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Spain: Spain Finance Profile 2012






Spain Finance Profile 2012

The necessary adjustment is underway and output has stabilized. Imbalances accumulated during the long boom have begun to unwind, though unemployment has soared. The recovery is likely to be weak and fragile, with significant downside risks.

Challenges :
Spain’s economy needs far-reaching and comprehensive reforms. The challenges are severe : a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, a banking sector with pockets of weakness, and difficult financial market conditions.

Policies and staff views :
Ambitious fiscal consolidation is underway. But it is based on potentially optimistic macroeconomic projections and the achievement of the targets should be made more credible. A bold pension reform, along the lines originally proposed by the government, should be quickly adopted. This needs to be complemented with growth-enhancing structural reforms, especially overhauling the labor market. Consolidation and reform of the banking system needs to be accelerated. Such a comprehensive strategy, especially with broad political and social support, would underpin investor confidence, and time is of the essence.

Authorities’ views :
The recovery is likely to be stronger than staff envisage, boosted by rebounding private consumption and buoyant exports. Fiscal policy is on track to achieve the ambitious targets and any slippage would be promptly met with additional measures. Significant labor market reform is likely in the coming weeks, and pension reform is underway. Savings bank consolidation, which should also be complete in the coming weeks, will substantially reduce banking sector pressures.


1. The deleveraging of the non-financial private sector poses significant risks for the economic outlook. Household and corporate indebtedness reached about 210 % of GDP, significantly higher than the euro area average of 160 % and a two-fold increase since the inception of the EMU. This dynamic was to a large extent driven by excessive housing investment and the associated expansion in the construction and real-estate sectors. An abrupt adjustment has taken place, with households dramatically adjusting their savings and companies sharply reducing their net borrowing. However, the correction of these imbalances to more sustainable levels has further to go and the necessary deleveraging constitutes a source of vulnerability for the macro-economic outlook.


2. Spanish households have become heavily indebted, in particular to finance house purchases. The pace of the increase in indebtedness was one of the fastest in the EU. From a lower than average debt to gross disposable income ratio compared to the euro area at the beginning of the decade (of close to 60 %), Spanish households become some of the most indebted (at over 125 % in 2009). The growing financing need, even in the context of fast income growth during the boom years, stemmed from the rapid expansion in household residential investment, coupled with a relatively low savings rate. More than three quarters of the increase in liabilities was used to finance mortgage purchases, the overwhelming majority of which are floating rate. This has been linked to various factors, among which tax incentives and the high propensity of Spanish households to invest in realestate, reflected by the high rate of owner-occupied residences (at 86 %, the highest in the euro area). Variable-rate loans represent over 90 % of mortgages - compared to an average of 44 % in the euro area2 - which is indicative of the vulnerability of households to monetary tightening and risk-premia shocks. Due to increased indebtedness and the monetary policy cycle, the interest burden has more than doubled from the start of the decade, to over 7.5 % of gross disposable income in 2008, before falling back to around 6.2 % in 2009.
While a number of factors mitigate the vulnerabilities arising from high indebtedness, risks are high and skewed towards the poorer households. About 75 % of the debt of Spanish households consists of housing, the majority of which are primary residences, implying lower default risks than for consumer credit. In addition, residential mortgages in Spain have been predominantly of the traditional type, while riskier products, such as home equity loans and buy-to-let mortgages have been negligible. The share of mortgages with a loan-to-value ratio exceeding 80 % has been limited – Spain has largely avoided the problems stemming from “subprime” mortgages. While debt service has increased over time (until declining recently), it has so far remained on average manageable, with principal plus interest payments currently totaling about 18 % of gross disposable income.

3.However, the distribution of household debt, income and wealth is quite skewed. Households in the lower %iles of the income distribution are significantly more indebted than in other large economies with highly leveraged households3 (such as the UK and the US). While the indebtedness ratio increased by 30 % between 2002 and 2005 for the median indebted household, the figures are greater for low income and mediumhigh income group – at around 40 and 50 % respectively. For the poorest indebted households, debt payment increased from 30 % of gross disposable income in 2002 to 38 % in 2005 and for about a quarter of these households, debt to gross household wealth exceeds 75 %. However, relatively few low income households have debt (19 % in Spain, compared with 53 % in the US4) and households have used borrowing largely to purchase housing, implying a reduction in rent payments. Even taken into account these factors, the financial burden ratio of low income households is high and likely to have increased compared to the latest available survey from 2005. Taking also into account the adverse macroeconomic developments, such as the high unemployment and the tightening of financial conditions, imply that low income households may come under considerable financial strain.

4. While the asset side of the balance sheet is dominated by non-financial assets (housing), net financial worth has been declining until recently. Even with the recent decline in real-estate prices, at around 800 % of disposable income, the housing wealth of Spanish households is the highest among the large OECD countries. On the other hand, financial assets expanded at a lower rate than liabilities prior to the crisis. Household financial net worth declined from close to 200 % of gross disposable income in 2000 to about 110 % at the end of 2009, which is lower than the euro area average of around 190 %. The relatively low level of financial assets of Spanish households is also a source of vulnerability, since it reduces the amount that can be used to pay off debt in the event of adverse shocks. The financial asset allocations of Spanish households are broadly similar to other European countries, dominated by deposits and equity (including mutual funds) – each about 100 % of gross disposable income - and investments in insurance and technical reserves – at about 35 % of gross disposable income (partly linked to the fact that life insurance is required by credit institutions for house purchase loans). Large valuation swings have affected both financial and the non-financial assets, partly as a correction the overvaluations from the boom years.

5. Significant adjustment in household balance sheets is taking place. Gross disposable income, which grew faster than the euro area average until the crisis – at 7 % per annum compared to less than 4 % – decelerated sharply after the second half of 2008, including a quarter of outright contraction in 2009:Q3 (and 1 % increase for the year). This dynamic has been driven by a sharp fall in the two main sources of income: employee compensation and proprietors’ income, with automatic stabilizers - the increase in net social transfers received and declining income taxes –only partly mitigating these effects.
The shock to current incomes, wealth losses on financial and non-financial assets, coupled with the increased uncertainty, in particular regarding labor market prospects, have lead to a dramatic increase in the savings rate. From 11 % on average over the last decade (compared to 14 % for the euro area as a whole), the savings rate spiked to 18.8 % in 2009 – the largest increase in the EU. As a consequence, from a net borrower position of 3.8 % of gross disposable income just before the crisis, households’ reverted to being net lenders to the economy - to the extent of 10.3 % of disposable income in 2009.
During the crisis, the composition of household financial assets has shifted towards less risky and more liquid instruments, in particular deposits, as well as recent increases in mutual funds and insurance technical reserves, while there has been a reduction in liabilities by somewhat less than 1 % in 2009. However, while the debt-to-income ratio has declined to 125 % in 2009, the debt-to-GDP ratio has continued to increase (to 86 % at the end of 2009), as overall economic activity displayed a stronger cyclical decline than household income.

6. Going forward, maintaining a high savings rate is critical to reducing household debt ratios to more substainable levels. According to staff’s baseline projections, given continued high uncertainty, which increases the precautionary behavior of households, the savings rate is likely to remain elevated for the medium-term, gradually declining to a level close to the euro area average (14-15 %). As housing investment continues to contract in 2010-11, households’ net lending capacity remains substantial, though gradually declining.

Households will use this additional financial capacity partly to build financial assets and partly to reduce debt. In particular, the composition of household portfolios would shift towards more liquid and safer investments (e.g. currency, deposits, government securities and insurance technical reserves). New credit to households would remain negative in 2010 as lending conditions continue to be tighter than in the euro area and would revert to positive territory afterwards, however at weak growth rates. Households’ net financial assets would improve and debt ratios gradually decline, as growth recovers. However, this scenario is subject to risks. On the upside, a faster recovery and increased confidence would lead to a lower savings rate. Under the scenario in which households revert to their pre-crisis savings rate of around 11 %, the debt ratios would likely continue to increase (though this could be compensated by households allocating more of their available resources to debt reduction).

Under a more adverse macroeconomic scenario, which may include financial market shocks, financial asset price declines and a sharper adjustment of the property market, the savings rate would remain even higher and deleveraging could be significantly more abrupt.