Luis M Linde: The international economic environment and Spain's
economy
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 2013, Madrid, 4 October
2012.
* * *
Ladies and gentlemen,
The appearance by the Governor of the Banco de España before this Committee at the start
of the annual debate on the State Budget is a tradition I am most pleased to embrace. I shall
try to be as clear and direct as possible on those issues I consider most important.
The Draft State Budget Law for 2013 is being presented against a background of singular
difficulty for the Spanish economy.
I intend, first, to discuss the international economic context, in particular in the euro area;
second, to look at recent developments in the Spanish economy, with particular reference to
competitiveness and fiscal consolidation; and finally, to analyse the key features of the draft
Law.
Without overstaying my welcome, I shall, before ending my address, briefly discuss the
clean-up and restructuring programme for our banking system which, as you know, took a
significant step forward on 28 September with the publication of the evaluations of the whole
of the Spanish banking system. If you wish, we can go into greater detail on this matter in the
round of questions, given its importance for restoring confidence in our economy, in activity
and in employment, and, in short, for the implementation of the Budget for 2013.
The international context
The international context is a primary factor of difficulty. The latest analyses and projections
show signs of weakness, which can be explained to some extent by the difficulties the
European economies are facing in overcoming a sovereign debt crisis that has now lasted for
more than two years. While the growth forecast for the world economy as a whole in 2012
stood at around 4% a year back, this has now dipped to around 3%. The forecast for the
United States has improved, but that for the euro area as a whole has fallen from growth of
1.1% a year ago to a decline of 0.4%. And the growth forecast for the emerging economies
has edged down from above 6% to around 5%.
The forecasts for 2013 have also been lowered, especially for the euro area as a whole. The
sluggishness of the international economy and, in particular, of the euro area is bearing down
on our ability to recover.
Euro area governance
I would therefore find it useful to start with a comment on euro area governance and its
problems.
In my appearance before the Economic Affairs Committee last July, I addressed the source
of the sovereign debt crisis in Europe and the main reasons for its depth and development. I
believe I should reiterate that, to overcome the crisis, a new version of Monetary Union
governance will be needed.
There have so far been two different stages in the reform of European governance. In the
first, efforts focused on remedying the shortcomings detected in macroeconomic and
financial policy oversight and coordination, and on the creation of financial assistance
mechanisms. In the second stage, following the June 2012 Summit of euro area Heads of
State or Government, a banking union, greater fiscal integration and a common economic
policy framework were proposed.
Here you may recall that the European Commission communicated its plans for the banking
union to the Parliament and the Council on 12 September, with a legislative proposal to give
form to the first of the three pillars which would underpin such a union: a common
supervisory mechanism for which ultimate responsibility would be centralised at the
European Central Bank, while there would be scope for some degree of decentralisation,
enabling the knowledge and experience of national supervisors to be harnessed.
The move is just a preliminary one and should be viewed with caution, since in order to
complete the banking union an integrated bank crisis management mechanism and a
common deposit guarantee scheme will be needed. This will not be possible without
progress towards a fiscal union, an area that obviously poses most significant political
difficulties.
Along these same lines, I believe we should welcome the European Central Bank Governing
Council's decision on 2 August to set in train the so-called Outright Monetary Transactions.
This comprises a programme to purchase public debt on secondary markets, subject to
compliance with specific conditions, as part of the financial support programmes of the
European Financial Stability Facility and its successor, the European Stability Mechanism.
Since the start of this crisis the ECB has adopted a series of conventional (short- and
medium-term liquidity provision, changes in the deposit rate) and non-conventional measures
(long-term liquidity provision, debt purchases) aimed at preserving the sound functioning of
monetary policy, which is tantamount to saying the transmission of the policy rates the ECB
wishes to maintain at all maturities. These measures have also been useful in buying time for
governments to correct the macroeconomic imbalances and the shortcomings in the
institutional design of the euro which are, in part, at the source of the current fragility. The
Outright Monetary Transactions are a further example of this type of non-conventional
measure.
The new initiative is aimed at making sovereign debt markets work normally again, as their
yields bear indirectly, but significantly, on households' and firms' financing costs. The aim is
fully compatible with the ECB's mandate, as the President of this institution has stressed on
various occasions.
Evidently, the announcement of this programme has had a stabilising effect. But given the
nature of the problems at the source and in the development of this sovereign debt crisis, the
role that any ECB decision may play in resolving it can hardly go beyond mitigating the risks
of serious accidents and of providing more time so that the decisions that must be taken in
areas other than the ECB may come to fruition.
The Spanish economy
Let me now turn to the key features of our current economic situation.
The Spanish economy has been greatly affected by the financial tensions in the euro area,
which emerged with the outbreak of the international financial crisis in 2007-2008, and the
public finances problems of several euro area members, beginning with Greece. In our case,
the crisis reached us and, in turn, we contributed to its unfolding as a result of the doubts
over the sustainability of our public finances, our poor growth expectations and the scale of
our foreign debt, which essentially built up during the real estate boom.
Economic policy has striven to overcome various factors of vulnerability in a very adverse
macroeconomic setting. The results of the reforms undertaken are still incipient, and we must
persevere with this strategy, which is the only realistic way of resuming sustained growth.
As recent events in Europe show, there are feedback loops from public finances and their
problems to the banking system and its problems, and from the latter to activity and
employment. In turn, job creation and growth are essential ingredients for progress on fiscal
consolidation. Accordingly, economic policy-making should continue to be structured around
two main goals: promoting competitiveness and growth, and restoring the sustainability of
public finances. I shall briefly refer to these two major issues before analysing the Budget for
2013.
Competitiveness and employment
First, let us look at developments in employment and competitiveness, two closely
interconnected problems.
In terms of economy-wide unit labour costs, the cumulative loss to 2008 in respect of the
1998 level stood at 18%. In industry, and measuring competitiveness always in terms of unit
labour costs, it was almost 30%. Naturally, labour costs are not the only explanation for the
increase in unemployment, but they have undoubtedly been a major factor. That there were
serious failings in the regulation of our labour market is something that practically all
international economic organisations have been pointing out for years. The reform of our
labour legislation was unavoidable.
The changes made are essentially geared to increasing the flexibility of our labour market:
the priority of firm-level agreements, limits on the so-called "ultra-activity" of agreements, new
regulations governing dismissal for objective reasons and greater facilities for maintaining
wage restraint at companies in difficulty are all elements of change aimed at preventing
dismissals and higher unemployment from being the only option for many companies to stay
in business.
The macroeconomic projections accompanying the Budget for 2013 include the stabilising of
our unemployment rate at around 25% of the labour force, a rate double the average for the
European Union countries. This rate of unemployment is, quite simply, dramatic. Hence the
enormous importance of economic recovery and of greater labour market flexibility: these
two variables complement one another, and without both operating simultaneously, net job
creation will not be possible.
Fiscal consolidation
I shall now move on to public finances and to the nature of the fiscal drive needed.
In 2007 Spain posted a budget surplus of close to 2% of GDP and a public debt/GDP ratio of
37%, then one of the lowest among the euro area members. However, this apparently
healthy state of affairs concealed a precarious situation owing to the presence of high tax
revenue that had a significant temporary component tied to the major expansion of the
construction and real estate sector, and to unsustainable spending dynamics.
Indeed, the end of this expansion uncovered the risks latent in that situation. Almost half of
the deterioration of more than 13 pp of GDP over only two years from 2007 to 2009 - a
turnaround in public finances unprecedented in Spanish economic history - was due to the
fall in revenue, largely associated with the disappearance of the aforementioned
extraordinary revenue. Meantime, public spending climbed significantly, largely as a result of
the increase in unemployment benefits and in the interest burden, but also as a result of
spending on pensions and on government consumption. A further expression of the rapid
deterioration in the deficit was the most substantial rise in public debt as a proportion of
GDP.
The first conclusion that may be drawn from this analysis, and one which is very relevant for
understanding our present difficulties, is that the budget deficit arising with the crisis was
eminently structural. That is to say, it was not only due to the downward cycle, or to the
temporary discretionary measures with no lasting effect on public finances. In any event, the
outcome has been that the public debt/GDP ratio has not stopped growing since 2007, and
we will end the current year 2012 with a level close to 85%: i.e. an increase of almost 50 pp
of GDP over a period of only five years, which in itself is an indicator of the seriousness of
our crisis.
Reducing the budget deficit from its 2009 peak is proving anything but easy. Indeed, the
correction made in 2010 and 2011 was very scant, and was of course less than that initially
planned and desired. The budgetary adjustment is being made in highly adverse economic
and financial circumstances, compounded by the impact in the short run of the austerity
measures on economic activity. Moreover, stabilising the proportion of debt to GDP, which is
a key figure for restoring market confidence, is all the more difficult against a backdrop of
meagre growth or recession and of high interest rates on public debt.
Yet these contractionary forces can be mitigated if credibility in the process of fiscal
consolidation can be attained. From this standpoint, following the heavy slippage in the
deficit in 2011, the target of 6.3% of GDP for this year and the fiscal adjustment path to which
we have committed to 2014 should be the means by which the doubts of the European
authorities and the markets are dispelled.
The information currently available (on central government figures to August) indicates that
there are risks of slippage from the target set for 2012. Given the importance of achieving the
target, additional measures under the Budgetary Stability Law should be considered that
provide for the target to be met. I have some points to make in this connection.
First, most of the slippage seen has originated from adverse developments in public revenue,
partly deriving from the very nature of the adjustment under way in the Spanish economy.
The fact that, at present, the only source of improvement in economic activity is the external
sector (neither higher exports nor lower imports generate, per se, increases in tax revenue)
means that the prospect of buoyant public revenue is scant, and is compounded by the
intensity of the real estate adjustment. Against this background, maintaining a prudent
projection of public revenue is essential.
Second, instruments are needed that enable early detection of potential slippage in revenue
and expenditure during the fiscal year. The new Stability Law demands significant
improvements in the transparency of general government conduct, particularly in relation to
the budget outturn figures for regional and local government, which should be released with
the same periodicity, degree of detail, lag and ready accessibility as central government
data.
Third, the mechanisms enabling the prompt correction of any potential slippage must be
reinforced. Once again, the Stability Law includes new instruments, such as the automatic
adjustment of regional government spending in specific cases of non-compliance, the
possibility of establishing sanctions and also of central government imposing adjustment
measures. These new provisions may be effective in ensuring discipline, a matter that is all
the more important following the extraordinary measures adopted by the State to offer
liquidity support to regional and local government, such funds being conditional upon
compliance with adjustment plans.
And, fourth, the reinforcement of the credibility of the fiscal consolidation process takes on
great importance in the current situation of the sovereign debt crisis. It may be of help here to
establish a medium-term budgetary horizon providing sufficient details of the expected trend
of public revenue and spending and the assumptions on which they are based, and on the
contents of the planned measures and the expected effect they will have. That would all
contribute to reducing economic agents' uncertainty and would help identify the problems
ahead in the medium term.
In the fiscal consolidation process, the long-term perspective is fundamental. Over this
horizon, it is well known that the biggest challenge to public finances stems from the
pressure that population ageing will exert on specific expenditure items, particularly pensions
spending. Following the Social Security reform approved in July 2011, a specific definition is
now needed of the so-called "sustainability factor", which should result in an automatic
adjustment of the system's parameters if imbalances are detected in the long run.
The 2013 budget
Before moving on to the Budget for 2013, I would like to specify the framework for debate of
the draft legislation.
Spain is a very decentralised country in terms of public spending, more so than certain
countries with a federal political structure. Currently, almost half the consolidated public
spending in Spain, i.e. net of transfers between general government sectors, is by regional
and local government.
Based on figures for 2011, central government was responsible for only 22% of total public
spending; regional government for 34%; local government for 12%; and the Social Security
system for 32%. That is to say, overall central government and social security spending in
2011 accounted for only 54% of the total, while that of regional and local government
amounted to 46%. The picture given by the State and Social Security Budget is thus
necessarily incomplete in respect of overall general government spending.
Admittedly, prior to the presentation of the State Budget, Parliament and the Senate have
approved the budget targets, both for overall general government and for each of its
sub-sectors, on the proposal of the Government and following a report by the Fiscal and
Financial Policy Council and the Local Government National Board. Yet clearly the budgets
of each regional government and each municipality are approved separately, there being no
document containing information on all of them, together with that on the State and Social
Security Budget. Hence, although we do have ex-post information that enables the public
spending outcomes and outturn for the four major spending groups - central, regional and
local government, and the Social Security system - to be analysed, we do not have an
ex-ante or prior document that provides a detailed analysis of budgetary projections for
overall general government and its compatibility with the objectives set.
It should be recalled, however, that the new Budgetary Stability Law introduced substantial
improvements in this respect. Specifically, it stipulates that, before 1 October each year,
regional and local government shall submit information on the essential items contained in
their forthcoming budgets to the Ministry of Finance and General Government. Then, before
15 October, the Ministry of Finance and General Government will release a report on the
alignment of this budgetary information with the stability objectives, in such a way that the
Ministry may make recommendations should it perceive slippage. And, finally, before 1 April
the following year, the Minister of Finance and General Government has to submit a report to
the Government on the degree of fulfilment by all tiers of government of the objectives in the
initial budget. I consider that these reports should in fact offer this complete picture of the
budgetary projection that we are today lacking.
I would further remind you that the Government has announced the creation in 2013 of an
Independent Fiscal Authority to ensure compliance with budgetary regulations. This type of
institution has proven useful in other developed countries in enhancing budgetary policy
credibility. It is, however, crucial that such an institution should enjoy a degree of
independence, effective responsibilities and resources in line with best international
practices.
I will now discuss the essential features of the State and Social Security budget for 2013.
Macroeconomic setting and fiscal deficit
The draft State Budget for 2013 is part of a macroeconomic setting in which real GDP is
estimated to decrease by 0.5% as a result of a negative rate of change in national demand of
2.8%, which would be partially offset by a 2.3 pp contribution from the external sector.
This projection of a 0.5% decline in GDP in 2013 is clearly optimistic compared with the fall
of around 1.5% currently projected by most international organisations and analysts.
That said, I would like to make two observations. Firstly, if indeed the fall in activity in 2013 is
closer to 1.5% than 0.5%, the foreseeable impact on the deficit can be estimated at 0.3 pp of
GDP. This deviation is substantial, but it would be possible to correct it during the year.
Secondly, all projections of changes in activity should be viewed with caution and with some
distance. The history of forecasting errors and corrections to all manner of projections
- including those of international institutions, large investment banks, government and, of
course, the Banco de España - would fill many pages. In short, while considering that the
rate of change in GDP for 2013 contained in the Budget is certainly optimistic, I would like to
add that I do not think it is a serious difference or that it should detract credibility from the
fiscal consolidation exercise undertaken in 2013.
The Budget proposes an overall general government budget deficit target, in National
Accounts terms of 4.5% of GDP, down from 6.3% projected for 2012, excluding from this
year the impact of the support measures for financial institutions. The target for 2013 is in
line with our European commitments and will require a reduction in the primary deficit of
almost 2.5 pp of GDP.
In terms of the different agents, a deficit target, in National Accounts terms, of 3.8% of GDP
is proposed for central government and the Social Security system, compared with a deficit
of 4.5% of GDP projected in 2012, which would represent an improvement of 0.7 pp of GDP,
similar to that projected for the regional governments, which should reduce their deficit from
1.5% in 2012 to 0.7% in 2013. The adjustment would be completed with the projected
reduction of 0.3 pp in local government to reach a balanced budget in 2013.
Revenue
On the revenue side, this budget tightens the fiscal pressure both in terms of direct and
indirect taxation, with a range of new measures. Furthermore, it should be recalled that, in
2013, the measures approved in 2012 in relation to higher personal income tax rates, the
increase in the rate on income from fee-earning activities, changes to corporate income tax
and the rise in VAT rates will still have a significant impact.
Despite the background of recession, the tax take is projected to increase overall by 3.7%.
The net effect of all the tax regulation measures with an impact in 2013 is estimated to be
approximately €7.2 billion. Net of this impact, revenue would fall by 0.5%.
As for the Social Security Budget, the 1 pp reduction planned last July is postponed or ruled
out, and a 1.1% fall is projected in 2013 in total social security contributions compared with
the initial budget for 2012.
The projected tax revenue for 2013 is subject to downside risks because it is based on the
assumption that the revenue targets for 2012 will be achieved. However, on the information
currently available, it cannot be ruled out that revenue performs worse than expected in
2012. If this risk materialises and is not countered by appropriate action in the remainder of
the year, that would make it difficult to achieve the targets set for 2013, compounding the
possible effects of a bigger decline in GDP than that assumed in the budgetary
programming.
Expenditure
On the expenditure side, the weight of three items should first be underlined: Social Security
system contributory pensions, unemployment benefits and the interest on government debt.
In 2012, these three items are equivalent to 20% of GDP and will account for approximately
36% of total public spending. In 2013, these percentages will foreseeably increase
significantly.
Noteworthy among the measures considered on the expenditure side are: the freezing of civil
servants' and public-sector employees' salaries, although they will recover their December
extra payroll, which, together with not filling vacancies, will result in a very low increase in
personnel costs in relation to serving employees of around 0.1%. Real investments are
reduced by 46%, whereas the interest burden increases by more than €12 billion.
In the Social Security system, spending on contributory pensions, sickness and other
benefits will grow by slightly more than 5%, factoring in the raising of pensions by 1%.
Foreseeably, however, spending on unemployment benefits will fall by slightly more than
6% due to the projected stability in unemployment figures and to regulatory amendments to
the benefits system. Note, however, that changes in expenditure on social security pensions
in 2013 will be affected by the revision that should be made, taking into account the inflation
rate recorded to November 2012. Since an increase of 3.5% is projected and the
corresponding adjustment payment could be around 2.5%, that would represent an increase
in spending of approximately €3 billion in 2012, which would be consolidated in 2013 and in
future years.
I should mention that, in the next budget, one of the most important agreements of the
so-called Toledo Pact will finally be concluded, in connection with the separation of the
system's sources of financing: on one hand, contributory pensions will be financed
exclusively by contributions; and, on the other, the non-contributory top-ups and
non-contributory pensions will be financed by taxes. This separation, which began to be
applied in 2002, will be completed in 2013: and this is good news for the proper functioning
of the system as a whole and for its future.
Public debt
As I indicated above, from the beginning of the crisis in 2007 until the end of 2012, the ratio
of our public debt - as defined in the Excessive Deficit Protocol - to GDP has increased by
50 pp. Undoubtedly, this is the highest increase over the shortest period in this ratio in
Spain's economic history. The increase from 2011 to 2012 will amount to 16 pp of GDP, of
which: 7 pp are explained by the deficit (4 pp by the primary balance and 3 pp by interest);
nearly 1 pp is due to the fall in nominal GDP nominal, and 8 pp are attributable, essentially,
to the financing of the Plan to Pay Suppliers and €30 billion of the amount estimated by the
FROB to be drawn down from the European Financial Facility before year-end.
This ratio is projected to grow more moderately in 2013, from 85% to 91% of GDP, i.e. an
increase of 6 pp compared with the 16 pp we will record in 2012, and will be almost
exclusively due to the increase in the interest burden on public debt because, if the
projections are fulfilled, the primary deficit will be 0.7% of GDP in 2013.
Clean-up and restructuring of the banking system
I would not like to conclude without commenting, albeit very briefly, on the programme for the
clean-up and restructuring of our banking system.
As you know, a further step has been taken with the publication of the estimates of capital
needs, based on the stress tests performed by an independent appraiser, supported by audit
firms and real estate appraisal companies under the supervision of the European
Commission, the European Central Bank, the International Monetary Fund and with the
participation of the Ministry for Economic Affairs and the Banco de España.
I will not repeat here the figures already published and explained and which were yesterday
commented on by the Minister for Economic Affairs and Competitiveness before the
Economic Affairs Committee.
However, I do want to say that the exercise performed is unprecedented in terms of its depth
and detail, the severity of the macroeconomic assumptions accepted and the scrutiny to
which it was subject throughout by experts from the institutions I have mentioned above.
But there is still some way to go in the clean-up and restructuring of our banking system. The
Memorandum of Understanding signed last July sets out the steps now to be taken, which
the Spanish authorities - and, rest assured, the Banco de España - will comply with as
precisely as possible.
The restructuring or resolution plans for banks owned by the FROB must be approved before
December 2012. Also, before November, we shall have at our disposal the recapitalisation
plans of banks which cannot meet their capital shortfall without State aid, on the
understanding that banks which are not considered viable will be resolved orderly in
accordance with the terms of the corresponding resolution plan. Banks that can meet their
capital shortfall without resorting to State aid will be required to implement their
recapitalisation plans before June 2013.
The other key component of the Clean-up Programme is the Asset Management Company
which should be operational at the beginning of 2013. It is key because it will permit the
clean-up of the banks requiring State aid to be completed and will provide a suitable horizon
for the management and sale of the mass of assets to be transferred.
Conclusions
The Budget for 2013 involves a considerable drive in respect of fiscal adjustment. It attempts
to bring about a correction in the primary deficit, net of interest on public debt of almost
2.5 pp of GDP. In the depth of a recession, that is very difficult, but necessary in order to
meet the targets to which Spain is committed within the framework of the European Union
and the euro area.
We have some data which, although not warranting excessive optimism, do indicate that an
adjustment is being achieved. We are going to end 2012 with a current account almost in
balance, and in 2013 it will probably run a surplus. The recession has a contributing factor,
but not the only one. We also have a clear improvement in competitiveness based on
changes in our labour costs and in productivity.
The most pressing problem facing the Spanish economy is to restore market confidence.
There is no other way to achieve this than meeting the fiscal consolidation targets,
completing the clean-up and restructuring of our banking system, continuing with the process
of private and public deleveraging and moving ahead with the reforms undertaken to improve
our competitiveness.
If we manage to make progress on those fronts in 2013, I am confident it will be possible to
resume economic growth and to create net employment in 2014.