Luis M Linde: Overview of the Spanish economy against the background
of the euro crisis
Testimony by Mr Luis M Linde, Governor of the Bank of Spain, before the Parliamentary
Budget Committee in connection with the draft State Budget for 2014, Madrid, 4 October
2013.
* * *
My first appearance as Governor of the Banco de España before this Committee was last
year, amid a very difficult situation for the Spanish economy and a serious euro crisis. Since
then, fortunately, the situation has improved and the most serious uncertainties surrounding
the future of the common currency have been dispelled.
Allow me to begin by stressing the importance that strengthening the Economic and
Monetary Union and Spain's participation in it has for our economy and for the well-being of
Spanish society.
The difficulties we are facing should not mask the benefits the Spanish economy has reaped
from its participation in the European project and in its most significant institution in terms of
integration, namely monetary union. It is worth citing some figures.
In the 1986-1990 period, Spanish per capita GDP stood at 78% of the average of the
countries then comprising the European Union. In the 2007-2012 period, despite the severity
of the crisis in Spain, the percentage figure relative to the same group of countries, which are
the richest in the Union, was at 93%. And if we focus on infrastructure, which is so important
for any country's growth potential, the last 20 years have seen the weight of investment in
infrastructure in Spain far exceed the European Union average. Specifically, over the past
two decades, the weight of public investment in GDP in Spain has held, year by year, at
1.25 pp above the European Union average. That has allowed almost full convergence in
terms of our public capital endowment, in proportion to our population, with the core
European countries.
From this standpoint, which we should not lose sight of, I shall refer to the economic and
financial situation in Europe and to recent developments in the Spanish economy, with
particular reference to economic policies and to the draft budget for 2014. To conclude I have
some comments, which I feel bound to make, on the headway in our bank restructuring.
The euro area
For some months, the economic and financial situation in Europe has shown some
improvement, against an international background marked by signs of recovery in the United
States and Japan, and by some loss of momentum in the emerging economies, most
particularly China.
Following six consecutive quarters of contraction, euro area GDP growth has moved back
into positive territory. Underpinning this change in sign is a pick-up in internal demand, which
has added to the progress in net exports. The growth of 0.3 pp in euro area GDP in the
second quarter of 2013 has, naturally, been a positive surprise and plots a favourable course
for the Spanish economy. But its duration and intensity are by no means assured. Indeed,
recently revised medium-term forecasts for the euro area as a whole continue to augur very
moderate GDP growth rates and overly high unemployment levels.
In the financial domain, the degree of market fragmentation is lessening considerably, but is
still not fully compatible with the normal functioning of a monetary union and with efficient
monetary policy transmission. The cost at which households, credit institutions and the
different levels of government can currently finance themselves in the countries subject to
most tension is still above what the ECB monetary policy stance would warrant.
The ECB has in fact continued to reinforce its expansionary monetary policy stance
throughout the year, both through conventional conduct and through non-conventional or
extraordinary measures.
In May there was a fresh cut in official interest rates which, along with the maintenance of the
unlimited liquidity provision policy, is serving to set money market interest rates at extremely
low levels.
In July the ECB Governing Council decided to take a further step in its strategy of reinforcing
its expansionary monetary policy stance with the use of a new instrument, known in the
parlance as "forward guidance". Thus, after the May cut in rates, in July the ECB announced
that the Governing Council expected rates to remain at the new level, or at a lower level, for
a protracted period.
In any event, the contribution monetary policy can make to resolving the problems at the root
of the crisis is limited, and can hardly go beyond providing the time needed for other
economic policies to bear fruit, policies that do have the wherewithal to curb these problems.
For full normalisation of the area to come about, Member States must successfully see
through the adjustments to their domestic economic policies to adapt them to what a
monetary union requires to function.
From this perspective, I believe we should assess the progress made towards banking union
in Europe. In the coming days, the European Union Council will approve the legislation to
underpin the creation of the Single Supervisory Mechanism (SSM). That will formally set in
train the process that will culminate in the assumption, by the ECB, of microprudential
supervision in the euro area in autumn next year.
There is virtual consensus around the conviction that the banking union will be a decisive
instrument for breaking the loop between banking risks and sovereign risks, enabling the
degree of financial fragmentation still prevailing in the area to be reduced and, we trust,
ultimately eliminated. But to harness the full potential of the banking union, it is important to
ensure the quality of the bank review exercises to be conducted before the ECB assumes its
new supervisory responsibilities.
But the banking union will not reach its full potential if progress is not made in the design of
its other component parts, most notably a single resolution mechanism and fund, i.e. a
harmonised or common procedure for the treatment of bank crises.
Spain
I shall now turn to the situation of our economy.
The Spanish economy is showing signs of improvement, although the momentum for a
sustained recovery remains weak. During the current year the rate of contraction of
economic activity has eased, posting a quarter-on-quarter decline of only 0.1 pp in the
second quarter. The as yet incomplete data for the third quarter suggest that this
improvement has continued in recent months, meaning activity in Spain may have ceased to
fall in the July-September period and may have even posted a slight increase, following two
years of continuous declines.
I thus believe it is not unwarranted to state that the Spanish economy appears to be
overcoming the second recession of this protracted crisis.
Several factors lie behind this change. Undoubtedly, the pick-up in euro area activity has
contributed, along with a highly favourable tourist season. But the sound course of exports,
and to non-euro area destinations moreover, indicates that the most notable gains in
competitiveness are contributing considerably to this improvement.
The labour market figures for the past two quarters offer positive signs. They indicate that the
pace of job destruction has been curbed along with a fall of 1 pp in the unemployment rate,
which still stands at slightly over 26% of the labour force. The greater momentum of hiring
habitually seen in the summer months and the decline in the labour force have influenced
these developments; but they no doubt also reflect a favourable reaction by employment to
the adjustment under way in labour costs.
As the Banco de España has previously indicated and reiterated just a few days ago,
evaluating the results of the labour reform approved last year requires prudence for two key
reasons: it is a structural reform, whose effects, in any event, can only be felt in the medium
and long term; and it was implemented amid a full-blown recession. That said, the analysis
that can now be conducted shows better results - a lower fall in employment and greater
wage restraint - than those indicated by forecasting models. As previously stated in other
parliamentary appearances, I believe the reform was vital, that it has been correctly oriented
and, most essentially, that practically all experts and international organisations had been
stressing its necessity for several years. I believe its effects will be positive and that this will
be clearly perceived once activity begins to pick up.
Comparing the present situation with that a year ago, there has evidently been notable
progress in restoring confidence in the Spanish economy. The growing normalisation of
external funding flows and the fall in the sovereign risk premium clearly illustrate this.
However, the pass-through of this improvement in overall financing conditions is still proving
limited, whereby the financial restrictions continue to weigh down most significantly on
private-sector spending and investment decisions in Spain.
All told, the slowing trend in inflation has continued over recent quarters and further headway
has been made in correcting the main imbalances.
The increases in the annual rate of the consumer price index in the first half of this year have
slackened as the effects of the tax rises and increases in administered prices from July to
September last year have been stripped out. According to the flash estimate, the CPI rate
stood at 0.3% in September. It is therefore likely that its annual rate of change will stand
below 1% in December. Running such a moderate inflation rate evidently contributes to
alleviating the impact of weak incomes on households' and firms' purchasing capacity. The
legislation on the deindexation of the economy will be a valuable instrument for entrenching
this trajectory.
But the clearest example of the marked re-balancing the Spanish economy is undergoing is
the elimination of the external deficit. In 2013 to date, we have achieved a net financing
position with the external sector, a trend which will foreseeably continue and become more
accentuated over the rest of the year, to the point of placing the overall balance of payments
on current and capital account for the whole of 2013 at over 2% of GDP. Nonetheless, the
accumulation of major external deficits between 2007 and 2011 (amounting, over these five
years, to €328 billion, 32% of our GDP in 2012) has led to a high debit international
investment position, and years will be needed to reasonably reduce our dependence on
external saving.
Private-sector deleveraging continues to progress, although the unfavourable course of
income is checking the speed of the process. It is moreover likely that debt/income
rebalancing will prolong the contraction of credit at the aggregate level, although we may
expect its impact to be increasingly less. This is compatible with a reallocation of funds
towards the more productive agents with healthier financial positions. In any event, measures
are needed aimed at reallocating funds towards firms with greater potential in terms of
activity and employment and with financing difficulties, a situation particularly prevalent
among small and medium-sized enterprises.
Fiscal consolidation
Let me now address the public finances situation.
The general government deficit target for 2013, at 6.5% of GDP, entails a reduction of almost
5 pp from its 2009 of 11.2% of GDP. The reduction is difficult because it is taking place in a
highly adverse macroeconomic setting, therefore equating to a real adjustment on a much
greater scale, as indicated by the decline in the cumulative structural primary deficit in this
period, which can be estimated at around 7 pp of GDP.
Progress here has called for the adoption of numerous measures, both on the revenue and
expenditure sides.
On the revenue side, it has been sought to offset the effects on tax receipts of the collapse in
the real estate sector, and of the weakening of tax bases. To this end, there have been rises
in practically all taxes. On the expenditure side, measures have been aimed at correcting the
unsustainable dynamics that had begun to take root in the pre-crisis phase and at
compensating for the strong upward pressure that the crisis exerted on all items, such as the
higher interest burden and unemployment benefits.
Fiscal consolidation has also been pursued through far-reaching changes to our budgetary
framework, with the constitutional reform and the approval of new budgetary stability
legislation, which have made for great progress in transparency and have broadened the
range of instruments available to strengthen public spending discipline.
Slippage in the budget deficit targets set between 2009 and 2011 affected the credibility of
the adjustment process. The greater degree of success in meeting targets last year gave rise
to unquestionable benefits in terms of restored credibility. That has contributed to easing the
pressure on the risk premium and smoothed the way for agreements in Europe, under the
Stability and Growth Pact and the Excessive Deficit Procedure. The European authorities
agreed last July to allow a milder fiscal adjustment path for Spain, in particular for 2013 and
2014, which is more consistent with the current macroeconomic conditions and those that will
prevail in the coming years.
For this improved credibility to take root, the deficit targets must be met. Information on the
budget outturn in 2013 is still limited. In the first half of the year, the deficit improved relative
to the same period a year earlier (without considering the impact of the assistance to the
financial sector which, as is known, does not count for these purposes). The budget outturn
in the second half of the year must, therefore, be very strict at all levels of government if
slippage is to be avoided at the end of the year. While there are risks, I trust we can meet the
target this year of cutting the deficit to 6.5%.
The headway in budgetary consolidation should not mask the fact that the effort needed to
ensure Spanish public finances are redressed is still most considerable. Let us not forget the
distance still existing between the present situation and the requirement set in the Stability
Pact and in the new Budgetary Stability Law for the medium term, which is to have a
structural balance in equilibrium. Closing this gap will require further adjustments that will
never prove easy because restoring growth will be a gradual process.
We must also be mindful of the problems posed by the dynamics of the public debt/GDP ratio
and its perspectives in the short term. So far, and as is usual in the initial phases of fiscal
consolidation processes, this ratio has continued growing, with a forecast for 2014 of 98.9%
of GDP. Reversing this trajectory is vital for ensuring the future sustainability of public
finances, but it will require running primary surpluses for a prolonged period; naturally, the
sooner we achieve sustained economic growth, the smoother this adjustment process will
be.
To tackle these challenges, institutional developments geared to ensuring budgetary rigour
must be pursued. The independent fiscal responsibility authority, which will foreseeably start
up in 2014, must reinforce the quality and independence of budgetary programming. Here I
would like to mention the planned review of regional government financing arrangements and
the creation of the committee of experts for the reform of the tax system, who are expected
to submit their report in the coming months.
As for the public pension system, I shall reiterate what I said before the Economic Affairs
Committee last June on the presentation of the Annual Report of the Banco de España.
The public pension system is a fundamental factor of economic and social stability and it is in
everybody's interest to address the risks of shortfalls arising as a result of demographic
developments. The sustainability of the pension system - i.e. certainty as to the ability to
fund it appropriately - is essential for giving stability to public finances and for the credibility
of any programme to consolidate total public spending.
For the system to be sustainable, it must find a way to accommodate its key elements,
namely the retirement age, the means of calculating pensions and the so-called
"sustainability factor". I hope and trust that political forces will continue working on this
delicate and very important matter, in the spirit of the Toledo Pact agreed almost 20 years
ago, and which has repeatedly been supported by our parliamentary institutions.
The major budgetary figures and the macroeconomic aggregates for 2014
The 2014 Budget is the first to be drawn up following the entry into force of the latest
European budgetary governance reform, which introduces into countries' budgetary
procedures an assessment by the European Commission of draft general government
budgets.
In Spain's case, this reform will lead to the availability of a single document drawing together
the main budgetary items of all levels of government, i.e. one that includes the regional
governments. In a country as decentralised in terms of public spending as Spain, as
decentralised or more so than other countries with a federal political structure, the
preparation of this documentation is a fundamental requirement for the appropriate
assessment of budgetary forecasts. According to the agenda set, this document will be
available, at the European level, in the coming days. I shall therefore refer solely to the State
and Social Security budgets.
The draft State budget for 2014 is set against a macroeconomic background in which real
GDP is forecast to grow by 0.7%. This macroeconomic scenario, whose central forecast is
export growth above 6%, is prudent and in keeping with the forecasts of most national and
international agencies. It outlines a gradual recovery in activity and employment in a setting
in which the ongoing budgetary adjustment and the deleveraging of households and firms will
continue, and in which the competitiveness regained in 2012 and 2013 will not be lost.
In step with our European commitments, an overall general government budget deficit target,
in National Accounts terms, has been set at 5.8% of GDP, against the figure of 6.5% forecast
for 2013. In terms of the different agents, a National Accounts deficit target of 3.7% of GDP
has been set for central government, against 3.8% in 2013, and in the case of the social
security system and the regional governments the figures mark an improvement of 0.3 pp of
GDP, taking the respective deficits to 1.1% and 1%. Local governments should maintain in
2014 the balanced budget already forecast for 2013.
As in previous years, three expenditure items - the public debt interest burden, pensions and
unemployment benefits - will continue to condition budgetary programming. Indeed, while in
the initial consolidated State budget for 2013 these three items accounted for around 18.2%
of GDP, in 2014 they are expected to represent around 18.5% of GDP and close to 55% of
total consolidated public spending. The budgetary adjustment will therefore continue to focus
on government consumption, for which a real-terms reduction of 2.9% is projected in 2014
for overall general government, based partly on the civil servant wage freeze and on the
extension of austerity policies in relation to public-sector employment; and, moreover, on the
reduction in public investment. A further expenditure-containing factor will stem from the
envisaged revision of pensions, set at 0.25%, in line with the floor established in the draft law
defining the sustainability factor.
How do these figures compare with those for the euro area as a whole? In terms of GDP, the
weight of unemployment benefits continues to stand far above the euro area average, as a
result of our high unemployment. Interest payments on debt in Spain are also expected to
exceed the euro area average, while spending on pensions would continue to be below the
average, given that demographic developments in our country remain more favourable.
On the revenue side, a 2.4% increase in total tax receipts (including the share of regional
and local government) is forecast, with very few tax changes. These are concentrated in the
broadening of corporate income tax bases approved last June. In the case of personal
income tax and VAT receipts, increases of 1.7% and 2.7% are projected. As to social
security contributions, the main regulatory change consists of a 5% increase in the maximum
contribution bases.
Progress in the reform of the banking system
Before concluding, I shall briefly mention the progress in the reform and strengthening of our
banking system. This task is at the heart of the responsibilities and concerns of the Banco de
España, and, as we all know, it has required a most considerable contribution of public
funds.
At present we are at a most advanced phase in the ongoing recapitalisation and restructuring
of our banking sector.
As you know, the starting point was in 2009, when the FROB (the Fund for the Orderly
Restructuring of the Banking Sector) was created, and the process moved up a gear in 2011
further to Royal Decree-Law 2/2011 on the strengthening of the financial system, which
raised capital requirements. But the decisive steps were taken in 2012, with Royal Decree
Laws 2/2012 and 18/2012 on the clean-up of the financial system, the Memorandum of
Understanding agreed in July with the European Commission, and the financial support
facility of up to €100 billion annexed to this agreement; and, finally, Law 9/2012 on the
restructuring and resolution of credit institutions.
Against this background, each bank's capital needs were identified on the basis of a rigorous
stress test and, in accordance with the European authorities, restructuring or orderly
resolution plans were drawn up and approved for those banks requiring them.
In 2012, backed by public financial assistance, the institutions classified under "group 1" of
the Memorandum of Understanding were recapitalised, and their problem construction and
real estate development-related assets were transferred to SAREB (the asset management
company for assets arising from bank restructuring).
Into 2013, the "group 2" institutions subject to the exercise have been recapitalised, their
troubled assets have been transferred to SAREB and the hybrid instrument management
(burden-sharing) exercises have been conducted at all banks requiring them, except at one,
where they began recently and will be concluded in the coming days.
The public financial assistance to financial institutions in various forms of capital, since May
2009, has risen to €61.37 billion, €38.83 billion of which were under the Financial Assistance
Programme agreed with the European authorities. Verification by the international authorities
of the fulfilment of the conditions agreed in the July 2012 Memorandum of Understanding,
the last round of which concluded only a few days ago, confirms that the Memorandum and
its deadlines have been strictly adhered to and that the main objective, the restructuring and
recapitalisation of our banking system, has progressed satisfactorily.
As earlier stated, the Council of the European Union will shortly approve the Regulation
governing the SSM, which will commence operating after a transitory period of one year. It is
envisaged that more than 90% of the Spanish banking system, measured by volume of
assets, will be supervised by the SSM.
Prior to the ECB effectively taking over supervisory responsibilities, a bank asset review and
valuation is planned which will give rise to the requirement of a level of capital to be met by all
banks subject to the review and, where necessary, to the setting up of additional coverage.
It is worth noting that our banks are starting from a very reasonable level, both from the
perspective of the accounting classification of their assets, and from that of asset coverage
and provisioning, the result of the review conducted last year under the stress tests and of
the above-mentioned recapitalisation processes. Recently, banks' review of refinanced loans
has also concluded, a process which contributes to shoring up their position ahead of the
forthcoming evaluation of the quality of their assets.
Likewise, and once more with a view to reinforcing the solvency of our banking system, the
Banco de España has recommended that banks moderate the distribution of dividends
during 2013 and that, in any event, the cash dividends paid out should not exceed 25% of
attributable consolidated profit. Naturally, all banks are following this recommendation.
The solvency position of Spanish banks has clearly improved in 2013. Average core capital
in our banking system will stand at around 10.5% as at December 2013, more than 1 pp up
on the same figure a year earlier.
Further, since the start of 2013 liquidity conditions at Spanish banks have improved, and
there has been a re-balancing of their funding sources. This is the outcome of the diminished
tensions on the sovereign debt markets and of improved confidence, along with the lesser
fragmentation of euro area money and capital markets.
In this respect, retail deposits, which fell, especially in the summer months of 2012, have
since been faring better. Since early 2013, they have been posting positive rates of change.
The pick-up in deposits has seen the retail funding gap - i.e. the percentage of credit that
banks cannot cover with deposits - narrow. That allows them to reduce the need to resort to
less stable funding sources, such as the wholesale markets.
Against this backdrop, the resort to Eurosystem funding, though holding at still-high levels,
has diminished most significantly from its peak last summer, registering a decline of 31% in
the first eight months of 2013.
In terms of profitability, the exceptional drive by banks in 2012 to comply with provisioning
requirements exerted a significant impact on their profit and loss accounts. Indeed, for the
year as a whole, losses of over €40 billion were recorded. The first half of 2013 has marked a
change in this tendency. Banks' consolidated profit rose to somewhat more than €8.2 billion,
despite the fact that provisions continue to adversely affect profit and loss accounts in a
period in which the proportion of non-performing assets remained high.
The signs of improvement in the sector are not free from risks. In a setting characterised by
low economic growth, sluggish activity and relatively low interest rates, banking sector
margins will continue to be subject to downward pressures. Foreseeably, moreover, doubtful
assets will continue to increase in the short run, although their impact in terms of provisions
will be less than in the recent past. Against this background, banks must persevere in their
efforts to improve efficiency and contain operating costs. In particular, it is essential that
banks subject to restructuring and recapitalisation plans strictly comply with the requirements
established in those plans.
Conclusions
The difficulties the Spanish economy has been facing call for efforts to be made by all. The
Budget you are to discuss is pivotal to the continuation of these efforts and to an exit from
the crisis. The analysis I have attempted to convey seeks to show that these efforts are
beginning to bear fruit in the gradual strengthening of the recovery. I believe if we manage to
maintain the policy of expenditure control, structural reforms and the reinforcement of our
financial system, the year 2014 may mark the start of the recovery in activity and
employment.
Thank you for your attention.