Jaime Caruana: Presentation of the Bank of Spain's annual report
Speech by Mr Jaime Caruana, Governor of the Bank of Spain, to the Governing Council of the Bank of
Spain on the presentation of the annual report, Madrid, 14 June 2002.
* * *
A year ago I addressed you in my first presentation of an Annual Report, that for the year 2000. At the
time I highlighted the importance of an impending event: the introduction of euro notes and coins. This
event clearly symbolised the culmination of monetary union in Europe, a process set in train ten years
earlier and coming to fruition against a background of enormous expectation not free from uncertainty.
It is only fair today to start by stressing the success of the cash changeover, which was notably
smooth despite the complexity inherent in such a singular, large-scale and radically novel operation.
Underpinning this success was the collaboration of all the sectors concerned: households and firms
and, in particular, the banking system and the distribution sector, without whose contribution the
changeover of notes and coins would have simply been unviable. The fact that such a far-reaching
change should have found such widespread support in society ultimately reflects European citizens'
acceptance of their new currency and their confidence as to the benefits they may reap from it.
With the culmination of this process, the euro area is consolidated as an extensive and stable
monetary zone. This is an effective instrument for increasing the prosperity of European citizens and
one suited to playing a leading role in the international monetary system. It is also a magnet for other
European countries whose integration into the area will give it greater worldwide influence. A dynamic
process is now under way in the area in which those economies that are most flexible and best
equipped with physical, technological and human capital will be those that most benefit from
participation in the common European venture.
To date, the Spanish economy has been able to draw on its progressive economic and monetary
integration in Europe to move towards correcting some of its structural imbalances, to further real
convergence with the core European countries and to pursue increasing external openness. In
parallel, Spain has re-geared its economic policies towards stability and has pushed through the
liberalisation of its financial, factor and product markets. This modernisation and openness drive has
led to a substantial change in Spain's position in the world economy, which includes strategic
ownership interests in certain regions in which it has invested strongly.
Undoubtedly, the main challenge now facing the Spanish economy is to consolidate this position
against a background of heightened competition, rapid technological change and future European
Union enlargement.
The Annual Report presented today illustrates the benefits that the Spanish economy has obtained
from participation in Economic and Monetary Union, even under the particular circumstances of a
generalised slowdown in the world economy, as was the case in 2001. The advantages stemming
from price stability, budgetary discipline and the reforms undertaken are enabling the phase of
lacklustre growth to be overcome without halting progress in real convergence. The pattern has
differed from previous cycles, where the imbalances incubated in expansionary phases would
inescapably result in periods of recession and job destruction.
In this first part of my address, I shall give an overview of world economic developments last year and
discuss the response of the euro area economy to the new international setting, paying particular
attention to the performance of the Spanish economy. In the second part, I shall refer to matters
relating to financial stability, banking supervision and the role of the Banco de España in these areas.
The world economy
The slowdown in the world economy in 2001 was more short-lived and milder than expected, despite
the emergence of several adverse shocks which it was thought, at the time, would have a strongly
negative impact. First, there was the correction of the speculative bubble in the industries most closely
related to new technologies and telecommunications. This prompted a substantial decline in these
companies' earnings and their share prices on the stock market, and a rapid adjustment to the
overinvestment that had built up. Next were the repercussions of dearer oil prices in 2000, which were
partly corrected in 2001 but which have rebounded again this year. Further, the crises in Turkey and
Argentina once more highlighted the vulnerability of some emerging economies and certain
shortcomings in the architecture of the international financial system. And finally, there were the
attacks of 11th September, which had a specific and strongly depressive effect on confidence.
Despite this build-up of adverse effects, the world economy proved notably resilient. This was all the
more striking considering that on this occasion the downturn coincided in the three main areas (the
United States, the European Union and Japan), which a priori heightened the risk of a deep and
prolonged decline in world output. With the exception of Japan, the industrialised countries avoided
going into recession, while the emerging economies, although seeing a decline in their growth rates,
have on the whole remained more buoyant than the developed countries.
The opening months of 2002 have gradually confirmed the greater buoyancy of the world economy.
This is clearer in the United States, but is also perceptible in other countries. Activity, confidence and
employment indicators have all firmed, and GDP growth forecasts have been revised upwards.
Nonetheless, elements of uncertainty remain in place over the strength and timing of the ongoing
recovery. These relate essentially to the persistence of certain imbalances in the US economy (linked
mainly to the shortfall in private saving and the high foreign deficit), the weakness of the Japanese
economy and the crises besetting certain emerging countries.
It is worth inquiring into the causes of the world economy's resilience in the face of these shocks.
Firstly, it is probably indicative of the greater microeconomic flexibility of both the developed and the
emerging economies. It appears the structural reforms of recent years, aimed at increasing the
adaptability and responsiveness of economies to adverse effects, are beginning to bear fruit.
Consequently, it is crucial to further such reforms, especially in times of plenty, when their cost is
lower, so that when lean times arrive the economy has the spontaneous adjustment mechanisms in
place to reduce the cost and duration of the crisis.
Secondly, from the macroeconomic policy standpoint, the recent economic slowdown shows the
importance of having sufficient fiscal and monetary policy leeway to be able to react to adverse
disturbances, meaning in turn that prices and public finances should have performed favourably during
economic upturns. Fortunately, on this occasion, the slowdown found the main economies in a
relatively balanced inflationary and budgetary situation. This was conducive to a monetary policy
response (which was more intense in the United States, in step with the sharper reduction in the pace
of activity in this country) and to the operation of the automatic stabilisers, without jeopardising the
long-term fundamentals.
The notable exception is Japan. Here there is no further room for additional stimuli on the demand
side owing to the economic and financial problems inherited from previous years. And this has led to
the economy going into recession for the third time in ten years. In the other industrialised countries,
the prompt economic policy response largely accounts for the mildness of the slowdown.
Thirdly, part of the explanation for the swift recovery in the main economies in the face of the
aforementioned shocks lies in the fact that efficient, sound financial systems are in place, which have
been propitious to the smooth working of the monetary policy transmission mechanism. I will return to
this idea later on discussing financial stability.
In most of the main countries, then, the cuts in intervention rates have fed through appropriately to
banks' lending and deposit rates, and the liquidity provided by central banks has passed through the
credit channel to households and firms, where expenditure decisions are taken. The exception once
more here is Japan, where the financial sector's problems have prevented the pass-through of
monetary policy stimuli.
Fourthly, the limited knock-on effect of the Turkish and Argentine crises to other emerging countries, in
contrast to similar previous situations, also contributes to explaining why the slowdown in the world
economy has been relatively mild. This phenomenon is all the more notable given that two relatively
large countries of potentially systemic significance are involved. And particularly so Argentina, which
was the biggest sovereign issuer among the emerging countries.
The more orthodox and disciplined policies of the main emerging countries have been rewarded on
this occasion by the international financial markets. As the dispersion of spreads testifies, markets
appear to have increased their ability to discriminate between countries with better and worse
fundamentals. This greater ability has been partly due to increased transparency in the emerging
countries themselves, as a result of reforms in recent years including the application of statistical
codes and standards of good practice. It is also partly attributable to improved risk management by
investors on international financial markets.
In sum, behind the greater resilience of the world economy in facing adversities, it appears there are
positive factors which have tended to increase economies' capacity for spontaneous adjustment, the
responsiveness of macroeconomic policies and the discipline exerted by international financial
markets. Hence the importance of persevering in the coming years along these lines, especially
bearing in mind the growing economic and financial interdependence of different countries and regions
and their exposure to global shocks.
Euro area and monetary policy
The euro area fell prone to the slowdown affecting the world economy in 2001, although the impact on
the euro zone differed from that on other areas.
The initial idea that the euro area could sustain growth on its own has not held up in reality. Indeed,
some particular features of the area (such as the notable falling off of residential investment in
Germany) exacerbated the slowdown in activity in 2001. Nonetheless, the euro area does appear to
be emerging from this slump relatively satisfactorily, helped by the absence of significant imbalances
and by an economic policy response which have contributed to shortening the recessionary bout and
tempering its impact on employment.
At the onset of 2001 inflation was on a rising path, influenced by various essentially temporary factors
such as dearer oil prices, crises in the meat industry and the depreciation of the euro. Its trajectory
changed mid-year, partly following that of oil prices, and it fell to 2% in December. Although inflation
stood above the 2% level throughout the year, medium-term inflation expectations broadly converged
towards levels consistent with price stability. This contributed to wage moderation, preventing the
temporary rebound in prices from having a durable effect on inflation.
Thus, against a backdrop marked by the progressive slowdown in activity, by moderate cost pressures
and by price expectations on the part of agents that coincided with the monetary authority's targets,
the inflation outlook improved as the year unfolded.
The monetary policy stance, marked by the tightening carried out in 2000 in a very different
macroeconomic setting, gradually became accommodative of the new circumstances and several
interest rate cuts were applied, proving conducive to the economic recovery.
I would like to underscore two different factors that were pivotal to the assessment of the inflation
outlook and the intensity of the monetary policy response in 2001. The first was wage moderation, and
the second the reaction by the economic authorities to the attacks on 11th September, particularly in
the light of the sizable rise in economic uncertainty and the immediate deterioration of confidence
levels. The firm, concerted response by the monetary authorities in the main economic areas softened
the initial impact on financial markets and meant that the effects on the world economy were relatively
short-lived, though sharp, and confined to specific sectors.
Broadly, the design of the euro area members' fiscal policies in 2001 prevented expansionary
discretionary measures being adopted. Such measures would have jeopardised the sustainability of
recent fiscal consolidation achievements and, given the lag with which such measures operate, they
could have had a counter-productive effect on the cyclical stability of the economies in the area.
However, the available estimates of the structural budget balance show that, at the aggregate level,
there was a slight deterioration last year as a result of the tax cuts applied in certain countries before
the cyclical weakening had become apparent.
Further, fiscal results have shown that, in certain countries, not enough room for manoeuvre was
available to absorb the budgetary effects of the slowdown without drawing too close to the limits set in
the Stability and Growth Pact. Clearly, in such cases the consolidation drive made has not been
sufficient to attain a balanced budgetary position. In this respect, it is of paramount importance that
EMU members maintain the commitments entered into under the Pact and do so symmetrically, as
reflected in the conclusions of the Barcelona Summit.
The appropriate response by economic policies to the slowdown in 2001 has therefore contributed to
the recovery of the European economy apparently under way since the beginning of the current year.
The intensity and duration of this new phase of recovery will be influenced by conditioning factors that
are largely external to the area, such as oil prices, or the sustainability of the US recovery, given the
persistence of its financial imbalances. But, above all, a sound recovery will depend on the ability of
European economies to underpin their growth with domestic factors supportive of robust investment
that increases productive capital.
The monetary policy stance should be tailored to the prospects of maintaining price stability.
Particularly important in this respect (besides oil prices, which have already hampered any reduction in
inflation in the first half of the year) is continuing wage moderation which, in some countries, is
beginning to be questioned.
The single market and monetary union provide the European economy with a particularly suitable
framework for developing its growth potential and for consolidating it as one of the central pivots of the
world economy. Notwithstanding, the area still lacks sufficient flexibility and innovative capacity to
compete satisfactorily with other more dynamic areas, mainly in the more technologically advanced
industries. The Barcelona Summit has clearly shown the ability of the European authorities to pinpoint
key issues and to design a blueprint for reforms (of differing ambition but of equal importance) that will
make Europe a more dynamic economy. While greater ambition would conceivably have been
desirable, meeting the targets laid down in Barcelona on schedule would entail a qualitative change of
enormous importance.
The Spanish economy
The weakening of the international economy and the loss of buoyancy in the European economy
contributed in 2001 to prolonging the gradual slowdown in activity in Spain in train since the previous
year, when the first symptoms of the previous lengthy expansionary phase having run its course were
discerned. Consumption and investment in construction were the main underpinnings of growth in our
economy, while productive investment and exports were the chief components dampening it. That
said, GDP increased by 2.8% in 2001, clearly above the figure of 1.5% posted in the euro area.
The maintenance of high job creation rates during 2001, set against the slowing trend marked by
general developments in the economy, and the favourable financial conditions in place contributed to
sustaining household income and helped underpin consumer spending and residential investment.
However, the declining course of investment in capital goods steepened in the face of heightening
uncertainty, worsening expectations and slowing final demand, which the generous financial
conditions were unable to offset. The effects on activity were reinforced by the fall in the growth rate of
exports as from the early months of 2001.
In any event, the trends apparent at the beginning of the year 2002 (namely greater growth in the
economy in quarter-on-quarter terms but with something of a loss of steam in job creation and in
consumption, accompanied by a check on the rate of decline of investment and continuing
sluggishness in exports) are consistent with a scenario of gradual recovery, but fail to dispel the
uncertainty over its intensity and scale.
The profile of the Spanish inflation rate during 2001 was similar to that in the euro area as a whole,
albeit maintaining a positive gap. After rising in the opening months, in the wake of dearer food and
energy product prices, inflation dipped appreciably in the second half of the year, largely due to the
course of oil prices on international markets. At the end of 2001 it stood at 2.7% in year-on-year terms.
However, the initial data for 2002 have shown a more marked rebound in the 12-month growth rate of
consumer prices than that recorded in the euro area as a whole, due partly to temporary factors that
should be reabsorbed in the coming months.
Of concern to us is the persistence in the Spanish economy of inflationary biases reflected in the
inflation gap with the euro area, especially when they are manifest in the behaviour of unit labour
costs. I shall refer to the risks this entails later.
The change in the cyclical pattern of the Spanish economy
As I said at the outset, these features of the recent slowdown in the Spanish economy have shown up
a different pattern of behaviour than that followed in previous cycles. The factors accounting for this
change are related both to the conditions of greater macroeconomic stability attained by the Spanish
economy in its convergence towards and integration into the euro area, and to the progress made in
terms of structural reforms. These factors have had a bearing both on the balanced nature of the
upturn in the second half of the nineties and on the mildness of the recent deceleration.
The greater macroeconomic stability has been underpinned, as is known, by a notable fiscal
consolidation drive and by wage moderation. In the upturn, these conditions provided the economy
with a most significant expansionary boost, prompting rapid convergence towards the real income
levels of the core European countries, without this translating into the emergence of significant
macroeconomic imbalances. During the more recent phase of lower economic growth, the absence of
imbalances left over from the expansionary phase continuing favourable monetary conditions have
tempered the intensity of the adjustment, allowing real convergence to continue.
The presence of a credible environment of price stability and fiscal equilibrium is a necessary condition
for further headway in real convergence by the Spanish economy, as it moves into a phase of
recovery. Consequently, particular attention must be paid to the fiscal policy stance and to monetary
and financial conditions.
The year 2001 saw the attainment of a balanced budget, without the slowdown in the Spanish
economy preventing strict compliance with the commitments made under the Stability Programme,
consistent with the requirements of the Stability and Growth Pact. Last year, moreover, new fiscal
discipline measures were adopted which will contribute to maintaining sound public finances in the
medium term. I refer here to the budgetary stability legislation and to the new regional government
financing arrangements, which increase the degree of fiscal co-responsibility of the regional
governments under the transparency requirements demanded of general government.
I have already mentioned that monetary and financial conditions in the Spanish economy were more
generous than in the rest of the euro area, although the significance of this difference lessened as
demand lost momentum. The credit aggregates grew at high rates for the third year running. That said,
they did slow during the year, in step with cyclical developments, although this remains insufficient.
The growth of financing to Spanish households and corporations translated last year into a fresh
increase in this sector's debt as a percentage of GDP, with the rise in lending to households for house
purchases proving particularly notable. The greater ease with which the private sector has been able
to finance its spending decisions has contributed to limiting the depth of the ongoing cyclical
slowdown, but at the expense of incurring high debt levels. The increase in private debt is a logical
response to the new setting of lower interest rates in the Spanish economy, but it has also increased
the exposure of this sector to potential adversities.
As the expansionary effects of this process of adaptation by our economy to the new environment
ease off, progress towards real convergence at similar rates to those at present will require that growth
be underpinned by more stable factors.
Main challenges facing the Spanish economy
This overall positive assessment of the Spanish economy, even during the recent slowdown, should
nonetheless not conceal the presence of certain rather unsatisfactory aspects. These include the
positive gap with the euro area in terms of price and cost growth, the flatness of investment in capital
goods and low productivity gains. To further real convergence, these problems must be overcome.
In this connection, economic policy action should be geared primarily to promoting competitiveness, in
the broadest sense of the term, where aspects linked to the behaviour of prices and costs combine
with others related to growth potential.
Regarding the behaviour of prices, and despite the substantial progress made towards nominal
stability since the mid-nineties, the persistence of an inflation differential with the euro area poses risks
in respect of future competitiveness. The wage restraint characterising the most recent phase of the
Spanish economy has passed through unevenly to the sectors exposed to competition and those
sheltered from it. In the exposed sectors, price increases cannot be far removed from those made
abroad, whereas in the sheltered sectors there has been a continuous tendency to widen margins,
irrespective of where the economy is in the cycle. Hence, the combination of a rather inflexible wage
structure and still-insufficient competition in certain services sectors has led to the phenomenon of
dual inflation, which feeds the inflation gap with the euro area.
Another fundamental variable for the economy's competitiveness is productivity, although it is difficult
to measure and interpret. Clearly, what lies behind the low labour productivity gains in recent years is
the beneficial effect of employment-promoting policies, which have raised the economy's
employmentgenerating capacity. However, research indicates that such low gains may also be reflecting a low
increase in certain components of the stock of capital and an insufficient incorporation of technological
progress.
The most significant means of expanding the economy's growth potential has therefore been the
incorporation of workers into the labour force. This is a suitable way to improve the Spanish
economy's endowment and utilisation of productive factors, and should be maintained. But it cannot
be the sole avenue. In parallel, investment must be bolstered, especially in those forms of capital most
conducive to the incorporation of technical progress and innovation. Policies supportive of a more
flexible and efficient corporate environment and aimed at the better functioning of the economy must
also be persevered with.
The investment in new technologies in recent years has already had a positive influence on Spanish
productivity, although its overall effects have been blurred by the less dynamic behaviour of other
types of investment. Looking ahead, a step-up in investment in technological capital will require the
complementary promotion of investment in human capital and in capital goods to help spread
innovation across the economy as a whole.
As regards policies aimed at promoting market flexibility and efficiency, the liberalising momentum of
the reforms undertaken must be carried further. The Annual Report underscores the advisability of
land market reform, given its consequences for the formation of real estate prices and costs and its
influence on labour mobility. It further stresses the need to pursue liberalisation and competition
policies in the network industries (telecommunications, electricity, transport and distribution, etc.), as
the benefits of better workings here will spread to all productive activities.
In the labour market, the persistently high ratio of temporary to permanent employees alongside a high
unemployment level (especially among certain groups), with labour shortages in certain industries and
regions, highlights the need to press ahead with reform. In particular, the incentives for effective
participation in the labour market must be further improved, as must the decentralisation of collective
bargaining, so that it is better suited to the conditions firms face and to workers' characteristics.
To conclude this part of my address, let me stress the importance of building on the balanced budget
obtained in 2001 by introducing improvements into the structural aspects of general government
conduct. Public spending must be increasingly efficient, so that it contributes to increasing the
economy's stock of capital and productivity. Moreover, the necessary adjustments should be made so
that due attention to the growing demands that will be made of the public sector as a result of the
ageing of the population (to cover pensions, health, care for the aged, etc.) will not lead in the long run
to situations jeopardising public finances.
Financial stability
I shall devote the second part of my address to financial stability. From this perspective, I shall discuss
the main consequences of some of the earlier-mentioned shocks the international financial system
underwent last year.
I should like to begin with some reflections drawn from the crises experienced by certain emerging
countries. First, let me mention the importance of compatibility between the exchange rate regime
chosen by a country and its overall economic policies and institutional structure. No exchange rate
regime can, on its own, protect an economy from financial crises if it is not accompanied by
appropriate and coherent policies.
A second reflection is that the presence of and adherence to a legally sound, open and stable
institutional framework that is respectful of creditors' and debtors' rights is the only way to generate the
confidence and support of international financial markets in such a way that domestic saving shortfalls
may be financed.
My third reflection considers the need for clear, credible criteria beforehand as to how to distribute the
costs of crises. Such criteria should strike a balance between both domestic and foreign private
creditors.
Coverage of the shocks experienced by the international financial system last year would be
incomplete without some reference to the set of shortcomings highlighted in the so-called ENRON
case, which goes beyond the particular scope of this company and reveals weaknesses of a more
institutional and systemic nature. These events were significant since they showed that, even in
economies with more sophisticated institutional arrangements, some types of conduct with great
destabilising potential may occur. The ENRON case was important not only in quantitative terms but
also, and especially, in qualitative terms, witnessing a series of legally dubious practices which go
beyond the strictly financial field: conflicts of interest, serious corporate governance shortcomings,
excessively ad-hoc accounting practices deviating from prudential principles and from what is a fair
view of the real economic situation, manipulation of information, etc. And all this set against the
inoperativeness of the internal and external control mechanisms of the company.
We have thus been faced with a broad litany of serious problems affecting many of the institutional
requirements and elements that are so vital for maintaining confidence, for the efficient allocation of
resources, for the orderly working of any financial system and for the effective supervision thereof.
I shall return to these matters later. But let me first say that, faced with the above-mentioned
multifarious shocks, the international financial system showed a capacity for resilience that should be
viewed as highly satisfactory. It is not easy to assess which factors have contributed to increasing, and
to what extent, such resilience.
Among them, however, mention should be made of the following: the priority given to stability by many
monetary and fiscal authorities during the preceding long expansionary phase; the improved workings
of more integrated and better informed international financial markets with increasingly flexible trading
systems; the high levels of solvency, via own funds and provisions, attained by banks during the
previous upturn, which has made it easier to soak up the losses now arising; and, finally, the advances
made by many banks in risk management, providing for better risk identification and monitoring, risk
diversification and the reallocation of risk towards final investors, on increasingly efficient derivatives
markets.
Despite the resilience of the international financial system, both the independent developments within
the system and the aforementioned events which perturbed the markets have repercussions for
banking supervision. These are worthy of mention. Before doing so, however, I shall offer a brief
overview of the financial situation last year in Spain.
Spanish banking system
Inevitably, the Spanish financial system was affected during 2001, albeit unevenly, by the
aforementioned shocks. The economic slowdown throughout the year translated into a lesser rate of
banking activity than in previous years, resulting in growth in total assets of 7.3% in consolidated
terms. Though below this, the growth rate of credit remained high, especially in respect of mortgage
lending, which made for an increase in the level of debt and, in turn, saw credit markets gain weight
relative to securities markets.
The Spanish banking system was scarcely affected by the shocks discussed earlier, with the
exception of the Argentine crisis, whose repercussions were more telling.
Notwithstanding, our banks are weathering the storm caused by the Argentine crisis thanks to an
appropriate and prudent provisioning policy. Although this has meant reduced earnings, these have
still continued to outgrow those of most of the major international banks.
The cyclical turnaround has also led to an increase in bad loans. Yet owing to the relatively strong
growth of credit, this has not been reflected in default ratios, which have held at historical lows. The
solvency of Spanish banking institutions was bolstered last year, breaking with the trend seen since
1997, although this improvement is mainly attributable to secondary capital. As a result, credit
institutions' capital adequacy ratio stands three percentage points above the regulatory minimum,
calculated in accordance with Spanish rules, and almost five percentage points higher according to
the criteria of the Basel Banking Supervision Committee.
As a result of the lower rate of banking activity, combined with the impact of the crisis in Argentina,
with the consequences of the full implementation of the statistical provision and with the unfavourable
performance of stock markets, the growth of net attributable earnings after tax declined to 6.9% in
2001. Although this growth is but one-third of that posted the previ