Euro Area Policies: Staff Report for the 2017 Article IV Consultation with Member Countries

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Member Countries


2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Member Countries

Key Messages

The recovery is firming, with growth and job creation returning in many countries that went through severe downturns. Accommodative policies have played an essential role in securing the recovery. High-debt countries should take advantage of the recovery and the remaining window of monetary accommodation to reduce vulnerabilities and rebuild buffers. Euro area countries should grasp the opportunity provided by the recovery and the political momentum to push for deeper integration and complete the architecture of the Economic and Monetary Union (EMU). At the same time, persistent competitiveness gaps and a lack of income convergence across countries could challenge the cohesion of the monetary union, and need to be addressed by decisive actions at the national level. Structural reforms to boost productivity in lagging countries should be accompanied by measures to support external rebalancing through higher wage inflation and domestic demand in net external creditor countries.

Context: The Recovery is Firming

1. The recovery has strengthened, supported by domestic demand. Growth reached 1.8 percent in 2016, despite a challenging external environment marked by depressed global trade and elevated uncertainty triggered by the U.K. vote to leave the European Union (EU) (Brexit) (Table 1). In line with divergent post-crisis trends, robust growth in Germany and Spain contrasted with weaker growth in Italy (text figure). Domestic demand, especially private consumption, accelerated in several countries supported by monetary stimulus, a mildly expansionary fiscal stance, lower energy prices, and stronger labor markets. The euro area unemployment rate has fallen to 9.3 percent in May from its 2013 peak of 12 percent, but with large variations across countries (text figure).

Table 1.

Euro Area: Main Economic Indicators, 2014–22

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Sources: IMF, World Economic Outlook, Global Data Source; Reuters Group; and Eurostat

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

Contribution to growth.

Includes intra-euro area trade.

In percent.

In percent of GDP.

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

Latest monthly available data for 2017.


Real GDP Level

(2007Q1= 100)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: Eurostat; and Haver Analytics.

Unemployment Rate


Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: Eurostat; and Haver

2. Recent data point to steady and broad-based growth (Figure 1). Growth held firm in the first quarter of 2017 at 1.9 percent year-on-year, benefiting from both a robust domestic demand and improved net exports. PMIs and business surveys strengthened in early 2017, suggesting that firms are benefiting from the recovery in global manufacturing and trade. Euro area manufacturing export growth rose to 4.5 percent in the past six months compared to a year ago. Consumer confidence remains above its long-term average.

Figure 1.
Figure 1.

Euro Area: High Frequency and Real Economy Developments

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: AMECO; Bloomberg Financial LP; Haver Analytics; and Eurostat.

3. Financial conditions in most countries remain strongly accommodative, though long-term interest rates have risen. The strengthening of the global economic outlook, stronger inflation data, and expected further reduction in monetary stimulus in the U.S. have pushed core yields up. Furthermore, sovereign spreads widened in several countries with high public debt in early 2017, possibly due to concerns about political developments, though yields have stabilized after the French elections (text figure).


10-Year Sovereign Bond Yields

(Basis points)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Bloomberg, LP.

4. Headline inflation has picked up, but core inflation remains stubbornly low (Figure 2). Average annual inflation reached 1.6 percent in the first six months of 2017, reflecting a rise in energy prices and stronger readings in Germany and Spain. Base effects in energy will likely subside further in the coming months, pushing inflation down to more subdued levels by the end of the year. Inflation expectations for the most part have increased slightly. Meanwhile, underlying inflation averaged 1.0 percent between January and June, reflecting subdued nominal wage growth, weighed down by anemic productivity growth, still elevated unemployment in some countries, and a high prevalence of part-time employment (text figure).

Figure 2.
Figure 2.

Euro Area: Inflation Developments

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

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


(Percent, yoy)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Eurostat; Haver.

Wage and Part-time Jobs

(In percent)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Eurostat; Haver.

5. The euro area’s external position is in line with medium-term fundamentals. The region’s current account surplus rose to about 3.3 percent of GDP in 2016 (Figure 3). The CPI-based real effective exchange rate (REER) appreciated by about 1.1 percent over the same period, consistent with the gradual strengthening of the euro area recovery. As of May 2017, the REER has depreciated compared to its average level in 2016 by around 1 percent. Overall, the euro area’s external position in 2016 remained broadly in line with the level implied by medium-term fundamentals and desirable policies (Table 2).

Figure 3.
Figure 3.

Euro Area: External Sector Developments

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.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.
Table 2.

Euro Area: External Sector Assessment

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6. But imbalances at the national level remain sizeable, as adjustments have mainly taken place in countries with large net external liabilities. Net external debtor countries, which earlier had persistent current account deficits, such as Portugal and Spain, have maintained surpluses over the past four years, leading to a small improvement in their net foreign asset positions (Figure 3). The persistent surpluses of large net external creditor countries, such as Germany and the Netherlands, have not shrunk significantly or have even grown larger, diverging from the levels consistent with medium-term fundamentals, due to high national saving and comparatively weak domestic investment. Absent adjustment, the net international investment positions of persistent surplus countries look set to grow markedly over the medium term.

Underlying Weaknesses: Sluggish and Divergent Productivity Growth

7. Income convergence across euro area countries has stalled (Box 1). Euro area countries experienced steady convergence of real GDP per capita in the decades leading up to euro introduction, but convergence stalled thereafter. Since the outset of the crisis, income has tended to diverge. While countries such as Germany are now well above their pre-crisis GDP levels, for other countries, such as Italy, the effect of the crisis has been more persistent, and GDP is only expected to return to its pre-crisis level in the mid-2020s. Convergence of real income levels is not a prerequisite for a functioning monetary union, but is considered a key objective of the economic integration process. It is important for the cohesion of the monetary union, by helping to ensure that the gains from integration are shared, especially in a low-growth environment where distributional issues are more pressing.

8. This lack of convergence in part reflects that productivity growth fell behind in countries with lower per capita income. Gaps in labor productivity across countries have been persistent, partly reflecting that total factor productivity (TFP) growth slowed more in countries with low initial levels of productivity (text figure). At the same time, wage growth outpaced productivity growth, contributing to a build-up of competitiveness gaps, as shown by divergence in relative unit labor costs (ULC) between Germany, on one hand, and Portugal, Spain, Italy and Greece, on the other (text figure).


TFP Dynamics

Average annual per capita growth rates in percent, unweighted

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: AMECO, Haver Analytics, and IMF staff calculations.Note: Productivity groups defined on the basis of labor productivity in 1999. High initial productivity countries comprise AUT, BEL, FIN, FRA, DEU, IRL AND NLD, and low initial productivity countrires comprise GRC, ITA, PRT and ESP. The cutoff for the low and high initial productive countries is based on the median of the observed productivity value in 1999. Low initial productivity is the average of countries below the median in 1999 and high initial productivity is average of countries above the median in 1999. No 1990s data available for Austria.

Real Effective Exchange Rate

(Relative nominal unit labor cost, 2000=100)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: Penn World Table; Eurostat; AMECO; INS; WEO; and staff calculations.Note: Trade-weighted relative unit labor costs for the total economy in 2011 PPP-adjusted international dollars.

Real Income Convergence 1/

Economic and Monetary Union (EMU) was expected to foster greater macroeconomic stability and income convergence. The single currency would stabilize exchange rates and lower interest rates for countries in the union. Policymakers also assumed that by eliminating exchange rate uncertainty and reducing cross-border transaction costs, the single currency would increase capital mobility and intra-regional trade, thereby boosting growth and helping income convergence between countries (Aglietta and Brand, 2013). Without recourse to devaluation, the discipline imposed by monetary union would increase incentives for policy reforms to boost productivity growth (European Council, 1989). While EMU succeeded in establishing a credible monetary policy framework and deepened financial integration, many national governments failed to exercise sufficient fiscal discipline or to undertake needed structural reforms.


σ-Convergence Across EA Countries, 1960–2015

Coefficient of variation, PPP GDP per capita

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: WEO database and IMF staff calculations.1/ Excludes Luxembourg.2/ Includes Ireland from 1970 and the Netherlands from 1980 onwards.3/ Includes Lithuania from 1995 onwards.

Real convergence has disappointed. Contrary to expectations, the catching-up process of EA-12 countries with lower GDP per capita has stalled. In the decades before EMU was founded, euro area countries with lower GDP per capita grew faster than richer ones (β-convergence). However, regressions show a lack of β-convergence in GDP per capita from 1993 to 2015. Time-series plots of cross-country dispersion of GDP per capita (σ-convergence) reveal a gradual slowdown in convergence leading up to euro adoption, and divergence since the crisis, reversing the initial narrowing in income dispersion.


β-Convergence Across EA Countries, 1993–20151

PPP GDP per capita

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: WEO database and IMF staff calculations.1/ As GDP not logged, R2 values shown differ from results in Table 6.2/ Excludes Luxembourg, and in the case of euro area 19 Lithuania due to missing data.

New euro area members converged rapidly in the run-up to their accession. Income levels of countries that joined the euro area in 2007 or later continued to converge up to their accession, though their convergence has also slowed since the crisis. Nevertheless, convergence has been higher among the EA-19 than within the European Union, suggesting that the common currency per se is not the reason for the slowdown in convergence.

The lack of convergence reflects a lack of productivity catch-up. A decomposition of annual GDP per capita growth across countries with high and low initial productivity levels shows that both groups of countries experienced a slowdown in total factor productivity (TFP) growth. However, the countries with low initial productivity had consistently lower TFP growth and a more pronounced slowdown.


Growth Decomposition

Average annual per capita growth rates in percent, unweighted

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Note: Productivity groups defined on the basis of labor productivity. Countries with high initial productivity include Austria, Belgium, Finland, France, Germany, Ireland, and the Netherlands. Countries with low initial productivity include Greece, Italy, Portugal and Spain. No 1990s data available f or Austria.Sources: AMECO, Haver Analytics, and IMF staff calculations.

Policies that raise productivity growth would help foster convergence. Labor and product market reforms tend to boost productivity more in countries with low productivity levels, and can therefore help these countries to catch up, reducing the disparities with higher-income countries. 2/

1/ See Selected Issues Paper on “Real Income Convergence in the Euro Area.”2/ See Selected Issues Paper on “Can Structural Reforms Foster Real Convergence in the Euro Area?”

9. Since the crisis, the disparities in competitiveness have been reduced, but gaps remain. Nominal wage growth in Germany has averaged about 2½ percent annually since 2009, outpacing the rise in labor productivity. Despite the rise in own ULCs, Germany continued to gain competitiveness relative to its trading partners—with its nominal ULC-based REER depreciating by around 7 percent over the same period. In Greece, Portugal and Spain, the ULC reduction occurred mostly during 2009–13 and was to a large extent driven by labor shedding, accompanied by wage declines in the case of Greece. In Italy, despite job cuts, wage growth outpaced labor productivity growth, leading to a rise in ULCs. Since 2014, Spain’s ULCs have been stable, with wage growth in line with labor productivity (supported by job creation), though ULCs in Italy have continued to rise (text figures). Additional job and wage cuts would have high social costs, implying that further adjustment should focus on raising TFP.


Factors Driving ULC Changes

(Percentage points, 2009–2013)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: OECD; Eurostat.1/ Increases in output lead to declines in ULC.

Factors Driving ULC Changes

(Percentage points, 2014–2016)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: OECD; Eurostat.1/ Increases in output lead to declines in ULC.

10. Competitiveness gaps were associated with persistent external imbalances across the euro area. Rises in ULC-based REER prior to the global financial crisis were associated with lower average current account balances over the period. Over the same period, poorer current account performance was also associated with lower pre-existing net international investment positions immediately after the euro adoption (text figures). As noted above, some net external debtors have made large price adjustments, bringing down their ULCs (also relative to trading partners) since the crisis. Further narrowing of competitiveness gaps would help reduce external imbalances.


REER and Current Account

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF Balance of Payment; PWT9.0; IMF staff caulcations.Note: Positive change on REER is appreciation.

Net Foreign Assets and Current Account

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF Balance of Payment; External Walth of Nations II.Note: Finland and Luxembourg (both outliers) are excluded.

Outlook and Risks: A Continued Recovery, Clouded by Uncertainty and Thin Buffers

11. The cyclical upturn is likely to continue in the near term. Growth is expected to reach 1.9 percent this year and slow modestly to 1.7 percent in 2018. Germany and Spain will remain the main growth engines, whereas Italy and France will benefit to varying degrees from the recovery. European Central Bank (ECB) policies are expected to remain accommodative and the aggregate fiscal stance to be mildly expansionary. A pick-up in exports, mirroring the strengthening in global trade, should benefit business investment, which has so far been subdued. After surging in early 2017, headline inflation is anticipated to slow in 2018 to 1.5 percent, as base effects from higher energy prices dissipate.

12. With growth modestly above potential, the output gap is expected to close by 2019. While there is uncertainty surrounding estimates of output gaps, this assessment is supported by a range of indicators that suggest aggregate economic slack is limited. Capacity utilization, employers’ perception of labor shortages, and optimism about demand growth are all near pre-crisis levels. Subdued wage growth could signal underutilized resources in the labor market, but it could also reflect that anemic productivity growth is holding back the scope for wage increases, including in countries with closed unemployment gaps (e.g., where observed unemployment is lower or equal to structural unemployment). While there is considerable variation in output gaps across countries, the dispersion is at its lowest level since the crisis. The countries with the most economic slack are now generally reducing their output gaps faster than others, but will still take several years to fully close these gaps.

13. Unresolved legacy problems are holding back a stronger medium-term outlook. The post-crisis recovery has been slow in many countries, reflecting the still ongoing repair of impaired public and private balance sheets. At the same time, potential growth remains weak, in part linked to insufficient structural reform efforts and adverse demographics. The jobless rate will return close to its pre-crisis level of 8 percent only by 2021. It will remain around double-digit levels in a group of countries accounting for more than one third of the euro area population. Inflation is expected to move slowly toward the ECB’s medium-term objective, settling at 1.9 percent in 2021.

14. Against this backdrop, risks are large and policy buffers remain thin (Table 3). Public debt-to-GDP ratios in high-debt countries have barely declined. By failing to rebuild buffers over the last few years, highly indebted countries could face difficulty coping with higher borrowing costs when monetary accommodation is reduced, exacerbating economic divergences. Their policy space to respond to the next shock will be limited. Furthermore, European bank distress, exacerbated by a structurally weak profitability outlook and still high non-performing loans (NPL) ratios, could have knock-on effects on the broader financial sector and real economy, and on sovereign yields in vulnerable economies.

Table 3.

Euro Area: Risk Assessment Matrix 1/

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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.)

15. With persistent structural problems—such as low productivity growth, and high unemployment and income inequality—the threat of inward-looking policies remains present. Externally, rising protectionism and uncertainty emanating from Brexit negotiations or from new U.S. policies could weigh on the global economy and on the euro area through trade, financial, and investment channels. Inside the euro area, concerns about populist undercurrents and possible policy shifts toward euro skepticism remain extant. Doubts about the merits of integration in some camps, as well as concerns about high youth unemployment and increasing inequality, could be exacerbated by low growth and profound societal changes. The challenges of reducing inequality of opportunity in several countries have also become more acute (Box 2). A renewed surge in refugee or migrant inflows could trigger border controls, curtailing the free movement of people and goods within the EU. Any disruption of economic activity within the euro area would have important negative spillover effects on the global economy.


Young People Not in Employment, Education, or Training (NEET)

(In percent of all young people; 15–29 years; 2015 estimates)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: OECD.

16. On the upside, a stronger-than-anticipated global recovery could facilitate countries’ reform efforts. Recent gains in business sentiment and a sharper-than-expected recovery in global trade flows could underpin stronger momentum in investment and exports. If countries take advantage of the ensuing stronger cyclical upswing and favorable financial conditions to reduce debt and implement reforms, confidence could increase and the momentum could become entrenched, sustaining the pickup in activity.

Authorities’ views

17. The authorities expect growth to continue at a steady pace. With a supportive policy mix, reduced political uncertainty, and improved global economic cycle, the authorities’ forecasts are in line with the Fund staff’s forecast in 2018. The European Commission (EC) viewed risks as more balanced than before, but still tilted to the downside, reflecting a shift from domestic political risks towards external risks. The ECB also saw downside risks, predominantly from global factors, but considered risks to be balanced, as the current positive cyclical momentum has increased the chances of a stronger-than-expected economic upswing. They both remained concerned about the vulnerability of high-debt countries to a sudden repricing in bond markets, and noted that the window of opportunity to deliver on reforms is shrinking. On the external side, they flagged risks related to the uncertainty from U.S. policies and geopolitics.

18. An acceleration in underlying inflation is conditional on stronger wage growth. The authorities noted that while headline inflation is gathering momentum, driven by higher energy prices, underlying inflation remains anemic. The ECB expects a slight moderation in inflation in 2018, followed by a gradual move toward the medium-term price stability objective, broadly in line with Fund staff’s forecast. Subdued wage growth is weighing on underlying inflation despite the robust decline in the jobless rate, which seems to suggest that a considerable degree of underutilization (e.g., in terms of hours worked) still characterizes the labor market.

Inequality of Income, Inequality of Opportunity, and Growth 1/

Income inequality has increased in several euro area countries over the last few decades. The rise in and persistence of market income inequality is often cited as an important contributor to rising populism, societal stress and demands for protection (Alesina et al., 2017).2 For these and many other reasons income inequality is undesirable. But its effect on growth is ambiguous and disputed in the literature.

Pinning down the impact of inequality on growth is a challenge. Theoretically, the effect can go either way. An increase in income inequality arising, say, from substantial rewards to risky entrepreneurship and innovation, could boost economic growth. By contrast, higher inequality could impair growth if low-income households are persistently less productive because of slower human capital accumulation and greater financial exclusion.


Market Income Gini, 1984–2013

(In Units)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: OECD statistics.

We explore whether the relationship between income inequality and growth depends on equality of opportunity. Inequality of opportunity is measured using data on various indices of intergenerational mobility, such as the elasticity of son’s income to father’s income. Our hypothesis is that in economies characterized by low equality of opportunity, income inequality acts as a drag on growth. An increase in income inequality becomes entrenched across generations due to various market failures connected with social stratification. This retards growth, by holding back human capital development or causing talent misallocation. On the other hand, in countries with high equality of opportunity, an increase in income inequality is easily reversed precisely because low-income people have access to the same opportunities as others. In such societies, an increase in income inequality is less harmful to growth.


Intergenerational Income Elasticity

(Higher value indicate lower intergenerational mobility)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Corak (2015).

Econometric results show a negative effect of widening income disparities on growth in the presence of high inequality of opportunity. Most euro area countries fall into this category. The implication is that reducing income inequality can accelerate growth in the euro area. There is no trade-off between efficiency and equity. Over the long run, addressing the root causes of inequality of opportunity can make growth less sensitive to shifts in income distribution. International experience suggests that leveling the playing field requires reforms that touch on human capital investment and job creation, and those promoting innovation, including by lowering barriers to labor and product markets.


Marginal Effect of Income Inequality on Growth

(In percentage points)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF staff estimates.
1/ See Selected Issues Paper on “Inequality of Opportunity, Inequality of Income, and Long-Term Growth.”2/ Alesina, A., Stantcheva, S., and Teso, E., 2017. Intergenerational Mobility and Preferences for Redistribution, NBER Working Papers, No. 23027, January 2017.

19. Although concurring with the Fund’s view on the real exchange rate, the authorities differed in their assessment of the overall current account. The EC and the ECB both saw the 2016 real exchange rate as roughly aligned with medium-term fundamentals, possibly skewed slightly towards undervaluation. Similar to the Fund, the ECB saw the 2016 current account as being in line with fundamentals, but the EC considered it to be stronger than implied by fundamentals. Differences in analytical methodologies between the EC and IMF, mainly related to the treatment of demographics, explain much of the discrepancy.

20. The authorities concurred that an improved medium-term outlook hinges on delivering on reforms that strengthen resilience and increase productivity. The EC shared staff concerns about low productivity acting as a drag on potential growth, and the lack of convergence. They argued that EU-level initiatives were important to seed the ground for convergence through higher productivity, and warned that a lack of further EU coordination would exacerbate the effects of poor policies at the national level. The ECB noted that part of the post-crisis reduction in competitiveness gaps had been achieved through wage containment, not only labor shedding, but agreed that reforms were needed to close remaining gaps.

Policies to Rebuild Buffers, Foster Convergence, and Reduce Imbalances

21. Actions at the central and national level are needed to address the euro area’s major risks and challenges. The euro area should grasp the current political momentum to push forward much-needed collective actions to strengthen the EMU. At the same time, a further widening of income gaps between countries could threaten the ability of policymakers to build support for common solutions. Decisive actions at the member-state level are essential to address the challenges: restart convergence, reduce imbalances, and address vulnerabilities. The desired policy mix covers actions on several fronts: (i) promoting structural reforms to boost potential growth; (ii) using fiscal space where available, while consolidating in high-debt countries; (iii) continuing monetary accommodation; (iv) repairing bank balance sheets; and (v) enhancing fiscal integration through a central fiscal capacity, completing the banking union, and advancing the capital markets union, as laid out in the EC’s recent Reflection Paper on the Deepening of the EMU.

A. Structural Reforms to Raise Productivity and Restart Convergence

22. Faster progress on structural reforms would raise productivity growth, thereby helping to revive income convergence and narrow competitiveness gaps. Labor and product market reforms tend to boost productivity more in countries with low productivity levels and can therefore help reduce productivity gaps, contributing to income convergence (see Figure 4).2 At the same time, reforms can help rebalancing across euro area countries. For net external debtors, reforms that raise productivity growth above the pace of wage increases will lower ULC, thereby reversing competitiveness gaps. For large net external creditors, measures to encourage higher domestic investment and lower unduly high saving rates can reduce excessive current account surpluses, while at the same time improving their capital stocks and lifting potential growth.

Figure 4.
Figure 4.

Euro Area: Structural Reforms Reduce Productivity Gaps

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: OECD, IDB Employment Protection Database, Product Market Regulation Database; and IMF staff estimates.1 Productivity groups are based on average productivity above and below the median labor productivity level in 1999.2 The most and least regulated countries are based on the median value in 2000 and 2003 respectively of the OECD’s employment protection legislation indicator for employees on regular contracts and the professional services regulation indicator.3 Reforms occur at t = 0. The estimation method is the local projection method (Jorda, 2005) controlling for lagged log of productivity level, past crisis dummies, country and timer fixed effects. The reform dummy enters additively, and in interaction with lagged log level of productivity. The dashed lines denote 90 percent confidence bands.

23. Progress on structural reforms has been sluggish both at the national and central level.

  • Compliance with the Country-Specific Recommendations (CSR) under the European semester remained weak in 2016, notwithstanding efforts to streamline the number of recommendations (text chart).

  • At the EU level, the EC is implementing the 2015 Single Market Strategy, but progress has been mixed. While some initiatives, such as legislation to remove geographical discrimination in e-commerce within the Single Market (geo-blocking), are quite advanced, others such as the European Services e-card and minimum standards for corporate debt restructuring and insolvency, could face protracted negotiations among member states.3 Overcoming national opposition, the Comprehensive Economic and Trade Agreement (CETA)—the first comprehensive trade agreement between the EU and an advanced economy (Canada)—was signed in 2016, but prospects for the Transatlantic Trade and Investment Partnership (TTIP) agreement with the U.S. remain uncertain.4 The EU is making progress in negotiating ambitious free trade agreements (FTAs) with Japan, Mexico, and Mercosur.


Country Compliance with Country Specific Recommendations (CSRs)

(Average Index, full compliance = 4)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

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

24. The cyclical recovery and supportive financial conditions present an opportune time to push ahead with reforms. Partly reflecting country-specific reform agendas (Table 4), the main priorities for structural reform are:

  • Product market reforms. Countries should improve the business climate, public administrations and insolvency regimes (e.g., Italy and Portugal) and reduce cross-border entry barriers in the professional and retail sectors (e.g., Greece). Progress in completing the single market in services, energy, digital commerce, and transport would increase competition and allow firms to reap cross-border economies of scale. So would ambitious trade agreements, accompanied by policies to support adjustment to trade and to ensure that the gains from trade are evenly and widely distributed. This could provide a significant boost to potential output across the euro area.5

  • Labor market reforms. To lower structural unemployment and increase labor force participation, policies should focus on reducing the labor tax wedge (e.g., Germany), improving active labor market policies (e.g., Italy and Spain), and reforming distortive unemployment benefits (e.g., France) and excessive job protection for permanent contracts (e.g., Portugal and Spain). The latter needs to be designed carefully in countries with weak growth to minimize short-term costs.

Table 4.

Structural Reform Plans and Progress in Selected Euro Area Countries

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Source: IMF country teams.

25. Strong and credible reforms could be incentivized through, and their impact amplified by, the judicious use of fiscal policy.6 Countries with fiscal space could accompany structural reforms with some upfront fiscal stimulus focused on shifting spending toward high-return investments and reducing the adjustment cost of reforms (e.g., Germany’s fiscal easing would also boost the effect of its recommended structural reforms). Countries without fiscal space should sequence reforms carefully, within a credible medium-term framework, prioritizing product market reforms as they entail few short-term costs (e.g., Italy, Spain and Portugal). The short-term economic effects of employment protection and unemployment benefit reforms could be minimized through budget-neutral fiscal support as part of a broader reform package (such as combining job protection reforms with measures to facilitate the setting up of small businesses). In any event, reforms with permanent fiscal costs—such as labor tax cuts and higher spending on active labor market policies—should be implemented in a budget-neutral manner in all countries to avoid compromising fiscal sustainability.

26. Instruments at the EU level should be used more effectively to incentivize reforms. The weak implementation of CSRs in most countries, including by those six countries identified with excessive imbalances under the Macroeconomic Imbalance Procedure, suggests that the EU instruments are currently not being used effectively. To build credibility, stronger enforcement of the governance framework is needed.7 This could be complemented by incentives, in the form of targeted support from European Structural and Investment (ESI) funds, flexibility under the fiscal rules to reward strong reforms, and outcome-based structural reform benchmarks.8 Finally, independent national productivity boards can help build greater national consensus and ownership for reforms.

Authorities’ views

27. The authorities agreed that structural reforms are critical to reverse the declines in productivity growth. There has been progress in some areas such as financial services, labor taxation, and active labor market policies. Moreover, considering a multi-annual rather than annual horizon, the large majority of CSRs have seen progress, reflecting that some reforms take time to implement. Nevertheless, measures to reduce labor market duality and improve the business climate have lagged due to resistance from vested interests in a fragile political environment. Countries, especially those without fiscal space should prioritize product market reforms to improve the investment climate and create more effective insolvency regimes and public administrations, as they have few short-term economic costs and significant medium-term gains. The authorities noted that they were indeed pursuing ambitious “new generation” FTAs and that Single Market reforms remain a priority.

28. Efforts are underway to further incentivize and build ownership of reforms. Reform agendas laid out in CSRs are being supported by technical assistance through the Structural Reform Support Service; flexibility under the Stability and Growth Pact (SGP) for structural reforms (recently for Finland and Lithuania); and, going forward, by establishing tighter links between CSRs and ESI funds. The benchmark set by the Eurogroup on the labor tax wedge appears to have helped implementation, and a second benchmark—on pensions—was adopted by the Eurogroup in March 2017. Additional benchmarks, such as on insolvency practices, are being developed. In countries with excessive imbalances, the EC intends to continue to enforce the Macroeconomic Imbalance Procedure by “specific monitoring,” which is helping to provide peer pressure for reforms, in lieu of opening an Excessive Imbalance Procedure, given the need to further foster ownership and improve traction. The ECB, on the other hand, calls for a full implementation of the Macroeconomic Imbalance Procedure. Going forward, national productivity boards will need to play a vital role in building consensus for reforms. Finally, to address protectionism, trade negotiations will henceforth be conducted in a more transparent manner, with greater public consultation with member states, civil society, and other stakeholders.

B. Rebuilding Fiscal Buffers and Promoting Growth

29. The aggregate fiscal stance of the euro area is expected to be mildly expansionary in 2017. The structural fiscal balance is expected to ease by 0.3 percentage points of potential GDP (Figure 5). The fiscal easing comes primarily from Germany, and, to a lesser extent, from Italy, France, Finland, and Portugal (Table 5).

Figure 5.
Figure 5.

Euro Area: Fiscal Developments and Policies

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF World Economic Outlook database; Fiscal Monitor; and Fund staff calculations.
Table 5.

Euro Area: A Scorecard Approach to the Near-Term Fiscal Stance

article image
Sources: Haver Analytics; WEO.

Primary gap is P-P*, where P is the structural primary balance as % pot. GDP in 2016 and P* is the debt stabilizing primary balance in the medium term defined as (r-g)*d, where d is for 2015 and (r-g) is for 2021.

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 2018. Spain’s IMF advice is in terms of the change in the structural primary balance.

Source: EUR desks.

Source: EC Spring 2016 Country-Specific Recommendations (CSR) for 2017. “…” indicates no specific value provided for the fiscal adjustment CSR.

The SGP’s debt reduction rule requires an annual debt/GDP ratio reduction of at least 1/20 of the difference from the 60 percent target if the debt ratio>60. For countries with EDPs opened before December 2011, a transitional debt rule applies for 3 years after exiting the EDP.

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

30. For 2018 and beyond, with a closing output gap, the rationale for additional fiscal cyclical support at the euro area level is waning. The output gap is projected to shrink to −0.2 percent of GDP in 2018, and to close in 2019, suggesting that further fiscal easing may not be needed for the euro area as a whole. At the same time, output gaps vary considerably across countries, ranging from below −1 percent of GDP in France and Italy, to +0.8 percent of GDP in Germany, though fiscal space in countries with large output gaps is constrained by high debt levels (text figure).


Output Gap and Public Debt, 2018

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF WEO and IMF staff

31. While the overall euro area fiscal stance is broadly consistent with staff advice, the composition is not. The structural primary balance is expected to ease slightly in 2017 and remain stable in 2018, broadly in line with the sum of staff’s advice to euro area members.9 However, the heterogenous distribution of fiscal space at the member-state level calls for differentiated fiscal strategies (text figure):

  • Countries with fiscal space should use it now, to boost public investment and promote structural reforms, helping to increase potential growth over the medium term.10 It would also boost domestic demand and inflation in the near term and reduce sizeable external surpluses. Furthermore, positive cross-border growth spillovers, while likely modest, could support the efforts of other countries to rebuild fiscal buffers and implement reforms. Germany’s projected fiscal easing goes in this direction, but remains well below staff’s recommendations. The Netherlands fiscal stance is expected to be tighter than staff advise.

  • High-debt countries with relatively less fiscal space need to adjust now to rebuild buffers and reduce vulnerabilities. Most high-debt countries have so far not saved the windfall interest reductions from monetary accommodation (text figure). It is important to make decisive progress on fiscal adjustment before monetary accommodation is reduced. Otherwise, countries could face dangerous debt dynamics as interest rates rise—running the risk that self-fulfilling expectations could emerge if markets begin to doubt fiscal sustainability. Delaying consolidation would imply larger and faster adjustment measures, which would be more damaging to growth than a more gradual approach. Contrary to staff’s advice, however, most of the more highly indebted countries are expected to ease in 2017, including France, Italy and Portugal. In 2018, high-debt countries are expected to consolidate, though full details on adjustment measures will not be available until draft budgets are published in October.

  • Flexibility under the SGP can and should be used to incentivize credible structural reforms. The SGP permits a one-time deviation of up to ½ percent of GDP from the required fiscal adjustment path to encourage major structural reforms. Italy, for example, availed of this flexibility in 2016. In all cases, credibility is central, and is best achieved through concrete upfront actions.

  • All countries should undertake growth-friendly fiscal rebalancing. On the revenue side, there may be benefits from shifting from personal income taxes to indirect taxes, including emissions taxes, and property taxes, as well as from base broadening while lowering marginal tax rates.11 On the spending side, outlays can be shifted to investment from less productive areas such as poorly targeted transfers.12

  • In a downside scenario, countries that are currently constrained by fiscal rules can use the additional latitude provided in the SGP. In case of country-specific shocks, automatic stabilizers should be allowed to operate. For countries in the Excessive Deficit Procedure (EDP), the deadlines to reduce the headline deficit can be extended. For countries in the preventive arm, the required fiscal effort can be lowered if the output gap falls below 1½ percent of GDP. In a severe, euro area-wide downturn, the escape clause should be invoked to suspend temporarily the fiscal adjustment that would otherwise be required.


Fiscal Stance: Forecast vs. IMF Policy Advice

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF WEO and IMF staff calculations.Notes: Fiscal stance at t is the change in the structural fiscal balance from t-1 to t. Euro area “advice” is the sum of IMF advice to individual euro area countries. IMF advice for 2017 from most recently published Article IV.

Change in Structural Balance and Components, 2015-17

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: IMF WEO and Fund staff calculations.

Heatmap of Selected Fiscal Indicators for Key Country Examples

article image

Heatmap based on latest published debt sustainability analysis (DSA) for each country, except for SGP requirements, which are taken from the European Commission. Benchmarks are indicative and correspond to those used in the MAC-DSA.

Low risk (green)<400 bps; 400 bps<Medium risk (orange)<600 bps; High risk (red)>600 bps. Calculated over the last 3 months before DSA published.

Low risk (green)<30; 30<Medium risk (orange)<45; High risk (red)>45. The flag color reflects that a larger non-resident investor base can make a country more vulnerable to rollover risk. It does not take into account that a more diversified non-resident investor base could indicate market confidence, nor that a more concentrated investor base could reflect stonger domestic sovereign-bank links, which could represent a vulnerability.

Low risk (green)<1; 1<Medium risk (orange)<1.5; High risk (red)>1.5.

Low risk (green)<17; 17<Medium risk (orange)<25; High risk (red)>25.

Debt level and GFN benchmarks are 85 percent and 20 percent of GDP, respectively. ‘Green’ means debt level (GFN) remains below the benchmark in the last year before the projections and over the projection period, ‘red’ means the respective benchmark is breached for at least one year in the last year before the projections or over the projection period.

No (green), yes (red). The EDP for Portugal was closed in June 2017.

32. Expanded EU centrally financed investment can help countries with continued demand shortfalls and raise potential growth. The plan to expand and extend the European Fund for Strategic Investment (EFSI) by €200 billion, for a total of at least €500 billion by 2020, is welcome. It is envisaged to be accompanied by measures to better ensure “additionality” (i.e., that private sector financing for projects would not be available in lieu of the EFSI financing), an enhanced investment advisory hub for greater geographic and sectoral diversification, and increasing transparency of EFSI governance. EFSI financing could also prioritize projects of common interest, such as those related to developing the energy union and addressing climate change, especially in countries with negative output gaps and high levels of debt, where the demand impact would be greatest. In line with this, in percent of GDP terms, Spain, Portugal, Italy and Greece, are among the top six recipients of EFSI-related investment.

EFSI Related Investment Shares and Investment-to-GDP

(Percent, through end-2016)

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Source: European Investment Bank, IMF WEO, and Fund staff calculations.Note: Total financing for EFSI related investment approved through end-2016 was euro 163.9 billion, though actual investments will only take place over a number of years.

33. Compliance with and enforcement of the SGP have been weak, undermining its credibility and impeding further fiscal integration. While the fiscal framework needs to be reformed, credibility requires that the rules be respected. If they are not, the time consistency of fiscal policy will remain in question. Enforcement has suffered from weak political will, as exemplified by the decision not to sanction Portugal and Spain for failing to take effective action to meet their EDP targets in 2016. Moreover, while well-defined flexibility in the SGP—such as for structural reforms—is useful, the recent absence of quantitative fiscal targets in the CSRs for 2018, which imply greater discretion for the EC in assessing compliance with the rules, weakens the SGP’s credibility. Steps need to be taken to restore SGP credibility.

  • An independent European Fiscal Board. The new European Fiscal Board, charged with assessing the aggregate fiscal stance and even-handedness in the application of the SGP, is now operational and will need to demonstrate its independence through its actions.

  • A simpler and more transparent fiscal framework. Over the medium term, the rules should be amended to (i) focus on a single fiscal anchor and a single operational target with well-considered escape clauses; (ii) make enforcement more automatic; and (iii) create better incentives for compliance with the rules.

34. A common stabilization function would permit a more accommodative fiscal stance in a downturn, while supporting fiscal discipline in good times. Such a central fiscal capacity (CFC) could also help incentivize compliance with fiscal rules, as access to it should be conditional on member states’ compliance with the rules. As discussed in the 2016 Article IV consultation, there are several possibilities for the design of a CFC.13 In particular, a modest tax-transfer scheme with a “rainy day fund” built up in good times could provide meaningful macroeconomic stabilization to countries hit by shocks, while a borrowing-lending scheme could help finance public investment. A CFC would be essential to completing the EMU architecture, highlighting the importance of utilizing the favorable political momentum, together with better SGP compliance to build political support for further fiscal integration.

35. Looking ahead, Brexit will require politically difficult decisions on the EU budget. The annual gross contribution of the UK to the EU budget has averaged about 13 percent of the total over 2013–15, with an annual net contribution of about €11 billion. Maintaining (non-UK) spending at the current level would require higher contributions from richer EU members or a new source of revenue. Cutting spending would imply lower agricultural and structural funds (about 75 percent of EU spending). Priority should be given to preserving structural funds, which are a major income source for many Central and Eastern European countries and help promote convergence.

Authorities’ views

36. The authorities consider that a broadly neutral fiscal stance remains appropriate for the euro area in 2018, given the remaining trade-off between sustainability and stabilization needs. Fiscal indicators have improved considerably, with a headline deficit of 1.5 percent of GDP in 2016. Only two euro area countries had deficits above 3 percent and eight have reached their Medium-Term Objectives for the structural balance. While the economic recovery is steady, with a closing output gap, labor market slack suggests that there is still scope for higher growth without triggering inflationary pressures. At the same time, focusing on the overall euro area fiscal stance hides the issue that debt sustainability is mainly relevant from a country-specific perspective, with several countries facing elevated sustainability risks in the medium term.

37. The authorities see scope for a better differentiation of the fiscal stance across countries than planned in the Stability Programs. As recommended in the recent CSRs, countries with fiscal space should make use of it, including in Germany, where the fiscal stance could be more expansionary to support future growth. Countries without fiscal space should take advantage of the current negative interest rate-growth differential to reduce excessive levels of debt and rebuild buffers. However, in some cases, such as Italy, the EC highlighted the need to consider the impact of budgetary adjustment on the recovery and employment when assessing compliance with the rules, suggesting that it would use its margins of appreciation. The ECB argued that the window of opportunity for high-debt countries to act is shrinking fast, and that complying with the rules would be the best way to establish credibility.

38. Political determination is needed to strengthen the EMU. A common stabilization function would complement national budget stabilizers and allow smoother aggregate fiscal policy for the euro area. To have the necessary political support, it should not lead to permanent transfers, though a borrowing capacity would be needed to allow sufficient stabilization. The establishment of a CFC could be combined with other EMU deepening measures, such as the creation of safe assets. With a CFC to support stabilization needs, national fiscal rules could focus on sustainability.

C. Maintaining an Accommodative Monetary Stance

39. Monetary policy is appropriately accommodative (text figure). The ECB’s decision last December to extend the asset purchase program (APP) through end-2017, while reducing the monthly purchase amount, signals its strong commitment to maintain accommodation until there is a sustained upward shift in the path of inflation. Even with the purchase reduction, the planned purchases this year remain significant relative to the net issuance of medium- to long-term sovereign bonds. The decision to relax the constraint against buying bonds whose yield is below the deposit rate has significantly expanded the pool of eligible assets for purchase.


Eurosystem Balance Sheet and Deposit Rate

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: ECB; and Haver Analystics.

40. Monetary easing has improved financial and credit conditions through various channels (Figure 6).

  • Asset purchases have supported portfolio rebalancing and compressed risk premia. Net portfolio investment outflows likely indicate investors rebalancing towards non-euro area debt securities due primarily to negative interest rate differentials vis-à-vis other advanced economies. In the two years following President Draghi’s Jackson Hole speech in August 2014, where he indicated that the ECB would begin sovereign bond purchases, the euro area average term spread fell by around 80 basis points. The 10-year bond yield spread (to German bunds) narrowed by around 40 basis points for both Italy and Spain. However, since last summer, the average term spread has risen to slightly above the level in August 2014 (Figure 6). This is partly due to rising inflation expectations amid good economic indicators, but may also reflect higher credit risk in some countries as the prospect of reduced monetary accommodation moves closer. In recent months, sovereign spreads and CDS spreads have also increased in some high-debt countries.

  • Corporate bond issuance has picked up. After the announcement of the corporate sector purchase program (CSPP) in March 2016, corporate issuance—in particular, among firms with investment grade—increased significantly (text figure). Yields, especially for high-yield corporates, have also declined markedly since then, albeit amid other compounding factors.

  • Bank lending volumes have improved and lending rates declined, with limited side-effects on bank profitability. Bank Lending Surveys indicate that targeted longer-term refinancing operations (TLTROs) enabled participating banks to replace more costly sources of funding and extend the maturity of liabilities. While the full impact of the TLTROs is still unfolding, ECB studies suggest that they have supported higher lending volumes in less vulnerable countries and a slowdown of the contraction in bank lending in vulnerable countries. The Survey on the Access to Finance of Enterprises (SAFE) suggests that improvements in financing conditions were widespread across firm sizes and countries, including in SMEs. Bank profitability remains stable in the low interest rate environment as increasing lending volumes, lower wholesale funding costs, and revaluation gains on securities holdings offset compressed lending margins.


Non-Financial Corporates’ Bond Issuance

(Billions of euros)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: Dealogic and staff calculations.
Figure 6.
Figure 6.

Euro Area: Monetary Policy Channels

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: ECB; Bloomberg Financial LP; Haver Analytics; and Eurostat.1/ A zero-coupon yield curve represents the yield to maturity of hypothetical zero-coupon bonds.2/ MFI (new business) lending to corporations, under €1 million with maturity 1–5 years. Ex-post real rates using HICP.

41. Subdued underlying inflation points to the need for monetary policy to remain strongly accommodative for an extended period. The costs of a long period of inflation undershooting continue to exceed those of a temporary overshoot. The calls from some quarters for an exit from monetary accommodation are therefore premature. Consistent with its public pronouncements, the ECB should look through transitory episodes of above-target inflation, focusing on its area-wide medium-term objective. The recent removal of the easing bias in the ECB’s forward guidance on policy rates was warranted by the disappearance of deflation risk. However, any further change in the forward guidance or policies should be underpinned by a clear shift in the path of actual inflation or a much stronger assessment of the inflation outlook. For a sustained recovery of euro area inflation, some countries must accept inflation above the ECB’s “below, but close to, 2 percent” objective (text figure). In particular, in countries where the output gap is closed and wage growth is subdued, authorities could encourage faster wage and price growth in their public communication. As U.S. monetary policy continues to normalize, it will also be important to guard against unwarranted tightening of financial conditions in the euro area.




Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: World Economic Outlook.

42. The Eurosystem should continue to address collateral scarcity. The gap between unsecured money market rates and German repo rates remains very wide, despite some recent narrowing, likely helped by the introduction of a cash collateral facility in December (text figure). Moreover, the two-year German bond (Schatz) yields have recently reached new lows, diverging from the Overnight Index Swap (OIS) rates (text figure). This could reflect several factors such as regulatory policies that made it more attractive to hold safe and liquid securities and the declining issuance of German bonds, but was likely exacerbated by the ECB’s removal of the deposit rate floor for the APP in December. Developing a common securities lending framework for national central banks—including by allowing for non-sovereign collateral, using standardized legal agreements, and harmonizing features like costs, maturity, haircuts, and roll-over capacity—would facilitate access to high-quality collateral and improve market functioning, thereby enhancing the effectiveness of asset purchases and monetary transmission.


EONIA and Repo Rates


Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Bloomberg Financial LP.; ECB; and IMF staff calculations.

EONIA OIS Spread to Schatz


Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Bloomberg Financial L.P.

Authorities’ views

43. The ECB stressed its commitment to continued monetary accommodation. Viewing the current monetary stimulus as highly effective in supporting financial conditions and the recovery, it explained that asset purchases acted on the full yield curve while the negative deposit rate was especially potent in the short to medium segment. The latter segment was critical as a pricing benchmark for loans to non-financial corporations (NFCs). The mix of negative rates and asset purchases thus reduced borrowing costs for both NFCs and households, compressed risk premia across a wide range of asset classes, and encouraged portfolio rebalancing as illustrated by higher equity prices as well as lower bond yields. The compressing effect on bank profitability has so far been mitigated by valuation gains, improved asset quality, and higher lending volumes, yet could become more evident going forward.

44. The ECB agreed on the need to maintain strongly monetary accommodation until there is a sustained adjustment in the path of inflation towards levels below but close to 2 percent. Its commitment to keep policy rates low for an extended period, well past the horizon of net asset purchases, is guided by inflation prospects, which, in turn, are influenced by the recovery in output. Wage growth has been subdued, likely reflecting the large remaining slack in the labor market.

45. The ECB concurred on the importance of an effective securities lending program across the Eurosystem to avoid collateral scarcity and ensure effective transmission. The cash collateral scheme introduced in December was well received by markets and has been used more extensively where collateral scarcity is most binding (such as in Germany). The ECB noted, however, that securities lending programs are subject to the risk-management concerns of individual national central banks, as only part of the public sector purchase program (PSPP) is risk-shared.

D. Repairing Banks’ Balance Sheets and Completing the Financial Architecture

46. Bank funding conditions have improved, but profitability remains lackluster (Figure 7). Although revenues have fallen, they have been partly offset recently by lower funding costs, leaving net interest margin broadly flat. The sector’s aggregate return-on-assets (ROA) remains above 2010 levels, bolstered by higher asset valuations and the ongoing recovery. However, costs-to-assets ratios remain stubbornly high. Medium-sized banks, in particular, still struggle to improve their ROAs. The overall low euro area ROA and a return on equity well below the cost of equity raise doubts about the sustainability of banks’ business models and their ability to adapt to a stricter regulatory and supervisory environment alongside growing challenges posed by Fintech. Partly due to tougher regulatory limits on leverage, the economic recovery may not be enough to boost returns to meet investor expectations. Large banks reliant on market funding are incentivized to drop unprofitable business lines, reduce costs, and consolidate. 14 By contrast, for banks supervised by the Single Supervisory Mechanism (SSM), almost half of their assets have ownership and governance structures with little exposure to market pressures and may require greater supervisory efforts to adapt and consolidate.

Figure 7.
Figure 7.

Euro Area: Banking Sector Developments

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: Bloomberg, LP; SNL; ECB, Consolidated Banking Data (CBD2); S&P Global Market Intelligence; and IMF staff calculations.1/ Monetary financial institutions are: central banks, credit institutions, other deposit-taking corporations, and money market funds.2/ Based on 28 banks.

Return on Equity and Cost of Equity

(Percent, weighted by Common Equity)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Source: Bloomberg; and IMF staff calculations.Note: Indicators are calculated by Bloomberg based on a sample of 154 banks. The Return on Equity is the net income to average total common equity. The Cost of equity is derived from a CAPM model and equals the risk-free rate + [beta × equity risk premium], where default risk-free rate is long-term bond rate.

Bank Profitability and Components

(percent of average assets)

Citation: IMF Staff Country Reports 2017, 235; 10.5089/9781484312346.002.A001

Sources: ECB, Consolidated Banking Database (CBD2); and IMF staff calculations.Note: Based on all domestic banking groups and standalone banks.

47. High NPL stocks in some countries hinder adjustment and monetary transmission. Over the last two years, NPLs in the euro area have been reduced by about €160 billion, but the stock remains high at about €1 trillion. More than 90 percent of the reduction in NPLs is accounted for by larger banks, and over 60 percent has occurred in Spain and Ireland. In Italy, which has the largest stock of NPLs, progress has been too slow, with NPLs falling by only about 5 percent relative to the 2015 peak level of €324 billion. Household debt has been the predominant component of NPL reductions, partly reflected in falling household indebtedness in some countries, although causality is hard to establish. Corporate debt accounts for a small share of the reduction, implying that corporate NPL stocks remain stubbornly high. Earlier staff analysis suggests that high corporate debt can lower the sensitivity of firms’ investment to demand improvements.15