Journal Issue

Euro Area Policies: Staff Report for the 2016 Article IV Consultation—Supplementary Information

International Monetary Fund. European Dept.
Published Date:
July 2016
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1. This supplement provides information that has become available since the issuance of the staff report. The information does not alter the thrust of the staff appraisal.

2. On June 23, the people of the United Kingdom voted to exit the European Union. With the announcement by Prime Minister Cameron that he will resign, a new U.K. government is expected to decide when to trigger Article 50 to start the formal and legal process of leaving the EU, and discuss possible new trade arrangements.

3. The referendum result surprised financial markets and triggered widespread risk aversion, including in the euro area. The euro depreciated against the US dollar by 2.2 percent as of July 1 but was broadly unchanged in nominal effective terms. Sovereign yields initially rose in some countries but have significantly declined during the week following the referendum (with the exception of Greece and Portugal) as German Bund yields reached record lows. Equity markets in the euro area initially fell but have since recovered to around 5 percent below their pre-referendum level. Equity declines were led by bank share prices which have fallen by 17 percent, with sharper drops in Greece, Ireland, and Italy. Despite the financial turbulence, there is little evidence to date of market dysfunction: liquidity has not dried up, and most financial prices have recovered partially from their post-vote troughs. This partly reflects the actions and willingness of the Bank of England, the ECB, and other central banks to backstop liquidity in euros and other currencies.

4. The U.K. is an important trading partner for the euro area, as the destination for about 13 percent of euro area exports, and also has close financial links with the region. Its exit from the EU is expected to negatively affect euro area economies through trade, financial and confidence channels. On this basis, staff now project euro area real GDP to grow by 1.6 percent this year and 1.4 percent next year, somewhat lower than the staff report projections (see table). Inflation has also been revised downward slightly in light of the slower pace of growth.

5. The revised forecast for the euro area is broadly consistent with the “limited scenario” outlined in the 2016 U.K. Article IV report and accompanying Selected Issues paper, in which output in the U.K. is assumed to be 1½ percent below the baseline by 2019. The mark-downs for the euro area reflect likely weaker investor confidence on account of heightened uncertainty, greater financial market volatility, and lower import demand from the U.K. Given the euro area’s substantial weight in world trade, this slowdown would have spillovers to many other economies, including emerging markets but the impact is expected to be limited.

6. Looking ahead, the risks to the outlook remain firmly on the downside and are mainly political. Uncertainty will persist as long as the U.K.’s new status vis-à-vis the EU is not clear. The recommendation in the staff report that collective actions should be taken to improve the governance of the economic union and make it more cohesive remains valid, and has now taken on greater urgency.

7. Reflecting the U.K. referendum result, staff also updated the euro area page for the External Sector Report (attached). Specifically, the revised page now notes that the U.K.’s decision to exit the EU does not affect staff’s external assessment for 2015, but may have implications for the assessment going forward, which will be assessed in the context of future ESR and euro area reports. In addition, EBA results and the latest euro real exchange rate movements are updated, reflecting new information after the issuance of the staff report, neither of which affects staff’s assessment of the euro area external position in 2015.

Table 1.Euro Area: Main Economic Indicators, 2016–2018
Staff report
Real GDP (percent)
Inflation (percent)
Preliminary forecast update
Real GDP (percent)
Inflation (percent)
Source: IMF staff estimates.
Source: IMF staff estimates.
Table 2.External Sector Assessment
Euro AreaOverall Assessment
Foreign asset and liability position and trajectoryBackground. The net international investment position (NIIP) of the euro area deteriorated to -17 percent of GDP in 2009, but has since recovered to around -4 percent in 2015. The improvement was driven by stronger current account balances and modest nominal GDP growth. On a gross basis, the steady rise in both asset and liability positions in the pre-crisis period reversed sharply in 2008, due to a sudden stop of financial flows. Since 2009, gross positions have rebounded, reaching 225 percent of GDP for assets and 229 percent of GDP for liabilities in 2015.

Assessment. Projections of continued current account surpluses suggest that the NIIP-to-GDP ratio will continue to improve at a moderate pace, while gross positions will likely remain sensitive to swings in asset prices. Despite recent improvements, some countries with sizable net foreign liabilities still remain vulnerable to a sudden stop in capital flows.
Overall Assessment:

The external position of the euro area in 2015 was broadly consistent with the level implied by medium-term fundamentals and desirable policies. In 2016, the current account is projected to remain broadly unchanged.

Given still sizeable imbalances at the national level, further adjustment is needed by net external creditors to strengthen domestic demand (reducing surpluses) and net external debtors to raise productivity and competitiveness (raising surpluses or lowering deficits). The U.K.’s decision to exit the EU may affect euro area’s external position through trade, financial and confidence channels, which will be assessed in the context of future ESR reports.
Current accountBackground. The current account (CA) balance for the euro area strengthened in 2015 to 3.2 percent of GDP (cyclically adjusted 2.7 percent), up from 2.5 percent of GDP in 2014, with two-thirds of the improvement reflecting a higher energy balance from lower oil prices. The CA increase was broad based but reflects different drivers at the national level. The current account of debtor countries, such as Spain and Portugal, improved during the crisis but mainly through import compression. More recently, external competitiveness gains from price and wage adjustments have strengthened these current accounts. On the other hand, the surpluses of some large creditor countries, such as Germany, continue to grow, reflecting still-weak investment and stronger fiscal positions.

Assessment. The EBA model estimates a CA gap of -0.2 percent of GDP for 2015, with a CA norm of 2.9 percent of GDP. This calculation of the CA norm, however, does not fully account for factors such as the recent improvements in Germany’s demographic outlook reflecting in part the recent refugee wave or the still-large need in Spain to improve the NIIP. Taking into account these factors and the uncertainties in model-based estimates, staff assesses the CA gap to be in the range of -0.5 to 1.5 percent of GDP for 2015, leaving the underlying CA broadly consistent with the level implied by medium-term fundamentals and desirable policies. 1/2/
Real exchange rateBackground. The CPI-based real effective exchange rate depreciated by 8.6 percent from 2014 to 2015, reflecting the euro area’s weak cyclical position, lower inflation, and the accommodative monetary policy. Compared to the 2015 average, the REER has appreciated by 1 percent as of June 2016, as the modest nominal effective appreciation has been offset only partly by weaker inflation in the euro area relative to its trading partners. The euro depreciated in the days after the U.K. decided to exit the EU. This decision does not affect staff’s external assessment for 2015, but may have implications for the assessment going forward, which will be assessed in the context of future ESR and euro area reports.

Assessment. The EBA index REER model points to an overvaluation of 1.2 percent, while the level REER model suggests an undervaluation of around 6 percent; the CA regression model using standard trade elasticities indicates a 1 percent overvaluation. On balance, staff assesses the euro area average real exchange rate in 2015 to be undervalued by 0-10 percent. The REER gaps are large in many member countries, ranging from an undervaluation of 10-20 percent in Germany to an overvaluation of 5-10 percent in Spain. The large differences in REER gaps within the euro area highlight the continuing need for debtor countries to improve their external competitiveness and for creditor countries to boost domestic demand.
Potential policy responses:

Continued monetary accommodation is appropriate to lift inflation closer to the ECB’s medium-term price stability objective, which should also help increase demand and facilitate relative price adjustments at the national level. Monetary easing should be complemented with policies to strengthen private sector balance sheets, structural reforms to enhance productivity and improve competitiveness, and more growth-friendly fiscal policy. Countries should fully use fiscal space where available to expand investment and promote structural reforms, while those without fiscal space should continue consolidating. At the regional level, centralized investment schemes should be explored to support growth. A more balanced policy mix would better boost domestic demand, lift inflation, and rebuild policy buffers, helping to reduce external imbalances, including within the euro area.
Capital and financial accounts: flows and policy measuresBackground. The rise of the CA surplus in 2015 was mirrored by financial outflows on a net basis. In particular, the financial account deficit was driven predominantly by portfolio debt outflows, which were partly offset by increases in portfolio equity inflows.

Assessment. The trend of financial flows has followed closely developments in the current account. Capital outflows arise in the context of easing financial conditions due primarily to the ECB’s monetary accommodation. Looking ahead, reducing capital outflows would depend crucially on improving domestic growth prospects and institutional and structural reforms that strengthen the resilience of the EMU and raise potential growth.
FX intervention and reserves levelBackground. The euro has the status of a global reserve currency.

Assessment. Reserves held by euro area economies are typically low relative to standard metrics, but the currency is free floating.
Technical Background Notes1/ The IMF EBA analysis for the euro area covers 11 euro area members, which are Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain. The assessments of CA and REER gaps for the euro area are derived from GDP-weighted averages of the assessments of the individual countries listed above, as well as from estimates for the euro area as a whole.

2/ When applying GDP-weighted aggregation for the euro area, the CA is corrected for reporting discrepancies in intra-area transactions, as the CA of the entire euro area is about ½ percent of GDP less than the sum of the individual 11 countries’ CA balances (for which no such correction is available).

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