Economic and Financial Report

December 2011

I. The international economy and the euro crisis

Since the worsening of the euro crisis in the middle of the year, growth in the advanced economies has weakened and fears of a relapse into recession have increased. Emerging economies have maintained steady growth and are continuing to drive the expansion of international trade thanks to their domestic demand. Global imbalances, particularly as regards investment and savings flows, and their reflection in current account balances and levels of international reserves, remain significant. Wholesale money markets continue frozen, significantly obstructing financing capacity and the flow of credit.

The euro crisis has become extremely severe, calling into question the currency's viability. The measures taken in the wake of events have not had the desired effects. The crisis has exposed a flawed initial design and an inability to ensure consistent economic policies in different Member States. At the same time it has revealed the lack of institutions and instruments able to prevent or resolve situations such as that we currently face.

To overcome this situation it is essential that the Greek crisis be resolved and that the sustainability of the sovereign debt of solvent countries be ensured. This requires that the Stability and Growth Pact (SGP) be strengthened and that the European Financial Stability Fund (EFSF) be given sufficient resources to stem the risk of contagion. Without detriment to its independence, the European Central Bank (ECB) also needs to be allowed to cover the liquidity shortage in exceptional circumstances (making it the lender of last resort). This all requires progress to be made towards common governance and for national sovereignty to be ceded to supranational institutions, as happened when the single currency was configured. The measures adopted at the summit on 9 December are headed in this direction, and although many questions remain unanswered, the way is now open for greater fiscal and economic coordination.

From the economic policy standpoint, the adjustment and rebalancing programmes for economies in difficulty must be accompanied by structural reforms to boost their growth potential. In turn, countries with a moderate public deficit and a strong current account surplus, should contribute to reviving activity through more expansionary expenditure policies.

The prospects for growth in 2012 have been revised downwards repeatedly. The scope for employment growth is therefore limited and exceptionally high unemployment rates look set to persist. In terms of prices, a significant moderation of inflation is forecast. The outlook for 2013 is more positive, although forecasts are highly uncertain and downside risks remain. In any event, everything will depend on the policies applied, in particular the ability of the euro area to end the crisis.

The Spanish economy

The Spanish economy is facing a critical situation that requires firm and decisive action. After suffering the deepest recession since the restoration of democracy, growth has stalled and job losses continue, resulting in unacceptably high unemployment. The euro-area sovereign debt crisis has undermined market confidence, making funding more difficult and expensive to obtain. The outlook for the coming year suggests meagre –or even negative– growth with a further deterioration in employment. Over the longer term, doubts exist as to the ability of the Spanish economy to sustain the welfare state unless structural changes are made.

On balance, 2011 will be worse than initially expected. The deterioration of the crisis in the euro zone, the continuing tensions in money markets, and the increased difficulty of access and cost of funding have led to a stagnation in activity. GDP growth over the year as a whole will be around 0.5%, yielding a negative growth rate in the fourth quarter of the year, which may extend into early 2012. The year will also end with further job losses and rising unemployment. Moreover, the economy will have registered a setback in terms of the process of real convergence with the euro zone.

The year will end with an average increase in consumer prices of just over 3 percent –compared with 1.8 percent in 2010– and a differential with the euro area of around half a percentage point. In terms of costs, stronger progress in apparent labour productivity –largely due to the sharp fall in employment– has led to a drop in unit labour costs and the differential with the euro zone. Spain’s net borrowing ended the year below 4 percent of GDP, with a drop of almost 1 percentage point on the previous year's figure. The adjustment in the housing market is still underway in real terms -activity and occupation, housing starts, sales, etc.– but less so in prices. The general government deficit is on a downward trend. Nevertheless, the task is being complicated by sluggish economic growth, and further adjustments will need to be implemented to meet the goals set and commitments made.

The restructuring of the banking sector, despite the progress made, is by no means complete, and further steps need to be taken, particularly in terms of cleaning up balance sheets, eliminating excess capacity and containing operating costs. Finally, the deleveraging of both the public private sector is a laborious process representing a drag on growth, as it raises savings to the detriment of spending.

Growth prospects for the next few years have deteriorated and the forecasts have undergone repeated downward revisions. Real GDP growth, weighed down by the contraction in domestic demand, is set to stagnate in 2012, or even contract slightly, which will inevitably lead to further job losses and unemployment rising from already unacceptable levels. The forecasts point to a moderation in inflation, a further reduction in net national borrowing, and a decrease in the general government deficit, in line with the objectives pursued –which will require the adoption of additional measures– and further progress, albeit modest, in the deleveraging process.

This scenario calls for a serious reflection on the economic policy options available. Indeed, to overcome this situation the vicious circle of adjustment, low growth, unemployment and deteriorating public accounts needs to be broken. Therefore, policies cannot be limited to merely adjusting the imbalances, but must be accompanied by measures to boost growth potential. Demand-side policies having been exhausted, structural reforms are the only viable solution.

In the short term, the goal must be to focus on restoring market confidence, which, to a large extent, is dependent on putting a credible budgetary consolidation plan in place and completing the restructuring of the banking sector. However, investors’ confidence in Spain will not be restored unless they see the foundations being laid for sufficient growth to enable debt payments to be met. Therefore, although austerity measures are unavoidable, they will not solve the problem alone, and may make matters worse unless they are accompanied by other measures to enhance competitiveness and growth by making fuller and more efficient use of the factors of production (i.e. raising employment levels and enhancing productivity, respectively).

In the case of fiscal consolidation, reducing the deficit relies on containing and rationalising spending. Any increase in the tax burden should fall on indirect taxation and on no account on labour costs. Given Spain’s degree of decentralisation, strict compliance by all levels of government is essential. Without undermining their provision and universality, pensions, health, education and social benefits, need rationalisation to ensure their sustainability by maximising efficiency.

The aim of employment-law reform has to be to facilitate hiring, encourage job creation and break down the discrimination between different groups (permanent and temporary contracts, young people, etc.). It is necessary to simplify the ways in which employees are hired, moving towards a model of permanent contracts with severance costs that depend on the number of years' service. Decentralising collective bargaining and giving company-level agreements priority over sector-wide ones –so that pay can be matched to productivity– and settling labour disputes in tribunals rather than the courts, are two more key elements.

In an open economy, which forms part of Europe’s monetary union, and is facing ever stronger global competition, it is essential to strengthen our businesses' ability to compete. Competitiveness cannot come down to merely containing labour costs; the emphasis needs to be put on specialisation, increasing value-added, and accessing new markets. This requires companies to devote resources to innovation, product and service quality, and extending their marketing networks. To this end, the government should ensure an optimal environment in terms of macroeconomic stability, fair competition, and a flexible and efficient legal and administrative framework.

Notwithstanding the restructuring of the public accounts, the reduction of certain costs associated with business activity should be studied (social security contributions, tax on reinvested profits, etc.). This should be offset, if necessary, with increased indirect taxation. The aim should be to modify relative internal and external prices (internal devaluation) in order to promote exports and substitute imports with domestic production, where advantageous, thereby helping revive activity and reduce the need for external finance. The fact that Spain’s business costs are relatively high compared to the euro zone as a whole, and that indirect taxes are lower, leaves room for manoeuvre for an adjustment of this kind.

The profound crisis which began four years ago has highlighted excess capacity in the financial sector due to the sharp drop in the volume of business. This has been joined by the difficulties accessing wholesale markets and increased borrowing costs accompanying the euro-zone sovereign crisis. At the individual level, the business model, difficulty accessing markets, or lack of profitability, may mean some institutions need to be restructured. However, if the restructuring requires the use of public money, the essential goal must be to ensure future viability, i.e. the ability to operate in the market without outside assistance.

In summary, there are two main scenarios, depending on whether the structural reforms Spain’s economy needs are implemented or not.

A policy of budgetary adjustment, without decisive action on supply-side policies, may initially reassure the markets but the sluggish rate of growth that will accompany it over a long period of time will not only make adjustment of the outstanding imbalances harder (unemployment, public accounts, financial restructuring, etc.) but also raise concerns about Spain’s ability to meet its debt payment commitments, and again trigger a loss of market confidence, with the consequent impacts on the availability and cost of financing.

Alternatively, a credible programme of budgetary consolidation based on rationalising spending, coupled with an ambitious package of structural reforms, would help raise expectations, market confidence and encourage agents’ decision-making. All in all, this would not only boost the potential for growth and job creation, but also accelerate the inescapable adjustment of Spain's fundamental imbalances.

Madrid, 20 December 2011