Ten years ago, heads of state of the European Union (EU) gave the go-ahead for the third stage of Economic and Monetary Union (EMU), approving the introduction of the euro in 11 EU member states on January 1, 1999.
Since then, four more EU member states have adopted the currency, and the Slovak Republic is set to follow at the beginning of 2009.
On the occasion of its annual review of the euro area’s economic policies, the IMF’s Executive Board hailed this anniversary, noting that monetary union has been a distinct success and that EMU’s policy frameworks have turned the euro area into a zone of stability in the international economy.
But the IMF’s Executive Directors also emphasized that economic union remains a work in progress: the euro area’s productivity growth has been disappointing and there are wide economic disparities among the 15 countries that are using the euro today.
Beset by shocks
A number of developments are compounding these structural challenges. The euro area economy is under strain following a series of shocks, including from the commodity and financial markets. Oil prices have recently hit record highs, financial stocks have fallen substantially, borrowing costs and credit default spreads have risen, and term spreads in money markets remain at elevated levels.
Most of these shocks are global, but the euro area faces the specific problem that the euro has borne a disproportionate burden of the dollar’s depreciation (see Chart 1). IMF staff estimate that the real effective exchange rate of the euro is now at least 10 percent more than what is warranted by medium-run fundamentals.
Chart 1Too much of a good thing?
The euro has appreciated against the main global currencies.
Citation: 37, 9; 10.5089/9781451967968.023.A006
Source: Haver Analytics.
Although the euro area economy initially held up well, it now faces a combination of uncomfortably high inflation and decelerating activity. Inflation has reached an EMU record of 4.1 percent (although it remains below 2 percent if energy and food are excluded), and growth is rapidly losing steam. IMF staff expects growth to remain weak for the next few quarters before reaccelerating toward trend during 2009 (see Chart 2).
Chart 2Rough patch
Growth in the euro area is expected to be sluggish for several quarters.
Citation: 37, 9; 10.5089/9781451967968.023.A006
Sources: Eurostat; and IMF staff calculations.
1 Preliminary IMF World Economic Outlook forecast.
Difficult policy choices
In this setting, monetary policy has to balance the risk that the current price shock could result in a generalized and durable increase in inflation, against the prospect that slowing growth will gradually start exerting downward pressure on prices and wages.
Much depends on how labor costs and inflation expectations evolve. The wage moderation seen over the past decade has been a consistent positive surprise, indicating that past labor market reforms have improved the trade-off between inflation and employment. This is reassuring, as is the absence of signals that inflation expectations are becoming unhinged. Nonetheless, risks of second-round effects remain.
The ongoing financial turmoil complicates the policy challenge: financial conditions have tightened substantially since last summer and the financial environment remains under strain. In this context, monetary policy tightening carries risks of its own. After raising its main policy rate to 4.25 percent on July 3, the European Central Bank (ECB) announced that it would continue to monitor all developments very closely and do what is necessary to deliver price stability—the single needle in its policy compass. IMF staff believe that policy rates are best kept on hold.
Managing the credit crunch
The ECB has played a crucial role in containing the impact of the global financial turmoil, within a liquidity management framework that has proved itself flexible and robust. The key issue going forward is restoring the depth and orderly functioning of interbank markets. In this regard, the ECB is rightly keeping its operational framework under continuous review, notably with respect to the collateral it accepts.
But the ECB’s liquidity operations cannot address the basic problems behind the turmoil, and the outlook for financial stability remains highly uncertain. While the euro area’s banking system is essentially sound, its operating environment and profitability have been adversely affected.
If there is a silver lining to the turmoil, it is perhaps that it has added impetus to the debate on the EU’s financial stability framework. The EU’s commitment to build a single market for financial services requires a move toward greater joint responsibility and accountability for financial stability. Important progress has recently been made toward this objective, including the adoption of common principles for cross-border crisis management and a related Memorandum of Understanding that is intended to put these principles into practice.
However, national financial stability frameworks will need to be aligned with these principles. This will require strong political leadership—of the kind that led to the creation of the euro 10 years ago.
A disciplined approach
Financial and other stresses should not divert attention from the sound fiscal and structural policies that remain key to the euro area’s long-term economic performance.
The euro area and its member states are best served by sticking to a rules-based fiscal policy framework—as provided by the Stability and Growth Pact (SGP). The SGP has helped deliver greater fiscal discipline, but further progress in lowering government deficits and debt is key to meeting the costs of population aging, which are set to mount rapidly after 2010.
Moreover, past and ongoing structural reforms are bearing fruit, most notably in raising labor utilization. To capitalize on this and build a prosperous economic union, structural policies will need to focus in a coordinated way on still-sheltered services markets and on countries’ ability to adjust to shocks.
In sum, the euro area has much to celebrate as it ponders the first 10 years of its existence. And it is well positioned to head off the risks stemming from the continued fallout of the credit crunch—provided it makes the right policy choices.
Martin Cihák and Wim Fonteyne
IMF European Department
This article is based on the IMF staff report on Euro Area Policies and associated documents (http://www.imf.org/external/np/sec/pn/2008/pn0898.htm).
Emerging Europe Closing Income Gap with Advanced Europe
Europe’s emerging economies have been growing fast. The region’s annual real GDP growth has averaged close to 6 percent in the past five years, accelerating the recovery that started in the late 1990s. Growth has been particularly rapid in the Baltics, followed by Southeastern and Central Eastern Europe.
Compared with other emerging economies, only emerging Asia has been growing faster in the current decade. This performance has allowed emerging Europe to start closing its large income gap with the advanced European economies. But the region still has far to go. Even if growth continues at the average rate of the past five years, it would take 20 years for Central and Eastern Europe to catch up with Western Europe.
The new EU members in the Baltics and most of Central Eastern Europe have made substantial progress on the structural front, reducing the role of the state in the economy and creating a business-friendly environment that has led to a wave of new investment, including foreign direct investment. They are also very open to international trade and have labor markets that are more flexible than those of the euro area.
In contrast, and despite recent progress, Southeastern Europe has fallen behind on reforms compared with the rest of emerging Europe, partly because many of the countries have yet to join the EU and so have not benefited fully from the EU harmonization process. That said, these countries’ lower incomes per capita could facilitate fast growth once the right policies are put in place.
Though macroeconomic policies could do more to address overheating concerns in some countries, they have been broadly conducive to the region’s catching up. Partly due to cycle-driven revenues, most countries have relatively low fiscal deficits, or even small surpluses, and low levels of government debt.
Independent central banks across the region have also improved their credibility in safeguarding macroeconomic stability. But rising inflation, primarily driven by developments in commodity markets, poses new challenges.
Although Central and Eastern Europe will likely continue catching up with Western Europe, growth is expected to slow down in 2008–09. In fact, the region has been growing at rates faster than even its strong fundamentals seem to justify.
Estimates from an empirical growth model that quantifies the impact of such fundamentals on growth suggest that although potential growth is high throughout emerging Europe, actual growth rates have been even higher in recent years in all countries but Hungary. The difference is the largest in the Baltics, primarily in Latvia, followed by Southeastern Europe and by Central Eastern Europe. On average, the region is estimated to have grown about 2 percent faster than its potential during 2003–07.
The catching-up process may prove volatile in countries with large external imbalances. Current account deficits, although not inconsistent with regional convergence, are well above estimates justified by fundamentals, making those countries subject to risks of an abrupt adjustment. High levels of external debt are also a source of vulnerability.
Moreover, the recent speed of financial deepening in the region has been extreme—indeed, it has been slowing during 2008. The pace of credit expansion relative to economic growth has exceeded that in other emerging economies, especially if lending by nonbank financial institutions and direct borrowing from corporates and, increasingly, households abroad is included in addition to bank lending.
Together with sound macroeconomic policies, further progress in structural reforms will be key to ensure smooth catching up in emerging Europe.
IMF European Department