Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances

Spain is experiencing macroeconomic imbalances which require specific monitoring and decisive policy action. In several dimensions, the adjustment of the imbalances identified last year as excessive has clearly advanced and the return to positive growth has reduced risks. Yet, the magnitude and inter-related nature of the imbalances, in particular high domestic and external debt levels, mean that risks are still present. The Commission will continue a specific monitoring of the policies recommended by the Council to Spain in the context of the European Semester, and will regularly report to the Council and the Euro Group. This monitoring will rely on post-programme surveillance.

More specifically, the adjustment has been supported by decisive policy actions at the EU level and by Spain. In particular, the recapitalisation and restructuring of weaker banks have dispelled systemic concerns about the financial sector and allowed a smooth ending of the financial assistance programme at the beginning of 2014. The current account has turned into surplus, as a result of a combination of import compression and strong exports, supported by competiveness gains. The housing market has approached stabilisation. Employment destruction appears to be coming to an end. On the policy front, the comprehensive agenda of structural reforms outlined in the 2013 NRP is mostly completed from legislative point of view, and attention is shifting to a challenging implementation phase. These positive developments have led to a strong return of confidence, manifest in the fall in market risk premia, the return of foreign capital inflows and the rise in business and consumer confidence.

Yet, the adjustment is far from complete and vulnerabilities persist. More specifically, the very high stock of private and public debt, both domestic and external, continues to pose risks for growth and financial stability. Despite its recent contraction, unemployment remains at alarming levels. The re-orientation of the productive system towards exporting sectors and the recovery in international competitiveness will have to be maintained to reduce the very large stock of external liabilities and the burden that it causes in terms of negative flow of incomes towards the rest of the world. The adjustment of private sector balance-sheets is advancing, but high unemployment and falling incomes have limited the pace of deleveraging of households. Non-financial corporations have reduced debt at a somewhat more sustained pace. Going forward, the challenge is ensuring that deleveraging will go hand in hand with positive credit flows to financially healthy borrowers. Removing hindrances in the functioning of the product and financial markets and efficient insolvency procedures could reduce the drag on growth from deleveraging. In the labour market, building on the positive effects of recent reforms on internal flexibility and wage settings, additional reforms could be envisaged. Finally, significant revenue shortfalls, higher social expenditure and costs of bank recapitalisation have led to a substantial pressure on government deficits and a steep rise in government debt to high levels. The 2013 fiscal deficit target might have been missed, although the improving macroeconomic prospects should allow Spain to meet the 2014 headline target. Ensuring a reduction in government debt in the medium-term will require sustained fiscal efforts.

Excerpt of country-specific findings on Spain, COM(2014) 150 final, 5.3.2014

Executive Summary and Conclusions 7

1. Introduction 11

2. Macroeconomic developments 13

3. Imbalances and risks 19

3.1. CompetiTIveness and sustainability of the external position 19

3.1.1. Overview 19

3.1.2. Drivers of export performance 21

3.1.3. Drivers of imports 25

3.1.4. Income balance and capital transfers. 27

3.1.5. Medium-term evolution of net international investment position 27

3.1.6. Euro area dimension 28

3.1.7. Conclusions 30

3.2. Indebtedness and Deleveraging 31

3.2.1. Overview 31

3.2.2. Financial sector developments 32

3.2.3. Adjustment in the housing market 35

3.2.4. Drivers of indebtedness and deleveraging in the households sector 37

3.2.5. Drivers of indebtedness and deleveraging in the non-financial corporations sector 41

3.2.6. General government debt 42

3.2.7. Conclusions 45

3.3. Labour market performance 46

3.3.1. Overview 46

3.3.2. Drivers of labour market performance 47

3.3.3. Medium-term prospects 53

3.3.4. Conclusions 55

4. Policy challenges 59

References 64

LIST OF Tables

2.1. Key economic, financial and social indicators - Spain 18

LIST OF Graphs

2.1. External and domestic demand, contributions to growth 13

2.2. Decomposition of debt by sector (non-consolidated) 14

2.3. Decomposition of rate of change of ULC, rate of change of ULC in (EA/EU) 15

2.4. Relative shares of tradable and non-tradable sectors 15

2.5. Change in employment and average propensity to export by industry 16

2.6. Poverty dynamics 17

3.1. Decomposition of external position (current and capital accounts) 19

3.2. Current account, gross components 19

3.3. Share in world exports of goods and services (2000=100) 20

3.4. Net lending/borrowing by sector 20

3.5. Decomposition of net international investment position 20

3.6. Decomposition of the Real Effective Exchange Rate (REER) 21

3.7. Geographical and sectoral composition of nominal (USD) rate of change of goods exports (normalised to world goods exports) 22

3.8. World market shares for services 22

3.9. Allocative efficiency - manufacturing sector 24

3.10. Non-cyclical current account 25

3.11. Imports of energy and non energy product 26

3.12. Imports by broad economic category 26

3.13. Financial account balance by sector 27

3.14. Decomposition of rate of change of NIIP 28

3.15. Spanish imports as percentage of country exports (2011) 28

3.16. Exposure of foreign MFIs to Spain (ultimate risk basis - selected countries) 29

3.17. Exposure of foreign MFIs to Spain by sector (ultimate risk basis) 30

3.18. NIIP by sector 30

3.19. Non-performing loans 33

3.20. Bank loans 33

3.21. Credit impulse to NFC 34

3.22. Housing prices 35

3.23. Households indebtedness indicators 36

3.24. Contributions to annual growth of households' debt 36

3.25. Decomposition of y-o-y changes in debt-to-GDP ratios, households 37

3.26. Debt sustainability, households 37

3.27. Financial position of households 38

3.28. Doubtful loans ratio of NFC by sector 41

3.29. NFC indebtedness and financial burden 41

3.30. Debt sustainability, non-financial corporations 42

3.31. Profit margins, NFC 42

3.32. Activity and unemployment 46

3.33. Unemployment by duration 47

3.34. Employment distribution by sector 47

3.35. Employees as a percentage of active population 48

3.36. Evolution of activity rates by age 49

3.37. Evolution of activity rates by gender 49

3.38. Evolution of fixed-term and indefinite contracts 50

3.39. Wages, ULC, unemployment 2000-2013 52

3.40. Use of flexibility measures by company (July 2013) 53

3.41. Unemployment rate, by level of education attained 55

LIST OF Boxes

3.1. Insolvency procedures in Spain 39

3.2. Long-term projections of general government debt 44

3.3. Main features of the 2012 labour market reform 50

3.4. Model simulation of the possible impact of a tax shift in Spain 56

LIST OF Maps

No table of contents entries found.

In April 2013, the Commission concluded that Spain was experiencing excessive macroeconomic imbalances, in particular as very high domestic and external debt levels continued posing risks for growth and financial stability. In the Alert Mechanism Report (AMR) published on 13 November 2013, the Commission found it useful, also taking into account the identification of excessive imbalances in April, to examine further the persistence of macroeconomic risks and to monitor progress in the unwinding of imbalances. To this end, this In-Depth Review (IDR) provides an economic analysis of the Spanish economy in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP). The main observations and findings from this analysis are:

· The correction of macroeconomic imbalances has progressed, allowing a return to positive economic growth and prospects of a stabilisation in the labour market. Spain entered the financial crisis with high external debt, poor cost competitiveness, high private sector debt, a fragile financial sector and an overheated housing market. The burst of the housing bubble triggered a sharp adjustment, aggravated by the drying up of external capital inflows as the crisis progressed. A number of policy measures were taken to reinforce the financial sector, restore competitiveness and shore up public finances. The third quarter of 2013 marked the end of Spain's longest recession in decades and employment interrupted a long decline in the fourth quarter of 2013 (in quarterly terms). The return to positive growth occurred as domestic demand started to exercise less of a drag on growth amid recovering confidence and gradually easing financing conditions (although still relatively onerous for smaller borrowers). Going forward, the recovery can be sustained only if it does not result into a halt or reversal of the adjustment process, as the ongoing correction of the original imbalances still has a long way to go and new areas requiring close attention have emerged.

· The current account has adjusted swiftly and is now in surplus (1.1% of GDP in 2013), while indices of competitiveness have recovered a significant part of the deterioration during the pre-crisis boom. While cyclical factors explain a share of the improvement in the trade balance behind the turnaround in the current account, this latter appears to also have firm structural roots. In particular, exports, which remained resilient despite the loss in cost competitiveness in the years preceding the crisis, accelerated considerably in 2012 and 2013, with expansion both at the intensive and the extensive margins as the pressure for internationalisation increased amidst contracting domestic demand. Exports of services have been particularly dynamic. The import performance has been more mixed, as Spain has a high import intensity of final demand and higher oil prices countered the reduction of import volumes of non-oil goods. Yet, as a significant part of the slump in domestic demand during the crisis is likely to be permanent, imports will remain correspondingly lower. The current account balance is projected to increase further in the coming years, to 1.6% of GDP in 2014 and 1.8% of GDP in 2015 according to the 2014 Winter Forecast.

· The banking sector has been bolstered by the recapitalisation of weaker banks, the transfer of problematic assets to Sareb (the asset management company) and overall positive earnings results in 2013. In January 2014 Spain successfully exited the financial sector recapitalisation programme initiated in July 2012, having met all bank-specific and horizontal policy conditionality. However, despite favourable overall leverage ratios, the banking system is still exposed to challenges from the ongoing restructuring process, weak macroeconomic prospects, possible further adjustment in the construction sector and in the real estate markets and shrinking business volumes.

· The adjustment of the construction sector and housing market appears to be approaching stabilisation. Between 2006 and 2013 the share of residential investment in total GDP fell by around 8 pps. to 4.4%, below the previous historical low of 7% in 1997. Both residential investment and construction are still falling. The fall in house prices accelerated in 2012, and by the third quarter of 2013, the cumulative decline since the peak in the third quarter of 2007 was 36.2% in nominal terms and 43.8% in real terms. While there are indications of a slowdown or even stabilisation in the price correction at the end of 2013, given the still weak demand for housing and the remaining large stock of unsold houses some further adjustment cannot be excluded.

· Despite the progress achieved, the economy remains vulnerable given still large stocks of accumulated imbalances. The turn-around in flow variables is impacting stock variables only slowly, also due to the contribution from denominator effects are forecasted to remain contained in the short to medium run due to subdued nominal GDP growth. Large domestic (private and public sector) and external debt will weigh on demand and keep the economy vulnerable to shocks. The large pool of unemployed - a large share of which are long-term unemployed - will likewise require a sustained pace of job creation and effective activation policies over time to be reabsorbed.

· Driven by valuation and denominator effects, the negative net international investment position deteriorated further in 2013, in spite of the positive net lending position. The NIIP was -97.8% of GDP in the third quarter of 2013, down from -91.4% of GDP in 2012. The positive impact of net external lending of 1.9% of GDP was more than offset by negative valuation and denominator effects – the former linked also to the recovery in prices of Spanish financial assets and the appreciation of the euro exchange rate. Even disregarding valuation effects, it could still take a decade of large current account surpluses to reduce the NIIP significantly. Beyond the magnitude, the liability composition of the NIIP adds to external vulnerability, given the large share of loans and fixed income instruments.

· Private sector deleveraging is advancing gradually. The total stock of non-financial private sector debt was 210% of GDP in the third quarter of 2013 in non-consolidated terms (189% of GDP if consolidated). This is some 22 pp. of GDP lower than the peak in the second quarter of 2010, but still high. Most of the decline is due to non-financial corporation debt, which is down by 16 pp. of GDP since the peak. Based on historical evidence and considering the magnitude of the debt overhang, deleveraging pressures will take still time to work out and continue to weigh on domestic demand and on the financial sector.

· The imbalances accumulated in the private sector have spilled over to the public sector. General government debt has increased by almost 60 pps of GDP since 2007 and is forecast just below 100% of GDP in 2014. Worries about the banking sector, high budget deficits and the rapid increase in public debt, together with wider concerns about the stability of the euro area, all contributed to a brisk rise in Spanish risk premia, especially in 2012. Risk premia have narrowed considerably since the peak in mid-2012 (the 10-year sovereign bond yield spread has fallen from above 600 bps. in summer 2012 to less than 200 bps. in February 2014) and nominal yields are currently historically low. Due to the exceptional macroeconomic conditions, in July 2013 the Council extended the deadline for correcting the excessive deficit by two years to 2016. At present, the achievement of the 2013 budget deficit target appears still subject to risks.

· Structural inefficiencies have magnified the fall in employment. Limited firms internal flexibility in the use of resources, duality, unresponsive wages and the sharp contraction in the labour-intensive construction sector, have intensified labour shedding as a response to the economic contraction. The concentration of fixed term contracts among youngsters and low skilled, moreover, has led to a disproportionate burden of adjustment on these groups of workers. The labour reforms have contributed to enhance firms' internal flexibility and the responsiveness of wage bargaining to economic conditions. A positive impact on labour market duality is much less clear at this stage, but this may also be partly due to the high level of economic uncertainty, which may make companies favour temporary employment. However, a persistence of duality and lack of workers mobility when the recovery is more consolidated would be an obstacle to allocative efficiency and productivity growth. The labour market is also characterised by mismatch of labour demand and supply – both from a skill and a geographical perspective.

· As the Spanish economy is tightly interconnected with the rest of the euro area, developments in Spain could have a significant impact on the other economies, and vice-versa. The contraction of domestic demand impacted on Portuguese exports, almost one fourth of which are directed to Spain. The Spanish market is less important for other euro area economies, but nevertheless significant. Moreover, large flows of intermediate and final goods in some sectors (e.g. in transport equipment) show that Spain's production structure is closely integrated in particular with France and Germany. While the large share of exports directed to the euro area shelters Spain from movements in the euro exchange rate, an appreciation of the euro would impact on Spain's exports outside the euro area exports, which have been playing a growing role in recent years. Financial links between Spain and the rest of the euro area are also intense. The high reliance of Spanish banks on loans from the rest of the euro area (in particular France and Germany) implies that financial shocks in other large euro area Member States could impact on the funding of Spanish banks.

The IDR also discusses the policy challenges stemming from these imbalances and what could be possible avenues going forward, in particular to promote the allocative efficiency of the Spanish economy and support the on-going macroeconomic adjustment. A number of elements could be considered:

· The structural reform agenda has been advanced decisively in the last year, although there are still some important outstanding items and full implementation of ongoing reforms will be essential to reap the expected economic benefits. Beyond the measures to restructure the financial sector, many structural measures have been taken in accordance with the priorities identified in the National Reform Programme and the 2013 Country Specific Recommendations by the Council. The recent pension reform has improved the long-term sustainability of public finances, while public administration reforms are aiming at a rationalisation in competencies and a leaner administration. Public finance management has been reinforced by the internal stability pact between the central state and the regions, which is already delivering fruits and could be used to full potential, and by the new independent fiscal institution soon to become operational. The forthcoming reform of the tax system, still to be elaborated, could contribute to make the tax system more growth-friendly and tax revenues less volatile. The labour market reforms and social partners' agreements have increased flexibility and tempered the fall in employment. Measures in product and services markets are important to enhance competition, thereby bringing down profit margins and strengthening productivity, but they are still in the implementation phase in some cases while the reform on professional services has been delayed. The success of measures adopted to balance the electricity tariff system will be fully tested in 2014, the first full year of implementation, while competition in the retail and transport sector could be increased further. Going forward, the delivery on the ground of the reform strategy will be essential to the prospects of a sustained recovery. Such delivery depends often on joint implementation efforts by various tiers of government. Furthermore, as experience with the rebalancing process and reforms accumulates and is analysed, there could be scope for complementary policy measures to smoothen the adjustment and stimulate growth.

· Easing the reallocation of capital and labour would underpin both potential growth and the external adjustment. Effective competition in product and services markets and in network industries, as well as an enhanced business environment, would contribute to growth and to export potential and could also help to reduce the relatively high import content of final demand. Dealing with legacy debt and the restructuring of viable companies, allowing them to increase investment, would be facilitated by effective corporate insolvency and pre-insolvency frameworks. Incentives to consolidating the financial position of firms, and thus their resilience to shocks could come from removing the debt bias in corporate taxation. A review of the personal insolvency framework could provide a modernised legal framework for lending to individuals and reduce risks of permanent financial distress amongst households. In the face of the evidence of higher competitiveness and stronger export capabilities in larger companies, reviewing administrative and tax provisions that discourage small companies from growing could usefully be explored. Tax and other policy measures that would act to lower the high oil intensity and dependency of the economy would also contribute positively to the external equilibrium.

· Ideally, access to finance for valuable projects and a reduction in aggregate debt levels should go hand in hand. This would happen if valuable companies and creditworthy individuals have access to external funding, while overextended borrowers continue to work out their overhang. While this healthy discrimination in lending appears to be occurring to an extent, credit conditions for smaller borrowers have been easing only slowly and remain relatively onerous. The coming into full operation of the measures to strengthen access to non-bank financing will probably help, but asymmetric information between banks and SMEs could remain an obstacle to overcome in the light of widespread bank restructuring. Furthermore, there could be merits in close monitoring and further reinforcing banks' capital positions (as the Bank of Spain has been recommending in its supervisory role), in view of the ongoing rise in NPLs, still adjusting real estate and construction sectors and the bank balance sheet comprehensive assessment in 2014.

· Reabsorbing the very large unemployment over time rests on markets for labour, product and capital and a business environment that support the reallocation of resources towards the most productive sectors of the economy. The strong correlation between work status and measures of material deprivation suggests that reducing unemployment is critical to addressing social difficulties in the medium term. While a recovery in demand will help reabsorbing the cyclical part of unemployment, the behaviour of the labour market before and during the crisis points to deep structural shortcomings, which the recent reforms have started to tackle. Moreover, the adjustment that the Spanish economy is undergoing emphasises skills and geographical mismatches between labour demand and supply. Recent labour market reforms have increased internal flexibility and enhanced the responsiveness of wages to prevailing market conditions, while several new measures aim specifically at facilitating the entry of young and unqualified workers in the labour market. Mismatches could be alleviated by an intensification of Active Labour Market Policies (ALMP), the strengthening of public employment services and the extension of vocational training. The dual VET system aims at a greater employability of future generations; enhanced coordination between education and labour market policies could help to rationalise the offer of formal education vocational training and work-based training. Close cooperation between central and regional authorities would help to make best use of scarce financial resources and avoid fragmentation. Also relevant from an allocative efficiency point of view is the limited mobility of resources currently employed under contracts of indefinite duration, which could be related to the partly job-related protection legislation rules. Containing labour costs, via wage moderation and productivity increases, remains important to bridge the gap between labour demand and supply. Reducing non-wage costs for companies, possibly as part of a revenue-neutral tax shift from labour to consumption and other taxes (e.g., environmental or recurrent taxes on property), could provide a contribution to employment and cost competitiveness.

· With continued fiscal discipline in line with EU commitments and rules Spain can reverse the rise in general government debt during the crisis. Meeting the budgetary targets set out in the Council 2013 EDP recommendation and moving speedily thereafter towards the medium-term objective of a balanced budget would set public debt on a steady decline. Should growth turn out above expectations, accelerating correspondingly the reduction in the headline deficits would further underpin confidence and resilience to shocks. The credibility of the consolidation strategy is reinforced when this is underpinned by structural measures, of which significant ones have already been taken recently, such as in the area of pensions, public administration reform, des-indexation of public sector contracts. The forthcoming tax reform could contribute to solid public finances by reducing the volatility of revenue and by taking into account the need for alignment between revenues and expenditure in the medium-term.

On 13 November 2013, the European Commission presented its second Alert Mechanism Report (AMR), prepared in accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention and correction of macroeconomic imbalances. The AMR serves as an initial screening device helping to identify Member States that warrant further in depth analysis to determine whether imbalances exist or risk emerging. According to Article 5 of Regulation No. 1176/2011, these country-specific “in-depth reviews” (IDR) should examine the nature, origin and severity of macroeconomic developments in the Member State concerned, which constitute, or could lead to, imbalances. On the basis of this analysis, the Commission will establish whether it considers that an imbalance exists in the sense of the legislation and what type of follow-up in terms it will recommend to the Council.

This is the third IDR for Spain. On the basis of the previous IDR, published on April 10 2013, the Commission concluded that Spain was experiencing excessive macroeconomic imbalances, in particular as very high domestic and external debt levels continued posing risks for growth and financial stability. Overall, the Commission finds it useful, also taking into account the identification of excessive imbalances in April, to examine further the persistence of macroeconomic risks or their unwinding. To this end this IDR provides an economic analysis of the Spanish economy in line with the scope of the surveillance under the Macroeconomic Imbalance Procedure (MIP).

Against this background, Section 2 provides an overview of the general macroeconomic developments. Section 3 looks more in detail into the main imbalances and risks, focussing in particular on (3.1) competiveness and the sustainability of the external position; (3.2) indebtedness and deleveraging and, (3.3) the performance of the labour market. Section 4 discusses policy challenges.

Return to positive output growth and stabilising financial markets amidst further adjustment of imbalances

The correction of imbalances is advancing, with some variables adjusting at a higher speed than others. The recapitalisation and restructuring of weaker banks has contributed to restoring financial stability and confidence and set the ground for a relaxation of financial market stress. On the external side, the current account has turned into a surplus, with exports fuelled by a growing internationalisation of companies and improving cost competiveness. It will nevertheless take a long series of current account surpluses to narrow the large net negative external investment position and reduce substantially external debt. Private sector deleveraging has continued, with corporations reducing debt levels more rapidly than households, but also in this case the current trends in flows will need to be sustained over time to reduce the still elevated debt stocks. Meanwhile, reversing the fall back from the crisis on the labour market and on public finances have become major economic challenges. General government debt has reached high levels and is still increasing. In the labour market, the fall in employment appears to be finally bottoming-out but reabsorbing the large number of unemployed, many of them long-term and low-skilled, will be a major undertaking.

The third quarter of 2013 marked the end of the longest recession in decades. After a first dip between Q3-2008 and Q4-2009, the Spanish economy recorded anaemic growth in 2010, entering again in recession in the second quarter of 2011 with soaring unemployment. Following the GDP stabilisation in Q3, growth picked up in Q4-2013 on the back of a less negative contribution from internal demand, confirmed by a generalised improvement of economic sentiment indicators. Private consumption and investment are set to accelerate further in 2014 contributing positively to growth, while the contribution from the external trade position is expected to decline (Graph 2.1). Key macroeconomic indicators covering 2007 to the current forecast horizon (i.e. 2015) are summarised in table 2.1.

Financial markets have stabilised. A marked return of market confidence on Spain was manifest in the narrowing of sovereign debt yields spreads vis-à-vis the core euro area Member States, surging stock market prices and the resumption of foreign financing. Domestic deposits also increased, allowing Spanish banks to reduce their reliance on the Eurosystem. The financial sector recapitalisation programme ended successfully in January 2014, leaving banks much stronger than one and half year earlier. Yet, the restructuring and downsizing of the financial sector is set to continue.

Financing conditions for the non-financial private sector have been gradually easing, most notably for large borrowers. The reinforcement of banks' balance sheets and recovering confidence on Spain in financial markets have led to greater availability and a lower cost of financing for larger companies. At the same time, in spite of recent signs of easing and differentiation across companies, lending standards and terms for SMEs remain on average relative onerous, pointing to market fragmentation and the impact of the weakening or cutting of historical links between banks and customers. The financial sector is discussed in greater detail in section 3.2.

House prices have adjusted sharply and appear to be approaching stabilisation. The cumulative fall between Q3-2007 and Q3-2013 was 36.2% in nominal terms and 43.8% in real terms. Even though prices were still falling at a 7.9% year-on-year rate in Q3-2013, they increased by 0.7% compared to the previous quarter, the first positive quarterly growth rate since Q2-2010. The market is also characterised by much differentiation across locations. However, given the large stock of unsold houses, it cannot be excluded that the adjustment may have somewhat further to run, and price developments going forward might also be influenced by the sale strategies of Sareb (the asset management company) and commercial banks. The housing market and the construction sector are discussed in detail in section 3.2.

Deleveraging pressures remain a drag on growth. The strong contraction of credit has been the main driver behind the reduction in private sector indebtedness, but the contraction of GDP has impeded a more rapid stabilisation of indebtedness ratios (Graph 2.2). The gradually improving economic outlook can be compatible with a continuation of deleveraging. Both households and non-financial corporations are expected to maintain positive net lending positions even as consumption and investment, as well as demand for credit, pick up.

Whereas the private sector is on a path of deleveraging, general government debt is still expanding. Rising social expenditure, the disappearing of a rich tax base linked to construction and stabilisation interventions in the financial sector have put general government debt on an increasing trend: from 2007 to 2012 it increased by almost 60 pps. and it is set to approach 100% of GDP in 2014. Deleveraging pressures in the private and in the public sector are discussed in section 3.2.

Strengthening current account and competitiveness, but not reflected yet in the net international investment position

The current account has turned into surplus (1.1% of GDP in 2013), after almost two decades of negative balances. The improvement was driven by the trade balance, with exports accelerating considerably in 2012 and 2013, while import volumes continued to contract. The current account balance appears set to increase further in the coming years, according to the 2014 Winter Forecast.

The process of internal devaluation advances, resulting in low inflation and a recovery in price and cost competitiveness. During the boom period Spain registered a protracted positive inflation differential with the euro area and the EU that entailed a strong deterioration in cost and price competitiveness. With the fall in domestic demand and surging unemployment during the crisis, inflationary pressures eased, first narrowing and then reversing the differential with the euro area and the EU. Headline and core inflation have fallen to around zero in late 2013 and are expected to remain very contained during 2014. The real effective exchange rates (REERs) and nominal unit labour costs (ULCs) have fallen by 12.0% and 6.8% respectively since 2009 (Graph 2.3).([1]) Productivity gains (largely associated with labour shedding) together with moderate wage developments in later years explained the recovery in competitiveness. The successful implementation of ongoing structural reforms in product and services markets would support competitiveness. In particular, measures aimed at overcoming regulatory fragmentation in the internal Spanish market and at instilling better regulation principles across all general government levels should enhance competition and reduce economic rents in sheltered sectors.

Several indicators suggest a structural improvement of Spain's export capacity. The analysis of cyclically adjusted current account suggests that the non-cyclical balance could be somewhat lower than the headline figure. Exports have increased both at the extensive and the intensive margins. Considering the fixed costs associated with penetration in foreign markets, it is unlikely that these gains will be reversed in the future. A part of the real import decline is also likely to be permanent, as domestic demand and growth expectations are not expected to return to pre-crisis levels.

In spite of the current account surplus, the NIIP has continued to deteriorate as a ratio of GDP, on account of contracting GDP and negative valuation effects. The latter reflect positively increased confidence in the perspectives of the Spanish economy. Yet, a high external debt (especially in the form of loans) exposes the economy to vulnerabilities – as it became evident in the wake of the crisis. The external performance is discussed in detail in section 3.1.

Ongoing reallocation of resources

The adjustment process has produced a sharp alteration of the composition of employment and value added. The contraction of value added and employment relative to the pre-crisis level has concerned all branches of the economy. In relative terms, the share of tradable sectors in value added has interrupted its long declining trend and the same applies when looking at the share of tradable sectors in the compensation for employees (see Graph 2.4). The change in the relative composition 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).

Export-oriented firms have fared better. Micro-level data shows that exporting firms recorded better performance index of industrial production and higher profitability rates (based on firms' balance sheet data). Furthermore despite low rates of aggregate capital utilisation, investments in equipment have registered a significant increase in the last months of 2013, whereas sub-branches of the tradable sectors reported positive expectations about employment creation. The combination of this evidence suggests that a process of re-allocation of capital and labour is on-going despite the fact that it not yet visible at a high aggregate level (i.e. tradable versus non-tradable). This conclusion is also supported by a recent analysis of the Ministry of Economy. Since the onset of the crisis, as graph 2.5 depicts, exporting industries (e.g. automotive, transport equipment, chemicals and pharmaceuticals, machinery and equipment) have suffered much less than the average. A similar pattern is found with respect to credit: i.e. a much lower aggregate reduction in exporting industries.

Record high unemployment and worsening social indicators

The macroeconomic adjustment process in the context of a dual and rigid labour market resulted in unprecedented employment destruction, which is only starting to stabilise. The external rebalancing and the deleveraging pressures necessarily required an adjustment also in the labour market. However, in a dual and overly rigid labour market, the fall in aggregate demand produced an exceptionally high employment destruction (more than 4 million jobs were lost since the beginning of the crisis). The unemployment rate stood at 26.4% in 2013, below the record high of 27.2% in Q1 of 2013. The reduction was however mainly due to falling activity rates. Reductions in the labour force have mainly been driven by net migration outflows. The participation of the younger population also decreased, while the ratio of individuals not in education, employment, or training to total population in young cohorts (the NEET rate) has been increasing sharply.

There is an increasing risk that long term unemployment will cause hysteresis effects. Spain has historically witnessed sudden and extensive surges in unemployment in economic downturns. A sticky wage adjustment process and the significant share of fixed-term contracts contributed to a high elasticity of employment to GDP. While employment perspectives should improve as economic activity picks up, the structural transformations the Spanish economy is undergoing (and in particular the downsizing of the construction sector) accentuate the mismatch between labour demand and supply, and the large share of long-term unemployment (52.2% of total unemployment in Q4-2013) risks generating significant hysteresis effects with a negative impact on the structural rate of unemployment. Notwithstanding the positive impact of recent labour market reforms on internal flexibility and wage setting, future employment outcomes will also depend on improved matching in the labour market (to which ALMP and training and education can contribute) and on the success of reforms in product markets and business environment (see section 3.3).

Social indicators have worsened substantially with the crisis and higher unemployment. With social indicators typically strongly correlated with the performance of the labour market, the surge in unemployment in Spain has had a direct impact on poverty (see Graph 2.6). Between 2007 and 2012, the population at-risk-of-poverty (AROP) ([2]) increased from 19.7% to 22.2%, whereas the percentage of the population of people at-risk-of-poverty or social exclusion (AROPE) increased from 23.3% to 28.2%.([3]) The difference between the two measures is mainly driven by the increase in the number of households with very low working intensity (from 6.8% to 14.3%).([4]) Poverty has a strong gender profile, with poverty rates for single women well above the average. Families with two or more children are also particularly exposed to poverty risk, with the AROPE for household with three children or more being above 45%. Child AROPE rates, already high by comparative perspective, increased further to 33.8% - i.e. almost 10 pp. higher the euro area average.([5]) High poverty rates in households with children are consistent with a high average early school leaving rates, which at 24.9% in 2012 is amongst the highest in the EU. The rate has decreased in recent years, possibly also on account of lower employment opportunities for low-skilled workers.

Poverty has increased also amongst the employed, whereas the elderly have on average been relatively sheltered during the crisis. In terms of labour market status, recent years marked a strong increase of poverty amongst the adult unemployed population (from 49.5% to 62.3% between 2007 and 2012) and an increase in poverty rates amongst the employed population. The latter finding can be explained both in terms of falling earnings and of spill-over of labour market status of other members of the household. Retirees, on the other hand, appear to have been on average relatively sheltered over the crisis: the poverty rate for those aged 65 and more dropped from 27.9% to 16.6% between 2007 and 2012.([6])

Higher social expenditure and intra-household solidarity have cushioned to some extent the rise in poverty levels. Expenditure on social protection in Spain increased from 20.8% of GDP in 2007 to 26.1% of GDP in 2011.([7]) However, a significant share of the increase is due to expenditure on pensions which rose from 9.2% of GDP to 11.4% of GDP. Moreover, over the same period the number of beneficiaries (all typologies) increased from 1,246,300 to 2,698,500, and the number of beneficiaries of social assistance from 400,500 to 1,184,100.

With falling disposable incomes, housing costs (including the repayment of mortgages) have become a heavier financial burden. The percentage of mortgage holders declaring to bear a heavy financial burden for the repayment of debts increased from 53.7% to 64.2% between 2007 and 2012.([8]) The situation of the labour market clearly drags on the process of deleveraging and weigh on prospects for banks' profitability. Whereas the NPL rate on mortgages has so far been contained, it remains on an upward trend. The increasing length of unemployment spell risks reducing the capacity of affected households to face their financial commitments.

3.1. CompetiTIveness and sustainability of the external position

3.1.1. Overview

The bust of the housing bubble and the financial crisis has prompted a sharp current account adjustment. From a deficit of 10% of GDP in 2007, the current account registered a surplus of 1.1% of GDP in 2013 (Graph 3.1), which is forecast to widen to 1.8% of GDP by 2015. Indicators of competitiveness have also improved, reversing a good part of the losses accumulated in the boom period. ULC have been falling since 2010, on the back of labour shedding induced productivity growth, and – more recently – subdued wage dynamics.

The export performance has been very robust, contributing to the re-balancing of the economy. Exports of goods and services increased from, respectively, 17.6% and 8.8% of GDP in 2008, to 23.5% and 10.6% of GDP in 2013 (Graph 3.2). Export of goods as a share of GDP is still well below the share of Germany (42.7% in 2013), but compares well with two other large euro area economies (21.4% of GDP and 25% of GDP in France and Italy respectively). Moreover, the share of services in Spanish exports is well above other large euro area economies (Germany, France and Italy are at 7.7% of GDP, 6.1% of GDP and 5.4% of GDP respectively) and comes close to the performance of the UK (12.3% of GDP).

The evolution of Spanish exports' market shares also compares well with other large euro-area economies (despite decreasing in relative terms due to globally increasing trade flows – see Graph 3.3). From 2008 to 2013 the export market share for goods decreased only marginally, from 1.8% to 1.7% (the corresponding values for other large euro area economies are: Germany: 9.0 to 7.8; France: 3.8 to 3.2; Italy: 3.4 to 2.8). Advanced countries’ nominal shares 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. That was the case before 2007, also in Spain, where export shares fell more in real than in nominal terms due to high export prices. However, since 2007 real shares have performed better than nominal shares owing to price and wage moderation in advanced countries. The recent development of export market shares in Spain, particularly in real terms, points to structural competitiveness gains. The evolution of the real share in comparison with the nominal indicates the exporters’ moderation of prices paves the way for a positive behaviour of exports in the medium term.

In spite of a sharp contraction in real imports, imports values proved quite resilient. Following the trade collapse of 2009, import of goods attained 24.7% of GDP in 2013 – i.e. not far from pre-crisis levels, whereas the import of services attained a ratio of 6.9% of GDP in 2013 – i.e. above pre-crisis levels. As discussed below this is largely due to the behaviour of import prices – in particular energy (for more details see discussion in section 3.1.3 and Graph 3.11).

The turnaround in the current account is the counterpart of deleveraging in the private sector (see Section 3.2). Non-financial corporations and households have moved into very large net lending positions, more than compensating the large net borrowing position of the government (Graph 3.4). Going ahead, further reductions in the budget deficit would support a larger surplus in the current account even in the event of a stabilisation of private sector net lending.

In spite of the current account surplus, the Net International Investment Position (NIIP) deteriorated in 2013 on account of negative valuation effects. In Q3-2013 the NIIP stands at –97.8 % of estimated GDP, i.e. more than 15 pps higher than before the crisis and more than 60 pps higher than the value in the early 2000s (Graph 3.5).

This section will continue with a discussion of the drivers of exports and imports, the level and the structure of the NIIP and trade and financial links with the rest of the euro area, before providing some conclusions.

3.1.2. Drivers of export performance

Spanish exports have been resilient in a medium-term perspective. Remarkably, this was the case also during the sizeable pre-crisis deterioration competitiveness indicators (Graph 3.6). This well-known phenomenon has been referred to as the ‘Spanish paradox’. ([9]) Econometric evidence confirms the long-term positive relationship between relative-price-based competitiveness indicators and exports, but also suggests that other factors (non-cost determinants) may more than compensate the dynamics of relative costs and prices. ([10]) In empirical studies, the real exchange rate typically explains well below 10% of the change in (country-specific) exports; world (trade) developments explain about 80%, while the residual 15% is linked to a path dependency that implicitly captures other unspecified factors. Moreover, Spain stands out in these analyses in that the explicative power of cost competitiveness and path dependency are below the average of other countries.([11]) The higher explanatory power of foreign demand suggests that other factors have allowed Spain to benefit relatively more from the increase in global trade flows and thus offset the negative dynamic of aggregate losses in cost competitiveness.

The export mix (in terms of products and geographical markets) and the relative efficiency of exporting firms can help explain the export performance of Spain. Firstly, the concentration of exports in growing regions and/or growing markets contributes to determining the export performance of a country. Other factors include the extent of competition of other countries as well as the role of exporting industry in other sectors (i.e. high or low dependence). Secondly, the analysis of the behaviour of firms is key to understand the aggregate export performance of a country. ([12]) This analysis typically relies on micro-data at firm-level in order to capture the heterogeneity that exists both across sectors and across different enterprises of different size.

Spain has been successful in stepping up its export product and geographical specialisation. The change in goods export market shares can be decomposed through a shift-share analysis in four components, namely: (i) initial product specialisation; (ii) initial geographical specialisation; (iii) market share gains in product markets and (iv) market share gains in geographical destinations. Although the negative contribution of initial geographical specialisation (mostly the EU) was more sizable in the case of Spain than Germany (Graph 3.7), in recent years Spain has registered larger positive contribution from penetration in new geographical markets – mainly the Emerging And Growth Leading Economies (EAGLEs). The decomposition also shows a relatively favourable contribution (relative to Germany) of the initial product specialisation and market share gains signalling that, despite the lower technological content of its export, Spain was able to withstand relatively well increasing competition from developing economies.

A more granular analysis points to specific strengths of Spain's goods export mix. Spain fares well in terms of levels of global complexity and connectivity. ([13]) The average complexity of Spanish exports is more than double that of global exports, whereas its average industry connectivity is above the global average. Amongst the best performing industries are sectors with a high weight in Spanish exports such as machinery (33%), other chemical products (11%) and other metallic products (8.9%).

The performance of export of services has also been positive – both in quantitative and qualitative terms. Spain's share in world's service exports is significantly greater than its share in goods' export (3.3% versus 1.6% in 2012), mainly on account of its large tourism sector. While the share of Spain in world tourism has been decreasing in the last decade([14]), Spain has been able to expand its share in other services – mainly services to enterprises – characterised by higher value added and possibly higher future growth potential (see Graph 3.8). The share of turnover in foreign markets increased in most sub-sectors related to services to enterprises, 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 and tax consultancy as well as in management consultancy activities. Whereas the increase in the export markets for goods mainly occurred in the EAGLEs, the expansion of export of services was concentrated in North America and in the UK.([15])

At micro level, Spanish exporting firms are more efficient than non-exporting firms, and compare well to euro area competitors. The data point to higher productivity levels amongst Spanish exporting firms (typically bigger than non-exporting firms) ([16]) and to broadly comparable export propensity at the extensive margins to peers in other euro area countries. ([17]) This is consistent with the economic literature that has highlighted the importance for international competitiveness of firm-level factors (capacity to specialise and exploit new and dynamic markets) besides structural conditions prevailing in the individual countries including labour- and product-market functioning, the degree of technological diffusion, innovation, taxation and financing constraints.([18])

The relative strength of exporting firms appears to have offset part of the deterioration in aggregate competitiveness measures. Productivity performance at the firm level is the result of improvements in product quality and processes, but also relative strengths in relation to the management of the firm, distribution channels and after-sales services. ([19]) Antrás et al. (2010) find that when firm-level ULC developments are considered (instead of aggregated ULCs), Spain’s export performance is less paradoxical. Productivity growth in the largest firms has outperformed that of smaller firms over the past decade and, in turn, the exports of those firms increased faster than those of other smaller firms. It thus appears that the behaviour of Spanish companies has in some instances allowed them to overcome structural weaknesses vis-à-vis their peers in other countries: 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; the proportion of Spanish firms that invest in R&D is lower, but Spanish score better in the generation of process innovations; the participation of Spanish firms in global value chains is lower and predominantly passive (by contrast, a higher percentage of Spanish firms import standardised inputs, in line with the Spanish economy’s high import dependence).([20])

The export base is widening. The overall success of Spanish firm internationalisation strategy can be measured against the increase in export at the intensive and extensive margin. According to data released by ICEX (Spanish Institute of Foreign Trade), the number of Spanish exporting firms has grown significantly in recent years, at an annual average of 6.0% from 2008 to 2011. According to provisional data for 2013, the number of exporting firms further increased by 11.7% - a year-on-year rate similar to the record increase of 12.6% registered in 2011. ([21])

The size distribution of Spanish companies, skewed heavily towards micro companies, drags on the aggregate export capacity of the economy. Most of the variables positively contributing to export propensity and/or intensity are more frequently observed (or have higher average values) in larger firms. As pointed out in several early studies – there is a strong positive correlation between company size, productivity and export potential. ([22]) Interestingly, even when taking into account the contribution of the other variables discussed above, company size remains the single most significant factor explaining the export performance. ([23]) This contributes to the high degree of concentration of exports. Despite the recent increase in the extensive margin, moreover, the increase at the intensive margin has been largest amongst largest companies. This has resulted in a further increase in the degree of concentration of exports. ([24])

Structural factors, and in particular low allocative efficiency, appear to constrain firms' growth and hamper the export potential. The above evidence suggests that low aggregate productivity was less rooted in micro-level determinants, but rather in structural features that prevent an efficient allocation of resources and more productive firms to grow faster. This view is supported by a recent study by the Bank of Spain which shows that (i) the loss of competitiveness during the boom did not occur among the largest firms with the greatest presence in international trade and (ii) the aggregate slow-down in productivity is the result of a lack of flexibility, which prevented resources from being efficiently reallocated between sectors and firms.([25]) Commission services estimates further confirm this result. Allocative Efficiency (AE) for the manufacturing sector is defined in Graph 3.9 as the percentage increase in manufacturing productivity in Spain and in Germany connected with the actual allocation of employment across firm size classes, relative to a baseline scenario in which employment is allocated randomly (according to a uniform probability distribution) across the different firm size categories. The slightly positive value means that resources are allocated in a more efficient way relative to the baseline. The maximum attainable level assumes that the size class with the highest labour productivity has a 100% market share, while maintaining the observed labour productivity level per size class and unweighted average labour productivity level for the calculation of the index. Lower figures for allocative efficiency point to forces in the economy preventing competition to work properly, such as excessive regulation, rent-seeking and ineffective procurement. The gap with respect to the optimal allocation is much larger for Spain than for Germany. ([26])

3.1.3. Drivers of imports

A significant part of the fall in imports is likely non-cyclical. In constant prices, total imports fell by almost 17% between 2008 and 2013. Regressing imports on final demand components confirms that this fall was mainly driven by contacting private consumption and investment in equipment and in construction, whereas the pick-up of exports contributed positively to imports.([27]) As part of the fall in demand is itself structural, the corresponding fall in imports can be considered as permanent. In particular, the downsizing of construction (explaining around 30% of the fall in imports) can be assumed to be lasting and revised expectations and higher risk premia are likely to have lowered the expected trajectory of private investment and consumption.

At the same time, the cyclical component of the current account remains important. According to Commission services estimates, the cyclically corrected current account features only a marginal surplus in 2013 (Graph 3.10). Moreover, these estimates are subject to the uncertainty related to the estimation of potential output and might underestimate the potential for a rebound in in imports when demand picks up and/or potential output growth reverts to normal values. ([28])

The relative high use of foreign inputs by Spain's industries limits the capacity to compress imports. Preliminary evidence suggests that despite an initial reduction in the import content of exports, as trade volumes resumed, the import content of exports returned to its historical high levels. The latter was estimated by Commission Services at almost 30% in the years before the crisis.([29]) Importing intermediate goods raises the probability of exporting, probably because of the accessibility to a greater variety of inputs at a lower cost, and it could thus signal the efficiency of exporting sector in leveraging the benefits of international specialisation. ([30]) The Spanish economy is also more specialised than other euro area economies in sectors featuring relatively higher import content. Moreover, for several industries (and especially for the large automotive industry), import dependence may be explained by the relative weight in production of subsidiaries of foreign firms. Indeed, there appears to be a positive relationship between FDI and import intensity and Spain shows by far the highest ratio of stock of FDI to GDP amongst large euro area economies (almost 48% in 2012). However, FDI have not all gone into productive activities – much of it went into real estate - and the generalised high import content in all branches of the economy might also be linked to inefficiencies in the domestic markets. ([31]) ([32])

Import values, moreover, resumed relatively quickly, on the back of increasing oil prices and the high structural dependence of the Spanish economy on fuel products. The import of goods in terms of GDP could have been almost 1 pp lower between 2008 and 2012, had the index price of fuels and lubricants remained at the value of 2008.([33]) The high dependency of Spain on energy products represents a weakness for its external position (Graph 3.11).

The process of internal devaluation could foster import substitution. In particular, if restored competitiveness translates into lower prices on domestic markets, import substitution could occur – at least for import goods that are subject to greater price elasticity. The impact is therefore likely to occur more with respect to consumer goods, which however have limited weight in total imports (Graph 3.12).([34])

3.1.4. Income balance and capital transfers.

High net external debt implies a significant negative income balance. The evolution of the income balance is closely linked to the composition of the debt – both in terms of instrument and in terms of borrower. Net financial flows will remain sensitive to variations in risk premia on Spanish assets. In recent times, official flows not only cushioned the withdrawal of private capital, but also allowed to contain interest payments, despite mounting debt (Graph 3.13). In 2013, the flow of income to remunerate foreign capital was in the order of 1.1% of GDP and it is set to increase to 1.8% of GDP in 2015.

The balance of current transfers and of capital account should nearly offset in the coming years. The balance of current transfers (or secondary incomes) is mainly made of transfers between public administrations and remittances. Transfers to the EU budget should remain broadly in line with the evolution of GDP. Remittances from foreign workers working in Spain have fallen significantly as many immigrants have returned to their countries of origin in the wake of the crisis, and there has been an increase in remittances from abroad. The contribution of current transfers from the EU budget is likely to reduce slightly. All in all, the balance of transfers will likely maintain over the medium term a negative, but decreasing contribution to the net financing position. As per the balance of capital transfers, it has traditionally been positive (about ½ pp. 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.

3.1.5. Medium-term evolution of net international investment position

The re-absorption of the NIIP will require a prolonged period of significant current account surpluses. A prolonged period of large trade deficits and negative income transfers contributed to the sizable deterioration of the NIIP (Graph 3.14). Going ahead sizable trade balances surpluses will be needed to offset the negative contribution of the balance of primary income. Even if the current account were to reach a record level of 3.4% of GDP, it would take about 10 years for the NIIP to reach -35% of GDP. This would imply a surplus in the trade balance and balance of current transfers of about 6.5% of GDP. A more realistic scenario would be to attain by the end of 2023 a NIIP of -50% of GDP. This would require still sizable average current account balance and a balance of trade and current transfers of 1.7% of GDP and 5.1% of GDP respectively –i.e. a figure in line with current forecast for 2014 and 2015. Note however that such projections are extremely sensitive to the underlying hypotheses.([35]) The projections moreover neglect the impact of valuation effects.

The weight of loans and bonds increases vulnerability to external shocks. With regard to the structure of its NIIP, Spain has a large net external debt (-88.1% of GDP, mostly due to liabilities related to bonds and loans), while its equity position improved sharply in the last few years and turned positive in 2010.([36]) Measures to reduce the corporate debt bias, i.e. favouring a shift in companies financing towards equity, would at the same time strengthen the competitive positions of Spanish enterprises, and impact favourably on the composition of NIIP.

3.1.6. Euro area dimension

Spain is tightly interconnected with the euro area through trade and financial linkages. Spain's GDP is about 10.6% of overall euro area output and the Spanish market is the destination of a significant share of other euro area's exports. At the same time, in spite of an increased geographical diversification of exports in recent years, Spain is directing about 50% of its exports in goods and more than 40% of its services to other euro area Member States. The main euro area destinations are the large euro area economies. France, Germany and Italy account respectively for 17.2, 10.3 and 8.2% of total export of goods in 2011. Portugal also accounted for 8.2% of the total exports of goods in 2011. Germany is the largest euro area exporter to Spain: 11.8% of Spanish imports come from Germany. Germany is closely followed by France (10.8%), while a significant share is also represented by imports from Italy (6.6%) and the Netherlands (4.1%). Outside the euro area, about 7% of Spanish imports come from China, and around 4% from the US and from the UK. From the perspective of the exporting countries, Portugal features the highest link, with exports to the Spanish market constituting more than a fifth of total exports (graph 3.15). Exports from France and Italy to Spain make up around 7% and 6% respectively of these countries' total exports.

The extensive trade linkages within the euro area are also a reflection of Spain's participation in international value chains. A significant share of the imports and export linkages between Spain on one side and France and Germany on the other side are related to the high degree of integration in specific industries, particularly the automotive sector. Due to these interdependences, fluctuations in domestic demand or other types of shocks, that originate in one of them is likely to be transmitted to the other. Portuguese exports to Spain, on the other hand, are diversified as no industry captures more than 10% of total exports.([37])

Whereas concerns about Spain's financial and macroeconomic stability and the on-going adjustment process have had contractionary effects on other parts of the euro area, the direct role of trade linkages is likely not to have been major. To assess the extent to which economy activity in one country spillover across border, inter-sectoral and inter-regional links need to be taken into account. The spillover effects from low growth in Spain can be quantified by simulating a 1% reduction in domestic final demand in Spain.([38]) The results show that the spillover effects generated by the domestic final demand changes tend to be small in a static perspective. Portugal is impacted the most, followed by France and Italy. The impact on Portuguese exports, a decrease by 0.16 percent, is almost 3 times larger than the impact on French exports. French and Italian exports decrease by some 0.06% and 0.05% respectively. This impact is in contrast with the sharp contraction in trade witnessed in the years following the crisis. It is indeed likely that simultaneous contractionary effects lead to more than addictive results. In this respect, the simultaneous adjustment of several euro area peripheral countries might have a stronger impact than what suggested in a single country simulation. In the case of Portugal, moreover, even the static simulation suggest a sizable negative impact, considering that the magnitude of the contraction of final demand in real value between 2007 and 2013 was in the order of 10 pp.

Spain would be to a limited extent be affected by an appreciation of the euro. The discussion in section 3.1 has highlighted the resilience of the Spanish export sector, which suggests that moderate exchange rate variations should not alter fundamentally exports prospects. Moreover the growing contribution of non-tourism service exports should also reduce the risk of negative spillovers from an appreciation of the euro, considering that services tend to be less price elastic.

The external private sector has significantly reduced its exposure towards the Spanish financial sector. Graphs 3.16 and 3.17 highlight the substantial reduction of the exposure of foreign banks towards the Spanish private sector and especially the banking system. The reduction has been particularly significant for German banks, which had significantly increased their exposure in the boom years. The exposure of the French banking system was also sizable. Recent data show a comparable exposure of Germany and France of about EUR 90 and EUR 80 billion respectively. The exposure of the UK is in the order of EUR 60 billion, whereas the exposure of the Dutch and US banks is below EUR 40 billion.

This reduced private sector exposure has been offset to a large extent by the official sector. Private capital outflows were compensated by an increased recourse to Eurosystem financing by Spanish banks, and Spain also drew EUR 42 billion from the financial sector assistance programme. With the stabilisation of financial markets, Spanish banks have been able to reduce their Eurosystem borrowing. The net claims of the Banco de España vis-à-vis the Eurosystem decreased from a peak of EUR 406.3 bn in Q2-2012 to EUR 263.7 bn in Q3-2013, while recovering confidence on Spanish assets led to an increase in the share of public debt owned by foreigners. Consequently in Q3-2013, the external liabilities of the Bank of Spain and of the General Government amounted to 26.3% of GDP and 37.0% of GDP respectively. The net liabilities were somewhat less, given the reserves of the Bank of Spain and other assets held by the Government, yet the joint net liabilities represent more than half of the Spanish NIIP.

Spain exposure to the euro area is relatively limited, but risks could come from its exposure to foreign markets. According to BIS data, Spanish exposure to foreign banks is estimated at EUR 1,118 bn in September 2013 (i.e almost 110% of GDP). Almost EUR 500 bn correspond to exposures with EU Member States, of which however exposure to euro area is less than EUR 200 bn. The highest exposure within the euro area is with Portugal (about EUR 50 bn), followed by Germany and France (EUR 44 bn and EUR 31 bn respectively). Outside of the euro area, exposure with the UK is almost EUR 300 bn. At present, the risk of negative spillover could rather come from Spain's significant exposure with Latin America (more than EUR 350 bn, concentrated in Mexico and Brazil).

3.1.7. Conclusions

A significant part of the current account adjustment is likely to be of permanent nature. This permanent component is however the result of both 'good news', i.e. the very positive export performance, and 'bad news', i.e. the likely longer-lasting reduction in domestic demand and potential output. More granular analyses points to elements of intrinsic strength at firm level that have supported the export performance, as well as to a dynamism. Moreover, there is growing internationalisation of companies and geographical diversification has also increased. Considering the fixed costs of entering foreign markets, these trends are unlikely to reverse. Exports are thus set to remain a main growth driver, in particular if supported by policy measures that prioritise higher allocative efficiency through better functioning labour and capital markets and enhanced access to technology while removing all hurdles to company growth.

A significant reduction in the large negative external liabilities will take many years. Meanwhile, the large external financial dependence will remain a source of vulnerability. The external adjustment will need to be supported by cost dynamics, via higher productivity and appropriate wage dynamics. A contribution could come from a tax shift geared to increasing employment (see Box 3.4). The process of internal devaluation would also support increased import substitution. Some structural weaknesses on the import side – 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.

The risk of direct negative spillover from the rest of the euro area appears limited. Spain in particular has benefited from broadening its geographical markets. The high share of non-tourism exported services and the demonstrated performance in non-cost competitiveness provides a protection from the risks posed by an appreciating euro. The financial exposure of Spain is spread globally, and overall limited towards euro area Member States, with the exception of Portugal. With still visible financial fragmentation affecting Spanish lending markets, financial and economic prospects in Spain remain however sensitive to the progress in the ongoing reinforcement of euro area governance.

3.2. Indebtedness and Deleveraging

3.2.1. Overview

Private sector deleveraging has accelerated since the end of 2012, in particular for non–financial corporations. Households and non-financial corporations' debt more than doubled in terms of GDP in the decade following the introduction of the euro, on the back of loose financing conditions and overoptimistic income expectations. Credit flows were above 20% of GDP on average and annual credit growth rates averaged 18% during 2000-2007. With debt of 230% of GDP (non-consolidated data) in 2010 (215% of GDP in consolidated terms), the Spanish private sector became amongst the most indebted across the Member States. The deleveraging process started in 2010 and gained momentum as of the second half of 2012. By the third quarter of 2013, the stock of debt amounted 210% of GDP in non-consolidated terms (189% of GDP in consolidated terms), some 22% of GDP lower than the peak reached in the second quarter of 2010, out of which almost 15 pp. were registered since the second quarter of 2012. The distribution of the correction is uneven, most of which being due to the fall in debt of non-financial corporations by 19% of GDP since the peak (consolidated data).

This process has gone in parallel with restructuring in the banking sector and a sharp correction in the real estate market and construction. Spanish banks suffered considerable funding and capital stress with the implosion of the real estate bubble, which caused a sharp deterioration in their asset portfolio and systemic concerns about the banking sector and the capacity of the sovereign to support it, culminated in the summer of 2012. While credit demand was falling in line with economic activity, banks also had an incentive to shed risks to rebuild their capital ratios, in an environment of heightened risk aversion. The recapitalisation and reform process undergone in the last couple of years have all but eliminated such systemic concerns, and set an essential basis for a renewed capacity of banks to provide lending to the real economy at more favourable conditions. Meanwhile, the fall in both prices and activity indicators in the housing market has continued apace, bringing this market closer to an inflection point.

In contrast to the private sector, general government debt has continued to increase. The expansion of aggregate social expenditure and the disappearing of a rich tax base linked to construction coupled with stabilisation interventions in the financial sector have led to a sharp increase in government debt, which is set to reach nearly 100% of GDP in 2014, about 60 pps. of GDP higher than in 2007.

This section will continue with an overview of development in the financial sector and the housing market, and then move to analyse sectoral debt development in the household, non–financial corporations and government sectors before providing some conclusions.

3.2.2. Financial sector developments

The Spanish banking sector has been adversely affected by the burst of the real estate and construction bubble and the economic recession that followed. Several Spanish banks have accumulated large stocks of problematic assets. With the exception of a few large and internationally diversified credit institutions, Spanish banks lost access to wholesale funding markets on affordable terms, thus becoming highly dependent on Eurosystem refinancing. Moreover, the borrowing capacity of Spanish banks was severely limited by the impact of rating downgrades on collateral availability. Concerns about viability of some of these banks became a source of market stress and eventually led to the Spanish government requesting external financial assistance from EFSF/ESM in June 2012. The Programme, as agreed by the Eurogroup on 9 July 2012, covered a period of 18 months([39]) and entailed an external financing by the euro area Member States of up to EUR 100 billion. Eventually, the total amount of funds disbursed was limited to EUR 41.3 billion.

By the end of the financial assistance programme, the resilience of the Spanish banking sector had improved considerably. In particular, the solvency position of banks has been bolstered after the recapitalisation of parts of the banking sector, the transfer of assets to Sareb and overall positive earnings results over 2013. On average core tier 1 capital ratio stood at 10.5% while total own funds ratio was at 12% at the end of September 2013. Compared to their peers, Spanish banks are not amongst the banks with the highest capital ratios, but rank favourably in terms of overall leverage.

The exposure of the Spanish banking sector to the construction and real estate development sector has been significantly reduced. According to the Banco de España, the total exposure amounted to EUR 308 billion at the end of December 2011. By the end-2012, the exposure of Spanish banks to the construction and real-estate development sector had decreased by around 50% of the total (net of provisions). Somewhat more than half of the reduction is explained by the transfers to the Sareb, while 40% of the reduction derives from the provisions made by institutions as a consequence of RDL 2/2012 and RDL 18/2012.([40]) These two Royal-Decree Laws established new provisioning requirements to cover asset impairments related to the banks’ real estate activity

Some recent policy measures will contribute to shore up banks' core capital. This is also important in view of the new EU Regulation on capital requirements ([41]) and the comprehensive assessment to be carried out by the ECB in 2014 along with the entry into force of the new single supervisor. First, the Banco de España issued a recommendation on a maximum 25% of paid-in-cash dividends for 2013 and, more recently, also for 2014. Second, the tax legislation on deferred tax assets (DTAs) was amended and it will allow banks to avoid the deduction of an amount which has been initially estimated at around EUR 30 billion from the fully loaded common equity tier 1.([42])

The liquidity situation and the financing structure of the Spanish banking sector have been strengthened. In particular, banks are shifting towards more stable sources of finance such as deposits and the repo market. The annual growth rate of household and non-financial corporate deposits reached about 4% and 7%, respectively as of December 2013, reversing a declining trend recorded in most of 2012. In turn, the liquidity generated by the fall in the loan-to-deposit ratio is being used by banks to reduce their reliance on the Eurosystem and on the wholesale market.

Notwithstanding the advanced stage of the cleaning up of balance sheets, the ongoing restructuring of banks might continue to weigh on credit conditions for smaller customers. The ratio of non-performing loans (NPLs), which typically lags the cycle, continued to increase in recent months and reached 13.6% at the end of December 2013 (Graph 3.19).([43]) This rise has been driven by the higher stock of impaired assets but also, increasingly, by the denominator effect, i.e. shrinking total loan portfolio. While the stock of impaired assets rose by EUR 20 billion between June and December 2013, total loans declined by EUR 71 billion during the same period. In addition, most recent increases have been also driven by the reclassification exercise of the restructured loans portfolio performed by banks on guidance from Banco de España.([44]) Going forward, the increases in NPL ratio at system level are expected to be more limited. Nevertheless, the risk stemming from increasing NPLs is mitigated by a comfortable coverage ratio.

Sustaining profitability will remain a challenge given the modest medium-term GDP growth outlook and the low policy interest rate environment. The third quarter of 2013 has confirmed the positive trend for bank profitability in 2013, which is on average above both the baseline and significantly above the adverse scenario of the 2012 stress test by Oliver Wyman. For the vast majority of banks the net interest incomes have declined compared to the first three quarters of 2012 due to both the impact of low interest rates on assets with floating rates (i.e. mortgages) and shrinking business volumes. The latter trend is expected to continue in the medium-term as households and non-financial corporation continue to deleverage. In spite of this and of the significant contribution from non-recurring items in some cases (including revenues from the burden sharing exercises for some state-aided banks, incomes from the carry trade activity and sales of assets), pre-provisioning profits demonstrate the banks' capacity to generate internal resources. Furthermore, although provisioning requirements are still high, they are on a clear declining trend, and operating costs are being reduced rapidly.

Bank lending has been on a declining path since 2007 but a stabilisation may be approaching. Recent data shows some deceleration in the contraction of domestic bank private credit (Graph 3.20). Adjusted for the effect of the asset transfer to Sareb, private domestic credit declined by around 7.7% y-o-y in December 2013. Whereas the decline in domestic credit to households accelerated to about 5.3% y-o-y, the contraction in bank credit to non-financial corporates decelerated to around 10% in the last three months of 2013, and was also alleviated by increasing market issuance by larger companies.

The biggest annual contraction in lending took place in the construction and real estate sectors. This was also partly due to the transfers of assets to Sareb, while lending to other economic sectors contracted at a slower pace. This shows that the reallocation of resources in the Spanish economy continues. Despite ongoing contraction in stock of loans to NFCs, 'credit impulse' defined as the change in new credit issued as a percentage of GDP, is pointing to a turnaround in activity (Graph 3.21). This is confirmed by the most recent data on new lending to NFCs, which recorded an annual increase of around 7% in December 2013. These data are consistent with banks' funding and capital plans, in which private sector lending is expected to bottom out in 2015 driven by lending to NFCs.

Going forward, lending conditions are expected to improve. Standards for approving loans have stabilized in the second half of 2013. In the fourth quarter bank lending survey, there was a slight easing of credit conditions for SMEs, for the first time since the first quarter of 2010. Therefore, the tightening trend observed since the beginning of the crisis appears to be bottoming out, in particular as banks expect some credit standards relaxation for loans to NFCs and consumer credit in the next three months.

While banks continue to consider weak solvent demand as the main contributor to the ongoing decline in lending to the private sector, frictions on the supply side have also played a role, affecting in particular SMEs. These frictions relate to the on-going restructuring process, regulatory changes (i.e. reinforced capital requirements) and persisting euro area financial market fragmentation. In particular, the restructuring of the financial sector might have weakened or broken long-term lender/borrower relations. Asymmetric information is particularly harmful to SMEs. While larger companies can access non-bank financing sources (i.e. by issuing bonds or raising equity), SMEs rely predominantly on bank financing and, hence, are disproportionally affected by the on-going restructuring. Despite the recent reduction in the banks' cost of funding, lending rates remain elevated, especially for SMEs and households.

There is encouraging evidence showing that lenders are effectively differentiating between companies. According to the Banco de España, on average, most indebted companies and sectors at the start of the crisis have been deleveraging faster.([45]) By contrast, firms that started from a low level of debt have actually increased their leverage over the period, indicating that credit continues to flow to companies in a stronger financial position. The pattern has been similar for large companies and SMEs. However, in general the latter have reported difficulties in accessing credit.

The evolution of the real estate market remains important for banks' future profitability. In recent quarters the Spanish banking sector has become a key player in the real estate market, including housing. In the first half of 2013 the five largest Spanish banks and Sareb sold around 35,000 properties, amounting to 25.5% of all the transactions in urban properties (houses and other properties attached to them) according to the Spanish Official Association of Notaries.([46]) Banks have incentive to sell the properties as their net accounting value was drastically reduced after the new provisioning requirements for non-performing loans and repossessed properties introduced by RDL 2/2012 and RDL 18/2012. At the same time, they continue their accumulation of real estate assets, which implies that the number of repossessions exceeds the number of sales. Therefore, the on-going adjustment in the housing market and construction sector needs to be carefully monitored.

3.2.3. Adjustment in the housing market

The Spanish housing market has adjusted sharply following the burst of the housing and lending bubble. The share of residential investment in total GDP fell from 12.5% of GDP in 2006 to 4.4% in 2013, below the previous historical low of 7% in 1997, and the adjustment is still ongoing, with residential investment falling by 8.3% y-o-y and investment in construction by 10.3% in the third quarter of 2013. Employment in the construction sector fell by around 1.8 million between Q3-2008 and Q3-2013, and continues to fall even though the weight of construction in employment, at 5.8%, is below its historical average.

The fall in house prices, which accelerated in 2012 and the first half of 2013, might be approaching an end. The cumulative fall in house prices between Q3-2007 and Q3-2013 was 36.2% in nominal terms and 43.8% in real terms. While nominal prices were still falling in annual terms by 7.9% Q3-2013, they increased by 0.7% compared to the previous quarter, the first positive quarterly growth rate since Q2-2010 (Graph 3.22). Another sign that the housing market might be approaching stabilization are recent statistics on home sales, which tend to react faster to changes in supply and demand than house prices. After declining continuously since 2007, annual home sales have stabilized at around 320,000. For the first ten months of 2013, 235,000 houses were sold, 11.3% more than in the same period last year. This stabilization comes on the back of increasing foreign demand (foreign investment in the Spanish real estate sector grew by 28% in December 2013, y-o-y, according to Banco de España). However, domestic demand for housing remains weak given high unemployment and tight credit conditions.([47]) Similarly, there are also preliminary signs of stabilization in building permit applications, albeit at a very low level of around 35,000 a year (compared to a record 866,000 in 2006).

Yet, further adjustment in house prices cannot be excluded. Demand for housing is still weak and the stock of unsold houses, estimated at around 400,000-580,000, very large.([48]) The acceleration of business activities of Sareb and of sales of real estate assets by Spanish banks could also contribute to bring forward any further price adjustment. While it is difficult to forecast future house price developments, on balance, available studies suggest that the degree of overvaluation is much reduced, although some undershooting of prices cannot be ruled out.([49]) Declining house prices negatively affect household wealth, as over 80% of total wealth is real estate related.

Housing market policy distortions contributed to the housing boom. Spain is characterized by high home ownership rate of 85% compared with 72% for the whole EU. Apart from cultural factors placing a strong preference on house ownership, a housing policy skewed towards promoting home ownership (i.e. tax deductions) was one of the factors that contributed to the housing bubble in Spain. The high incidence of home ownership in Spain is mirrored by the underdevelopment of the rental market. Only 11% of houses are rented compared to 28% for EU average. This lack of viable rental market may have aggravated the adjustment process in the years following the burst of the bubble to the extent that it has limited labour mobility.

Spain has taken measures to remove tax and regulatory distortions in favour of house ownership and hindering the rental market. Apart from the elimination of a general tax deduction on new house purchases in December 2012, most recent measures have improved the institutional framework of the rental market. The Law on liberalisation of the rental market (Law 4/2013 ([50])) adopted in May 2013, increased the flexibility of the regulatory regime and strengthened incentives for landlords and legal certainty. In addition, social housing policy has been also recently redirected towards support for tenants, i.e. rented accommodation. While it is too early to see any impact of these recent changes on the share of households living in rented accommodation in Spain, some encouraging signs can be observed. In particular, 11 new real estate investment trusts have been set up and listed on the stock market since the reform. In addition, further development of rental opportunities is also one of the strategic goals of Sareb. In this context, Sareb is also working with several regional governments to assist them in their social housing policies by temporary leasing up to 2 000 homes.

3.2.4. Drivers of indebtedness and deleveraging in the households sector

Acquisition of dwellings has been the primary driver of households' rise in indebtedness. The household debt-to-GDP ratio more than doubled since 2000, to peak at 87% of GDP in 2010 (Graph 3.23). Debt as a share of gross disposable income or as a share of assets displays a similar picture. Such brisk increase in indebtedness was mostly explained by the credit demand for housing purchases. Total credit to households grew by some 20% on average between 2004 and 2007. Residential mortgages' contribution to annual credit growth stood well above 10 pps. until 2007, recording highs above 20 pps. in 2005 and 2006, whereas the contribution of consumer credit was much lower. The sharp deceleration of credit growth to households at the onset of the crisis and the contraction of credit growth thereafter has naturally been led by a negative contribution from credit for dwellings purchases (Graph 3.24).

Household debt is falling gradually but it remains high. Household debt has fallen from a peak of 87% of GDP in 2010 to 78.2% of GDP in the third quarter of 2013.This reduction has occurred mostly through negative credit flows (Graph 3.25), whereas the long average maturity of the stock of outstanding mortgages has slowed down debt reduction. To gauge how far the correction has advanced, a first approach is to compare current debt levels to static benchmarks such as the MIP threshold ([51]) or the pre-boom debt ratio, e.g. in year 2000. According to this approach, the required remaining adjustment of the debt-to-GDP ratio for households would stand at 23 to 35 percentage points (Graphs 3.26). In an alternative approach private debt is considered sustainable if the notional leverage is stationary - i.e., if deflated debt evolves in line with deflated assets.([52]) Between 2001 and 2007 the gap between actual household debt and its balanced or sustainable path widened rapidly. However, the recent correction, together with the increase in the sustainable level since 2007, has significantly narrowed the gap, by almost 20 pps. to some 21 pps of GDP at the end of 2012.

The interest burden has remained contained (Graph 3.27) as a result of the fall in the Euribor rate, to which most mortgages interest rates are linked, as well as of refinancing programmes offered by credit institutions.([53]) Yet, over-indebtedness is a heavy burden for lower income households that have contracted debt (about 15% of those in the lowest 20% of the income distribution according to ECB data), as debt service has absorbed an increasing share of their disposable income, in some cases above 100%. Nevertheless, the rate of NPLs on mortgages has remained until recently very subdued, owing to a strong paying back culture and limited recourse to personal default (see Box 3.1 for more details).

Household debt is expected to continue to fall in the coming years. Household deleveraging efforts will be eased by a recovery of the economy and of the labour market, leading to gradually higher incomes, and supported by the recent sharp recovery in financial asset prices, which has allowed households to recoup some of the wealth losses during the crisis. Easing financing conditions and a stabilisation of house prices, on the other hand, could result in a revival of new credit. These forces will impact on the behaviour of the savings rate. Wealth losses on financial and non-financial assets, increased uncertainty and the sharp increase in unemployment spurred a surge in the saving rate to around 16% in 2009 (possibly also suggest offsetting to an extent a fiscal expansion at the time) (Graph 3.27). Since then, consumption smoothing in a context of falling incomes has led the saving rate to decline sharply to below its long-term historical average level of 11%. A moderate recovery of the savings rate approaching to the historical average, as embodied in the Commission services' 2014 winter forecast, would be consistent with a mild increase in consumption and households maintaining a substantial net lending position. Together with more favourable denominator effects as GDP growth turns positive, the maturity profile of outstanding mortgages could also favour a more rapid decline in debt the coming years. A reform of personal insolvency could help speed up the restructuring of distressed household debt, but any such reform would need to carefully take into account financial stability considerations.

(Continued on the next page)

Box (continued)

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

Corporate deleveraging has accelerated in the recent quarters. The adjustment in the corporate sector tends naturally to be faster than in the households sector, as a result of larger debt write-offs, mainly on construction and real estate loans, and the shorter maturity of debt. In the run-up of the crisis non-financial corporation debt increased from around 45% of GDP in 1996 to above 140% (non-consolidated data) in 2010 largely in real estate and construction sectors. In consolidated terms, debt amounted to almost 130% of GDP. A decline was initiated thereafter, bringing down the debt/GDP ratio to 132% of GDP by the third quarter of 2013, still well above the euro area average of 97% (non-consolidated data).

Deleveraging is sharpest in the construction and real estate sectors. After being responsible for more than half of total credit flows between 2000 and 2007([54]), the construction and real estate sectors have seen a drop in bank debt by 13% of GDP (thereby representing around 36% of total bank lending to non-financial corporations in the third quarter of 2013). This adjustment also reflects the larger incidence of write-offs on lending to these two sectors and the transfer of assets to Sareb. While the ratio of doubtful loans to total loans is around 12% for industry and services non-related to real estate or construction, it reaches 31% and 34% in construction and real estate activities, respectively, with 60% of total doubtful loans being linked to real estate and construction activities (Graph 3.28). Non-performing loans in these two sectors have stepped up in the last quarters. More generally, disaggregated lending analyses by the Banco de España show that the reduction in debt is more intense in companies that very highly leveraged at the beginning of the crisis.

Despite the recent correction, non-financial corporations remain highly indebted both with respect to their assets as well as their capacity to repay debt. Beyond the debt-to-GDP ratio, the debt-to-asset ratio is also high, at above 110% in the third quarter of 2013 (consolidated data for both assets and debt) compared with around 80% in the euro area. Likewise, non-financial corporations debt is five times higher than the gross operating surplus (a proxi for firms' capacity to generate income), (Graph 3.29). Comparing to other benchmark (as explained in in the section on households) such as the MIP threshold or the debt ratio in year 2000, the required remaining adjustment would still be - 44 to 59 percentage points of GDP respectively (Graphs 3.30). With respect to the sustainable notional leverage the gap between current non-financial corporation debt ratio and their balanced path has remained broadly stable, amounting to some 19 pps. of GDP at the end of 2012.

The evolution of profits will influence the pace of future adjustment. Net lending of the non-financial corporate sector has risen sharply, especially in the most recent quarters, as a result of increased savings and the fall in investment. The increase in gross savings has been mainly driven by the increase in gross operating surplus, related to a reduction in employment and real wages, and to a lesser extent from an increase in value added. Profit margins have also increased as tight credit conditions led firms to rely more heavily on own financing, mainly retained earnings (Graph 3.31), s in line with what has happened in other euro area countries recovering from high indebtedness, high cost of financing or both. With the stabilisation of the economy and of financial conditions, the adjustment in non-financial corporate balance sheet is expected to moderate in the medium-term. While corporate savings would be supported by improved profitability, investment would be expected to pick up amidst improved expectations and rising capacity utilisation.

3.2.6. General government debt

General government debt has reached high levels. Buoyant economic growth, a particularly tax-rich composition and sizeable revenue windfalls, especially linked to the housing boom, led government debt to decline significantly during the pre-crisis phase, to 36.3% of GDP in 2007. The outbreak of the economic and financial crisis reversed this trend. The collapse of tax bases, surging unemployment, fiscal stimulus in the early years of the crisis have caused large general government deficits and a rapid debt incre