Euro Area Policies: Staff Report for the 2010 Article IV Consultation with Member Countries Supplementary Information

The EU crisis was caused by unsustainable policies in some member countries, and has put the spotlight on the deficiency of area-wide mechanisms in disciplining fiscal and structural policies. Despite a strong and far-reaching policy response, market confidence will take time to restore. Fiscal sustainability needs to be established. Growth needs to be boosted through swift implementation of structural reforms. The resilience of the banking system must be improved and its stability assured. Progress in building the EU’s financial stability architecture should be pursued.

Abstract

The EU crisis was caused by unsustainable policies in some member countries, and has put the spotlight on the deficiency of area-wide mechanisms in disciplining fiscal and structural policies. Despite a strong and far-reaching policy response, market confidence will take time to restore. Fiscal sustainability needs to be established. Growth needs to be boosted through swift implementation of structural reforms. The resilience of the banking system must be improved and its stability assured. Progress in building the EU’s financial stability architecture should be pursued.

1. This supplement provides an update of economic and policy developments since the release of the staff report (7/1/10). The thrust of the staff appraisal remains unchanged. Also attached is a draft background section of the Public Information Notice (PIN).

2. Recent data confirm a continuing recovery with heightened downside risks. Real activity has so far weathered the financial tensions in the euro area, with production and orders data improving and the rise of unemployment decelerating (Figure 1). Developments have been mixed across countries, however, and average gains in production have recently moderated. Business and consumer confidence indices deteriorated markedly in May. Annual inflation fell to 1.4 percent in June, after 1.6 percent in May.

Figure 1.
Figure 1.

Euro Area: Short-term Indicators of Economic Activity

Citation: IMF Staff Country Reports 2010, 221; 10.5089/9781455205790.002.A002

Source: Haver Analytics and Datastream

3. After falling sharply against major currencies, the euro exchange rate has appreciated in recent weeks, but remains more volatile than usual. Improved investor sentiment has helped the euro move up from its trough of early June. In real effective terms, the euro is close, if marginally above its long-term average. The external current account is near balance, not far from an expected small surplus in the medium term. In the current environment, assessing the fundamental value of the euro is subject to unusually high uncertainty. With that caveat, the euro exchange rate as of July 13 appears to be close to, if still slightly above its fundamental value as corroborated by recent CGER assessments (see table).

Euro Area Estimates of Euro Overvaluation

(In percent)

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Source: Fund Staff estimates

4. Financial conditions are beginning to stabilize, though tensions remain. Over the past weeks, financial stocks recovered somewhat from the lows reached in June and credit default spreads of euro-area banks and sovereigns have slightly receded but remain at elevated levels (Figure 2). Greece has managed to issue 6-month T-bills at a yield of 4.65 percent, though long-term rates remain prohibitive. Other countries affected by market tensions have succeeded to issue across the maturity spectrum at acceptable, if somewhat elevated yields.

Figure 2.
Figure 2.

Euro Area: Financial Indicators

Citation: IMF Staff Country Reports 2010, 221; 10.5089/9781455205790.002.A002

Sources: DataStream; and Bloomberg.1/ Euribor refers to “the best price between the best banks” provided by Euribor panel members.2/ The one-year banks CDS premium is the average of premia for the “best” five Euribor panel banks out of 24 with the lowest premium.

5. The redemption of the ECB’s first one-year refinancing operation went well and purchases under the SMP have been diminishing. While the majority of banks did not reapply for ECB refinancing on July 1, a significant number remain heavily reliant on ECB financing facilities. At its policy meeting on July 8, the ECB reiterated its expectation of moderate inflation in 2011 and left the policy rate unchanged. The total outstanding purchases under the SMP amounted to euro 60 billion on July 9. President Trichet, emphasizing that the ECB remained vigilant, noted that the need for interventions under the SMP seemed to have diminished in view of improved functioning of secondary markets.

6. The EFSF is set to be fully operational by end July 2010. The EFSF framework agreement is in force as two thirds of member states have signed off. However, completing the legal procedure for issuing guarantee commitments for at least 90 percent of the total will take until end July, at which point the EFSF will have the authority to issue bonds.

7. CEBS announced that results of ongoing EU bank stress tests will be released on July 23, 2010. In line with staff recommendations, the exercise now covers a wider range of institutions than initially envisaged, up from 25 to 91 banks representing 65 percent of the EU banking sector. For now, markets have taken a favorable view of these stress tests, as suggested by the shrinking premium of bank over corporate CDS spreads and a modest reduction in counterparty and liquidity risk indicators (Figure 2). Nevertheless, some uncertainty regarding the stringency of the tests is likely to remain. In another welcome development, several member states extended their bank debt guarantee and recapitalization schemes and some are expected to do so in the coming days.

8. Over the past few weeks, the Commission and the ECB made further contributions to the ongoing debate on the reform of economic governance:

  • The ECB governance proposals, released on June 10, emphasize the quasi-automaticity of sanctions to bolster enforcement of the Stability and Growth Pact, more intrusive ex-ante surveillance of macroeconomic policies, a mechanism modeled after the Excessive (budget) Deficit Procedure to monitor and eventually correct internal (current account) imbalances in the euro area, and a permanent crisis resolution mechanism.

  • The Commission Communication of June 30 fleshed out the proposals described in the Staff Report. Most notably, it joins the ECB in proposing binding instruments to correct internal imbalances; and, in line with staff advice, envisages binding minimum benchmarks for national fiscal frameworks, including enforceable rules and better statistics. It also proposes to expand the use of financial sanctions as an enforcement mechanism, including through the suspension of certain commitments from the EU budget (e.g. transfers from cohesion funds or CAP reimbursements to national budgets) in case of excessive deficit and an immediate suspension of the related payments in case of non-compliance. The July 12 meeting of the Council task force endorsed this approach. The Communication also provides a detailed time line for the early peer review of budget plans and reform programs, on which the ECOFIN Council of July 13, 2010 requested specific implementation proposals.

  • Next step. The Commission will transpose these proposals into draft amendments to secondary legislation by end-September, based on existing Treaty provisions mandating economic policy coordination (Article 121) and authorizing the Council to create new instruments of enhanced coordination in the euro area (Article 136).

Euro Area Policies: 2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Member Countries
Author: International Monetary Fund