1. Advanced Europe: Tackling the Sovereign Crisis
- International Monetary Fund. European Dept.
- Published Date:
- May 2011
Despite headwinds from sovereign and financial tensions, the recovery continues. But downside risks still loom large, and divergences across advanced Europe persist. To avoid a protracted period of low growth punctuated by economic, financial, and social crises, further bold measures at the national level are needed to address weak banks, credibly restore fiscal health, and bolster structural reforms. An additional strengthening of the EU-wide policy response, building on the March 24–25 decisions, will also be essential, as will stronger economic governance and an integrated financial stability framework at the EU level to prevent the buildup of macroeconomic imbalances as witnessed prior to the crisis. Meanwhile, monetary policy can remain accommodative, though normalization lies ahead as economic slack wanes and the balance of inflation risks shifts.
Recovery Is Becoming More Self-Sustained …
Despite lingering financial tensions, growth in advanced Europe has strengthened. The initial momentum provided by fiscal stimulus, the restocking cycle, and the global upswing is gradually giving way to a more broadly based recovery in which private domestic demand is playing a larger role (Figure 1.1). And while the worst postwar recession is likely to leave lasting scars on the level of output, the recovery is now tracking the pattern and timing of past upturns in the euro area, with growth back to precrisis rates two and a half years after the failure of Lehman Brothers (Figure 1.2).
Figure 1.1Euro Area: Contributions to GDP Growth, 2006:Q1–2010:Q4
Sources: Eurostat; and IMF staff calculations.
Note: Contributions from inventories and statistical discrepancy not shown.
Figure 1.2Euro Area: Current Crisis Compared with Past Episodes, 1960:Q2–2010:Q4
Sources: Eurostat; Organization for Economic Cooperation and Development; and IMF staff calculations.
However, this general picture masks substantial divergences in growth trajectories (Figure 1.3 and Table 1 in the Introduction and Overview). The initial recovery in the core euro area and Nordic countries occurred at a more gradual pace than elsewhere in the world. But government-supported work-time reductions minimized the upsurge in unemployment (for example, in Germany and Italy)and strong social safety nets cushioned the blow to households (for instance, in France), sowing the seeds for private consumption to resume gradually as the employment outlook stabilized. In turn, the improvement in profitability prompted firms to unfreeze the investment plans put on ice during the crisis, even as banks remained reluctant to lend, while the robust recovery in global trade continued to support the more competitive economies, including Germany and Sweden, which rebounded firmly in 2010 (Box 1.1).
Conversely, in the most vulnerable euro area countries, the correction of precrisis imbalances has forced a major adjustment. Front-loaded fiscal tightening under intense market pressures and continuous private sector deleveraging are taking their toll on activity. As detailed in Chapter 3, a legacy of poor competitiveness and inappropriate trade specialization also hinder export growth, and current account deficits remain large, especially in Greece and Portugal (Chen, Milessi-Ferretti, and Tressel, forthcoming; and Jaumotte and Sodsriwiboon, 2010). In Ireland and Spain, the correction in credit flows following the burst of the real estate bubble triggered extensive job loss in the construction and financial sectors. The UK economy is facing considerable short-term uncertainty, as growth turned flat in late 2010–taking out temporary weather-related effects—and fiscal consolidation accelerates. However, the adjustment of its exchange rate and its accommodative monetary policy stance should help mitigate the contractionary effect of its sizable up-front fiscal adjustment.
Unemployment responses to the crisis have varied extensively across countries (Figure 1.4). In most of Northern Europe, the deterioration in labor markets was generally contained compared with past recessions—despite a more severe output contraction—with firms resorting to labor hoarding. In some countries, part-time schemes further supported job retention. In Germany and Norway, for example, the unemployment rate barely inched up during the crisis. In contrast, it rose markedly in some other countries, such as Spain and Ireland, where activity in the construction sector contracted sharply following the burst of housing bubbles, leaving many low-skilled workers without jobs. Youth unemployment, in particular, increased substantially. In extreme cases like Spain, close to one young worker out of two is now out of work, raising the specter of a “lost generation.” Likewise, temporary contract workers bore the greatest burden of the adjustment, and where it was not already high before the crisis, the long-term unemployment rate is creeping up.
Figure 1.4Selected European Countries and the United States: Unemployment Rate, January 2006–December 2010
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
1EA4: Greece, Ireland, Portugal, and Spain.
2Rest of Euro Area (RoEA): Excludes Greece, Ireland, Portugal, and Spain.
Because adjustments have been concentrated in these specific populations, they are likely to be associated with losses in human capital and rising inequality, potentially threatening Europe’s social cohesion and stability.
… Despite Divergent Growth and Financial Tensions
Protracted recessions in part of the euro area present challenges to growth in advanced Europe. So far, the growing traction from domestic demand has remained immune to the slump in the euro area periphery. This is not surprising, given limited trade linkages between northern Europe and the euro area periphery (Table 1.1). For example, Germany, Sweden, and Switzerland sell less than 6 percent of their exports to Greece, Ireland, Portugal, and Spain combined, two to three times less than combined trade with the dynamic regions of central and eastern Europe and emerging Asia. This disconnect is somewhat less evident for the United Kingdom, given its tight trade linkages with Ireland, although the depreciation of the pound has cushioned the effects.
|Central and Eastern Europe||8.8||4.8||3.5||6.0||3.5|
|Asia excl. Japan||7.0||4.7||5.2||6.1||5.8|Box 1.1Domestic Demand and Recovery in the Large Euro Area Countries
Given lingering uncertainties and market pressures, what does the future hold for domestic demand in the euro area? This box investigates the question using econometric analysis for the four largest countries of the euro area, and finds that growth divergences will continue to be underpinned by differing trajectories for domestic demand. For Germany, the worst of the crisis seems over and domestic demand is set to expand. At the other end of the spectrum, the adjustment in Spain still has a long way to go. France stands in between, as its strong social safety net tends to smooth fluctuations. Although domestic demand has recovered moderately, Italy’s growth prospects remain weak against the backdrop of trend losses in competitiveness.
While private domestic demand is beginning to play a larger role in the euro area recovery, there are important differences across the four largest economies (first figure). Consumption is recovering in France and Italy, while it remains fairly sluggish in Germany and is barely growing in Spain (on a cumulative quarter-over-quarter basis since 2009:Q2). Investment is on the rebound in Germany, but it remains sluggish in Italy and lagging in France, and it continues to plunge in Spain. This box will elaborate on these dynamics and offer some implications for the recovery looking ahead, drawing on behavioral equations for consumption and investment estimated for each of the four large euro area countries.
Large Euro Area Countries: Cumulative Quarter-over-Quarter Growth and Contributions
Sources: Eurostat; and IMF staff calculations.
Improving income and labor market conditions are supportive, while stabilization in credit markets is a boon in Italy and France, although negative wealth effects remain a drag in Spain (second figure).
The divergent income dynamics that supported consumption in Spain but not in Germany during the crisis are now reversing (third figure). In Spain, despite skyrocketing unemployment, overall real disposable income was resilient during the crisis, reflecting increased transfers and postponed tax payments. In Germany, despite good employment performance during the crisis, a drop in self-employed earnings and capital income drove real disposable income down marginally. However, disposable income is picking up in Germany and is poised to support consumption in the coming quarters, while ongoing labor market adjustment and fiscal withdrawal in Spain may weaken consumption.
Cumulative Quarter-over-Quarter Consumption Growth and Dynamic Contributions
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
Wealth effects continue to restrain consumption in Spain, while they have turned supportive elsewhere. Wealth effects exerted a strong drag on consumption during the downturn in all countries but Germany—where real estate prices had remained muted before the crisis. Since then, the pickup in financial wealth and housing prices has started to support consumption again in France and, to a lesser extent, in Italy. However, Spain continues to experience a significant housing market correction that will hinder consumption in the near term.
Four Large Euro Area Countries: Real Disposable Income
Source: IMF, World Economic Outlook database.
While car scrapping schemes played a stabilizing role during and beyond the recession, their withdrawal is weakening consumption. In Germany, almost all the support provided during the crisis has already been subtracted, but in Spain further negative “payback” effects are possible in the coming quarters.
The accelerator effect has turned positive, except in Spain, but higher labor costs remain a constraint, as do higher costs of capital, except in Germany (fourth figure).
The growth accelerator will continue to support investment as the recovery strengthens, but Spain’s depressed outlook will remain a constraint. The growth rebound in Germany pushed up demand for capital goods from firms to a much larger extent than in Italy and France. In Spain, a depressed outlook continues to weigh on investment decisions.
The negative effect of higher labor costs on firms’ profitability will wane, while stabilizing credit supply is poised to support investment again, with Spain the exception. Reflecting in part the resilience of employment even as output dropped, unit labor costs rose in the wake of the crisis, but the negative profitability effects are set to fade, and firms are now better positioned to resume investment, having preserved human capital during the downturn. Gradual repair of banks’ balance sheets and the stabilization in lending conditions will, to some extent, provide increasing support to investment, although Spain’s ongoing housing market correction will be a curb in the near term. In addition, increasing tiering in costs of capital will remain a challenge as long as sovereign bond markets stay under pressure.
Large Euro Area Countries: Cumulative Quarter-over-Quarter Investment Growth and Dynamic Contributions
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
The renewed bout of financial turmoil has arguably mattered more. As the situation in the Irish banking sector deteriorated, a new wave of market turbulence erupted in November 2010. Sovereign risks intensified again in the euro area periphery countries, spilling over to more countries, including Belgium and Italy. Government bond spreads surged to substantially higher levels than those experienced during the turmoil in May 2010. These developments raised further concerns about periphery governments’ ability to support still-weak banking sectors, while pressuring banks’ balance sheets—which contain significant amounts of domestic sovereign bonds. This adverse feedback loop between the sovereign and the banking sectors in the periphery threatened to fundamentally disrupt funding markets (Figure 1.5). Pressures became increasingly severe in Ireland and led the authorities to embark on an adjustment program supported by the EU and the IMF (Appendix). Similarly, Portugal has now asked for external financial assistance.
Figure 1.5Selected Euro Area Countries: Change in Sovereign and Bank Credit Default Swap (CDS) Spreads, January 2010–March 20111
Sources: Bloomberg L.P.; Datastream; and IMF staff calculations.
1 Trendlines indicate changes from January to December 2008 for the 2008 trend line, and changes from January 2010 to March 2011 for the 2011 trend line.
Spillovers to the real economy have nonetheless remained largely confined to affected countries. The crisis-management framework put in place in the spring was activated quickly. The European Central Bank (ECB) stepped up its Securities Markets Program, which has now accumulated €76.1 billion of securities. The European safety net set up in May 2010 was tapped to fund part of the Irish program, with the European Financial Stability Facility (EFSF)successfully issuing its first supporting bond in January 2011. In addition, the ECB extended the full allotment regime of its refinancing operations until at least July 2011. These measures helped mitigate the perception of risk for core countries’ banks, though without completely eliminating it (Figure 1.6). And a concomitant strengthening of national reforms allowed Spain to decouple from other periphery countries in early 2011.
Figure 1.6Euro Area: Banking Sector Risk Index, 2007–11
Sources: Bloomberg L.P.; and IMF staff calculations.
1Normalized score from a principal component analysis on 5-year senior bank credit default swap spreads, estimated using daily data (Jan.1, 2005–Apr. 15, 20110). The core risk index comprises CDS spreads of 26 banks and the EA4 risk index 13 banks. The first principal component captures 84.5 percent of the common variation across core country banks and 86.1 percent across EA4 country banks.
2EA4: Greece, Ireland, Portugal, Spain.
The Outlook Remains for Uneven Growth …
Growth prospects will depend critically on the way in which the remaining tensions in the euro area periphery and European financial sectors are resolved. Under the assumption of credible policies to restore confidence and address underlying weaknesses (see below), the forecast remains for a gradual and uneven expansion, with countries under market pressures continuing to lag behind the recovery in northern Europe. Real GDP is projected to expand by 1.6 percent in 2011 and 1.8 percent in 2012 in the euro area, driven by the strengthening recoveries in Germany, France, and other smaller northern euro area economies, where better employment prospects have improved households’ income outlooks, despite higher commodity prices. Although fiscal consolidation is set to dampen growth somewhat, steps taken to restore the soundness of public finances will bolster confidence and help pave the way for a more solid medium-term outlook. Robust growth in emerging countries and better short-term prospects in the United States will continue to provide support to the tradable sector (Figure 1.7), but less so in the euro area periphery countries, which will suffer from deeper fiscal austerity measures, sharper private sector balance sheet deleveraging, and more severe structural unemployment. Thus, intra-euro area growth differentials will persist, with 2011 growth projected to range between –3 percent in Greece and 2½ percent or more in Austria, Finland, Germany, and Luxembourg.
Figure 1.7Selected European Countries: Key Short-Term Indicators
1Seasonally adjusted; deviations from an index value of 50.
2Percentage balance; difference from the value three months earlier.
The outlook also foresees differentiated recoveries outside the euro area, although for different reasons. Despite some support from the depreciated pound and a rapid unfreezing of past investment decisions, stronger headwinds from a front-loaded fiscal strategy and higher household debt levels will restrain growth somewhat in the United Kingdom, to 1.7 percent in 2011 and 2.3 percent in 2012. Switzerland, having suffered less from the global crisis and benefiting from a healthy fiscal outlook, is more advanced in the recovery cycle, although the appreciation of its currency will weigh on exports. All in all, growth can be expected to converge gradually toward potential, at 2.4 percent in 2011 and 1.8 percent in 2012. In Sweden, rapidly improving financial conditions have propelled the economy out of recession faster than elsewhere, but with growth foreseen at 3.8 percent in 2011 and 3.5 percent in 2012, the first signs of overheating, especially in the real estate sector, are emerging.
One overarching concern is whether the recovery—and investment, in particular—can proceed despite persistent weaknesses in European banking sectors. As discussed earlier (IMF, 2009), recoveries following financial crises tend to be weak, with firms’ investments suffering particularly badly from sluggish credit. Although these features have definitely been at play in advanced Europe since 2008, no decisive evidence yet indicates that a true credit crunch is taking hold. Household credit has begun to recover and credit to enterprises appears to have bottomed out in the euro area, as banks managed to slow down the deleveraging process (Figure 1.8 and Box 1.2). Moreover, enterprise credit is typically a lagging indicator because firms initially finance new investment from internal resources. Indeed, the balance sheets of large firms in the core economies are generally in good shape, allowing them to self-finance their expansion projects and, in some places, to provide funding to suppliers—thus alleviating somewhat the tighter lending standards affecting small and medium enterprises. Large firms have also continued tapping capital markets at costs that remain attractive by historical standards. Barring a shock to confidence, investment is therefore expected to continue recovering in the near term, albeit gradually. However, constraints on bank intermediation are likely to appear during the next few years, as regulatory changes in the context of Basel III and the EU’ s bank resolution proposals, the necessary shift away from wholesale funding, and the normalizing of monetary conditions will force banks to reprice risk. In the meantime, banks in the euro area periphery countries will also have to work through a growing share of doubtful assets.
Figure 1.8Euro Area: Credit Developments
Sources: European Central Bank; and IMF, World Economic Outlook database.
… With Substantial Downside Risks
In that context, although the resilience of the global recovery could provide somewhat stronger-than-expected momentum to the recovery in advanced Europe, downside risks still loom large. Japan’s natural disaster, geopolitical problems in the Middle East, and disruptions to energy supplies could derail global growth, with detrimental consequences for the most export-dependent European countries, and for private consumption. Deep-rooted financial and structural problems in the most vulnerable euro area countries are likely to keep European confidence volatile, and new spells of anxiety in financial markets could emerge if, for example, the political resolve to tackle the crisis disappoints.
Box 1.2Deleveraging in the Euro Area
Despite some reduction since the beginning of the crisis—mainly through higher capital—euro area banks’ leverage remains high by international standards.1 In the run-up to the crisis, euro area banks had high leverage multiples (asset to capital ratios) that allowed them to turn relatively low operating performance into high return on equity (first figure). This high leverage was achieved through heavy reliance on short-term wholesale funding, which dried up as counterparty risk concerns related to subprime and periphery debt exposures surged. Reductions in bank leverage ratios have been particularly strong in the euro area periphery (Ireland, Greece, and Spain), even though large banks in these countries were generally less leveraged than those in the core. Deleveraging also occurred in core countries, particularly in Austrian, Belgium, French, and Italian banks. The reduction was achieved mostly through an increase in capital buffers, although a decline in assets took place in the context of bank restructuring in Ireland, Belgium, and Luxembourg (second figure).
Sources: ECB Monetary and Financial Institutions (MFI) statistics; and IMF staff calculations.
1EUR4 is the weighted average of France, Germany, Italy, and Spain.
While the overall level of assets changed relatively little, two specific classes of assets—international claims and loans—contracted significantly in the wake of the crisis. International claims, which expanded steadily in the years before the crisis, contracted sharply as interbank markets froze during the global crisis, and again during the Greek crisis in May 2010 as wholesale funding markets came under stress (third figure). Among domestic claims, the bulk of the adjustment was driven by loans to nonfinancial corporations, which declined in the periphery (Ireland, Spain), but also in countries whose banks were exposed to subprime products (Germany, Belgium). Lending to households has been more resilient overall and continued to expand in the majority of countries (fourth figure).
Contributions to Change in Bank Leverage
Sources: ECB Monetary and Financial Institutions (MFI) statistics; and IMF staff calculations.
1EUR4 is the weighted average of France, Germany, Italy, and Spain.
Ongoing regulatory reforms to reduce banking sector vulnerabilities may reinforce deleveraging pressures. The new set of regulations known as Basel III designed by the Basel Committee on Banking Supervision (BCBS) requires higher and better quality of capital, especially for systemically important financial institutions (SIFIs). IMF analysis estimates that implementation of the Basel III rules over a three-year period could reduce European SIFIs core Tier 1 ratios by as much as 2.1 percentage points, from 9.0 to 6.9 percent (Ötker-Robe, Pazarbasioglu, and others, 2010), some of which would need to be offset by banks. This could entail in particular further deleveraging during the coming years and result in further contractions in some asset classes if retained earnings fall short or additional capital cannot be raised easily. However, because implementation is spread out over eight years—until early 2019—the impact on assets may be weaker.
Change in International Claims of Euro Area Banks
Source: BIS locational banking statistics by nationality.
In turn, deleveraging is likely to dampen future activity, although the effect appears manageable. Deleveraging affects real activity through two opposing channels. Lower bank leverage has a confidence-enhancing effect as larger capital buffers increase banking sector soundness and lead to lower risk premiums and cheaper funding, in turn supporting credit. Nonetheless, deleveraging caused by the shrinking of assets can constrain bank credit supply, and hence, activity. Estimates coordinated by the Financial Stability Board and the BCBS—in which the IMF participated—suggest, however, that the impact on aggregate output of the transition toward higher capital standards would remain modest: An increase by 1 percentage point in the capital target over an eight-year period would shave off 0.1 percent from the level of GDP (Macroeconomic Assessment Group, 2010).
Change in Loan Volume, September 2008–December 2010
Sources: ECB Monetary and Financial Institutions (MFI) statistics; and staff calculations.
1France, Germany, Italy, and Spain.
Deleveraging would also negatively affect credit. A complementary econometric panel analysis shows that credit growth, both to firms and households, is negatively affected by bank leverage. The effects are relatively large for the corporate sector, with a 10 percent increase in bank leverage estimated to reduce credit growth to nonfinancial enterprises by 2¾ percent in the euro area. Because initial conditions differ, the impact varies across euro area countries (fifth figure). The analysis also points to the role of household indebtedness in dampening credit, both to households and firms, suggesting that the legacy of the crisis and necessary private sector balance sheet adjustment will weigh on lending in the near term, independently of bank deleveraging. A 10 percent increase in the household debt ratio is estimated to reduce credit growth by 3 percent in the euro area, as banks compensate for higher risks or lower return on their stock of mortgages, or on new loans, by tightening lending standards across a broader set of borrowers, while more indebted households reduce their demand for credit.
Euro Area Countries: Estimated Effects of Bank and Household Leverage on Credit Growth Relative to the Euro Area Average1
Sources: ECB Monetary and Financial Institutions (MFI) statistics; and IMF staff calculations.
1The model estimates, at a quarterly frequency for a panel sample of euro area countries and for the period 2008–2010, the relationship between credit growth and the log of bank leverage and log of household debt-to-GDP ratio of the previous quarter. The chart reports the estimated impacts on credit growth of initial leverage and household debt for each country, all expressed in deviation from the euro area average.
A major point of pressure in the immediate future stems from large rollover needs in euro area periphery countries from both the banking and the sovereign sectors. Combined bonds due in 2011 amount to 10 percent of GDP or more in Greece, Portugal, and Spain—roughly twice the 2007 amount. Rollover needs have also increased significantly in Belgium, Ireland, and the United Kingdom. More generally, crisis-related funding pressures in high-deficit countries have forced governments to assume additional risks by shifting to shorter maturities and to rely more heavily on private syndication (De Broeck and Guscina, 2011). In periphery countries, this pressure is compounded by a shrinking investor base. In addition, as explained in the April 2011 Global Financial Stability Report (IMF, 2011), banks’ reluctance to deleverage—as they then have to book the accompanying losses—have made them increasingly eager to find alternative funding sources to reduce dependence on wholesale markets. In some countries (for example, Spain and Greece), this has triggered a competition war for retail deposits, putting unsustainable pressures on interest margins. In other countries, covered bonds issuance has picked up, but over-collateralization required even for the best rated banks means that only a limited portion of their balance sheets can be funded in this way. And reliance on ECB funding has become entrenched for a number of second-tier banks in large European countries; nearly all banks in Greece, Ireland, and Portugal; and some small and mid-sized Spanish saving banks.
With liquidity pressures remaining acute, a negative shock could rapidly spill over through the periphery and potentially beyond. Despite some reduction during the last year, cross-border exposures remain sizable and concentrated within euro area creditor countries (Waysand, Ross, and de Guzman, 2010) (Figure 1.9). Hence, the system would still be severely tested if euro area stresses were to intensify.
Figure 1.9Selected Advanced Countries: Claims on Domestic Banks and Public Sector1
Sources: Bank of England; Bankscope; BIS Consolidated Banking Statistics; IMF, International Financial Statistics; and IMF staff calculations.
1The exposures were adjusted using data from the Bank of Ireland to account for the fact that a significant portion of the claims are claims on foreign banks domiciled in Ireland.
2EA3: Greece, Ireland, and Portugal.
3Other EA countries includes Austria, Belgium, Ireland, Portugal, and the Netherlands.
4The exposures are calculated in percent of the equity of banks that have foreign exposures. Banks that do not have exposures to Greece, Ireland, Portugal, and Spain are not included in the computation.
Inflation Picks Up
Inflation will continue to pick up throughout 2011 against the backdrop of accelerating commodity prices. In the euro area, headline inflation is expected to exceed the 2 percent ECB target for most of 2011 before moderating to 1.7 percent in 2012, although the impact on core inflation and inflation expectations is seen to be minimal for now (Figure 1.10). Higher inflation is foreseen throughout the currency union: in the core, higher commodity prices are accompanied by narrowing output gaps (for example, in Finland), while in the periphery, indirect tax changes contribute to positive headline inflation. Ireland, nonetheless, is expected to experience subdued price increases in 2011, at 0.5 percent, following two years of deflation. Outside the euro area, the pickup in inflation has been further amplified in the United Kingdom by a series of VAT increases and the lagged effects of the currency depreciation: inflation is expected to stay significantly above the Bank of England target, at 4.2 percent in 2011, before cooling to 2 percent in 2012, as base effects come into play. In contrast, monetary tightening and the unfolding appreciation of the krona are expected to keep Sweden’s inflation more stable, at 2 percent in both years, despite the strength of its economy. Switzerland too is expected to continue experiencing very low inflation, at just 1 percent, as the appreciation of the currency feeds through. Nonetheless, in all countries, inflation risks have become tilted to the upside, and guarding against second-round effects will be critical.
Figure 1.10Selected European Countries: Headline and Core Inflation, January 2006–March 2011
Sources: Eurostat; Haver Analytics; national authorities; and IMF staff calculations.
1 Harmonized index of consumer price inflation (excluding energy, food, alcohol, and tobacco).
Turning the Page on the Crisis: Policy Requirements
Policy actions taken in Europe since the emergence of the sovereign debt turmoil helped to contain the crisis, but not sufficiently to decisively put it behind us. Bold steps are needed to assuage market concerns about sovereign and financial risks and to tackle the underlying root causes of the crisis. Ultimately, more rather than less economic and financial integration will be key to the region’s success, along with a strengthening of euro area-wide economic governance. Although policymakers have started addressing these difficult issues—most notably at the March 2011 European Council—further improvements in the macroeconomic landscape will depend on rapid implementation of their commitments.
Strong National Policies as the First Line of Defense
Strong national policies to rectify structural weaknesses remain crucial throughout Europe and are the foundation for restoring confidence in the countries under severe market pressures. In the euro area periphery, adjustments to past imbalances will take time to deliver better growth and employment prospects. Measures to date have been wide ranging (Table 1.2). But it will be essential for governments to maintain their resolve to tackle fiscal consolidation, repair their financial systems, and continue critical structural reforms.
|Greece||* Front-loaded fiscal adjustment (measures worth 8 percent of GDP in 2010), through elimination of 13th and 14th month bonuses and freeze of public wages and of pensions; increase in VAT rates, indirect taxes, and nontax revenues; cuts in operation costs and investment spending; rationalization of pharmaceutical spending; wage cuts and tariff increases in public enterprises.|
* Reduction in public employment through attrition.
* Pension reform aimed at reducing pension spending from 12½ percent of GDP to 2½ percent over 2010–60.
* Reforms to fight tax evasion, improve tax compliance, and improve budget controls and fiscal reporting.
|* Introduction of government-guaranteed uncovered bank bonds usable as collateral at the ECB.|
* Set-up of a financial stability fund as a backstop for capital needs for viable banks under pressure.
* Strengthened banking supervision through enhanced reporting requirements and reduced reporting lags.
|* Freeze/reduction in minimum wages and relaxation of collective dismissal and employment protection regulation to facilitate job reallocation.|
* Reform of collective bargaining system, in particular to allow firms to opt out of industry-level agreements.
* Liberalization of regulated professions.
* Liberalization of road transportation sector; and reform of the railway sector.
* Strengthening of the competition authority.
* Easing of business licensing and startups; and full implementation of the Services Directive.
* Fast-tracking of large investment projects.
|Ireland||* Front-loaded medium-term consolidation plans (measures worth 6 percent of GDP in 2009–10, 9½ percent of GDP over 2011–14) through public sector wage and employment reductions; social transfer reforms (including through entitlement reforms); savings on capital spending; a broader income tax base; and VAT increase.|
* Institutional reforms, including a medium-term budgetary framework and a budgetary advisory council.
* Increase in the retirement age starting in 2014 and reform of public sector pension entitlements for new entrants.
|* Asset valuation and stress tests to provide an assessment of capital needs to achieve a regulatory capital ratio of 10.5 percent.|
* Prudential liquidity assessment to calibrate stable funding of the banking system.
* Substantial downsizing of the banking system, including by unwinding noncore assets and resolution of unviable banks.
* Strengthening of the bank resolution framework.
* Strategy to address the financial weakness of credit unions.
|* Removal of structural impediments to competitiveness, including by amending competition legislation.|
* Reform of benefits system to incentivize work and eliminate unemployment traps.
* Independent assessment of the electricity and gas sectors, with possible privatization of state-owned assets, to reduce energy costs.
|Portugal1||* Front-loaded fiscal adjustment, through tax increases, cuts in public wages by 5 percent, hiring and pension freeze, cuts in social spending and transfers to local governments.|
* Introduction of quarterly fiscal targets.
* Reforms under way to introduce a medium-term budgetary framework, program budgeting, and an independent fiscal council.
|* Set up a financial stability facility for liquidity and capital support.|
* Banks increased core tier 1 capital ratio to 8 percent following Bank of Portugal’s recommendation.
|* Administrative and credit-support measures targeted at export-oriented firms.|
* Reforms of the wage-bargaining system, reduction of dismissal costs, and promotion of flexibility in working hours.
* Reinforcement of active labor market policies, especially for young job seekers.
* Deregulation of the rental market.
* Measures to reduce informal activity, fraud, and tax evasion.
|Spain||* Front-loaded fiscal adjustment (4.1 percent of GDP measures in 2010–11) through tax increases, a 5 percent cut and freeze in public wages, pension freeze, and cuts in investment and subnational government spending.|
* Improved dissemination and transparency of regional budgets.
* Pension reform, with increases in the statutory retirement age, the length of contribution for full pension rights, and the reference period to compute pension.
|* Law on savings banks to allow equity-like instruments to have voting rights, reform their legal statute with option to become listed, and strengthen corporate governance requirements.|
* Increase in core capital to 8 percent and to 10 percent for institutions reliant on wholesale funding and with limited private shareholding.
* Individual recapitalization plans requested and assessed by Banco de España.
* Extended support of the FROB (public recapitalization fund) through the purchase of common equity.
|* Reduction in dismissal costs and criteria, and reform of the collective bargaining system, in particular to allow firms to opt out of collective agreements.|
* Reinforcement of active labor market policies, and enhanced links between vocational training, businesses, and the general education system.
* Cut in social contributions for part-time employment of the young and the long-term unemployed.
* Simplification of administrative procedures to set up a business.
* Greater independence and powers of network industry regulators.
* Improved incentives for the rental market and removal of tax incentives for housing investment.
Structural reforms will also be needed elsewhere in Europe because solid sustainable growth will be a major postcrisis antidote to entrenched unemployment, declining standards of living, and deteriorating fiscal positions. Efforts to increase employment rates in the core euro area and to improve educational outcomes in the whole region would go a long way to achieving these goals. In Scandinavian countries, measures are already in the works to lower labor taxation (Sweden) or reorient labor market policies toward upgrading skills (Denmark). The agreement by European leaders on the “Pact for the euro” is encouraging in the sense that it cuts through the debate about whether and what reforms are still needed, but national authorities must now commit to the immediate implementation of specific actions. In parallel, better surveillance needs to be established within the euro area to flag and to nip in the bud future macroeconomic imbalances to avoid a replay of the current crisis (see Chapter 3).
These reforms can and should go hand in hand with reducing inequalities, which are strongly linked to unemployment and more generally to the low rate of labor utilization in Europe (Box 1.3). In countries where unemployment remains unacceptably high, measures put in place to improve labor market functioning also aim to equalize opportunities for all citizens, by reducing rents for insiders in both the labor and product markets. Pension reforms that lengthen the contribution period in line with rising life expectancy increase intergenerational fairness (for example, in France, Greece, and Spain). Measures to harmonize employment protection between types of job contracts should reduce the disproportionate burden on temporary workers—those last hired and first fired. Removing the hurdles to entering closed professions and decisively fighting tax evasion will level the playing field, too. Finally, tighter regulation on banks will ensure that the fallout from excessive risk taking by a few does not have to be shouldered by taxpayers.
Box 1.3Unemployment and Inequality in the Wake of the Crisis
Unemployment rose more in the euro area periphery than in other European countries, but youth and temporary workers everywhere were particularly hard hit by the crisis. In most of northern Europe, the deterioration in labor markets was generally contained compared with past recessions—despite the sharper output contractions experienced this time—with firms resorting to labor hoarding, and in some countries part-time schemes further supported job retention. In contrast, unemployment rose more sharply in some peripheral countries, such as Spain and Ireland, where the burst of housing bubbles exacerbated the recession (figure). And the more fragile segments of the labor market—young, low-skilled, and temporary workers—suffered the most. With long-term unemployment slowly creeping up, there is a risk that many unemployed will become discouraged and leave the labor market. This would have adverse consequences on Europe’s social fabric, public finances, and growth.
How have labor market developments likely affected income inequality in Europe during the crisis? What features of labor markets aggravated the impact of the crisis on inequality? And what can be done to alleviate the problem? Cross-country econometric analysis of the determinants of inequality in Organization for Economic Cooperation and Development countries (over a period, 1980–2005, that does not include the recent crisis) suggests that the recession likely exacerbated inequality through rising unemployment and dwindling job creation, despite the safety nets and automatic stabilizers at work. A jobless recovery or ingrained long-term unemployment could further worsen economic disparities and undermine both economic performance and social cohesion. “How” the economy recovers and grows (that is, which income groups benefit the most) will matter for income inequalities.
Cross-country differences in income inequality reflect the interplay of labor, social, and educational factors. In line with the literature, the following robust results were found (see table):
Labor utilization significantly influences income distribution. Unemployment is found to have a regressive impact on income equality, and a higher employment rate is associated with lower economic disparities. Social expenditures play an important role in alleviating income inequality across all specifications, highlighting the supporting role of unemployment benefits in times of crisis, and more generally of social protection in assisting the most vulnerable. Educational attainment, proxied by the share of population with at least secondary education, is associated with a more even income distribution.
The longer the unemployment duration, the higher the income inequality. Both short- and long-term unemployment widen income dispersion, with a slightly higher coefficient for the latter, reflecting deeper income losses as the spell of unemployment lengthens.
Better job opportunities for underutilized groups enhance equity. Higher employment rates for women and youth reduce disparities.
Dual labor markets worsen inequality. A higher share of temporary contracts in total employment contributes to widening income distribution because it tends to be associated with more wage and benefit disparity between the temporary and permanent workforces. This is particularly relevant for countries that used a “dual” system to enhance labor market flexibility, resulting in increased use of temporary contracts.
The results suggest that the rise in unemployment during the crisis increased inequality by an estimated 2 percentage points in the euro area as a whole, and by as much as 10 percentage points in Greece, Ireland, Portugal, and Spain, where the labor market situation deteriorated much more sharply. The recession also increased the number of discouraged workers who dropped out of the labor force, a factor that is likely to have further exacerbated income disparities. On the other hand, social safety nets are likely to have cushioned the impact of unemployment on inequality.
Impact of the Crisis on the Labor Market
Sources: Eurostat; Fraser Institute; Organization for Economic Cooperation and Development; World Economic Forum; and IMF staff calculations.
1Structural capacity indicators are constructed as country averages of assigned scores from 1 to 3 on the nine variables of the structural reform heatmap by Darius and others (2010), where a higher score indicates a greater need for structural reforms.
This suggests the following policy recommendations:
More inclusive labor markets will be required to narrow income inequalities. Evidence shows that a pervasive dual system, with a flexible temporary workforce and a highly protected permanent workforce, can actually increase unemployment (Blanchard and Landier, 2002; Jaumotte, 2010; and Dao and Loungani, 2010). Combining that evidence with the analysis here suggests that reforms to rebalance employment protection—with a view to supporting job creation—by relaxing protection on regular workers while enhancing it for temporary workers would be beneficial for income equality, too. Improving wage-bargaining arrangements to allow wages to reflect productivity more closely in countries where they have grown most out of line would also help.
Active labor market measures could help reduce structural unemployment. Longer unemployment duration poses a risk of entrenching cyclical unemployment into a structural phenomenon as workers lose human capital and become detached from the labor force. Lam (forthcoming) found evidence of the effectiveness of certain active labor market measures, such as job-search assistance, training, and incentives to private sector employment, in improving employment rates and, in turn, countering structural unemployment.
The young need to be better integrated into the labor market. Policies could ensure better integration between employment services and the education system through outreach programs, training, apprenticeships, and access to job-search assistance measures.
|Unemployment||0.21* (0.12)||0.46*** (0.09)|
|Long-term unemployment||0.50*** (0.15)|
|Short-term unemployment||0.38* (0.22)|
|Employment||-0.15*** (0.06)||-0.22*** (0.04)|
|Women employment||-0.16*** (0.03)|
|Youth employment||-0.09*** (0.03)|
|Temporary contract employment||0.13* (0.07)|
|Social expenditures to GDP||-0.76*** (0.08)||-0.86*** (0.08)||-0.87*** (0.08)||-0.71*** (0.07)||-0.64*** (0.08)||-0.81*** (0.08)||-0.80*** (0.11)|
|Population share with at least secondary education||-0.09*** (0.03)||-0.08*** (0.03)||-0.08*** (0.03)||-0.09*** (0.03)||-0.08*** (0.03)||-0.08*** (0.03)||-0.04 (0.04)|
|Constant||58.47***||47.97*** (0.03)||48.49*** (0.20)||64.00*** (3.20)||56.27*** (2.24)||55.53*** (2.67)||47.37*** (3.24)|
A Stronger Euro Area-Wide Safety Net
European leaders took further steps to strengthen the crisis management framework at their March 2011 summit, but a number of elements of the required comprehensive package remain to be clarified. The main new elements are threefold.
The lending capacity and pricing of the facilities were adjusted. Policymakers committed to increasing the effective lending capacity of the EFSF to €440 billion—but without yet specifying how. The lending capacity of the European Stability Mechanism (ESM), the successor to the EFSF beyond 2013, will reach €500 billion using a combination of paid-in capital, callable capital, and guarantees. Pricing for ESM loans will be in line with IMF pricing principles. Accordingly, the loan conditions for Greece have been relaxed through a decrease in the interest rate and an extension in maturity, but not those for Ireland.
Decisions to provide financing under the ESM will be made by mutual agreement in the Eurogroup—by which non-abstaining member states must agree unanimously—on the basis of debt sustainability analysis, which will involve the IMF. In addition to lending to member countries, the euro area-wide facilities will be allowed to participate in primary markets in the context of a program with strict conditionality, on an exceptional but yet-to-be defined basis.
Private sector involvement in the context of ESM loans will remain an action of last resort, decided on a case-by-case basis consistent with IMF policies, and financing will be provided only if debt sustainability is demonstrated to be achievable. Collective actions clauses will be introduced starting in June 2013 and ESM loans will enjoy preferred creditor status.
Clearer parameters for the crisis management mechanisms are certainly welcome but challenges now lie in their implementation. The larger effective size of the EFSF should bolster market confidence, provided the mechanism by which this is secured is clarified as soon as possible, and a decision on adapting the interest rate charged on EFSF loans taken to help support fiscal sustainability. Beyond 2013, the proposed permanent facility, with its emphasis on prevention and early support, provides a robust and orderly framework for assisting euro area members, including through strict conditionality to support discipline. To broaden the avenues of support, though, some added flexibility in the instruments would be helpful. Additionally, in the shorter run, the interdependence between national banking systems and sovereigns remains unaddressed, and the onus of dealing with financial sector issues was left squarely with the national authorities, despite the high potential for cross-border contagion.
Accelerate Financial Sector Reforms and Resume Financial Integration
Indeed, addressing weaknesses in the banking sector remains a prerequisite for breaking the negative interaction between sovereign debt risks and banking risks. The agenda includes reducing uncertainty about asset quality, increasing capital buffers of viable banks, and identifying and resolving insolvent banks. While the July 2010 EU stress tests increased transparency with regard to banking sector exposures, they failed to identify the most pressing risks, as evidenced in Ireland where the two largest banks—at the core of the country’s difficulties—passed the stress tests. The new round of stress tests to be released in June 2011 will need to be far more probing. And to give teeth to these tests, member states need to put in place credible and specific ex ante plans to deal with the vulnerable institutions identified by the stress tests. In some countries, such as Ireland, Spain, and the United Kingdom, national supervisors have already moved ahead. But in many other countries, the resolve to put the banking sector on a stronger footing still needs to be demonstrated.
An additional issue is that financial integration in EU banking markets remains incomplete. While capital flows cross borders with little impediment, and banks transact freely in the money market, other elements of the financial system, including portfolio allocation, securitization, and retail banking, remain very much national affairs. Moreover, apart from some regional clusters, cross-border mergers and acquisitions are still limited. This is unfortunate because deeper financial integration carries the potential to alleviate some of the current banking sector weaknesses, allowing, in particular, for the injection of fresh capital in circumstances where domestic sources are constrained. Clearing the obstacles to further financial integration will require rapid progress on the single rulebook for banks and harmonization of supervisory practices. Standardization of products and more uniform consumer protection regimes are also needed (see Chapter 3 for more details).
The need for an integrated, pan-European approach to supervision and regulation has become even more evident. The European Supervisory Authorities (ESAs) and European Systemic Risk Board (ESRB)—all launched in January 2011—will provide much needed tighter coordination of financial supervision and macroprudential policies within the euro area and the EU. Adequate resources, good information gathering and sharing, and focused coordination of their activities will be critical to the success of these new institutions.
Moving toward a robust and flexible framework for crisis management and resolution, with appropriate tools and mandates to intervene and resolve ailing institutions at an early stage, is equally urgent. The EU proposal to harmonize these tools across countries is the right step toward ensuring more orderly ex ante solutions. But more needs to be done to progress from a setting structured along national lines to an integrated EU framework that fully addresses unavoidable coordination problems. Clear rules for allocating losses to private stakeholders and sharing the burden of potential public support among member states are still missing; so are mechanisms for rapid financing of resolution efforts—including through a deposit guarantee scheme prefunded by the industry. Ultimately, only a European Resolution Authority would be able to deal cost effectively with the resolution of cross-border EU credit institutions, thereby underpinning a truly single financial market while maintaining financial stability.
Restore Fiscal Health
Securing public debt sustainability constitutes another vital ingredient to an enduring solution to the crisis. With the recovery gradually broadening, now is the time to start reconstituting the fiscal buffers that proved essential during the recession and to secure medium-term sustainability. Absent such action, markets would feel increasingly uncomfortable funding ever-rising public debt in Europe—as they did in the most vulnerable euro area countries—in turn, jeopardizing the recovery. Getting the speed, size, and composition of the fiscal adjustment right is imperative too. Sovereigns that have come under market scrutiny have had no choice but to front-load the consolidation, but other European countries can afford to phase in the tightening to smooth over time the negative impact on domestic demand and employment.
Along this metric, current plans are appropriately differentiated (Figure 1.11). Greece, Ireland, Portugal, and Spain, as well as the United Kingdom—where the fiscal position deteriorated relatively more during the recession—have committed substantial fiscal consolidation for this year and for 2012–13, while Germany approaches the task at a slower pace. For the euro area as a whole, the fiscal improvement will reach 1¾ percentage points of GDP this year and ¾ percentage point the next two years (Table 1.3). In addition, the expected composition of the consolidation in the euro area and other European countries over the next three years is broadly appropriate, with the bulk of the deficit reduction occurring through expenditure reductions.
Figure 1.11Selected Advanced European Countries: Changes in General Government Fiscal Deficits, 2010–13
Source: IMF staff calculations.
1Greece, Ireland, Portugal, and Spain.
2Excluding bank support measures for Ireland.
|Current Account Balance to GDP||General Government Overall|
Balance to GDP1
|Advanced European economies2||0.5||0.8||0.9||0.9||-6.3||-6.1||-4.5||-3.6|
|Other EU advanced economies|
|Non-EU advanced economies|
The negative impact of fiscal consolidation on growth is expected to be limited this year for most European countries, but more substantial in 2012—a suitable timing given the strengthening recovery. Lagged effects from the stimulus measures still occurring in 2010 in most countries will likely smooth the effects of the consolidation measures, with the drag on growth this year ranging from 1½ to 2 percentage points in Greece, Portugal, and Spain to ½ percentage point or less in Austria, Germany, Ireland, and Switzerland (Figure 1.12).
Figure 1.12Selected European Countries: Impact of Fiscal Policies on GDP Growth, 2011–121
Source: Ivanova and Weber (forthcoming), based on IMF, World Economic Outlook database.
1 The approachapplies multipliers to the changes in public expenditure and revenue ratios to GDP, both in the domestic country and in its trade partners, to derive the impact on growth. Fiscal policy affects growth in the same year and in the following year (lagged effect).
2 United Kingdom estimates use weighted average of fiscal year numbers.
Still, these fiscal consolidation strategies will only fully work if embedded in credible medium-term plans. Some countries—such as Greece, Ireland, Portugal, and Spain, but also Austria, France, Germany, Italy, and the United Kingdom—have already elaborated specific consolidation plans beyond this year. Others have yet to flesh them out.
Set the Stage for Gradual Monetary Policy Normalization
With the recovery in train, monetary policy should also move closer to normalization. In countries most advanced in the recovery cycle, central banks have already started raising policy rates (for example, Israel, Norway, and Sweden). The ECB has recently followed suit as the output gap in the euro area is gradually closing—even after taking into account fiscal consolidation. In a few countries both inside and outside the euro area, strong momentum in mortgage credit and housing prices highlights the risk that assets could become overvalued again when loose monetary conditions are in place for too long (for example, Austria, Finland, France, Sweden, and Switzerland) (Figure 1.13). Conversely, in the United Kingdom, where the recovery is currently more tepid and fiscal tightening stronger, policy rate normalization may need to proceed more slowly.
Figure 1.13Selected European Countries: Residential Real Estate Prices
Sources: Bank for International Settlements; Organization for Economic Cooperation and Development; Global Property Guide; and national sources.
1 Latest data for Belgium, Finland, Greece, Ireland, Italy, and the Netherlands are 2010:Q3.
2 Average data for Austria are 2001–07.
In the shorter term, commodity price increases pose a challenge to the anti-inflation credentials of central banks: following the recent surge in commodity prices, fuel and food inflation now accounts for between half and three-quarters of current headline inflation across Europe, in sharp contrast with just a year ago (Table 1.4). Although core inflation is projected to remain low, and the impact of recent increases in commodity prices should prove temporary, central banks will have to keep a watchful eye on wage developments and inflation expectations for potential second-round effects. Removal of automatic wage indexation mechanisms in countries where they are still in place (for example, Spain) would help prevent these second-round effects from materializing.
|Inflation||of which: Contribution|
from food and fuel
|Inflation||of which: Contribution|
from food and fuel
In the euro area, remaining fragility in the financial system could hold growth back, justifying a flexible approach to exiting extraordinary crisis measures. The eventual exit will need to occur gradually as national actions to strengthen banking sectors are implemented and systemic uncertainty recedes. Depending on these, the ECB may need to extend further in time its regime of full-allotment refinancing for some of its liquidity operations, while refining its collateral framework to discourage systemic bidding, minimize distortions to market-based bank financing, and avoid moral hazard associated with unlimited liquidity provisions. Meanwhile, macroprudential policies will need to play a larger role in mitigating risks in member countries where these conditions encourage less cautious lending behaviors.
Strengthen Preventive Surveillance
In the run-up to the crisis, the Stability and Growth Pact (SGP) failed to prevent the trend increase in public debt. Stronger enforcement, as well as required corrective actions on a preemptive basis—even before the Excessive Deficit Procedure is activated—and until medium-term objectives are reached, will go some way to improving its effectiveness. However, national fiscal frameworks must also be strengthened, given member states’ reluctance to relinquish additional fiscal prerogatives to the center. Some countries have announced their intentions to introduce national fiscal rules (for example, Germany and France). There is also room to strengthen fiscal governance arrangements, transparency, and public finance management at the national level. The planned EU directive to define minimum standards and goals for such frameworks should help ensure they are fully in line with common objectives.
Coordination fell short of identifying the broader risks of growing macroeconomic imbalances within the EU, and even more important, within the euro area. As further detailed in Chapter 3, rather than a lack of fiscal integration, it was the inability of national authorities to react to local developments in credit, demand, and wages that led to the buildup and eventual bursting of imbalances in some countries, with detrimental consequences for the area as a whole. The new Excessive Imbalance Procedure should be strengthened to provide an effective platform for discussing and coordinating national responses at the EU level.