The Evolving Landscape
Imminent Tail Risks have been Addressed, but the Growth Crisis has Deepened
1. Policy actions at the euro area and national level have reinforced the collective commitment to the euro. The ECB’s Outright Monetary Transactions (OMTs) framework has removed dangerous tail risks related to euro area breakup (Box 1). Initial progress on banking union—the Single Supervisory Mechanism (SSM) agreement, the European Stability Mechanism (ESM) framework for direct bank recapitalization, the Bank Recovery and Resolution directive (BRRD)—has demonstrated the commitment to improving EMU architecture. Other critical steps to address the crisis have included: the completion of the ESM firewall; the extension of official loan maturities to program countries; and the agreement on Greece and Cyprus. These actions, along with reductions in external imbalances and progress by national governments in restoring the health of public finances, have boosted confidence in the long-term viability of the monetary union.
Box 1.The Impact of OMTs
Financial market stresses in the euro area reached unsustainable levels by mid-2012. Sovereign yields for some large periphery economies were effectively on an unsustainable path that was reinforced by market panic. The liquidity crisis made monetary policy dysfunctional and generated tail risks of euro area exit. In this context, the ECB’s commitment to do “whatever it takes”—including by establishing the OMTs framework—improved the functioning of monetary policy and safeguarded the viability of the euro.
The announcement of OMTs reduced tail risks (see Spillover Report). Spreads on periphery government bonds declined from unsustainable levels, translating into lower private borrowing costs in these economies. As perceptions of redenomination risk receded, capital flight from the periphery gradually reversed, and Target 2 imbalances narrowed. Outside the euro area, funding costs of emerging European sovereigns declined to record low levels; safe haven flows to small advanced European countries (Switzerland, Denmark) subsided. Financial market volatility declined across large systemic economies.
2-year Sovereign Spread to DEU
Target 2 Balance
2. Severe market stresses have subsided, although private borrowing costs have remained too high in the periphery. In these economies, sovereign borrowing costs have declined from unsustainable levels. This has led to slightly lower private borrowing costs, spurring bond issuance among some banks and firms. Capital flight has gradually eased, bank deposits have stabilized, and Target 2 imbalances have narrowed. This has contributed to some early repayment of official liquidity support (LTROs) by stronger banks, though largely from core countries. Still, periphery bank risks are significantly higher than in the core. And lending rates to corporations continue to vary widely among euro area members, especially for smaller enterprises.
Bank Credit Default Swap Spreads
Periphery: Greece, Ireland, Italy, Portugal, and Spain. Core: Austria, France, Germany, the Netherlands, and Belgium
3. Notwithstanding substantial stabilization over the last year, the recent turbulence in global markets has tightened financial conditions in the euro area. The prospect of scaled-back U.S. monetary support—observed in the wake of the May 2013 Federal Open Market Committee meeting—has led to higher sovereign yields across the region, reversing some of the gains achieved in the periphery since the OMTs announcement. Unlike previous bouts of stress, German yields have also increased, limiting the scope for periphery yields to decline without a further compression in their relative spreads. At the same time, euro area money market rates have also increased, raising expectations of higher interbank funding costs and leading to tighter monetary conditions.
10-year Sovereign Yields
Sources: Bloomberg and staff calculations.
Interbank Interest Rate Expectations
4. Growth has continued to disappoint. GDP contracted by 0.3 percent in the first quarter of 2013, after declining by 0.6 percent in 2012. Real activity in the euro area remains below pre-crisis levels. Recessionary forces have persisted in most periphery countries, as households and firms continue to struggle with heavy debt, high borrowing costs, and contracting credit. The growth weakness has also spilled over to core economies (France, Germany) added to budgetary pressures, and weighed on banks’ asset quality across the area.
WEO Growth Projections and Revisions
Lending to Non-financial Corporates, Less than 1 Million Euro
Source: ECB and staff calculations.
5. Inflation has fallen below the ECB’s primary objective and is expected to remain subdued, raising concerns about underlying deflationary trends. Headline inflation, at 1.6 percent in June 2013, has declined to levels last seen in mid-2010. Inflation in the large economies (Germany, Italy, and Spain) is now close to the euro area average, while it is significantly lower or even negative in program countries. Core inflation has also moderated since early 2012—to about 1½ percent in the first quarter of 2013—reflecting increasing slack throughout the euro area. Although survey-based inflation expectations remain broadly anchored, market-based indicators for some large euro area countries have begun to drift downward. In turn, below-objective inflation has complicated relative price adjustment and the reduction in debt burdens.
6. At the same time, mounting social and political tensions pose an increasing threat to reform momentum. With real activity shrinking, the euro area unemployment rate has reached record highs (over 12 percent in May), especially among the youth. Rising social stresses threaten the political commitment to sustain adjustment efforts at the national level, especially in countries where policy space to support growth and tackle unemployment is limited.
Unemployment and Political Strife, 2007-12
7. Although much needed, deeper integration is hard to accomplish. As important decisions on EMU architecture require national support by 17 members, the hurdle for reaching a collective agreement is always high. Moreover, building political support for such decisions can take considerable time, especially when they involve thorny issues such as burden-sharing or ceding national control. Hence, making swift progress on completing the banking union—by introducing a single resolution mechanism (SRM), agreeing on common backstops and safety nets—and moving toward greater fiscal integration are proving exceedingly difficult.
The Elusive Recovery
Legacies of the Crisis are Restraining Growth
8. What is the root cause of the persistent and pervasive weakness in growth? Persistent financial market fragmentation, weak bank balance sheets, low demand, and creeping uncertainty, as well as structural weaknesses, all reinforce each other and contribute to contraction of real activity.
SME Lending Rate and Output Gap, 2012
- Financial market fragmentation continues to undermine monetary transmission and the flow of credit to the periphery. In spite of the positive effect of the OMTs announcement, differences in sovereign and private risk premiums, stronger sovereign-bank links, and other factors (e.g., regulatory hurdles, national regulatory ring fencing) continue to hamper cross-border interbank activity and elevate funding costs for periphery banks. This pushes up private lending rates, preventing the transmission of easier monetary conditions to these economies. Access to credit for small and medium enterprises (SMEs) is the first victim of these pro-cyclical financial conditions.
- Weakness in bank balance sheets is a key contributing factor to fragmentation. Despite improved capital ratios following the EBA recapitalization exercise, banks across the euro area continue to reduce leverage, largely by shedding assets. Meanwhile, profitability remains muted, partly reflecting increased provisioning needs due to nonperforming loans. Given the weak macroeconomic backdrop, bad loans will almost certainly increase further, placing additional pressures on banks’ capital buffers and limiting their ability to support the recovery, especially in the periphery.
- Low demand is also weighing on real activity, as sovereigns, banks, firms, and households continue to repair their balance sheets. These headwinds are particularly strong in some periphery economies, especially where all sectors, including the government, are highly indebted (Box 2).2 But core countries are not immune, as firms and households withhold investment and consumption amidst heightened uncertainty. Fiscal consolidation will continue to be a drag on growth even if the pace of adjustment is expected to moderate from last year: on current policies, fiscal adjustment for the aggregate euro area is expected to reach about 1 percent of GDP in structural terms, after a 1½ percent adjustment in 2012.
- Heightened uncertainty about euro area prospects and policies is holding back private investment and durables consumption. With the crisis reaching the core, this uncertainty is amplifying own economic challenges that some core economies face (e.g., France).
- Long-standing structural weaknesses in labor and product markets are making it difficult to adjust relative prices, deploy resources into new productive sectors, and restore competitiveness in the periphery. This is despite ongoing adjustment efforts to rebalance these economies. At the same time, remaining gaps in product market reforms are constraining productivity (and trend growth) in the core and the periphery.
- External imbalances within the euro area are narrowing only gradually (see Box 4). This is mostly due to the slow adjustment in relative prices, given incomplete structural reforms and small inflation differentials (see ¶29).
Box 2.Indebtedness and Deleveraging in the Euro Area
High debt and the simultaneous deleveraging of firms, households, banks, and the public sector can weigh on growth through various channels. High debt increases agents’ vulnerability to asset price shocks, financial volatility, and uncertainty. Negative feedback loops between highly-indebted private sectors, a weak financial sector, and a sovereign under stress may constrain demand and credit conditions. In particular, uncertainty about the private sector’s ability to service its high debt burden can raise questions about banks’ asset quality, and impair financial sector intermediation. Asset holdings could buffer the impact, but they are often illiquid or unevenly distributed across agents.
Household Deleveraging Episodes
Sources: Eurostat; Haver; national statistical agencies; and IMF staff calculations.
1/ September 2012, except for Ireland, Denmark, Netherlands (June 2012) and Cyprus and Norway (end-2011).
2/ 1970 for Canada, 1990 for Japan and Germany, 1980 for others.
The Impact of High Debt on Growth
Sources: Staff estimates, see Selected Issues Paper.
Balance sheet adjustment in the euro area may prove more challenging now than in other episodes and regions in the past.
- A look at previous episodes of household deleveraging is revealing: historically, almost all of the run-up in household debt (during the boom period) tends to be reversed. But in the euro area, the reduction in debt-to-GDP ratios has barely started, and the boom was more pronounced. Furthermore, in past deleveraging episodes, the debt reversal was largely facilitated by high inflation and growth, and supported by expansionary fiscal policy. Because these factors will not contribute much to the ongoing deleveraging process in the euro area periphery, the adjustment is likely to be protracted and have to rely more on reductions in nominal debt. The contrast with history is similarly sobering when it comes to corporate debt.
- Econometric analysis suggests that when all three sectors (government, households, and firms) are highly indebted, the negative growth impact of debt is highest. In addition, high corporate and household debt is associated with worse growth outcomes than public sector indebtedness. This suggests that headwinds are likely to be particularly strong in the periphery where all sectors are highly indebted.
Policies that directly support the workout of bad debt in the financial and private sectors can help avoid a protracted period of stagnation. While the policy space to support private sector deleveraging is more constrained than in the past, experience suggests that direct and decisive policy actions can support deleveraging. More specifically, at the national level, insolvency regimes need to be made more effective (e.g., by facilitating out-of-court settlements, reducing time for insolvency proceedings) and provide more flexibility in dealing with personal or corporate bankruptcy. Policies to encourage debt write-offs and help facilitate the transfer of non-performing assets to new owners would also support the repair of bank balance sheets (e.g., by fostering a market for NPL-backed securities).
Periphery: Spreads and Volume at issuance
Periphery is defined as Italy, Ireland, Portugal, and Spain
Bank Core Tier 1 Ratio, 2012
Growth and Balance Sheet Stress
EDP Target Date
Box 3.Fragmentation and Monetary Transmission in the Euro Area
Euro area financial markets remain fragmented, despite the range of ECB actions to address bank funding problems and eliminate excessive risk in sovereign markets. Following the introduction of OMTs, sovereign and corporate risk has fallen, but bank CDS spreads remain elevated. Term funding costs are still high for periphery banks, weighing on bond issuance, while declining asset quality is raising provisioning needs. Cross border banking flows remain low, and lack of market finance makes weak banks highly reliant on official liquidity. These factors have contributed to driving retail interest rates in stressed markets significantly above those in the core, impeding the flow of credit, and undermining the transmission of monetary policy.
Banks’ provisions to pre-provision income
Interest and credit channels are impaired. Declining interbank activity has undermined the interest rate channel. The bank lending channel is still impaired as a result of lack of term-funding for certain banks and weak bank balance sheets. In addition, ongoing corporate and household balance sheet adjustment is feeding into low demand for credit and higher nonperforming loans.
Fragmentation and the broken monetary transmission mechanism impact SMEs disproportionately, as evidenced by higher lending rates for small loans and high loan rejection rates for SMEs as compared to larger entities. Ensuring credit availability to viable SMEs is essential to support the recovery in the euro area, particularly as they account for about 80 percent of employment and 70 percent of value added in Italy, Spain, and Portugal.
A simple econometric model finds that interest rate pass-through has been affected by the above factors. In particular, the regression results support the notion that funding costs, credit risk, and leverage have become important determinants of lending rates since the onset of the crisis, particularly for stressed countries, and that these factors appear to be more relevant for small loans, typically associated with SMEs.
These findings highlight the importance of cleaning up bank balance sheets and other measures to increase access to credit to SMEs. Repairing bank balance sheets and making further progress on a banking union are essential to restore confidence in the financial system, weaken bank-sovereign bank loops, reduce fragmentation, and support credit and growth. At the same time, given that bank balance sheet repair will take time to complete, it is important to stem the decline in the real economy through various measures to support credit supply.
Box 4.Rebalancing the Euro Area: Where do We Stand and Where to Go?
Background: Before the crisis, large net foreign liabilities accumulated in the periphery (Greece, Ireland, Portugal, and Spain) as a result of deteriorating competitiveness and domestic demand booms fueled by intra-euro area capital flows. Meanwhile, export-oriented economies (Germany, Netherlands) experienced rising external surpluses. Since the crisis, current account deficits in the periphery economies have narrowed markedly, but these external adjustments could reflect depressed demand or more structural developments. Given downward pressures on demand (associated with public and private deleveraging) and limited policy space, the challenge for the euro area is to reduce internal imbalances while restoring growth and employment.
- Substantial REER adjustments have taken place in deficit economies, largely driven by declining unit labor costs through wage adjustments and labor shedding. CPI deflators have been sticky, while GDP deflators have declined in the periphery relative to trading partners.
- Nevertheless, there is limited evidence of reallocation of resources across sectors. And ongoing adjustment in current account balances is partly driven by cyclical factors, especially in Greece.
- While relative price adjustment plays some role, improvements in export performance are very dependent on external demand, including from within the euro area (Italy and Portugal), and remain partly determined by initial trade specialization.
- Further adjustment in relative prices would be needed to restore competitiveness (in the order of 5-15 percent in deficit economies based on current account or REER targets).
- Beyond price adjustments, resources need to be reallocated to more productive sectors and countries need to move up in the value chain, while labor and product markets need to become more flexible.
- Going forward, converging to net foreign asset positions considered safe elsewhere will prove challenging for some countries, while others are projected to continue accumulating large foreign surpluses.
Policy implications: Further improvements in competitiveness are important for deficit economies, which need to lower costs and shift resources to tradable sectors to spur growth and rebalance their external position. In addition to continued efforts to reform labor and product markets, easing credit constraints affecting SMEs would help support entry and investment in tradable sectors. In surplus economies, product market reforms would ease entry in non-tradable sectors and boost domestic demand, which could help support rebalancing the euro area. Also, a decrease in euro area uncertainty would support a pick-up in investment and domestic demand, notably in Germany. This would contribute to a sustained reduction in current account surpluses over the medium term.
Sources: WEO, EER, DOTS, and IMF staff
Net Foreign Asset Postion
Note: NFA/GDP implied by WEO projections, assuming no valuation effects going forward.
Real Wage Sensitivity to Unemployment Rate and Labor Market Duality
Relative Unit Labor Costs
9. Against that backdrop, the outlook remains for very weak growth and inflation.
- Euro area GDP is expected to contract for a second year in 2013, by 0.6 percent, before recovering modestly in 2014 on account of stronger external demand and a very gradual improvement in lending conditions to the private sector. Growth in 2014 is forecast to reach 0.9 percent, with a very sluggish recovery thereafter. In the absence of further policy action, staff sees trend growth at only 1 percent over the medium term.
- At the same time, large output gaps and base effects related to past indirect tax increases will place downward pressures on prices. Inflation is expected to stay at around 1½ percent over the next two years, and a level substantially below the ECB target is foreseen to persist even over the medium term.
10. Risks are tilted to the downside (see Table 1). Because policy space is limited, public debt ratios are very high and still rising, and economic slack is already substantial, further negative shocks—either domestic or external (e.g., sovereign bond stress, a bumpy exit from unconventional monetary policies (UMP) in other advanced economies, higher oil prices) could have a severe impact on the growth and inflation outlook.
|Nature/Source of Main Threats||Likelihood of Risk (high, medium, or low)||Expected Impact of Risk (high, medium, or low)||Policy Recommendations|
|1. Financial stress re-emerges and bank-sovereign links re-intensify (triggered by stalled or incomplete delivery of euro area policy commitments)|
|2. Financial stress re-emerges and bank-sovereign links re-intensify (triggered by stalled or incomplete delivery of national policy commitments)||Medium||High|
|3. Protracted period of slower European growth|
|4. Advanced economies bond market stress|
|5. Distortions from unconventional monetary policy in other advanced economies|
|6. Oil price surge|
The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of the staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).
The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of the staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).
- In the near-term, continued turbulence in global markets—due to expectations of earlier-than-anticipated UMP exit in the U.S.—could lead to additional, and unhelpful pro-cyclical increases in borrowing costs within the euro area. This could further complicate the conduct of monetary policy and potentially damage area-wide demand and growth. Financial market stresses could also quickly reignite, not only because sovereign debt levels remain high but also from incomplete or stalled delivery of policy commitments at the euro area level—progress on banking union, single rulebook, and final agreement on ESM direct recapitalization—or delays in fiscal adjustment and structural reforms at the national level.
- In the medium-term, there is a high risk of stagnation, especially in the periphery. This could stem from larger-than-envisaged effects from private and public sector deleveraging, entrenched fragmentation, and delayed structural reforms. Such an outcome could push the periphery toward a debt-deflation spiral. In the core, real activity could also suffer due to confidence effects and trade links. Persistently high unemployment and subdued investment would erode the region’s growth potential. In such a scenario, euro area and global GDP levels might be about 4 percent and 1 percent below the baseline by 2018, respectively (see Spillover Report).
The Implications for Policy
11. The challenge to revive growth and jobs calls for a comprehensive policy response. There are many factors weighing on growth. Therefore, no single action can address it (see text chart). Instead, reviving growth requires complementary policy actions on multiple fronts to: (1) reduce fragmentation (by repairing bank balance sheets, advancing the banking union agenda); (2) support demand (by undertaking further monetary policy measures, pacing fiscal adjustment); and (3) boost trend growth and foster rebalancing (by implementing structural policies). As these efforts proceed, it is imperative to maintain support from the center. This would contain adverse feedback loops between weak growth, weak sovereigns, and weak banks (see flow chart).
12. While difficult to achieve, unwavering political backing for institutional reforms remains critical and is in the interest of all EMU members. This would help reduce, in particular, the euro area policy uncertainty that has been holding back domestic demand, including in the core. Policies to address the multiple challenges would be mutually reinforcing. For example, measures to address fragmentation and improve credit conditions in the periphery would help foster investment and job creation in new productive (tradable) sectors. This, in turn, would help restore competitiveness and raise growth. Likewise, policies to boost growth and jobs would facilitate sovereign, corporate and household balance sheet repair. This would strengthen bank balance sheets and ultimately reduce fragmentation. Conversely, considering these policy actions in a piecemeal way could disappoint, and further undermine confidence. The dividends of such reforms could be significant over the medium term—about 3 percent and 1 percent in terms of euro area and global output levels within five years (see Spillover Report).
A. Reversing Fragmentation
Repairing Banks’ Balance Sheets is a Prerequisite3
13. Restoring banking sector health is essential for the recovery. As discussed in the recent EU FSAP, the crisis has shown that frail banks have been unable to function as proper financial intermediaries during the recovery. Instead, they have relied on elevated lending rates to boost profitability and enhance capital buffers—especially where funding costs remain high. In addition, these banks have been either unable or unwilling to recognize and provision for higher losses, leading to further balance sheet weakness, limiting their ability to lend, and reinforcing fragmentation.4 Reversing these dynamics means recognizing losses, filling capital holes, closing or restructuring nonviable banks.
14. By lifting confidence in the euro area banking system, a credible assessment of banks’ asset quality would help lower funding costs and address fragmentation. Such an exercise would help resolve the uncertainty about bank balance sheets and improve the prospects for attracting private capital to weak banks. This, in turn, would help unclog credit flows.
- The forthcoming Balance Sheet Assessment (BSA) of euro area banks, required ahead of the start of the Single Supervisory Mechanism (SSM), to be followed by stress tests, provides such an opportunity. It is also critical to establish the ECB’s credibility as a supervisor. Key elements to ensure the effectiveness of this approach include: (1) a forward-looking framework that incorporates risks to growth and is clearly communicated well in advance of the exercise; (2) harmonized methodologies and stringent standards for nonperforming loans, provisioning rules, and risk weights (as proposed by the EBA); and (3) full coverage of banks coming under direct supervision of the SSM.
- Independent third-party involvement (preferably from the private sector), along with the ECB, the EBA and national authorities, would be essential to ensure full credibility and transparency of the exercise. In the absence of such involvement, prospects for raising private capital would be jeopardized.
15. An agreed strategy on how to address capital shortfalls would be critical to prevent pro-cyclical deleveraging. Absent such a strategy, there is a high risk that the BSA and the following stress tests would be counter-productive: if banks shed assets to preemptively build buffers, this would reinforce fragmentation rather than resolve it. In addition, the incentives to conduct a thorough and credible exercise could be skewed. Conversely, a clear plan on filling capital gaps would encourage a realistic write-down of assets and full recognition of losses, which would encourage private capital. Where private funds are insufficient, the public sector would need to provide capital in countries with available fiscal space. However, in the event both private capital and fiscal space are limited, clarity on a common backstop would be critical. In particular, it would avoid the re-ignition of adverse bank-sovereign links and improve incentives for regulators to recognize losses. Competition and state-aid rules may also need to be reassessed to ensure that conditions attached to public support do not lead to excessive deleveraging.
16. The ESM can serve as an effective common backstop. The recent agreement on the main features of the ESM direct recapitalization framework—including the conditions for access, time of entry, burden sharing, valuation, conditionality, and governance—is an important step forward. Nevertheless, several issues remain:
- Timing. The timing of the final agreement on the ESM direct recapitalization is still uncertain, as it is linked to the legislative processes of the BRRD and DSG Directive.
- Conditionality and burden sharing. State aid conditionality would be a prerequisite for ESM direct recapitalization, which could raise issues about the use of bail-ins under the forthcoming EC rules. The role of bail-ins in ensuring burden sharing with the private sector has been clarified usefully in the BRRD (see discussion in ¶21). But if its early activation is required for ESM direct recapitalization, the new regime should be applied consistently across countries and with due regard to any adverse consequences for financial stability, especially in the event of resolution of large systemic institutions.
- Size and access. Although it is difficult to pre-judge the eventual needs, the limit for ESM resources available for direct recapitalization has been set at €60 billion (subject to review by the ESM Board). However, when needed, ESM direct recapitalization should be available on a timely basis, so that the ESM can be seen as an effective and credible common backstop.
In Parallel, Policies at the National Level Can Help Address High Private Debt
17. Improved national legislative and judicial frameworks could support an orderly deleveraging of the non-financial sector. Where needed, addressing high private sector debt directly can facilitate the early rescue of viable firms and a speedy exit of nonviable ones, opening the door to a rebound in investment and a reallocation of resources to more productive sectors. Doing so would also strengthen the quality of banks’ assets beyond the BSA, allowing for a revival in credit. If effective, national insolvency regimes would also support the clean-up of banks’ balance sheets by accelerating the workout of bad private sector debt. Yet, out-of-court restructurings—a speedy, cost-effective alternative to court-supervised proceedings—are still underutilized tools in many jurisdictions, notwithstanding recent advances in insolvency regimes in several euro area countries. A stronger institutional infrastructure and supporting bank regulatory policies could provide further incentives for debtors and creditors to engage in debt restructuring.
A Fuller Banking Union would Solidify Efforts on Banks’ Balance Sheets
18. The banking union has an essential role to play in supporting bank balance sheet repair and reversing fragmentation.5 The recent agreement by the European Council on the BRRD is welcome. But swiftly advancing the roadmap for the banking union, outlined by the Council in December 2012, is key to ensure that all elements are in place—the SSM, the SRM, common safety nets, and the accompanying directives. Further delays and dilution of the roadmap, including on the SRM, would preserve an unsatisfactory status quo and run the risk of destabilizing confidence again.
19. An effective SSM is a precondition to a systematic approach to supervision, as highlighted in the EU FSAP. This would, in particular, help reverse fragmentation by restricting ring-fencing imposed at the national level.
- While posing significant challenges, the remaining steps to make the SSM operational need to be finalized without delay. These include: passing the SSM legislation through the European Parliament (expected in September); clarifying outstanding legal uncertainties (e.g., on the respective responsibilities of the ECB and national authorities); finalizing a common supervisory model and detailed manual; and ensuring full cooperation of national supervisors. Guaranteeing full sharing of supervisory information (between national supervisors and the ECB) and building up supervisory capacity at the ECB would be critical to establish the credibility of the new supervisor in the forthcoming balance sheet review.
- Early intervention powers are essential to prevent banks’ problems from becoming systemic. The current crisis has shown the deleterious effects when those are lacking, especially in the absence of a robust resolution mechanism. To be fully effective, the ECB would need to be able to bring any bank under its direct supervision, take early intervention measures (e.g., capital conservation measures, the replacement of management, or sale of bank activities), and initiate resolution.
20. But without a strong SRM complementing the SSM, the credibility and effectiveness of the banking union would be jeopardized. As recommended by the EU FSAP, an SRM should become operational by the time the SSM becomes effective. Leaving resolution responsibilities at the national level while supervision is centralized carries significant risks, such as perpetuating bank-sovereign links and creating potential conflict (and deadlock) among national authorities in cross-border resolution. In that respect, such a framework would fail to break away from the current ineffective setting. Conversely, an SRM based on a centralized resolution authority—Single Resolution Authority (SRA)—would allow for swift decisions on burden sharing arrangements and ensure least cost resolution.6 To effectively break bank-sovereign links, the SRA would need to have access to an effective common fiscal backstop, ultimately backed by a combination of ex ante and ex post industry levies. A credit line by the ESM could be a bridge to that permanent solution.
21. Clear rules on the role of bail-ins will reduce uncertainty for private investors. In particular, spelling out the pecking order in the event of bank intervention helps provide the right incentives for investors, allows for market discipline, and minimizes the cost of resolution to taxpayers. In this context, the Council’s recent agreement is an important milestone.7 It confirms the role of bail-ins as an instrument to ensure burden sharing for nonviable banks and specifies a minimum amount of “bail-in-able” instruments (8 percent of total liabilities). In addition, the bail-in provisions allow flexibility in application to allow for specific threats to financial stability or institutional factors. Keeping such flexibility to a minimum level will help promote a level-playing field across banks and countries. While allowing exceptions could open the door to inequality of treatment across countries, the “constrained discretion” will also make the framework more credible by addressing concerns about systemic cases and minimizing value destruction and risks to financial stability.
22. Enforcing depositor preference across EU member states will also play an important role in ensuring financial stability, along with progress on the DSG Directive. The BRRD and its new bail-in rules introduce tiered depositor preference—a major step forward that has been supported fully by IMF staff.8 These rules are expected to come into force in 2018, but they may be applied on a case-by-case basis before then. Details on the mechanisms to constrain discretion and the criteria for exempting liabilities may need to be clarified. In this context, strong powers at the center (SRM) will make sure that the bail-in rules are applied predictably and consistently across countries. This will improve incentives for early intervention, sever the bank-sovereign links, and ensure least-cost resolution.
Targeted Monetary Policies are Necessary to Reduce Fragmentation in the Shorter Run
23. While efforts to clean up bank balance sheets and strengthen the banking union proceed, the ECB should play a role in preventing an escalation in fragmentation.9 At the current juncture, support to the corporate sector through reduced borrowing costs is critical to prevent a further deterioration of the macroeconomic outlook. On current plans, the BSA will not be conducted until early 2014, and the benefits of better capitalized banks and a more complete banking union will take even longer to accrue. Meanwhile, the risk of a vicious circle is setting in, with the recession and higher non-performing assets leading to further bank losses, and deeper fragmentation. To stem that risk, the ECB could provide additional term funding to avert a more severe contraction in credit and target measures to support SME financing—as a temporary bridge until the banking sector is in a position to intermediate growth again. While this strategy would require the ECB to take additional credit risks onto its balance sheet, these could be mitigated by offsetting measures or a potential backstop provided by the European Investment Bank (EIB).
- Providing term funding. One possibility is for the ECB to build on the existing approach to provide term funding for weak but solvent banks, to better match the duration of their assets. A new LTRO of longer tenor (3-5 years) combined with a review of current collateral policies to lower haircuts on specific assets (e.g., additional credit claims linked to SME loans and asset backed securities) would achieve such a target. And taken together, these measures would be akin to credit easing.
- Targeted credit easing. Another complementary avenue is for the ECB to undertake targeted credit easing measures, by explicitly linking additional liquidity to new SME lending, along the following two options:
- i) Targeted LTROs, akin to the Funding for Lending Scheme implemented in the U.K., but with stronger incentives for banks to participate by keeping the cost of funding through the scheme low. In particular, costs close to ECB policy rates are likely to elicit interest from banks in stressed countries where term funding costs remain elevated, thereby supporting monetary policy transmission and credit.
- ii) Direct ECB purchases of private assets: Such purchases would have the advantage of bypassing the banking system while balance sheets are being repaired. Private assets could include: securitized assets (supporting SME financing), corporate bonds, commercial paper, and covered bonds. However, the impact would be constrained, at this stage, by the small size of the securitized market and regulatory hurdles that would take time to overcome.
B. Supporting Demand
The Weak Growth and Inflation Outlook Warrants Further Conventional Monetary Policy Action
24. Further policy rate cuts, including negative deposit rates, would help support demand and bring inflation back in line with the primary objective. The room for cuts remains limited. Yet reducing the interest rates on the deposit facilities (marginally) below zero could help anchor expectations of a looser monetary stance and would be a strong form of forward guidance (see below). In particular, this would lower expectations of future increases in policy rates and further encourage banks with excess liquidity to reengage in the interbank market and extend credit. While lower bank profitability may either drive up interest rates on loans or fees on certain banking services for those banks (the “unintended consequences”), this is likely to affect mostly core banks, which on average are stronger at this juncture.
25. Explicit forward guidance would help anchor interest rate expectations and reduce funding uncertainty. The ECB’s forward guidance introduced in early July is helpful in this regard, but it may need to be relied upon further if conditions worsen. This is particularly relevant given the ongoing decline in excess Eurosystem liquidity and risks to interbank rates from global monetary shocks (i.e., uncertainty about the exit from unconventional monetary policies in the U.S.). In this context, the ECB could consider various additional actions, including reducing interest rates into negative territory, continuing full allotment MROs at fixed rates beyond mid-2014, or extending this to additional LTROs. Intervening directly in short-term euro area money markets could be another (and potentially powerful) option to signal the intended policy stance.
Pacing Fiscal Adjustment Would also Restrain Headwinds to Growth
26. For the area as a whole, the negative growth impact of consolidation could reach as much as 1-1¼ percentage point this year. Across the EMU, the pattern of adjustment remains highly pro-cyclical, with larger consolidations in the periphery and broadly neutral (or mildly expansionary) stances in Germany and Austria.
27. In this context, the challenge is to avoid excessive damage on demand while putting debt levels on a sustainable downward path. To ensure that negative growth surprises do not trigger additional consolidation, defining and assessing adjustment in structural terms is key, as was done in the context of the recent postponement of the EDP deadline. Nevertheless, given weak growth prospects, these deadlines may still prove to be overly ambitious in some cases, and even more flexibility may be useful, particularly if countries use that fiscal space to implement ambitious structural reforms (e.g., entitlement and tax reforms), or to recapitalize viable banks. In this context, the small projected loosening of the fiscal stance in Germany is appropriate. If downside risks materialize, countries that are not under market pressure would benefit from a slower pace of fiscal adjustment.
28. A credible medium term framework is a precondition to pace fiscal adjustment.
- Budgetary frameworks. To preserve credibility in the coordination process and ensure that consolidation is sustained over a longer horizon, there is a strong argument for using well-defined, multi-year budgetary frameworks—with fiscal measures identified in advance—and realistic macroeconomic assumptions underlying medium-term adjustment plans.
- Implementation and enforcement. Ownership of medium term objectives is expected to improve as national legislation and independent fiscal agencies assume a stronger role in the future, following the entry into force of the Fiscal Compact, Six Pack, and Two Pack. In this setting, the credibility of the framework would only be as strong as its implementation, especially regarding enforcement provisions. Therefore, achieving a timely implementation, a uniform degree of ambition across national setups, and consistent objectives between national and supranational layers would be important tests for the governance framework.
- Complexity. More broadly, the growing complexity of the current framework, in which the center has relatively weak enforcement capabilities, may cast doubt on its efficiency and acceptability by the public. Over time, a potential remedy could be to strengthen the role of the center and lay the foundations for greater risk sharing. This would help prevent idiosyncratic shocks (or policies) from morphing into a systemic crisis in the future.
C. Carrying on with Structural Policies
Ambitious Structural Policies are Instrumental for Growth, Jobs, and Rebalancing
29. A new growth agenda could help catalyze efforts at both the area-wide and national levels. Although the benefits from reforms will take time to accrue, a firm commitment to attainable targets could lift confidence, even in the short term.
- Fostering job creation. The ongoing rebalancing in the periphery has been skewed toward labor shedding, disproportionally affecting the young. Labor market reforms should be aimed at tackling labor market duality, promoting bargaining arrangements conducive to sustainable wage developments, and enabling firms to absorb shocks. Meanwhile, severance costs for permanent job contracts should be aligned with EU norms where they are significantly higher. At a minimum, employment protection should be more systematically linked to the length of employment in the firm, and increase continuously with tenure to avoid the threshold effects that characterize dual systems.10 By promoting the incentives for companies to hire, these reforms would facilitate the reallocation of resources to exporting sectors and increase trend growth, thereby fostering job creation and more sustainable adjustment. Area-wide, improved portability of pension and unemployment benefits would contribute to increasing labor mobility across the region. Bilateral national initiatives can also support migration from regions of high unemployment to areas with skill shortages (e.g., through job and language training). Across the euro area, incentives targeted at female and older workers would help raise labor force participation rates where they are particularly low.
- Promoting greater integration. Although the Single Market has fueled European growth over the past decades, labor mobility and cross-border competition in services remain limited. A targeted implementation of the Services Directive would help reduce barriers to entry in protected professions, foster competition by promoting cross-border provision of services, and enhance productivity and living standards. In addition, a new round of Free Trade Agreements could secure access to growing markets, including in emerging Asia. It could also provide a much-needed push to improve services productivity through deeper integration, which is under discussion in the transatlantic trade and investment partnership.
- Boosting competitiveness. Allowing firms’ wages to respond more flexibly to collective agreements and adjusting wage floors at the industry level would also foster internal devaluation. Lowering regulatory barriers to entry and exit of firms, simplifying tax systems, and tackling vested interests in the product markets—including measures to increase competition in the transportation, energy and other network industries—would support competitiveness and raise purchasing power throughout the euro area. (For instance, electricity prices for industrial users in Italy are some 50 percent higher than the European average.)
- Supporting credit provision and investment. The securitization schemes proposed by the EC and the EIB would provide some credit support to SMEs and therefore help reduce fragmentation. In the proposed options, SME loans would be securitized, using funds from EU and EIB amounting to €10.4 billion. The funds could be leveraged up to 10 times, depending on the degree of risk pooling among member countries. These options would support bank capital, SME lending, and capital market development over the medium term. However, the initial impact is likely to be limited, unless the scheme is front-loaded, covers new and existing loans, and risk pooling is maximized through wide member participation. Over time, efforts to further develop capital markets would help reduce the dominance of bank-based financing, especially for SMEs.
Many of the above reforms, along with reforms at the national level, would also support rebalancing.
30. The overall current account balance has strengthened, but divergences within the euro area have persisted.
- The euro area current account balance reached 1.2 percent of GDP in 2012, up from a deficit of 1.5 percent of GDP in 2008. Part of the adjustment owes to cyclical factors, as weak demand compresses imports in the periphery. But it also reflects some competitiveness gains stemming from national adjustment efforts in the periphery. This is evident from the improvement in export performance of these economies. But wage adjustments have so far had a limited impact on export prices, and weak euro area demand has been a drag on exports.11
- The adjustment, however, has been somewhat asymmetric. Since the onset of the crisis, the current account balances in deficit countries have more than halved—due to both lower imports and higher exports. The overall external position in surplus countries, notably Germany, has barely changed, although Germany’s current account balance with the rest of the euro area has narrowed significantly.
Euro Area Current Account Balances, 2001-12
Germany: Current Account Balance by Region,
31. The euro is assessed to be consistent with its equilibrium value. Staff analysis—based on fundamental determinants, desired current account adjustment, and aggregation of views for individual member states—suggests that the euro real effective exchange rate is close to its equilibrium, after declining by 10-15 percent from its peak at the end of 2009.12 On balance, this reflects a moderate undervaluation in surplus economies, and overvaluation in most deficit economies. Further adjustments in relative prices and sizeable real exchange rate depreciations—in the order of 5-15 percent according to the 2013 External Stability Report—are estimated to be necessary for some peripheral countries to regain competitiveness. Staff estimates suggest that the nominal exchange rate and the relative price adjustment have played a role in explaining recent export performance, although the magnitude of these effects is somewhat uncertain.
32. Further policy actions in both surplus and deficit economies are necessary to rebalance the euro area. In surplus economies, increasing productivity in non-tradable sectors would improve disposable incomes and consumption in these economies and lead to higher external demand, which could support the rebalancing efforts of the deficit countries. In addition, reducing euro area uncertainty would support a recovery in private investment, which would help narrow current account surpluses (notably in Germany). In deficit economies, continuing structural adjustment would deliver a shift of resources to tradable sectors where consumption booms led to excessive growth in non-tradable sectors in the run-up to the crisis (see 2013 External Sector Report).
The Authorities’ Views
33. There was broad agreement between staff and authorities that more credible progress is needed on bank balance sheet repair and EMU architecture. With differences of views among member states becoming increasingly prominent in these areas, the authorities—the ECB and the European Commission (EC)—stressed the importance of decisive policy actions in boosting confidence in the euro banking system and the long-term viability of the monetary union. They concurred that while the situation is substantially better than in mid-2012, the challenge to restart growth and reduce policy uncertainty remains. The authorities agreed that more progress was needed to complete the EMU architecture, including by providing a fuller banking union and achieving greater fiscal integration, to address the underlying weaknesses, fully restore confidence, and lay the foundations for higher durable growth.
34. The authorities broadly agreed with the assessment of economic developments in the euro area, and the downside risks to growth. The authorities noted the strong headwinds to growth from ongoing fragmentation, private sector deleveraging, and still-weak confidence. They elaborated that while significant progress in deleveraging had been achieved in some countries, and stronger asset positions may lessen the overall need to deleverage (particularly in the household sector), overall balance sheet weakness is restraining growth.
35. A credible assessment of bank asset quality is essential to restore confidence in the euro area banking system. The BSA and following stress tests are seen as critical elements that will establish the credibility of the SSM, and that the quality and comprehensiveness of this exercise should not be compromised, though this will be challenging. The authorities underlined the importance of having the ESM backstop in place ahead of the BSA to motivate national authorities and to address capital shortfalls where fiscal space is insufficient. But they also recognized that full approval of the BRRD and the DGS directive is a pre-requisite for finalizing the ESM direct recapitalization framework, and this could take some time. Nevertheless, they agreed that pro-cyclical outcomes should be avoided by effectively communicating the exercise, involving third party expertise, and having in place clear strategies for recapitalization and restructuring.
36. The ECB and EC strongly prefer a centralized resolution mechanism to make a banking union work. They stressed that a single resolution authority with strong powers was essential for the credibility and effectiveness of the SSM.
- The EC noted that such an authority could be established within current EU Treaties, under the condition of giving the decision-making power to the EC since it is the only institution apart from the ECB that can lawfully take decisions at the European level. But some member states hold the strong view that a treaty change is necessary, and this could significantly delay establishment of a single resolution authority.
- There was common concern that a weaker proposal, based on a network of national resolution authorities, could prevail, limiting the SRM’s ability to act in an efficient manner. In addition, the authorities fully supported the introduction of bail-ins as best practice resolution tools, but noted that this should only be deployed when a bank is deemed nonviable, and not as a recapitalization tool.
- The authorities welcomed the finalization of the CRR/CRDIV and Council agreement on the BRRD. However, they stated that other elements of the single rule book (e.g., the DGS Directive) should be agreed upon and transposed in national legislations as soon as possible. In late June, the European Council reiterated its goal of reaching agreement on adopting the BRRD and DGS directives by end-2013 for transposition into national law by end-2014. The authorities supported depositor preference (with full protection of insured depositors and a clear pecking order ranking uninsured depositors as the last to suffer losses among uninsured unsecured claimants), and favored minimizing the degree of flexibility left to national authorities in the application of resolution tools.
37. There was broad agreement on the potential need for further monetary policy action, particularly if conditions worsen substantially, although not all of staff’s proposals could be implemented easily. The ECB introduced explicit forward guidance for interest rates in early July and would consider further standard and non-standard measures (including negative deposit rates) if domestic and external conditions worsen. At the same time, the authorities cautioned that the impact of such measures are likely to be more muted, particularly in comparison with the OMTs, given that fragmentation is not only due to capital market failures but also to higher overall macroeconomic risks. The authorities noted therefore that while monetary policy plays a role in demand management, structural policies play a more important role in managing overall macroeconomic risks. In addition, they stressed the risk that further monetary policy actions to relieve demand pressures could blunt incentives to take difficult measures at the national level. On direct asset purchases, the authorities emphasized that the small market size of securitized assets and regulatory hurdles could limit its effectiveness.
38. The authorities broadly acknowledged the importance of setting EDP targets in structural terms. They explained that while the targets are set in nominal terms, structural adjustment has always been critical for assessments. In this context, the European Commission noted that if the outlook worsens, they would be ready to extend the deadlines accordingly. The authorities cautioned that linking EDP extensions to structural reforms should not be seen as a tradeoff, as these extensions were justified on economic grounds. Nevertheless, they emphasized that structural reforms are being pushed through the European Semester, where the extensions have been granted.
39. Substantial progress has been made in strengthening governance over the past year. At the same time, the authorities concurred with staff on the need for ensuring strong implementation of the new governance frameworks at both the national and European levels.
- To strengthen the credibility of fiscal frameworks in the medium term, implementation of country specific recommendations, and evenhandedness in applying the frameworks were of particular importance. While acknowledging the complexity of the frameworks, the authorities pointed out the need to address country specific issues and changing economic circumstances within the current legal setup.
- There was agreement that greater fiscal integration, combined with stronger governance frameworks, including a stronger role for the center, could in principle provide the basis for more risk sharing, making the euro area more resilient to future shocks.
- The authorities argued that targeted and limited contractual arrangements, such as the proposed Convergence and Competitiveness Instrument (CCI), could provide a useful mechanism to incentivize reforms. The CCIs could be linked to the European Semester and the Macroeconomic Imbalances Procedure (MIP). It was noted that financial support would have to rely on existing budgets and that moral hazard would have to be addressed. The authorities called for a strong implementation and follow-up on recommendations issued in the MIP, in particular for those countries where imbalances were deemed excessive (Spain and Slovenia).
40. The authorities agreed that the ongoing rebalancing is incomplete. While wages are adjusting and exports are improving in the periphery, there are limited signs of symmetric adjustment in surplus countries. The authorities highlighted that higher total factor productivity is essential to boost competitiveness. They noted that adjustment would be facilitated by the implementation of the Services Directives, which will generate higher productivity and stronger demand in the surplus countries, while facilitating the provision of credit to SMEs.
41. On structural reforms, the authorities highlighted key priority areas. On labor markets, they noted that pan-European training initiatives would signal solidarity and enhance firms’ incentive to hire young workers. Other priorities included implementing the Services Directive, reforming the energy sector, improving lending to SMEs, and fostering cross-border labor mobility.
42. There was general agreement with staff’s risk assessment. The authorities noted that renewed financial market stress could result from policy complacency and still rising sovereign debt ratios. These could be compounded if stress triggered additional fiscal consolidation. In the medium term, they shared the view that the drag from private and public sector deleveraging could be higher than expected, but noted that a slow labor market response could be expected given euro area labor market institutions, and that hysteresis effects were unlikely. The authorities emphasized that they considered the likelihood of a stagnation scenario to be relatively low, because they saw adjustment well advanced in many countries. On external risks, they noted that a larger than expected slowdown in demand from emerging economies, coupled with a fall in commodity prices, could weaken external demand prospects for the euro area and exert downward pressure on prices. A rise in long term interest rates, particularly in excess of what may be warranted by a pickup in world or U.S. growth could have a very detrimental impact on sovereign financing costs for the euro area, though they noted that the impact would not necessarily discriminate against yields of crisis economies. While the authorities saw risks to inflation outlook as balanced, they expressed concern that in a negative scenario of protracted low inflation, inflation expectations could become unanchored.
43. Substantial collective actions have reinforced the commitment to the monetary union. The ECB introduced the OMTs framework to address severe distortions in sovereign bond markets and thereby increase the effectiveness of monetary policy. The completion of the ESM firewall, the extension of official loan maturities to program countries, the improvement in the policy coordination framework, and the agreement on Greece and Cyprus have been equally important steps in combating the crisis. In addition, national governments continue to make progress in restoring the health of public finances and advancing structural reforms. These actions helped tackle dangerous tail risks related to the breakup of the euro area.
44. But the macroeconomic environment continues to deteriorate. Demand is weak and unemployment is increasing, stoking social and political tensions in parts of the euro area. Financial market fragmentation persists, hampering monetary transmission and the flow of credit to where growth is weakest. At the same time, consumers and businesses are restrained by large debt overhang and ongoing balance sheet repair, while fiscal policies are pro-cyclical. Structural weaknesses in labor and product markets are making it difficult to restore competitiveness. In turn, the risks of stagnation and long-term damage to potential growth are increasing, and this would cause broad negative spillovers to the rest of the world, particularly to other EU and southeastern European countries.
45. Further policy efforts are needed to address the twin challenges of growth revival and job creation. This requires policy actions on multiple fronts, many of which are mutually reinforcing (and cannot be effective if implemented in isolation): repairing banks’ balance sheets and facilitating the resolution of private debt, making further progress on banking union, providing sufficient demand support, and advancing structural reforms.
46. Although hard to achieve, undisputed resolve and steadfast support for deeper integration will go a long way toward restoring confidence. Undivided support at the national level for collective initiatives can bolster area-wide stability. On the other hand, significant delays and perceived frictions among member states can create uncertainty for investors and consumers. Therefore, demonstrating swift progress on the remaining elements of the banking union and advancing toward greater fiscal integration would send a strong positive signal and underpin confidence.
47. Sound bank balance sheets are essential to reduce fragmentation and revive credit growth. A comprehensive, forward-looking balance sheet assessment is needed to quantify any potential capital needs before the SSM in place. But a clear plan on how capital shortfalls will be addressed must be in place before the results are announced. Clear communication, and the involvement of an independent third party, would ensure transparency and boost confidence. Losses should be fully recognized, failed banks should be closed and restructured, and frail systemic banks should receive public support where private capital is insufficient. For this, a credible national fiscal backstop needs to be available ahead of time. But where both private capital and fiscal space is limited, a common backstop, such as that provided by the ESM, should be used, making it necessary to reach agreement as soon as possible on its availability for direct recapitalization. If needed, the flexibility in the recently agreed framework should be used to the fullest to prevent a flare-up of negative sovereign-bank loops in the context of the BSA and stress test exercises. At the national level, efficient insolvency regimes and strong institutions are needed to facilitate the work out of excessive private debt, which would complement the cleanup of bank balance sheets.
48. A strong banking union is essential to reduce fragmentation. The SSM regulation should be approved without delay. A centralized and more systematic approach to supervision would prevent ring-fencing by national authorities, help reverse fragmentation, and reinforce incentives for early intervention in frail banks. A strong SRM, based on a centralized authority with the independent power to trigger resolution and make decisions on burden sharing, is critical to minimize risks to the credibility of the SSM and to ensure timely and least cost resolution while protecting financial stability. By contrast, compromise solutions that leave resolution at the national level while supervision is centralized carry significant risks, including of perpetuating bank-sovereign links and potential conflict between national authorities in cross-border resolution. The SRM should become operational at around the time when the SSM becomes effective in 2014. This will enhance the ECB’s effectiveness as a supervisor. The ESM can initially provide a fiscal backstop, and access to its funds for direct recapitalization should not be unduly restrictive. Ultimately the SRM should also be backed by ex ante and ex post levies on industry resources. In addition, swift adoption of the BRRD and the DGS Directive—including clarification on bail-ins, depositor preference, and deposit limits—is essential to advance the banking union.
49. In the meantime, additional unconventional monetary support could help reverse fragmentation. Taking its current approach forward, the ECB should ensure term funding needs for weak but solvent banks through an additional LTRO of sufficient tenor. This would be most effective if accompanied by lower collateral haircuts, particularly on SME loans. To tackle fragmentation and repair monetary transmission more decisively, the ECB should consider further unconventional policies, including through a targeted LTRO (linked to new SME lending), or direct purchase of select private assets.
50. Additional monetary easing will likely be necessary, given the very benign inflation outlook. Further policy rate cuts, including negative deposit rates, would support demand across the euro area and address deflationary pressures. The ECB’s forward guidance will help anchor interest rate expectations, which is now even more necessary because of market uncertainty about the exit from unconventional monetary policies in the United States.
51. Pacing fiscal adjustment remains key. The extension of EDP deadlines is welcome, but current targets could still prove too ambitious. Additional flexibility may need to be given to countries, especially if that fiscal space is used to implement ambitious structural reforms (including to entitlement and taxes) or to recapitalize viable banks. Moreover, if downside risks materialize, the pace of fiscal adjustment should be slowed further.
52. Recent reforms have strengthened fiscal governance, but there are several outstanding issues that need to be tackled. The super-imposition of different layers of rules has made the overall framework increasingly complex. Moreover, concerns remain about the implementation, enforcement, and transparency of the various rules, including at the national level. In this context, proving by practice the capability of the framework to deliver credible medium-term fiscal anchors will be critical, not least to allow for sufficient short-term flexibility. In the longer run, fiscal governance will need to evolve further to strengthen the role of the center and lay the foundation for greater fiscal risk sharing.
53. There is also a pressing need for further structural reforms. Efforts at both the area-wide and national levels should be catalyzed, including through fostering greater integration. A targeted implementation of the Services Directive should be undertaken to remove barriers to protected professions, raise productivity, and promote cross-border provision of services and competition. A new round of free trade agreements could provide a much-needed push to improve services productivity. And within countries, labor market rigidities should be tackled to raise participation, address labor market duality, and promote more flexible bargaining arrangements.
54. While the euro is assessed to be broadly in line with fundamentals, there are still substantial competitiveness gaps between countries. Meanwhile, further productivity gains in the tradable sector and adjustment in relative prices should help rebalancing in the periphery. And increasing productivity in non-tradable sectors would improve disposable incomes in surplus economies, which could support the rebalancing efforts of the deficit countries.
55. The staff proposes that the next consultation on euro area policies in the context of the Article IV obligations of member countries follow the standard 12-month cycle.
|Reform priorities||Recent progress||Staff recommendations|
|Demand and Supply|
|Gross fixed investment||-0.3||1.4||-4.3||-3.4||1.2||2.0|
|Final domestic demand||0.7||0.3||-1.7||-1.2||0.5||0.9|
|Foreign balance 2/||0.7||0.9||1.6||0.7||0.4||0.4|
|Unemployment rate 4/||10.1||10.2||11.4||12.3||12.4||12.1|
|Public Finance 5/|
|General government balance||-6.2||-4.2||-3.7||-3.1||-2.6||-2.1|
|General government structural balance||-4.6||-3.7||-2.3||-1.4||-1.1||-0.8|
|General government gross debt||85.7||88.0||92.8||95.9||96.5||95.8|
|External Sector 5/, 7/|
|Current account balance||0.0||0.2||1.2||1.6||1.9||2.1|
|Interest Rates 4/, 6/|
|EURIBOR 3-month offered rate||0.8||1.4||0.2||0.2||…||…|
|10-year government benchmark bond yield||3.8||4.3||2.3||2.7||…||…|
|Exchange Rates 6/|
|U.S. dollar per euro||1.33||1.39||1.30||1.30||…||…|
|Nominal effective rate (2000=100)||103.2||104.2||99.7||103.1||…||…|
|Real effective rate (2000=100) 6/||95.3||95.0||90.3||92.2||…||…|
Projections are based on aggregation of WEO projections submitted by IMF country teams.
Contribution to growth.
Includes intra-euro area trade.
In percent of GDP.
Latest monthly available data for 2013.
Projections are based on member countries’ current account aggregations excluding intra-euro flows and corrected for aggregation discrepancy over the projection period.
Projections are based on aggregation of WEO projections submitted by IMF country teams.
Contribution to growth.
Includes intra-euro area trade.
In percent of GDP.
Latest monthly available data for 2013.
Projections are based on member countries’ current account aggregations excluding intra-euro flows and corrected for aggregation discrepancy over the projection period.
Figure 1.Euro Area: High Frequency Indicators
Sources: Haver Analytics and Eurostat.
Figure 2.Euro Area: Financial Market Fragmentation
Sources: ECB; Haver Analytics; Dealogic; Bloomberg; and IMF staff calculations.
1/ Sovereign and bank CDS exclude Greece and are weighted by total debt.
2/ Periphery is defined as Italy, Ireland, Portugal and Spain. The spread is that of periphery bank issuance costs over those of the core banks. The bonds are 1-10 year in tenor.
3/ Banks are first averaged within own country, and then added across country groupings.
4/ Core is defined as France, Germany, the Netherlands, and Belgium.
Figure 3.Debt Overhang in the Euro Area Figure 4.Euro Area: Inflation Developments
Sources: European Central Bank, Eurostat, Haver Analytics, and IMF staff calculations.
Figure 5.External Sector Developments
Sources: Haver, WEO, and IMF Staff calculations.
Figure 6.Fiscal Developments and Policies
Sources: IMF July 2013 WEO and WEO vintages.
Figure 7.Banking Sector Health
Sources: BIS; Bloomberg; Dealogic; ECB; IMF FSI and staff calculations.
1/ Banks are first averaged within own country, and then added across country groupings.
2/ Periphery is defined as Greece, Italy, Ireland, Portugal, and Spain. Other euro area is defined as Austria, France, Germany, and the Netherlands
3/ Net liquidity provided minus repayments announced.
Statistical data for the euro area are produced by Eurostat and the ECB in collaboration with national statistical institutes (NSIs), and the national central banks (NCBs) of countries participating in the Economic and Monetary Union. The statistics are of sufficient quality, scope, and timeliness to allow for effective macroeconomic surveillance. This appendix summarizes developments and desirable improvements.
1. Strengthened cooperation on European statistics. The European Statistical System (ESS) and the European System of Central Banks (ESCB) cooperate under separate legal frameworks reflecting their governance structures. A Memorandum of Understanding (MoU) has recently been established between the ESS and the ESCB creating a new body—the European Statistical Forum, which includes the heads of the NSIs and the statistics departments of the NCBs—to further strengthen cooperation. The Forum will also ensure consistency of the statistical work programs of the ESS and of the ESCB. The MoU preserves the role of the Committee on Monetary, Financial and Balance of Payments Statistics (CMFB) to implement cooperation on transversal or cross-cutting issues between the two statistical systems.
2. Developments in statistics to enhance fiscal and economic governance. The Enhanced Economic Governance Package (so called “Six Pack”)2 contains legal requirements that have implications for the collection and dissemination of fiscal data and statistics.
- Enhanced fiscal data reporting. Eurostat established a Task Force on the implications of the Directive under the “Six Pack” on the collection and dissemination of fiscal data. The objective is to provide timely, regular and publicly accessible monthly and quarterly fiscal data based on public accounts for all sub-sectors of general government, data on contingent liabilities, and other indicators with potential impact on the general government deficit and/or debt. Conceptual frameworks to publish monthly and quarterly fiscal data and annual data on government contingent liabilities have been adopted. A detailed reconciliation table describing the link between nationally based fiscal data and the ESA95 based data will also be published. Eurostat intends to collect and publish selected indicators (contingent liabilities, non-performing loans). The publication of data will start in 2014.
- Proposal for a regulation on the provision and quality of statistics for the Macroeconomic Imbalances Procedure (MIP). The Commission recently submitted a draft proposal for a regulation on the provision and quality of statistics for the MIP to the Council and the European Parliament. The draft regulation introduces new tasks for the Commission (Eurostat) on assessing and validating relevant data against various quality criteria. The proposal includes analyzing member states’ inventories of the sources and methods used to compile the MIP data, and developing and implementing an improvement action plan.
3. Improved compilation and reporting of national accounts. The revised European System of Accounts (ESA 2010) is to be implemented by member states by September 2014. It is an important contribution to reinforcing economic governance with efforts to update and improve the current methodological framework. The main methodological changes and challenges in the implementation of ESA 2010 are:
- Recognition of the investment nature of expenditure on research and development. Research and development expenditure is to be recorded as gross fixed capital formation and no longer as current expenditure. The identification and treatment of research and development expenditure as investment is consistent with the Europe 2020 strategy.
- More detailed analysis and presentation of pension schemes. A compulsory supplementary table on pension entitlements will be required to show the liabilities of all pension schemes, including those of government, whether they are unfunded or funded. This will improve comparability across countries and quantify the implicit government liabilities from future pension obligations. These implicit government liabilities will not be reported in the core financial accounts and will not impact the Maastricht debt.
- Challenges ahead: The challenges ahead include improvements in the timeliness for the main national accounts aggregates (from t+70 to t+60 days) and quarterly sector accounts (from t+90 to t+85 days), and the backward calculation of time series.
4. Recent developments in European statistics to support monetary policy. Several recent advances in European statistics help to improve the calibration of conventional and unconventional monetary policy:
- Financial sector surveillance supporting monetary policy decisions. Since 2013, individual balance sheet information on some 246 large euro area banks is transmitted on a monthly basis to the ECB. This supports the analysis of deposit and lending decisions of the non-financial private sector, and provides insights into the sources of bank funding. Quarterly data on the activities of non-bank financial institutions, including investment funds other than money market funds and including hedge funds, financial vehicles engaged in securitization and insurance companies and pension funds, are now collected by the ECB, complementing existing data relating to money market funds. These data facilitate the study of the shadow banking system.
- Further improvements in data reporting. The ECB and the IMF Statistics Department are finalizing the migration of the balance sheet data for depository corporations to the IMF’s Standardized Report Forms (SRFs) for monetary statistics. Work continues on mapping data for Other Financial Corporations.
- Household Finance and Consumption Survey. Complementing existing surveys of the non-financial corporate sector, the ECB published first results of the Household Finance and Consumption Survey (HFCS) in April 2013, which provides detailed household-level data on various aspects of household balance sheets and related economic and demographic variables, including income, voluntary pensions, employment and measures of consumption. Subsequent data collection should aim to increase coverage to all euro area countries and comparability of cross-country data.
- Sector accounts.3 The euro area quarterly institutional sector accounts have further improved, showing euro area non-financial assets by institutional sector, total euro area economy data on produced non-financial assets are available by main asset type as well as household housing wealth and from-whom-to-whom data for loans and deposits, which support the analysis of interconnectedness. At the country level, gaps remain regarding the non-financial assets position of sectors. The ECB is part of a research project led by the IMF Statistics Department on global flow of funds and balance sheet approach matrices. Matrices for the euro area and for the 17 countries of the euro area have been agreed. These provide metadata on data availability of international investment position data broken down geographically.
5. European statistics that support financial stability.
- Risk dashboard for the European Systemic Risk Board (ESRB). To provide statistical support to the ESRB, the ECB has developed a risk dashboard released in September 2012. The initial set of 45 indicators will be regularly updated and revised.
- ESCB Register of Financial Institutions and Affiliates (RIAD). Further to its function to set up lists of individual financial institutions in the euro area, the RIAD has been recently upgraded to include information on banking groups and conglomerates to support financial stability analysis and the management of collateral in market operations.
6. Prospects for the banking supervision. A new European Parliament and Council Regulation is expected to confer to the ECB the sole responsibility for the prudential supervision of all banks located in the euro area and in those EU member states that voluntarily would adhere to the Single Supervisory Mechanism (SSM) New statistical reporting will be required to enable the ECB to perform its expected duties within the SSM. The ECB will collect supervisory data for the banking groups under ECB’s direct supervision, based on the harmonized Implementing Technical Standards (ITS) of the EBA, which has six parts: financial reporting, consolidated reporting, asset encumbrance, large exposures, liquidity ratios, and leverage ratios. Additional ad hoc datasets, including but not limited to those required for stress-testing purposes, may also be requested.
7. Steps to improve Balance of Payments statistics:
- Transition to BPM6. Both Eurostat and the ECB are engaged with member states to implement the new methodology. The new ECB data requirements related to the BPM6 implementation are due by mid-2014. It is envisaged that members will gradually move their national compilation systems to the new methodology between 2013 and mid-2014.
- Aggregation of EU/EA current account and adjustment of intra-EU/EA trade. Asymmetries in intra-EU/EA exports and imports persist, but they are relatively stable over time. Methodological differences arise for two main reasons: the partner country allocation and the treatment of goods in transit. Eurostat and the ECB engage with countries in regular “reconciliation rounds” that facilitate the exchange of bilateral data.
8. Data Gaps Initiative (DGI). The ESS and the ESCB are working closely to implement the amended legal acts on European statistics that are aligned to the ESA 2010 and BPM6. The new European statistics also supports the SDDS Plus and G-20 DGI Recommendations. Going forward, European economic and financial statistics will be fit to support the G-20 Mutual Assessment Process and similar global surveillance exercises.
The mission would like to thank euro area authorities, in particular President M. Draghi (European Central Bank), Chairperson A. Enria (European Banking authority), Head of Secretariat F. Mazzaferro (European Systemic Risk Board), Managing Director K. Regling (European Stability Mechanism), Vice-President O. Rehn (European Commission), and President H. Van Rompuy (European Council), as well as their staff for their time, support, and accessibility. The mission has also benefitted from the Fund’s bilateral Article IV consultations with euro area countries and from discussions with national authorities during meetings of the Eurogroup and the Eurogroup Working Group.
For further details, see 2013 Selected Issues Paper and April 2013 Global Financial Stability Report (on corporate indebtedness).
The policy advice in this section stems from and is consistent with the analysis and recommendations of the EU FSAP, completed earlier this year.
For more details, see April 2013 Global Financial Stability Report.
This builds on the recommendations of the 2012 Article IV Consultation for the Euro area that the immediate priority is a banking union for the euro area, with a common supervisory framework, deposit guarantee scheme, and bank resolution authority. See also Staff Discussion Note 13/1 A Banking Union for the Euro Area.
The powers and tools of SRM should be aligned with emerging best practices, as described in the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions.
Council of the European Union, June 27, 2013, Council Agrees Position on Bank Resolution.
“Eligible” deposits (of natural persons and micro, small and medium-sized enterprises) will be preferred to other unsecured creditors, with insured deposits preferred to unsecured deposits.
For more details, see Blanchard O., F. Jaumotte, P. Loungani, (2013), “Labor Market Policies and IMF advice in Advanced Economies during the Great recession”, IMF Staff Discussion Note 13/02.
Both External Balance Assessment and CGER estimates suggest that the 2012 euro area current account was about 1-2 percent stronger than implied by fundamentals, and that the real effective exchange rate (REER) was broadly in equilibrium, within a range of 0-5 percent. The External Sustainability (ES) approach indicates a REER undervaluation of up to 13 percent, based on the assumption of a constant net foreign asset (NFA) position. However, this assumption may not be appropriate for all countries in the euro area: given the large accumulated external debt in the periphery, the NFA position needs to be further strengthened in these countries.
The European Department is grateful for the participation of experts from the IMF Statistics Department (STA) in the consultation. Claudia H. Dziobek acted as the STA coordinator.
Enhanced Economic Governance Package, composed of five regulations and one directive, was adopted by the European Parliament and Council in November 2011.
The sector accounts integrate the flow-of-funds and the non-financial assets, transactions and other flows.