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, 7 October 2008.
* * *
Budgetary discussions this year are taking place at a time when the Spanish economy is
deep in a process of adjustment proving much more pronounced than initially expected. The
international backdrop is marked by the weakening of the US economy, sharp rises in oil and
commodities prices and, above all, the scale and persistence of the turmoil on international
financial markets. Given the latest events in the United States and Europe, it is no
exaggeration to say that we are faced with a global financial crisis without precedent in
recent times which will require an overhaul of the principles that have governed the
regulation of international finances in recent decades.
The world economy is in exceptional circumstances, with a general loss of economic
dynamism, surging inflationary pressures and serious financial instability problems. These
are exacerbating and accentuating the adjustment of the Spanish economy which the
exhaustion of the cycle had already set in train, following a long period of expansion.
Moreover, this is the first occasion on which the Spanish economy has faced such a process
since joining the Economic and Monetary Union, which provides undoubted buttresses but
also poses considerable challenges. The economic policy debate behind the preparation and
approval of the Budget is thus of crucial importance.
The far-reaching changes in the Spanish economy in recent decades have equipped it with
the wherewithal to overcome this difficult stage and to subsequently resume a path of
sustained growth, allowing convergence to continue. But if these factors are to operate, the
authorities and all agents must face up to the current circumstances and make the required
efforts, and economic policies must prevent any slippage and enable the factors conducive to
the resumption of sustained growth to come into play.
Naturally, I shall focus today on the diagnosis of the situation of the Spanish economy and on
its economic policy implications. But these would both be incomplete without some, albeit
brief, reference to the deterioration of the international setting and to the economic outlook in
the euro area which, as you know, will determine monetary policy developments.
Last year, the growth of the world economy reached 5%. The forecasts available for this
year, however, place the figure below 4%, with scarcely any scope for the start of a recovery
in 2009. Moreover, any recovery will be moderate, slow and subject to a degree of
uncertainty fuelled, among other developments, by a rise in major inflationary pressures in
most economies. In my view, there are three basic factors behind this deterioration of the
global economic situation.
The first is the adverse behaviour of the US economy, weighted down by the continuing
decline in its real estate sector, which is depressing household and investor confidence. Until
relatively recently, the emerging economies have been considerably more dynamic, partly
offsetting the greater slackness in the more industrialised countries such as the United
States. However, doubts over the real ability of these economies to continue posting robust
growth rates amid the virtual stagnation of the more advanced countries are ever greater.
The increase in oil and commodities prices is the second of the basic factors behind recent
developments in activity and inflation at the global level, despite the relative easing since the
summer. The effects of these price rises have been fully felt in the more advanced
economies, while in the emerging economies the pass-through of higher energy costs is
proving slower and is still far from complete.
But it is the third of these factors that will most likely influence developments in the world
economy in the coming quarters. I refer here to the severe worsening of the financial crisis in
United States and in much of Europe, and to the turmoil on international financial markets.
Somewhat more than a year back now, when the US subprime mortgage crisis broke, there
was great uncertainty over the scope and duration of the episode then beginning. Today,
there is unfortunately no doubt that we are facing a global financial crisis of enormous
proportions.
Although at first the difficulties appeared to be confined to just a few investment funds and
relatively minor US mortgage institutions, the overall number of banks affected has since
widened considerably. We have witnessed a process, with no practical solution in sight,
involving nationalisations, bankruptcies, bank interventions, the creation of new investor
guarantee schemes and considerable curbs on market practices, such as those affecting the
short-selling of equities.
The list of institutions affected includes most notably: the major investment banks, whose
business model has succumbed to the turmoil; the US government-sponsored mortgage
agencies; one of the biggest worldwide insurers; and major US credit institutions. In Europe,
UK, Danish and Icelandic banks have been involved, as have more recently those from euro
area countries such as Belgium, the Netherlands, Luxembourg, France and Germany.
Moreover, several European governments have announced their readiness to guarantee
their banks' deposits.
The foregoing developments pale into insignificance in the face of the importance of the US
Treasury's decision to propose a far-reaching programme whose stated aim is to tackle
globally the serious problems besetting the American financial system. The initial
appropriation of $700 billion for this programme, and its dramatic presentation by the US
Treasury Secretary, illustrate the scale of the problem. As you are aware, the plan was finally
approved following heated debate in the House of Representatives and in the Senate.
Clearly, beyond its effects on specific banks, this unprecedented crisis is profoundly shifting
some of the key coordinates that have framed global financial developments in recent
decades. An economy such as Spain's, which has been financing a substantial proportion of
its expenditure abroad, can hardly isolate itself from the consequences of such deep-seated
changes.
International financial markets have moved from a situation of widespread risk
undervaluation to one in which extraordinary caution is exercised in their evaluation. Past
experience has clearly shown the tendency of markets to overreact. It is even possible that
certain recent developments reflect, at least partly, an excessive reaction. But it is
unreasonable to expect that, once the situation has returned to normal, international
financing conditions will simply be as they were prior to the summer of 2007, which nobody
today hesitates to qualify as excessively lax.
Likewise, few question the fact that the expansion of the balance sheets of a large number of
major financial institutions exceeded limits which should not have been overstepped. The
current deleveraging process may initially reflect the correction of some of the excesses
committed. But taking a broader view, it also reveals a more fundamental movement towards
a general reduction in the debt levels of financial intermediaries and the containment of credit
flows, the effects of which must likewise be felt by the ultimate borrowers, namely
households and firms.
Finally, I should point out that the magnitude of the imbalances generated and the scale of
intervention designed have prompted a necessary pause for reflection on the role the
economic authorities should play in developing and supervising financial markets.
For the moment, however, I shall simply reiterate that one of the aspects highlighted by the
current financial crisis is how important it is for central banks to have the appropriate
instruments with which to manage their liquidity provision policies with sufficient flexibility.
And all the more so in the presence of turmoil which, as at present, is profoundly altering the
operation of the channels through which liquid resources are normally re-distributed among
the various banks that apply for them. In this respect, it is widely acknowledged that the
Eurosystem's monetary policy operational framework is allowing euro area banks' liquidity
requirements to be met, thereby preventing the emergence of additional pressures that might
exacerbate the situation on financial markets.
In any event, returning to the most important macroeconomic developments that will
influence the performance of the Spanish economy, it is clear that financial conditions in the
euro area, as in the rest of the world, have tightened notably. Such tightening has
compounded the adverse effects of the oil and commodities shocks on agents' real incomes
and output capacity. The latest data, for the second quarter of the current year, show how
the growth rate in the euro area has weakened to 1.4%, standing below potential. The latest
ECB projections pointed to increases of between 1.1% and 1.7% this year, and between
0.6% and 1.8% in 2009, subject to considerable uncertainty and to downside risks that have
increased in recent weeks.
In addition, while growth was slowing, inflationary pressures were heightening and inflation
expectations were being revised upwards, which has raised the risk that they may become
unanchored. Nobody doubts that an eventual loss of control of inflation, with the subsequent
deterioration in price expectations, would contribute to seriously exacerbating a slide towards
economic weakening in the area.
Such is the difficult setting in which the ECB Governing Council has had to take its monetary
policy decisions. These decisions have been pondered bearing in mind at all times the
impact of tighter financial conditions and of the change in the dynamism of demand. Thus,
against a backdrop of growing uncertainty, it was decided to hold interest rates steady until
last July, when the materialisation of some of the previously identified risks to price stability
made a 25 bp increase necessary.
At the recent Governing Council meeting, however, we noted a weakening in activity in the
area and the fact that the latest price data point to the onset of some easing. Inflationary
risks have therefore diminished somewhat, though they have not disappeared, meaning that
monetary policy should continue contributing to containing them. Given the seriousness of
the tensions on international financial markets, we also reiterated the readiness of the
Eurosystem to provide all the liquidity required for as long as should prove necessary.
Let me now turn to the Spanish economy. As I was able to explain to you here before the
summer, the change in cycle in Spain had started before the episode of financial turmoil,
making itself felt mainly in the real estate sector, which set in train a correction of the
excesses that had built up during the long expansionary phase.
These excesses had largely arisen owing to the global environment of financial laxity and
undervaluation of risk, and to monetary and financial conditions that were particularly
accommodative for Spain following EMU membership. These conditions were based on
interest rates that held at low levels over a very extensive period and which were conducive
to rapid indebtedness by households and by firms, mainly those related to the real estate
sector.
In any event, the adjustment of the real estate sector began slowly, mirroring the gradualism
with which the determinants of residential investment changed. Hence, as the change in
monetary policy stance that began in late 2005 progressively passed through to household
and corporate borrowing costs and as the overpricing of housing became more patent, the
dynamism of the sector eased off.
However, this gradual pattern was altered when the international financial crisis raised credit
risk premiums across the board, blocked a most significant part of banks' wholesale funding
mechanisms and spread uncertainty and mistrust, most particularly in respect of economies
subject to real estate adjustments. Against this background, the demand for housing fell off
drastically, when the production of houses was still at a very high volume. House prices, after
several years of increasingly more moderate rises, began to post small declines in some
market indicators as from the second quarter of this year, while housing starts fell by almost
half. This abrupt change in scenario, together with the tightening of financing conditions,
which I shall address in greater detail later, meant that real estate companies had to
restructure, with some of them even going bankrupt. This series of factors compounded the
correction of the residential sector with adverse consequences for employment, which is
acting as the main channel through which the adjustment of the sector is spreading to the
rest of the economy.
Household consumption is rapidly reflecting the deterioration in confidence, against a
backdrop of considerable financial tensions, and the abrupt turnaround in the employment
situation. As a result, a certain rise in the saving rate consistent with the current scenario of
greater uncertainty and financing difficulties might be taking place. I should stress that this
far-reaching slowdown in private consumption is the factor that is most contributing to the
loss of dynamism in the economy. Business investment also slowed rapidly, in line with the
changing financial conditions, the profile of domestic demand and the deterioration in
business confidence. Nonetheless, exports are sustaining a relatively high growth rate,
despite worsening world trade so far this year, and they are providing some support to
investment in equipment.
This sound performance of foreign sales, along with the marked cut in the rate of increase of
imports, has seen the external sector make a positive contribution to GDP growth for the first
time since 2001, partly cushioning the slowdown in national demand. Net external demand is
therefore providing a buffer of support against the widespread weakening trend.
On the supply side, the fact that the sharp adjustment in employment is taking place just
when labour costs are posting high increases is of particular relevance. This is because
collective bargaining is taking on board the deterioration in inflation expectations and
because the activation of indexation clauses is passing through last year's inflation deviation
to wages. Unfortunately, there is a risk that this will occur again in 2009, potentially causing
second-round effects in an economic situation in which the behaviour of employment is very
important, as I stated, for regulating the cyclical downturn in the economy. Furthermore, this
increase in wages has not been accompanied by productivity gains on a similar scale.
Therefore, the increases in unit labour costs continue to be higher than those of our trading
partners. If, moreover, business margins were to continue widening as they have in the past,
the difficulties for the economy of competing abroad would increase, undermining one of the
potential sources of recovery.
Inflation posted a rapid increase in the first half of the year, despite the loss of momentum of
activity. As in other countries, the surge in oil and food commodities prices largely explains
this, although the Spanish economy's high energy dependence and low energy taxes have
tended to amplify this effect. The latest figures point to the start of what should be a phase of
gradual containment, though I shall return to this point later.
Among the factors that have weakened expenditure growth is the tightening of financial
conditions. Given its close relation to the international financial crisis, it is appropriate to
focus on the analysis of the behaviour of credit in Spain during this period.
Loans granted by resident banks to Spanish households and firms began to slow before the
increase in defaults on US subprime mortgage loans unleashed the present international
financial crisis. The gradual increase in financing costs, the downward revision of
expectations of future income and rises in wealth, and the very levels of debt attained had
already acted before the summer of 2007 to lower the growth rate of debt towards a more
sustainable pace.
Naturally, greater caution in risk assessment and the sharp reduction in international
financing flows that the international financial crisis has entailed have further dampened the
supply side, likewise contributing to slowing credit.
As an overall result of both forces, the latest figures show year-on-year growth rates of
financing to Spanish households and firms of around 10% and 7%, respectively. Analysed
from a shorter time perspective, the expansion of credit proves somewhat more moderate,
although it is not significantly removed from nominal GDP growth. As might be expected in
the current situation, characterised by greater uncertainty and risk aversion, new loans are
being granted under more onerous conditions than in the past, which include lower
loan-tovalue ratios and shorter maturities.
The trajectory followed by credit in Spain to August may be said to be behaving in a manner
consistent with the process of adjustment the Spanish economy is undergoing and with the
prevailing global conditions, which entail higher financial costs, heightened risk aversion and
serious difficulties in obtaining funds on international financial markets.
From the standpoint of financial stability, Spanish banks have demonstrated greater
resilience than their counterparts in many other countries. But as I have previously stated,
there is no room for complacency here, since the challenges ahead are considerable. A crisis
such as that currently rocking worldwide financial markets can hardly be neutral for those
who depend on such markets to a relatively greater extent. And nor can the fact that a
sizeable portion of the Spanish financial system's financing flows is tied in one way or
another to the real estate sector be ignored either.
However, for numerous reasons, including most notably the quality of our regulation and
supervision, Spanish banks have not been involved either in the generation, marketing or
acquisition of the toxic financial products that are inflicting such harm on the international
financial system. Their levels of efficiency, profitability and solvency have placed them,
moreover, in a position of relative strength to withstand this crisis.
Accordingly, and in the light of the events currently unfolding daily in the international
financial system, I wish to make a call in my capacity as governor of the Banco de España
for calm, and to reiterate my confidence in the Spanish financial system, which is well
managed, regulated and supervised. I can assure you that at present there is no threat to
Spanish depositors' savings.
All these considerations on the international financial crisis add great uncertainty to the
outlook for growth in the Spanish economy. The information available points to practically
zero or even negative quarter-on-quarter rates of change in the second half of the year, and
to the extension of the adjustment into 2009, with rates of increase in output that are more
difficult to gauge but which will probably also be weak. The ongoing correction of residential
investment may be expected to intensify, since the figures for work under way will show next
year that housing starts have ground to a halt. It is likewise foreseeable that the slowdown in
consumption will continue, due above all to the weakness of employment, and that business
investment will mirror the decline in activity. Accordingly, the contribution of domestic
demand to GDP growth might turn negative, and would only be relieved by the external
sector if the buoyancy of exports and, as seems likely, the slowdown in imports continue.
The importance that the dynamising effect of the external sector acquires in the current
circumstances highlights the relevance of competitiveness in the future.
The foreseeable trend of inflation points to increasingly more moderate average price
increases during the rest of the year, owing largely to the baseline effects of the energy and
processed food price increases late last year and to the recent declines in crude oil prices,
provided these are sustained. This trajectory should extend over the coming year, further
supported by the sluggishness of demand. However, to attain fuller and more sustainable
convergence with the euro area, the upside risks stemming from the indirect and
secondround effects of cost and price increases this year must be prevented from materialising.
The macroeconomic basis on which the government has drawn up the State Budget for 2009
includes, in its main outline, the trajectory of the macroeconomic adjustment I referred to
earlier. But it is subject to major downside risks, especially as regards the course of domestic
demand and, in particular, of residential investment. It should further be borne in mind that
the global economic situation and the impact of the international financial turmoil tend to
heighten these risks.
The design of the Budget should take into consideration the pronounced change in the
economy's cyclical situation, and bear in mind the speed at which public finances are being
affected. In previous public appearances I have warned that the sound fiscal results of the
previous years had a component very closely linked to the expansion of the real estate
sector, which would tend to disappear in lower growth phases. Unfortunately, the loss of
momentum of tax revenue is proving acute. And combined with the significant
revenuerelated impact of the expansionary measures taken this year, that means that the end-year
figures for public finances in 2008 will be worse than projected only a few months ago, and
that the general government balance at the end of the year will be in deficit.
The weakness of activity in 2009 will give rise to a deficit-widening dynamic which, given the
uncertainty facing us, will mean that that the deficit may be greater than forecast in the draft
Budget. I must reiterate here the call for prudence in fiscal policy management, whereby
budgetary policy should focus on allowing the automatic stabilisers to continue deploying
their intended countercyclical effect, while preserving the bases for maintaining a sound
position in the long term. Given the uncertainty surrounding the world growth scenario, it is
important that fiscal policy should retain room for manoeuvre in the face of potential
situations of greater weakness. Nothing could be worse than having to face fresh turmoil
when the only option possible is that of having to reduce the deficit, as we have had to do in
the past and as has happened recently in other developed countries. Further, the major
advantage for the Spanish economy that maintaining a comparatively low public debt/GDP
ratio entails should be preserved.
Watchfulness will also be needed to prevent current expenditure overruns that reduce the
leeway available to undertake public investment programmes and fulfil other productive
expenditure commitments made in the Budget. We should not forget that when public
overspending occurs, the subsequent adjustment usually falls on productive spending and,
most particularly, on public investment, with adverse consequences for long-term growth
potential. In the current circumstances, moreover, having some scope to carry out the
infrastructure investment plans under way is crucial for smoothing the adjustment in the
construction sector.
The State Budget should, in my view, comply with these premises. But the regional and local
governments also have a major role to play in this task, since they account for a most
significant portion of public spending - and, in particular, of public investment - and are
facing a phase of rapid decline in their revenue-raising capacity.
Elsewhere, a worrying aspect of the scenario I have described is the speed and intensity of
the response by employment, which is amplifying the effect of the correction of the housing
sector on the rest of the economy. This reveals the persistence of inadequacies in the
workings of factor and product markets that mean that the weight of the adjustment falls on
the level of employment, hindering the necessary reallocation of productive factors across
sectors.
The behaviour of wage costs and the high margins seen in certain activities tend, moreover,
to make the inflationary episode more persistent, with the adverse consequences this may
have for price and cost-formation habits and for the trend of the relative prices and costs that
bear on the economy's competitiveness.
It is therefore very important not to lose sight of the fact that the main instrument available in
the current circumstances is that of making structural reforms that enhance the economy's
flexibility, liberalise certain sectors and markets, and increase competition. Despite the efforts
made in recent decades, there are still numerous areas of the Spanish economy that need
reforms. I do not intend to address these in detail, but I shall refer briefly to those spheres
where I consider pressing action is needed. And I should stress that it is here where the
potential room for manoeuvre to counter weakening growth in the euro area is to be found.
In the labour market, it is imperative to bring about a milder reduction in employment in
cyclical slowdowns. In this connection, we must explore channels which provide a response
by wages to changes in the economic environment, aligning them to productivity gains, and
avoiding upward inertia in the face of external shocks introduced by mechanisms such as
wage indexation clauses. It is also vital to hold long-term unemployment at low levels, and to
do this the move from unemployment to employment status must be made easier, improving
the workings of employment services and the effectiveness of active policies.
In the housing market, the regulations governing renting must be improved to make it more
flexible and profitable so as to promote the acquisition of houses for investment purposes,
and thus help reduce excess supply. Further, putting these houses on the rental market
would make it easier to meet the population's demand for residential services.
In services activities and, in particular, in the distributive sector there is also much scope to
set in place a more competitive environment and achieve sizeable gains in efficiency. I
consider that the transposition of the services directive offers a unique opportunity for
headway in achieving the objective of reducing our rate of inflation and increasing the
economy's competitiveness and household purchasing power in a setting in which incomes
have been dented by dearer oil and the slowdown in employment.
With the same objectives, improvements in the regulation of the network industries and, in
particular, of the energy sector should be made to promote competition and increase energy
efficiency. The same applies for port, airport and railway freight transport services, sectors
which are essential for strengthening the competitiveness of Spanish industry and exporters.
To conclude, I am confident that if the Spanish economy is capable of mobilising the
potential nurtured over many years of building up stability and improving the workings of
markets and institutions, then it may rise to the challenges and difficulties facing it and
continue to make progress in the medium term in narrowing the welfare differences with the
most advanced countries.