ECONOMIC HEALTH CHECK
Euro Area Recovering, But Lasting Growth Requires Collective Push
July 27, 2015
- Euro area recovering but stronger growth needed to boost jobs
- More balanced policy mix can generate large growth dividends
- Cleaning up bad bank loans can help support more lending and investment
The euro area recovery is strengthening, but the weak medium-term outlook calls for focus on four key areas: increasing demand, cleaning up bank balance sheets, stepping up structural reforms, and strengthening governance, said the IMF’s latest review of the currency union.
Although unemployment is still high, steady job growth and rising real wages have underpinned a rebound in consumption, the report said. Strong policy actions by the European Central Bank (ECB) have also boosted confidence and improved financial conditions.
Among the large economies, Germany continues to grow slightly above 1½ percent, while Spain is rebounding strongly. Italy is emerging from three years of recession, and activity in France picked up at the beginning of this year.
The recovery is supported by cheaper oil, monetary easing, and a weaker euro, with growth in euro area economies expected to rise modestly to 1.5 percent this year and 1.7 percent in 2016.
But medium-term prospects are less bright. “Several factors cloud the outlook for growth over the next five years,” said Mahmood Pradhan, mission chief for the euro area. “These include high unemployment, especially among the youth; large corporate debt; and, rising non-performing loans (NPLs) in the banking system.” Slow progress on structural reforms has also dampened the business climate and reduced growth potential. As a result, the euro area remains vulnerable to shocks. “A moderate shock to confidence—whether from lower expected future growth or heightened geopolitical tensions—could tip the block into prolonged stagnation,” said Pradhan.
To counter the risks of stagnation, the report called for a stronger collective push to strengthen the recovery and make the monetary union more resilient.
Staying the course on the expanded asset purchase program, or quantitative easing (QE) is essential, says the report. “While quantitative easing has already improved financial conditions and raised inflation expectations, international experience suggests that its impact on the real economy will take more time,” said Pradhan. But strengthening bank and corporate balance sheets could significantly amplify the impact of quantitative easing via more bank lending to revive credit growth. While there are currently few signs of scarcity in sovereign bond markets, the ECB should develop a common securities lending framework to increase the availability of collateral for market participants. Macro-prudential policies should serve as the first line of defense against potential financial stability risks.
On fiscal policy, the report encourages countries to adhere to their commitments under the Stability and Growth Pact. Countries with limited budget space (such as France and Portugal) should save interest windfalls from quantitative easing to pay down debt. Others (such as Germany and the Netherlands) should use them to support investment and structural reforms. Doing this now in a period of low interest rates, can have a powerful growth impact. There is a further call to expedite the centralized investment initiative (“Juncker Plan”) to support demand, especially in countries with limited fiscal room.
Cleaning up bank balance sheets to support new lending
The ECB’s 2014 Comprehensive Assessment of European banks enhanced transparency and strengthened capital positions. The report, however, notes NPLs have continued to rise and are dangerously high in some economies—eroding bank profitability and locking up capital that could otherwise support new lending. Expeditiously reducing NPLs could generate significant capacity for new lending, particularly in countries with high bad loans.
Three complementary actions to remove bad loans from bank balance sheets quickly include: strengthening prudential supervision; undertaking insolvency reforms to accelerate court procedures and facilitate out-of-court settlements; and developing a market for bad loans to help corporate restructuring. Asset management companies (AMCs), for example, could help banks to work with investors to offload bad loans. In some cases, public sector involvement in AMCs may be beneficial, subject to EU State aid rules.
Advancing reforms within a stronger, simpler governance framework
The report urges authorities to leverage the opportunity provided by the cyclical upturn and monetary accommodation to accelerate structural reforms. At the national level, priorities include reforms to make hiring and firing easier; improve the business climate; and promote competition. At the regional level, the priorities are to implement swiftly the Services Directive to eliminate long-held national barriers; enhance insolvency regimes; and push more strongly for a single market in capital, transport, energy and the digital economy.
The report also calls for a stronger and simpler governance framework to support such efforts. Important components of this framework would include: benchmarking reforms against outcomes (that are clearly observable and measurable), stronger EU oversight with less discretion in applying existing rules, and better financial incentives for reforms. A capital markets union would help diversify funding sources for small- and medium-sized enterprises, reduce reliance on bank lending, and promote more cross-border finance.
The fiscal framework has become more complex following successive reforms over the past years, the report observed. To make it more effective, it should be simplified by focusing on two main pillars: a single fiscal anchor (public debt-to-GDP) and a single operational target (an expenditure growth rule) linked to the anchor.