Mission Concluding Statement 

Spain has made the most of the historic opportunity presented by euro-area membership. Decisive management of macroeconomic policies over recent years, together with structural reforms and wage moderation, have contributed to an unprecedented combination of strong output and employment growth with price stability. Unemployment stands at its lowest level in decades, and Spanish firms are at the forefront of global markets. These successes have won broad recognition for the efforts of the authorities, and for the contributions of all elements of Spanish society.

The policy challenge now is to sustain and broaden the ongoing expansion to allow for continued growth in real incomes and employment, to successfully address regional economic concerns, and to lay the groundwork for dealing with the medium- and long-term pressures that will result from population aging. This will require further skillful management of macroeconomic policy and a continuing commitment to structural reforms.

Prospects and Policies for 2000-01

The moderation of domestic demand growth that occurred over the course of 1999 is likely to continue this year. However, the ongoing recovery in Spain's main trading partners in Europe, combined with the depreciated state of the euro, has already led to strong growth in exports: this will likely result in GDP growth of at least 4 percent this year, and of no less than 3½ percent in 2001. With organized labor reaffirming its commitment to wage moderation and maintaining the social dialogue, employment should continue to grow strongly, and the rate of unemployment should drop to around 14 percent by end-year and around 13 percent by end-2001. Monetary conditions are likely to remain easy--from a purely Spanish perspective--in the near term.

Consumer price inflation has accelerated in recent months, and in June stood at 3.4 percent, well in excess of the official projection for end-year. It is likely to decline over the remainder of the year, but to exceed 2½ percent as an annual average. Inflation should moderate further in 2001. Combined with the relatively rapid growth of credit and asset prices in recent years and the emergence last year of a current account deficit of about 2 percent of GDP, the present rate of inflation--above the euro area average--has raised concerns about possible overheating in the economy, although conclusive evidence of this has not yet emerged. Much of the recent increase in headline inflation reflects developments in oil prices: underlying and services price inflation, while relatively high, have been stable. Some of Spain's inflation differential relative to the euro area average may also be related to the convergence process. Nevertheless, in the context of euro area membership the risks are clear. To the extent that the inflation differential arises from excess demand pressures it could result in a gradual loss of competitiveness in the medium term, posing a threat to continued growth of output and employment. Moreover, this could well occur in the setting of an appreciation of the euro.

Given these risks, further progress on structural reforms to increase the supply elasticity of the economy is essential. In addition, fiscal policy should seize on the strong economic environment to complete a medium-term objective of reaching structural fiscal balance (that is, a zero deficit after adjusting for effects arising from the economic cycle). While the achievement of structural balance would be desirable in its own right, it would also contribute to moderating any price pressures resulting from excess domestic demand, and would signal the government's continuing commitment to price stability.

In this setting, the authorities are to be commended for their recent decision to modify the deficit target for this year to 0.4 percent of GDP and to accelerate the schedule for fiscal adjustment relative to their Stability Program. Indeed, with continued strong control of expenditure, and if revenues remain buoyant, it should be possible to achieve structural balance next year. With output expected to be above its long-run (or "potential") level, this would imply a nominal budgetary surplus of at least ¼ percent of GDP in 2001, slightly in excess of the official target. Should inflationary pressures escalate, the authorities need to stand ready to tighten fiscal policy further.

Fiscal Policy in a Medium- and Long-term Perspective

The achievement of structural balance will usher in a new period for fiscal policy, bringing both opportunities and challenges. The first issue, confronting all advanced economies, is to deal with future pressures on expenditure resulting from population aging. Measures implemented under the Pacto de Toledo have allowed the social security system to run an operating surplus, but significant doubts have been raised in many quarters about their sufficiency to ensure the long term sustainability of the pension system. While long term projections are inevitably subject to uncertainty, most analysts agree that because of Spain's relatively favorable current demographic structure the shock to the public finances arising from population aging (which will affect both pensions and health care) will arrive here somewhat later than in other European countries, but that--when it does arrive--the impact of the shock may be substantial. Thus, rather than a cause for complacency, Spain's favorable short-term demographics provide an opportunity to introduce early reforms that will have a less disruptive impact on participants than the more dramatic measures that could be required if action were deferred.

These longer-run pressures on public spending should be met by a combination of fiscal and structural policies. From a budgetary perspective, the best course of action would be to allow the social security system to continue to accumulate a surplus over the medium term, while fiscal policy concentrates on achieving and maintaining structural balance in the accounts of the remainder of the public sector. This surplus would represent a downpayment on future expenditures to which the public sector is already committed, and must therefore be protected. This means that any future tax reform that reduced revenues would need to be accompanied by offsetting measures to permanently reduce expenditure. Measures to reduce outlays on pharmaceuticals, to control spending on transfers, and to increase private sector participation in infrastructure investment could be introduced. The identification and implementation of steps to control expenditure would be facilitated by the development of a multiyear budgeting framework, to ensure that spending cuts are evaluated strategically and do not fall on investment.

It will also be important to ensure a closer link between pension benefits and contributions. More specifically, possible reform measures include a further lengthening of the reference period for calculating the pensionable base; steps to discourage early retirement and to encourage workers to remain in the labor force after reaching age 65; and an increase in the role of private, complementary pension plans. These would be desirable reforms to raise participation and reduce distortions even in the absence of sustainability concerns. No measures should be taken that would increase incentives or widen eligibility for early retirement under the public system. Ongoing discussions on the renovation of the Pacto de Toledo will be of great importance in appraising and addressing these issues.

Similarly, population aging and rising incomes, as well as the development of increasingly sophisticated and expensive technologies, will put growing pressure on health care expenditure in coming years. Recent reforms have helped slow the growth of health care spending, but additional measures are likely to prove necessary -- particularly for pharmaceuticals, which absorb a disproportionate share of health care expenditure in Spain. It will be essential to ensure that the continued devolution of health care spending to regional governments is accompanied by firm expenditure control.

At least as pressing is a second challenge: to reach agreement on a thorough reform of financing relations among state, community and municipal governments. Devolution of expenditure from the state to lower levels of government holds the promise of increasing efficiency by allowing spending to be tailored more precisely toward local needs. Moreover, the regional and local governments have played a significant role in deficit reduction, and are committed to achieving balance in their own fiscal accounts next year. However, now that the transfer of expenditure responsibilities is nearly complete, it is time to reach consensus on a new financing framework that is more transparent, features hard budget constraints, and encourages all levels of government to make more efficient use of the resources available to them. Reforms could include widening the revenue bases available to regional and local governments, to reduce their variability from year to year and to eliminate the reliance of local authorities on revenues arising from a relatively small number of sources, such as property, which has introduced serious unintended and unfortunate distortions. Reforms should also ensure transparency over the scope and financing needs of public enterprises owned by community and municipal governments (whose growth, however, has slowed recently).

Any reform will need to balance the potentially competing goals of giving regional and local governments greater responsibility for generating their own revenues against elements of solidarity that will ensure that all governments have the financial wherewithal to provide an effective level of services. And, with the increasing decentralization it will be necessary to develop mechanisms to prevent the burden of any future discretionary fiscal tightening from falling disproportionately on the expenditure of any one level of government.

Product Market Reforms

The package of measures introduced last month sends a strong signal of continuing commitment to reform. In time, the reforms should result in increased competition in key sectors of the economy such as telecommunications, energy, and retail sales, as well as encourage investment in new technologies among small and medium-sized firms. This, in turn, should stimulate growth in output and employment in other sectors. Measures to increase savings and encourage competition among pharmacies are also welcome.

In much of Spain, one confronts the paradox of housing shortages and high rents coexisting with large tracts of undeveloped property. This results in part from problems in the land and housing markets, and--by reducing labor mobility--contributes significantly to regional disparities in unemployment rates. Reforms introduced as part of the June package of structural measures will help, but, as noted above, a more permanent solution needs to emerge from the upcoming reform of local government finances. In addition, rules regarding contracts for rental housing should be revised to relax the requirement that they be renewable for five years at the discretion of the renter, to improve the supply of rental housing.

Existing regulatory mechanisms have served Spain well, but the financial and human resources of the Tribunal de Competencia could be strengthened. In due course, a broad review of the powers of regulatory bodies would also be appropriate. Further reforms will be needed in the commercial sector to more fully liberalize opening hours and calendars and to remove remaining restrictions on price competition at the retail level, as well as in key sectors such as electricity.

Labor Market Reforms

The labor market reforms of 1994 and 1997 have clearly been steps in the right direction, and further reforms should seek to consolidate and build on these gains while continuing to emerge from a cooperative process among unions, employers and the government. The number of permanent contracts has increased steadily in the period since the 1997 reform, although the number of temporary contracts has grown as well, meaning that the share of temporary contracts has declined only modestly. Nevertheless, the reform demonstrates that reducing dismissal costs is a key to generating growth of permanent contracts. Programs to subsidize employer social security contributions for certain classes of workers hired on permanent contracts may also have contributed to stimulating the growth of permanent employment. However, the existence of various subsidy schemes for different categories of workers reduces the transparency of efforts to stimulate employment, and the authorities should consider replacing the present variety of subsidy schemes with a single program targeted at the same groups. They should also seek to enhance the coordination of these subsidies with those offered by community and municipal governments. In addition, tripartite negotiations on new reforms should avoid any tendency to introduce additional subsidies.

To some extent, temporary employment--which is high in Spain compared to other European countries--may be substituting for part time employment, which is relatively less common in Spain. Previous efforts to stimulate part time employment through the creation of a new, permanent contract were appropriate, but need to be strengthened considerably: unions, employers and the government should work together to develop revisions to the contract that would satisfy all parties. In many countries, part time employment has been an important vehicle for stimulating female labor supply, particularly for women with family responsibilities, and this could be the case in Spain as well. Proposed reforms to address social security contributions for women returning from maternity leave are also welcome in this regard, but should be introduced in a cost-effective manner.

Regional disparities in unemployment rates remain a troubling feature of the labor market. Clearly, this is a complex problem that reflects a variety of factors--including impediments to mobility; mismatches between the skills needed and offered; insufficient wage variation; and, in some areas, shortages of critical infrastructure. A successful resolution will require action by employers, unions and all levels of government. Despite the fact that two-thirds of workers covered by collective bargaining agreements are employed under contracts negotiated at the provincial, community, or firm level, this does not appear to have resulted in sufficient wage variation to bring local labor markets closer to balance, and additional measures to make wage bargaining more responsive to local labor market conditions are needed. As noted above, reforms to land and rental housing markets can redress some of the barriers to labor mobility. Mobility is also hindered by a lack of mechanisms to enable regions to share information about existing job vacancies. Just as information about product markets has been dramatically enhanced by new technologies, so information in labor markets needs a similar breakthrough. The better the information that unemployed individuals have about job vacancies in other regions, the more likely they will be to find satisfactory employment.

The 2000 budget contains an increase in spending on active labor market policies to provide better training to unemployed workers, which is also welcome. To be most effective, this should be targeted to provide skills most in demand in labor markets. The authorities' intention to increase infrastructure investment can also contribute to a reduction in regional unemployment rates, provided it is allocated as a priority to areas and projects that offer the greatest potential benefits. Creative partnering of public and private investment can help reduce the strain on the public finances, but care is needed not to create contingent liabilities.

Financial Sector Issues

Spanish banks are well-capitalized and profitable, and have taken a leading position in global markets, particularly in Latin America. Nonetheless, throughout the euro area the advent of the common currency will pose new opportunities and challenges for market participants and regulators alike. Similarly, the rise of new technologies like the internet creates the promise of important new developments in the financial system but brings with it potential risks. The establishment of the Nuevo Mercado will contribute to the vitality of the economy by providing access to capital markets for firms that have strong growth potential, and the creation of the Latibex is further evidence of the potentially very profitable niche that Spain has created as a bridge for capital flows between Europe and Latin America. Existing regulatory mechanisms, which involve the Bank of Spain, the Comisión Nacional de Mercado de Valores and the Dirección General de Seguros, are functioning well, although of course regulators will need to continue to respond flexibly to new demands as markets evolve. For example, as the share of pensions in household savings rises in the future it will likely prove necessary at some point to dedicate additional resources to their supervision. In banking supervision, the recent move by the Bank of Spain to increase provisioning requirements is path-breaking and well-timed: it will prepare now for the inevitable day when nonperforming loans rise in response to an eventual economic slowdown.

The economic transformation of Spain in recent years has been striking. Equally striking is that it has occurred without social upheaval--testimony to the commitment of the authorities, unions and employers to work cooperatively to allow the economy to achieve its potential. Continued cooperation in meeting current and future challenges is essential, not least because many of them are closely related. For example, the reform of local government finances will have implications not just for regional and municipal budgets but also for housing markets, labor mobility, employment, and thus the health of the social security system. Similarly, reforms to labor and product markets will have positive repercussions throughout the economy. The challenges are not minor, and the main risk ahead may be a lapse into complacency following the achievements of recent years. Instead, Spain should seize the current opportunity to continue the reform process with an eye first and foremost toward ensuring further steep reductions in unemployment from its still strikingly high level of 15 percent and achieving a broader distribution of the benefits of economic growth. A deepening of reforms would also engender a more rapid convergence of incomes to the levels of other European Union countries, much greater resilience in the face of shocks to the economy, and a more secure economic future for coming generations.