Euro Area Policies
2007 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Member Countries

The Euro Area Policies’ 2007 Article IV Consultation reports that the economy is poised for a sustained upswing because of cyclical considerations and policies, which have had a forward-looking cast. The area’s external position and the real effective exchange rate of the euro are within range of medium-term equilibrium. Stabilizing inflation below 2 percent might well require a further gradual tightening of monetary policy. Increased contestability and integration in the financial sector is also key to improving performance.

Abstract

The Euro Area Policies’ 2007 Article IV Consultation reports that the economy is poised for a sustained upswing because of cyclical considerations and policies, which have had a forward-looking cast. The area’s external position and the real effective exchange rate of the euro are within range of medium-term equilibrium. Stabilizing inflation below 2 percent might well require a further gradual tightening of monetary policy. Increased contestability and integration in the financial sector is also key to improving performance.

I. Report on the Discussions

A. Cyclical Developments and Prospects

1. The economy is moving from recovery to upswing and the fundamentals are improving (Figure 1, Table 1). Real GDP growth is running around 2½ percent; fiscal deficits are markedly lower than a few years ago; and strong export growth, improving profitability and balance sheets, and accommodative financial conditions have fostered a broad based upswing of investment and employment (Figures 2-4).

Figure 1.
Figure 1.

Euro Area: Cyclical Developments

(Annualized quarter-on-quarter percent change, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Eurostat; Datastream; and IMF, World Economic Outlook.
Table 1.

Euro Area: Main Economic Indicators

(in percent change)

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Sources: IMF, World Economic Outlook; Eurostat, ECB Monthly Bulletin.

Contribution to growth, in percentage points.

Includes intra-euro area trade.

In percent.

In percent of GDP.

Based on normalized unit labor costs.

Based on ECB data, which exclude intra-euro area flows.

Data for goods.

Calculated as the sum of individual countries’ balances.

Figure 2.
Figure 2.

Euro Area: Investment, 1996-2006

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Eurostat; ECB; Haver Analytics; and IMF staff calculations.
Figure 3.
Figure 3.

Euro Area: Evolution of the Cycle since the 1970s 1/

(With respect to trough values)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: ECB; IMF, World Economic Outlook; and Fund staff estimates.1/ Cycle troughs: current—2003Q2; past—1993Q1; previous cycles—an average of two cycles with troughs in 1975Q1 and 1981Q1; trough definitions are in line with EC; Sample: 1971Q1-2006Q3.
Figure 4.
Figure 4.

Euro Area: Households and Consumption

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: OECD and Haver Analytics.1/ Balance of opinion on financial and general economic situation.2/ Based on nominal compensation per employee and changes in the debt service of a 20-year fixed-rate mortgage.3/ 2006 figures are in part staff projections.
uA01fig01

The recovery has been led by investment and exports.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: Eurostat.

2. The external setting is generally considered propitious. Specifically:

  • Import demand growth in partner countries is projected to slow down only moderately, from about 7½ percent annually over the past couple of years to around 6½ percent through 2008.

  • The area’s external current account is broadly balanced and export growth has been dynamic, notwithstanding the recent appreciation of the euro’s real effective exchange rate (¶32).

  • Financial market volatility and risk premia remain historically low.

uA01fig02
Sources: IMF, World Economic Outlook; European Commission; OECD; and Fund staff calculations.1/ In billions of U.S. dollars.2/ Rest of the world calculated as residual (excludes global discrepancy).3/ Excludes intra-area trade (ECB data).4/ Nominal PPP GDP per hour.5/ Total hours worked per capita.6/ Nominal PPP GDP per capita.

3. Accordingly, projections are for growth around 2½ percent through 2008. This represents a slowdown from the recent pace, which was just over 3 percent over the four quarters to 2006:Q4 and 2007:Q1. This reflects the unwinding of the German VAT, the tightening in macroeconomic policies during 2006-07, and the fading of exceptionally favorable export performances observed in 2006.

The recovery is expected to continue.

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Not adjusted for working days.

Mid-point.

Based on a simple average of spot prices of UK Brent, Dubai, and West Texas Intermediate crude oil.

Based on Brent crude oil prices.

4. With potential growth rate estimates currently just above 2 percent, the projections imply a gradual increase in resource utilization. All capacity utilization indicators are moving up and some are already close to previous cyclical peaks. However, labor does not appear to be a major constraining factor thus far, even at the level of individual countries (Figure 5). While unemployment rates have fallen below the 2000 trough, equilibrium rates are likely to have fallen even further and labor force participation and population are on the rise (Figure 6). Key developments include: (i) the deregulation-enabled shift of employment toward part-time and temporary jobs; (ii) the rising labor force participation of women and older workers; (iii) high immigration; and (iv) less generous welfare.1

Figure 5.
Figure 5.

Euro Area: Indicators of Capacity and Labor Constraints

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: European Commission; European Committee; Haver; and IMF staff estimates.1/ Percent balance equals percent of respondents reporting an increase minus the percent of respondents reporting a decrease.
Figure 6.
Figure 6.

Euro Area: Labor Market Indicators, 1997-2006

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Eurostat; OECD; EC Quarterly Business and Consumer Survey; and IMF staff estimates.1/ Excluding Greece, Luxembourg, and Slovenia.2/ Males, 25-54 years old.
uA01fig03

The decline in population growth has reversed owing to increased migration.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: European Commission.
uA01fig04

Wages have been moderating…

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: EC-AMECO database.1/ See IMF Country Report No. 04/235, Chapter 1.
uA01fig05

…and labor is not constraining production.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: European Commission.

5. The risks to growth were generally seen to be small and to the upside in the short run but widening and moving to the downside over the medium run. The external risks were viewed as on the downside and increasing over time. They relate mainly to renewed upward pressure on oil prices, a hard landing of the US economy, a malign unwinding of global imbalances, and flight from risk. Domestic risks were seen to be on the upside over the coming year but broadly balanced over the medium run. In the short run, consumer spending could accelerate faster than anticipated, as consumer confidence is relatively strong and employment and other conjunctural indicators are in expansionary territory (Figure 7). Moreover, equity markets are more fairly valued and corporate balance sheets stronger than at the peak of the previous boom. With emerging equipment capacity constraints, investment could grow more than expected. Regarding the medium run, household saving rates might stabilize rather than rise again in 2008, as assumed in WEO projections. But there are also domestic medium-run weaknesses, notably those related to stretched housing sectors and, to a lesser extent, insufficient competitiveness in some significant parts of the area (Figure 8).

Figure 7.
Figure 7.

Euro Area: Leading Indicators

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Eurostat, Reuters, IFO, INSEE, National of Belgium, and staff calculations.1/ Year-on-year percent change, three-month moving average, right scale.2/ Standardized over 1991-2004 period.3/ Year-on-year growth, right scale.4/ Quarter-on-quarter growth, right scale.
Figure 8.
Figure 8.

Euro Area: Price, Income, and Cost Dispersions

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: IMF, World Economic Outlook.1/ Excluding Ireland and Luxemburg.2/ Estimated equation: xt,i-x-t=αi+βt(xt-1,i-x-t-1)+ɛt,,i where xt,i-growth/inflation of each member state; xt- -euro area growth/inflation; βt -persistence parameter.
uA01fig06

Risks to growth are tilted to the upside in the near term and downside over the long term.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

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B. Inflation and Monetary Policy: Removing Policy Accommodation

6. While headline inflation has been somewhat volatile, measures of underlying inflationary pressures have been inching up. Financial market-based measures, analysts expectations, and various indicators of underlying inflation (core, trimmed means, etc.) have been rising gradually since the troughs of 2005 (Figure 9). The euro-area headline HICP has been running just under the 2 percent threshold. The effects of the January 2007 VAT increase in Germany, which may have added around ¼ percentage point at the area-wide level, have been masked by stabilizing oil prices.

Figure 9.
Figure 9.

Euro Area: Inflation and Labor Costs, 1999-2007

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Eurostat; ECB; and Haver Analytics.1/ Excludes energy, food, alcohol, and tobacco.

Inflation is seen close to 2 percent in 2008.

article image

Mid-point.

Based on a simple average of spot prices of UK Brent, Dubai, and West Texas Intermediate crude oil.

Based on Brent crude oil prices.

Fund staff estimates. ECB projection assumes 0.5 percentage point for 2007 and none for 2008.

7. Although still quite moderate, wage demands are expected to firm somewhat more than productivity over the projection horizon. Backward looking indicators show subdued wages through 2006 and wage settlements—lately in Germany’s metal sector—continue to surprise on the downside. Amid supply side-driven moderation, the cyclical response of wages appears to have diminished (Figure 10). Nonetheless, continued high oil prices and improving labor market conditions were seen to provide ground for higher pay, notably in Germany where compensation had been exceptionally subdued. With firms already well-placed to increase margins somewhat further, cost increases would likely translate into price increases as well.

Figure 10.
Figure 10.

Euro Area: Labor Costs and Labor Utilization

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: OECD, ECD, and Fund staff estimates.1/ Excluding Greece and Portugal; weighted by employment.
uA01fig07

Inflation risks appear balanced.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

1/ For methodology, see WP/06/197.

8. Looking ahead, the central view was therefore that underlying inflation would gradually firm. Staff and ECB forecasts are for HICP inflation hovering around 2 percent through 2008, implying that an acceleration in costs would make up for the unwinding of the effect of the VAT on year-on-year inflation. Staff models point to roughly balanced risks (Figure 11), although fully capturing upside risks related to indirect taxes as well as administrative and oil prices with these models is difficult. The ECB put greater emphasis on the upside risks, including those related to wages and ample liquidity. Credit to nonfinancial corporations is increasing rapidly but that to households, notably for mortgages, is slowing down noticeably, suggesting that past rate hikes are feeding through (Figures 12-13).2 Nonetheless, M3 continues to expand at a brisk pace (lately increasingly on account of less liquid components), although its recent dynamism may currently overstate somewhat the robust underlying rate of monetary expansion, according to ECB staff. Fund staff is skeptical about M3 as an indicator of short-to medium-run inflation.3

Figure 11.
Figure 11.

Euro Area: Model Forecasts of Inflation

(Year-on-year, in percent)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: IMF staff calculations, see IMF Working Paper 06/197.
Figure 12.
Figure 12.

Euro Area: Monetary Policy and Market Expectations, 1999-2007

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: Datastream; ECB; Eurostat; and staff calculations and forecasts.1/ Survey of Professional Forecasters.
Figure 13.
Figure 13.

Euro Area: Money and Credit, 1980-2007

(in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: ECB; Datastream; Bloomberg; and staff calculations.1/ Deviations from 1990-2004 mean.2/ Deviation (in percent of the actual real stock of M3 from an estimate of the long-run real stock of M3, consistent with long-run inflation of 1.75 percent a year and assuming that the real money gap was zero in January 1999.
uA01fig08

Taylor rules suggest rates need not move much above 4 percent.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

1/ The coefficients on the changes in inflation and unemployment are 0.5 and 1.25 correspondingly.2/ The formula gives equal weight (0.5) to the deviation from the inflation target and the output gap; the nominal natural rate is assumed to be 4.15 percent.

9. Some further monetary policy action is likely to be necessary. As expected, following the mission the ECB raised rates to 4 percent on June 6, 2007, and markets foresee rates just under 4½ percent by the end of this year. Concurrently, long-term interest rates have moved up noticeably as of late, implying some tightening of monetary conditions. With the area’s growth projected to remain close to or above potential, and the possibility of some further upward pressure on factor utilization and prices, staff thought that (aside from global inflation trends) the scope and timing of further action would need to depend on (i) the extent to which reforms and demographics have improved labor supply; (ii) the extent to which the incipient acceleration of productivity is structural or cyclical; and (iii) the evolving distribution of (mainly demand-side) risks—including those related to the exchange rate (¶32)—to activity further out, which are presently seen to be on the downside.

C. Fiscal Policy: Adjusting During the Upswing

10. Fiscal policy surprised on the upside in 2006. Standard measures suggest that the area’s cyclically-adjusted fiscal deficit fell by almost 1 percentage point of GDP in 2006–exceeding staff’s ½ percent of GDP benchmark for countries at a significant distance from their medium-term objectives (MTO). This was led by large reductions in Germany, France, and (upon considering the expiration of one-off measures), Italy. Other EDP countries have also met their commitments and, more generally, higher-than-budgeted revenues have been allocated to debt reduction, even if not to the full extent by all countries.

Fiscal Developments, 2005-09

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Sources: WEO, ECFIN and Fund staff projections.

Excludes net deficit increasing one-off measures in Italy in 2006 (1.5% of GDP).

Germany, Greece, Italy and Portugal, as of May 31, 2007.

11. Spurred by these strong outcomes and buoyant prospects, the Eurogroup Ministers announced their intention to accelerate the consolidation of the area’s public finances. Specifically, they committed to achieve their (country-specific) MTO at the latest by 2010 and agreed, notwithstanding a still negative output gap according to agreed measurement techniques, that “good times” prevail. Under the Stability Growth Pact (SGP) rule book, this implies a commitment to adjust by more than ½ percent of GDP annually for those countries that have not yet reached their MTO.

12. There was agreement at staff levels, therefore, that the reformed SGP had worked well thus far, but also concerns that the true test of its preventive arm still lay ahead. The challenges remain sizeable, particularly in some countries. Despite progress under the SGP’s dissuasive arm, cyclically-adjusted fiscal positions today are not appreciably different from those attained in 2000. Moreover, recollections of the very large negative corrections made ex post to the structural positions estimated for 2000 prompted caution about relying unduly on current estimates. Indeed, there was agreement that the standard cyclical adjustment might overstate the true structural adjustment that occurred in 2006 because it did not allow for the potential procyclicality of revenue elasticities. The shared view was that, pending deeper analysis, it would be prudent to consider only about half of the observed reduction in the deficit ratio as structural, a figure that is broadly consistent with the decline in the cyclically-adjusted expenditure ratio (adjusted for one-off operations). In addition, while significant progress had been made in preparing for the effect of the aging of the population on public expenditures,4 conservatively estimated increases of 3¾ percent of GDP by 2050 remained in the pipeline.5 Staff therefore argued that, even if growth was likely to be stronger, a repeat of the damaging SGP debates of 2002-04 was a distinct possibility. The reason is that some countries—Italy, and to a lesser extent France and Greece—would remain uncomfortably close to the 3 percent ceiling given the stage of the cycle, a view that was shared by EC and ECB staff.

EU: Aging-related Expenditure, 2004-2050

(In percent of GDP)

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Source: AWG Report, European Policy Committee.

Assumes that healthcare costs rise in line with wages rather than per-capita GDP; and that the probability of receiving formal long-term care rises gradually.

Structural Balance Medium-term Objectives and Adjustments Needed

(in percent of GDP)

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Based on Fund staff estimates for the 2006 structural balance.

13. Staff therefore pressed for full adherence to the SGP’s norm of at least ½ percent of GDP adjustment per annum by countries that remained short of their MTOs. On present budgetary plans, staff thought that little adjustment was in the offing through 2008, particularly in some key countries, a concern that was shared by Commission and ECB representatives (Figure 14). There was broad agreement that various institutions, from independent ad-hoc committees to fiscal rules to medium-term expenditure budgeting are useful means to overcome political economy distortions to fiscal policy, depending on a country’s institutional setting. The Commission observed that euro-area countries were making appreciable progress on this front, pointing to greater emphasis on medium-term planning, spending rules, and enforcement mechanism in stability programs (SPs). Staff welcomed these measures as they could help bring forward the credibility gains from adopting complementary fiscal and structural policies, but noted that peer pressure within the framework of the SGP would also need to play an important role.

Figure 14.
Figure 14.

Euro Area: Fiscal Developments

(in percent of GDP, unless otherwise noted)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: European Commission; IMF, World Economic Outlook; and IMF staff calculations.

D. Structural Policies: Integrating Europe and Raising Labor Utilization

Advancing economic integration in the currency union

14. The currency union countries have been integrating rapidly since EMU but structural reforms and more financial integration would help reduce remaining country dispersions and alleviate their repercussions on households and firms. Area-wide shocks now explain the bulk of growth and inflation developments in individual member countries (Box 1), suggesting that the union has been integrating at considerable speed. As a result, the share of shocks that is country-specific is no longer high by international standards for currency unions. However, their persistence is still a concern, partly explaining appreciable divergences in national competitiveness (Figure 6). There was agreement that adjustments in national competitiveness needed to proceed more rapidly, notably through wage flexibility, and that continued labor and product market reform was critical to that effect. In addition, further financial integration could contribute to income smoothing among EMU members.

EMU Dispersions

Under EMU, common shocks explain a much larger portion of member countries’ output and inflation developments than before, and the transmission of shocks has become increasingly similar. In particular, common factors are driving around 60 percent of growth and inflation during EMU, up from around 20 percent for growth and 30 percent for inflation before EMU. To a small extent, common shocks still trigger different responses across countries, accounting for some 20 percent of growth and inflation dispersions, down from 60 percent for growth and 30 percent for inflation dispersions before EMU. Remaining country-specific shocks to growth and inflation, however, have a fairly large persistent component. Partly these shocks are driven by one-off factors that take time to unwind, notably the EMU-related declines of interest rates and increases in real estate valuations in various countries that featured high pre-EMU real interest rates. Partly they reflect income and price convergence. These two developments are difficult to account for separately, because the relatively less-wealthy countries were also those with relatively high pre-EMU interest rates. Staff research suggest that they can account for a large proportion of remaining country-specific shocks (see “Growth and Inflation Dispersions in EMU: Reasons, the Role of Adjustment Channels, and Policy Implications,” forthcoming IMF Working Paper).

uA01fig09

Euro Area: Contribution of Common Shocks Before and After EMU

(in percent)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: IMF Staff calculations

Further integration of the financial system could increase risk sharing and income smoothing in response to remaining country-specific shocks. Staff research suggests that the financial system has played a role as a shock absorber however, it is still far from achieving its full potential. The results indicate that its role for risks sharing has not increased substantially over time. Findings in the literature suggest that the contribution of the financial sector to income smoothing could be increased significantly—by up to 20 percentage points—if its level of integration reached that of the United States.1/

1/ See Marinheiro, C. F., 2003, “Output Smoothing in EMU and OECD: Can We Forego Government Contribution? A Risk Sharing Approach,” CESIFO Working Paper No. 1051.

15. Beyond reducing dispersions, all saw further market integration also as a boon for euro-area productivity. Euro-area productivity compares well internationally on tradables and poorly on nontradables, notably wholesale and retail trade and financial services. Similarly, among EU countries those with less regulated product markets have tended to post better growth performances over the past couple of decades, without necessarily experiencing larger social inequities. Indeed, staff analysis suggests that successful reformers focused on increasing labor supply through benefit reform and lowering tax wedges and government consumption. Greater labor supply translated into employment growth more effectively in the presence of liberal labor and product markets.6 There was broad agreement among staff, EC, and ECB officials on the synergies between labor and product market reform and hence on the benefits from eliminating remaining barriers to the full integration of goods and services markets (Figure 15), including obstacles to foreign entry. Accordingly, the discussions focused on the key EU policy initiatives that seek to advance integration and market contestability, including the Lisbon Agenda, the Services Directive, and the Financial Services Action Plan (EU FSAP).

Figure 15.
Figure 15.

Euro Area: Economy-wide Regulations

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: OECD, and based on a database compiled for the April 2004 WEO.
uA01fig10

Productivity in manufacturing has performed better than in services.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

The Lisbon Agenda and the Services Directive

16. The implementation of the Lisbon Strategy is improving, as evidenced by the renewed issuance of country-specific economic policy recommendations. The Strategy was adopted by EU heads of state in 2000 to make Europe more dynamic and competitive and relaunched in Spring 2005, after initially disappointing results. Some estimates put the Lisbon Agenda’s growth impact at about ½-¾ percentage points of GDP over the medium run. EC officials explained that aside from product, services, and financial market reform, as well as R&D, priorities under the Strategy include several additional measures, notably improving flexibility and security on labor markets as well as education and training. Within these broad priorities, countries define their own National Reform Programs (NRP) that the Commission evaluates, making recommendations that are submitted for endorsement by the European Council.

17. Staff argued NRP under the Lisbon Strategy still needed to better harness the synergies between reforms and become more transparent. The NRP are helpful in harnessing synergies between reforms that boost labor supply, which are typically nationally-led, and those that liberalize product and services markets, which are increasingly EU-led. While there are some signs of progress, in the staff’s view, too many countries are still not using the NRP to those effects and too many NRP are too vaguely specified to be monitorable and hence as credible as they might be.

18. The Commission countered that the Agenda had already fostered a closer dialogue between Ministries within countries in designing NRP. Furthermore, work is underway to improve the analysis of growth bottlenecks and their linkages to specific structural reforms as well as the monitoring and quantification of such reforms. Commission officials were particularly keen on improving coordination between national reforms and Community-led initiatives, including areas covered by EU structural and social policies. Staff agreed on the need for more coordination but pressed for the country-specific recommendations to place greater emphasis on improving the monitorability and domestic governance of NRP.

19. Member states are to implement the Services Directive through national laws, regulations, and administration by December 2009. The mission pressed for an early and good faith implementation of the Directive (meaning no abuse of the its public interest exemptions), which could be fostered by publishing country-specific transposition status timetables and scheduling a formal mid-term review by the European Commission. The liberalization of the services markets would also need to be extended to sectors not covered by the Directive, notably professional services. Commission staff explained that the transposition of the Directive would be a complex undertaking with different requirements for different countries.

E. Financial Sector Integration and Stability

20. Financial sector integration is a key avenue to boosting Europe’s growth prospects. National accounts data suggest that: (i) about half of the euro area’s just under 1 percent annual productivity growth gap during 1996-2003 relative to the United States can be traced back directly to the financial sector (excluding insurance); (ii) labor productivity in business and financial services has been moving broadly sideways since 1993; and (iii) the euro area is doing much better with respect to productivity in insurance, which at the level of major financial institutions appears more European and global than banking. While productivity data on financial services are not without problems, it is clear that the direct growth benefits of integration may well be large; that indirect benefits, notably from financial-sector-enabled restructuring and innovation, may be larger still; and that financial integration will foster more cross-border risk sharing and a better pass-through of monetary policy.

uA01fig11

Banking is the least “Europeanized” of activities.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: Veron (2006).Geographical distribution of activity (topline indicator, generally revenue or operating income) for a sample of 55 among Europe’s 100 largest companies by market capitalization.

Financial integration and development

21. The achievements to date are major but so are the remaining obstacles. In terms of progress on the ground, wholesale markets are now relatively well-integrated, notably interbank and corporate bond markets, but less so equity and securitization markets and there is considerable scope to further develop arms-length financing. Retail market integration is lagging, particularly in banking—on some measures the least “Europeanized” sector of the economy. Europe has put in place a strong policy framework to advance integration, comprising the EU’s Financial Services Action Plan (EU FSAP) and the Lamfalussy process, with its several levels that focus on the development and implementation of legislation. On the regulatory front, the policy achievements within this framework are major: there has been much legislative and regulatory convergence, pushed forward in particular by the 2006 Capital Requirements Directive (CRD) for banks and investment firms, the forthcoming Solvency II Directive for insurance companies, and the Markets in Financial Instruments Directive for financial markets. The key challenge is to ensure the uniform implementation of the directives by national prudential authorities, which is the responsibility of the Level 3 (committees of supervisors) and 4 (enforcement by the Commission) of the Lamfalussy framework. Progress in this regard as well as with respect to supervision and crisis prevention, management, and resolution is mixed, however.

uA01fig12

Productivity gaps relative to US are the largest in trade and financial intermediation, while Europe does well in insurance business.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

1/ Including auxiliary activities, excluding insurance.2/ Excluding compulsory social security.

Financial integration and development

22. Major initiatives are underway to develop European capital markets and “arms-length” finance as well as to promote retail market integration.

  • Transposition into national laws of the Markets in Financial Instruments Directive (MiFID). This will radically reshape the investment services landscape in Europe and has, for example, already led several major banks to plan a trading platform to compete with domestic stock exchanges in Europe. MiFID establishes a comprehensive regulatory regime for regulated financial markets, other trading systems, and investment firms. It simplifies and extends the “single passport” system for investment firms, enabling them to do business anywhere in the EU on the basis of home-country authorization, with a minimum of red tape. The Directive also enables investment firms to process client orders outside regulated markets. Overall, the Directive is expected to lead to major changes in the architecture of capital markets and financial intermediation in Europe both via increased competition and faster technological change.7

  • Work is underway to integrate securities clearing and settlement systems, which is central to integrating Europe’s capital markets. In particular, key post-trading services providers signed a Code of Conduct in November 2006 committing them to (i) price transparency; (ii) interoperability; and (iii) unbundling of services, by January 2008. Progress will be monitored and, if deemed insufficient, could lead to renewed work on a directive. Additionally, the ECB is evaluating opportunities to provide efficient settlement services in central bank money for securities transactions, processing securities and cash legs on a single platform (Target 2-Securities).

  • Other policy initiatives cover bank mergers and acquisitions; the integration of payments systems (SEPA); retail products (e.g., mortgages, bank accounts); and investment funds.

It will take some time before these and other initiatives yield their full benefits. The mission welcomed the progress and encouraged work on converging national securitization markets. Securitization can play a major role in developing capital markets, spreading risks, and reducing economic divergences. It can also foster a more efficient, market-driven division of tasks between capital markets and banks.

The financial stability dimension

23. The financial system is viewed as relatively healthy. Equity markets have returned close to previous highs or above; and volatility and risk premia remain unusually low, notwithstanding recent turbulence. Bank profitability has strengthened through 2006 (Table 2, Figure 16), although it remains structurally low in parts of the area, and the insurance sector has benefited from recovering asset prices. Balance sheets are generally strong (Figure 17), as reflected also in relatively benign developments of market-based indicators, such as distance to default for large European banks. While concerned about rapid growth of credit (especially in foreign currency) in various NMS, officials did not see significant vulnerabilities for euro-area financial institutions as a whole.

Table 2.

Financial Conditions of Large and Complex Banking Groups in the Euro Area

(2004 - H1 2006)

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Sources: Individual institutions’ financial reports and ECB calculations.
Figure 16.
Figure 16.

Euro Area: Banking Sector Developments

(100 Largest Banks; in percent, unless otherwise noted)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: FitchIBCA database; Datastream; and Fund staff calculations.
Figure 17.
Figure 17.

Euro Area: Leverage Ratios, 1999-2006

(Debt as a ratio to equity or net worth)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: IMF staff calculations based on quarterly European sector accounts by the ECB and Eurostat.
uA01fig13
Sources: Staff calculations based on data from Datastream. Note: Distance to default is the difference between the expected value of assets at maturity and the default threshold, which is a function of the value of the liabilities. A higher distance to default is associated with a lower probability of default.

24. Financial indicators may have peaked, however. There are signs that the credit cycle is gradually turning: nonfinancial corporate rating downgrades have been more frequent than upgrades and leverage in parts of the corporate and household sectors may have become excessive. Also, ECB analysis suggest that the vulnerability of the financial system to an abrupt and unexpected loss of market liquidity appears to be increasing. Other concerns are the external downside risks; the rising complexity of financial instruments; and, to a lesser extent, the activities of highly leveraged nonbank financial institutions.8 EC and ECB staff discounted worries about “subprime-like” mortgage products, a market that is far less developed in Europe than in the United States. They thought that few of the large euro-area banks have significant direct exposures to subprime activity in the United States. EC and ECB officials agreed on the desirability of stress testing to gauge potential cross-border vulnerabilities in Europe but observed that differences in supervisory data and confidentiality issues need to be addressed first. In the meantime, they implement less sophisticated stress tests using publicly available data on financial products and large crossborder financial institutions (LCFI). These had confirmed the robustness of the financial system.

25. Turning to the stability framework, Europe has for years sought to establish the right balance between the impulse to strengthen integration on the one hand and to preserve national accountability for financial stability on the other. In 1993, the Second Banking Directive introduced home-country control and mutual recognition, resulting in a “single passport” that enabled any bank licensed in any EU country to open branches (not subsidiaries) in other EU countries on the basis of its home license. However, branching entails a loss of control of host countries over domestic financial stability, for which they remain accountable, and often is less attractive than market entry via subsidiaries. Accordingly, the single passport has not delivered a single “rules book” of prudential policies and practices. A new impetus toward reform of the financial stability framework came with the 1999 Financial Services Action Plan (FSAP), which had as one of its objectives the introduction of state-of-the-art prudential rules and supervision. To support this objective and pursue convergence of supervisory practices, the FSAP was complemented with the Lamfalussy framework, a tiered process that relies on committees of national supervisors to effect convergence of national rule books and practices. Combined, the FSAP and Lamfalussy process have achieved major progress but less so in key areas, notably crossborder crisis prevention, management, and resolution. In the meantime a number of LCFI have begun to dominate the European banking landscape and crossborder consolidation is accelerating, even though it remains behind other sectors of the euro-area economy.9 As a result, the importance of crossborder bank linkages and the potential for contagion among the major European banks are increasing (Box 2). Against this background, the authorities have initiated various stock-taking exercises.

26. The core problem, which is widely recognized, is that national authorities’ fiduciary responsibilities are toward national treasuries, and this limits their incentives to work toward a common EU-wide stability framework. The dominant strategy for supervisors in an LCFI crisis will likely be to look out for the national treasury, using informational advantages to that effect, notwithstanding MoUs on information sharing and cooperation. A scramble for assets in an LCFI crisis is thus likely and would have significant crossborder spillovers, preventing efficient and effective crisis management and resolution. In this set-up, it is natural for national prudential authorities to fear loss of control over domestically-active financial players. The desire to maintain control to better protect national financial stability is a factor contributing to customization and “goldplating” of EU directives, which risks delivering a collection of national rather than a single set of best EU prudential policies and practices; opposition to a framework for systematic multilateral supervisory data sharing;10 and, perhaps most importantly, a reluctance to agree to EU principles and procedures for crossborder financial crisis prevention, management, and resolution.

Spillover Risks Among the Major European Union Banks

The scope for cross-border spillovers among the major European banks can be examined using the Extreme Value Theory framework, which analyzes co-movements between extreme events (“co-exceedances”), specifically the co-movement of extreme negative (left-tail) realizations of banks’ soundness measures. The soundness measure chosen in this analysis is the distance-to-default (DD), defined as the difference between the expected value of assets at maturity and the default threshold, which is a function of the value of the liabilities. A higher DD is associated with a lower probability of the bank’s default. It is generally a useful proxy for default risk if stocks are traded in liquid markets.

The DD for 27 of the largest European Union banking groups were computed for May 2000-April 2007 using daily stock price and annual balance sheet data. A binomial logit model was used to estimate the probability of a bank experiencing a large negative DD change in response to large negative shocks to the DD changes of other banks. Large negative shocks were defined as those falling in the 10th percentile of the left tail of the common distribution of the changes in the DD across all banks. Four control variables—changes in the slope of the term structure, and the volatility of the domestic, regional and world stock market indices—were also included in the model to account for common factors affecting all EU banks.

Significant Co-Exceedances among EU Banks, May 2000-April 2007

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Source: IMF staff calculations, based on data from Bloomberg LP; and © Bureau van Dijk Electronic Publishing - BankScope.

The number of bank pairs for which co-exceedances were found significant at the 5 percent level in the given period.

The number of significant links (in the previous line), in percent of all possible contagion channels (i.e., as percent of all possible domestic and cross-border pairings of banks, respectively).

The results (see table) suggest that although spillovers within domestic banking systems generally remain more likely, the potential for extreme events to spill over from one bank to another appears to have increased, both among domestic banks and across the border. The number of significant cross-border links is already larger than the number of significant links among domestic banks, adding another piece of empirical evidence supporting the need for greater cross-border supervisory cooperation in the EU.

27. While it is generally acknowledged that Europe’s financial stability framework needs to be strengthened further, views differ considerably on priorities. Some policymakers see a burden sharing agreement as the cornerstone of a reformed framework and thus a natural entry point toward more joint responsibility. These representatives argue that such an agreement is a condition for prudential authorities to fully internalize any spillovers of domestic actions—essential to minimize the EU-wide collective costs of LCFI failures (and therefore moral hazard)–and for advancing key reforms across a broad range of issues (e.g., more information sharing). Others consider talk about ex-ante mechanisms to share costs of LCFI failures as premature and entailing moral hazard and risks of forestalling practical steps towards financial integration. In their view, a host of other issues need to be settled first. Nonetheless, some proposals to instill more joint accountability and responsibility of national prudential authorities have been tabled, notably: (i) introducing EU-related references in the mission statements of national supervisors and qualified majority voting (in lieu of unanimity) in Lamfalussy Level 3 committees; and (ii) elaborating LCFI-specific MoUs covering crisis prevention, management, and resolution, including agreement on EU principles and procedures that these MoUs should incorporate.

28. Staff pressed for imparting to the system a greater sense of joint responsibility and accountability, considering it essential to meaningful progress in the prevention and the efficient and effective handling of LCFI solvency crises. In this regard, staff views the issue not as one of centralized versus decentralized supervision but about finding the right balance between the national and system-wide priorities. One possibility would be to couple proposals to introduce a European orientation into the mandates of prudential authorities and qualified majority voting at Level 3 committees with a parallel mandate for these and other authorities to elaborate principles and procedures seeking efficient and effective LCFI oversight as well as crisis prevention, management, and resolution. These principles and procedures would have to aim at minimizing collective costs of potential LCFI failures facing EU states. While such an approach might eventually have to address the allocation of costs across states, agreement at this juncture on a mandate to minimize collective costs could be expected to accelerate work toward a balanced strengthening of Europe’s financial stability framework, notably through establishing a database for sharing supervisory information on LCFI, including with the ECB; reducing differences in supervisory powers; enhancing pre-crisis sanctions and tools; harmonizing and improving the operations of deposit insurance; and understanding and improving the operation of bank insolvency laws in an area-wide context.11

F. Spillovers

Euro adoption

29. With the Maastricht criteria for entry having been controversial, staff asked how euro adoption for the NMS would be managed. The inflation and exchange rate criteria, if taken to their limit, amount to a real income convergence criterion.12 While this has not been much of an issue thus far, per capita incomes in most NMS are appreciably lower than in the euro area. Hence, higher inflation or nominal exchange rate appreciation in these NMS can (but need not) be consistent with medium-term equilibrium. With real income convergence set to extend over a horizon stretching significantly beyond current market expectations on official plans for euro adoption, staff asked how the euro-adoption process—notably the emphasis on sustainability with respect to inflation convergence—would be managed. Clarification is particularly important in view of the fact that financial positions and transactions in NMS suggest that economic agents have expectations of euro adoption within the next 5-7 years.

uA01fig14

NMS are driving exports of euro-area countries.

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Source: IMF, Direction of Trade Statistics and Fund staff calculations. Growth rates refer to exports of goods denominated in euros.
uA01fig15
Sources: Eurostat; National Statistical Offices; and IMF staff estimates.

30. Interlocutors responded that while the Treaty did embody an expectation to join, the timing was open and the euro-adoption process was well understood. Expectations of early entry had over time been replaced by much more cautious statements by all involved, especially over the past year, without causing market tensions. Furthermore, EC officials stressed that the “real income convergence” argument was overstated. They clarified that “sustainability” in the context of the price stability criterion meant that inflation had to be within Maastricht bounds without reliance on one-off factors, with the assessment involving backward-looking analysis as well as a forward-looking assessment with a prudent use of forecasts. Specifically, the examination uses Commission forecasts to assess medium-term prospects for inflation and includes a statement on whether the candidate country is likely to meet the reference value in the months after the examination. In the meantime, all interlocutors considered it key that the NMS seeking euro adoption strengthen their policies further to ensure a successful operation in the monetary union. In this regard, EC and ECB officials underscored the useful disciplining effect of the Maastricht criteria. They also emphasized that the process was an open one, and countries meeting the criteria welcome, as was clear from the recent admission of Cyprus and Malta.

Europe’s part in addressing global imbalances

31. Staff welcomed the broad-based structural reform efforts underway, as these would help strengthen prospects for an orderly resolution of global current account imbalances. Structural reforms are of course necessary primarily for domestic reasons but they can help the adjustment process essentially by helping sustain world growth in the face of a U.S. current account adjustment. The authorities’ multilateral consultation commitments are all in the structural and financial sector area (Table 3) and are a subset of the initiatives discussed above. They stressed that the implementation of these reforms is continuing.

Table 3.

Euro Area: Policy Progress and Plans Relevant to the IMFC Strategy1

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For detailed description of the policy progress and plans see the IMFC report at: http://www.imf.org/external/np/sec/pr/2007/pr0772.htm.

For details, see White Paper on Financial Services Policy 2005-2010, available at: http://ec.europa.eu/internal market/finances/docs/white paper/white paper en.pdf

32. Staff calculations suggest that the euro’s real effective exchange rate remains broadly in line with medium-term fundamentals. EC and ECB officials presented broadly similar calculations but suggested that the exchange rate might be somewhat more appreciated than suggested by the staff, although still broadly in line with medium-term fundamentals. Over the past 6 months, the euro, which floats freely and independently, appreciated slightly in real effective terms, reflecting partly stronger portfolio inflows. According to staff calculations, the euro continues to be close to equilibrium, as are the area’s balance of payments and net international investment positions (Figure 18, Tables 4-5). Furthermore, exports are growing at a healthy pace. Staff downplayed concerns about the latest exchange rate movements for the recovery.

Figure 18.
Figure 18.

Euro Area: External Developments

(in billions of U.S. dollars; unless otherwise specified)

Citation: IMF Staff Country Reports 2007, 260; 10.5089/9781451813074.002.A001

Sources: ECB; Haver Analytics; IMF, World Economic Outlook.1/ Staff estimate, based on a time series estimate with stochastic trend, a macroeconomic balance approach, and an external sustainability assessment.2/ Rest of the world calculated as residual (excludes global discrepancy).3/ Excludes intra-area trade (ECB data).
Table 4.

Euro Area: Balance of Payments

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Sources: ECB; Datastream.

End of period stocks.

Table 5.

Euro Area: Net Investment Position 1/

(in percent of GDP)

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Source: European Central Bank.

Data correspond to the end of the indicated period. They are expressed as a percent of the cumulated GDP of the four quarters ending on that date.

Europe’s role in promoting world trade

33. With trade having consistently been a boon to Europe’s productivity performance, an ambitious conclusion to the Doha Round is very much in the EU’s interest. There are pressures from some political quarters for the Commission to take a tough stance in the Doha negotiations because of social considerations. However, the evidence for trade liberalization driving income inequality in Europe is weak (Box 3). Also, in the staff’s view trade policy is a poor instrument to manage income inequality. The Commission noted that the successful conclusion of the Doha round remains the foremost EU trade policy priority, but that it had already shown sufficient flexibility on agriculture in private discussions in July 2006. They took the view that other key participants need to make additional concessions, including the United States on agricultural subsidies and Brazil, India, and other emerging economies on industrial goods and services. Staff emphasized that a willingness to agree to additional liberalization by the EU, in particular on agriculture tariffs, is needed for an ambitious outcome to the Round. Additional liberalization in agriculture would also provide a greater incentive for the EU’s key trade partners to agree to greater liberalization in areas of particular interest to the EU, including industrial tariffs and trade in services.

34. Staff stressed that free trade agreements (FTAs) were no substitutes for multilateral trade liberalization in the Doha Round and should not be allowed to distract political energy and attention from the Doha Round negotiations. Earlier this year, the EU has embarked on a new series of FTA discussions with Asian countries, including the ASEAN countries, India, and Korea, as part of its Global Europe initiative. These discussions come on top of a wide array of ongoing FTA discussions, including those with the Andean countries, Central America, Mercosur, and the 79 African, Caribbean, and Pacific (ACP) countries (the latter in the context of Economic Partnership Agreement (EPA) discussions). The Commission stated that the EU’s bilateral agenda is a complement to, and not a substitute for, multilateral negotiations. Staff agreed that bilateral agreements may provide benefits to their participants and may be able to secure liberalization in “new” areas that fall outside the scope of Doha Round negotiations. However, they are inferior to multilateral liberalization for both members and non-members; and their pursuit may divert political energy and negotiating capacity away from securing an ambitious Doha Round outcome, both in the EU and the FTA partner countries. The Commission responded that the Asian FTAs will only begin serious negotiations in 2008, after the target for conclusion of the Doha Round.

Income Inequality and Globalization

There is growing concern in Europe over the impact of globalization on high and evenly shared living standards but this is difficult to substantiate in the data. To a large extent, these concerns have surfaced in response to slowing wage growth and falling labor income share in aggregate national income data. However, these data may tell little about the underlying distribution of incomes, as measured by Gini coefficients on household disposable incomes. While Gini data also suggest that inequality has increased in most industrialized countries, this development was much less pronounced in euro-area countries, unlike what labor income shares data suggest.

uA01fig16