Spain is immersed in a prolonged recession. The depressing impact on activity of private sector deleveraging and the need for sizeable fiscal consolidation following the bust of the domestic credit boom has been compounded by the euro area debt crisis and structural rigidities in the labour market, resulting in a steep increase in unemployment and a banking crisis. The prospect of an immediate recovery remains remote as deleveraging of the private sector still has a long way to go while the feedback loop between government finances and the banking sector remains strong, notwithstanding the loan of up to 100 billion euros from the euro area governments to recapitalise the banks. This feedback loop must be broken. Further structural reforms are needed to boost employment, notably among youth, and improve competitiveness, helping to reduce the current account deficit further. Given the major risks that have built up, decisive policy action on all these fronts is urgent if the situation is to be turned around.

Viable banks with capital needs should be recapitalised promptly and non-viable banks should be resolved in an orderly manner as soon as possible, as foreseen in the Memorandum of Understanding.

The economy is undergoing a prolonged recession since the outbreak of the global crisis in late 2008. The bust of the housing boom and persistent domestic structural weaknesses, especially in the labour market, have been compounded by the European debt crisis. Deleveraging in the private sector has resulted in a contraction of domestic demand, adding to mass unemployment and generating high government deficits (). The feedback loops between confidence in government solvency and banking sector health, which reflect in part the absence of appropriate euro area institutions (OECD 2011a, 2011b), have resulted in high risk spreads on interest rates for government debt (). This in turn has raised funding costs for banks and has kept lending conditions tight.

Spain is facing a severe banking crisis, reflecting the bursting of a housing and credit boom, which has resulted in a high debt burden of the private sector and a deep recession. The mutual dependence of the banks’ and the government’s funding conditions has deepened the crisis, although the planned development of a banking union in the euro area may soften these feedback loops. Deleveraging is progressing, but is likely to weigh on economic growth for several years. Rapid and comprehensive recognition of bank losses is key for restoring confidence in the banking sector and moving towards economic recovery. This requires the rapid resolution of non-viable and the recapitalisation of viable banks with capital needs. The government has taken important steps by tightening the provisioning rules on the banks’ real estate exposures. A euro area credit line of up to 100 billion euros will provide funds at favourable terms to capitalise banks, subject to conditions which, when met, will help overcome the banking crisis. Action needs to be taken to force the holders of the substantial hybrid capital and subordinated debt issued by banks to absorb losses, especially when the holders of these instruments are institutional investors. Reform of bankruptcy procedures would help shifting resources from insolvent companies to productive use and could provide more effective relief for those households who have no reasonable prospect of being able to repay their debt.

The unemployment rate among young people has reached painfully high levels, in particular among those young people with low levels of education. There are two crucial policy priorities to improve employment prospects for youth in Spain. First, in the very short term, there is need for quick action to target well-designed active labour market programmes to the most disadvantaged youth and provide more job-search assistance and guidance for all youth experiencing difficulties in finding a job in the current labour market. Second, the current crisis is an opportunity to tackle some of the structural weaknesses in the Spanish youth labour market. This implies in particular reforms to prevent youth from dropping out of education at a very early stage and to improve the school to work transition of young people. Key issues are to better match skills acquired in education to those asked for by businesses, as well as to establish an effective system of vocational education, and to reduce remaining demand side barriers, notably labour market duality and a rigid collective bargaining system, which both have prevented an efficient allocation of labour resources in the past and a flexible adjustment during the crisis.