Euro Area Policies: Staff Report for the 2014 Article IV Consultation With Member Countries

This 2014 Article IV Consultation highlights that the euro area recovery is taking hold. Real output has expanded for four consecutive quarters, and financial market sentiment has improved markedly. Complementary policy actions have supported demand, boosted investor confidence, and eased financial conditions. At the national level, governments have made further progress repairing sovereign and bank balance sheets and implementing structure reforms to restore competitiveness. At the area-wide level, the ECB has taken a wider range of measures to support demand and address fragmentation. Over the medium term, there is a risk of stagnation, which could result from persistently depressed domestic demand owing to deleveraging, insufficient policy action, and stalled structural reforms.


This 2014 Article IV Consultation highlights that the euro area recovery is taking hold. Real output has expanded for four consecutive quarters, and financial market sentiment has improved markedly. Complementary policy actions have supported demand, boosted investor confidence, and eased financial conditions. At the national level, governments have made further progress repairing sovereign and bank balance sheets and implementing structure reforms to restore competitiveness. At the area-wide level, the ECB has taken a wider range of measures to support demand and address fragmentation. Over the medium term, there is a risk of stagnation, which could result from persistently depressed domestic demand owing to deleveraging, insufficient policy action, and stalled structural reforms.

Context: From Crisis to Recovery

1. The euro area recovery is taking hold (Figure 1). Real activity has expanded for four consecutive quarters. An incipient revival in domestic demand, owing partly to reduced fiscal drag, is adding to the impetus from net exports.

Figure 1.
Figure 1.

Euro Area: High Frequency Indicators

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: Haver Analytics and Eurostat.

Domestic and Foreign Demand

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001


EA Fiscal Consolidation

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

2. Financial market sentiment has improved dramatically (Figure 2). Sovereign and corporate yields have fallen markedly, benefiting from increasing foreign demand. This has narrowed sovereign spreads between stressed and core economies, and supported corporate bond issuance and equity markets across the region. Bank funding costs have also declined, helping banks to raise capital and deleverage their balance sheets.

Figure 2.
Figure 2.

Financial Market Developments

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: Bloomberg; Bank of America Merrill Lynch; ECB; National Central Banks; IMF WEO and IFS; and staff calculations.1/ EUR-denominated NFC and Financial bonds. 1–5 year tenor.2/ GIP: Greece, Ireland, and Portugal. Others: Austria. Belgium. Finland, and the Netherlands.3/ Loans < €1 million, maturity 1-5 years, new business. Loans are an unweighted average. Core: Germany, France, Belgium, the Netherlands. Stressed: Greece, Ireland (excluded from May 2011 onwards), Italy, Portugal, Spain.4/ Spread between 24 and 12 month tenors.

3. Strong policy actions have boosted investor confidence and laid the foundations for recovery. At the national level, governments have made further progress repairing sovereign and bank balance sheets and implementing structural reforms to restore competitiveness. At the area-wide level, the ECB has taken a wide range of measures to support demand and address fragmentation. The Comprehensive Assessment of systemically important banks is on track to be completed in October 2014 before the ECB assumes supervisory responsibilities in November 2014. Further progress on building a banking union—such as the agreements on a Single Resolution Mechanism (SRM), backed by a Single Resolution Fund (SRF), the Bank Recovery and Resolution Directive (BRRD), and the deposit insurance harmonization directive—has demonstrated the collective commitment to EMU.

4. But the appetite for further integration has diminished. The euro-skeptic outcome of the European elections may pose risks to the single market (particularly the free flow of labor) and test the credibility of the nascent fiscal governance framework. With the economic recovery taking hold and financial markets rallying, additional progress on reforms may be prone to reform fatigue—both at the national and euro area level.

5. And lingering damage from the crisis has manifested itself in several ways.

  • Real activity and investment in the euro area have yet to reach pre-crisis levels. In the first quarter of 2014, euro area growth was weaker than expected and unevenly distributed across countries. Investment continues to be constrained by limited access to credit in stressed countries (Box 1).

  • Financial markets are still fragmented. Private borrowing costs remain too high in stressed economies. The flow of credit to the private sector in stressed economies is contracting at a faster rate than for the euro area as a whole, with SMEs in particular subject to credit rationing. Moreover, cross-border banking flows continue to shrink, suggesting that liquidity provision is becoming splintered along national lines.

  • Inflation remains worryingly low. Both headline and underlying inflation rates are fluctuating below 1 percent—away from the ECB’s price stability objective of close to (but below) 2 percent for headline inflation (Figure 3). They remain low even in the core. Energy and food price developments, euro appreciation, and structural reforms have contributed to disinflationary pressures but cannot fully explain them. The still-sizeable output gap continues to pull down inflation. Although long-term inflation expectations remain anchored, short- and medium-term expectations have been drifting down.

  • Unemployment and debt are still stubbornly high. The average unemployment rate for the euro area remains at 12 percent, although it is much higher in economies under stress. Youth unemployment is even more elevated, averaging 24 percent across the region, but with unprecedented highs in stressed economies (e.g., over 50 percent in Greece). Private and public debt levels remain elevated in many countries (Figure 4).

Figure 3.
Figure 3.

Euro Area Inflation Developments

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: Haver Analytics; Eurostat; and IMF staff calculations.
Figure 4.
Figure 4.

Debt Overhang in the Euro Area

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: ECB, OECD, IMF IFS and staff calculations.1/ For the Netherlands, first observation is 2005. Corporate debt includes intercompany loans which can differ significantly across countries.2/ France and EA are 2012 data.3/ Long term average since 1999 but varies with data availability.4/ First observation for Netherlands is 2005. Country data are not consolidated, EA is consolidated.

SME Real Corporate Lending Rates

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001


Gross Fixed Capital Formation: 2014Q1

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

6. For the euro area as a whole, the external position is assessed to be broadly in line with medium-term fundamentals and desired policies (Figure 5). But this masks the asymmetry of past adjustments and some continued imbalances, viz. an undervaluation in some creditor economies and overvaluation in most debtor economies (see 2014 External Sector Report). In debtor countries, relative price adjustments have been proceeding gradually. While these efforts have contributed to a rebound in exports, slumping internal demand has accounted for much of the reduction in current account deficits in these economies. This has not been matched by stronger demand and lower external surpluses in the core. Hence, the current account surplus of the euro area as a whole has grown further, putting upward pressure on the euro. Staff analysis indicates that further adjustments in relative prices are still needed for some countries to regain competitiveness. Such adjustments will be increasingly difficult to achieve, given nominal rigidities in these countries and low inflation in trading partners. A fall in the surpluses of creditor countries would allow debtor country surpluses to increase further without pressure for euro appreciation. In addition, although the euro is broadly in equilibrium in real terms, a weaker nominal exchange rate (and higher inflation) would help support the recovery by improving cyclical conditions.

Figure 5.
Figure 5.

External Sector Developments

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook database; and IMF staff calculations.1/ Peats: 08Q1 for ESP, 08Q2 for IRL and PRT, 09Q4 for GRC, DEU, FRA, and ITA.2/ The distance between the dots and bars represents changes from 2008 to the latest available data, in general 2013Q3.3/ NFA/GDP implied by WEO projections, assuming no stock-flow adjustments or valuation effects going forward.

Investment in the Euro Area: Why has it been Weak?1/

Investment has been hit hard since the onset of the crisis. It remains below its pre-crisis level, particularly in stressed countries and it has been weaker than in most previous recessions and financial crises

Staff analysis shows that output changes can explain broad trends in investment in the euro area and selected individual countries. But, in most cases and with the exception of Spain, a model controlling for output changes only does not fully account for the decline in real non-residential private investment after the European sovereign debt crisis.

The elevated cost of capital, greater financial constraints, high corporate leverage, and uncertainty have also weighed on investment across the euro area. The relative importance of different factors varies across countries. The real cost of capital is important in explaining investment in many cases.2 In addition, financial constraints (from the EC consumer and business survey) have limited investment, particularly in stressed countries. High corporate sector leverage and uncertainty are additional impediments to investment in Italy, Spain, and to a lesser extent in Portugal and France.


Euro Area vs. Other Financial Crisis Episodes

(Percent of GDP)

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: WEO 2014, Chapter 3; and staff calculations.Notes: Gross fixed capital formation in percent of GDP. The entire sample of advanced economy financial crises between 1970 and 2007 identified by Laeven and Valencia (2012). Dashed red lines denote 90 percent confidence bands; and black line denotes the actual evolution of the investment-to-GDP ratio in the euro area from 2007 to 2013. X-axis units are years; t = 0 denotes the year of the financial crisis.

Output changes and country specific impediments explain the weak investment performance well. While output dynamics play a dominant role in determining investment, the real cost of capital, credit rationing (proxied by a financial constraints variable), high corporate indebtedness, and uncertainty are additional factors pulling down investment across the euro area, particularly after the European sovereign debt crisis. For example, while investment in cumulative terms (since 2010Q2) has been below the levels that would have been predicted by controlling only for output changes (about 3 to 6 percent of GDP), once the other factors are controlled for the “missing” investment declines to about ½ to 2 percent of GDP.

Investment is expected to pick up as the recovery strengthens and uncertainty declines. However, a sustained recovery in investment will require dealing with the corporate debt overhang and financial fragmentation. Corporate debt-to-equity remains elevated in some stressed countries, and the deleveraging process is still at an early stage. At the same time, borrowing costs need to be substantially lower particularly for smaller firms.

1 Prepared by Bergljot Barkbu, Pelin Berkmen, Pavel Lukyantsau, Sergejs Saksonovs, and Hanni Schoelermann.2 The real cost of capital is calculated as a weighted average of financing costs of bank loans, corporate bonds, and equities, adjusted for inflation and depreciation. In stressed economies it is currently higher than its historical average, while for Germany it is lower. See the accompanying Selected Issues Paper for further details.

Outlook: A Long Road to Full Recovery

7. Despite recent improvements in financial markets and economic prospects, the obstacles to strong, sustained growth remain substantial.

  • Insufficient aggregate demand is weighing on real activity and pulling down inflation across the euro area, as corporates, households and banks all attempt to repair their balance sheets. Despite the reduced drag from fiscal policy, contracting credit and high borrowing costs are constraining investment in countries with large output gaps, large debt burdens, and high unemployment.

  • Impaired balance sheets continue to inhibit monetary transmission and the flow of credit, particularly to SMEs. Weakness in banks’ balance sheets and uncertainty about their quality are contributing to fragmentation, constraining the ability and willingness of banks to support credit and investment. Corporate and household debt overhangs in some countries are further reinforcing fragmentation along national borders.

  • Remaining structural gaps in capital, labor, and product markets present hurdles to financing investment, deploying resources from non-tradable to tradable sectors, adjusting relative prices, raising productivity, and creating jobs.

8. Against this backdrop, the outlook is for a modest recovery and subdued inflation (Table 1).

  • Growth is projected at a little over 1 percent this year and 1½ percent next year. This is predicated on a further pick-up in domestic demand, owing to limited fiscal drag, better lending conditions, and resilient external demand. In the medium run, the euro area economy is expected to expand at a moderate pace (1½ percent), reflecting the many constraints to growth bequeathed by the crisis. Thus, the output gap is not expected to close until 2019.

  • Inflation is expected to remain below the ECB’s primary price objective for a protracted period. Persistent output gaps, weak credit conditions, and an impaired monetary transmission mechanism—especially in stressed economies—will combine to contain prices. Annual inflation in the euro area is forecast at 0.7 percent this year, before picking up to 1.2 percent in 2015.

  • The current account surplus of about 2¼ percent of GDP is forecast to persist, with the pick-up in domestic economic activity balanced by sustained external demand from major trading partners (e.g., the US and China).

Table 1.

Euro Area: Main Economic Indicators, 2011–19

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Sources: IMF, World Economic Outlook, Global Data Source, DataStream, and Eurostat

Projections are based on aggregation of WEO projections submitted by IMF country teams.

Contribution to growth.

Includes intra-euro area trade.

In percent.

In percent of GDP.

Latest monthly available data for 2014.

Projections are based on member countries’ current account aggregations excluding intra-euro flows and corrected for aggregation discrepancy over the projection period.

9. Risks are still tilted to the downside (Table 2). With limited policy space in the near term, further negative shocks—either domestic or external—could sour financial market sentiment, halt the recovery, and push the economy into lower inflation and even deflation (see Risk Assessment Matrix). Bond market stresses could re-emerge if the AQR or stress tests uncovered unexpectedly large capital shortfalls in the absence of a common fiscal backstop. External risks could stem from a slowdown in emerging market growth, escalation of geopolitical conflict, and an abrupt exit from unconventional monetary policies in the United States (see Spillover Report). Over the medium term, there is a high risk of stagnation, which could stem from persistently depressed domestic demand due to deleveraging, insufficient policy action, and stalled structural reforms. More positively, improved confidence could raise growth above forecast levels. For example, greater political and policy certainty could boost investment sentiment and create a virtuous cycle.

Table 2.

Risk Assessment Matrix1/

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The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of the staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).

10. A protracted stagnation could have significant spillovers on neighboring European countries through trade and financial channels. Staff analysis suggests a 1 percentage point slowdown in the euro area could reduce growth in emerging European countries by an estimated ½-¾ percentage points. Low inflation is already affecting countries in the region, especially those that peg their currencies to the euro, with core inflation in some of these countries in negative territory. In this context, further unconventional monetary easing in the euro area would generate positive spillovers for trade partners by supporting domestic growth and inflation, outweighing potentially adverse effects on balance sheets (due to possible currency depreciation).

The Policy Agenda: Strengthening the Recovery

11. To strengthen the recovery, policy efforts should focus on three priority areas: (1) support demand (to reduce spare capacity and combat low inflation/deflation risks); (2) repair balance sheets and completing the banking union (to tackle fragmentation, revive credit supply, and ensure financial stability); and (3) advance structural reforms (to boost investment, employment, productivity, and foster rebalancing). Such policies would help mitigate risks to the recovery and reduce spillovers from low growth and low inflation to the rest of the world (see Spillover Report).

Providing more demand support to tackle low inflation and strengthen the recovery

12. Further monetary policy easing would counteract the dangers posed by an extended period of low inflation. Several considerations point in the same direction:

  • Damage from “lowflation”: By keeping real interest rates and real debt burdens elevated, very low inflation stifles demand. Given significant downward nominal rigidities in debtor economies and low inflation in creditor economies, it also makes difficult the adjustment in relative prices and real wages that must occur for sustainable growth to take hold.

  • Deflation risk: Negative external shocks and/or further euro appreciation could easily push inflation into negative territory.

  • Undershooting target: A persistent failure to meet the inflation target could undermine central bank credibility and de-anchor inflation expectations. Staff analysis suggests that even a small and temporary decline in inflation expectations could have sizeable output effects (see Spillover Report).

  • Expectations: Past deflationary episodes illustrate that long-term expectations tend to adjust too little and too late to provide a useful signal for monetary policy (Figure 6). In this context, the recent downward movement in short- and medium-rum inflation expectations could be worrisome.

  • Shrinking balance sheet: The contraction of its balance sheet (in the context of LTRO repayments) has made it increasingly difficult for the ECB to credibly communicate that monetary conditions will be kept sufficiently accommodative, particularly when conventional policy space is almost exhausted. This puts upward pressure on the euro, pulling inflation down further.

Figure 6.
Figure 6.

Japan’s Deflation Episode and Current Euro Area Developments

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Source: Consensus Forecasts; ECB; FSA, Bank of Japan, Ministry of Finance; Haver Analytics; National central banks; and WEO.1/ At end-fiscal year (i.e. end-March of following year) except for FY2013 refers to half-year ending September 2012. Credit is based on calendar year. All banks but Shinkin banks included.2/ JPN: leverage in 2002 (beginning of deleveraging) and in 2013. Debt at EA level is non-consolidated.3/ The BoJ is indexed to 1990Q1=100, and the ECB is indexed to 2007Q4=100.

EA Inflation and Inflation Expectations

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001


Interest Rate and Indebtedness

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

13. Most recently, the ECB announced a wide range of actions. Fully in line with past staff recommendations,2 these measures will help tackle low inflation and address fragmentation. Collectively, they should lead to a substantial expansion of liquidity.

  • The reductions in policy interest rates (by 10 basis points for each the MRO and deposit rates, taking the latter to negative territory, and by 35 basis points for the MLF) will provide a credible signal of the ECB’s accommodative stance, and will limit the level and volatility of money market rates. The broad application of the negative deposit rate will ensure that banks do not arbitrage their deposit holdings across other facilities.

  • The targeted credit easing (TLTROs) will support term funding and ensure credit provision. The substantial tenor and successive operations of the TLTROs are likely to attract a wide range of banks, thereby helping to address both fragmentation and low inflation. While the initial TLTRO allocation may offset some of the repayment of the previous 3-year LTRO coming due, the new TLTRO offers significant incentives for banks to use the facility. Nevertheless, the ECB has only indirect control over the expansion of its balance sheet, as take up depends on banks’ demand.

  • The extension of fixed rate full allotment will strengthen the ECB’s forward guidance and ensure the continued availability of liquidity.

  • The suspension of sterilization of the SMP holdings is warranted given low inflation and new measures to boost liquidity. It will help ease money market pressures by freeing up around €165 billion (current SMP holdings).

  • The extension of existing collateral eligibility will enhance access to liquidity facilities for stressed banks.

  • The preparatory work related to outright purchases of ABS is being intensified. If and when implemented, direct ABS purchases would circumvent the banking system, helping to address fragmentation and providing the ECB direct control over the expansion of its balance sheet. However, the ABS market is small, limiting its effectiveness to address low inflation.

Monetary Policy Options 1/

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Check marks reflect subjective evaluation of relative importance of the measures in addressing low inflation and fragmentation.

14. Also reassuring is that if inflation remains too low, the ECB has expressed willingness to do more. In staff’s view, this should involve a substantial balance sheet expansion, including through asset purchases.

  • The deepest potential market for asset purchases—and therefore likely the most effective in significantly expanding the ECB’s balance sheet—is the sovereign bond market. Buying sovereign assets, in proportion to ECB capital key, would reduce government bond yields, induce higher equity and corporate bond values, and ultimately raise demand and inflation expectations across the euro area. Such purchases can work even in a bank-centric system. Higher asset prices caused by ECB purchases would strengthen bank balance sheets and hence their capacity to lend, while stronger corporate balance sheets (from higher equity and bond values) would increase banks’ willingness to lend to them.

  • Private asset purchases may be preferable on many counts, but the volume of eligible securities appears small and yields on assets like covered bonds have already compressed sharply. Buying private assets would also entail very uneven help across the area and favor the banks that hold more marketable assets. Nonetheless, the ECB could allocate a portion of its interventions to these markets. A mix of purchases from highly rated private bond markets (including NFCs and securitized assets) would complement interventions in sovereign markets, directly transmitting lower interest rates to the real economy through the credit channel.

  • A large-scale, non-targeted LTRO on a long-term, fixed-rate basis could also deliver a sizeable expansion of the ECB balance sheet and send a credible signal of the ECB’s accommodative stance. Its impact would be especially powerful if the establishment of the SSM facilitates the cross-border flow of liquidity within and between banks.

  • By signaling the ECB’s commitment to its price stability objective, the above measures would likely have an important impact through expectations. They may also counter appreciation pressure on the euro, pushing up flagging inflation.

15. The broadly neutral (area-wide) fiscal stance this year strikes a balance at the current juncture (Table 3 and Figure 7). On the one hand, persistently high debt ratios continue to cast a shadow over the medium term, and risks to fiscal forecasts remain significant. On the other hand, the still-large output gap would argue for fiscal support. Against this background, the fiscal response has to remain flexible. Large negative growth surprises should not trigger additional consolidation efforts. Moreover, if deflation risks materialize and monetary policy options are depleted, the escape clauses in the fiscal framework may need to be used to respond in these circumstances.

Table 3.

A Scorecard Approach to the Near-Term Fiscal Stance from April 2014 WEO

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Includes large scale purchase of government securities, and credit easing measures.

Primary gap defined as P-P*. P is the structural primary balance as % GDP in 2013. P* is the debt stabilizing primary balance in the medium term defined as (r-g)*d, where r is a weighted average (by average maturity) of the 2013 effective interest rate and the average 10-year yield over the last 6 months minus 2%, g is av. potential growth in 2016-2018 and d is the debt ratio in 2013.

Weighted average of subcategories (red = 5, yellow = 4, grey = 3, light green = 2, dark green =1). Monetary policy space modifies the weight on the cycle: i.e., if full monetary policy space, fiscal policy is determined by sustainability concerns. If zero monetary space, then fiscal policy determined by the weighted average of cyclical and sustainability factors. The weight for cyclal conditions are reduced by: “Limited” = 25% adjustment, “significant” = 50%, “substantial” = 75%, “full” = 100%.

The values for each variable are colored depending on their signal for the fiscal stance based on the thresholds.

Staff estimated structural headline adjustment from Authorities’ budget plans submitted to EC under the Six Pack, as percent of potential GDP, slightly different from change in CAPB.

Staff advice for Germany is to consider an additional deficit of -0.5 percent of GDP, with the caveat that spending should be tilted towards public investment.

France Stability Program 2014-15, April 2014.

U.K. Fiscal year, and public sector.

Fiscal Monitor April 2014, IMF.

Figure 7.
Figure 7.

Fiscal Developments and Policies

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: WEO and IMF staff calculations.

16. While significant progress has been made to strengthen the fiscal governance framework in recent years, critical gaps remain. Successive reforms of the SGP have had many positive elements, including stronger economic underpinnings for the rules; a tighter link between fiscal targets and the debt objective; better enforcement; and greater flexibility and specificity. Nonetheless, these reforms have made the system increasingly complicated, creating risks of overlap and inconsistency between rules, as well as difficulties of public communication (Box 2). Staff advised examining the complexity of the framework over the medium term, and looking into the possibility of reducing the number of rules (e.g., by consolidating the preventive and corrective arms of the SGP and possibly focusing on some measure of the structural balance as the single operational target). Another area is to enhance the credibility of the rules and foster compliance (e.g., by introducing administrative sanctions, accelerating procedures in predefined cases, and continuing to strengthen national fiscal frameworks).

The Stability and Growth Pact—Design and Implementation Issues1/

The implementation of the fiscal governance framework has revealed gaps in the design of rules and enforcement mechanisms:

  • The rules of the system have become exceedingly complex. Successive legislative changes have added new constraints and procedures, creating possible inconsistencies and redundancies. Individual rules have also become more sophisticated, in particular those specified in cyclically-adjusted terms.

  • The structural budget balance is undermined by large measurement errors. The structural balance indicator is now at the center of the fiscal surveillance system both in the preventive and the corrective arms. However, its calculation relies on output gap estimates, which are generally underestimated in real time, making the structural balance prone to significant downward revisions (on the order of 0.5 percent of potential GDP per year).

  • The SGP may reduce incentives to foster long-term growth. Two issues feature prominently in current discussions. The first is that the SGP may limit the space to finance structural reforms that entail sizeable short-term budgetary costs. Although the 2005 reform explicitly recognized that these costs should be accommodated, the present framework has so far only been applied to some types of pension reforms. Going beyond pension reforms is proving contentious. A second question is whether the MTO and, to a lesser extent, the 3 percent deficit cap, discourages public investment by limiting the capacity to borrow to fund projects that increase long-term growth potential.

  • Enforcement mechanisms may need to be strengthened further. Sanctions and corrective actions are mild compared to existing federations. In addition, the unique EU governance structure undermines the incentives for strict implementation (the Council has the final word on monitoring decisions, while the EC only makes recommendations), although recent changes to voting procedures may have partially mitigated this problem. Finally, supranational controls are not sufficient to ensure fiscal discipline at the national level, as credible enforcement has also to take place at the level where fiscal sovereignty is exerted.


Supranational Constraints and Rules on Fiscal Aggregates

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

1 Prepared by Luc Eyraud (FAD) and Tao Wu (EUR).

Mending balance sheets and completing the banking union to reduce fragmentation and revive credit

17. The ECB’s Comprehensive Assessment of bank balance sheets is well underway, with results expected to be announced in October 2014. Importantly, the asset quality review (AQR) establishes consistent definitions of capital and NPLs across national jurisdictions, and incorporates independent third party involvement in valuing bank assets, thereby ensuring cross-comparability of asset quality and providing transparency to the market.


Timeline of the ECB’s Comprehensive Assessment

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

18. In general, the exercise is proceeding well (Figure 8). Capital hurdle rates are appropriately set higher than the regulatory minimum under Basel III: an 8 percent Common Equity Tier 1 (CET1) ratio is required under the baseline and 5.5 percent under the stress scenario. However, the treatment of sovereign risk might be perceived as too lenient by markets.3 Staff recommended development of an effective and clear communications strategy for the test results—particularly in light of some national discretion over the treatment of sovereign holdings, the lack of an adverse scenario incorporating a complete assessment of deflation risks, and the heterogeneity in stress test parameters across national and EU-wide variants. Staff welcomed independent third-party involvement in the AQR, but urged that efforts be made to ensure uniformity in the level of such involvement across countries.

Figure 8.
Figure 8.

Euro Area: Banking Sector Developments

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Sources: Bloomberg LP; Dealogic; ECB, World Bank, World Development Indicators database, and IMF staff calculations.1/ Core economies = AUT, BEL, DEU, FRA, NLD; stressed economies = ESP, GRC, IRL, ITA, and PRT.2/ Core economies = BEL, DEU, FRA, and NLD; stressed economies = ESP, IRL, ITA, and PRT.

19. Banks falling below the required capital ratios will be expected to remedy the shortfall speedily. Banks falling below the AQR requirement will have 6 months to fill the gap, while banks falling below the stress test requirement in the adverse scenario will have 9 months. Moreover, banks will be asked to present a formal plan describing their recapitalization strategy to supervisors—for their approval—within two weeks of the results being announced. Staff welcomed the simplicity and clarity of this approach, but raised two issues:

  • Timetable: Staff supported the ambitious recapitalization timetable. As noted earlier, many banks have been raising capital well in advance of the publication of the AQR and stress test results. This reduces the chances that they will need to raise capital after the exercise. However, if capital needs are high and the market environment unfavorable, it is reassuring that the framework has some flexibility to respond to such circumstances. But the authorities should continue to encourage banks potentially in need of capital to act pro-actively, taking advantage of current favorable market conditions.

  • Bail-ins: If a bank proves unable to raise its minimum capital ratio to the desired level, the conversion of subordinated debt to capital must be applied before recourse to public support under EU state aid rules. Staff urged careful consideration of financial stability concerns when applying any capital conversion or bail-in provisions: if necessary, the systemic risk exception or proportionality principle should be invoked to mitigate risks.

20. The credibility of the exercise would be markedly enhanced by a common fiscal backstop, which would help sever sovereign-bank links. In particular, direct recapitalization of banks from the ESM should be an option in case private capital is insufficient. There has been recent political progress in making operational ESM direct recap. But the timetable remains uncertain and the proposed threshold to access the mechanism is very high: direct recap must be preceded by bail-ins of at least 8 percent of eligible bank liabilities (in line with the BRRD); and the country’s fiscal position must rule out the possibility of indirect recapitalization (via the sovereign) from the ESM.


Banking Union - A Qualitative Review

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

21. There has been substantial progress toward a banking union along three dimensions: bank regulation, supervision, and resolution. However, the design will not fully sever bank-sovereign links in the foreseeable future, possibly delaying financial reintegration.

  • Single Supervisory Mechanism (SSM): The SSM is on-track to become fully operational in November 2014. The transition to a single supervisor should increase the fungibility of liquidity within cross-border banking groups in the euro area, thereby reducing financial fragmentation. Joint supervisory teams are being created to oversee individual banks, with staff drawn mainly from national central banks and regulatory authorities, but also the ECB. Staff stressed the need to guard against implementation risks, including the treatment of home-host supervisory coordination and—for banks with relevant activities outside the euro area—the importance of reciprocal macro-prudential policies through supervisory colleges, as discussed in the 2013 FSAP.

  • Single Resolution Mechanism and Fund (SRM/SRF): Compared with earlier plans, the final agreement specifies a more streamlined decision-making process with faster mutualization. However, the SRM decision-making procedure remains cumbersome, the SRF transition period too long (8 years), and its financial capacity limited given the concentration and size of large financial institutions. This raises questions about the ability of the framework to deliver least-cost, effective, and timely resolution in a systemic banking crisis. The possibility of a credit line with the ESM will help, but such concerns could be more directly mitigated by making direct bank recapitalization via the ESM less stringent.

  • Backstop: There remains a need for a common fiscal backstop that could be deployed quickly in the event of a systemic crisis, when industry-based funds and purely national deposit insurance schemes may be insufficient. By supporting confidence in the banking sector, the availability of such a backstop could reduce the likelihood it would be used. Moreover, potential support measures for systemically relevant non-bank activities, such as insurance and central counterparties may need to be considered.

22. Macro-prudential authority will be shared between the SSM and national competent authorities (NCAs). While the SSM will take over primary supervision of the largest banks from the NCAs, the ECB and the national central banks in the SSM area, via the Financial Stability Committee (FSC), will assess any system-wide vulnerabilities and the scope for macro-prudential policies. Staff urged the ECB to continue joint discussions with national authorities and the European Systemic Risk Board (ESRB) on macro-prudential coordination under the new dispensation (as highlighted in last year’s FSAP recommendations), especially with respect to EU banking activities outside the euro area and policy measures related to non-banking sectors. Staff also encouraged effective cooperation with national authorities on anti-money laundering (AML) frameworks.

23. Working out the corporate debt overhang will play an important role in repairing bank balance sheets and supporting investment. Although many countries have taken steps to reform their insolvency regimes, continued progress is needed on harmonizing and strengthening national insolvency frameworks, encompassing terminology, definitions and processes. Measures should also be taken to: (1) facilitate out-of-court settlements; (2) reduce impediments to more efficient debt restructuring (e.g. incentives for creditor coordination in debt restructuring, and schemes to provide priority financing for restructured entities); (3) standardize debt restructuring contracts for SMEs; (4) strengthen liquidation procedures to enable rapid exit of non-viable firms; and (5) introduce guidance on tax incentives and debt resolution procedures in line with international best practice.

Advancing structural reforms to boost growth and address imbalances

24. Structural reforms can play an important role in reviving investment, employment, and productivity, as well as resolving intra-euro area imbalances. To this end, national reforms to improve labor market functioning and increase competition in product and service sectors need to progress further (Table 4 summarizes staff’s country-specific recommendations and priorities). These would be helped by reform efforts at the euro area level to implement the Services Directive, negotiate free trade agreements, and further integrate energy markets to mitigate possible disruptions in global commodity markets due to geopolitical events. Specifically, an energy strategy aimed at increasing interconnections of national networks could help ensure security of gas and electricity supply by pooling and allocating energy reserves across countries more efficiently. In addition, some reforms, such as capital market development, youth unemployment, and rebalancing have both national and area-wide dimensions.

Table 4.

Structural Reform Plans and Progress in Selected Countries

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Source: IMF country teams

25. Improving SMEs’ access to finance is crucial to investment and growth. SMEs account for around 80 percent of employment and 70 percent of value added in Italy, Spain, and Portugal. SMEs applying for loans are experiencing difficulties in obtaining credit from banks, particularly in Spain and Italy, where about a fifth of SMEs were credit rationed during the last 6 months, either because their applications were rejected or offers were prohibitively expensive.

26. Developing diversified funding markets would help ensure lending to viable smaller firms and enhance financial system resilience (Box 3). In particular, SME securitization could draw upon a large existing pool of assets and reduce the high reliance on bank-intermediated funding, while helping firms to rebalance their financial structure towards longer maturities and attracting new investors. Securitization would boost bank liquidity, free up regulatory capital, and allow banks to lend again. SME securitization could also improve the transmission of monetary policy, facilitate cross-border investment, and boost the growth of other funding markets. Staff recommended policy actions in the following areas:

  • Regulatory frameworks: Capital regulations should appropriately differentiate between high-and low-quality SME-backed securities. Most securitization transactions in Europe showed remarkable resilience during the financial crisis. This was largely due to conservative loan origination standards; high equity participation and servicing being retained by the originator, together with issuer due diligence; and adequate post-issuance monitoring. Reducing the capital intensity of safer structures would encourage the supply of simpler (less capital intensive) transactions, with greater transparency of the underlying SME loans. This could also involve a more even capital treatment for different institutional investors (banks, insurance companies, and asset managers) and the use of SME loans as collateral in refinancing operations. Harmonization of reporting requirements would not only broaden the investor base but create scope for developing securitization instruments that pool SME loans on an EU-wide basis.

  • Public sector support: The official sector should be a catalyst by creating institutional demand when markets are insufficiently developed. Area-wide and national initiatives—such as the joint EC–EIB SME initiative, the EIB-EIF securitization program, or plans by several national central banks to support the bundling of SME-backed loans for ECB refinancing—move in the right direction, but should be broadened to have a significant impact.

Capital Market Development: SME Financing in the Euro Area1/

The corporate sector in Europe is highly dependent on bank-based financing, with only the largest firms able to directly access capital markets. Developing diversified funding for small- and medium-sized enterprises (SMEs), including through securitization, could help overcome the adverse effects of financial fragmentation and support cross-border investment.

But SME securitization faces several challenges.2 Unfavorable economic terms (e.g., the high cost of issuance, a lack of uniform reporting standards, and cumbersome insolvency regimes) and adverse cyclical factors (e.g., cheap alternative funding sources for banks and rising SME loan default rates in stressed economies) reduce the incentives for issuance. In fact, most recent transactions have been arranged for funding purposes and do not offer any regulatory capital relief for issuing banks. In 2013, more than half of all issuances were “retained”—well in excess of the 5 percent “skin in the game” regulatory requirement under CRD2—for use as collateral for short-term funding from Eurosystem liquidity facilities (“securitization to repo”). Moreover, pending regulatory changes—Basel III for banks and Solvency II for insurance companies—have weakened the institutional investor base by adversely affecting the capital intensity of holding highly-rated securitization transactions and their eligibility for liquidity purposes.

Current initiatives to improve the economics of SME securitization are too small and too narrowly focused to have a broad impact. A joint EC-EIB SME lending program using EU structural funds will be operational by end-2014, and will complement the existing funding schemes for SMEs provided by the EIB/EIF. Both efforts provide greater official support to mostly bank-sponsored SME lending, but fall short of standardized mechanisms to entice non-banking funding sources and schemes that would allow direct capital market access. In April 2014, the EC issued recommendations on a new approach to business failure and insolvency, aimed at addressing some of the structural impediments to SME financing.3

Reforms in the following areas would facilitate development of the SME securitization market:4

  • The regulatory regime should appropriately differentiate between high - and low-quality securitization transactions. Reducing the capital intensity of safer structures to reflect the resilience of European asset securitization markets during the financial crisis would encourage the supply of transactions that fund real economic activity. This could involve a revised capital treatment for transactions that meet higher standards of loan portfolio disclosure and performance monitoring.

  • Official sector involvement could help incubate market-based solutions for risk transfer. The EIB/EIF could initially act as guarantors or strategic investors (risk sharing) while guarding against long-term distortionary effects by making any risk-sharing time-bound. In this regard, a targeted change to the ECB collateral framework could provide incentives for creating a viable structure for the entire transaction rather than only that part of it placed with the ECB (possibly in combination with an ECB liquidity facility and the option for outright asset purchases of SME transactions to establish a floor to market prices).

  • Structural improvements could further facilitate market development. National insolvency frameworks should continue to be strengthened, with a view to cleaning up banks’ balance sheets and boosting the quality and transparency of collateral. Greater harmonization of SME lending standards and credit registries across countries would facilitate the establishment of a truly single market. Also, forms of non-bank intermediated securitization (such as trade receivables) and equity finance should be explored in areas where structural impediments to asset securitization are too high and cannot be overcome in the near term.

1 Prepared by Ali Al-Eyd and Andy Jobst.2 The European securitization market is relatively small and has contracted by more than one-third since the start of the financial crisis to €1.4 trillion (roughly a quarter of the size of the U.S. market).3 European Commission, 2014. Commission Recommendation of 12 March 2014 on a New Approach to Business Failure and Insolvency (2014/135/EU). See also European Commission, 2013, Finance for Growth, Report of the High-Level Expert group on SME and Infrastructure Financing.4 In May 2014, the ECB and the Bank of England published a comprehensive review of existing obstacles to a better functioning of the securitization market in the European Union, which includes some arguments that are also reflected in these recommendations.

27. The crisis has left a legacy of unacceptably high unemployment, especially in stressed economies. For instance, euro area countries hit hardest by the crisis have had unprecedented increases in youth unemployment rates, ranging from 25 percent in Ireland to over 40 percent in Spain on average during 2007–13. Large and persistent youth and adult unemployment rates lower potential output due to skill attrition and depreciated human capital. Youth unemployment also leads to a lower probability of future employment and lower wages, and erodes social cohesion and institutions.


EA and US: Unemployment Rate

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001


EA and US: Youth Unemployment Rate

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

28. A comprehensive and country-specific approach will be necessary for addressing high unemployment. Staff analysis suggests that youth unemployment in the euro area has been especially sensitive to cyclical conditions (Box 4). Nonetheless, structural factors also make a difference: a larger tax wedge, higher minimum wage (relative to median wage), and lower spending on active labor market policies (ALMPs), especially on training, are associated with higher unemployment. Overall, a broad, comprehensive strategy to tackle youth unemployment is needed, which involves both measures to boost growth and remove country-specific structural impediments. The latter could include properly designed, cost-effective ALMPs, together with measures to lower hiring costs (by reducing the tax wedge and better aligning minimum wages to average labor costs) and improve skill levels (by providing work-related training).

29. Further policy efforts in both creditor and debtor economies are necessary to prevent intra-euro area imbalances from re-emerging as the recovery takes hold. In addition to supportive macroeconomic policies, product and labor market reforms are crucial to rebalance the euro area. Higher infrastructure investment in the creditor countries could improve disposable incomes in these economies and lead to higher external demand, thereby reducing excessive surpluses including vis-à-vis the rest of the world. Further improvements in competitiveness are particularly important for stressed economies, which need to lower costs, shift resources to tradable sectors, and reduce external debt. Staff analysis shows that in a “good” rebalancing scenario—with higher public investment in creditor countries and more structural reform progress across the euro area—would improve current account balances in debtor economies, while reducing the surpluses of creditor economies. The growth dividends under this scenario could be substantial, ranging from a ½ to ¾ percentage point rise in growth annually over a five year horizon (Box 5).

Youth Unemployment in the Euro Area: Okun’s Law and Beyond1/

The business cycle is the most important driver of unemployment in the euro area. It explains up to 70 percent of changes in the youth (age 15-24) unemployment rates in stressed euro area countries. Youth unemployment rates are more than twice as sensitive to the business cycle as adult (age 25-64) rates, regardless of how the business cycle is measured (output growth or output gap). This may be because relatively more youth are employed in the cyclically sensitive industries (e.g. construction) as well as the concentration of employment in SMEs which have been severely affected by the crisis. Therefore, sustained growth is key to reducing youth unemployment, especially in stressed countries. For example, an additional percentage point of annual growth could lower the unemployment rate from 0.8 percentage points in Greece and Portugal to 1.9 percentage points per year in Spain.

Structural features of the labor market have significant effects on the size of unemployment.1

A one percentage point increase in hiring costs (tax wedge, ratio of minimum to median wages) raises youth unemployment rates by 0.2 to 1.2 percentage points. A higher benefit replacement rate increases youth unemployment rates by up to 1.3 percentage points. An increase of 1000 euros in ALMP spending per unemployed person can lower youth unemployment rates by up to 0.3 percentage points. Skill levels also play a role, especially for long-term unemployment, while collective bargaining (e.g., union density), labor market duality (e.g., protection of regular workers) have more mixed effects, consistent with the literature. These estimates are robust to different empirical specifications.


Okun’s law coefficients /1

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

/1 Shaded bars and dots indicate results and are not significant.Source: Eurostat and IMF Staff Estimates

Effects of Labor Market Features on Youth Unemployment Rates, median and range, percentage points

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

TWEDGE – Tax wedge, MIN2MED – the ratio of minimum to median wages, GRR – gross replacement rate, ALMP – total spending on active labor market policies per unemployed.Source: Eurostat and IMF Staff Estimates

Structural characteristics also affect the responsiveness of unemployment to the business cycle. For example, in stressed economies such as Greece and Spain, a higher tax wedge makes unemployment rates more pro-cyclical.

These results are subject to important caveats. Given data limitations, the estimations assume that structural factors have the same effect across countries. Moreover, the variables do not capture every relevant detail of the labor market structure, e.g. eligibility requirements for unemployment benefits differ across countries, and the tax wedge may vary across income levels in a given country, and in progressivity across countries.

1 Prepared by Angana Banerji, Huidan Lin and Sergejs Saksonovs. See companion SIP for other variables considered and methodological details.

External Rebalancing in the Euro Area: Developments and Policies1/

The euro area has shifted into strong surplus since the crisis. However, country-level developments underlying this shift have been highly asymmetric, with debtor economies (such as Greece, Ireland, Portugal, and Spain) seeing large improvements in their current accounts (sometimes into surplus), while creditor economies (like Germany and the Netherlands) have maintained their surpluses. At the sectoral level, the change in current accounts has been largely driven by falling private investment, mostly from the corporate sector.


Regional Composition of the Euro Area Current Account

(percent of GDP)

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Source: IMF World Economic Outlook database and IMF staff calculations.Note: Italy and Spain do differ significantly in the magnitude of their net foreign liabilities. See Table 1 of the External Rebalancing Selected Issues Paper.

Composition Changes from 2007 to 2012

(percent of GDP)

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Source: Eurostat database and IMF staff calculations.

Statistical analysis indicates that euro area external imbalances can be traced to deviations in both saving and investment from model-based estimates. Creditor economies with large surpluses (such as Germany) have seen persistent under-investment and over-saving in recent years, compared to what would be predicted by a model incorporating fundamentals (see text figure). On the other hand, the analysis also points to persistent and substantial overinvestment by some debtor economies prior to the crisis (such as Spain). The magnitude of over-investment in debtor economies has fallen since the crisis, but there is a risk that this reflects, at least in part, the large output gaps that remain in these economies and will unwind as they recover.

Scenario analysis suggests that gains from further structural reforms and public investments by creditor economies would narrow external imbalances and boost output compared to the baseline. Simulations from the IMF’s EUROMOD general equilibrium model indicate that higher public investment in creditor economies and more structural reform progress across the euro area would improve current accounts in debtor economies, while reducing the surpluses of creditor economies. This would help reduce excessively high net external liabilities in some debtor economies (such as Greece) and temper the net external assets of some creditor economies (such as the Netherlands). More importantly, potential growth and productivity would improve across the board, with growth dividends ranging from ½–¾ percentage points of real GDP over the medium term. This would be accompanied by faster closing of the output gaps and higher inflation (helping aid relative price adjustment).


Estimated Current Account Imbalance for Germany

Citation: IMF Staff Country Reports 2014, 198; 10.5089/9781498342865.002.A001

Source: IMF staff calculations.

The External Stability Report’s assessment suggests that the euro area as a whole exhibits an external position and real exchange rate that are broadly consistent with fundamentals. The 2013 real exchange rate gap is estimated to be somewhere between -5 and 0 percent, while the current account gap is estimated to be between -½ and 1 percent of GDP. However, this masks imbalances in constituent member economies, with some showing real exchange rate overvaluation (such as Spain) and others undervaluation (such as Germany). There is a need for continuing structural reforms in product and labor markets in both creditor and debtor economies to help rectify these imbalances. Moreover, in a few creditor economies, there is some scope to use fiscal space to boost public investment.

1 Prepared by John Bluedorn, Shengzu Wang, and Tao Wu.

The Authorities’ Views

30. The authorities broadly agreed with the assessment of economic developments in the euro area and the downside risks to growth. They noted that the recovery, despite showing signs of being sustained, was still too weak to make a significant impact on high unemployment and debt levels. They acknowledged strong headwinds to growth from persistently weak credit conditions, financial fragmentation, and private sector deleveraging.

31. The ECB’s recent package of policy measures demonstrates its resolve to raise inflation towards the price stability objective and counter financial fragmentation. The authorities agreed with staff that low inflation makes adjustment difficult and emphasized that a prolonged undershooting of the inflation objective is not acceptable to the Governing Council of the ECB.

32. The ECB considered this package sufficient to address low inflation and support greater bank lending. But they are ready to respond swiftly if inflation remains unacceptably subdued including, potentially, asset purchases to expand the ECB’s balance sheet. Despite their limited size, private asset purchases could address fragmentation by injecting liquidity and supporting credit. Quantitative easing (QE)—mainly through sovereign but also private asset purchases—is an option, particularly if external risks materialize and the inflation outlook worsens. Nevertheless, it should be acknowledged that QE is no panacea, and is subject—just like any other measure—to some limitations. Despite some uncertainty about standard transmission mechanisms in an environment of already very low sovereign yields, the expectations channel is expected to play a significant role in transmitting an ECB balance sheet expansion into higher inflation.

33. The EC agreed that the broadly neutral fiscal stance at the euro area level is helping sustain the recovery, but cautioned against the risk of policy complacency. Member states’ 2014 consolidation plans are now based on more realistic macroeconomic assumptions, perhaps reflecting the role of the new fiscal councils. The composition has also improved with less reliance on capital spending cuts. But the EC argued that a premature relaxation of SGP targets to tackle weak aggregate demand would undermine the credibility of the recently-reformed framework. Nonetheless, if inflation remained subdued after the monetary policy arsenal had been exhausted, the escape clauses of fiscal rules could be activated.

34. On fiscal governance, the authorities acknowledged that some revisions to the framework were necessary but emphasized legal and political constraints to introducing radical changes. They noted that the complexity of the existing framework owed much to prior attempts to make the framework more flexible (and less pro-cyclical) in the face of large shocks. The EC also saw benefits in creating more incentives to foster long-term growth and fill the investment gap but warned that modifying the rules to accommodate structural reforms and higher public investment would create loopholes and make procedures even more complex. They also cautioned against an overly pessimistic view of existing enforcement mechanisms, pointing to the track record of several member countries successfully exiting the EDP.

35. The authorities were optimistic that the ongoing AQR and associated stress tests would be successfully completed. This will provide a major boost to confidence in the banking sector and facilitate balance sheet repair. The authorities pointed out that since the middle of 2013 there has already been a large improvement in European banks’ capital positions. Total capital has risen almost €90 billion, nearly 4 percent, since May 2013. Coordination between the ECB and national competent authorities (NCAs) is so far proceeding smoothly, and independent third party involvement in asset valuations has been an integral part of the process. Clear and prompt recapitalization plans would be required of banks found to fall short of AQR or stress test hurdle rates. Recent improvements in the funding environment for banks should be conducive to banks’ ability to fulfill the ambitious timetable for recapitalization. The timetable is expected to be strictly followed, in order to preserve the credibility of the exercise. That said, the authorities agreed with staff that banks may be granted some flexibility in extraordinary circumstances. They also concurred that financial stability concerns would be appropriately taken into account in all decisions.

36. Major progress has been made on the banking union. The authorities noted that the transition to a single supervisor is likely to facilitate cross-border liquidity provision within the euro area, which could help reduce financial fragmentation. The SSM is making institutional preparations—including hiring staff—to ensure that it will be ready to assume supervisory responsibilities in November. The authorities highlighted that recent agreements had made SRM decision making procedures less cumbersome—improving the prospects for quick resolution in a crisis—and the SRF transition period made shorter. Apart from a quicker overall mutualization of national compartments, they pointed to the front-loaded nature of the timetable, with 40 percent of the SRF funds being mutualized by the end of the first year of operation, and 60 percent by the end of the second year. They also noted that passage of the BRRD, which will become fully operational in 2016, has established tiered depositor preferences and a bail-in tool for creditors. Moreover, the Directive on Deposit Guarantee Schemes harmonizes the coverage and speed of payout of national deposit guarantee schemes across the EU.

37. On a common fiscal backstop for the AQR and more generally for bank resolution, the authorities pointed to recent progress in enabling direct bank recapitalization from the ESM. They agreed with staff that the threshold envisaged for direct recap is very high, but argued that this was broadly appropriate in light of the desire to minimize the chances that public aid would be deployed. The principle that creditors rather than taxpayers should be liable for payments in case of bank failures or capital shortfalls is firmly entrenched in the resolution framework.

38. The authorities agreed that the ongoing rebalancing is incomplete. Wages are adjusting and current account positions are improving in the debtor countries. But these developments are occurring against a backdrop of still-large output gaps and could be partially reversed as economic activity recovers. Further efforts in these countries should focus on microeconomic reforms to improve competitiveness. Meanwhile, there are limited signs of symmetric adjustment in surplus countries. The authorities agreed that higher infrastructure investment in these countries should contribute towards reducing intra-euro area imbalances.

39. On structural reforms, the authorities agreed with staff that action was needed on both the national and regional levels. The “Youth Guarantee Scheme” will provide EU structural funds to support country-specific programs, subject to an assessment by the EC. It will be targeted at countries where youth unemployment exceeds 25 percent. Progress was also being made on fostering a single market for energy, with wholesale prices for gas and electricity converging across countries. The most pressing challenges were to inter-connect national electricity grids, and harmonize country-specific climate change measures to achieve the common target for renewable by 2020. Negotiations continue on a free trade agreement with the US, and with other countries, although greater political uncertainty could slow the momentum.

40. The authorities welcomed staff’s emphasis on capital market development. They viewed this area as an integral part of the drive toward a Single Market. In this context, they supported proposals for facilitating greater SME access to finance. Widening the existing EIB-EIF program for SME securitization and exploring synergies with the EC-EIB SME Initiative would foster greater capital market integration. The authorities saw merit in pursuing a number of proposals: differentiated capital intensity of high- and low-quality securitization transactions; more equitable regulatory treatment of securitized and non-securitized SME loans; harmonization of loan reporting requirements, credit scoring, and credit registry information; and non-bank intermediated forms of structured finance, such as cash flow (receivables) securitization.

41. The authorities generally agreed with staff’s risk assessment. Surges in global financial market volatility due to revised expectations of US exit from UMP could complicate the ECB’s own polices to increase inflation expectations and support demand, if the ECB forward guidance proved less effective under such scenario. A protracted slowdown in emerging markets (EMs) could weigh on growth prospects through the trade channel, although such a channel is unlikely to be strong and there could be a potential offset from capital flow substitution from EMs to euro area periphery countries. An escalation of geopolitical tensions could have adverse—and uneven—consequences for several euro area countries, but the authorities observed that it was very difficult to attach meaningful probabilities to this event. They also noted that such risks seemed to have diminished recently. They agreed that internal risks arising from stagnation or a de-anchoring of long term inflation expectations remained germane. However, the authorities argued that some of these risks were interlinked, and the impact would be high only if they were all to be realized at the same time. Moreover, the probability of such scenarios materializing was reduced by the endogenous policy response that signs of stagnation would call forth, in particular as regards balance sheet repair. They attached a higher likelihood to the danger of reform fatigue setting in, especially in light of a more euro-skeptic configuration in the new European Parliament.

Staff Appraisal

42. The euro area’s economy has now expanded for four consecutive quarters, with varying strength across countries. Financial market sentiment is buoyant, sovereign spreads have narrowed to pre-crisis levels and bank funding costs have declined sharply. These improvements have been grounded in vigorous policy actions. The ECB has provided demand support through conventional monetary policy—including the recent rate cut and negative deposit rates—while the fiscal drag in 2014 has diminished. Rapid progress has been made with establishing a banking union, with the ECB ready to assume supervisory authority in November, soon after the results of the ongoing AQR are announced.

43. But the recovery is neither robust nor sufficiently strong. Investment remains well below pre-crisis levels, constrained, at least in part by the continuing contraction of bank credit. Credit conditions in periphery countries are particularly weak, with many SMEs—a major source of output and employment—being rationed. Unemployment, especially youth unemployment, remains unacceptably high, and the private debt burden remains elevated in many countries. Therefore, greater growth momentum is required to substantially repair the damage from the crisis.

44. Inflation has been too low for too long. This stifles demand by keeping real interest rates and real debt burdens too high, while making the unfinished task of rebalancing more difficult. A protracted period of inflation below the central bank’s target could de-anchor expectations and undermine monetary policy credibility. And a negative external shock could tip the economy into deflation.

45. Concerted policy efforts are needed to strengthen the recovery. ECB actions have provided welcome demand support. Successful execution of the AQR and a common fiscal backstop are needed to facilitate balance sheet repair and sever bank-sovereign feedback links. And structural reforms are needed to tackle high unemployment and facilitate intra-euro area rebalancing.

46. The ECB’s recent policy package signals its determination to address low, below-target inflation and fulfill its mandate. Collectively, the wide range of measures should lead to a substantial expansion of liquidity. The provision of targeted term funding for banks should encourage credit to SMEs, especially in stressed economies.

47. But if low inflation and fragmentation are not reversed, a substantial expansion of the ECB’s balance sheet may be necessary to complement the recent package. This could be achieved through a large program of asset purchases—primarily sovereign assets for reasons of market depth—or a new non-targeted LTRO on a long-term, fixed-rate basis. Both asset purchases and a large-scale LTRO involve balance sheet risk for the ECB, strengthening the pre-commitment to accommodative policy, and thereby influencing inflation expectations.

48. The overall broadly neutral fiscal stance of the euro area in 2014 strikes an appropriate balance between demand support and debt sustainability considerations. Negative growth surprises should not trigger additional consolidation efforts.

49. Successful completion of the AQR will facilitate bank balance sheet repair. The ambitious timetable for recapitalization of banks should be feasible given markedly improved market conditions, but some flexibility might be necessary if several banks need to raise capital at the same time. Creditor bail-ins for systemically important banks, if necessary, would need to be applied with due consideration given to financial stability concerns. Efforts are also needed to reduce the corporate debt overhang, by strengthening national insolvency frameworks and facilitating debt restructurings.

50. There has been rapid progress towards a more complete banking union. The transition to a single supervisor—the SSM—should facilitate cross-border liquidity provision, thereby reducing fragmentation. SRM decision-making procedures have been simplified, and the timetable for mutualization of the SRF has been shortened.

51. Work needs to continue on establishing a common fiscal backstop to effectively sever sovereign-bank links. While the proposal for ESM direct recap is a step in the right direction, as currently envisaged the thresholds for such support are too high.

52. Capital market development should be encouraged to provide an alternative to bank lending. Developing capital market financing alternatives, like greater securitization for corporate funding, would help ensure lending to viable smaller firms, enhance the resilience of the financial system, and improve monetary transmission. To bolster securitization markets, regulatory risk weights for high quality (simple and transparent) liquid asset-backed securities should be reduced. This would free up capital for further lending.

53. More structural reforms are necessary to tackle high unemployment, burnish competitiveness, and facilitate rebalancing. A comprehensive strategy to tackle youth unemployment would involve both measures to boost growth and remove country-specific structural impediments. The latter could include cost-effective ALMPs, measures to lower the opportunity cost of employment, and better-targeted training programs. Higher infrastructure investment in the creditor countries would help reduce excessive surpluses. Meanwhile, competitiveness-enhancing reforms to product and labor markets in debtor countries would aid further rebalancing, by boosting export growth as the recovery takes hold and import compression unwinds. Efforts should continue to implement the Services Directive, make progress with free trade agreements, and more closely integrate energy platforms and policies.

54. Over the medium term, ideas to simplify and strengthen the fiscal governance framework should be explored. Consideration should be given to a more parsimonious framework with a single objective and an economically sound operational lever. The credibility of the rules would be enhanced by much stronger enforcement mechanisms. Boosting the ability of the center to fund public infrastructure projects—such as cross-border investments in transportation, communications and energy networks—would help lay the foundations for sustained growth, while keeping countries within the bounds of the fiscal framework.

55. Staff proposes that the next Article VI consultations on euro area policies follow the standard 12-month cycle.

Appendix. Statistical Issues1

European statistics are developed, produced, and disseminated within their respective spheres of competence by the European Statistical System (ESS) and the European System of Central Banks (ESCB). The ESS, composed of Eurostat and the national statistical institutes (NSIs), and the ESCB, composed of the ECB and the national central banks (NCBs), operate under separate legal frameworks reflecting their respective governance structures and cooperate closely when designing their respective statistical programs.2 The European statistics produced by the two statistical systems are of sufficient coverage, quality, and timeliness for effective macroeconomic surveillance. This appendix provides an update on developments of statistical issues since the previous Article IV consultation of the euro area.

1. Significant progress has been made in implementation of the new international statistical standards. The shifts to the new European System of National and Regional Accounts (ESA 2010) and to the Sixth Edition of the IMF’s Balance of Payments International Investment Position Manual (BPM6) are well on track.3 Eurostat and ECB are working closely with all stakeholders on preparing the new data compilation and transmission, as well as methodological and statistical revisions. According to the current schedule, the new set of national accounts under ESA 2010 will be compiled and disseminated from September 2014, and the new euro area BOP statistics in line with the BPM6 will be published from Q4 2014. Monetary and financial statistics (e.g. interest rate, investment funds, financial vehicle corporations, securities issues) have also been adapted and new statistics will become available in 2015.

2. These new changes are to bring remarkable benefits to economic surveillance and analysis. The new statistical standards would allow economics data for the euro area to be disseminated in a timely manner with broadened coverage. In particular,

  • Broadened data coverage and shorter transmission periods. ESA 2010 comes with a modified transmission program to Eurostat from the member states, with extended coverage (e.g. of non-financial assets and pension schemes) and advancement of transmission deadlines. Under the new schedule, national account aggregates are now to be transmitted at t+60 days (rather than t+70 days). The quarterly non-financial accounts by sector intended for euro area aggregates will be transmitted by the euro area countries at t+85 days (instead of t+90 days).

  • Flash quarterly GDP estimates at T+30 days. In parallel to the adoption of ESA 2010, a Task Force (TF) is established by the National Accounts Working Group to assess the feasibility to produce a flash estimate of the euro area and European Union quarterly GDP at T+30 days The TF started its work in June 2013 and intends to finalize the work by the end of 2015. Provided that the compilation of reliable T+30 days estimates is deemed to be feasible by the TF, a first T+30 flash estimate for the euro area and EU quarterly GDP could be published for Q1 2016.

  • More detailed analysis and presentation of pension schemes. A compulsory supplementary table on pension entitlements will be required from 2017 to show the liabilities of all pension schemes, including those of government, whether they are unfunded or funded. This will improve comparability across countries and quantify the accrued-to-date pension entitlements of private households. Under ESA 2010, unfunded pension obligations of general government will not be reported in the core financial accounts and will not impact the Maastricht debt.

  • Improved statistics and coverage of balance of payments data under BPM6. The ECB’s data reporting requirements on external statistics under the BPM6 are more detailed, particularly as regard the instrument detail within the various functional categories of financial transactions. The first dissemination of BPM6 data will also be accompanied by comprehensive back-data, whose length will depend on national data availability and quality. In addition, a more detailed geographical breakdown of the euro area international investment position will be available on a quarterly basis, instead of the current annual frequency.

3. The implementation of the new international statistical standards, combined with improved national data collections, will result in revisions to the economic statistics. Revisions of historical GDP components are expected to raise GDP estimates for most EU members, partially due to the capitalization of research and development (R&D) expenditure and military weapons. The methodological revisions will for most countries coincide with regular benchmark revisions in which new data sources and methods will be introduced. While the exact impact on GDP levels varies across countries and they are not available until the data compilation is fully completed, the average impact of methodological changes (leaving aside statistical changes) on nominal EU GDP is expected to be an increase of 2.4 percent. In addition, the inclusion of part of illegal activities is likely to raise GDP estimates for some countries. Overall, as these re-categorized expenditures are relatively stable as share of GDP over time, most of methodological revisions are expected to affect GDP levels backwards with a limited impact on growth profile.

4. There are remarkable improvements in government finance statistics to enhance economic and fiscal governance. The Enhanced Economic Governance Package (so called “Six Pack”) adopted in 2011 required adoption of measures for the collection and dissemination of monthly and quarterly fiscal data based on public accounts, and data on contingent liabilities for all general government subsectors.4 Eurostat established a Task Force on the implications of the Directive under the “Six Pack” on the collection and dissemination of fiscal data. Important progress has been achieved up to date.

  • Enhanced fiscal data reporting. By the end of 2013, countries brought into force the provisions necessary to comply with these requirements. Since February 2014, monthly fiscal data5 for central and state government and social security funds are publicly accessible for almost all countries on their national websites. A complete set of the general government accounts (including also local government) is available on a quarterly basis since end June 2014.

  • Planned publication of general government contingent liabilities. In parallel to the new ESA transmission program, national publication of annual data on contingent liabilities and other indicators with potential impact on fiscal deficit and/or debt will start from October 2014. Eurostat will collect and disseminate new comparable sets of data regarding contingent liabilities and potential obligations of general government, such as the amounts of guarantees, the debt of public corporations, nonperforming loans, and potential obligations under Public Private Partnerships.

5. Important steps are taken at the European level to support the ECB’s role as a single supervisor and monetary policy. In October 2013 a new EU regulation conferred to the ECB the sole responsibility for supervision of large banks in the euro area and in those EU member states that voluntarily adhere to the Single Supervisory Mechanism (SSM).6

  • Expanded data collection and collaboration. The ECB will collect supervisory data for the banking groups based on the harmonized Implementing Technical Standards (ITS) of the European Banking Authority, which has six parts: financial reporting, consolidated reporting, asset encumbrance, large exposures, liquidity ratios, and leverage ratios. Additional ad hoc datasets, including but not limited to those required for stress-testing purposes, may also be requested. Data is also to be transmitted directly from national supervisory authorities when the national central bank is not the supervisory authority.

  • Financial sector surveillance supporting SSM and monetary policy. Since 2013 balance sheets of 246 monetary financial institutions (MFIs) are transmitted to the ECB on a monthly basis. This supports the analysis of deposit and lending decisions of the financial sector, and provides insights into the sources of bank funding. Quarterly data on the activities of non-bank financial institutions, including investment funds other than money market funds and including hedge funds, financial vehicles engaged in securitization and insurance companies and pension funds, are now collected by the ECB, complementing existing data relating to money market funds. Analytical results based on these data are regularly transmitted to the ECB decision-making bodies to support monetary policy.

  • Securities holdings statistics. A new dataset on securities holdings statistics is being collected by the ECB since end 2013 on the basis of the ECB Regulation concerning statistics on holdings of securities. The new data contains security-by-security information on holdings of individual securities by institutional sectors. Additionally, a second module comprises security-by-security information on the holdings by each of the largest euro area banking groups (i.e. also including the securities held by their subsidiaries and branches, both inside and outside the euro area) identified as important for the stability and functioning of the financial system in the euro area and in each euro area country.

  • The survey on the access to finance of SMEs in the euro area (SAFE). 7 ECB conducted the tenth semiannual survey on SME financing conditions, which provides evidence mainly on changes in the financial situation, financing needs, and access to financing from October 2013 to March 2014. The survey results suggest that financing conditions for SMEs continue to differ significantly across euro area countries and are in general more difficult than those of larger companies. Increasing quantitative coverage are to be expected in future surveys on firm characteristics including investment, export intensity, employees, and lending conditions such as interest rates, payment delays, and sources of financing. Moreover, from 2014, a larger version of the survey which is conducted every second year together with the Commission will become annual.

  • Further improvements in data reporting. The ECB and the IMF Statistics Department are finalizing the migration of the balance sheet data for depository corporations to the IMF’s Standardized Report Forms (SRFs) for monetary statistics. Work continues on mapping data for Other Financial Corporations.

6. Ongoing efforts aim to enhance the statistics for the Macroeconomic Imbalances Procedure (MIP). The ESS and the ESCB cooperate closely to assure the quality of MIP relevant statistics. In July 2013 the Commission submitted a draft proposal for a regulation on the provision and quality of statistics for the MIP to the European Parliament. The aim of this proposal is to develop a robust quality monitoring procedure in order to ensure the highest quality of the MIP relevant data. The proposal is currently under discussion at working party meetings of the Council.


The mission would also like to thank euro area authorities, in particular President M. Draghi (European Central Bank), Chairperson Danièle Nouy (Single Supervisory Board), Head of Secretariat F. Mazzaferro (European Systemic Risk Board), Managing Director K. Regling (European Stability Mechanism), Director General M. Buti (European Commission), and Chairperson A. Enria (European Banking Authority), as well as their staff for their time, support, and accessibility. The mission has also benefitted from the Fund’s bilateral Article IV consultations with euro area countries and from discussions with national authorities during meetings of the Eurogroup and the Eurogroup Working Group.


See the staff report for the 2013 Article IV consultation with member countries.


Sovereign holdings in the trading book and available-for-sale (AfS) portfolios are to be marked to market. National supervisors may allow the use of prudential filters for unrealized losses in sovereign AfS holdings, while hold-to-maturity (HtM) holdings will only be subject to changes in risk weights arising from banks’ internal models (and remain zero-rated under the standardized approach).


Prepared jointly by the European (EUR) and Statistics Department (STA) of the IMF in consultation with the Eurostat and ECB. Claudia H. Dziobek acted as the STA coordinator.


The ESS is defined by Article 4 of Regulation (EC) No. 223/2009 of the European Parliament and of the Council on European statistics. The ESCB performs its statistical function on the basis of Article 5 of the Statute of the ESCB and of the ECB.


The transition to ESA 2010 is regulated by EU Regulation No. 549/2013 and the transition to BPM6 is regulated by EU Regulation No. 555/2012 and ECB Guideline ECB/2011/23, as amended. Changes to monetary and financial statistics are regulated by the ECB.”


See Council Directive 2011/85/EU on requirements for budgetary frameworks of the Member States.


The monthly fiscal data are cash based in the majority of countries, but the link with the accrual ESA 95 accounts is explained in the explanatory notes and a reconciliation table.


See EU regulation No. 1024/2013.


The total euro area sample size was 7,520 firms, of which 6,969 (93 percent) had fewer than 250 employees.

Euro Area Policies: Staff Report for the 2014 Article IV Consultation With Member Countries
Author: International Monetary Fund. European Dept.