IMF Executive Board Concludes 2009 Article IV Consultation on Euro Area PoliciesPublic Information Notice (PIN) No. 09/95
July 30, 2009
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2009 Article IV Consultation with the Euro Area is also available.
On July 17, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation on Euro Area Policies.1
The euro area remains in recession, with signs of improvement yet to evolve into a recovery. The large drop in financial wealth, an associated increase in private savings, tight financing conditions, and the adjustment of global imbalances are key drivers of the economic decline, exacerbated by the correction of home-grown imbalances in some countries. Bank credit to the private sector is very subdued and efforts to reduce leverage and capital shortages of banks seem to be negatively affecting recent bank loan developments. Given the tight financial and trade integration of Europe, adverse feedback loops have been operating across borders and between the financial and real sector, with the recession now adding to the financial sector’s woes. The recent improvement in sentiment and high frequency and other leading indicators has thus far been signaling only a reduction in the pace of contraction in output, while the shape and timing of the recovery remain highly uncertain. The ongoing crisis is also likely to dampen growth potential, in part reflecting structural rigidities.
The euro area is facing strong disinflationary pressures. Headline inflation has fallen sharply to zero percent in May 2009 from its peak of 4 percent in mid-2008, largely reflecting base effects from the steep decline of commodity prices, but also the significant weakening in economic activity. Core inflation excluding energy, food alcohol and tobacco eased by less, declining to an average of 1.6 percent, after hovering around 1.9 percent during 2007–2008. Given large output gaps, inflation is widely projected to remain significantly below 2 percent in 2009–2010. Against this background the ECB has eased monetary policy significantly, with policy rates currently at 1 percent from 4.25 percent in early October 2008.
The euro area’s financial system remains under considerable strain although actions undertaken by policymakers have helped contain systemic risk. The ECB has deployed a wide array of unconventional measures: it lengthened the term funding of its liquidity provision, widened its collateral requirements, and has been providing unlimited term funding at fixed rates since October 2008. Other policy actions so far have focused on stabilizing the banking system and preventing bank runs, but their take-up, especially of resources for recapitalization has fallen considerably short of amounts made available and disclosure has remained limited, reflecting differences in approach across countries. For the largest cross-border institutions, coordinated stress tests are under way with the aim to provide an aggregate view of the resilience of the EU’s banking system.
The EU members have agreed to an overhaul of their financial stability arrangements. The two new cross-border institutions to be created—a European System of Financial Supervisors and a European Systemic Risk Board—will seek to address existing shortcomings in the EU’s financial stability arrangements and the tensions with advancing the EU’s single financial market objective that have been exposed by the global financial crisis.
The fiscal position of the euro area is projected to deteriorate significantly, as public finances are used to shore up the financial system and cushion the downturn. Euro area governments have committed large resources to guarantee, recapitalize, and resolve financial institutions. As a result, the euro area’s fiscal deficit is projected to increase from 0.6 percent of GDP in 2007 to 6.9 percent by 2010, pushing up government debt significantly over the period.
Executive Board Assessment
The Executive Directors welcomed the broad arsenal of macroeconomic policies and financial sector interventions deployed by euro area authorities and Member States to address the crisis. Directors emphasized that further decisive policy action, especially in the financial sector, is essential to achieve a recovery and return to self-sustaining growth. They also noted that the crisis could dampen potential growth, calling for reinvigorated structural reforms.
Directors observed that the euro area is in recession, amid some tentative signs of improvement. While survey indicators have been recovering and the fall in indicators of economic activity slowing, the remaining stresses and risks in the financial system, and rising corporate defaults and unemployment are weighing on the expected recovery. Thus, Directors expected the decline in activity to moderate through the remainder of 2009 and to give way to a modest recovery in 2010, but underscored the significant uncertainty surrounding this scenario.
Directors considered that a resolute and well-coordinated approach to relieve financial stress is essential for a durable recovery, and that backing from national authorities will be key. They welcomed the intention of national authorities—in cooperation with the relevant EU institutions—to thoroughly assess the financial position of banks, including the impact of the recession. Such an assessment should be accompanied by comprehensive follow-up action involving suitable disclosure, recapitalization, measures to address the problem of impaired assets, and resolution of unviable financial institutions. To facilitate resolution, national resolution toolkits should be expanded to allow national authorities to take control of financial institutions at an early stage.
Directors welcomed the June 2009 European Council endorsement of an ambitious reform of the EU’s financial stability architecture, including through the creation of a European Systemic Risk Board and the establishment of a European System of Financial Supervisors. They emphasized that the reform should be implemented according to the envisaged timetable and on a well-coordinated basis. Securing adequate resources, effective decision-making mechanisms, and independence for the new entities, as well as an unconstrained information flow within the new architecture, will all be essential. Directors underscored that the European Supervisory Authorities will need sufficient legal scope to establish a single rulebook, effectively transposed at the national level. In parallel, the accelerated work under the ongoing crisis management roadmap should address weaknesses in the crisis resolution framework, as well as burden sharing issues at the EU level.
Directors welcomed the ECB’s far-reaching unconventional (ECB: non-standard) measures to support liquidity and credit as well as its accommodative monetary policy stance. They emphasized that, given large and increasing output gaps and inflation projected to remain very low for some time, it will be essential to maintain this stance as long as disinflationary pressures persist. Directors noted that this could best be done by keeping interest rates low through the unlimited provision of term funding. They emphasized that a crystallization of downside risks would require a more forceful signal to keep interest rates low, while retaining all unconventional options open to deal with contingencies. Directors commended the ECB for embedding exit strategies in the design of most of its unconventional policies.
Directors agreed that fiscal policy will need to continue to support economic activity in 2010, but emphasized that credible medium-term consolidation programs should be put in place to address solvency concerns. Directors were of the view that planned discretionary measures are broadly appropriate, given the large automatic stabilizers. They emphasized that application of the SGP, which would support fiscal consolidation once the recovery takes hold, will need to be bolstered by a strengthening of national fiscal institutions to foster ownership of consolidation goals. Accordingly, Directors noted that surveillance over progress toward medium-term consolidation objectives should be stepped up at both the EU and national levels.
Directors underscored that the crisis provides a window of opportunity to push forward with intensified structural reforms needed to address long-standing rigidities. With economic restructuring ahead, they encouraged a heightened focus on training, education, and job-matching. Directors emphasized that implementing the services directive, revamping the Lisbon agenda, and facilitating an ambitious and early conclusion of the Doha round will contribute to the foundations of a solid recovery.