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At the conclusion of the IMF staff's discussions with a country's authorities in the context of Article IV consultations, which usually take place annually, the IMF mission often provides the authorities with a statement of its preliminary findings prior to the preparation of the staff's report to the Executive Board. In the case of the Article IV consultations with the Euro-area countries, surveillance of monetary and exchange rate policies includes discussions with the European Central Bank and other Euro-area authorities. The following statement was provided to the authorities following these discussions.
Concluding Statement of the IMF Mission on the Economic Policies of the Euro Area
(In the context of the 2001 Article IV Consultation Discussions with the Euro-Area Countries)
June 27, 2001
1. Buffeted by adverse shocks, the euro-area economy has weakened appreciably more than expected. HICP inflation reached 3.4 percent in May and growth projections are gravitating towards 2 percent for this year, and even lower in assessments that put a high weight on cyclical indicators. Nonetheless, absent further shocks and presuming continued wage moderation, we expect the situation to improve over the next twelve months, gradually but surely on inflation; and more haltingly on growth, which may be held back by a tepid global environment that seems to matter more to euro-area performance than previously suspected. In this setting, structural policies need to be reinvigorated and oriented toward strengthening employment creation; monetary policy needs to remain forward-looking; and fiscal policy needs to retain its medium-term orientation, notably by sticking to agreed or implied expenditure plans, while accepting the operation of automatic stabilizers on the revenue side.
2. The shocks have been large. The initial impact of the increase in oil prices and the weakening of the euro has been compounded by the animal disease and weather-related shocks to food prices and exacerbated by the slowdown in the United States, which is gradually spreading throughout the world economy. The surprise is the extent to which these shocks have affected euro-area performance. Compared with outturns over the previous four quarters, growth in final domestic demand since the second quarter of last year has been cut by well over half. This is mainly because private consumption has been dragged down by the weakness in real disposable income as large increases in prices undermined the beneficial effects of continued—albeit slackening—employment growth fostered by wage moderation. But fixed investment has also slowed, partly for non-cyclical reasons, but partly also as a result of fading domestic and external demand. Unexpectedly, it is net exports that have strengthened over the period (presumably in part because of the depreciated exchange rate), so that growth of GDP has been better sustained, slowing by only a third over the period mentioned (to 2¼ percent).
3. These are rather different developments from those that had been envisaged, and warrant caution in thinking about prospects. On the one hand, there are good grounds for believing that the pass-through of price shocks has peaked, in which case consumption should gradually firm, all the more so as households begin to spend more of past tax cuts. Moreover, very short-run cyclical adjustments (e.g., in inventories) may also crest in the first half of this year, so that some bounce-back toward trend growth may come later in the year. However, cyclical indicators are still very weak, the financial position of enterprises has softened, and the largest economy in the area seems to be harder hit by the shocks and less able to achieve a sustained employment-based recovery than other members of the union. Moreover, while we expect some pick up of the global economy next year, the strengthening is expected to be muted. On balance, therefore, while we expect growth to gradually firm back toward potential over the coming year, we see the risks as being on the downside.
4. In this setting, what is the role of policies? We should make clear that we do not view macro policies as explaining developments. On the contrary, some initial fiscal policy settings were unduly expansionary, but turned out fortuitously to be broadly appropriate to the situation. And monetary policy acted properly, first to raise interest rates to preserve price stability and, in May, to ease as prospects for medium-term price stability improved in the face of slackening M3 growth, continued wage moderation, and softening activity. Looking forward, the need is essentially for a pragmatic application of the underlying policy frameworks. Decisively more is needed on structural policies, particularly if the euro area is to fulfill the aspirations of the Lisbon Summit.
5. Structural reforms are needed both to strengthen the resilience to shocks and to bolster the area's production potential. Progress has been mixed. While liberalization remains elusive in a number of sectors and countries, there has been measurable progress toward more competitive product markets over the past few years. Labor market reforms have lagged, however. Admittedly, a number of countries have been successful in dealing with some of the distortions in their labor markets, but progress has been quite uneven and there have been signs of backsliding in a few cases. Moreover, little has been done to address the disincentives, associated with the tax and benefit systems, to seek and keep jobs. Steps in this direction are urgently needed both to relieve bottlenecks in some countries and to achieve a fuller utilization of human resources, as foreseen by the Lisbon Summit. Similarly, the integration of capital markets—surely one of the greatest potential rewards of EMU—remains impeded by the myriad of national regulations, regulations that are often defended by the regulated. The Lamfalussy Report recommendations aimed at streamlining the legislative process are a much welcome step, and it is hoped that rear-guard fighting from vested interests will not thwart implementation of the Financial Services Action Plan.
6. Monetary policy faces a challenging environment, with prospects for medium-term price stability remaining relatively comforting, but with headline inflation rates that risk provoking increased wage claims. In our view, which is broadly also that of the ECB, the rise in overall inflation can mostly be explained by shocks to food, oil, and import prices. In our estimates, inflation measures purged of direct and pass-through effects of these influences have remained broadly stable at around 1½ percent. Other measures, such as the GDP deflator and, most fundamentally, wage indices, remain restrained. First-pillar information also supports the view that medium-term price stability is not at risk. Hence, absent further shocks and presuming continued wage moderation, year-on-year inflation can be expected to decline in the near future and to fall below 2 percent during the first half of next year.
7. Against this background, the key issue is whether recent headline inflation rates will prompt increases in wage claims inconsistent with price stability over the medium term. In our view, the strong (and commendable) record of wage moderation that has been established, the prospective decline in headline inflation rates, and increasing signs that euro-area growth may well dip to below-potential rates argue for taking a reasonably sanguine view on wage prospects. Thus, with all signs pointing to continuing restraint in underlying inflation, and downward risks to real activity limiting threats to price stability, scope for further policy easing is emerging. When will such opportunities arise? In the absence of clear signs that wage moderation is jeopardized, a turning point in HICP inflation will support the expectation of headline inflation falling below 2 percent next year and allow room for an interest rate cut. Based on current indications, this situation could well occur in the near future. Alternatively, a further weakening of prospects would also warrant monetary action, even if the inflation turn-around proved relatively slow in coming. Were wage discipline to weaken, however, a firm monetary stance would be necessary to retain confidence that price stability was not undermined.
8. Communicating policy is, of course, important in retaining credibility. The ECB ranks highly on most formal measures of transparency. In this regard, we welcome the move toward increased analysis and public dissemination of first- and second-pillar information. However, market participants still have appeared, on occasion, to lack a clear understanding of the rationale for policy actions. Thus, the search for ways to reinforce market understanding of the application of the two pillars in policy formation needs to continue.
9. The euro remains in our judgment undervalued. Nevertheless, the forces that have led to the undervaluation may be more deep-seated than earlier believed, although they are not yet fully understood. Much of the weakness in the euro against the dollar is shared by other currencies, and appears to reflect factors specific to the U.S. economy. One factor could be the surge in U.S. equity valuations since the mid-1990s, and the consequent boost to aggregate demand and capital inflows. This shock appears to have topped out; while there are as yet no signs of a pronounced reversal, asset markets remain vulnerable to a change in investor sentiment. In addition, portfolio shifts associated with the start of the monetary union may account for another significant part of the weakness of the euro. In our view, explanations that trace the weakness of the euro to the stance of monetary policy or to the way it is implemented are unpersuasive.
10. Turning to fiscal policy, at this cyclical juncture the challenge is to safeguard the credibility of the Stability and Growth Pact (SGP) while tailoring its implementation to the requirements of a well-functioning monetary union. This calls for sustaining medium-term budgetary consolidation without resorting to pro-cyclical policies that risk prolonging the downturn. Past experience is not encouraging in this regard. Countries have typically opted to smooth fiscal balances rather than the economic cycle, delaying in the process much needed underlying fiscal adjustment. Recent instances in point are the 2001 budgets, which were often unambitious given the 2000 outturns and the 2001 growth rates on which they were premised.
11. The evolving interpretation of the SGP is a welcome antidote to these proclivities as it rightly stresses the need for policymakers to focus on underlying (or cyclically-adjusted) budgetary positions, thus allowing the automatic fiscal stabilizers to operate. This reading is generally accepted for those euro-area countries that have already brought their underlying budgetary positions into line with their SGP commitments. However, countries that lag in fiscal consolidation (in part because of their failure to stay the course in more buoyant times) are still expected to fulfill nominal budgetary targets. While we have some sympathy for this view—particularly in the case of high-debt countries—pro-cyclical attempts to make up for lost ground risk exacerbating slowdowns and may again prove self-defeating.
12. There is a better approach that is consistent with both the letter and spirit of the SGP and is firmly geared to attaining sound fiscal positions in the medium term. This would be to hold lagging countries to the expenditure paths indicated in their Stability Programs and to accept the revenue and deficit paths implied by output developments and existing tax structures. Such a stance would ensure the same pace of underlying fiscal consolidation as had previously been accepted or proposed, and avoid pro-cyclical behavior.
13. The tendency toward pro-cyclical smoothing of deficits is in a measure hardwired into fiscal systems. In particular, some euro-area countries base the financing of their large social insurance systems on relatively strict interpretations of pay-as-you-go (PAYG) financing principles, forcing pro-cyclical changes in financing parameters in response to business-cycle fluctuations. In the current context, this implies that, even though the automatic stabilizers may be allowed to play this year, emerging financing shortfall would trigger pro-cyclical compensatory policy actions next year. To provide breathing space from the straightjacket of narrowly interpreted PAYG financing precepts, consideration could be given to using reserve funds to allow for more cyclical variation in fiscal positions. However, looking ahead to 2002 and absent adaptations along these lines, we see a danger that key euro-area countries may in practice favor pro-cyclical policies while deviating from the spending rules contained in their Stability Programs.
14. Given the prominent role of the EU in the multilateral trading system, we welcome the high priority the EU is giving to reaching agreement on the scope of a new trade round in the run-up to the WTO Ministerial in Doha. A new round would help contain protectionist pressures and provide a needed boost to global growth. While the general sentiment toward a round seems to have improved, substantive differences in the positions of key players still appear to be unresolved. Leadership and flexibility on the part of the EU will therefore be critical factors in achieving a consensus.
15. After the welcome adoption of the "Everything-but-Arms" initiative, the EU recently took steps to simplify its General System of Preferences and to restore preference margins. It has also continued to expand its network of reciprocal free-trade agreements with developing countries. These initiatives can improve market access for eligible countries, but they need to be complemented by multilateral liberalization to reduce trade diversion and improve the allocation of resources within the EU through increased international competition. In this regard, more rapid progress in liberalizing highly protected sectors (such as agriculture, processed foods, textiles and clothing) would provide significant benefits to the EU while enhancing the trade and growth prospects of developing countries. Agriculture deserves particular mention in this context since high boarder protection and producer subsidies under the Common Agricultural Policy (CAP) continue to impose significant costs on trade partners by depressing world market prices and pre-empting markets. Comprehensive reform of the CAP is needed to support the liberalization of agriculture and prepare for EU enlargement.