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EURO AREA POLICIES

STAFF REPORT FOR THE 2021 ARTICLE IV CONSULTATION WITH MEMBER COUNTRIES ON COMMON EURO AREA POLICIES—SUPPLEMENTARY INFORMATION

February 2, 2022

Prepared By

This supplement provides information that became avaiiabie after the issuance of the staff report. The thrust of the staff appraisal remains unchanged.

1. The rapid spread of the Omicron variant has led to updated near-term projections, but the medium-term outlook remains broadly unchanged (Table 1). The recent surge in Covid-19 cases across Europe led to renewed mobility restrictions in many countries, slowing the recovery of services. In addition, elevated energy prices and supply chain disruptions continued to weigh on manufacturing. To reflect these developments, projections were revised in the January 2022 Update of the World Economic Outlook along the following lines:

• Euro area GDP growth in 2022 has been revised down to 3.9 percent (-0.3 p.p. relative to the staff report projections), reflecting carryover from slower growth in 2021Q4 and 2022Q1. With a gradual dissipation of headwinds to growth, economic activity is projected to bounce back in 2022Q2 and subsequent quarters, resulting in an upward revision to growth in 2023 to 2.5 percent (+0.3 p.p.). Growth over the medium term remains broadly unchanged, and so is the projected path of the output gap, which is still expected to close in 2024.

• Average headline inflation for 2022 has been revised up further to 3.0 percent (+0.4 p.p. relative to the staff report projections), as elevated energy prices and supply-side constraints are expected to persist for longer. Inflation is nevertheless expected to be on a downward trajectory through 2022 as these factors diminish, with end-of-period inflation close to target. Inflation over the medium term has also been revised up, but staff still expect headline and core inflation to remain below the ECB’s new symmetric 2 percent target over the projection horizon.

^{Table 1.}

Euro Area: Main Economic Indicators

^{Table 1.}

Euro Area: Main Economic Indicators

View Table

^{Table 1.}

Euro Area: Main Economic Indicators

View Expanded

2. Recent developments and data further illustrate a mix of strong demand, the impact of Omicron, and near-term inflation pressures. Preliminary data point to a significant slowdown in real GDP growth to 0.3 percent (q/q) in 2021Q4, below staff’s projection of 0.6 percent. However, with an upward revision to growth in 2021Q3 (+0.1 p.p.), the estimated 2021 growth outturn of 5.2 percent is in line with the January 2022 WEO Update, and 2021Q4 GDP is now higher than pre-crisis. Headline inflation reached a record high of 5.0 percent (y/y) in December 2021, driven primarily by elevated energy prices and persistent supply-side disruptions, as well as a strong rebound in demand. However, month-on-month inflation dynamics have softened, with core inflation increasing only slightly, to 2.7 percent (+0.1 p.p.). The unemployment rate declined to a record low of 7 percent in December, although total hours worked remained about 2 percent below pre-crisis levels in 2021Q3. Recent wage developments confirm the baseline view of limited second-round effects.

3. Rising tensions between Russia and Ukraine are an important new risk to the near-term outlook. While a number of countries have important trade and financial linkages with Russia, for the euro area as a whole the main exposure comes through natural gas imports, of which about Vis comes from Russia. Natural gas is also the second most important energy source in the euro area, accounting for 20 percent of the energy mix. As a result, escalating Ukraine-Russia tensions pose a new downside risk to growth and an upside risk to inflation, through elevated food and energy prices and other channels. Much will depend on how events unfold in the coming weeks, and on any policy response from other nations and Russia. The additional uncertainty further complicates the task confronting policymakers. The impact of the 2014 hostilities in Crimea and associated measures taken in response was fairly muted, although gas and energy markets are much tighter now than they were in 2014.

4. The updated EBA leaves staff’s assessment of the external position unchanged. The current account surplus declined to 2.2 percent of GDP in 2021Q3 from 2.9 percent of GDP in the first half of 2021. This reflected the rising costs of imports, particularly energy. Subsequently, the surplus increased in October and November 2021. For the 2021 as a whole, the euro area current account surplus projection has been revised up by 0.4 percentage points of GDP to 2.9 percent. This marginally widens the staff current account gap estimate from 1.4 to 1.5 percent of GDP. Accordingly, staff continues to assess the external position in 2021 as moderately stronger than the level implied by medium-term fundamentals and desirable policies (Table 2).

^{Table 2.}

Euro Area: External Sector Assessment

¹The export and import elasticities are taken as the average of estimates from Consultative Group on Exchange Rate Issues (CGER)-inspired export and import equations using various types of REERs relevant for the euro area (with an ADL (2,2,2) model on quarterly data 2000–19). The trade balance elasticity is calculated using the share of exports and imports for extra-EA trade in GDP.

^{Table 2.}

Euro Area: External Sector Assessment

Overall Assessment: The external position in 2021 is assessed as moderately stronger than the level implied by medium-term fundamentals and desirable policies. However, this assessment is preliminary and subject to a wide range of uncertainty arising from the preliminary nature of data and Covid-19 adjusters for 2021. The final assessment will be provided in the 2022 External Sector Report. Data for the first three quarters of 2021 show an increase in the seasonally adjusted current account (CA) surplus to 2.7 percent of GDP, on the back of stronger external demand, especially for services. The CA surplus is estimated to have reached 2.9 percent of GDP for 2021 as a whole. In the medium term, the euro area’s CA surplus is projected to remain broadly at the 2021 level, although the range of uncertainty around this projection is exceptionally high given the nature of this crisis. Imbalances that existed prior to the Covid-19 outbreak could remain sizable at the national level. Potential Policy Responses: Short-term policies should continue focusing on containing the Covid-19 outbreak and reducing scarring from the crisis. The recent initiatives both at the national and EU-levels, including NGEU, have supported these efforts and could potentially help reduce the CA surplus by supporting investment and consumption, thereby increasing imports. Going forward, monetary policy should remain accommodative until inflation has durably converged to the ECB’s medium-term price stability objective while fiscal support should remain in place until the expansion phase is firmly in train, before gradually consolidating towards medium-term objectives. If imbalances in policy gaps that existed prior to Covid-19 were to persist at the national level, then countries with excess CA surpluses should continue to strengthen investment and potential growth, whereas those with weak external positions should undertake reforms to raise productivity, reduce structural and youth unemployment, and enhance competitiveness as the acute phase of the pandemic recedes. Euro area-wide initiatives to make the currency union more resilient (e.g., banking and capital markets union and fiscal capacity for macroeconomic stabilization) could further reinvigorate investment and, hence, reduce the aggregate CA surplus.
Foreign Asset and Liability Position and Trajectory	Background.The NIIP of the euro area had fallen to about -23 percent of GDP by the end of 2009 but has since risen substantially to about -3.3 percent of GDP by mid-2021. The rise was driven by stronger CA balances and modest nominal GDP growth. Relative to 2020, the NIIP increased by 1.3 p.p. of GDP, reflecting primarily the net increase in outbound FDI and debt portfolio securities, partially offset by a milder increase in inbound portfolio equity and other investment. Gross foreign positions were about 271.2 percent of GDP for assets and 274.4 percent of GDP for liabilities as of mid-2021. Net external assets reached elevated levels in large net external creditors (e.g., Germany and the Netherlands), whereas net external liabilities remained high in some countries, including Portugal and Spain. Assessment. Projections of continued CA surpluses over the medium term suggest that the NIIP-to-GDP ratio will rise further, at a moderate pace. The region’s overall NIIP financing vulnerabilities appear low. Despite rising CA balances over the medium term, large net external debtor countries still bear a greater risk of a sudden stop of gross inflows.
2021H1 (%GDP)	NIIP:-3.3	Gross Assets: 271.2			Debt Assets: 104.3	Gross Liab.: 274.4	Debt Liab.: 104.0
Current Account	Background. The CA balance for the euro area is projected to increase to 2.9 percent of GDP in 2021 from 1.9 percent of GDP in 2020. The services balance has recovered especially strongly, alongside the primary income balance, while the goods balance remained somewhat constrained by supply chain disruptions. Both private and public sector saving are estimated to have increased compared to 2020, outpacing the increase in investment. Some large creditor countries, such as Germany and the Netherlands, continued to have sizable surpluses, reflecting high corporate and household saving and weak investment. At the end of the projection horizon, the CA balance will be above the pre-pandemic level, mainly driven by higher private sector savings in Italy and some smaller countries, including Ireland. Assessment. The EBA model estimates a CA norm of 1.0 percent of GDP, against a cyclically adjusted CA of 2.5 percent of GDP. This implies a gap of 1.5 percent of GDP. IMF staff analysis indicates a somewhat higher CA norm than estimated by the EBA model, consistent with the assessed external positions of euro area member countries. The higher CA norm considers policy commitments to reduce the large net external liability positions in some countries (e.g., Spain) and uncertainty about the demographic outlook and the impact of recent large-scale immigration (e.g., Germany). In addition, adjustments to the underlying CAwere made in Ireland and the Netherlands given measurement issues. Adjustments for the transitory impact of the Covid-19 crisis on the shift in household consumption composition, medical goods, and tourism are estimated at 0.3 percent of GDP. Considering these factors and uncertainties in the estimates, including the cyclical adjustment, the IMF staff assesses the CA gap to be 1.5 percent of GDP for 2021, with a range of 0.7 to 2.3 percent of GDP. This assessment is preliminary and may change as more data for 2021 becomes available. The final assessment will be published in the 2022 ESR.
2021 (% GDP)	CA: 2.9	Cyc. Adj.CA: 2.5	EBA Norm: 1.0	EBA Gap:1.5	Covid-19Adj.:0.3	Other Adj.: -0.4	Staff Ca Gap: 1.5
Real Exchange Rate	Background. The CPI-based REER appreciated by 0.5 percent in 2021 compared to 2020. This reflected a nominal appreciation of 1.7 percent, which was partially offset by weaker euro area inflation relative to its trading partners. The ULC-based REER depreciated by 2.1 percent. Assessment. The staff CA gap implies a projected REER gap of -4.1 percent in 2021, applying an estimated elasticity of 0.35.1 The EBA REER index model suggests an overvaluation of 6.2 percent, and the EBA REER-level model implies an undervaluation of 0.2 percent. Consistent with the staff CA gap, staff assesses the REER gap to be in the range of -6.4 to -1.9 percent. As with the CA, the aggregate REER gap masks a large degree of heterogeneity in REER gaps across euro area member states, ranging from an undervaluation of 12.2 percent In Ireland to an overvaluation of 5.1 percent in Belgium. The substantial differences in REER gaps within the euro area highlight the continued need for net external debtor countries to improve their external competitiveness and for net external creditor countries to boost domestic demand.
Capital and Financial Accounts: Flows and Policy Measures	Background. Mirroring the CA surplus in 2020, the euro area experienced net capital outflows, largely driven by portfolio investment, which more than offset the net inflow of direct and other investment into the euro area. Net capital outflows from the euro area in 2021 were largely driven by outbound FDI and portfolio debt investment. Assessment. Gross external indebtedness of euro area residents increased by 0.4 percentage point of GDP in the first half of 2021 as higher external debt of deposit-taking institutions has offset a reduction in Eurosystem and nonfinancial sector liabilities.
FX Intervention and Reserves Level	Background. The euro has the status of a global reserve currency. Assessment. Reserves held by euro area economies are typically low relative to standard metrics, but the currency is free floating.

¹The export and import elasticities are taken as the average of estimates from Consultative Group on Exchange Rate Issues (CGER)-inspired export and import equations using various types of REERs relevant for the euro area (with an ADL (2,2,2) model on quarterly data 2000–19). The trade balance elasticity is calculated using the share of exports and imports for extra-EA trade in GDP.

View Table

^{Table 2.}

Euro Area: External Sector Assessment

Overall Assessment: The external position in 2021 is assessed as moderately stronger than the level implied by medium-term fundamentals and desirable policies. However, this assessment is preliminary and subject to a wide range of uncertainty arising from the preliminary nature of data and Covid-19 adjusters for 2021. The final assessment will be provided in the 2022 External Sector Report. Data for the first three quarters of 2021 show an increase in the seasonally adjusted current account (CA) surplus to 2.7 percent of GDP, on the back of stronger external demand, especially for services. The CA surplus is estimated to have reached 2.9 percent of GDP for 2021 as a whole. In the medium term, the euro area’s CA surplus is projected to remain broadly at the 2021 level, although the range of uncertainty around this projection is exceptionally high given the nature of this crisis. Imbalances that existed prior to the Covid-19 outbreak could remain sizable at the national level. Potential Policy Responses: Short-term policies should continue focusing on containing the Covid-19 outbreak and reducing scarring from the crisis. The recent initiatives both at the national and EU-levels, including NGEU, have supported these efforts and could potentially help reduce the CA surplus by supporting investment and consumption, thereby increasing imports. Going forward, monetary policy should remain accommodative until inflation has durably converged to the ECB’s medium-term price stability objective while fiscal support should remain in place until the expansion phase is firmly in train, before gradually consolidating towards medium-term objectives. If imbalances in policy gaps that existed prior to Covid-19 were to persist at the national level, then countries with excess CA surpluses should continue to strengthen investment and potential growth, whereas those with weak external positions should undertake reforms to raise productivity, reduce structural and youth unemployment, and enhance competitiveness as the acute phase of the pandemic recedes. Euro area-wide initiatives to make the currency union more resilient (e.g., banking and capital markets union and fiscal capacity for macroeconomic stabilization) could further reinvigorate investment and, hence, reduce the aggregate CA surplus.
Foreign Asset and Liability Position and Trajectory	Background.The NIIP of the euro area had fallen to about -23 percent of GDP by the end of 2009 but has since risen substantially to about -3.3 percent of GDP by mid-2021. The rise was driven by stronger CA balances and modest nominal GDP growth. Relative to 2020, the NIIP increased by 1.3 p.p. of GDP, reflecting primarily the net increase in outbound FDI and debt portfolio securities, partially offset by a milder increase in inbound portfolio equity and other investment. Gross foreign positions were about 271.2 percent of GDP for assets and 274.4 percent of GDP for liabilities as of mid-2021. Net external assets reached elevated levels in large net external creditors (e.g., Germany and the Netherlands), whereas net external liabilities remained high in some countries, including Portugal and Spain. Assessment. Projections of continued CA surpluses over the medium term suggest that the NIIP-to-GDP ratio will rise further, at a moderate pace. The region’s overall NIIP financing vulnerabilities appear low. Despite rising CA balances over the medium term, large net external debtor countries still bear a greater risk of a sudden stop of gross inflows.
2021H1 (%GDP)	NIIP:-3.3	Gross Assets: 271.2			Debt Assets: 104.3	Gross Liab.: 274.4	Debt Liab.: 104.0
Current Account	Background. The CA balance for the euro area is projected to increase to 2.9 percent of GDP in 2021 from 1.9 percent of GDP in 2020. The services balance has recovered especially strongly, alongside the primary income balance, while the goods balance remained somewhat constrained by supply chain disruptions. Both private and public sector saving are estimated to have increased compared to 2020, outpacing the increase in investment. Some large creditor countries, such as Germany and the Netherlands, continued to have sizable surpluses, reflecting high corporate and household saving and weak investment. At the end of the projection horizon, the CA balance will be above the pre-pandemic level, mainly driven by higher private sector savings in Italy and some smaller countries, including Ireland. Assessment. The EBA model estimates a CA norm of 1.0 percent of GDP, against a cyclically adjusted CA of 2.5 percent of GDP. This implies a gap of 1.5 percent of GDP. IMF staff analysis indicates a somewhat higher CA norm than estimated by the EBA model, consistent with the assessed external positions of euro area member countries. The higher CA norm considers policy commitments to reduce the large net external liability positions in some countries (e.g., Spain) and uncertainty about the demographic outlook and the impact of recent large-scale immigration (e.g., Germany). In addition, adjustments to the underlying CAwere made in Ireland and the Netherlands given measurement issues. Adjustments for the transitory impact of the Covid-19 crisis on the shift in household consumption composition, medical goods, and tourism are estimated at 0.3 percent of GDP. Considering these factors and uncertainties in the estimates, including the cyclical adjustment, the IMF staff assesses the CA gap to be 1.5 percent of GDP for 2021, with a range of 0.7 to 2.3 percent of GDP. This assessment is preliminary and may change as more data for 2021 becomes available. The final assessment will be published in the 2022 ESR.
2021 (% GDP)	CA: 2.9	Cyc. Adj.CA: 2.5	EBA Norm: 1.0	EBA Gap:1.5	Covid-19Adj.:0.3	Other Adj.: -0.4	Staff Ca Gap: 1.5
Real Exchange Rate	Background. The CPI-based REER appreciated by 0.5 percent in 2021 compared to 2020. This reflected a nominal appreciation of 1.7 percent, which was partially offset by weaker euro area inflation relative to its trading partners. The ULC-based REER depreciated by 2.1 percent. Assessment. The staff CA gap implies a projected REER gap of -4.1 percent in 2021, applying an estimated elasticity of 0.35.1 The EBA REER index model suggests an overvaluation of 6.2 percent, and the EBA REER-level model implies an undervaluation of 0.2 percent. Consistent with the staff CA gap, staff assesses the REER gap to be in the range of -6.4 to -1.9 percent. As with the CA, the aggregate REER gap masks a large degree of heterogeneity in REER gaps across euro area member states, ranging from an undervaluation of 12.2 percent In Ireland to an overvaluation of 5.1 percent in Belgium. The substantial differences in REER gaps within the euro area highlight the continued need for net external debtor countries to improve their external competitiveness and for net external creditor countries to boost domestic demand.
Capital and Financial Accounts: Flows and Policy Measures	Background. Mirroring the CA surplus in 2020, the euro area experienced net capital outflows, largely driven by portfolio investment, which more than offset the net inflow of direct and other investment into the euro area. Net capital outflows from the euro area in 2021 were largely driven by outbound FDI and portfolio debt investment. Assessment. Gross external indebtedness of euro area residents increased by 0.4 percentage point of GDP in the first half of 2021 as higher external debt of deposit-taking institutions has offset a reduction in Eurosystem and nonfinancial sector liabilities.
FX Intervention and Reserves Level	Background. The euro has the status of a global reserve currency. Assessment. Reserves held by euro area economies are typically low relative to standard metrics, but the currency is free floating.

¹The export and import elasticities are taken as the average of estimates from Consultative Group on Exchange Rate Issues (CGER)-inspired export and import equations using various types of REERs relevant for the euro area (with an ADL (2,2,2) model on quarterly data 2000–19). The trade balance elasticity is calculated using the share of exports and imports for extra-EA trade in GDP.