Spain is recovering according to IMF

Spain has turned the corner. The recovery started in the second half of 2013 and gained strength in the first quarter of this year, with the economy growing at the fastest pace since 2008. Led by robust exports and a sharp improvement in financial market conditions, confidence has recovered and is feeding into rising private consumption and business investment. Critically, labor market trends are improving. We expect the recovery to continue over the medium term.

This recovery reflects the collective efforts of Spanish society. In particular, decisive policy actions are now beginning to bear fruit:

• Difficult decisions about spending, taxes, and pensions, have strengthened Spain’s budget and pension system, thus helping protect Spain’s welfare state for the future.

• By forcing weak banks to repair their balance sheets, the successfully-completed financial sector program is supporting the recovery by improving lending conditions.

• These budgetary and financial sector measures, together with crucial efforts at the European level, have helped reduce the government’s borrowing costs to record lows, catalyzing the recovery.

• The labor reform and wage moderation are helping turn job destruction to job creation. Compared to a year before, unemployment fell in the first quarter of 2014 and jobs, as measured by social security affiliations, increased by about 200,000 in April.

• These collective efforts have substantially improved the prospects for creating jobs and raising living standards. Without these efforts, the recession might still be continuing and unemployment still rising.

But the Spanish people are still suffering from the legacy of the economic crisis. Most importantly, 5.9 million people are unemployed, more than half of them for more than a year. As a result, average household income remains below pre-crisis levels. Households, firms, and the government still face heavy debt burdens.

Thus all these efforts need to continue to ensure the recovery is strong and long-lasting. The recovery also has to be inclusive so that the unemployed benefit from more job opportunities. We suggest four priorities areas for action.

1. Helping firms expand, hire, and invest

Firms have been under incessant pressure to cut costs, including by cutting jobs. The necessary process of reducing firms’ debt could help growth and job creation if more of it were to come from creditors restructuring the excessive debt of operationally-viable firms. By reducing these firms’ financial stress and allowing them to grow, all parties could gain. International experience suggests that a comprehensive strategy, catalyzed by the official sector but involving all stakeholders, could help “fast-forward” this process without undermining payment culture. For example, banks could agree to a voluntary code of conduct, similar to that for individuals, which would offer operationally-viable, but heavily-indebted, SMEs a menu of standardized restructuring terms. Given the broader public interest in unleashing the growth potential in such firms, the government should also participate, for example, by allowing outstanding tax and social security claims of such firms to be restructured to sustainable levels if other creditors do the same, without undermining tax compliance.

Debt reduction should also be facilitated by further enhancing the insolvency framework building on the recent improvements, with a focus on helping SMEs, including individual entrepreneurs. In this regard, consideration could be given to introducing a personal insolvency framework that would allow insolvent debtors to have a fresh start after having given up their non-exempt assets and a substantial period of good faith efforts to pay the outstanding debt. Experience in other European countries has shown that such a framework can be designed to be in the interests of the financial sector and preserve Spain’s strong payment culture.

Efforts should also continue to bolster banks’ ability to support the economy. While the banking system is now much stronger and safer and lending conditions are starting to ease, credit is still contracting faster than desirable, which hampers the recovery. In large part, this is due to a lack of solvent demand from firms—fostering debt restructuring (as above) would help. But, despite recent progress, a significant part is due to banks raising their capital ratios more by shrinking lending than by raising capital. Thus to support the recovery, banks should continue to raise capital levels over time, including by limiting cash dividends and bonuses, and reducing costs.

2. Lowering regulatory barriers to boost jobs and growth

Lowering regulatory barriers that constrain Spain’s businesses would help them become more efficient and increase employment. Together with continued wage moderation, this would help ensure the recovery translates into more jobs for the unemployed, greater job security for the employed, and lower costs of living. These actions would also further improve competitiveness so that the remarkable improvement in Spain’s external trade continues—critical to make the recovery long-lasting.

This requires many specific actions across a wide range of fronts. In particular, by implementing the Market Unity law, which aims to remove barriers that hinder businesses from being created and from operating throughout Spain’s regions. For example, some 2,700 regulatory barriers have been identified, most at the regional level—all levels of government should ensure these are quickly eliminated. Removing regulatory barriers in professional services is similarly important—an ambitious draft law needs to be submitted to Parliament without further delay and passed without granting special treatment for vested interests.

Further efforts would make Spain’s labor market more dynamic and inclusive. More needs to be done, especially by regional governments, to help the unemployed improve their skills and find work by implementing plans to more widely use private job placement agencies, improving training services by opening them up to competition, and establishing a single portal for job vacancies throughout Spain. Striking a better balance between highly-protected permanent contracts and precarious temporary contracts would increase hiring on permanent contracts, and thus encourage firms to invest more in their workers. Further enhancing the ability of individual firms to adapt remuneration to their specific conditions would better align productivity to wages and help struggling firms stay in business. These changes would help ensure any future downturns result in fewer job losses.

3. Pursuing growth- and job-friendly fiscal consolidation

Spain has made strong progress in cutting its deficit in the last two years in highly challenging conditions. But the deficit is still very large, and debt, already above the Euro area average, is rapidly approaching 100 percent of GDP. Getting debt to trend down is vital to ensure the recovery is long-lasting and will require further efforts to reduce the deficit. These efforts need to be gradual and well-designed to minimize the drag on growth and employment. In particular, the forthcoming tax reform is a critical opportunity to achieve three key goals:

• To protect public services for current and future generations, revenues need to increase. In particular, there is room for increasing indirect revenues. Raising excise duties and environmental levies, and gradually reducing preferential treatments in the VAT, would bring Spain’s collection effort more into line with its European peers. This should be combined with clearly-identified measures to protect the most vulnerable.

• Help create jobs for the low skilled. This could be done by incentivizing firms to hire the low skilled by cutting the social security contributions firms pay when employing them. To protect the social security system, the cost would be covered by government transfers.

• Promote inclusive growth. The base of income taxes should be broadened by reducing exemptions and special treatments. There is scope for gradually cutting corporate income tax rates to promote growth (though not to 20 percent, which is below the EU average). However, given the imperative to sustain revenues and preserve progressivity, there is less scope for significantly cutting top personal income tax rates.

4. More support from Europe

Stronger policies by Spain’s European partners would help the recovery in both the Euro area and Spain. In particular, by lowering the borrowing costs of Spanish firms and households, and by increasing the demand for Spanish exports. IMF staff has recommended more monetary easing by the ECB to achieve the ECB’s price stability objective, and to support demand while reducing financial fragmentation. It has also urged progress toward a more ambitious banking union.

Source: IMF

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