06.10.2020
Parliamentary testimony: presentation of the Banco de España
Annual Report 2019
Pablo Hernández de Cos
Governor
Mr. Chairman, ladies and gentlemen:
My appearance once more before this Committee is to present the Banco de España Annual
Report 2019. It was approved by the Bank's Governing Council last June and published that
same month. This year the Report has been dedicated to the impact of the pandemic on
our country's economy, and to discussing what the role of economic policies should be to
achieve our common priority objective: to minimise the impact of this grave crisis for our
citizens' well-being. Along with summarising the content of the Annual Report, in my
appearance I shall offer an update of the economic situation caused by the pandemic and,
where appropriate, a review of some of the Report's messages. This is particularly
appropriate in a setting like the present, which is rapidly changing and subject to high
uncertainty.
1 The macroeconomic situation
In the strictly economic area, the health crisis and the measures needed to contain it have
caused a deep recession worldwide, with a high degree of synchrony. The high mark for
this recession was last spring.
Subsequently, the practically simultaneous lifting in most regions of the bulk of the
antipandemic measures taken allowed global activity to rebound.
However, the severe losses incurred while the strictest measures were still in force have
been only partially recouped. As a result, current activity and employment is still clearly
below the pre-crisis level in almost all world regions.
Moreover, what we are seeing is an uneven recovery; not only because it is stronger in
some regions than in others, but also because, from the standpoint of the productive
sectors, some segments - in particular those in which social interaction plays a more
significant role - have been markedly affected.
And, finally, the recovery is characterised by fragility. This is because its continuation is
subject to uncertainty over the intensity of the fresh outbreaks of the virus that might occur
in the coming quarters, until we have an effective medical solution.
The incomplete nature of the recovery I mention is, of course, patent in the case of the euro
area. And not only regarding the developments observed to date. If we take the latest
projections of the European Central Bank (ECB),1 released scarcely one month ago, we see
that its baseline projection points to a prolongation of the improvement seen since May for
the coming quarters. Yet that does not prevent the area's GDP from declining by 8% this
year. And that despite the fact that one of the assumptions of this scenario is that the
epidemiological situation will not worsen in the coming quarters. What is more, at end-2022,
the area's level of GDP is expected to stand almost 4% below the level projected in the
previous Eurosystem forecasts (dating back to December 2019) prior to the outbreak of
COVID-19.
In Spain, economic activity since the pandemic broke has closely followed the path marked
by the introduction of the lockdown measures and their subsequent lifting. The data for the
first half of the year show record declines in GDP, with a 22.1% reduction relative to
end2019. This fall-off is greater than for the euro area on average, owing to the fact that the
lockdown measures adopted during the state of alert were stricter. And it is also because
of certain structural characteristics of our economy, such as the greater relative weight of
the sectors most affected by this crisis, a Spanish business sector mostly comprising small
and medium-sized enterprises, and a substantially higher temporary employment ratio.
The progressive lockdown-easing steps were accompanied by a gradual improvement in
activity, leading GDP to grow in the third quarter at a double-figures rate following the sharp
decline in the second quarter.
However, we should not be led by an excessively benign interpretation of these apparently
favourable figures. As I stressed, the current recovery is, across the various regions, partial
in nature. But the incompleteness of the rebound is more evident in Spain than in other
economies. As a result, the level of activity attained in the third quarter this year in Spain
would still be some 12.3% and 9.5% below that of the same period a year earlier, according
to the two scenarios recently published by the Banco de España.
Moreover, although the lifting over May and June of the bulk of the measures restricting
people's movement and activity in numerous sectors led to a swift recovery in Spanish
output in those months, there were mounting signs during the summer that the rebound
was losing momentum. In this respect, a set of high-frequency indicators appear to show
that, especially since mid-August, there has ceased to be any significant additional headway
in this recovery.
This apparent slowdown in the improvement in activity has coincided with an upsurge in
COVID-19 infections, which have not ceased to increase since early July. Further, although
the rebound in the virus has been common to many other countries, it has been more acute
in Spain. As a result, compared with the main European economies, Spain is currently
posting notably higher figures for new infections per 100,000 inhabitants.
This worsening epidemiological situation has led to the progressive reinforcement of certain
social distancing measures. While these restrictions are so far limited, they are affecting the
process of economic recovery. It is highly likely that this adverse impact will have been
particularly acute in the tourist sector, which moreover operates at peak over the summer
period.
Indeed, the rebound in the pandemic in Spain during the summer led the authorities in many
tourist-issuing countries, which include the main European markets, to announce various
measures discouraging travel to Spain.
Accordingly, the levels of activity in the sector during the summer were at some distance
from those for the same period a year earlier. Thus, for instance, only 77% of the hotel
establishments that had opened in August 2019 did so in the same month in 2020, and only
slightly over 40% of hotel rooms offered were taken up. On the information available, it is
even possible that tourist activity may have worsened in September, given the high level of
cancellations of prior reservations, the step-up in the year-on-year decline in air traffic and
the downturn in spending using cards issued by non-residents. And, evidently, the latest
pandemic-related developments in Spain do not contribute to brightening the outlook for
these sectors of activity in the coming months.
Beyond the short term, the outlook for the Spanish economy, as for other countries, is
shrouded in uncertainty, linked to how the pandemic evolves. This is why the Banco de
España opted, in its publication dated 16 September,2 to present more than one scenario
in relation to the possible course of the economy over the next two years, as it had already
done last April and June. In this case, two scenarios were released. They share a common
assumption about an effective medical solution being found and widely distributed among
the population as from the second half of 2021. That is in line with the time horizon which,
despite the high uncertainty, epidemiologists appear to be tentatively viewing as most
realistic.
The difference between the two scenarios lies in the assumptions made about the course
of the epidemiological situation in the coming quarters. Specifically, the first scenario
considers, set against the second, that fresh outbreaks will require more limited containment
measures in terms of their intensity and of the productive sectors directly affected, which
will be confined to leisure and hospitality. Consequently, the adverse effects on production
and employment will also be on a smaller scale, not only as a result of the lesser severity of
the restrictions on activity, but also because the degree of uncertainty is also expected to
be lower. Accordingly, this variable would dent households' and firms' spending decisions
to a lesser extent.
Under either of the two scenarios, the decline in Spanish GDP in 2020 would be very high.
For the year on average, the fall would be -10.5% and -12.6%, respectively. In Spain's case,
it is all the more patent than in other countries that, despite the fact the source of the crisis
is a shock which is in principle transitory, its consequences will have a relatively high degree
of persistence. In this respect, the projected level of GDP for end-2022 is still expected,
under the first scenario, to be around 2 percentage points (pp) below the pre-pandemic level
at the end of last year, and more than 6 pp down under the less favourable scenario.
The impact of the crisis on labour utilisation is proving very severe. Part of this effect has
come about through the termination of employment relationships. That has meant that, at
end-September, Social Security registrations were 2.3% down on a year earlier (almost
440,000 people). An even bigger portion of the reduction in the use of labour has been in
the form of the recourse to furlough schemes (ERTEs by their Spanish name). Indeed, in late
September, work for almost 730,000 workers (a still-high figure, although it is admittedly
almost 80% below the April high) was still fully or partially suspended.
The series of actual Social Security registrations, constructed stripping out the figures for
workers on furlough, still showed, on average monthly data, a year-on-year decline of 6.2%
in September. The path of progressive recovery observed since May held up in September,
albeit at a lesser pace than in the previous months. Moreover, heterogeneity across the
productive sectors is very high. Compared with the pre-crisis level, the decline is particularly
marked, in percentage terms, in certain services such as hospitality, which is particularly
affected by the social distancing measures. Moreover, in absolute terms, the sizeable fall in
actual registrations in this sector is indicative of the importance of tourism for Spain's
economy.
In the coming quarters employment, in terms of hours worked, is expected to follow a very
similar path to that of economic activity, showing declines of over 10% in 2020 and a
subsequent recovery. Meantime, the increase in unemployment is being contained in the
short term by the resort to furlough arrangements. In annual average terms, the
unemployment rate is expected to rise significantly this year (to 17.1% of the labour force
under the first scenario and to 18.6% under the second) and also in 2021, before starting to
descend in 2022 (when, in annual average terms, it would stand at 18.2% and 20.2% under
the respective scenarios).
Both scenarios forecast inflation to hold at a moderate pace over the projection horizon.
Core inflation has slowed notably in recent months as a result of the weakness of demand
stemming from the pandemic. Looking ahead, the persistence of a high degree of cyclical
slack will mean inflation in non-energy industrial goods and in services will continue to run
at relatively low - though growing - rates until end-2022.
The risks underlying the scenarios for economic activity published by the Bank remain tilted
to the downside. And more unfavourable developments than those contained in the second
scenario, i.e. the harsher of the two considered, cannot be ruled out. In particular, in light of
the recent course of the pandemic, we cannot preclude the resort to more severe lockdown
measures than those envisaged in the scenarios. Moreover, there is much uncertainty over
how long will be needed before we have an effective medical treatment, and there are some
risks that it will be delayed beyond mid-2021. Lastly, uncertainty remains on the external
front, especially concerning the possibility of the Brexit negotiations concluding without an
agreement at the end of the transition period or of US-China trade tensions worsening.
However, as I shall set out later, the launch of the Next Generation EU (NGEU) European
recovery fund, which was not taken into account in the aforementioned scenarios, given the
still-high lack of specifics for key tenets of the programme, is a factor operating in the
opposite direction. The NGEU fund is a significant reaffirmation of the European
construction process. Spain, moreover, would be one of the Member States with potentially
most to gain, given the comparatively more serious impact of COVID-19 on our economy to
date and the high likelihood that its consequences will be more persistent.
2 The risks to financial stability
The unprecedented impact of the pandemic on economic activity has entailed a very
significant increase in the risks to global financial stability. The forceful economic policy
response (by the monetary, fiscal and supervisory authorities) and the effect of the
farreaching international financial reform implemented in the past decade are helping mitigate
and manage these risks. Indeed, the financial system has been acting to date as a mitigating
rather than an amplifying factor of the impact of this crisis.
But we should not be complacent. As I have stressed, the scale of this shock is very great,
and its duration uncertain. I shall now review how the main risks in this area have evolved
recently, drawing on the analysis of the effect of the crisis on various agents in the economy:
non-financial corporations, households, the real estate and financial sectors, and general
government.
Non-financial corporations (NFCs) faced this shock from a more favourable financial
position than was the case before the global financial crisis. Specifically, in recent years
they had lowered their debt levels substantially, to below the European average at
end2019, and had higher liquidity buffers. Moreover, the sectoral distribution of activity was
more balanced than prior to the previous crisis.
However, the information for the first half of the year shows that NFCs have seen their
profitability plummet. Their return on assets (ROA) halved, falling from 4% to 2%, and the
proportion of NFCs with low profitability increased. Simulations by the Banco de España
point to a strong contraction in firms' profitability in 2020 as a whole, with SMEs trending
more unfavourably, especially those in hospitality and leisure, motor vehicles, wholesale and
retail trade, and transport and storage.
The simulations on firms' liquidity, on the basis of the aforementioned macroeconomic
scenarios and incorporating the impact of the economic policy measures implemented,
anticipate that the percentage of firms with liquidity needs in the period spanning the second
and fourth quarters of this year will increase as a result of the pandemic by almost 10 pp, to
70%.
The information on bank lending shows that firms are resorting to this source of financing
to cover a sizeable portion of their liquidity needs. Specifically, the outstanding balance of
NFCs' borrowing from national credit institutions increased at a record-high pace, shifting
from an annual contraction of 1.1% in February to an annual expansion of 8.1% in June.
That said, this increase eased to 7.2% in July. One of the key factors behind the rise in credit
over these months was the progressive activation of the Official Credit Institute's guarantee
facility for NFCs and individual entrepreneurs, which proved particularly favourable to SMEs.
In fact, of the €174 billion lent to NFCs from December 2019 to June 2020 via new lending
business, €71.5 billion (41%) corresponded to guaranteed loans.
As a result, the sector's aggregate debt-to-GDP ratio has risen for the first time since 2010,
to 82% in 2020 Q2 (the highest level since 2017), owing both to the increase in debt and to
the decline in GDP. True, the intensity of these rises will be corrected to some extent when
the GDP data for the coming quarters are incorporated. But the simulations by the Banco
de España also suggest a deterioration in the financial position, measured as each firm's
net debt relative to its net assets. This would be greater in the SME segment and in the
sectors most affected by the pandemic.
As was the case with firms, households' financial position improved significantly following
the previous global financial crisis. At the same time, mortgage-related lending standards
have been much more prudent, although consumer credit has been growing at high rates in
recent years and certain groups of households have remained in a situation of vulnerability.
However, household income has been considerably cut in the current crisis, owing to the
reduction in hours worked and the increase in unemployment. Households' gross
disposable income fell by 8.8% year-on-year in the first half of 2020.
In parallel, lending to households has fallen off in recent months as a result of the decline in
new lending business. The reduction has been more marked in the consumer credit
segment, while new financing for house purchases fell less sharply. Overall, although the
moratoria on loans, which affect 7% of the outstanding balance of lending to households,
have checked the decline in lending to this sector by reducing the volume of loan
repayments, its year-on-year growth rate dipped to -0.8%, compared with the 0.3%
increase in February.
This has entailed an increase in the financial pressure borne by households. Thus, for the
household sector as a whole, the debt-to-gross disposable income (GDI) ratio rose by
almost 4 pp in the first half of the year to 95%. Once again, the intensity of this increase in
debt will foreseeably ease to some extent with the GDI data for Q3. The increase in
household saving not earmarked for debt service (a consequence of the heavy decline in
consumption) appears to have been channelled to bank deposits, which posted a
year-onyear increase of 7.1% in July. However, updated information on the distribution of this
saving within the household sector is not available, making it difficult to assess to what
extent this development is softening the greater degree of financial pressure for certain
groups of households.
In this connection, the heterogeneity in households' financial situation is proving very
significant from the financial stability standpoint. Taking the Banco de España's Survey of
Household Finances (EFF), we find that the industries most affected by the pandemic used
youths and women proportionally more than other sectors, also employing a higher
percentage of low-wage workers. These lower wages would be partly offset by the fact that
the employees concerned lived with other household members with higher income. As
regards their finances, 28% of workers in the social industries lived in 2017 in households
whose financial assets amounted to less than one month's income, and around 8% had
bank debts whose payments exceeded 40% of the household's gross income. Accordingly,
the labour income and financial situation of the households of workers in the social
industries were in 2017 more fragile than those of employees in other, regular industries.
Overall, then, the non-financial private sector's financial position has worsened. The
consequences of this for credit institutions' results will become fully patent in the coming
quarters. Clearly, too, the improvements in the quality of the Spanish banking sector's
balance sheet and in its solvency levels in the past decade have placed it in a better position
to absorb this crisis and to continue providing the financing the economy needs. And the
sector's risks to financial stability have been mitigated by the various economic policy
measures adopted.
In any event, banks' income statements have already been adversely affected. Specifically,
in the first half of 2020, the consolidated net result of the Spanish banking system as a whole
was negative (around -€9.5 billion), a decline of almost €20 billion compared with the profit
recorded in June 2019, and making for a return on assets (ROA) of -0.5% (1.1 pp less than
in June 2019) and a return on equity (ROE) of -7.3% (15 pp down on a year earlier).
This negative performance is due, particularly in the case of the two biggest banks, to the
deterioration of the goodwill of their subsidiaries abroad. This illustrates how, in a global
crisis such as the current one, the international diversification of Spanish banks' business
will foreseeably be less useful than in past crises for containing and mitigating the attendant
effects.
Indeed, the net profit of the Spanish banking system as a whole would have been positive
had this downturn in goodwill and other extraordinary adjustments not been taken into
account. In any event, the fall in profitability was also due to greater provisioning in
anticipation of future asset impairment, whereby impairment losses doubled compared with
2019. That explains why, for the other banks without an international presence, the
reduction in profits averaged 60%.
The sector's profitability is thus far below what investors demand. As a result, the
price-tobook ratio (which compares listed banks' market capitalisation to their book value)
contracted markedly in March in Spain, as it did in the other European countries, falling to
around 0.4. Subsequently, however, it picked up to some extent.
As stated, one aspect of recent developments that should be assessed is the fact that much
of the adjustment in results is due to expectations of loan impairment provisions that have
not yet materialised but will do so in the coming quarters, allowing these provisions to be
appropriately distributed over time. In fact, the downturn in economic activity caused by the
pandemic has so far only fed through moderately to non-performing loans, with but a slight
rise in Q2 which, given the high growth of credit, has provided for additional reductions in
the NPL ratio. Recurring income has already begun to feel the effects but, so far, expenses
have also adjusted downwards.
The downturn in banks' profitability has not yet led to a reduction in their solvency. Indeed,
in the first half of the year, solvency has increased slightly. That highlights the significance
of the measures adopted by economic policymakers in their respective areas. The
recommendation not to pay out dividends has enabled banks to add these resources to
their capital buffers, the numerator of the solvency ratio. Further, risk-weighted assets, the
denominator of the solvency ratio, have fallen owing to the use of the guarantee programme
and to the rapid changes to European capital rules in late June. These amendments were
dubbed "Quick Fix", and I shall refer to them later. The ECB's decisions, for their part, have
helped keep very loose financing conditions for banks in place.
But this situation must not lead to complacency. As I have previously stated, the foreseeable
impairment of assets will, based on our analyses, significantly impact banks' solvency.
Moreover, this impact will differ from bank to bank, depending on their starting point and on
their different exposure to the sectors most affected by this crisis.
In this connection, the ECB has recently undertaken a vulnerability analysis of the banks
under its supervision. The aim was to conduct a forward-looking test of banks' resilience to
the shock caused by the pandemic. The results of this exercise, which I will now refer to, do
not differ very much in qualitative terms from the provisional results we obtained at the
Banco de España in the FLESB stress test exercise, whose final findings will be published
in our autumn Financial Stability Report. As usual, I shall be submitting those results to this
House.
The baseline scenario posited in the vulnerability exercise included the most likely effects
of the crisis on macroeconomic variables, namely cumulative declines in euro area GDP this
year and in the next two years of around 1%. The exercise estimated a 2 pp reduction in
the solvency of European banks as a whole to 12.6% on average, above the prudential
requirements in place. While there is cross-bank heterogeneity, these results highlight the
fact that, on one hand, banks have faced this crisis with greater margins of safety, partly as
a result of the regulatory changes made in the wake of the international financial crisis. On
the other hand, the results also show the effectiveness of the measures implemented to
date to mitigate the impact of the crisis. Such measures include most notably the guarantee
programmes, the ECB's extraordinary refinancing measures and the recommendation to
banks not to pay out dividends, thereby strengthening their resilience.
Under the harsher scenario in which the cumulative decline in euro area GDP mounts to 6%
by 2022, the 5.8 pp reduction in the solvency ratio is much bigger, leaving average CET1 at
8.8% of risk-weighted assets. Moreover, under this scenario a significant proportion of
banks would remain below the minimum prudential requirements. As you know, the
probability of this scenario materialising is low but not negligible; should it do so, it might
possibly be necessary to adopt additional measures to those already implemented. I shall
return to this issue later.
The latest developments in Spain's public finances reflect the impact of the pandemic,
which has been particularly severe in our country, and of the measures adopted to contain
it. All of which has translated into a significant increase in the budget deficit and public debt,
and also in the contingent obligations assumed by the different tiers of government.
Specifically, general government debt stood at 110% of GDP in June (14.6 pp more than in
December 2019).
The Banco de España's macroeconomic projections forecast a very marked deterioration
in the general government balance for the whole of 2020 and a partial correction in the
following two years. The debt-to-GDP ratio in 2020 is expected to grow by more than 20 pp
under scenario 1 and by some 25 pp under scenario 2, up to 116.8% and 120.6% of GDP,
respectively.
High public debt also means future vulnerability. In the short term this risk has been
mitigated: first by the measures taken by the ECB, which have prevented fragmentation of
the euro area sovereign debt markets; and second by the European response, with the
launch of mechanisms to jointly address the costs of the pandemic. However, if such a high
level of public debt were to remain in place over time, the Spanish economy would be
exposed to a situation of chronic vulnerability to changes in investor sentiment in the
financial markets.
For its part, the negative net international investment position of the Spanish economy
and the foreign debt position have risen, in terms of GDP, as a consequence of valuation
effects and of the fall in output. Specifically, in 2020 Q2, the negative net international
investment position stood at 77.4% of GDP, 6.5 pp more than in Q1, influenced by the sharp
contraction in output. The nation's gross external debt rose by €56.8 billion in 2020 Q2,
owing solely to valuation effects, to 188.1% of GDP, a record high. The high net liability
position of the Spanish economy continues to be another factor of vulnerability, especially
in the present setting of high uncertainty over future economic developments.
Before completing this overview of the recent changes in financial stability risks, I would like
to refer briefly to the most recent performance of the financial markets and the real estate
market.
Starting with the financial markets, it is evident that this crisis is also having a major impact
on the valuation of many financial assets, and on their volatility. Initially, the stock markets
underwent a severe correction and the volatility of equities and debt securities rose sharply.
Subsequently, following the global monetary and fiscal policy response, the stock markets
began to recover and volatility to decline. Indeed, both in the United States and the euro
area, some market valuation indicators, such as earnings per share, have returned to
alltime highs. This could suggest a certain disconnect between the rapid and significant recent
recovery in financial markets and the more moderate changes observed in the
macroeconomic data and the concerns regarding corporate sector weakness.
In this respect, despite the slowdown in recent months in the pace of credit rating
downgrades, after widening sharply between March and May the spreads on high-yield or
speculative grade corporate debt (i.e. with an external rating below BBB), ceased to improve
in June in Europe and in the United States. They have thus remained short of their pre-crisis
levels, in contrast to the case of investment-grade corporate debt (external rating of BBB or
higher).
This deterioration in corporate credit quality is a further factor of vulnerability for financial
stability. Past experience shows that extensive credit rating downgrades in the corporate
sector can generate adverse second-round effects that exacerbate crises. A recent study
by the European Systemic Risk Board (ESRB) illustrates how important this vulnerability
may be. Specifically it is estimated that investment funds and insurance companies hold the
bulk of BBB rated corporate debt holdings, one-third of which are associated with sectors
considered to be pandemic-sensitive. A large-scale downgrading of this debt to below
investment-grade status would entail considerable potential losses for the entire European
Union (EU) financial system.
Credit rating agencies play a fundamental role in this process. Accordingly, when making
their assessments, they need to take into account the long-term outlook for the corporations
concerned and avoid excessively procyclical behaviour. Indeed, this time round, credit
rating agencies appear to have been more cautious than in the global financial crisis and, to
date, there has been no recurrence of incidents comparable to those seen in the past. In
any event, the results of this exercise show the systemic importance of this vulnerability and
the need to be ready to provide a sufficient, internationally coordinated response, depending
on how the pandemic develops worldwide.
Turning now to the real estate market, this sector's starting point was unquestionably less
vulnerable than in the previous crisis, after a very significant correction both in housing
investment and house prices in the past decade and with a much lower share of
highlyleveraged new mortgage origination since 2008.
The performance of the real estate market during this crisis has also been very uneven
across countries. In Spain, both the number of sales and activity in the housing segment
have fallen very sharply. However, prices have proved to be more resilient, although real
asset prices traditionally take longer to correct than financial asset prices. Meanwhile, prices
in the non-residential real estate segment (i.e. offices, warehouses and commercial
property) show highly polar behaviour, between the main areas where prices are holding up
and the other areas where they are declining significantly. In any event, how well the sector
ultimately recovers once the health crisis is over will depend on the greater or lesser degree
of persistence of the adverse economic and financial effects.
3 The economic policy response
The rest of my address will focus on analysing the economic policy response to this crisis,
and how this response must now adapt to the latest developments connected with the
pandemic and its economic impact.
3.1 Monetary policy
In the monetary policy sphere, it is now almost seven months since the ECB began to roll
out an extensive package of measures that sought to mitigate the impact of the pandemic
on the euro area economy. This vigorous and robust response from the ECB was crucial to
address the tightening of financial conditions observed in the initial phases of the pandemic
and, therefore, to avoid a more severe impact on the real economy.
Today it is appropriate to reflect on the motives that prompted the ECB to adopt these
measures, to review their progress and, lastly, to analyse the financial and macroeconomic
impact they have had, both in Spain and in the euro area overall.
COVID-19 emerged in the euro area in a setting of low inflation and broad monetary
stimulus, with policy rates at all-time lows, new net purchases of assets under the asset
purchase programme (APP) and a schedule set for the targeted longer-term refinancing
operations (TLTROs-III). From the outset, the ECB faced three significant pandemic-related
challenges: first, the need to stabilise financial markets throughout the euro area, to head
off cross-country financial fragmentation; second