Jaime Caruana: Presentation of the Annual Report of the Bank of Spain
Address by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of The Basel Committee
on Banking Supervision, to the Governing Council of the Bank of Spain on the presentation of the
Annual Report, Madrid, 13 June 2003.
* * *
Ladies and gentlemen,
Twelve months ago, on presenting last year's Annual Report, I highlighted the significance of the year
2002 as the final step in the replacement of the peseta by the euro. Some of the features
characterising economic developments last year were also discernible at that point: uncertainty and a
crisis of confidence prompted by a wide-ranging set of shocks to which I shall refer during this speech.
This conjunction of factors is perhaps not so much the outcome of chance as it is of the fact that, in a
globalised economy, shocks that might previously have had local effects now feed through rapidly and
sharply to the world economy as a whole. Given this adverse external environment, it is worth
reflecting on the conditions our economy should maintain to continue with the process of convergence
towards the income levels of the most advanced countries. As on previous occasions, I shall
commence with a brief review of the international economic environment.
The world economy experienced a modest, hesitant and, in terms of its geographical distribution,
uneven recovery in 2002. Against a backdrop of notable uncertainty, the growth of the main
economies was lower than expected. This was especially the case in the euro area but also in the
United States, while stagnation continued in Japan. Certain emerging regions, such as Asia and
Central and Eastern Europe, were more buoyant. But the economic results in Latin America were very
poor. Inflation rates generally held at low levels and the trade imbalances between the main areas
increased.
Some of the uncertainty bearing on the world economy was associated with a complicated geopolitical
situation. Unfortunately, it cannot be said that all the factors holding back an international recovery are
behind us. The swift conclusion of the Iraq war has eliminated some of the main factors of uncertainty
and this, along with cheaper oil and improved stock market prices, should contribute to entrenching a
scenario that allows a more robust though still moderate pace of growth, even though doubts remain
about the vigour of growth in a climate of lacklustre private investment.
But the confidence crisis besetting the world economy was not only the result of the geopolitical
situation. The disclosure of a series of irregularities in the financial statements of certain major
companies, especially in the United States, fuelled a notable lack of confidence about the information
provided to the markets and called into question not only companies' reported earnings, but also the
suitability of accounting regulations and the independence of auditors and investment banks. Given a
stock market climate already depressed by the ongoing correction of the bubble that affected the
technology and communications sector, this lack of confidence further propelled the downward trend
on the equity markets, which favoured the fixed-income markets. Moreover, the crises in certain
emerging economies continued, especially in Latin America, and this also contributed to the general
risk-aversion of investors on international financial markets.
A key feature of recent developments in the world economy is that the aforementioned shocks, whose
common denominator is their impact on agents' confidence, affected all the developed economies and
some of the emerging ones almost simultaneously. This highlights how, in an increasingly globalised
world, the transmission channels on which expectations turn (and which exert a key influence on the
financial markets) are extremely rapid. All economies, especially the most developed ones, are prone
to the impact of this type of disturbance, whose origin may be very remote and whose relationship to a
specific national economy's fundamentals may seem far-removed.
The loss of confidence stemming from the aforementioned shocks was, in turn, amplified by various
deep-seated imbalances in the world economy which have not been corrected or have even
worsened, including most notably the US current-account deficit and persistent deflation in Japan.
These underlying weaknesses stoked up uncertainty and a climate of mistrust in various segments of
the world economy, all of which contributed too to checking and postponing the onset of recovery.
Against this background of closely interacting national economies, mention should be made of the
high dependence of the rest of the world on the US economy, which proved greater than expected,
despite the fact that the results in the United States were not particularly buoyant. Such dependence is
a cause for concern since the United States is, at the same time, the main source of growth for the
rest of the world and the main raiser of savings on the international capital market, a situation that is
hardly sustainable over the medium and long term. Moreover, the saving/investment mismatch in the
United States has been heightened recently by the clearly expansionary bias of monetary and, above
all, fiscal policy.
In these circumstances, a swift correction of the US external deficit, while undoubtedly desirable in the
medium and long run, might affect numerous other economies most adversely in the short term
through causing a contraction in the external demand of these economies at a time at which their
growth is rather low. A lesson to be drawn from this complex situation is that when international
economic disequilibria increase and swell out of all proportion, there is a risk that their correction will
be at the least timely moment and with significant costs in terms of growth and well-being.
Last year the main economies adapted very differently to the above-mentioned shocks. The United
States drew benefit from the flexibility of its economy, which allowed a better and swifter adaptation to
a more demanding environment, while policies took on an unmistaken expansionary stance.
Conversely, the Japanese economy had neither the flexibility to adapt, owing to its numerous rigidities,
nor scope for stimulus from its demand-side policies, whose room for manoeuvre essentially petered
out some time back. Finally, the euro area economy, also beset by structural rigidities, was relatively
inflexible in that fiscal policy leeway was directly proportionate in each country to the consolidation
drive pursued in the previous upturn, with room for manoeuvre proving greater in the case of the single
monetary policy.
Consequently, the experience of recent years shows how vital it is to harness economic upturns so as
first, to increase the flexibility of economies in order to absorb more readily the impact of adverse
disturbances; and further, to give economic policies sufficient headroom in contractionary phases. In
this context, it is of paramount importance that macroprudential policies should remain particularly
vigilant and react promptly and decisively in the face of potential signs of weakness in the segments of
the financial system under their supervision.
In the wake of the crises of recent years, an increasing number of emerging economies undertook -
with varying degrees of ambition and success - structural reforms aimed at greater flexibility. Yet these
improvements did not prevent crises from continuing in some of these countries, virulently so in Latin
America in 2002. In late 2002 and early 2003, the economic outlook and the trend of financial
variables in Latin America improved perceptibly, especially following the positive developments in
Brazil and Argentina.
The recent crises have highlighted deep-seated shortcomings in the legal and institutional workings of
these countries. Emphasis has thus been placed not only on the need to pursue policies supportive of
monetary, financial and fiscal stability, but also on how important an institutional framework respectful
of property rights and private enterprise is for fostering growth in these countries.
Factors of a more global nature have also been pivotal in the recent crises. These have been related
to greater risk-aversion on international financial markets, which has caused capital flows to some of
these emerging economies to shrink. International markets have, however, tended to be more
selective, and there have been fewer episodes of crises spreading from one country to another,
although contagion cannot be said to have disappeared completely.
The recurrence of these crises has led to reflection on the so-called "architecture" of the international
financial system. Numerous reforms have been proposed in this connection. And some have been
adopted, and are generally in the initial stages of implementation. Much remains to be done in this
area, although the acceptance of sovereign bonds incorporating the so-called collective action
clauses, issued by Mexico, Brazil and Uruguay, offer grounds for hope.
The euro area
In an international setting, as described, of a moderately expanding world economy and heightened
geopolitical tension, the pace of growth in the euro area in 2002 was markedly weak. At 0.8%, it was
far lower than had been expected at the end of the previous year. This performance has highlighted
the considerable exposure of the euro area to global shocks and the burden the structural deficiencies
still beleaguering the area entail for it.
However, although economic buoyancy has diminished across the board, there have been
considerable differences in the growth of the different Member States. In particular, among the four
major countries in the area, only Spain has remained moderately dynamic in this unfavourable setting,
while the biggest economy, Germany, has deteriorated markedly. Thus, while high and growing
synchrony has been observed over the past decade, this still remains below what should be the case
for a fully integrated economic area. Persisting divergences underscore the need to refine the single
market and reaffirm the role to be played by national policies when it comes to ensuring the proper
functioning of each of the member economies.
It is also significant that the scant growth in the euro area in 2002 was mostly based on the
contribution of the external sector. As a result, the shocks buffeting the European economy had a
particular influence on internal demand, which was considerably slack throughout the year. That is a
feature that may hold future growth back, once the euro has left its past weakness behind and has
appreciated considerably against the dollar.
In any event, the bleaker outlook for employment and the deterioration in financial wealth were
conducive to an increase in the household saving ratio, consequently reducing their propensity to
consume. The sluggishness of expenditure naturally affected investment plans which, in turn, were
discouraged by the decline in stock market prices, balance-sheet restructuring by the most debt-ridden
companies and the tightening of lending conditions by banking institutions in certain countries.
The limited adjustment capacity of the European economy was manifest in the relative lack of
responsiveness of nominal wages to the economic slowdown. Job creation was affected as a result,
especially in the second half of the year. This lack of flexibility, along with the rigidities of price
formation in the industries least exposed to competition, also hindered the moderation of inflation
rates, thereby conditioning the European Central Bank's monetary policy decisions.
The loss of momentum behind the process of reforms in 2002 is telling if it is borne in mind that the
European economy is still far from achieving its goals in terms of greater flexibility and integration of
the markets for goods and factors, the promotion of innovation and the incorporation of new
technologies into productive processes.
Generally, demand-side policies contributed to tempering the scale of the slowdown, although the
potential constraints on these policies were manifest throughout last year. In particular, the insufficient
consolidation of public finances in certain countries in the previous upturn has considerably eroded the
stabilising capacity of fiscal policy in the current cyclical phase. Therefore, a number of countries had
to curtail the operation of the automatic stabilisers and some had to run budget deficits above 3% of
GDP, which triggered the related excessive deficit procedures. Evidently, the unfavourable economic
situation is testing the multilateral surveillance mechanisms of budgetary policies. But the report
drafted by ECOFIN, based on a proposal by the Commission and recently taken up by the European
Council, has contributed to reinforcing the validity of the Stability and Growth Pact and to clarifying its
application.
The single monetary policy has also reacted to the cyclical slowdown, maintaining conditions
propitious to the growth of economic activity while bolstering the credibility of its commitment to price
stability. However, continuing inflationary pressures, linked in part to the aforementioned rigidities in
price- and wage-formation mechanisms, have naturally limited the scope of the more relaxed
monetary policy stance. In any event, the key ECB interest rate stands today at 2%, 125 basis points
down on a year ago. That constitutes a tailored response to the weakness of economic activity and to
the improved inflation outlook over the period to date, brought about by the substantial appreciation of
the euro.
The economic environment has been appreciably alleviated in recent months by the rapid outcome of
the Iraq war and, in particular, by the favourable impact of this on oil and stock market prices.
Nevertheless, uncertainty over the European economy's capacity promptly to embark on a path of
sustained recovery has not been sufficiently dispelled. In particular, the hesitancy of the US economy,
the deterioration in its current-account and budget deficits, continuing imponderables in respect of the
international political situation and the current volatility of financial and foreign currency markets may
affect the European economy's growth prospects, given its dependence on the external environment.
Along with these, there are other factors more specific to the area (such as the sluggishness of
business investment, doubts about the scale of the consequences of the stock market crisis for
demand, and the persistent weakness of some of the major Member State economies) that might
delay the expected acceleration in activity in the euro area which, in all likelihood, will grow in 2003
below potential for the third year running.
On the institutional front, highly significant events for the process of European construction have taken
place in 2003. The signing of the Treaty of Accession to the EU by ten new countries, which took place
in April and will be effective in May 2004, marks the start of a phase of far-reaching changes which will
pose sizable challenges for the competitiveness and cohesion of the area and for the strengthening of
the effectiveness of the European institutions. In this connection, the European Convention plans in
the coming weeks to announce its proposed draft of the future European Constitutional Treaty, which
shall be agreed at the Inter-Governmental Conference to be convened in 2004. As regards monetary
policy, the ECB Governing Council has, with a view to adapting the operating arrangements of the
euro area to the possible entry of new members, recently recommended changes in its voting
procedures, in accordance with the provisions of the Treaty of Nice. The proposed Recommendation
was approved by the European Council of 21 March 2003 and introduces a rotation system
whereunder the number of governors entitled to vote at any one time is restricted to 15, divided into
three groups on the basis of their voting frequency. Without delving into the details of the approved
formula, I should like to stress that the criteria of representativeness used in determining the voting
rights of each member of the Council will place the Governor of the Banco de España within the first
group of Governors, who are authorised to vote in the ECB governing council most frequently, on an
equal footing with Germany, France and Italy.
The Spanish economy
In an adverse external setting, the key characteristic of the period analysed in the Annual Report was
the capacity shown by the Spanish economy to sustain a comparatively high growth rate of 2%, and to
continue generating employment, which increased by 1.3%. For yet another year, therefore, there was
further headway in real convergence towards the average GDP per capita levels of the euro area.
This performance has confirmed a new pattern of response by the Spanish economy during cyclical
downturns, which would in the past have given rise to sharp adjustments in activity and employment,
following the prior build-up of forceful disequilibria. This change in the behaviour of the economy is
partly related to the persistence of the expansionary effects derived from Spain's membership of EMU,
in terms of substantial interest rate cuts and a significant reduction in inflation expectations. Above all,
however, the Spanish economy's greater resilience to the external deceleration has been due to its
present regime of macroeconomic stability and to the structural reforms undertaken.
In particular, I wish to stress the benefits arising from fiscal policy, which has enabled the balanced
budget not to be jeopardised in the cyclical downturn. Also notable are the improvements in the
workings of the labour market which, combined with the moderate increase in real wages, have
continued to ensure high employment generation. This has been one of the most positive features of
recent economic developments, and has helped underpin agents' spending decisions and the process
of real convergence, mainly via the increase in the rate of employment.
In terms of its components, growth in 2002 saw a prolongation of the trends already perceptible in
2001, and was based on the strength of household spending and the momentum of infrastructure
construction. As explained in detail in the Annual Report, set against the significant slowdown in
exports and the fall-off in capital investment, household consumption grew at a rate of close to 2% in
2002. This growth was underpinned by the increase in disposable income, contributing to which, in
turn, were the interplay of net general government transfers to households and higher employment.
Moreover, the rise in households' property assets, to which I shall refer later, also helped sustain
consumption, offsetting the losses in financial wealth brought about by the heavy stock market
declines.
House purchases, the other component of household spending, have grown over the past two years at
a lower rate than that observed in the period to 2000. More recently, this spending component has
been subject to opposite-moving influences: on one hand, house-price rises may have dampened the
demand for habitual dwellings; but on the other, the fact that the return on residential investment has
held far above that provided by other forms of investment (financial assets in particular) has
encouraged house purchases. In any event, investment in housing has continued to sustain the
increase in construction. And further contributing factors here have been the forceful investment in
infrastructure, carried out both by general government and by non-financial corporations related to this
sector.
Although this consumption- and construction-led growth pattern has provided suitable support for
progress in real convergence, some of the elements on which it is based are likely not to continue in
the future. In particular, the intensity of the expansionary effects of the sizable decline in interest rates
and the rise in property values will foreseeably diminish, both these factors, along with employment,
having been underpinned by the buoyancy of household expenditure. Moreover, the fact that in the
past households expanded their spending and reduced their saving (simultaneously increasing their
debt, as I shall discuss later) means more moderate behaviour is to be expected -and desirable- in the
future, geared to a restructuring of their saving ratio. Indeed, this began to be seen already in 2002.
As regards gross capital formation, investment in infrastructure has had a key part in enlarging the
economy's productive capital stock. But it cannot play this leading role indefinitely. Consequently, it is
particularly important that the flatness of business investment and, especially, of spending on capital
goods in recent years, which has hampered productivity gains and the incorporation of technological
innovations, should be put behind. In principle, the current high ordinary returns accruing to
companies coupled with low financial costs are propitious to investment regaining buoyancy, as
expectations progressively clear.
On the prices front, certain temporary factors, such as the physical introduction of the euro and dearer
oil, fuelled increases in domestic prices, against the background of relatively sustained growth in
consumer demand. This prompted a rise in the inflation rate, which stood at end-2002 at 4%. This
increase in inflation has been partly reversed, thanks to the improvement in recent months which has
seen this rate cut by around one percentage point. However, the bout of rising inflation last year fed
through in part to wages, highlighting the importance of reinforcing wage moderation. In fact, the
inflation differential with the euro area, despite narrowing recently, has remained persistent. And that
may pose a risk for future competitiveness.
In the area of price formation, a cause for concern is the differences that continue to be seen in
business margins, depending on whether industries exposed or not to competition are involved. In the
former, mainly export-geared companies, the rate of change of prices has been virtually zero for over
a year, reflecting the efforts exporting companies have to make to compete in markets experiencing a
particularly delicate situation. In parallel, other industries less exposed to competition continue to
increase their operating margins considerably.
The Spanish economy's resilience in the face of the adverse external environment in 2002 offers
bright prospects for short- and medium-term developments, having placed it in a sound starting
position for more dynamic growth as the international climate improves. However, the expansionary
impulses stemming from EMU membership will tend increasingly to have a lesser effect, while the
economy will have to address new challenges arising from the stiffer competition that EU enlargement
will entail.
Consequently, the growth pattern may not reside so much on consumption and construction but will
have to be underpinned to a greater extent by investment and exports, meaning that dynamism will
depend particularly on their profitability and competitiveness. National economic policies will thus have
to be geared to strengthening these elements by promoting macroeconomic stability, business
profitability and the competitiveness of the productive system.
As earlier indicated, budgetary policy has contributed to domestic stability by means of fiscal
consolidation and the control of the budget deficit. If in the future, against a background in which
European monetary conditions will remain relatively generous for the requirements of the Spanish
economy, demand pressures were to persist and contribute to sustaining an inflation differential
unwarranted by the process of real convergence, it might be advisable to move towards a budgetary
surplus position. That would additionally help tackle the problems of the long-term sustainability of the
pensions system.
Maintaining competitiveness, which is one of the main long-term challenges, will require continuing
wage moderation and higher productivity gains. To do this, certain changes must be made to the
collective bargaining system so that settlements are more closely related to the specific situation of
firms. It is also necessary to increase the incentives for the stable hiring of employees, reducing the
segmentation and duality brought about by the still-high numbers of temporary employees as a
proportion of the total labour force, despite the fact this proportion has fallen in recent years. In this
respect, the reform of hiring arrangements in the past has been in the right direction, as it has reduced
the differences in terms of costs between temporary and permanent employment contracts.
Stepping up investment in capital goods and establishing conditions conducive to the incorporation of
technological progress, especially in the ICT field, are vital factors for boosting productivity gains in the
economy. Nevertheless, as the experience of other countries (particularly the United States) has
shown, to reap the potential benefits of the incorporation of new technologies through investment also
requires setting a more flexibly working economy in place, pushing through structural and liberalising
reforms, and designing an appropriate regulatory framework.
Structural reforms aimed at promoting flexibility, innovation, human capital formation and
competitiveness should not be considered as having only medium- and long-term effects. The recent
history of the Spanish economy illustrates the relative speed with which their effects have become
visible, when they have been applied with perseverance and consistency. This is because they alter
the expectations of agents, who incorporate the new framework into their behaviour almost
immediately.
The foregoing takes on special importance in the face of the challenges EU enlargement entails. The
similarities between the productive specialisation of our economy and that of the accession countries,
combined with their low-cost and highly trained labour, pose a challenge to the Spanish economy,
which has to face stiff competition in those industries in which Spain is more specialised. It will be
necessary to bolster the competitive capacity of the Spanish productive structure through
productdifferentiation and quality-enhancing strategies, by improving its endowment of technological and
human capital and by developing the technologically most advanced industries. But Spanish
companies must also set in train strategies enabling them to harness the opportunities of enlargement
and to increase their presence in the new areas of the single market, channelling their foreign direct
investment efforts in that direction.
Financial aspects of the Spanish economy
Some of the financial features of recent developments in the Spanish economy are of particular
importance. As I have said, monetary and financial conditions remained generous in the Spanish
economy and, in step with this, financing received by households and firms grew by around 14% last
year. This increase, which far outpaced the average for the euro area countries, led to a fresh increase
in the private sector's debt ratios which, in a few short years, have attained the average levels for the
euro area.
Significantly, the ongoing resort by companies and, above all, by Spanish households to debt in order
to finance higher investment and consumption levels is principally a reflection of the favourable impact
on agents' expectations of the new setting of macroeconomic stability, which provides for higher
sustainable growth in income and employment.
One of the clearest consequences of the recent trend of financial flows in the Spanish economy has
been the contribution made to curbing the scope of the recent cyclical downturn in Spain. That has
helped the private sector maintain buoyant expenditure on the basis not only of its current revenue but
also of its expectations of future income.
Moreover, the downward course of interest rates in recent years, which continued in 2002, has meant
that the gradual growth of Spanish household and corporate liabilities has been accompanied by a
less marked increase in the financial burden associated with these debts. Relative to the sector's
income, this burden tended to stabilise last year around levels which may be qualified as normal on
international comparisons.
Yet it cannot be ruled out that the volumes of debt built up may ultimately affect the pace of economic
recovery, since they restrict the headroom available for firms and households to continue increasing
their resort to borrowed funds. Ideally, then, the growth rate of debt should moderate, so that the
sector's spending decisions may move more in line with current income, thereby maintaining the
soundness of the financial position of Spanish households and firms. It should further be borne in mind
that the greater levels of debt attained have also tended to heighten the sensitivity of agents' spending
decisions to changes in the variables determining the effective cost of financing.
In the case of households, most of the financing received has been earmarked for house purchases,
the main component of household wealth. That has strengthened residential investment and prompted
rapid growth in property asset prices.
A brief review of the past behaviour of the variables habitually considered as the basic determinants of
property prices provides for a better understanding of their recent trajectory. Changes in the population
pyramid, increased immigration, the growth of the demand for second homes by residents and
nonresidents and, above all, the continuous growth of income and the pronounced fall in interest rates are
factors that help explain the trend growth of the relative price of housing in Spain. In addition, the
unfavourable course of stock market prices in the last three years has enhanced the attractiveness of
alternative investment opportunities, such as those offered by real estate.
Yet in a market such as that for property which, by its very nature, sees supply adjust relatively slowly,
demand pressures such as those arising from the aforementioned factors may cause excessive price
reactions that tend to be corrected subsequently. This appears to be the situation currently in our
country where, even with a significant rise in the rate at which houses are built, property values may
have exceeded the levels consistent with the trajectory of their determinants. In such a situation, it is
likely -and desirable- that house-price growth rates will be brought back progressively and in an
orderly fashion to levels more in line with their fundamentals.
This process, which should run parallel to gradual moderation in the resort to credit financing by the
households and companies most directly involved in the real estate business, would prevent house
prices from moving too far away from their equilibrium value. It would therefore reduce the likelihood of
sharper adjustments ultimately taking place in the housing market, the influence of which on the
overall working of the economy cannot be understated. For a sounder functioning of the complex
markets for land and housing, at least two groups of measures would be required. On one hand, those
aimed at influencing the determinants of house prices and, in particular, the regulations and practices
restricting the supply of land. And on the other, those intended to correct the distortions behind the
marked bias in the Spanish market towards owner-occupied as opposed to rented housing.
With regard to the financial system, the year 2002 was, once again, a particularly complicated one.
Adding to the usual effects any economic slowdown and correction of excesses built up in upturns will
involve were other factors, including most notably corporate and accounting shortcomings of a
structural nature, which have undermined the very institutional foundations of markets. This crisis of
confidence was exceptional due above all to the doubts cast on elements as fundamental as the
recording of transactions at listed companies, the veracity of information provided to investors,
conflicts of interest within companies and between these and their main financial agents or auditors,
and the most elementary mechanisms of corporate governance.
Within this complex picture, two positive features should be underscored. First, one highly favourable
aspect of recent developments in the world economy, which I mentioned in the presentation of last
year's Annual Report, is the resilience generally shown by the financial system in the industrialised
countries,