Authorities’ Views⁹

21. The authorities generally shared staff’s assessment of the macroeconomic outlook. They noted that the economy had been resilient to the war in Ukraine and ensuing energy crisis, largely due to the agile policy response, including successful diversification of energy sources, demand reduction, and deployment of fiscal support measures. With positive momentum coming from the lower energy prices, abating supply constraints, and a strong labor market, the authorities saw a gradual expansion in the course of 2023 and 2024. Policy tightening will continue to weigh on demand. Over the medium-term, the authorities see somewhat less scarring from the war in Ukraine and lower energy prices than staff, with limited losses to the level of output.

22. Headline inflation is on a downward path and core inflation is likely to have peaked, but the declining path is projected to be gradual given the upward pressures from, among others, strengthening wage growth. The authorities projected that core inflation will gradually decline during the second half of 2023 and into 2024 as tighter financial conditions weigh on demand and lower energy prices feed through to price setting. Given the recent contractual agreements concluded in late 2022 and in the early months of 2023, the projected wage growth in the euro area is expected to accelerate in 2023 and moderate in 2024. Sustained moderation in non-energy inflation is thus predicated on the expectation that wage growth will moderate somewhat and that firms’ profit margins will compress and partly accommodate recent increases in labor costs.

23. The authorities agreed that risks to growth are tilted to the downside and risks to inflation remain skewed to the upside. They stressed that the upside risk to inflation relates to the persistence of core inflation, which could turn out higher than expected in case of stronger-than-expected wage growth coupled with unabated profit margins. Upside surprises on inflation could also lead to a stronger reaction of monetary policy, leading to more pronounced tightening of lending standards than currently assumed. Additional tightening could come from renewed market stress and weigh on investment and consumption, highlighting in particular the potential adverse effect on heavily indebted households and firms. In this context, lack of policy consistency could also pose a risk as an expansionary fiscal stance with untargeted support measures would necessitate stepping up monetary policy tightening. While the threat of gas shortages has significantly abated, future developments in energy prices remain highly uncertain, and a return of higher energy prices, including due to an escalation in the war in Ukraine, could adversely affect growth and inflation. In addition, the authorities noted the downside risks related to the external environment, including a slowdown in the US or in the global economy and financial market tensions. On the upside, a resilient labor market could boost growth, or the economy could again surprise with greater resilience than expected of households and corporates.

24. The authorities concurred with staff’s assessment of the Euro area’s external position, noting that the sharp deterioration in the current account balance in 2022 is likely to be temporary. They saw a gradual increase in the current account balance over the forecast horizon as terms of trade improve, external demand strengthens, and the services sectors, particularly tourism, fully normalize. While noting that the euro area aggregate current account is likely to stay somewhat below pre-pandemic levels over the forecast horizon, the authorities saw external imbalances persisting at the country levels and highlighted the role of national policies to address them.

Continued Monetary Policy Tightening

25. With headline and core inflation remaining persistently high, monetary policy should continue to tighten. Recent policy rate hikes have shifted market rates up, to above the estimated neutral rate, bringing the monetary policy stance into contractionary territory.¹⁰ Going forward, a more restrictive stance than at present,. In this regard, while the policy interest rate path assumed in staff’s baseline (¶14) is projected to bring inflation to target by mid-2025, uncertainty around this baseline projection is high, with risks skewed to the upside. Staff’s analysis of robust monetary policy decision making, presented in Annex I, suggests that, when inflation persistence is uncertain, the economic losses to be incurred from reacting too late are larger than those from reacting too forcefully early on, because underestimating persistence could entrench high inflation and force central banks to ultimately tighten more and for longer to bring inflation back to target, resulting in a sharper downturn.¹¹ Staff therefore sees merit in further hikes of the key policy rates than assumed in the baseline to limit the risks of a meaningful overshoot of inflation above the baseline projection and a potential upward shift in inflation expectations. Moreover, a tightening bias, with stronger responses to upside than downside surprises on inflation, would be appropriate. That said, uncertainty around the path of inflation is high and two-sided, and a flexible meeting-by-meeting approach to setting the interest rate path allows responding swiftly to any potential changes in the inflation outlook, including those that may result from shifting financial conditions or fiscal policy settings (¶46–47).

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Expected Path for Short-Term Interest Rates

(Percent)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: Bloomberg Finance L.P.; and IMF staff estimates and calculations.Note: The staff projection for the policy rate is based on a Taylor rule and a DSGE model calibrated to the euro area. The grey area denotes the range staff recommends for the policy rate, based on the model described in Annex I that suggests a tightening bias.

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26. Policy rates should remain the primary monetary policy tool, with quantitative tightening (QT) aiming to reduce the Eurosystem’s footprint in financial markets. The accommodation provided by the ECB’s bond holdings is no longer needed. However, the tightening in the monetary policy stance should be primarily achieved through the key policy rates rather than a reduction of the Eurosystem’s bond holdings as the former makes a return to the effective lower bound—which can constrain policy in a downside scenario—less likely. Moreover, the transmission of policy rates to financial conditions and economic activity are better understood, and their changes are easier to communicate. At the same time, there is scope to use the current tightening cycle to reduce the Eurosystem’s footprint in financial markets and ensure that issuer limits do not become binding should the need to restart large scale asset purchases arise once more. Temporary accounting losses for the Eurosystem coming from higher policy rates should have no bearing on monetary policy decision making (Annex II).¹²

27. QT should stay gradual and cautious, consistent with a learning-by-doing approach. A gradual and predictable path for QT allows market participants to adjust their expectations for the additional supply of bonds that need to be absorbed, thereby facilitating a smooth adjustment in bond prices and minimizing adverse impacts on financial stability (Box 3). In this regard, the ECB’s decision to stop reinvesting all APP maturing assets as of July 2023 while continue to reinvest the principal payments from maturing securities purchased under the PEPP at least until end-2024, is appropriate. Going forward, a state-contingent approach would formally provide the flexibility to adjust course if financial conditions change sharply.

^{Box 3.}

Euro Area: The Potential Impact of Quantitative Tightening

The Eurosystem’s large asset holdings dramatically increased its footprint in financial markets. The side effects of a large balance sheet include a reduction in the availability of safe securities for collateralized lending. The share of sovereign free float—securities held by entities other than central banks, insurance, and pension funds—was cut in half since the start of QE, reaching 40 percent out of the €10.3 trillion in outstanding euro area sovereign bonds by end 2022. The fall in the Bunds’ free float was even more dramatic, dropping threefold during the same period to 20 percent of the issued stock by end 2022. In addition, Eurosystem refinancing operations (including TLTROs) also contributed to pressure on the availability of public sector collateral which needs to be pledged to the ECB to access this borrowing. A measure of scarcity based on the difference between the yield of an asset and the similar asset swap rate, confirms increased scarcity, particularly with the introduction of the PEPP during 2020–22. However, TLTRO repayments—by which banks take back their pledged collateral—along with lower risk aversion by investors have likely eased scarcity in recent months (the asset swap spread has declined but remains almost double the pre-QE average).

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Safe Asset Scarcity

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: Bloomberg Finance L.P.; ECB; and IMF staff calculations.Note: A positive difference between the area swap rate and the euro area government yields indicates that investors are prepared to pay a premium for government bonds, which signals scarcity.

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Sovereign Bonds Free Float

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: ECB; Haver Analytics; and IMF staff calculations.Note: Free float (broad measure) is defined as holdings of sovereign bonds by price sensitive investors, excluding insurance and pension funds.

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Estimates suggest that fully unwinding the ECB’s asset purchase programs would likely have significant effects on long-term yields. Work by Eser and others (2019) and Altavilla and others (2021) suggest yields fall, on average, 3.6 to 5.4bp per €100bn of asset purchases by the ECB. Applying these elasticities to the stock of QE purchases, which amounted to €4.9 trillion, the level of accommodation provided to the 10-year GDP-weighted zero-coupon yields of the four largest euro area jurisdictions is on average between 176 and 265bp. Such effects are, however, highly state contingent and can be much higher in periods of market stress than when markets are tranquil (DAmico and King, 2013).

A gradual and predictable QT path is likely to have a small impact on the monetary stance while reducing the footprint in financial markets over time. The reduction of the APP portfolio by €15 billion a month until June 2023, followed by the full redemption of maturing APP assets, will reduce the total portfolio by about €334 billion between June 2023 and May 2024 or around 2.3 percent of euro area GDP in 2023. This will translate into a 12–18bp increase in the term premia and long-term bond yields, roughly equivalent to an annual increase in the policy rates of 15–22bps. This is a small fraction of the 400bp increase in the ECB’s deposit facility rate since July 2022, in line with the notion of maintaining the policy rate as the primary monetary stance tool.

Authorities’ Views

28. The ECB agreed that it was crucial for the monetary policy stance to remain sufficiently restrictive territory for as long as necessary. However, they noted that risks of being insufficiently restrictive or overly restrictive are now more symmetric in light of uncertainties regarding both inflation persistence and policy transmission. The monetary policy stance was viewed as restrictive at the time of the mission and transmitting fast to financing conditions, while its transmission to real activity and inflation was also starting to materialize. The ECB emphasized a meeting-by-meeting (data-dependent) approach with a clear reaction function to setting policy rates and determining the appropriate level and duration of restriction, without pre-committing to a particular interest rate path in the near term, given the elevated level of uncertainty.

29. The current pace of balance sheet reduction was viewed as appropriate. The ECB documented a smooth absorption by the market during March and April when only about half of the maturing assets on the APP portfolio were reinvested. On this basis, the ECB felt that discontinuing all APP reinvestments is likely to have a small impact on the monetary stance. Overall, the ECB agreed that a measured and predictable approach to balance sheet reduction was appropriate and saw scope for it to continue for an extended period, even if the endpoint was yet to be determined. The ECB emphasized that financial fragmentation, if it materialized, would be dealt with the flexible reinvestment of PEPP’s maturing assets and, if needed, through TPI, but did not rule out in principle the possibility of altering the speed of balance sheet reduction (or using other instruments at its disposal) in a hypothetical severe scenario.

Maintaining Financial Stability

30. The banking sector as a whole appears resilient to a further tightening of financial conditions, but pockets of vulnerability in the financial system cannot be ruled out. Close monitoring, public disclosures, and contingency planning, including in the more heterogenous and less regulated NBFI sector, will be key to limiting financial stability concerns.

31. Supervisors should continue to monitor and assess banks’ interest-rate risk and the appropriateness of banks’ risk management strategies. Bank interest-rate-risk stress tests can both alleviate uncertainty over the valuation of bank assets held to maturity and establish the degree of bank resilience to potential further interest rate increases, especially in member states where flexible-rate loans are more prevalent. Supervisors should also monitor and more frequently stress test bank and market wide liquidity conditions, to ensure that higher interest rates, TLTRO repayments (which may affect banks unevenly), and QT do not trigger systemic liquidity events. Such monitoring should extend also to less significant institutions, as the recent turbulence in the United States underscores the potential for a systemic loss in confidence even from stress in medium to small sized banks. The authorities should stand ready to provide liquidity to solvent banks via existing or new liquidity facilities to prevent liquidity problems from morphing into solvency ones.

32. As financial conditions are likely to tighten further, banks need to proactively increase their buffers for higher credit and market risk. Corporate insolvencies and NPLs will likely rise with slowing growth. Residential real estate prices, which have on average appreciated by more than 20 percent since the beginning of the pandemic (and by close to 40 to 50 percent in several countries), are correcting, and commercial real estate (CRE) markets exhibit declining liquidity as transaction volumes have fallen. CRE price corrections may affect banks directly as highly leveraged borrowers could choose to default over repaying the banks, and indirectly by softening the demand for credit as collateral values fall. The exposure of banks to RRE prices is cushioned by still-low unemployment and recourse clauses in mortgages, but in a scenario where households, especially those with variable rate mortgages, fall into financial distress, banks would be affected. Hence, the authorities should continue to monitor conditions in real estate markets, interest coverage ratios in the corporate sector, and households’ debt service capacity, and run frequent stress tests with up-to-date information on these factors.

33. Although European banks have comfortable buffers against credit losses, there should be no complacency regarding bank capital. Under the WEO baseline scenario, staff estimates suggest that the aggregate common equity tier 1 capital (CET1) ratio of euro area banks would increase from 14.6 percent in 2023 to 15.5 percent in 2025. In a moderate downturn, however, the aggregate CET1 ratio could fall by as much as 1.9 percentage points to 12.7 percent in 2023 but would partially recover to 13.4 percent in 2025 on the back of better economic activity. The performance of some banks under the adverse scenario, however, is somewhat more negative, with the capital ratio of those at the bottom 20 percent showing a decline in the CET1 ratio of almost 2.7 percentage points to 11.5 percent in 2024. Moreover, six banks would breach the bank-specific threshold for the Maximum Distributable Amount in 2024, which would trigger restrictions on dividend payouts (see Annex III),¹³ although only one bank could see a capital shortfall relative to the combined pillar 1 and conservation requirement of 7 percent. The capital erosion in the downturn scenario underscores the need to conserve and build further bank capital to avert strains. Supervisory action to prevent instances of extraordinary high dividend payments are more efficient approaches to ensuring bank capital accumulation compared to across-the-board dividend restrictions (which avoid bank-level stigma but may impede banks’ future access to capital markets) or windfall taxes on bank profits (which are undesirable from a prudential perspective as they hinder bank capital accumulation).

34. Macroprudential policy could have a useful role to play by ensuring that banks experiencing temporarily high profits buttress their buffers against risks before the financial tightening peaks. While supervisory pressure is the first line of defense, it is also advisable to tighten countercyclical capital buffers (CCyBs), as a step toward positive neutral rates for the CCyB, in jurisdictions where banks are experiencing temporarily high profits. Maintaining borrower-based measures can help preserve resilience in leverage-prone markets. When national regulators do not have such measures at their disposal,¹⁴ policymakers should work to expand the macroprudential toolkit. In the meantime, supervisors should require banks to stress-test the credit risk of new mortgages (at origination) to higher interest rates and lower disposable incomes.

35. Vulnerabilities in the NBFI sector also require continued monitoring. While life insurers have benefited from rising interest rates and have shown robust profitability and solvency, nonlife insurers have been adversely affected by valuation losses in fixed income assets and higher inflation while other segments of the NBFI sector, including investment funds, experienced significant outflows. In the absence of liquidity management tools, redemption or liquidity pressures in the NBFI sector can affect the wider financial system and the real economy through funding links to banks and their effect on commercial and residential real estate prices. A wider implementation of macroprudential tools that limit leverage and liquidity mismatches in such entities—including robust liquidity management tools—while closely monitoring and reducing the risk that activity migrates to less-regulated parts of the sector, would therefore be a welcome step. Furthermore, given the significant cross-border activities of NBFI entities within the EU and the scope for cross-border regulatory arbitrage, enhanced cooperation between national authorities, and the strengthening of the EU agencies that can enhance such coordination, are key (Annex IV). Finally, closing data gaps on the NBFI sector is essential to enable effective regulation and supervision and to prevent activities from migrating to the less-regulated parts of the sector.

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Liquidity and TLTRO Repayment by Country

(Sep 2022)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: EBA; ECB; and IMF staff calculations.

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36. The recent turbulence in financial markets and heightened focus on vulnerabilities also underscores the urgent need for progress in strengthening the EU’s financial architecture (even if results may take time). Despite the progress observed so far in implementing the recommendations from the 2018 Financial Stability Assessment (FSAP; Annex V), there is scope for continued improvements to financial sector oversight.

• Crisis management arrangements need to be strengthened further. Recent banking system stress elsewhere underscored the criticality of rapid interventions in problem banks. Appropriately, the recent European Commission proposal on crisis management and deposit insurance aims to broaden the applicability of central resolution powers to midsized and smaller banks, while improving resolution funding arrangements, including by facilitating more-flexible use of national deposit guarantee funds. However, the proposal does not address key rigidities in the current framework, including on bail-in requirements, especially in systemic situations. More substantive reforms, including introducing a systemic risk exemption from minimum bail-in requirements, would add needed flexibility. Progress is also needed on the ratification of the amended European Stability Mechanism (ESM) treaty (which would operationalize the ESM’s financial backstop to the Single Resolution Fund (SRF) and thus make crisis management arrangements more credible), and on a pooled European Deposit Insurance Fund (which would delink the ability to provide deposit insurance from the creditworthiness of the sovereign, thus limiting divergence in financial conditions).

• Meaningful progress on the BU and CMU would enhance cross-border risk sharing and financial resilience, and deepen access to finance for households and firms, and improve risk-sharing, supporting macroeconomic stability, growth, and convergence in the euro area. The Commission’s recent CMU legislative package includes important steps toward harmonizing insolvency processes across member states. Stronger insolvency frameworks would expand firms’ access to credit, help banks resolve NPLs, promote entrepreneurship, and deepen Europe’s debt markets.

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Time to Resolve Insolvency Proceedings

(Years)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: Business Enabling Environment.

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37. A full implementation of the capital requirements envisaged under Basel III is essential. The EU’s provisional agreement on the implementation of Basel III contains multiple deviations from this accord. According to previous EBA estimates, these would reduce the expected increase in EU banks’ Tier 1 aggregate capital requirements by about 3 percentage points compared to a faithful implementation of Basel III. Diluting macroprudential standards for banks is not desirable, especially in view of the recent events in other jurisdictions, which have clearly illustrated the dangers of selective implementation of banking regulation.

38. Strengthening the EU’s AML/CFT regime will also help safeguard financial integrity against emerging risks (including from virtual assets) and prevent regulatory arbitrage. Key priorities include: improving information sharing between prudential and AML/CFT supervisors, which is critical for overlapping supervised entities and enforcement of sanctions; establishing a single AML/CFT rulebook and supervisory authority (in strong cooperation with the SSM) to ensure consistency of financial integrity oversight in the euro area; and maintaining the transparency of beneficial ownership to mitigate risks from cross-border tax crimes, corruption, sanctions evasion and money laundering. The latter objective urgently needs to be reconciled with the 2022 ruling by the Court of Justice of the European Union which found that the 2018 EU Anti-Money Laundering Directive interfered with personal data protection rights of beneficial owners. In addition, the adoption of the Regulation on Markets in Crypto-Assets (MiCA) will help ensure that crypto-asset service providers have robust AML/CFT controls.

39. Finally, the EU should tackle overbanking. Europe’s banking system has a long-standing problem of low profitability due to too many banks and branches. The authorities can ameliorate this problem by ensuring that the largest banks have sound business models that are conducive to consistent return on assets and equity, encouraging banks to improve cost efficiency and trim the branch network, and facilitating the exit of less efficient banks. This would permit a more dynamic banking sector and enhance financial stability.

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Bank Profitability: Return on Assets, 2022Q4

(Percent)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: ECB; IMF Financial Soundness Indicators; and Haver Analytics.

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Authorities’ Views

40. The authorities emphasized that bank capital, liquidity, and profitability remain strong and were confident that the banking system will be able to withstand the ongoing tightening cycle. The authorities noted that banks benefited from the so far limited pass-through of higher policy rates to deposit rates. While NPLs continue to decline thanks to NPL reduction strategies adopted in the aftermath of the Global Financial Crisis and Euro Area sovereign debt crisis, credit risk related to tighter credit conditions may materialize with a delay, as consumer, CRE, and SME loans could be exposed to an economic slowdown. The authorities noted that forthcoming TLTRO repayments would, overall, not lead to excessive pressure on banks’ funding because banks have had enough time to prepare and have in aggregate comfortable excess liquidity and ability to tap into bond markets. They also assessed that valuation losses from banks’ HTM portfolios are modest and would be largely absorbed by higher bank profits arising from higher net interest income.

41. The authorities agreed that vulnerabilities associated with tighter financial conditions nevertheless warrant continued monitoring. They noted that banks’ capital and liquidity are robust and that the ongoing EBA-ECB bank stress test (which considers an adverse scenario with low growth and high inflation and interest rates) will be testing bank resilience. Furthermore, the authorities monitor banks’ interest rate and liquidity risks building on the SSM’s 2017 stress test exercise and 2019 thematic reviews, scrutinize banks’ interest rate risk management with quarterly reviews with a focus on outliers, and analyze banks’ funding profiles, including deposit stickiness and interest rate assumptions and forward liquidity plans. The authorities agreed with the need to rebuild regulatory capital buffers to sufficient levels—including through a positive-neutral rate for the CCyB—so that they can be released when needed, provided the buildup does not have a procyclical effect on credit growth.

42. The authorities anticipate that the Basel III implementation will be fully legislated by end-2023. The European Commission expressed commitment to the faithful implementation of Basel III, where any deviations are strictly temporary. The authorities noted that, in contrast to several other jurisdictions, the EU’s Basel III implementation also covers smaller banks with very different business models which require some adjustment in capital requirements. In the authorities’ view, only the deviation related to counterparty risk appears material, whereas the deviations related to unrated corporates and mortgages are expected to have a minor effect on required capital.

43. The authorities viewed the Commission’s CDMI proposal as an integral part of the BU architecture. The authorities assigned high importance to a more flexible and effective use of DGS funds possible once creditor hierarchy is changed, and a greater backstop to the SRF once the ESM treaty is ratified by all member states. They noted that the CMDI proposal was designed as a coherent package, with its individual elements working in concert with the others. The authorities saw some value but limited political scope for a systemic exemption for smaller banks in distress and expected that this issue could be solved by transferring assets and liabilities to another bank rather than by standalone resolution.

44. The authorities agreed that more work needs to be done regarding the regulation of the NBFI sector. This work could clarify the use of regulatory tools for investment funds for macroprudential purposes and reflect the fact that more centralized coordination of such macroprudential tools in the EU may be desirable. Work on a legislative proposal on money market funds is also planned. The authorities also noted that ESMA is currently reviewing the AIMF and UCITS directives to refine liquidity requirements on funds that may meet large redemptions.

45. The authorities agree that strengthening AML/CFT supervision remains a priority. In recent years, the ECB has significantly enhanced its channels for collaboration with national AML/CFT authorities in the EU regarding ML/TF issues of banks under its supervision. The creation of the Anti-Money-Laundering Authority (AMLA), which is now undergoing the trialogue process, will allow AML/CFT supervision of banks, financial institutions, and likely crypto-asset service providers at the European level.

A Restrictive Fiscal Policy Stance

46. Under the baseline, fiscal policy is projected to tighten moderately in 2023 and further in 2024 (Text Table 2). The euro area aggregated cyclically-adjusted primary balance (CAPB) as a share of potential GDP is projected to improve by 0.4 percentage points in 2023—largely explained by the expiration of the “Super-bonus” program in Italy (with most other countries maintaining a neutral fiscal stance). For 2024, under existing policies, the CAPB would improve by an additional 1 percent of potential GDP, of which around one-third is in high-debt countries.

^{Text Table 2.}

Euro Area: Public Finance Indicators, 2021–2028

(Percent of GDP)

Source: IMF staff estimates.

^1/Percent of potential GDP.

^{Text Table 2.}

Euro Area: Public Finance Indicators, 2021–2028

(Percent of GDP)

			Projections
	2021	2022	2023	2024	2025	2026	2027	2028
Overall fiscal balance	-5.3	-3.6	-3.5	-2.7	-2.3	-2.1	-2.0	-2.0
Primary balance	-4.0	-2.1	-2.0	-1.0	-0.5	-0.2	-0.1	-0.1
Structural balance 1/	-3.5	-2.4	-2.8	-2.3	-2.2	-2.1	-2.1	-2.1
Structural primary balance 1/	-2.2	-0.9	-1.2	-0.7	-0.4	-0.2	-0.1	-0.1
Cyclically adjusted primary balance 1/	-2.8	-2.1	-1.7	-0.7	-0.4	-0.2	-0.1	-0.1
Gross public debt	95.1	91.2	89.4	88.2	87.1	86.3	85.6	85.1

Source: IMF staff estimates.

^1/Percent of potential GDP.

View Table

^{Text Table 2.}

Euro Area: Public Finance Indicators, 2021–2028

(Percent of GDP)

			Projections
	2021	2022	2023	2024	2025	2026	2027	2028
Overall fiscal balance	-5.3	-3.6	-3.5	-2.7	-2.3	-2.1	-2.0	-2.0
Primary balance	-4.0	-2.1	-2.0	-1.0	-0.5	-0.2	-0.1	-0.1
Structural balance 1/	-3.5	-2.4	-2.8	-2.3	-2.2	-2.1	-2.1	-2.1
Structural primary balance 1/	-2.2	-0.9	-1.2	-0.7	-0.4	-0.2	-0.1	-0.1
Cyclically adjusted primary balance 1/	-2.8	-2.1	-1.7	-0.7	-0.4	-0.2	-0.1	-0.1
Gross public debt	95.1	91.2	89.4	88.2	87.1	86.3	85.6	85.1

Source: IMF staff estimates.

^1/Percent of potential GDP.

47. A tight fiscal policy stance in 2024 will help avoid additional inflation pressures and rebuild fiscal space. At the aggregate level, staff analysis suggests than an improvement in the CAPB of around 1 percent of potential GDP in 2024—which would be achieved under current policies—would bring the targeted benefits. In particular, country authorities should allow temporary energy support programs to expire and avoid extending or replacing these with other spending programs. This will require that any new expansionary policy measures introduced during the preparation of the 2024 budget are offset by other discretionary policy changes. Temporary revenue windfalls from higher-than-expected inflation should also be saved.¹⁵ While an aggregate euro area fiscal tightening of 1 percent is broadly appropriate, individual countries may need more tightening than currently in the baseline to contain fiscal risk and build fiscal space. Specifically, a restrictive fiscal policy stance would:

• Allow less monetary policy tightening and thus help reduce the risk of financial market disruptions. However, given heterogeneous country conditions, fiscal adjustment would differ across countries, with more effort appropriate where inflation is high.¹⁶

• Support debt reduction and restoration of fiscal space against future shocks and longer-term spending pressures, including pensions, health, energy security and the green transition. Ambitious consolidation is particularly essential in high debt countries—many of which have seen a persistent increase in their fiscal deficits (¶55).

Clear communication of the rationale for fiscal consolidation is necessary to secure broad support. For high-debt countries with a larger need for fiscal consolidation, it is important that it is accompanied by strong growth-enhancing reforms (see ¶74–79).

48. Better -targeted energy support programs could support fiscal consolidation and help achieve climate and equity goals. European countries acted quickly in response to the surge in energy prices in 2022 to introduce a variety of energy support packages. On average, euro area countries announced the equivalent of 2.6 percent of GDP in energy support measures for 2022 and 2023, of which more than two thirds are untargeted. The cost is substantially larger than that of fully compensating the bottom 40 percent of households for the increase in the cost of living coming from the energy price shock. Bonuses or rebates on energy bills (that are not linked to the current volume of consumption) or block tariffs are simple options which would improve on the current policy design in many countries. Better targeting of energy support measures would strengthen the incentives for energy conservation and help in reducing inflation. Reclaiming the relief from the better-off through income taxation would also make support more progressive (Arregui and others, 2022).

49. Relieving supply constraints will also ease policy tradeoffs. The fast expansion of LNG import capacity, including through floating terminals in Germany, was an important step in tackling the surge in natural gas prices. Continued efforts to close remaining European infrastructure bottlenecks in line with the REPowerEU plan are important, while avoiding a buildup in medium-term excess capacity. Policies which encourage labor supply, while less likely to deliver results in the very short term, are another crucial aspect of expanding supply amid tight labor markets (¶78).

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Fiscal Cost: Estimated Cost for Targeted Support versus Announced Measures for Households

(Percent of GDP, 2022–2023)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: Arregui et al., 2022; and IMF staff calculations.

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Authorities’ Views

50. The authorities argued that the aggregate fiscal stance projected for 2023 and 2024 is broadly appropriate, although there is high heterogeneity across countries. They also emphasized the importance of phasing out energy support measures by the end of 2023 as energy prices continue to decline and initiating an improvement in the underlying fiscal positions that would help enhance fiscal sustainability in the medium term. The authorities noted that conditions for fiscal consolidation are currently favorable also because of windfall revenue gains created by unanticipated inflation and argued for the importance of using them to further improve fiscal balances. A potential return of higher energy prices is a risk but, according to the authorities, its negative impact can be offset by targeted energy support measures. According to the authorities, the introduction of a minimum corporate profit tax could also help toward fiscal consolidation in some member states.

Policy Response in Adverse Scenarios

51. A downside scenario of intensified financial instability could take different forms. For instance, it could manifest as a weakening of banks’ asset quality and credit provision on the back of higher corporate insolvencies or a sharp correction in real estate prices. It could also take the form of a loss of confidence in banks, or a sharp increase in borrowing costs of high debt countries due to a sharp change in market sentiment or solvency concerns. Regardless of the initial source of instability, localized or more systemic liquidity stress could act as an amplifier.

• Financial sector policies. Authorities would need to promptly address banking weaknesses by early interventions in troubled institutions, orderly resolution of any unviable institutions, and use liquidity support tools to avoid contagion and unwarranted insolvencies. The latter could take the form of emergency liquidity assistance to specific banks or new broadly available facilities if needed; they should be temporary and targeted to the extent possible to reduce moral hazard. In a downside scenario, the authorities should also release the CCyB.

• Monetary policy. In a financial instability scenario such as those in ¶18, the authorities should aim to maintain the separation principle and continue to use monetary policy to fight inflation and liquidity tools to ensure financial stability. To the extent that financial system distress tightens credit and has disinflationary effects, the monetary policy stance would need to be adjusted. In a severe stress scenario, a temporary halt to QT or a postponement of TLTRO repayments may be needed. If sovereign markets are disrupted, the ECB could flexibly reinvest maturing assets under PEPP or activate the TPI. Sovereign solvency-related concerns should be addressed through the ECB’s Outright Monetary Transactions and the ESM’s macro-adjustment programs.

• Fiscal policy. Given weaker growth, automatic stabilizers should be allowed to operate. Discretionary support should be reserved for a severe scenario and be well targeted.

52. Further adverse supply shocks, or more persistent inflation than expected, would require tighter monetary policy even if policy tradeoffs would worsen. Renewed gas price spikes due to a full shutoff of Russian gas combined with a harsh winter, for example, could keep inflation elevated for longer and imperil the anchoring of inflation expectations. In such a scenario, the monetary policy stance would need to be even tighter than under the baseline, implying more aggressive policy rate hikes during 2023 and 2024 barring a sharp reduction in medium-term expected inflation. With tighter monetary policy, closely monitoring and addressing any financial stability risks would be critical. Should systemic financial stress arise in a scenario of higher-than-expected inflation, clear communication on the separation of tools, targeted liquidity support and a cautious approach to adjusting the monetary policy stance—only once disinflationary effects are becoming more certain—would be warranted. While automatic fiscal stabilizers should be allowed to operate, large increases in the structural deficits should be avoided to maintain a coherent monetary-fiscal policy mix. Countries with limited fiscal space should restrict their overall fiscal balances, including through measures to offset spending increases.

Authorities’ Views

53. The authorities argued that they have the appropriate tools to respond to an adverse scenario. They agreed that the two main downside scenarios highlighted by Fund staff—one driven by financial sector stress caused by either rising insolvencies and sharp real estate price corrections or by a loss of confidence in banks, possibly due to contagion from abroad, and another by further adverse supply shocks or persistent inflation—could in principle be envisaged. ECB staff were of the view that the ECB’s current toolkit would allow an adequate response and, in particular, noted that existing open market operations facilities (MRO and LTROs) provide an ongoing effective instrument to meet short-term liquidity needs. The ECB emphasized that any fragmentation in the transmission of monetary policy due to divergent movements in sovereign spreads unwarranted by fundamentals could be tackled through a flexible reinvestment of maturing bonds in the PEPP portfolio or through the TPI. ECB staff did not rule out completely the possibility of altering the speed of balance sheet reduction in a highly severe scenario but reiterated the primacy of key interest rates for setting the monetary policy stance, and that the balance-sheet rundown would occur passively in a measured and predictable way. If financial turbulence were to stem from nonbank financial institutions, the ECB could consider appropriate responses to stem financial contagion but did not see a need for a dedicated standing liquidity facility for nonbanks. The authorities also agreed that, in a severe downside scenario, well-targeted discretionary fiscal support could be deployed.

Safeguarding Fiscal Sustainability

55. The fiscal outlook is weaker than prior to the pandemic and buffers have been eroded. Euro area public debt increased sharply in 2020 and, despite strong nominal GDP growth, is about 6 percentage points of GDP above 2019 levels at present. Though currently declining, its level in 2025 is projected to be 12 percentage points of GDP higher than the pre-pandemic projection for that year. The consolidated euro area fiscal deficit has been revised up because of persistently higher spending-to-GDP ratios—average euro area medium term fiscal deficits are now more than 1½ percent of GDP higher than projected prior to the pandemic, with slightly less than half reflecting higher debt service costs.

56. Fiscal space in the euro area should be rebuilt over the medium term, with more ambitious and front-loaded adjustment in high-debt countries. Higher debt and deficits imply that euro area countries need to intensify their efforts to rebuild fiscal space through a sustained and growth-friendly improvement in the primary fiscal balances, which should reach a surplus by 2026 and improve further at least until 2028. For some high-debt and deficit countries, this implies decisive (but not without historical precedent) improvements in the overall balance of between 0.5 and 1.0 percent of GDP annually for several years to put debt on a firmly downward path over the medium term. Such fiscal consolidation efforts are more likely to be successful if they curb expenditure growth while safeguarding growth-enhancing public investment. Countries with medium-to-low debt and strong fiscal balances have more flexibility and should ensure that sufficient resources are allocated to growth-enhancing public investments and support to vulnerable households.

57. The ongoing reform of the EU economic governance framework is an opportunity to promote sustainable public finances, enhance macro-economic stabilization, and secure the provision of common public goods. The current fiscal framework is complex (with operational targets dependent on unobservable variables), unable to properly account for country-specific circumstances, and offers limited scope for managing tradeoffs between containing fiscal risks and output stabilization. Compliance with the rules has been uneven, and they have not generated sufficient debt reduction in relatively good times. The key objective of the reform is to remedy these shortcomings, including by setting ambitious, but realistic, fiscal plans with well-defined escape clauses for severe shocks, and facilitating countercyclical policies. The new framework should also strengthen national ownership, raise the status of fiscal rules in the national policy debate, and increase compliance, which would lead to durable reductions in deficit and debt ratios over time.

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Fiscal Outlook

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: IMF staff estimates and calculations.

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58. In late April, the European Commission tabled a legislative proposal to reform the EU’s economic governance framework. In line with Fund staff’s view, the proposal calls for a risk-based approach to determining consolidation paths with a focus on medium-term fiscal plans, operationalized through multi-year net primary expenditure paths.¹⁷ Such paths are expected to deliver with a high probability (according to a debt-sustainability analysis; DSA) declining debt-to-GDP ratios after four years for countries with debt above 60 percent of GDP. The adjustment period can be extended from four to seven years for countries that commit to reforms or public investments. As a safeguard, the debt-to-GDP ratio is required to be below its initial level at the end of the adjustment period. During the adjustment period, countries are also required to keep net primary expenditure growth below medium-term GDP growth, on average. In addition, the Commission’s proposal calls for an expanded role for national fiscal councils in fiscal policy making and surveillance. During the adjustment period, a minimum annual reduction in the deficit of 0.5 percent of GDP must be maintained if the general government deficit exceeds the reference value of 3 percent of GDP.

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Cyclically Adjusted Primary Balance

(Percent potential GDP)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: IMF staff estimates.

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59. The proposal is welcome as it would facilitate a risk-based fiscal adjustment path for countries with high debt levels, while avoiding procyclicality. The use of DSA to set the adjustments paths for high-debt countries allows the consideration of country characteristics, including country-specific initial conditions and risks, which should foster ownership. Moreover, net primary expenditures as operational targets eliminate incentives to substitute expenditure programs with tax expenditure, allow for changes in the size of government (overall spending and revenues as a share of GDP), and let automatic stabilizers operate, thus embedding countercyclicality into the framework. At the same time, some aspects of the proposal require cautious implementation. The possibility of extending the adjustment period can provide incentives for reforms that increase long-term growth (and thereby support consolidation), but longer adjustment periods also raise the risk that fiscal targets are ultimately not met. Moreover, predicting the impact of investments and reforms on output is challenging in practice, and estimates can prove optimistic ex-post. To mitigate these risks, it will be crucial to establish and enforce clear criteria for extending the adjustment period and to rely on conservative estimates of the GDP effects. In addition, complete transparency on key technical aspects, including on how cyclical unemployment expenditure and discretionary revenue measures will be calculated, will be essential. It is vital that an agreement is reached soon so the new framework can anchor fiscal policies in 2025 and beyond.

60. The current proposal could be further strengthened by an EU-wide fiscal capacity and by introducing an independent European fiscal council (EFC). The war in Ukraine reinforces common and imminent needs to enhance EU’s energy security and accelerate the green transition. A central fiscal capacity in the EU, absent in the current reform proposal, could improve the provision of such common public goods and strengthen macroeconomic stabilization. Moreover, an EFC could help establishing the credibility and impartiality of the new framework, since the latter relies on relatively complex DSA analysis to set the ‘technical trajectory’ for fiscal aggregates. National fiscal councils (NFCs) would also benefit from an independent EFC, which could serve as a node in a network of NFCs, helping promote good practices and standards, and provide an independent voice regarding risks and the execution of the framework.

61. The introduction of a minimum corporate profit tax will support the needed fiscal consolidation across the euro area while ensuring a level playing field. The adoption in November 2022 of the Council Directive on a minimum level of taxation for multinational enterprises is a welcome step in meeting the commitments under Pillar II of the OECD/G20’s Inclusive Framework Agreement. The Directive—which commits member states to introduce by 2024 a minimum corporate profit tax of 15 percent for enterprise groups—will mitigate incentives to compete through low corporate tax rates and preferential tax regimes. By mitigating incentives for tax competition between countries, the minimum tax can also improve tax collections, which will help with fiscal consolidation. The Directive also reduces profit-shifting opportunities for companies within the EU.

Authorities’ Views

62. The authorities agreed with the need for ambitious and differentiated medium-term fiscal consolidation, aiming to build fiscal space and improve long-term fiscal sustainability. They pointed out the deterioration in debt dynamics created by higher debt to GDP ratios and less favorable interest-growth differentials. In this context, they stressed the importance of a swift adoption and implementation of the proposed economic governance reform, which would base the fiscal framework on country-specific and risk-based adjustment paths with medium-term net primary expenditure paths as the primary operational target. They agreed that the implementation of the rules could pose some challenges, including the difficulty with the assessment of the long-term growth impact of public investments and structural reforms, which must be prudent. They argued that a qualitative evaluation based on established methodology was feasible, and that the framework contained sufficient safeguards to preserve the integrity of fiscal adjustment paths. The authorities noted that should the member states not reach an agreement on the legislative reform proposal by the end of 2023, a transitional arrangement—consistent with the current EU legislation—should guide member states fiscal position to ensure that fiscal risks remain contained.

Delivering the Green Transition and Energy Security while Strengthening Trade

63. The Russian invasion of Ukraine has made it more important to accelerate the transition to reliable low-carbon energy sources. The Fit for 55 package details the specific commitments EU countries have made to reduce emissions by 55 percent by 2030 (relative to 1990 levels). Many of these envision shifting from coal to gas as a bridge fuel during the period when renewable energy sources and related technologies are developed and installed. As gas prices are set to remain substantially higher than historical levels over the medium term, it is critical to ramp up green energy generation and related investments (e.g., upgrading power grids) to avoid a durable return to coal power generation. This has been estimated to require substantial additional investments of around €400 billion per year between 2021 and 2030, a figure that has surely risen with inflation.

64. Initial fears of a sharp tension between the green transition and energy security concerns due to the energy crisis have not played out. While the usage of coal and oil increased last year, leading to higher emissions in the power sector, renewable capacity (especially wind and energy) expanded at a record pace and important efficiency gains were made in both residential housing and industry, contributing to an estimated reduction of 2.5 percent in total EU carbon emissions in 2022 (IEA, 2023). Overall, the energy shock is likely to be favorable for the green transition as energy efficiency got a boost (Box 2), renewable electricity production became more cost-attractive, and policy initiatives accelerated. The latter includes REPowerEU, the extension of the Carbon Border Adjustment Mechanism (CBAM) and of the Emission Trading System (ETS) to more goods and sectors (see below), and the introduction of the Green Deal Industrial Plan (GDIP), which aims at achieving the EU’s green and energy security goals, while ensuring the competitiveness of EU clean tech industries. EU carbon prices have settled at over €90 per ton of CO2, a level compatible with spurring further efficiency gains even as energy prices ease somewhat. At the same time, some EU countries remain far from achieving their carbon commitments, highlighting the importance of maintaining policy momentum.

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Reduction in GHG Emissions

(Billions of tonnes; annual avg. percent change in parentheses)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Sources: EEA; and IMF staff calculations.Note: EEA data until 2021 for total emissions incl. LULCF. 2022 data is extrapolated based on CO2 emissions from IEA data.

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EU Carbon Emissions and Progress Towards Reduction Targets

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

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65. An EU Climate Investment Fund (CIF) would help to ensure that the EU’s emissions reduction goals are achieved in a cost-effective manner. Part of the additional investments needed for the EU to reach its emission reduction goals will be borne by the public sector or require public sector incentives/assistance to get the private sector to move quickly enough. An EU CIF could better internalize cross-border externalities from carbon emissions, and seek to reduce emissions more cost-effectively, including by allocating funds to countries and sectors with the highest rate of return on carbon abatement. It could also be used to help preserve the EU single market amidst potentially growing subsidies for clean technologies in the context of the temporary relaxation of state-aid rules (through 2025, through the Temporary Crisis and Transition Framework) and uneven fiscal space. Moreover, it could help relieve constraints due to limited fiscal space in some countries, even if it is designed to avoid permanent cross-country transfers.

66. The recent agreement on the ETS reform is expected to strengthen EU’s climate policy instruments and is an important step toward achieving the EU’s climate goals. The reform sets an ambitious emission reduction goal of 62 percent by 2030 (relative to 2005 levels) for the ETS-covered sectors—a significant increase compared with the current objective of a 43 percent reduction target. The agreement also envisioned establishment of a new social Fund, which will support vulnerable households in the energy transition, and a separate emissions trading system (ETS II)—expected to be implemented in 2027—to fossil fuels used in buildings, road transport, and certain industrial sectors. Aligning the two emissions trading systems over the longer run would help reduce potential distortions in emission reduction incentives across EU sectors.

67. As part of the EU Green Deal, in December 2022, the EU institutions agreed on a wider scope for the CBAM. The mechanism will cover a broader set of goods than earlier envisaged and will apply to imports from non-EU countries except countries covered by the EU ETS. Third countries will be able to apply for exemptions from the CBAM if they have an equivalent domestic carbon pricing mechanism in place. The CBAM, which is planned to permanently enter into force in 2026, will be phased in gradually from 2023 as free allowance allocations for industries are progressively phased out. The CBAM would help equalize the price on the carbon emitted during the production of carbon intensive goods that are entering the EU with the internal EU price and thus help to encourage cleaner industrial production in non-EU countries. Nevertheless, it should be implemented in line with WTO, and—to the extent possible given the administrative difficulties—be based on actual embodied carbon content of traded products rather than benchmarks. The EU should also step up its efforts to ensure that least developed countries can adjust to its policies on environmental sustainability.

68. The EU’s GDIP includes some welcome steps to advance the EU’s green transition, but some of its elements could have distortionary effects. The plan complements ongoing initiatives to reduce emissions, such as streamlining regulatory and permitting processes, enhancing training to upgrade skills, and fostering the conditions for green innovation, including by creating regulatory sandboxes. However, it also extends and expands the relaxation of state-aid rules, including by allowing member states to grant subsidies or tax incentives to match what is being offered by other countries and design country-specific schemes to support investment in the production of critical materials and green products. While such subsidies can play a role in accelerating the green transition and address some supply chain-related security concerns in the context of growing geo-economic fragmentation risks, they could potentially lead to higher fiscal costs and potential inefficiencies and distortions, including to the EU single market. Moreover, protectionist provisions that include domestic content requirements, or otherwise discriminate between foreign and domestically produced goods and services, if introduced, could disrupt global supply relationships with adverse effects on trade and investment. Any subsidies given under the relaxed state aid rules should thus be limited in scope, duration, and size. Coordinating fiscal support for clean tech sectors across member states, including under an EU-wide facility, could help to limit potential distortions to the EU single market. A common multilateral approach—consistent with the WTO rules—on the appropriate use and design of subsidies, underpinned by thorough analysis of the cumulative effects of various countries’ subsidy packages on climate and economic effects, would be an important achievement.

69. In this period of weakening trade policies and high trade tensions, the EU should remain open and minimize trade distortions. In responding to discriminatory trade measures and potentially distortive subsidies, the EU has avoided excessive responses that would have further harmed the European economy and escalated international tensions. It has implemented or is developing several new tools, including the Foreign Subsidy Regulation, the EU FDI Screening Regulation, the upgraded Export Control Regulation, the Chips Act, the Anti-Coercion Instrument, and a possible outbound investment mechanism. Applications of these tools should be narrowly targeted to specific objectives and the authorities should resist calls to use such tools to provide a competitive advantage to domestic industries.

70. The EU should also increase efforts to strengthen the WTO. Amid high trade tensions and the uncertain commitment of some major players, EU leadership is paramount in completing new WTO-based agreements and reforming the WTO. Priorities could include the strong implementation of the recent plurilateral agreement on Services Domestic Regulation, the conclusion of strong plurilateral agreements on Investment Facilitation and E-Commerce, improving policy predictability by fully restoring the WTO dispute settlement, and stronger efforts on agricultural and industrial subsidy practices. In this vein, a February 2023 EU paper presented constructive ideas for improving the WTO’s “deliberative function” and shed further light on the subsidy issues that were recently examined by several institutions (IMF, OECD, WB, and WTO, 2022).

Authorities’ Views

71. The authorities reiterated the need to accelerate the green transition by investing in renewables and improving energy efficiency. They noted that RePowerEU, the reformed ETS, and the GDIP are key to achieve energy security, reduce dependencies, and mitigate emissions. While noting that an EU Climate Investment Fund could be valuable to help finance public investments with cross-border spillovers, they highlighted the political hurdles associated with establishing such mechanism and argued that, at present, the focus should be on the implementation and absorption of the existing instruments and on the financing from various initiatives toward the implementation of the 2030 objectives in the Fit for 55 package.

72. The importance of the GDIP in enhancing the competitiveness of Europe’s green industry and in accelerating the transition to climate neutrality was stressed by the authorities. They noted that steps taken by the EU in response to key trading partners initiatives to accelerate the green transition and to remedy supply chain issues will be in line with EU’s international obligations. They recognized that the temporary relaxation of state aid rules may adversely affect the level playing field within the EU given the uneven fiscal space but noted that granting higher aid to match the aid received for similar projects by competitors located outside of the EU is subject to enhanced scrutiny and is given only after providing evidence of material relocation risks. They also pointed out that the proposed European sovereignty fund could potentially provide greater flexibility in using existing resources to EU countries with less fiscal space.

73. Openness and a multilateralism are seen as essential elements of the authorities’ Open Strategic Autonomy agenda and of their trade policy. The authorities argued that trade openness is key to create opportunities for the domestic industry and to provide access to important inputs. At the same time, they noted that de-risking supply chains through diversification is an important policy objective as it would strengthen resilience. The authorities also noted that CBAM will be phased-in gradually during 2023–34, as free allowances are phased out and while the EU helps its trading partners prepare for the new regime. Moreover, the authorities consider WTO reform a key element in overall trade policy and see the next WTO Ministerial Conference as a critical opportunity to advance the WTO reform agenda with a view to restoring a fully functioning WTO dispute settlement system. It is also important to make progress on multilateral negotiations on fisheries subsidies and the reduction of trade-distorting agricultural support, as well as concluding the plurilateral negotiations on e-commerce and investment facilitation, and initiating a work program on industrial subsidies. The authorities are actively engaging in efforts to restore an effective WTO dispute settlement system which they see as urgent.

Boosting Productivity and Growth

74. In aggregate, the EU’s long-standing productivity challenges remain unresolved and possibly accentuated by the recent shocks. Productivity growth had been subdued for several decades now, and while this has been a phenomenon across advanced economies, euro area labor productivity has been on a long downward trend relative to the United States. This trend may have accelerated since the onset of the pandemic, with significant heterogeneity across member states. In absolute terms, labor productivity grew broadly at the pre-pandemic rate over 2020–2022. However, this masks a near standstill in total factor productivity (TFP) and a smaller positive contribution of labor composition relative to the pre-pandemic years (as lower skilled workers were pulled into employment amid record low unemployment rates), which was offset by a slightly larger contribution of capital.

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Labor Productivity

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

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75. Next Generation EU (NGEU) could help boost growth by delivering much needed structural reforms and investments. With an equivalent amount of 6 percent of 2020 GDP, NGEU offers financial support to member states conditional on the implementation of investment and reform projects. The largest share of investment is dedicated to climate change (around 40 percent), followed by digitalization (around 20 percent), where the EU continues to lag the US. IMF staff estimates suggest that if implemented as planned, overall European GDP would be boosted by around 1.5 percent by the end of the program in 2026. The RePowerEU plan, which was recently incorporated into National Recovery and Resilience Plans (NRRPs) and allows for additional reforms and investments to phase-out Russian energy imports, could also boost efforts to accelerate the transition to the green economy. The shorter permitting times agreed in REPowerEU are welcome given the delays to wind and solar deployment in some regions.

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Digital Adoption in the EU and the US

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: European Investment Bank. A firm is identified as partially digital if at least one digital technology was implemented in parts of the business; and fully digital if the entire business is organised around at least one digital technology. Firms are weighted using value added.

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Europe: Permitting Process Duration

(Years)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: Interim Report from RES Simplify project, March 2022.

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^{Box 4.}

Euro Area: The Long-term Impact of the Energy Price Shock on Output and Income Divergence

The recent energy price shock has a substantial impact on EU’s energy use and generation. The increase in energy prices following Russia’s invasion of Ukraine—has been larger for Europe than for the rest of the world. Although recently declining, energy prices in Europe are projected to remain elevated relative to the pre-pandemic levels, resulting in a permanent change in terms of trade with implications for factor incomes, aggregate output, and income divergence within the EU.

Model simulations¹ show that a permanent shock to oil and gas prices in the EU will result in a loss of income for all factors of production. As the EU imports most of its energy, an increase in oil and gas prices will lead to an increase in the cost of production—especially in sectors that are energy intensive (manufacturing of chemical, transportation, metal, petroleum products)—and will lead to lower returns on factors of production. Real wages and return on capital will decline, albeit, not uniformly across sectors. Services sectors, which mostly rely on domestic demand, will likely be hurt more given that they will gain less from the real exchange rate depreciation. Conversely, unskilled workers and capital owners in energy exporting economies (EEE) would on average benefit from the price shock, while input factor incomes in other parts of the world (ROW) would decline, although to a lesser extent than in the EU.

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Input Factor Incomes

(Percent change)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: IMF staff calculations.

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A permanent global realignment of energy prices will likely lead to a sizable decline in the aggregate EU output with further increase in income divergence. While energy exporters see an improvement in their terms of trade and a real exchange rate appreciation, with the size depending on their energy exports, the EU—a large energy importer—will see a deterioration in the terms of trade and a long-term decline of real GDP level by about 1.5 percent–-threefold the impact on the rest of the world. Moreover, given the different energy mix and sectoral composition across EU countries, the impact is likely to vary significantly, widening income gaps. In this regard, countries with lower real wages would experience larger decline, partly because of their heavier reliance on fossil fuels. Accelerating the green transition would thus help member states reduce vulnerabilities in energy intensive sectors and close income gaps.

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Real GDP Value

(Percent change)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: IMF staff calculations.EEE: Energy Producing Economies. ROW: Rest of the World.

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Wage Income Divergence

(Percent change)

Citation: IMF Staff Country Reports 2023, 264; 10.5089/9798400248634.002.A001

Source: IMF staff calculations.

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¹ See “Geoeconomic Fragmentation: What’s at Stake for the EU”, EUR departmental paper (forthcoming). Results are based on simulations using a Global Computable General Equilibrium model, of a stylized energy price shock entailing EU increases of about 160 percent in gas prices (55 percent in the rest of the world) and 30 percent increase in oil prices (same in the rest of the world) compared to 2017 price levels. Gas and oil exports from Russia to the EU are assumed to be cut by 90 percent, compared to 2017 levels.