Spain

Research guide to European Monetary Union

Political background

The government’s top priority is early membership of the Emu in 1999. A tighter fiscal policy stance, measures to increase competition in goods and services markets, further reforms of the rigid labour market and a general move towards a more private corporate instead of a public corporate economy via the sale of public companies are all intended to make the Spanish economy fit for Emu.

As the main political parties share the government’s Emu ambitions (with the exception of the Communists) politics should not interfere negatively in the preparations for Emu.

Fiscal policy

Spain’s fiscal position has improved considerably since 1993 when economic recession hit public accounts and the budget deficit widened to 7.5% of GDP. Last year the deficit target of 4.4% of GDP was met for the first time in several years, increasing the government’s credibility that it may also hit this year’s objective of 3% of GDP. The conditions to achieve this seem to be in place, ie stronger economic growth and lower interest rates. While the biggest European economies are struggling to achieve their budget targets in the face of stagnant economic growth, the outlook for the Spanish public accounts is hence more positive. The slowdown in growth Spain experienced in the course of last year was far less pronounced than in other countries and GDP growth moved up close to potential already in Q4 1996. Backed by growing consumer confidence and continuing good export prospects economic growth should accelerate further this year to close to 3% by the end of the year. Still, the revenue targets set out in the Spanish budget seem to be overly optimistic and additional spending cuts may be required. However, the government has assured the outside world that it would react rapidly to any imbalance. This together with the close monitoring of spending and a certain cushion against unexpected revenue shortfalls (especially in the social security budget) through lower-than-budgeted interest payments should ensure that the overall public-sector deficit will end the year at or close to the Maastricht limit of 3% of GDP.

The stability pact agreed in Dublin last December obliges the member states to maintain budget discipline in the coming years. In this respect, the recent presentation by the Spanish government of a medium-term fiscal plan for the three years up to 2000 is positive. The government envisages a reduction of PSBR next year to 2.5% of GDP and a further reduction towards 1.6% of GDP at most by the end of the decade. Under the implied assumption that the economy continues to grow at an average of 3% in real terms the deficit projections do indeed seem feasible. However, it would be risky to rely largely on a benign growth and interest rate environment. To achieve a sustainable fiscal position in the longer term, further structural reforms, for example in the healthcare and the public pension systems will be necessary. Under the government’s deficit and growth assumptions, the debt level which last year rose more strongly than expected to above 69% of GDP, would fall to approximately 65% of GDP by the end of the decade. This year alone, the debt-to-GDP ratio is likely to be reduced by one percentage point to 68.2% of GDP as the government intends to use a large portion of its privatization proceeds (of around Pta1,600 billion or 2% of GDP) to retire debt.

Inflation and monetary policy

The second main focus of government policy is to reduce inflation via government-regulated prices and the liberalization of goods and services markets. In this respect, the cut in electricity tariffs and natural gas prices, the freeze of national telephone tariffs until May 1998 and the large cuts in international phone call rates envisaged for this year as well as the reduction of business margins in the pharmaceuticals sector should subtract close to 0.5 of a percentage point from the underlying inflation trend. In addition, measures have been announced to increase competition in the energy, telecommunications and real estate markets which should help to sustain a low-inflation environment over the medium term. Meeting last year’s inflation targets has considerably increased the credibility of both the government and the central bank that this year’s targets can also be met. This in turn should help to keep wage growth under control – in fact the first statements from Spanish trade unions point to moderate wage increases of around 3%, below last year’s increase of 4% and only slightly above the year-end target of the government (2.6%). Even if the economy accelerates in the course of the year, consumer price inflation should hence be kept below the 3% level.

The significant reduction of inflation together with a tighter stance of fiscal policy have allowed the Bank of Spain (BoS) to lower interest rates by 350bp since the beginning of last year, and the positive inflation outlook means that some additional room for easing exists in the coming months. Based on the harmonized price index compiled by EUROSTAT, which will form the basis for the Maastricht assessment next year, an inflation rate above the 3% level will probably be sufficient to fulfil the inflation criterion. This is higher than the reference value derived from the national indices as, according to EUROSTAT, the two most stable countries – Sweden and Finland – have higher inflation rates. Hence, Spain should have no difficulty in fulfilling the criterion. However, the Bank of Spain rightly opted to tighten its target at the beginning of the year. The bank now aims at CPI inflation of 2.5% (previously below 3%) by the end of 1997 and below 2% in the course of next year. The more ambitious target and uncertainties regarding the Emu process which could affect the peseta will most probably lead to a more cautious stance of monetary policy than last year. Currency-induced imported inflation is a risk to this scenario. Since December 1996 the peseta has lost more than 11% of its value against the dollar and on a trade-weighted basis the peseta is close to the low of March 1995 – when the peseta was devalued by 6% within the Exchange Rate Mechanism (ERM) – and almost 2% down compared with December. While import prices at the end of last year still showed rather moderate price pressure, continued currency weakness could push up the CPI by as much as 0.3 to 0.5 of a percentage point over the next couple of months.

Will Spain make it into the first round of Emu?

On the one hand, the significant improvement in economic fundamentals will mean that the Spanish Emu ambitions have to be taken seriously. Should the fiscal and monetary targets be met, Spain has undoubtedly made a greater adjustment effort in the last two years than either France or Germany. As Prime Minister Aznar has tied his political fate to taking Spain into Emu in the first round and the failure to deliver this would hurt the political credibility of his government, he can be expected to fiercely call for an equal assessment of all countries based solely on economic performance and the fulfilment of the Maastricht criteria in 1997. On the other hand, political considerations have gained relevance over the last few weeks in the hard-core countries suggesting that the Euro would lack strength if the so-called “peripheral” countries are included in monetary union right from the start and that the German government will have difficulties selling a broad Emu to a sceptical public in an election year. While the hard-core’s unease mostly relates to Italy, Spain’s comparatively short track record in sound macroeconomic policies and the consequently lower credibility of any government to maintain these policies over the longer term, have left it vulnerable to the delay discussion as well. Interestingly, financial markets have reacted in a far more relaxed fashion to the outlook of a delayed entry of the “peripheral” countries than to the perspective that the whole Emu project could be postponed. Investors obviously hold the view that should the Emu straightjacket be removed, Spain (and Italy) would likely loosen their fiscal policy stance, demanding a higher risk premium for holding these countries’ assets in such a scenario. On the contrary, should a delay be negotiated for the high-yielders only and Emu go ahead on January 1 1999, the current convergence efforts would likely be maintained and the “outs” would join with a short delay of one or two years. This would give these countries some extra time to adjust their still existing macroeconomic imbalances: in the Spanish case the very high unemployment rate of more than 20% of the workforce. Whether economics or politics will decide in the end is still an open question. However, the German insistence on a narrow economic interpretation and its own difficulties in fulfilling the fiscal criteria should strengthen Spain’s Emu chances.

Outlook for the peseta

The positive outlook for economic fundamentals should underpin the Spanish currency this year. Despite the recent bouts of turbulence in the foreign exchange markets as a result of upcoming doubts about the timely start of Emu in general and Spain’s participation in 1999, the peseta is still one of the stronger ERM currencies, trading above its central parity of Pta85.07/Dm. Greater volatility than last year – when the peseta traded close to a level of Pta84/Dm for most of the year – seems likely as sentiment in the financial markets will probably swing between Emu pessimism and optimism. However, exchange rate stability is one of the prerequisites to join monetary union (probably the most relevant one) and the Bank of Spain can therefore be expected to continue its efforts to stabilize the currency close to current levels by intervening in the foreign exchange markets. Since the beginning of last year, the BoS has very successfully kept the peseta within the informal bands of the ERM of ±2.25% to the central parity, and the BoS’s considerable foreign reserves (above $65 billion in March 1997) provide it with an important cushion against unwelcome currency fluctuations. The Spanish currency should therefore trade in a tight range between Pta84/Dm to Pta86/Dm.

Only in the case that an indefinite postponement of the Emu project gains further likelihood would a major crisis in the foreign exchange markets become a probable scenario. While the peseta alongside the lira would suffer most, any slide of the peseta should be smaller than in the past as economic fundamentals are considerably sounder and Spanish domestic investors are traditionally less inclined to shift funds out of the country in times of crises as seems to be the case in Italy. Prior to the first ERM crisis in 1992 the peseta was clearly overvalued and the current account deficit had widened to close to 4% of GDP in that year while it has posted moderate surpluses since 1995. The last devaluation of the peseta in March 1995 was (apart from the strong fall in the dollar) due to political instability and fears about a surge in inflation. None of these factors is present now which should limit the fall of the peseta in this worst-case scenario.

Market structure

Market turnover increased considerably in the last few years according to figures provided by the Bank for International Settlements (BIS) and the Bank of Spain. Between 1992 and 1995 average daily turnover increased by almost 50% to around $18 billion. Transactions in the peseta against the dollar are by far the most important, accounting for roughly 50% of all foreign exchange transactions, followed by Deutschmark (17%) and trading in dollar against Deutschmark (18%), with all other currencies playing only a minor role. Activity is concentrated on the foreign exchange swap market with a total daily turnover of some $10 billion compared to a volume of $7 billion in the spot market in 1995. By far the most popular currency pair for swaps is Pta/$ which last year accounted for more than 90% of all swap transactions. On the contrary, most of the Pta/Dm transactions are done in the spot market with the intervention practice of the Bank of Spain being an important explanation. Stability in the Exchange Rate Mechanism of the European Monetary System is mainly considered against the anchor currency and the Bank of Spain almost exclusively intervenes against the Deutschmark. Turnover in outright forward transactions is minor and even fell last year.

Current account and exchange rate

Pta versus $ and trade-weighted exchange rate

1990 1991 1992 1993 1994 1995 1996 1997

Source: Deutsche Morgan Grenfell

Spain purchasing power parity

1986 through to 1996