Assessment of short-term economic prospects

The economic situation and prospects in the euro area are now considerably weaker than expected a couple of months ago. Both the global nature and the strength of slowdown have been underestimated whilst the resilience to external shocks may have been overestimated. A gradual resumption of the recovery in the euro area, based on sound fundamentals, could be expected once the external shocks wane. However, the events of 11 September added to the already fragile economic situation. Rather than modifying the underlying reasoning, the implications are that the short-term growth prospects have dimmed further. Economic growth in the euro area seems now likely to be well below 2 % in 2001 and a bottoming out of the slowdown before the end of the year seems unlikely.

While there are clearly substantial uncertainties about unfolding events, one should not overlook that the economic fundamentals in many countries have in many respects improved in recent years, and that this leaves the world somewhat less vulnerable than it might otherwise be as was pointed out by the IMF’s Economic Counsellor at a recent press conference.

The euro area maintains solid fundamentals. Thanks to the considerable improvement in the macroeconomic setting, including progress in fiscal consolidation, and to the ongoing process of structural reforms the euro-area economy is now in a better shape to deal with cyclical fluctuations. In addition, the progressive deceleration in inflation and in inflation expectations, recent tax reductions and favorable financing conditions are important conditions for a gradual strengthening of domestic demand in the euro area as a whole. Further declines in oil prices could contribute decisively to better conditions for stability and growth. The key to minimise the impact of the economic downturn and to restore sustained, non-inflationary growth lies in re-establishing confidence quickly. Against this background, it is worth noting that euro area policy makers have demonstrated their commitment to react rapidly and appropriately. The commitment to maintain sound budgetary policies and to continue with the process of structural reforms will help to bolster confidence.

Monetary policy and the outlook for price stability

The ECB broadly agrees with the Fund’s overall assessment of euro area monetary policy. In the course of the year 2001, medium term inflationary pressures in the euro area have subsided significantly. Already prior to the attacks on the US on 11 September 2001, this has allowed the governing council of the ECB to reduce its key interest rates by 50 basis points in total (by 25 basis points on 10 May and 30 August). On two issues relating to this period, however, the staff report needs to be clarified. First, the ECB’s analysis of monetary developments is not carefully enough reflected in the staff report. Second, the report gives too much weight to the decline in headline HICP inflation in the decision to reduce ECB interest rates on 30 August 2001. In this respect, it may also be worthwhile recalling that monetary policy decisions are not taken by focusing on one pillar only or on specific set of indicators but rather are made in a forward-looking manner, based on all the information available to the ECB Governing Council.

In the aftermath of the tragic events in the United States on 11 September, the Eurosystem ensured a calm and orderly functioning of the financial markets. To this aim, on the two days following the terrorist attacks, the Eurosystem carried out liquidity-providing fine tuning operations. In addition, in order to be able to provide European banks with liquidity in US dollars, the US Federal Reserve System and the ECB agreed on a foreign exchange swap operation.

In addition to these immediate measures, the Governing Council of the ECB considered it necessary to reassess the outlook for price stability and the monetary policy stance in the euro area. In the assessment of the Governing Council, the recent events in the US were likely to weigh adversely on confidence in the euro area, reducing the short-term outlook for domestic growth. As this was likely to further reduce inflationary risks in the euro area, a lowering of the ECB’s key interest rates was deemed appropriate. As a consequence the Governing Council decided on 17 September to lower the ECB key rates by 50 basis points, in concert with a decision by the FOMC of the US Federal Reserve System on the same day. This decision was fully consistent with the monetary policy strategy of the ECB.

Looking ahead, the Governing Council is confident that the slowdown in economic growth in the euro area will be short-lived, given the sound economic fundamentals of the euro area economy. This notwithstanding, economic developments will be carefully monitored by the Governing Council in order to assess their effects on the outlook for inflation. In this respect, the ECB agrees with the Fund that the risk of too strong increases in wages, in a context of lower growth and declining inflation, seems not very acute at this stage, and actual wage growth observed so far has been moderate. Finally, it is worth recalling that monetary policy has to take into consideration developments on the fiscal front when assessing the outlook for price stability over the medium term.

Coming to the introduction of euro banknotes and coins in a few months time, the ECB has no reason to believe that this event should affect materially the outlook for price stability in the euro area. In this respect, we broadly agree with the arguments put forward in the report underpinning this assessment. Moreover, we believe that the commitment of the Governing Council to maintain price stability over the medium term is also an important contribution to ensure that the changeover does not affect price developments.

The participation of the ECB in a ROSC exercise comprising three modules (Transparency in Monetary Policy and in Payment Systems Oversight, Euro 1 compliance with CPSS Core Principles for Systemically Important Payment Systems and TARGET compliance with the Core Principles) reflects its commitment to meet international standards and codes, as well as its support for the international financial institutions’ efforts to foster compliance with best practices. Such participation should also be seen as a complement to the ROSC and/or FSSA modules prepared at the level of individual euro area Member States.

The ECB agrees with the overall assessment by the IMF staff. It shows that the ECB and the Eurosystem have achieved a very high degree of compliance with transparency principles applicable to monetary policy and payment system oversight, as almost all principles in the Code of Good Practices on Transparency in Monetary and Financial Policies are deemed to be observed. Areas where full observance has not yet been achieved are not directly related to the policy and operational frameworks of the ECB monetary policy. The reports also confirm that Euro 1, the Euro Banking Association’s payment system, fully observes all the Core Principles, while TARGET, the real-time-gross-settlement system for the euro, has fulfilled the policy objectives for which it was set up and is almost fully in line with the applicable Core Principles, even if room for limited further improvement has been identified.

Exchange rate developments

The euro exchange rate remains undervalued. The IMF staff’s conclusions on the euro’s weakness are broadly appropriate. As regards the role of equity prices, in particular the markedly sharper rise in stock market capitalisation in the USA, the failure of the euro to appreciate in correspondence with the fall in equity prices since spring 2000 may not be accounted for by this explanation. Concerning the outlook for the euro, the staff’s judgement that, since policy has not played a direct role in weakening the euro, there is little scope for policy actions to correct in the short-term what is deemed to be an undervalued exchange rate, is appropriate.

Fiscal policy

The most relevant issue is the degree to which automatic stabilisers should operate (and not “if they should operate), depending on each country’s particular budget situation.

The IMF staff plays down the virtues of the EU budgetary framework both in the run-up to EMU and in Stage 3. This framework, and in particular the focus on nominal balances, was instrumental to the success of the Maastricht fiscal retrenchment. Indeed, a majority of countries have now close-to-balance or surplus positions. Avoiding excessive government deficits is a central element in the architecture of economic policy in EMU. More generally, the favorable implications for cyclical stabilization of sticking to the spirit of the SGP, whereby achieving close to balance allows the automatic stabilizers to operate fully in the event of a cyclical downturn, are not adequately acknowledged.

As to the IMF staff’s suggestion for shifting the attention of the SGP from budget balances to spending targets, the framework provided for by the rules of the SGP is flexible enough to be consistent with different mechanisms which member states may develop to ensure compliance with medium term goals. Actually, a number of countries pursue fiscal strategies resting on expenditure targets. Thus, expenditure targets can usefully support the SGP goals, but should not replace them.

Revenue developments, as admitted by IMF staff, cannot be disregarded, and limiting the monitoring of budgetary developments to expenditure targets may not suffice in securing the avoidance of excessive deficits.

All in all, the SGP is working effectively and should be preserved. Its built-in flexibility allows combining strong discipline with cyclical stabilisation. The implementation of the new Code of conduct for the preparation of stability and convergence programmes, approved by ECOFIN ministers last July, should contribute to improve the effectiveness of the euro-area budgetary framework. The Code stresses the usefulness of taking into account the country’s cyclical position when assessing its compliance with the SGP medium-term objective.

Structural policies

The IMF staff rightly emphasizes the benefits in terms of increased potential growth, employment and improved resilience to shocks, to be generated by resolute reforms of product and labour markets. Such reforms have been significant, especially of product markets, but further progress remains to be made.

A number of crucial obstacles have not yet been tackled in both markets. The strengthening in the functioning of euro-area product markets is significant, but in some areas progress has been slower, such as the creation of an Internal Market for services, liberalisation of energy markets, public procurement or administrative reform.

Further progress in labour market reform is clearly needed, especially on measures to strengthen the effective labour supply and labour participation. Whilst progress has been made in certain areas such as tax reform and in active labour market measures that address employability and equal opportunities, benefit system reform that addresses incentive structures, duration and eligibility remains largely untackled. Nevertheless, all Member States have taken action to various extents, and some have made good progress in labour market reform.

Financial market integration

Financial-market integration requires a common framework of market regulations for the Union as a whole. This common framework of regulations is to be put in place by implementation of the Financial Services Action Plan (FSAP). The Lisbon European Council identified financial-market integration as a priority of economic reform, and this is reflected in the deadline of 2005 set for implementing the FSAP. While implementation of the FSAP is broadly on track, there is a need to accelerate progress if the deadline is to be achieved. To this end, it is essential that the recommendations of the Lamfalussy Committee on EU securities markets regulation, which have been endorsed by the Stockholm European Council, should be put into operation immediately.

The systemic risk associated with financial-sector integration and consolidation points to a need for close co-operation among national supervisors and the central banks in preventing and managing financial crises. In response to concerns expressed in some quarters, including the Fund, the current arrangements for crisis prevention and management at the EU level have been studied. While no institutional changes were deemed necessary at this stage, a series of concrete proposals to improve cross-border co-operation in financial supervision have been put forward, in particular in an EFC report (Brouwer II), which was endorsed by Finance Ministers and Central Bank Governors in Spring 2001. Substantial progress has been made in implementing these proposals.

Euro changeover

The unprecedented event of the changeover to the euro banknotes and coins will come about in an efficient and organised manner. The Eurosystem, governments of participating Member States, the European Commission and other public and private bodies are all working together closely to ensure that the introduction of euro banknotes and coins will be smooth. The preparations, including operations to frontload banks and retailers, are already progressing satisfactorily. Communication efforts are being intensified, particularly to foster the awareness of small and medium-sized enterprises, local authorities and the public regarding the necessary preparations. Retailers and citizens, including vulnerable groups, are also being assisted to become familiar with the new banknotes and coins, including the security features, before their introduction. Finally, important progress has also been made in establishing a comprehensive framework against counterfeiting.

Trade policy

The EC continues to work very hard towards the launch of a new Round of trade negotiations at the forthcoming Doha WTO Ministerial. The multilateral approach to trade liberalisation is the preferred method of the EC and the best way to ensure a strong and fair WTO system of multilateral rules, as is made clear in the 25th October 1999 Council conclusions that provide the basis for the EC negotiating position at the WTO.

A new Round should address those issues of most interest to developing countries, such as improved market access, including in products of most importance for those countries. The “Everything but Arms” initiative, which constitutes a unique and unprecedented policy move toward LDCs, improved trade related technical assistance and capacity building, and the proposed changes to the EC’s GSP regulation constitute a major package of EC measures in favour of developing countries. The EC is also supporting significant progress on the further implementation of Uruguay Round commitments in advance of the Doha Ministerial. There is a need for an improved coherence in the international system, in order to make trade and other policies, such as environment and social policies, and food safety, mutually supportive.

Finally, in the year 2000, 31 new EC anti-dumping investigations were initiated: a 64 percent decrease on the 86 new investigations that had been launched in 1999. None of the new investigations in 2000 were in the agricultural or textile sectors.