Economic Health Check
Eurozone: More Reforms Needed to Strengthen Recovery
By Mahmood Pradhan, Petya Koeva Brooks, and Angana Banerji
July 14, 2014
- Support demand to combat low inflation and boost employment.
- Mend balance sheets, complete banking union to restart credit.
- Do structural reforms to spur productivity and redress external imbalances.
The euro area is recovering, but policymakers must address deep-seated obstacles to growth to ensure a strong and durable recovery, according to the IMF’s latest report on the currency area.
There is finally something to cheer about in the eurozone, the report’s authors said. The economy is gradually recovering, and financial markets are upbeat. Strong policy actions have helped engineer this turnaround.
But the recovery is turning out to be weaker than expected, the report said, and not all countries are growing. Output and investment are still well below pre-crisis levels. High unemployment, large debt burdens, higher real interest rates in stressed economies, weak banks and contracting credit pose obstacles to the resurgence of domestic demand. This leaves the region too dependent on foreign demand, and exposed to external risks, be it geopolitical fissures, or slowing growth in trading partners. The outlook for growth is modest.
Low inflation is pervasive, said the report’s authors, who noted that if inflation remains well below the price stability objective of the European Central Bank (ECB), debt burdens will grow more onerous, real interest rates will remain unnecessarily high, stifling demand, and central bank credibility could be eroded.
There are also supply-side roadblocks to growth, the report noted. Rigidities and gaps in capital, labor, and product markets continue to hamper productivity, job creation, and the shift of resources from the non-tradable to the tradable sector. Persistently high unemployment and low investment could reduce the economy’s capacity to grow in the foreseeable future.
Reform fatigue is setting in, the report observed. The outcome of the European elections may not bode well for further integration within the eurozone, jeopardizing reforms necessary to support the recovery.
To counter these risks, the report called for concerted policy efforts to strengthen the recovery and raise inflation.
Support demand until Europe is back on its feet
Public policy needs to prop up domestic demand until the threat of lowflation has subsided and banks are ready to lend again The ECB’s recent actions aim at just that. But the ECB may need to do more if inflation stays stubbornly low, the report said. It may need to expand its balance sheet substantially, as other major central banks have done, to provide a strong signal that it will use every available tool to fulfill its price stability mandate.
On fiscal policy, the overall neutral stance appropriately walks a fine line between containing the trajectory of public debt and supporting demand. But policymakers should not reach for budget cuts if growth slips below expectations.
Repair balance sheets, get credit flowing
Euro area policymakers have made very good progress towards a more complete banking union, the report noted. The Single Supervisory Mechanism (SSM) will become operational later this year, facilitating the flow of funds across borders and reducing financial fragmentation. The decision-making process for the Single Resolution Mechanism (SRM) has been simplified, and burden sharing of the Single Resolution Fund (SRF) has been improved.
Meanwhile, bank balance sheets are also being strengthened. The ECB’s Comprehensive Assessment of bank balance sheets is well under way. The ambitious timetable for banks to remedy capital shortfalls following the exercise should be feasible given markedly improved market conditions. However, banks should be urged to pro-actively raise capital, the report urged.
Nevertheless, a common fiscal backstop is still needed to sever the pernicious link between banks and sovereign balance sheets. Political agreement on allowing the European Stability Mechanism to directly recapitalize banks is a step forward, but the bar should not be set so high as to make it too difficult for banks to access this facility. For the corporate sector, it will be important to facilitate debt restructuring, including by strengthening national insolvency frameworks.
Unleash growth potential by improving economic structures
The report argued that it will be difficult for growth to take-off in a sustainable manner until structural barriers are reduced. This means developing capital markets, so that small and medium-sized firms have other means of financing besides banks, and banks can safely manage risks and create more room on their balance sheets to increase lending. Product and labor market reforms need to continue apace, to boost productivity and investment, make the eurozone’s exports more competitive, and increase employment. Lower hiring costs and effective training programs could help reduce high youth unemployment rates, for example. The Services Directive should be implemented in order to open up protected professions and increase competition by promoting cross-border provision of services.
Over the medium-term, the overly complicated fiscal framework could be simplified and enforcement strengthened. To protect vital public investment, the ability of the center to fund certain projects—such as cross-border investments in transportation, communications, and energy networks—should be boosted.
In short, the IMF report concludes, the eurozone must keep reforming in order to sustain and strengthen its recovery.