Executive summary 1

1. Scene setter: Economic situation and outlook 4

2. Imbalances, risks and adjustment 12

2.1. External sustainability and competitiveness 13

2.2. Indebtedness and deleveraging 29

2.3. Labour market 43

3. Other structural issues 50

3.1. Fiscal framework and taxation 51

3.2. Labour market, education and training and social policies 57

3.3. Products and services markets 63

3.4. Network industries and environment 67

3.5. Public administration and judicial system 71

A. Overview Table 74

B. Standard Tables 85

LIST OF Tables

1.1. Key economic, financial and social indicators 8

1.2. The Macroeconomic Imbalance Procedure scoreboard 9

2.1.1. Current account and net international investment position scenarios (2015-24) 23

2.2.1. Distribution of the stock of corporate debt in Spain, according to the leverage of firms, 2013 (1) 31

3.5.1. Out-of-sample predictions for the impact of efficiency-enhancing judicial reforms on business dynamics and FDI 68

AB.1. Macroeconomic indicators 80

AB.2. Financial market indicators 81

AB.3. Taxation indicators 82

AB.4. Labour market and social indicators 83

AB.5. Labour market and social indicators (continued) 84

AB.6. Product market performance and policy indicators 85

AB.7. Green growth 86

LIST OF Graphs

1.1. Real GDP growth and contributions 3

1.2. Breakdown of debt by sector (non-consolidated) 4

1.3. Net lending (+)/net borrowing (-) by sector 4

1.4. Breakdown of the change of unit labour costs in Spain 5

1.5. Share of employment in tradable and non-tradable sectors 5

1.6. Labour market indicators 6

1.7. Poverty indicators in Spain 6

2.1.1. Evolution of price competitiveness in Spain 11

2.1.2. Breakdown of the net international investment position 11

2.1.3. Adjustment in the current account 12

2.1.4. Market shares in world exports of goods in the main EU economies in volume and in value (2000=100) 13

2.1.5. Changes in share of exports of goods in EU economies (volume) 13

2.1.6. Geographical specialisation of Spanish exports 14

2.1.7. World market shares for Spanish exports of services 15

2.1.8. Structure of Spanish exports of goods 16

2.1.9. Breakdown of Spanish exports by technological content 16

2.1.10. Shares of top-quality exports by country (value) 17

2.1.11. Share of export products by quality rank 17

2.1.12. Energy dependency of the Spanish economy 18

2.1.13. Import content of exports of medium-high and high technology products 18

2.1.14. Spanish imports by broad economic category 18

2.1.15. Average industrial firm size in Spain (2011) 19

2.1.16. Labour productivity distribution by firm size class (2011) 19

2.1.17. Evolution of the share of tradable sectors 20

2.1.18. Non-cyclical current account balance 20

2.1.19. Private and total capital inflows 21

2.1.20. Contribution to changes in the NIIP 22

2.1.21. Savings and Investment by Sector 22

2.1.22. Spain's funding dependence on partner countries (2012) 23

2.2.1. Breakdown of debt by sector 25

2.2.2. Bank loans to the private sector 26

2.2.3. Non-performing loans ratio 26

2.2.4. Bank sector profitability 27

2.2.5. Residential investment as percentage of GDP 28

2.2.6. Evolution of House Price Index and MFI loans for house purchase 29

2.2.7. Breakdown of year-on-year changes in debt-to-GDP ratios, households 29

2.2.8. Household leverage in Spain 30

2.2.9. Breakdown of year-on-year changes in debt-to-GDP ratios, non-financial corporations 31

2.2.10. Distribution of corporate debt in Spain by firm size, according to the insolvency risk of the firm holding the debt, 2013 (1) 32

2.2.11. Distribution of corporate debt in Spain by sector, according to the insolvency risk of the firm holding the debt, 2013 (1) 33

2.2.12. EBITDA over interest on financial debt, Spanish SMEs 34

2.3.1. Employment and unemployment evolution 38

2.3.2. Activity rates 39

2.3.3. Unemployment by duration 39

2.3.4. Open-ended and fixed-term contracts 40

2.3.5. Wages and unit labour costs 40

2.3.6. Negotiated wages 41

2.3.7. Compensation per employee 41

3.1.1. Tax rates in personal income taxation 49

3.1.2. Environmental tax revenue by type of tax (2012, percentage of GDP) 51

3.2.1. Youth unemployment 52

3.2.2. In-work poverty 53

3.2.3. Early school leaving in Spain, break-down by macro-regions 54

3.3.1. Allocative efficiency in selected professional services and countries, 2011 60

3.3.2. Existing restrictions before and after the implementation of the services directive 61

3.4.1. Evolution of the electricity tariff deficit in Spain, 2000-2013 62

3.4.2. Features of the motorway network in Spain compared with other Member States, 2011 64

LIST OF Boxes

1.1. Economic surveillance process 7

2.2.1. Long-term projections of general government debt 35

2.3.1. The tax reform and its impact on the tax wedge 43

LIST OF Maps

No table of contents entries found.

The recent overall economic and financial developments confirm the stabilisation that has been unfolding over the last two years in Spain. In 2014 and early 2015, economic growth in Spain was supported by rapid employment creation, easier financing conditions, improved confidence, and lower energy and oil prices. These factors are expected to continue to support growth in the short to medium term, despite high private and public debt levels continuing to exert a drag on growth. Financial markets have stabilised, but the country remains vulnerable to sudden changes in global investor sentiment. Labour market conditions are improving, but unemployment remains very high. Social indicators are continuing to deteriorate, although the positive evolution of labour markets may bring some improvement over the next years. Moreover, negative inflation in 2014 provided some relief in real gross disposable income for households in a context of continued wage moderation. Housing prices seem to be close to bottoming out.

In March 2014, the Commission concluded that Spain was experiencing macroeconomic imbalances that require specific monitoring and decisive policy action. In several dimensions, adjustment of the identified imbalances has advanced, and the return to growth has reduced risks. Nevertheless, the nature, magnitude and interrelations between the imbalances, in particular private and public sector indebtedness, the negative net international investment position and the various policy challenges in the labour market still expose Spain to risks. This Country Report assesses Spain's economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Spain in the light of the findings of the 2015 Alert Mechanism Report, in which the Commission found it useful to further examine the persistence of imbalances or their unwinding. The main findings related to macroeconomic imbalances contained in this country report are:

· Despite a positive development in recent years, the current account surplus narrowed significantly in 2014. This is caused by the slowdown in the main Spanish export markets and the rebound of imports linked to robust domestic demand. Spain's external sector performance is also affected by the high import content of exports, Spain's energy dependence, the relatively smaller size of Spanish firms, and the high sensitivity of exports to changes in relative prices and costs.

· The large stock of external liabilities has kept increasing, making Spain vulnerable to adverse shocks or shifts in market's confidence. The overall high stock of private and public debt, both domestic and external, poses risks for growth and financial stability. The recovery of private sector balance sheets is advancing, backed by credit contraction.

· Job creation has gathered pace, but unemployment remains very high. Youth joblessness is very high, and long-term unemployment risks becoming structural, and leading to labour and social exclusion. Labour market segmentation remains a challenge.

· Negative macroeconomic developments in Spain would have a significant impact on other euro area countries. Structural reforms in Spain can contribute to supporting activity in the euro area.

· Boosting private and public investment would help Spain further increase productivity growth and improve competitiveness. Further investment to increase security of supply and stimulate competition in energy markets remains a priority. Spain's research and innovation performance still suffers from i.a., inadequate funding and governance.

· While the 2014 reform of the personal and corporate income tax simplifies the tax system, its impact on the achievement of budgetary targets is still unclear.

· Despite progress made, starting-up and operating a business in Spain remains relatively cumbersome, a fact that could slow the number of new firms. A competition-enhancing reform in professional services has been on the agenda for long to intensify business dynamics and contribute to lower consumer prices. A fragmented corporate structure of the Spanish economy exacerbates cyclical problems with bank financing.

· Early school leaving is decreasing, but remains very high. Combined with relatively low basic skills', this can limit Spain's growth potential.

· The ongoing reform of public administration can contribute to efficiency gains and fiscal savings. Enhancing the efficiency of the judicial system is also an important lever to improve Spain's business environment.

· The recent reforms of the electricity and gas sectors will possibly reduce the tariff deficits from 2014 onwards. But the effectiveness of measures to limit potential liabilities for public finances stemming from transport infrastructure is still uncertain.

This Country Report also assesses progress towards implementing the 2014 Country Specific Recommendations. It concludes that on average, Spain has made some progress in implementing them. Most significant progress has been recorded on the operationalization of the new independent fiscal authority on easing the establishment of large-scale retail premises and on the reform of the public administration. Spain made some progress in the implementation of the recommendation on tax reform, improving the cost-effectiveness of the healthcare sector, conducting a spending review, completing the reform of the savings banks, widening SMEs' access to finance, removing the remaining bottlenecks in the corporate insolvency framework, enhancing the effectiveness of active labour market policies and promoting labour mobility, applying the education reform, putting in place the national Youth Guarantee system, increase transparency of administrative decisions, implementing the law on market unity, facilitating business licensing and eliminating the deficit in the electricity system. Only limited progress is recorded on the recommendations on social issues, combatting labour market segmentation, strengthening public employment services, implementing the new national strategy for science, technology and innovation, enhancing cooperation between higher education and employers and adopting pending judicial reforms. Lastly, there has been no progress on the implementation of the recommendation on professional services, on creating a state research agency and on increasing control mechanisms at sub-central government level.

The Country Report discusses the policy challenges stemming from the analysis of macro-economic imbalances:

· Re-orientation of the economy towards exporting sectors and competitivenessʼ recovery is a necessary condition for reducing the large stock of external liabilities. Removing obstacles to firm growth, supporting SMEs to expand their markets and enhancing innovation appear key to boosting export capacity, job creation, compete more efficiently also in internal markets and enhancing overall productivity.

· Ongoing deleveraging pressures continue to impact economic growth. The adjustment of private sector balance-sheets is advancing, but the deleveraging of households is taking place at a slower pace.

· While the public deficit remains on a declining path, without further consolidation efforts in the medium term Spain would not bring down the general government debt.

· High long-term unemployment and high segmentation continue to hamper productivity growth and working conditions. Without adequate targeting and implementation of active labour market and activation policies, including re-skilling towards sectors with job-creation perspectives, addressing the unemployment problem remains a challenge.

· Other policy challenges that Spain faces include consistent implementation of reforms at regional level, creation of conditions for an innovation-friendly business environment, improvements in business licensing, reform of professional services, completion of measures on insolvency; reinforcement of links between education and the labour market and strengthening of public employment services, and improvements in water and waste management.

After three years of recession, growth resumed again in 2014 and prospects for 2015 and 2016 are on the rise. After having expanded by 0.5 % quarter-on-quarter in both the second and the third quarters of 2014, economic activity has gained further momentum in the last quarter and is expected to accelerate further in 2015 and 2016. The positive growth outlook is backed by better labour market prospects, loosening of financial conditions, improved confidence and reduced uncertainty about the strength of the recovery, and lower energy and oil prices. These factors are expected to continue to support growth in the short to medium term, although high private and public debt levels continue to exert a drag on growth through deleveraging pressures.

Domestic demand, led by private consumption, keeps driving growth while the contribution from net exports has turned negative again in 2014. Growth is set to continue to be mainly driven by domestic demand, led by robust private consumption and investment (Graph 1.1). Strong private consumption has been underpinned by higher than expected job creation, as well as negative inflation in 2014 that provided some relief to households for their real gross disposable income in a context of continued wage moderation. The sizeable drag from the external sector observed over the first half of 2014 has been due to the slowdown in Spain's export markets and an exceptionally robust pick-up in imports that partly reflected renewed confidence and temporary measures. As these effects phase out, the negative contribution of the external sector is expected to narrow in 2015 and to turn neutral in 2016.

Investment was one of the main factors behind the recovery. Some of the factors holding down investment in recent years (weakness of private demand, financial fragmentation, fiscal consolidation, uncertainty) are starting to recede, although others (deleveraging, sectorial rebalancing) are likely to have a more lingering effect. Key macroeconomic indicators covering from 2007 to 2016 are summarised in Table 3.2.1.

Financial markets have stabilised and financing conditions for the private sector have loosened, but the country remains vulnerable to sudden changes in global investor sentiment. A clear return of market confidence in Spain was manifested in the narrowing of sovereign debt yields spreads vis-à-vis the core Member States of the euro area, surging stock market prices and the resumption of foreign financing. After the completion of the programme for recapitalisation of the financial sector, balance sheet restructuring of the sector continued. These factors have led to a greater availability and a lower cost of financing for the Spanish private sector. Nevertheless, Spain remains sensitive to swifts in markets confidence that translate quickly into changes in risk premia.

Graph 1.1: Real GDP growth and contributions

Source: European Commission

After seven years of correction, housing prices seem to be bottoming out. The cumulative fall between Q3-2007 and Q1-2014 amounted to 36.2 % in nominal terms. Some indicators suggest that housing prices might have bottomed out in 2014, and residential investment is foreseen to start growing again in 2015. However, the large stock of unsold houses limits the potential for fast price increases. The housing market and the construction sector are discussed in detail in section 3.2.

Deleveraging by the private sector remains on track, but is far from complete. Credit contraction continues to be the main driver behind the reduction in private sector indebtedness, while, contrary to previous years, positive nominal GDP growth did not hinder deleveraging in 2014 (Graph 2.2). Negative inflation did impede a faster aggregate adjustment though. Recent data show some deceleration of credit contraction and that aggregate deleveraging is to some extent taking place selectively, with the financial sector ready to fund healthier corporations with positive growth prospects. Both households and non-financial corporations are expected to maintain positive net lending positions (Graph 1.3) even when consumption and investment are forecast to keep registering relatively high growth rates.

Graph 1.2: Breakdown of debt by sector (non-consolidated)

Source: European Commission

While the annual public deficit continues on a declining trend, overall public debt will keep rising. Public finances continued to improve in 2014, and, according to the Commission winter 2015 economic forecast, the deficit for the year as a whole would narrow to around 4.5 % of GDP, net of bank recapitalisations in both years. Going forward, the deficit reduction relies more on the improving economic outlook than additional consolidation measures. While pension expenditure is forecast to continue rising, falling unemployment should limit the amount of social transfers in the near future. The public debt ratio, which increased very rapidly during the financial crisis and its aftermath, is expected to continue to grow and reach around 102.5 % of GDP by 2016. Deleveraging pressures in the private and public sectors are also discussed in section 3.2.

Graph 1.3: Net lending (+)/net borrowing (-) by sector

Source: European Commission

After a sizeable adjustment, the current account is expected to have turned negative again in 2014, mainly due to weak external demand and temporary factors, but is expected to post small surpluses in 2015 and 2016. After almost two decades of negative balances, the current account registered a surplus of 1.5 % of GDP in 2013. However, the slowdown of emerging economies in the second half of 2013 added to the deceleration in the EU in the first half of 2014, thereby dragging exports. By contrast, rising domestic demand fuelled imports, also pushed by some transitory factors such as car-scrapping schemes and retained consumption and investment in previous years. This led to a sharp deterioration in the trade balance, partly offset by a rising surplus in the balance for services. Moreover, the balance of primary income was very negative due to the large stock of external liabilities and rising return of assets in Spain. However, the current account balance is set to become positive again in the coming years, based on a recovery in the trade balance due to a combination of higher exports and the decline in oil prices.

Exports are forecast to gain momentum but, given their high import content, they will also raise imports. The most dynamic demand components in 2015 are expected to be exports, as a result of ongoing improvements in price and non-price competitiveness and the projected recovery in Spain's main export markets, and equipment investment. As both elements embed a high share of imported content, total imports are also expected to remain robust.

Graph 1.4: Breakdown of the change of unit labour costs in Spain

Source: European Commission

The process of internal devaluation continues, resulting in further progress in price and cost competitiveness, but negative euro area inflation is hindering the adjustment. The fall in domestic demand and soaring unemployment experienced during the crisis eased inflationary and wage pressures, reversing cost and price competitiveness losses that accumulated in the boom years vis-à-vis other euro area countries. Since 2009, the real effective exchange rates (REERs) and nominal unit labour costs have fallen by 13.2 % and 4.5 %, respectively. Productivity gains, together with ongoing wage moderation explain most of progress in restoring price competitiveness between 2009 and 2013 (Graph 1.4). Structural reforms in product and services markets are now starting to bear fruit, and have contributed to recent improvements in competitiveness. However, very low or even negative inflation in the euro area might be an obstacle for further progress in restoring price competitiveness even despite wage moderation in Spain. Headline inflation was negative and core inflation fell to around zero in the second half of 2014. Negative headline inflation rates are expected to prevail over most of 2015 and to remain very low thereafter.

Spain's export capacity has improved. Exports have increased due to both the increase in the number of exporting companies, and the value exported by exporting company. Considering the fixed costs associated with penetration in foreign markets, it is unlikely that these gains will be reversed easily in the near future. Moreover, a noticeable geographical diversification has taken place, which helped sustain Spanish exports in the run-up to, and during, the crisis.

Despite the sizeable current account adjustment in recent years, the net international investment position as a ratio of GDP deteriorated slightly more because of negative valuation effects. While this reflects increased confidence in the Spanish economic outlook, the high level of external debt (especially in the form of loans) remains a source of concern, as it leaves the economy highly vulnerable to negative shocks. The external performance and overall competitiveness are discussed in detail in section 3.1.

Graph 1.5: Share of employment in tradable and non-tradable sectors

Source: European Commission

The adjustment process has produced a sharp change in the composition of employment and value added. In relative terms, tradable sectors as a proportion of value added have interrupted their long declining trend and the same applies when looking at total employment (Graph 1.5). The change in the sectorial composition of the economy was mainly driven by the collapse of the construction sector and real estate development and to a lesser extent by the downsizing of the financial sector (this mainly in value added terms).

Employment growth was been stronger than expected during 2014, and the unemployment rate - although it remains very high - decreased in 2014 for the first time since 2007. As the Spanish economy gathered pace during the course of 2014, job creation responded positively, in part due to the increased flexibility introduced by labour market reforms enacted in recent years, and also to wage moderation. Activity rates increased (albeit slightly) for all age groups, including the young, and the rate of young people not in employment, education or training, remains broadly stable (Graph 1.6). However, the very high unemployment rate, namely youth and long-term unemployment, and elevated segmentation, remain major challenges.

Graph 1.6: Labour market indicators

Source: European Commission

High structural unemployment rates have negative consequences on employability, skills development, social conditions and wage developments. Sustained high structural unemployment rates could bring upward wage pressures in the medium term, which could reverse gains in competitiveness achieved in recent years and bring to a halt the necessary external adjustment process. Moreover, after a period of substantial increases, productivity is only expected to record modest increases in the coming years, resulting in less a favourable evolution of unit labour costs. Therefore, enhancing labour productivity growth is essential to preserve competitiveness.

Social indicators have seen a drastic deterioration since the crisis, although the recent positive evolution of labour markets may lead to some improvement over the coming years. The percentage of the population at-risk-of-poverty ([1]) and at-risk-of-poverty or social exclusion ([2]) rose sharply between 2007 and 2012 (Graph 1.7). It is estimated that 12.6 million people were at risk of poverty or social exclusion in 2013. ([3])

Graph 1.7: Poverty indicators in Spain

Source: European Commission

Box 1.1: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 IDR for Spain published in March 2014, the Commission concluded that Spain was experiencing macroeconomic imbalances requiring specific monitoring and decisive policy action, in particular, developments in the areas of household debt, linked to the high levels of mortgage debt and structural characteristics of the housing market, as well as unfavourable developments in export market shares. This Country Report includes an assessment of progress towards the implementation of the 2014 country-specific recommendations adopted by the Council in July 2014. The country-specific recommendations for Spain concerned public finances and taxation, financial sector reform and access to finance, labour market reforms, youth policies, education and training, social inclusion, product and services markets reforms, network industries, and the reforms of public administration and the judiciary.

Table 1.1: Key economic, financial and social indicators

(1) Domestic banking groups and stand-alone banks. (2) Domestic banking groups and stand-alone banks, foreign-controlled (EU and non-EU) subsidiaries and branches. (3) Real effective exchange rate (*) Indicates BPM5 and/or ESA95 Source: European Commission, 2015 winter forecast; ECB

Table 1.2: The Macroeconomic Imbalance Procedure scoreboard

Flags: e: estimated. p: provisional. Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the first threshold concerns Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). (3) House Price indicator: e = Eurostat estimates. Source: European Commission

The sizeable current account deficits accumulated during the expansionary phase led to a sharp increase in external debt. Slack financial conditions led investment expenditures by households and non-financial corporations to expand significantly. A great deal of this went into residential investment, bringing about a brisk increase in the prices of dwellings and a worrying housing bubble. Buoyant growth in domestic demand coupled with increasing resources diverted to non-tradable sectors fuelled imports, while exports could not keep pace. At the same time, fast growing domestic demand brought about sustained wage and price increases which, combined with subdued productivity growth, translated into a sharp deterioration of competitiveness. Nevertheless, the resulting current account deficit was easily financed by foreign capital inflows (mainly debt) due to the disappearance of the country risk premium, despite the large accumulation of foreign liabilities.

Graph 2.1.1: Evolution of price competitiveness in Spain

Source: European Commission

The outbreak of the financial crisis precipitated the burst of the housing bubble, while prompting a sharp current account adjustment. The collapse of domestic demand dragged down Spanish imports of goods and services down from 31.7 % of GDP in 2007 to 28.1 % in 2013. In turn, exports of goods and services, which had already performed remarkably well in the run-up to the crisis despite accumulating price competitiveness losses, rose from 25.7 % to 31.6 % of GDP over the same period. This was a result of both the contraction of GDP and the improvement in competitiveness indicators, in particular the drop in unit labour costs (Graph 2.1.1).

Despite the sizeable adjustment in the current account, the negative net international investment position (NIIP) keeps increasing and remains a major risk. From a peak deficit of 9.6 % of GDP in 2007, the current account turned into a surplus of 1.5 % of GDP in 2013. However, the adjustment in the current account has not yet translated into a reduction of external liabilities. The net international investment position deteriorated sharply until 2009 and has remained since then at around 15 percentage points higher than before the crisis (Graph 2.1.2). Despite a positive net lending position of the economy vis-à-vis the rest of the world in 2013 of 2.1 % of GDP, the negative net international investment position rose further by more than 5 percentage points, to above 95 % of GDP as a result of valuation effects that partly reflect an improvement of investor's confidence.

Graph 2.1.2: Breakdown of the net international investment position

Source: European Commission

A significant negative net international investment position is a cause of concern as it exposes Spain to adverse shocks or shifts in market confidence. Reducing the large stock of external liabilities would require Spain to record larger current account surpluses than at present over sustained periods of time. Even under relatively benign growth and inflation scenarios, Spain would still need to achieve a record current account surplus of 1.7 % of GDP on average over the 2014-24 period in order to halve its NIIP-to-GDP ratio by 2024. This compares to the 0.1 % deficit and 0.6 % surplus forecast for 2014 and 2015, respectively.

The adjustment in the current account stems mainly from the trade balance of goods. The improvement in the current account balance was due to both a higher surplus in the balance of services and, more importantly, a reduction in the trade deficit of goods. Although the trade balance of goods remained in deficit, the correction between 2007 and 2013 amounted to 7.4 percentage points of GDP (see Graph 2.1.3).

Graph 2.1.3: Adjustment in the current account

Source: European Commission

The Spanish exports-to-GDP ratio is similar to other large euro-area economies. While still well below the figure for Germany, Spanish exports of goods as a percentage of GDP in 2013 (22.3 %) are in line with those in France or Italy, and above the UK. Moreover, at 9.3 % of GDP in 2013, exports of services were above the levels in the largest euro area economies and stood close to the UK (11.9 % of GDP).

Since the crisis, Spanish market shares of world exports have advanced relatively better in terms of volumes rather than values, outperforming most other major EU economies. The Spanish market share of world exports of goods in value terms (nominal) decreased by only 0.1 percentage points since 2007, to 1.7 %, whereas more sizeable declines were observed in most euro area and EU economies, including the largest ones. Advanced countries’ nominal shares of world exports tend to evolve relatively better than real shares. As competition in more standard products intensifies, these countries usually export more sophisticated and high-quality products characterised by higher unit-values. This was also the case of Spain before 2007, where export shares fell more in volumes (real) than in value (nominal) terms, partly due to increasing export prices. However, since the outbreak of the crisis, the world market share of Spanish exports in volumes has remained broadly constant, indicating that exports in volume have behaved relatively better than in values, and that there has been an implicit reduction in unit values of exports (Graph 2.1.4). This suggests both structural competitiveness gains derived from price and wage moderation and a trend towards exports of products of medium and medium-low quality.

Despite the overall positive evolution of the external sector in recent years, the current account surplus is forecast to have turned into a deficit of 0.1 % of GDP in 2014. The slowdown in the euro area, along with the deceleration of emerging economies that started in the second half of 2013, has weakened the external demand for Spanish exports, despite which exports keep registering relatively high growth rates (4.6 % year-on-year in Q3-2014). Given that more than half of Spanish exports are destined to the euro area, with exports to France, Italy, and Portugal combined accounting for almost 30 % of total exports, negative inward spillovers to the Spanish economy from the slowdown of the euro area have been significant. At the same time, strong domestic demand keeps pushing imports, which grew by 8.2 % year-on-year in the third quarter. This is due to strong growth in private consumption and investment, but also to the high dependence of Spanish industry on imports of intermediate and energy goods and technology, as explained in section 3.1.3. Accordingly, the positive growth contribution from the external sector turned negative again in 2014, resulting in a current account deficit of EUR 3.6 bn. until November, compared with the EUR 12.3 bn. surplus over the same period of 2013.

Graph 2.1.4: Market shares in world exports of goods in the main EU economies in volume and in value (2000=100)

Source: IMF WEO and European Commission Calculation

However, the current account is forecast to record a surplus again in 2015. Short-term prospects are that the deterioration observed in 2014 could be temporary. According to the Commission winter 2015 economic forecast, the current account will register surpluses of around 0.6 % and 0.5 % of GDP in 2015 and 2016 respectively, based on the envisaged recovery of Spanish external markets, which, jointly with ongoing competitiveness gains would push exports up. Likewise, the fall in oil prices are set to alleviate the energy bill, while transitory factors — such as some retained demand during the crisis and the incentives to buy motor vehicles that explained the brisk pick-up in imports in 2014 — should phase out.

Although much of the current account adjustment has been permanent, the cyclically adjusted current account remains in deficit. In cyclically-adjusted terms, the current account deficit narrowed significantly until 2013, indicating that most of the external adjustment has been of a structural nature. This said, the non-cyclical current account remains in deficit, and worsened somewhat in 2014. This fact highlights the problem that the Spanish economy typically brings about current account deficits in recovery and expansionary phases. This trend seems to prevail.

The adjustment in the current account brought the economy back to net lending vis-à-vis the rest of the world. From a net borrowing peak of 9.2 % of GDP in 2007, Spain registered a net lending of 2.1 % of GDP in 2013. This was in parallel with the private sector also moving from net borrowing to net lending positions, partly offset by the net borrowing recorded by the general government.

Drivers of export performance

Despite accumulating competitiveness losses over the expansion phase, Spanish exports have proved quite resilient. The real effective exchange rate recorded a sustained appreciation between 2001 and 2007. This was due to both nominal effective exchange rate appreciation and persistently positive inflation and unit labour costs differentials. Notwithstanding such price competitiveness losses, the loss of export market share in real terms (volumes) was less acute than in the main EU economies, as discussed in the previous section (Graph 2.1.5), in a context of global increases of world trade flows.

Graph 2.1.5: Changes in share of exports of goods in EU economies (volume)

Source: European Commission

Resilience of exports is closely linked to progressive openness to international trade flows. At the beginning of the previous decade the European market was by far the main destination for Spanish exports of goods, with 60 % going to the euro area and around 12 % to other EU economies. While exports to European markets remained the lion's share, this geographical pattern started to show significant changes towards a higher degree of international diversification (Graph 2.1.6) after the outbreak of the crisis. The share of exports in value going to the euro area declined by some 7 percentage points since 2007 as other destinations gained prominence. Exports to the emerging and growth-leading economies (EAGLEs) have been the most dynamic, rising by almost 1.5 percentage points since 2007, from 6.8 % to some 8.2 % in 2014. Accordingly, this geographical diversification contributes to explaining why Spain benefited from the increase in world trade, and managed to partly offset losses in price/cost competitiveness in the run-up to the crisis.

Graph 2.1.6: Geographical specialisation of Spanish exports

Source: DataComex

Spain has benefited from the growth in world trade in recent years. The elasticity of Spanish exports of goods with respect to world income growth (which is an important factor behind the growth in world trade) is above 1, in line with estimates for other advanced economies.([4]) In the case of Spain, this is usually associated with its opening to international trade flows and its reorientation to products with medium-high technological content, with typically higher income elasticity than products embedding a lower technological content.

Price competitiveness gains during the crisis have played a positive but limited role to explain recent improvements. Spanish exports of goods have a relatively high (negative) long-term relative price elasticity compared with other advanced economies. Nevertheless, the real exchange rate typically explains well below 10 % of the variance in (country-specific) exports, as opposed to world trade, which explains about 80 %.([5]) The remaining residual at some 10 % is deemed to capture other unspecified factors (non-cost determinants), which may have more than compensated the dynamics of relative costs and prices.

The performance of services exports has also been positive. Spain's share in global exports of services is significantly greater than its share in exports of goods (3.3 % against 1.6 % in 2012), mainly on account of its large tourism sector. The share of Spain in world tourism has been decreasing in the last decade as its tourism model relies mainly on coastal seasonal tourism, which is subject to increasing competition from cheaper destinations. However, Spain has been able to expand its world share of exports in other services – mainly services to businesses – characterised by higher value added and possibly higher future growth potential (Graph 2.1.7). The share of turnover in foreign markets increased in most subsectors related to services to businesses, especially in software publishing, computer programming, consultancy and related activities, engineering activities and related technical consultancy. Significant penetration in foreign markets also occurred in accounting, bookkeeping and auditing activities, tax consultancy and management consultancy activities. Whereas the increase in the export markets for goods mainly occurred in the emerging and growth-leading economies, the expansion of export of services was concentrated in North America and in the UK.

Graph 2.1.7: World market shares for Spanish exports of services

Source: WTO and European Commission Calculation.

Much of the positive export performance has been due to price and cost competitiveness developments in the largest firms. The distribution of firms by size typically explains a large part of the export penetration of a given sector, as bigger firms typically export a higher proportion of their production than smaller firms. Moreover, over the last decade, largest firms have witnessed more favourable unit labour costs behaviour due to higher productivity growth. The recent price and cost competitiveness gains should pave the way for further positive export developments in the medium term. It thus appears that the behaviour of large Spanish companies has in some instances allowed them to overcome structural weaknesses vis-à-vis their peers in other countries. For example, the proportion of high-skilled employees is lower in Spanish firms, although the presence of managers with international experience and of employees participating in training courses is high. In addition, the proportion of large Spanish firms that invest in R&D is lower, but Spain scores better in the generation of process innovations.([6])

The export base is widening but the small size of firms acts as a drag on the export capacity of the economy. The extensive margin (i.e. the growing number of companies exporting) also plays a significant role in explaining the resilience of exports. The number of Spanish exporting firms grew by around 50 % between 2007 and 2013, including regular exporters (those that have exported for at least four consecutive years). Considering the fixed costs of entering foreign markets, these trends are unlikely to reverse. However, 70 % of them export only occasionally and more than 85 % of total exports are undertaken by the largest 5 000 companies. Besides, the small average size of Spanish firms compared with their European peers is a limiting factor affecting export capacity (the intensive margin, or the average quantity exported by exporting firms), as larger firms tend to be more productive and export a higher share of their output.([7]) Moreover, and contrary to their larger peers, Spanish SMEs perform below the EU average in terms of product/ process innovations, according to the European Commission 2014 Innovation Union Scoreboard.

The high price-elasticity of Spanish exports reveals a specialisation pattern skewed towards labour-intensive products but with medium-high technological content. High price elasticity is typically associated to a high share of labour-intensive industries, are usually more sensitive to relative price developments. Despite the large share of food and primary products, Spanish exports of goods are mainly concentrated on intermediate goods, the bulk of which are chemical products (around 14 % of total exports), equipment goods (transport equipment amounts to some 5 % of total exports), and motor vehicles, whose importance is on a clearly downward trend (Graph 2.1.8). Motor vehicles and transport equipment account for around 20 % of total exports. While Spanish exports in these categories mainly correspond to mature demand segments, they typically involve medium to medium-high technological content (Graph 2.1.9). However, when compared to other advanced economies, the proportion of exports of high and medium-high technology goods, Spain ranks relatively low. Moreover, the import content of Spanish exports is comparatively high. In sum, the participation of Spanish firms in global value chains is lower and predominantly passive (as a recipient of inward foreign direct investment flows).

Graph 2.1.8: Structure of Spanish exports of goods

Source: DataComex

Spain is also specialized in exports of medium-low quality products. Despite their technological content, the quality of Spanish exports of goods ranks relatively low compared with other EU and OECD countries (Graph 2.1.10).([8]) Furthermore, the average quality of Spanish exports decreased in relative terms between 2007 and 2011, with such decline being especially striking in exports of top-quality products (Graph 2.1.11). This reduction in average quality is likely to be linked to the increasing presence of small Spanish firms — typically less productive — in foreign markets during the crisis, which may conceal improvements in overall quality. This 'left-hand side- skewed quality distribution resembles somewhat those of Portugal, Poland, the Czech Republic, Slovakia, Bulgaria, Romania and Lithuania in the EU but also China. Cost competition is stronger in low and medium-low quality segments, which is consistent with the relatively high price/cost elasticity estimated for Spanish exports. Hence, in order to safeguard the resilience of exports with this pattern of specialisation, Spain is forced to rely heavily on cost and wage moderation, which underscores the need to move upwards along the export-quality ladder and increase labour productivity.

Graph 2.1.9: Breakdown of Spanish exports by technological content

Source: Ministry of Economic Affairs and Competitiveness and Banco de España

The deceleration in exports in 2014 is explained by the slowdown of external demand, but is reckoned to be fleeting. After having grown by 7.3 % in real terms on the year in the second quarter of 2013, exports of goods and services started to lose momentum, due to the deceleration of emerging economies and followed by the main euro area economies over the first half of 2014. However, price competitiveness gains continued on account of the negative growth of unit labour costs and very low or even negative inflation. Positive signals are observed though. In particular, a significant acceleration was observed in the third quarter of 2014, with exports of goods and services growing by 4.6 % on the year compared to 1.5 % in the preceding quarter. Looking forward, the euro depreciation along with the envisaged recovery of Spanish external markets should add to previously accumulated competitiveness gains, thereby paving the way for enhanced export performance in the short-to-medium term.

Graph 2.1.10: Shares of top-quality exports by country (value)

Source: European Commission Calculation based on Comext and Orbis data

Graph 2.1.11: Share of export products by quality rank

Source: European Commission Calculation based on Comext and ORBIS data.

Drivers of imports

The decline in final demand during the crisis triggered a sizeable fall in imports, although not all of this reduction has been of a permanent nature. As the crisis entailed a downward adjustment of potential output, part of the adjustment in imports is deemed to be permanent. Despite the fall in domestic demand, the strong export resilience sustained imports due to their high import content. In constant prices, total imports fell by almost 24 % between 2007 and 2013, while final demand did so by 10.5 %. These figures suggest a long-term final demand elasticity of imports above 2 (in line with available estimates in the literature), which is high compared to the main euro area Member States. However, part of the reduction in imports may just obey to cyclical factors. Recent developments corroborate this assessment, as the increase in imports witnessed over 2014 has been driven by the incipient recovery and the pick-up in final demand. Insofar as the recovery becomes firmer, imports are expected to remain buoyant, in line with their historical pattern.

The Spanish industry is highly dependent both on imports of intermediate and energy goods and on technology, which are less responsive to relative price developments. The price elasticity of imports is rather low (between -0.02 and -0.6). The low sensitivity to prices is consistent with a high dependency on imports of intermediate goods and the structurally elevated dependence on energy products (Graph 2.1.12), in particular oil and gas as sources of primary energy. Likewise, Spanish imports depend considerably on goods involving more advanced technological developments, for which income elasticity is typically high while price elasticity is low. In general, import intensity in manufacturing sectors is almost 20 % higher in Spain than in the other main euro area economies.([9]) In particular, automotive and chemical industries, the main export industries in Spain, have very high import content (63.3 % and 54.8 % respectively), mostly intermediate goods. A high demand for imported intermediate inputs cannot per se be considered as a sign of inefficiency in the national industrial sectors. High import penetration of intermediate goods could be due to a better integration in international value chains and a more efficient use of the comparative advantages. However, the difference in import content compared with the most advanced EU economies is especially salient in manufacturing industries grouped under the headings of high and medium-high technology (Graph 2.1.13), which might suggest a structural shortcoming in domestic technology.

Graph 2.1.12: Energy dependency of the Spanish economy

Source: European Commission

Foreign direct investment and the relative weight of subsidiaries of foreign firms in production can help explain the high import dependency. There appears to be a positive relationship between foreign direct investment and import intensity, and Spain shows by far the highest ratio of stock of foreign direct investment to GDP amongst large euro area economies (almost 55 % in 2014). This seems to be mostly the case for the large automotive industry.

Despite its limited potential, the process of internal devaluation could also foster import substitution. In particular, if restored competitiveness translates into lower prices on domestic markets, import substitution could also occur — at least for import goods that are subject to higher price elasticity. The impact is therefore likely to occur more in consumer goods, typically more responsive to relative prices, in spite of their limited weight in total imports (Graph 2.1.14).

Graph 2.1.13: Import content of exports of medium-high and high technology products

Source: OECD Stan database

Graph 2.1.14: Spanish imports by broad economic category

Source: European Commission

Assessing the evolution of competitiveness

Average company size in Spain is below other European countries. Over 90 % of firms are micro-firms (less than 9 employees) (Graph 2.1.15). More than half of workers in Spain are employed in small companies (below 50 employees) compared to 23 % in Germany and 32 % in France. This applies to both the manufacturing and services sector. Sectorial specialisation may partly explain the average firm size, but there is evidence that institutional and technological factors also influence the size of firms.([10]) Indeed, Spanish SMEs provide almost three quarters of all private sector jobs and 64 % of value added, rates that significantly surpass the EU average. This is in particular because of the group of microenterprises that account for 40 % of the Spanish private sector workforce and 28 % of value added.

Graph 2.1.15: Average industrial firm size in Spain (2011)

Source: European Commission

The small size of Spanish firms plays a decisive role in explaining lower productivity. Very small companies tend to be characterised by lower levels of productivity than larger ones (Graph 2.1.16), as the latter invest more in R&D, especially in sectors in which scale effects are more important, such as manufacturing. Moreover, larger companies may also benefit more from investments in information and communications technologies. Hence, an increase in firms' size could spur aggregate productivity growth.

Economic policy has actively supported, in Spain and elsewhere, the creation, survival and expansion of small and medium sized companies (SMEs). Policy intervention aims at addressing market failures for those companies, such as difficulties in accessing credit and their lack of resources to optimise their tax burden. This should not come as a big surprise. SME represent a sizeable share of overall business activity. The employment creation of small firms (by both new firms and of small established firms) in Spain is much larger than their corresponding share in employment, a pattern that broadly holds across sectors.([11]) However, new Spanish firms seem to grow more slowly than in other European countries. The high proportion of small firms and the low presence of larger businesses might therefore reflect two features: start-ups are often small and there is a large proportion of more mature businesses that do not grow.

Graph 2.1.16: Labour productivity distribution by firm size class (2011)

Source: European Commission

The challenge for SMEs policy is to support company creation while at the same time setting out the conditions for company growth. To this end, easing the barriers for businesses to be created, operate and grow, would result in increased investment and growth opportunities. This would support the ongoing internal and external rebalancing process by facilitating the reallocation of resources from the non-tradable to the tradable sectors of the economy, thereby enhancing economic efficiency.([12])

Investment in equipment and other products evidences the reallocation of resources towards tradable sectors, thereby paving the way for a more sustained growth model. In the run-up to the crisis Spanish growth relied excessively on the production of non-traded goods, especially construction and real estate activities, with small contributions to overall productivity growth. This pattern implied an inefficient allocation of resources that precluded funds from flowing into activities with a higher value added and hampered a more dynamic export performance. The brisk adjustment undergone by the housing market has entailed an implicit reallocation of resources towards tradable sectors (Graph 2.1.17) and to investment in equipment and others, as opposed to construction, which should underpin export performance and external rebalancing

Graph 2.1.17: Evolution of the share of tradable sectors

Source: European Commission

The cyclical component of the current account remains important. Insofar as the fall in demand is itself permanent, a part of the corresponding fall in imports observed in previous years can be considered as permanent. Yet, the output gap remains very high, at -6.1 % of potential GDP according to the Commission autumn 2014 economic forecast. Based on these estimates, the cyclically adjusted current account balance would amount to -1.2 % of GDP in 2014, compared to the envisaged headline deficit of 0.1 % of GDP (Graph 2.1.18). These estimates are subject to some uncertainty related to the estimation of potential output and might therefore underestimate the potential for a rebound in imports when demand firms up further and/or potential output growth reverts to normal values.

Further reforms aimed at enhancing labour productivity are essential for a faster current account adjustment. The still underlying current account deficit unveils structural weaknesses in Spanish competitiveness, linked to high import dependency but also to insufficient export penetration. Therefore, stepping up the pace of the reform agenda in the areas of business environment, and in labour and product markets would help overcoming such weaknesses, while leading to more balanced growth in recovery phases.

Graph 2.1.18: Non-cyclical current account balance

Source: European Commission

Income balance, capital transfers and financial account

Spain has traditionally recorded a negative income balance with the rest of the world, reflecting a large negative net international investment position (NIIP). After peaking in 2008, the negative contribution of the income balance to the current account has decreased by three quarters, reaching -0.7 % of GDP in 2013, mainly driven by lower return on foreign portfolio investments on Spanish assets in the 2008-13 period.

The income balance is expected to deteriorate slightly in 2014, to -1.4 % of GDP. This is the consequence of several offsetting effects, one driven by lower risk premia on Spanish assets, and the another driven by higher returns on assets. On the one hand, as a large part of Spain's external liabilities are made up of debt instruments, lower interest rates have reduced the cost of debt servicing. Moreover, the overall level of gross external debt during the course of 2013 and 2014 declined. On the other hand, returns on Spanish assets have improved throughout 2013 and 2014, thereby raising the overall income assigned to remunerate foreign financial assets has increased. So far, the 'return on assets effect' has prevailed over the 'interest rate effect', resulting in a deterioration of the income balance in 2014. Over the medium term, the evolution of the income balance will mainly depend on the returns on Spanish assets held by foreign agents (and the return on foreign assets held by Spanish agents), and the speed of the reduction in the stock of external liabilities.

The contribution of current transfers to the current account has also been negative in Spain since the early 2000s, and it is expected to remain so. This is mainly the consequence of the negative net contribution of workers' remittances, reflecting the fact that Spain hosts a large foreign population. Over the medium term, the contribution of current transfers could deteriorate slightly, as the net receipts from the EU budget will decrease from 2014 onwards, and as the labour market gradually improves, potentially resulting in increased migrant workers' remittances abroad. The balance of capital transfers has traditionally been positive, (about 0.5 percentage points of GDP between 2008 and 2013) on account of capital transfers from the EU. However, these transfers are also likely to decline in absolute and relative terms in the years to come.

In 2014, the Spanish financial account recorded a positive value of 1.0 % of GDP, reflecting a net lending position vis-à-vis the rest of the world. In terms of lenders, as Spanish financial institutions have gradually regained market access, private flows have been flocking again into Spain, meaning that the reliance of official flows has been reduced even further (Graph 2.1.19).

Looking at the different components of the financial account, it appears that the reduction in debt instruments has been substantial. This reduction comes mainly from the reduction in Target II balances, which have been partly compensated with net positive private debt inflows. At the same time, the pace of equity flows has not changed significantly since 2012.

Graph 2.1.19: Private and total capital inflows

Source: European Commission and IMF

Structure and prospects for the net international investment position

Spain's net international investment position continued to deteriorate throughout 2013, until reaching almost -100 % of GDP in Q1-2014. This deterioration has mainly been driven by negative valuation effects, as a consequence of rising asset prices in Spain, which have increased the value of external liabilities. These have been partly offset with by a net lending position vis-à-vis the rest of the world (see 'net transaction effects' in Graph 2.1.20). Much of the increase in the net lending position has been achieved through a reduction in investment, both by corporations and households (mainly residential). In terms of financing needs by institutional sector, both households and corporations have recorded a positive net lending position, which has been partly offset by a net borrowing position for the general government (Graph 2.1.21).

Graph 2.1.20: Contribution to changes in the NIIP

Source: European Commission

A large share of Spain's external liabilities is made of debt, which increases the vulnerability to external shocks. These instruments are more volatile and sensitive to changes in investor confidence, and, unlike equity, they have to be serviced regardless of the economic situation of the debtor. On the positive side, the net level of external debt decreased during the course of 2013 and 2014 in the context of the ongoing deleveraging process in the private sector. However, part of this decrease was offset by growing public sector debt, resulting in an only modest reduction of external debt. Over the medium term, the net level of external debt is expected to continue on a downward trajectory, as deleveraging needs in the private sector are estimated to be still significant, and as fiscal consolidation limits any further increases in public sector external debt.

Although Spain has improved its external position in recent years, further external adjustment is needed to put the net international investment position (NIIP) on a downward trajectory. Even under relatively benign growth and inflation scenarios, it would call for larger current account surpluses than at present to reduce the large negative net international investment position by 2024 (Table 2.1.1). For instance, assuming a baseline scenario of a 3.9 % nominal GDP growth on average over the 2015-24 period (an average of 2.2 % real growth and 1.7 % GDP deflator per year)([13]), it would be sufficient for Spain to achieve a 3,7 % current account deficit to stabilise its net international investment position at -95 % of GDP by 2024. However, if it were to bring down its net international investment position to -50 % of GDP by 2024, Spain would need to achieve a record current account surplus of 1.7 % of GDP on average over 2014-24. This compares with a forecast current account deficit of 0.1 % in 2014, and an estimated cyclically adjusted current account deficit of -1.2 % in 2014. Under more pessimistic scenarios, such as a 2 % nominal GDP growth over the same period (for instance, an average real GDP growth of 1 % and a GDP deflator of 1 %), Spain would need to achieve a 3 % of GDP current account surplus on average over the same period in order to bring down its net international investment position to -50 % of GDP. These simulations illustrate that Spain is still vulnerable to changes in economic conditions, and that larger external surpluses need to be achieved to bring down decisively its large stock of external liabilities.

Graph 2.1.21: Savings and Investment by Sector

Source: European Commission

Inward, outward and euro area spillovers

Spanish exports rely heavily on markets where growth has been weak in recent years. The three largest markets for Spanish exports are France, accounting for more than 4.5 % of Spanish GDP, Germany (3.4 %) and the UK (also 3.4 %). Exports to Italy, Portugal and the United States, are also significant, implying that inward spillovers to the Spanish economy from the slowdown in some of these markets have been significant.

Spain has a large financial exposure to non-euro area countries, implying that, beyond price effects, it is also exposed to exchange rate movements. Spanish foreign financial assets are largest in the UK (17 % of Spanish GDP), but also the USA, France and the Netherlands (about 8 % of Spanish GDP each). However, Spain also has a large exposure to Latin American countries, with a combined exposure to Mexico, Chile, Argentina, and Brazil of almost 12 % of its GDP.

Table 2.1.1: Current account and net international investment position scenarios (2015-24)

(1) The table above shows the current account balance needed to achieve different NIIP values by 2024, based on several nominal GDP growth scenarios (2) NIIP stabilisation implies a NIIP level of -95 % of GDP by 2024 (3) These simulations do not take into account REER and valuation effects (4) Other assumptions are average yields (nominal effective) over the 2015-24 of 3.1 % for domestic yield, and of 3.5 % for foreign yield (5) Domestic yield is the long term interest rate (as in AMECO and long-term projections) (6) Euro area / foreign yield is the underlying long-term interest rate on foreign assets, and the spread "external liability-domestic yield" is based on the median 2004-12 spread between returns of foreign liabilities and the long-term interest rate Source: European Commission Calculation

Foreign claims of Spanish banks are also the largest in non-euro area countries. According to BIS data, the Spanish banking sector was highly exposed to the UK, with claims worth approximately 30 % of Spanish GDP, which were concentrated on the non-bank private sector. Banking sector exposure to the USA, Brazil and Mexico is also high.

However, most of the main investors in Spain are euro area countries, which — given the recent overhaul of the euro area architecture, including the Banking Union — could be a relative shield from sudden capital flow reversals (Graph 2.1.22). The main gross investors in Spain were France (25 % of Spanish GDP), followed by the UK (23 %), Germany (19 %), the Netherlands (17 %, including large equity investments), and Luxembourg (13 %). As regards financing specifically from foreign banking sectors, the main players are, once more, France, Germany and, to a lesser extent, the UK.

Graph 2.1.22: Spain's funding dependence on partner countries (2012)

(1) Gross Spanish foreign liabilities as a % of Spanish GDP Source: European Commission Calculation

At the same time, the Spain is a significant source of trade and financial outward spillovers. The Spanish market is an important export destination for Portugal, representing more than 6 % of Portuguese GDP and 3% of its value added. Large share of service exports to Spain are also observed in Luxembourg, Ireland and Malta. In turn, gross financial exposures to Spain were highest in Ireland (36 % of Irish GDP), the Netherlands (29 %), Malta (23 %) and Portugal (21 %). Specifically, the exposures of the banking sectors of EU countries to the Spanish economy are largest for Portugal, at close to 10 % of Portuguese GDP, and to a lesser extent the Netherlands and France.

Spain is a major funding partner and investor in Portugal and Ireland. Debt and equity claims amount to 32 % of Portuguese GDP and 25 % of Irish GDP, respectively. Spain is also a significant investor in the Netherlands, Hungary, Malta and the UK.

Spillovers from simultaneous growth enhancing reforms at the euro area level can be significant for all euro area Member States. Structural reforms lead to higher aggregate demand, which, if adopted simultaneously by all Member States, have a small effect on the trade balance. However, they have a positive effect for output and employment.

Medium-term prospects for external adjustment

Although a significant part of the current account adjustment is likely to be permanent, imports are expected to respond to faster growth in the short-to-medium term. Exports have been quite resilient helped by the growing internationalisation of export companies and further geographical diversification. Considering the fixed costs of entering foreign markets, these trends are unlikely to reverse. The narrowing current account surplus during 2014 is explained by the slowdown in external markets, but also by high import growth linked to the pick-up of final demand. In particular, the reallocation of resources towards tradable sectors, namely manufacturing, is likely to push imports as the import content of tradable production is higher than in other non-tradable sectors such as construction or real estate. Accordingly, while current account surpluses are envisaged in the medium term, their magnitude might not be great.

Large current account surpluses would be needed over long periods of time in order to bring down the large stock external liabilities. The substantial external financial dependence will remain a source of vulnerability, both due to its size and its composition (mainly debt). The ongoing private sector deleveraging process is expected to continue over the medium term, as deleveraging needs are still considerable. So far, all the external adjustment has been undertaken by corporations and households, mainly through a reduction in investment, having detrimental effect on potential growth. The external adjustment will need to be supported by cost dynamics, via higher productivity and appropriate wage dynamics. The process of internal devaluation would also support increased import substitution, although its contribution could be limited given the large dependency on imports of energy and intermediate goods, with typically a lower sensitivity to relative prices. In particular, the external reliance on imported energy products could be mitigated by reforms and tax policies geared to reduce energy intensity and the high oil dependence.

Spain needs to preserve price competitiveness gains and enhance production of quality goods. Spain is mainly active in in market segments of mature demand and low quality, where competition is stronger than for high-quality products and products embedding a high technological content. Therefore, is of the utmost importance for Spain to keep production costs, including labour costs, under control. In this respect, Spain would benefit from moving towards higher quality segments by promoting innovation further. Quality upgrading would help downplay the relevance of cost competitiveness, thereby delivering higher mark-ups while allowing higher wage increases, for which enhancing labour skills is key. Moreover, enhancing R&D and innovation would help increase the technological content of Spanish manufacturing, while reducing import dependency. To this end, legal and economic barriers to company growth seem to be key factors hindering the export capacity of the Spanish economy, both in terms of exports volumes, and in terms of unit values.

The household and corporate sectors are reducing their debt overhang. Spain's private sector considerably increased its debt burden in the years before the crisis. Still in Q3-2014, the total stock of private sector debt amounted to 182 % of GDP in non-consolidated terms (72.4 % household debt and 109.7 % non-financial corporations debt), some 36.8 % of GDP lower than the peak in Q2-2010.([14]) Most of the reduction is due to the fall in debt of non-financial corporations (NFCs) since the peak of 24.5% of GDP (Graph 2.2.1). Credit contraction has been the main channel of private sector deleveraging, with aggregate bank lending on a declining path since 2010. Recent data show some deceleration in this contraction and confirm previous evidence that aggregate deleveraging is, at least to an extent, taking place selectively, with the financial sector ready to fund healthier corporations with positive growth prospects. On the household side, deleveraging continues to progress more gradually. Gross disposable incomes have been stagnating, also to support competitiveness of the Spanish economy and its external adjustment.

In contrast to the private sector, general government debt has been on an increasing trend. In the wake of the crisis, the private sector in Spain moved in a short period from a net borrowing to a net lending position, at the same time squeezing consumption and investment. In order to cushion the social effects of the structural adjustment in the economy, the public sector ran higher general government deficits leading to an increase in the public debt of around 60 percentage points of GDP compared with 2007.

Private sector deleveraging has been going in parallel with restructuring in the banking sector. The implosion of the real estate bubble caused a sharp deterioration in banks asset portfolios. Systemic concerns about the banking sector and the capacity of the sovereign to support it came to a head in the summer of 2012. The ensuing financial assistance programme for the banking sector set the basis for cleaning up bank balance sheets in order to provide new lending to the real economy and support the economic recovery. Meanwhile, after several years of price correction the housing market seems to have passed the turning point.

Graph 2.2.1: Breakdown of debt by sector

Source: European Commission

Financial sector developments

The burst of the real estate bubble and the economic recession that followed has altered both the quality and composition of bank assets, forcing banks to restructure their activity and clean up their balance sheets. In the wake of the crisis, lending to non-financial corporations contracted especially quickly, and has to a certain extent been replaced by the holding of government securities.([15]) Following the return of confidence to the Spanish economy, government financing from domestic banks declined gently in Q2/Q3-2014, although the total stock of credit to the private sector was still contracting by 7 % year-on-year in December 2014. In particular, credit to households was declining by around 4.7 % year-on-year while credit to non-financial corporations was still shrinking by about 9.6 % (Graph 2.2.2). In line with the economic recovery, the decline in lending activity has decelerated in recent months. In November 2014, for the first time in more than four years, month-on-month growth in the stock of loans to firms was observed. Banks managed to double their pre-tax profits in the first nine months of 2014 relative to the previous year due to lower provisioning following an improvement in asset quality. Nevertheless, reduced credit volumes and an environment of low interest rates exert a downward pressure on bank interest income. The future development of the real estate market will have an important impact on bank profitability.

Graph 2.2.2: Bank loans to the private sector

Source: Banco de España

In some segments of bank lending, notably lending to SMEs, new credit is growing, supported by declining nominal interest rates to firms. As regards the flow of new lending, a steady improvement can be noticed in the case of credits below EUR 1 million (a proxy of credit to SMEs) which have been growing since Q4-2013. ()By contrast, the dynamic of new credits of above EUR 1 million has still been negative and remains volatile, because larger companies have increasingly resorted to the issuance of corporate bonds and external loans. The demand for loans is sensitive to the level of lending rates, and bank lending rates to firms have been following a downward trend,([16]) so a further gradual recovery in lending is expected. As higher financing costs for SMEs in Spain also reflect sovereign spread, it is expected that, with sovereign upgrades, corporate ratings will also improve, making banks less reluctant to lend at lower rates.

After a steady deterioration in the aftermath of the crisis, the average quality of bank assets started to improve as of late 2013. The non-performing loans (NPLs) ratio increased steadily between 2008 and 2013, reflecting deterioration in the quality of loans after the burst of the real estate and construction bubble and the recession that followed. Non-performing loans ratios varied across different types of loans, with doubtful loans representing more than one third of the loan portfolio to the real estate and construction activities in the beginning of 2014. The total volume of doubtful loans reached its peak in late 2013 and has been declining ever since. As the volume of the non-performing loans has been falling more rapidly than the total volume of bank loans, the non-performing loans ratio decreased from 13.6% in December 2013 to 12.7% in November 2014, a still high proportion (Graph 2.2.3).

Graph 2.2.3: Non-performing loans ratio

Source: Banco de España, European Commission

Banks still seem unwilling to engage more actively in the restructuring of their loan portfolios. Restructured or refinanced loans accounted for 14.2 % of total loans to the private sector at the end of June 2014, a rate similar to that in March 2013.([17]) Based on the classification criteria of Banco de España (BdE), 49.5 % of restructured or refinanced loans were classified as doubtful, 18.7% as substandard and 31.9% as performing loans. Similar to the case of non-performing loans, refinanced and restructured loans show a high degree of concentration in real estate (23.3 % in construction and 25.5 % in mortgages).

The liquidity situation and the access to funding of the banking sector improved further in 2014. After the access of Spanish banks to the interbank and wholesale markets was severely curtailed at the peak of the crisis in July 2012, the situation has gradually normalised, including during 2014. Net borrowing from the Eurosystem declined to EUR 141bn at the end of December 2014, about EUR 61bn less than a year before. The total amount of deposits in banks was declining at a rate of about 2 % year-on-year in December 2014, but due to the faster reduction in the stock of loans, the loan-to-deposit ratio of the banking sector improved substantially to 91.4 %, around 2.1 percentage points less than year before. The decline in household deposits reflects a recovery in consumption and a growing preference for alternative investment vehicles, such as mutual and pension funds, in a context of low bank deposit interest rates. Although banks have regained access to wholesale markets, their reliance on this source of funds declined due to their favourable liquidity situation in the context of reduced lending.

Provisioning needs and financial assets impairments were weighing on banks’ earnings in recent years, but bank profitability started to improve again in the first nine months of 2014. Financial assets impairments had a particularly negative impact on banks profitability in 2012 when the banking sector recorded a significant loss, but they have been declining since. On the other hand, since 2012, bank non-interest income was boosted thanks to falling sovereign yields, which contributed to capital gains on bank holdings of government securities. Spanish banks increased their profits in the first nine months of 2014 in year-on-year terms, mainly due to an improved profitability in the first quarter of the year. Improved earnings were driven primarily by a further reduction in financial asset impairment compared with the first half of 2013 (Graph 2.2.4). Operating income before provisioning was similar to the previous year.

Graph 2.2.4: Bank sector profitability

Source: Banco de España, European Commission

The solvency of Spanish banks was further strengthened in 2014. The improvement in the solvency ratio is due to both higher capital (the numerator effect) and lower risk-weighted assets (the denominator effect). Spanish bank capital levels rose further during the first half of 2014. The common equity tier 1 capital under the new capital requirement regulation stood at 11.6 % in June 2014. Total regulatory own funds ratio increased to around 13.5%. In view of the results of the asset quality review and the stress test, and in order to shore up further their capital levels, some banks have managed to raise equity or other non-core capital instruments, such as subordinated debt or contingent capital instruments that qualify as own funds. In addition to this, BdE extended its recommendation on a maximum 25% of paid-in-cash to be also applied during 2014, leading to a strengthening of the core capital of Spanish banks.

Overall, the comprehensive assessment has highlighted that the restructuring that the sector has undergone has brought Spanish banks back on track. On 26 October 2014, the European Central Bank and the European Banking Authority disclosed bank-by-bank results of their comprehensive assessment of the major European institutions, including the 15 most significant Spanish banks. The reference date for the assessment was 31 December 2013. As of that date, only one former savings bank — Liberbank — failed to be above one of the three capital thresholds envisaged in the European Central Bank methodology, showing a very small shortfall of EUR 32 million stemming from the asset quality review. However, Liberbank managed to raise fresh equity amounting to EUR 637 million already during the first half of 2014 and therefore needs no additional capital to meet the comprehensive assessment minimum requirements. The other 14 Spanish banks were, after asset quality review adjustments as of December 2013, assessed to be well above the critical threshold of 8 % for the common equity tier 1 capital ratio and remained above 7.5 % under the adverse scenario, thus exceeding the minimum 5.5 % required. Five institutions were above 9 %, including BFA-Bankia. The results confirm that the restructuring helped to recover solvency of the Spanish banking sector at large, which is a necessary condition for a resumed growth in lending.

Only a well-capitalised and solvent banking sector can reconcile the deleveraging process with the provision of new lending to the viable part of the economy. The performance and resilience of the banking sector have continued to strengthen in the wake of the financial assistance programme. Nevertheless, shrinking credit volumes across the main areas of business are putting a potential strain on the prospective profitability of banks. Looking forward, unless they strengthen further their capital positions, and given lack of restrictions on dividends, banks will have only a limited margin to support the cleaning up of their balance sheets and to provide sufficient credit to productive sectors of the economy.

Adjustment in the housing market

The correction of the Spanish housing market after the burst of the construction bubble has been sharp. Spain witnessed a construction boom prior to the crisis. The share of residential investment exceeded 10 % of GDP each year between 2003 and 2008. In the crisis, it fell from the peak of around 12.5 % in 2006 to 4.1 % in the first half of 2014 (Graph 2.2.5), and is now lower than the average for the euro area. Nominal house prices have decreased by 36 % from the peak in Q3-2007 (Graph 2.2.6).

Graph 2.2.5: Residential investment as percentage of GDP

Source: European Commission

Housing prices seem to have reached a trough, but further movements in prices cannot be excluded. While it is difficult to forecast future house price developments, on balance, available studies suggest that the degree of overvaluation is much reduced.([18]) Standard valuation metrics suggest that housing prices might have reached a trough in 2014, registering growth of 0.8 % year-on-year in Q2-2014 and 0.3 % in Q3. However, some long-lasting downward pressure on demand for housing might delay price recovery. Despite the recent drop, Spain still has one of the highest home ownership rates in Europe. According to the Spanish statistical institute INE, the annual increase in the number of households is projected to slow down to around 60 000 in the next 15 years, compared with much higher increases observed prior to the crisis.

Graph 2.2.6: Evolution of House Price Index and MFI loans for house purchase

Source: ECB, European Commission

Recent rental market reforms support the adjustment process in the housing market. In 2013 Spain amended its legislation to create a larger and more efficient housing rental market. Law 4/2013 on the promotion of the rental housing market strengthened the legal rights of owners but also provided greater flexibility in ending rental agreements. A more flexible and efficient rental market should facilitate the conversion of vacant units into rental accommodation. Together with the elimination of tax-deductible mortgage payments from the beginning of 2013, in the long term it is expected to reduce the bias towards home ownership and the volatility of house prices.

Drivers of indebtedness and deleveraging in the households sector

Household deleveraging is mainly affected by the stock of mortgage loans. The majority of household loans are long-term (around 96 % of the total stock of loans in household liabilities) and related to housing (over 78 % of the stock), primarily mortgages. The composition of household debt was slightly affected by the crisis, as the stock of short-term loans declined by more than a quarter after the peak in Q2-2008, while long-term loans reached their peak only two years later, and have since declined by 15 %. The decline in long-term loans was more muted despite the prevalence of variable-rate mortgages, which have helped to make low interest rates available to households and thereby contain their interest burden.([19])

Negative credit flows have been the main driver of household deleveraging. Nominal income growth has been less supportive than in other episodes of house price busts, and GDP growth contributed negatively to household deleveraging in 2012-13 (Graph 2.2.7). With the pick-up in the labour market and increasing economic confidence supporting household demand for loans, one can expect that negative net credit flows will play a smaller role in deleveraging from now on. In Q2-2014, household debt still remained on average at least 10 percentage points of GDP higher than in the euro area and should be reduced further to reach equilibrium level.

Graph 2.2.7: Breakdown of year-on-year changes in debt-to-GDP ratios, households

Source: European Commission

Indebted Spanish households are among the most financially fragile in the euro area. Indebted households in Spain have one of the highest debt-to-income ratios in the euro area (at 145.9 %), and are particularly sensitive to an interest rate shock. As adjustable rate loans prevail in Spain, after a hypothetical 300 basis points increase in the interest rate, the median debt-service-to-income ratio of indebted Spanish households would increase from around 25 % to 30 %, and 36 % of indebted households would face a ratio greater than 0.4. Moreover, a combined interest rate and income shock (a 5 percentage point increase in unemployment rate) would lead to an increase in the proportion of indebted households having a positive probability of default by more than one third, to 9.1 %.([20])

Graph 2.2.8: Household leverage in Spain

Source: BdE, European Commission

The decline in household debt-to-assets ratio in 2014 was more pronounced than the decline in debt-to-gross disposable income ratio. Since Q2-2013, the outstanding financial assets of Spanish households have been considerably boosted by favourable developments in financial markets. In Q2-2014, household holdings of equity and investment fund shares were back to the levels last seen in the beginning of 2008. However, as the country remains vulnerable to sudden changes in global investor sentiment, one cannot exclude some fluctuations in the debt-to-assets ratio in the future. Moreover, the debt-to-gross disposable income ratio is much higher than the debt-to-assets ratio. Since its peak, it has improved to a lesser extent given the significant drop in employment and wage restraint during the long recession in Spain (Graph 2.2.8).

The authorities oppose further reforms of the personal insolvency framework following those implemented in 2013, which could already to some extent support household deleveraging. Following the adjustment in house prices after the boom, a significant proportion of households still remain in negative equity. Nevertheless, the rate of non-performing loans on mortgages has until recently remained very subdued, for various reasons including conservative credit standards, lower original loan-to-values ratios, and the environment of low interest rates. Spain does not have a personal insolvency procedure in place that would force creditors to negotiate a settlement agreement or repayment plan with debtors, consumers and entrepreneurs, when they are unable to service their debts. Some improvements have been put in place by the authorities to force creditors to enter into such negotiations, such as the implementation by banks of the ‘Code of Good Practice on protection of low-income mortgage borrowers’, which has facilitated several agreements (i.e. payment in kind for properties). Spain relies heavily on enforcement procedures (such as the mortgage enforcement procedure) that do not provide the same guarantees and possibilities for debtors as personal insolvency procedures. In 2013 and 2014, the Court of Justice of the EU declared certain Spanish procedural rules incompatible with EU law, as they did not provide sufficient protection for mortgagors against unfair terms in consumer contracts. To address the rulings, the authorities have revised the mortgage legislation. They are of the view that further reforms of the mortgage foreclosure legislation at this time could impair the existing solid payment culture and should take into account the proper functioning of the mortgage market, including mortgage-backed securities and the stability of the banking sector. Despite the recent efforts to improve enforcement procedures, the lack of a personal insolvency framework remains an obstacle for financially responsible individual debtors to receive a fresh start.

Drivers of indebtedness and deleveraging in the non-financial corporations sector

Seen from a macroeconomic perspective, the deleveraging process in Spain has been successful so far. The stock of domestic credit to non-financial corporations (NFCs) declined by more than 35% since the peak in Q1-2009, and total financing to firms (including not only loans, but also their other liabilities) decreased by less than 25%. This is because firms increasingly resort to foreign borrowing and issuing securities. The bulk of deleveraging took place in construction and real estate sectors, which have been responsible for around 75 % of the decline in the stock of domestic credit to non-financial corporations.

Graph 2.2.9: Breakdown of year-on-year changes in debt-to-GDP ratios, non-financial corporations

Source: European Commission

Negative credit flows have so far been the main driver of the fall in corporate debt-to-GDP ratio. Net negative credit flows can have significant knock-on effects on economic activity. As in the case of household debt, the reduction of the debt-to-GDP ratio resulting from negative net credit flows was partially offset in 2012 and 2013 by contracting GDP (Graph 2.2.9). With the turnaround in economic activity, real GDP growth started to contribute positively to reducing the relative indebtedness of non-financial corporations. In contrast, inflation under the harmonised index of consumer prices is expected to remain negative in the short term; the GDP deflator will therefore constitute a headwind for corporate deleveraging.

The remaining deleveraging needs in Spain are still high. Despite the fact that Spain has already seen a significant reduction in private indebtedness, private sector deleveraging needs are probably still well in excess of 30 % of GDP, with debt liabilities (loans and debt securities) of Spanish non-financial corporations at least 10 percentage points of GDP higher than the euro area average in Q2-2014. The deleveraging pressures imply that private debt will continue to weigh on economic activity in the years to come.

Table 2.2.1: Distribution of the stock of corporate debt in Spain, according to the leverage of firms, 2013 (1)

(1) The results on the distribution of corporate debt are based on a firm level dataset from the Bureau Van Dijk's Orbis database. The data refer to the fiscal year 2013, which on the date of the download (December 2014) were available in Orbis for a large majority of firms, but not for all. Subsidiaries of resident companies with consolidated financials were excluded to avoid double-counting. Firms operating in finance and insurance, public administration, health and social services, and education were excluded. Debt is defined as the sum of loans and non-current liabilities. Capital employed is the sum of debt and equity. Earnings before interest, taxes, depreciation and amortisation (EBITDA) are directly taken from the database. The thresholds for debt/capital employed (70% and 90%) and the debt/EBITDA (6x and 12x) are approximately equal to the 75th and 90th percentile across the pooled sample of firms from fifteen EU countries (which include vulnerable and core countries). Reported figures represent the share of debt held by firms in a given solvency bucket, as a percentage of the total amount of debt. Source: Orbis, European Commission

High debt levels have been exerting downward pressure on demand for domestic loans. Credit supply constraints and the relatively high spread on interest on corporate loans compared with the core euro area have eased in recent quarters, suggesting that negative credit growth in Spain has primarily been reflecting weak demand for loans. When looking at the entire range of financing instruments available to Spanish non-financial corporations, the decline in their total financing is slowing and is lower than the decline in domestic bank financing to non-financial corporations. This is because Spanish firms increasingly resort to foreign borrowing (the total stock of external loans to non-financial corporations increased significantly in the first half of 2014, growing by 11.8 % year-on-year in December 2014), and issuing securities (the stock of securities issued by non-financial corporations was 2.4 % higher than in December 2013).

Despite the recent correction, there are still pockets of highly indebted firms. A significant proportion of non-financial corporations remain highly indebted both with respect to their assets as well as their capacity to repay debt. Analysis of microeconomic distribution of debt suggests that in 2013 almost 30% of the stock of corporate debt in Spain was held by firms for which the ratio of debt to capital employed exceeded 90%, or the ratio of debt to earnings before interest, taxes, depreciation and amortisation (EBITDA) was higher than 12 (Table 2.2.1). Firms which register both a high ratio of debt to EBITDA, or debt to capital employed, face the highest risk of insolvency. The problem of potentially insolvent firms is particularly acute in the construction and real estate sector, but hotels and restaurants or other services are also significantly affected (Graph 2.2.11). Moreover, the debt of SMEs is potentially at higher risk of insolvency than the debt of large firms (Graph 2.2.10). Also, aggregate figures on debt service capacity hide a growing divergence among non-financial corporations, especially SMEs, as a large proportion of firms have earnings before interest, taxes, depreciation and amortisation lower than their interest expense (Graph 2.2.10). Some of the firms had temporary liquidity problems, abating with an improving economic environment in 2013, but others have become insolvent.

Several corporate insolvency reforms have recently been adopted because small firms rarely file for bankruptcy and an excessive proportion of firms entering insolvency end up being liquidated. The number of insolvencies in Spain increased in the wake of the crisis, but is still relatively low. Due to the severity of the crisis, and the fact that Spanish firms usually delay entering insolvency for too long, the firms that ultimately initiate the proceedings are on average in a much more difficult financial situation than their European peers. Spain made some progress in removing the remaining bottlenecks in the corporate insolvency framework. In September 2013, the Entrepreneurship Law (Law 14/2013) established a new type of out-of-court procedure suitable primarily for SME debtors. In March 2014, refinancing agreements, a pre-insolvency procedure suitable for bigger debtors, were also subject to considerable reform (Royal Decree-Law 4/2014, approved by the Spanish Parliament as Law 17/2014). Finally, in September 2014, the government made the proper insolvency procedures more flexible (Royal Decree-Law 11/2014). If the recent reforms are at least partially successful, one should expect not only a higher proportion of insolvent firms avoiding liquidation, but also a higher incidence rate of pre-insolvency and insolvency, as firms will be less reluctant to start the proceedings.

Graph 2.2.10: Distribution of corporate debt in Spain by firm size, according to the insolvency risk of the firm holding the debt, 2013 (1)

(1) For the definition of the level of insolvency risk see the table above. Source: Orbis, European Commission

Insolvency reforms should support a restructuring of corporate debt. Debt write-offs and debt-to-equity swaps have been facilitated; however the impact of the reforms on debt restructuring was not visible until June 2014, when the latest data became available. There are concerns whether the out-of-court agreements is fully suitable for smaller debtors, the refinancing agreements fully attractive for debtors and whether the institutional capacity of the insolvency framework is at its maximum. The authorities are nevertheless convinced that, after the September 2014 reform, creditors have greater incentives to reach agreements in the pre-insolvency phase.

The overall deleveraging of the private sector is accompanied by an ongoing reallocation of financial resources. Despite the strong decline in the bank financing of the private sector in recent years, a significant proportion of Spanish firms did not reduce their bank financing during the crisis. Between 2004 and 2007, more than half of firms were increasing or keeping stable their bank financing. In 2012 and 2013, this proportion fell below 40 %, and even to lower levels in energy, construction and real estate, the sectors that had experienced investment bubbles. The differences between sectors point towards an ongoing reallocation of financial resources in the economy.([21]) In line with the incipient economic recovery, the proportion of SMEs increasing or keeping stable their financing increased slightly in 2013. The 2013 results for large firms are not as clear cut, but need to be treated with caution, as those firms have better access to alternative sources of financing, such as bonds, equities, or foreign loans.

Most SMEs still face onerous financing conditions despite the improving availability of bank financing and progress in completing the ongoing measures to widen the access to finance for firms. A fragmented corporate structure of the Spanish economy has been exacerbating problems with bank financing during the crisis, as SMEs are more affected by cyclical funding conditions, and — due to their limited transparency — they have problems in tapping capital markets directly. This situation is aggravated by long delays in receiving payments, particularly from the public sector. While the availability of equity and mezzanine financing remains limited, new measures have been taken to foster venture capital and the credit lines of Spain's development bank (ICO) have also been strengthened. Currently, a draft law to further facilitate the financing of businesses is being discussed in the Spanish Parliament.

Graph 2.2.11: Distribution of corporate debt in Spain by sector, according to the insol