Miguel Fernández Ordóñez: Recent developments in the Spanish
economy
Testimony by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, before the
Senate Budgetary Committee, Madrid, 23 November 2009.
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Ladies and gentlemen,
I appear before this Committee as part of the parliamentary discussion of the State Budget
for 2010, at a time when the deep international financial and economic crisis is giving way to
a recovery, albeit one that is expected to be slow and not free from uncertainty. Following the
successive downward revisions to growth projections during the summer of 2007, the outlook
has begun to improve in recent months. Indeed, many countries are posting positive growth
rates for the third quarter of 2009.
Yet we must acknowledge that this improvement is largely the outcome of the extraordinary
large-scale measures adopted globally to boost demand and support the financial system.
We still do not know whether the incipient world recovery is sufficiently self-sustaining for the
exceptional stimuli to begin to be withdrawn without the risk of economic activity falling again.
In the case of the Spanish economy, the situation is more complex. While there has been a
similar or even lesser decline in output than in other developed countries. However, the
effects in terms of employment and public finances have been sharper. Hence the role
economic policies must play to consolidate the recovery is essential. We are thus at a
crossroads where it is vital to make the right diagnosis and select the right economic policy
tools.
As my appearance is part of the parliamentary discussion of the Budget, I shall be analysing
the Spanish fiscal policy situation. Allow me, however, to refer also to other policies I
consider essential to resume the path of budgetary stability and to emerge from this crisis in
the best possible condition. First, though, I would like to briefly assess the international
setting and the economic outlook for the euro area which, as is well known, determines
monetary policy.
Projections from various international institutions (such as the IMF and, more recently, the
European Commission and the OECD) suggest we will resume positive growth rates in most
countries in 2010 and 2011. But they constantly stress that these estimates are shrouded in
greater-than-usual uncertainty, since the take-off of productive activity needs a sound
financial basis, which in turn requires that the normal functioning of intermediaries and
financial markets be fully restored.
In these circumstances, one of the main difficulties governments and central banks face is to
identify the right time to disengage the extraordinary measures adopted in the financial, fiscal
and monetary fields. A premature withdrawal might undermine the progress made, while
maintaining an expansionary policy over an excessive period might give rise to further
imbalances that are difficult to reverse and have negative consequences for growth. For the
time being, what is needed is to move forward in the design of stimulus-withdrawal
strategies, so these may be applied when the right time comes.
The euro area has also shown some improvement recently, with positive growth rates in
some countries as early as in the second quarter. The latest figures suggest that economic
activity may be expected to show positive growth rates across the area in the third quarter.
That said, the upcoming recovery will be slow, meaning that quite some time will elapse
before pre-crisis output levels are restored.
Public finances have worsened considerably in the euro area owing both to the operation of
the automatic stabilisers, which have responded to the cyclical downturn, and to the
discretionary measures adopted to boost demand and the action taken to support the
financial system. The financial crisis and the decline in activity have severely affected some
European credit institutions, which have come to depend largely on public-sector support and
which are immersed in a process of adjustment that may have repercussions for their ability
to effectively channel funds in the future.
On the inflation front, we have continued to witness year-on-year declines in consumer prices
in the euro area, due above all to notably lower oil prices than a year ago. Most forecasts
suggest positive inflation rates will resume in the area in the coming months, as the
comparison effects with the levels reached by commodity prices twelve months back cease
to apply. Yet the considerable slack in productive capacity and the sluggish recovery in
demand and activity across Europe suggest that inflation rates, while positive, will hold at
moderate levels in the near future, with no risk of deflation discernible for the moment.
Given the incipient pick-up in activity and the continuation of very modest levels of both
actual and expected inflation, the official interest rate for the euro area, at 1% since last May,
is at the appropriate level. Switching our focus to the Spanish economy, the decline in output
in 2009 is not going to be sharper than in other countries, but the contrast with the growth
rates of the ten previous years is more patent. The fact is, as I have explained on other
occasions, the Spanish recession shares features with other countries, but has its own
hallmarks, such as the real estate adjustment and the behaviour of the labour market. The
powerful external contractionary forces generated by the international crisis compounded the
internal adjustment on which the Spanish economy had embarked, exacerbating the decline
in domestic spending and employment.
The latest figures indicate that, as in the euro area and the rest of the world, the sharpest
phase of contraction in the Spanish economy is now behind us. According to the data
released some days back by the INE, activity slipped once more in the third quarter, unlike in
other developed countries, although it did so at a quarter-on-quarter rate of 0.3%. This rate
was more moderate than in the first two quarters, when the decline was 1.6% and 1.1%,
respectively. The fall-off in activity, which stood at 4% compared with the same period a year
earlier, was the result of the marked weakness of national demand, particularly private
spending. Only the public components of domestic demand retained positive growth rates,
due partly to the inertial component of certain expenditure items (such as purchases of
goods and services) and partly to measures adopted to mitigate the decline in demand, such
as the State Fund for Local Investment. And, as has been the case since the opening
quarters of 2008, the strong contractionary effect on activity exerted by the fall in domestic
spending was lessened by the positive contribution of the external sector, largely due to the
notable decline in imports.
The strong contraction in demand in recent quarters is helping correct some of the
imbalances that had built up in the Spanish economy during the boom period. These include
the excesses in the real estate sector, high private-sector debt, the external deficit and the
inflation differential. However, the adjustment is operating through a considerable decline in
activity and the marked destruction of the general business and employment fabric, which is
giving rise to a sharp increase in unemployment.
The previous strong concentration of resources in the real estate market is diminishing most
rapidly, with an acute decline in housing starts. Yet although the decline in residential
demand has been very abrupt, lower interest rates and the fall in house prices have placed
affordability indicators at more moderate levels, which is helping to stabilise real estate
purchases in recent months.
In the case of lending to the private sector, we have witnessed increasingly negligible and
even negative growth rates, and this pattern will probably prevail over the coming quarters.
These developments in lending have a most significant cyclical component, accentuated by
the tension on international financial markets. After the strong increase in household and
corporate debt ratios in the previous upturn, it was inevitable these ratios would fall to
improve the financial position of households and firms, and to assist in the resumption of a
sustainable path of spending. The strong adjustment in spending is also bringing about a
sharp reduction in the external deficit which, after posting a figure close to 10% of GDP in
2007, may be below 5% of GDP in 2009. The adjustment is based, above all, on the decline
in imports and on lower commodities prices; accordingly, for this correction to firm when
demand picks up, a more substantial contribution by exports will be needed and, in this
connection, our export base and the productivity of our companies must continue to be
strengthened.
In terms of inflation, we are also seeing a significant correction, as there has been a negative
inflation differential with the euro area for almost a year. In particular, there have been
substantial declines in industrial goods prices over the past year, while services prices,
traditionally prone to very high rates of increase, have eased substantially and have even
been growing at a lower rate than in the euro area in recent months. Admittedly, this negative
inflation differential is very closely linked to the weakness of demand in Spain. But it is a
promising sign of the competitiveness on which the pick-up in activity should be based, so it
is important that this price moderation should be preserved in the near future.
As I said earlier, there are two adverse consequences of the way in which these imbalances
are being corrected: the excessive toll imposed on employment by the crisis, owing to the
poor functioning endemic in our labour market, and the deterioration of public finances.
Job destruction began with great virulence in construction and subsequently spread to
manufacturing industry and market services. It was centred above all on temporary contracts,
given the prevailing duality in the labour market. In recent months employment has continued
to fall, although the State Fund for Local Investment has slackened the effect. The
unemployment rate skyrocketed from 8% in 2007 to almost 18% in the third quarter this year,
when it stabilised due partly to the strong slowdown in the growth rate of the labour force.
This slower labour force growth was the consequence of part of the population being
discouraged by poor employment prospects and of the return of some immigrants to their
countries of origin.
As in other countries, the outlook for the Spanish economy remains uncertain, although this
has abated somewhat recently in light of the brighter figures for the world economy. It is likely
that the recovery in the Spanish economy will lag that in the euro area to some extent. This is
due above all to the marked weakness of investment, not only in the case of housing, but
also in that of business investment, given the very low levels of capacity utilisation. While
public investment will continue to account for a high proportion of GDP in 2010, this figure
will be lower than in 2009.
The outlook for private consumption is more uncertain. The main determinants of
consumption will not be favourable, given the foreseeable behaviour of employment and the
difficulty of reversing the high unemployment rate. Yet as the decline in households'
consumption has been much more drastic than that of their incomes, the saving rate is
climbing to very high and indeed unprecedented levels. Hence, if the factors of uncertainty
were to abate, consumption might contribute more significantly to the recovery.
Given these constraints, the main support factor of activity in 2010 has to be the external
sector. This will be assisted by the earlier recovery of our main trading partners and the
relatively favourable course that Spanish exports are following.
Foreseeably, a phase of gradual growth will begin over the course of the coming year, based
on a continuing positive contribution of external demand and on a progressive pass-through
of the improvement in the world economy to business investment and employment. On
average, however, 2010 might still see a moderate decline in activity, the result above all of
the carry-over effects of the negative rates in 2009. The growth path in 2010 might also be
affected by the VAT rise announced for next July, since this measure might bring forward
some spending decisions to the second quarter, raising demand and activity in this period
but reducing them in the second half of the year. This slow path of recovery in activity
broadly matches the government's macroeconomic forecasts on which the State Budget for
2010 is based.
The setting I have described highlights the significant challenges the Spanish economy
faces. For the recovery to materialise and firm, the Spanish economy must first check and
then absorb unemployment, restore health to business and household finances, rebuild
confidence in the economy's productive capacity and reduce the large budget deficit.
To achieve these goals, I reiterate that it is vital to adopt an ambitious agenda of reforms.
The economic policies pursued since the start of the crisis have focused on countering in the
short run a very adverse economic and financial situation, and there is broad consensus that
the efforts made have contributed positively to this end. However, now the foundations for a
potential turnaround are discernible, the structural problems of the Spanish economy must
be addressed to avoid the risk of a scenario of protracted economic sluggishness.
Regarding monetary policy, the cuts in official rates by the ECB are helping alleviate financial
pressure in the private sector. And this is a factor which, given the prevalence of floating
interest rates in Spain, will continue to alleviate the burden on households and firms over the
coming quarters.
Fiscal policy has also contributed to softening the downturn in activity by means of a highly
significant budgetary effort that has been greater than that in other developed countries. The
cost, though, has been a very swift and sharp rise in the budget deficit which, on the latest
official government figures, might rise to around 10% of GDP this year.
Irrespective of how long the cyclical change takes to exert positive effects on the budgetary
situation, I would like to draw your attention to the fact that much of the deficit generated over
the past two years has a significant structural component; and the recovery, therefore, will
not correct this component. Indeed, despite the fact that in the coming years revenue will
foreseeably increase owing to the reversal of the temporary effects of some of the
activitysupporting measures adopted in recent years, it should be borne in mind that the
exceptionally high revenue obtained during the real estate boom will not recur. At the same
time, in connection with public spending, primary spending has held at a high growth rate in
recent years, attaining levels that cannot be sustained for much longer and which, therefore,
it will be necessary to reduce.
In turn, the deterioration in the budgetary position is taking the form of a rapid increase in
public debt and, therefore, too, in the amount of resources needed to meet the payment of
the interest burden.
It should also be stressed, as various recent past episodes in some developed countries
show us, that the dynamics of rising debt can prove difficult to reverse. All the more so when
some factors that helped towards its reduction in the past, such as lower interest rates and
the high growth of nominal GDP, can no longer be counted on.
The need to reverse the high structural deficits and to prevent the risks linked to debt
dynamics from materialising thus evidences the fact that there is no more room for
expansionary budgetary policy. Given the fiscal imbalance that has built up, it will be
essential to devise a transparent and credible budgetary consolidation strategy for the
medium term that will require the adoption of ambitious measures, especially on the
expenditure front.
In a setting in which the recovery is still uncertain, the necessary fiscal adjustment should be
designed in such a way as to minimise the potential adverse effects on economic growth.
That attributes great importance to the composition of the adjustment and, from our own
experience, measures based on public spending cuts, especially non-productive spending on
consumption and investment, may be most fruitful in this respect. Nonetheless, given the
scale of the imbalance it seems clear that certain features of the tax structure will also
inevitably have to be revised. Selecting tax measures is never easy, and less so when the
tax base is being considerably eroded. Accordingly, the tax instruments that cause least
distortion and help reduce fraud should be chosen, so that long-term growth prospects are
not compromised. And in this respect, indirect taxes, in addition to offering higher tax-raising
potential, are more neutral from the economic efficiency standpoint.
In any event, one of the main risks of fiscal consolidation strategies entailing tax increases is
that the increases in revenue may end up being used to finance new spending demands.
Consequently, a strict application of the budget is especially necessary to ensure that new
revenue is used in full to reduce the budget deficit.
The government has reiterated on several occasions its commitment to budgetary stability,
and its intention to resume deficit levels compatible with a balanced budget in the horizon
defined by the European authorities in the application of the Stability and Growth Pact rules,
which has recently been extended to 2013. The State Budget for 2010 is a first step within
this general consolidation strategy.
But we should be mindful of the fact that we are at the start of a long process in which the
credibility of the policies adopted plays a fundamental role. To ensure that the medium-term
budgetary objectives are realistic, economic policymakers must convey to economic agents
their resolve to exert rigorous control over the deviations in revenue and spending that may
occur.
In this connection, and given the high degree of decentralisation of the Spanish State, it is
vital that the regional and local governments should be committed to controlling and reducing
the deficit through compliance with the principles laid down in the law on budgetary stability.
It is particularly important that the regional government budgets that are approved in the
coming months should accept the fiscal consolidation strategy as a key objective, that they
adopt far-reaching structural reforms on public spending and that they ensure their budget
outturns are rigorously in compliance with this objective.
Finally, in light of the huge amount accounted for by the public spending component linked to
the deterioration of employment, it should be stressed that the viability of any budgetary
consolidation strategy for the Spanish economy will depend on this strategy adopting a
jobgenerating growth pattern that, as occurs in other countries, provides for a significant
reduction in unemployment. To this end, the main instruments available to national economic
authorities are supply-side and structural reform policies geared to promoting job creation,
smoothing the switchover to new productive activities and increasing the economy's
efficiency and productivity. The future of the Spanish economy hinges greatly on these
policies, not only in the long run but also in the more immediate term.
The priority of these reforms should be to generate a rapid and deep-seated change in the
prevailing labour market trends. That requires altering a good number of the institutions that
currently regulate this market. In particular, innovative hiring arrangements are needed to
facilitate job creation and to overcome the marked segmentation currently in place which has
adverse consequences for employee training, job stability and for efficiency and equality in
the economy. In turn, collective bargaining should be reformed so that internal organisation
and labour costs are better tailored to the specific situation of each company and to cyclical
developments, but also so as to equip firms with the flexibility they need to increase
productivity.
But there are other measures we should not rule out, even though their effects may take
longer to materialise. This is the case, firstly, with education. Undoubtedly, improving
education is the most important issue pending for economic growth in Spain. True, we have
made progress in some areas; but it is no less true that there are incipient signs that the
increase in the level of educational attainment of the workforce observed in the second half
of the 20th century is slowing. The reform of the education system, moreover, would
complement that of the labour market. This is because the current labour market set-up
discourages people from spending longer in education since it fails to differentiate
appropriately between skill levels, leaving the young facing temporary contracts or
unemployment, with the adverse effects I have already mentioned.
It is also essential to move to boost the knowledge economy so that it may contribute to
strengthening technological capital and to bridging the gap afflicting the Spanish economy in
this field. This should be done in parallel with pertinent measures to further the liberalisation
of goods and services markets, the current regulation of which involves in some cases a
diminished level of competition. One key area for progress along these lines is liberalisation
in the services sector, as it encompasses some of the most dynamic activities and some of
those with most job-creating capacity. Likewise needed is further headway in liberalisation
and competition in the network industries, so that the conditions in which inputs are supplied
to other productive activities allow Spanish companies to compete on an equal footing with
our trading partners. And let us not forget the housing market. Further improvements to
rental regulations are needed to make this option more flexible and profitable, so that the
purchase of housing for investment purposes is encouraged, thus helping reduce the supply
overhang, and broadening the possibilities of meeting the population's demand for residential
services.
Finally, I must reiterate that the soundness of the financial system is essential for ensuring
the financing flows needed to restore economic dynamism. While the Spanish financial
system has shown notable resilience to the direct and indirect effects of the international
financial crisis, the intensity of the adjustment the Spanish economy is undergoing against a
background of protracted financial tension adds further factors of pressure in terms of asset
impairment, an increase in bad debts and a narrowing of bank margins. Faced with these risk
factors, not all banks are equally prepared, whereby the availability of appropriate
mechanisms, such as those offered by the FROB (the Fund for the Orderly Restructuring of
Banks), will help banks face the restructuring necessary with the best results for the
functioning of the economy and the least cost to taxpayers. However, I must say that, if
reforms are not adopted promptly, high unemployment might be prolonged, which would
contribute to increasing financial institutions' difficulties and would prevent the soundness of
the financial system from acting, as it has to date, as an essential pillar of economic growth
in Spain.
Allow me to conclude by stressing that the Spanish economy is at a decisive crossroads. If
far-reaching reforms are not promptly adopted, we face the prospect of slow recovery with
high levels of unemployment and public spending. Conversely, if the right - although not
easy - decisions are promptly taken, we will be able to resume a path of high growth based
on a more productive and sustainable pattern. To achieve this it is vital to apply medium-term
stability strategies and ambitious structural reforms, which should be well co-ordinated and
credible. In devising these reforms the broadest possible consensus would be desirable, as
that would increase their soundness and effectiveness. But clearly conveying to society that
the seriousness of the situation requires far-reaching reforms will be of paramount
importance. We would thus be taking a decisive step in leaving this crisis behind us, and the
foundations would be laid so that Spain may take up a new phase of vigorous growth and
high job creation