IMF Executive Board Concludes Article IV Consultation on Euro Area PoliciesPublic Information Notice (PIN) No. 12/80
July 18, 2012
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 2012 Article IV Consultation on Euro Area Policies is also available.
On July 16, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation on Euro Area Policies.1
The euro area crisis has intensified. Adverse links between banks, sovereigns, and the real economy have deepened, driving sovereign borrowing costs and risk premiums to record levels. Investors are withholding funding from member states most in need, moving capital "north" and abroad to perceived safer assets. This has contributed to divergences in liquidity conditions and lending rates within the euro area, adding to already-severe pressures on many bank and sovereign balance sheets and raising questions about the viability of the monetary union itself.
Economic activity has weakened and is likely to remain subdued, particularly in the hard-hit periphery countries. After averaging 1.5 percent in 2011, euro area GDP growth is expected to be -0.3 and 0.7 percent in 2012 and 2013, respectively. In this context, headline inflation is projected to fall well below 2 percent by 2013 and to remain there through 2014. Strong headwinds to growth—including much tighter financing conditions, subdued confidence, and fiscal consolidation—are likely to be compounded by banks and households repairing balance sheets and consumers acting cautious amidst heightened uncertainty. This will add further pressure to the high level of unemployment and increase the risk of stagnation and long-term damage to potential growth as unemployed workers lose skills and new workers find it difficult to join the active labor force.
There are severe downside risks to the outlook, with possible substantial regional and global implications. Reinforced negative bank-sovereign linkages could further weigh on confidence, growth, and public debt trajectories, while boosting sovereign spreads and risk premiums. Depending on the pass-through of weaker growth and financial market stress, the global spillovers are likely to be significant. The potential for failure of a systemic bank, or stalled reform or fiscal adjustment efforts at the country level, could spill into the euro area and beyond.
Major policy actions have averted an even more rapid escalation of the crisis. The European Central Bank has lowered its policy interest rates to historic levels, and conducted special liquidity interventions to ease bank funding pressures. The European and global firewall has been enlarged and will provide added liquidity insurance to sovereigns, while the adoption of the Fiscal Compact will strengthen budgetary discipline. Moreover, national governments in deficit countries have embarked on fiscal consolidation and reaffirmed their debt sustainability and deficit targets.
Most recently, European leaders agreed to steps toward a banking union that, if implemented in full, will help break the adverse links between sovereigns and banks. In particular, plans to establish a single supervisory mechanism, followed by the possibility of using European Stability Mechanism (ESM) resources to recapitalize banks directly, were defined. In addition, the leaders re-affirmed a willingness to consider using existing resources from the European Financial Stability Facility (EFSF) or the ESM to purchase sovereign bonds. However, despite these initiatives, bank and sovereign stresses persist, reflecting continued market concerns that a sustainable solution has yet to be achieved.
Executive Board Assessment
Executive Directors noted that the euro area continues to face a number of economic challenges amid increasing financial stresses and market fragmentation, with considerable downside risks to the already weak growth outlook, notably a further intensification of the sovereign debt crisis. Directors welcomed the many policy actions taken recently to restore growth and financial stability, including the rate cuts by the European Central Bank (ECB) and the enlarged European firewall. They urged prompt and full implementation of the important initiatives agreed at the European Leaders’ Summit in June, as well as further collective action to strengthen the crisis response and mitigate spillovers. Directors underlined the urgency of completing the reform of the monetary union architecture and promoting strong, balanced growth across the euro area—key to restoring confidence in the near term and ensuring the long-term viability of the euro. They highlighted that these are the responsibilities of the euro zone as a whole and of each member state.
Directors stressed that, as the crisis had reached a critical stage, it is important that policymakers continue to demonstrate shared and unequivocal commitment—with a clear, credible roadmap—to a deeper integration of the euro area. They agreed that the immediate priority is to break the adverse loops between banks, sovereigns, and growth prospects. This requires action on three major fronts:
• First, steps toward a banking union, comprising a pan-European deposit guarantee scheme and a pan-European bank resolution scheme—both backed with common resources—together with a common supervisory framework.
• Second, greater fiscal integration, with stronger governance arrangements and risk sharing, balanced by appropriate safeguards. Directors welcomed the Fiscal Compact and the proposed “two pack” as important steps toward better governance, aligning national policies with common objectives through enhanced European oversight.
• Third, structural reforms in both deficit and surplus countries to raise trend growth and address external imbalances within the euro area. Directors emphasized in particular the need to reform the labor and product markets, and to facilitate wage and price adjustments to boost competitiveness.
Recognizing that many of these steps would necessarily take some time to implement and have full effect, Directors underscored the importance of the following policies directed at the immediate situation:
• First, crisis measures, financing under the enlarged European firewall facilities, and continued official funding support. Directors welcomed the authorities’ commitment to use EFSF/ESM resources flexibly. They looked forward to early progress toward a single supervisory mechanism for euro area banks, paving the way for direct recapitalization of banks by the ESM. Directors agreed that the ECB will have to continue to play a role in the crisis response, including through liquidity provision and securities purchases. A few Directors also noted that clarifying the seniority status of sovereign debt holdings by the ECB would help address market concerns.
• Second, supportive monetary policy. Noting fundamentally weak inflationary pressures, Directors generally saw scope for further monetary easing, especially if downside risks to growth materialize, including through additional non-standard measures in view of the impaired monetary transmission mechanism.
• Third, fiscal consolidation that is as growth friendly as possible and at a differentiated pace based on individual countries’ circumstances. To deal with growth surprises in the short term, Directors encouraged member states to focus on structural fiscal targets and exploit the flexibility built into the Fiscal Compact.