What's new: The new fiscal measures will have to be approved by the cabinet on Friday. The extra savings amount to â?¬15 billion in 2010-11. This is equivalent to about 0.5% of GDP this year and 1% of GDP next year. Measures include: abolition of â??birth payment' of â?¬2,500 per household, 5% cut in civil servants' wages this year and a wage freeze next year, elimination of 13,000 public-sector jobs, suspension of index-linked pensions in 2011, and spending cuts at the regional level.
Our take on the measures: There are very few details on the various measures at this stage, but taken at face value, we think this belt-tightening package is praiseworthy. However, Spain will need to come out of a deep fiscal hole even assuming that all the various measures are implemented swiftly and in full. Factoring in the announced savings into our forecasts, we now expect the budget deficit at 9.4% of GDP this year and at 6.7% the next.
Is this enough? It all depends on what â??enough' really means. This is an important step in the right direction, but our impression is that there is scope for more ambitious deficit-reduction measures, or for front-loading the adjustment to a greater extent. In all, then, it seems to us that this package is within the range of what is reasonable to put in place at the current juncture - perhaps closer to the lower end - i.e., less aggressive fiscal adjustment - of the possible outcomes.
The next steps: Apart from seeking parliamentary approval, Spain will need to present the fiscal consolidation measures - along with Portugal - to the Ecofin Council on May 18. The adequacy of such measures will be assessed by the European Commission in June, in the context of the excessive deficit procedure. Will these measures be sufficient? We will have to see the details, but we reiterate that, to convince the Commission, as well as markets and rating agencies, leaning towards more austerity - rather than putting in place an austerity package that is â??just about right' in terms of achieving the fiscal targets - can be a winning strategy, in our view. Put differently, this plan does not seem to leave any room for error.
What about structural reforms? Another aspect of Spain's short-term policy plans relates to the various reforms that the government will need to put in place. Indeed, while the fiscal effort has been stepped up - thus contributing to balance the books - there does not seem to be any emphasis on addressing a number of deficiencies, ranging from (lack of) competitiveness to a potentially unsustainable trajectory of spending on pensions, which may contribute to ensure fiscal sustainability in the long term - this is where the risks really lie. If anything, this is perhaps one of the areas where the Ecofin Council and the European Commission may see considerable scope for improvement.
Liquidity risks versus solvency risks: Spain is solvent, in our view - especially taking a medium-term view. Market concerns had (and still have) to do with the difficulty to roll over the debt at an affordable cost. The recent policy initiatives at the European level (see Fast-Track to Fiscal Union? May 10, 2010) have reduced these refinancing risks - and today's initiative by the Spanish government certainly contributes to convey a message of commitment towards fiscal restraint. Yet the separation between liquidity and solvency risks is artificial, we think. Even a solvent country may need to restructure the debt if it is unable to roll it over. While short-term risks have diminished, the long-term picture still remains uncertain.
What does it all mean for GDP growth? Clearly, this new fiscal package will hit the economy, which has just emerged from recession. Today's flash report showed that Spain's GDP expanded by 0.1%Q in 1Q - after having contracted for six quarters in a row. Naturally, this is good news. But we revise down our GDP growth forecasts for this year and the next to -0.9% and 0.4%, respectively (previous forecast: -0.7% in 2010; 0.8% in 2011). What's more, we think the risks remain skewed to the downside - courtesy of the ongoing housing market downturn and the potential restructuring of the savings banks. And, should more fiscal tightening be required at some stage (quite possible), the chances are that we may be looking at a double-dip further down the line.
What to watch: The timing of the various fiscal measures will be crucial, in our view. The VAT rate hike in July will be a first test to assess how the economy reacts to a more stringent fiscal policy. Moreover, we are monitoring the labour market very closely, at this stage. The jobless rate is approaching 20%. That is worrying, but we believe it will pick up soon. We are not so much concerned that, at face value, unemployment is high. We are more concerned that employment will not pick up visibly for quite some time. At this stage, we expect zero job creation through 2011. The upshot is that, with no clear substitute for the construction sector as the engine of growth, we believe that Spain will underperform the euro area over the next five years, from an economic standpoint.
The draft version of the legislation which will be presented to PM Recep T. Erdogan and then to the cabinet is expected to be voted on at the parliament in June. In the absence of any legislative setbacks, this should assure that the budget of 2011 will be set up on a new fiscal rule that will assure a rather fast correction in any deviation from the fiscal targets. This is particularly important ahead of the general elections, scheduled to take place by mid-2011, in our view.
Currently, there exists no fiscal anchor such as an IMF Stand-By Arrangement that would assure enforceability of the fiscal targets, and the only way to force discipline on fiscal authority would be through indirect punishment by raising the cost of borrowing via increased risk premiums. Also, future external shocks, such as the one experienced in 2008/09 that resulted in a recession, leave the door open for excessive fiscal stimulus, which in turn requires a vast amount of tightening that usually results in volatility in real GDP growth. The proposed Fiscal Rule, in our view, will replace the need for other anchors such as the IMF.
How will the rule work: The targeted real GDP growth rate had been set at 5% per annum while the government deficit to GDP target is set at 1%. According to the fiscal rule, the coefficients for both the correction in the deviation from the overall government deficit and the necessary cyclical adjustment had been set at 0.33 (see below).
â??a = -0.33 (a(t-1) - 1) - 0.33(b - 5)
Where
â??a : Adjustment in general government deficit / GDP
A (t-1) : Previous year's general government deficit / GDP
b : Real GDP growth rate
Implementation: According to the Turkish Treasury, the implementation of the rule will be as follows: "The general government deficit ceilings for the next three years will be calculated in accordance with fiscal rule, which will be determined in the Medium-Term Program and Fiscal Plan. In case of a change in general government deficit to GDP ratio of the previous year and/or real GDP growth rate in a given year, the deficit ceiling will be updated and announced to the public. Whether there is a deviation from the rule in a given year shall be determined by comparing general government deficit to GDP ratio with the final ceiling Budget performance continuously monitored during the year. If a possibility of exceeding the ceiling emerges, alternative measures will be prepared and submitted to the Council of Ministers by the Minister chairing the Economic Coordination Council. In an event of declaration of state of emergency due to natural disaster, dangerous epidemics or heavy economic and financial crisis, additional central government expenditures directly related to the state of emergency that are not projected in the budget will be treated as exceptions from the rule."
Reporting: "Minister of Finance and Minister in charge of the State Planning Organization shall inform the Planning and Budgetary Commission of the Grand National Assembly of Turkey in a special agenda meeting within 15 days following the publication of Medium-Term Program and Fiscal Plan. Fiscal statistics on general government shall be disclosed quarterly and annually by the Ministry of Finance through the Fiscal Rule Surveillance Report. Fiscal statistics on the state-owned enterprises shall be disclosed quarterly and annually by the Undersecretariat of Treasury. Reports on long-term actuarial balances of pension and general health insurance systems shall be published annually." In our view, especially the frequent and systematic disclosure of the statistics other than the central budget increases the credibility of fiscal results and the increased transparency once again acts as a good substitute for IMF Stand-By monitoring.
Auditing: According to the draft legislation, the Turkish Court of Accounts will assess and report the accuracy, reliability and the conformity of the fiscal results with the predetermined standards set by the Fiscal Rule. An assessment report will be published within three months following the publication of the Surveillance Report published by the Ministry of Finance.
Supplementary rules: According to the legislation, there will be no â??Special Revenue - Special Appropriation' implementation and all netting-outs and write-offs will be budgeted. This will increase the transparency. Also, the domestic borrowing of all local administrations will be subject to the consent of the Treasury in addition to the required approval of the Ministry of Interior. One of the key risks associated with fiscal implementation at local administrations in the past had been the level of opaqueness.
Risks: Since the draft version of the legislation regarding the Fiscal Rule had not been legislated and the final details are yet to be released, we refrain from making any solid criticisms at this point. However, we have three question marks regarding the implementation of the fiscal rule, the monitoring, and the sanctions against possible rule breaches. On the implementation side, there exists an open door for a revision of the parameters as well as the possibility for some interim fiscal action as and when it is deemed necessary by the Ministry of Finance. However, there are no specific details regarding the possible frequency of changes or the timing as far as how fast the corrective fiscal action might be taken. On the monitoring and the sanctions front, we understand that the Ministry of Finance will be monitoring the performance while the auditing will be made by the Court of Accounts. There is no indication what, if any, type of sanctions could be imposed on the fiscal authority in case the Fiscal Rule is breached.
All in all, in an era of sovereign debt concerns and immense fiscal deficits, we believe that Turkey's efforts to curb the deficit and lower debt ratios are commendable and should pay off with a lower risk premium on borrowing. The general elections set to take place in 2011 would be considered a fiscal risk factor but a successful implementation of the proposed fiscal rule should minimize this, in our view. Hence, we would expect the sovereign rating to go though a positive assessment after this, and a rating action cannot be ruled out.
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