Financial Stability and Fiscal Policy in Europe: The Spanish Economy

Financial Stability and Fiscal Policy in Europe: The Spanish Economy

Jorge Sicilia

Joint Central Bankers Conference: Unconventional Government Policies

New Orleans, November 15-17, 2012

Financial Stability and Fiscal Policy in Europe

November 2012

Main messages

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2

3

Given the limitations in the design of European institutions, heterogeneity of fiscal imbalances and banking conditions in EMU produce a distorting financial fragmentation, exacerbated by market fears of euro breakup and supervisory ring fencing

Spanish fiscal imbalance has been the result of housing and financial bubbles. Fiscal consolidation is working, but the process is low and costly in recession times

Bank restructuring in Spain is helping to discriminate among institutions.

Solutions at the European level: a road map to a genuine EMU, with a banking and (eventually some type of) fiscal union, and policies from ECB to restore a more normal functioning of the monetary transmission mechanism.

Solutions at the Spanish level: (1) fiscal adjustment, (2) complete banking restructuring, and (3) structural reforms to increase potential growth.

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November 2012

1. Financial Stability and Fiscal Policy in Europe

The fragmentation of financial markets in EMU

Page 3Page 3

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Spain Italy

EFSF established

GER, FRA

agreement on PSI

ECB purchases

SPA and ITA

bonds

October summit still

leaves doubt on

Greece. EFSF leverage

ineffective

ECB’s first

LTRO Increasing Doubts on Spain

(fiscal, reforms, banking)

Inconclusive Greek

elections. Risk of

Greek exit

ECB,

The euro is

irreversible.

Massive bond

purchasing

with

conditions

10-y yields, Spain and Italy, %Source: BBVA Research and Haver


November 2012



Country risk premia in periphery reflect imbalances

heterogeneity, but not only

Country risk premia in periphery reflect imbalances

heterogeneity, but not only

Imbalances have interacted with the convertibility risk,

contributing to exacerbate financial tensions

Imbalances have interacted with the convertibility risk,

contributing to exacerbate financial tensions

The ECB announcement (OMT) has significantly

reduced convertibility risk

The ECB announcement (OMT) has significantly

reduced convertibility risk

Page 4

* Components; (i) the cross country coefficient of variation of bank lending rates to corporates and households (average) (ii) the Target 2 balances of surplus (iii) gross liquidity provision by Eurosystem as a share of bank assets and (iv) the interquartile range of Euro area countries’ two-year government bond yields. To combine these varied indicators, we calculate a Z-score for each, and then estimate the first principal component of these Z-scores

EMU: Composite measure of financial fragmentation*Source: Bloomberg and BBVA Research

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November 2012



The monetary policy transmission mechanism in

Europe relies in banks, which reflect the tensions in

funding in their lending conditions

The monetary policy transmission mechanism in

Europe relies in banks, which reflect the tensions in

funding in their lending conditions

But there is a very long way to go to return to the

previous level of financial integration

But there is a very long way to go to return to the

previous level of financial integration

Heterogeneity among countries will remain, mainly on

two fronts: fiscal and banking sector

Heterogeneity among countries will remain, mainly on

two fronts: fiscal and banking sector

* Not including ongoing merger processes and fiscal credit. With them, €54bn

EMU: Change in interest rate on new bank loans(In basis points, December 2010 to July 2012)Source: ECB, IMF and BBVA Research

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NTH

GER

FIAU

FR

BE

SP

IT

CY

PT

IRE

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120

140

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-20 0

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10

0

Corporate loans

Households lo

ans


November 2012

Fiscal Imbalances (% GDP)Source: BBVA Research based on AMECO


Spanish imbalances in European perspective

Page 6

Banking imbalances : capital injections and market opennessSource: BBVA Reaerch based on European Commissionand ECB

ES

DE

IT

IE (43%)

PT

FI

NL

BELU

FR

EL

AU

CY

SK MTSI

-1%

1%

3%

5%

7%

9%

11%

13%

15%

-80% -60% -40% -20% 0% 20% 40% 60%

Pu

bli

c C

ap

ita

l In

ject

ion

(%

GD

P)

Target Position (%GDP)


November 2012

Low real interest rates (EMU, risk under-pricing) and population growth due to immigration

Low real interest rates (EMU, risk under-pricing) and population growth due to immigration

Economic growth driven by strong demand. Potential growth of rest of sectors close to 2%Economic growth driven by strong demand. Potential growth of rest of sectors close to 2%

Unlimited liquidity in international financial markets, searching for low risk financial assets

Unlimited liquidity in international financial markets, searching for low risk financial assets

Banks: high competition in volumes with low prices. Savings banks allowed to operate out of original

regions and influenced by politics

Banks: high competition in volumes with low prices. Savings banks allowed to operate out of original

regions and influenced by politics

A simple type of financial engineering: increase of mortgages’ term and LTV with low interest ratesA simple type of financial engineering: increase of mortgages’ term and LTV with low interest rates

Explanatory factorsSpain: Value added growth by sectors (%y/y)Fuente: BBVA Research a partir de INE


The three faces of the housing and financial bubble

Page 7


November 2012

Credit to Private Sector (% GDP)Source: BBVA Reaerch based on Bank of Spain and ECB

7% 10% 6% 7% 7% 6%

30%

63% 62%

29% 38% 40%

44%

89%77%

41%

53% 49%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

Dec-00

Dec-08

Sep-12

Dec-00

Dec-08

Sep-12

Spain EMU

Consumption Housing Businesses

Real

Estate

13%

43%

36%

Spain: current account balance and capital flows(% of GDP)Source: BBVA Research based on Bank of Spain data


The three faces of the housing and financial bubble

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Oct-11

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Oct-12 (e)

Eurosystem

Rest

FDI inflows

Current account (calculated as a residual; rhs axis)


November 2012

The housing and financial bubble gave place to extraordinary revenues for the public sector:The housing and financial bubble gave place to extraordinary revenues for the public sector:

(1) VAT for total price of houses, (2) corporate taxes of financial and real estate companies, (3) import taxes

due to the huge current account deficit

(1) VAT for total price of houses, (2) corporate taxes of financial and real estate companies, (3) import taxes

due to the huge current account deficit

Despite the fact that these revenues were extraordinary, public spending increased in the same amount, particularly in the case of regional governments

Despite the fact that these revenues were extraordinary, public spending increased in the same amount, particularly in the case of regional governments

2. Fiscal Policy

The response of the fiscal balance: the bubble

Page 9

Spain: Tax base for corporates and VAT as % of GDPSource: AMECO and BBVA Research

0,0

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1980

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2011 e

Dweling purchase operation of VAT Consolidated tax base of Corporate Tax


November 2012

Surpluses in 2005-7 based on extraordinary revenues, but structural deficit above 1.5% of GDP

Surpluses in 2005-7 based on extraordinary revenues, but structural deficit above 1.5% of GDP

With the crisis all these revenues disappeared (below their steady state values) and the Government implemented expansionary fiscal policies

With the crisis all these revenues disappeared (below their steady state values) and the Government implemented expansionary fiscal policies

Since 2009 a significant fiscal consolidation process begun. In 2014 if target achieved, better structural

deficit than in 2007.

Since 2009 a significant fiscal consolidation process begun. In 2014 if target achieved, better structural

deficit than in 2007.

2. Fiscal Policy

The response of the fiscal balance: the adjustment

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November 2012

Spain: fiscal adjustment and GDP growth Source: BBVA Research based on INE

-2

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0

1

2

3

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5

2011 2012 2011 2012

Fscal adjustment (in GDP pp) GDP growth, %

Composition of fiscal adjustment towards 2014: 25% revenues measures, 75% expenditure measures

Composition of fiscal adjustment towards 2014: 25% revenues measures, 75% expenditure measures

Debate on fiscal multipliersDebate on fiscal multipliers

Despite the significant adjustment expected in 2012 (around 4%of GDP in measures), the economy will only

contract by around 1,4%

Despite the significant adjustment expected in 2012 (around 4%of GDP in measures), the economy will only

contract by around 1,4%

2. Fiscal Policy

Fiscal consolidation: composition and multipliers

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November 2012

3. The financial sector

Banks’ weaknesses became apparent after the bubble

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1. The risk of credit portfolios was underestimated: NPL represented in June 2012 16% of GDP

1. The risk of credit portfolios was underestimated: NPL represented in June 2012 16% of GDP

2. Branches and employment also boomed: 25% of excess capacity

2. Branches and employment also boomed: 25% of excess capacity

4. Too much reliance on ECB funding: 35% of GDP

4. Too much reliance on ECB funding: 35% of GDP

3. Too much reliance on wholesale funding: 35% of total banking assets in 2012

3. Too much reliance on wholesale funding: 35% of total banking assets in 2012


November 2012


The MoU: a comprehensive and definitive plan

1. Solvency: The €100bn credit line exceeds the foreseeable needs (€59bn in bottom up stress test)

2. Cleaning-up of balance sheets will be further enhanced. Tremendous provisioning effort with minimum public funds

4. Mergers: further consolidation in the sector with resolution of non-viable entities and restructuring of ailing entities.

3. Bad bank: segregation of real estate assets will enhance transparency and focus on banking business

5. A new framework of crisis management, bank restructuring and resolution, with burden sharing

After a slow restructuring process, the MoU is a comprehensive and definitive plan

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November 2012

With these results, an important step of the

restructuring process has been completed

With these results, an important step of the

restructuring process has been completed

Entities will present recapitalization plans, and

public capital injection will be around €40bn

Entities will present recapitalization plans, and

public capital injection will be around €40bn

The heterogeneity of the system is confirmed:

Solvent institutions manage 70% of the assets

The heterogeneity of the system is confirmed:

Solvent institutions manage 70% of the assets

According to Bank of Spain, non-viable entities will

be sold, but not liquidated

According to Bank of Spain, non-viable entities will

be sold, but not liquidated

Capital needs, adverse scenario* (€bn)Source: Bank of Spain

-30

-20

-10

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10

20

30

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po

San

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ank

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nk

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kia-

BFA

€ 59bn

* Not including ongoing merger processes and fiscal credit. With them, €54bn


Stress test results: a very heterogeneous sector

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November 2012

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The future: drivers and determinants

DeleveragingDeleveraging

• Credit/GDP: from 160% to

110%

• Convergence: 5-10 years

LiquidityLiquidityLiquidityLiquidityLiquidityLiquidityLiquidityLiquidity

• ‘Back to basics’: deposits

will play a more important

role

• Banking union will avoid

finacial fragmentation

RegulationRegulationRegulationRegulationRegulationRegulationRegulationRegulation

• More capital and liquidity

• Alternatives to bail-out for

resolution

ProfitabilityProfitabilityProfitabilityProfitabilityProfitabilityProfitabilityProfitabilityProfitability

• Retail: (-) volumes (+) prices

• Wholesale: (-) liquidity

(+) risk aversion

• Higher provisions


November 2012

Page 16

4. The solution at the European level

The road map to a more genuine EMU

• Periphery countries: deleveraging and reforms

• European level solutions: implementations of the banking union

with a common supervision and direct bank recapitalization (ESM)

• Fiscal union: sovereign debt mutualization & Treasury

• Complete banking union: single resolution mechanism and deposit

guarantee

Medium run advances on integration: political agreement between core & periphery

Medium run advances on integration: political agreement between core & periphery

The final stage:A more stable monetary and

economic union

The final stage:A more stable monetary and

economic union

Measures adopted Measures adopted

• Fiscal rule (fiscal compact)

• Surveillance of all imbalances (European Semester)

• Permanent rescue fund (ESM)

• ECB: a credible and effective backstop (OMT)

• Road map to a European banking supervisionShort run: pending on approvalShort run: pending on approval


November 2012

GDP growth is crucial for the correction of imbalances (deficit, debt, credit and NPL)GDP growth is crucial for the correction of imbalances (deficit, debt, credit and NPL)

Illustrative Examples: public debts sustainability exercises

Illustrative Examples: public debts sustainability exercises

No margin of maneuver for demand policies: supply policies needed

No margin of maneuver for demand policies: supply policies needed

Spain: public debt sensitivity to different assumptions (% of GDP)Source: BBVA Research and Minhap

5. The solution at the Spanish level

The quest for growth to correct imbalances

Page 17

30

40

50

60

70

80

90

100

110

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Spain Baseline

Spain Baseline +100 bp risk premmia

Spain Baseline -1pp of growth

Spain baseline + both risks

Assumptions: averages (2012-2018)

Spread with

Gemany (pp)*

GDP Nominal

Growth

Primary Public

Surplus (+) /

Deficit (-)

Macro Baseline 278 2.6 0.9


November 2012

Reduce implementation risk of fiscal policies

Reduce implementation risk of fiscal policies

Reduce long term risks on public finances

Reduce long term risks on public finances

Budget Stability Law, Structural budget targetsBudget Stability Law, Structural budget targets

Pension reform that increases progressively retirement age, and number of working years used to calculate pension.

Copayment on medicine expenditures and justice procedures.

Pension reform that increases progressively retirement age, and number of working years used to calculate pension.

Copayment on medicine expenditures and justice procedures.

Reduction of unfair dismissal costs (to 33 days per year worked from 45), clarify economic dismissals (20 days), prioritize firm

agreements

Reduction of unfair dismissal costs (to 33 days per year worked from 45), clarify economic dismissals (20 days), prioritize firm

agreements

Increase of consumption taxes, elimination of tax deduction on home purchases

Increase of consumption taxes, elimination of tax deduction on home purchases

Labor marketLabor market

Sufficiently high backstop, a credible and transparent process, and a clear calendar with a specific deadline to end it decisively

Sufficiently high backstop, a credible and transparent process, and a clear calendar with a specific deadline to end it decisively

Restructuring of financial sector

Restructuring of financial sector

Improve tax efficiencyImprove tax efficiency

Reduction of red tape (open a business). Eliminate electric tariff

deficit.

Reduction of red tape (open a business). Eliminate electric tariff

deficit.

Improve market

regulation

Improve market

regulation


Structural reforms: what has been done?

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November 2012


Structural reforms: what is pending?

Reduce implementation risks in fiscal policy

Reduce implementation risks in fiscal policy

Reduction of medium term risks on public

finances

Reduction of medium term risks on public

finances

Aggressive implementation of Budget Stability LawAggressive implementation of Budget Stability Law

Truly Independent, Credible, Budget Agency, further pension system reform (Bring forward sustainability factor, promote late

retirement, etc.)

Truly Independent, Credible, Budget Agency, further pension system reform (Bring forward sustainability factor, promote late

retirement, etc.)

Liberalize energy, telecom, professional services sectorsLiberalize energy, telecom, professional services sectors

Alternative sources of funding, centralize instrumentsAlternative sources of funding, centralize instruments

Improve competitiveness

Improve competitiveness

Improve active labor market policies, dual formation, education reform

Improve active labor market policies, dual formation, education reform

Labor market and Human capitalLabor market and Human capital

Promote small firm growth

Promote small firm growth

Improve property rights of leasers, reduce operating costs of firms

(market unity)

Improve property rights of leasers, reduce operating costs of firms

(market unity)Improve regulationImprove regulation

Financial Stability and Fiscal Policy in Europe: The Spanish Economy

Jorge Sicilia

Joint Central Bankers Conference: Unconventional Government Policies

New Orleans, November 15-17, 2012

Financial Stability and Fiscal Policy in Europe: The Spanish Economy

Economy & Finance