Spain’s performance has remained remarkably strong thanks to the structural reforms implemented since the mid-1990s and the sound macroeconomic policy framework. Employment has expanded strongly, enabling the economy to grow more rapidly than the euro area average, even during the recent slowdown. To sustain this strong performance over the medium term, it is necessary to continue the reform process. First, the persistent inflation differential with the euro area is worrying as it erodes competitiveness progressively and could lead to a period of slower growth. This inflation differential, which is partly the consequence of exceptional factors, highlights the need for continuing labour market reforms, and for strengthening competition in certain sectors. Additional reforms in these areas would also help in bringing down unemployment, which is mainly structural and, in spite of its considerable reduction, remains among the highest in the OECD. Second, productivity gains have remained small, partly as a consequence of positive effects of strong employment growth. Accelerating real convergence requires removing the obstacles to the development of higher value added activities, promoting the improvement of human capital, reducing the innovation gap and stepping up the slow diffusion of new technologies. Third, a reform of the real estate market is desirable, to raise labour mobility, to improve resource allocation and to prevent the risk of a speculative bubble from developing. Last, reforms are needed to prepare against the consequences of ageing. They should be phased in now to ensure the sustainability of the public finances, which will be under threat from sharply rising spending on pensions and medical and social services as from 2020-25.

Spain has not escaped the international economic slowdown since 2000 but has fared better than most countries. Output growth for 2002 reached 2 per cent, which means that the positive growth differential with the euro area remained at 1¼ percentage points, its average level since 1996. This strong growth performance, which is similar to that of the United States since the mid-1990s (Figure 1), is due mainly to strong job creation which has boosted domestic demand, especially private consumption and residential investment. However, robust growth of employment did not prevent a cyclical rise in the unemployment rate to 11½ per cent in late 2002, the first increase since 1994, which is also due to the low sensitivity of the labour force to economic conditions and the steep rise in immigration. Despite an easing of labour market pressures and a slightly negative output gap, inflation has not slowed, partly because of exceptional factors such as the changeover to the euro. In February 2003, consumer prices were 3¾ per cent higher than a year earlier. The inflation differential with the euro area of about 1¼ percentage points since 1999 tends to erode the economy’s international competitiveness.

Beyond the short term, fiscal policy will face three major challenges. The first challenge will be to preserve the progress made with fiscal consolidation, while at the same time maintaining sufficient flexibility in the new, more decentralised fiscal framework that is in force since 2002-03. The second medium-term challenge relates to raising public sector efficiency further in this new framework. Thirdly, and over the longer term, reforms are needed to prepare Spain for the consequences of population ageing as the viability of the public finances will be threatened by the steep rise in pensions and medical and social expenditure as of 2020-25.

In recent years, strong growth of output and employment were underpinned by a wide-ranging structural reform programme and a sound macroeconomic policy framework, while real interest rates have come down to low levels. Privatisation of large public companies was almost complete by 2000, and was accompanied by several liberalisation "packages" that included an early introduction of competition in network industries, among other measures. Labour market reforms that lowered severance payments for most new permanent contracts, together with real wage moderation and the use of temporary contracts have boosted the employment ratio from 50.7 per cent in 1997 to 58.8 in 2002. At the same time, the unemployment rate fell by 5.5 percentage points, even though it is still – at over 11 per cent in late 2002 – one of the highest in the OECD.

For much of the 20th century, Spain experienced significant net emigration. But over the last decade, the net flow has reversed and Spain has become an immigration country. A number of factors, including its geographic position, historical links with Latin American countries, and a strong growth performance compared with most other EU countries, has made Spain an attractive recent estination for migrants. With the sharp rise in the inflow of immigrants, Spain is facing the challenge of defining an overall policy on immigration. And the challenges are numerous. These include most importantly decisions on the size of the immigrant inflow and the way immigrants should be selected in the case of non-EU immigrants, ways to cope with the still large number of illegal immigrants and means to integrate better the immigrants that stay.