rate of expansion of the world economy is more
uncertain. The increased efficiency and productivity gains brought about by globalisation, through
greater trade integration and a far-reaching reallocation of resources and factors, might begin to
weaken. In this setting, the emergence of protectionist tendencies - such as those manifest in the
difficulties of moving the Doha round forward - is an added risk to continuing high growth.
Inflation has remained contained worldwide. The growing integration of the emerging economies into
the global economy, providing abundant low-cost labour, coupled with heightened competition on
world markets and technological innovation have allowed price increases to moderate significantly.
The anchoring of inflation expectations, to which the credibility acquired by central banks in their
efforts to preserve price stability has contributed, and the headway in the programmes for structural
reform and increased flexibility in economies have likewise eased inflationary pressures.
All these developments have helped contain the upward pressures stemming from the impulse of
domestic demand and have made the task of monetary policies easier. In 2006, as the strength of
economic growth progressively alerted to the emergence of inflationary pressures, the monetary policy
stance became less expansionary in virtually all economies, developed and emerging alike, and
inflation rates held at low levels overall, without any substantial passthrough of higher energy prices to
core inflation being discernible.
Yet the reduction in spare capacity and labour market tightening will heighten inflationary pressures in
many economies, and further oil price rises cannot be ruled out. Moreover, as the business cycle
matures, the task of monetary policymakers may become more difficult, especially for certain central
banks like the Federal Reserve which will have to square inflationary risks with those stemming from
the economic slowdown.
The euro area
As already stated, the euro area economy finally managed to emerge from the phase of low growth
experienced in recent years. GDP for the area grew at a rate of 2.9% in 2006, almost double that of
the previous year and the highest rate since 2000. For the year as a whole, inflation, measured by the
rate of increase of the HICP, stood as in 2005 at 2.2%, much influenced over the course of the year by
oil price movements. Core inflation moved mildly upwards during the year, perhaps reflecting some
minor indirect effect of the rise in energy prices against a background of strengthening activity and
employment. Nonetheless, there has been notable wage moderation so far, perhaps in response to
greater labour market flexibility and growing competitive pressures worldwide. But it remains to be
seen how wages will react in the face of more buoyant domestic demand.
Throughout 2006 the stance of demand-side policies was consistent with the pick-up in private agents'
spending. However, in the monetary policy realm, the strength of the recovery warranted a gradual
adjustment in monetary conditions by the European Central Bank. Following the rise in official interest
rates in December 2005, the ECB continued in 2006 progressively to withdraw the stimulus provided
in recent years in the light of the observed risks to price stability in the medium term.
Turning to budgetary policies, the improvement in the business cycle contributed decisively to tax
revenue growing substantially above forecast in 2006 and to the euro area budget deficit declining by
almost 1 pp. Given the persistence of high deficits in many countries, it is of paramount importance to
harness the opportunity provided by the current boom to complete the ongoing restructuring of public
finances and to push through measures to boost productivity and employment generation.
Precisely in this latter area, the year 2006 saw progress - albeit uneven across countries and
economic policy areas - in the application of the structural reform agenda. Undoubtedly, the
favourable performance in 2006 in terms of employment and growth in activity is largely the result of
the course of the business cycle. But it seems likely there are also incipient positive effects stemming
from the structural reforms already implemented, which may be responsible for the high rate of job
creation in this phase of the recovery and the rise in productivity. That would show how efforts to
heighten incentives for labour market participation, to further market liberalisation and to create an
environment conducive to innovation and the development of human capital ultimately bear fruit,
highlighting the need for sufficient political resolve to persevere with the course of action embarked
upon.
At the end of the first half of 2007, the outlook for the euro area is the brightest in recent years. For
one thing, domestic demand is expected to retain its current momentum. Investment in particular
should continue to benefit from the persistence of propitious financial conditions, the strength of
corporate earnings and the soundness of companies' financial position, while household expenditure
should continue expanding thanks to favourable employment developments. For another, exports are
expected to continue faring favourably despite the likely easing in world growth. This central scenario
faces the downside risk of a bigger-than-expected slowdown in the world economy. But, in contrast, a
better performance of the European labour market might raise forecast growth rates.
The inflation outlook for 2007 and 2008 suggests the rate of change of the HICP will hold at around
2%, in line with the definition of price stability. However, it cannot be ruled out that the strength of
activity will lead to higher wage demands and to greater price-setting autonomy on the part of
companies. Adding to these upside risks to inflation is the possibility of fresh oil price increases. In the
expected setting of robust economic activity, wage moderation will remain an essential ingredient for
containing inflationary expectations, which would help prolong the upturn. In the opening months of
2007, the ECB has continued closely to monitor these risks and, in general, economic developments
in the area, so as to ensure that inflation expectations remain in line with the definition of medium-term
price stability.
The Spanish economy
As indicated, the Spanish economy continued its long upturn last year, moving on a mildly accelerating
path throughout the year. It posted a year-on-year rate of 4% in 2006 Q4, and 4.1% in Q1 this year.
The buoyancy of activity is proving greater than forecast in early 2006. The recovery in the euro area
has boosted exports, following their sluggishness in previous years, especially in 2005, and has
supplemented the main factors that have been underpinning the expansion of the economy.
There was some re-balancing in 2006 of the relative contributions of domestic expenditure and of net
exports to GDP growth, following three years of progressive divergence between these two
components. Overall, the contribution of net external demand improved, despite which the net
borrowing of the nation increased once more, to 7.8% of GDP. Within domestic demand, consumption
slowed slightly in 2006 and construction began to show signs of decelerating in Q4, a trend that ran
into early 2007. However, investment in capital goods underwent a significant increase which is
holding in the year to date.
Behind these developments in the Spanish economy, along with the improved external environment, is
the continuing influence of the favourable factors that have underpinned its dynamism throughout this
cyclical upturn. First, there is the impulse stemming from the Spanish economy's integration into the
euro area. That has been acting as a powerful spur to demand, as a result of the effects on confidence
and expectations and, naturally, of the expansionary financial conditions that have continued to prevail
in 2006, despite the change in the stance of the single monetary policy dating back to the closing
months of the previous year. Further, there are the factors that have provided for growth on the supply
side, including most particularly the growing demographic boost to the Spanish economy over the past
decade, which is contributing, among many other aspects, to generating a substantial expansion in the
Spanish economy's growth capacity. Finally, the importance of reform initiatives in recent decades
cannot be ignored, as these have promoted market flexibility and dynamism among agents and
institutions. And pivotal too have been the recent macroeconomic and financial policies, which have
been a guarantee for stability.
All these factors have acted simultaneously, mutually reinforcing one another in such a way that it is
difficult to assign a specific weight to any of them. Let me refer first to the demographic impulse, to
which particular attention is devoted in the Annual Report presented today. Migrant flows, drawn by
the substantial and constant expansion of demand, have been in turn a key factor in supply dynamics.
This is because the rise in the immigrant population has increased the economy's productive capacity
by means of the incorporation of abundant labour resources, while it has at the same time contributed
to sustaining domestic spending growth. The Report highlights the fact that the contribution of
immigration to income generation has been greater than that arising from the mere increase in
population, also helping to raise per capita income. The Report also indicates that the effects on the
expenditure side seem to help galvanise investment and that, in the labour market, they have
introduced elements of wage flexibility and boosted mobility. Furthermore, the dynamic effects of
immigration have been bolstered by the impact of the growing participation of women in the labour
market.
With regard to demand-side impulses, it should be stressed that economic buoyancy has continued to
be underpinned by monetary and financial conditions which, despite their gradual normalisation over
the course of last year and in 2007 to date, remain loose for the Spanish economy. Although the cost
of bank credit for households and firms and of fixed-income securities issues rose as the single
monetary policy adopted a more neutral stance, these costs reached levels which, from a historical
perspective, should be classified as moderate.
In any event, somewhat less generous financing conditions than those prevailing during the recent
period of exceptionally low interest rates are better suited to the circumstances of the Spanish
economy. Consequently, they provide some relief following a lengthy phase of high demand pressure,
while helping to make our growth pattern healthier.
The strength of demand has been met by very favourable elements in the supply-side response. All
the productive branches contributed positively to the expansion of output, though mention should be
made of the continuing momentum of construction and the notable dynamism of the manufacturing
branches, closely linked to the recovery in the European economies. It is worth noting once again the
Spanish economy's continuing high employment-generating capacity, both in 2006 and in early 2007,
since this feature is playing a key role in the continuity of this long expansionary cycle. The strong
growth of employment in 2006, at a rate of more than 3% for the year on average, contributed
decisively to sustaining domestic spending. And it has also enabled the growing incorporation of the
population (particularly the female population) into the labour market to be compatible with further cuts
in the unemployment rate, which stood at 8.5% on average in 2006, the lowest level since the late
1970s and practically on a par with the euro area average rate. The behaviour of employment denotes
changes of some depth in the Spanish labour market, such as the marked fall in the structural
unemployment rate, which may be interpreted as an increase in the scope available for generating
employment without wage pressures arising.
The counterpart to an employment-intensive growth pattern has been modest increases in actual
productivity. It is difficult to offer an accurate diagnosis of the reasons for this, given the difficulties of
measuring and estimating productivity in the presence of significant structural changes, such as the
composition effects arising from the concentration of growth in sectors that are relatively less dynamic
productivity-wise. But what are possibly being reflected here are shortcomings in the quality of factors
of production and in the characteristics of the business sector.
That said, the responsiveness of supply is not proving sufficient to counter the pressure of expenditure
on price formation. On one hand, compensation per employee quickened somewhat in 2006, but to a
lesser extent than did wage settlements, as a result of the changes in composition and the factors
boosting labour market flexibility that I referred to earlier. On the other, in a climate of buoyant sales,
the widening of business margins continued, albeit at a lesser rate than in previous years. All these
factors, combined with the rise in oil prices in the first half of the year, meant that inflation rose in 2006
and that the inflation differential with the euro area stood at 1.4 pp.
Inflation began to perform more favourably in the closing months of 2006, a trend that has run into
2007, with the related differential being cut to 0.5 pp. Foreseeably, these inflation dynamics will remain
in place for several months. But it should not be forgotten that the improvement has a temporary
component, linked to the path of oil prices, and that core inflation remains at 2.5%, despite the
continuing restraint of import prices. Price and cost increases in 2006 once again outpaced those of
our competitors, prolonging the deteriorating trend of the indices that measure relative prices and
costs. Insofar as this difference is not warranted by quality improvements, the trend of these indices
reflects a loss in competitiveness, whose adverse consequences for growth will become patent once
domestic demand moves back onto a normal footing.
The outlook for the Spanish economy points to the continuation of the main features recently
observed, namely: the restructuring of spending, thanks to a gradual easing in domestic demand,
particularly in consumption and residential investment, and an improvement in the contribution of net
external demand. The confirmation of these trends would allow for the projection forward of economic
dynamism at somewhat more moderate rates, in line with growth potential.
For this to occur, however, further progress in slowing spending and household and corporate debt,
and in improving the economy's supply-side conditions, is needed. We must not forget that the long
expansionary phase of the Spanish economy has been accompanied by a buildup in certain
imbalances that pose considerable risks to its sustainability. Thus, until they are sufficiently corrected,
we should avoid complacency. Admittedly, recent months have seen slower growth in household debt
and a gradual slowdown in house prices, while the inflation differential with the euro area has
narrowed. But it is important these processes continue to head off the risks the Banco de España has
been warning about.
Economic policymakers have a major responsibility to take advantage of the current economic
prosperity to adopt, on a preventive basis, the measures required to harness the existing opportunities
and to mitigate the risks that may arise. The change in the single monetary policy stance dating back
to late 2005 has contributed to gradually normalising the financial conditions under which households
and firms take their spending decisions, although monetary conditions are still accommodative for the
Spanish economy.
Turning to fiscal policy, buoyant revenue, which continues systematically to grow above budget, has
provided for an improvement in programmed objectives. Achieving fiscal surpluses in expansionary
phases, as established under the new budgetary stability laws, not only proves suitable for easing
demand pressures, but also for retaining sufficient room for manoeuvre in the face of potential
deviations from the scenario of economic dynamism and, naturally, for further restructuring public
finances in order to absorb the future consequences of population ageing. This is, unquestionably, the
main challenge for public finances in the medium term. The agreement reached last year under the
Toledo Pact also addresses the goal of ensuring the sustainability of the pensions system, although
the measures adopted are still of limited scope.
It should be recalled, however, that the high growth of public revenue has a difficult-to-estimate
temporary component that is linked in part to the strength of the real estate sector. Accordingly,
budgetary consolidation may require an additional effort to control primary spending. The collaboration
of regional and local government is vital in this connection, as they are responsible for major spending
components such as public investment, health and education. This consolidation strategy should,
moreover, be compatible with an improvement in the quality of public finances, since that is essential
for raising incentives and for helping overcome the shortfalls in education, innovation and productivity.
But when you are part of a monetary union, the most valuable economic policy instrument is, as our
own experience indicates, the deepening of reforms in order to increase the responsiveness of supply
and the adaptability of the business and productive sectors to the major changes the economy is
undergoing, such as globalisation and population growth.
Specifically, the dynamism and flexibility injected into the labour market by the aforementioned
phenomena of immigration and growing female participation need to be accompanied by the
development of a more appropriate institutional framework, without forgoing the unquestionable
achievement of good industrial relations. Despite the progress achieved by labour market reforms in
recent years, the need remains to better tailor collective bargaining arrangements to the different
industry- and firm-level requirements and to reduce the costs associated with permanent contracts.
These measures should be complemented by others aimed at improving the quality of the labour
factor, by giving greater priority to educational policy in order to redress the secondary education
deficit, adapt university courses to new demands and promote effective continuous training for
workers.
Improving the efficiency of the economy likewise requires increasing investment in physical and
technological capital, fostering innovation, pushing through privatisation where appropriate and
stepping up the pace of the processes undertaken in recent years to heighten competition. The
infusion of competition is particularly relevant in industries pivotal to spreading gains in efficiency to
the rest of the economy, such as the network industries, the telecommunications market, the energy
sector and rail transport. Some of these liberalising measures are detailed in the National Reform
Programme so that, irrespective of the need to design other new measures, it would be advisable to
apply this Programme more resolutely. Also, advantage should be taken of the transposition of the
Services Directive to define a more straightforward and competitive regulatory framework for these
activities.
Education, innovation, market liberalisation and, broadly, all reforms geared to increasing productivity
are of the utmost importance looking ahead to the long term. In recent years the welfare of Spanish
citizens has been increasing thanks to better use of the labour factor. This is worth celebrating since
for a long time the Spanish economy's main problem was in fact a persistently high unemployment
rate. But as we draw closer to success in this area (the long-term unemployment rate is now around
2%), it will be more difficult to obtain additional welfare gains as a result of increases in the
employment rate. Before it is too late, we should realise that productivity is the main source of welfare
in the long run, and the policies that promote this are therefore decisive for shaping the future of the
Spanish economy.
The financial system
The behaviour of Spanish households and corporations in 2006 once again posed fresh challenges to
the financial system. Given that public and private investment continued to increase, the net borrowing
of the economy rose from 6.5% to 7.8% of GDP. But what is more, household and corporate
purchases of financial assets inside and outside Spain increased, the result being that gross financing
required by both sets of agents climbed from 35.6% to 44.7% of GDP.
Indeed, although household consumption posted a somewhat lower growth rate than in 2005, as
disposable income moderated even more, household saving as a proportion of household disposable
income continued falling. Given that investment in housing continued to increase at a high rate,
household net borrowing rose to 1.5% of GDP. Nonetheless, changes in interest rates and property
price levels themselves began to temper the demand for housing, with the volume of transactions
easing off and a slowdown in prices. Yet significant underpinnings for the dynamism of housing
demand in the medium and long run remain as a result of socio-demographic factors - such as the
thrust of immigration, the growing incorporation of women into the labour market and the reduction in
the average family size - which will continue to translate into substantial increases in the number of
households. These socio-demographic factors, which were not present in the final stages of the
previous upturn in this market, will allow activity to stabilise, on this occasion, at higher levels than was
the case then.
In the new setting of less relaxed financial conditions, Spanish households began to resort less to
credit as a means of financing their expenditure. But the slowdown was still modest, it affected only
house purchase loans and it did not suffice to curb the rising trend of the sector's debt/income ratio.
The associated interest burden also increased, further boosted by the rise in interest rates. Thus,
although there has been some headway in Spanish households adapting their spending and saving
patterns to the progressive withdrawal of the monetary stimulus, this is still limited.
In the corporate realm, however, the presence of other factors meant that the increase in interest rates
scarcely affected corporate investment and debt. As earlier stated, investment in capital goods
became the most dynamic expenditure component in 2006, owing principally to two factors: the
pressure exerted by demand on the degree of capacity utilisation, which drew close to its historical
high; and the sound results posted by most companies along with their favourable outlook.
The buoyancy of investment was duly reflected in the sector's debt ratios. These increased once
again, fuelled by bank lending growth rates of around 30%. Significantly, however, a very sizeable
portion of funds raised was earmarked for financing Spanish institutions' participation in various
mergers and acquisitions. These M&A operations showed renewed vigour in 2006 not only in Spain
but also worldwide.
As in the case of households, the simultaneous increase in liabilities and in the related borrowing costs
translated into an increase in the interest burden borne by corporations. Foreseeably, the ongoing
moderate rise in interest rates will ultimately emit a timely signal to companies to adjust their
investment and business expansion projects to real future earnings possibilities. In that way the
financial risks that might jeopardise the continuity of investment will be lessened.
The financial institutions of all countries benefited from an exceptionally benign environment, in both
macroeconomic and financial market terms. Specifically, the balance sheets and income statements of
Spanish credit institutions were notably sound, with returns on equity not only greater than those of the
previous year but also far above those relating to risk-free assets. Their ROE stood at around a level
of 20%, 3 bp up on 2005, with a spread of 16% over long-term government bond yields. These trends
are similar to those observed in major international institutions, which show sound levels of returns on
equity along with wide spreads over government bond yields.
Yet this situation should not lead to complacency. On the contrary, it is precisely the favourable
circumstances of financial institutions, as reflected in their levels of profitability and solvency, that
allows us to discuss more freely the risks and uncertainties they must face in the coming years.
Financial innovation and the activity of new market agents should be viewed as positive
developments. The emergence in recent years of new products, such as credit derivatives and CDOs
(collateralised debt obligations), and deeper markets for other more traditional products, such as
asset-backed securities, have provided financial market agents with a new range of profit and risk
possibilities, allowed more dynamic and intensive risk management, and made for greater diffusion
and better diversification of risk. Similarly, the emergence of new operators, with investors prepared
not only to assume new risks but particularly to do so over longer terms, has in recent years enabled
shocks to be absorbed on markets with a lower level of stress and, subsequently, lower volatility.
Finally, regulated and non-regulated financial institutions alike, by increasingly having better risk
management systems, combined with supervisory and regulatory models based not on coercive
restrictions but on providing incentives for proper risk management, contribute clearly to market
stability. Unsurprisingly, as a result of all these factors, the international financial system has
demonstrated notable stability and substantial capacity to absorb adverse impacts level-headedly,
ensuring that the few episodes of overreaction have been very short-lived.
However, these structural improvements should not mask the fragilities inherent in this new and more
complex environment. The improvements based on proper risk management and diversification are
genuine ones. But they entail considerable management complexity and the growing involvement of
agents not subject to prudential supervisory arrangements who do not yet have tried and tested
experience in managing the risks assumed in more adverse economic environments. Moreover, their
information on such risks is abundant, but not systematised, and is fragmentary and limited in depth. It
is therefore likely that the risk of financial crises in the future will be less, but it is also possible that, if
such crises emerge, they will do so with greater intensity than in the past.
The improvements arising from new products and financial agents have enabled institutions to spread
risks and dilute the impact that an upward revision of the risk premium might have on their balance
sheets. But there is considerable uncertainty about the final destination of financial risk, since this is
neither created nor destroyed, only transformed or diluted. The most desirable outcome would be for
risk to end up at new institutions that can withstand negative returns in the short term without having to
close out positions or cut back risk exposures.
If ultimately it is pension funds that are going to retain the risk, concern should be voiced about the
mismatch between increasingly sophisticated financial markets that defuse the risk in an optimal
fashion and consumers whose financial knowledge has not evolved in step with market sophistication,
and who remain rooted in a very elementary financial culture.
Spanish credit institutions, with a traditional business model based on long-term relationships with
retail customers, are more sheltered from this complexity than other international banks that are more
active on financial markets and have deeper interactions with the markets. But in a globalised world
with complex interrelations, we can no longer think solely in national terms. And especially when our
financial system finances its ordinary activity not only through its Spanish customers but also with
funds raised on the European market.
The growing integration of the single financial markets can now be seen in many facets. First, some
market segments, of particular importance for Spanish institutions, already enjoy full integration, and
talking of the Spanish environment in this connection is meaningless. The integration of the interbank
markets, the public debt markets and the markets for subordinated debt and preference share issues
is, quite simply, complete. In the market segments of high-volume business financing, and equities,
the degree of integration in the recent period has been substantial. And in other markets, such as
retail banking, a lesser degree of integration is compatible with growing cross-border competition
through M&As or branches and subsidiaries. In addition to this there is the practical importance and
potential impact that European regulations emanating from Brussels have for Spanish institutions.
Such regulations include most notably the IFRSs (International Financial Reporting Standards), the
new Capital Requirements Directive (the Basel II Directive) and the Markets in Financial Instruments
Directive (MIFID).
On the basis of all these elements, the conclusion is that the prudential supervisor of Spanish credit
institutions cannot disregard the growing practical importance of the European environment, which
precludes thinking in strictly Spanish terms. This is so with regard to the diagnosis of institutions, to the
risks they face in the medium and long run, and to the instruments they have to mitigate such risks.
Traditionally, the Spanish supervisory model has been able to combine a demanding stance in respect
of institutions' risks with incentives for best-practices management. This has positioned Spanish
institutions among the most efficient and profitable in the world, and the Spanish economy has
benefited from a highly competitive financial system. In the coming years the challenge is successfully
to transmit these values in the European context, but also to assimilate the best international - and
specifically European - supervisory practices. We must allow our institutions to harness the benefits
the single financial market can offer them. Accordingly, in overseeing