July 14, 2014
On July 9, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with the Euro Area.
The euro area recovery is taking hold. Real output has expanded for four consecutive quarters, and financial market sentiment has improved markedly. Complementary policy actions have supported demand, boosted investor confidence, and eased financial conditions. At the national level, governments have made further progress repairing sovereign and bank balance sheets and implementing structure reforms to restore competitiveness. At the area-wide level, the ECB has taken a wider range of measures to support demand and address fragmentation. Progress on building a banking union continues, with the ECB set to assume supervisory responsibilities in November 2014, following the planned completion of the Comprehensive Assessment of systemically important banks. Additional steps—such as agreements on a Single Resolution Mechanism (SRM), backed by Single Resolution Fund (SRF), the Bank Recovery and Resolution Directive (BRRD), and the deposit insurance harmonization directive—demonstrate collective commitment to EMU.
But the recovery is neither robust nor sufficiently strong. Weak aggregate demand is weighing on real activity and pulling down inflation across the euro area, as corporates, households and banks continue to repair their balance sheets. Financial markets are still fragmented, with contracting credit and high borrowing costs constraining investment in countries with large output gaps, large debt burdens, and high unemployment. In this context, euro area GDP is expected to grow by just over 1 percent this year, before expanding by 1.5 percent in 2015. Headline inflation is expected to remain below the ECB’s primary price objective for a protracted period, underscoring the risks from low inflation. And there are remaining structural gaps in capital, labor, and product markets, presenting hurdles to financing investment, intra-euro area rebalancing, and raising productivity.
Risks to growth are still tilted to the downside. With limited policy space in the near term, further negative shocks—either domestic or external—could undermine financial market sentiment, halt the recovery, and push the economy into lower inflation and even deflation. A common fiscal backstop would strengthen the credibility of the asset quality review (AQR) and stress tests. The recovery is also subject to external risks, including a slowdown in emerging market growth, escalation of geopolitical conflict, and an abrupt exit from unconventional monetary policies in the United States. Over the medium term, there is a risk of stagnation, which could result from persistently depressed domestic demand due to deleveraging, insufficient policy action, and stalled structural reforms. More positively, improved confidence could raise growth above forecast levels.
Executive Board Assessment2
Executive Directors welcomed the strong policy actions taken at the euro area and national levels to prop up demand and ease financial conditions, which have improved market sentiment and recovery prospects. Directors emphasized that sustained, higher growth is needed to reduce unemployment and debt burdens in the euro area while also generating positive spillovers to the rest of the world. This requires concerted efforts that focus on additional demand support, completion of bank balance sheet repair and of a banking union, and further advancement of structural reforms. Directors underscored the importance of continued collective commitment to completing the architecture of the Economic and Monetary Union.
Directors welcomed the exceptional measures recently taken by the European Central Bank (ECB) to address low inflation and strengthen demand, as well as its intention to use further unconventional instruments if necessary. They agreed that if inflation remains too low, consideration could be given to a large-scale asset purchase program, primarily of sovereign assets. Directors noted that the signaling of the ECB’s commitment to its price objective would eventually raise inflation expectations across the euro area.
Directors acknowledged that the neutral area-wide fiscal stance is broadly appropriate, balancing growth with debt sustainability considerations. They stressed, however, that national fiscal policies should be carefully calibrated to support growth where space permits, making use of the flexibility under the fiscal framework and avoiding further consolidation in the event of large negative growth surprises, while adhering to the medium-term objective of reducing public debt-to-GDP ratios. Directors also recommended using the escape clauses in the fiscal framework if deflation risks materialize and monetary policy options are depleted. They saw scope for streamlining the governance framework over the medium term with a view to improving its clarity and compliance.
Directors underlined the urgency of repairing bank balance sheets and reducing financial fragmentation. While supporting the broad strategy and the ambitious timetable for bank recapitalization, they saw merit in maintaining some flexibility to take account of market conditions and financial stability concerns. They also considered that a common fiscal backstop would decisively sever bank-sovereign links and enhance the credibility of the ECB’s Comprehensive Assessment of bank balance sheets. Directors were encouraged by
the substantial progress toward a banking union, and looked forward to further advancement at the national level to facilitate corporate debt resolution, including by strengthening insolvency and debt restructuring frameworks.
Directors stressed the need to step up structural reforms with a view to promoting employment, competitiveness, and intra-euro area rebalancing. Priority areas include: (i) diversifying funding markets through securitization, especially to credit-constrained smaller firms; (ii) removing country-specific structural impediments to tackle high youth unemployment; and (iii) higher public investment in creditor countries and continued competitiveness-enhancing reforms in debtor countries. Directors also encouraged steps to improve labor market functioning and increase competition in product and services sectors, which would support efforts at the euro area level to implement the Services Directive, negotiate free trade agreements, and further integrate energy markets.