Spain Reform Delays Add to Bank Cleanup Hurdles, EU Says

Spain is backsliding on economic reforms, fueling risks for its banking system in the midst of an overhaul that faces “significant challenges,” the European Commission said.

“Progress in delivering of some key product and services market reforms has been slow,” the Brussels-based commission said today in its second review of Spain’s bank rescue program. “Persistent efforts are needed to compound the progress achieved to date” on the banking system and “to overcome the still significant challenges.”

Officials from the commission and the European Central Bank visited Madrid from Jan. 28 to Feb. 1., and the International Monetary Fund participated in the review. The cleanup of the banking industry is on track so far, the report said.

Prime Minister Mariano Rajoy is hesitating over EU demands to remove privileges from party operatives, union members and professional advisers in an attempt to contain the fallout from a series of corruption scandals rocking his party. Rajoy’s failure to rein in power companies, who’ve benefited from 29 billion euros ($38 billion) of government guaranteed debt in the electricity system, is jeopardizing the prospect for economic recovery, the commission said.

“The ‘electricity tariff deficit’ implies a considerable contingent liability for the budget as well as non-negligible macroeconomic risks,” the report said.

Meeting Commitments

The commission sought to play up the positive side of the review as the euro area struggles to regain investor confidence, restore growth and prevent the financial crisis from deepening again.

“The commitments of the memorandum are being met despite the ambitious deadlines and thus the repair and reform of the Spanish financial sector is well under way now,” European Union Economic and Monetary Affairs Commissioner Olli Rehn told reporters yesterday. He said Spain’s efforts are “an essential step toward normalizing lending conditions for Spanish households and businesses.”

While Rajoy has scope to eliminate reduced sales tax rates on some goods and increase fuel taxes, he has made little progress on fixing Spain’s two-tier labor market, the report said. Under Spanish labor law, companies incur costs for firing mostly older, unionized workers on permanent contracts. That means young people bear the brunt of the economic crisis, with 56 percent of those under 25 unemployed.

Opaque Budget

Budget rules approved last year lack transparency, and the government is dragging its feet over a pledge to set up an independent fiscal council. It has yet to cut losses generated by the country’s pension system, according to the report.

The Spanish government won’t take any further austerity measures this year even as it has “taken note” of the commission’s suggestions, Economy Minister Luis de Guindos told reporters in Brussels today. “In 2014 and 2015, we will take the appropriate measures depending on the path for deficit reduction and the macroeconomic scenario.”

Spain will present its new stability program in the coming weeks, de Guindos said. The steps of the country’s deficit reduction have yet to be defined and Rehn has signaled the program may be eased, he said.

Feasible Path

De Guindos said Spain has to consider the impact that budget cuts will have on growth. “The path must be feasible and credible,” he said.

Spain requested European aid for its banks last year as concern mounted that losses at former savings banks, including the Bankia group, would contaminate public finances. Under the program, the country took about 41 billion euros to recapitalize lenders and fund a “bad bank” known as Sareb to absorb the soured property assets of nationalized firms.

Banks must ensure they have enough capital to withstand losses and adopt “prudent” dividend policies to generate additional capital internally, the report said. The impact of early repayments of ECB’s three-year loans on Spanish lenders’ profitability and liquidity conditions will merit further analysis. There is also a potential risk on mortgage portfolios, as any increase in interest rates would put more pressure on households’ debt burdens.

Bad Bank

While “there is at present no reason to foresee” more program disbursements, efforts are still needed, including a “robust and credible” business plan for the Sareb, said the document, which contains information through Feb. 15.

“It’s important that Sareb is able to offer its clients funding conditions that are in line with market conditions, so that it can compete on equal footing” with the country’s banks, the report said. Domestic lenders have already adopted “aggressive commercial practices” to sell real estate properties rapidly in anticipation of future competition with Sareb, it said.