Euro area recovery and risks

The authorities broadly share staff’s view that in the central scenario the recovery, which has been more robust than expected, is set to continue with the near-term outlook depending crucially on the strength of domestic demand. In 2016, the economic recovery has entered its fourth year and by now economic activity exceeds the pre-crisis peak. Supportive factors in 2016 include still relatively low levels of oil prices and the euro, strong support from a very accommodative monetary policy, and slightly expansionary fiscal policy in the euro area as a whole. However, the growth dynamics are hampered by several factors. Among them are the remaining legacies of the crisis, low potential growth, slowing economic growth in several emerging market economies (including China), but also weak performances in several advanced economies outside Europe. Moreover, the relatively slow expansion of global trade and elevated geopolitical and policy-related uncertainty are weighing on the economic activity in Europe. Regarding the external position, according to Commission’s 2016 Alert Mechanism Report, the euro area surplus is considered to be above what could be explained by fundamentals.

The staff’s assessment highlights that uncertainty and downside risks to the growth outlook have recently increased. The authorities agree on this assessment. On the external side, risks relate to the expected rebound in emerging markets and the smoothness of Chinese transition, to moves in oil prices and geopolitical tensions. On the domestic side, risks mainly relate to overall policy uncertainty and the capacity to implement common solutions to common challenges. Moreover, one of the risks identified in 2016 Commission Spring Forecast has materialized, with the outcome of the UK referendum, which not in the central scenario of the IMF’s forecast. This will affect not only the economy of the UK but also the economy of euro area. The size of the impact will however depend on the forthcoming negotiations. In the near term, political and economic uncertainty during the exit negotiations can lead to financial market tensions and higher risk premia, as well as confidence effects. The medium-term impact will depend very much on the future bilateral regime between the EU and the UK and the policy response by the EU. In that regard, any assessment of the implications of the exit remains preliminary.

The authorities agree with the medium term outlook presented in the report for the central scenario. We also broadly share the view that the factors responsible for low medium term growth are related to weak investment, population aging and a slowdown of TFP growth. Our own work also supports the view presented in the report that financial legacy issues (over-borrowing and non-performing loans) are important for explaining weak investment. More work is needed to fully understand the slowdown in TFP growth in the euro area. Here the picture differs across euro area economies. More progress needs to be made in disentangling the various factors such as ageing effects, entry barriers, skill mismatch, sectoral change, mis-measurement of value added of services and new consumer products. An important question is also to what extent the crisis has accelerated the productivity decline due to financial constraints on innovators and adopters.

Complete the banking union and accelerate bank balance sheet repair

As a result of supportive monetary policy and the progress achieved towards the Banking Union, financial conditions continue to improve and banks have strengthened their capital and liquidity buffers. Lending rates have declined in the euro area and credit growth has turned positive. According to the latest surveys, companies (including SMEs) do not see availability of bank funding as their main constraint. The authorities expect that, as the recovery firms up, these trends will continue.

Nevertheless, more needs to be done to accelerate and advance bank balance sheet repair across the euro area. Despite some recent decline, non-performing loans (NPLs) ratios remain elevated, especially in some Member States. The authorities agree that addressing this challenge requires a comprehensive strategy combining efforts by bank supervisors, national and, potentially, European policy makers. The legal and institutional framework could also usefully be revisited in many Member States. This includes foreclosure and bankruptcy laws and procedures, the supervisory treatment of provisioning requirements and non-performing and forborne loans, as well as market rules for distressed loan sales and tax rules. Progress on these fronts is currently being made in several Member States. The authorities would have to further explore how the incentives framework can be strong enough for banks to address their NPLs while respecting the applicable EU rules on state aids and on bank resolution (BRRD).

At the same time, banks will need to do their part to restore sufficient levels of profitability – while at the same time recognizing that pre-crisis profitability will not return – e.g. by growing their non-interest income, reducing costs, and adapting their business models to the evolving economic context and technological progress. The authorities agree that further consolidation of the banking system is needed in several countries.

The authorities broadly share staff’s views concerning the completion of the Banking Union. Further steps will have to be taken in terms of reducing and sharing risks in the financial sector, in the appropriate sequence, in order to address a number of remaining challenges. The next steps are outlined in the roadmap endorsed by the June Ecofin Council.

Progress is continuing towards the objective of establishing a Capital Market Union in the EU. New rules have already been enacted to support investment by insurers and reinsurers in infrastructure projects. A legislative proposal to restart securitization markets in Europe was agreed in record time by Member States in December 2015, and is currently being considered by the European Parliament. A proposal was also presented to simplify prospectus requirements and reduce burdens for companies issuing shares and bonds. The authorities are also assessing the submissions received in the context of the so-called "Call for Evidence" with a view to determine whether the EU’s legislative framework is working to support growth across the EU.

Strengthen the fiscal framework while assessing centralized support

On the fiscal policy side, the authorities broadly agree with the Fund’s assessment that, in line with European fiscal rules, fiscal policies should reflect the economic conditions and sustainability risks at Member State level, while ensuring an effective co-ordination of economic policies. Fiscal adjustment in structural terms came to a halt in 2015 at the euro area level. For 2016 a slightly expansionary fiscal stance is expected for the euro area, before turning broadly neutral in 2017. This is deemed appropriate given the combined need to reduce high debt levels and to support the closure of the output gap. The fiscal effort should be differentiated by individual Member States in compliance with the requirements under the Stability and Growth Pact (SGP), while considering stabilization needs, as well as taking into account possible spillovers across the Member States, including for the euro area as a whole. The authorities fully agree that there is further scope for improving the efficiency of tax systems and reducing the tax wedge on labor. Insufficiently productive expenditure should be further reduced.

Authorities emphasize that a predictable, transparent and consistent application of the SGP is key to fully enforce commitments, to ensure that all Member States are treated equally and to preserve the credibility of the Stability and Growth Pact (SGP)in a protracted phase of low inflation and slow growth. The Commission and Member States are currently discussing ways to improve transparency and predictability and reduce the complexity of the fiscal rules. Options to increase reliance on a single operational target are being explored, while the medium-term budgetary objectives are already in place to anchor fiscal policy. However, a pro-cyclical bias needs to be avoided. Further strengthening of national fiscal frameworks should focus on ensuring their effective functioning to support the conduct of responsible fiscal policies, in compliance with the SGP.

On the windfall from lower interest payments, the authorities agree that countries with high debt should preferably use windfall gains, where available, to make further progress in improving debt positions.

The European Fund for Strategic Investments (EFSI) was successfully launched last year and is expected to have already mobilized investments of over EUR 106 billion in 26 Member States. Work is ongoing to provide public and private project promoters with valuable technical assistance including facilitating access to the EFSI. The European Investment Project Portal launched on 1 June 2016 increases the visibility of investment opportunities across Europe for investors worldwide. The European Commission will propose an extension of EFSI beyond the initially planned time horizon of 3 years, subject to a thorough assessment of its efficacy and impact. While, in the current circumstances, it is important to strengthen short-term and medium-term growth prospects, any additional "centralized investment schemes", as proposed in the report, would need to be carefully assessed. An experts group set up by the Commission will consider these issues in relation to the second stage under the Five Presidents’ Report.

Monetary policy and the outlook for price stability

The ECB’s monetary policy remains supportive to the economic recovery. It has decisively contributed to the easing of financing conditions and to supporting the recovery in credit creation to firms and households. Moreover, additional monetary stimulus is expected from the measures that are still at an early stage of implementation, notably from the corporate sector purchase programme (CSPP) and the second wave of targeted longer-term refinancing operations. This will contribute to further rebalancing the risks to the outlook for growth and inflation.

The ECB closely monitors the evolution of the outlook for price stability and, if warranted to achieve its objective, will act by using all the instruments available within its mandate. Obviously, monetary policy does not act in isolation. Solid public finances and structural reforms are crucially important for higher sustainable economic growth in the euro area.

Prioritize structural reforms and their governance

The authorities agree that well-designed and sequenced structural reforms can have a sizeable positive medium-term impact on potential growth and contribute to enhance the adjustment capacity of the euro area. Moreover, the short-term impact of structural reforms in product and labor markets on growth can be maximized if determined implementation boosts confidence. A coordinated implementation of reforms by the Member States can produce higher gains, while synergies with fiscal and monetary policy can generate additional positive spillovers.

Member States have advanced reforms over the last year but the pace of reforms was slower than in the previous year and uneven across countries. There was more progress in addressing country-specific recommendations (CSRs) in Member States experiencing imbalances than in the others, reflecting a larger need for reform, enhanced monitoring including a more regular policy dialogue with the EU institutions and, in some cases, stronger market pressure. While significant progress was observed with regard to CSRs in the areas of financial services and active labor market policies, much remains to be done in other important areas such as addressing weaknesses in the business environment, improving the functioning of labor markets and reducing barriers in the services sector.

The authorities agree on the reform priorities highlighted by the staff. The 2016 European Semester has put particular emphasis on removing barriers to investment, improving the business environment and productivity, making public expenditure more supportive to growth, and improving employment, human capital, social inclusion and protection.

Many efforts have been made to streamline the European Semester in order to increase political ownership and accountability, strengthen its credibility and improve the implementation of the CSRs. A greater focus has been on euro area challenges and on the interdependence between economies. The Commission is progressively putting in place benchmarking and cross-examination exercises across policy or thematic areas, to foster a common understanding of challenges and policy responses and to increase reform implementation. Cross-country analyses and benchmarking exercises have become important tools to support policy advice given in the country-specific recommendations, facilitating a transparent discussion of best practices and fostering reform implementation in various policy areas.

Reinforcing the Single Market is essential to enhance firms’ capacity to innovate, invest, become more productive and create jobs. Complementing the necessary reform efforts of the Member States, the Commission has launched initiatives to reinforce the Single Market and create a business-friendly environment, notably through initiatives to develop a Capital Markets Union; to further deepen the Single Market for goods and services; to create a Digital Single Market; and improve the Single Market in transport and energy.