Staff Concluding Statement of the 2022 Article IV Mission

Spain: Staff Concluding Statement of the 2022 Article IV Mission

November 23, 2022

Washington, DC:

Economic Outlook

The Spanish economy continues to recover from the COVID pandemic, but
it is facing new headwinds from Russia’s invasion of Ukraine.

The unprecedented public support measures in 2020–22 have helped protect
firms and households. The labor market recovery in 2022 has been robust,
with employment exceeding its pre-pandemic level. Tourism and other
services have performed especially strongly. However, the sharp rise in
global energy and food prices, the slowdown of activity in Spain’s trading
partners, the deterioration of consumer and business confidence, and
tighter financial conditions have slowed the recovery of output.

The high inflation over the past year has been largely caused by
surging energy prices and persistent supply constraints.

Headline inflation has declined from double-digit levels in the summer to
7.3 percent in October, largely reflecting the drop in European gas prices
and the impact of the Iberian mechanism. Core inflation – a measure of
price changes excluding energy and unprocessed food prices – remains
elevated at around 6 percent, driven by a gradual passthrough of higher
energy costs to broader prices and, possibly, diminishing spare capacity in
the economy. So far, there have been no signs of a wage-price spiral as
wage growth has been contained, but the share of workers affected by wage
agreements with indexation clauses has ticked up. The increase in the price
of imported energy is a negative terms-of-trade shock for the Spanish
economy. The loss of purchasing power due to this shock cannot be avoided
and will have to be absorbed through temporarily lower real incomes of
households and firms. A broad agreement to share income losses across
society (pacto de rentas) could reduce the risk of inflation
persistence.

Economic growth is projected to reach 4.6 percent in 2022 and 1.2
percent in 2023.

Growth is expected to be relatively weak in the coming quarters reflecting
weak external demand and the deterioration of consumer confidence. Activity
should pick up in the course of 2023, supported by further easing of supply
constraints, continued recovery in contact-intensive services and the
acceleration of Next Generation EU (NGEU) investment spending. Output is
projected to reach its pre-pandemic level by early 2024. Headline inflation
is expected to moderate gradually in 2023 reflecting a high base in 2022,
the reduction of supply bottlenecks, and some normalization of global
fossil fuel prices. Nevertheless, both headline and core inflation are
likely to remain above the 2-percent target until 2024.

Uncertainty around the outlook is high and risks are mostly to the
downside.

Risks to energy security are relatively low given Spain’s limited
dependence on Russian gas and well-developed liquified natural gas
infrastructure. The main downside risk is a possible further increase in
energy prices caused by either continued disruptions in supply or
insufficient adjustment in demand in the European energy market. Other
risks include a more abrupt slowdown of the global economy or a sharper
tightening of financial conditions, for instance due to a
larger-than-anticipated increase in monetary policy rates in response to
more persistent inflation in the euro area. On the upside, a faster
unwinding of households’ accumulated excess savings could boost private
consumption.

Energy Policies

The prompt rollout of public support has mitigated the impact from the
steep rise in energy prices, although greater targeting of the measures
would be desirable.

Several measures, including the expansion of the electric and thermal
social bonds, the increase in the minimum vital income, and the sectoral
direct aid for firms, have been appropriately targeted to the most
vulnerable at a relatively low fiscal cost. Spain has also put in place an
innovative cash-transfer program to provide support to lower-income
households not covered by the minimum vital income. Nonetheless, similar to
other European countries, most of the fiscal support has gone to measures
that are untargeted and distort price signals, such as electricity tax
reductions and fuel rebates. The latter have been fiscally costly, with
benefits accruing disproportionately to higher-income households. The
Iberian mechanism lowers electricity prices and therefore somewhat reduces
incentives to adjust demand, but unlike most other measures that affect
prices, it does not impose a fiscal cost.

With gas prices likely to remain well above pre-crisis levels for some
time, support policies should adapt to provide the right incentives to
reduce demand and increase supply, while containing fiscal costs.

Direct transfers, for example in the form of lump-sum vouchers (ideally
linked to income or household size), would be preferable to measures that
reduce prices. Other possible measures that preserve price signals to a
large extent include block tariffs (which increase with the amount of
energy used) and/or further expanding social tariffs (discounts for
vulnerable households, such as the Spanish bono social). These
measures can be made more progressive by recouping the support from
higher-income households through the tax system. Keeping the corporate
support measures targeted is appropriate. Over the medium term, continued
progress to overcome fossil fuel dependency and to increase energy
efficiency would be needed to ensure energy security and bring energy
prices down in a sustainable way.

Fiscal Policies

Public finances continued to improve in 2022, but public debt remains
high and sustained consolidation effort would be needed to rebuild
buffers.

The government’s response to the pandemic was very effective but also
costly: public debt was 118 percent of GDP at the end of 2021. The expected
reduction in the fiscal deficit in 2022 is driven by strong revenues and
the withdrawal of Covid measures, which more than offsets the cost of the
energy measures. Revenue performance has been supported by the recovery in
activity, high inflation, a buoyant labor market, and a relatively high
elasticity of revenue to output. The latter could be temporary in nature,
and it is prudent to assume that it would come down over time, at least
partially. The impact of inflation on several expenditure items, such as
pension payments, will not materialize until next year. Moreover, the need
for support to mitigate the impact of high energy prices would likely
extend into 2023. In addition, the sustained rise in interest rates will
increase the share of resources devoted to debt payments over time,
narrowing the fiscal space. Over the longer term, rising spending on
age-related programs due to demographic changes would put further strain on
public finances. For all these reasons, it is important to implement a
steady multi-year fiscal consolidation that would create space to respond
to negative shocks in the future.

Starting discretionary fiscal consolidation in 2023 will help boost
investors’ confidence and contain inflationary pressures.

In the context of diminishing spare capacity in the economy and rising
financing costs, a moderate reduction in next year’s primary structural
fiscal deficit—by one quarter to one half percentage point of GDP—is
recommended to help ease price pressures and reinforce commitment to fiscal
discipline. The increased use of NGEU funds, which is deficit-neutral,
could offset the negative impact of consolidation on growth. The draft
budgetary plan envisages a reduction of the structural deficit by 0.3
percentage points. This pace of consolidation is broadly appropriate,
although there are implementation risks since it relies in part on
continued strength in revenues and on lower spending on energy support in
2023. The full extent of energy measures in 2023 is yet to be defined:
moving away from broad to more targeted measures could indeed provide
savings relative to the current year. Increasing the consolidation effort
to at least 0.6 percentage points per year starting in 2024 would set debt
on a firm downward path and help achieve a close-to-balanced structural
fiscal position (consistent with Spain’s national fiscal framework) by the
end of the decade. The consolidation effort will ultimately be guided by
the reformed EU fiscal framework once it is implemented.

With energy prices expected to remain high next year, raising
additional temporary revenues to fund support for the most vulnerable
is welcome, but monitoring of the impact of the measures is warranted.

The budget proposes raising taxes temporarily for corporations and
high-income households that have been less affected by the energy crisis,
to fund support for the most vulnerable, which is appropriate. The new
levies for the energy and banking sectors are applied on revenues instead
of profits, and therefore do not take costs into account. While bank net
interest income is expected to increase in the near term in tandem with
higher rates, tighter financial conditions and a weaker macroeconomic
outlook could have a material impact on costs via an increase in impaired
assets in stress scenarios. It will be important to monitor the impact of
the levies on credit availability, credit costs, and banks’ resilience, as
well as on the incentives of energy companies to invest. Finally, these
measures should remain temporary and should not be considered substitutes
for the necessary medium-term tax reform (see below).

An early formulation of credible medium-term fiscal plans could help
build the necessary social consensus and support investor confidence.

Over the medium term, fiscal consolidation should rely on mobilizing
additional revenues and enhancing spending efficiency. A revenue reform
could broaden tax bases and strengthen environmental taxes, in line with
the recommendations of the expert review of Spain’s tax system released
earlier this year. Measures that may have a disproportional effect on the
low-income population should be accompanied by targeted spending to protect
the most vulnerable. To ensure steady progress towards emission reduction
goals, carbon pricing can be strengthened in the future, when global fossil
fuel prices decline. Spending efficiency improvements should be guided by
the spending reviews done by the fiscal responsibility authority (AIREF).

Additional measures will be needed to offset the increase in future
spending resulting from the 2021 pension reform.

The reform permanently indexed pension payments to CPI inflation and
repealed the sustainability factor, which is expected to raise annual
pension outlays by more than 3¼ percent of GDP by 2050 compared to a full
implementation of the previous legislation. Only part of the increase would
be offset by other measures adopted in the first phase of the reform. Spain
has introduced new measures in 2022, including the reform of the
contribution system for the self-employed, and has committed to additional
reforms by the end of 2022, including extending the computation period for
the calculation of the retirement pension and raising maximum earnings
subject to contributions. These measures could have a positive financial
effect, but whether they are sufficient to preserve the sustainability of
the pension system will depend on the specific design details.

Financial Policies

The financial sector has weathered well the pandemic and the fallout
from the war in Ukraine so far.

Private sector balance sheets have continued to strengthen, in line with
the recovery in economic activity. Aggregate borrower stress indicators
have remained low in 2022 so far, including for publicly-guaranteed
pandemic loans. However, credit risks have increased for firms that have
been affected by the energy crisis and for lower-income households, which
have accumulated less savings and have been more affected (in proportion of
their income) by the increase in energy and food prices. House prices have
accelerated over the last year, but there is no evidence of a significant
misalignment with fundamentals so far. While activation of sectoral
macroprudential tools is not necessary at the moment, rising housing prices
warrant close vigilance.

The worsening of the macroeconomic outlook and the tightening in
financial conditions will likely erode borrowers’ repayment capacity
going forward.

Spanish borrowers are highly exposed to rising interest rates, given the
high share of variable-rate mortgages (about 75 percent of all mortgages).
Higher interest rates are also set to increase firms’ financial burden,
with a more severe impact for small- and medium-sized enterprises (SMEs).
As mitigating factors, most new mortgages in recent years have been
extended at a fixed rate, the majority of publicly-guaranteed pandemic
loans also have a fixed rate, lending standards have strengthened since the
great financial crisis, and households and corporates have deleveraged
significantly. Mortgage relief measures, currently under discussion, should
be targeted to the most vulnerable households.

Stress testing exercises suggest that bank capital buffers remain
broadly adequate, but close monitoring is needed to ensure continued
resilience.

Banks frontloaded provisioning during the pandemic, in anticipation of
higher expected losses. While losses have not materialized, the economy is
now facing new headwinds. In a context of high uncertainty, supervisors
should continue making sure that bank loss recognition is sufficiently
forward-looking and that provisioning levels are appropriate. Banks will
need to continue taking into account the new macroeconomic context in their
capital planning and use the positive near-term impact of interest rates on
profitability to further strengthen resilience if needed. If risk scenarios
materialize, banks should be encouraged to use capital buffers and be
allowed to restore them only gradually. The recent reform to the private
debt resolution framework in Spain is comprehensive, incorporating new
tools to help resolve financial distress in order to address the unique
needs of microenterprises and to align the framework with the European
Directive. Strong implementation will be critical, including ensuring
sufficient resources for the judicial system.

Structural Policies