Jaime Caruana: Presentation of the Annual Report
Address by Mr Jaime Caruana, Governor of the Bank of Spain, at the presentation of the Annual
Report to the Governing Council of the Banco de España, Madrid, 18 June 2004.
* * *
Ladies and gentlemen,
The recovery in the international economy - which was described as modest, hesitant and uneven in
the speech presenting last year's Annual Report - progressively gathered momentum during 2003 and
early 2004, as well as extending to other regions. Adding to the initial buoyancy of the US economy
was the considerable dynamism of a large number of east Asian countries, including most notably
China. The Japanese economy, flagging in a marked depression during the previous decade, picked
up clearly, and the central and eastern European countries sustained relatively high growth rates. Only
the euro area, among the industrialised economies, and Latin America, among the emerging group,
showed a more hesitant recovery in activity.
The favourable developments in the international economy were compatible with continuing low
inflation, despite the notable rise in oil and other commodity prices. The risk of deflation which, at
times, it was feared might affect some of the main economies, including the United States, faded as
the recovery firmed. The sound behaviour, on the whole, of the financial markets and the trend of
confidence indicators seem largely to indicate that expectations about the future course of the world
economy are now brighter again.
The firming of the recovery is attributable in no small measure to markedly expansionary
macroeconomic policies which, in many countries, have resulted in significant increases in public and
private debt levels. Against a background of very generous monetary policies and ample global
liquidity, the financial markets saw asset price rises and very low interest rates, which also helped
anchor the pick-up in demand. Risk premia diminished on both private-sector bonds and on the
sovereign debt of emerging markets, which received greater capital flows. As a result, the economic
recovery and the soundness of financial markets fuelled one another, in a virtuous circle that has
broadly been maintained in the opening months of 2004, although recently a rise has been seen in
long-term interest rates and in emerging markets' sovereign risk premia.
Latin America was the emerging region which encountered most difficulty in joining the upturn in the
world economy in 2003. Crises in certain countries and bouts of financial instability in others have
prompted heavy exchange rate depreciations and upward price pressures in recent years. Against
this, the authorities reacted with more restrictive demand-side policies that set back any take-off in
their economies. As these policies have eased, and as external financing conditions have improved
and the increase in commodity prices firmed, the Latin American economies have attained
progressively higher growth rates, particularly as from the closing months of 2003. However, certain
factors of vulnerability remain in the area. These relate to the high levels of public and foreign debt
and to the high dependence on foreign capital, which advise perseverance in maintaining
macroeconomic stability and in furthering structural reforms, especially those aimed at strengthening
the institutional framework and the respect for property rights
One salient aspect, in my view, which arises from the examination of the international situation is the
fact that the firming of the economic recovery did not contribute to correcting the external imbalances
between the main regions. On the contrary, despite the marked depreciation of the dollar, both the US
external deficit end the surplus of Japan and the rest of Asia increased, while the slight surplus in the
euro area hardly changed. Possibly, the deprecation of the dollar may not yet have had a corrective
effect on foreign trade flows since, as we know, this tends to come about with a considerable delay
and, in the short term, the exchange rate deprecation may even lead the deficit to widen. But the scant
impact of the dollar depreciation on the current-account balances of the main areas appears also to be
related to the asymmetry in the reaction of the main currencies: while much of the nominal effective
depreciation of the dollar in 2003 was bilaterally against the euro, the Asian economies and, to a
lesser extent, Japan, checked the rising trend of their currencies by means of heavy intervention on
the foreign-exchange markets which has contributed to increasing their already high levels of reserves
even further.
It is something of a paradox that the decline of the dollar has been concentrated against the currences
of the least dynamic economies whose current accounts are relatively balanced, while it has held very
stable against the currencies of the highest-growth countries which account for most of the US trade
deficit. In any event, the contribution exchange-rate movements may be expected to make in
correcting global external imbalances is limited; what are needed are economic policy adjustments by
the main countries. Not only was no headway made in 2003 in this area, but economic policies
remained oriented, in certain cases, in the opposite direction to what was needed to reduce the
imbalances, especially as regards the US budget deficit.
As mentioned, the international economic outlook has improved appreciably in 2003 and early 2004.
In turn, the recovery will foreseeably take hold in those countries most ahead in the cycle, while those
most behind are expected gradually to join the upturn. Nonetheless, certain risks remain and should
be borne in mind when assessing the future course of the recovery.
An initial risk is that the persistence of current-account imbalances may exacerbate volatility on
international foreign exchange and financial markets. Achieving a distribution of world growth more in
line with more balanced current-account positions without jeopardising the recovery is, therefore, one
of the main challenges facing the world economy.
In the case of the United States, the correction of the external deficit necessarily involves reducing the
high budget deficit, which is a result of the highly expansionary fiscal policies pursued in recent years.
The United States and other countries must, in the near future, adjust their monetary policy towards a
stance more in keeping with a more advanced cyclical position, departing from what are at present
very low official interest rates that entail a notable stimulus for activity. In this respect, an appropriate
communication policy, avoiding the overreactions to which financial markets are prone, is essential.
This is particularly important, moreover, given the continuing geopolitical uncertainties and the fact that
the recent oil price rises, were they to become entrenched, would bear unfavourably on both price
stability and the cause of global recovery, making the task of central banks more complicated.
In sum, ahead of the current upturn in the international business cycle, we should bear in mind one of
the main lessons of previous cycles. This is, namely, the importance of taking advantage of the good
times to make the adjustments needed to correct imbalances and to equip economic policies with
greater room for manoeuvre that may be used when more difficult times arrive. It is therefore vital that
the emphasis of economic policy shift from the short to the medium term, as regards both the fiscal
and monetary strands of policy and structural reforms.
And it is also crucial to harness the upswing to bolster the financial sector, the soundness of which has
enabled the world economy to better withstand the severe shocks it has undergone in recent years.
The euro area
Last year the euro area remained in a period of low growth that began in 2001. In the second half of
the year the first signs of recovery were detected, which appear to have strengthened in early 2004.
That said, the area remains far less buoyant than the rest of the main regions and its prospects are
still considerably uncertain. This prolonged phase of relatively sluggish economic activity has been the
outcome, among other things, of a series of global shocks and, more recently, of the pronounced
appreciation of the euro amid heightening international financial imbalances.
But the unsatisfactory results of recent years also appear to be indicative of the excessive vulnerability
of the European economy to developments in its external environment and of the chronic weakness of
its internal demand, which favourable monetary and financial conditions have been unable to counter.
The performance of the euro area has proven somewhat disappointing when set against the
expectations generated at the outset of Monetary Union over five years ago. Among other objectives,
the Union was intended to increase the economic prosperity of European citizens. However, we
should not ignore the progress made in overcoming some of the structural shortcomings during the
process of monetary integration. In the past decade major headway has been made in many countries
in areas such as the downsizing of the public sector, the efficiency of the tax system and, more
unevenly, the workings of markets.
That should not prevent us from acknowledging the weaknesses the European economy still exhibits.
In particular, in a more competitive international environment, the continuing rigidities in goods and
labour markets and the absence of sufficient incentives for innovation and the incorporation of new
technologies are inhibiting investment in Europe, to the beneft of other more dynamic geographical
areas. As a result, growth potential is being significantly impaired. Likewise, population trends in
Europe are exerting growing pressure on the financial viability of the current public arrangements for
social security and health-care. That tends to make those aspects of labour regulation and tax
systems that act as a barrier to joining the labour market and to the reduction of the dependency ratio
even more onerous.
It may thus be the case in the current circumstances that agents perceive more clearly the potentially
negative influence on their future income of structural deficiencies, and that this is inhibiting their
propensity to spend. Accordingly, defining and boosting the reform agenda, in line with the
commitments made at the Lisbon and Barcelona Summits, is not just necessary for ensuring greater
sustainable growth in the medium tend; it is also a crucial requirement for improving agents'
confidence and, thereby, contributing to the dynamism of activity, likewise in the more immediate term.
In a situation such as the present one, in which the flatness of private spending is largely a result of
uncertainty about the future course of the economy, demand-side policies should be acknowledged to
be of limited effectiveness in countering the weaknesses of output growth. When agents view the
future with some mistrust, measures that are intended to be expansionary and geared to increasing
activity in the short term may well prove counter-productive if they are perceived as unsustainable or
even harmful in the medium term.
From this standpoint, it is vital for monetary policy conduct that the firmness of the central bank's
commitment to price stability be reiterated, as an essential requirement for ensuring a higher level of
well-being in the medium term. The ECB's actions have been consistent with this analysis: it has
squared the reduction of interest rates to their lowest levels in recent decades, in step with the
sluggish growth, with its drive to keep - through its actions and its communications policy - inflation
expectations in line with its own definition of the objective of monetary policy.
The medium and long-term view is likewise essential for orienting budgetary policy. In the current
Annual Report
economic conditions the describes, discretionary measures entailing a significant
deterioration in budgetary balances cannot be expected to have generalised expansionary effects on
activity. This is because such measures may inhibit private spending and tend to exacerbate the
challenges posed by population ageing. What is really important is that national budgets should not
lead to structural imbalances that may jeopardise the sustainability of public finances and the proper
functioning of Monetary Union. This is the best formula for contributing, at the current juncture, to
reinforcing agents' confidence and boosting the favourable effects of European economic integration.
Against the background of the exceptional institutional characteristics of European monetary
integration, it cannot be ignored that fiscal indiscipline in specific countries has negative externalities
for the area as a whole; consequently, it is vital to maintain rules - such as those ìn the EU Treaty and
the Stability and Growth Pact - limiting the fiscal autonomy of the Member States. This requirement is
even more pressing now that ten new countries have joined the EU and expressed their wish to adopt
the euro once they meet the attendant conditions.
Given the current difficulties with the EU's fiscal discipline arrangements, the priority would appear to
be to ensure the proper functioning of the multilateral surveillance and control procedures of the
current rules. Such rules should be accepted by all the Member States as the sole means of
maintaining the effectiveness and credibility of the regulatory framework.
In any event, the upturn in activity that the European economy appears to have embarked upon
should prove conducive to pushing through national governments' reform plans and to strengthening
the fiscal commitments currently in place. That said, there are some uncertainties in the current
situation, namely geopolitical instability, the rise in oil prices and the global macroeconomic
imbalances which, naturally, affect the outlook for the euro area economy.
Despite such uncertainties, the European economy should post notably higher growth this year than
last, on the basis of expanding export markets and a gradual recovery in internal demand. At the same
time, the momentous step taken in European construction with EU enlargement should be an
additional incentive for seeing through the economic and institutional reforms needed to revitalise
European growth.
The Spanish economy
Addressing the behaviour of the Spanish economy in 2003 and in 2004 to data, I should begin by
pointing out that our economy has, once again, managed to improve on the trajectory followed by the
euro area. Internal demand in particular has continued to respond to the expansionary impulses
provided by monetary conditions that have remained very generous for Spain's domestic situation.
The more disciplined application of other economic policies and a more flexible reaction on the supply
side of the economy, in line with the structural reforms undertaken, have helped maintain a setting
favourable to the progressive strengthening of activity. This confrms that the slowdown which touched
bottom in May 2002 has been put behind.
The growth differential with the euro area widened to almost two percentage points and held at around
this level in 2004 Q1. As a result, real convergence continued apace last year and Spanish per capita
GDP vis-à-vis the former EU-15 stood at 87.4%, one point up on 2002. Relative to the enlarged
25-member EU, this percentage rises to 94.4%, due to the lower level of development of the new
members.
The buoyancy of the economy in 2003 and in early 2004 continued to be underpinned by the same
foundations as in previous years, following a similar pattern. Firstly, as earlier mentioned, highly
favourable financing conditions have remained in place. These have been characterised by low
interest rates (which were cut further to historical lows), high rates of credit expansion and a notable
rise in the value of non-financial assets, adding to which in 2003 was the rally on stock markets.
Secondly, budgetary discipline has provided the necessary counterpoint to the stimuli stemming from
monetary and financial conditions, giving soundness and firmness to the environment of
macroeconomic stability. The resolve with which fiscal consolidation has been pursued in Spain was
manifest in 2003 in a general government surplus of 0.3% of GDP and in a fresh reduction in the
public debt ratio, which stood at 50.8% of GDP, far below the European average and the reference
value set in the Treaty on European Union.
Any overview of the bases underpinning economic growth should also highlight, albeit in third place,
the continuing support provided by strong employment generation. The moderation of labour costs,
which fell again in real terms in 2003, and the greater flexibility of hiring arrangements as a result, inter
alia, of the successive reforms introduced, were the factors behind the improved working of the labour
market as from the late nineties which has led to a high capacity for employment generation. The
improvement has proved to be a firm support for the sound performance of the economy, as it has
enabled labour supply to increase, allowing a flexible response to increasing demand. Al the same
time, the increase in employment has boosted household income expectations, which has helped
sustain domestic demand.
The composition of the Spanish economy's growth has continued to be essentially underpinned by
household consumption and construction. The improvement in the determinants of private
consumption, which accelerated in 2003, was also assisted by the easing of the inflation rate last year.
That made for an increase in the purchasing power of disposable income. Residential investment,
despite the strong increase in the relative price of housing, continued to rise at a high rate. And this,
combined with notable growth in public infrastructure works, fuelled the sustained increase in
construction.
Investment in equipment and exports of goods and services also recovered in 2003, but their
contribution to GDP growth was still modest. Indeed, it was these components which kept the pace of
recovery moderate. Investment in equipment increased by 1.9%, leaving behind the heavy contraction
of 2002. However, the pattern of its recovery is, so far, relatively weak in comparison with other similar
cyclical phases. The financial restructuring being implemented by certain large corporations, which
has limited their ability to spend on new projects, and persisting factors of uncertainty over the pick-up
in demand may have been behind the as-yet subdued response of this investment component
Goods exports expanded at a faster rate than their markets, despite the loss of competitiveness
induced by the appreciation of the euro. This favourable result was offset, however, by the sluggish
behaviour of tourism and by the rise in imports, boosted by the euro appreciation. Consequently, net
external demand exerted a significant contractionary effect on GDP, which has run into the opening
months of 2004. It should be borne in mind, moreover, that the employment adjustment in the
industries most exposed to foreign competition may be reflecting the fact that the defence of market
share is, in some cases, based on unsustainable processes that erode the economy's overall
competitiveness in the medium term.
Notable among the achievements in 2003 was the improvement in inflation which, after starting the
year at a rate of 4%, ended it at 2.6%. This sizable downward adjustment partly reflects the removal of
certain transitory elements from the index which had had an upward effect in 2002, but it was also the
result of the restraining impact of import prices, favoured by the euro appreciation and the slowdown in
oil prices. Overall, the reduction in inflation contributed to sustaining the purchasing power of income
and provided for a narrowing of the inflation differential with the euro area to levels more in line with
those experienced before the introduction of euro notes and coins.
Into 2004, economic trends in Spain point to a continuation of the path of gradual recovery, with no
far-reaching changes in the composition of growth in the short run. Growth remains buoyed by similar
factors to those driving it in the recent past, although investment in equipment can be seen to be
firming. Nonetheless, the fresh outbreak of oil price rises has had a significant inflationary impact
which has reversed part of the progress made last year and in early 2004. This new shock, to which
the Spanish economy remains relatively sensitive, may, if it continues, entail a net drain on income.
That would hamper the force of domestic demand, which would compound the foreseeably diminished
momentum under such circumstances of external markets. Despite these risks, the outlook is for
growth in 2004 and 2005 of around 3%, close to the economy's potential, which would be based on a
very gradual change in its composition, as productive investment progressively strengthens in
response to improved corporate earnings and to the completion of the restructuring currently under
way.
The longer-term projection of this trajectory, to ensure the sustainability of growth rates above the euro
area average, nevertheless requires far-reaching changes in the growth pattern to dispel the risks that
have been incubated. It is crucial that investment in equipment should gain in momentum and that its
greater vigour be accompanied by more expansionary, export-led net external demand. The
improvement in these components would then provide for a situation in which the necessary
moderation in household spending, especially on house purchases, did not lead to a loss of
dynamism.
It should not be forgotten that some of the factors behind the buoyancy of expenditure may tend to
lose steam or even disappear The most patent case here is that of the prolonged expansionary
influence exerted by lower interest rates. The current scenario of exceptionally low interest rates is the
result of a very particular economic situation at the European and international level. And although
EMU membership ensures moderation in rates, it is likely these will return to more neutral levels as the
recovery in the area takes hold. Nor is it conceivable that the exceptional intensity of employment
generation per unit of output in recent years can become a permanent feature. Probably, once the
labour market has been fully adjusted to a situation of price and wage stability and to a more flexible
regulatory framework, the relationship between job creation and growth in the economy will resume a
pattern more in step with long-term trends.
In this respect, it should further be borne in mind that the maintenance over a prolonged period of time
of a strong expansion in domestic demand, driven by substantially generous monetary and financial
conditions, entails pressures which, if they build up, may emerge precisely when some of the factors
upholding growth begin to show signs of petering out.
The foregoing comments indicate that the favourable growth prospects for the coming years cannot be
taken as guaranteed over the longer term. The Banco de España has been signalling the fact that the
prevailing growth pattern harbours certain risks that may emerge in the form of a deterioration in
competitiveness and financial imbalances in the households and non-financial corporations sector.
Although the trajectory of the Spanish economy has not yet been hampered by the emergence of
these risks, any future deterioration could impair further progress in real convergence.
Competitiveness can be undermined on several fronts. The first of these is the maintenance of a
persistent inflation differential with the euro area. This differential is partly related to the fact the
Spanish economy is ahead in the cycle, but it has also to do with the presence of elements of inertia in
wage and price formation in Spain associated with structural shortcomings in certain markets for
factors, goods and services. Another significant front is limited productivity growth, which is not only
lower than in the United States but also than in most of the European countries. Admittedly, low
productivity gains can be explained in terms of the intense employment generation in the economy
and of a composition of growth which, in recent years, has been largely based on construction and on
services. But they nevertheless reflect low productive investment, a limited incorporation of
technological improvements into the stock of productive capital and the relative lack of competition in
certain segments of the economy.
Safeguarding a sound competitive position for the Spanish economy is undoubtedly a priority for
economic policy management within EMU. As I have said, the activities most exposed to foreign
competition have begun to feel the effects of the losses in competitiveness that have built up. And
after squeezing their margins in recent years, they have begun to adjust their staff levels. Competitive
pressures are heightening, moreover, as new competitors emerge on the international scene with a
similar specialisation pattern to Spain and with a notable edge due to their low labour costs. In
particular, the enlargement of the EU to 25 countries, while entailing the opening up of potential new
markets for Spanish products, means above all a substantial increase in competition. The Spanish
productive system must prove itself able to respond to this with dynamism, innovation and flexibility, as
it has in the past when opening up to its external environment.
The second source of risk lies in the patterns of financial behaviour of the private sector of the
economy. It is well known that the strong growth of household and corporate demand has been
accompanied by a notable rise in borrowing and in their debt ratios. Although this has not led to any
deterioration in the financial position of these sectors (because their assets have also risen in value) or
to rises of the same magnitude in their debt burden (thanks to lower interest rates), their higher
indebtedness has made them more vulnerable to adverse changes in economic and financial
conditions.
Household debt cannot grow indefinitely at the rapid pace of recent years. The higher indebtedness
and the increasing weight of floating rate loans, along with the rising share of equities and real estate
in households' asset portfolios, have made their spending decisions more sensitive to interest rate and
asset price movements, in a situation complicated by the limited disposable savings remaining after
debt service.
The property market is particularly significant in this respect because most household indebtedness is
linked to house purchases. Although the supply of housing has responded fairly flexibly to the
increased demand and the price trajectory has not departed substantially from the pattern seen in
previous upturns, a certain degree of overvaluation of these assets is detectable in Spain. This
overshoot, which was not corrected in 2003, makes it particularly necessary for buyers and sellers in
this market to act cautiously. A gradual absorption of the overvaluation would establish a frarmework
of greater financial stability for households and forestall interference in their consumption decisions.
To address the risk factors mentioned above appropriately, it is necessary to embrace a gradual
change towards a growth pattern that is better balanced and more squarely based on those
expenditure items that most contribute to building the economy's productive potential and
competitiveness. The economic authorities can contribute to this by focusing the available economic
policy instruments on sustained macroeconomic stability, market flexibility and higher potential growth.
In the case of fiscal policy, a primary role must continue to be played by budgetary stability to prevent
demand-side pressures from exacerbating the existing risks, particularly in the present circumstances
of monetary conditions that are overly generous given the degree of firmness prevailing in domestic
spending. Consequently, the restrictive fiscal policy stance should be maintained and the budget
balance further improved, in step with the foreseeable firming of the recovery. This stance is also
needed to meet the medium- and long-term challenges to public finances. Here, the possibility that the
current pace of revenue growth may not be sustainable in the future, the probable rise in financial
expenditure (which has so far assisted consolidation), the foreseeable cutback in European funds from
2007 onwards and, in the longer term, the uncertainties over the sustainability of the pension system,
are factors that strengthen the case for surpluses in public finances in good times to stave off the
reappearance of major imbalances in the future.
From this standpoint, the allocation of pensions to the Reserve Fund with a charge to the social
security surplus is unquestionably an essential part of this strategy, although the amount of the funds
involved so far is small in comparison with the magnitude of the risk of increased pension expenditure
due to population ageing. Therefore, an attempt will have to be made aver the next few years to
entrench the social security surplus and thus ensure that this practice continues for a sufficiently long
period at a sustained rate. That said, achieving a soundly based social security system in the medium
term may require more ambitious policies, including reform of certain aspects of the pension systems.
At the same time, the maintenance of sustained growth over time requires a more efficient economy
with a more flexible pattern of specialisation and a more intensive incorporation of new technologies.
However, with a view to the future, this pattern, which has enabled a part of the considerable
unemployment generated in the past to be absorbed, cannot be considered satisfactory. First,
because the scant headway in productivity undermines the basis of competitiveness and, second,
because demographic developments indicate that, within a few years, employment will tend to make a
lower contribution to growth.
I am not going to list here the measures for raising productivity, but I would like to remind you of the
fundamental role of structural reform in this respect. As pointed out in the Annual Report, it is
particularly important to push ahead with labour market reform (in the areas of wage negotiation and
hiring), improve the workings of the housing market (and of the related land market) and continue with
the liberalisation of the network industries. Measures are similarly required to foster the incorporation
of technological innovation in productive processes and to improve the stock of infrastructure and of
public capital. The current house price situation means that urgent action is needed to overcome the
restrictions on the supply of land via more flexible town planning to make building land more readily
available and to improve the workings of the rental market. Finally, although the improvement of the
services sector depends on many structural considerations, the importance of more flexible retail trade
regulation for price formation and the economic system's overall efficiency should not be overlooked.
In short, without making any attempt to cover the entire scope of the economic policy requirements in
the present situation, I do feel it is important to emphasise that fiscal stability and structural reforms
can provide an appropriate means of addressing risks arising in relation to competitiveness and to the
growing indebtedness of the non-financial private sector, which are the ones that could jeopardise the
continuity of real convergence.
Financial system
2003 brought an improvement in the situation of the international financial markets and, in this
favourable setting, the financial institutions of a good number of countries reported better results and
higher profitability. The difficult times of past years, during which most institutions showed notable
resilience, led many of them to undertake reforms designed to reduce costs, such as the sale of
non-strategic assets, and these decisions should now be bearing fruit.
The improved situation of financial institutions at the international level seems to be borne out by the
favourable outlook for their future performance that agents operating in the markets have. In 2003 this
perception was reflected in rising stock market prices, reduced implied volatilities and narrowing risk
premia.
Spanish deposit institutions, thanks to their sound initial position and the fact that the Spani