Miguel Fernández Ordóñez: Recent developments in the Spanish
economy
Testimony by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, before the
Parliamentary Committee on Budget Affairs, Madrid, 17 April 2012.
* * *
Ladies and gentlemen,
I appear today before this Committee as I have regularly done so each time the State Budget
has been debated in Parliament. This picture of normality is in stark contrast to the
exceptional circumstances which mark the economic background against which the
2012 Budget is being debated.
The Spanish economy is currently immersed in a complex and costly adjustment process
which entails, among other things, a major fiscal consolidation drive. The adjustment must,
moreover, be made in an external context strongly influenced by a sovereign debt crisis in
the euro area which, for reasons not very different from those that have made this
adjustment necessary, is affecting us most severely. Under these conditions, the State
Budget for this year takes on singular importance.
Allow me first to remind you that the sovereign debt crisis in Europe, far from being resolved,
took on a new dimension last summer. Then, tensions spread to the debt of certain Member
States with sounder fundamentals and economic policies more in step with the patterns of
behaviour befitting a monetary union than those of the countries initially affected. From being
confined to a relatively limited group of particularly vulnerable economies, the crisis became
systemic.
It is not easy to pinpoint the ultimate reasons behind this qualitative leap. True, at the root of
the crisis as it initially unfolded, various macroeconomic imbalances of a fiscal, financial and
competitiveness-related nature built up by some economies played a pivotal role. Yet, at the
same time, the very accumulation of these imbalances and the difficulty of devising a widely
accepted strategy to redress them in an orderly fashion within the euro area highlighted the
existence of substantial weaknesses in the European economic governance framework.
These included most notably the absence of a powerful and flexible crisis-management
mechanism to provide financial support to members in difficulty. These mechanisms are
essential for heading off tensions at a sufficiently early stage in the process, which is when
tackling them is less difficult.
The duality of the problems, with one purely national component and another genuinely
European one, coupled with the growing interrelatedness of euro area economies as a
whole, created a breeding ground in which the tensions took on a systemic nature.
Moreover, it is widely known that, to correct the weaknesses detected in the initial design of
the euro project, the Member State governments have embarked on a thorough revision of
the mechanisms for European governance. This process has already yielded some results,
including the legislative initiatives adopted in what is known as the "six plus two package";
the Treaty establishing the European Stability Mechanism, the new permanent European
crisis-management mechanism; or the Treaty on Stability, Coordination and Governance in
the euro area. But the flip-side is that this process has moved forward in fits and starts, it has
not enjoyed a broad degree of consensus and it has sometimes failed to be as rigorous and
ambitious as the gravity of the situation required.
Likewise, since the onset of the tensions there has been - occasionally notable - headway in
the ongoing adjustment of the most vulnerable national economies, sometimes in step with
the strict conditionality imposed under the financial support programmes under way. But
here, too, action has broadly tended to be behind instead of ahead of events.
In these conditions, it is the European Central Bank that has positioned itself as the
fundamental bulwark against the crisis. And, ultimately, this is buying time for the Member
State governments, in both their responsibility for domestic economic policies and as
co-managers of the common European Project, to make resolute progress in resolving the
problems at the root of this crisis.
We should not forget that the extensive range of non-conventional measures deployed by the
ECB since the start of the crisis - the 3-year LTROs being one of the most recent and
successful examples here - are, by their very nature, limited over time. And, more important
still, these measures do not affect the fundamental imbalances which are ultimately at the
source of and responsible for the crisis.
Unfortunately, the tensions we have once again experienced in recent weeks are a powerful
reminder that the crisis is still far from over and that our economy's situation remains a
particular cause for concern in Europe.
And this despite the fact that since the start of the sovereign debt crisis, and more forcefully
so in recent months, Spain has implemented major reforms.
A frequently voiced criticism of the ECB's 3-year LTROs is that such an extremely generous
provision of liquidity will tend to mask the underlying problems of the most vulnerable
financial systems, thereby weakening the thrust of governments' reforms in this area. This
has not, of course, been Spain's experience. A glance at the measures adopted in Spain
shows that the process to clean up, restructure and recapitalise the Spanish credit system
has lost no momentum whatsoever. Rather, the opposite is true. Throughout last year and in
the opening months of 2012 the process has been stepped up to adapt it to changing
circumstances, marked by a growing deterioration in economic and funding conditions. After
resolving the governance and ownership-structure problems affecting the system in the initial
stages of the tensions, efforts have focused recently on further strengthening banks' capital
and provisions, thereby keeping up the pressure for the necessary restructuring of the sector.
In a different sphere, a labour market reform has recently been approved which affects core
aspects of this market's workings. On one hand, its aim is to decentralise collective
bargaining and increase firms' internal flexibility. As I previously stated in this House, both of
these aspects are essential for adapting labour market conditions to firms' specific
circumstances and, ultimately, for allocating the productive resources available more
efficiently, in particular labour, to different economic activities and sectors. On the other, by
rationalising the conditions under which permanent contracts may be terminated, the reform
shapes an environment which will be more conducive to job creation and job stability, once
the current difficult circumstances are behind us. Overall, the labour market changes should
help promote the adjustment of working and productivity conditions as means for restoring
competitiveness.
However, it cannot be ruled out that some of the effects of this reform will not be immediately
discernible and that, given the setting of sluggishness and uncertainty in which Spanish
economic activity is currently unfolding, there may be some further adjustment in
employment levels. This effect would be softened if firms were swiftly to use the various
forms of internal flexibility provided by the new labour legislation.
In turn, the favourable effects of this reform will be amplified if they are accompanied by
measures that enhance the competitive environment in which firms take decisions and that
provide for the liberalisation of sectoral aspects that are key to ensuring efficient and flexible
economic behaviour. Ambitious measures here would help bring about a virtuous circle
which, through job creation and growth, would see more rapid progress in the difficult tasks
of the financial deleveraging of the private sector, the normalisation of the banking system
and fiscal consolidation. Confining myself to this latter consideration, without a recovery in
employment it will prove costlier to further budgetary adjustment, since the increases in
revenue will be limited and because turning expenditure around will require an additional
effort to offset the necessary increase in unemployment benefit payments.
In any event, budgetary policy is key in circumstances such as the present. As I stated
earlier, we are in the middle of a sovereign debt crisis. There is no doubt that the Spanish
economy's vulnerability has a significant fiscal component, although our difficulties are
compounded by the persisting downturn - and its dreadful impact on employment - and the
still-high dependence on external funding. The budget deficit ended last year at a level of
8.5%, far off the 6% target set in the Stability Programme. And the year-end public debt/GDP
ratio was 68.5%, more than 30 pp up on 2007, before the international financial crisis broke.
In turn, the deficit targets have been set at 5.3% for 2012 and at 3% for 2013, which entails a
most significant budgetary effort. It is crucial, however, to rigorously meet these targets.
Attaining them is vital for restoring credibility in the Spanish economy, and here the overall
interests of all economic and social agents and all levels of government converge. A high
degree of unity and consensus among the respective parties will be pivotal to success in the
arduous task ahead. Failure in fiscal consolidation would lead us to scenarios involving
further contraction and further losses in employment and welfare.
The exceeding of the deficit targets last year has highlighted the difficulty of correcting fiscal
dynamics in adverse cyclical situations. But it has also revealed the faults existing in the
monitoring, early warning and budgetary control procedures then in force, especially for the
regional governments, which the budgetary stability law currently before Parliament and
which I shall refer to later must correct.
In this respect, the experience of the last two years shows how important it is that budgets be
prepared on the basis of a prudent macroeconomic scenario and that the measures are
suitably designed to ensure their effectiveness. It is also important to have early information
available on the budget outturn, so that any deviations can be corrected in time. These
principles affect both the Stage Budget, the reason for my appearance here today, and the
regional government budgets, which I am not going to discuss, although I do wish to take this
opportunity to convey my concern regarding the obsolescence of some of the assumptions
on which the latter were prepared during the latter months of 2011. These assumptions need
to be updated and the appropriate measures urgently adopted to ensure that the regional
governments achieve their targets.
Allow me to refer briefly to the delicate cyclical situation that frames the context of the State
budget for 2012. The intensification of the sovereign debt crisis from the summer of last year
interrupted the mild recovery that the Spanish economy had begun a year earlier, with a
decline in GDP of 0.3% in the final quarter of 2011. This pattern ran into the first quarter of
this year, so that the Spanish economy is, once again, in recession.
As in the case of the 2008-09 recession, national demand is displaying the greatest
weakness. All domestic demand components declined in the fourth quarter of 2011 and have
continued to do so during the first few months of this year. A strongly negative factor during
all these ups and downs has been the need to reverse the accumulated imbalances (the
assignment of excessive resources to housing, high indebtedness and competitiveness
losses), as part of an adjustment process that has still to be concluded. More recently the
intensification of the sovereign debt crisis and its effects on the financial system has
compounded matters, leading to a tightening of the economy's financing conditions and
eroding agents' confidence. The downward revision of euro area growth prospects and the
stepping up of fiscal consolidation have contributed to a further contraction in consumer
demand and investment, and the acceleration in the decline in employment has further
fuelled these trends.
In the face of slack national demand, the external sector has once again acted as a shock
absorber, alleviating the negative impact of lower spending on output. In recent quarters,
however, this relief has come about more through the channel of lower imports than that of
more buoyant exports, which is attributable to the parallel weakness of some of our main
European customers.
In these conditions, the outlook for 2012 is not favourable and remains subject to a high
degree of uncertainty. Broadly, the Banco de España's view does not differ greatly from that
of the Government implicit in the macroeconomic table accompanying the Budget. The
process of adjustment of national demand will continue. Private consumption will be affected
by the decline in employment and by the lower support that general government will be
giving to household income. However, the impact of these two factors will be partly offset by
more moderate price increases and, probably, by a continuation of the decline in the saving
rate, although the margin available for this to smooth the pattern of private consumption is
increasingly limited.
Business investment will undoubtedly be affected by the slackness of domestic spending and
because many firms will continue aiming to reduce their level of indebtedness. Nor are
significant changes in the ongoing adjustment of residential investment foreseeable. On the
demand side, no improvement can be expected in affordability conditions given the outlook
for private sector income and wealth and, on the supply side, the overhang of unsold housing
will continue to hold back the launching of new construction projects.
The need to reduce the levels of indebtedness of all sectors and the prevailing conditions of
access to external financing will continue to curb the possibilities for any expansion in
domestic spending. Exports might be the only component of output to increase in 2012.
Admittedly, the international situation is subject to a high degree of uncertainty and, in
particular, the activity of the euro area as a whole is expected to flatline or fall slightly. But it
is also true that the behaviour of exports has been very favourable over the last two years
and Spanish firms have been increasingly diversifying their exports towards third markets
with more dynamic demand.
Unfortunately, the stimulus provided by external demand will not suffice to offset the effect of
the other contractionary forces on employment, which can be expected to fall further. If the
labour reform were to begin to produce its effects soon, wages might grow somewhat slower
than in 2011. And along with productivity gains, that would lead to further declines in unit
labour costs, thus enabling competitiveness gains to be made. Prices will continue on the
moderating path on which they embarked in the second half of last year, although the risk of
rising energy prices has not disappeared.
To sum up: the scenario described indicates that domestic demand will continue to adjust in
step with the ongoing financial deleveraging and fiscal consolidation. In these circumstances,
it is vital that the gain in the share of our sales, both abroad and at home, should be the main
driver of activity in Spain. And, accordingly, achieving sustained competitiveness gains,
which must come from the implementation of ambitious supply-side reforms and measures,
is crucial. If these reforms and measures should restore confidence in the Spanish economy,
reduce financing costs and improve the foundations for future growth, 2013 may witness a
recovery.
In this situation, the 2012 Budget forms part of a more general medium-term consolidation
strategy, requiring the collaboration of all levels of government. Details will be available in a
few weeks, when the Government presents the Stability and Growth Programme to the
European authorities. The Stability Programme should contain precise and explicit details of
all the elements on which this consolidation process will be based. The targets set by this
Programme must anchor the budget measures of the coming years, ensuring that the
general government deficit can be reduced to below 3% of GDP in 2013 and, subsequently,
that a balanced budget can be achieved. In addition, they must seek to stabilise the public
debt ratio and subsequently reduce it to below 60% in 2020.
The fiscal consolidation so defined must be considered unavoidable and necessary to
restore economic growth in the medium term, although the size and timing of the adjustment
required may have negative effects on activity in the short term. In an environment like the
present one, characterised by the extreme sensitivity of economic agents to economies'
fiscal situation, in particular in the euro area, any other strategy that might jeopardise the
achievement of the fiscal targets in the terms established would have very negative
consequences for market confidence in the Spanish economy, seriously damaging its growth
possibilities both in the short and in the medium and long term. By contrast, strict compliance
with the commitments made may generate a virtuous circle of improvements in confidence
and expectations that is conducive to the recovery.
The 2012 Budget for the State and the Social Security system, along with the budgets of the
regional and local governments, are the first link in this strategic chain. It is vital that these
budgets be fully consistent with achievement of the target set for the budget deficit of 5.3% of
GDP this year, down from 8.5% of GDP in 2011. This reduction in the budget deficit requires
an unprecedented adjustment in the primary structural deficit, since it must offset the
expected increase in the interest burden and the effect that the fall in economic activity is
forecast to have on public finances.
The draft State Budget for 2012 details the measures proposed to meet targets in the case of
the State and the Social Security system, distributing the adjustment on both the public
revenue and expenditure sides. Admittedly, as I have noted on previous occasions in this
House, the evidence on the effectiveness of previous fiscal consolidation processes
implemented in other developed economies shows that it increases when they are
concentrated on public expenditure, in unproductive expenditure. However, the scale of the
adjustment required in our country is so great that we need to make use of all the
instruments available, including taxes.
The 2012 Budget envisages an increase in revenue from tax measures falling basically on
household and corporate income. Also, a special charge is imposed for the regularisation of
hidden assets. The revenue-raising potential of these measures is expected to offset the fall
in revenue due to the unfavourable trend in tax bases deduced from the macroeconomic
scenario accompanying the Budget. Last year's experience, when the bulk of the budget
deviation stemmed from the adverse performance of government revenue, showed that it is
essential to budget prudently for this variable. In this respect, the projected course of overall
budget revenue is subject to downside risks. The reasons for this are various. First, because
both the expected corporate income tax receipts and any other tax revenue will depend on
the ultimate effectiveness of the numerous legislative changes, which is particularly uncertain
in the case of the special charge on undeclared income. It should also be emphasised that
the Spanish economy is in the midst of a process of macroeconomic adjustment and, as
noted above, its growth prospects depend on the external sector, which tends to yield only
moderate increases in tax revenue in the short and medium term, particularly if this is
accompanied, as in the Spanish case, by an adjustment in the real estate sector.
On the expenditure side, the draft Budget proposes highly significant reductions
concentrated in capital expenditure and also in current transfers and goods and services
purchases. In the case of transfers to government-owned corporations, it is important for the
planned reduction to be accompanied by adjustments of similar size in the effective
expenditure of these entities, so as to achieve a lasting reduction of the imbalances. Here,
too, the Budget projections are generally not free from risk. First, because it is often difficult
to restrain the high inertia of certain items, frequently resulting in the past in overshooting
with respect to the initially budgeted figure, particularly in the case of goods and services
purchases. Nor can we rule out further unfavourable changes in those items, such as
unemployment or pension benefits, whose size depends on external factors, such as the
unemployment rate, population or inflation. This is related to the fact that the risk of deviating
from the budget is higher in social contributions.
It is essential to prevent these risks from materialising by ensuring a meticulous and rigorous
budget outturn allowing budget deviations to be detected in time and any required remedial
action to be taken. Should this be necessary, additional adjustments would have to be made
in current expenditure, given that the freedom of action in relation to capital expenditure has
shrunk enormously, and new tax measures would have to be taken, preferably in the area of
indirect taxation, which has fewer distorting effects on growth and the allocation of resources
and where the tax burden in Spain is lower than in other developed countries. Looking
ahead, moreover, it cannot be ruled out that the temporal tax increases applied may have to
be replaced in time by measures of a permanent nature.
Simultaneously, it is important that the process of budgetary consolidation be accompanied
by a strengthening of the national budgetary framework, so as to allow governments at all
levels to meet their commitments. In this respect, the reform of the Constitution in September
2011 so as to include the deficit and debt ceilings set at European level, which was
subsequently implemented in the draft budgetary stability law, was designed to meet this
need and is fully consistent with the recent EU governance reforms.
Following the approval of the budgetary stability law by Parliament, it is crucial that all the
instruments envisaged in it, particularly the monitoring and control mechanisms and those
aimed at ensuring that the targets set are met by all levels of government, be set in train
immediately. I think it is worth looking more closely at this law because the success of the
fiscal consolidation process depends largely on whether it is applied properly.
The 2011 budget outturn highlighted the consequences of the unavailability of information,
which prevented budget deviations from being detected in time and delayed the activation of
mechanisms to ensure the consolidation targets were met. The new stability law should
significantly improve the transparency of government action in at least three respects. First, it
is essential for the budget outturn of local and regional governments to be published
regularly, with the same periodicity, level of detail, lag and ease of access as that of the
State. Second, the information contained in the State and regional government budgets must
be improved, so that the assumptions underlying revenue and expenditure projections are
known and the information is made available on these items in national accounts terms,
which is the relevant definition for the existing fiscal rules. Finally, the information in the
adjustment plans at the various levels of government should be made public and presented
in a format allowing it to be analysed and compared with the initial budgets.
In addition, the mechanisms obliging government deficits to be corrected have clearly proved
to be insufficient. In this case, the draft stability law includes new coercive instruments to
ensure the budget targets are met by all levels of government. Provision is made for
imposing sanctions, regional government expenditure must be automatically adjusted in
certain cases of non-compliance and it is even envisaged that the central government may
impose compulsory adjustment measures on local and regional governments. I consider that
these new legal mechanisms can be extremely effective in ensuring discipline if they are
applied rigorously and appropriate procedures are established to supervise the budget
outturn during the year. In this respect it is vital, as established in the law's passage through
Parliament, that these provisions are applied as from their approval, in time to be used in the
current consolidation process.
Finally, the draft stability law retains the clause stipulating "no bail-out" between governments
which was introduced in the previous law. I consider that, as at European level, this clause is
crucial to prevent the cost of a government's inadequate fiscal conduct from being passed on
to others and to ensure that the capital market exercises disciplinary effects. At the same
time this draft law allows regional and local governments to request extraordinary liquidity
support measures from the State. In this case a plan to ensure that the fiscal targets will be
fulfilled must be submitted and the payment of each tranche of financial aid must be
dependent on such fulfilment. In this respect, in the opening months of this year, the
Government set in train various regional and local government support mechanisms in order
to smooth the refinancing of their existing debts or payment to trade creditors. The financing
mechanisms agreed also require fulfilment of adjustment plans. It is now crucial to insist on
strict compliance so that this type of aid does not provide inappropriate incentives.
The consolidation strategy must, finally, be completed while keeping in mind the medium-
and long-term factors affecting public finances, particularly those deriving from the pressure
exerted by population ageing on certain items of expenditure. In this connection, following
the enactment in July 2011 of the Social Security Reform Law, an appropriate definition of
sustainability is needed as soon as possible so that the system's parameters may be
automatically adapted to demographic changes.
In short, the current budgetary imbalance has become one of the main obstacles to growth of
the Spanish economy. Correcting it is urgent and unavoidable. What is thus needed is a
fiscal adjustment strategy based on commitments made at European level. This strategy has
to be accompanied by a strengthening of the national budgetary framework, as reflected in
the constitutional reform, and by the application of the medium and long-term reforms that
enable the challenge of population ageing to be addressed. The credibility of this strategy,
which calls for absolute rigorous compliance with the short-term objectives set in the 2012
draft Budget law, will determine whether economic agents regain their confidence in our
economy, which is the key to a sustained recovery of activity.
Thank you.