Euro Area Policies: Staff Report for the 2016 Article IV Consultation

The recovery continues with stronger growth in recent quarters, but downside risks have increased, amid growing political divisions and euroskepticism. Medium-term prospects remain weak, with high public and private debt and slow progress in structural reforms weighing on growth. And there is very little policy space to cope with adverse shocks.


The recovery continues with stronger growth in recent quarters, but downside risks have increased, amid growing political divisions and euroskepticism. Medium-term prospects remain weak, with high public and private debt and slow progress in structural reforms weighing on growth. And there is very little policy space to cope with adverse shocks.

Key Message: Euro Area at a Crossroads

Growing political divisions and skepticism have put the euro area at a critical juncture. The usual approach of “muddling through” appears increasingly untenable, raising the risks of stagnation and further fragmentation. High public and private debt and large structural gaps leave the union with limited policy buffers to address shocks. To strengthen the union, more decisive collective actions are needed. These should include completing the banking union, expanding centralized sources of investment, and prioritizing structural reforms that can provide near-term demand support. Stronger enforcement of the fiscal and economic governance frameworks is critical for building support for greater risk sharing and centralized support. Faster cleanup of bank balance sheets would enhance the effectiveness of monetary policy and support corporate restructuring and deleveraging.

Context: Recovery Continues, but Risks Rising

A. Recent Developments

1. The euro area recovery strengthened recently. Growth in 2015 picked up to 1.7 percent, led by domestic demand as net exports contributed negatively (Table 1; Figure 1). Private consumption was supported by lower oil prices and higher employment, while rising demand and easing financial conditions helped lift business investment. All of the large economies are contributing positively to regional growth (text figure). The fiscal stance remained broadly neutral in 2015, compared to the large drag on growth in 2011–13. Unemployment has fallen, but is also above pre-crisis levels (text figure).


Euro Area: Growth Contributions


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Eurostat and IMF staff calculations.

2. Growth varied widely across countries. Growth in 2015 accelerated or stayed steady across the four major euro area economies. Performance across the rest of the euro area varied more widely, with Ireland expanding by nearly 8 percent, while Greece lapsed back into recession. In nearly all countries, domestic demand was the main driver of growth. Despite the fastest expansion since 2012, overall euro area growth remained relatively subdued, especially when compared to the recoveries in the U.K. and U.S. (text figure).


Unemployment Rate since the Financial Crisis


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Haver Analytics.

3. Recent data suggest that despite the financial turmoil earlier this year, the modest recovery is set to continue. First quarter GDP growth came in stronger than expected at 0.6 percent quarter-on-quarter, the second straight quarter of faster GDP growth. High frequency indicators, including industrial production and PMI, point to a continued modest expansion, although at a slower pace than earlier in 2016, while confidence remains elevated.


Real GDP

(2008Q1= 100)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bureau of Economic Analysis; Haver Analytics; WEO and IMF staff calculations.

European financial markets have recovered after the sharp global selloff earlier this year, but are well below their 2015 peaks, lagging other advanced economies.

4. Inflation remains stubbornly low (Figure 2). Euro area headline inflation was -0.1 in May 2016, reflecting mainly ultra-low oil prices throughout the year. Core inflation was 0.8 percent. Prolonged low inflation, far below the ECB’s medium-term price stability objective, reflects both falling commodity prices and the large output gap, estimated at around -2 percent of GDP in 2015. Low inflation has also weakened inflation expectations, with the 2-year/2-year inflation swap rate hovering around 0.9 percent (text figure).


Various Inflation Measures

(Percent, y-o-y)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg, L.P.; and Haver Analytics.

5. The external position strengthened in 2015, supported by lower oil prices and a weaker euro (Figure 3). The euro area current account surplus rose to 3.2 percent of GDP in 2015, up 0.7 percentage points from 2014, led by the oil balance. Overall, the euro area’s external position in 2015 remained broadly consistent with the level implied by medium-term fundamentals (Table 2). In 2015, the real effective exchange rate (REER) depreciated by some 8.5 percent, reflecting the euro area’s weak cyclical position, low inflation, and accommodative monetary policy, ending broadly in line with the level consistent with medium-term fundamentals. So far in 2016, the REER has appreciated by some 2 percent.

6. Yet progress in external rebalancing remains slow (Figure 3). The euro area current account improvement was broad-based but reflects different drivers at the national level. The current accounts of debtor countries, like Portugal and Spain, improved due to competitiveness gains from price adjustments. But surpluses of some large creditor countries, such as Germany, have moved further away from levels suggested by fundamentals due to weak investment and stronger fiscal positions. Stock imbalances remain large, varying greatly across countries; countries with sizeable net foreign liabilities may be vulnerable to a sudden stop in capital flows. Given sizeable imbalances at the national level, further adjustment is needed by external creditors to strengthen domestic demand (reducing surpluses) and external debtors to raise productivity and competitiveness (improving current accounts).

Figure 1.
Figure 1.

High Frequency and Real Economy Developments

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Haver Analytics; and Eurostat.
Figure 2.
Figure 2.

Inflation Developments

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: ECB; Eurostat; Haver Analytics; and Fund staff calculations.

B. Near-term Outlook and Risks

7. Growth is projected at 1.7 percent this year and next. The near-term outlook depends crucially on the strength of domestic demand. The ECB’s policies should support easier financial conditions and activity, while the fiscal stance is projected to turn mildly expansionary, mainly due to higher refugee-related spending in some countries and some relaxation of the fiscal stance elsewhere. After reaching 0.3 percent in 2016, headline inflation is anticipated to pick-up only gradually, reflecting the persistent output gap.

8. Against this weak backdrop, downside risks have increased (Table 3). Externally, a further global slowdown could spill over and derail the domestic demand-led recovery by reducing investment and employment. Domestically, the risks are mainly political: fallout from a “Leave” or marginal “Remain” vote in the U.K. referendum, insufficient progress on a common response to the refugee surge, and/or further terrorist incidents. A “Yes” vote for Brexit could trigger volatile currency movements and financial contagion in the near term.2 Combined with the refugee surge and security concerns, a “Leave” or unconvincing “Remain” outcome could fuel euroskeptic sentiment with deteriorating trust between member states, increasing financial fragmentation and uncertainty.3 Domestic macroeconomic risks stem primarily from prolonged low growth and inflation, which leave the region inherently more vulnerable—even a small shock could tip the economy into recession. Other risks include banking and financial sector weaknesses in some countries.

9. The inflow of refugees could pick up again quickly and put at risk the free flow of goods and services within the union. While the number of refugees traveling from Turkey to Greece has fallen sharply, it is too early to fully judge the March agreement’s ultimate effectiveness in returning “inadmissible” new migrants to Turkey. Moreover, migration from North Africa could rise and conflicts in the Middle East could reignite, spurring new flows. An intensifying of the refugee surge could prompt additional border controls, curtailing the freedom of movement of people and goods within the EU. The impact on GDP from higher cross-border business costs could be significant, with estimates ranging from 0.4 to 1.2 percent of GDP, depending on the price impact (Box 1).

Figure 3.
Figure 3.

External Sector Developments

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook and Financial Flow Analytics databases; and IMF staff calculations.1 REER Peaks: 08Q1 for ESP, 08Q2 for IRL and PRT, 09Q4 for EA, GRC, DEU, FRA, and ITA.2 NFA/GDP implied by WEO projections, assuming no stock-flow adjustments or valuation effects going forward.3 Net private inflows, comprising debt and equity inflows, exclude inflows to the official sector. Debt inflows are the sum of portfolio debt, bank and other, and derivatives, while equity inflows are the sum of FDI and portfolio equity. Creditor countries include DEU, NLD, AUT, BEL, FIN, LUX, and MLT. All other euro area countries are classed as debtor economies.

The Surge in Refugees in Europe—Economic Impact and Risks

Unprecedented surge in refugees. Conflicts in the Middle East and North Africa have caused a sharp increase in the number of refugees, with the majority fleeing to nearby countries. The EU registered about 1,260,000 new asylum seekers in 2015, more than double the 2014 number. However, the number of refugees traveling to Greece from Turkey—a main gateway—has reportedly fallen considerably after the March EU-Turkey agreement.


First-Time Asylum Applicants 1

(Thousands of people)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Eurostat.1/ Data for Czech Republic, Denmark, Ireland, Greece, Spain, France, Cyprus, Luxembourg, Malta and Romania through December 2015. Data for Bulgaria, Croatia, Latvia, Lithuania, Austria, Portugal, Slovenia, Slovakia, Finland and the U.K. through January 2016.

Economic impact. In the short run, the fiscal outlays associated with providing for refugees will lead to a modest boost to GDP growth, raising EU GDP by some 0.1 percent by 2017, though the effects are more pronounced in the main destination countries such as Austria, Germany, and Sweden. International experience shows that rapid integration of migrants in the labor market is associated with better economic outcomes over the medium term. A recent Fund Staff Discussion Note finds that for the EU as a whole, GDP could be between 0.2–0.25 percent higher by 2020, depending on the speed of integration.1

Downside risks. Continued inflows of refugees could further strain the systems for accommodating and processing asylum seekers in EU entry and destination countries. The lack of success in agreeing or implementing a comprehensive response could deepen political divisions in the EU and lead to the reestablishment of more permanent border controls. Such measures are unlikely to solve the challenges associated with the refugee surge, but could have considerable economic costs. The effects of a non-cooperative response could also spillover to countries outside the EU, as refugees are contained in conflict-neighboring countries and barriers to trade within the Schengen area rise.


Asylum Applicants in the EU-28 by Regional Breakdown

(Percent, 2015)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Eurostat; and IMF staff calculations.

Economic cost of reestablishing border controls. About 3.5 million persons cross internal Schengen borders every day and intra-EU goods trade amounts to €2,800 billion each year. Reestablishment of border controls within Schengen could create significant costs for road freight transport, cross-border passenger mobility, tourism, and border control administration. The European Commission estimates that such controls would generate direct costs between €5 and €18 billion annually (0.03-0.12 percent of GDP). The think-tank France Stratégie predicts that border controls would reduce trade between Schengen countries by 10-20 percent, lowering the GDP of EU Schengen countries by 0.9 percent by 2025. A study by the Bertelsmann Foundation assumes a 1–3 percentage points increase in import prices, reducing GDP for the EU by 0.4–1.2 percent by 2025.

1 See “The Refugee Surge in Europe: Economic Challenges,” IMF Staff Discussion Note 16/2, January 2016.

Medium-Term Prospects Remain Mediocre

10. Crisis legacies of high unemployment, high public and private debt, and deep-rooted structural weaknesses weigh on the outlook. Business investment has started rising but lags the recovery, reflecting chronic weak demand, high corporate indebtedness, and weak growth prospects. Total debt (public and private) is above pre-crisis levels (text figure). Staff analysis indicates that the corporate debt overhang, particularly for SMEs, was a factor behind the decline in investment since the crisis, suggesting that slow progress in deleveraging is holding back investment (Box 2). Relatedly, high levels of nonperforming loans (NPLs) continue to undermine bank profitability and constrain new lending in some countries. Productivity also remains well below pre-crisis levels.

11. As a result, growth five-years ahead is expected to be about 1.5 percent, with headline inflation reaching only 1.7 percent. Average potential growth over the next five years has improved slightly, but remains subdued at 1.2 percent. Workforce aging is a drag through its impact on total factor productivity according to staff analysis.4 Unemployment is declining but only by 2021 does it reach its 2001–2008 average of about 8.5 percent. Without further reforms and faster growth, it will take several years to return unemployment to pre-crisis levels in hard-hit countries. Continued downward revisions to nominal GDP over the medium term have intensified debtors’ adjustment challenge (text figure).


Total Debt-to-GDP

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Haver Analytics.Note: EA financial corporate debt is non-consolidated.

12. Prolonged low growth and inflation leave the economy vulnerable to shocks with limited policy buffers. Given low inflation, high debt, and low potential growth, the euro area is vulnerable to a demand shock that pushes the economy into a recession and lowflation.5 In a stagnation scenario where a demand shock lowers investment growth by ¼ percentage points annually for five years and pushes up spreads, growth and inflation could fall to about one percent, worsening public and private debt burdens and external imbalances. Fiscal space is limited and unevenly distributed with countries with large output gaps also burdened with high public debt. With limited national fiscal space and the lack of a euro area-wide countercyclical instrument, the burden would fall on the ECB to press further with unconventional policies.


Nominal GDP Projections


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: WEO and IMF staff calculations.

The Drag from Debt: Firm-Level Investment in the Euro Area

Business investment in the euro area since the crisis has remained weak.1 Gross investment by non-financial corporations (NFCs) relative to GDP for the euro area fell with the global financial crisis, from about 24 percent of GDP in 2007 to a low of about 21 in 2009. The average euro area country saw investment drop almost six percentage points of GDP over the period 2007–2014. At the firm-level, the investment fall and slow recovery is most evident at small and medium enterprises (SMEs; see text figure).


Non-Financial Corporations Net Investment in the Euro Area

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Orbis Database and IMF staff calculations.Note: Euro area sample includes 8 countries (Austria, Belgium, Germany, France, Finland, Italy, Portugal, and Spain). The figure shows unweighted median of firms’ real net investment as a percentage of firms’ real lagged capital stock. SMEs include firms with less than 249 employees while large firms include firms with 250+ employees.

High corporate indebtedness may partly account for the weakness of firms’ investment. High debt may raise the risk of new lending, as more of a company’s collateral is likely encumbered, raising their external finance premium. Without financing, firms may be unable to invest even when they see high return opportunities. Moreover, highly indebted firms may decide to invest less, as the returns from additional investment are used more to pay off existing debtholders rather than benefit shareholders. Leverage for SMEs rose with the crisis, while remaining stable for large firms. After peaking in 2010, SME leverage has come down, but only very slowly and remains above its pre-crisis level (text figure).


Non-Financial Corporations Leverage Ratio in the Euro Area

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Orbis Database and IMF staff calculations.Note: Euro area sample includes 8 countries (Austria, Belgium, Germany, France, Finland, Italy, Portugal, and Spain). The figure shows unweighted median of firms’ debt as a percentage of firms’ total assets. SMEs include firms with less than 249 employees while large firms include firms with 250+ employees.

Staff analysis suggests that firms’ investment ratio is about 3 percentage points lower on average across firm sizes for a 10 percentage point rise in leverage. The analysis draws on a large sample of firm-level data from the ORBIS database for eight euro area countries (Austria, Belgium, Germany, France, Finland, Italy, Portugal and Spain) from 2003–2013. Controlling for other determinants of investment, the estimated impact of leverage on investment is about 25 percent larger for SMEs than large firms.


Impact on Investment Ratio of a 10pp Increase in Firm Debt-to-Asset Ratio

(Percentage points change in investment-to-capital ratio)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Orbis (BvD Publishing) and IMF staff calculations.Note: Estimates are based on a non-linear fixed-effects panel regression fitting the firm-level investment-to-capital ratio on leverage, sales, SME dummy, leverage interacted with firm-size class, sales growth interacted with leverage, sales growth interacted sith firm size, and a triple interaction of leverage, SME dummy, and sales growth. The model also controls for long-term debt, the log of total assets, sector*country*time effects and firm-fixed effects. The sample is composed of Austria, Belgium, Germany, France, Finland, Italy, Portugal and Spain. The time dimension is 2000 to 2013. Firm level data are from Orbis, BvD Publishing.

High debt is also associated with a weaker response of firm investment to demand. The sensitivity of investment to sales growth (a proxy for demand) has declined, to only about a quarter of its level prior to the crisis—the firm investment ratio rises by about one percentage point for a 10 percentage point rise in sales growth, compared to a pre-crisis rise of over four percentage points. Post-crisis, investment by highly leveraged firms is much less responsive to demand.

Measures to reduce corporate indebtedness could help boost firm investment. It could also enhance the transmission of monetary and fiscal policies to investment. The shutdown of unviable firms and debt restructuring for viable but distressed firms (the flipside of some NPLs held by banks) could facilitate a more growth-friendly deleveraging and promote a reallocation of resources to more productive firms, providing new opportunities for investment.

1 See Selected Issues Paper on “Investment, Firm Size, and the Corporate Debt Burden: A Firm-Level Analysis of the Euro Area” for further details.

Euro Area: GDP Growth Simulations


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Euro Area: Inflation Simulations


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.

13. Stagnation in the euro area would spill over to the global economy through weaker imports and higher global risk premia. As the second largest economic bloc worldwide, a stagnating euro area would be a major drag on global growth and trade. The euro area still accounts for a significant share of global GDP (almost 17 percent), but its contribution to global growth has declined since the global financial crisis (text figure). Under a stagnation scenario, the euro area’s current account would increase by 0.4 percent by 2021, with real imports contracting 2.8 percent in 2021. Other EU countries’ exports would fall by 1.4 percent in 2021, while exports for the rest of the world would decline by 0.4 percent. Stagnation in the euro area could also lower confidence and raise global risk aversion.


Global Nominal GDP Share


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: WEO.

Authorities’ views

14. The authorities were positive on near-term growth. Domestic demand—underpinned by low oil prices, a mildly expansionary fiscal stance, accommodative monetary policy, and employment gains—would continue to drive growth and put it slightly above staff’s forecast by 2017. They agreed that risks remain to the downside, dominated by geopolitical factors, including the refugee surge and skepticism about Europe highlighted by the U.K. referendum.

15. Inflation is expected to rise more rapidly. The ECB expects oil price developments and monetary policy actions announced in March to support a faster recovery in headline inflation than expected by staff. Core inflation remains subdued so far. Although the labor market is improving, the shift towards low-paying service jobs and other compositional changes are holding down aggregate wage growth.

16. The authorities differed slightly in their assessment of the real exchange rate. The ECB viewed the current account in 2015 as broadly in line with fundamentals, while finding the real effective exchange rate so far this year to be marginally stronger than implied by fundamentals. The European Commission (EC) projects it as somewhat undervalued for 2016. Both stressed stronger investment by creditor countries as necessary to narrow persistent external imbalances within the euro area.

17. They concurred that the medium-term outlook is lackluster, with potential growth only around 1 percent. Refugee inflows and higher participation will temporarily boost the labor contribution, but weak investment, aging, and limited total factor productivity improvements weigh on potential. The EC shares concerns about stagnation risks, as well as the possibility of more fundamental threats to the monetary union if divergent diagnoses about current challenges prevent steps toward further integration.

Comprehensive, more Balanced Policies to Boost Growth and Strengthen the Union

A. Prioritize Structural Reforms and Strengthen Economic Governance

18. Progress on structural reforms has flagged, holding back potential growth. Reform progress has been notable in countries under adjustment programs, but the overall pace is too slow given the large structural gaps in many countries. Compliance with the 2015 Country Specific Recommendations (CSR) under the European Semester has worsened relative to that for 2013-14 CSRs (text figure). Implementation of the Services Directive, especially in retail and professional service sectors, has been slow, particularly in the larger economies. Sizeable cross-country differences in productivity persist, especially in services where productivity remains below pre-crisis levels, lagging other advanced economies (text figure). Without faster progress on structural reforms, potential growth in the euro area will remain low, limiting the ability of countries to rebuild buffers and address crisis legacies.


Country Compliance with Country Specific Recommendations (CSRs)

(Index, full compliance = 4)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: European Commission.Note: The EC assesses progress on CSR on the scale: none (0), limited (1), some (2), substantial (3), full (4).1/ IRL and PRT data are for 2014 since these countries fell outside the Macro Imbalance Procedure framework in 2013.

Service Sector Productivity,: US and Euro Area

(Index 2007 = 100)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Haver Analytics.

19. The cyclical recovery presents an opportunity to push forward on structural reforms, prioritizing those that provide demand support.6 A mix of product market, labor market, and public administration reforms can significantly increase potential output over five to ten years and bring spending forward.7 Structural reforms have already paid dividends in some places, such as Spain and Portugal (text figure), although large rigidities remain. Drawing on national reform priorities (Table 4), the emphases should be on:

  • Product market reforms. Product market reforms can boost medium-term output and employment regardless of cyclical conditions, with higher effects on employment when demand policies are supportive. Reducing entry barriers in the professional and retail sectors, improving the efficiency of public administration, and strengthening insolvency regimes can increase competition, improve the business climate, and facilitate investment. Completing the single markets in services, energy, digital commerce, and transport as well as an ambitious Transatlantic Trade and Investment Partnership (TTIP) agreement would enhance productivity and competition.

  • Labor market reforms. Reforms should focus on lowering unemployment and increase labor force participation among the young, elderly, women, and the long-term unemployed. Priority should be given to shrinking the labor tax wedge and expanding cost-effective active labor market policies (ALMPs), since these reforms are likely to boost growth and employment even if budget neutral and with larger effects if accompanied by fiscal support. Reducing excessive protections for regular workers and excessive unemployment benefits may also help in some cases, but care must be taken when they are implemented, as they can exacerbate downturns. To achieve the medium-term benefits of these reforms while mitigating adverse short-term consequences, countries can make credible commitments to act, perhaps by introducing legal changes that become effective over time.


Euro Area: Labor Market Reform and Outcomes

(Bubble’s size indicates the level of labor market rigidity in 2013)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: OECD and IMF staff calculations.

Euro Area: Product Market Reform and Outcomes

(Bubble’s size indicates the level of product market rigidity in 2013)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: OECD and IMF staff calculations.

20. The economic governance framework needs to be strengthened significantly to better incentivize structural reforms. Stronger enforcement of the current framework—including opening the Excessive Imbalance Procedure (EIP) against repeat offenders—would increase compliance and build credibility.8 To improve enforcement, the 2016 European Semester and Macroeconomic Imbalance Procedure (MIP) should link country-specific recommendations (CSRs) to ambitious outcome-based structural reform benchmarks.9 Benchmarking will improve transparency and accountability by reducing scope for excessive discretion in enforcing the framework.10 These benchmarks should target euro area best practices to reduce structural gaps, foster convergence, and improve flexibility in factor markets (Box 3), while greater use of EU legislation in areas where it has jurisdiction would strengthen implementation. Flexibility under the SGP for structural reforms and targeted use of European Structural and Investment (ESI) funds and EU technical assistance (the 2015 Structural Reform Support Service) should be used to support reforms. To help incorporate euro area-wide priorities into national reform agendas, independent national competitiveness boards with a broad remit (as in Germany, the Netherlands, and Australia) could be created.

Authorities’ views

21. There was broad agreement on reform priorities. Significant progress has been made on financial services and ALMPs, while regulatory reforms to strengthen the business environment and employment, increase female labor market participation, and reduce barriers to competition in the services sector have been slow. In response, the 2016 European Semester emphasizes removing barriers to investment, including through more efficient public administrations, lower regulatory burden for firms, improved regulatory frameworks in services and network industries, and effective insolvency regimes. TTIP negotiations have accelerated, a free trade agreement has been concluded with Vietnam, and, negotiations are underway with some ASEAN countries.

22. The implementation of the macroeconomic governance framework has prioritized effectiveness over enforcement. Instead of opening an EIP, which would be politically contentious, the EC will use the “specific monitoring” tool to assess reform implementation in countries with continued excessive imbalances, helping generate peer pressure for action. In line with the Five Presidents’ Report, the ECB suggested that a full and effective use of all instruments available under the MIP—including its corrective arm—could help spur reforms. The introduction of reform benchmarks is progressing slowly due to the need to build consensus among member states and data limitations in some areas (such as insolvency regimes). Nevertheless, in addition to the labor tax wedge, the EC is analyzing the scope for benchmarking in insolvency frameworks and reducing regulatory barriers in the service sector. The number of CSRs has also been further streamlined in 2016, but this has complicated the targeting of European Structural and Investment (ESI) funds to support reforms.

Operationalizing Outcome-Based Structural Reform Benchmarks

Context. The Five President’s Report emphasizes the benefits of convergence of structural policies toward best practice in Europe.1 In 2015, the Eurogroup agreed to benchmark the labor tax wedge to GDP-weighted EU averages for a single worker (in a budget neutral manner) as part of the European Semester. Considerations for selecting structural reform benchmarks to begin operationalizing the framework are offered below. Reform measures should be prioritized taking into account countries’ cyclical positions and policy space (paragraph 19).

Selection criteria.

  • Operational. Reform benchmarks should be closely linked to the ultimate reform outcomes. To ensure transparency and accountability, the benchmarks should be sufficiently concrete and measurable, and directly under the control of policymakers to ensure they can be enforced. To move forward quickly, indicators should be selected from the existing pool of measures. They could be supplemented and improved over time. To assist monitoring, the data should be available at least on an annual frequency.

  • Economic. To improve the resilience of the monetary union, benchmarks should focus on completing the single market and increasing product and labor market flexibility. This would facilitate faster adjustment to economic shocks, limiting negative spillovers to other member states, as well as boosting productivity, enabling members to thrive independently within the monetary union

Six priority benchmarks. The following six indicators—selected in key reform areas (Table 4)—meet the above criteria and could be prioritized: (i) OECD indices on regulatory barriers in professional services sectors; (ii) the licenses needed to engage in retail trade; (iii) employment protection in regular work contracts; (iv) the labor tax wedge; (v) the World Bank measure of the number of days to enforce a contract; and (vi) measures of public sector value added per employee. Figure 8 illustrates the cross-country gaps and the impacts of reforms for three of the six benchmarks.

“Best practice” threshold. For most of the selected indicators, OECD best practice lies within the euro area, making it a natural target towards which other euro area countries could converge. Reforms which have fiscal implications (like the labor tax wedge) could be implemented in a budget neutral manner (that is, with compensating fiscal measures) and over a longer horizon, especially in countries without fiscal space.

Example (labor tax wedge). The average labor tax wedge for the euro area is higher than that in non-euro area OECD countries (Figure 8). This has a bearing on labor force participation and employment, particularly among the young, elderly as well as women. Empirical analysis shows that a reduction in the labor tax wedge can boost employment and output in the short term as well as the medium term (Figure 8). For example, the estimates indicate that reducing the labor tax wedge by 1 percentage point can raise output and employment by 0.8 and 1.2 percent respectively after 4 years.

Consistent with this analysis and the above selection criteria, the Eurogroup agreement to benchmark the labor tax wedge is a good start. However, the target could be more ambitious as the benchmark remains above the euro area and OECD averages, and far exceeds euro area best practice.

1 See the Five Presidents’ Report, June 2015.

B. Promoting Investment, Rebuilding Buffers, and Improving Fiscal Governance

23. Looking ahead, fiscal policy should aim for a broadly neutral stance to support the recovery while promoting sustainability. After several years of consolidation, the fiscal stance turned mildly expansionary in 2016 (Figure 4 and text figure). Fiscal easing is coming mainly from Germany, and to a lesser extent, Austria and Italy. Beyond 2016, the overall fiscal stance for the euro area is projected to turn slightly contractionary as the impact from refugee-related spending wanes in some countries while others resume their consolidation plans.


Composition of 2016 Change in Structural Balance

(Percent of Euro area GDP)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: IMF, WEO; and IMF staff calculations.

24. Fiscal policy could be better targeted geographically, but fiscal space is limited in many countries (Table 5). Taking into account debt sustainability, SGP targets, and national fiscal rules, fiscal space is scant or nonexistent at the country level. High debt constrains many countries, leaving fiscal space concentrated mainly in countries with small or no output gaps and little need for countercyclical support.


Saving vs. Spending of Interest Windfall

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: IMF staff estimates.

25. At the same time, high debt countries have slowed their adjustment, leaving very limited policy buffers. The pace of adjustment, as measured by changes in the structural primary balance, slowed in high debt countries, from an average of 1.4 percent of GDP over 2010–12 to near zero over 2014–15. This is despite the large windfall savings from lower interest rates which have been spent instead of used to repay debt (text figure). This has helped make adjustment less procyclical, but is also a missed opportunity to rebuild policy buffers and has undermined the SGP’s credibility.

26. To rebuild buffers and stimulate investment, countries should pursue more growth-friendly fiscal reforms. Countries with fiscal space should use it to promote investment and structural reforms. Those without space should adhere to their consolidation plans and rebuild buffers. All countries should undertake growth-friendly fiscal rebalancing, boosting public investment and reducing high marginal tax rates on labor and capital, accompanied by cuts to unproductive spending and steps to broaden the tax base.11 In the event of a severe, euro area-wide downturn, the escape clause should be invoked to suspend temporarily the fiscal adjustment that would otherwise be required under the SGP. However, even setting aside the SGP, national fiscal space is limited given high debt burdens in several countries, underscoring the need for regional support mechanisms to address sharp downturns without raising country debt burdens.

27. At the regional level, expanding centrally-financed investment schemes would lift both near-term and potential growth. The European Fund for Strategic Investment (EFSI) has approved over €100 billion in projects so far, mainly in research, development, and innovation, but for the EU rather than targeted to the euro area. Accelerating project approvals and disbursements as well as removing structural barriers would help catalyze private investment. Additional centralized investment schemes, financed via an expanded EU budget or a new common fund, could invest in projects of shared interest such as the digital single market, energy union, climate adaptation and mitigation, refugee settlement, and European transportation and communication networks.

28. To restore credibility and build support for further integration, the fiscal framework needs upgrading. SGP compliance has been weak as countries renege on commitments and request more time to meet their targets.12 To bolster the credibility of the framework and better ensure fiscal discipline, the EC will need to step up its enforcement procedures against countries that violate SGP rules. At the same time, the fiscal framework needs to be enhanced through simpler rules with more automatic enforcement and an independent fiscal board.

  • Adopting a simpler framework. While successive reforms have improved parts of the framework, they have also added to its complexity, hampering effective monitoring, public communications, and compliance. Simplifying the framework should focus on two main pillars: a single fiscal anchor and a single operational target.13 Such targets would be easier to implement, less reliant on output gap estimates, and more aligned with national budget frameworks.

  • Ensuring the independence of the European Fiscal Board (EFB). To enhance enforcement and monitoring, the European Fiscal Board (EFB), which is slated to start in 2016, should be made fully independent in assessing the aggregate fiscal stance and implementation of SGP fiscal rules. This could be achieved by separating the EFB from the European Commission which is in charge of enforcing the rules and by ensuring strong ties with national fiscal councils through the EU Network of Independent Fiscal Institutions (EUNIFI).

29. Over the medium term, further fiscal integration should be pursued, conditional on stronger compliance with the fiscal rules and progress in structural reforms. As described in the Five Presidents’ Report, greater fiscal integration is key to longer-term European integration. A number of options could be considered, including a “rainy day” fund to cushion against country-specific shocks or a common unemployment insurance scheme that targets short-term unemployment to limit the scope for permanent transfers.14 Taken together, these elements of a fiscal union could form the foundation for a euro area treasury with limited revenue and expenditure functions that could also borrow to address large common shocks.15 Any new centralized financial support, however, would need to be conditional on adhering to fiscal and structural reform commitments to guard against moral hazard risks. Creating such an institution would also require some loss of sovereignty and ultimately treaty change to ensure its political legitimacy and accountability.

Authorities’ views

30. Public deficits and debt remain high due to the weak recovery and lack of national ownership, leaving some countries exposed to shocks. Some countries in the corrective arm put more emphasis on compliance with nominal deficit targets, such as the 3 percent of GDP reference value, than on the structural adjustment targets. Without further adjustment, countries with high debt or financing needs are vulnerable to rises in interest rates or a growth slowdown. But the EC argued that without the SGP, fiscal positions would be much worse. The authorities acknowledged that the transparent, and consistent application of the SGP is crucial to maintain confidence in the fiscal framework. This will also enable countries, especially those with high debt, to achieve timely progress towards sound fiscal positions and build sufficient buffers in good times, reducing their vulnerability to future shocks. On the EFB, the EC plans to appoint members by the summer, indicating that the quality of the appointments would be more important in ensuring the board’s independence than structurally separating it from the EC. The ECB highlighted that the mandate and institutional independence of the EFB could be clarified and strengthened further.

31. Fiscal space is limited. The authorities concurred that based on various sustainability measures as well as the SGP, national space is limited and unevenly distributed. They noted however that the rules were designed to protect against deficit bias in normal times, with monetary policy countering large common shocks. At this conjuncture, the authorities agreed that the few countries with fiscal space within the SGP should use it and that centralized fiscal support could be expanded to deliver a more balanced policy mix. At the same time, the ECB argued that all countries have scope for a more growth-friendly composition of fiscal policies—countries without fiscal space can still pursue fiscal policies which support both the recovery and medium-term growth in a budgetary neutral manner.

32. A central fiscal capacity would improve the policy mix, but is politically difficult to achieve. Given deep concerns over moral hazard and transfers outside of a political union, the authorities saw gradual moves toward greater fiscal integration as the best approach. Initially, existing centralized schemes such as the EFSI might be expanded. Linking centralized support to SGP compliance and structural reform implementation could address moral hazard concerns, while greater private risk sharing would reduce the burden on public risk sharing. An experts group will be formed later this year to consider how to move to the second stage under the Five Presidents’ Report, including options for a fiscal stabilization function for the euro area.

Figure 4.
Figure 4.

Fiscal Developments and Policies

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: IMF World Economic Outlook database; and Fund staff calculations.

C. Maintaining Monetary Easing to Guard Against Low Inflation

33. Monetary policy is appropriately accommodative and open-ended (Figure 5). The ECB’s March policy package—a further cut of all policy rates, an increase in monthly asset purchases to €80 billion, including for non-financial corporate bonds, and new targeted longer-term refinancing operations (TLTRO II)—which was reaffirmed in June, strongly signaled the ECB’s commitment to meet its price stability objective. Linking the TLTRO II borrowing rate to new lending should expand credit supply, while mitigating the impact of negative rates on banks’ interest margins (Annex 1). These credit easing measures will help stimulate demand by reducing bank and corporate funding costs.

34. Monetary easing has improved financial conditions through various channels.

  • Asset purchases have compressed sovereign term premia and supported portfolio rebalancing. Term spreads have fallen by 50 basis points and the euro has depreciated by 6 percent in real effective terms since President Draghi’s Jackson Hole speech in August 2014 indicating that the ECB would pursue QE. Corporate issuance has also picked up significantly after the announcement of the corporate bond purchase program in March (text figure).


    Impact of Policy Measures on Changes in Excess Liquidity and Private Sector Lending

    (EUR billion)

    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: Bloomberg, ECB, Haver and IMF staff calculations.Note: 1/ Most of the expiring funding via LTROs was absorbed by the first TLTROs starting in Sept. 2014; 2/ Securities held for monetary operations, including SMP; 3/ MFI loans to private sector.

    Euro Area: Corporate Bond Issuance

    (EUR billions, annualized)

    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: Dealogic and IMF staff calculations. */ ending at the start of QE (Sept. 2014); **/ Sept. 2014-Feb. 2016.

  • Bank lending rates have declined and credit picked up modestly. SME lending rates have fallen across the euro area, while credit standards and conditions have eased. The ECB’s Bank Lending Survey suggests that most banks used TLTRO I funds to increase corporate and household lending (text figure).

    Figure 5.
    Figure 5.

    Monetary Policy Channels

    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: ECB; Haver Analytics; and Eurostat.1 Greater than or equal to zero implies tightening of credit standards / rising loan demand.

  • International experience suggests that pass-through to the real economy will take time. Despite the turnaround in lending, full credit recovery after QE typically takes more time. In Japan (2010) and the U.S. (2010), credit continued to pick-up several years after the start of QE (text figure). In the euro area, credit growth has already turned positive after one year but remains weak.

35. Measures to improve market functioning could enhance the effectiveness of asset purchases and monetary transmission. The growing gap between the ECB’s deposit rate and the overnight German bund repo suggests potential scarcity of some sovereign bonds under QE (text figure). This in part has been exacerbated by the different modalities for re-lending purchased securities across national central banks (NCBs). Developing a common securities lending framework for NCBs, similar to the ECB’s own lending framework, would facilitate access to high quality collateral. To alleviate potential shortages, the ECB should encourage NCBs to lend securities via multiple central counterparties to better distribute collateral through the system.

36. But given the very weak outlook for inflation, the ECB should stand ready to ease further if inflation remains below its anticipated adjustment path. Disinflationary pressures remain strong, with 11 countries reporting negative inflation in May (Figure 2). Inflation expectations seem increasingly influenced by commodity prices and low headline inflation, with second-round effects weighing on core inflation. Staff analysis suggests that de-anchoring risks have increased, highlighting the need for greater sensitivity to inflation developments (text figures).


Headline Inflation During QE

(Percent; YoY rates; time t=start of QE)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Haver Analytics. Note: Time t indicates the starting month of QE in the respective country.

Long-term Inflation Expectations and De-anchoring Risk


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Bloomberg L.P., Haver, and IMF staff calculations. Note: 1/ coefficient value based on 2-year rolling window estimation of inflation expectations following Gerlach and Svensson (2003).

Loans to Private Sector During QE

(Indexed (100) to time t=start of QE)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Haver Analytics; WB, WDI; IMF, WEO.Note: US; Commercial Bank Credit to the Private Sector; Japan; Domestic MFI Credit to the Private Sector; EA; MFI Loans to Private Sector;

Deviation of Inflation and Long-term Inflation Expectations from Price Stability Objective


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

37. However, further deposit rate cuts face limits. To date negative interest rates have had an overall positive effect, helping to lower bank funding costs and boosting asset values. In some countries, the rate cut has passed through to corporates and households, thereby contributing to a modest credit expansion and bolstering the economic recovery. However, looking forward further cuts could weigh on bank profitability if deposit rates remain sticky while lending rates fall (Annex 1). This is particularly relevant in banking systems with high shares of variable rate loans and wide deposit bases, such as Italy, Portugal, and Spain. Moreover, banks in surplus countries where excess reserves are concentrated would bear a disproportionately higher cost from negative interest rates.


Scope of Available Assets after Completion of Current Asset Purchase Program (APP) as of end-March, 2016

(EUR billion)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Source: Bloomberg L.P., Dealogic, ECB, and IMF staff calculations.Note: 1/ The values are reported in nominal terms and take into account existing and planned purchases until March 2017 as well as issuer/issue limits (incl. SMP), and exclude government debt securities outside the eligible maturity range of between 2 and 30 years and securities trading below the deposit rate (as cap on the eligible market for each asset class); the amount is also reduced by further by the allocation of purchased based on the pro-rated ECB capital key (without Greece and Cyprus); 2/ includes sub-national and agency debt securities. For all securities, only the non-encumbered market was considered.

38. Additional monetary easing—if needed—should therefore rely more on expanding asset purchases. Staff analysis suggests that after applying various limits and the ECB’s capital key, an additional €2.4 trillion of assets after planned purchases through March 2017 would be available, which could more than accommodate a one-year extension of the program (equivalent to about €960 billion in purchases; text figure). Modest changes to the program could dramatically increase the scope for more purchases. For example, allowing the purchase of bonds with yields below the deposit rate would increase the pool of short-dated sovereign debt, permitting purchases to be more evenly distributed across the yield curve.

Authorities’ views

39. The ECB views current easing measure as effective. Asset purchases have compressed the term premium significantly, eased lending standards, and reversed the contraction in loan growth. QE may have contributed to the buildup of excess liquidity in creditor countries, but the associated portfolio rebalancing has also helped reduce financial fragmentation, benefiting lending in debtor countries.

40. The ECB encourages a more holistic assessment of negative rates’ impact on the bank lending channel. Negative rates have complemented asset purchases by further flattening the yield curve. Further rate cuts might entail diminishing returns due to lower bank profitability as deposit rates in some countries might fail to adjust. However, the impact of negative rates on bank profitability would be mitigated by valuation gains and improved asset quality (as borrowers’ debt service burdens decline). TLTRO II can further help reduce the potentially adverse impact by lowering funding costs.

41. The ECB concurred with the need for effective securities lending programs across the Eurosystem to avoid collateral scarcity. No shortages were currently evident, as most NCBs have initiated active securities lending programs. The ECB noted that further enhancements towards collateral accessibility and common principles could improve efficiency while recognizing the heterogeneity of underlying markets.

42. The ECB stands ready to ease further if needed to ensure inflation stays on the adjustment path towards its price stability objective. The TLTRO II and corporate sector purchase program (CSPP) implemented in June 2016 are expected to provide additional stimulus. The ECB remarked that it closely monitors current inflation dynamics, including the risk of second-round effects entrenching low inflation expectations into the wage and price-setting mechanisms. If warranted to achieve its objective, it will act by using all the instruments available within its mandate.

D. Repairing Balance Sheets and Completing the Banking Union

43. The financial sector in Europe is struggling to adjust to a prolonged period of low growth and inflation (Figure 6). Bank profitability remains low, partly reflecting the anemic recovery and flattening yield curve, but also the lingering effects of crisis legacies and the slow adaptation of business models to the new environment, including from the rise of fintech. High NPL ratios weigh on banks in several countries, including Cyprus, Greece, Ireland, Italy, and Portugal, while large banks in France and Germany face challenges from high leverage. Many banks are engaging in a process of derisking, including reducing the size of their correspondent bank networks, which could have spillovers elsewhere. This reflects both tighter regulatory requirements and a more challenging economic environment, particularly for large global banks. More generally, European banks’ low price-to-book values and the euro area’s large size of bank assets to capital markets compared to other banking systems suggest that many countries suffer from “overbanking,” pointing to a need for further consolidation and restructuring. Low investment returns have also affected pension funds and life insurers, eroding their ability in some cases to meet their guaranteed commitments.

44. Bank balance sheet repair has been slow in several countries. Write-off rates increased in 2015, helping to bring down NPL ratios for the first time since the global crisis, but their pace remains too low given the stock of NPLs. High NPLs inhibit credit growth, reduce bank profitability, and impair monetary policy transmission. Waiting for a strong recovery to resolve NPLs appears unrealistic and there will need to be some recognition of losses. Staff analysis suggests that in some countries, banks would need to expand lending significantly under difficult conditions to offset the drag on profitability from NPLs (Annex II).

45. A comprehensive approach to accelerating NPL resolution is needed to help raise bank profitability, stimulate lending, and facilitate consolidation. The SSM has set up a task force to formulate best practices for NPL resolution across member states, as well as identify problem banks for enhanced supervision, but much more needs to be done. A time-bound, comprehensive strategy is urgently needed to address the NPL problem and can be part of a broader strategy for promoting consolidation in some banking systems:16

  • Incentivize faster resolution through stricter supervision. More conservative provisioning and collateral valuation, capital surcharges, and time limits on NPL disposals, would incentivize banks to resolve NPLs more quickly, while nonviable banks should be restructured or liquidated. The SSM should set aggressive time-bound NPL disposal targets following up on the results of the EU stress test that informs the Supervisory Review for Evaluation Process (SREP).

    Figure 6.
    Figure 6.

    Banking Developments

    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: Bloomberg; Dealogic; ECB; EBA Transparency Exercise (2015); U.S. Federal Reserve; Extract from Figure 5, Langfield and Pagano (2016); IMF FSI database; IMF WEO; national authorities; and IMF staff calculations.Notes: 1 Euro area ROA is weighted by country bank assets.2 As of End-Sept. 2015 for the United States and End-June 2015 for the Euro area.3 As of end-Q2 2015 (for IRE and ITA, end-2014); assumes unchanged write-off rate, future loan growth in line with nominal GDP, and non-performance of new loans at pre-crisis default rates.

  • Strengthen and harmonize corporate insolvency and foreclosure frameworks. Lengthy court procedures should be shortened and out-of-court arrangements encouraged. Such reforms would increase the value of collateral and help close the pricing gap holding back NPL sales.

  • Promote active markets in distressed assets. Stricter supervision and insolvency reforms should be accompanied by measures to develop distressed debt markets to facilitate NPL disposals. International experience suggests that private and publicly supported asset management companies (AMCs) can play a role in kick-starting such markets by facilitating the sale of impaired assets to specialist investors. In systemic cases where state intervention may be warranted, EU State Aid rules should be exercised flexibly as permitted, recognizing that the correct determination of “market prices” is difficult without a functioning market.17 AMCs should be open to foreign participation, including by pan-European institutions, which could assist in funding and governance.

46. Completing the banking union requires establishing a common deposit insurance scheme while also mitigating banking sector risks. There has been some notable progress, with the financing of the Single Resolution Fund (SRF) to back the year-old Single Resolution Mechanism (SRM). However, the final pillar of a common deposit insurance system is still missing, leaving bank-sovereign risk links largely intact. The European Deposit Insurance Scheme (EDIS) proposed by the EC in November 2015 is a step in the right direction, linked to member states’ implementation of the Deposit Guarantee Scheme Directive (DGSD) and with a gradually increasing insurance coverage. But until banking sector risks have been reduced to the satisfaction of all member states, agreement on the proposal is likely to prove elusive.

47. Greater risk sharing should proceed hand in hand with measures to reduce banking sector risks. Risk sharing, without risk reduction, may lead to moral hazard and unintended transfers, while risk reduction alone fails to address the need for a common backstop in a systemic crisis. The solution is to proceed simultaneously on both fronts. In addition to swifter NPL resolution, further risk reduction could include:

  • Capital. Extending the recently announced agreement between the ECB and national competent authorities on national options and discretions to less significant institutions would further harmonize and strengthen the definition of capital.

  • Recovery and resolution. To enhance the effectiveness of the Bank Recovery and Resolution Directive (BRRD) and curtail bail-in surprises, differences in creditor hierarchies across countries in bank resolution should be clearly communicated to investors or a common hierarchy established. The SRB and national resolution authorities (NRAs) should deploy more quickly the BRRD’s minimum requirements for own funds and eligible liabilities (MREL) to clarify how bank losses could be absorbed. In general, regulatory uncertainty regarding new requirements should be reduced to allow banks to plan for a smooth transition. To ensure that the BRRD functions smoothly in a crisis, supervisors and resolution authorities should test how bail-in and cross-border coordination would work, especially for large and complex banks.

  • Sovereign exposures. A more risk sensitive prudential treatment of banks’ sovereign exposures could be considered, phased-in gradually and following the guidelines of the international review being undertaken by the Basel Committee.


Euro Area: Change in Price of Default Protection of Banks and Sovereigns, Jan. until mid-Feb. 2016 1/

(Percent change/percent of Tier 1 capital)

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg LP, EBA Transparency Exercise (2015) and IMF staff calculations.1 Senior CDS contracts at 3-year maturity; banks CDS is weighted by total assets of each bank; the percentage value shows the indicates net domestic sovereign exposure relative to Tier 1 capital of each sample bank.

48. Greater risk sharing in the banking sector also requires a common fiscal backstop. A common fiscal backstop, such as a credit line from the ESM, is needed for both the EDIS and the SRF to minimize the chances that bank-sovereign risk links reemerge, particularly during the transition to being fully financed (see text figure). In times of systemic stress, the ESM could be empowered to engage in precautionary direct bank recapitalizations of viable banks to safeguard financial stability as allowed under BRRD, with the appropriate conditionality.

49. Faster progress on the capital markets union would also spur greater private risk sharing and non-bank financing alternatives. Some headway has been made with the changes to insurers’ capital changes for infrastructure investment under Solvency II and the proposal for simple, transparent, and standardized (STS) securitization, which should be swiftly adopted. Beyond these measures, a more ambitious and clearer timeline for deeper institutional changes, such as the harmonization of insolvency regimes, would be beneficial.

50. Macroprudential policies may need to be deployed in some countries, to address nascent real estate bubbles as well as weaknesses in the insurance sector (Figure 7). Marked house price appreciation may require some macroprudential measures, such as limits on loan-to-value ratios. In some countries, the life insurance sector is vulnerable to investment returns falling under guaranteed minimums. Supervisors should respond by encouraging business models to shift towards products less reliant on guarantees and monitor the situation closely. Although it is not vested with supervisory powers regarding anti-money laundering and combating the financing of terrorism (AML/CFT), the ECB could also consider entering into memorandums of understanding (MoUs) with the designated national authorities to ensure effective AML/CFT supervision and cooperation in line with international standards.

Authorities’ views

51. The authorities agreed that the banking system’s high NPLs and persistent, low profitability are priorities and stated that tailored approaches are required. Banks have also responded to the weak earnings environment and heightened regulatory uncertainty by derisking, including by reducing their correspondent bank networks. To restore profitability, banks will need to grow their non-interest income, reduce costs, and adapt their business models to the tougher regulatory and supervisory environment. On NPLs, the ECB will request banks to implement tailored NPL reduction strategies and communicate their plans to address NPLs. However, the pace of NPL reduction will likely be gradual to mitigate the risk of market disruptions and a credit squeeze. Consolidation is also needed, but should be done properly through a mix of mergers, portfolio divestments, and exits, based on sound business plans. Expanding private risk sharing through a capital markets union would be another means of improving the economy’s robustness and reducing its reliance on banks.

52. Deep concerns over moral hazard and possible transfers by some member states have held up progress on banking union. Further risk sharing through EDIS and a fiscal backstop for the SRF was seen as necessary, even though it may take some time before banking sector risks and moral hazard were deemed sufficiently addressed by some member states. However, the authorities cautioned against holding up completing the banking union by making risk reduction a precondition. They also believed that it was important that any steps to reduce sovereign risk exposures be aligned with global standards.

53. Although financial stability has improved, the authorities highlighted some area for close scrutiny, including real estate and life insurance in some countries. The authorities also thought that the financial system was more resilient, with higher capital levels and more robust regulatory and supervisory frameworks, in both bank and non-bank financing. However, the challenge of low interest rates for life insurers and pension funds was recognized as a possible issue, but primarily for the medium-term.

Figure 7.
Figure 7.

Financial Stability

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg; Haver Analytics; Eurostat; ECB; IMF, RES-MFU; Figure 3.15, GFSR (2016, April), Chapter 3; and IMF staff calculations.Notes:1 The interest rate sensitivity is a measure of the change in the indicated variable for a one percentage point fall in the policy rate.

Synergies from Comprehensive, more Balanced Policies

54. Combining structural, fiscal, and monetary policies would capitalize on important synergies. Structural reforms—by raising potential output and strengthening the monetary union’s capacity to respond to shocks—can reduce the burden on countercyclical demand policies. Some structural reforms can also bring forward spending by raising expected future output. Faster NPL resolution would enhance the effectiveness of monetary policy by unclogging the credit channel and reducing private debt overhangs. Greater public investment by countries with fiscal space and more growth-friendly fiscal policy would boost both demand and supply, generating positive spillovers within the union. Centrally-financed investment schemes can overcome national fiscal constraints, providing more targeted support to affected countries without increasing national debt stocks and also supporting needed consolidation in high debt countries as recommended by the Fund in some cases. Take together, a collective effort to close output gaps more quickly would lift overall inflation, pushing down real interest rates across the area. Higher inflation and growth in turn would facilitate external rebalancing through relative price adjustments, rather than further painful internal devaluations.

55. The gains from a comprehensive, more balanced policy mix would be substantial, for Europe and the world. Using the IMF’s EUROMOD macroeconomic model, staff assessed the impacts of a comprehensive approach, including: (i) continued monetary accommodation by the ECB; (ii) use of existing fiscal space including flexibility under the SGP for structural reforms, amounting to around 0.4 percent of euro area GDP over 2017-18;18 (iii) centrally-financed investment in the euro area of around 1 percent of GDP for 2017-21 similar to the current EFSI, with some targeting to countries with larger output gaps; (iv) reduced credit risk premia from a cleanup of bank balance sheets, and (v) implementation in 2018 of product and labor market reforms per the G20’s 2014 Comprehensive Growth Strategy. Taken together, the main findings relative to the April 2016 WEO were (text figures):19

  • Higher growth and inflation. Euro area growth would be 0.3 percentage point higher on average in 2017 and 2018, closing the euro area output gap by 2018—about two years earlier than currently projected. By 2021, output would be 2.2 percent higher than the baseline, equivalent to another one and a half years of growth at current rates (text figure). Headline inflation would reach 2 percent by 2019 compared to a baseline of only 1.7 percent by 2021.

  • Stronger fiscal positions. Aggregate euro area public debt would be 3 percent of GDP lower by 2021, with declines larger in high debt countries (4 percent of GDP on average). Fiscal deficits in these countries would also be about 0.4 percent of GDP lower each year, helping to rebuild buffers to guard against future shocks.


    Euro Area: GDP Growth Simulations


    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: IMF, World Economic Outlook; and IMF staff calculations.

    Euro Area: Government Gross Debt

    (Percent of GDP)

    Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

    Sources: IMF, World Economic Outlook; and IMF staff calculations.

  • External spillovers. The euro area’s current account surplus would decline to 2.2 percent of GDP by 2021, generating positive spillovers to the rest of the world. Germany’s current account surplus would be average of 0.3 percent of GDP lower each year.

56. A comprehensive approach would also provide valuable insurance against the risk of stagnation. A similar coordinated policy response applied to the downside stagnation scenario outlined in the previous section would help maintain growth and policy buffers. The results highlight how even a small centralized fiscal capacity can enhance the union’s resilience to shocks by complementing common monetary policy and better targeting stimulus. By providing insurance against large shocks through a centralized fiscal capacity linked to a stronger governance framework, countries would have greater incentives to pursue major fiscal and structural reforms, paving the way for further integration and risk sharing.

Authorities’ views

57. A more comprehensive policy approach is desirable but not straightforward to achieve. The authorities agreed that a more balanced policy mix, including from centralized investment, would be preferable and could have significant benefits for growth and inflation, including in the event of a downturn. However, there is limited appetite in countries with fiscal space to use it, and the challenging political environment would make it difficult to create new mechanisms for centralized or targeted investment support. Political support for such centralized initiatives would require stronger compliance with the fiscal rules and progress in structural reforms.

58. Nevertheless, the results of staff’s comprehensive policy scenario are broadly consistent with the authorities’ analysis. They noted though the potential gains could be lower if inflation expectations were to become unanchored, the costs from balance sheet cleanup were higher, or structural reforms have a disinflationary impact, although this could be mitigated by careful sequencing or other complementary demand support.

Staff Appraisal

59. The euro area recovery continues with stronger growth in recent quarters. Domestic demand is leading the recovery, supported by low oil prices, a neutral fiscal stance, and accommodative monetary policy. Exports have slowed in line with weakening external demand. Inflation is extremely low, with disinflation in several countries and inflation expectations adjusting downwards.

60. The external position has strengthened, but imbalances persist. The euro area current account surplus rose further, buoyed by a weaker euro and an improved oil balance, and is broadly consistent with its medium-term fundamentals. But progress on external rebalancing within the euro area has slowed. While the current accounts of debtor countries, such as Portugal and Spain, have improved due to competitiveness gains, the surpluses of some large creditor countries, such as Germany, continue to grow.

61. The medium-term outlook is for steady but modest growth. Growth remains weighed down by crisis legacies including high unemployment and non-performing loans in some countries. Business investment, particularly by SMEs, is recovering slowly, held back by corporate debt overhangs, while productivity remains well below pre-crisis levels. With the output gap closing only slowly, inflation pressures are expected to remain subdued, raising the adjustment challenge for debtors.

62. The risks to the baseline have increased markedly. An external slowdown could disrupt the domestic demand-led recovery. Moreover, political divisions from the refugee surge could deepen, putting at risk the free movement of goods and services within the single market. A “leave” or marginal “remain” vote in the U.K. referendum could lead to heightened uncertainty and fuel further euroskepticism.

63. The euro area has reached a critical juncture, with strong collective actions needed to strengthen the union. Monetary policy alone cannot address structural gaps and imbalances. Without more decisive actions to boost growth and strengthen the monetary union, the euro area will remain vulnerable to instability and repeated crises of confidence. And the current “muddling through” policy approach will become increasingly untenable.

64. Ambitious structural reforms are essential to raise potential growth in the face of demographic headwinds, and to reduce macroeconomic imbalances. A stronger governance framework, with CSRs linked to outcome-based benchmarks, could better incentivize reforms. Benchmarks should be concrete, measurable and clearly linked to the ultimate reform objective. Candidates include the labor tax wedge, OECD indices on regulatory barriers in professional services, employment protection, and other business climate indicators. Progress towards meeting common benchmarks could also be a precondition to accessing centrally-financed support.

65. Fiscal support should come from countries that have fiscal space and from an expansion of centralized investment schemes. Countries with fiscal space should use it to promote public investment and structural reforms, while high debt countries should use interest savings from QE to reduce debt. Centrally-financed investment schemes could provide additional fiscal support. The EFSI could be enlarged, or new centralized funds established for common projects such as the energy union, refugee settlement, and climate adaptation and mitigation. Over the longer term, a centralized fiscal capacity, such as a euro area treasury, would make the euro area more resilient, helping address large country-specific and common shocks.

66. Generating political support for expanding centralized investment will require stronger SGP compliance and enforcement. Stricter adherence to the fiscal rules is critical for rebuilding trust in the fiscal framework and backing for more centralized initiatives. This could be supported by simplifying the fiscal rules, making their enforcement more automatic, and establishing an independent European Fiscal Board. To incentivize adherence to the rules, a country’s access to centrally-financed investment schemes could be linked to SGP compliance and implementation of structural reform recommendations.

67. Monetary policy is appropriately accommodative. The March easing measures—scaled-up monthly purchases, corporate bond purchases, and the updated TLTRO—should further ease financial conditions and expand credit. Negative interest rates to date have helped lower bank funding costs, improve asset quality and ease lending standards. However, the burden of negative deposit rates falls disproportionately more on banking systems with large excess reserves, while further rate cuts may unduly squeeze banks’ net interest margins, especially in countries more dependent on deposit funding, and where large variable-rate mortgage portfolios are prevalent.

68. If the inflation outlook deteriorates or fails to converge more quickly to the anticipated adjustment path, further easing would be warranted. This should come primarily from expanding the scope of asset purchases, which would allow scaling-up monthly purchases and/or extending the life of the program.

69. Bank balance sheet repair should be accelerated. Bank profitability remains weak, reflecting the mediocre recovery, low rate environment, legacy problems and regulatory uncertainty. The SSM’s NPL taskforce should act aggressively to set targets for banks to reduce their impaired assets. This should be accompanied by insolvency reforms and efforts to facilitate distressed debt markets, including through AMCs. In systemic cases where state intervention may be warranted, the EU State Aid rules should be exercised flexibly as permitted. NPL resolution could be part of a broader strategy to foster consolidation in the banking sector and facilitate the exit of nonviable banks.

70. A common deposit insurance scheme (EDIS) and a common fiscal backstop are essential to complete the banking union. In parallel with the implementation of EDIS, measures to reduce banking sector risks could be considered, including the prudential treatment of sovereign risk, which should be closely coordinated with global standards. Further progress on the capital markets union could also reduce risks by helping diversify financing sources and fostering greater private risk sharing.

71. It is proposed that the next Article IV Consultation on euro area policies take place on the standard 12-month cycle.

Table 1.

Euro Area: Main Economic Indicators, 2013–2021

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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 for Jul 2016.

Contribution to growth.

Includes intra-euro area trade.

In percent.

In percent of GDP.

Latest monthly available data for 2016.

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

Table 2.

External Sector Assessment

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Table 3.

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).

Table 4.

Structural Reform Plans and Progress in Selected Euro Area Countries

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Source: IMF country teams
Figure 8.
Figure 8.

Structural Reform Benchmarks

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: OECD, Product Market Regulation Database; OECD/IDB Employment Protection Database; Haver Analytics; and IMF staff calculations based on Chapter 3 of the April 2016 World Economic Outlook (Appendix 3.2 has definitions and methodology) and IMF Working Paper 16/62.
Table 5.

A Scorecard Approach to the Near-Term Fiscal Stance1

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Figures in this table are based on the April 2016 WEO.

Primary gap is P-P*, where P is the structural primary balance as % pot. GDP and P* is the debt stabilizing primary balance in the medium term defined as (r-g)*d, where d is for 2014 and (r-g) is for 2020.

The values for each variable are colored depending on: (i) their signal for the fiscal stance based on the thresholds for sections 1-2, and (ii) change in fiscal stance for section 3.

Enough to exit EDP in 2017.

Enough to exit EDP in 2016.

Source: EUR desks.

Source: EC assessment of draft 2016 budgetary plans (November, 2015).

SGP debt rule is triggered 3 years after a country with debt/GDP > 60 percent reaches its MTO. It requires an annual debt/GDP ratio reduction of at least 2/20 of the difference from the 60 percent target.

Note: MTO is defined as percent of GDP, while structural balnce is defined as percent of potential GDP.

Annex I. The Impact of Negative Interest Rate Policy on Bank Profitability1

1. The transmission of negatives rates to the financial markets and broader economy so far has been smooth. Money markets in the euro area have quickly adjusted to modestly lower deposit rates on banks’ excess reserves under the ECB’s negative interest rate policy (NIRP), showing that the zero lower bound is less binding than previously thought. Negative policy rates have also passed on to the wider economy by lowering lending rates for both firms and households.

2. However, going forward, sticky deposit rates could diminish bank profitability and impair pass-through to lending rates. The transmission of a lower negative marginal policy rate to lending rates reduces bank profits from intermediation unless deposit rates can adjust downwards. So far, many banks have been able to offset declining interest income with higher lending volumes, lower funding costs via capital markets, lower provisioning and capital gains from investments. There has also been some room for deposit rates to adjust downwards, preserving bank profitability, but there is likely to be a lower bound below which disintermediation occurs. This is particularly relevant in countries with high shares of variable rate loans and high dependence on deposit funding, such as Italy, Spain, and Portugal (text figure). Excess bank reserves facing a negative ECB deposit rate are also concentrated in banking systems of surplus countries.

3. Bank profitability is likely to suffer if low lending growth does not offset diminishing interest margins. Based on the historical interest pass-through and term premia effects of easing measures, it is possible to determine the minimum annual increase in lending over the average maturity term of the current loan portfolio required to offset the projected decline in net interest margins (NIMs). It is estimated that the combination of NIRP and the recently expanded asset purchase program lowers NIMs of euro area banks in 2016 by 11 basis points on average, with a larger decline in countries with a higher proportion of variable rate loans and a higher cost of risk (such as Italy and Spain). Based on staff analysis, aggregate lending would need to increase 2.3 percent annually (up from 1.8 percent at end-January) for banks to maintain current profitability over the amortization period of their current loan book (text figure, chart 5). The calculation ignores possible improvement in asset quality and increase in asset prices associated with monetary easing.

4. The ECB’s TLTRO II may mitigate the potentially adverse impact of NIRP on bank profitability. Granting banks access to cheap funding facilitates pass-through of the marginal policy rate to the wider economy. Moreover, it helps maintain profitability in countries where banks face a high cost of risk and/or would refrain from lowering lending rates to preserve profit margins (text figure). In some countries, however, current lending growth remains low and falls below the required benchmark to access TLTRO II funding at the most favorable terms. Therefore, lower funding costs through TLTRO II would benefit only new lending and does not offset the negative impact of asset re-pricing on existing loans.


Annual Loan Growth Required to Maintain Net Interest Margin, end-2015

(y/y percent change) 1/

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg L.P., EBA Transparency Exercise (2015), ECB, SNL, and IMF staff calculations.Note: 1/ based on the historical pass-through of policy rates and the elasticity of net interest margins to changes in term premia between Jan. 2010 and Feb. 2016; total mortgage and corporate loans at end-2015 to EA residents.; scenario assumes an increase of monthly asset purchases (until Sept. 2017) by the ECB and a deposit rate cut of 10bps (as per ECB decision on March 10).; */ assumes that new lending is fully funded using TLTRO- I funds at a weighted average borrowing rate of -20bps.

ECB TLTRO-II Benchmarking: Net Lending to Non-Financial Corporates and Households, Dec. 2014-Jan 2016


Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg L.P., Haver, and IMF staff calculations. Note: 1/ Net lending growth required to qualify for TLTRO II borrowing at the ECB deposit rate (-0.4%).
Figure A1.
Figure A1.

The Impact of Negative Rates on Bank Profitability and Credit Growth Implications

Citation: IMF Staff Country Reports 2016, 219; 10.5089/9781498353298.002.A001

Sources: Bloomberg L.P.; Haver Analytics; EBA Transparency Exercise (2015); ECB; SNL; and IMF staff calculations.Notes: 1 Volume-weighted average based on lending to both non-financial corporates and households.2 Deposit rate less three-month money market rate.3 MFI=monetary financial institutions.4 Other household and non-financial corporates.5 Calculated for new agreements between June 2014 and Jan. 2016 (lending spread) and June 2014 and March 2016 (NIM). Lending spread is calculated as the difference between the lending rate for new business less the three-month money market rate; the only until Jan. 2016.6 NPEs as of End-June 2015; change of NIM between June 2014 and March 2016.7 Based on the historical pass-through of policy rates and the elasticity of net interest margins to changes in term premia between Jan. 2010 and Feb. 2016; total mortgage and corporate loans at end-2015 to EA residents.; scenario assumes an increase of monthly asset purchases (until Sept. 2017) by the ECB and a reduction of the deposit rate by 10bps (as per ECB decision on March 10).

Annex II. Can European Banks Grow out of their Problems?

High levels of NPLs continue to constrain bank profitability and new lending. Staff analysis suggests that while banks in a baseline recovery would be able to generate profits on