EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 508 final COMMISSION STAFF WORKING DOCUMENT Country Report Spain 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2020) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the MIP in-depth review 3.1.Introduction 3.2.Imbalances and their gravity 3.3.Evolution, prospects, and policy responses 3.4.Overall assessment 4.Reform priorities 4.1.Public finances and taxation29 4.2.Financial sector37 4.3.Labour market, education and social policies46 4.4.Competitiveness, reforms, and investment63 4.5.Environmental sustainability80 Annex A: Overview table84 Annex B: Commission debt sustainability analysis and fiscal risks93 Annex C: Standard tables94 Annex D: Investment guidance on Just Transition Fund 2021-2027 for Spain100

Annex E: Progress towards the Sustainable Development Goals (SDGs)102 References107



LIST OF Tables Table 1.1:Key economic and financial indicators – Spain Table 2.1:Overall assessment of progress with 2019 CSRs * Table 3.1:Outward spill-over heat map for Spain Table 3.1a:Spill-over effects of a 10 year public investment programme in Spain Table 3.2:Current account balance and net international investment position sensitivity analysis Table 3.3:MIP matrix Table 4.2.1:Financial soundness indicators, all banks in Spain Table 4.4.1:Investment barriers Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators98 Table C.6:Green growth99 LIST OF Graphs

Graph 1.1: Composition of GDP growth Graph 1.2: Contributions to potential growth Graph 1.3: Investment rate, 2015 prices Graph 1.4: Capital intensity and capital productivity Graph 1.5: Net lending / borrowing by sector Graph 1.6: Employment and GDP - levels compared to 2008 Graph 1.7: Analysis of unit labour costs Graph 1.8: Regional disparities on selected indicators Graph 2.1: Overall multiannual implementation of 2011-2019 CSRs by February 2020 Graph 3.1: Current account and net international investment position Graph 3.2: Analysis of the rate of change of net international investment position Graph 3.3: Gross external debt by sector-type of financial assets Graph 4.1.1: Debt as% of GDP - ES Graph 4.2.1: Loans to the private sector Graph 4.2.2: Overvaluation gaps based on price/income, price/rent and fundamental model-based benchmarks Graph 4.2.3: Sources of financing of the Spanish economy, 2018 Graph 4.2.4: Government support to SMEs Graph 4.2.5: Debt breakdown by sector Graph 4.2.6: Households: Breakdown of y-o-y changes in debt-to-GDP ratio Graph 4.2.7: Non-financial corporations: breakdown of y-o-y changes in debt-to-GDP ratio

Graph 4.2.8: Gap to the fundamental-based and prudential benchmarks for household and NFC debt Graph 4.2.9.a: GDP per head and house price growth Graph 4.2.9.b: Change in share of households living in rented accommodation Graph 4.2.10: Population with housing costs over 40% of their income Graph 4.3.1: Key labour market indicators Graph 4.3.2.a: Employment rates of graduates (20-34) 3+ years after graduation, and gap to average per level of education, 2018 Graph 4.3.2.b: Pupils enrolled in dual VET (as% of total pupils in upper-secondary VET, 2017) Graph 4.3.3: Population (25-64) by educational attainment Graph 4.3.4: At-risk-of-poverty or social exclusion rate and its components Graph 4.3.5: In-work poverty rate Graph 4.3.6: Estimated coverage ratio of regional minimum income schemes, 2018 Graph 4.3.7.a: Average family benefits per child (PPPs/month) – 2019 Graph 4.3.7.b: Children support in 2019 from taxes and benefits (pps/month) - breakdown by decile Graph 4.4.1: Changes in current account and drivers Graph 4.4.2: Trade balance by product type (Jan-Sep) Graph 4.4.3: Trade balance in services Graph 4.4.4: Share of high-tech exports Graph 4.4.5.a: Expenditure by international tourists, 2018 Graph 4.4.5.b: Tourism demand, employment and GDP; annual growth Graph 4.4.6: Real GDP growth and its supply-side determinants

Graph 4.4.7: A decomposition of Spain’s productivity gap to the EU average Graph 4.4.8: TFP growth, management practices indicator and employers’ educational attainment Graph 4.4.9: Evolution of business and public R&D intensity, 2000-2017 Graph 4.4.10: Regional competitiveness index, 2019 Graph 4.4.11: GDP per capita (in PPS) in Spain, 2017 Graph 4.4.12: GDP per capita by NUTS2 regions: level in 2010 and growth rate 2010-2017 Graph 4.4.13: Unemployment rate and population educated to tertiary level, 2018, Spain NUTS2 regions LIST OF Boxes Box 2.1: EU Funds and programmes to address structural challenges and to foster growth and competitiveness in Spain Box 3.1: Public investment and potential spill-overs 22 Box 4.1.1: General government debt Box 4.1.2: Spending reviews Box 4.2.1: Housing affordability in the recovery Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights 47 Box 4.3.2: How vocational education and training can contribute to address skills needs 52 Box 4.3.3: Child poverty in Spain 59 Box 4.4.1: Tourism industry 65 Box 4.4.2: Management practices and productivity 68 Box 4.4.3: Investment barriers and challenges in Spain 71

Executive summary Spain has to sustain continued growth and jobs creation amid old and new emerging challenges ( ). Spain has enjoyed six years of strong economic growth accompanied by dynamic job creation; between 2013 and 2019, real GDP grew by 16.5% and employment by 14%, well above the euro area average. However, some structural weaknesses and crisis legacies have not been fully overcome yet. The still high external and internal debt, both private and public, remain a source of vulnerability. Unemployment has declined, but too many people remain without a job or struggle to make a decent living. Economic efficiency, as measured by total factor productivity, remains subdued, due to low innovation in many firms and regions, regulatory fragmentation, market barriers, labour market segmentation, and skills gaps. Spain is also one of the European countries most exposed to climate change, which poses important policy challenges for water and waste management, energy and resource efficiency, emissions and renewable energy. The Spanish economy is on a moderating growth path. Real GDP growth is expected to have slowed down from 2.4% in 2018 to 2.0% in 2019. Economic activity is expected to moderate further to 1.6% in 2020 and 1.5% in 2021, remaining above the euro area average. The job creation recorded since 2014 is forecast to continue but slow down. Unemployment is set to decline to 12.8% in 2021, which is still higher than before the economic and financial crisis and well above the 7.3% forecast for the euro area. Supporting growth, productivity and the green transformation through public investment would have positive spill-overs on other Member States. Simulations show that a fiscally neutral investment programme financed by indirect taxes and focused on boosting skills, research and innovation, as well as on addressing challenges related to energy, water management, carbon emissions and climate change, would support Spanish growth and increase productivity, while facilitating the green transition. It would also have a small but positive impact on the rest of the euro area. Spain has made limited progress on the 2019 country-specific recommendations (CSRs) ( ): There has been some progress in the following areas: ·Measures are being implemented at central and regional level to modernise and increase the capacity of public employment services, as well as to improve their cooperation with social services. Weaknesses persist in some regions. There has been limited progress in the following areas: ·The institutional framework governing the management of public finances has not been strengthened. Recommendations stemming from spending reviews by the independent fiscal authority (AIReF), if implemented, have the potential to increase efficiency and effectiveness of public spending in several policy areas. ·The newly created governance structure for public procurement is not yet fully operational. The adoption of the nation-wide public procurement strategy envisaged for 2018 is delayed. ·Efforts to reduce the use of temporary contracts in the private sector are showing limited success. Action has focused on fighting abuse and not on the drivers of the widespread use of temporary contracts. The on-going review of the effectiveness of hiring incentives may suggest avenues for reform. ·The government has not yet taken action to simplify the system of national unemployment assistance. Coverage and adequacy of regional minimum income schemes remain low in many regions. Measures taken in 2019 to improve support for families are positive, but can have very limited impact on poverty reduction. ·A new strategy for vocational education and training (VET) sets out measures to improve the attractiveness and quality of intermediate VET education. Its implementation may contribute to reducing early school leaving and addressing the lack of technical skills in the labour market. ·There has been limited progress on fostering innovation, resource and energy efficiency and on developing rail freight infrastructure. Improvements in the funding and governance of the research and innovation system have been modest. On electricity interconnections with neighbouring countries, work is ongoing but further progress is needed. ·The Law on Market Unity remains an important tool to promote better regulation and overcome market fragmentation, but its implementation is proceeding slowly. The indicators of the Social Scoreboard supporting the European Pillar of Social Rights point to a number of challenges. Although improving, the employment rate remains low, including for women. Many young people leave school early or are neither in employment nor in education and training. Social transfers (other than pensions) have limited impact on poverty reduction, particularly among children. There was some progress on reaching the national targets under the Europe 2020 Strategy. Spain is on track to achieve its tertiary education attainment target. There was some reduction in the high share of people at risk of poverty. Sizeable gaps remain on employment and early school leaving rates, even though both have been improving. Spain is currently on track to achieve its targets for renewable energy, but further investment will be needed. Spain is still not on track to meet its targets for energy efficiency and continued investment, notably in buildings, will be required. There was little progress towards the targets for R&D investment. Spain is making progress towards achieving the Sustainable Development Goals (SDGs). Spain has made most evident progress with SDG 3 “Good health and well-being”. Moderate improvements are also recorded for a broad range of the other SDGs. This notwithstanding, some of the individual underlying indicators are significantly lower than the EU average (share of early school leavers, people at risk of poverty, research and innovation, perception of corruption, recycling of municipal waste, land degradation and water). () The main findings of the in-depth review contained in this report and the related policy challenges are as follows:

·Spain's net external liabilities declined further. On the back of robust GDP growth and a continued current account surplus, Spain's net external liabilities have continued reducing at a steady pace, but they still amounted to just below 80% of GDP in Q2-2019. ·The reduction of private debt has continued, but remains high. Total private debt is projected to have decreased to 132% of GDP in Q2-2019. However, the pace of debt reduction has slowed down for both non-financial corporations and households. ·The government debt-to-GDP ratio has continued its slow decline, but remains very high. Government gross debt is expected to decline slightly from 96.7% of GDP in 2019 to 96.0% in 2021, mainly driven by GDP growth. Spain’s government deficit remains stubbornly high, as the level of taxation is low in relation to expenditure. Risks to overall fiscal sustainability remain significant in the medium to long term. In particular, government plans to permanently re-link pensions to the consumer price index and to dissociate initial pension levels from changes in life expectancy would, in the absence of adequate compensatory measures, increase pension expenditure significantly in the medium to long term and worsen inter-generational equity. This occurs in a context where future adequacy of pensions is expected to be, on average, above than in the EU, and poverty mostly affects younger age groups, including children. ·Unemployment is still very high, despite its rapid decline in recent years. The Commission expects the unemployment rate to continue declining to 12.8% in 2021. High unemployment affects in particular young people and low-skilled workers. New action plans aimed at improving the support to young and long-term unemployed workers hinge upon a strengthened capacity of public employment services. The 22.3% increase in the minimum wage in 2019 has raised labour costs, especially in some sectors and regions. Its impact on employment and in-work poverty has not been quantified yet. In the meantime, a new increase has been agreed in 2020 and further ones have been announced until 2023. The new government has also announced its intention to revisit aspects of the 2012 labour market reform, which is recognised to have underpinned strong job creation during the recovery. ·The widespread use of temporary contracts weighs on productivity growth and fuels inequality and in-work poverty. The share of employees on a temporary contract is the highest in the EU, at around 26%. This has negative impact on human capital formation, impeding faster labour productivity growth. Temporary contracts are increasingly shorter and commonly used even in sectors with little seasonality. Employment subsidies are not effective at promoting stable employment. ·Labour productivity growth has been relatively weak in recent years. It even decreased slightly in 2018 and 2019. Total factor productivity however, has grown broadly in line with the EU average. Other key structural issues analysed in this report, which point to particular challenges for Spain’s economy, are the following: ·Spain’s innovation performance is below the EU average in all regions. Innovation suffers from public and private underinvestment in R&D, and the coordination of research and innovation policy across different levels of government remains a challenge. Lack of cooperation between academia and businesses hampers knowledge diffusion. Business innovation is constrained by the low absorption capacity of small firms. Regulatory fragmentation across regions also makes it more difficult for firms to scale-up. Regulatory barriers continue to restrict competition in certain professional services and in retail. A more effective implementation of the Law on Market Unity would promote competition and better regulation, and reduce regulatory fragmentation. ·The low innovation performance of the economy is also related to shortages of technical skills. High early school leaving rates undermine equal opportunities and contribute to the high share of low skilled in the population. The low attractiveness of vocational education and training amplifies shortages of medium to high technical skills. School-to-work transitions remain difficult, as job opportunities are limited and often of low quality. At the same time, the economy does not create enough high-skilled occupations, reflecting its low innovation dynamics. ·Spain is improving on digitisation, but the low number of information and communication technologies specialists and the slow uptake of digital technologies by small and medium-sized companies hampers exploiting its potential. Very small enterprises, which represent a large proportion of firms in Spain, cannot reap the benefits of digitisation as easily as larger companies do. Small and medium-sized enterprises often refer to a shortage of information and communication technology’s specialists as a constraining factor for taking greater advantage of the digitising trend. There is room to continue improving the very good performance of Spain in the provision of digital public services. ·The share of people at risk of poverty or social exclusion continues to decrease but it is still high, particularly for children. Labour market challenges and the low impact on poverty of social transfers result in one of the highest risks of poverty or social exclusion for children in the EU The weakness of family benefits and income guarantee schemes limits the poverty reduction effect of social transfers. Regional minimum income schemes are estimated to only reach 20% of their potential beneficiaries nationwide, with strong regional disparities. Even though fertility rates are much below the population replacement level, family benefits in Spain remain the lowest in the EU. They reach only half of the children at risk of poverty or exclusion as a strict means test for child benefits results in low coverage, and tax allowances are of limited benefit for lower income families. ·Incomplete connections for energy and goods transport by rail prevent Spain from fully benefitting from the EU single market. Progress in electricity interconnections with neighbouring EU countries would help Spain achieve the interconnection 2030 target (which should allow at least 15% of the electricity produced by its power plants to be transported across its borders to neighbouring countries). Investment is also needed to enable more freight to be transported by rail. Notably, support is needed to advance on connections with France and Portugal and to ports and logistic hubs. ·Spain is one of the Member States most exposed to climate change. Climate change adaptation, risk prevention and disaster resilience require investment. Infrastructure for water and waste management is uneven across the country, posing significant environmental challenges. In some urban areas, air quality is also an issue. At the same time, Spain’s environmental tax revenues remain among the lowest in the EU. ·Further action would accelerate the transition towards clean and sustainable mobility, as well as the decarbonisation of energy and the increase in energy efficiency, in particular at building and district scale. Spain is bound to miss its 2030 CO2 emissions targets, if it does not implement the ambitious policies outlined in the draft National Energy and Climate Plan. Transport is the sector where greenhouse gas emissions keep growing most. To reduce the current reliance on carbon-intensive road freight, investments need to focus on making better use of the rail system. ·The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for the period 2021-2027 includes a Just Transition Fund, a dedicated just transition scheme under InvestEU, and a new public sector loan facility with the EIB. It is designed to ensure that the transition towards EU climate neutrality is fair by helping the most affected regions in Spain to address the social and economic consequences. Key priorities for support by the Just Transition Fund are identified in Annex D, building on the analysis of the transition challenges outlined in this report. ·Territorial cohesion challenges persist. Regional disparities exist in the areas of employment, educational outcomes, early school leaving rates, poverty and inequality. Despite a significant improvement in digital infrastructure, the urban-rural divide persists. At the same time, Spain faces problems of ageing and depopulation in rural areas, as well demographic pressures in the major urban areas. ·Stronger and sustained coordination between the national, regional and local authorities would render the implementation of policies more effective. Coordination amongst different levels of government is key and remains a challenge in policy areas where both national and regional levels are involved in reforms. These include better regulation and the implementation of internal market rules, as well as active labour market policies, education, health care and social services. 1. Economic situation and outlook Economic outlook

The Spanish economy is now set on a moderating path. After expanding by 2.4% in 2018, GDP growth decelerated to 2.0% in 2019, still well above the euro area (see Graph 1.1). ( ) In 2019, the reported quarterly composition of growth has been very volatile, but overall, domestic demand weakened compared to the previous year due to both lower private consumption and investment, whereas the contribution of net exports to growth became positive. Lower private consumption growth has been partly due to weak demand for durable goods, possibly related to technological uncertainty in the automotive sector, and to an increase in precautionary savings by households. Economic activity is expected to decelerate further to 1.6% in 2020 and 1.5 % in 2021, despite a small rebound of consumption. This is mainly due to a declining contribution of net exports to growth. Private consumption growth is expected to increase slightly and then stabilise as households’ financial position improves and some of the temporary factors limiting car purchases gradually fade away. Still, consumption is expected to grow at a lower rate than disposable income over the forecast horizon, resulting in additional increases in households’ savings rate. Net exports should moderate but continue supporting growth. The contribution of net exports to growth has been positive since mid-2018 due to unusually low import growth, partly reflecting weakness in the demand for durable and investment goods. The import intensity of final demand is expected to return to its historic average as the demand for durable and investment goods recovers, pushing up import growth. Export growth is projected to remain subdued amid trade tensions and weak global growth. As a result, the contribution of net exports to growth is expected to diminish in 2020 and become broadly neutral in 2021. Graph 1.1:Composition of GDP growth Source: European Commission 2020 winter interim forecast. Risks to the outlook are mainly on the downside. Risks are related to external developments such as further restrictive measures on trade, a more protracted slowdown in world GDP growth than anticipated, geopolitical tensions and the UK’s withdrawal from the EU. On the upside, trade tensions could be resolved faster than assumed, giving rise to a stronger rebound of foreign trade. Domestic risks refer to the impact of uncertainty, which could weigh more than expected on consumption and investment decisions. It is estimated that potential growth will continue to rise. Potential output growth plummeted during the crisis, reaching -0.5% in 2012. Since then, it has kept increasing, and it is estimated to reach 1.5% by 2021, converging to the euro area average (see Graph 1.2). About two thirds of this increase come from labour. The contribution of capital and total factor productivity (TFP) to potential output is now in line with the euro area average, after a post-crisis increase. Graph 1.2:Contributions to potential growth Source: European Commission. Investment Investment is expected to recover slightly over the forecast horizon after a weak end of 2019. Equipment investment growth, which has been negatively impacted by weakness in the manufacturing sector is expected to recover slightly, in line with final demand. Residential investment is set to decelerate further as the cycle matures, whereas non-construction investment is expected to recover somewhat after contracting in 2019. As a share of GDP, non-construction investment has reached its pre-crisis peak, but remains below the euro area average (see Graph 1.3). The investment rate stood at 18.9 % in 2019, above the minimum of 17% recorded in 2013, but still 2 pps below the euro area average. Non-construction investment now stands at 9.9 % of GDP, in line with its pre-crisis peak, but below the euro area average (11.2% of GDP). However, construction investment has barely increased its weight in GDP since 2013. It stood at 9.1% of GDP in 2019, far from its pre-crisis peak at more than 16%, and also below the EU average (10% of GDP). Graph 1.3:Investment rate, 2015 prices Source: European Commission 2019 autumn forecast. Both capital intensity and the productivity of capital in Spain are below the euro area average, although capital allocation has improved. In the pre-crisis period investment flowed to non-tradable sectors, and in particular construction, which at the time had high profitability but low productivity. This resulted in high capital intensity, but low productivity of capital (see Graph 1.4). This trend was reversed during the recovery, as net capital formation did not keep pace with strong job creation. This resulted in a decline in capital intensity, but an increase in the productivity of capital relative to the euro area, suggesting that capital allocation has improved. Total factor productivity also improved slightly relative to the euro area, also suggesting a structural improvement in the quality of investment. Graph 1.4:Capital intensity and capital productivity Source: European Commission 2019 autumn forecast. External position The current account surplus is expected to widen until 2021, both in nominal and cyclically adjusted terms. The revised national accounts also reveal that in recent years Spain’s current account surplus has been about 1% of GDP higher than previously estimated. After declining in 2018, the current account surplus is expected to increase in 2019 and then improve slightly more in 2020 and 2021, owing to a reduction in the goods’ trade deficit. In cyclically-adjusted terms, the current account surplus is also expected to increase this year, and rise further over the forecast horizon, reaching a record high 3.4% of GDP in 2021. Persistent current account surpluses are translating into a reduction in Spain's net external liabilities, which nevertheless remain high. Despite the current account surpluses registered since 2013, negative valuation effects (partly reflecting improvements in confidence and the higher value of Spanish assets) have limited the improvements in the net international investment position (NIIP). Still, the NIIP has fallen by more than 17 pps of GDP since its peak, but remained at a sizeable -79.6% of GDP in Q3-2019. The continued current account surpluses and robust nominal GDP growth projected until 2021 will facilitate a further improvement in the NIIP (see Section 3). By sectors, the net lending position of the private sector since 2009 (largely due to the corporate sector) has been partly offset with the borrowing position of the general government sector (see Graph 1.5). Graph 1.5:Net lending / borrowing by sector Source: European Commission 2019 autumn forecast. Private and public debt The stock of private debt has continued declining, but deleveraging needs persist. Despite substantial debt reduction among both households and corporates (in consolidated terms), private sector debt remains high, at 130.6% of GDP in Q3-2019. This is a reduction of more than 70 pps since its peak (of which about 45 pps by non-financial corporations (NFCs) and 25 pps by households). Since 2017, the decline has been driven by robust growth in nominal GDP, which has more than offset positive net credit flows. The private debt-to-GDP ratio is expected to remain above its prudential threshold and fundamental benchmark, pointing to deleveraging needs for NFCs and especially for households (see Sections 3 and 4.2).

The housing market keeps recovering, both in terms of activity and of prices, but it is slowing down. Activity in the housing market, both in terms of transactions and new construction, has picked up strongly in recent years, but remains far from its pre-crisis levels, and has started to slow down in 2019. Growth in house prices has also started to moderate, but it varies greatly across regions, with larger increases in the major cities and the coastal areas. On aggregate for the whole country, the valuation gap is closing. In big cities, the increased propensity to rent after the crisis created upward pressure on rental prices (see Section 4.2). The high public debt ratio is set to continue decreasing slowly. Under a ‘no policy change’ scenario, the general government debt ratio is forecast to fall slightly from 97.6% in 2018 to 96.0% of GDP in 2021. The decline is expected to be driven by nominal GDP growth and falling interest expenditure. After decreasing by 0.5 pps to 2.5% of GDP in 2018, the general government deficit is projected to narrow to 2.3% of GDP in 2019. Under this ‘no-policy change’ scenario, the deficit is projected to decline further to 2.2% of GDP in 2020, and to 2.1% in 2021. The primary balance is likely to remain broadly unchanged around zero, whereas the average cost of debt will continue falling as long as the cost of issuance remains below the average cost of debt. Inflation Headline inflation is projected to remain subdued but increase gradually as core inflation rises. HICP inflation fell from 1.7% in 2018 to 0.8% in 2019, mainly because of a decline in oil prices. It is then forecast to increase to 1.3 % in 2021, as further declines in oil prices partly offset the gradual pickup in core inflation. The increase in core inflation is set to be driven by the increase in wages, which have a large weight on the services component of the HICP index. The inflation differential with respect to the euro area is expected to remain slightly negative in 2020 and 2021. Labour market Employment growth is set to moderate, in line with the cyclical slowdown. Spain has recovered 2.5 million jobs since Q1-2014, i.e., two thirds of the jobs lost during the crisis (see Graph 1.6). However, the employment rate remains 6.0 pps below the EU average (at 67.8% in Q3-2019). The labour market started to lose traction in the second half of 2019, and job creation is expected to continue declining, especially in 2020 and 2021. The unemployment rate is set to continue falling to below 13% in 2021, still far above the euro area average. Despite the positive trend since 2014, the labour market integration of young people and of the long-term unemployed remains a challenge (see Section 4.3.1). Graph 1.6:Employment and GDP - levels compared to 2008 Source: Eurostat [namq_10_pe, namq_10_gdp] Labour market segmentation and skills’ gaps persists, hindering productivity growth. At [26.1% in Q3-2019], Spain is the EU country with the largest share of employees on temporary contracts (compared to 13.4% on EU average). This hinders human capital accumulation and ultimately productivity growth. In addition, temporary workers face a high rate of in-work poverty (21.3% in 2018, 14 pps more than permanent workers, one of the largest gaps in the EU). Other labour market factors hindering productivity growth are related to skills gaps and mismatches (see Section 4.3). Wage growth is expected to have peaked in 2019, and to outpace inflation in 2020 and 2021 as well. After growing by 1% in 2018, compensation per employee rose to 2.1% in 2019, resulting in the first increase in real wages since 2015. This is due to both the increase in the minimum wage enacted at the beginning of 2019, and rising negotiated wages in bargaining agreements. Wage growth is expected to decelerate slightly but continue growing above inflation in 2020 and 2021. As productivity growth was negative in 2019, unit labour costs peaked at 2.4%. They are set to rise more slowly in 2020 and 2021, though still faster than the euro area average (see Graph 1.7). Graph 1.7:Analysis of unit labour costs Source: European Commission 2019 autumn forecast. Poverty, inequality and social inclusion Social indicators continue to improve on the back of falling unemployment, but child poverty remains among the highest in the EU. In 2018 (EU-SILC survey, income year 2017), the percentage of people at risk of poverty or social exclusion (AROPE) declined slightly to 26.1% (3.1 pps below the peak in 2014) but remains well above the EU average of 21.9%. Though figures are improving, children (0-17) remain the age group worst affected; at 29.5%, the rate is 5.5 pps above the EU average and among the highest in the EU. The impact of social transfers in reducing child poverty is the lowest in the EU (see Box 4.3.3). Income inequalities continue to decrease, but remain among the highest in the EU. In 2018 (income year 2017), the income of the top 20% was 6.0 times that of the bottom 20%, compared to 6.6 times in 2017 (income year 2016). Flash estimates ( ) point to a further improvement in 2019. The Gini coefficient ( ) also fell slightly, from 34.1 in 2017 to 33.2 in 2018. However, both indicators remain well above the EU average (of 5.2 and 30.9 respectively) and their pre-crisis levels (see Section 4.3) Regional disparities Significant regional socio-economic disparities persist in Spain. The evolution of GDP per head across regions throughout the recovery has been closely linked to labour market developments, and in particular the employment rate (see Section 4.3). Education indicators also show wide regional disparities, particularly in the rate of early school leavers ranging between 7% and 24% in 2018. Other socio-economic indicators also present significant territorial disparities at subnational level, including those related to R&D expenditure, poverty and competitiveness (see Graph 1.8). Graph 1.8:Regional disparities on selected indicators Source: European Commission. ]] Sustainable Development Goals There is political consensus in Spain on supporting the United Nations 2030 Sustainable Development Goals. The establishment of Vice-Presidencies for Social Rights and the Agenda 2030 as well as for Climate Change and the Demographic Challenge in the new government reflect this commitment. However, meeting the sustainability challenge will require close cooperation between the different levels of government (European Commission, 2019g). Other important challenges in the implementation of Agenda 2030 in Spain will include the coordination with other ministries so as to ensure policy coherence, as well as budget alignment and the definition of indicators for adequate monitoring and accountability. Spain is making progress towards achieving the Sustainable Development Goals (SDGs). On the basis of the trends in the Eurostat indicators over the last five years, the area where progress has been most evident is SDG 3 “Good health and well-being”, where all the underlying indicators showed an overall improved performance, despite some regional variations in access to certain types of health care. Furthermore, moderate improvements are seen for a broad range of the other SDGs such as SDG 1 “No poverty”, SDG 2 “Zero hunger”, SDG 4 “Quality education”, SDG 8 “Decent work and economic growth”, SDG 9 “Industry, innovation and infrastructure”, SDG 10 “Reduced inequalities”, SDG 11 “Sustainable cities and communities”, SDG 13 “Climate action”, SDG 16, “Peace justice and strong institutions”, and 17 “Partnerships for goals”. Notwithstanding the improvements, the current levels for several of the individual underlying indicators are significantly lower than the EU average, such as for the share of early school leavers, people at risk of poverty, research and innovation, perception of corruption, recycling of municipal waste, land degradation and water.

Table 1.1:Key economic and financial indicators – Spain Source: Eurostat and ECB as of 4-2-2020, where available; European Commission for forecast figures (Winter forecast 2020 for real GDP and HICP, Autumn forecast 2019 otherwise). 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 76% of all country-specific recommendations addressed to Spain have recorded at least ‘some progress” ( ). 24% of the CSRs recorded 'limited' or 'no progress' (Graph 2.1). The reforms implemented during the economic crisis and in the following years have contributed to Spain’s strong economic performance and job creation until now. However, reform progress slowed after 2014. There has been some back-tracking on the pension reforms and the new government has announced a reversal of some elements of the 2012 labour market reform. Coordination between the national and the regional governments is crucial, but remains a challenge in several policy areas covered by the CSRs. Earlier recommendations on the financial sector have been addressed. Following macro-financial stabilisation, the Spanish banking sector enjoys high liquidity and adequate capitalisation. Profitability is under pressure due to the low interest rates, but confidence in the Spanish banking sector as a whole has been restored. There has been little progress in the area of fiscal governance. The new governance structure for public procurement is still not fully functioning, almost two years after the entry into force of the law on public sector contracts. The elaboration of the National Public Procurement Strategy scheduled for 2018 is delayed. There have been no other steps to strengthen the fiscal framework. Seven reviews of public expenditure in specific policy areas have been completed and the results of four on-going reviews are expected in the first half of 2020. Finally, if the departures from the 2013 pension reform are made permanent without adequate compensatory measures, pension expenditure will increase significantly and worsen inter-generational equity in the medium to long term. Graph 2.1:Overall multiannual implementation of 2011-2019 CSRs by February 2020 Source: European Commission. There was some improvement in the delivery of labour market policies, but their effectiveness remains modest and labour market segmentation persists. The share of temporary contracts in total employment remains high at above 26% in Q3-2019. In the public sector, the use of temporary contracts has increased further in 2019, despite the pledge to reduce it. Measures to reduce temporary contracts have focused on fighting abuse. Efforts to strengthen the public employment services continue in some regions. The implementation of the new Action Plan for Youth Unemployment and the ReincorporaT Plan for the long-term unemployed is on track, but hiring subsidies still absorb about 40% of the budget for active labour market policies and do not seem to be very effective. Initiatives are on-going to reduce skills mismatches and early school leaving. Medium to high-level technical skills, and especially ICT specialists, are in shortage. The new Strategic Plan for Vocational Education and training (VET) may play a role in reducing skills mismatches and early school leaving, once fully implemented. The business sector’s role in the design of qualifications is being reinforced, and work is underway on a Digital Skills National Strategy. There has been limited progress in increasing the support for families and the effectiveness of social assistance. The 2019 increase in the amount of the means-tested child allowance can only have a very limited impact on poverty reduction. National unemployment assistance schemes remain fragmented and the coverage of regional income guarantee schemes remains very limited in many regions, with the number of beneficiaries not even reaching 20% of the potential beneficiaries on average in the country. There has been limited progress on investment to foster innovation, resource and energy efficiency and to complete rail freight infrastructure and electricity interconnections. The draft National Climate and Energy Plan is ambitious in scope, but it relies to a large extent on mobilising private investments, which have not materialised yet. There has been some progress on the ongoing development of electricity interconnections with France and with Portugal. There were certain steps taken to support sustainable mobility, but overall there was limited progress in fostering resource efficiency. Investments in rail infrastructure for freight have not increased in 2019. Spending on R&D remains low compared with other Member States. Coordination of research and innovation policies across government levels remains a challenge and the evaluation of research programmes and policies is not systematic. The assessment of this CSR does not take into account the contribution of the EU 2021-2027 cohesion policy funds. () There has been limited progress in the area of better regulation. Despite some actions to improve the implementation of the Law on Market Unity, a stronger commitment by regions and local authorities could help to overcome excessive market fragmentation and foster better regulation in Spain. Overall, policy advances have been very modest, leaving Spain’s remaining structural weaknesses unaddressed. A more decisive implementation of reforms and new policy initiatives in several areas remain key to increase productivity, potential growth, social inclusion, and the green transformation. The European Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2018, Spain has received support for some 20 projects. In 2019, several projects were delivered on the ground. The Commission, for example, supported the authorities in the review of the public expenditure on the reimbursement of prescription-dispensed medicines and in the promotion of e-Justice. The Commission also assisted the Spanish Ministry for Ecological Transition in the preparation of strategies for coastal protection of the provinces of Cadiz, Malaga and Almeria in Andalusia in order to address the effects of climate change. Work started in 2019 on new projects (namely, to improve the implementation of dual VET in Spain, to help the Spanish Public Employment Service implement the Action Plans for Youth Employment and for Long-term Unemployment, as well as on the reform of the insolvency and pre-insolvency frameworks). Box 2.1: EU Funds and programmes to address structural challenges and to foster growth and competitiveness in Spain Spain is one of the countries benefiting most from EU support. The financial allocation from the EU Cohesion policy funds ( I ) for Spain amounts to €42.5 billion in the current Multiannual Financial Framework, equivalent to around 0.5% of its GDP. By the end of 2019, 31.7 billion (around 75% of the total amount planned) were allocated to specific projects, while only €12.9 billion were reported as spent by the selected projects ( II ), showing a level of implementation well below the EU average, requiring prompt measures to accelerate the implementation of the programmes.

While bringing about a more harmonious development through reducing economic, social and territorial disparities, EU Cohesion policy funding also supports to a great extent structural challenges in Spain. The Cohesion Policy programmes for Spain have allocated €10 billion for smart growth, €8.5 billion for sustainable growth and sustainable transport and €11 billion for inclusive growth. In 2019, following a performance review ( III ) €1.7 billion have been made available for Spain within performing priorities.

EU Cohesion policy funding is contributing to the transformation of the Spanish economy, by promoting growth and employment via investments, among others, in research, technological development and innovation, competitiveness of enterprises, sustainable transport, employment and labour mobility. By 2019, investments driven by the European Regional Development Fund (ERDF) increased accessibility by building or upgrading more than 200 km of roads; supported research, as over 11,000 researchers work in improved research infrastructures; promoted energy efficiency realising more than 40 MW of additional capacity to produce renewable energy; achieved 1,400,000 additional households with access to broadband of at least 30 Mbps, the upgrading of schools for 200,000 pupils, as well as the reduction of greenhouse gas emissions by 250,000 tons of CO2 t-eq. The European Social Fund (ESF), as well as the Youth Employment Initiative (YEI), of which Spain is the biggest beneficiary, supported notably the rollout of the 2014 education reform and the set-up of youth policies durably anchored in public employment services, based on strong partnerships. Over 4 million actions, including workshops, trainings and outreach campaigns, so far led to 1.8 million qualifications and 884 970 jobs. 200,000 young people (50%) were still working or engaged in training or education after completing a Youth Guarantee programme.

Agricultural and fisheries funds and other EU programmes also contribute to addressing the investment needs. The European Agricultural Fund for Rural Development (EARDF) and the European Maritime and Fisheries Fund (EMFF) provides support worth, respectively, €12.3 billion and €1.6 billion. Spain benefits also from other EU programmes, such as the Connecting Europe Facility, which allocated €1 billion to projects on strategic transport networks, Horizon 2020 allocated EU funding of €4.2 billion (including 1800 SMEs), and COSME unlocked €4.1 billion of loans to 98 913 SMEs.

EU funding contributes to the mobilisation of important private investment. By the end of 2018 European Structural and Investment funds (ESI Funds)-supported programmes alone ( IV ) mobilise additional capital by committing about €2.3 billion in the form of loans, guarantees and equity ( V ), which isamount to 7% of all decided allocations of the European Structural and Investment funds (ESIF).

EU funds invest substantial amounts on actions in line with the Sustainable Development Goals (SDGs). In Spain the European Structural and Investment Funds support 13 out the 17 SDGs and up to 96% of the expenditure is contributing to progress in achieving these goals.



Table 2.1:Overall assessment of progress with 2019 CSRs * Source: European Commission. * The assessment of CSR3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. The regulatory framework underpinning the programming of the 2021-2027 EU cohesion policy funds has not yet been adopted by the co-legislators pending inter alia an agreement on the multiannual financial framework (MFF).

3. Summary of the main findings from the MIP in-depth review Table 3.1:Outward spill-over heat map for Spain Source: IMF, OECD, TiVa, BIS and European Commission. 3.1. Introduction In spring 2019, Spain was identified as having macroeconomic imbalances (European Commission, 2019k). Large stocks of external and internal debt, both public and private, continue to constitute vulnerabilities in a context of still high unemployment, and have cross-border relevance. In addition, low potential growth amplifies the risks related to Spain’s macroeconomic imbalances, and hampers their unwinding. The 2020 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Spain to assess the unwinding of the imbalances (European Commission, 2019b). This chapter summarises the findings of the analyses carried out as part of the macro-economic imbalances procedure (MIP) in-depth review that is contained in various sections in this report ( ). 3.2. Imbalances and their gravity Spain’s net international investment position (NIIP) remains very negative. Although the stock of net external liabilities (79.6% of GDP in Q3-2019) is gradually declining, it remains large and exceeds prudential and fundamental-based benchmarks. However, the composition of external liabilities somewhat mitigates vulnerabilities.

Private sector deleveraging needs remain sizeable, despite a significant reduction of debt. Private sector debt, in consolidated terms, came to 130.6% of GDP in Q3-2019 (with household debt accounting for 57.4% of GDP and non-financial corporation debt for 73.2% of GDP). This is slightly below the MIP scoreboard threshold of 133%, but well above the prudential and fundamental-based benchmarks for both households and corporations. The general government debt ratio is expected to have decreased slightly further in 2019, but it remains very high. The Commission’s 2019 autumn forecast projects a decrease of 1.6 pps by 2021, to 96.0% of GDP. Despite being on a downward trend, the stock of public debt remains too high, posing significant risks for fiscal sustainability in the medium and long term. Although unemployment has fallen rapidly, it remains very high. Unemployment for 15-74 years old stood at 13.8% in Q4-2019, following a reduction of 12 pps since its peak in 2013. However, this is the EU’s second highest rate. Long-term and, especially, youth unemployment have also fallen steeply during this period, but more than 30% of the active population under 25 was still without a job in Q3‑2019. Moreover, the share of temporary contracts (26.1% in Q3-2019) has not decreased in the last three years, which has a negative impact on potential growth, productivity, and social cohesion. Low productivity and potential growth, in turn, hinders the correction of imbalances. The Spanish economy could be a source of significant spill-over effects to the rest of the EU. This stems from its relatively large size and its level of integration with other Member States, especially those with which Spain has significant trade links, such as Portugal, and financial and/or banking linkages (see Table 3.1). Box 3.1 includes a simulation that illustrates how a fully financed large public investment programme could boost economic growth in Spain, with potential spill-over effects on other Member States. 3.3. Evolution, prospects, and policy responses External sustainability Graph 3.1:Current account and net international investment position Source: Eurostat and own calculations. Spain’s current account surplus is above the level explained by fundamentals. The current account surplus is the result of a trade surplus in services, which more than offsets the trade deficit in goods (see Section 4.4.1). The trade deficit in goods, the main reason for which is a large deficit in energy products, has remained contained despite the closure of the output gap, contrary to previous expansions. In addition, export performance has evolved positively despite global trade tensions. Accordingly, the cyclically adjusted current account balance is expected to widen in 2019 to 3.0%, and to increase further this year and in 2021, when it is expected to reach a record high of 3.4% of GDP (see Graph 3.1). This also exceeds the current account norm explained by fundamentals, estimated to be a surplus of about 1% of GDP in 2018 ( ). Persistent current account surpluses are slowly translating into a narrowing of Spain’s external net debtor position. High nominal GDP growth and continued external surpluses have driven a slow but steady narrowing of Spain's NIIP (see Graph 3.2) to 79.6% of GDP in Q3-2019. However, revised financial accounts reveal a slower reduction of Spain´s negative NIIP than previously estimated, on account of more negative valuation effects in recent years, and especially in 2017 and 2018. Looking ahead, continued current account surpluses and continued nominal GDP growth projected until 2021 are expected to result in further improvements in the NIIP. Graph 3.2:Analysis of the rate of change of net international investment position Source: Eurostat.

Box 3.1: Public investment and potential spill-overs The European Commission’s QUEST model ( VI ) was applied to simulate the impact of a public investment package totalling €130 billion over 10 years. The assumed additional public investment is equivalent to 1% of GDP at its 2019 level, every year over a decade. This simulation follows the 2019 country-specific recommendations on investment-related economic policy. Consequently, the public investment package is assumed to include growth and productivity-enhancing expenditures on research and innovation, skills, the green transformation in the areas of transport, energy, carbon emissions, water management, recycling, and environmental damages from extreme weather events. For simplicity, the simulation assumes that neutralising fiscal measures in the form of increased indirect taxes are implemented. The output elasticity with respect to the public capital stock is assumed to be 0.12, which is a mid-range estimate (Arslanalp et al., 2010). Monetary policy is assumed to retain its accommodative stance at the zero lower bound for the first two years and gradually normalise afterwards. A sustained increase in public investment would have positive domestic and cross-border spill-overs. The demand effect (higher export demand for foreign goods and services) leads to positive spill-overs, but investments also result in capital deepening and higher efficiency, which improves competitiveness towards trading partners. Whether the overall spill-over effect is positive or negative depends on the relative strength of the two effects. As seen in Table 3.1.a, under the stipulated assumptions, increasing the public investment rate in Spain boosts output and productivity (output per hour) as well as the trade balance and the public debt, thereby reducing current macroeconomic imbalances. It also shows that in spite of a relative loss of competitiveness of the rest of the euro area compared to Spain, the demand effect from a Spanish public investment programme could still generate a small, but positive spill-over effect to the rest of the euro area. In this simulation exercise, the realisation of sizable positive spill-overs hinges upon an accommodative monetary policy ( VII ). Assuming a prolongation of the accommodative stance beyond 2 years could result in even stronger effects on the GDP of the rest of the euro area. This gain is associated with the export demand effects from a stronger depreciation of the euro, and with a strengthening of the real interest rate decline. Conversely, a monetary contraction would neutralise the spill-overs onto the rest of the euro area or make them negative. Table 3.1a:Spill-over effects of a 10 year public investment programme in Spain Source: European Commission services model simulation This simulation complements earlier QUEST simulations modelling a demand stimulus or structural reforms. Earlier simulations include an increase in public investment and a reduction in personal income tax (European Commission, 2017a), increases in expenditure on R&D and education (European Commission, 2018a), and implementation of structural reforms to close performance gaps (European Commission, 2019a).

The composition of Spain’s external liabilities in terms of instruments and maturity mitigates some of the vulnerabilities. The net international investment position excluding non-defaultable instruments (NENDI), which are the most risky type of external liabilities ( ), stood at -54% in 2018, below the prudential threshold (-60%). The reduction of the NENDI since 2011 (20 pps of GDP), has been faster than that of the NIIP (a decline of 9 pps). This reflects an improvement in the net foreign direct investment (FDI) position due to a large foreign investment inflows, and somewhat reduces vulnerabilities. Moreover, a non-negligible part of external debt is central bank liabilities stemming from monetary operations of the Eurosystem (see Graph 3.3), which carry fewer refinancing risks than that of the private sector. In addition, most of the external debt has maturities of one year or more (about 76% of general government and private sector external debt, excluding intercompany loans), and average maturity has been increasing in recent years, further reducing risks. Table 3.2:Current account balance and net international investment position sensitivity analysis Source: Own calculations. Reducing decisively Spain´s large external liabilities would require maintaining large current account surpluses for sustained periods of time. Spain’s NIIP is still far from a level that could be considered prudential (‑61% of GDP in 2019) or in line with fundamentals (-23% of GDP) (see Graph 3.1) ( ). Although at present the current account surplus exceeds the level implied by fundamentals (see footnote 12), further progress in reducing the NIIP could prove more challenging under less benign growth scenarios (see Table 3.2). Measures to raise non-cost competitiveness through investment in research and innovation, as well as improving labour skills have been modest so far (see Sections 4.3 and 4.4). Graph 3.3:Gross external debt by sector-type of financial assets Source: Bank of Spain Private indebtedness and deleveraging Private sector deleveraging has advanced, but is now driven mainly by robust nominal GDP growth. In Q3-2019 consolidated private sector debt stood at 130.6% of GDP, 73.6 pps lower than its peak in 2009. Of this reduction, the largest decline is attributable to corporate debt (46 pps of GDP), but household deleveraging (27.6 pps of GDP) has also been significant. On the corporate side, the reduction in the total stock of debt has halted since 2018, as new credit has continued to flow and larger companies have continued to borrow by issuing securities, supporting investment. The total stock of debt has also remained unchanged for households since 2018, as there have been growth in new credit to finance durable consumer spending and for house purchases, coupled with a reduction in the repayment of mortgages. The latter should however be seen in relation to the reduction in total housing debt. Still, despite the stabilisation of the nominal stock of debt, the debt to-GDP ratio for both households and corporations has continued to decline, driven by robust nominal GDP growth. Overall, the private debt ratio decreased by 6 pps in 2018 (4 pps for NFC and 2 pps for households). The pace of deleveraging is expected to slow down in 2019, when the debt ratio is projected to decline by 4 pps (3 pps for NFC and 1 pp. for households). Deleveraging needs remain for both corporations and households. The financial position of Spanish households has strengthened thanks to improvements in the labour market, and their financial burden has been reduced by the prevailing low interest rates. However, growth in in consumer credit may make households, especially the over-indebted ones, more vulnerable to adverse shocks (Bank of Spain, 2019d). Although the debt-to-GDP ratio is expected to be below the MIP threshold (133%) in 2019, it will still be well above prudential levels and fundamental-based benchmarks for both households and NFCs, indicating that deleveraging needs persist for both segments (see Section 4.2.3). In particular, NFCs debt is expected to reach 72% of GDP in 2019, against a prudential threshold of 58% and a fundamental-based benchmark of 60%. Household debt is projected to fall to 58% this year, also above prudential and fundamental-based levels of 41% and 43%, respectively. The housing market keeps recovering, but activity slowed down in 2019. House prices, after rising for the last six years, are starting to decelerate. Still, they increased by about 5% in the year up to Q2-2019. The valuation gap is closing for the country as a whole (see Section 4.2.1), but there is considerable heterogeneity across regions, partly reflecting a still large stock of unsold houses in some areas and a buoyant rental housing market in others. The recovery of house prices does not seem to imply potentially harmful dynamics, but price developments in some regions deserve attention, raising concerns about affordability (see Section 4.2 and Box 4.2.1). Investment in residential construction has been increasing since the last quarter of 2015, but remains below pre-crisis levels (5% of GDP in 2018, compared to about 12% of GDP in 2006). Public debt Public sector debt remains very high, and its pace of reduction is expected to slow down. After falling by 3.1 pps of GDP between 2014 and 2018, public debt is projected to decrease slightly further, by 1.6 pps, by 2021. The decline is expected to be driven by nominal GDP growth and falling interest expenditure, while the primary balance is likely to remain broadly unchanged around zero. After a 0.5 pps. decrease, to 2.5% of GDP in 2018, the reduction in the general government deficit is expected to slow down, narrowing to 2.3% of GDP in 2019. In the absence of a 2020 budget law, the deficit is projected to decline further to 2.2% of GDP in 2020, and, assuming that there is no change in policies, to 2.1% in 2021. The average cost of debt is expected to continue falling as long as the cost of issuance remains below the average cost of outstanding debt. While there appears to be no immediate risk of fiscal stress, risks to fiscal sustainability remain significant in the medium to long term (see Section 4.1.1). Considered in isolation, the announced departures from the 2013 pension reform risk increasing the long-term cost of ageing. Unless offsetting measures are taken, sustainability risks would significantly increase. Discussions on these issues are expected to be resumed within the ‘Toledo Pact’ (the parliamentary committee dedicated to pension issues). Limited progress was made in improving fiscal governance. The implementation of plans to strengthen the framework for public sector contracts and public procurement is pending. Unemployment Unemployment is set to continue falling, despite the projected slowdown in job creation. Employment growth is expected to slow in 2020 and 2021, in line with the cyclical slowdown. However, the unemployment rate is set to continue falling, to below 13% in 2021, which is still well above the EU average. There has been no reduction in labour market segmentation, despite an increasing share of permanent contracts among new jobs. A high level of labour market segmentation, long-term unemployment, and population ageing remain challenges for higher productivity and potential growth (see Section 4.3). In addition, the activity rate has started to decline as young people stay longer under education. Wage growth is expected to have peaked in 2019, and to remain above inflation in 2020 and 2021. After growing by 1% in 2018, accelerated to 2.1% in 2019, resulting in the first increase in real wage since 2015. This is due to both the increase in the minimum wage enacted at the beginning of 2019, and rising negotiated wages in bargaining agreements. Although wage growth is expected to decelerate slightly, wages are forecast to continue growing at a rate above that of inflation in 2020 and 2021. After peaking in 2019, unit labour costs should rise more slowly in 2020 and 2021 as productivity growth is set to turn positive, but they should still grow faster than the euro area average. Consequently, Spain is expected to register small cost-competitiveness losses vis-à-vis the euro area in 2019 and 2020, which should become broadly neutral in 2021. However, cost-competitiveness gains accumulated in recent years are not expected to be reverted, and export market shares are expected to evolve favourably. The minimum wage will further increase in 2020, though the impact on employment of the 2019 hike has not yet been quantified. When the increase in the minimum wage entered into force, in January 2019, employment was still growing robustly. Employment growth has slowed down since then, but on the basis of available information, it is difficult to assess at this stage the part of the slowdown that can be attributed to the minimum wage increase. However, data from Social Security affiliations indicate that employment for some groups in specific sectors (e.g., domestic workers, agriculture) is likely to have been affected. In January 2020, the government further raised the minimum wage by 5.6% (up to €950 in 14 instalments), in agreement with social partners. This is estimated to bring the minimum wage to approximately 60% of the median gross monthly earnings for a full time worker in 2020. In 2018, only three Member States and all with much lower unemployment rates, had a minimum wage above this threshold. 3.4. Overall assessment The reduction of macroeconomic imbalances in Spain has progressed further, but vulnerabilities remain. Private sector debt reduction has continued to advance driven by high nominal GDP growth, but deleveraging needs remain. The pace of debt reduction is expected to slow down as new credit flows increase. Public sector debt has been slightly reduced since its peak, a process that is expected to continue despite the projected general government deficits. The current account surplus is expected to increase this year, supported by structural improvements in trade performance, and is now above prudential and fundamental based levels. Persistent external surpluses are slowly translating into a reduction of external liabilities, but these remain very high. In particular, the level of external debt, although has been reduced, remains high. Unemployment is set to continue falling, despite a deceleration in job creation, but remains very high. Reducing long-term and youth unemployment, along with lowering the share of employees in temporary contracts, is critical to raise the growth potential of the Spanish economy. In addition, the low potential growth amplifies the risks related to Spain’s macroeconomic imbalances, and hampers their unwinding. Overall, policy action to reduce the stock of imbalances or their potential implications has been limited across most policy areas (see Table 3.3). General elections in 2019 and delays in forming a new government hampered the implementation of far-reaching reforms. Measures to reduce labour market segmentation have focused on fighting the abuse of temporary contracts. Limited progress was made with fiscal governance, notably regarding the implementation of plans to strengthen the framework for public sector contracts and public procurement. The departures from the 2013 pension reform will increase the long-term cost of ageing, unless they are offset by other measures. Reforms aimed at reducing skills mismatches, fostering research and innovation and improving the business environment have been delayed.





Table 3.3:MIP matrix (Continued on the next page) Table (continued) Source: European Commission. 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Debt sustainability and fiscal risks* The general government debt ratio is only slowing decreasing and remains high. After peaking at 100.7% of GDP in 2014, it had fallen by about 3 percentage points to 97.6% of GDP by the end of 2018. The Commission 2019 autumn forecast projects a further slight decrease to 96.0% of GDP by 2021. The decline is entirely driven by a still favourable interest rate-growth rate differential, which is partly offset by debt-increasing effects stemming from the primary balance and stock-flow adjustments. As the private sector debt ratio has declined faster than the government debt ratio, general government debt now makes up a much larger share of the total indebtedness of the economy. At around 44% in the first half of 2019, the share has more than doubled since 2010, the year in which private sector debt peaked. The lower interest rates in recent years have allowed the Spanish Treasury to extend maturities. The average life of outstanding debt increased significantly from a low of 6.2 years in 2013 to around 7.5 years in 2018. In 2019, the pace slowed down, with average life edging up only slightly to 7.6 years in November. After falling steeply from a peak of around 4% in 2011, the cost at issuance remained stable at around 0.6% in 2015-2018, before decreasing further to around 0.3% in November 2019. The low cost at issuance has continued to exert downward pressure on the cost of outstanding debt, which stood at slightly below 2.4% in November 2019, down from around 4.0% in 2011. The rolling-over of maturing debt and the coverage of new financing needs at low rates are likely to result in further decreases in the cost of outstanding debt in the near future. After peaking at 3.5% of GDP in 2013, interest expenditure gradually decreased to 2.4% of GDP in 2018. Spain does not appear to face immediate risks of ʻfiscal stressʼ, but sustainability risks are high in the medium term and medium in the long term ( ). The value of the early-detection indicator of fiscal stress, the S0 indicator, is below its critical threshold. However, some fiscal variables point to possible short-term challenges, especially if financial markets’ perceptions were to change rapidly. Among the variables with a value above their critical threshold are the gross financing needs, the cyclically-adjusted deficit and net government debt. Financial markets’ perceptions of Spain’s sovereign risk remained fairly stable in 2019, with most of the major rating agencies maintaining their rating and S&P even upgrading it by one notch in September 2019 (Moody’s: Baa1, S&P: Au, Fitch: A-, all with a stable outlook). The 10-year sovereign yield spread against the German bund has narrowed somewhat compared to the situation in 2018. According to the Commission 2019 autumn forecast, Spain is forecast to have a structural government deficit of at least 3% in both 2020 and 2021, reflecting a relatively low level of taxation in relation to expenditure. This is still some way from the medium-term objective of having a zero structural balance. Spain faces high fiscal sustainability risks in the medium term. This conclusion is based on both the sustainability gap indicator (S1) and a debt sustainability analysis. The former indicates that Spain's structural primary balance would need to improve by 3.8% of GDP in cumulative terms over the five-year period to 2026 relative to the baseline ‘no-fiscal policy change’ scenario to bring the debt-to-GDP ratio to the reference value of 60% by 2034. This would require an ambitious structural primary balance by European standards ( ). About three quarters of the very significant S1 value are attributable to the distance of the debt ratio from the 60% reference value and, to a somewhat lesser extent, to the unfavourable initial budgetary position, but only to a limited extent to the projected age-related public spending. However, these numbers are based on the same policy assumptions as those underlying the 2018 Ageing Report (European Commission, 2018d). The recent policy debate on pensions indicates that the mechanism by which pensions are revalued may undergo changes in the near future. In particular, the Commission services estimate that the relinking of pensions to inflation announced by the new coalition government in its programme could lead to an increase in pension expenditure by 2050 of around 4% of GDP. This estimation is close to projections made by the Bank of Spain, the IMF and the think tank FEDEA, but above the estimate of AIReF (2% of GDP) (see Box 4.1.1 of European Commission, 2019a). The new government has also announced its intention to eliminate the sustainability mechanism included in the 2013 reform aimed at adjusting the initial pension level to changes in life expectancy. According to preliminary estimates by the Commission services, this would add at least 0.7% of GDP to long-term pension expenditure.( ) Eliminating both elements of the 2013 reform risks benefitting today’s pensioners at the expense of future generations, unless offsetting measures are implemented. Even when implementing fully the 2013 reform, Spanish pensioners would in the long-run still be expected to enjoy replacement rates above the EU average. A debt sustainability analysis shows that the Spanish general government debt is expected to fall slightly to 95.7% of GDP by 2030 (last projection year). This projection, which assumes normal economic conditions and a constant structural primary balance after the last Commission forecast year (2021), is driven by a gradual worsening of the primary deficit being only partly offset by a favourable and decreasing interest rate-growth rate differential in 2021-2024, and by a constant primary deficit being more than offset by favourable snowball effects thereafter. The analysis also shows that the level of the debt ratio is highly sensitive to shocks (see Box 4.1.1). In the long term, Spain faces a medium fiscal sustainability risk. This conclusion stems from combining the sustainability gap indicator (S2) with a debt sustainability analysis perspective described above. The former shows a gap of 1.8% of GDP that needs to be closed to stabilise debt over the long term. The gap is mainly due to the unfavourable initial budgetary position, though also, to a limited extent, to the projected ageing costs. As was the case for the S1 indicator, the S2 indicator is also based on assumptions regarding pension expenditure that may prove too low, if the announced reversals of some of the pension reforms materialise. Under the more adverse Ageing Working Group risk scenario (whereby healthcare and long-term care costs would exceed those expected from purely demographic factors due to non-demographic drivers such as technological changes and catching-up effects), the S2 indicator would double, to 4.0% of GDP. 4.1.2.Fiscal framework Limited steps have been taken to improve public procurement and the fiscal framework. The law on public sector contracts entered into force in March 2018. It was designed to establish a more consistent public procurement framework, but the governance bodies for which the law provides, are not yet fully set up or completely operational, and the adoption of the nation-wide public procurement strategy has been delayed. The effectiveness of the new law will depend crucially on the resources allocated to its implementation and the degree of ownership at all levels of government (see Section 4.4.2). On 4 February 2020, the Council of Ministers adopted a Royal Decree Law on contracts of entities operating in the sectors of water, energy, transport and postal services, which – once validated by the Parliament – aims at finally completing the transposition of 2014 Public Procurement Directives. There have been no other steps to strengthen the fiscal framework, such as making use of the mechanisms to prevent and correct deviations from the fiscal targets more automatic and strengthening the contribution to fiscal consolidation of the domestic spending rule (see European Commission 2018a, p.28-29, and European Commission 2018b).

To improve the efficiency of public spending, key areas are undergoing thorough reviews. Spain’s Independent Authority for Fiscal Responsibility (AIReF) completed seven expenditure reviews in 2019 and four new reviews are underway. They have the potential to lead to improvements in the efficiency and effectiveness of public spending (see Box 4.1.2). Implementation of the recommendations based on the completed reviews has started, but it will be mainly up to the new government to bring the results of the reviews to fruition. Box 4.1.1: General government debt The government debt trajectory has been simulated under different scenarios. Under the baseline scenario, general government debt is forecast to decrease slightly until 2021, then rise again to 96.9% of GDP by 2024, before falling again by the end of the projection period in 2030, by which time it will amount to about 95.7% of GDP. The baseline, derived from the Commission 2019 autumn forecast, is consistent with the forecast implicit interest rate and the shares of short-term and long-term public debt. It makes a number of technical assumptions. First, over the post-forecast period, the structural primary balance (before the cost of ageing) is set constant at the value projected for 2021, at -1.0% of GDP, on the assumption that no further structural adjustment is made. The cyclical component of the primary balance is calculated using (country-specific) budget balance sensitivities over the period until output gap closure is assumed (2024). Second, the nominal interest rates on new and rolled-over debt are assumed to converge linearly to market-based forward rates (in particular, the long-and short-term interest rates are assumed to converge to 1.7% and 0.4%, respectively) by the end of the 10-year projection period. ( VIII ) Third, the GDP deflator is assumed to change linearly until it reaches 1.9% in 2024 and to remain constant thereafter. Fourth, the stock-flow adjustment is set to zero after 2021. Finally, medium-term real GDP growth projections are based on the T+10 methodology agreed with the Economic Policy Committee. This implies that medium-term real GDP growth is assumed to average 1.0% both in 2019-2024 and in 2025-2030. Graph 4.1.1:Debt as% of GDP - ES Source: European Commission. More favourable assumptions on real growth would lead the debt ratio to follow a lower path to reach 90.5% of GDP in 2030. By contrast, under more unfavourable assumptions on GDP growth and interest rates, the debt ratio would increase to 106.3% of GDP by 2030. 4.1.3.Taxation

Spain has a low tax-to-GDP ratio compared with other EU Member States. In 2018, its tax revenues amounted to 34.7% of GDP, compared with EU and euro area averages of 39.2% and 40.6%, respectively. The share of consumption



taxes remains relatively low, at 9.4% of GDP, also reflected in a relatively low implicit tax rate on consumption of 13.8%, below the EU/euro area averages of 16.9% and 16.8%. At 16.8% of GDP, the share of taxes on labour also remained below the EU average of 19.6% of GDP, with an implicit tax rate of 34.2% in 2018. Box 4.1.2: Spending reviews The use of spending reviews has risen across Member States since the financial crisis, given the need for fiscal consolidation and the call to improve the quality of public spending. In 2017, the Council recommended that Spain undertake a comprehensive expenditure review in order to identify possible areas for improving spending efficiency (Council of the European Union, 2017). In response, the government commissioned AIReF, Spain’s independent fiscal institution, to carry out a number of targeted spending reviews, mostly within the central government sector (with the cooperation of the sub-national government level), over the following three years, to identify potential savings or efficiency gains. The 2018 reviews comprise seven evaluations focusing on specific subsidy programmes, in the following areas: prescription drugs ( IX ), active labour market policies, university education scholarships, promotion of talent and employability in R&D and innovation (pre- and post-doctoral aid programmes), the re-industrialisation and industrial competitiveness programme, the Spanish national postal service, and, finally, an overall evaluation of the strategy and procedures for granting subsidies. AIReF’s methodology has been to assess the efficiency, effectiveness, and the adequacy and suitability of the instruments used and of the overall framework. The review of healthcare spending in medication dispensed through prescriptions, excluding hospital spending, covered about €10 billion of total public expenditure. This represented about 14% of public healthcare expenditure or 0.9% of GDP in 2017. Following a thorough review, 18 measures were proposed to improve governance; procedures to do with the pricing, selection and purchase of medicines; and efficiency and equity (see also Section 4.3.4). Not all potential savings are easy to quantify, but if the recommendations were implemented in the next few years, AIReF estimates this could yield savings of at least €2 billion (AIReF, 2019a) The main purpose of the other six spending reviews was to identify inefficient policies, procedures or requirements, without having specific saving targets. First, the review of active labour market policies, covering about €6.5 billion of public expenditure in 2017, highlighted 27 proposals for improvement. Serious deficiencies and shortcomings have been identified, calling into question the quality of public spending (or best value for money) in this area. This indicates a need for a far-reaching discussion of how national employment system works. In particular, the evaluation of the PREPARA programme showed that it was not effective (see also Section 4.3.1). Training courses provided for unemployed people have not been sufficiently evaluated, and there is a lack of information and data in general for better monitoring of results (AIReF, 2019b). Second, the university scholarship system accounted for €812 million of public expenditure in the 2016-2017 academic year, representing about 25% of the budget of the Ministry of Education and Vocational Training (since most funds earmarked for education are disbursed at regional level). This scholarship system is a cornerstone of education policy, designed to guarantee equal opportunities. AIReF issued 13 proposals, notably to bring forward the calendar and improve procedures so that scholarships are granted in good time and the amounts made available are allocated in proportion to individual students’ needs (AIReF, 2019c). Third, AIReF issued 19 recommendations for improving the State Programme for the Promotion of Talent and its Employability in Research, Development and Innovation. This programme benefited from €305 million in 2017, about 5% of the R&D+I budget. Although the programme is a relatively small budget item, the funds earmarked for it have fallen sharply, although serious challenges remain in terms of boosting Spain’s competitiveness and productivity (see Section 4.4.1). In particular, AIReF recommended a strategic reorientation of the Programme, focusing on excellence, reviewing the coverage and generosity of grants, fostering public-private collaboration in grants, and optimising the processes making up the Programme’s grants system (AIReF, 2019d). Fourth, AIReF proposed that the Reindustrialisation and Industrial Competitiveness programme should be redefined with regard to the programme’s strategic framework, the specific objectives to be met, its scope, the type of instruments and its management model. Close to €4.9 billion was granted in loans between 2008 and 2016, and the outstanding balance was €3.3 billion by the end of 2017. Overall, the analysis found that results are negligible compared with the administrative costs and overall amount of loans granted through the programme (AIReF, 2019e). Fifth, the evaluation (including international comparisons) of the postal service operator and the provision of the universal postal service highlighted deficiencies regarding the compensation mechanism and the functioning of the operator. Eight measures were proposed to improve the operation of a service accounting for €1.45 billion of public expenditure between 2011 and 2020 (AIReF, 2019f). Sixth, the cross-cutting review of strategy and procedures followed when granting public subsidies highlighted that the regulatory framework is outdated, the strategic planning is inconsistent and the inter-administrative coordination mechanisms (involving the use of sectoral conferences) are rather ineffective. AIReF suggested, among other things, developing a new system of strategic planning, monitoring and assessment of public policies and revising the General Subsidy Law and Regulation in terms of scope and content. It also suggested improving sectoral conferences by making them more participatory and specialised, instead of limiting them to the distribution of funds from central to regional government, as observed in some instances (AIReF, 2019). The 2019 reviews comprise four evaluations focusing on specific expenditure items: expenditure on hospitals, investment in public transport infrastructure ( X ), hiring incentives, and tax benefits. The review of spending on tax benefits is wide-ranging, representing 2/3 of tax benefits or €23.5 billion granted in 2018. The four reviews are expected to yield first results in 2020. Overall, the first phase of the spending reviews has had a clear impact in the public debate on transparency and accountability. It has also promoted an evaluation culture. Work has started on implementing the recommendations stemming from the reviews, but it has been limited by the caretaker nature of the government in 2019. In its Draft Budgetary Plan for 2020, the government set out its policy aims of implementing the results of three spending reviews (i.e. prescription drugs, framework for subsidies, and hiring incentives).The Draft Budgetary Plan therefore included savings on social transfers (€50 million in 2019 and €200 million in 2020) and on subsidies (to limit their growth to 1% year-on-year as from 2020 in nominal terms), and incorporated higher revenues from social contributions (€500 million in 2020). These spending reviews were a high-quality one-off initiative, which could prove valuable if thoroughly implemented by the authorities responsible and taken into account when drawing up future budgets. The last phase (2020 reviews) has not started yet. The total tax-revenue-to-GDP ratio has risen above the level that prevailed in the years prior to the boom and bust episode of a decade ago. After peaking at 36.5% of GDP in 2007 and bottoming out at 29.7% of GDP in 2009, total tax revenues have gradually recovered and, as indicated, reached, 34.7% of GDP in 2018 (European Commission, 2020d). While personal income tax revenues are clearly above their pre-boom average, corporate income taxes still fall short of that level. The level of taxation remains relatively low in relation to expenditure. As noted, according to the Commission 2019 autumn forecast, Spain is forecast to have an average structural government deficit of more than 3% of GDP in 2020-2021, the largest in the euro area. Due to the difficulties of forming a government and securing a parliamentary majority for a 2020 budget law, parliament was dissolved in September and general elections took place in November 2019. A new government has been formed in January 2020, but the 2018 budget law has been further extended until a new budget law is adopted.

The new coalition government programme has announced increases in expenditure on health, education and housing, amongst others. The programme also announces measures to increase revenues, such as a higher effective corporate tax rate (although the tax rate for SMEs is set to be lowered from 25% to 23% for firms with less than €1 million turnover) and higher top rates in personal income taxation, as well as the introduction of new taxes (on certain digital activities and on financial transactions). However, the impact of the announced measures still has to be assessed. Meanwhile, there remains scope to increase revenue from other taxes like consumption taxes, recurrent property taxes and environment-related taxes, with relatively limited impact on economic growth. Spain collects relatively little value added tax (VAT) revenues, despite a very low compliance gap and a standard VAT rate close to the EU average. This is due to extensive use of reduced and super reduced rates, resulting in a large VAT rate gap. In 2017, it stood at 13%, above the EU average of 10% (European Commission, 2018e). While the reduced rates in Spain have some progressive effect on average – almost entirely because of lower rates on food – lower rates on many items are actually regressive. This is true, for instance, of the reduced rate for restaurants and hotels. In contrast, the VAT compliance gap continued to narrow. This gap – calculated as the difference between the theoretical VAT liability and the revenue actually received as a percentage of the former – came to 2% in 2017 (down from a peak of 12% in 2013). This is significantly below the EU average of 11%. Environmental taxes in Spain are still below the EU average, despite increases in recent years. They came to about 1.8% of GDP in 2018, compared with an EU average of about 2.4% of GDP. They are also relatively low when measured as a share of tax revenues. In particular, energy taxes (including transport fuel taxes) yielded little revenue and amounted to about 1.5% of GDP in 2018, compared with an EU average of about 1.9%. In 2018, transport taxes accounted for 12.7% of total revenues from environmental taxes, compared with an EU average of about 19.7%. For example, excise taxes on diesel and petrol are relatively low in Spain (see also Section 4.5). The draft National Energy and Climate Plan submitted to the European Commission in February 2019 tasks the Ministry of Finance with coordinating a study on how to reform the tax system in order to facilitate a low-carbon economy. Environmental taxes are generally considered less detrimental to growth than other taxes, such as those on labour. They can provide an incentive to limit environmentally damaging activities by integrating the full cost of the latter in the price. However, care should be taken to ensure that the design of the tax system maintains its revenue-raising capacity in the long-run. The distributional effects of environmental taxes depend on how the additional fiscal revenue is used to compensate low-income households (Zachmann, 2018). A more coherent environmental taxation structure in Spain could help address the environmental challenges described in Section 4.5. Spain relies to a relatively low extent on recurrent property taxes. While revenues from property taxation in Spain are slightly above the EU average (2.6% compared with 2.5% of GDP in 2018), the recurrent element is below the EU average (1.2% of GDP compared with 1.5% in 2018), while transaction taxes exceed the EU average (1.5% compared with 1.0% of GDP in 2018). Recurrent property taxes are considered to be among those least detrimental to growth and are preferable to transaction taxes, as they allow a more efficient allocation of assets and higher labour mobility. The R&D tax credit, although generous, is producing relatively limited results and the debt bias remains high. Despite the high implicit R&D tax subsidy rate, well above 30% (OECD, 2018), the business R&D intensity rate was only 0.7% of GDP in 2018, ranking in the bottom third in the EU. Moreover, large firms tend to be more responsive to it than small ones. Another issue is that the tax credit introduces a relative advantage for debt financing (compared to equity). While figures show a reduction in this debt bias, it remains relatively high (in fact, it is the second highest in the EU). A further reduction could encourage more equity investment.

The ageing of the tax authority’s workforce is an area of concern. OECD data on the human resources of the Spanish tax administration shows a high level of ageing staff; in 2017 only around 17% of the workforce was younger than 45. This figure needs to be read in conjunction with 2017 data showing that Spain has the lowest number of tax agents per head of population of all EU countries in the OECD (OECD, 2017).

This points to possible shortages of human resources in future, with an adverse impact on tax collection. Procedures to hire 1300 civil servants were launched in 2019 (tax inspectors, tax technicians, tax agents, custom police agents and auxiliary officials). 4.2. Financial sector Macro-financial stabilisation has continued, yet emerging risks need to be closely monitored. Amid continued robust economic activity, Spanish yields have decreased and its sovereign rating has been raised. Financial sector reform and stabilisation policies have been maintained. Banks enjoy overall relatively good profitability, strong liquidity and adequate capitalisation, and they continued to reduce their non-performing loans (NPL). Access to finance is considered the least important obstacle by firms, including SMEs. Finally, private sector debt has continued declining. However, economic growth is weakening, and banks’ profitability remains affected by the very low interest rate environment. The banking sector’s NPL ratio is still higher than the EU average, and moderation in real estate market activity could slow down sales of non-performing real estate assets by banks. Venture capital remains underdeveloped. The pace of reduction of private sector debt slowed down and deleveraging needs persist. 4.2.1.Financial sector * The Spanish banking sector enjoys strong liquidity and adequate capitalisation, but profitability remains under pressure. In recent years, the improving economic climate, declining credit risk, better operational efficiency along with the significant improvement in asset portfolio quality contributed to the strengthening of the sector’s profitability. At the end of 2018, the return on equity stood at 7.3%. While this is among the highest ratios in the EU, it remains below its pre-crisis level. In addition, in the first half of 2019, Spanish banks’ consolidated profit was down by 11.5% year on year. Their return on equity decreased by 1 pp. to 6.6% and the return on assets fell by 8 basis points to 0.49%, according to Bank of Spain data. According to European Central Bank (ECB) data, the common equity tier 1 (CET 1) ratio of Spanish banks increased by 40 basis points year-on-year, to 12.2% at the end of June 2019, higher than the required levels for all credit institutions but still below the EU average (15.0%). The EBA (2019) estimated that once Basel III is fully implemented, capital requirements might somewhat rise for the Spanish banks. Spanish banks continued to reduce their non-performing loans (NPLs) during 2018 and the first half of 2019. The share of NPLs in total loans (as reported by Bank of Spain based on domestic activity) went down by 1 pp. to 5.3% in June 2019 year-on-year, in a context of slightly decreasing volumes of credit. When the foreign activity of Spanish banks is taken into account, ECB data show that the NPL ratio for Spanish banks decreased to 3.4% in June 2019, still slightly above the EU average of 2.9% (see Table 4.2.1). Asset recovery by the asset management company SAREB ( ) is progressing, but at a slow pace. After 43% of SAREB’s expected lifetime (from its inception in 2013 until 2027, when it is supposed to be liquidated), 34% of assets have been sold and 30% of senior debt has been repaid. Sales have recently slowed down, partly due to the moderating real estate market activity but also the new strategy of SAREB, aimed at recovering real estate collaterals with in-house capacity rather than selling NPLs. The new strategy may eventually deliver higher recovery values, but its implementation will have to be closely monitored as it might entail high operating costs and could pose risks to the materialisation of the planned recoveries within SAREB’s lifespan. The outstanding volume of credit to the private sector is still decreasing. In September 2019, it was 1.6% lower than a year before. The reduction was driven by the decline in the stock of credit to non-financial corporations (NFCs) (-2.5% year‑on‑year in September 2019) (Graph 4.2.1), reflecting the clean-up of NPLs, but also decelerating new lending, especially to SMEs. By contrast, the stock of domestic credit to households remained flat; while mortgage loans continued to decline (by 1.4% year-on-year in September 2019), consumer credit increased further (8.3% year‑on‑year in September 2019). According to the Bank Lending Survey (Bank of Spain, 2020), in the fourth quarter of 2019, credit standards for approving loans tightened for enterprises, as well as for households for house purchases and consumer credit. Net demand for loans to enterprises and housing loans to households declined during the fourth quarter. Graph 4.2.1:Loans to the private sector Source: Bank of Spain, own calculations

Resolution plans have been drafted or approved for all Spanish banks, including significant, less significant and small institutions. The Minimum Requirement for own funds and Eligible Liabilities (MREL) targets set based on the Directive 2014/59/EU on Bank Recovery and Resolution may pose some challenge for some smaller Spanish banks. The non-banking financial sector has shown an expansionary profile in recent years. In the low-interest rate setting prevailing in recent years, the performance of the specialised lending institutions (SLI), insurance companies, investment funds and pension funds has generally shown an increased activity with broadly positive profitability levels, according to Bank of Spain data. Credit granted by SLIs has increased steadily, and their profitability is higher than that of deposit-taking institutions' business in Spain. The main insurance companies have also increased their assets, whereas their return on investment has remained relatively stable. In 2019, the pension funds’ assets as well as investment funds' assets increased as a result of positive returns. Table 4.2.1:Financial soundness indicators, all banks in Spain Source: ECB - CBD2 - Consolidated banking data; own calculations. 4.2.2.The housing market The Spanish housing market continues to recover, though activity slowed down in 2019. While the housing market and construction sector have continued to recover from the sharp adjustment that followed the crisis, several indicators of housing activity, such as the number of housing transactions and new mortgages, slowed down in 2019. This is probably due, to some extent, to changes in the mortgage legislation enacted in the first months of the year. The supply of new housing has been increasing over the last three years (by about 9% year-on-year on average between 2015 and 2018), but started to slowdown in mid-2018. Average house prices in Spain stopped accelerating in 2019, but there were large differences across regions. Unsubsidised house prices increased by 4.7% year-on-year in the third quarter of 2019. Prices of new dwellings went up by 6.6% and those of used dwellings by 4.4%, indicating a deceleration in both cases relative to their previous accelerating path. Despite this increase, house prices remain below the pre-crisis peaks, in both nominal and real terms (by around 18% and 30%, respectively). According to some price valuation indicators ( ), house prices are still undervalued in Spain, but other indicators suggest the gap has closed (see Graph 4.2.2). House price developments vary greatly across regions, with larger increases in the major cities and the coastal areas, which have made housing less affordable, especially in the rental market and for younger households (see Box 4.2.1). Graph 4.2.2:Overvaluation gaps based on price/income, price/rent and fundamental model-based benchmarks Source: Own calculations 4.2.3.Access to finance Access to finance is not the most important concern for firms. The latest Survey on Access to Finance of Enterprises in the euro area (SAFE) conducted by the ECB, covering the period April to September 2019, shows that Spanish firms still perceive “finding customers” and