Miguel Fernández Ordóñez: Recent developments in the Spanish
economy
Testimony of Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, to the
Parliamentary Budget Committee, Madrid, 9 October 2007.
* * *
Ladies and gentlemen,
My appearance before this Committee as part of the Parliamentary discussion of the State
budget for 2008 comes at a time when shocks are still reverberating through some of the
major international financial markets, and the attendant uncertainty inevitably bears on the
analysis of the economic situation.
In my appearance before the Parliamentary Committee on Financial Affairs on 17
September, I examined in detail the origin and the main implications for ECB monetary policy
and for the Spanish economy of these shocks, which emerged last summer against a
background of marked momentum of the economy and of world trade.
A significant part of this dynamism - reflected in growth rates above 5% for world output and
above 6% for trade - derives from the sound performance of the emerging economies in
recent years; indeed, they seem to have been less affected by the shocks than the more
developed Western economies. This is, in fact, a significant feature of the present bout of
turbulence which, if I may briefly recall, originated in a financial market of a developed
country (the US sub-prime mortgage market). The turbulence was initially transmitted to
other international financial markets through sharp corrections in the credit quality of certain
complex structured financial products which, at least apparently, were relatively concentrated
in the financial systems of a number of developed economies. The Spanish economy is not
one of them. Although I will pass quickly over this point, which I addressed in depth in my
recent appearances before Congress and the Senate, I do wish to remind you of the safety
buffer afforded by the Spanish financial system's non-exposure to practices and products of
this type and by the soundness of our credit institutions in terms of profitability, solvency and
ample provisions.
In the economies most directly affected, credit institutions active in originating and
distributing these complex structured products have prompted tensions in the interbank
markets in which the liquidity provided by central banks to the financial system is
redistributed. The rapid response of the central banks, led by the US Federal Reserve and
the European Central Bank, prevented these tensions from acting as a channel through
which the instability was further amplified. We must acknowledge, however, that there are
still uncertainties hindering the normalisation of these markets and that dissipating them will
require an additional effort by institutions to increase the transparency of their operations.
The euro area stands ready to face these shocks from a solid position and, therefore, with
significant resilience. That said, in the second quarter of 2007 the euro area's GDP grew less
than expected, although it held at levels in line with potential growth.
The fundamentals underlying this growth pattern remain firm, so conditions are generally
favourable for the continuation of the current economic boom. Significant in this respect is,
firstly, the favourable trend of employment, which is a necessary, albeit not sufficient,
condition for the increased buoyancy of private consumption in the area. Secondly, European
firms on the whole enjoy a healthy financial position and are posting substantial profits, a
situation which is conducive to the growth of private productive investment.
In the external sector, however, most of the available forecasts point to a loss of steam in the
US economy in the coming quarters. But this will be countered by the continued thrust of the
emerging economies which, as stated, are showing notable resilience to the type of financial
tensions currently at large.
The sound economic performance of the area has, moreover, been compatible with
continued low inflation rates. The rise evidenced by the September figure - which will
probably continue in the closing months of this year and in the opening months of 2008 - is
largely attributable to the more volatile components of the HICP. Firstly, it is strongly
influenced by energy prices, which in the closing stages of 2007 are unlikely to repeat the
favourable pattern of late 2006, so the growth rate of the HICP is being subjected to an
upward base effect of some size. Secondly, the demand pressures and decreased supply in
the markets for certain food products are exerting upward pressure on the prices of those
products.
This is, in short, the macroeconomic situation of the euro area as it faces the financial market
shocks. The time elapsed and the information it has been possible to gather since the
summer are clearly insufficient to predict with any accuracy the most likely effects of this
turbulence on the European economy in the medium term.
Before July, the persistence of the global imbalances and of protectionist pressure in some
markets, the uncertainty over the future behaviour of oil and commodity prices, and the
pressure that more buoyant employment might exert on wage demands made for a scenario
in which the balance of risks to euro area activity growth and price stability was moving
downwards in the first case and upwards in the second.
Subsequent events in international financial markets since then suggest an increase in
downside risks to activity, which may have mitigated to some extent the risks to price
stability, which continue to be upward. However, uncertainty is still very high in relation to at
least three factors that may be crucial for the outcome of this bout of turbulence.
First, more information has to be gathered to determine more accurately the extent of the US
slowdown and its possible transmission to the world economy. Second, the ultimate effects
that the upward revision of credit risk premiums will have on the cost and availability of
private sector financing will have to be determined. These premiums had reached very low
and, in general, scantly discriminatory levels in recent years against a background of
widespread optimism and economic boom, and so may have led to probably excessive
investment in certain potentially high-risk activities. Such a revision is, in itself, a healthy sign,
but it is yet to be seen how large it will be and whether it will be orderly, as would be
desirable. Also, the significance, and the impact on European corporate and consumer
confidence, of the poor functioning of some markets will largely depend on how long this bout
of turbulence lasts.
Against this backdrop of uncertainty, on 4 October the ECB Governing Council decided to
hold official interest rates unchanged, reiterating its commitment to price stability, close
attention to ongoing developments and readiness to act as necessary to prevent the risks to
price stability from materialising. At the same time, the ECB has expressed its determination
to use the resources available to it to smooth the process of normalisation of European
interbank market conditions.
As I mentioned before Parliament scarcely a month ago, these events come at a time when
the Spanish economy continues to show considerable buoyancy, with GDP growth in the first
half of the year around or slightly above a rate of 4% and employment growth somewhat
higher than 3%. This period saw the continuation of the slight moderation in domestic
demand first seen in 2006 and of the improvement in the contribution of net external demand
to growth, which began that same year, enabling the composition of domestic and external
sources of expenditure to be brought more into balance.
But the change in composition extended also to domestic demand, where lower relative
household spending growth and stronger business investment were observed during the first
half of the year. Indeed, the gradual moderation in household consumption initiated some
quarters ago continued, reflecting a natural adaptation to less generous monetary and
financial conditions as a result of the interest rate rise under way since late 2005 and of the
weaker wealth effect on consumption due to slower house price rises. However, the
buoyancy of employment and its effect on income prospects are helping to smooth the
adjustment of consumption to more sustainable levels.
It is precisely this behaviour of employment, which continues to be underpinned by
considerable demographic dynamism that is the main factor behind the gradualness of the
first-half slowdown in residential investment, since also in this case the higher interest rates
and the lower expectations of capital gains are making for less vigorous housing investment.
The change in monetary and financial conditions also induced a certain moderation in their
demand for credit, contributing to a progressive stabilisation of household debt ratios.
Corporate investment and borrowing plans are being affected somewhat less perceptibly by
the rise in interest rates. Particularly notable is the continued strength of productive
investment in a situation of high profitability and favourable business expectations. In fact, it
has become the most buoyant component of domestic demand, although moving on a mildly
decelerating trend in the second quarter. Also apparent in the last few months is an incipient
change in the purpose of loans extended to firms, with a slowdown in those used to finance
real estate and construction activities, and an increase in those to industrial firms.
Net external demand is helping to mitigate the impact of slower spending on growth, mainly
due to the moderation in imports in the first half of this year, probably in response to the mild
slowdown in final demand. Meanwhile, exports, after the good results last year, are showing
the effect of more contained world - and especially European - growth and perhaps the
effect of the euro's appreciation on sales to non-Community countries. Spain's net borrowing,
although it has continued to increase, is doing so more slowly than in previous years.
The changes I have described in GDP composition on the expenditure side have been
feeding through to the various productive branches which, as a whole, have remained most
robust in the first half of this year. Noteworthy in this respect is the strength of industrial
production and the mild slowdown in construction activity.
But the most notable feature on the supply side was again the abundance of labour
resources, which continue acting to smooth the adjustment of activity to the buoyancy of
demand, preventing cost pressures and excessive prices. The growth of consumer prices,
spurred by a temporary turnaround in oil prices in the first half of the year, posted a
year-onyear rate of 2.2% in August, leaving the differential with the euro area close to its historical
low. However, it is very likely that, once the base effect of the energy price falls in the closing
months of 2006 has been stripped out, inflation will again rise and that at the end of this year
it will reach levels similar to those at end-2006. This is in fact suggested by the HICP growth
flash estimate of 2.7% for September.
In examining the outlook of the Spanish economy for the coming quarters, it has to be kept in
mind that there are still few indicators of the situation since the turbulence erupted on
international financial markets. Nonetheless, the available information indicates that the
profile of smoothly moderating activity apparent since the second quarter continued in the
third quarter, and this pattern can be expected to persist throughout the rest of the year, with
scant deviations from the forecasts published by the Bank on 30 March (3.7% for 2007). This
slight slowdown is based on domestic demand and, more specifically, on the consumption
and residential investment components, while the contribution of net external demand to
growth in the first half of 2007 improved further. The slowdown in GDP seems to point to a
gradual shift to a growth rate of around 3% in 2008 as a result of some rebalancing of the
domestic and external sectors. However, the shocks affecting the international financial
markets since August have also increased uncertainty over the forecasts for the Spanish
economy and have possibly heightened the downside risks.
Allow me to spell out some of the factors behind this scenario of a smooth slowdown,
compatible with continued highly dynamic activity and employment.
First, the change in monetary and financial conditions will foreseeably ease the adjustment to
a more sustainable pace of private-sector spending and indebtedness. This adjustment
started some time back and is proceeding smoothly. Second, the progressive normalisation
of the real estate market, against a background in which the demographic factor and the
buoyancy of employment are lending greater support to housing demand than in previous
property cycles, would limit the effect of slower house price rises on consumption and soften
the impact of the cyclical change on residential investment.
At the same time, the step-up in private- and public-sector investment in recent years has
raised the level of capitalisation of the economy following a prolonged period of intense job
creation, and this should manifest itself in higher long-term potential growth. Although it is
unlikely that the expansion of business investment and non-residential investment in
construction will maintain the pace of recent quarters, the growth outlook for both spending
components is, at first sight, favourable.
In any event, it seems unlikely that productive investment alone can offset the lower
contribution from household spending. Hence, as I pointed out in my previous testimony, the
role of net external demand will be fundamental in making some containment of spending
compatible with a continued growth rate of around 3%. As we have seen in the last few
years, the contribution of this variable to growth depends very much on the performance of
Spain's export markets, but also on the competitiveness of Spanish production. Therefore, a
scenario of recovery in net exports such as that described requires Spanish firms to push
ahead with the improvement in competitiveness made by them in response to the sharp
ongoing adjustment in the structure of world trade due to the entry of new competitors. At the
same time, the slower momentum of final demand should manifest itself in a certain
slowdown in imports, curbing the leakage of spending out of Spain.
However, as I indicated in September, it is precisely in the external economic environment
where the main factors of risk to the macroeconomic scenario outlined above are to be
found. If the recent bout of financial instability and of heightened international uncertainty
were to significantly affect the buoyancy of Spain's export markets, the capacity of external
demand to contain the adverse impact of a slowdown in domestic spending would be
diminished and, accordingly, the efforts required to improve competitiveness would be even
greater.
Domestically, the continued dynamism of employment and the gradual normalisation of the
property market are fundamental for keeping income expectations and, consequently,
agents' spending plans on a mildly slowing course. In any event, the Spanish economy is
witnessing a process in which construction investment is diminishing in importance as the
engine of growth. Therefore, it is essential to have a sufficiently flexible mechanism of
resource allocation to enable industrial activity and services to take over from construction,
furthering the change in output composition that has been taking place in the last few
quarters.
In the current circumstances, economic policies have an important role to play by holding the
euro area firmly on course to meet its macroeconomic stability objectives, which are those
that make sustained growth possible and shore up the economy against shocks and
outbreaks of insecurity and uncertainty. As mentioned above, the main task of monetary
policy is to ensure euro area price stability in the medium term, and it is against this
background that monetary conditions have gradually been normalised since December 2005.
This process has been correcting the benign monetary conditions of the Spanish economy in
recent years and promoting a more balanced growth pattern.
The most valuable contribution fiscal policy can make is to ensure the commitment to
budgetary stability. This commitment has been essential for establishing the conditions
propitious to the recent long period of economic growth of the Spanish economy and it is
particularly relevant to the macroeconomic setting I have described.
The latest official forecasts for the general government account are for a surplus of 1.3% of
GDP in 2007. This would amply meet the requirements of the Stability and Growth Pact and
enable a further reduction of the public debt/GDP ratio. Moreover, it represents an
improvement of 30 bp on the target set in the latest update of the Stability Programme. This
improvement basically reflects a positive deviation of tax revenue with respect to budget, in a
setting of higher-than-expected growth.
The target set in the draft State Budget for 2008 for the general government surplus is
1.15%, in a macroeconomic scenario characterised by a mild slowdown in GDP. The
projected decrease in the surplus is based essentially on tax cuts mainly affecting personal
and corporate income tax, whereas on the spending side the draft Budget sets a growth rate
for the State in line with expected nominal GDP growth. This entails strict compliance with
the ceiling established in the Budget Stability Law in June.
In any event, it should be kept in mind that the Budget is based on a projection for end-2007
that is very prudent on the revenue side. The strong buoyancy of receipts in the year to date,
particularly in direct taxes, might enable the latest official projection of the surplus for 2007 to
be exceeded. Should this occur, under a macroeconomic scenario similar to that assumed in
the Budget, this improved result in 2007 should be carried over to the budget for 2008 and
thus enable another surplus in excess of projections. What is most important is that, as in
previous years, the additional revenue that may arise should not lead to increased spending,
but rather to a higher surplus.
Regarding the size of the budget surplus, I wish to underline that the current situation of
public finances is, in part, temporary. This is because, after ten years of rapid expansion at a
rate that has recently exceeded potential growth, the actual buoyancy of tax revenue has
naturally been associated with the buoyancy of domestic demand and, in particular, with the
vigour of the real estate sector, and therefore has a temporary component that would tend to
disappear in an economic slowdown. It is therefore imperative to preserve the stabilising
potential provided by the current state of public finances so that phases of less dynamic
private spending can be faced with strength and the ability to react and, above all, so as to
be prepared for unexpected contractionary shocks. This approach is especially valid in the
current climate of uncertainty, in which a continued economic policy of rigour and budgetary
stability is one of the most valuable resources when it comes to preserving internal and
external confidence in our economy.
Perseverance in the strategy of budgetary consolidation is also necessary from a
mediumterm perspective so as to be in the best possible position to address the foreseeable impact
of population ageing, aside from the required further progress in reform of the pension
system.
Regarding the co-ordination of this strategy, I would like to add two more comments. First, it
is very important that all tiers of government contribute effectively, particularly the regional
governments, whose weight in public spending policies has become most substantial.
However, the official forecast is that, overall, these territorial governments will still post a
deficit in 2007 despite the benign economic circumstances over the last few years.
Second, budgetary stability should be accompanied by an improvement in the quality of
public finances to secure advances in the allocation of factors of production, particularly
human and technological factors, and in the efficiency of the economy. The spending policies
included in the draft Budget give priority to areas of key importance for improving
productivity, such as increased resources for research and development, education and
infrastructure, although other priority items entail increases in current primary spending. It is
important that the envisaged increase in resource allocation be managed efficiently through
the use of better suited mechanisms to assess and select public policies so as to enable real
increases in productivity.
The budget is not, however, the only instrument, nor often the most appropriate one, to
achieve the aim of raising the efficiency of the economy. Structural policies designed to make
factor and product markets more flexible will be called on to make an essential contribution to
this aim and, for this purpose, it is necessary to persevere with and extend the processes of
liberalisation undertaken in recent years. Policies of this type, which enable growth potential
to be raised and make for the efficient allocation of resources in the economy, are pivotal in
the present conjuncture, which, as stated earlier, requires a rebalancing of the sources of
growth of the Spanish economy.
Thank you.