Short-term economic outlook

A gradual recovery is in progress in the euro area after the deep economic recession came to an end in the third quarter of last year. The turnaround was driven in large part by the exceptional crisis measures put in place by authorities in the euro area, in the EU and outside.

The normalization of the financial situation in the euro area was interrupted by a severe sovereign debt crisis caused by an exceptional combination of adverse economic and policy factors in Greece. In response, Member States agreed on a package of bold measures to preserve financial stability in Europe: the European Financial Stabilization Mechanism (EFSM) and the European Financial Stability Facility (EFSF). The practical arrangements concerning the establishment of the European Financial Stability Facility are well on track and the Facility is expected to be fully operational by the end of July. In parallel with the creation of the financial instruments, the Member States experiencing particular market stress committed to accelerate fiscal consolidation and structural reforms, while the European Central Bank introduced the Securities Market Program.

Turning to the real economy, the euro area is benefiting from a strong external environment and inventory restocking, whereas weak domestic demand components continue to restrain the recovery. Investment is held back by the still relatively low level of capacity utilization, deleveraging and heightened risk aversion. Consumption growth is primarily constrained by weak wage and employment growth. The smaller-than-expected impact of the economic crisis on the euro area labor market is explained by past measures taken to enhance market flexibility combined with the use of short-term measures and, in some Member States, by labor hoarding. The remaining slack in the economy keeps wage growth and inflation in check. The speed of recovery is varying across euro area Member States, reflecting their individual circumstances and the policies they pursue.

Looking ahead, the authorities broadly concur with the forecast presented by the staff and expect the euro-area economy to grow by about 1% in 2010 and 1½% in 2011. The authorities see the risks broadly balanced, though the probability of downside risks has increased compared to the Commission’s Spring Forecast.

Monetary policy and the outlook for price stability

The euro area annual HICP inflation stood at 1.4% in June, but is expected to display further volatility in the next few months, with a tendency to somewhat higher rates later this year. The inflation rates in 2011 should remain moderate, benefiting from low domestic price pressure. Risks to the outlook for inflation are broadly balanced. The underlying pace of monetary expansion is moderate, as annual growth rate of bank loans to the private sector is still weak, with positive growth in loans to households and negative growth to non-financial corporations. Against this background, the current key ECB interest rates remain appropriate.

As regards ECB’s non-standard measures, with bond market tensions intensifying in April and especially in the early days of May this year in some euro area countries, and spreading to other markets and countries, on May 10, 2010, the ECB re-introduced some non-standard measures that had been withdrawn, such as six-month refinancing operation with full allotment. Furthermore, a Securities Markets Program (SMP) was introduced, implying Eurosystem interventions in private and public bond markets. Its aim is to address the malfunctioning of some securities markets, and restore an appropriate monetary policy transmission mechanism. Following the introduction of the program, bond spreads of euro area countries generally have declined, though still standing at elevated levels. All non-standard measures, including the SMP, are by construction temporary in nature.

Turning to money markets, the maturing of the first 1-year Long-Term Refinancing Operation (EUR 442 bn) at the end of June went smoothly, as banks had been given the opportunity to refinance themselves in other operations with full allotment. With banks choosing to refinance less than the maturing amount, excess liquidity in the money market decreased somewhat, causing short-term interest rates such as the overnight interest rate (EONIA) to rise slightly, though still standing close to the interest rate on the ECB deposit facility.

Fiscal policy

The euro area authorities share the staff assessment on the broad neutrality of the fiscal stance in the euro area in 2010 and the need for the stance to become clearly restrictive as from 2011. However, in some countries the challenges regarding sustainability were exacerbated by financial market tensions, requiring strengthened consolidation efforts already in 2010, despite the prospects of only moderate recovery, in order to secure fiscal sustainability and to limit contagion effects.

The euro area authorities agree with the staff that the overall objective should be for fiscal consolidation efforts to be supportive of the economic recovery. As underlined by the staff, this can be made possible by focusing on structural expenditure reduction as well as improved streamlining of public expenditure programs. Pension reforms would also strengthen long-term commitment to sound public finances. However, the euro area authorities note that fiscal adjustment plans also need to be tailored to country-specific situations as indicated in the Orientations for fiscal policies in the euro area Member States issued on June 7, 2010 by euro-area Finance Ministers. A coordinated differentiation in the speed of consolidation is warranted by frontloading consolidation in a number of Member States in order to avoid adverse debt dynamics, also taking in to account macro-financial stability considerations. Additional measures should be implemented in 2011 and beyond, where and when necessary, in order to ensure the achievement of the budgetary targets and to underpin the credibility of consolidation strategies. For the credibility of fiscal consolidation in all Member States it is essential that the measures adopted are of a permanent nature and embedded in a comprehensive strategy of structural reforms. Concerning the composition of adjustment, the magnitude of the required corrections means that it is likely that a combination of spending and tax measures will be necessary. While expenditure-based consolidations are in general preferable in order to limit medium to long-term adverse effects on growth and to reinforce credibility, tax increases may also assist in achieving structural fiscal adjustment objectives.

State of the banking sector

The sovereign crisis in the euro area led to renewed stress in the banking sector, as many banks are exposed to sovereign risks and market participants started questioning the solvency of some segments of the euro-area banking system. Although most of the euro area’s large banking groups returned to modest profitability in 2009 and their capital positions increased to above pre-crisis levels, credit risk is still considered to be the most important risk for the banking sector in most of the Member States. The increasing tension was quickly mirrored in tightening money market conditions and higher funding costs. These developments signal that trust among banks remains fragile as long as there are doubts about the solvency of the potential counterparts.

Since the outbreak of the financial crisis the EU has taken significant measures to support the banking sector, including:

• guarantee schemes – the approximate volume of guarantees authorized by the Commission until 31 March 2010 under schemes amounts to € 2 747 billion and ad hoc guarantees to a total of € 402.8 billion;

• recapitalization schemes – the total volume of approved recapitalization measures (both schemes and ad hoc cases) by the end of March 2010 stood at € 503.1 billion, which corresponds to around 4% of EU GDP, whereas the amount effectively used was € 241.6 billion or 2% of EU GDP;

• impaired asset measures – the nominal amount of total assets covered by the asset relief interventions reached € 376 billion;

• restructuring plans.

As the staff noted, keeping support to the financial sector at current levels in place for too long would allow banks with structural problems to unduly postpone the necessary restructuring and could lead to growing competition distortions. The return to normal market conditions is important for a sustained recovery. It is essential, therefore, that banks accelerate balance sheet repair to minimize the need for government intervention. In this respect, transparency in the existing quality of bank balances would encourage the distressed institutions to restructure and would help to lift doubts about the soundness of the financial system as a whole.

The staff is right to emphasize the role of stress tests in this context. The authorities consider that the extended coverage as well as the planned publication of the CEBS stress test will be a crucial step. The objective of this extended exercise is to assess the overall resilience of the EU banking sector and the bank’ ability to absorb further possible shocks on credit and market risks, including sovereign risks, and to assess the current dependence on public support. The exercise is being conducted on a bank-by-bank basis, using commonly agreed macro-economic scenarios for 2010 and 2011.

The macro-economic scenarios, which include a set of key macro-economic variables, envisage adverse conditions in financial markets and a shock on interest rates to capture an increase in risk premia linked to a deterioration in the EU government bond markets. The scope of the stress testing exercise has been extended to include key domestic credit institutions in Europe, in addition to the major EU cross-border banking groups. In each EU Member State at least 50% of the national banking sector, in terms of total assets, is covered. Banking groups have been tested on a consolidated level. This means that subsidiaries and branches of an EU cross-border banking group have been included in the exercise as a part of the test of the group as a whole. For the EU, the 91 banks covered represent 65% of the EU banking sector.

Financial regulation

The European Commission and the EU governments initiated numerous regulatory reforms in the financial sector, which have been an integral part of the responses to the crisis. The Commission’s communication on “Regulating Financial Services for sustainable growth” of June 2, 2010 takes stock of the ongoing initiatives and lists the initiatives to be undertaken and completed before the end of 2011. The initiatives cover the issues highlighted by the staff and largely go in the indicated directions.

In particular, on July 8, the European Parliament approved amendments to the Capital Requirements Directive (“CRD 3”) as regards capital requirements for trading book and for securitization, and the supervisory review of remuneration policies. Further possible changes to the Capital Requirement Directive (“CRD 4”) are underway. The proposed amendments relate to liquidity standards, definition of capital, leverage ratio, counterparty credit risk, counter-cyclical measures including through-the-cycle provisioning for expected credit losses, systematically important financial institutions and single rule book in banking. This legislative proposal will be presented by the Commission this autumn and will mirror the revisions proposed under Basel III. Following on the regulation on credit rating agencies adopted in 2009, the Commission proposed on June 2, 2010 a draft regulation amending this legislation and setting up a direct and a centralized EU oversight of the rating agencies by the future European Securities and Markets Authority (ESMA), planned to be established in 2011. The Commission also intends to propose by next fall additional measures to strengthen competition in the credit rating market and to reduce excessive regulatory reliance on credit rating in the financial system. The EU is also currently working on a complete set of tools on crisis prevention and management. In October 2010, the Commission will publish an action plan on crisis management, leading to legislative proposals for a complete set of tools for prevention, management and resolution of failing banks. Discussions continue on the new supervisory framework in the EU. It is expected that the legislative process in the European Parliament and the Council will be concluded in September and the new institutions will become operational at the beginning of 2011.

Structural reform and growth

The authorities concur with the staff that a key challenge is to promote policy strategies that create growth and employment, restore sustainability of public finances and at the same time address the long-term challenges of globalization, ageing and climate change. This is the objective of the Europe 2020 strategy, on which a political agreement was reached by the European Council of June 2010. The strategy is designed to promote reforms in various areas, such as employment-boosting reforms of the labor market, reforms of the research and education systems, measures to promote “green” growth, and product market reforms. The strategy also encompasses reforms directly aimed at improving quality of government expenditure that can have immediate and longer-term positive fiscal impact (for example, raising effective retirement ages and reform of age-related expenditure, such as healthcare) as well as boosting revenues. As to the short term focus of the Europe 2020 strategy, priority should be given to frontloading reforms that bolster jobs and growth but have no or positive budgetary impact (e.g. regulatory measures) or which strengthen fiscal sustainability over the long run (e.g. pension reforms). Credible commitments now to implement growth-enhancing reforms in the medium term could also boost confidence, and through expectations of stronger fiscal positions translate into lower risk premia.

The June ECOFIN Council endorsed a report identifying the main bottlenecks to sustainable growth, which specifies areas in each Member State where structural reforms are necessary to remove the bottlenecks that constrain sustainable growth. Proposals on the enhanced governance arrangements are being elaborated, providing for a more comprehensive, integrated and effective approach to economic policy co-ordination. Also, improving the effectiveness and efficiency of the EU budget through stronger prioritization and better alignment of EU expenditure with Europe 2020 goals will be discussed in the context of the upcoming EU budget review and the next multi-annual financial framework. The Commission is going to outline concrete proposals in autumn.

Intra-euro-area imbalances

The authorities recognize that competitiveness divergences and underlying imbalances are a matter of common importance for euro area Member States and warrant appropriate and timely policy measures. In March 2010, the Eurogroup committed to address the issue of competitiveness divergences and macroeconomic imbalances swiftly and effectively and to put in place an ambitious and comprehensive policy response covering appropriate measures in four broad areas: budgetary and wage policies, labor markets, goods and services markets and the financial sector. Moreover, the Ministers committed to make sure that the agreed policy response is coordinated in the euro area, designed to address the specific vulnerabilities and needs of each country and facilitates the smooth functioning of the EMU.

As rightly pointed out by the staff, action is required in all euro area Member States, but the nature, importance and urgency of the policy challenges differ significantly depending on the countries considered. Given vulnerabilities and the magnitude of the adjustment required, the need for policy action is particularly pressing in Member States showing persistently large current-account deficits and large competitiveness losses.

Economic governance

The global economic crisis has shown that the current mechanisms of economic policy coordination and surveillance need to be strengthened. The authorities have therefore embarked on a comprehensive debate on the improvement of economic policy coordination in the euro area and in the EU as a whole. In line with proposals by the Commission, the European Council of June 17, 2010 endorsed a first set of orientations as regards budgetary and broader macroeconomic surveillance. The European Council also invited the Task Force on economic governance chaired by the President of the European Council and the Commission to rapidly develop further these orientations and make them operational.

Surveillance under the new framework will incorporate areas such as macro-economic imbalances that were hitherto not systematically part of surveillance. Also, surveillance will henceforth be conducted in an integrated fashion, meaning that the reporting on fiscal policy under the Stability and Growth Pact on the one hand and the reporting on macroeconomic imbalances and macro-relevant structural reforms will occur simultaneously. This alignment in time will mean that the basis for the policy guidance will be a fully integrated analysis across policy areas for each Member State.

Within fiscal surveillance the European Council agreed to strengthen the preventive and corrective arms of the SGP, with sanctions attached to the consolidation path towards the medium term objective; to give much more prominent role to debt and overall sustainability; to ensure that all Member States have national budgetary rules and medium term budgetary frameworks in line with the Stability and Growth Pact; and to ensure the quality of statistical data by making statistical offices fully independent for data provision.

In order to safeguard macroeconomic stability and to prevent harmful macroeconomic imbalances, the Council agreed to develop a scoreboard to better assess competitiveness developments and imbalances in Member States and to allow for an early detection of unsustainable trends. The Council also called for developing an effective surveillance framework, reflecting the particular situation of euro area Member States. Moreover, as of 2011 all strands of surveillance will be coordinated together in the first half of the year in order to give clear ex ante guidance for all economic policies, and especially fiscal policy, on the national level in the second half of the year.