Short-term economic outlook

The authorities broadly share staff’s view on the outlook, particularly that a successful handling of the sovereign-debt crisis and tackling negative feedback loops between banks and sovereigns are essential for increasing investor and consumer confidence and the return to a recovery path. The Commission services’ spring forecast suggests that, for the year 2012 as a whole, GDP is expected to shrink by about 0.3% before recovering in 2013 to a rate of around 1%. Given weak output growth, unemployment rates are expected to remain close to current levels. Risks to the growth outlook are elevated and tilted to the downside. The main risk remains an aggravation of the sovereign-debt crisis with financial contagion and a sharp drop in credit availability. Another prominent downside risk stems from geopolitical uncertainty that could lead to a surge in oil prices.

The real economy continues to suffer from the impact of the European sovereign-debt crisis. In the first half of 2012, tensions in financial markets only temporarily eased in the wake of policy decisions and unconventional liquidity provision; confidence has stopped deteriorating but remains at low levels. In the first quarter output remained stable, but up to mid-2012 unemployment has been increasing further and consumer price inflation has remained above long-term averages. Leading indicators and survey data (e.g. Economic Sentiment Indicator, Eurozone PMIs) do not provide encouraging signs for the near-term outlook. The euro area remains faced with elevated financial stress and with the need to complete the adjustment of internal and external imbalances, to repair financial sectors and to achieve sustainable public finances. Market expectations that further efforts are needed in these areas cast shadows over the outlook for the real economy.

Monetary policy and the outlook for price stability

Early July, the ECB decided to lower its key interest rates by 25 basis points. This step was motivated by further dampened inflationary pressure over the medium term, as some downside risks to economic activity have materialised. As a result, our main policy rate (MRO rate) now stands at 0.75% while the deposit rate stands at 0.0%.

Euro area annual inflation was 2.4% in June 2012 (Eurostat flash estimate), unchanged from May. Inflation should decline further in the course of 2012 and be again below 2% in 2013. Underlying price pressures should remain moderate over the medium term given modest growth and well-anchored inflation expectations. Information from the monetary analysis is consistent with price developments remaining in line with price stability over the medium term. On-going weak loan growth largely reflects the current cyclical situation, heightened risk aversion, and balance sheet adjustments of households and firms which weigh on credit demand. Risks to the outlook for inflation are broadly balanced over the medium term: on the downside they relate to weaker than expected euro area growth; on the upside risks could stem from further increases in indirect taxes and higher than expected energy prices.

As regards non-standard monetary policy measures, the ECB in June decided that all Eurosystem refinancing operations will continue to be conducted as fixed-rate tender procedures with full allotment for as long as necessary and at least until the end of the last maintenance period of 2012, on 15 January 2013. Furthermore, measures were taken to improve access of the banking sector to these operations by enhancing collateral availability, notably as regards asset-backed securities. Reflecting demand for ECB refinancing operations, there is a large amount of excess liquidity in the euro area banking system at present.

Fiscal policy

Authorities share the general view reflected in the staff assessment of the fiscal situation of the euro area, which shows a need for consolidation, which is essential to restore confidence though this is intertwined with short-term negative prospects for growth. Of paramount importance is the principle of differentiated consolidation, shared by the Staff report, which judges budgetary adjustment needs on a country-by-country basis. Furthermore, consolidation must be as growth-friendly as possible and should be underpinned by structural reforms to boost growth potential. The multi-annual fiscal adjustment plans of Member States that are coordinated at the Union level and guided by the overhauled fiscal governance architecture following the ‘six-pack’ reforms lend significant credibility to the euro area’s long-term fiscal adjustment aim, especially so if accompanied by structural reforms.

Authorities would further like to stress that the fiscal effort under the Stability and Growth Pact (SGP) has been assessed in cyclically-adjustment terms since 2005, and indeed constitutes a cornerstone of fiscal policy coordination in the euro area and EU. Any impression that a structural adjustment focus constitutes a ‘flexible’ interpretation of the Pact is therefore inaccurate. It should also be noted that the Stability and Growth Pact duly guides fiscal policies based on both nominal and structural budget balance targets. Consolidation in 2011 has been in line with plans in spite of lower-than-planned growth with a sizeable reduction in deficit of more than 2 pp. of GDP in the euro area. It should further be noted that, contrary to the assertion in the staff’s accompanying Selected Issues paper, planned fiscal efforts in the euro area overall do not fall significantly short of SGP requirements. According to current budgetary plans by euro area Member States in their Stability Programmes, Member States will implement structural adjustment high enough to improve their structural fiscal position by 1½ pp. of GDP in 2012 and 1 pp. of GDP in 2013 in the euro area, so as to generally respect the expenditure rule and the progress towards the debt benchmark over the planning period (up to 2015), both rules introduced by the ‘6-pack’. According to SGP budgetary plans and Commission services’ macroeconomic projections, on which SGP requirements should be assessed, all Member States will respect the debt rule by the end of their transitional period and will be broadly in line with the expenditure benchmark.

Financial sector policies

The Staff Report rightly focuses on the pivotal role that the banking system plays in the current crisis, notably in terms of financial stability concerns emanating from certain banking systems in their own right, as well as from adverse feedback loops between banks and sovereigns. Ambitious restructuring measures have been launched to strengthen vulnerable banking systems either using resources set aside through the financial programmes dedicated to countries under EU assistance programmes, or through programmes directed specifically at recapitalization and restructuring of individual banks.

Authorities further stress that the October 2011 recapitalization exercise performed by the European Banking Authority (EBA) represents an indispensable step towards addressing financial stability concerns, and therefore merits mention. The 2011 EBA recommendation required 71 banks to establish an additional capital buffer, including a buffer for sovereign exposures, such that banks’ Core Tier 1 capital reaches a level of 9% by the end of June 2012. In accordance with the EBA overview report, the recommendation is being implemented with success on aggregate, as the EBA’s initial estimates for banks’ capital plans are in excess of the estimated capital gap by no less than 26%. Moreover, and contrary to widespread criticism, the exercise does not appear to have been accompanied by disruptive deleveraging. Overall, the exercise represents a valuable tool to better scrutinize the deleveraging process that is ongoing in the euro area banking system and to make sure it does not harm the flow of credit towards the real economy.

Financial stability mechanisms

The euro area has made significant progress on enhancing and increasing its firewalls, notably by agreeing on an improved ESM Treaty, signed on 2 February 2012. The new ESM Treaty establishes a permanent European Stability Mechanism which will provide the Eurozone firewall with a full fresh lending capacity of €500bn. Combined with the already engaged EFSF fund, the overall firewall power is €700bn., as agreed at the 30 March Eurogroup meeting. The authorities confirm that preparations for the ESM have advanced well and all efforts are now undertaken to finalise as soon as possible the Treaty ratification process so that the new mechanism can become operational.

The Euro Area Summit decisions of 29 June reaffirm the strong commitment of the euro area to do whatever is necessary to ensure financial stability, in particular through the flexible and efficient use of existing EFSF/ESM instruments, in order to stabilise markets for Member States respecting their EU commitments. As an immediate follow-up, the ECB will serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner. Furthermore, the decision to allow the ESM to engage in the direct recapitalisation of banks once an effective single supervisory mechanism is established marks important progress towards more flexibility but also towards reducing the bank-sovereign link. This measure, together with the decision that ESM assistance will not carry preferred creditor status for Spain, is likely to have a positive effect on the economic and fiscal situation in Spain.

Banking Union

With regard to the authorities’ plans for moving towards a banking union, significant progress has been made at the 28/29 June summit, where the euro area Heads of State or Government stated that proposals for a single supervisory mechanism involving the ECB will be presented by the Commission in September or October. The authorities consider banking union proposals as a matter of priority. They agree that the existing EFSF/ESM framework could play a role in deepening financial integration in the euro area. In particular, as also suggested in the Staff Report, the ESM might play a role in financing recapitalisation once an effective single supervision mechanism is in place. Furthermore, in order to establish a more unified prudential framework, the Commission’s legislative proposals for a single rulebook - a unified financial regulation framework – will be considered as a priority, as will the Commission proposals concerning deposit guarantees and bank resolution.

External Imbalances

The euro area as a whole currently registers a current account that is practically balanced, as has been the case in almost every single year since the creation of the currency area. The Commission’s spring projections indicate that the area’s current account will slightly strengthen in 2012 and 2013, while remaining close to the equilibrium. The net international investment position (NIIP) of the euro area is slightly negative, and should remain relatively stable; it is not as such a source of any specific tensions.

In spite of this benign view of the currency area as a whole, the authorities do concur with the Fund’s staff that external imbalances of some euro area countries remain unsustainably large, a persistent source of financial tension and an indicator of resource misallocation. The reduction in those imbalances is a major challenge and a crucial objective for the euro area. Anyhow, over the last four years, there has already been a tangible reduction in these imbalances, in particular in the most vulnerable countries. Notably for Greece and Portugal, the reduction in their current account deficit (2008-12) has been of, or above, 9 percentage point of GDP, while the external accounts of Spain, Cyprus, Slovenia and Slovakia are also moving in the right direction. While part of the correction is driven by the different cyclical position of the economies, some of the improvement is estimated to be structural. The Fund’s staff rightly indicates that the correction in imbalances has been mainly the result of a compression in imports resulting from a contraction in domestic demand in these countries; however, in several countries, such as in Portugal, exports have shown promising dynamism.

While the Staff Report rightly calls for progress in real effective exchange rate adjustment, some adjustment on this front is already evident. The authorities agree that a faster adjustment in price and cost competitiveness in the vulnerable countries would be desirable. The labour market reforms that several countries are adopting with voluntarism contribute to this adjustment and have to be tailor-made depending on the characteristics of each labour market. The adjustment in costs should continue not only in the programme countries, but also in other deficit economies.

Policy arrangements under the European Semester as part of the Macroeconomic Imbalances Procedure are guiding Member States’ external adjustment through in-depth country reviews examine causes of, and suggest responses to, harmful macroeconomic imbalances in a number of selected countries – 12 for the first review. Furthermore, the differentiated pace of fiscal consolidation and the decisive structural reforms that both the Commission and the Eurogroup have been promoting should also contribute to address external imbalances. In deficit countries, they should increase labour productivity and overall competitiveness, while in surplus countries households’ disposable income and the business environment would be supported, which will translate in higher consumption, investment and imports and have positive spill-overs for the whole euro-area. Wage developments in surplus countries also suggest an ongoing rebalancing.

Growth and Structural Reforms

Structural reforms are critically important to enhance the EU economy’s overall efficiency and speed up its capacity to adjust. In a positive feedback loop an improved growth outlook will support other objectives by enhancing confidence and boosting employment, contributing to successful fiscal consolidation and to the stability in the banking sector, as well as easing the situation in vulnerable countries. The comprehensive overhaul of economic governance and surveillance that has occurred since the crisis has upgraded economic policy coordination in the euro area, as the successful conclusion of the second European Semester by the June European Council shows. The EU Semester comprises country-specific recommendations in the fiscal and structural domain for each Member State plus the euro area as a whole. The focus on implementation of structural and fiscal measures has been sharpened through concrete country-specific recommendations for each and every Member State, building in part on the follow-up to last year’s Semester.

As a means to drive forward Europe’s focus on growth and prosperity, the June European Council further adopted a new Compact for Growth and Jobs for Europe. It presents a coherent set of priorities for action at national, EU and euro area levels. Euro area Member States will benefit from measures agreed at the EU level as part of the Compact, which amount to €120bn. (1% of EU GDP). These include a reallocation of EU structural funds, focusing them on growth and competitiveness, increasing the lending capacity of the EIB so as to boost investment at the European level and launching a pilot phase for project bonds. These measures will allow reaching a better balance between fiscal discipline and growth prospects, as advocated by the Staff report. Authorities note that a further impetus for growth will come from realising the full potential of the Single Market, especially for the services sector.