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The following OECD assessment and recommendations summarise chapter 1 of the Economic survey of Spain published on 19 November 2008.
The key challenge is to tap new sources of economic growth to accelerate recovery
The long period of virtually uninterrupted strong growth since the early 1990s has ended. This is likely to bring about lasting and profound economic changes. Housing construction is slowing sharply from an unsustainable level, and private consumption is also adjusting to more restrictive conditions in financial markets at home and abroad. The slowdown, although still at an early stage, has already had a significant impact on unemployment and is set to deepen in 2009, as the slide in housing construction is steepening. Some driving factors behind the robust historical performance – low real interest rates following euro adoption, ample credit availability, rising female labour force participation and massive immigration – are losing steam, portending only a modest rebound. Although predicting future potential growth is tricky, productivity gains have been weak, notwithstanding rapid capital accumulation, and it is as yet too early to assess whether the recent improvement will be sustained. Implementing an ambitious programme of structural reforms would surely enhance productivity performance in the medium and long term.
Decomposition of real Gross Domestic Product
Contributions of growth, year on year
Source: OECD, Analytical database.
Nevertheless, the eventual recovery will benefit from some notable strengths. Banking institutions are, in the aggregate, comparatively well placed to absorb losses which will result from their lending exposure to domestic residential construction and to withstand ongoing international financial market turmoil. Fortunately, lending practises have in important respects remained relatively prudent. Looking further ahead, the vast expansion of educational attainment at the tertiary level, surpassed by only a few OECD countries, provides a huge opportunity for future gains in living standards. However, severe labour market segmentation and low geographical mobility are holding back the integration of young highly qualified workers in the labour market. Moreover, rising tertiary attainment notwithstanding, the supply of poorly educated workers with meagre employment prospects is still substantial and growing – in large part because of immigration – while the availability of young people with intermediate vocational skills is limited, despite high returns to such skills.
A marked adjustment in private domestic demand is underway
Rising short term interest rates, most recently caused by the ongoing global financial turbulence, have triggered the end of a decade long boom of investment, especially in residential construction, and of consumption which together had pushed up the current account deficit to over 10% of GDP. The slowdown is deepening, as the drastic decline in housing starts has yet to fully feed through to activity, and the large number of new dwellings that have recently come on stream have added to oversupply. Private agents are also adjusting to tighter financing conditions and increased uncertainty worldwide. Export market performance has held up well, but foreign markets are weakening. The disinflationary impact of the sharp deceleration of domestic demand would be enhanced by boosting flexibility in wage and price setting, thereby limiting the negative impact on activity. If future wage bargaining continues to provide ex post indexation to the current inflation shocks, the recent impact of oil and food price increases on inflation will be at least partly passed on to wages. Competitiveness will be damaged, and the downturn will be accompanied by particularly heavy output and employment losses. Should the total elimination of inflation indexation clauses in collective bargaining not be feasible in the short run, these clauses should be redesigned with a view to minimise second-round effects on inflation. To this end any indexation should be limited to an inflation measure that excludes oil and other commodity prices, and further reduces the degree of indexation. Making it easier to opt out of collective agreements would also be helpful.
Freeing up the savings banks could provide added resilience
Although domestic financial intermediaries’ balance sheets are heavily exposed to the shrinking domestic residential construction sector, cushions against losses that will result from this exposure are substantial, and supervisors have discouraged imprudent mortgage lending practices. However, the exposure of the unincorporated, private domestic savings banks – which hold about half of total banking sector assets and are, as any other bank, under the supervision of the Bank of Spain – is higher than that of other commercial banks, and their particular legal status places some limits on their ability to raise external equity. This could diminish their ability to offset any reductions in their solvency without resorting to tighter lending standards, although resulting macroeconomic effects could be mitigated if other institutions were to step in to fill the gap. No investor can own more than 2.5% of a savings bank’s equity, and scope for takeovers are limited, even among savings banks themselves, as such mergers require regional governments’ approval. Consideration should be given to lowering barriers for savings banks to raise external equity. Such steps could include lifting the requirement of regional government approval for mergers and raising the limit on individual shareholdings. Separately, loan defaults could rise more markedly if employment losses are large; this would especially affect young workers living independently. The indexation of interest rates on mortgages to short term interbank rates heavily exposes the economy to changes in such rates (which have risen sharply in recent months) especially in view of high private household indebtedness. The government is appropriately taking steps to raise information requirements on interest rate risk for loan customers and has lowered the costs of switching to mortgage rates which are less flexible. However, a small transaction tax is still weighing on such costs. Transaction costs for switching to less variable mortgages should be lowered further.
Growth of credit granted by savings banks and commercial banks
1. Contributions to total credit growth. Residential lending comprises loans for home purchase as well as loans to firms in the real estate service (including property development) and the residential construction sector.
Source: Banco de España (2008), Boletín Estadistico.
Fiscal policy has appropriately turned expansionary, but scope for further discretionary stimulus is limited
The government has introduced a package of expansionary measures to offset the sharp deceleration of activity, including an income tax rebate of € 400 – in addition to the adjustment of tax brackets and basic income tax allowances to inflation in the 2008 Budget Law - as well as an acceleration of public investment projects and an expansion of public lending guarantees for social housing. New child benefits payable at birth were already partly introduced in 2007. Overall, these expansionary measures have an expected budgetary impact of around ¾ per cent of GDP. Although the resilience of the financial sector is likely to help limit the fall out of the residential construction downturn, and adjustment is inevitable, taking out some insurance was appropriate to limit the risk of a downward spiral in activity and employment, reinforced by declining house prices. However, some of these measures could be more closely linked to policy priorities for structural reform. In particular, the resources taken up by the new tax allowances and child benefits could be more effectively used to lower the relatively high tax wedge on low income workers with children by means of an in-work benefit (see below). In any case, fiscal policy expansion is nearing its limits, as the government has recognised in its budget proposal for 2009.
The attention of fiscal policy makers needs to turn to the medium term, as revenue gains are likely to diminish considerably even beyond the current cyclical downturn. This is because, as the current account returns to a sustainable position, economic growth will shift from domestic to external demand, which is less tax rich, and some of the drivers of economic growth in the recent past are likely to weaken. In addition, current primary spending relative to GDP has drifted upwards and ageing related spending pressures will rise. The central government has therefore presented a draft budget that curbs spending growth, including on defence and some subsidies. Fiscal policy could be more supportive of structural reform, raising the growth potential, by cutting remaining unproductive spending and further removing distortions in the tax structure. Conversely, structural reform can contribute to improving sustainability of government finances by making it easier to eliminate spending aimed at offsetting adverse consequences of inappropriate policy settings (see below). Medium term spending priorities need to be more stringently determined and tied to structural reform priorities. On the revenue side, the recent decision to fully allocate pollution permits to firms participating in the EU greenhouse gas emission permit scheme for free until 2012 foregoes the opportunity to reduce the national debt without recourse to distorting taxation and risks undermining incentives to reduce emissions that result from the trading scheme. The government should auction greenhouse gas emission permits after 2012. It should therefore support the elimination of the cap of 10% on the share of permits that can be auctioned according to EU rules. Also size thresholds in the taxation of business profits provide disincentives for successful businesses to grow. Differences in corporate tax rates according to firm size should therefore be phased out.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Spain 2008 is available from:
For further information please contact the Spain Desk at the OECD Economics Department at email@example.com. The OECD Secretariat's report was prepared by Andrès Fuentes and Eduardo Camero under the supervision of Peter Jarrett. Research assistance was provided by Sylvie Foucher-Hantala.