Spain’s economy has been performing very well but the pace of the reforms needs to be accelerated to foster continuing convergence
For a decade now, Spain’s performance has been remarkable. Growth has been robust, allowing real convergence at a fairly brisk pace, with the standard of living differential with the euro area average shrinking from 20% to less than 13% between 1995 and 2003. Fiscal consolidation, the fall in interest rates due to the introduction of the single currency, structural reforms pursued since the mid 1990s and a surge in immigration have created a virtuous circle of rapidly rising activity sustained by strong job creation. But where there is much light, there is also shadow: unemployment is still widespread; productivity gains have remained meagre; inflation is relatively high, eroding international competitiveness; and the surge in house prices is a cause for concern. Against this background, it will be important to tackle the impediments to the continued dynamism of the Spanish economy by accelerating the pace of structural reform. Preserving conditions that will ensure that convergence continues at a rapid pace should involve:
Maintaining macroeconomic stability and competitiveness. The inflation differential with the euro area has to be reduced. Actions should include improving the collective bargaining system and strengthening competition in the sheltered sectors. The real estate sector also needs to cool down. House prices have almost doubled in real terms since 1998, increasing the risk of a fall in the medium term, while the associated rapid increase in household indebtedness also makes domestic demand more vulnerable to higher interest rates. Reforms to housing policy should play a vital role.
Boosting productivity gains. Stronger productivity gains are needed to raise the pace of convergence. Spain is lagging in human capital investment and technological development, while various market distortions may hinder the emergence of activities with higher value added. It is important for Spain to avoid being locked into a specialisation in relatively low-technology sectors where it is likely to face growing competition from countries with lower labour cost.
Keeping public finances sound. To retain the benefits of fiscal consolidation, while providing quality infrastructure and public services, it will be important to improve fiscal management and, especially, relations between the different levels of government in view of the very decentralised institutional framework. In the longer term, one of the main challenges is to guarantee the fiscal sustainability of the pension schemes, which is threatened by population ageing.
In the absence of policy changes, the inflation differential and modest productivity gains will erode the competitiveness of Spanish firms
The factors underpinning strong growth in recent years continued to operate in 2004, but the accompanying strains persisted and this put a damper on the results. Interest rates remained low in real terms, immigration continued at a rapid pace and real wage gains remained moderate. The increase in activity, which has reached 2¾ per cent, continued to depend on solid growth in household spending, underpinned by strong job creation which has reduced unemployment to less than 10½ per cent. These positive developments have, however, been accompanied by productivity gains that are very modest, at just ½ per cent, as well as a surge in property prices and household borrowing. The inflation differential with the euro area of close to 1 percentage point has persisted. The positive growth differential with the euro area, which amounted to 1¼ percentage points on average between 1996 and 2003, narrowed to ¾ of a percentage point in 2004 because of less favourable foreign trade developments, despite the improvement of the international environment. Although the appreciation of the euro, coupled with the rise in relative labour costs, has weakened price competitiveness in recent years, industrial firms have been able to maintain their market share until 2003 either by reducing margins and, more recently, by adjusting the workforce. This situation, which shows up in a widening dichotomy between developments in the exposed and sheltered sectors, seems difficult to maintain over the longer term.
Prudence would argue for a somewhat tighter fiscal stance in the medium term
The policy of balancing the government account in structural terms, which the authorities intend to pursue over the coming years, could result in a slightly expansionary macroeconomic policy stance. For 2005, this poses no problem as the output gap is still slightly negative, while growth will probably be close to potential at 2¾ per cent. Though this projection is a little more pessimistic than that of the authorities, because of a somewhat higher oil price assumption, balancing the budget should be feasible because tax receipts are likely to remain buoyant since the nominal increase in GDP (Gross domestic product) could exceed the official projection. Looking beyond the short term, the persistence of low real interest rates and the property boom should keep domestic demand growing swiftly, but the resulting strains on capacity should be limited by a weakening export performance. While fiscal policy should play some role in ensuring against the risk of excessive domestic demand pressures and be in line with long-term fiscal needs, reducing the inflation gap requires above all structural reforms.
The narrowing of the inflation differential with the euro area requires structural reforms
Narrowing the inflation differential with the euro area, which has amounted to a cumulative 8 percentage points since 1997 and is threatening the robustness of growth, should be a priority. The differential is eroding competitiveness while it stimulates domestic demand by reducing real interest rates. This fosters strong growth of sheltered, often less productive, sectors. The persistence of this differential cannot be ascribed to price convergence that is driven by the catch-up process, a so-called Balassa-Samuelson effect. Demand pressures partly explain the inflation differential, though real wage gains have been moderate, and capacity constraints have been similar to the euro area. Another reason for the persistence of the inflation differential is related to a high degree of nominal price and wage inertia, due to insufficient product market competition in several sectors and to the existing wage bargaining system. Nominal wage increases have remained above the euro area average in a context of low productivity gains and, in several sheltered sectors, where demand pressures are stronger and effective competition is still relatively weak, enterprises are able to pass on relatively rapid labour cost increases into prices.
Improving productivity performance requires reforms in many areas
Improving the sluggish labour productivity performance is key for accelerating the pace of convergence with the leading OECD countries. Labour productivity growth has been dragged down by a composition effect as a large number of low-skilled workers entered the labour market. However, the slowdown is pronounced and suggests that other factors are at work, in particular labour market institutions, which do not provide strong incentives to raise productivity, and problems arising in the education and training system. These have adverse effects on R&D (Research and development) activities and the absorption of new technologies, and have also weighed on equipment investment, resulting in a lower capital-output ratio. In all these areas there is wide scope for improvement and the government’s objective to raise performance in many of these domains is well placed, even though the results of such reforms will no doubt take time to be visible.
Important fiscal challenges need to be addressed
Concerning the public finances, the authorities are confronted with three main challenges.
First, the macroeconomic policy framework needs to ensure not only sound public finances, but also that a pro-cyclical fiscal stance is avoided.
Second, good framework conditions need to ensure that the wide-ranging transfer of spending and tax responsibilities to the regions leads to a sound management of their resources, while balancing costs and benefits at the regional level when providing new services.
Finally, a coherent strategy will need to be implemented to guarantee the long-term sustainability of public finances, with particular attention to the public pension schemes.
The fiscal consequences of ageing provide a strong reason for reducing public debt more quickly ahead of the ageing shock as a complement to a pension reform. This could be achieved by balancing the budgets of central and regional governments over the cycle, while accumulating the surpluses of the pension schemes.
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