Short-term economic outlook

The euro area economy is in the second year of a robust economic recovery, growing at solid rates. The upturn is driven by strong growth of exports which benefit from continued favorable global demand conditions. On the domestic side, investment activity has been firming over several years and should give, despite a softening of construction investment in the course of the year, a substantial contribution to output growth also in 2007. Private consumption has shown some strengthening as well but remains weaker than in previous upswings. However, with unemployment having fallen to a level not seen in 25 years, rising consumer confidence should eventually feed into the spending behavior of households.

Short-term indicators point favorably to output growth at or above potential in the second and third quarter of this year. While hard data are somewhat mixed, especially those related to private consumption, survey indicators suggest that confidence remains high among both consumers and enterprises. For the year as a whole, output growth should therefore stay above 2½ percent. Looking ahead, the euro area economy is expected to grow further at a sustained rate also in 2008, as a moderation in capital spending should be largely compensated by stronger consumption growth. Although it is too early to have a definite view, the improved outlook is mostly due to a cyclical upturn. At the same time, there are signs that some structural factors may also be at work as well.

The euro area authorities largely share the staff’s view on real GDP growth in 2007 and 2008. We note that the discrepancy which existed a year ago regarding the projections for private consumption has largely disappeared. The authorities also broadly concur with the risk scenario put forward by the staff. In particular, over the medium term the risks are slightly tilted to the downside and related to the possibility of a sharper than expected slowdown in the United States, potential protectionist pressures, financial market risks, further unexpected oil price increases and the potential of a disorderly unwinding of global imbalances. In the short term, however, the risks to the outlook are broadly balanced.

Monetary policy and the outlook for price stability

The ECB broadly agrees with the Fund staff’s assessment that some further monetary policy action is likely to be necessary to stabilize inflation rates below 2 percent, in line with its definition of price stability. After the increase in key interest rates in June the ECB’s monetary policy is still on the accommodative side, given the continued positive economic environment in the euro area. The Governing Council of the ECB will continue to act in a firm and timely manner to ensure price stability over the medium term.

Turning to the outlook for price developments, annual HICP inflation was 1.9 percent in the first half of 2007. However, in assessing future inflation trends it is important to look beyond any short-term volatility in inflation rates, in particular as last year’s volatility in energy prices is giving rise to significant base effects, which have and will strongly influence the short-term profile of annual inflation rates.

At the policy relevant medium-term horizon, the Governing Council of the ECB holds the view that the risks to price stability remain on the upside. In the Governing Council’s view, with a high degree of resource utilization and continuously improving labor markets in the euro area economy, capacity constraints are emerging which could lead in particular to stronger than expected wage dynamics and profit margin developments. Such developments would pose significant risks to price stability. In addition, upside risks to price stability arise from increases in administered prices and indirect taxes beyond those anticipated so far, and the potentially pro-cyclical fiscal policy stance in some euro area countries. Further risks may arise from further unexpected oil price increases.

Cross-checking the outcome of the ECB’s economic analysis with that of its monetary analysis confirms the existence of upside risks to price stability at medium to longer horizons. The underlying rate of monetary expansion remains strong, as reflected in continued rapid growth of the broad monetary aggregate M3 and the still high level of credit growth. Following several years of robust monetary growth and the continued vigor of money and credit expansion, liquidity in the euro area remains ample. In this environment, upside risks to price stability prevail at medium to longer-term horizons. Therefore, monetary developments continue to require very careful monitoring, particularly against the background of the current economic expansion and still strong property market developments.

In this light, the Governing Council will continue to monitor closely all developments in order to ensure that risks to price stability over the medium term do not materialize and that inflation expectations in the euro area remain solidly anchored at levels consistent with price stability. Solid anchoring of inflation expectations is a prerequisite for monetary policy to make an ongoing contribution towards supporting sustainable economic growth and job creation in the euro area.

Fiscal developments and fiscal policy

The euro area authorities share the staff’s assessment of the improved budgetary situation, including some uncertainty related to the sustainability of the recent tax revenue performance.

In 2006, the general government deficit in the euro area fell for the third consecutive year, while the debt ratio recorded its first decline since 2002. Taken at face value, the improvement seems to be structural. However, as rightly pointed out by the staff, since the buoyancy of tax revenues may reflect both permanent and temporary factors, the jury is still out on the actual determinants of the estimated improvement in the structural budget balance in 2006.

The authorities welcome the staff’s overall positive assessment regarding the functioning of the reformed Stability and Growth Pact (SGP). In this context, it is important to emphasize that countries with excessive deficits have made significant structural efforts to correct their deficits within the deadlines established under the reformed SGP. At the same time, the authorities agree that the agreed rules of the preventive arm of the Pact should be fully implemented, and that further progress is needed to reach sound budgetary balances in the medium term.

The staff’s focus on the necessity to reach the Medium Term Objectives (MTOs) fits well to the orientations for fiscal policies in euro area Member States adopted by the Eurogroup on April 20, 2007. The Eurogroup emphasized the need to make the preventive arm of the Pact work in the current good economic times by stepping up consolidation towards the MTOs and avoiding pro-cyclical loosening. This would create the necessary scope for the full working of the automatic stabilizers in less favorable economic times. It would also allow reducing debt levels and contribute to the sustainability of public finances.

The euro area authorities find interesting the staff’s suggestions for strengthening the national fiscal policy rules and national governance mechanisms to improve the implementation of the preventive arm of the Pact and help to strengthen budgetary positions. The Commission has recently put forward a number of proposals aimed at improving the effectiveness of the preventive arm of the Pact. These proposals are being currently examined by the euro area authorities. In this context, it is worth noting that Member States already developed strategies to improve spending efficiency such as more use of performance information and of medium term budgetary frameworks.

Structural policies

The euro area authorities share the staff’s assessment of progress made in the area of structural reform. We are now close to the end of the first three-year cycle in the revised Lisbon strategy. In the coming months, policy directions for the next cycle covering the period 2008 to 2010 will be established.

As regards the functioning of the revised Lisbon strategy, experience suggests that the new governance based on a partnership between Member States and the EU is creating a greater sense of “national ownership” of objectives and commitments. The suggestions of the staff for greater transparency in reform commitments and for harnessing the synergies in reform efforts are timely and well considered. Considerable efforts are now being devoted to improve methods for evaluating National Reform Programs, the Lisbon Community Program, and their externalities. Moreover, a major element in ongoing reflections is how to achieve a better interaction between reform initiatives at national and EU level.

The most recent assessments of progress with structural reforms carried out by the Commission and the Council provide signs that many reforms are underway. Good progress has been made towards boosting R&D and innovation, improving regulation and enhancing the business environment, especially for small and medium-sized enterprises. Also, the shift to a knowledge-based economy appears to be well underway. If announced plans entailed in the National Reform Programs are implemented as intended, R&D spending will rise to 2.8% of GDP by 2010, up from 1.9% of GDP in 2005.

Also, important steps have been taken to reinforce the sustainability and the quality of public finances. Governments have been generally setting out appropriate measures to improve their budgetary positions and deal with projected increases in pension and health-care costs. Nevertheless, achieving sound finances in the medium to long term as well as raising the efficiency and effectiveness of public spending remain significant challenges.

Some reforms have started to deliver benefits, though many reforms are yet at an early stage and will need to be fully followed through to make a lasting economic impact. In this context, the authorities agree with the staff that market contestability in sheltered sectors, especially in services, needs to be improved. A successful and timely implementation of the Services Directive is essential for improving the regulatory environment in services. On the staff’s suggestion that the coverage of the Directive be extended to cover professional services, the authorities clarify that although a series of services are excluded from the application of the Directive, it does apply to most professional services.

Analysis suggests that past structural reforms enacted by euro area Member States might have added a structural component to the recent cyclical upswing. There is evidence of structural improvement on the labor markets: structural rates of unemployment have declined since 2000, and there have been large and sustained increases in the employment rates of women and older workers. Labor productivity in the euro area is also experiencing a strong recovery. Nevertheless, the nature of this productivity pick-up is not fully certain. Although there are signs that it is not entirely cyclical, it is too early to draw confident conclusions.

Financial sector issues

The euro area authorities share the staff’s view on the importance of the financial sector integration process for the region’s growth performance. In order to better understand the productivity gap in financial services (ex insurance), it would be helpful to have more details on the staff’s research, including the impact of potential measurement discrepancies. Financial integration has been an EU policy priority since 1998 and now forms an integral part of the Lisbon strategy as a means to deliver a more productive use of capital and higher output potential.

Stimulated by regulatory reform and the euro introduction, the process of EU financial integration is well underway, in particular in wholesale markets. Measures of the Financial Services Action Plan (FSAP) are almost fully transposed by Member States, but the staff rightly emphasizes the crucial role of supervisors and the Commission in ensuring their consistent implementation. In this context, the functioning of the Lamfalussy process is currently under review, and possible improvements may be discussed later this year. Further, in accordance with the principle of Better Regulation, the Commission has launched an external study on the evaluation of the FSAP policies. Regarding ongoing work, the major initiatives highlighted by the staff reflect the priorities set in the White Paper on Financial Services Policy for the period 2005-2010, while the Green Paper on Retail Financial Services published early this year has confirmed the Commission’s commitment to targeted measures in the retail area.

With regards to macro-stability risks, euro area authorities remain optimistic on the financial sector’s capacity to absorb adverse shocks, while acknowledging risks associated with a turning of the credit cycle. The authorities also agree with the staff’s recommendations that ensuring the adequacy of supervisory structures is crucial as financial integration progresses.

Building on previous analysis and the outcome of crisis simulation exercises, a report on developing EU financial stability arrangements is just being finalized by an Ad Hoc Working Group established after the informal Ecofin meeting in Helsinki in September 2006. The main challenges in this respect are to develop cooperation and tools for prevention, management and resolution aimed at the minimization of overall costs in the event of a potentially systemic cross-border crisis and providing appropriate incentive structures for all involved parties.

There is also ongoing work within the FSC on the challenges for the current supervisory framework. In this context, the euro area authorities welcome the staff’s analysis and suggestions as an input to the ongoing debate, but warn against a too alarmist tone which in our view fails to acknowledge the developments of the past years, both at the legislative level and in regard to the enhancement of cooperation and coordination arrangements of the crisis management.

Euro area integration

The euro area authorities emphasize the open character of the euro area enlargement process within a rules-based framework, as reflected in the recent decision on euro adoption by Cyprus and Malta on January 1, 2008. While authorities subscribe to the position that real income catching-up is not a separate convergence criterion, they stress the importance of achieving nominal convergence in a sustainable manner, with the assessment involving both backward- and forward-looking elements. It implies that countries should not rely on one-off measures or a temporary downward shock to meet the criterion only during a short time frame. As reported by the staff, euro area authorities underscore the key role of strong policies in preparation for euro adoption. In particular, fiscal and structural policies should be orientated towards ensuring a successful long-term performance under monetary union.

International economic relations

As noted by the staff, the euro area’s contribution to the resolution of global imbalances - as agreed in the context of the multilateral consultations - is part of the more broadly based Lisbon Strategy for Growth and Jobs. Also for domestic reasons, the euro area authorities are therefore firmly committed to its implementation.

It is important, however, that other participants of the multilateral consultations also deliver on their commitments and that countries that did not directly participate in the consultations contribute to the adjustment effort needed for an orderly correction of global imbalances. The Fund can continue to play a very useful role in the process through its monitoring, both in the context of the Article IV consultations and in the context of its regional and multilateral surveillance.

Regarding trade policy, the euro area authorities share the importance attached by the staff to an ambitious conclusion of the Doha Round. Throughout 2006 and 2007, the EU continued to play a key role in the efforts to push forward the negotiations. In particular, the EU was instrumental in the re-launch of the negotiations in early 2007 - after a 6 months suspension of the talks. Despite the difficulties encountered during negotiations, it remains the EU’s firm intention to ensure its successful conclusion.

The EU has lately launched a new generation of carefully chosen bilateral free trade agreements with Asean countries, South Korea and India, which should help tackle some non-tariff barriers and step up the EU’s engagement with rapidly growing Asian economies. The authorities concur with the staff’s view that the free trade agreements should not be substitutes for an ambitious liberalization under the Doha Development Agenda. Indeed, they are not. They are designed to be complementary to the multilateral trade liberalization. The EU’s priority is to ensure that any new free trade agreement is a stepping stone for, rather than a stumbling block to, progressive liberalization within the WTO system.