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Analysis

Linde: Spanish outlook ‘strong’

by Ben Robinson, OMFIF Economist

Linde: Spanish outlook ‘strong’

Spain is on target to achieve its expected growth rate of 2.8% this year, according to Luis Maria Linde, governor of the Banco de España, speaking at an OMFIF City Lecture on 9 February.

While this is partly due to ‘temporary tailwinds’ including low oil prices and a weak euro, Spain’s growth – the strongest out of any large euro area country – is mainly a result of structural reforms and fiscal readjustments.

Above all, increased budget discipline and reforms to the labour market and public pensions have strengthened government finances and reduced unemployment by around 5.4 percentage points from its 2013 peak. Increased exports and deleveraging of corporate and household debt – debtto-GDP ratios are down by 30% and 16%, respectively, since 2010 – have resulted in a current account surplus of around 1% of GDP (Chart 1).

Spain -current -account -balance -USE

The primary budget balance has moved from a deficit of 5.2% of GDP in 2010 to a 0.6% surplus in 2015. The general government budget deficit fell to 4.8% in 2015 from 11.1% in 2009, though it remains above the 3% target set by the European Commission (Chart 2).

Spain -budget -position -USE

Labour market reforms which have made hiring and firing workers easier and
which increase flexibility in labour and pay negotiations mean firms no longer ‘adjust to economic slowdown by dismissing workers or closing down’. These reforms were credited with increasing Spanish competitiveness, with the harmonised price index standing at around minus 0.4% in January against a euro area average of plus 0.4%.

A restructuring of Spain’s banking sector has reduced the extent of non-performing loans on balance sheets to 11.2% (Chart 3). While still high by historical standards, they are on a downward trend, having fallen 18.8% year-on-year to August (latest available data). The composition of NPLs has shifted, as economic growth in Spain led to a decrease in domestic NPLs of 19.6% year-on-year to June.

Spain -NPL---3-USE (1)

Meanwhile bank solvency levels are above regulatory minimums, with common equity tier 1 capital standing at 12.4% and the overall capital ratio at 14.3% in June 2015, further strengthening the banking system.

Euro optimism at a low ebb

Despite these promising signs, optimism in the euro area remains at a low ebb, notwithstanding 11 quarters of growth and a boost from low oil prices.

There are concerns that low interest rates, low inflation and further quantitative easing are limiting confidence in the underlying strength of the euro area economy.

Some participants suggested that it is increasingly difficult to separate successful national policies from the stimulus effects of European Central Bank monetary policy. This challenges the ability of investors and businesses to make long-term decisions. There is a general belief that QE
has artificially lowered borrowing rates and increased moral hazard. This has distorted asset prices, led to diminishing returns and resulted in a misallocation of financial resources.

More worrying for some observers is the effect of these measures on the risk premia of sovereign debt on banks’ balance sheets.

These are generally seen as being too low, requiring reclassification to a higher level of the sovereign debt of peripheral European countries.

Low interest rates have reduced bank profitability in the euro area, creating further difficulties. The loan-deposit gap is at a historically narrow level.

Several participants at the meeting expressed concern over the prospect of a further reduction in interest rates at the 10 March ECB monetary policy meeting, where there has been speculation of a further cut in the ECB’s deposit rate from minus 0.3% to minus 0.4%.

Large-scale banking reforms

One potential solution to low bank profitability and low banking activity levels is to conduct large-scale banking reforms to address foreclosure and bankruptcy laws, expand the role of bad banks and allow room for cross-border consolidation.

However there is some doubt about the political appetite in Spain for such a restructuring, especially in view of the political limbo since the 20 December elections.

An alternative is to open up the consumer banking market to cross-border competition, part of attempts at increasing competitiveness through banking union. Such proposals would require an increase in European financial and political integration, which faces significant public opposition.

On 8 February the presidents of the German and French central banks stated that the only two viable alternatives facing the euro area were closer integration – including a common euro area treasury – or a decentralised approach to decision-making, which might imply a reassessment of the risk premia paid by different sovereigns.

Closer economic integration is an unlikely development in the near term. Meanwhile the prospect of increasing risk premia – which participants at the meeting emphasised are set by the markets and not by the ECB – was generally agreed to have severe implications for financial stability. Participants suggested that the move towards integration would be via ‘small steps’, rather than a ‘single leap’.

Further structural changes

Other potential structural changes in Europe include the apparent willingness of Germany to agree to the UK’s demand that the EU be considered a ‘multicurrency bloc’.

Participants were unsure of the implications of such a proposal, and whether it would require a change in the framework of the EU.

Some suggested that it would require abandoning the ‘guiding philosophy’ of the EU since its inception, which has always been about economic integration and the single currency. It may also make coordination between European states impossible, given that each country would gain greater control over domestic financial regulations in a multicurrency bloc, leading to intra-European regulatory differences. 

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