Testimony of the Governor of the Banco de España before the Senate in
relation to the draft State Budget for 2018
Luis M. Linde
Governor

Ladies and gentlemen,
I appear before you today as part of the Senate's debate and approval process for the State
Budget for 2018.
Allow me to begin by reviewing the current international economic setting of the Spanish
economy and its outlook. I shall then refer to the main aspects of this draft Budget. To
conclude, I will mention what, in my opinion, are the main challenges for fiscal policy in
Spain in the coming years.
The external setting of the Spanish economy
The external setting of the Spanish economy broadly remains favourable, although the
global economy is subject to factors of risk that should not be ignored.
Following several quarters of upward surprises, the opening months of this year have - more
so in the euro area - seen some moderation in global economic activity whose scope is still
uncertain. Notwithstanding, the information available continues to point to the maintenance
of the current upturn over the next two or three years, underpinned by the correction of the
previous imbalances, agents' confidence, the favourable financing conditions and the boost
from the expansionary fiscal policies in the United States.
On the financial markets, despite the bout of marked volatility last February, asset values
remain high by historical standards. At the same time, recent weeks have seen an
appreciation of the dollar, which would be consistent with the expectations of further US
interest rate rises, at a swifter pace than that in other economic areas. However, this
appreciation might also be partly in response to a certain safe-haven effect, in a context in
which certain risks appear to be rising, in particular in some emerging markets and areas
subject to a high degree of political uncertainty. This latter factor is also contributing to
heightening the uptrend in oil prices witnessed in recent months.
The decline in activity observed in the euro area during the first three months of 2018, from
0.7% to 0.4% in terms of the GDP growth rate relative to the previous quarter, should be
analysed with care. On one hand, it should be borne in mind that last year's growth was
particularly sharp (the highest since the start of the crisis, almost a decade ago); accordingly,
it is reasonable to expect there should be some moderation. On the other, the as-yet very
partial information available does not allow us to specify to what extent the change
witnessed may have been due to transitory factors, relating to the weather and the high
number of strikes in recent months in certain euro area countries, as opposed to other more
durable factors. In any event, forecasts continue to suggest that the sustained rates of
increase of euro area activity will continue in the coming months, albeit with a tendency to
ease.
As to inflation, the latest data continue to evidence very moderate behaviour, with an
increase in April, for the euro area as a whole, of 1.2%. The projected reduction in the degree
of slack in the economy should enable inflation rates in the area to draw closer to levels
compatible with the Eurosystem's objective of price increases below, but close to, 2%.
Spanish economic developments and outlook
Regarding the Spanish economy, the INE estimate for GDP growth in the first quarter of
2018 shows a rate of increase of 0.7%, in line with the two previous quarters.
That said, there has been a slight decline of 0.2 pp in the year-on-year rate of change from
3.1%, at end-2017, to 2.9% in the first quarter of this year, which is consistent with the
continuation of the current upturn, albeit at a somewhat lower rate of increase than that
observed in the past three years. On the latest projections published by the Banco de
España in late March, output is expected to expand by 2.7% in 2018, 2.3% in 2019 and
2.1% in 2020.
The latest information would broadly confirm this scenario, albeit with a possible slight
upward revision this year and next, as a result of the greater fiscal boost built into the draft
State Budget for 2018 and in the recently published Stability Programme Update for the
period 2018-2021, on which I shall comment later.
It is estimated that the growth of our economy will continue to be underpinned, above all,
by national demand, but with a positive - though diminishing - contribution from the external
sector. In particular, household consumer spending and residential investment will continue
to be assisted by rising employment, the sector's improved financial position, the fiscal
impulse and favourable financial conditions. Also, the growth of demand and of corporate
earnings, higher capacity utilisation and the aforementioned propitious financial conditions
will continue to provide for significant increases in investment in capital goods.
Nonetheless, the tailing off of some of the temporary factors that have supported the
increase in activity in Spain in the most recent period would explain the moderation in
growth expected in the coming years. This would be the case were there to be a reversal in
the trend of oil prices, in the expansionary effect of monetary policy and in the momentum
of external markets, following their significant dynamism last year.
As regards prices, the latest data continue to show, as in the euro area as a whole, very
moderate behaviour, with the year-on-year growth of the CPI standing at 1.1% in April. The
Banco de España projections published in March augured an increase of 1.2% for the year
as a whole; however, it might ultimately be higher owing to the impact of the recent rises in
oil prices. In this respect, the current volatility on the oil markets adds further uncertainty to
the evolution of prices in the short term. In any event, for the more stable components of
inflation (excluding energy), a gradual rise is forecast, in line with the expected increase in
the degree of use of productive resources.
The main risks and factors of vulnerability
In this scenario, a series of risks should be highlighted.
Globally, behind the recent increase in economic activity, an expansionary stance has
underlain demand-side policies in most geographical areas, in particular in the case of the
monetary policy still maintained by the main advanced economies. By their very nature, it is
to be expected that these measures will be reversed in the future, which might affect agents'
expectations. While the various economic authorities are committed to a process of
monetary normalisation, in as gradual and orderly a way as possible, specific bouts of
tightening on financial markets, as seen in the early months of this year, should not be ruled
out.
Against this backdrop, the US Administration's recent measures also contain elements of
uncertainty or risk.
First, US fiscal policy has adopted a clearly expansionary stance, in a context of maintaining
GDP growth rates clearly above potential over a prolonged period. Further, the decisions
announced in respect of tariffs, mainly - but not only - vis-à-vis China, might, although they
still affect only a limited group of sectors, trigger retaliation, with clearly negative effects on
activity and global trade. This adverse circumstance would, within the EU, be combined
with the still-uncertain impact of Brexit on the UK economy and its trading partners. Finally,
as the United States has broken the nuclear agreement with Iran, there might be further
tensions on the oil market, with adverse effects on world growth.
In the current setting these risks are relevant to the Spanish economy, given that it still has
high levels of public and external debt, which make it particularly vulnerable to negative
developments on the international capital markets. At the same time, further increases in oil
prices might particularly affect our economy in view of its high foreign energy dependence.
Elsewhere, the political situation in Catalonia does not appear to have stabilised, thereby
posing a further factor of uncertainty, with potentially adverse consequences for the Spanish
economy as a whole.
In the medium term, the expansion of our economy should cease to rest on the expansionary
impulses of demand-side policies and come to depend on more durable factors. The
estimates available on potential growth are relatively modest, meaning it is crucial to attempt
to address some of the problems restricting it. These include most notably high structural
unemployment, population ageing, a poor productivity trend and the technological capital
deficit.
Budgetary policy in 2018
I shall now discuss the main items of the draft State Budget for 2018 approved by the
Government on 27 March, and complemented by the Stability Programme Update for the
period 2018-2021, submitted to the European authorities on 30 April.
This second document already includes some of the measures added to the draft Budget
in its passage through Parliament. It is particularly useful in that it offers an overview of
overall Spanish general (central, regional and local, including the Social Security system)
government budgetary policy, providing a broader time perspective of four years. In a
country as decentralised as Spain, it is impossible to properly assess public spending and
revenue policies without this overview. At the same time, an effective fiscal policy,
particularly when the starting point is a budgetary imbalance like ours, should be part of a
consistent multi-year plan with specific measures.
The Budget and the Stability Programme include macroeconomic projections that point to
increases in real GDP in Spain of 2.7% in 2018, and slightly lower levels in the following
years: 2.4% in 2019, and 2.3% both in 2020 and in 2021. Nominal GDP is expected to
increase by around 4.3% over the entire forecasting horizon. The growth forecast and its
composition are broadly consistent with the baseline scenario of the Banco de España's
macroeconomic projections I outlined earlier.
The Stability Programme envisages an overall general government deficit of 2.2% in 2018,
in line with the requirements of the Stability and Growth Pact. That should be conducive to
Spain exiting the "excessive deficit" situation still prevailing. For the following years, further
declines in the budgetary imbalance are envisaged, until resuming a slightly positive balance
in 2021, for the first time since 2007. All tiers of government, including Social Security funds,
should attain budgetary equilibrium in this horizon, according to the Programme.
For 2018, the drive to correct the budgetary imbalance is totally concentrated in central
government and in Social Security funds, which should reduce their respective deficits by
1.2 pp and 0.4 pp of GDP to 0.7% and 1.1%. Conversely, the targets for regional and local
government for 2018 are less demanding than last year and stand at -0.4% and 0% of GDP,
respectively, compared with -0.3% and a surplus of 0.6% posted by these administrations
in 2017.
The fulfilment of these targets and the macroeconomic projections should lead to a decline
in overall general government debt to 97% of GDP in 2018, and 89.1% in 2021, down 1.3
pp and 9.2 pp, respectively, on 2017.
Significantly, practically the entire adjustment in 2018, and somewhat more than two-thirds
of that in the period 2018-2021, would be due to the cyclical effect, whereby the structural
budgetary effort would be relatively modest.
In terms of its composition, the Stability Programme envisages an increase in revenue
somewhat outpacing that in GDP, in line with what occurred in 2017. Expenditure,
meantime, after having posted very low growth in the past four years, is expected to
increase by 2.7% on average over the 2018-2021 period, although its weight in GDP will
continue to diminish.
On the revenue side, the Stability Programme includes the personal income tax cuts
included in the draft Budget for 2018, which mainly affect the lowest-earning taxpayers, and
which are expected to reduce the revenues relating to this tax in 2018 and 2019. This would
be partly offset by the introduction of a new tax on certain digital services, which might
contribute to raising resources by around €600 million in 2018 and by €1.5 billion in 2019,
according to the Programme. However, this new instrument is still relatively undefined,
meaning it is difficult to judge its tax-raising potential. Overall, and as stated in my last
appearance before Parliament in relation to the Budget, achieving the public revenue targets
for the current year, 2018, will entail a greater response by tax revenues to growth in
economic activity than has been historically observed.
As regards the expenditure forecast for 2018, its more expansionary trend relative to
previous years is mainly due to the agreements reached on employment and compensation
of public-sector employees, on one hand, and on the revaluation of pensions, on the other.
The agreement reached by the Government with the main trade union organisations
includes an increase in public-sector employees' remuneration of 1.75% in 2018, plus
additional funds for targets and specific bodies that might entail a further 0.4 pp increase in
total gross wages. In the following years, to 2020, there would be even higher increases
than these. The budgetary plan also includes an extension to the hiring policy of the last two
years, raising replacement rates in some sectors and enacting additional measures affecting
working hours and temporary employment. Against this background, the estimated 2%
increase in public-sector employees' remuneration in the Stability Programme for 2018 will
probably be surpassed.
With respect to welfare benefits, the Stability Programme reflects the 1.6% settlement for
the revaluation of public pensions, both in 2018 and 2019. This increase will be 3% this
year, 2018, in the case of minimum and non-contributory pensions. I shall later return to
this. In any event, given the trend growth in the number of pensions and the substitution
effect arising from the new pensions replacing those that are terminated, which are generally
higher than was earlier the case, the forecast growth in the budget earmarked for welfare
benefits in 2018 (3.7%) may also be surpassed.
Among the remaining expenditure items for this year, goods and services purchases will
notably continue to be contained, and interest payments to decline, while there will be a
significant increase in public investment. This latter development is partly in response to the
inclusion in 2018 of the expenditure associated with amounts for which the government may
be liable under the insolvency-related legal proceedings currently affecting certain toll
motorways. But even after adjusting for this effect, public investment is expected to be more
expansionary than other items, as was the case in 2017. All told, public investment is
expected to stand at 2.1% of GDP in 2018, excluding the temporary effect arising from the
above-mentioning legal proceedings, a level far below the average for the previous two
decades, which was 3.6%.
Overall, it may be concluded that the attainment of the budget deficit target for this year,
namely 2.2% of GDP, is subject to significant risks. If they are not to materialise, potential
slippage from the projections must be monitored so that there is time to react and the
objectives pursued are not compromised. In this respect, the forecasts published by the
European Commission several weeks ago should be taken as a warning sign, given that a
deficit almost 0.5 pp of GDP higher than this target is estimated. Should this failure to hit
the target be confirmed, the structural deficit would also be impaired, making fiscal policy
in 2017 procyclical, given the estimation that the output gap would have already moved into
positive territory.
The importance of budgetary consolidation
I should now like to move on to the importance of budgetary consolidation.
Since 2009 Spain has embarked on an intense process of public finances consolidation,
which has entailed a reduction in the overall general government deficit of 8 pp of GDP.
Achieving such an adjustment proved very difficult, given the prevailing circumstances.
Yet even if the budgetary targets for 2018 are met, public finances, as projected in the draft
Budget, will still be in deficit to the tune of 2.2% of GDP, while public debt will be standing
at around 97% of GDP. Given that the Spanish economy is regaining, according to most
analysts, a neutral or slightly positive cyclical position, this will entail, for 2018, a structural
deficit - i.e. the cyclically adjusted total deficit - higher than the budgeted figure of 2.2%.
Against this background, the Stability Programme Update considers a continuation of the
fiscal adjustment which, in any event, would still entail in 2021, eight years after the start of
the economic expansion, a structural deficit of over 1 pp of GDP and public debt of almost
90% of output.
Maintaining levels of public debt around those currently prevailing in the Spanish economy
involves significant costs that need to be taken into account. It entails the deviation of major
resources for interest payments and, above all, vulnerability in the face of episodes of
tightening financing conditions on international markets, restricting the possibilities of
pursuing a countercyclical fiscal policy at times of economic recession.
In sum, it is most important to harness the current favourable circumstances of the Spanish
economy to redress, as soon as possible, our structural deficit and public debt levels,
bringing them in line with the standards set by our legislation and European regulations.
I would underscore, too, the challenge posed by the ageing of our population, in particular
for our pension system. This is essentially a medium and long-term challenge; but for that
very reason, tackling it appropriately is more difficult than other, shorter-term challenges.
The latest Social Security reform, in 2013, introduced two automatic adjustment
mechanisms (the Sustainability Factor and the Revaluation Index) which sought to ensure a
balance between the system's revenue and expenditure. The draft Budget and the Stability
Programme Update have introduced measures to increase pensions above the level
established by the Revaluation Index, in 2018 and 2019, and to delay the entry into force of
the Sustainability Factor, from 2019 to 2023.
Allow me to reiterate what I have said in various addresses regarding this matter: it is a
priority that we define, in accordance with social preferences, the substitution rates for the
pension system that it is sought to ensure; and then, that we adjust revenue accordingly, so
that sustainability is ensured. I believe this is a structural issue, requiring a debate not
confined to the habitual discussions of an annual budget.
Conclusions
To conclude, I wish to highlight the fact that the Spanish economy is in its fifth consecutive
year of growth, with the prospect that this trend will continue in the coming years, albeit at
progressively more moderate rates. Set against this baseline scenario are a series of risks,
which might shorten or moderate the current upturn. Accordingly, efforts to continue
improving the Spanish general government budgetary position should not be delayed, so
as to be able to effectively withstand potentially negative future developments. In this
respect, fulfilment of the objectives set in the draft State Budget for 2018 and in the recent
Stability Programme Update is crucial. Success will require strict implementation of
spending policies and the continuous monitoring of revenue.
As this is my last appearance before the Senate as Governor of the Banco de España, and
to conclude, I should like to express my gratitude for the consideration that has always been
extended to the Bank and to me in this chamber, and for the quality of the interventions and
questions raised on which I have had to comment. I have always thought, and have said so
on different occasions, that the lower and upper houses are the "natural fora" in which an
institution such as the Banco de España should preferentially express itself, cooperating
and contributing, as best it can, to parliamentary functions.
Thank you for your attention.