Stepping up the pace of reform is crucial to securing sustained growth and job creation - SpainWatch Report by BBVA Research
“The medium-term prospects for the Spanish economy are better than they seemed a couple of months ago. However, the breathing space in markets is conditional upon there being no relaxation when it comes to ploughing ahead with the reform process, crucial to sustained growth and job creation.”
- (1888PressRelease) August 17, 2010 - The report highlights that the Spanish banking sector stress tests, which were stricter and more transparent than elsewhere in Europe, show just how solid the country’s financial system is.
The SpainWatch report on the third quarter published by BBVA Research suggests that European fiscal consolidation must reduce the structural component of the deficit, which has reached significant proportions in all countries. On the plus side, it emphasises that the adjustment underway is swift and aimed at reducing spending, boosting confidence in the private sector, thereby partly offsetting the negative impact on growth stemming from the reduction in public demand.
Accordingly, if fiscal consolidation is thorough, “the repercussions on European economic activity will be more limited and transitory than if the fiscal adjustment were hesitant or less strict.”
The notable increase in financial stress in the second quarter is starting to ease as unwinding begins of the vicious circle formed by financial risks deriving from the sovereign debt woes, which ended up pushing market risk upwards and absorbing liquidity, especially in Europe.
In this connection, the SpainWatch report states that publication of the results of the solvency tests (stress tests) in the euro zone financial system had the positive effect of easing stress, although there has been a clear differentiation between the various countries.
“In particular”, the report states, “these tests may act as a powerful boost to dispel the uncertainty regarding the Spanish financial system, since they were conducted thoroughly and their results were both highly informative and credible.” There is no doubt that the risks for Europe and for the global economy from the financial markets are still the main cause for concern.
Improvement in the risk premium
Against this backdrop, according to BBVA Research, the Spanish economy grew again in the second quarter, albeit sluggishly (around two tenths of a point), slightly faster than in the first quarter of 2010.
“Considerable doubts linger regarding the sustainability of the recent economic recovery, coupled with the contractive effects of the austerity plan and the impact on consumer and investment decisions stemming from the greater uncertainty in capital markets, and a transitory and limited relapse of the economy in the third quarter cannot therefore be ruled out.” For now, based on the information available for July, the third quarter began with weak growth again, of around one tenth of a point.
At all events, the report states that in all likelihood from now on confidence will increase and risk perception will fall. In fact, the fundamentals of the Spanish economy justify lower risk premiums that those observed when the report was completed.
Specifically, the private sector is well on the way to correcting imbalances: savings rates remain high and there have been corrections in investment in sectors with surplus capacity. This has brought financing needs down, which is not the case in other countries that had similar imbalances at the start of the crisis.
Furthermore, “The fiscal consolidation process underway contains most of the ingredients for success since it hinges largely on reducing spending; tax hikes have so far focused on indirect taxes; the reduction of the structural deficit comes during the first few years of the adjustment; and the Spanish economy benefits from the credibility it has gained by strictly adhering to fiscal targets in the past.”
In any case, the report adds that Public Administrations must be prepared to take any additional measures necessary to correct deviations in the public deficit with respect to the targets set, and to ensure that these measures and those already included in the budget for 2011 do not undermine business and household confidence, by minimising their impact on future growth prospects. The adjustments should come more on the current spending side than by sacrificing public investment in infrastructure, education or research, development and innovation.
A more efficient fiscal system
Furthermore, any discussion of potential tax increases must be seen as an opportunity to promote an efficient fiscal system. In particular, it is necessary to take into account the differences between marginal rates in Spain and those of neighbouring countries, which distorts decision-making concerning employment and investment among households and businesses.
In Spain, indirect taxaion is still among the lowest in the EU, despite the recent VAT hike. According to the report, “Spanish society must be aware of the differences and similarities with other European countries, so that the fiscal structure may move towards a system that will reduce the burden on household income and corporate profits, placing more emphasis on indirect taxation.”
Lastly, for BBVA Research, neither is it advisable to significantly increase current marginal rates on income from employment in order to achieve more progressive scaling, since Spain’s tax system is already progressive enough compared to the rest of Europe.
In the last few months, accelerated structural reform has come on the heels of the adjustment processes being implemented by private players and the public sector. In particular, the main achievements have been labour market reform and the new Savings Banks Act, coupled with the financial sector restructuring process and publication of the aforementioned stress test results.
Explaining the labour reform
As for labour reform, SpainWatch highlights that, when it is put to Parliament, solutions must be found to reduce the duality in the labour market and to achieve a legal framework that affords greater certainty to both businesses and workers. “While Royal Decree Law 10/2010 is a significant improvement on the previous legislation, it might not be enough to solve the problems plaguing the Spanish labour market”, says the report.
“If economic agents do not perceive that the reform completely dispels uncertainty regarding the grounds for objective dismissal or salary opt-out conditions, then it will not have the desired effect on job creation and the reduction of temporality.”
Accordingly, for the reform to be as efficient as possible it must be known in detail by all stakeholders in the labour market. This means clearly and simply telling citizens, and in particular the entire business community, about the advantages and scope of the changes introduced under the new law once it has been approved by Parliament.
With regard to the new Savings Banks Act, although the solvency tests should dispel most of the uncertainty concerning the Spanish financial sector, the economic scenario going forward remains uncertain. While the capital market is gradually opening up, government support via the FROB (bank recapitalisation fund) is pivotal for the institutions that need to raise capital. The recent changes to the Savings Banks Act came in timely fashion, opening up new channels to raise private capital and, in exceptional circumstances, enabling the FROB to bail out individual entities with clear recapitalisation needs.
All of this helps the financial sector restructuring process, which will have to plough ahead to ensure that institutions operating in the Spanish market are profitable in the long term, and to guarantee the existence of an even playing field in which they can compete on an equal footing.
Ploughing ahead with the reforms
The SpainWatch report concludes that “all of the above means that the medium-term prospects for the Spanish economy are better than they were a couple of months ago. With the measures in place and the many others that must be implemented in the short term, financial stress should ease in the next few months and the economy should return to sustained growth able to generate employment from 2011 onwards.”
“However”, the report adds, ”the breathing space in markets is conditional upon there being no relaxation when it comes to ploughing ahead with the reform process.” There are still some pivotal objectives pending. For example, the energy deficit is still a huge burden on the Spanish economy’s external financing needs. The credibility of public accounts in the medium term must be consolidated through measures to ensure the sustainability of the pensions system. More importantly still, labour-intensive sectors like the services sector must be boosted through greater liberalisation.
“Only by stepping up the pace of structural reform will the Spanish economy be ensured a swifter recovery towards higher growth”, according to BBVA Research. http://www.bbvaresearch.com/
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