Economic recovery in spain 2014 en

Economic recovery in Spain will gain momentum in 2014-2015

June 2014

The Consejo Empresarial para la Competitividad (CEC) is composed by the following chairmen and CEOs* Mr. César Alierta. Telefónica. CEC Chairman Mr. Isidoro Álvarez. El Corte Inglés Mr. Isak Andic. Mango Mr. Emilio Botín. Banco Santander Mr. Antoni Brufau. Repsol Mr. José Manuel Entrecanales. Acciona Mr. Isidro Fainé. La Caixa Mr. Francisco González. BBVA Mr. Antonio Huertas. MAPFRE Mr. Pablo Isla. Inditex Mr. José Manuel Lara. Grupo Planeta Mr. Florentino Pérez. ACS Mr. Rafael del Pino. Ferrovial Mr. Juan Roig. Mercadona Mr. Ignacio Sánchez Galán. Iberdrola Instituto de la Empresa Familiar, represented by: Mr. Simón Pedro Barceló. Grupo Barceló Mr. Javier Moll. Editorial Prensa Ibérica Mr. Leopoldo Rodés. Havas Media Group CEC Managing Director: Mr. Fernando Casado * Alphabetical order

Consejo Empresarial para la Competitividad Pl. Independencia, 8 - 4º 28001 MADRID - Spain T. (+34) 915 223 084

Layout by: IMAGIAofficina.es Printed by: EGRAF, S.A. Date of publication: June 2014 Legal deposit: M-18163-2014

Table of contents

1. Spanish economic recovery will gain momentum in 2014-2015

02

Recovery of the Spanish economy is confirmed

02

Recovery shows a pattern similar to that of past recoveries

03

Exports were the main driving force behind this growth

03

Investment will consolidate its recovery in 2014

05

Investments in machinery and capital goods continue to grow

05

Real estate investment: this time it’s different

07

Private consumption and employment grow

09

The effort to reduce public deficit will be less over the next two years

11

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

14

The historic improvement in the trade balance continues which forecasts current account surpluses equal to 2%-3% of GDP in 2014-15.

14

21

Improvement in quality and quantity of financial flows

Spain continues to be very attractive for productive foreign investment

21

The return of confidence is also reflected in positive portfolio flows

24

This improvement in confidence, thanks to external support, was also consolidated in “key players”

26

3. The clear progress in adjusting the existing imbalances continues Debt of Spanish non-financial companies is reduced

28

Debt reduction of Spanish households picks up

32

Adjustment to the real estate market is nearing their end

34

Data on activity allows the surplus supply that existed to be adjusted

34

Increasing demand of non-residents and investors

35

Price adjustments nearing their end but with differences between provinces

36

The banking sector has already carried out an in-depth restructuring

28

36

4. The process of transforming the Spanish economy must be continued

40

There is room to increase the degree of economic openness

40

Unit labour cost containment is key...

41

… as well as increasing productivity for sustainable recovery

43

The value of education and human capital in the labour market

45

The main reforms initiated must be consolidated

47

48

Reform of public administrations: in search of efficiency in processes

Labour Reform: simplification and greater flexibility

49

49

Fiscal reform focused on growth and employment creation

Progress in reforms yet to be implemented

51

Reinforce the commitment to innovation, new technologies and digital economy

51

Energy policy focused on improving competitiveness and the industrial rebirth

52

Towards a high-quality and stable education system focused on current and future world challenges

53

1

Spanish economic recovery will gain momentum in 2014-2015

Recovery of the Spanish economy is confirmed After 2012, a year marked by distrust, the deterioration of financial tensions and the acceleration of fiscal consolidation processes and structural reforms, the expectations that the CEC presented a year ago in this same publication forecast that 2013 would be a year of transition of the Spanish economy towards a new growth cycle.

However, this was not the mainstream view of the analysts’ consensus. In particular, 70% of the research services that made predictions one year ago regarding the growth of the Spanish economy expected less of a change in GDP for 2014 than that forecast by the CEC, and 20% of them even forecast the continuation of a recession period and drops in activity.

Fortunately, economic activity increased in 2013 as expected. Therefore, during the third quarter of last year, the technical recession ended and the economy once again set a positive growth rate. This recovery, which was strengthened over the last quarter of 2013 and the first quarter of 2014, was in any case insufficient to avoid the 1.2% drop in GDP for 2013 as a whole.

The most important factor behind this improvement was the rapid and decisive action taken by European and Spanish institutions. In particular, the commitment to do “whatever necessary” to avoid a euro-break up on the part of the ECB built a bridge which allowed European governments to take measures to break the vicious cycle between sovereign bonds and the financial sector and, in Spain’s case, it enabled part of the financial sector to be restructured and recapitalised, and reforms to be implemented that improved the country’s capacity for growth. The structural reforms adopted, including the labour market reform, and the commitment shown to fiscal consolidation were also key factors for laying the foundations of the recently begun economic recovery, along with the continuous improvement in Spanish economic internationalisation.

02

Recovery shows a pattern similar to that of past recoveries As mentioned a year ago, the cycle changes in Spain seem to have a specific order and the indications observed at that time held the promise of an imminent turning point. In particular, recoveries have historically begun with a change in the trend of exports, which in this case have already accumulated four years of growth and which will be covered in more detail in the next section of this report.

Just before the turning point of the economy, the increase in productivity and the containment of salary increases reduced unit labour costs, consolidated growth in exports and increased gross operating profit. This improvement in the companies’ financial position is a step towards increasing investments in machinery and equipment, as there is more certainty with regard to the prospects of demand and since certain capacity restrictions are expected to no longer apply in the medium term. Therefore, the performance of the majority of the remaining macroeconomic variables coincides with the GDP. As shown below, this has effectively been the scenario seen in the Spanish economy and, therefore, the expectations of a sustained recovery from this point forward are confirmed.

Exports were the main driving force behind this growth Spanish exports of goods and services have grown consistently since 2012 above those of the EU. For example, since the first quarter of 2012, exports in Spain grew, in real terms, 12.1% compared to 2.1% in the EMU (see graph 1). In particular, as it will be shown below in this report, Spanish exporters have not only been especially successful in diversifying their destinations and type of products (75% of the growth in exports during the crisis is due to these factors), but they have also been able to beat out competitors in terms of price, as shown by the average inflation of 1pp below that observed in the rest of the EMU since the beginning of the crisis.

03

1.  Spanish economic recovery will gain momentum in 2014-2015

Graph 1: Total exports of goods & services (1Q12-4Q13 % of cumulative change, sa)

Spain Portugal Netherlands Switzerland Austria Eurozone European Union Belgium Germany Denmark Italy United Kingdom Ireland France Finland Sweden Norway -5%

0%

5%

10%

15%

Source: BBVA Research from Eurostat

This improvement in competitiveness was driven by the strong growth in productivity, which, together with the containment of salary increases, contributed to an actual improvement of 14% in unit labour costs since the maximum reached prior to the crisis (see graphs 2 and 3). Even more important is that the labour market reform will enable this competitive edge to most likely become permanent, unlike in the past, where it was achieved through temporary instruments such as devaluations in the exchange rate.

04

Graph 2: Productivity (2008 = 100)

Graph 3: ULC (2008 = 100) 110

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70 2008

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France

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These factors generally explain why the growth in exports was resistant to the crisis in 2013 (up 4.9% year-on-year), and will continue to be resistant in 2014-15 (up 6.1% and 6% year-on year, respectively), thereby giving rise to a historic trade surplus unseen since 1987. Although the contribution of foreign demand to growth is expected to decrease over the next two years, this same competitive edge that is allowing Spanish companies to gain market share abroad, is allowing them to do the same in Spain, thereby limiting the growth of imports and, therefore, allowing the contribution of foreign demand to growth to remain positive at around 0.5% of GDP.

Investment will consolidate its recovery in 2014 Investments in machinery and capital goods continue to grow The deleveraging process of the private sector was carried out thanks to the increase in net savings of households and companies. In particular, the increase in productivity, the containment of salary increases and the decrease in expenses resulted in five consecutive years in which the private sector had the required financing capacity to allow for a clear improvement in its financial

05

Italy

2012

2013

United Kingdom

1.  Spanish economic recovery will gain momentum in 2014-2015

position (see graph 4). It is therefore to be expected that, together with the increase in foreign demand for Spanish goods and services, the aforementioned may translate into a process of growth in investments (see graph 5), once the strong uncertainty is reduced. In fact, this is exactly what happened: over the last year, economic policy decisions considerably reduced the uncertainty faced by producers, both at the European level and in Spain. This can be seen in the significant reduction in the risk premium (more than 500bp since its maximum in mid-2012), or in the increase in net financial wealth (recovery of around 25% from June 2012 to September 2013), in both cases as a result of the return of capital flows to Spanish financial markets.

This explains why investments in machinery and equipment increased by 2.2% in 2013 and linked four consecutive quarters of positive growth. From this point forward, this scenario of greater certainty and growth in exports is expected to continue driving investments in machinery and equipment. However, in view of this improvement in exports, it is important to note that the improvement in the financial conditions, and the fact that it is easier to access financing, will trigger new investment projects that will reduce its dependence on the good performance of exports.

Graph 4: Spain: financing needs (-) / capacity (+) abroad (as a % of GDP)

Graph 5: Spain: exports and investments in machinery and equipment (2008 = 100) 140

10%

130 5% 120 110

0%

100 -5%

90 80

-10% 70

Source: BBVA Research from INE

Investment in equipment and machinery

Dec-15

Dec-14

Jun-13

Mar-14

Sep-12

Dec-11

Jun-10

Mar-11

Sep-09

Dec-08

Jun-07

Mar-08

Sep-06

Dec-05

Jun-04

Exports of goods and services

Source: BBVA Research from INE

06

Mar-05

Sep-03

Total

Dec-02

Public sector

Jun-01

Non-financial companies

Mar-02

Households

2013

Sep-00

2007

Dec-99

60

-15%

Real estate investment: this time is different One of the characteristics of past recoveries in Spain was the growth in residential investments, even before that of economic activity as a whole. Actions regarding monetary policy, reducing real interest rates, boosted risk taking on the part of savers, causing them to first invest in the residential sector. In fact, it is this type of behaviour that was recently seen in certain autonomous communities along the Mediterranean coast, where the increase in purchases by foreigners or even non-resident Spaniards revived sales. However, in general, such a high level of imbalance in the sector, with relatively high surplus supply, of around 2.2% of residential assets —once frictional stock is discounted— and what still remains of the deleveraging process to be carried out, implies that residential investment shall remain weak over the coming quarters.

In any case, the regional distribution of unsold new housing continues to be mixed. While there are certain regions where the imbalance is still significant (La Rioja, Valencia, Castilla-La Mancha, the Canary Islands and Murcia), there are other regions where the proportion of unsold new housing is significantly below the average, such is the case in Extremadura, Cantabria, Navarra and, to a

Graph 6: Spain: contribution to growth from housing sales (in pp)

Graph 7: Surplus supply of new unsold housing: 2013 projections (as a % of residential assets) 6%

10%

5%

0%

4% -10% 3% -20% 2%

-30%

1%

Foreigners

Spanish

Other

Source: BBVA Research from Ministry of Public Works

Total

Source: BBVA Research from INE

07

EXT

CNT

PVA

NAV

AST

MAD

GAL

AND

CYL

ARA

ES

CAT

BAL

VAL

CAN

CLM

MUR

RIO

2013

2012

2011

2010

2009

2008

0% 2007

-40%

1.  Spanish economic recovery will gain momentum in 2014-2015

lesser extent, Madrid and the Basque Country. These differences will be felt in the recovery of the sector, thereby giving rise to different growth processes based on the particular characteristics of each of the markets.

In any case, an improvement is expected in the key aspects related to purchasing housing over the next two years. Firstly, the projections for the job market point towards the creation of employment beginning this year.

Secondly, mortgage interest rates will continue to be stable, and may even drop slightly in 2014 and reach level around 3% in 2015 due to a decrease in the mortgage spreads. Lastly, the recovery of financial wealth and the fact that the process of correcting housing prices is nearing completion may affect demand positively.

The demand for housing from foreigners is expected to remain strong and is even expected to grow over the next two years. In addition, international investors have become more interested in the sector, especially in the second half of 2013 (see the section on current adjustments).

The context within which the market will operate in 2014-2015 will therefore be different from that of the most immediate past: in an environment where there is a progressive recovery of demand, supply will continue to be adjusted due to the scant number of houses that will be completed over the coming years, which could bring stability to housing prices in 2015. The latest data confirms that since mid-2012 the number of purchase and sale transactions for new housing significantly exceed that of new housing offered on the market, a difference that has been gradually growing, which indicates an increase in the rhythm at which unsold housing stock is absorbed.

Therefore, after six years of intense adjustments to the real estate sector, with a cumulative drop of around 54% in activity since its height in 2007, 2014 is becoming a year of transition towards stability and is expected to end with an adjustment towards more moderate housing investment than that of recent years (down 3.5%). In 2015 we will start to see a recovery in this component of investment. Therefore, the ratio of investment to GDP has reached record lows: in 2013 it stood at 4.4% and is expected to drop to around 4.1% in 2014, significantly lower than the 1980-2013 historical average of around 7.8% (see graph 8).

08

Graph 8: Spain: housing investment (as a % of GDP)

14

12

10

8

6

4

2

Source: BBVA Research from INE

Private consumption and employment grow Although there have been improvements in indicators that traditionally precede the recovery in GDP (exports, investments in machinery and equipment) and changes have been detected in public policies aimed at avoiding additional deterioration of domestic demand (less uncertainty, more flexible public deficit goals), the turning point in indicators such as private consumption or employment was expected once the GDP growth cycle began and this is in fact what happened. In particular, the progress regarding economic activity and the improvement in the efficiency of the job market as a result of the labour reform passed in 2012 led to an increase in the number of people working in the private sector, which was greater than that which could have been deduced from the historic sensitivity of employment to changes in GDP. However, the Spanish economy destroyed 494 thousand jobs in 2013 (295 thousand less than in 2012). These results gave rise to a new spike in the unemployment rate (from 1.3pp to 26.1%) despite the 1.1% reduction in the workforce.

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2015 (e)

2014 (e)

2013

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1. Spanish economic recovery will gain momentum in 2014-2015

It is important to note that this reform is largely responsible for the containment of salary increases that would have prevented the destruction of around 220 thousand jobs in 2012 and 2013, and would have avoided the destruction of around 1 million job positions had it been applied in 20081.

From this point forward, mixed signals are received from the data on the number of persons registered within the Social Security system, with employment acceleration, and the data from the quarterly survey of the labour market, which continue to show job destruction. In any case, the consolidation of the recovery will enable the positive trend to continue and the number of jobs in 2014 to increase by 0.6%, a figure which should increase to 1.3% in 2015.

Accordingly, the unemployment rate will also depend on the behaviour of the workforce and, according to our predictions, should be around 24.8% in 2014 and under 24% in 2015.

The progress regarding household’s disposable income as a result of this turning point in the labour market, the improvement in their perception of the economic situation, the increase in net financial wealth and the term of the Efficient Vehicle Incentive Programme (PIVE) would have offset the deterioration in non-financial wealth of homes, which would have stimulated private consumption in recent months. In the future, private consumption will grow in 2014 and 2015, underpinned by the improvement in key aspects. The cycle change in the job market will therefore contribute to the increase in gross household income both this year and, especially, the next. Accordingly, the expected increase in net financial wealth, the lack of inflationary demand and the expectation that official interest rates will remain at record lows will offset the deterioration in non-financial wealth. Consequently, household consumer expenditure will grow by around 1.5% in 2014 and this rate is expected to pick up slightly in 2015.

1

10

See “Persistence of unemployment and salary dynamics in Spain”, in Situación España, Second Quarter of 2013, BBVA Research.

The effort to reduce public deficit will be less over the next two years In addition to the aforementioned improvement in exports, investments in machinery and equipment, and private consumption, there is also less negative contribution to domestic demand as a result of the unavoidable process of reducing public deficit. In particular, in 2012 and 2013 the government implemented measures that could have exceeded 6.5% of GDP in order to reduce public deficit from 9.1% of GDP (not including aid to part of the Spanish financial system) to 6.6% of GDP at the end of 2013. The difference between the size of the measures taken and the effective reduction that took place has to do with the cyclical deterioration and its impact on total expenses and income of public administrations.

This fiscal consolidation has been one of the greatest carried out in developed economies and, therefore, it has allowed its European partners to recognise the great effort that has been made. It should be noted that the cumulative fiscal effort, measured by the change in the primary structural balance, was almost 10% of GDP, reaching a 1.4% surplus in GDP in 2013.

This also allowed to set deficit objectives more consistent with the economic scenario. For example, the objective of reaching a deficit in public accounts of less than 3% of GDP was delayed by a few years until 2016, which allowed for more attainable goals in the short term. Reducing public deficit to 5.5% of GDP in 2014 and to 4.2% in 2015, which is that currently planned, would imply an effort of around 1.5% in terms of GDP, since the expected economic recovery should reduce certain expenses (unemployment, interest) and improve certain components of income. This fiscal policy, which is more consistent with the recovery, will therefore enable public spending to progressively reduce its negative contribution to growth over the coming years.

Similarly, it should be mentioned that, in accordance with the tax measures announced up until now, the tax balance would improve by 1.1% of GDP in 2014 and almost 0.6% of GDP in 2015, thereby allowing the government to be more proactive in complying with its budgetary commitment to Brussels.

These measures are equivalent to the envisaged improvement in the structural balance in this period, which would facilitate compliance with the tax objectives in a scenario of nominal GDP growth. In addition, the effect on growth should 11

1.  Spanish economic recovery will gain momentum in 2014-2015

be less than that in the recent past, since only half of the measures would be the result of an increase in revenues, while the remaining would result from a reduction in public spending, mainly as a result of the application of CORA2.

Lastly, it is important to note that the harmful multiplier effect of a restrictive fiscal policy is clearly less in a financial climate of improvement and certain stability such as the current environment in Spain.

To sum up, over the last twelve months, there has been a significant improvement in key aspects of the Spanish economy. The economic policy decisions taken at the European level, and the reforms carried out in Spain, explain the environment of greater certainty. This was a step towards a process of recovery that has similarities and differences with regard to previous recoveries from a recession. In particular, exports, net deleveraging of companies and families, and investments in machinery and equipment have preceded the recovery process and point towards sustainability in the medium term. The fact that exports have grown despite the recession in Europe is especially positive, since this growth was achieved without devaluing the currency, which would convert the competitive edge obtained into a more permanent process.

The aforementioned is mostly due to well-focused reforms that have allowed companies to have more flexibility and that have saved jobs. Similarly, these reforms will boost employment creation even more than in previous recoveries. In fact, this can be seen the recent increase in the number of jobs and, if consolidated, would represent a turning point in the prospects of household income which seems to be positively affecting consumer expenditure. All of this has resulted in a scenario of moderate recovery, in which the GDP of the Spanish economy is expected to grow by around 1.3% in 2014 and around 2% in 2015.

2

12

Commission for the Reform of Public Administrations.

13

2

The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country The historic improvement in the trade balance continues which forecasts current account surpluses equal to 2%-3% of GDP in 2014-15.

Since 2008 Spanish exports of goods have increased on average at a nominal growth rate of 7% per year3, a rate which is similar to that recorded from 2002 to 2007. However, although the growth rate of exports has been similar to that prior to the crisis, this took place despite the slowdown of global growth from 4.8% during the 2002-07 period to 3.2% over the last six years.

This buoyant export sector performance meant that Spanish exports of goods in 2013 reached 234 billion euros, which in terms of per capita means that each Spaniard now exports 5,026 euros, approximately 1,000 euros more than in 2008. It should be noted that Spain is one of the few developed countries whose exports grew in 2013. Compared to Spain’s 5.2% increase in foreign sales, exports fell by 1.6% in France, by 0.2% in Germany and by 0.1% in Italy, which is in line with the events taking place in the EU, while in the USA exports grew by almost half, up 2.1%. Only Japan saw a growth rate greater than that of Spain, with an increase in foreign sales of 9.5%.

This dynamic growth was made possible as a result of the diversification of Spanish exports both in terms of product and destination.

• I n analysing the breakdown in 42 categories, the concentration has decreased by 4% since 20094. The greater weight of capital goods (now representing 21% of total exports), thanks to the increase in sales of machinery and transport material, as well as in consumer goods (textiles, clothing, jewellery and watches) and agroindustry, is noteworthy of mention.

• H owever, what was surprising about this process of expansion was the diversification by destination. In analysing the breakdown of foreign sales to 200 countries, the Herfindalh concentration index shows a drop of more than 20%. The share of exports to Europe decreased by

3 4

14

This rate excludes 2009 where exports fell by 16%.

According to the Herfindalh index, the concentration by product of Spanish exports since 2009 went from 680 to 655.

more than 6pp to 67.9% of the total at the end of 2013. Exports to the eurozone decreased by 8pp to 48.1%, the weight of exports to Latin America (Brazil accounts for 45% and today is the destination of 6.5% of spanish exports) increased by 1.6pp, the share of exports to Africa increased by 1.2pp to represent 7% of the total (60% accounted for by North Africa), and the weight of exports to Asia increased to 0.6pp to represent 5.3% of the total.

• G raph 9 shows the breakdown of Spanish exports by destination in 2009 and in 2013. There is also a breakdown by destination of German exports in 2013. In general, the growing trend observed in Spanish exports is to have a distribution similar to that of Germany, reducing sales to eurozone countries and increasing exports to the majority of emerging countries, especially to Europe and Asia. In fact, in view of the differences, it could be asserted that the share of exports to the eurozone could be reduced further and those to Asia and emerging European countries could be increased. However, there will logically be differences since, due to cultural and economic ties, the weight of Latin America for Spain is double that for Germany, which is also true for Africa, and specifically North Africa.

Graph 9: Distribution of exports by destination (as a % of total) 56% 48%

36% 31%

18%

20% 16% 9% 4%

Eurozone Germany

Rest of Europe Spain (today)

4%

North America

5%

6% 3%

Latin America

5%

6%

5%

7%

7%

9% 4%

2%

Asia

Africa

Spain (2009)

15

Other

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

It would therefore be logical for exports to continue growing at high rates over the coming years as a result of transferring the portfolio of Spanish exports to destinations with stronger growth. In fact, this should continue to be the strategy of the export sector since, as detailed in several reports, from today until 2020 the weight of trade between countries in the northern hemisphere will likely decrease by half (from 40% to 35% of the total), while trade between countries of the southern hemisphere will increase significantly from the current 16% to 25% in 2020.

The number of exporters grew to an average annual rate of 11.4% in the 2011-13 period. This means that the number of exporters today is 53% greater than prior to the crisis, which contrasts with the net decrease of total companies of more than 6% since the beginning of the crisis.

• M adrid is the regions with the largest growth in terms of the number of exporters, growing at a rhythm of twice that of the country’s average.

Madrid is followed by Extremandura, where the number of exporters grew over the past three years at an average annual rate of 17.8%, followed by Cantabria. The regions with the least dynamic performance in terms of the number of exporters include Catalonia (annual average of 6.5%) and Galicia (8.7%).

• H owever, the number of companies that export regularly5 presents a positive but very modest trend, since at the end of 2013 there were 6% more than just prior to the crisis. However, the fact that four consecutive years of exporting are needed (since at least 2010) and taking into account that the number of exporters began to increase starting from that year, it should not be discarded that as of 2014 the number of regular exporters will begin to increase significantly.

The great challenge of the Spanish business fabric is to increase the average size per company, since large enterprises have very similar export intensity to that of the main European countries, with the advantage that the historic ties and the geographical proximity allow diversification by destination to be greater than other European countries.

5

16

A company is considered to regularly export when it has carried out export activities consecutively over the last four years.

Graph 10: Number of exporters +53% 150,992

98,798

+6%

38,938

No. of exporters 2013

41,163

No. of regular exporters

Pre-crisis

Not only will the competitiveness of the economy and Spanish companies continue to be fundamental in this progress towards greater internationalisation, but also the commitment of public and private sectors with the key player, the company, by means of “commercial diplomacy” and the de facto support with credit lines through COFIDES, ICO, FIEM, CESCE and ICEY to support growth in the short and medium term. Developing the internationalisation certificates and bonds market, together a greater ability to access guarantees and collaterals in internationalisation transactions, will be fundamental in this regard, whereby these types of financing initiatives should be key in the strategic internationalisation plan for the 2014-2015 period.

• I n 2013, 66% of exporters that received financing or 71% of SMEs created or stabilised employment in Spain (vs. only 34% in 2012).

• A t least 1,000 internationalisation projects had explicit financial support from these organisations. This support also entailed raising external financing of 2.5 billion euros.

• A s mentioned in this section, there is a clear focus on internationalisation plans by diversifying markets and products so that the improvement is not cyclical but rather structural, whereby the following are especially noteworthy of mention: 17

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

- A growing financial weight towards projects in emerging countries such as Mexico, Peru and Colombia in Latin America; Angola and South Africa in Africa; Southeast Asia and, especially, in developed countries towards the USA market.

- Growing presence in the food and agriculture sector, where innovation, safety and product quality is especially valued, the extensive Energy sector, the Automotive sector, the Engineering sector and the Transport Infrastructure sector.

The aforementioned factors, such as diversification by products and especially countries, the improvement in competitiveness thanks to the reduction in unit labour costs (see below), the increase in the tendency to export and the priority of public institutions to promote this approach have led to a structural change in Spanish exports. Graph 11 shows the average annual growth in exports of goods and services under two scenarios during the 2002-08 and 2010-13 periods. The dark blue bars of the graph indicate the estimated growth in exports taking into account the diversification pattern, the organic growth of the countries to which Spain exports and the export propensity prior to the crisis. The light blue bars include the changes in the geographical pattern and the export propensity since 2010, and the organic growth of the countries to which Spain exports. Lastly, the green bars relate to the growth in exports of goods and services seen in the national accounts of Spain. Various conclusions can be reached:

• D uring the 2002-08 period, exports increased at an average annual rate of 3.5%, which is below the rate at which they would have increased (5.1%) had the organic growth of the destination countries and the diversification pattern been taken into account. This represents a loss of growth of almost 0.5pp per year.

• H ad this pre-crisis pattern been preserved, Spanish exports would have increased by 2.8% per year vs. 6.6% in the 2010-13 period, which would have represented a 1.1pp less in GDP growth than that actually recorded.

18

• H owever, if the improvement in the exporting tendency and the diversification by geographical areas are included, the growth rate of exports would increase to 6.6%, a rate similar to that finally recorded. This means that since 2010 these changes have been incorporated into the Spanish export sector, thereby more than doubling the theoretical growth in exports.

• L astly, over the next three years (2014-16), exports will likely grow by 5% considering the pre-crisis pattern and taking into account the growth estimates of the destination countries, which is very much in line with the 5.5% growth estimated by the International Monetary Fund. On the other hand, if the current exporting pattern is maintained, which is what should happen, exports would increase at an average annual rate of 9%, which would represent additional GDP growth of almost 1pp per year from the levels currently envisaged.

Graph 11: Growth in exports of goods and services (average annual growth rate, constant prices) 9.0

8.8

6.6

6.6 5.5 *

5.1

5.0 3.5 2.8

2002-2008 Exports of goods and services (yoy, estimated), pre-crisis pattern

2010-2013 Exports of goods and services (yoy)

2014-2016 Exports of goods and services (yoy, estimated), post-crisis pattern

* This corresponds to the growth forecast for exports of goods and services carried out by the IMF in April 2014

19

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

This improvement in exports, together with the adjustment to imports, has represented a shift of more than 84,060 million euros in the trade balance since 2007 (8.1% of GDP). That said, almost 60% of this adjustment (see table 1) is explained by the increase in exports, whereas the remaining 40% would be from the drop in imports. If exports are broken down into three groups: goods related to the primary sector, medium-high added value goods and durable consumer goods (more elastic than income and more related to the construction sector), we see that two-thirds of the improvements in exports were a result of high-added value goods, while food and energy accounted for the rest. Lastly, durable consumer goods are those that suffered the most following the drop in the volume exported.

Table 1: Improvement in the trade balance (2013 vs. 2007) Trade balance improvement (as a % of GDP)

% accounted for by exports

Primary sector*

0.4%

42%

Medium-high added value goods**

6.1%

65%

Durable consumer goods***

1.6%

-7%

Total

8.1%

59%

2013 vs. 2007

* Food, energy products and raw materials ** Semi-finished goods, manufactured goods, capital goods and other merchandise *** Automotive sector and other durable consumer goods

With regard to the drop in imports, the analyses carried out6 recently indicate that, despite the fact that the deterioration in final demand explains a high percentage of the negative performance of imports throughout the economic crisis, the Spanish economy is immersed in a process of substituting imports (non-energy) for domestic production, which would explain the 42% drop in imports. Specifically, and for the first time in over two decades, domestic products had a competitive edge in terms of price over imported goods, which evidences the current internal devaluation process in progress. In addition, this competitive edge in terms of price was reinforced by a relative demand for imports that was more flexible with regard to the relative price, which enhanced the substitution process. This is also reflected in the competitiveness indicators calculated using various methods, which reflect improvements since the beginning of the crisis between 8%-10% 6

20

Situación España, 4Q13 BBVA Research. Substitution of imports for domestic production during the crisis: preliminary evidence.

compared to the main partners. In other words, our domestic and export cost indices increased by 8%-10% less than those of other partners.

Over the next two years, the projections made by international and Spanish organisations estimate additional improvements in the current account balance from surplus levels of around 1% of GDP in 2013 to a range of 2%-3% in 2015. This is the result of maintaining an annual growth rate of 5%6% in exports and a progressive recovery in imports7.

Accordingly, not only did the foreign trade deficit turn into a surplus for the first time since 1987, thanks to the aforementioned improvement in competitiveness and diversification, but there are also signs that this will continue in the future as shown in the paragraphs above. This view would also be backed by the last report on positioning countries towards foreign trade prepared every two years by the World Economic Forum. The last report placed Spain among the leaders (in fourth place) in terms of growth potential, mainly as a result of the availability and quality of its transport infrastructure and services. The return from trade credit (main obstacle in recent years) and the improvement of ICTs in the value chain would be the additional leverage needed to back this improvement in the future.

Improvement in quality and quantity of financial flows Spain continues to be very attractive for foreign investment in production Foreign direct investment (FDI) has always played a major role in Spain’s economic history. According to the recent unified data available from the UNCTAD, FDI stock in Spain is 47% of GDP, which is above that of the United States (26.2%), France (39.5%), Germany (21.1%) and Italy (17.7%). In addition, annual foreign direct investment flows have always been positive and relatively stable since the mid-’90s, representing between 5% and 24% of total investment in Spain. Even in 2009, the worst year in terms of growth in recent history, FDI inflows were 6.8% of total investment. According to UNCTAD data, Spain was ranked thirteenth worldwide in terms of FDI received8 and third in the EU15, only after the United Kingdom and Ireland.

7 8

F or example, the la Caixa research service estimates that if Spain maintains the competitive edge it has had since the beginning of the crisis, it could have trade surplus of more than 125 billion euros in 2018. h ttp://unctad.org/en/Pages/Publications/Global-Investment-Trends-Monitor-(Series).aspx.

21

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

In 2013, there are several noteworthy aspects regarding the figures on foreign investment into and out of Spain. Firstly, foreign direct investment in production received increased in 2013 by almost 9% to 15,800 million euros. Secondly, 80% of this investment received was assigned to “greenfield” investments, in other words, investments that have the greatest impact on production and employment in the country. Lastly, in 2013 the divestment process of Spanish companies abroad was slowed down, which shows that the process of adjusting the trade balance was coming to an end.

With regard to investment received, the concentration by country in 2013 is very similar to that of previous years. The first seven countries investing in our country account for 75% of total flows received. Of these countries, the greatest increases came from France (905 million euros) and the United Kingdom (863 million euros), while the greatest losses were experienced by the USA (-983 million euros) and Luxembourg (-482 million euros). With regard to other countries, the increase in 2013 of 240 million euros from Hong Kong, the 250 million euros from Japan and the 440 million euros from Mexico are worth mentioning. In terms of areas, the EU-15 as a whole accounted for 73% of total investment, up 16.5% compared to 2012. Latin America also increased its investment in Spain by 48% and gained weight in total investment from 5.2% in 2012 to 7.1% 2013.

In historic terms and as was the case with exports, the concentration by country of origin of the FDI inflows decreased over time. In fact, 2013 was the year with the greatest diversification in history. Graph 12 shows the breakdown by country of FDI in 2013 with regard to the average of the last decade (19982007). The main conclusion reached is the drop in the weight of non-euro countries (especially the United Kingdom) and the increase in the share of emerging countries, especially in Latin American.

22

Graph 12: Breakdown of FDI inflows by country 60% 57%

25%

17% 11%

9% 4%

4%

2%

Rest of Europe

North America

5%

5% 1%

0% 2013

1998-2007 Eurozone

7%

Latin America

Other

Asia

Africa

It is important to note the growth position of foreign multinationals in Spain, which, according to the latest available data, total more than 13,000 foreign companies (70% of which are represented by the top 100 on the Forbes list) that are responsible for 7% of employment. With regard to the number of projects, Spain received 660 FDI projects over the last 24 months from almost 500 companies, significantly above the average of the Nordic countries (100), Switzerland or Italy (around 180), the Netherlands or Ireland (around 300) and even France (550). This investment represented the net creation of 58,000 jobs.

Accordingly, Sovereign Wealth Funds continue to focus on Spain, maintaining and even increasing investments in various spanish companies9. Over the last year, funds such as the Norwegian fund maintained its investments in Spain, while others, such as that of Singapore, China or Qatar, significantly increased their investments in our country.

9

S overeign Funds 2013. KMPG, Invest in Spain and Esade.

23

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

Numerous recent examples, such as those listed below, despite the private consumption crisis that we have experienced, confirm the attractiveness of Spain, which is ranked first in Europe in terms of quality of life for expatriates and third worldwide, a country with excellence in innovation activities and as a key platform in high added value sectors:

• E stablishment in Spain of European R&D districts of leading multinationals in added value sectors (videogames, cloud computing, aeronautics, sound equipment, biotechnology), • Strong investments in cutting-edge technology projects (biomass, healthcare, information technology, electronic machinery), • Increase in plant capacity in key sectors (pharmaceutical, automotive, auto parts, electric equipment) or • Notable commitment of foreign investment in Spanish logistics platform.

The return of confidence is also reflected in positive portfolio flows Changes in the Spanish financial balance reflect, on one hand, the deleveraging situation and, on the other hand, the recovery of confidence that Spain is undergoing. Graph 13 shows, by period, net FDI flow, portfolio and other investments (loans) over various periods on a net basis. Therefore, from 2005 and 2007 the portfolio and loan flows showed positive values while the net FDI was negative due to the fact that the inflows (30.5 billion euros) were less than the outflows (72.3 billion euros) as a result of the strong commitment of Spanish multinationals to invest abroad. Subsequently, from 2008 to 2012 portfolio flows (bonds and equity) disappeared and were replaced by loans, while net FDI stagnated. Lastly, 2013 reflects the greater confidence in the country with positive net portfolio flows and FDI inflows reaching record highs in the 2005-07 period, together with the deleveraging process, which explains high loans repayment.

24

Graph 13: Spain: financial account changes (billion euros) 82.5

45.2

2005-07

2008-12

Investment portfolio

Other investments

FDI

-25.3

2013

Total

This greater confidence is reflected in several indicators of Spanish public debt, where despite the demanding issuance timetable we continue to see a stable appetite:

• T he demand/supply ratio has remained unchanged at a level of 2.5 since the beginning of 2013 for both long-term and short-term issuances. In 1Q14 a slight improvement was recorded which was in line with the confirmation of the scenario of economic recovery observed in recent months, thereby allowing the issuance of 34% of that envisaged in bonds and obligations for the entire year and 28% of the total estimated needs,

• T he proportion of long-term debt (bonds and obligations) continues to increase and already represents almost 90% of the total stock (vs.

80% in 2009), which provides stability and predictability to the cash refinancing plans and allows the total average life of the debt to be raised to almost 6.3 years,

25

2. The current account surplus and the restoration of the financial balance strengthen Spain’s financing capacity in relation to the rest of the world and our attractiveness as a country

• T he percentage of debt in the hands of non-residents, by type of investor, at the end of 1Q14 stood at 40.3% of the total, up from the record low of 34.8% recognised in 2011. From 2010 to 2012, non-residents barely accounted for 6% of the debt issues, while in 2013 they purchased 94% of the total debt flow. A portion of this greater share by non-residents was at the cost of less exposure of Spanish financial institutions.

This improvement in confidence, thanks to external support, was also consolidated in “key players” That mentioned above is reflected in the change in view and discourse of the rating agencies when talking about Spain. The significant adjustment carried out in the current account, the exceptional capacity of the Spanish economy to refocus on tradable sectors and the competitive edge earned thanks to the reduction in unit labour costs, are the main reasons which, according to the rating agencies, would rule out any drop in rating in the near future.

In addition, rating agencies continue to view positively the government’s commitment to reform (reform of public administrations and fiscal reform) as well as the path taken until now with the approval of the reform of the labour market, the financial sector and the pension system.

In addition to that mentioned, there were various positive surprises in the last quarters of 2013 which dispelled two of the main doubts regarding the Spanish economy: i) credibility of and commitment to the fiscal adjustment and ii) the clear turning point in economic growth.

26

• C redibility of the fiscal adjustment once the 2013 fiscal objective was in fact met. The deviation in current terms is barely 500 million euros, whereby growth below that budgeted would explain most of the deviation. The prospects for compliance in 2014 are optimistic, although doubts have arisen regarding the 2015 objective once the neutrality of the fiscal reform is expected. In addition, the pressure on the capacity to refinance the maturities has disappeared, which is reflected in the lengthening of the term of the debt and the return of foreign investor interest.

• E conomic recovery, with the end of the recession between 2-3 quarters previously envisaged by most analysts and a growth based more on domestic demand and an improvement in the labour market situation.

It should be taken into account that the figures on employment created in March show how employment in the construction industry was generated for the first time since 2007, and how the industry continues to create jobs for the third consecutive month and services for the eighth consecutive month. In the first quarter of 2014, employment was therefore created at an annual rate of 2.5%, up 1.4% compared to the fourth quarter of 2013.

Lastly, it should be mentioned that most international bodies (mainly the OECD and IMF) and business surveys are confident in Spain’s ability to increase exports and its path towards internationalisation. Therefore, the latest IMF projections estimate there will be a continued improvement in the Spanish current account until reaching a surplus of 3.4% of GDP in 201910.

Along this same line, business community believes that Spain will increase its share in world trade over the coming years, and be able to maintain or even strengthen its rhythm of exports that began during the crisis11. In any case, this improvement in exports should be sustainable and will allow the country not only to have financing capabilities in relation to the rest of the world for the first time in 16 years, but also to maintain this capability over the medium term.

10 W EO projections of April 2014.

11 “ The Spanish economy in 2033” report of PWC.

27

3

The clear progress in adjusting the existing imbalances continues

After having seen in the previous section how the main imbalance in the Spanish economy (the export sector) was successfully corrected, we are going to review the trend in the main imbalances generated by the Spanish economy during the period of economic expansion: the high level of debt in the private sector. As in the case of the export sector, streamlining decisions regarding consumer expenditure and investment in a context of lower domestic demand as a result of the economic crisis, together with the credit crunch, contributed to improving private debt ratios starting in 2011. Since then and until 2013, Spanish private debt fell 25 points of GDP to 207%, whereby the business sector accounted for 14 points of this reduction as a percentage of GDP. This is one of the reasons that explains the fact that the private sector currently has a financing capacity of more than 7% of GDP. Spain’s level of private debt is returning to levels that are considered sustainable, which is one of the conditions to ensure the economic recovery in progress is sustainable and that it is accompanied by a progressive improvement in domestic consumption and employment.

Therefore, the government must continue with its policy of adjustments and modernisation, adjusting debt levels and preventing the crowding out of private sector investment. Since 2008, the government increased the weight of its debt/GDP ratio from 40.2% to 93.9% at the end of 2013, following a growing leveraging path that is contrary to the deleveraging carried out by companies and households, which has also affected bank financing with the growing weight of the government and a decrease in the financing capacity of companies and households. It is essential that the government, companies and households maintain the common objective of optimising their leverage ratios in order to lay the foundations for sustainable growth which facilitates the creation of employment. Lastly, as seen in the section below, measures will continue to be implemented in order to increase productivity from all key economic fronts and agents.

Debt of Spanish non-financial companies is reduced Spanish companies contributed significantly to the deleveraging process of the Spanish private sector, carrying out processes to optimise investments, divestments, cost adjustments and process efficiencies. From the record highs posted mid-2010, the debt recognised on corporate balance sheets dropped 28

by 188,600 million euros, 14 points of the GDP. Another factor that heavily influenced this trend is the drop in the weight of short-term bank financing in total loans: at the beginning of the 2000s, they represented 25% of the loans and in 2013 represented less than 10%. Therefore, non-financial companies are slowly finding new forms of financing, thereby reducing their exposure to the financial sector (see graphs 14 and 15).

Over the next two years companies will likely continue to improve their financial position, with additional reductions in their debt levels, especially bank debt, albeit at a slower pace than that seen in 2012 and 2013. Even when there are significant differences by activity sector, in aggregate terms, business margins must be maintained or even reduced by taking into account the restrictions in order to continue adjusting labour costs and expectations regarding gradual recovery for income. In addition, as investment in fixed assets is revived, the available resources and incentives to repay debt are less. In any case, the financing capacity of the business sector may, on average, be around 3% of GDP in 2014 and 2015.

Graph 14: Debt of Spanish companies (as a % of GDP). 3Q13: latest available data

Graph 15: Financing structure of Spanish non-financial companies (trillion euros)

150%

4.5

140%

4 3.5

130%

3

120%

2.5 110% 2 100%

1.5

90%

Gross debt

Net debt *

(*) Net debt = gross debt less cash and deposits Source: Afi, Bank of Spain

Trade debt

Current financial debt

Non-current financial debt

Equity

Source: Afi, Bank of Spain

29

13

12

11

10

09

08

07

06

05

04

03

02

00

s13

s12

m13

s11

m12

s10

m11

s09

m10

s08

m09

m08

s07

s06

m07

0 m06

70% s05

0.5

m05

80%

01

1

3.  The clear progress in adjusting the existing imbalances continues

One of the main signs of the deleveraging process in which Spanish companies are immersed is the change in their saving position. At the beginning of the 2000s, the sector as a whole made annual decisions regarding investments in fixed assets (machinery, transport equipment, etc.) for an amount similar to 15% of GDP, while the savings generated, understood as the volume of net income, was around 10% of GDP. This gave rise to certain financing needs, covered mostly by debt, of around 5% of GDP. Since 2010, the companies have altered their financing position and have become net lenders to other institutional sectors. This trend can be explained not only by the intense contraction in investment expenditure, but also by the process of adjusting costs (especially labour costs) which gave rise to the slowdown in demand. The improvement in the gross debt/EBITDA ratio (total liabilities excluding capital) and net debt/EBITDA ratio (deducting the value of the financial assets in cash and deposits) is also a good indicator of corporate stabilisation. These ratios dropped by between 30%-40% at the end of 2013 with regard to those at the beginning of the crisis.

The aforementioned deleveraging, along with the recovery of operating profit (up 4% in 2013), enabled the ratio of debt to gross operating profit to be reduced to the levels in 2002 (approximately 8x times from a ratio greater than 12x in 2007), thereby also confirming the strong reduction in debt and the substantial improvement in companies’ capacity to repay debt. The expected recovery in domestic demand will allow net income to be increased, thereby bolstering the recovery of operating profit in the future. It is important to note, in line with that mentioned above, that the improvement in operating profit to 21% of GDP (vs. 17% in pre-crisis years), has allowed the debt ratios to return to 20012004 levels in terms of available income or operating profit.

30

Table 2: Level of income, consumption, savings and investment in fixed assets of Spanish companies Billion euros; cumulative data over 12 month

2008

2013

% of change

GVA (gross value added)

517.4

505.5

-2.3%

EBITDA (gross operating profit)

181.1

214.0

18.2%

Available gross income or gross savings

66.3

151.3

128.3%

+ Net capital transfers

12.7

9.6

-23.8%

= Capital resources

78.9

160.9

103.9%

– Gross capital formation*

-180.1

-118.2

-34.4%

= Financing capacity (+) / needs (–)

-101.2

42.8

* Includes amortisation and depreciation. Plus acquisitions of non-productive non-financial assets (land) Given that 3Q13 provides the latest available data, the position in 2013 is the cumulative result of the last four quarters.

Source: Afi, INE

The still high deleveraging rate is being translated into sharp drops in outstanding credit balances. However, since the end of 2013 we have begun to glimpse the first signs of recovery in terms of the volume of new loans granted to SMEs; a trend that was also confirmed by the latest bank loan survey carried out for 1Q14.

For example, in 1Q14 new transactions granting loans to companies for less than one million euros reached a volume of 31 billion euros, compared to the 28 billion euros in the same period of 2013.

The incipient recovery envisaged for granting new bank loans will benefit those companies with viable business models that were adversely affected by the adjustments to demand and the credit crunch. In this regard, there were several recent initiatives focused precisely on providing corporate financing. Royal Decree Law 4/2014, on urgent measures regarding refinancing and restructuring corporate debt, intends to facilitate debt refinancing agreements, other than insolvency proceedings, in order to ensure the survival of viable companies which, as a result of their high level of debt and economic situation, are unable to meet current financing conditions.

31

3.  The clear progress in adjusting the existing imbalances continues

The recovery of bank lending will therefore be essential in order to slowdown the mortality in the small and medium enterprises segment. New financial initiatives other than through banking channels need to be developed, such as the creation of Alternative Fixed Income Market, although the relative importance of the market in the structure of Spanish corporate financing is still very low.

Debt reduction of Spanish households picks up The deleveraging process of households is going slower than that carried out by companies, however it has begun to pick up speed as of 2012. The debt assumed by households reached record highs in 2010 at 130% of their gross income available, whereas at the end of 2013 this debt represented 116%, despite the adjustments to family income. In terms of GDP, the debt ratio was reduced by 10 points (87.7% in 2010 compared to 77% in 2013). In fact, net debt transactions (new loans granted less repayments) were negative for an amount of 35,000 million euros in 2012 and 43,000 million euros in 2013, which is consistent with the low rate at which new mortgage loans were granted. For example, in 2013 the new loans granted to households to acquire housing amounted to 21,400 million euros, compared to the 31,300 million euros in 2012 and very far from the 139,000 million euros of 2007.

The sharp reduction in housing investment and the adjustment to consumer expenditure allowed the drop in available income (due mainly to the destruction of employment and the progressive containment of salary increases) to be offset, giving households a margin to repay the debt. In this regard, Spanish households shifted from having borrowing needs, understood to be the difference between the savings generated and the housing investment, of almost 3% of GDP in 2007 on having a savings surplus for almost the same amount.

The notable improvement that the recovery of the net financial wealth of households is having on restructuring their balance sheets is worthy of note in this section. At the end of 2013, Spanish families reached record levels of net financial wealth, surpassing the maximum reached in 1Q07 with an improvement of approximately 370 billion euros (a 54% revaluation) compared to the record lows of 1Q09, a consequence of the continuous positive flow of net financial wealth to the balance sheets as a result of their financial assets appreciating and repaying their liabilities at a faster rate. Although net financial wealth continues to be below pre-crisis levels in terms of available gross income, this ratio could 32

be reached in 2014, reducing the need to increase savings and, therefore, not putting pressure on private consumption.

The aforementioned allowed 4Q13 to be the first quarter in five years with an annual growth rate for total net wealth –including real estate– that was positive (1.2%), after two consecutive quarters with positive quarterly growth.

Following the sharp adjustment in the value of families’ total real estate wealth (almost 1.6 trillion euros since the maximum of 2Q08), it is to be expected that the normalisation and subsequent recovery thereof still places more emphasis on the driving effect of total wealth on family consumption.

From this point forward, our projections give continuity to the debt reduction process of households although, and just as in the case of companies, at a more contained rate. In 2014 and 2015, net debt transactions could be negative amounting to 20 billion euros per year. In this regard, the distribution of the debt by segments of household income is key. The recent context of interest rates reaching record lows reduces the incentives for households without income restrictions to repay their debt at a quicker rate; accordingly, it is difficult for the improvement in income expectations to be focused on the lower income percentiles that bear a greater financial burden. The combination of both effects, together with the incipient increase in consumer expenditure, should slowdown the debt containment process.

Graph 16: Debt of Spanish households (as a % of their gross available income)

Graph 17: Savings and housing investment of Spanish households (as a % of GDP) 13%

140%

12% 130%

11% 10%

120%

9% 110%

8% 7%

100%

6% 90%

5%

Source: Afi, Bank of Spain

Gross savings (available income less consumption)

Source: Afi, Bank of Spain

33

s13

s12

Housing investment

m13

s11

m12

s10

m11

s09

m10

s08

m09

s07

m08

s06

m07

s05

m06

s04

m05

s03

m04

13

12

11

10

09

08

07

06

05

04

3Q13: latest available data

m03

4%

80%

3.  The clear progress in adjusting the existing imbalances continues

Adjustments to the real estate market are nearing their end Data on activity allows the surplus supply that existed to be adjusted After five years of adjustments to the sector, current activity levels indicate an increase in supply of 35,000 homes/year, a level much lower than the annual demand for new housing of around 148,000 homes, which would indicate that the margin for an additional reduction would be very scant. In fact, this situation is already giving rise to an increase in approvals in those provinces where demand is recovering even more. As seen in the first section, the weight of this sector in the economy was significantly reduced, whereby it went from representing 12.5% of GDP in 2006 to 4.4% in 2013, which limits its additional negative contributions.

To put the situation into perspective, this ratio is much less that the historical average in Spain (8%) and only slightly less than the current ratio of the European Union as a whole (4.6%).

The new housing stock for sale has been gradually reduced at an increasing rate since 2009 and, according to data from the Ministry of Public Works, stood around 580,000 in 2012. Based on the rate of activity, the reduction will be more intense over the coming years, boosted by a progressive recovery in demand.

Graph 18. Spain: New housing stock for sale (units) 750,000

625,000

500,000

375,000

250,000

125,000

Source: Ministry of Public Works and National Secretariat of Nutrition and Food Safety (SESAN)

34

15 (e)

14 (e)

13

12

11

10

09

08

07

06

05

04

0

Increasing demand of non-residents and investors Despite the tax changes that have conditioned the underlying housing demand, the trend of this demand in the future is conditioned by the type of buyer:

• R esidents: despite the fact that it should be improving in line with the economic situation, principal housing demand will continue to be weak. Social demographic trends, contained margin for improvement in available income and more demanding financial and tax conditions will be the main hindering factors. However, the reduction in the uncertainties and the improvement seen in the confidence of families is expected to begin to reflect a gradual improvement in normal housing demand.

• F oreign residents and non-residents: the purchases show a clear acceleration with growth rates of 12% in 2013, representing 16% of the total transactions. Purchases were above 40% in the main tourist provinces along the Mediterranean coast and the Canary Islands.

• I nvestors: the large share that investors have in residential and non-residential purchases shows that the price adjustment expectations have begun to no longer be a factor limiting demand.

The growing development of real estate investment companies and the inflow of foreign funds in the market will allow the investor base to expand in the sector and will give rise to greater professionalization for segments such as the rental one. Although at first glance the interest seems to focus more on other areas of the market –offices and retail–, there are also significant transactions in the residential sector due in part to the impression that most of the price adjustments have already taken place. Three real estate investment companies are currently listed, the SAREB has carried out a dozen transactions with wholesale investors and important financial institutions have outsourced the management of the real estate portfolio, which gives depth to players of this type.

35

3.  The clear progress in adjusting the existing imbalances continues

Price adjustments nearing their end but with differences between provinces The price of housing decreased by 38% in real terms from its maximum values, a percentage greater than the overstatement estimates given by various studies.

Throughout 2013 there was a change in the rate of reduction to 4.2% compared to the 9.7% decline of 2012. The changes in the prices reflect the trends seen in demand, with more moderate adjustments and even increases in the provinces where foreign demand has greater weight and in those that attract greater investment.

Graph 19: Spain: Housing price (year-on-year % of change and 1Q08 (max) = 100) 25%

110

20%

100

15%

90

1 0%

80

5%

70

0%

60

-5%

50

-10%

40

-15%

30 Mar-96

Annual change

Mar-99

Mar-02

Mar-05

Mar-08

Mar-11

Level (1Q08 = 100) (right scale)

Source: Ministry of Public Works and Bank of Spain

Although a swift recovery of the real estate market is not to be expected over the next two years, the record lows, both in housing starts and in demand, are expected to be left behind in 2013 in terms of flows, which will be reflected by the levelling off of the general drop in prices during this year and stability in 2015.

The banking sector has already carried out an in-depth restructuring The reform of the financial system was a fundamental element in ending the crisis. The actions taken have driven the stabilisation of the sector by means of:

• A sharp increase of the provisions, since from the beginning of the crisis, the sector provided provisions equal to 25% of GDP, 36

• A 46% reduction in exposure to the real estate sector, without taking into account the provisions, • The performance of a strict stress test that identified vulnerable entities (30% of the sector) and their capital needs, thereby dispelling any doubts as to the solvency of the rest of the sector and carrying out a series of actions amounting to almost 100 billion euros, • The necessary recapitalisation of entities with public money and the segregation of assets to the SAREB, for almost 51 billion euros, which represented a 52% deterioration and a transfer of 200 thousand assets (including real estate assets and loans to developers), • The approval of several reforms, including the governance of the savings bank sector and the introduction of improvements regarding the supervision and acting capacity of the Bank of Spain.

The restructuring and recapitalisation of entities, and the compliance of all milestones agreed upon with European authorities has led to the definitive end of the financial assistance programme in January 2014. This has allowed Spanish banks to recover their solvency and to access financial markets, thereby reducing the need to resort to assistance from the European Central Bank. These improvements are seen clearly in:

• The changes in the capitalisation of listed entities in relation to their book value, which went from levels of 0.5 in mid-2012 to amply standing at above 1 at the end of 2013.

• The solvency of the sector has increased considerably, as shown by the core tier 1 ratio which stood at 11% (see graph 20).

Graph 20: Core tier 1 in Spanish banks (as a % of risk weighted assets) 11%

10%

9%

8%

7%

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Jun-13

37

3. The clear progress in adjusting the existing imbalances continues

Lastly, there was a sharp adjustment to installed capacity with a 27% reduction in the number of offices between 2008-2013, until reaching the levels at the end of the 1980s, and major cutbacks to workforces of around 20% during this period, not to mention the significant consolidation of the number of entities from 45 savings banks in 2007 to the current figure of 9 commercial banks and two much smaller savings banks.

Graph 21: Spain: Operating branches (thousands) 45

40

35

30

25

20

1985

1990

1995

2000

2005

2010

Dec-13

Source: Bank of Spain

The latest bank survey indicators disclose several events that confirm not only the return to normalcy, but also a slow and gradual recovery of bank lending:

• The risk factors (either of the economy as a whole, or the company itself ) are no longer an unfavourable factor in the supply of credit,

• Demand for credit has increased for the first time in three years,

• The fragmentation of bank lending is gradually being resolved, as evidenced by the expected improvement in SMEs in Spain in accessing credit. The tightening that took place in country risk would also be expected to be transferred to bank loan rates which, together with other initiatives (ECB, Alternative Fixed-Income Market) that temper the problem, also lead to greater optimism.

38

The next steps for the sector must be based on four pillars:

• F uture capacity to obtain profitability is in line with the cost of capital currently required by the market. Despite the fact that the banking system is no longer posting negative figures, mainly as a result of the decrease in provisions and unproductive assets, the low turnover and the extraordinarily low interest rates make it extremely difficult to generate profit, thereby maintaining the pressure on entities to achieve efficiency gains.

• T o pass the asset quality tests and the stress test to be carried out by the European Banking Authorities in 2014. Although we do not have all the details, no significant impact on the Spanish financial system is expected.

After having passed an exhaustive exam regarding the lending portfolio in 2012, entities were restored and recapitalised, which generated greater cushions to absorb adverse scenarios.

• W ithdrawal from the public sector of the entities involved, with advances such as the sale of NovaGalicia or the 7.5% in Bankia and the asset management of the SAREB where, after the start-up, asset sale transactions had already begun to be carried out.

• E xpand the financing possibilities by developing and consolidating alternative mechanisms such as the Alternative Fixed Income Market or through purchasing senior tranches of asset backed securities.

In summary, following the restructuring carried out and the process of strengthening its balance sheets, the banking sector is prepared to accompany the economy in its recovery and to compete in the eurozone retail market that is being created. In addition, the diminishing regulatory uncertainties, the reduction in the financial fragmentation associated with the banking union and the pressure to generate profitable assets have once again made lending activities the focus point for entities, which can already incipiently be seen in the lending conditions and in financing flows.

39

4

The process of transforming the Spanish economy must be continued

There is room to increase the degree of economic openness The transformation of the Spanish economy is apparent in the reduction of the weight of industries related to construction activities and an increase in those engaged in the production of goods and services sold abroad. With regard to demand, the weight of investment in construction in relation to GDP dropped from 22% in 2007 to 10% in 2013, whereas exports of goods and services increased its share from 27% to 35% during that same period. With regard to supply, although the export industries are not easily identifiable in the Spanish accounts classification, since they are distributed among all production sectors, the whole of the transport, trade and tourism related sectors increased its weight in GDP from 21% to 24%. Since 2009 the industry has shown a trend to increase its weight in GDP (from 15.5% to 17.5%).

Accordingly, the fact that in this economic cycle the Spanish recovering starts with high levels of external debt enables it to maintain a foreign trade surplus as a necessary condition (although not sufficient) in order for the period of economic growth to be long lasting. In other words, the growth pattern must generate the capacity for external financing, even during years of expansion, unlike what is normally the case in our economy, such that foreign debt consolidates a downward trend, which may represent a reduction of around 50 billion euros over the next quarters until the end of 2015.

Graph 22: Weight of exports and imports on GDP (%) 45

Projections 40

35

30

25

20

Feb-07 Exports

Feb-09

Imports

Source: Spanish National Institute of Statistics (INE) and Banco Santander

40

Feb-11

Feb-13

Feb-15

The intense process of recovering competitiveness that began in 2008 will continue over the coming years based on two variables: cost control and improvement in the productivity of the economy, which will allow, among other things, a progressive increase in the weight of exports on the GDP until reaching 40% of GDP (see graph 22).

Unit labour cost containment is key...

The reduction in unit labour costs (ULC) with regard to our competitors recorded since 2008 has been one of the main elements on which the change in production of the Spanish economy has been based, with a cumulative drop of 8% since its peak.

Between 2008-2009 this improvement was based on the increase in productivity per employee as a result of the drop in employment; as of 2010 the reduction in ULCs was due to an increase in productivity (which accumulated and increased of 13%) and the containment of salary increases. The aforementioned shows that the ULCs of Spain compared to the EU are currently around the same levels as when the euro was adopted in 2000, while compared to broader groups of competing countries they are at somewhat higher levels, similar to those of 2004 (see graph 23).

There is a certain consensus with regard to the fact that over the coming years the reduction in our ULCs will continue with regard to competitors, although its origin will be slightly different from that of recent years: as we enter into a period of

Graph 23: Competitiveness indices relative ULCs, 1999 = 100 145

135

125

115

105

95

Mar-99 Compared to the eurozone

Mar-02 Compared to EU28

Mar-05

Mar-08

Mar-11

Compared to developed countries

Source: Bank of Spain

41

4. The process of transforming the Spanish economy must be continued

employment creation, the increase in productivity is expected to slow down and the improvements in competitiveness will come almost exclusively from internal cost containment.

In this respect, European Commission projections (see graphs 24 and 25) consider that the competitive edge of the Spanish economy will be extended in 2014 and 2015, exclusively as a result of the containment of salary increases, since growth in productivity in Spain is expected to be positive, although slightly less than that recognised compared to our competitors.

Graph 24: Nominal unit labour costs: Spain vs. industrialised countries (average annual growth) 3.7

Graph 25: Spain: breakdown of ULC growth (average annual growth)

4.0 5.5

1.0

1.0 0.6

-0.2

-0.8 -1.8

-1.9

2008-2009 Spain

2010-2013

2014-2015

Industrialised countries

2008-2009 Productivity (- sign)

Source: “European economic forecasts. Winter 2014”. European Commission

0.6

-2.5

2010-2013

2014-2015

Compensation per employee

Source: “European economic forecasts. Winter 2014”. European Commission

Our outlook, however, is more positive. With regard to costs, we are confident that salaries growth rate will be in line with the increases in productivity and the labour market situation. Accordingly, the containment of business margins is also expected to contribute to improving the competitiveness of the Spanish economy, since certain resources are highly underused (high output gap), the recovery of consumption in this economic cycle will be moderate and the structural reforms intended to improve operations of the markets (increasing competition) will produce results.

We are therefore confident that the improvement in productivity of the economy, resulting from the change in the production model and the structural reforms, exceeds the expectations of international organisations and, in general, that expected by the consensus forecasts.

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... as well as increasing productivity for sustainable recovery The improvement in productivity is a fundamental element in order for the Spanish economy to be able to extend the economic recovery that began in the second half of 2013 and, above all, in order to be able to increase its potential growth as it overcomes the effects of the crisis. The OECD estimates that the potential growth of the Spanish economy will be 1.3% in 2015, up from the average 0.9% in 2008-13. The Bank of Spain estimates that over a longer period of time this potential growth could reach almost 2%12. Recovering the rates similar to those of the pre-crisis period (around 3% in 2000-2007) could face two types of obstacles:

• I t is possible that there was a permanent increase in post-crisis financing costs. This could lead to lower growth investment rates compared to pre-crisis period.

• The possible adverse change in activity growth rates.

However, there is one factor in our favour to enable potential growth to increase which must be taken advantage of as much as possible: the application of structural reforms intended to improve the operations of the markets, in particular the job market, and drive changes in production models: •

eduction of the NAIRU (non-accelerating inflation rate of unemployment) R over the coming years, as a result of the impact of the labour reform and other measures implemented by the government. Given that none of the NAIRU estimates made by official bodies take into consideration these impacts13, there is room for an additional reduction in the NAIRU and, therefore, an increase in GDP growth beyond that considered by such official Institutions.

12 H ernández de Cos, P., Mario Izquierdo and Alberto Urtasun (2011). “An estimate of the potential growth of the Spanish economy”, Occasional papers N 1104, Bank of Spain.

13 T he European Commission has been particularly pessimistic in its NAIRU estimates for Spain, indicating higher figures that those given by the IMF, the OECD, the Bank of Spain or the Ministry of Economy, which implies a lower potential GDP estimate and a more narrow output gap, which would entail greater risk of inflation as the expansion cycle progresses. However, the estimation method of the European Commission has been greatly criticised, since it assumes static expectations on wage formation, which give rise to a highly pro-cyclical NAIRU estimate. Whereas other bodies introduce dynamic expectations, which better take into account the change that has taken place in wage formation in Spain.

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4. The process of transforming the Spanish economy must be continued

• A n increase in productivity by changing the economic model. If we analyse the sources of GDP growth, with regard to the supply side in the 2008-2013 period (table 3), we find that there was a sharp drop in the use of the labour factor behind the economic recession as well as a slowdown in the accumulation of capital in comparison with the 1996-2007 expansive period. Despite this fact, the capital factor continued to contribute positively to GDP growth (0.6pp of the annual average), even slightly higher than that posted in the European Union or in the euro area (0.4pp).

Table 3: Factors explaining GDP growth (contributions) 2008-2013 period, annual GDP PFT Employment Capital

Spain

UE27

EUR18

-0.6 0.5 -1.7

0.1 -0.2 -0.1

0.0 -0.1 -0.3

0.6

0.4

0.4

Source: European Commission and Banco Santander EUR18 = eurozone

• T he most notable is that the total factor productivity (TFP)14, which performed quite unfavourably in the 1996-2007 expansion period, has now positively contributed to GDP growth, performing better than that recorded in the European Union or in the eurozone.

Table 4: Factors explaining the growth in productivity (contributions) 2008-2013 period, annual averages.

Spain

UE27

EUR18

Apparent productivity of employment FT

2.1 0.5

0.3 -0.2

0.5 -0.1

1.6

0.5

0.6

Capital intensity (capital/employment)

Source: European Commission and Banco Santander

•

I n the future, the capital/employment ratio is expected to have a less dynamic behaviour, since although the investment process will be revived, this will be carried out by creating employment. However the increase in TFP may be consolidated, which will determine that the growth in productivity of the Spanish economy is greater than the European Union average.

14 The endogenous component of productivity which is not explained by the accumulation of labour and capital production factors.

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Therefore, on one hand we have a labour reform that introduces structural changes giving rise to increases in employment flexibility and permanent efficiency earnings and a production model for the changing Spanish economy, which should make compatible employment creation and an increase in productivity. However, on the other hand, a significant number of unemployed persons with productivity levels that are lower than those currently working need to be absorbed, which could result in a obstacle to TFP. To consolidate this increase in TFP, investment in human capital and R&D, and the structural reforms mentioned below must continue to be supported.

The value of education and human capital in the labour market Recent history with regard to human capital evolution in Spain has proved to be successful. In analysing the series offered by the Valencian Institute of Economic Research (IVIE)15, a significant improvement can be seen in the level of education for Spaniards over the last 50 years:

• In 1964, 12% of the population over 16 years of age was illiterate and 82% had at most a primary level of education. 4% of the population completed secondary education and only 2% went on to university.

• In 2013, the illiterate population was minimal (2% of the working-age population and 0.3% of the active population). Those with higher education made up 18% of the working-age population and 29% of the population currently working.

In relation to the job market, the level of education positively influences entry to the labour market, whereby in Spain it is profitable to get an education:

• Labor force participation rate of university graduates is 33 points higher than for those that have only completed mandatory education.

• Population from 25 to 64 years old with a higher level of education have a greater employment rate and higher salary level, which is true for Spain as well as the OECD and the EU21. In 2011, 80% of those people that completed higher education in Spain were incorporated into the labour market, whereas the population with secondary education or less reached an employment rate of 25%.

15 No. 144 Human Capital, IVIE and Bancaja.

45

4. The process of transforming the Spanish economy must be continued

• S imilarly, the role of education as a factor protecting against unemployment was reinforced during the crisis, since employees with higher education had lower unemployment rates not exceeding the rates reached prior to the crisis (13.9% in 2013 vs. 16.4% in 1995) as shown in graph 26.

• With regard to that mentioned above, having higher education studies in Spain means reducing the probability of unemployment over the long term by 70% compared to workers with only primary education, and by almost 40% compared to those that only completed secondary education.

• Lastly, salaries are clearly conditional upon an employee’s training. In Spain16 the average salary of a university graduate is 41% higher than that of someone who only completed secondary education and 63% higher than someone with only primary education.

Graph 26: Spain: Unemployment rate by education level (%) 60

50%

50

40%

40 30

29%

20

14%

10

Illiterate

Uneducated and primary education

Mandatory studies

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

0

University studies

Source: INE

Other indicators that show the clear transformation of the Spanish economy through improvement of its human capital is the change undergone in the structure of the production industry and, subsequently, in employment, towards sectors with greater productivity (see graphs 27 and 28). The weight of the services sector on employment from 1980 to 2013 increased from 45% to 76% and from 54% to 72% in the case of GVA (gross value added). Lastly, it should be noted that there is a twoway relationship between human capital and the production structure: advances in education enable the transformation of the production structure and vice versa, a change in production structure requires human capital with greater training.

16 Education outlook, OECD (2001).

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Graph 27: GVA (gross value added) by line of business 1980 vs. 2013 (%)

Graph 28: Spain: Employment by line of business 1980 vs. 2013 (%)

44.9

72.1

54.0

75.6

27.2 30.3

Source: INE

Industry

2013

Construction

Agriculture

13.5 6.0 4.9

18.6

7.8

1980

Services

9.3

17.5

8.3

1980

Services

Industry

2013

Construction

Source: INE

The main reforms initiated must be consolidated In recent years, the government has initiated an in-depth programme of structural reforms, the positive impact of which is already reflected in the signs of recovery of the Spanish economy. Those reforms related to the pension system, the financial sector, the labour market and controlling and reducing public expenditure are particularly worthy of note. In recent months, these reforms have been backed by the main international bodies such as the OECD, the International Monetary Fund and the European Commission, which recently removed Spain from the list of countries with excessive imbalances.

According to the 2013 Going for Growth report issued by the OECD, Spain holds first place in terms of reform momentum among the five largest European economies. This progress was also recognised by the three main rating agencies, Standard & Poor’s, Moody’s and Fitch, which improved their outlook for Spain.

All this is giving rise to a fundamental change in the Spanish economic model with significant improvements in competitiveness and productivity and a greater weight of innovation, technology and knowledge. However, it is essential not to fall into complacency and to continue moving forward with the structural reforms for the purpose of increasing the potential growth of the economy and promoting job creation, which is a top priority for Spain.

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Agriculture

4. The process of transforming the Spanish economy must be continued

Firstly, we consider consolidating the progress made through the reform of public administrations, the labour reform and the restructuring of the financial system to be of key importance. Secondly, it is essential to continue with the improvements in the economy’s competitiveness, and focus on the industrial rebirth and a model based on innovation and knowledge. Lastly, the tax system should be focused towards a system that is more favourable to growth and the job creation.

Reform of public administrations: in search of efficiency in processes In June 2013 the report of the Expert Commission for the Reform of Public Administrations (CORA) was submitted. The package of measures intends to incorporate management criteria in the public administrations that have been carried out in companies now for some time, for the purpose of increasing our public services at a lesser cost, in other words “to do more for less”.

The set of actions that are already in place will allow duplicities to be eliminated, processes to be simplified, the market unit to be guaranteed and the institutional structure to be alleviated. The various measures presented include the establishment of a zero-based budget for all public administrations; centralized purchases systems; an electronic invoice system that uses information technologies to reduce processing and filing costs; a single window for license and authorisation management; or the streamlining of payments to suppliers by announcing the average payment period of the various public administrations. At the end of 1Q14, in accordance with the public administration figures, almost 30% of the measures related to CORA were carried out and this figure is expected to reach 50% at the end of this year.

All of this must be reflected in the consolidation of public finances in order to be able to comply with the deficit objectives, which is key to guaranteeing the long-term sustainability of our growth model. In this regard, we estimate that the adjustment to the primary balance must be between 3% and 5% of GDP. In the event the government’s restructuring and rationalisation measures are not sufficient, supplementary actions may be adopted such as a plan to strengthen the struggle against tax fraud or an asset management plan for assets and privatisations.

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Labour Reform: simplification and greater flexibility Employment creation is without a doubt the top priority of economic policy. In this regard, the labour reform of 2012 has begun to see results, with a decrease in unemployment of almost 150,000 people in 2013, the first reduction since 2006, and a net creation of employment starting in 3Q13. The reform should therefore be positively valued since it has allowed for labour flexibility and facilitated job creation. According to the valuation carried out by the OECD, this has meant increasing the probability of transitioning from unemployment to employment (both very short-term temporary and medium- and long-term permanent work).

However, certain adjustments must still be carried out in order to implement the basic principles of the reform:

• Simplify the number of employment contracts, thereby reducing the labour market dualism and the large differences in protection between temporary and permanent contracts.

• Encourage the search for job positions through active and well-managed employment policies, especially for unskilled members of the labour force.

• Reduce tax costs of the labour factor which continue to be above the OECD average17.

Fiscal reform focused on growth and employment creation The full fiscal reform implemented in March 2014 as the result of the report of the expert commission intends to design a simple, sufficient and growth-oriented tax system that protects social development and reduces the negative effects on the market unit.

The proposal is structured into two phases. The first phase, starting in 2015, intends to reduce direct taxation by reducing personal income tax withholding rates and corporate income tax rates, which are offset through the elimination of tax credits, tax relief and tax exemptions, thereby maintaining tax revenue around 37%-38% of GDP. This reform is expected to stimulate growth, with an estimated positive impact in three years of 0.3% on GDP and 0.2% on employment. Subsequently, a fiscal devaluation would then be carried out starting in 2016, which would consist of reducing contributions (-3pp) to create employment, which would be offset by an increase in VAT. As a result, employment and GDP are expected to increase by 0.7%.

17

Going for Growth, 2013.

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4.  The process of transforming the Spanish economy must be continued

The CEC considers that the reform is generally headed in the right direction, intending to improve the competitiveness of the corporate sectors and promoting economic growth. It is therefore logical to implement a tax system that stimulates the fundamentals (employment and savings) and mitigates or moderates existing mismatches (effective taxation of consumption or environmental policy). With regard to personal income tax, we agree that this tax figure should be simplified, reducing the number of brackets and the marginal rates of the progressive scale, and improving the taxation on income from savings. With regard to wealth and inheritance taxes, we agree with the proposal to reduce these taxes, and even consider that one of them should be eliminated, since personal income taxes already fulfil the function of redistributing wealth and these taxes represent double taxation. It is important not to lose sight of the overall tax effect of taxing stock with regard to taxing income.

With regard to corporate income tax, we consider that the reduction in nominal rates will have a positive effect on growth and the creation of employment, as has been indicated by the European Union, the OECD and the IMF. However, the reduction in tax rates must be accompanied by a procedure such as that proposed by the expert commission, which allows the negative accounting impact of recognising deferred tax (assets and liabilities) at a new tax rate to be eliminated. In addition, the tax must have an effect on the companies’ true profits and, therefore, all expenses necessary to obtain such income must be allowed to be deducted, whereby the taxable profit approaches the accounting profit as much as possible. In order to facilitate the transition to a new growth cycle, companies must be allowed to recover their investments through adequate amortisation regimes and the provisions must be deductible. The rules limiting the deductibility of finance costs should not be detrimental to the natural form of financing of certain activity sectors or investment projects. It is also important to avoid international double taxation, thereby maintaining or improving the current mechanisms to avoid such double taxation and extend the period applicable for outstanding tax credits to at least five years or much it to the period for offsetting tax loss carryforwards. Measures should also be implemented to allow Spanish companies to regain internationalisation and to continue providing incentives for key activities to modernise the business fabric such as R&D. Lastly, with regard to discretional taxation imposed by the regions, we agree that certain taxes that have scant collection capabilities should be eliminated in order to maintain the market unit and avoid the same taxable events from being taxed by different bodies.

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Progress in reforms yet to be implemented Reinforce the commitment to innovation, new technologies and digital economy As seen previously, the growth in exports arose, to a large extent, from refocusing the economic structure which has evolved from a very labour intensive and low value added model to activity sectors driven by innovative and knowledge-based companies. The development and implementation of ICTs and the growing university population were key factors in this change in the economic model caused by the crisis.

However, despite having doubled over the last 15 years, R&D expenditure was 1.3% of GDP compared to the European Union average of 2%, thereby resulting in, for example, a lower number of patents per habitant compared to other European countries or lower efficiency of the technological parks implemented in Spain. For example, according to the innovation ranking developed by the European Union, Spain is below average in the group of countries known as “moderate innovators�. Although international competitiveness and the ability of companies to bring their innovations to the market are our main strengthens, the challenges of corporate investment in innovation and the capacity for innovation of SMEs must be addressed.

Therefore, the first step should be focused on increasing investment in advanced machinery and capital goods, software and hardware, and the capacity for innovation of SMEs. With regard to the latter, it is essential that these businesses reach a certain size, beyond which they begin to expand internationally and enter a virtuous circle of innovation and competitiveness.

A successful path of action on an international level is that of promoting public-private collaboration aimed at encouraging SMEs to develop their own innovation activities and to engage in Company-University collaboration aimed at developing and implementing new products and processes.

It is necessary to continue moving forward in the digital economy, which is a key factor in maintaining our competitive position. Factors such as bandwidth and connectivity to the Internet have an important multiplying effect on the productivity of the economy18. Therefore, governance of the Internet linked to the new global context will be key for confidence, accessibility and digital 51

4.  The process of transforming the Spanish economy must be continued

transparency. Similarly, greater competition from an environment open to innovation and greater interoperability between applications and services will be fundamental.

Lastly, the massive adoption of ICT will require an intelligent regulatory framework based on policies focused on results, with a case-by-case supervision and the appropriate framework for data protection and the free circulation of information within the European Union. Optimal investment in R&D requires clear public action in order for external factors to be reduced, both through the compliance of property rights and information mismatches between investors.

Energy policy focused on improving competitiveness and the industrial rebirth The energy sector is a key element for economic growth and employment creation, both as a result of its importance on the competitiveness of the industrial fabric, guaranteeing safe supply and quality, and as a result of the pulling effect of its investments and purchases.

In recent years, electricity invoices in Spain and in Europe have become more expensive due to costs not included in the generation of energy and its distribution through the electricity grids. In Spain, the costs not related to the supply and that relate to regional, environmental, social, industrial and tax policies represent over 50% of the price of energy for the consumer, whereas in the United States they are less than 10%. Consequently, residential electricity invoices in Spain are 2.5 times higher than those of the United States.

18 B y way of example, according to the International Data Corporation, companies that use cloud computing are able to reduce computer costs by between 10% and 20%.

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Therefore, the costs not related to what it costs to generate and distribute the energy should be eliminated, and the tax policy should be revised, which is what certain countries such as the United Kingdom, Belgium or Italy have been doing. In addition, as in the case of the financial sector, a common European policy that reconciles the sustainability and competitiveness objectives is needed, along with more interconnections to allow a single European market to be formed. Lastly, it is essential to create a single regulator that promotes a stable, predictable, transparent and harmonic framework that guarantees investments and does not encourage inefficient and socially unjust models.

Accordingly, the successive accumulation of tariff shortfalls in Spain gave rise to a debt of around 30,000 million euros, with a high debt service cost that is being borne by electricity consumers. The solution should be found in line with the measures taken regarding the banking recapitalisation process, in other words, to seek financing with low interest rates and long-term repayment. In essence, the problem is the same, the decapitalisation of the sector as a whole which endangers the economic sustainability of the system.

In short, a sustainable energy framework, with greater regulatory clarity, more Europe, more market and more long-term stability is needed. All in order to guarantee quality supply that is respectful to the environment, rewards energy efficiency and the balanced development of efficient renewable technologies, and facilities the industrial rebirth of the continent.

Towards a high-quality and stable education system focused on current and future world challenges The education system is a key element for a country’s long-term competitiveness and must respond to the world’s current challenges and needs. In this regard, the government’s recent education reform seems well focused on continuing to reinforce the average level of education and professional training, key factors for the development of the production system. Greater specialisation of students and technical training, the entry of concepts such as creativity in training, offering students 14 years old and up the possibility of choosing programmes, and moving the age forward at which professional training can be accessed are some of the measures necessary. Greater system standardisation and quality by implementing level tests with certain regularity and granting aid based on criteria of excellence are also necessary.

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4. The process of transforming the Spanish economy must be continued

As a starting point, our education system has positive elements which we must value and take into account when carrying out incremental continuous improvement. For example:

• We are the fourth country in Europe in terms of employees with higher level education in technical/scientific professions, with 40% of the population between 30 and 34 years old with university training, compared to less than 32% in Germany.

• The Shanghai ranking19, which classifies the top 500 universities worldwide, includes four Spanish universities between positions 200 and 300, and ten universities are among the top 500 worldwide. Although there is no Spanish university included among the top 100 or 200 in the world, 20% of Spanish public universities are included in the top 3% worldwide. Among the Top 200 in specific disciplines, Spain ranks 50th in maths, 96th in physics, 74th in chemistry, 94th in IT and, lastly, 146th in business and economics.

• We play a leading role in Europe in terms of business schools.

However, there is significant room for improvement in our education system, and we need to reassess the focus of training employees for the future. Quantitative aspects (financing, selection, follow-up) and qualitative aspects (excellence, effort, meritocracy, exemplariness and best practices) must also guide this transformation. The most urgent challenges of our system include the following:

• T he high level of school dropout in secondary education and professional training or academic failure. We cannot tolerate a 25% school dropout rate, which is double that of the European Union,

• T he need to increase the high school and professional training graduation rate. The second stage of secondary education has become a very important piece in a market where specific knowledge, abilities and competencies necessary in the world labour market are increasingly sophisticated and require the ability to respond to uncertainties and changing economic demands. In Spain, despite the fact that the graduation rate in the second stage of secondary education (88% of the typical graduating population) stood above the OECD average (83%) and

19 Academic Ranking of World Universities 2013 (ARWU).

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the EU21 average (83%), the number of graduates in this educational stage should continue to grow, since there is a large shortage in relation to the adult population. The labour market requires an efficient and attractive system for professional training at all levels which balances job market that is very much in need of qualified professionals.

• T he need to train employees currently working at companies.

Continuous training of entrepreneurs and professionals, which is being left behind, needs to be promoted so that they are able to adapt to changing processes and demands. The intensive use of temporary workers in the Spanish economy, due to a labour cost structure where temporary contracts were more advantageous than having permanent employees, has had a damaging effect on the quality of the workforce. It is to be expected that the labour reform, the main objective of which is to end this duality of permanent and temporary employees, allows for the return of investment in training within the company while at the same time retaining talent.

• B ring the university closer to the company and to the current needs of the job market. Given the high level of university graduates in Spain, greater emphasis should be placed on professionalising the university and orienting the university system to satisfy the market’s demands of the 21st century.

• L astly, it is essential to promote a long-term and stable view of our education model. According to experts, the results of an education policy begin to show after a period of at least ten years. However, in recent decades Spain has undergone continuous changes in its education system, adopting significant reforms over an average period of five years.

In short, our education system needs to be refocused towards new training niches that allow us to move to a production model that is actually based on growth, and in which innovation is the cornerstone that differentiates our professionals due to their ability to create added value.

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