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Spain Economic Outlook Spain Economic Outlook June 21 June, 21

Key messages The positive elements of the external environment of the Spanish economy are distinguished by the recovery of the emerging countries and the US, which would create the conditions for global economic growth of around 4%. However, there are significant elements of uncertainty in Europe deriving from increased risk aversion and the fragility of growth. In 21, the area will grow by.7%. In this context, and once the impact of fiscal consolidation measures has been accounted for, Spanish GDP will shrink by.6% in 21, while in 211 it should grow by.7%. While considerable progress has been made regarding the necessary adjustment of the private sector in order to reduce its high level of indebtedness, the public sector is embarking on a rigorous fiscal adjustment. The ambitious fiscal adjustment announced by the Spanish government is a very important step in the right direction. Its negative impact on growth in the next few quarters will be very limited. At the same time, it is a necessary condition for guaranteeing a sustained recovery scenario in the coming years. The necessary and unavoidable fiscal adjustment must be accompanied by ambitious structural reforms in the financial sector and the labor market. Page 2

Contents Spain Economic Outlook June 21 Section I International scenario: the challenges ahead for a sustained recovery Spain: An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation I The need for ambitious structural reforms Page 3

Section I International scenario: the challenges ahead for a sustained recovery The global economy is driven by two conflicting forces Positive spillover from the cyclical upturn in the US and in the emerging markets Negative spillover from the increase in risk premium spreading from Europe Growth in 21: World: 4.2% US 3% Latin America 4.6% Asia 5.8% Risk premium Fiscal consolidation Confidence Commodity prices World trade: will grow by 7% in 21 The European Stabilization Mechanism reduces the downward risk in the short term Page 4

Section I International scenario: the challenges ahead for a sustained recovery Negative spillover arising from the increase in sovereign risk in Europe RisksfortheEMU 1 Increase in risk premiums Faster than expected fiscal adjustment 3 Difference in growth vs. US Difference in interest rates vs. US 5 Support for the EMU 2 A new institutional framework A more depreciated exchange rate 4 Adequate and powerful incentives Positive impact on exports Page 5

Section I International scenario: the challenges ahead for a sustained recovery 1. Increase in risk premiums Negative spillover arising from the increase in risk premiums in Europe Financial tensions indicator (1 = January-7) First normalized principal component of the following series: OIS spread, implicit volatility, and banking and corporate CDS spread Source: BBVA Research Greece: 1-yr sovereign spread (bps) Fuente: Bloomberg and BBVA Research 12 1 July'7 Bear Stearns Lehman Brothers Stress Test Results European sovereigns 12 1 12 1 Bond Auction (8 bn ) Bond Auction (5 bn ) Eurogroup Statement Bond Auction (5 bn ) Formal request 12 1 8 8 8 8 6 6 6 6 4 4 4 Agreement on Greece 4 2 Jun-7 Aug-7 Oct-7 Dec-7 Feb-8 Apr-8 Jun-8 Aug-8 Oct-8 Dec-8 Feb-9 Apr-9 Jun-9 Aug-9 Oct-9 Dec-9 Feb-1 Apr-1 2 Jun-1 2 1-Dec 15-Dec 29-Dec 12-Jan 26-Jan 9-Feb 23-Feb 9-Mar 23-Mar 6-Apr 2-Apr Financial Stabilisation Mechanism 4-May 18-May 1-Jun 2 USA EMU Page 6

Section I International scenario: the challenges ahead for a sustained recovery 2. New institutional framework The European Stabilization Mechanism, together with the ECB's measures, should reduce uncertainty, at least in the short term It seeks to harmonize market discipline mechanisms and those resulting from fiscal rules, as it makes access to the stabilization fund conditional on the implementation of a credible fiscal consolidation plan. Market discipline is reinforced with European budget stability rules. Binding fiscal rules: Stability and Growth Pact Market discipline If conditions are not met Fiscal discipline If conditions are met Access to a bail-out mechanism, although subject to costly conditions Stiff penalty in the event of failure to comply: incentive appropriate to fiscal compliance The total amount of the plan is sufficient 72 billion EUR Strong incentive for fiscal compliance: access avoids speculative attacks Page 7

Section I International scenario: the challenges ahead for a sustained recovery 3. Faster fiscal adjustment The fiscal adjustments revealed recently follow the consolidation plans announced in late 29 Portugal and Spain speed up their plans The necessary adjustment is large and its effect on activity will be limited, but it will be gradual over time Europe: fiscal deficits (% GDP) Source: National Governments and BBVA Research 4 2 2 2.6 1.4 1.5 1-2 -2.7-3 -2-4.3-4 -3-3 -2.7-3.7-3.3-5.5-2.9-2.6-4.6-2.9-4.5-3.5-3.9-6 -6-4.6-5.3-5 -4.9-4.9-7.3-6 -5.5-4.4-8 -7.5-8.2-8.1-7.6-6.5-7.2-9.4-7.1-1 -9.4-9.1-12 -1-11.6-11.2-14 -12.3-12. -16-13.6-14.3 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 9 1 11 12 13 14 Germany France Italy Greece Ireland Portugal Spain United Kingdom New plan's adjustment in GDP pp Fiscal deficits projected in Stability and Growth Plans in January 21 New deficit path following austerity plans announced in May Germany, France and Italy have detailed austerity plans for 211 Spain and Portugal have disclosed measures for 21 with regard to the actions contained in the stability plans. Greece's adjustment is being slower UK will announce its new budget on June 22, and major changes are expected Page 8

Section I International scenario: the challenges ahead for a sustained recovery 4. The euro's depreciation The faster than expected depreciation of the euro towards its long-term equilibrium value will reinforce the area's exports, although its growth has so far been lower than in the US EMU: real effective exchange rate Source: BBVA Research Exports (% yoy) Source: BBVA Research based on BEA an Eurostat 1.7 1.5 1.3 1.1.9.7 15 1 5-5 -1-15 15 1 5-5 -1-15.5 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12-2 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 Jun-1 Sep-1 Dec-1-2 $/ Pound/ REER UEM US Page 9

Section I International scenario: the challenges ahead for a sustained recovery 5. Low interest rates Although economic growth could be slow from 21 onwards, the risk of a reversal of the current trend is limited in the US and inflationary pressure is still at an early stage In contrast, in Europe, in addition to a more fragile financial situation, the cyclical improvement seems to be uncertain and there are no inflationary pressures. Official interest rates (%) Source: BBVA Research based on ECB and Fed 4.5 4. 3.5 3. 2.5 2. 4.5 4. 3.5 3. 2.5 2. EMU: Core inflation (% yoy) Note: Benchmark based on ARIMA models Source: BBVA Research based on Eurostat 3. 2.5 2. 1.5 1. 1.5 1.5.5 1..5. Mar-8 Jun-8 Sep-8 Dec-8 USA Mar-9 Jun-9 Sep-9 Dec-9 Mar-1 UEM Jun-1 Sep-1 Dec-1 Mar-11 Jun-11 Sep-11 Dec-11 1..5.. -.5 Oct-8 Dec-8 Feb-9 Apr-9 Jun-9 Aug-9 Oct-9 Dec-9 Feb-1 Apr-1 2% 4% 6% 8% Benchmark Observed Jun-1 Aug-1 Oct-1 Dec-1 Page 1

Contents Spain Economic Outlook June 21 Section I International scenario: the challenges ahead for a sustained recovery Spain: an adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation I The need for ambitious structural reforms Page 11

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Adjustments underway that condition recovery Imbalances accumulated during the expansion period Financing needs Fiscal deficit Imbalances accumulated during the crisis Labor market Investment adjustment Increased savings Firm deleveraging Household deleveraging Structural reforms Financial sector restructuring Page 12

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation An adjustment that is at an advanced stage in the private sector The private sector has made significant progress in its adjustment process, with a considerable reduction in its financing needs The current account deficit recorded in recent years in Spain is a reflection of the dramatic increase in investment rather than a lack of competitiveness or a low saving rate. Investment rate GFCF as a share of GDP (in pp) GFCF: Gross fixed capital formation Source: BBVA Research from INE and AMECO 32 3 28 26 24 22 2 18 16 14 12 1 1999 2 21 22 23 24 25 26 27 28 29 Spain Portugal Greece EMU16 21(f) 211(f) 32 3 28 26 24 22 2 18 16 14 12 1 Current account balance As a share of GDP (in pp) Source: BBVA Research from IMF 2-2 -4-6 -8-1 -12-14 -16 Average 1999-27 28 29 21(f) Spain Greece Portugal EMU16 211(f) 2-2 -4-6 -8-1 -12-14 -16 Page 13

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation An adjustment that is at an advanced stage in the private sector The private sector has made significant progress in its adjustment process, with a considerable reduction in its financing needs The current account deficit recorded in recent years in Spain is a reflection of the dramatic increase in investment rather than a lack of competitiveness or a low saving rate. Spain: exports growth (%) Source: BBVA Research based on INE 1. 5.. -5. -1. -15. -2. Dec-5 Jun-6 Dec-6 Jun-7 Dec-7 Jun-8 Dec-8 Jun-9 Dec-9 Jun-1 % q-o-q (Right) % y-o-y (Left) Dec-1 Jun-11 Dec-11 5. 2.5. -2.5-5. -7.5-1. Spain: productivity growth and recovery of exports in 29 Source: BBVA Research based on Eurostat Real exports of goods and services (% change between 1Q9 and 4Q9 8. 6. 4. 2.. -2.. GR AT UK.5 IT 1. NL DE BE EMU12 1.5 IR FR 2. SP 2.5 Real productivity of labour per worker (% change betwen 1Q9 and 4Q9) PT 3. Page 14

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation An adjustment that is at an advanced stage in the private sector The need for financing for residential investment created imbalances in the current account While investment is adjusting in the sector, financing needs are also adjusting at the same rate, while in other countries the adjustment process is being delayed. Lower prices and interest rates have allowed significant improvements in access to housing. Construction employment share and current account balance: 1996-27 Soruce: BBVA Research based on AMECO Spain: housing affordability Tax-adjusted purchase effert as a % of household income Source: BBVA Research based on INE, Housing Department and Registradores Change per ratio CA/ GDP (percentage points) 8 6 4 2-2 -4-6 -8-1 -12-14 -6 KOR JPN -4 AUT -2 NDL BEL FRA PRT SWE ITA GRC 2 FIN DNK USA 4 ESP 29 ESP 6 IRL 8 Employment share in construction (percentage points) 1 45 4 35 3 25 2 15 1 5 1995 1996 1997 1998 2 21 22 23 25 26 27 28 21 (f) 211 (f) Page 15

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation An adjustment that is at an advanced stage in the private sector Households have also adjusted their financing needs The adjustment in savings has been especially significant in the case of households. The net wealth of Spanish households is higher than in other European countries. Households saving rate (% of gross disposable income) Source: BBVA Research and AMECO 2 Households net wealth (28) Source: BBVA Research based on OECD and Bank of Spain 1,2 15 1 5 (% Gross Disposable Income) 1, 8 6 4 2-5 1999 2 21 22 23 24 25 26 27 28 29 21 (f) 211 (f) Spain Italy United Kingdom France Germany EMU Greece Portugal Germany Spain Financial Non-financial Page 16

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Recovery in private demand Because a large part of the adjustment in the private sector has already taken place, private demand is starting to make a positive contribution to growth Considering the current information available for 2Q1, activity so far is behaving similarly to 1Q1. However, uncertainty exists as regards the future. Spain: quarterly GDP growth forecasts based on MICA-BBVA model by date of estimate Note: the figure in brackets is the percentage of the data set known at the last estimate date relative to the quarter of reference Source: BBVA Research.4.4.3.2.1. -.1 -.2 -.3 8-Jan 15-Jan 22-Jan 29-Jan 5-Feb 11-Feb 19-Feb 25-Feb 5-Mar 12-Mar 18-Mar 31-Mar 9-Apr 15-Apr 23-Apr 3-Apr 7-May 14-May 21-May 28-May 3-Jun.3.2.1. -.1 -.2 -.3 1Q1 (1%) 2Q1 (44%) Page 17

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Increased uncertainty Increased stress in capital markets involves an additional risk whose consolidation might result in a loss of confidence and a wavering recovery of domestic demand Consumer confidence in May-21 (montly variation of the standardized balance of answers) Source: BBVA Research based on European Commision Spain: private consumption and consumer (Sample: 1986-29) Source: BBVA Research based on INE and European Commision.3.3 3.2.1. -.1 -.2 -.3 -.4 -.5 -.6 -.7 NL FR DE EMU UK PT SP IT BE AT GR.2.1. -.1 -.2 -.3 -.4 -.5 -.6 -.7 Real private consumption expenditure (%q-o-q) 2 1-5 -4-3 -2-1 1-1 -2-3 Consumer confidence (net balance of answers) Page 18

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Measures Reduction of public deficit (% of GDP) Details of the measures Withdrawal of discretionary measures 2.7% Infrastructure Plan Plan E (.8% E (.8% of GDP) of GDP) Removal of 4 income tax credit Previous measures Increase in income Increase in revenues 1.% 2 pp rise in VAT, capital income taxation and other indirect taxes Immediate action plan.5% Reduction in investment and public spending New measures Adjustment plan submitted to the EC 1.5% 5% pay cut and wage freeze (.6% of GDP) Reduction of public investment (.6% of GDP) No increase in pensions and other welfare policies Cyclical impact on deficit 1.% Recovery Growth of activity short of in potential 212 and in 213 21 and 211 Additional measures needed 1.5% 8.2% Uncertainty surrounding the effectiveness of the adjustment plan is reduced Deficit would fall from 11.2% in 29 to 3% of GDP in 213 Page 19

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Uncertainty surrounding the short-term impact of the new fiscal measures The impact on GDP comes from multiple channels and transmission mechanisms Static channel (Keynesian effects) Dynamic channel (non-keynesian effects) Less public investment Public wages reduction The consolidation process is brought forward Reduction in aggregate demand Fall in employment Wealth effect:: lower accumulation of debt, taxes and interest rates Confidence effect ReductioninGDI Less pressure on prices Increase in net exports Increase in private consumption and investment Greater impact if the adjustment: Is perceived as unexpected Is permanent Greater impact if the adjustment: Is significant and concentrated on expenditures Is perceived as change of regime Page 2

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Uncertainty surrounding the short-term impact of the new fiscal measures Factors that reduce the negative effects of the fiscal adjustment in the short term The measures are a change in the time dynamics of the adjustment Clears up the uncertainty surrounding the final composition, size and credibility of the adjustment Reducedimpactonconsumption and investment If it is part of a change of regime in economic policy, it could increase the positive effects in the medium term Accelerated recovery of pricecompetitiveness Expected increase in exports If the adjustment had been postponed, the negative effects on the economy would have been much worse In the medium and long term, a rigorous fiscal adjustment will expedite the economy's recovery Page 21

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Uncertainty surrounding the short-term impact of the new fiscal measures If the package is perceived as a change of regime, the impact on growth could be offset by an increase in private demand. There are clear examples of this in the past. The problem is that now the fiscal adjustment coincides with an increase in uncertainty in the financial markets. Adjustment in structural primary balance (% of potencial GDP) Source: BBVA Research Private consumption (Average annual growth rate in %) Source: BBVA Research 12 5. 1 4.5 4. 8 3.5 3. 6 2.5 4 2. 1.5 2 Spain (1993-1999) Ireland (1985-1989) Denmark (1983-1986) Greece (199-1994) 1..5. Spain (1993-1999) Ireland (1985-1989) Denmark (1983-1986) Greece (199-1994) Page 22

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Uncertainty surrounding the short-term impact of the new fiscal measures The adjustment measures imply a change in the time dynamics of the fiscal consolidation process. Spain: budget balance as % of GDP PEC scenario Source: BBVA Research based on MEH and Central Government Spain: improvement in expected public deficit each year (as % of GDP) Source: BBVA Research based on MEH 4. -2-4 -6-8 -1-11.2-9.8-9.3-7.5-6. -5.3-4.3-3. -3. 3.5 3. 2.5 2. 1.5 1..5-12 29 21 (f) Update 21, Jan 211 (f) Update 21, May 212 (f) 213 (f). 21 Update 21, Jan 211 212 Update 21, May 213 Page 23

An adjustment that is at an advanced stage in the private sector and a necessary and feasible fiscal consolidation Public sector adjustment Uncertainty surrounding the short-term impact of the new fiscal measures Fiscal consolidation is necessary, but not sufficient: is must be accompanied by other structural reforms which will determine the final effects of the fiscal adjustment on growth. Spain: impact on GDP of the additional fiscal policy measures (on %yoy) Source: BBVA Research. -.5 -.1 -.15 -.2 -.25 -.3 21 211 Macroeconomic Forecasts (y-o-y growth rate, %) 29 21 211 Spain EMU Spain EMU Spain EMU Household consumption -5, -1, -,2,1,4,6 Public consumption 3,9 2,3 1,4,9,2,5 Gross Fixed Capital Formation -15,2-1,8-8,8-2,8-2,7,6 Equipment and other produc -2,6-15,5-7,9-2,3-1,1,3 Capital Goods -22,9-17,1-3,8-2,4 -,1 -,2 Construction -11,1-7,2-9,4-2,8-3,7,9 Housing -24,5-9,4-16,5-4,7-5,6 -,8 Internal Demand (*) -6,4-3,2-1,9,1 -,4,8 Exports -11,3-12,8 5,3 6,2 5,6 7,6 Imports -17,7-11,4 -,2 4,8,9 6,7 External Demand (*) 2,8 -,8 1,3,6 1,1,5 GDP -3,6-4, -,6,7,7 1,3 Pro-memoria GDP excluding housing -1,8-3,7,4 1, 1,1 1,4 GDP excluding contruction -2,2-3,7,8 1,2 1,5 1,3 Total employment (LFS) -6,8-1,8-2,7 -,5 -,3,3 Unemployment rate (% Active po 18, 9,4 19,4 1,4 19,2 1,6 Current account (%GDP) -5,4 -,8-3, -,6-1,1 -,5 Public surplus/deficit (%GDP) -11,2-6,3-9,6-6,6-6,6-5,2 CPI media anual -,3,3 1,2 1, 1, 1,2 (*) contributions to GDP growth Source: INE, Bank of Spain and BBVA Research Page 24

I The need for ambitious structural reforms The financial sector The solvency problems in the financial sector are limited and need to be addressed decisively The Spanish financial system has proven its strength. The default rate is below the one recorded in the 199s crisis and has started to drop. A significant part of credit is guaranteed (36% is housing credit), the exposure to construction and real estate corporates represents 25% of the total, and 3% corresponds to other production sectors, with a lower indebtedness. The bulk of the financial system is well capitalized. Only a limited number of institutions will need capital, that we estimate at around 5% of GDP around the year 213, which is perfectly acceptable as it corresponds to half the maximum indebtedness that the FROB can reach. Spain: total frequency of default Credit to private sector (%) * Frequency of default: number of credit that default during the quarter over the number credits in the portfolio, total credit to the private sector Source: BBVA Research based on Bank of Spain 3. 2.5 2. 1.5 1..5. 4Q t 4q t+1 4q t+2 4Q91-4Q98 cycle 4q t+3 4q t+4 4q t+5 Current cycle (3Q7-4Q9) 3. 2.5 2. 1.5 1..5. Spain: weight of the construction and real estate sector in the credit portfolio of financial institutions Source: BBVA Research 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % Average Page 26

I The need for ambitious structural reforms The labour market Should the evidence observed since the mid-199s recur, it would be possible to start creating employment with GDP growth rates of around 1% Reducing unemployment quickly requires growing well above that growth rate. To do so, and in order to create stable and productive employment, an ambitious labor reform is needed. Spain: GDP vs full-time equivalent employment Q1 1996 - Q1 21 (% yoy) Source: BBVA Research based on NSI Spain: economy excluding construction. GDP vs. full-time equivalent employment Q1 1996 - Q1 21 (% yoy) Source: BBVA Research based on NSI Full-time equivalent employment 8 6 4 2-2 -4-6 -8-8 -6 Lower growth of labour productivity -4-2 GDP Year-on-year GDP growth from which employment equivalent to full time is created: 1.3% (.8% employment LFS) 2 Higher growth of labour productivity 4 6 8 Full-time equivalent employment (non-construction) 8 6 4 2-2 -4-6 -8-8 -6 Lower growth of labour productivity -4-2 2 GDP - non-construction Higher growth of labour productivity Year-on-year GDP growth from which employment equivalent to full time is created in non-construction: 1.1% (.6% employment LFS) 4 6 8 Page 27

I The need for ambitious structural reforms The labour market The functioning of the Spanish labour market is not optimal 1. Dual labour market Promotion of permanent contracts In spite of the drop recorded during the current crisis, the temporary employment rate in Spain is still 1 percentage points above the EMU, with negative effects in the medium and long-term on: Productivity On-the-job training Geographical mobility Labor mobility Wage setting Employment volatility Aggregate demand Spain: temporary rate in 27 vs unemployment rate in 29 Source: BBVA Research based on INE Unemployment rate in 29 (% of active population) 28 26 24 22 2 18 16 14 12 1 2 Cat Mad Rio 25 Ara Pvas Bal CyL Ast Cant Nav 3 Esp Gal Val CLM 35 Cana Mur 4 Ext And 45 5 Temporary rate in 27 (% of employees with temporary contracts) Page 28

I The need for ambitious structural reforms The labour market The functioning of the Spanish labour market is not optimal 2. Inefficient wage determination system Improve collective bargaining In countries with decentralized wage and employment conditions bargaining (e.g. UK), the wage increase is more in response to productivity gains (internal factor) than other external variables (unemployment rate). In Spain, the correlation between productivity and wage growth is non-existent, as a result of the intermediate bargaining system. Spain: real labour compensation vs labour productivity. Annual growth distribution (21 industries, 25 years) Source: BBVA Research based on EU KLEMS Real labor compensation growth per employee (%) 12 8 4-4 -8-12 -12-8 (21 industries, 25 years -4 4 8 12 Real productivity growth per employee (%) Page 29

I The need for ambitious structural reforms Structural reforms In the absence of ambitious structural reforms, the economy will converge slowly at a growth rate of around 2%, slightly above the EMU growth rate. A favorable combination of structural reforms (labor and financial), accompanied by more reforms in the future, could take the economy back to growth rates of around 3% more quickly. Spain: time needed to reduce the unemployment rate by 1 points in various scenarios Source: BBVA Research based on Andres et al. (29) Spain vs. EMU: Potential GDP (% yoy) Source: BBVA Research 3.5% 25 2 2.5 3.% 2.5% Years 15 1 1. 15.1 14.7 14.3 13.3 6.5 2.% 1.5% 5 1.% (1) 199s growth model (2) Productivitybased growth (2)+single employment contract (2)+redesign employment benefits (2)+collective bargaining decentralization (2)+more efficient ALMP (2)+all the refoms simult..5%.% EMU 1997-28 29-22 Spain Page 3

Spain Economic Outlook Spain Economic Outlook June 21 June, 21