The economy is slowly emerging from a deep recession, which will have a lasting effect. While the depth of the recession in terms of real GDP has been similar to other advanced OECD economies, it has led to a much larger increase in unemployment and a sharper deterioration in government finances, both to a large extent structural. In Spain, the global crisis has been compounded by an unsustainable domestic demand boom driven by residential and business investment, resulting in rising private sector debt. While fiscal and financial policies had been relatively prudent before the crisis, investor confidence declined during the crisis and this may weigh on the recovery as sovereign spreads remain high. Nonetheless, following the publication of bank stress tests and bold policy initiatives, funding conditions have improved.

After a decade of rapid growth, Spain entered a recession of unprecedented depth and length in 2008. While the size of the contraction of output was broadly similar to that of other European economies, it has resulted in a massive rise in unemployment. The recession accelerated the adjustment of the current account deficit built up as a result of dynamic growth of private sector indebtedness, which had funded strong business and residential investment. The economy resumed slow expansion in the first half of 2010, but growth is expected to remain subdued owing to the necessary further adjustments in the housing sector and a high degree of private indebtedness. As a consequence, unemployment is expected to remain high. While fiscal consolidation will put an additional drag on the recovery in the short term, it is crucial to improve confidence among domestic and international economic agents.

Spain has recently exited a deep recession triggered by the global crisis. Growth is nevertheless expected to remain subdued as the economy still needs to correct part of the private sector imbalances built-up prior to the crisis despite a prudent macro-fiscal policy. Strong growth of private sector indebtedness, which reflected strong business investment as well as the overdevelopment of the residential construction industry, has led to a sizeable current account deficit, whose correction is underway. Rebalancing the Spanish economy and boosting potential growth will require full-fledged reforms, especially in labour and product markets. In particular, fostering competition in the service sector further could help reduce prices and improve competitiveness. Housing policies have advanced considerably in eliminating tax distortions in favour of housing ownership and removing barriers to the rental market, which can help support labour market adjustment and make a contribution to the absorption of the empty housing stock. However, the authorities should refrain from expanding the stock of social housing and favour instead means-tested benefits. Restructuring and reform of the savings banks has improved their resilience, although the role of regional governments in the savings banks’ management should be further reduced.

Spain’s government has recently introduced an ambitious set of consolidation measures. Should budgetary outcomes fall short of targets, the government should stand ready to introduce further measures, as announced. Such measures could include subjecting more goods and services to the standard value added tax rate. They could also be used to fund a reduction in some social security contributions paid by employers. Once sufficient progress towards fiscal consolidation has been achieved, a further reform of the tax system towards more growth-friendly taxes should be contemplated. Spain also faces a dramatic increase in ageing-related public spending, mostly on account of pensions. The government proposal to increase the statutory retirement age by two years is a welcome step but further reforms in the pension system will be necessary to contain expenditure growth. Rules on the budget balances for each level of government should be reviewed so as to induce regional governments to run larger budget surpluses when activity exceeds potential.

After steady employment growth since the 1990s, Spain has experienced the sharpest increase in unemployment among OECD countries during the crisis. Structural problems of the labour market have amplified the employment losses resulting from the crisis, which were considerably larger than in other OECD economies. Very high de facto severance payment of permanent contracts has resulted in a rigid dual market with adverse effects on unemployment and productivity. The collective wage bargaining system has hindered firms from adapting to macroeconomic shocks exacerbating their negative effects on the labour market. The recent labour market reform legislation is a positive step to reduce excessive protection of workers in permanent contracts, although some uncertainty remains on how courts will interpret it. It also makes it easier for firms to opt out from higher level collective agreements. The large drop-out rate from lower secondary education is an important factor explaining very high unemployment among young workers. Better access of young people to training is an effective tool to keep them out of a depressed labour market. Finally, the matching of people to jobs, notably through the public employment services, needs to be made more efficient, all the more so as the currently tight fiscal constraints make it imperative to get better value for public spending on active labour market policies. Although the recent reform allows private for-profit firms to provide placement services, more needs to be done. Performance of regional public employment services should be benchmarked and incentives of unemployment benefit recipients to search for a job increased.

Spain uses its natural water resources intensively, mostly in agriculture, thanks to a highly developed dam infrastructure. The limits for extraction of natural resources have largely been reached and climate change is expected to continue lowering natural water endowments markedly in future especially in dry areas of the country. The costs of exploiting alternative supply sources on a large scale, notably desalination and recycling, remain well above water prices paid by consumers at present. The government has recognised that water policies therefore need to switch to demand management, so as to ensure that available resources are put to most efficient and priority use. Scope for water savings is substantial, especially in agriculture, where much irrigation water generates little output. The government has subsidised the use of more efficient irrigation technology at considerable budgetary cost, which has contributed to a modest reduction of water use in irrigation in recent years. Nevertheless low water prices, combined with the free allocation of water concessions, still hamper an efficient use of water resources. Water prices will need to rise further so as to reflect service provision costs in full as well as the scarcity and environmental costs of water abstractions. Steps to better take into account water scarcity should include the progressive inclusion of market instruments, such as the tendering of water concessions as well as the elimination of some barriers to the exchange of such concessions among users. Benchmark regulation of water utilities would contribute to more efficient water supply and treatment services. Further steps need to be taken to halt excessive groundwater abstractions, including through improved monitoring and the introduction of charges on abstractions from overexploited aquifers.