Jaime Caruana: Key economic and financial developments in Spain
Address by Mr Jaime Caruana, Governor of the Banco de España, to the Governing Council of the
Banco de España on the presentation of the Annual Report, Madrid, 15 June 2001.
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Ladies and gentlemen:
In July last year, Governor Luis Angel Rojo completed his six-year mandate, as envisaged under the
Law of Autonomy of the Banco de España. During his term of office and that of the Deputy Governor,
Miguel Martín, the Banco de España experienced at first hand the far-reaching reform and
modernisation of our financial system, the process of economic convergence with Europe and the
milestone of our accession to the Monetary Union. As this is the first time I am called upon to present
the Annual Report to the Governing Council, I should like to begin by reiterating the gratitude of the
Deputy Governor and myself for the legacy of independence, credibility and rigour bequeathed by our
predecessors. The same values shall be our guiding principles in the coming years.
It is customary to devote this type of address to an analysis of the past year. Allow me to break with
this tradition and begin by referring to the future, to the year 2002. With the physical introduction of
euro notes and coins, that year will see the culmination of the transition to Monetary Union and may
well symbolise a new phase for the Spanish economy based on economic and financial stability,
integration and reform. Such principles will likewise underpin the work of this Bank in the future.
In the first part of this address, I shall highlight the key economic developments during the year 2000
and the opening months of 2001. In the second part, focusing on the financial system, I shall broach
macroprudential issues, along with matters relating to the structure and the performance of the sector.
Finally, I shall devote the third section to the role and activities of the Banco de España in this new
stage.
World economy
Growth in the world economy in the year 2000 was, at 4.8%, unusually high. The industrialised
economies, with the exception of Japan, and the emerging economies alike benefited from the boom
climate. At the same time, inflation rose in the industrialised countries, owing partly to the surge in oil
prices, and fell overall in the emerging economies. But the year 2000 was also a turning point;
economic activity progressively lost momentum, highlighting weaknesses that need to be tackled.
As in previous years, the US economy was the driving force of this expansion. Nonetheless, although
the United States saw its highest annual average growth for the past 16 years in 2000, the year also
marked the end of the recent exceptionally lengthy and intense upturn. Signs of a slowdown became
perceptible towards the summer and were confirmed as the second half of the year unfolded. As early
as the second quarter the financial markets had signalled their concern at the first symptoms of a fall
in corporate earnings. The decline in share prices was sharpest in securities linked to the new
economy, and was accompanied by a rise in the risk premia on lower-rated bonds.
The opening months of the year 2001 have seen a continuing slowdown in the US economy and its
extension to other areas, especially those with close trade links (Canada, Mexico and south-east
Asia).
This sluggishness in the US economy is in contrast to the resilience shown to date by the dollar, not
only against the euro but also in effective terms. Its robustness, linked to the relatively more
favourable medium-term prospects for returns on investment in the United States, might well prove
excessive given the US current-account deficit and the fact that the financial markets may
occasionally, even for protracted periods, keep exchange rates some way off what fundamentals
would appear to warrant.
In any event, doubts prevail over the intensity, duration and timing of the current phase of economic
adjustment in the United States. These doubts are tied to a series of imponderables, including most
notably: first, the extent to which the productivity growth rates observed to mid-2000 will be restored;
next, the depth of the decline in consumption which, even were it to restore potentially more balanced
levels of private saving in the long run, would also tend to heighten the loss of momentum of demand;
and lastly, the intensity and duration of the correction of corporate earnings, especially in the new
technology sector and, in connection with this, the extent of the correction of share prices. The scale
and duration of the slowdown in the United States will turn on the response to these questions.
The immediate prospects for the world economy appear to be closely linked to the US outlook,
whether because of its direct influence or because the other economies are exposed to the same
shocks. Before addressing the situation in Europe and Spain, I should briefly like to mention Latin
America.
The influence of US economic developments on Latin America is through two channels: one real and
one financial. The real channel, namely trade, is particularly marked in the case of Mexico, whose
growth forecasts for 2001 have been revised downwards, while it is rather more tenuous in the case of
the region's two other major economies, Argentina and Brazil. The financial channel partly offsets the
adverse effect of the real channel by means of the feed-through to Latin America of US interest rate
cuts, amounting to 2.5 points in the first five months of 2001. Overall, the slowdown in the US
economy is expected to draw the cyclical positions of the main Latin American economies closer
together.
Euro area
Economic results in the euro area in the year 2000 were favourable both in terms of growth and job
creation. The buoyancy of the US economy until mid-year and the greater competitiveness arising
from the depreciation of the euro contributed to this. On the negative side, the rise in oil prices has
adversely affected economic expansion in Europe.
The euro area is not immune to heightening uncertainty on the international economic stage. In
particular, the slowdown in the US economy may lead the diminishing growth path in Europe, initiated
at the end of last year, to be prolonged. That will hinge on the intensity and duration of the
deceleration in the United States and on the effect this may have on agents' confidence and on the
financial markets. In any event, activity in the euro area may be expected to remain relatively buoyant
insofar as domestic demand is underpinned by favourable income and financial conditions.
In the first half of 2000, monetary policy was progressively adapted to the deteriorating price outlook,
against a backdrop of an improved economic situation. Gradual interest rate rises were implemented,
though these did not prevent the monetary stance from being propitious to economic expansion
across the area. Indeed, monetary conditions were clearly generous in certain countries which, like
Spain, were ahead in the cycle and were experiencing greater price pressures.
Due to essentially temporary factors, euro area inflation climbed to above 2%. But the slowdown in US
economic growth and the subsequent deterioration in the world economic outlook tempered
inflationary risks as from the third quarter, paving the way in October for a halt in the succession of
official interest rate rises. In its evaluation of inflationary risks, the European Central Bank (ECB) has
since adopted a prudent stance, gradually modifying its assessment of macroeconomic conditions in
the area on the basis of developments in its external environment and of the data available on their
impact on the euro area. As a result, it trimmed its benchmark interest rate in May this year to 4.5%,
estimating that the lower economic growth envisaged for the euro area should mitigate inflationary
pressures in the medium run.
The ECB nevertheless monitors inflation developments in the euro area attentively. While the less
expansionary economic climate is tending to moderate price increases, risk factors - associated
mainly with uncertainty as to future wage restraint and to the feed-through to final prices of dearer
energy and other imported inputs - remain which could delay the forecast reduction in inflation rates in
the near future.
Having discussed the salient international economic developments over the past year, I should like to
highlight two conclusions arising from such developments which merit special comment. The first is
that technological progress does not imply the disappearance of macroeconomic disequilibria. And the
second is the differing position of the US and European economies, as regards both their cyclical
position and their medium-term growth outlook.
Technological progress does not presuppose the absence of disequilibria
Economic developments in the United States in recent years have been forcefully influenced by
technological innovation. Their effect has been felt, primarily, in the new economy industries. But,
gradually, they have also emerged in the more traditional industries as the latter have incorporated
technological advances into their production and distribution processes. As a result, not only has there
been a considerably higher economic growth rate than in the past two decades, but there is also
increasingly firm empirical evidence that the rate of expansion of trend productivity may have been
stepped up.
However, the fact that technical progress may provide a sustained boost to growth capacity does not
mean, as the experience of recent years in the United States clearly shows, that macroeconomic
disequilibria concurrently disappear. On the contrary, the favourable economic expectations in the
wake of technological progress prompted a strong rise in share prices and, by means of the low cost
of capital and the wealth effect, an expansion of domestic demand which, as from a certain point,
outpaced the growth rate of potential output, even under the most optimistic scenario of the effects of
the new economy.
The results of these maladjustments have been the notable decline in US household net financial
saving (to -4% of disposable income), the significant increase in corporate debt and, for the economy
as a whole, the widening of the already sizeable current-account deficit to 4.4% of GDP, albeit largely
financed by direct investment.
This build-up in disequilibria, against a background in which signs of upward pressures on prices were
also beginning to emerge, made it not only inevitable but also desirable that there should be a
slowdown in the pace of aggregate demand to rates compatible with the economy's growth potential.
And that necessarily entailed a temporary decline in productivity. The conclusion may thus be drawn
from recent experience that technical progress and the structural changes it entails do not mean the
disappearance or moderation of economic cycles. What technical progress does entail is an extension
to the limits of sustained non-inflationary growth capacity.
Differences in the euro area economy
As indicated, the euro area economy has been affected by the deteriorating international economic
climate and, in particular, by the sharp slowdown in the US economy. This is a natural consequence of
the growing interdependence of the various regional economic areas, brought about by the increase in
international trade and financial flows. Nonetheless, it would be mistaken to draw excessive parallels
between economies which, with their differing cyclical positions and structural characteristics, do not
share the same growth prospects.
In particular, many of the macroeconomic and financial disequilibria that have built up in the United
States are not be found in the euro area. Although investment has remained buoyant in recent years
in Europe, there is no sign of a surplus in capital goods being accumulated. Moreover, although the
European saving ratio has declined in recent years, it is still holding at appreciably higher levels than
in the United States. Finally, the private sector is in a less vulnerable wealth position, characterised by
lower relative debt and by less exposure to fluctuations in financial asset prices.
The sustained high private saving ratio and the fiscal consolidation drive undertaken by the euro area
Member States pursuant to the Stability and Growth Pact have helped the area as a whole achieve a
healthy external position. Foreseeably, these factors will mean that the euro area may sustain, in the
near future, a growth rate close to potential, albeit subject to the impact of developments on the
international front.
Against this background, it should come as no surprise that monetary policy has differed on each side
of the Atlantic. This discrepancy is, I believe, due not so much to differences in the statutory remit of
the respective central banks but rather to economic situations departing from different bases and
requiring different measures.
To meet the objective of increasing the economy's capacity for growth requires the contribution of
strands of economic policy other than monetary policy. In this respect, the European governments
have made headway in recent years in terms of fiscal consolidation, thereby increasing the room for
manoeuvre available in public finances to withstand adverse cyclical circumstances. Likewise, mention
should be made of the efforts to improve the workings of European product and factor markets, as part
of the so-called Cardiff and Luxembourg processes. These have provided for significance advances in
market integration and efficiency.
Despite these achievements, the challenges facing the European economy in the medium term go far
beyond the scope of the economic policy measures and reforms applied to date.
Thus, in a setting where public finances should be ready to withstand the foreseeable budgetary
consequences of the ageing of the population, effective additional measures to contain expenditure
are generally needed to exert a positive and durable influence on public finances. Likewise, budgetary
priorities must be established to favour those items, such as education or R+D, which can most
contribute to increasing growth potential in the medium term. In many countries there is ample room to
increase the efficiency of current tax systems. That said, in order to maximise their effectiveness, the
measures aimed at improving the quality of public finances must not be at the expense of fiscal
consolidation.
European structural policies must be pursued and deepened to achieve more integrated, flexible and
competitive markets and to remove the obstacles to the development and use of new technologies.
This is an important challenge requiring far-reaching reforms in widely differing areas such as the
education system, the financial markets and the mechanisms regulating economic activity. Success
here is pivotal if Europe is to aspire to competing in the cutting-edge industries and to satisfactorily
increasing the economy's overall productivity.
Many of the factors indicated here are among the objectives set out by the European authorities in
conclusions such as those of the extraordinary Lisbon summit last year. Notwithstanding, an air of
fatigue is palpable in some countries in respect of fiscal consolidation and structural reform. The scale
and significance of the challenges posed require that governments should not succumb to an
excessively short-termist vision that diminishes the momentum of the reforms needed and hampers
overall progress.
Spanish economy
For the Spanish economy, the year 2000 saw the culmination of a prolonged growth phase in which
further headway was made in real convergence with the other European countries.
The year closed with a real GDP growth rate of 4%, six-tenths of a point above that for the euro area
as a whole. Nonetheless, the growth rate of output moderated as the year unfolded as a result of the
appreciable slowdown in national demand, which was offset only partly by the improved contribution of
net external demand. The lesser momentum of demand was particularly evident in the capital
investment component, which reacted promptly to the change in expectations.
Consumer spending also slowed amid the greater uncertainty, rising prices and the loss of financial
wealth. But it is still holding at a sustained level as a result of the increase in employment. Lastly,
exports of goods and services have remained highly buoyant, despite lower growth in foreign markets.
This warrants reasonable optimism about the limited impact of the change in the international setting
on our economy. But this will largely depend on the correction of certain incipient imbalances which
gradually became apparent last year.
These imbalances have essentially been manifest in the price and cost differentials with the other euro
area countries, in the savings shortage, in the loss of steam of the investment process and in the
increase in the economy's borrowing requirements. As can be seen, all these imbalances are those
characteristic of an economy which, after several years of uninterrupted growth, is at an advanced
stage in the cycle (ahead of most of our trading partners). Their correction will be assisted by the
slowdown in demand already taking place. Indeed, the moderation of consumption has halted the
decline in the saving ratio and the slowdown in imports has lessened the deterioration in the external
deficit.
Despite their eminently cyclical nature, these tensions also highlight structural shortcomings which
continue to beset the workings of the economy. The risks arising from these imbalances should be
tackled through the economic policy instruments available, bearing in mind that monetary policy is no
longer available for domestic requirements.
Euro area monetary conditions have proved excessively generous for the Spanish economy in the
light of the expansionary setting in which it was immersed and of the intensity of the external shock in
the form of oil price rises. True, the monetary stance of the Eurosystem was altered as the inflationary
outlook for the area as a whole changed. But real interest rates remained low and long-term rates
declined. Moreover, the euro only ceased to depreciate well into the year, though it has subsequently
shown fresh signs of weakness.
The foregoing factors translated into a high rate of expansion of bank lending to the resident private
sector. This rate increased again last year by around 20%, although it has begun to show signs of
easing in the opening months of the year 2001. Growth was particularly marked in loans for the
purchase, construction and promotion of housing, against a backdrop of historically low real interest
rates and stiff competition among institutions in this market segment. Hence, in addition to boosting
domestic demand, the behaviour of credit has contributed to shaping a framework propitious to price
rises in the property sector.
These relaxed monetary conditions were only partly countered by fiscal policy, which adopted a
moderately restrictive stance. Fiscal policy results were better than scheduled, which has enabled a
balanced budget to be forecast for the year ahead. Balanced public finances, which are so favourable
for the economy, will tend to become entrenched with the disciplining procedures envisaged in the
draft law on budgetary stability. Under this legislation, any extra budgetary policy leeway should be
used to improve the general government financial balance.
Demand pressures contributed to inflationary tensions emerging. And these were accentuated by the
rise in oil prices. As a result, the 12-month growth rate of the consumer price index (CPI) stood at 4%
at the end of last year. In the early months of this year, the rate of increase of the CPI has stabilised at
around this figure, as oil market pressures have yet to disappear. Adding to this have been the
distortions in the market for meat products. At issue here in both cases are largely transitory factors
which should abate in the coming months. This, combined with the deceleration of the economy,
entails a significant change in the inflation outlook towards lower rates closer to the definition of price
stability formulated by the ECB, a definition which should continue to be the medium-term reference
for economic agents. There is a danger, however, that the feed-through of price rises to wages, via the
inflation adjustment clauses that do not exist in most European countries, will delay the expected
slowdown in consumer prices and, by exerting pressure on firms' costs, reduce the rate of growth and
of job creation.
The continuing inflation differential with the euro area average is a cause for concern insofar as it may
be indicative of problems of competitiveness. In the sectors (mainly manufacturing) most exposed to
foreign competition, excessive cost increases lead, because they cannot be fed through to prices, to
losses in profitability relative to foreign competitors. The sectors (mostly services) most sheltered from
competition can, by contrast, pass through cost increases in full to prices and, indeed, harness the
buoyancy of demand to increase margins, thereby contributing to maintaining inflation differentials.
This behaviour is harmful, above all, to the competitiveness of the economy as a whole, but also to the
development of those industries which seek to draw short-term benefit from the market power
bestowed on them by restricted competition.
The Spanish economy is in a position to continue posting a rate of expansion of around 3% in the
coming years, outpacing the euro area in this respect. But to achieve this it will be necessary to tackle
appropriately the imbalances that have emerged after a long phase of rapid growth. Failing to do this
would jeopardise the economy's competitiveness, which would be particularly worrying at a time of
faltering world growth and heightening uncertainty.
Social agents must adapt their behaviour accordingly to the patterns of nominal stability that have
inspired EMU, extending the moderation and stability that have presided over the initial years of the
Monetary Union. It is thus a question of entrenching a new culture in which wage, rental and other
income negotiations and price setting do not turn, as in the past, on a positive rate of inflation for the
economy as a whole but rather on supply and demand in each specific case.
The year 2001 is particularly important for embedding the possibilities of growth in the continuing
stability that has made the current phase of expansion possible. The different strands of economic
policy must thus strengthen the economy's flexibility and improve market workings.
From this encouraging though not risk-free outlook, I believe two issues may be highlighted. First, the
strengths and weaknesses of the job creation-intensive growth pattern we are following. And second,
the importance of fostering conditions appropriate to increasing medium- and long-term growth
potential.
Employment-intensive growth pattern
The growth pattern of the Spanish economy in recent years has been characterised by intense job
creation and, consequently, by a moderate increase in apparent labour productivity. During the period
1997-2000, real GDP ran at an average annual growth rate of 4.1%, and employment at 3.5%. The
increase in labour productivity was thus 0.6%. These figures contrast with those of the previous phase
from 1980 to 1996, in which the growth rates of output and employment were 2.5% and 0.6%,
respectively, making the productivity increase 1.9%.
For an economy such as Spain's, where the labour factor is still under-utilised, it seems advisable to
follow a job creation-intensive growth pattern, even though this involves a phase of scant apparent
labour productivity gains. This is provided that rates of investment and innovation are high and that the
foundations are laid for subsequent improvement. Indeed, this is what occurred in the US economy.
The case of the US economy is illustrative in this respect. As will be recalled, the United States
underwent, until the mid-nineties, a period in which its growth was based on employment, posting
labour productivity rates of increase which scarcely exceeded 1% per annum. The flexibility of its
labour market provided for greater relative growth of its labour-intensive services sector, at the
expense of traditional manufacturing industry where labour requirements per unit of output are less.
The substantial labour productivity gains, the outcome of the strong and persistent rate of investment
and the diffusion of technological innovation, only became clearly apparent when the US economy
reached a situation of virtually full employment.
If we compare this process with what has occurred in Europe in past decades, the greater rigidity of
European labour markets can be seen to have led investment to be channelled towards relatively
capital-intensive industries, slowing the expansion of the services industry. In fact, the services sector
employs 60% of European labour today compared with 76% in the United States. The lesser capacity
of Europe to generate employment translated into high unemployment rates (double that of the United
States, on average) and into a relatively higher increase in apparent labour productivity, at that time, of
over 1.5%. Consequently, the European economies, and Spain among them, are currently facing a
phase that the United States has already left behind, and one that should be geared to reducing the
prevailing high unemployment rate.
The challenge consists, precisely, of squaring the current job creation-intensive processes with
increases in investment incorporating recent technological advances and providing for a better use of
productive resources. The productivity gains arising from this process will become effective and
manifest, with increasing intensity, as current unemployment is absorbed. In turn, low productivity
makes the current growth phase particularly vulnerable to wage increases which, as they cannot be
offset, pass through to greater unit labour costs.
Increasing growth potential
The temporary advisability of following a job creation-intensive growth model should not lead to an
underestimation of the importance of boosting the factors underpinning the increase in the economy's
growth potential, in which connection the full and effective use of the resources available does not
suffice. It is also necessary to increase such resources quantitatively and qualitatively via investment
in human, productive and technological capital. In this process entrepreneurial innovation and the
incorporation of the new communications and information technologies play a pivotal role.
This will require flexible economic structures, whereby the policy of reforms in various areas must be
pursued. The labour market is a case in point. Following the recent reforms, the focus should be on an
efficient co-ordination of collective bargaining so that wages may grow in a differentiated manner and
thus adapt to the specific conditions of firms. In turn, this differentiated wage growth will spur labour
mobility across firms, industries and regions with different employment conditions. Likewise, policies
aimed at increasing labour market participation, especially of those groups traditionally outside the
market, should be reinforced. Reform in the market for land use, which is characterised by a lack of
competition and transparency, would also help lift obstacles to inter-regional labour mobility. In
education, investment in vocational training and in improving workers' skills must be stepped up. In
particular, their adaptation to the new technologies is vital if the labour shortages in this area are to be
reduced. Finally, the stock of both private and public productive capital must be increased through
maintaining high rates of investment, equipping the country with the infrastructure and capital needed
for a sustained increase in productivity.
It is thus a matter of seeing through the policy of reforms and the guidelines recently approved by
Spanish economic policymakers. This is of paramount importance for continuing the process of
convergence with the per capita income levels of the euro area, a process supported to date mainly by
the robustness of employment. As we approach European rates of employment, continuing cuts in the
differences will only be achieved if the rise in our productivity exceeds that of the euro area.
In the medium run, we should seek to attain a mix of buoyant job creation and high productivity rates.
That means sustaining a high growth rate in a durable manner without this giving rise to upward
pressures in costs, margins and prices. But this is only possible if we have an economy whose market
workings and institutions are much more flexible than at present.
Financial stability
Moving on to financial stability issues, one of the salient phenomena of recent years is the growing
significance of financial markets and their ever greater interrelatedness to the real economy.
In Europe, the development of capital markets is leading to a more balanced banking-market model.
Household share ownership in the European Union has increased in recent years: whereas in 1995
they accounted for 26% of financial assets, this proportion had risen to 37% in 1999. And to this figure
we must add indirect holdings via mutual funds, pension funds and other forms of collective
investment, the popularity of which has increased visibly.
One immediate consequence of these changes has been to tighten the linkage between financial
markets and the real sector. The fact that a growing portion of wealth is held in the form of securities,
whose price can fluctuate 24 hours a day on the world markets, has evident implications for the
dynamics of disposable income and consumption. In addition to this direct channel is that relating to
the cost of capital and its influence on investment by firms. Lastly, the securities markets also play a
key role in the formation of consumer and entrepreneurial expectations. Thanks to the constant
information flows from these markets, these agents continually adjust their assessment of the
economic environment.
The transmission channels from the financial sector to the real sector are, therefore, increasingly
flexible, rapid and complex. Two relevant and interrelated issues have arisen from discussions on this
area: the first is the extent to which the volatility of financial markets is being transmitted, also more
intensely and rapidly, to the real economy; and the second questions whether financial markets
amplify fluctuations in the real economy. Expressed otherwise, considering both issues in conjunction,
what is being discussed is the extent to which the behaviour of the financial markets exacerbates the
volatility and cyclicality of the real economy.
Regarding the first issue, there are recent examples pointing in opposite directions. There have been
episodes, such as the Asian crisis, involving the intense transmission of financial turbulence to the real
sector. However, it should also be acknowledged that the developed economies have shown a notable
degree of resistance to certain financial disturbances. In this case, the stable course of real variables
against such a volatile financial background should largely be attributed to the following factors. First,
to the existence of healthy financial systems with sufficient room for manoeuvre to absorb the impact
of varying shocks. Next, to a greater diversification of holders of financial instruments and of financial
operators. And finally, to the prompt reaction of the authorities. Conversely, when these conditions
were not present, pressures in the financial sector have tended to be transmitted relatively intensely to
the real sector.
The possible explanatory factors of this potential amplification of the cycle in the financial sector are
many-faceted and complex. These include most notably: heightened competition in the banking sector
and in financial markets, which in an upturn leads to riskier strategies that are only corrected when the
rise in bad debts highlights their consequences; a tendency of economic agents to over-react to
changes in their environment; herding, on occasions, which reinforces trends; and the use of common
assessment and risk management tools and a short-termist view of "shareholder value". All the
foregoing induce sharper fluctuations in asset prices. Prudential regulations may also occasionally
have proven conducive to an excessive emphasis on the short term when assessing risks.
What can the authorities do to counter these ten