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Economic, financial and regulatory environment

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THE GLOBAL ECONOMY WAS SOUND IN 2018, BUT EARLY DOUBTS REGARDING THE CONTINUATION OF THE GLOBAL EXPANSION SPARKED A DIP IN INVESTOR SENTIMENT THAT LED TO A SHARP DOWNTURN IN THE RISK MARKETS.

Macroeconomic performance remained solid in 2018. Global growth rose above 3%, exceeding potential for the second year running. Unlike in 2017, however, the performance of the main economies slackened over the course of the year, prompting a decline in the confidence of the economic agents. The United States stood out on the positive side; Europe, Japan and most of the emerging countries, on the negative side. Of the world's large economies, only the US grew faster in 2018 than in 2017 (2.9% vs 2.2%). The euro area weakened more than expected, slowing to a rate of 1.8%, down from 2.5% in 2017, reflecting the impact of the cooling of world trade, the change in emissions regulations in the automotive industry, the sharp hike in oil prices (until the October plunge), the uncertainty surrounding Brexit and Italy's budget confrontation with the European Commission.

The complex political situation in Europe, coupled with the US-China trade dispute and the tightening of monetary policy in the US, also worsened the balance of global risks, with the result that market sentiment turned sharply negative in the last few months of the year and the main stock indices lost considerable ground.

The complex political situation in Europe and the trade tensions between China and the US brought a worsening of the balance of global risks

2018 brought major changes in the normalisation of monetary policy, as the US Federal Reserve intensified its interest rate hikes and the ECB ended its asset purchase programme. Specifically, in the United States the Federal Reserve raised interest rates by one percentage point, to the 2.25%-2.50% range, and trimmed its balance sheet by almost 400,000 million dollars. In the euro area, the ECB went from purchasing 60,000 million of assets in 2017 to halting asset purchases at the end of 2018.

As a result of this tightening of monetary policy, US sovereign yields rose during the year, though less sharply at the longer maturities on account of the prevailing uncertainties and the fact that these maturities are less affected by changes in monetary policy. The spread between the 10-year and two-year maturities fell from 55 to 10 basis points, fuelling fears of a coming recession.

In the euro area, meaenwhile, the yield of 10-year bonds fell more or less across the board (20 basis points in Germany, 15 basis points in Spain), the most striking exception being Italy, where it rose 75 basis points.

EXPANSIONARY INERTIA IN SPAIN

Through inertia, the Spanish economy continued to expand strongly in 2018, albeit at a slowing rate, with GDP up 2.5%, slightly less than the previous year (3%).

This strong performance contrasts with the markedly weaker performance of Spain's European partners, widening the GDP growth differential to 0.7 points in Spain's favour (0.5 points in 2017).

The observed slowdown in growth is attributable to the loss of certain tailwinds that had been assisting economic growth, notably low oil prices, pent-up spending from the economic crisis, the surge in tourism and the positive performance of trading partners, among others.

In this context, the rate of job creation remained firm. Employment rose for the fifth year in a row. The number of people in employment, in EAPS terms, increased by almost 566,000, bringing the total to just over 19.5 million, while the unemployment rate fell to 14.4%, the best figure for a decade.

In 2018, growth was oriented more towards domestic demand, especially investment in capital goods, which was the fastest-growing component. Buoyed by strong demand and leveraging their borrowing capacity, companies continued to modernise their capital stock and incorporate digitisation in their production processes. At the same time, household spending moderated slightly, though remaining on a positive trend, under the impact of the upturn in inflation and the gradual absorption of pent-up spending, although employment growth has persisted and wages have started to recover.

The GDP growth differential between Spain and its European partners widened to 0.7 points, in Spain’s favour, during 2018

Construction investment grew faster, driven by the recovery of public investment, following the previous year's slowdown, and above all the upswing in the residential segment.

The housing market remained buoyant, supported by the favourable economic context and the improvement in financing conditions. After five years of recovery, property sales continued to grow at a brisk pace, though still well below pre-crisis levels, and new housing development gained momentum. House prices rose above the rate of inflation on average, but the upward pressure was particularly strong in certain urban areas where demand is high and the supply is especially limited.

Meanwhile, for the first time since 2015, external demand contributed negatively to GDP growth. This was attributable to the less favourable international context, due to the deterioration of world trade and the slowdown of the main European economies, which translated into a weakening of Spanish exports, both of goods and of services (tourism).

The readjustments, the external surplus and private sector deleveraging continued in 2018. For the seventh year running, the Spanish economy generated a net financing capacity, although as of September the surplus had fallen to 1.5% of GDP (2.1% the previous year). This healthy financial position made it possible for an increase in investment to be accompanied by a decrease in the high level of private debt, which sank to its lowest level since 2004 (153.5% of GDP).

After an initial spike, due to the hike in fuel prices, inflation moderated towards the end of the year, closing at 1.2%, ten points higher than in 2017. The annual average was 1.7% (2% the previous year).

OUTLOOK FOR THE WORLD AND FOR SPAIN

At the global level, the most likely scenario for 2019 is that growth will ease slightly. In general, most of the main economies are expected to grow somewhat slower than in 2018 and, among the developed economies, the gap in favour of the US is expected to be narrowed. Forecasts put the average growth at around 2.3% in the US and 1.2% in the euro area. The outlook for monetary policy in 2019 is for further rate hikes by the Federal Reserve, though at a slower rate (the market is expecting no more than an additional 25 basis points), while the ECB could start to raise rates in the last quarter.

Debt yields are therefore likely to increase, though to a very limited extent both in the US and in Europe.

The forecasts for Spain in 2019 point to continued growth, though at gradually decreasing rates, mainly due to slower growth in export markets, resulting in GDP growth in the region of 2.2%.

The main risks to this scenario, at the external level, are possible tensions in the financial markets, an escalation of protectionism and the uncertainty arising from budgetary policy in Italy and Brexit.

Internally, the political context may halt the application of the required structural reforms and fiscal consolidation, while high government debt limits the ability of fiscal policy to face future crises.

SPANISH BANKING SYSTEM

The Spanish banking system has continued to benefit from the buoyancy of the domestic economic environment, as is reflected in the growth of economic activity, the significant improvement in balance sheet quality and the increase in profitability.

The volume of lending to households stopped falling for the first time since 2010, ending the year slightly higher than the previous year. This result was due to a strong performance in new home loans and, above all, the growth of consumer lending in line with economic activity, which has been on an upward trend since 2016.

Meanwhile, the volume of lending to non-financial companies fell during 2018, mainly due to sales of portfolios of non-performing loans in housing-related sectors. Even so, the flow of financing showed a strong recovery in the form of new lending to companies through loans of more than one million euros, while loans of less than one million, usually associated with SMEs, continued their steady growth.

On the funding side, deposits performed favourably, while off-balance mutual funds were affected by increased market volatility in the second half of the year.

This year also saw a major improvement in the quality of banks' balance sheets. The volume of non-performing assets in Spain fell sharply, to below 75,000 million euros, which is 60% below the level recorded in December 2013, at the high point of the economic crisis. This decline has been assisted by the favourable economic conditions and active portfolio sales by banks under the tightening scrutiny of the supervisor. Thanks to this reduction, the total volume of non-performing loans in the resident private sector returned to 2009 levels.

Business growth and, above all, reduced impairment losses brought an improvement in banks' profitability in their business in Spain. Overall, return on equity remained below the cost of capital, restricted by an operating environment marked by extraordinarily low interest rates and, consequently, very tight margins. In this context, banks continued to seek efficiency gains through strategies such as cost containment, growth through mergers and acquisitions and investment in digitisation.

Capital ratios remained stable during the year, offsetting the negative impact of the temporary adjustments associated with Basel III and the additional capital adjustments arising from the introduction of IFRS 9 on the measurement of financial instruments. The strength of the Spanish banks was confirmed by the stress tests carried out by the European Banking Authority (EBA). In this exercise, the European banking industry in general proved stronger than in the 2016 tests. The Spanish banks in particular showed above-average resilience in the adverse scenario, despite having started from lower capital ratios.

On the regulatory front, the year was marked, at global level, by the end of the second phase of Basel III, aimed at reducing the excessive variability of risk-weighted assets and improving comparability between banks, thus completing the regulatory framework promoted by the G20 after the outbreak of the financial crisis.

In Europe, further progress was made in the roadmap for deepening the Banking Union with the creation of a financial backstop for the Single Resolution Fund, to be provided by the European Stability Mechanism. However, the third pillar of Banking Union, namely, the creation of a Common Deposit Guarantee Scheme, and full implementation of the MREL loss absorption requirement remain to be completed.

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