Summary: EXECUTIVE SUMMARY Implementation of Spain’s financial sector program remains on track. Essentially all measures specified in the program have now been implemented, as envisaged under its front-loaded timetable. Of note, capital-augmentation measures arising from last year’s stress test are now complete, SAREB has almost concluded its organizational development and is now accelerating the liquidation of its assets, and key reforms of Spain’s financial sector framework have been adopted or put in train. Macro-financial developments since the last progress report have been broadly positive. Output and unemployment have stabilized, with strong export growth. The clean-up of banks’ balance sheets under the financial sector program has significantly bolstered the system’s capital and liquidity, with all banks now having a core tier 1 capital ratio in excess of 9 percent, except for one relatively small bank that is in the process of being taken over by a stronger bank. Profits in the first half of 2013 also exceeded assumptions in the stress test’s base case. On the other hand, profitability was boosted at least in part by temporary factors, and nonperforming loans, which tend to lag changes in economic growth, are still increasing. Against this background of mixed but broadly positive developments, Spain’s financial markets rose briskly in recent months. Despite recent improvements, important risks remain, including those associated with the ongoing macroeconomic adjustment. The correction of Spain’s large external, fiscal, and financial imbalances is well underway, with policy actions at both the European and Spanish levels helping to ease market pressures over the last year. Nonetheless, significant further adjustment remains. Deleveraging by households and businesses, as well as planned fiscal adjustment over the next several years, will continue to weigh on domestic demand, such that the pace of recovery is likely to be restrained, with concomitant challenges for bank profitability that could in turn slow the recovery of credit conditions, reinforcing headwinds to growth and downside risks. There is also upside potential, especially in the medium term, in a scenario of strong policies and reforms by both Spain and Europe.

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