Jaime Caruana: Overview of the Spanish economy in 2004
Address by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee
on Banking Supervision, to the Governing Council of the Bank of Spain on the occasion of the
presentation of the Annual Report 2004, Madrid, 10 June 2005.
* * *
Ladies and gentlemen,
The performance of the world economy in 2004 was exceptional: growth exceeded 5%, the highest
rate for the last quarter of a century; inflation remained under control, with the exception of slight rises
in some emerging countries; and the climate on international financial markets was relatively relaxed,
allowing generous financing conditions in most countries. No headway was made, however, in
correcting the world economy's main disequilibria, which tended to worsen. Adding to these
imbalances was the shock of higher oil prices, which look more permanent than in previous episodes.
There are thus persistent risks and vulnerabilities which, if not corrected, might endanger the
continuity of growth.
Underpinning the buoyancy of the world economy was, above all, the contribution of US and, to a
greater extent, Chinese demand, along with that from other emerging Asian economies. There was
also a marked rise in activity in other emerging regions, such as Latin America and the central and
eastern European countries. Conversely, the economic performance in the euro area and Japan was
disappointing, with rates of expansion running below initial forecasts. That would appear to confirm the
scant flexibility of these economies and their limited responsiveness to changing conditions on world
markets.
Recent growth patterns have also led to widening divergence between the growth rates of the three
main developed areas, as the high rate of expansion of the US economy increased and that of Europe
and Japan declined or rose less than expected. This bore unfavourably on the global disequilibria, as
manifest in the widening US current-account deficit, the counterpoint to which was the rising surplus in
Japan, China and other Asian economies, as well as in the oil-exporting countries, while the slight
surplus in the euro area increased very moderately.
The prolonged deterioration of the US external balance - linked to a very expansionary fiscal policy
that has compounded the effects of scant private-sector saving in recent years - engendered
expectations of a depreciation of the dollar on international foreign exchange markets, which
materialised only partially and asymmetrically. Consequently, while the dollar depreciated significantly
against the euro until late 2004, it held very stable against the Asian currencies with which most of the
US external imbalance has been built up. The effective depreciation of the dollar was thus only 5% in
2004.
The dollar's fall in the period 2002-04 has not prompted a turnaround in the progressive widening of
the US external deficit, either because, as is well known, depreciations tend only to correct
currentaccount deficits with a lag, or because of the aforementioned asymmetry in the behaviour of the dollar
against the main currencies and the fact that it has scarcely depreciated against the currencies of the
countries that are running the counterpart surpluses. In turn, in a situation of large current-account
surpluses and strong capital inflows, the Asian countries with de jure or de facto fixed exchange rates
against the dollar continued to build up sizable international reserves.
The need of the Asian central banks to place these reserves also partly explains another salient
feature of economic developments in 2004: the maintenance of long-term interest rates at abnormally
low levels. This is also largely attributable to the persistence of low inflation expectations, set against
highly credible counter-inflationary monetary policies, and to the conditions of ample liquidity in which
international financial markets operated. For much of the year, European bond yields were markedly
synchronous with their US counterparts, despite the different position of the fundamentals of the two
economies. From November, however, European rates declined, moving progressively away from
US rates so that the yield spread between these areas widened considerably. This more recent
development is consistent with the uncertainty over economic recovery in the euro area and the
brighter outlook for the US economy.
But perhaps the most salient international economic development in 2004 was the persistent rise in oil
prices. At the root of this, above all, is the force of demand from the United States and China, in a
situation marked by production and refining capacity bottlenecks, arising from limited investment in the
past. Compared with other recent periods of oil price rises, such as the peaks in 1990 and 2000 linked
to geopolitical tensions, the increase in prices on this occasion fed through to a much greater extent to
long-term futures contracts, suggesting the markets are expecting oil prices to hold at high levels.
Despite this, and on the indicators available, dearer energy scarcely affected inflation expectations,
meaning the so-called second-round effects - linked to the reaction by wages - were avoided. On past
experience, it is these latter affects which are most damaging.
So far, the effects of higher oil prices have been surprisingly mild. But economic policies should
remain vigilant in the face of a potential pass-through to inflation expectations, all the more so when
there are other risks and vulnerabilities in the world economy which, in some respects, have not only
not diminished but have tended to increase. Of note, here, is the necessary re-establishment of a
more normal macroeconomic stance (the main countries' policies have been adding abnormally
expansionary momentum in the world economy in recent years), and the potential impact on financial
markets.
As regards monetary policies, the countries most ahead in the business cycle have already begun to
adjust their interest rates to a level more consistent with a neutral stance, and foreseeably those
further behind in the cycle will progressively pursue this trend as their economies gather steam.
Turning to fiscal policies, it is telling that these should have deteriorated both in areas with more
moderate growth rates, such as Japan and certain euro area countries, where it has been sought to
use fiscal policy for counter-cyclical purposes, and in other particularly dynamic economies, such as
the United States, where buoyant demand should have allowed more ambitious fiscal consolidation
goals. The exceptions to this pattern of deteriorating budget positions are in certain emerging
economies, where public debt is relatively high. This is the case of the Latin-American countries, which
have harnessed the favourable economic situation to improve their primary surpluses. The importance
of furthering fiscal consolidation in the medium term in the more developed economies becomes even
clearer if the long-term problems linked to population ageing are taken into account, while the
emerging economies, with high debt levels, need to persevere with budgetary discipline.
Restoring a more normal monetary and fiscal policy stance requires care, to ensure that the world
economy is not dislodged from a low-inflation path of recovery. It is particularly important to limit the
potential shock to international financial markets, which have been operating in very favourable
conditions marked by high liquidity, low risk premiums and an interest-rate term structure that has
been propitious to long-term borrowing.
In this respect, monetary measures to safeguard price stability must be accompanied by an
appropriate communication policy and consistency in the application of fiscal rules and commitments,
if the authorities are to avoid a sharp change in conditions on financial markets, which might induce
exaggerated reactions. In particular, although long-term interest rates should no doubt resume a level
more in keeping with past experience and with the current cyclical phase, this process should be
orderly and without excessive propagation towards credit risk premiums on the corporate-debt and
emerging sovereign-debt markets, or on foreign-exchange markets.
Another source of vulnerability of the international economy lies, as discussed, in the global
disequilibria. Broad international consensus has it that the correction of these imbalances requires an
increase in public and private saving in the United States, structural reforms to invigorate the euro
area economies and Japan, and greater flexibility in Asian exchange rates, especially in China. These
policies would gradually correct the present current-account mismatches and would have to be
accompanied by exchange-rate movements tending to bring positions closer to long-term equilibrium
levels.
The correction of these current-account imbalances would also ideally re-establish a more natural
direction of capital flows between developed and emerging countries. Compared with the anomalous
situation at present, in which these flows are from the latter countries to the former ones, owing to the
combined impact of the absorption exerted by the US economy and the exchange-rate policies in Asia,
a smoother working of the world economy should channel surplus saving from the more mature
economies to those where the return on capital is higher, as they are at a more incipient phase of
development.
It should be recalled that many of the achievements of the world economy in recent years, such as
moving on to a high, inflation-free growth path and infusing the emerging areas with greater dynamism
so as to allow them to achieve standards of living closer to those of the richer countries, are a direct or
indirect consequence of growing worldwide integration. Globalisation has thus given most countries
more fluid access to foreign markets while offering them incentives to concentrate on those industries
in which their comparative advantage lies, and it has provided consumers with a wider range of
products at more favourable prices. But it should not be forgotten that the rigidity of certain countries'
exchange-rate policies has ultimately triggered protectionist threats in others that see themselves as
adversely affected. It is thus vital not to succumb to these protectionist temptations and to persevere
with the liberalisation of international trade so that the trends which have allowed the world economy
to achieve its recent favourable results may become entrenched.
The euro area
The prolonged sluggishness of the euro area economy continues, with output growth of below 2% for
the fourth year running. In the first half of 2004 a more dynamic trajectory was discernible, in line with
the greater robustness of the world economy, presaging the onset of a firmer expansionary phase.
Activity has since weakened notably, however, and the first half of the current year has seen no
improvement. Nonetheless, the conditions remain in place to allow the rate of expansion of GDP to
increase gradually in the coming quarters, spurred by the continuation of relatively expansionary
financial conditions and by the momentum of the international situation.
Dearer oil and the appreciation of the euro have been holding back growth in the euro area for some
time, and these factors intensified in 2004. However, it would be wrong to attribute the protracted
period of low growth seen in the euro area to these factors. The euro area has in fact benefited in
recent years from a relatively sharp expansion of its export markets, allowing it largely to offset the
negative effects of the euro's appreciation. Moreover, the rise in the euro, along with progress in
reducing oil dependency, has softened the adverse consequences of higher oil prices.
At the root of the European economy's persistent weakness are, instead, the factors that hamper the
sustained buoyancy of domestic spending and which heighten its sensitivity to external developments.
The lacklustre consumption and investment of recent years are telling in this connection, and denote
the presence of structural shortcomings which dampen household confidence and dent corporate
profit expectations. Accordingly, questions such as the uncertainty over the viability of the public
pension system currently in place or the constraints preventing higher productivity growth not only
have long-term repercussions but also exert a contractionary effect on the present economic situation.
These overall characteristics of the area do not apply to all the member economies. Growth rates vary
considerably, largely due to the different degrees of vigour shown by internal demand. Amid these
divergences, Spain is one of the countries that has consistently posted substantially
higher-thanaverage rates of expansion.
The Eurosystem monetary policy has retained an accommodative stance, with the intervention rate set in
June 2003 unchanged at 2%. Although the forceful oil shock has hampered the reduction of inflation,
medium-term inflation expectations have held at a rate compatible with the Eurosystem's definition of
price stability, partly as a result of sustained wage moderation. The favourable trend of labour costs is a
natural corollary of the prevailing sluggishness of activity and of employment creation, but it also reflects
the credibility of the anti-inflationary goal of monetary policy. The European Central Bank has been able
to sustain monetary conditions propitious to the strengthening of activity although, as indicated earlier,
these have so far proven insufficient to achieve a satisfactory degree of dynamism. It thus appears that
the euro area has yet to harness fully the benefits arising from economic integration and the introduction
of the single currency.
The emergence of difficulties in furthering European economic integration has recently been
discerned. Cases in point are the problems affecting the fiscal discipline framework, the delays in
meeting the targets of the Lisbon Agenda and the obstacles still blocking, in certain industries, the
development of the single European market.
At the March 2005 European Council, the authorities attempted to correct the lack of ambition behind
the structural reforms and the scant consistency of budgetary policies with the disciplinary rules set by
adjusting some of the policy co-ordination mechanisms. However, only clear resolve on the part of the
authorities to fulfil their commitments would dispel the scepticism some of these proposals evoke.
In the fiscal policy realm, the European Council approved a reform of the Stability and Growth Pact.
Among other changes, provisions were made to pay greater attention to the particular situation of each
country when evaluating its budgetary position and to make the application of the corrective measures
envisaged in the Treaty more flexible. As a result of these changes, the economic rationality of certain
components of the Pact has perhaps been enhanced, though its complexity and the margin available
for discretion in its application have also undoubtedly increased. There are some favourable aspects
to the new rules, but they raise doubts as to the Pact's capacity to deliver the budgetary discipline that
proper functioning of the Monetary Union requires. Regardless of the fact that a full assessment of the
agreement reached can only be made once the related legal texts are known, it is imperative, to dispel
the uncertainty the reform process has aroused, that the European authorities should now apply the
revised rules unequivocally and strictly.
The European Council also revised the so-called Lisbon Agenda, with which it was hoped to
reinvigorate the European economy in the first decade of the new millennium. Assessment of the
results achieved at the half-way stage makes disappointing reading. The introduction of reforms has
been insufficient and the European co-ordination mechanisms have proven too weak to encourage the
adoption of the appropriate measures at the national level. The Council has sought to re-launch this
strategy, focusing on growth and employment, and altering the co-ordination arrangements between
the Council, the Member States and the Commission, so as to ease the way for the adoption and
monitoring of reforms at the national level. This new direction is appropriate, although more specific
measures giving a more determined political impulse to the process would have been desirable.
Such determination will be needed, in particular, to overcome the obstacles hindering completion of
the single market. Indeed, these were manifest in the European Council's request that the
Commission revise its draft directive on liberalising the provision of services in the Union.
The challenges facing the European economy are considerable and set in an institutional context that
has been disrupted by the "no" votes in the recently held French and Dutch referendums on the
ratification of the Constitutional Treaty. The difficulties of entrenching growth that is sufficient and
consistent with the European model and with the general public's expectations may have influenced
the disappointing results returned by these referendums. But this is something which is closely related
to the difficulties at the national level in pushing through the necessary reforms and explaining them
convincingly.
The significance and implications of these results should not be underestimated. But they need not
check European integration. Rather, they should act as a spur to further integration by means of
European and national policies that respond to the demands of the public. In any event, European
integration has not been a linear process in the past and I am fully confident that the European Union
will be capable of overcoming these difficulties just as it always has when obstacles have stood in its
way. On the plus side in the current circumstances is the fact that it has a currency shared by a large
number of countries and a federally organised central bank which are a focal point of stability and
exemplify Europeans' ability to embark on and co-ordinate ambitious undertakings that contribute
effectively to the collective well-being.
The Spanish economy
Spain, as I said earlier, has been one of the euro area economies that has continued to post high
growth rates, compared with the relative slackness of the area as a whole. The new base-year 2000
National Accounts estimates for Spain, released a few weeks ago, indicate that its GDP grew in 2004
at a significantly higher rate than the previous estimate (3.1% against 2.7%), albeit with a more
unbalanced composition. Moreover, the growth rate has remained on a mildly accelerating path, which
has continued into 2005 Q1, when output stood at 3.3% compared with the same period in 2004.
Annual
As indicated in the Report, it has not yet been possible to analyse in depth the new National
Accounts series, although the first comparisons with previous estimates indicate that both datasets
offer a fundamentally similar diagnosis of the economy's performance. In particular, the higher growth
the new figures - available so far from 2000 - show has confirmed the continuity of the long
expansionary phase in train since the mid-nineties. The expansion has been the result of the notable
momentum of domestic demand combined with high employment-generating capacity and the
extension of the supply side of the economy, two mutually reinforcing phenomena over these years
which have provided a sound base for growth.
Spanish euro area membership lay at the root of the significant expansionary impulses experienced by
household and corporate expenditure. The effects of the anchoring of inflation expectations and the
adjustment of interest-rate levels have recently been reinforced by the looseness of monetary and
financial conditions in the euro area. Progress towards fiscal consolidation and the maintenance of
balanced public finances have contributed decisively to shaping an environment of stability, which has
eased the financing of private expenditure and growth.
On the supply side, robust population and employment figures have made for favourable conditions in
which the expansionary demand impulses have translated into higher growth in activity and not into
greater pressure on productive capacity leading to disequilibria. That said, and as I will remark later,
this has not prevented the structural shortcomings of the economy from being manifest in upward
pressures on prices and costs and in a wider current-account deficit.
Job creation is being fuelled by an expanding labour force, to which the increasing inflow of immigrants
and the rising labour-market participation of women are both contributing. Regarding immigration,
population projections drawn from the 2001 census and the continuously updated municipal population
census show an impact that could hardly have been envisaged only a few years back. In any event,
strong employment generation has been accompanied by very modest productivity gains, a trend which
continued in 2004 when employment increased by 2.7%, compared with 2.5% in 2003, and apparent
labour productivity growth was only 0.4%.
Domestic demand quickened in 2004 by almost 1 pp, growing by 4.6%. The growth rate intensified as
the year unfolded, rising to a rate of 5.8% at the start of 2005. This acceleration has been driven by a
higher increase in private consumption and the renewed buoyancy of construction coupled with a
pick-up in investment in equipment. Households' expenditure has been underpinned by the recovery
in their disposable income, which has benefited from higher employment growth and from a
comparatively favourable contribution by general government, through the net effect of benefits and
taxes. But above all it is the increase in household wealth in recent years - largely linked to the rise in
real-estate asset values - and favourable financing conditions which are most underpinning household
consumption and residential investment decisions.
The behaviour of productive investment has, in recent years, reflected the opportunities and
uncertainties of this expansionary phase, many of them related to the external environment. However,
business investment progressively took a lead from the robustness of demand during 2004 and it
started the current year on a clearly more expansionary path. Lax financial conditions, the healthy
position achieved by those corporations with most investment potential and favourable expectations
about economic developments are behind this rise.
Set against the increase in domestic demand, external demand has exerted an increasingly
contractionary influence. Although world trade picked up in 2004, goods exports grew less than
external markets, while imports climbed at very high rates, increasing their penetration in the Spanish
market. Tourism is feeling the effects of competition from nearby destinations offering packages
similar to those of Spain at very competitive prices. The negative contribution of external demand to
GDP growth thus continued to expand over the course of 2004, without any signs of a turnaround in
2005. On the contrary, according to National Accounts data for Q1, the contractionary effect of net
external demand has stepped up significantly, against a backdrop of stronger domestic demand
pressures driven by high consumption and vigorous construction spending combined with a clearer
take-off in investment in capital goods.
Among the factors influencing this negative behaviour of net external demand, the causes and
repercussions of which I shall return to later, are the persistence of inflation differentials. Indeed, the
inflation differential with the euro area widened during 2004, reflecting a relatively sharper impact of
dearer oil on Spanish prices. Moreover, although the growth rate of labour costs eased, it remained
relatively high. As a result, the 12-month increase in consumer prices rose from 3.2% in December to
3.5% in April. It is expected to moderate in the coming months, however. Indeed, the initial estimate of
the HICP for May (3.1%) suggests it already has done.
At the onset of 2005 the Spanish economy was highly buoyant. This robustness continues to be based
on the momentum of domestic expenditure and on high job creation. While the impact of some of the
factors underpinning household spending may moderate in the coming quarters, most of the factors
operating in the recent past will continue to boost domestic demand and, in particular, productive
investment. Likewise, insofar as European markets recover and the effects of the euro appreciation in
2004 ease and are absorbed, the contractionary influence of external demand might be checked.
Under this scenario, the outlook for the economy in the short run points to a prolongation of the
expansionary phase, with sustained GDP growth rates similar to those observed in 2004.
These forecasts are subject, however, to some risk. This poses significant challenges for economic
policy, especially when it comes to promoting the sustainability of economic dynamism over a longer
term, under the constraints stemming from euro area membership. There are certain external risks
whose potential influence on Spain is significant, but which economic policy action can do little to
counter. This is the case with the dangers arising from the weakness of the euro area, from higher oil
prices and from the appreciation of the euro. What economic policy can do here is in line with what
policymakers can do to counter domestic risks, these undoubtedly being the most relevant ones for
policy design. Accordingly, I shall focus on analysing the nature of the latter and their possible
repercussions.
The domestic risk factors stem largely from the very prolongation of a long, domestic demand-led
expansionary phase, and can be grouped in two major areas. First, the losses in competitiveness that
have built up in the earlier described setting of inflation differentials and very low productivity gains,
which might ultimately check the generation of value added and job creation. And second, the
increase in household debt that has accompanied the expansion of consumption and residential
investment, which might constrain households' spending capacity, particularly if developments in the
housing markets were to prompt any uncertainty about the value of this sector's wealth, which is
strongly concentrated in real-estate assets. Although both areas of risk are inter-related, I shall deal
with each separately.
In respect of competitiveness, there are signs that the risks signalled by the Banco de España in the
past have already begun to materialise. The significant restraint on growth exerted by external
demand in the past year and the considerable widening of the Spanish economy's external deficit
point in this direction. Admittedly, these results partly reflect the influence of certain external factors,
such as dearer oil and the appreciation of the euro, which have dampened the positive impact of the
international recovery. Moreover, the deficit is also partly influenced by the cyclical divergences
between Spain and the euro area. But these factors do not suffice to explain either the scale of the
deficit or the speed at which it has widened, and they should not therefore conceal the existence of a
genuine deterioration relating to the losses in competitiveness built up in recent years, as I shall now
seek to illustrate.
But let me first address the significance and scope of an external deficit when the country concerned
belongs to a monetary union, so as to qualify interpretations whereby such a deficit would have
ceased to be a cause for concern. It is true that under the new circumstances there is no danger of a
burgeoning external deficit generating financial or foreign-exchange pressures that then trigger a
sharp adjustment in the economy, since fundamental variables such as the interest rate and the
exchange rate are determined at the area-wide level. But that does not mean that the economy is
immune to competitiveness problems. On the contrary, when a large external deficit emerges in a
monetary union as a result of an economy's difficulties in competing, a very costly dilemma may arise:
nominal costs are either adjusted head-on, or the loss of competitiveness will check the generation of
value added and job creation.
A first sign of competitiveness problems is to be found in the growing difficulties Spanish products face
in maintaining their market shares. Spanish export shares on foreign markets, which had held stable
since the start of Monetary Union, tended to decline in 2004, even on the European market. And the
fall-off in the tourist market is a similar development. Although there are specific factors that might
explain some aspects of this behaviour, the strength of growing import penetration in the domestic
market tends to confirm the diagnosis of diminished competitiveness of Spanish products on domestic
and foreign markets alike.
The concurrence of the incipient slide in export shares and the ongoing increase in import penetration
primarily reflects the higher relative prices of Spanish products as a result of persistent inflation
differentials and of the more recent appreciation of the euro. Testifying to this is the negative trend of
the traditional price competitiveness indicators, even when these are calculated with export deflators
that capture how the sector more exposed to foreign trade has narrowed margins to face growing
competitive pressure.
Behind the ongoing deterioration in price competitiveness lie a relative increase in unit labour costs,
reflecting continuing higher wage increases in Spain despite the moderation compared with previous
periods, and very low labour productivity gains. The existence of wage-setting and indexing
mechanisms that set a higher floor for nominal wage growth than in other countries hinders the rapid
absorption of external price shocks. And it also tends to hamper full convergence with the
arrangements required in an area of macroeconomic stability.
The problems posed by wage inertia are exacerbated by the lacklustre behaviour of productivity. As
noted on previous occasions, this partly reflects intensive growth in employment generation, which has
been most beneficial for entrenching the expansionary cycle of the economy and making more
efficient use of the labour supply available. But weak total factor productivity growth - the relative
position of which vis-à-vis the EU has continued to worsen - denotes the presence of other more
worrying factors which appear to be checking the incorporation of innovations and technical progress
into productive processes.
The lack of innovation in the productive system tends to stifle the economy's overall efficiency and its
long-term growth capacity. The indicators available for the stock of technological capital suggest a
considerable lag remains in place. Undoubtedly, specific features of the Spanish economy's pattern of
productive specialisation - which is very biased in manufacturing towards the production of
intermediate- and low-technology goods, and in services towards tourism activities - may partly explain
this phenomenon. But there are also shortcomings that are restricting the business sector's capacity to
incorporate advances in knowledge and to adapt productive processes, human resources
management and corporate strategies to an environment of heightened competition.
Of particular importance are the persistent mismatches between the skills and training levels of labour
and companies' requirements, and, above all, the rigidities in the workings of factor and product
markets, which discourage the adoption of more innovative strategies. I draw attention to these
limitations of the Spanish economy at a particular juncture in which foreign direct investment is slowing
considerably (FDI having been one of the main channels for the diffusion of technological advances),
and in which the weight of high-technology imports remains very limited, despite the surge in import
penetration.
The prolongation of the current trends might mean that the industries most exposed to foreign
competition have to adjust their staffing levels in order to maintain their business margins. Hence the
importance of creating an environment conducive to technological innovation and to higher
productivity, which I shall refer to later.
The second area where risks have arisen from the extended expansionary phase of the economy is
related, as earlier indicated, to the ongoing buoyancy of household spending on consumption and
residential investment. Thi