EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1008 final COMMISSION STAFF WORKING DOCUMENT Country Report Spain 2019









Including an In-Depth Review on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the MIP in-depth review 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4.Competitiveness, reforms, and investment Annex A: Overview table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard tables Annex D: Investment guidance on cohesion policy funding 2021-2027 for Spain References LIST OF Tables Table 1.1:Key economic and financial indicators - Spain Table 2.1:Overall assessment of progress with 2018 CSRs

Table 3.1:Outward spill-over heat map for Spain Table 3.2:Current account balance and net international investment position sensitivity analysis Table 3.3:MIP matrix Table 4.2.1:Financial soundness indicators, all banks in Spain Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Composition of GDP growth Graph 1.2: Contributions to potential growth Graph 1.3: Investment rate, 2010 prices Graph 1.4: Capital intensity and capital productivity Graph 1.5: Net lending / borrowing by sector Graph 1.6: Analysis of unit labour costs Graph 1.7: Activity, unemployment, long-term unemployment, youth unemployment, NEET Graph 1.8: Regional disparities on selected indicators

Graph 2.1: Overall multiannual implementation of 2011-2018 CSRs by February 2019 Graph 3.1: Current account and net international investment position Graph 3.2: Analysis of the rate of change of net international investment position— Spain Graph 3.3: Gross external debt by sector-type of financial assets Graph 4.1.1.1: Evolution of pension expenditure under the 2018 Ageing Report baseline and alternative scenarios Graph 4.1.2.1: Gross government debt — Spain Graph 4.2.1: Overvaluation gap with respect to price/income, price/rent and fundamental model-based valuation gaps Graph 4.2.2: Loans to the private sector Graph 4.2.3: Sources of financing of the Spanish economy Graph 4.2.4: Composition of debt — Spain Graph 4.2.5: Decomposition of y-o-y changes in debt-to-GDP ratios, households Graph 4.2.6: Gap to the fundamental-based and prudential benchmarks for household and NFC debt Graph 4.2.1.1: Determinants of private consumption (1), model forecasts for consumption (2) and savings' rate (3) Graph 4.2.1.2: Evolution of consumption by quintile, 2007-17 % change (left); and growth in consumption of durable goods by income level (right), 2008-17 % change Graph 4.2.1.3: Change in household financial balance sheets, 2008-17 % change (left), and change in income by income decile, 2008-17 % change (right) Graph 4.2.7: Decomposition of year-on-year changes in debt-to-GDP ratios, quarterly non-consolidated data, non-financial corporations Graph 4.3.1: The minimum wage as a percentage of average and median wage: the effect of planned increases in Spain Graph 4.3.2: Projected ratio of minimum to average wage in 2019 rate v. unemployment rate by region, 2017 Graph 4.3.3: Newly signed temporary and permanent contracts Graph 4.3.4: At-risk-of-poverty or social exclusion rate and its components

Graph 4.3.5: At-risk-of-poverty or social exclusion rate by age group Graph 4.3.6: In-work poverty Graph 4.4.1: Productivity gap, ES v. EA-3 in current prices Graph 4.4.2: REER based on unit labour costs Graph 4.4.3: Exports by total exported value by company Graph 4.4.4: Evolution of business R&D intensity and public R&D intensity 2000-2017 Graph 4.4.5: Regional convergence in GDP per head to the EU average – 2014-2017 Graph 4.4.6: Weighted dispersion in GDP per head across Spanish regions (1) Graph 4.4.7: RCI and regional R&D expenditure Graph 4.4.8: Disparities in the Regional Competitiveness Index by sub-pillar, across regions and compared to EU-average (1) LIST OF Boxes Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Spain Box 3.1: Outward spill-overs Box 4.1.1: Long-term sustainability implications of changes to the pension system and to health care policies Box 4.1.2: Medium-term projections for government debt Box 4.2.1: Determinants of private consumption Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.4.1: Global Value Chains: the role of Spain Box 4.4.2: Investment challenges and reforms in Spain

Executive summary Spain has continued to record strong economic growth and rapid job creation, but important challenges remain. Debt has been further reduced, but still represents a source of vulnerability. Unemployment is falling rapidly, in turn leading to a slight fall in poverty and social exclusion, but too many people remain without a job or work on temporary contracts and income inequality is marked. Productivity is growing in line with the euro area average. However, structural impediments to the free flow of productive resources, ranging from low innovation performance and skill gaps to fragmented product and service market regulation, are key drivers of Spain's productivity gap to the EU average. ( ). An evolving political context over the past year, with a change of government in June 2018 and new elections due in April 2019, has been reflected in general slow progress on reforms. 2018 marked the fifth year of robust economic growth for Spain, despite some deceleration. Real GDP grew by 2.5%, 0.5 percentage points less than in 2017. Economic activity was driven by consumer spending and capital formation, also helped by the expansionary measures in the 2018 budget. Growth is forecast to slow to 2.1 % in 2019 and 1.9 % in 2020, remaining well above the euro area average. Job creation is also expected to moderate, though unemployment will continue to fall to 13.3 % in 2020. Due to its size, the positive impact of economic reforms in Spain has the potential to spill over to other countries. Simulations show that ambitiously removing barriers in market regulation, helping unemployed or inactive people to find work or training, making the taxation structure more growth-friendly and increasing R&D subsidies would have a small, but positive impact on other euro area countries. Supporting Spain’s sustainable growth requires investments to foster innovation and resource efficiency, to promote skills and employability, to upgrade rail infrastructure for transporting goods, extend energy connections with Europe, as well as to promote job quality and social inclusion. Capital formation in Spain rebounded after the crisis, though mainly in the private sector. Further investment on public and private research and investment, including for small and medium-sized companies, as well as on digitisation and resource efficiency, would bolster competitiveness and the innovation capacity of the economy, if acting in synergy with investment on skills. Improvements to electricity connections and to rail transport for goods are needed to improve access to markets in Spain and in Europe. Resources supporting employability and social inclusion are key to address the existing labour market challenges and make growth more inclusive. In all these areas, investment should be targeted at addressing the specific regional needs. Annex D identifies key priorities for support by the European Regional Development Fund and the European Social Fund Plus over 2021-2027, building on the analysis of investment needs and challenges outlined in this report. Spain has made limited ( ) progress on the 2018 country specific recommendations (CSRs): There has been some progress in the following areas: ·Measures were taken to modernise the public employment services and improve their cooperation with social services, but their capacity to support jobseekers and meet employers’ needs remains limited. There were efforts to reduce the use of temporary contracts in the public sector. Action to fight their abuse in the private sector is bearing some fruit but the impact of hiring incentives remains limited. There has been limited progress in the following areas: ·The institutional framework governing the prudent management of the public finances was not strengthened. A new governance structure for public procurement is being set up, but a nation-wide public procurement strategy has still not been put in place. ·The implementation of the Law on Market Unity is an important tool to promote market unity and better regulation but its implementation is proceeding slowly. ·Advances in the funding and governance of the research, development and innovation system have been modest, despite some positive steps. Cooperation between universities and businesses remains weak. ·Efforts to better match initial vocational education and training and tertiary education to employers’ needs mostly focused on fostering dialogue between stakeholders. Regional disparities in educational outcomes persist. ·National unemployment assistance schemes are fragmented and there are gaps in the coverage of many regional income guarantee schemes. There has been little improvement in support to families, especially those most in need. On progress in reaching the national targets under the Europe 2020 Strategy, Spain is on track to reduce greenhouse emissions and to achieve its renewable energy and tertiary education attainment targets. Sizeable gaps remain on the employment and early school leaving rates, even though they are steadily improving. By contrast, there was little progress towards the targets for R&D investment and reducing poverty risk. The indicators of the Social Scoreboard supporting the European Pillar of Social Rights point to a number of challenges. Although improving, the employment rate remains low, including for women, who are still at a disadvantage to men in the jobs market. The proportion of people leaving education and training early is still high, and deep income and opportunities inequalities persist. The risk of poverty or social exclusion remains high, particularly for children, and social transfers (other than pensions) have a weak impact in its reduction. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·Risks to the sustainability of government finances remain significant in the medium to long term. Public debt is expected to have further declined slightly in 2018, to 96.9 % of GDP. Further declines are projected until 2020, supported by economic growth and a small primary surplus as from 2019. However, when adjusted by the impact of the economic cycle, Spain’s government deficit remains stubbornly high, as the level of taxation is low in relation to expenditure. On pensions, recent temporary departures from the 2013 reform and plans to re-establish the link of pensions to the consumer price index are likely to significantly increase expenditure in the medium and long run, unless compensating measures are taken.

·Reduction of private debt has continued but it remains high. Total private debt of households and non-financial corporations is projected to have fallen further over the twelve months to June 2018. As net lending from Spanish banks has resumed, the pace of debt reduction has slowed. Household debt has even stopped decreasing in 2018, largely due to growth in new consumer credit. ·Spain’s net external debt declined further but remains sizeable. The current account balance is expected to remain in surplus until 2020, despite some weakening. Together with still high GDP growth, this should continue supporting the improvement of Spain’s net international investment position. ·Unemployment continues to fall but it remains well above the EU average, especially for young people. Continued dynamic job creation has led to a significant reduction of the unemployment rate, which however remains very high. The increase in the minimum wage by 22.3 % in 2019 could help reduce in-work poverty but also have adverse effects on job opportunities for young and low-skilled workers. Other key structural issues analysed in this country report, which point to particular challenges for Spain’s economy, are the following: ·The widespread use of temporary contracts holds back Spain’s growth potential and social cohesion. Moving from a temporary contract to a permanent one remains difficult. Barriers to mobility of labour reduce opportunities for jobseekers and hamper its efficient allocation across the country. Incomplete and broken careers for many result in low entitlements to social protection and weigh on the adequacy and sustainability of the pension system. They also leave a large untapped pool of workers in the face of fast population ageing and low productivity growth. ·The proportion of people at risk of poverty or social exclusion decreased slightly in 2017 but remains high, particularly among children. Temporary workers, the low-skilled and those not born in the EU face one of the highest in-work poverty risks in the EU. Public spending on family benefits, which is half of the EU average, remains poorly targeted at low-income families. Healthcare delivery could better respond to emerging challenges related to population ageing, disabilities and chronic conditions. ·Skills mismatches and shortages weigh on productivity growth, especially in some regions. The proportion of people leaving education and training early without a qualification remains high and displays large regional variation, as do educational outcomes. The take up of vocational education and training by young students is still low, as is participation in adult learning. New tertiary graduates still face challenges finding suitable work. ·Innovation is hampered by a number of factors and this also affects productivity. Spain is a “moderate innovator” in the EU. The innovation performance of the country suffers from underinvestment in public and private R&D, but also from weak coordination across all levels of government and insufficient reliance on policy evaluation. Skills shortages and mismatches are another important barrier to the development and use of advanced technologies. Stronger cooperation between academia and businesses could contribute to the diffusion of knowledge and help increase the presence of innovative firms. All these factors underlie Spain's low performance in terms of knowledge-intensive exports, particularly services. ·Spain is making progress on digitisation, but still does not fully exploit the growth potential offered by it. Spain is among the best EU performers in terms of provision of digital public services, but there is still room for further efforts. Despite significant improvement in infrastructure, the take-up of ultrafast broadband remains low. Businesses, especially small and medium-sized enterprises, often refer to shortage of information and communication technology’s specialists as a constraining factor in production. ·The restrictiveness and fragmentation of regulation within Spain prevents companies from benefiting from economies of scale. Implementing more decisively the Law on Market Unity and removing identified restrictions for professional services would improve growth opportunities and competition in many services sectors. The large presence of small companies in the economy also explains Spain's productivity gap, as their productivity lags significantly behind that of larger firms. Small and medium-sized firms account for around half of R&D investment by firms, but are less able to absorb knowledge and technology. ·Incomplete connections for goods transport by rail and limited integration with the EU electricity and gas markets also prevent Spain from fully benefitting from the EU single market. Spain needs to invest further in electricity interconnections to achieve the target of at least 10% of its installed electricity production capacity by 2020. Investment is also needed to allow for greater use of rail for freight transport, including cross-border connections with France and Portugal and connections to ports and logistic hubs. ·Increasing the share of energy from renewables and energy efficiency for buildings would be conducive to more sustainable growth. Latest figures show an increase in final and in primary energy consumption and the latter now exceeds the indicative 2020 threshold. With a 17.5 % energy share of renewables in 2017, Spain is progressing well to meet its 20% 2020 target, but filling the gap to that target is still demanding. As CO2 emissions from transport are rising, further action is also needed to enhance the transition to a clean and sustainable mobility. ·Spain faces specific territorial cohesion challenges, such as depopulation and ageing in rural areas, on the one hand, and demographic pressure in some urban areas, on the other. Certain areas of Spain are amongst the most exposed in Europe to climate change and there are significant challenges in managing water and wastewater. ·Stronger and sustained coordination between national and regional authorities could make policies more effective. Spain’s high degree of decentralisation makes regions key actors for the successful implementation of policies and reforms. In policy areas where both national and regional levels of government are involved in reform implementation, coordination and accountability remain a challenge. 1. Economic situation and outlook Economic growth Spain has continued to record robust growth, but the economy has started to show signs of deceleration. The ongoing expansion is underpinned by a more balanced growth pattern than before the crisis, also reflecting the impact of the structural reforms implemented in the aftermath of the crisis. 2018 marked the fifth year of expansion of Spain's economic activity, with real GDP growing by 2.5 %, 0.5 percentage points less than in 2017 but still well above the EU average. ( ) Supported by the expansionary measures in the 2018 budget, private consumption and investment were the main growth drivers, while net exports detracted 0.4 pps. from growth (Graph 1.1). Graph 1.1:Composition of GDP growth Source: European Economic Forecast, autumn 2018

Economic activity is expected to moderate further in 2019 and 2020 as the cycle matures. Growth is expected to decelerate to 2.1 % in 2019 and 1.9 % in 2020. The deceleration would mainly be driven by a slowdown in private consumption, as pent-up demand is absorbed and households set aside part of their disposable income. The household saving rate is thus projected to rebound in 2019 from the historic low recorded in 2018 and increase slightly further in 2020. Job creation is forecast to ease, also due to the expected dampening impact of the increase in the minimum wage. Still, employment growth is set to remain robust and allow for further reductions in the unemployment rate. After years of buoyant growth, investment is also expected to moderate in 2019 and 2020 but continue growing above final demand, both in equipment and construction. Risks to the growth outlook mainly relate to the global environment. Most downside risks identified in the first half of 2018, including lower than expected global and EU growth and trade tensions, have materialized. This resulted in lower than expected growth of exports in 2018 and translated into small downward revisions of the growth forecast for 2019 and 2020. () Remaining downside risks to the global environment and increased uncertainty could further constrain growth over the two years. Graph 1.2:Contributions to potential growth Source: European Commission. Potential growth is projected to continue increasing. After plummeting during the crisis years, potential output growth has continued to increase, and is estimated to reach 1.5 % in 2020, converging towards the euro area average (1.6 %) (Graph 1.2). More than half of this increase comes from labour, mostly due to the fall of the structural unemployment rate (as proxied by the NAWRU), which nevertheless remains much higher than the EU average; and, as of 2016, positive migration flows. The contribution of capital and total factor productivity (TFP) to potential output is now in line with the euro area average, after having increased since the crisis. The output gap is expected to have become positive in 2018 for the first time since 2008, and slowly widen until 2020, when it will reach 2.2 %. Investment Non-construction investment now exceeds its pre-crisis peak. After reaching almost 30 % of GDP in the pre-crisis peak in 2007 (two thirds of which was construction), the rate of capital formation fell to 19 % in 2013, driven by the collapse in residential investment. Construction investment has started again to increase its weight in GDP but at 11 % of GDP in 2018, it remains far from its pre-crisis level. By contrast, non-construction (mainly equipment) investment now stands at a record-high of 11.5 % of GDP. Graph 1.3:Investment rate, 2010 prices Source: AMECO. Capital intensity in Spain is above the euro area average, but its productivity is still below, despite having improved. In the pre-crisis period investment flowed to non-tradable sectors, and in particular, construction, which at the time had high profitability but low productivity. This resulted in high capital intensity, but low productivity of capital (Graph 1.4). This trend was reverted during the recovery, as strong job creation resulted in a decline in capital intensity and an increase in its productivity relative to the euro area, suggesting that capital allocation has improved in recent years. The increase in total factor productivity growth relative to the euro area also points in this direction, suggesting a structural improvement in the quality of investment. Graph 1.4:Capital intensity and capital productivity Source: AMECO. External position The contribution of net exports to growth is expected to improve over the Commission’s forecast horizon. The contribution of the external sector to growth is projected to remain negative but improve in 2019, and turn neutral in 2020. Despite weak growth in global trade, exports are forecast to accelerate slightly in 2019 and 2020, as they recover some of the market shares lost in 2018. At the same time, imports are expected to decelerate broadly in line with final demand. The current account balance has declined, but is expected to remain in surplus. The current account surplus declined in 2017 and is expected to weaken further in 2018, due to the worse-than expected trade performance and a deterioration of terms of trade. It will then remain broadly stable at around 1 % of GDP over the period 2019-2020, as swings in terms of trade compound changes in export and import volumes. In cyclically-adjusted terms, and after years of improvement, the current account balance is expected to have declined slightly in 2018 to 1.5 % of GDP. Persistent current account surpluses are slowly translating into a reduction of Spain's net external liabilities. Despite the current account surpluses registered since 2013, negative valuation effects (partly reflecting improvements in confidence and higher value of Spanish assets) have limited the improvements in the net international investment position (NIIP). Still, the net international investment position has narrowed by more than 19 pps. of GDP since its peak, but at -80.6 % of GDP in Q3-2018, it remains very negative. Continued current account surpluses and high nominal GDP growth projected until 2020 are expected to facilitate a further improvement of the net international investment position (see Section 3). Across sectors, the net lending position of the private sector since 2009 (to a large extent due to the corporate sector) has been partly offset with the borrowing position of the general government sector (Graph 1.5). Private and public debt The stock of private debt has continued declining despite resumed growth of new credit, but deleveraging needs persist. Despite rapid substantial deleveraging by both households and corporates, private sector debt remains high. The debt level of the corporate sector has continued declining throughout 2018 despite the increase in new credit, driven by robust GDP growth. By contrast, the total stock of household debt has stopped declining in 2018 due to significant growth in new credit to finance durable consumer spending, as well as growth in lending for house purchases and a reduction in the repayment of mortgages. Deleveraging needs persist, particularly for some over-indebted households that are particularly vulnerable to changes in the economic and financial situation (such as low-income households) (see Sections 3 and 4.2). After the sharp adjustment that followed the crisis, the housing market and construction sector are recovering. Despite sustained increases in recent years, housing prices remain far from the pre-crisis maximum levels both in nominal and real terms. House price developments vary greatly across regions, with larger increases in areas where the stock of unsold houses is lower. Despite the pickup in housing investment in recent years, its volume in 2018-Q3 was still at less than half of the pre-crisis peak (see Section 4.2). Graph 1.5:Net lending / borrowing by sector Source: INE. The public debt ratio is set to continue its slow fall but remain high over the forecast horizon. The general government debt ratio is expected to decline slowly from 98.1 % in 2017 to 95.4 % of GDP in 2020, as strong nominal GDP growth, and – as from 2019 – a small primary surplus, more than offset the impact of interest expenditure and debt-increasing stock-flow adjustments over the forecast period. After reaching 3.1 % of GDP in 2017, the general government deficit is expected to decline further to 2.7 % of GDP in 2018, as still robust economic growth largely offsets the impact of the expansionary measures in the 2018 budget. According to the Commission 2018 autumn forecast, the headline deficit is then set to decline to 2.1 % of GDP in 2019 and to narrow to 1.9 % of GDP in 2020, on the back of continued firm economic growth and the net impact of the measures that had been announced in the 2019 Draft Budgetary Plan. The structural deficit is expected to worsen slightly to 3.1 % of GDP in 2018 and to remain almost unchanged over the following two years with unchanged policies. While some of the new expenditure mentioned in the Draft Budgetary Plan has already been adopted (notably, the increase of the minimum salary, the increase in pensions and the increase of the wage of public employees), the draft Budget Law for 2019 submitted to Parliament on 14 January 2019 was rejected on 13 February 2019. General elections shall be held on 28 April 2019. The situation of the general government deficit shall be reassessed in light of evolving circumstances in the forthcoming Commission 2019 spring forecast.

Inflation Core inflation is expected to increase gradually, as the output gap widens. Headline inflation reached 1.7% in 2018 and is forecast to decline to 1.2% in 2019 due to base effects as oil prices stabilise. It is then set to increase to 1.5% in 2020, driven by a gradual pick-up in core inflation, as wages increase, especially in 2019 under the impact of the increase in the minimum wage, and the positive output gap widens. Labour market Unemployment is set to continue falling, despite an expected slowdown in job creation. The economic expansion has been accompanied by strong job creation, supported by the impact of the previous labour market reforms and wage moderation. In net terms, more than 2.4 million jobs have been created since the recovery started in Q1-2014, bringing the unemployment rate to 14.5 % in Q4-2018 (seasonally adjusted). Employment growth started to slow down in 2018, but at 2.5%, it remained robust. Job creation is forecast to slow down further in 2019 and 2020 as a consequence of lower growth of final demand, as well as the expected dampening impact of the increase in the minimum wage in 2019. The unemployment rate is set to continue falling, to 13.3 % in 2020 (the lowest since 2008). Graph 1.6:Analysis of unit labour costs Source: AMECO, European Commission Nominal wages have started to grow again, and are expected to exceed inflation over the forecast horizon. After years of very moderate or negative growth, wages increased by 1 % in 2018. Wage growth is projected to peak at 2.4 % in 2019, also under the impact of the increase in the minimum wage, and then moderate but still be above inflation in 2020. As labour productivity is forecast to grow moderately over the forecast horizon, this will lead to increases in nominal unit labour costs (Graph 1.6). In 2019, these are expected to grow above the euro area average, but in 2020 Spain would continue to record cost competitiveness gains. Graph 1.7:Activity, unemployment, long-term unemployment, youth unemployment, NEET Source: Eurostat, LFS. A high level of labour market segmentation, long-term unemployment, and population ageing weigh on potential growth. The youth unemployment rate has decreased progressively, from 53 % in 2014 to 33.1 % in Q4-2018, as did the long-term unemployment rate (from 12.9 % in 2014 to 6.3 % in Q4-2018) (Graph 1.7). However, both rates continue to be among the highest in the EU. Although open-ended contracts represent an increasing share of job creation, this has not been sufficient to reduce the share of workers on temporary contracts (26.9 % in Q3-2018), which remains among the largest in the EU. Activity rates are stagnant since 2012 and slightly decreased in 2017. Population ageing is affecting the composition of the active population, and calls for increasing labour supply and the duration of working careers. A highly segmented labour market, population ageing and skills gaps and mismatches act as a brake on potential growth and productivity. Poverty, inequality and social inclusion Improvements in the social situation reflect progress in labour market conditions but poverty indicators remain above their pre-crisis levels. Since the peak of 2014, around 1.2 million people stopped being at risk of poverty or social exclusion. The proportion of people at risk of poverty or social exclusion (AROPE) has declined mostly thanks to a reduction in the share of people living in low work-intensity households. In 2017, the proportion of people at-risk-of-poverty, a measure of relative poverty, was 21.6 %, above the EU average (16.9 %) and its pre-crisis level (19.8 % in 2008). At the same time, the share of people experiencing severe material deprivation, a measure of absolute poverty, stood at 5.1 % in 2017 (below the EU average of 6.6%). As highlighted in the Social Scoreboard accompanying the European Pillar of Social Rights (see Section 4.3.3), the poverty-reducing impact of the benefits system remains below the EU average and is particularly low for children. Income inequalities remain high, while showing slight signs of improvement. In 2017 ( ), the relative income of the top 20 % of households was unchanged at 6.6 times that of the poorest 20 %, above the EU average (5.1). Flash estimates ( ) point to a slight improvement in 2018 (income year 2017). Likewise, the Gini coefficient ( ) decreased slightly from 34.5 in 2016 to 34.1 in 2017, while remaining above the EU average (30.3) and its pre-crisis level (32.4). In addition, the high proportion of children at risk of poverty or social exclusion (31.3 % in 2017) and high rate of early school leaving suggests many young people face a disadvantaged start in life, with low prospects for upward social mobility (OECD, 2018a). Regional disparities Significant regional socio-economic disparities persist in Spain. Regional disparities in terms of GDP per head have been closely linked to labour market developments, and in particular, the employment rate (European Commission 2018a, p. 9-10). Disparities in GDP per head increased after 2008 due to the asymmetric impact of labour shedding across regions, and started to decline only slightly after 2015 in parallel with the recovery of the labour market, but remain larger than in the pre-crisis period. Beyond GDP, many socio-economic indicators continue to present wide territorial disparities at regional level, such as innovation, entrepreneurship, competitiveness of small and medium-sized companies. Regional disparities are the widest in labour and social outcome indicators, where most regions underperform relative to the EU-average (see Section 4.3 and 4.4.3 and Graph 1.8). Graph 1.8:Regional disparities on selected indicators Source: Eurostat, European Commission calculations Table 1.1:Key economic and financial indicators - Spain Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise). 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 74 % of all country-specific recommendations addressed to Spain have recorded at least ‘some progress'. ( ) 26 % of the country-specific recommendations (CSRs) recorded 'limited' or 'no progress' (Graph 2.1). The reforms carried out during and in the years after the economic and financial crisis have contributed to the Spanish economy's strong performance in the last years. The speed of implementation has, however, slowed somewhat since 2014 and there has been some reform backtracking, namely in the area of pensions. In several policy areas subject to CSRs, both the national and regional levels of government are involved. In those areas, coordination and unclear accountability remain challenges to a successful reform implementation. Recommendations concerning the financial sector and insolvency framework have to a large extent been addressed, but the sustainability of public finances is still not ensured. The restructuring of banks that had received state aid has been accomplished and confidence in the resilience of the Spanish banking sector as a whole has been restored. The reform of the corporate and personal insolvency frameworks has facilitated private debt reduction and made company defaults less onerous. The 2011 and 2013 pension reforms made public finances more sustainable in the long term. However, the decision to temporarily depart from the index for pension revaluation in 2018 and 2019 will be costly. A more permanent relinking of pensions to the Consumer Price Index as from 2020 that is currently being discussed would further raise long-term spending on pensions, unless offset by other measures. The fiscal framework has seen various improvements since 2012, but the automatic implementation of the Stability Law's mechanisms is not ensured.

In labour market and social policy, significant gaps remain despite substantial progress in recent years. The past reforms of the labour market have supported strong employment gains, by increasing its responsiveness to economic growth. Still, unemployment and long-term unemployment remain high, especially among young and low skilled workers. Some steps have been taken to address the widespread use of temporary contracts, often of short duration. However, their impact has so far been modest. Progress has been less prominent in social policies, notably concerning income support schemes and family policies, as well as in education. Graph 2.1:Overall multiannual implementation of 2011-2018 CSRs by February 2019 Source: European Commission Limited progress has been achieved in implementing product market reforms and improving research and innovation in recent years. In the past few years, Spain has received recommendations to address regulatory fragmentation in its internal market and to strengthen research and innovation, a prerequisite for sustainable productivity growth. The Law on Market Unity has been in force for five years, and while it is being applied its impact is still limited. The lack of strong cooperation at all levels of government on market unity has so far translated into few tangible results. No policy measures have been taken to remove restrictions to firm growth or those affecting professional services, which had been the subject of previous years' CSRs. Public support for R&D remains low. There were a few advances in innovation governance and public-private cooperation in research and tertiary education, but some of the measures taken may need some time before they have a measurable impact. Overall, Spain has made limited progress in addressing the 2018 Country-specific Recommendations (see Table 2.1 and Annex A). While the strengthening of the public procurement framework saw limited advances, no progress has been recorded to strengthen the fiscal framework (CSR 1), and therefore in addressing the Council Recommendations for the Euro Area to ensure sustainable public finances and remove investment bottlenecks. In labour market, social and education policy (CSR 2), some regions have advanced towards better coordination between public employment and social services, and efforts have been undertaken to fight the abuse of temporary contracts and to reduce their number in the public sector. However, overall progress has been limited for CSR 2. The level of public investment in R&D remains unchanged in the absence of a new Budget Law for 2019 and there have been limited steps to enhance the evaluation culture for innovation policies. National courts are applying the Law on Market Unity. However, the few measures taken to help its implementation (work in sectorial conferences, trainings), have not had a visible impact yet. Overall, progress has also been limited on CSR 3. Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Spain Spain is one of the largest beneficiaries of EU funds, concentrated in areas of highest EU value-added and on existing challenges and opportunities. The European Structural and Investment Funds (ESI Funds) deliver a critical mass of investments to support Spain in fostering lasting socio-economic convergence, resilience and territorial cohesion. A total amount of EUR 39.9 billion was allocated to Spain for the 2014-2020 Multiannual Financial Framework, potentially representing around 0.5 % of the country’s current GDP. By the end of 2018, some EUR 24 billion were allocated to specific projects, representing about half of the total budget available for the 2014-2020 period (including the national contribution). In addition, around EUR 600 million were allocated to projects on strategic energy infrastructure and cross-border interconnections through the Connecting Europe Facility EU funding instrument. Spanish research institutions, innovative firms, researchers and academics benefitted also from Horizon 2020 EU funding instrument with EUR 3.3 billion disbursed so far. European Structural and Investment Funds support the implementation of the Country-specific Recommendations and structural reforms in Spain. Actions financed include closer collaboration between businesses and research institutions, thus boosting the research and innovation system. As a result, European Structural and Investment Funds helped more than 3 000 enterprises in building cooperation with research institutions and about 450 firms in introducing new products on the markets in 2017. European Structural and Investment Funds are also promoting access and adaptation to the labour market, investing in education and training, and combatting poverty, discrimination and social exclusion, with a strong focus on youth, in line with the principles of the European Pillar of Social Rights. So far, the European Social Fund and the Youth Employment Initiative have supported more than 3 million activities, among others, employment subsidies, traineeships, apprenticeships, counselling, training courses, dual Vocational Education and Training and social services targeting participants of different ages and backgrounds. EU funding contributes to mobilising significant private investment. EUR 1.4 billion of European Structural and Investment Funds (including the EUR 800 million for the SMEs Initiative) has been allocated to leverage additional private capital in the form of loans, guarantees and equity. The SMEs Initiative has already offered guarantees allowing 43 500 enterprises to receive loans and pursue their investments in the development of the companies. In addition, the Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. In Spain, work has started, for example, on assisting the Ministry of Justice to enhance the implementation of e-justice, on carrying out an expenditure review to identify possible areas for improving spending efficiency, and on improving the management capacity of the European Maritime and Fisheries Funds. The overall volume of approved operations by the European Investment Bank, with the European Fund for Structural Investment (EFSI) backing, amounts to EUR 8.3 billion, which is set to trigger a total of EUR 45.4 billion in additional private and public investments (February 2019). Spain ranks amongst the highest in the EU in overall volume of approved operations as a share of GDP. 86 projects involving Spain were approved under the infrastructure and innovation window of the European Fund for Structural Investment; amounting to EUR 7 billion which should, in turn, generate EUR 30.7 billion of investments. Under the SME component, 27 agreements with intermediary banks were approved for a total of EUR 1.3 billion, which should mobilise close to EUR 15.5 billion of total financing. This support is expected to benefit 129 854 small and medium-sized enterprises and mid-cap companies. As an example of project supported by the European Investment Bank, the Empresa Municipal de Transportes of Palma de Mallorca is receiving EUR 30 million to replace the company’s existing urban buses with new cleaner vehicles powered by compressed natural gas. EU action contributes to strengthen national, regional and local authorities as well as the civil society. More than EUR 700 million have been allocated for strengthening capacity of public administrations at different levels and prompting close cooperation with stakeholders. There are also other Commission initiatives contributing to boost the structural transformation of the economy. The pilot action on Industrial Transition helps to develop a comprehensive strategy for regional economic transformation building on their smart specialization strategy, clusters and digitization of industry plans. The action encourages interregional cooperation and the creation of value chains across European regions, identifies collaboration and funding opportunities at European, national and regional level, promotes regional and cluster partnerships focusing on mutual learning and sharing of good practices in innovation policies. More information at: https://cohesiondata.ec.europa.eu/countries/ES Table 2.1:Overall assessment of progress with 2018 CSRs Source: European Commission 3. Summary of the main findings from the MIP in-depth review 3.1.introduction In spring 2018, Spain was identified as having macroeconomic imbalances (European Commission, 2018n). These imbalances related, in particular, to external sustainability, private and public debt and labour market adjustment, in the context of weak productivity growth. The 2019 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Spain to assess the persistence or unwinding of the imbalances (European Commission, 2018b). This chapter summarises the findings of the analyses carried out as part of the macro-economic imbalances procedure (MIP) in-depth review that is contained in various sections in this report. ( ) 3.2.imbalances and their gravity Spain’s net international investment position (NIIP) remains very negative. The large stock of net external liabilities (-80.7 % of GDP in Q3-2018) leaves the country exposed to adverse shocks or shifts in market confidence, which could result in a tightening of credit conditions and international capital outflows. Favourable changes in the composition of external liabilities have somewhat mitigated the associated vulnerabilities. Private-sector deleveraging needs remain sizeable, despite a significant reduction of debt. Private sector debt, in consolidated terms, amounted to 134.6 % of GDP in Q3-2018 (of which 59.7 % of GDP was household debt and 75.0 % of GDP non-financial corporate debt). Despite a sharp reduction, debt levels are above their prudential and fundamentals-based benchmarks, for both households and non-financial corporations, suggesting that deleveraging needs persist for both segments (see Section 4.2.3). The still high level of private sector debt makes agents vulnerable to interest rate shocks, and its associated financial burden may still constrain consumption and investment of some agents. The general government debt ratio is expected to have slightly further decreased in 2018, but remains high. The Commission 2018 autumn forecast projects a decrease by 1.2 percentage points (pps.) in 2018, to 96.9 % of GDP. Despite being on a downward trend, the high stock of public debt continues to be a source of vulnerability for the economy in the face of potential changes in market sentiment. Unemployment is still very high, despite its rapid decline. Unemployment stood at 14.5 % in Q4-2018, after falling by about 12 pps. since its peak in 2013. Long-term and, especially, youth unemployment saw a similarly steep fall during this period, but more than one third of the active population under 25 was still without a job in Q3-2018. Moreover, the share of temporary contracts (26.9 % in Q3-2018) has not decreased during the last year. This could have a negative impact on potential growth, productivity, and social cohesion. The Spanish economy could provide significant spill-over effects to the rest of the EU. This stems from its relatively large size and its high degree of integration with other Member States, especially those with which Spain has significant trade links as well as financial and/or banking linkages (See Table 3.1). In particular, Portugal has a high trade exposure to Spain. Box 3.1 illustrates how structural reforms in Spain can boost economic growth in the country, with potential spill-over effects on other Member States. In particular, closing half of the gap with the best performers in a number of policy areas could boost GDP by 6 % over 10 years, with positive, albeit small, spill-over effects for the rest of the euro area. For Spain, the areas where the gap with the best performers are larger concern the business environment, taxation, skills and active labour market policies, as well as research and innovation. The simulations presented therein follow the spirit of the 2019 Council Recommendations for the euro area. Table 3.1:Outward spill-over heat map for Spain Source: UN, OECD, WIOD, BIS and Commission services.

3.3.evolution, prospects, and policy responses External sustainability and competitiveness The current account surplus decreased in 2018 as a consequence of both cyclical and transitory factors. After remaining relatively stable at almost 2 % of GDP in 2016 and 2017, Spain’s current account surplus weakened in 2018, to slightly above 1.0 % of GDP. Spain's net lending capacity also declined to 1.5 % of GDP. Cyclical and transitory factors, such as the increase in import prices, in particular oil prices, the slowdown in Spain's main export markets and the euro appreciation, have driven this decline. In addition, the composition of final demand has been skewed towards components with large import content (such as investment in capital goods and consumption of durables or exports in sectors with vertically integrated activities). Against this background, both the energy and non-energy trade balance contributed to weaken the current account surplus in 2018. In particular, the non-energy trade balance registered a deficit for the first time since 2011. In cyclically-adjusted terms, the decrease in the current account surplus has been limited (Graph 3.1). Structural factors are playing an important role in preserving the external trade surplus. A reduction in the import elasticity to final demand, as well as the increasing internationalisation of Spanish firms, suggest that a structural change has taken place in the Spanish economy (see (European Commission, 2018a). Accordingly, the cyclically adjusted current account balance (estimated at 1.5 % of GDP in 2018) has improved in recent years, and now exceeds the level required to reach a prudential level of the net international investment position (NIIP), and also the more demanding current account norm (that is, the one explained by fundamentals, at about 0.5 % of GDP in 2018) (Graph 3.1). ( ) ( ) Graph 3.1:Current account and net international investment position Source: Eurostat and own calculations. Persistent current account surpluses are slowly translating into a narrowing of Spain’s net debtor international investment position. In addition to high nominal GDP growth, continued external surpluses have driven a slow but steady narrowing of Spain's negative net international investment position (Graph 3.2) ( ). Negative valuation effects, mainly due to the appreciation of the euro, prevented a larger improvement in 2017 and 2018. Continued current account surpluses and high nominal GDP growth projected until 2020 are expected to result in further improvements in the net international investment position. The composition of Spain’s external liabilities helps to mitigate some of the vulnerabilities. Since 2013, the proportion of equity instruments in total external liabilities has been increasing, although from a very low level. Equity does not carry the same risks as debt for external sustainability, as, contrary to debt, its remuneration (e.g. dividend payments) can be adjusted during economic downturns. Against this background, the net international investment position excluding non-defaultable instruments (NENDI), which represents the net international investment position excluding equity, has improved faster than the overall net international investment position, crossing the prudential threshold for the first time in 2017 (falling to -56 % of GDP vs. a prudential threshold of -60 % of GDP). This is a reduction of 15 pps of GDP since 2012, against a decline of 6 pps of GDP of the net international investment position, partly reflecting an improvement in the net foreign direct investment (FDI) position. In addition, most of the external debt has maturities of one year or more (about 76 % of general government and private sector external debt, excluding intercompany loans), and has been increasing in recent years, reducing risks. In addition, a non-negligible part of the external debt are central bank liabilities stemming from monetary operations of the eurosystem (Graph 3.3). Graph 3.2:Analysis of the rate of change of net international investment position— Spain Source: Eurostat. Table 3.2:Current account balance and net international investment position sensitivity analysis Source: Owns calculations. Sustained current account surpluses would be needed for Spain to decisively reduce its still large external liabilities. While the current account surpluses recorded since 2013 have put the net international investment position onto a declining path, the amount of Spain’s net external liabilities is still far from having achieved a level that could be considered prudential or in line with fundamentals (see Graph 3.1) ( ). Even under a relatively benign growth scenario, Spain would need to maintain current account surpluses over a long period of time in order to bring down the large net international investment position decisively (Table 3.2). Graph 3.3:Gross external debt by sector-type of financial assets Source: Bank of Spain Private indebtedness and deleveraging Despite the growth in new credit, private sector deleveraging has advanced, reducing vulnerabilities. By Q3-2018, private sector debt - in consolidated terms - had been reduced by about 67.9 pps. of GDP since its peak in 2010. Most of this reduction is due to a decline in corporate debt (about 42.6 pps. of GDP), but progress in household debt reduction (over 25.3 pps. of GDP) has also been significant. The deleveraging process has reduced the exposure of both sectors to changes in interest rates ( ). The financial position of Spanish households has strengthened mainly thanks to improvements in the labour market. Furthermore, the financial burden of household debt has been reduced by the prevailing low interest rates. Deleveraging needs remain for both corporations and households, but the stock of loans to households has started to increase again. According to prudential and fundamentals-based benchmarks, both household and non-financial corporations' debt remains high and deleveraging needs persist (see Section 4.2.3). The continued reduction of private sector debt is driven by non-financial corporations (NFCs), whereas the stock of total household debt stabilized in 2018 after being on a downward trend since 2010. Significant growth in new credit to finance durable consumer spending, as well as growth in lending for house purchases and a reduction in the repayment of mortgages (due to a reduction in housing debt) explain this change of trend. Even though consumer credit has contributed to the economic recovery in recent years by supporting domestic demand, its rapid increase increases agents’ vulnerability to adverse shocks, especially if it goes to the most vulnerable households. On the corporate side, the debt reduction process has continued despite new credit flowing towards the less indebted and most productive firms, supporting investment (European Commission 2018a). Amid rising house prices, the construction sector has started to grow, but houses are still undervalued for the country as a whole. House prices have risen for almost five years in a row, although there is a high degree of heterogeneity across regions, partly reflecting a still large stock of unsold houses in some areas and a buoyant rental housing market in others. On average for the whole of Spain, house prices remain below pre-crisis levels, and their recovery does not seem to imply potentially harmful dynamics, but price developments in some regions deserve attention. According to standard price valuation indicators, overall house prices are still undervalued in Spain, although some indicators suggest this gap is closing (see Section 4.2). Investment in residential construction has been increasing since the last quarter of 2015, but remains below pre-crisis levels (5 % of GDP in 2017, compared to about 12 % of GDP in 2006). The insolvency reforms over recent years have facilitated private debt reduction. In a context of strong economic growth and easing access to finance, the number of corporate insolvencies decreased by 2.6 % in annual terms in the first three quarters of 2018 (by 0.8 % in 2017). The proportion of insolvency proceedings that ends in an agreement between creditors and debtors increased in 2017, compared to the previous insolvency framework before the 2014 and 2015 reforms (see Section 4.2.2). Public debt The reduction of public sector debt is expected to continue, but at a moderate pace. After declining by 2.3 % of GDP between 2014 and 2017, it is expected to narrow slightly faster, by a further 2.7 pps., until 2020, helped by still strong nominal GDP growth. For the first time since 2007, debt reduction is also expected to be underpinned by a primary surplus as from 2019. While interest expenditure remains on a declining path as previous improvements in financing conditions filter through to lower debt servicing costs, debt-increasing stock-flow adjustments are preventing a slightly faster debt reduction in 2019 and 2020. While there appears to be no immediate risk of fiscal stress, risks to fiscal sustainability remain significant in the medium to long term (see Section 4.1.1). Unemployment

Unemployment is set to continue falling, despite decelerating job creation. Employment growth is expected to slow down in 2019 and 2020, as a consequence of the slowdown in final demand, as well as the expected dampening impact of the increase in the minimum wage for 2019. Still, the unemployment rate is set to continue falling, to 13.3 % in 2020, which is still well above the EU average. Labour market segmentation has not declined despite the increasing share of permanent contracts among new jobs. A high level of labour market segmentation, long-term unemployment, and population ageing remain challenges for higher productivity and potential growth (see Section 4.3). After years of restraint, wages are set to increase, but cost-competitiveness gains will continue. Negotiated wage increases have been gradually recovering in recent years, reaching 1.7 % in October 2018. However, strong job creation has resulted in a negative wage drift, leading to very modest increases in nominal aggregate wage growth, or even negative in real terms in 2016-2018. This contained nominal unit labour costs (ULC) increases despite the low productivity growth during the period. Nominal wage growth is expected to peak in 2019 as a result of the increase of the minimum wage, and then to moderate, but remain above inflation in 2020. As labour productivity is forecast to grow only moderately over the forecast horizon, this will lead to increases in nominal unit labour costs. However, growth in nominal unit labour costs is expected to remain below the euro area, except for 2019, implying further gains in cost competitiveness. The increase in the minimum wage could reduce in-work poverty, but could also hurt the employment prospects of young people and the low-skilled. Spain has implemented a steep increase in the minimum wage in 2019 (of 22.3 %), above expected inflation and productivity growth. The expected impact of the increase in the minimum wage on employment may vary significantly across regions, sectors, and categories of workers, depending on the coverage. Existing simulations specific to Spain estimate that the recent increase in the minimum wage to EUR 900 would generate a negative employment effect of up to 0.8 % of total employment (some 125 000 net jobs). This negative effect would be greater for certain groups, such as women, young people, low-skilled workers and those on temporary contracts (see Section 4.3.1). 3.4.overall assessment The reduction of macroeconomic imbalances in Spain has progressed further, but vulnerabilities remain. Private sector debt reduction has continued to advance, but deleveraging needs persist. Non-financial corporation debt has continued to decline, while the outstanding level of households' loans has increased slightly again after years of decline. Public sector debt has been slightly reduced, a process that is expected to accelerate somewhat as government deficits are forecast to narrow further. Despite a weakening of the external surplus in 2018, largely due to cyclical and transitory factors, structural factors continue supporting the growth of exports and limiting that of imports. Nevertheless, in order to bring down decisively its large stock of external liabilities, Spain will have to record current account surpluses over an extended period of time. Unemployment is set to continue falling, despite a deceleration in job creation. However, reducing long-term and youth unemployment, along with lowering the share of employees in temporary contracts, is critical to raise the growth potential of the Spanish economy. Box 3.1: Outward spill-overs Structural reforms in Spain could have spill-over effects on other countries due to the large size of the Spanish economy. While the demand effect (higher export demand for foreign products) leads to positive spillovers, reforms typically also improve a country’s competitiveness and this can be at the (relative) expense of other countries. Whether the net effect is positive or negative depends on the relative strength of these two opposing channels and is likely to depend on the specific types of reforms. In a model simulation exercise ( I ), the impact of a comprehensive set of reforms is quantified for all EU Member States in a harmonised way (Varga and in ’t Veld, 2014). For a large set of structural indicators the benchmark is defined as the average of the three best performing countries, and then in the simulation these gaps are closed by half for all indicators together, for each country separately. An update of this exercise for Spain is shown in the table below, based on more recent indicators (but not capturing the reform measures introduced most recently). As the magnitude of the reform ‘shocks’ simulated here are based on a harmonized benchmarking exercise, they do not exactly correspond to past European Semester Country-specific recommendations, but they illustrate the potential impact that structural reforms can have on Member States’ economies and their spill-overs. The simulation for Spain shows that there may be a small but positive net spill-over to the rest of the euro area from structural reforms. The simulated reforms cover all areas: product market regulation and entry costs, labour market participation, taxation structure and R&D subsidies. For Spain, the largest ‘reform gaps’ identified are in the tax wedge (as captured by the relative share of labour tax revenues compared to consumption tax revenues) and product market regulation (services sector markups and entry costs). All together, this ambitious reform package can boost GDP by 6 % after 10 years, and 9 ¾ % after 20 years. The reforms raise competitiveness and boost exports, but imports also increase as a result of higher demand. As the terms of trade fall by about 3 % after 10 years, the trade balance to GDP ratio actually falls slightly by 0.3 pps. The net spillover to the rest of the EA is small but positive, and total EA GDP increases by 0.3 % after 10 years. Table 1. Spillover effects of structural reforms – Spain closing half of the structural reform gaps Note: increase in REER is a depreciation. Table 3.3:MIP matrix (Continued on the next page) Table (continued) Source: European Commission. 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Debt sustainability and fiscal risks* Although slowly decreasing, Spainʼs general government debt ratio remains high. After rising sharply in the years following the financial crisis, the general government debt ratio peaked at slightly over 100 % of GDP in 2014, about 65 percentage points above its low point of 2007. The Commission 2018 autumn forecast projects that the debt ratio will decrease from 96.9 % of GDP in 2018 to 95.4 % of GDP in 2020. This decrease follows from both favourable interest rate-growth rate differentials and – as from 2019 – primary surpluses more than offsetting debt-increasing stock-flow adjustments. As the private debt ratio has declined faster than the government debt ratio, general government debt now makes up a much larger share of the total indebtedness of the economy – at around 41 % in 2017 relative to around 20 % in 2010, the year in which private debt peaked (See Graph 4.2.4). The average life of outstanding debt has increased in recent years. As the Spanish Treasury took advantage of the lower interest rates to extend maturities, average life of outstanding debt has increased to slightly below 7.5 years. While the cost at issuance has risen slightly from a low of 0.61 % in 2016 to 0.65 % by 15 January 2019, it remains significantly below the cost of debt outstanding, which stood at 2.39 % on that same date (in 2011, both stood at around 4.0 %). This implies that there is still some margin to further reduce the average cost of debt in the near future. Spain does not appear to face immediate risks of ʻfiscal stressʼ, but sustainability risks are high in the medium and long term ( ). The value of the early-detection indicator of fiscal stress, the S0 indicator, is below its critical threshold. However, some fiscal variables point to possible short-term challenges, especially if financial markets’ perceptions were to rapidly change. Among the variables with a value above their critical threshold are the gross financing needs, the cyclically-adjusted deficit and net government debt. Financial markets’ perceptions of Spain’s sovereign risk seem to have improved over the last year, with upgrades from all major rating agencies in the first half of 2018. Since then, they have remained ‘A- stable’ or equivalent. The 10-year sovereign yield spread against the 10-year German bund is only slightly higher than a year ago. According to the Commission 2018 autumn forecast, Spain is still forecast to have a structural government deficit of 3.1% in both 2019 and 2020, reflecting a relatively low level of taxation in relation to expenditure. This is still some way from the medium-term objective of having a zero structural balance. Box 4.1.1: Long-term sustainability implications of changes to the pension system and to health care policies The adoption of the 2018 budget implied a departure from two key elements of the 2013 pension reform. These consist of, first, a temporary suspension of the annual revaluation mechanism during 2018 and 2019 and, second, a postponement from 2019 to 2023 of the entry into force of the so called sustainability factor, a mechanism by which the initial pension level is adjusted to changes in life expectancy. Regarding the former, the 2018 Budget Law contained a pension revaluation of 1.6 % in 2018 (compared to 0.25 % implied by the Index for Pension Revaluation (IPR)). In addition, the Government agreed to raise the minimum pension by 3 % in 2018 and to raise survivor pensions in both 2018 and 2019. The latter was already foreseen in the 2011 pension reform, but had been put on hold during the crisis years. The 2019 Draft Budgetary Plan submitted in October 2018 also announced a further top-up of the 2018 pensions to compensate for inflation being expected to overshoot 1.6 % in 2018. It also envisaged a further hike of minimum pensions of 3 % in 2019 and confirmed the intention to raise pensions in 2019 by the Consumer Price Index (CPI). All these measures were incorporated into the Commission 2018 autumn forecast. To ensure that they took effect on 1 January 2019 despite the absence of an adopted 2019 Budget Law, these changes were implemented through a Royal Decree Law adopted by the Government in December 2018. Taking all these short-term legislated measures into account, total pension expenditure would be considerably higher compared with the 2018 Ageing Report baseline scenario, which reflects the pre-reform-reversal situation. In particular, adjusting pensions to the Consumer Price Index instead of the Index for Pension Revaluation in 2018-19 could lead to a cumulated increase in pension expenditure of 0.2 % of GDP by 2019 compared with the baseline scenario. The permanent full relinking of pensions to inflation that is currently being discussed would lead to a significant increase in pension expenditure over the long term, unless compensating measures are undertaken. In September 2018, the parliamentary committee dealing with pension issues, the so-called Toledo Pact Committee, issued a recommendation to link pensions to inflation. This recommendation, which enjoys broad political support, is not binding. The recent Royal Decree Law requires that the indexing of pensions be implemented in such a way so as to ensure the social and financial sustainability of the system. According to preliminary projections by the Commission services, a straight relinking to the Consumer Price Index rather than the Index for Pension Revaluation would lead pension expenditure to be about 4 % of GDP higher by 2050 compared to the baseline scenario (See Graph 4.1.1.1).This is close to the projections made by other institutions, such as Bank of Spain, the IMF and the think tank FEDEA (2018). The independent fiscal authority, AIReF, estimates the impact to be less (2% of GDP) based on different assumptions. The sensitivity of the pension projections to changes in the assumptions regarding net migration is rather limited. The national statistical office (INE) has recently updated its demographic projections and AIReF has published a set of demographic forecasts for the first time. Both include net migration inflows that are higher than those included in the Commission 2018 Ageing Report. To gauge the importance of the demographic assumptions on the pension projections, the 2018 Ageing Report includes a high-migration sensitivity scenario (See Graph 4.1.1.1). It assumes that net migration flows are 33 % higher than in the baseline scenario throughout the projection period. While this scenario is expected to lead to a reduction in the weight of pension expenditure by about 0.5 % of GDP by 2050 as employment grows faster, by 2070 this reduction should have narrowed to 0.2 % of GDP, as migrants start drawing a pension after their working career. As concerns adequacy, the current net theoretical replacement rate (measured as the first pension benefit relative to the last wage before retirement, on the assumption of a 40-year career, average earnings and retirement at the age of 65) of Spanish public pensions are among the highest in the EU (96.8 %). In 2017, people aged 65 and over faced a much lower risk of poverty than other age groups, notably children (14.8% against 28.3 %). According to the 2018 Pension Adequacy Report, the theoretical replacement rate in Spain is set to decline in the long run (86.5 % in 2056), but would remain above the EU average also in a scenario where the 2013 reform is left intact. Further improving the duration and completeness of working careers would improve the adequacy and sustainability of future pensions. Also in the health care area, the Spanish authorities have recently implemented a new measure. In July 2018, the Spanish Government adopted a Royal Decree-Law extending health care coverage to undocumented and illegal immigrants (See Section 4.3.3). This Decree-Law was validated by Parliament in September 2018, establishing a legal right to health care.

Spain faces high fiscal sustainability risks in the medium term. This conclusion stems from both the sustainability gap indicator (S1) and from a debt sustainability analysis perspective. The former indicates that Spain's structural primary balance would need to improve by 5.2 % of GDP in cumulative terms over the five-year period to 2025 relative to the baseline ‘no-fiscal policy change’ scenario to bring the debt-to-GDP ratio to the reference value of 60 % by 2033. This would require an ambitious structural primary balance by European standards ( ). About half of the very significant S1 value is due to the distance of the debt ratio from the 60 % reference value and, to a somewhat lesser extent, the unfavourable initial budgetary position, but only to a limited extent the projected age-related public spending. However, these numbers are based on the same policy assumptions as those underlying the 2018 Ageing Report (European Commission, 2018d). The recent policy debate on pensions indicates that changes to the mechanism by which pensions are revalued may undergo changes in the near future. In particular, a relinking of pensions to inflation would lead to a significant increase in pension expenditure in the medium to long term (See Box 4.1.1). Debt sustainability analysis shows that under normal economic conditions and assuming a constant structural primary balance after the last Commission forecast year (2020), the Spanish general government debt is expected to reach more than 107 % of GDP by 2029 (last projection year). This projection is driven by a gradual worsening of the primary balance in the 2020-2024 period being compounded by an unfavourable and increasing interest rate-growth rate differential in the last part of the next decade. The analysis also shows that the level of the debt ratio is highly sensitive to shocks (see Box 4.1.2). In the long term, Spain is deemed at high fiscal sustainability risk. This conclusion stems from combining the sustainability gap indicator (S2) with a debt sustainability analysis perspective described above. The former shows a gap of 2.3% of GDP that needs to be closed to stabilise debt over the long-term. The gap is mainly due the unfavourable initial budgetary position, but to a limited extent also to the projected ageing costs. As was the case for the S1 indicator, the S2 indicator is also based on assumptions regarding pension expenditure that may prove too low, if the announced reversals of some of the pension reforms materialises. Under the more adverse Ageing Working Group risk scenario (whereby healthcare and long-term care costs would exceed those expected from purely demographic factors due to non-demographic drivers such as technological changes and catching-up effects), the S2 indicator would double, to 4.4 % of GDP. 4.1.2.Fiscal framework Some steps have been taken to improve public procurement and assess the efficiency of public spending. The implementation of the new governance structure for public procurement in Spain is ongoing, but the elaboration of the procurement strategy is still pending. The effectiveness of the new law will crucially depend on the degree of ownership at all levels of government (see Section 4.4.4). With support from the European Commission, the expenditure reviews, carried out by the Spanish Independent Authority for Fiscal Responsibility (AIReF) in 2018 and approved for 2019, have the potential to lead to improvements in the efficiency and effectiveness of public spending in selected areas ( ). Some provisions adopted through a Royal Decree in March 2018 further enhanced the functions and the role of the Independent Authority for Fiscal Responsibility (AIReF). Spain’s fiscal framework can be further strengthened, among other things, by pursuing a more automatic activation of measures to prevent and correct deviations from fiscal targets at the local level and by enhancing the contribution of the domestic spending rule to the sustainability of public spending (see European Commission 2018a, p.28-29, and European Commission 2018c). 4.1.3.Taxation Spain has a low tax-to-GDP ratio compared to other EU Member States. In 2017, its tax revenues amounted to 33.8 % of GDP, compared with EU and euro area averages of, respectively, 39.0 % and 40.2 %. The share of consumption taxes is very low, at 9.4 % of GDP, also reflected in a relatively low implicit tax rate on consumption of 15.9 %, below the EU/euro area average of 20.7 % and 20.6 %. At 16.3 % of GDP, the share of taxes on labour also remained below the EU average of 19.4 %, with an implicit tax rate of 32.0 % in 2017. In addition, the redistributive effect of household direct taxation is much below the EU average ( ). Box 4.1.2: Medium-term projections for government debt The government debt trajectory has been simulated under different scenarios. Under the baseline scenario, the general government debt is forecast to decrease slightly until 2020, before rising again until the end of the projection period in 2029, when it reaches about 107.3 % of GDP. The baseline has been derived from the Commission 2018 autumn forecast, consistent with the forecast implicit interest rate and the shares of short-term and long-term public debt. It makes a number of technical assumptions. First, over the post-forecast period, the structural primary balance (before cost of ageing) is set constant at the value projected for 2020, at -1.0% of GDP, hence assuming that no further structural adjustment is made. The cyclical component of the primary balance is calculated using (country-specific) budget balance sensitivities over the period until output gap closure is assumed (2023). Second, the long-term interest rate on new and rolled-over debt is assumed to be 3.0 % in real terms by the end of the projection period, while the short-term real interest rate reaches an end-of-projection value that is consistent with the 3.0 % long-term real interest rate and the value of the euro area yield curve. Third, the GDP deflator is assumed to change linearly until it reaches 2.0 % in 2023 and remain constant thereafter. Fourth, the stock-flow adjustment is set to zero after 2020. Finally, medium-term real GDP growth projections are based on the T+10 methodology agreed with the Economic Policy Committee and implies that medium-term real GDP growth is assumed to average 1.3 % in 2018-2023 and to slow to 1.0 % on average in 2024-2029. More favourable assumptions on real growth and interest rates would lead the debt ratio to follow a lower path to reach 96.8 % of GDP in 2029. By contrast, under more unfavourable assumptions on these variables, the debt ratio would increase to 119.1 % of GDP by 2029. The total tax revenue ratio to GDP has regained the level prior to the boom and bust episode of a decade ago. After peaking at 36.4 % of GDP in 2007 and bottoming out at 29.8 % of GDP in 2009, total tax revenues have gradually recovered and, as indicated, reached, 33.8 % of GDP in 2017, slightly above the 200-2017 average. While indirect taxes, such as Value Added Tax, are now clearly above its 2005-2017 average (+0.7 pps) and personal income taxes are somewhat above (+0.2 pps.), social contributions (-0.2 pps.) and, in particular, corporate income taxes (-0.4 pps.) still fall short of that level. The 2019 Draft Budgetary Plan contained tax measures that the authorities estimated would yield about 0.6 % of GDP in additional revenue. These included planned increases in corporate and personal income taxes, environmental taxes and wealth taxes and the introduction of new taxes on the digital economy and on financial transactions (see European Commission, 2018c) (). According to the Commission 2018 autumn forecast, Spain is still forecast to have a structural government deficit of 3.1% in both 2019 and 2020, reflecting a relatively low level of taxation in relation to expenditure. The situation should be reassessed in light of evolving circumstances in the forthcoming Commission 2019 spring forecast. Despite a standard Value Added Tax (VAT) rate in line with the EU average (21 % vs an EU average of 21.6 %), Spain collects relatively little Value Added Tax revenues. This is due to extensive use of reduced and super reduced rates, resulting in a large Value Added Tax policy gap. In 2016, it stood at 12.81 %, above the EU average of 9.95 % (European Commission 2018e). While, on average, the reduced rates in Spain have some progressive effect, which is almost entirely due to foodstuff, for many items they have a regressive effect. For instance, this is the case of the reduced rate for restaurants and hotels. The Value Added Tax compliance gap continued to decrease. The gap – calculated as the difference between the theoretical Value Added Tax liability and the revenue actually received as a percent of the former – amounted to 2.7 % in 2016 (down from a peak of 11.8 % in 2013). This is significantly below the EU average of 12.3 %. Spain has taken steps to reduce Value Added Tax fraud by increasing taxpayer reporting requirements through the Immediate Supply of Information system. The new system has produced a more automated environment, reducing the time to comply with Value Added Tax obligations from 35 to 30.5 hours per company and year. Environmental taxes are still below the EU average, despite increases in recent years. Environmental taxes in Spain amounted to about 1.8 % of GDP in 2017, compared to an EU average of about 2.4 % of GDP. In particular, energy taxes (including transport fuel taxes) yielded little revenue and amounted to about 1.5 % of GDP in 2016, compared to an EU average of about 1.8 %. Taxes on transport, such as vehicle taxes, only yield half as much revenue in Spain as the EU average (0.2 % compared with 0.5 % of GDP). Also, diesel is taxed relatively less than petrol in Spain, with a ratio of 0.73 in 2018 compared with an EU average of 0.81. Spain relies to a relatively low extent on recurrent property taxes. Recurrent property taxes are considered among the taxes least detrimental to growth and are preferable to transaction taxes, as the former allow a more efficient allocation of assets and higher labour mobility. While revenues from property taxation in Spain are slightly above the EU average (2.7 % compared with 2.6 % of GDP in 2017), the recurrent element is below the EU average (1.2 % of GDP compared with 1.6 % in 2017), while transaction taxes exceed the EU average (1.5 % compared with 1.0 % of GDP in 2016). The R&D tax credit is one of the most generous and generic in the EU. However, it does not seem to lead to a significant increase in private R&D investment. The uptake in tax incentives for R&D might be fostered by removing administrative barriers limiting their implementation (Cordón and Gutiérrez Lousa, 2010; Busom, Corchuelo and Martínez Ros, 2014). Evidence shows that the probability of using tax incentives decreases when firms, in particular small and medium-sized businesses, face financial constraints (Busom, Corchuelo and Martínez Ros, 2014). High compliance costs and an ageing workforce at the tax authority are two areas of concern. Tax compliance costs are relatively high in Spain due to the high ratio of direct tax obligations to turnover (2.6 %). Moreover, OECD data on human resources of the Spanish Tax Administration (Agencia Estatal de Administración Tributaria) shows a high degree of ageing staff, where less than 20 % were below the age of 45 in 2015. This figure has to be read in conjunction with 2015 data showing that Spain has the lowest number of tax agents per citizen among EU Member States that are OECD members (OECD, 2017b). This points to possible future human resource bottlenecks. Procedures have been initiated to hire 1300 civil servants in 2019 (tax inspectors, tax technicians, tax agents, custom police agents and auxiliary officials). 4.2. Financial sector The solvency and liquidity of Spanish banks is satisfactory amid positive credit flows to the private sector and continued debt reduction. Bank profitability has also improved, despite persistently low interest rates and high litigation costs. The non-performing loans ratio of Spanish banks, including their international activity, has continued to decline to just above the EU average and slightly below the euro area average. The ongoing restructuring and consolidation of the banking sector allows it to continue to optimise its business model and to lower its costs. The outstanding level of loans to the Spanish private sector has declined further, driven by non-financial corporations, but deleveraging needs persist. 4.2.1.Financial sector * Improved profitability allows Spanish banks to remain well capitalized, although the capital ratio is still below the EU average. On the back of the favourable economic environment, Spanish banks recorded a domestic return on equity (ROE) of 6.2 % in June 2018, up from 5.9 % a year earlier. The consolidated business recorded a more favourable return on equity of 8.9 % in June 2018 (8.2 % a year earlier). According to European Banking Authority data, the fully loaded common equity tier 1 (CET 1) ratio was 11.1 % at the end of June 2018, still more than 3 percentage points below the EU average (14.3 %). However, the results of the 2018 EU wide stress test exercise published on 2 November 2018 showed resilience of the four stress-tested banks in the event of a potential adverse scenario. The percentage of non-performing loans (NPLs) in the banking sector has decreased further. The total stock of non-performing loans for the corporate and household segments in Spain decreased to 6.4 % in June 2018, 2 pp. lower than a year earlier. When the foreign activity of Spanish banks is taken into account, the share of non-performing loans is even lower, at 4.1 % in H1 2018, close to the euro area average (4.2 %) and slightly above the EU average of 3.4 % (see Table 4.2.1). The progress achieved in the reduction of legacy assets was primarily due to the sales of non-performing loans portfolios, and to a lesser extent to recoveries and write-offs. By contrast, the divestment of SAREB’s assets in the first half of 2018 – both loans and real estate –was slower than planned and the company continued posting losses in the first half of 2018. This is related to the lower quality of its remaining portfolio compared to what has already been liquidated and the fact that the majority of SAREB’s real estate assets are concentrated in areas where prices are recovering slowly.

The housing market has consolidated its recovery, supporting the clean-up of banks’ legacy assets. The housing market and construction sector continued to recover from the sharp adjustment that followed the crisis. Unsubsidised house prices increased by 7.2 % year-on-year in the third quarter of 2018. Prices of new dwellings went up by 6.1 % and those of used dwellings by 7.3 %. Despite this increase, house prices remain below the pre-crisis peaks, in both nominal and real terms (by around 22 % and 32 %, respectively). According to standard price valuation indicators, house prices are still undervalued in Spain, but some indicators suggest the gap is closing (see Graph 4.2.1).( ) Price increases, however, differed substantially across autonomous regions. In Q3-2018, price growth ranged between about 2.2 % year-on-year in Extremadura and more than 11 % in the Madrid region, which together with Catalonia and the Balearic Islands recorded the largest increases. Regarding the volume of transactions, during the three-month period ending in October 2018, house purchases continued to increase at a strong, but declining, rate (10.8 % year-on-year compared to 18 % a year earlier) ( ). Residential investment is also increasing (to 5 % of GDP in 2017), although still at a much lower pace than before the crisis, and the stock of unsold houses remains high in some regions. This helps explain the above-mentioned regional differences in house price developments. Table 4.2.1:Financial soundness indicators, all banks in Spain Source: ECB - CBD2 - Consolidated Banking data; own calculations. Graph 4.2.1:Overvaluation gap with respect to price/income, price/rent and fundamental model-based valuation gaps Source: Own calculations The outstanding volume of credit to the private sector is still decreasing. In August 2018, the pace of reduction of banks' domestic assets declined further to about 1 % year-on-year, in line with the overall decline of the stock of domestic private credit. The decline was driven by credit to non-financial corporations (NFCs), which in August 2018 was 4.5 % lower than a year earlier (Graph 4.2.2). The strong reduction of credit to non-financial corporates mainly reflects the clean-up of non-performing portfolios linked to the construction and real estate sector. But even excluding this effect, non-financial corporations lending still registered a slight decrease. By contrast, the volume of outstanding bank loans to households increased by 0.3 % year-on-year in August 2018, prolonging the positive growth that started last June, for the first time since 2010. In the first half of 2018, according to the Bank Lending Survey (Bank of Spain, 2018c), credit conditions eased for both company loans and household lending. For the latter, this concerns both mortgage and, most notably, consumer lending. Although the volume of consumer credit in Spanish banks’ portfolios remains small, its large increase requires careful monitoring. Graph 4.2.2:Loans to the private sector Source: Bank of Spain, own calculations 4.2.2.access to finance While the banking system remains the biggest source of finance, other sources have emerged. In 2017, total bank loans in the economy reached a level equivalent to about 42 % of GDP, almost 3 pp lower than the previous year, but still above the EU average of around 35 % of GDP (see Graph 4.2.3). Non-bank financial intermediation through equity markets and debt issuance is below the EU average. The number of Spanish firms that raise funds through debt securities has increased notably in recent years (by 40 % between 2014 and 2017), as has the number of issuances by small-sized and medium-sized firms (less than EUR 100 million), which accounted for around 50 % of total issuances in 2017 compared to 40 % in 2014. The increasing number of issuances is in part associated with smaller firms that traditionally had not used this financing channel. While remaining a niche option compared to traditional financing sources, finance through venture capital is particularly important for higher risk and innovative projects and companies. In 2017, the volume of venture capital funding to Spanish firms was above the EU average. Finally, funds channelled through crowdfunding platforms, regulated in Spain in 2015, are growing rapidly, but remain marginal (see Bank of Spain, 2018c). Access to finance and availability of bank credit is no longer considered the most pressing problem by Spanish small and medium-sized enterprises. Overall, small companies heavily rely on bank financing and the availability of alternative financing is underdeveloped. On a positive note, Spanish banks are now far more willing to provide loans to small and medium-sized companies than in 2013 and this is continuing to improve. Similarly, the percentage share of rejected loan applications continues to fall — dropping by around 15 pps between 2012 and September 2018 (European Central Bank survey on the access to finance of enterprise, SAFE, April 2018 – September 2018). Graph 4.2.3:Sources of financing of the Spanish economy Source: Ameco, ECB, Invest Europe. New measures have recently been implemented to ease access to non-bank financing for small and medium-sized enterprises. Access to such funding is easier at the start-up phase, but much less so at the scale-up phase, when small and medium-sized companies seek to expand. During 2017 and the first quarter of 2018, several new measures were introduced to fill this gap, such as: a) the ‘ENISA growth’ (ENISA crecimiento) provides financial support to small and medium-sized companies to grow and improve competitiveness, b) the ‘ICO line FOND-ICOSME’ (línea ICO FOND-ICOPYME) also provides financial support to small and medium-sized companies to put a long-term growth plan in place. Funding is available either in the form of equity financing or through participative loans, c) the ‘Financing Industry’ (Financia Industria) provides personalised advisory services to industrial companies on how to access public financing, d) 'With a Guarantee, Yes’ (Con Aval Sí) is an electronic platform that aims to facilitate small and medium-sized company financing through mutual guarantee societies. 4.2.3.Private sector deleveraging * Private sector indebtedness continues to fall, although the stock of loans to households has stopped declining. In Q3-2018, the outstanding volume of private non-financial sector debt amounted to 134.6 % of GDP in consolidated terms, of which 59.7 % of GDP was held by households and 75.0 % by non-financial corporations. This is about 67.9 % of GDP lower than at its peak in Q3-2010 (Graph 4.2.4). Prudential and fundamentals-based benchmarks for private debt indicate that Spain still faces deleveraging needs ( ), but overall the deleveraging pace appears appropriate to allow private debt to converge to its fundamentals-based benchmark. Graph 4.2.4:Composition of debt — Spain Source: Eurostat The increase in new credit to households interrupted their deleveraging process in 2018. Household debt reduction was initially driven by negative credit flows, but GDP growth has progressively become the main contributor. However, since June 2018, nominal GDP growth has no longer been sufficient to offset the increase in net credit flows (Graph 4.2.5). Graph 4.2.5:Decomposition of y-o-y changes in debt-to-GDP ratios, households Source: Eurostat. Growth in new credit to households is driven by both loans for house purchases and consumer credit. The pace of decline in the stock of mortgage loans slowed down to around 1.2 % year-on-year in November 2018, while the stock of consumer credit increased by more than 13 % year-on-year. New loans for house purchases and consumer credit continued increasing by respectively 10.7 % and 6.2 % year-on-year in November 2018. Between the trough reached in April 2015 and August 2018, the stock of consumer credit has increased by 50 %, accounting for about 10 % of total households' loans. Consumer credit growth deserves careful monitoring as it poses risks that can materialize quickly if economic conditions become less favourable, impacting negatively on the most vulnerable agents (such as low-income households) ( ). The outstanding level of household debt has stabilised, despite remaining deleveraging needs (Graph 4.2.6) ( ). Although in 2017, the adjustment was faster than suggested by fundamentals, indicating a sufficient deleveraging speed, the household saving ratio is too low to guarantee household debt’s sustainability at aggregate level ( ). What is more, debt is unevenly distributed across households, and some over-indebted households – often living on low-income or jobless - are particularly vulnerable to changes in the economic and financial environment (Box 4.2.1).

Graph 4.2.6:Gap to the fundamental-based and prudential benchmarks for household and NFC debt Source: European Commission. Box 4.2.1: Determinants of private consumption Since the recovery started in 2013, real private consumption in Spain has been growing faster than real household disposable income, bringing the savings rate to a historic low, which, together with strong investment, has resulted in households becoming net borrowers again. In this respect, the role of pent-up demand, mainly for durable goods, that built-up during the crisis due to the decrease in household income, the rise in precautionary savings, and credit restrictions, is well documented (Bank of Spain, 2018d). The economic theory suggests that consumption evolves in line with household disposable income, consumer confidence, interest rates, and household wealth. In addition, a higher propensity to consume can be expected when increases in disposable income arise from employment growth compared to when it arises from increases in the wage per head, as it has been the case in recent years. In order to investigate whether these macroeconomic determinants can explain the strength of household expenditure in recent years, a private consumption equation is estimated ( II ). The results from this estimation suggest that consumption has evolved in recent years in line with fundamentals, and that the model would predict a pick-up of the saving's rate in the coming years (Graph 4.2.1.1). The results also suggest that growth in disposable income arising from job creation results in a higher propensity to consume than when it arises from increases in the wage per head. In particular, the model predicts that a 1% increase arising from employment growth would result in a 0.83% increase in consumption, compared to 0.19% arising from an increase in the wage per head. Additionally, the results of the estimation also show that high consumer confidence and low real interest rates have also played a positive but smaller role in explaining consumption growth in recent years. Finally, net wealth does not appear to have played a role in explaining the evolution of consumption in our model. ( III ) At the same time, the decline in the savings rate in recent years has been accompanied by a substantial increase in household net financial wealth, reducing the macroeconomic vulnerabilities associated to a low savings rate in the event of a negative shock, as agents would be better placed to smooth their consumption and investment pattern over the cycle. This improvement has taken place both due to an increase in financial assets and a crucially substantial decline in financial liabilities, especially long-term debt. However, it must be noted that part of the increase in financial assets has been not only motivated by net savings, but also to a large extent by valuation effects (in particular in equity) (Graph 4.2.1.3 left). Although consumption per capita in both nominal and real terms is still below its 2008 level, a more granular approach to the evolution of consumption by household type, reveals that most of the fall and subsequent recovery of consumption has taken place in the lowest income quintiles (Graph 4.2.1.2 left). In fact, consumption level is still substantially below the pre-crisis level in nominal terms only among the lowest income quintile group, which was also hit hardest by the crisis. In particular, the rise in the consumption of durable goods has been stronger among lower income groups than among the overall population, but nevertheless they remain well below their pre-crisis levels (Graph 4.2.1.2 right). Although lower income groups represent a small share of total expenditure, this could imply that consumption and savings' patterns have differed substantially among income groups. In particular, the lowest income deciles have experienced the strongest growth in consumption since crisis, despite lower income growth than the average (Graph 4.2.1.3 right), suggesting a larger fall in the savings rate among low-income groups (which in some cases, could be negative). This could be an indication of higher vulnerability of lower income households to changes in economic and financial conditions. The conclusion would be that, at an aggregate level, the strength of consumption in recent years can be explained by fundamentals, in particular, by strong job creation, and that a recovery in the savings rate could be expected over the near term. Besides, at an aggregate level, the low savings rate has been accompanied by an improvement in the financial position of families, and therefore the associated macroeconomic vulnerabilities are lower than in the pre-crisis period. However, a more granular approach suggests that income and consumption patterns have varied greatly across income levels and labour market status, and that low-income households may have seen an increase in their vulnerability in recent years. The financial burden of Spanish households continued falling in 2018, although at