Since 1986, Spain's economic performance in the EC has been highly successful, partly on account of a very favourable external environment. In Discussion Paper No. 388, Research Fellow José Viñals argues, however, that Spain has still to experience a large part of the combined `EEC-cum-1992' shock, which involves opening up the current and capital accounts. Viñals focuses on transmission mechanisms in the real and financial sectors, arguing that Spain could enjoy significant long-term gains from full integration into the EC by exploiting its comparative labour cost advantage and existing scale and scope economies.
Successful adjustment will,however, require the reallocation of productive resources from contracting to expanding sectors. Given rigidities in factor markets, the short- to medium-term result may be idle capacity and more unemployment. To realize the gains while minimizing the adjustment costs, Viñals concludes, it is essential that steps be taken to improve the functioning of the labour market, to develop long-term capital markets, and to let fiscal policy share with monetary policy the burden of achieving internal and external balance. This paper was produced for the CEPR project on `Economic Integration in the Enlarged European Community', described more fully in Bulletin No. 36.
In June 1989, the Spanish peseta entered the Exchange Rate Mechanism of the EMS, subject to a transitional 6% band, wider than for existing member currencies. The claimed advantages of obeying formally the rules of the System, compared to the former, managed floating policy, relate to the reduction of short-run exchange rate volatility and of long-run misalignments; the stabilizing effects of such reduced fluctuations; and the role of the System in enhancing the credibility of monetary policy.
In Discussion Paper No. 389, Viñals argues that EMS membership may well be the best available exchange rate arrangement for Spain, since it will reduce the size of short-run, unpredictable and self-reversing exchange rate fluctuations, and accommodate medium-run exchange rate movements. This will bring important benefits, since the EC accounts for 57% of Spain's imports, 66% of exports and a large portion of registered capital flows. A theoretically optimal exchange rate regime would maintain parities in response to monetary shocks, ensuring they are accommodated in money markets without affecting the real side of the economy, while allowing adjustments in relative prices in response to real shocks, but such a regime may be too complex to design and operate in practice.
Viñals argues that EMS membership may be particularly beneficial in altering the constraints on macroeconomic policy. By reducing the incentives to inflationary policies and allowing further doses of fiscal and wage discipline, it could provide the increased discipline needed to reduce inflation further. It will therefore ensure that the disinflationary benefits of the last decade are not lost and also help achieve lower and more stable inflation in the future, with lower output and employment costs. Achieving the necessary stability of the peseta exchange rate within the EMS will also require better coordination of monetary and fiscal policies. Though in the past EMS membership has not fostered fiscal discipline, Viñals argues, the large increase in capital mobility and the abolition of exchange controls will considerably increase the costs of fiscal indiscipline.
On optimistic growth assumptions, it may be sufficient to hold the structural primary budget deficit below 0.1-0.7% of GDP. On pessimistic growth assumptions, however, a surplus of 0.5% of GDP may be required to maintain the peseta exchange rate against the Deutschmark. EMS membership will therefore help Spain not only in the monetary field, but also in assisting fiscal reform. It would be desirable, Viñals concludes, to shift the mix of policy towards a less expansionary fiscal stance and less contractionary monetary policy, so that price and exchange rate stability can be achieved without capital controls.

Spain and the `EEC cum 1992' Shock
José Viñals et al.
The EMS, Spain and Macroeconomic Policy
José Viñals

Discussion Paper Nos. 388 and 389, March 1990 (IM)