## Real Income Convergence (cr17235) ## Source details **Canonical URL:** [Real Income Convergence (cr17235)](https://www.imf.org/-/media/files/publications/cr/2017/cr17235.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17235.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17235.pdf.json) --- ### Recovery and macroeconomic backdrop - Growth reached 1.8 percent in 2016 and held at 1.9 percent year-on-year in Q1 2017. - Euro area unemployment fell to 9.3 percent in May from its 2013 peak of 12 percent. - Euro area manufacturing export growth rose to 4.5 percent in the past six months compared to a year ago. - Average annual inflation reached 1.6 percent in the first six months of 2017; underlying inflation averaged 1.0 percent between January and June. - The euro area current account surplus rose to about 3.3 percent of GDP in 2016. - The CPI-based real effective exchange rate (REER) appreciated by about 1.1 percent in 2016; as of May 2017, the REER has depreciated compared to its average level in 2016 by around 1 percent. ### Financial conditions and inflation dynamics - Financial conditions: strongly accommodative in most countries; long-term interest rates have risen. - Core yields rose on a stronger global outlook and expectations of reduced U.S. monetary stimulus; sovereign spreads widened in several high public debt countries in early 2017 and stabilized after the French elections. - Headline inflation pickup driven by energy prices and stronger readings in Germany and Spain; base effects in energy expected to subside, pushing inflation down later in the year. - Underlying inflation weakness linked to subdued nominal wage growth, anemic productivity growth, still elevated unemployment in some countries, and a high prevalence of part-time employment. ### External sector and capital flows - Euro area external position in 2016 broadly in line with medium-term fundamentals and desirable policies. - Net external debtor countries (e.g., Portugal and Spain) maintained surpluses over the past four years, improving net foreign asset positions slightly. - Persistent surpluses in large net external creditor countries (e.g., Germany and the Netherlands) have not shrunk significantly; absent adjustment, their net international investment positions look set to grow markedly over the medium term. - Portfolio debt dominated capital outflows; net private inflows comprise debt and equity inflows, with creditor and debtor countries contributing. ### Underlying weaknesses: productivity and convergence - Income convergence across euro area countries has stalled: steady convergence of real GDP per capita leading up to euro introduction stalled thereafter; since the crisis income has tended to diverge. - Germany is well above its pre-crisis GDP levels; Italy’s GDP is only expected to return to its pre-crisis level in the mid-2020s. - Productivity growth fell behind in countries with lower per capita income. Gaps in labor productivity have been persistent; total factor productivity (TFP) growth slowed more in countries with low initial productivity. - Wage growth outpaced productivity growth in some countries, contributing to competitiveness gaps, evidenced by divergence in relative unit labor costs (ULC) between Germany and Portugal, Spain, Italy, and Greece. ### Competitiveness and unit labor costs (ULCs) - Nominal wage growth in Germany has averaged about 2½ percent annually since 2009, outpacing labor productivity. - Germany’s nominal ULC-based REER depreciated by around 7 percent over the same period despite rising own ULCs. - In Greece, Portugal and Spain, ULC reduction occurred mostly during 2009–13 and was largely driven by labor shedding, with wage declines in Greece. - In Italy, despite job cuts, wage growth outpaced labor productivity growth, leading to a rise in ULCs. - Since 2014, Spain’s ULCs have been stable, with wage growth in line with labor productivity; ULCs in Italy have continued to rise. - Further adjustment should focus on raising TFP because additional job and wage cuts would have high social costs. ### Near-term outlook and key macro projections - Growth: expected to reach 1.9 percent in 2017 and slow to 1.7 percent in 2018. - Germany and Spain remain main growth engines; Italy and France will benefit to varying degrees. - ECB policies expected to remain accommodative; aggregate fiscal stance expected to be mildly expansionary. - Headline inflation anticipated to slow in 2018 to 1.5 percent as energy base effects dissipate. - With growth modestly above potential, the output gap is expected to close by 2019. - Jobless rate will return close to its pre-crisis level of 8 percent only by 2021. - Inflation expected to move slowly toward the ECB’s medium-term objective, settling at 1.9 percent in 2021. ### Main economic indicator series (selected, 2014–22) - Real GDP (annual percent change): 1.2, 2.0, 1.8, 1.9, 1.7, 1.6, 1.6, 1.5, 1.5 - Private consumption (annual percent change): 0.8, 1.8, 2.1, 1.6, 1.5, 1.5, 1.5, 1.5, 1.4 - Gross fixed investment (annual percent change): 1.6, 3.2, 3.7, 3.1, 2.9, 2.7, 2.5, 2.4, 2.3 - Potential GDP (annual percent change): 0.9, 1.4, 1.1, 1.2, 1.3, 1.3, 1.4, 1.4, 1.4 - Output gap (percent of potential GDP): -2.5, -2.0, -1.3, -0.7, -0.2, 0.0, 0.2, 0.3, 0.4 - Unemployment rate (percent): 11.6, 10.9, 10.0, 9.2, 8.8, 8.5, 8.2, 8.0, 7.8 - Consumer prices (annual percent change): 0.4, 0.0, 0.2, 1.6, 1.5, 1.7, 1.8, 1.9, 1.9 - General government balance (percent of GDP): -2.6, -2.1, -1.5, -1.4, -1.1, -0.6, -0.4, -0.2, -0.1 - General government gross debt (percent of GDP): 94.4, 92.5, 91.4, 90.0, 88.5, 86.4, 84.0, 81.7, 79.3 - Current account balance (percent of GDP): 2.5, 3.2, 3.3, 2.9, 2.9, 2.8, 2.8, 2.7, 2.7 ### Risks and the Risk Assessment Matrix (key entries) - Retreat from cross-border integration: Likelihood: High; Expected Impact: High. Policy response: strong collaboration on UK–EU transition; support trade liberalization. - Policy and geopolitical uncertainties: Likelihood: High; Expected Impact: High. Policy response: structural reforms, balance sheet repair. - Intensification of security dislocation and migrant flows: Likelihood: High; Expected Impact: High. Policy response: rapid integration of refugees into labor markets; case-by-case fiscal accommodation. - Significant further strengthening of interest rates: Likelihood: High; Expected Impact: High. Policy response: structural reforms, balance sheet repair and fiscal consolidation in high-debt countries; ECB to maintain APP as appropriate. - European bank distress: Likelihood: Medium; Expected Impact: Medium. Policy response: ambitious NPL reduction targets, insolvency reform, development of distressed debt markets. - Euro area insurance sector stress from low interest rates: Likelihood: Low; Expected Impact: Low. Policy response: review products, transition to unit-linked instruments, consolidation. ### Policy priorities and recommendations - National-level: - Promote structural reforms to boost potential growth and raise TFP, prioritizing product market reforms (few short-term costs) and carefully sequencing labor market reforms. - Use fiscal space to boost public investment and support reforms; high-debt countries should consolidate and rebuild buffers. - Strengthen private sector balance sheets and repair bank balance sheets. - Euro area / EMU-level: - Continue monetary accommodation until sustained upward adjustment in inflation is evident. - Enhance fiscal integration: consider a central fiscal capacity (CFC) or common stabilization function conditional on compliance; design could include a modest tax-transfer rainy day fund or a borrowing-lending scheme to finance public investment. - Complete the Banking Union (including a common deposit insurance scheme with a common fiscal backstop) and advance the Capital Markets Union to foster private risk sharing. - Improve enforcement of the Stability and Growth Pact (SGP); consider a simpler, more transparent fiscal framework with a single fiscal anchor and well-considered escape clauses, and an independent European Fiscal Board. - Use EU instruments and incentives to support reforms: targeted ESI funds, SGP flexibility to reward reforms, outcome-based structural reform benchmarks, and independent national productivity boards to build consensus. - Fiscal policy design specifics: - The structural fiscal balance is expected to ease by 0.3 percentage points of potential GDP in 2017. - The SGP permits a one-time deviation of up to ½ percent of GDP to encourage major structural reforms (example: Italy in 2016); credibility requires concrete upfront actions. - Growth-friendly fiscal rebalancing: shift taxes from personal income to indirect taxes and emissions/property taxes; shift spending toward investment from less productive outlays. - In downside scenarios use SGP latitude: allow automatic stabilizers, extend EDP deadlines, lower fiscal effort in preventive arm if output gap falls below 1½ percent of GDP, or invoke escape clause in severe euro area-wide downturn. ### Fiscal support for reforms and EFSI - Countries with fiscal space could accompany structural reforms with upfront fiscal stimulus focused on shifting spending toward high-return investments and reducing adjustment costs of reforms. - Countries without fiscal space should sequence reforms within a credible medium-term framework, prioritizing product market reforms. - Plan to expand EFSI by €200 billion to at least €500 billion by 2020 is welcomed; total financing approved through end-2016 was euro 163.9 billion. - EFSI allocation (Country Investment Share examples): Italy 17.5, Spain 14.0, UK 13.2, France 13.0, Multi-country 11.1, Germany 9.3. - Country Investment/GDP (percent) examples: Estonia 3.0, Bulgaria 2.1, Spain 2.1, Portugal 1.8, Italy 1.7, Greece 1.7. ### Banking sector, NPLs, and distressed debt markets - NPLs reduced by about €160 billion over the last two years, but the stock remains high at about €1 trillion. - More than 90 percent of the NPL reduction is by larger banks; over 60 percent occurred in Spain and Ireland. - Italy: largest stock of NPLs; NPLs fell by only about 5 percent relative to the 2015 peak level of €324 billion. - Household debt predominated NPL reductions; corporate NPL stocks remain stubbornly high. - Recommendations: - ECB’s new guidance on NPL management needs strong follow-up with ambitious reduction targets and vigorous supervisory follow-up. - Apply framework with proportionality to smaller banks. - Modernize and harmonize foreclosure and corporate insolvency frameworks to raise NPL values. - Develop secondary distressed debt markets to avoid fire-sales; an EU-wide NPL clearinghouse and national AMCs guided by an EC “blueprint” could help. - Clarify which features of a proposed pan-European AMC comply with EU rules and which need modification. ### Banking union, liquidity and capital markets integration - Banking union remains incomplete; cross-border liquidity has been falling. - Ring-fencing of intragroup capital and liquidity pervasive. - Completing the banking union with a common deposit insurance scheme and fiscal backstop would foster liquidity flow and sever bank-sovereign link. - Finalize international standards to ensure integrity of risk weights and speed up BRRD MREL implementation and resolution planning. - Progress on CMU: adoption of STS securitization, political agreement on a venture capital fund, revised prospectus regime; pending items include securities ownership rules and corporate insolvency proceedings. - Brexit will shift some financial activity to EU-27; oversight and regulatory capacity need strengthening to manage relocation and higher transaction costs. ### Macroprudential, housing and data improvements - Credit and house price growth moderate overall; pockets of risk necessitate nimble macroprudential activation. - Credit gaps negative in many countries; some countries show overvalued residential and commercial real estate prices. - Recommend easing notification procedures for increasing banks’ mortgage risk weights and simplifying ECB top-up powers decision processes. - Data advances: expanded supervisory datasets (Supervisory Banking Statistics, MMSR, AnaCredit), Household Finance and Consumption Survey (second wave), and enhanced external and public sector accounting statistics (EPSAS) support policy design. ### Progress against previous IMF recommendations (selected) - Structural policies: compliance with 2016 CSRs patchy; some progress on single market in services and geo-blocking rules. - Fiscal policies: mixed actions on using fiscal space; EC proposed EFSI expansion by around €200 billion. - Monetary policies: ECB extended APP to end-2017; monthly net purchases between April and December 2017 set at €60 billion (down from €80 billion); APP parameters adjusted (maturity range and permit purchases below deposit facility rate). - Financial policies: SSM issued NPL guidance; EC advanced proposals on insolvency harmonization; discussions on distressed debt market measures ongoing. - Banking union: little progress on common deposit insurance and common fiscal backstop; adoption of leverage and net stable funding ratios; progress on harmonized creditor hierarchies. ### Staff appraisal — key judgments - Broad-based euro area recovery is an opportune backdrop to deepen integration; dispersion of growth rates across countries is now as low as since euro introduction. - Risks are more balanced near term but tilted to the downside long term; high-debt countries have few buffers and are vulnerable to higher borrowing costs. - Stagnant productivity holds back medium-term growth and complicates adjustment in the monetary union; national reforms and stricter enforcement of the Macroeconomic Imbalance Procedure combined with incentives could help. - Fiscal policy guidance: - Countries with fiscal space (Germany, the Netherlands) should use it to boost potential growth and encourage external rebalancing. - High-debt countries (Italy, France, Portugal) should consolidate to put debt on a downward path and rebuild buffers. - Sum of staff’s country-specific fiscal advice amounts to a broadly neutral euro area aggregate fiscal stance in 2018. - Monetary policy: remain accommodative until sustained euro area-wide inflation adjustment occurs; no change to ECB forward guidance or policies unless supported by actual inflation performance. - Financial sector: further action needed on high NPL stocks and low bank profitability—banks need restructuring, consolidation, and stronger resolution frameworks; EC can provide blueprints for national public AMCs and harmonize insolvency frameworks. - Completing banking union and building CMU are essential for resilience and better shock absorption. *Source: cr17235 (IMF).* ### 1. Real Income Convergence ____________________________________________________________________ 10 ### 1. Real Income Convergence ### Key findings on the recovery and macroeconomic backdrop - The recovery has strengthened, supported by domestic demand: growth reached 1.8 percent in 2016. - Growth held firm in the first quarter of 2017 at 1.9 percent year-on-year, benefiting from both robust domestic demand and improved net exports. - Euro area unemployment fell to 9.3 percent in May from its 2013 peak of 12 percent. - Euro area manufacturing export growth rose to 4.5 percent in the past six months compared to a year ago. - Average annual inflation reached 1.6 percent in the first six months of 2017; underlying inflation averaged 1.0 percent between January and June. - The euro area current account surplus rose to about 3.3 percent of GDP in 2016. - The CPI-based real effective exchange rate (REER) appreciated by about 1.1 percent in 2016; as of May 2017, the REER has depreciated compared to its average level in 2016 by around 1 percent. ### Financial conditions and inflation dynamics - Financial conditions remain strongly accommodative in most countries, though long-term interest rates have risen. - Core yields rose on a stronger global outlook and expectations of reduced monetary stimulus in the U.S.; sovereign spreads widened in several high public debt countries in early 2017 and stabilized after the French elections. - Headline inflation pick-up reflects a rise in energy prices and stronger readings in Germany and Spain, but base effects in energy are expected to subside, pushing inflation down later in the year. - Underlying inflation weakness is linked to subdued nominal wage growth, anemic productivity growth, still elevated unemployment in some countries, and a high prevalence of part-time employment. ### External sector and capital flows - The euro area external position in 2016 remained broadly in line with the level implied by medium-term fundamentals and desirable policies. - Net external debtor countries (e.g., Portugal and Spain) have maintained surpluses over the past four years, improving net foreign asset positions slightly. - Persistent surpluses in large net external creditor countries (e.g., Germany and the Netherlands) have not shrunk significantly; absent adjustment, their net international investment positions look set to grow markedly over the medium term. - Portfolio debt has dominated capital outflows; net private inflows comprise debt and equity inflows, with creditor and debtor countries contributing. ### Underlying weaknesses: productivity and convergence - Income convergence across euro area countries has stalled; steady convergence of real GDP per capita leading up to euro introduction stalled thereafter, and since the outset of the crisis income has tended to diverge. - Examples: Germany is well above its pre-crisis GDP levels, while Italy’s GDP is only expected to return to its pre-crisis level in the mid-2020s. - Productivity growth fell behind in countries with lower per capita income. Gaps in labor productivity have been persistent; total factor productivity (TFP) growth slowed more in countries with low initial productivity. - Wage growth outpaced productivity growth in some countries, contributing to competitiveness gaps, evidenced by divergence in relative unit labor costs (ULC) between Germany and Portugal, Spain, Italy, and Greece. ### Policy implications and recommendations (from analysis) - High-debt countries should take advantage of the recovery and the remaining window of monetary accommodation to reduce vulnerabilities and rebuild buffers. - Euro area countries should grasp the opportunity provided by the recovery and the political momentum to push for deeper integration and complete the architecture of the Economic and Monetary Union (EMU). - Structural reforms to boost productivity in lagging countries are essential to restore real income convergence. - Reforms in lagging countries should be complemented by measures to support external rebalancing through higher wage inflation and by boosting domestic demand in net external creditor countries. - Labor and product market reforms tend to boost productivity more in countries with low productivity levels and can therefore help these countries to catch up, reducing disparities with higher-income countries. ### Box 1 — Real Income Convergence: summary points - Expectations at EMU inception included greater macroeconomic stability and income convergence through reduced exchange rate uncertainty, lower interest rates, increased capital mobility, and deeper intra-regional trade. - Empirical evidence shows that real convergence disappointed: β-convergence in GDP per capita is lacking for 1993–2015; σ-convergence plots indicate a gradual slowdown in convergence leading up to euro adoption and divergence since the crisis. - Newer euro area members converged rapidly up to accession, though their convergence slowed after the crisis; convergence has been higher among the EA-19 than within the European Union. - The lack of convergence is driven in part by a lack of productivity catch-up: countries with low initial productivity had consistently lower TFP growth and a more pronounced slowdown. - Policies that raise productivity growth—especially labor and product market reforms—would help foster convergence by aiding catch-up in low-productivity countries. *EURO AREA POLICIES, INTERNATIONAL MONETARY FUND* ### 9. Since the crisis, the disparities in competitiveness have been reduced, but gaps remain. ### 9. Since the crisis, the disparities in competitiveness have been reduced, but gaps remain. ### Competitiveness developments and unit labor costs (ULCs) - Nominal wage growth in Germany has averaged about 2½ percent annually since 2009, outpacing the rise in labor productivity. - Despite the rise in own ULCs, Germany continued to gain competitiveness relative to its trading partners—with its nominal ULC-based REER depreciating by around 7 percent over the same period. - In Greece, Portugal and Spain, the ULC reduction occurred mostly during 2009–13 and was to a large extent driven by labor shedding, accompanied by wage declines in the case of Greece. - In Italy, despite job cuts, wage growth outpaced labor productivity growth, leading to a rise in ULCs. - Since 2014, Spain’s ULCs have been stable, with wage growth in line with labor productivity (supported by job creation), though ULCs in Italy have continued to rise. - Additional job and wage cuts would have high social costs, implying that further adjustment should focus on raising TFP. ### External imbalances and real exchange rates - Rises in ULC-based REER prior to the global financial crisis were associated with lower average current account balances over the period. - Poorer current account performance was also associated with lower pre-existing net international investment positions immediately after the euro adoption. - Some net external debtors have made large price adjustments, bringing down their ULCs (also relative to trading partners) since the crisis. - Further narrowing of competitiveness gaps would help reduce external imbalances. ### Near‑term outlook and key macro projections - Growth is expected to reach 1.9 percent this year and slow modestly to 1.7 percent in 2018. - Germany and Spain will remain the main growth engines; Italy and France will benefit to varying degrees. - ECB policies are expected to remain accommodative and the aggregate fiscal stance to be mildly expansionary. - Headline inflation is anticipated to slow in 2018 to 1.5 percent, as base effects from higher energy prices dissipate. - With growth modestly above potential, the output gap is expected to close by 2019. - The jobless rate will return close to its pre-crisis level of 8 percent only by 2021. - Inflation is expected to move slowly toward the ECB’s medium-term objective, settling at 1.9 percent in 2021. ### Risks, constraints, and structural impediments - Public debt-to-GDP ratios in high-debt countries have barely declined; failing to rebuild buffers could leave highly indebted countries vulnerable to higher borrowing costs when monetary accommodation is reduced. - European bank distress, driven by a structurally weak profitability outlook and still high NPL ratios, could have knock-on effects on the broader financial sector, the real economy, and sovereign yields in vulnerable economies. - Persistent structural problems include low productivity growth, high unemployment, and income inequality—raising the threat of inward-looking policies and political pressures. - External risks include rising protectionism, uncertainty from Brexit negotiations, and potential new U.S. policies. ### Policy priorities and recommendations - Member-state actions and collective EMU-level reforms are needed to restart convergence, reduce imbalances, and address vulnerabilities. The desired policy mix includes: - Promoting structural reforms to boost potential growth and raise TFP. - Using fiscal space where available, while consolidating in high-debt countries. - Continuing monetary accommodation. - Repairing bank balance sheets. - Enhancing fiscal integration through a central fiscal capacity, completing the banking union, and advancing the capital markets union. - Structural reform priorities (country-tailored) include: - Product market reforms: improve the business climate, public administrations and insolvency regimes (e.g., Italy and Portugal); reduce cross-border entry barriers in professional and retail sectors (e.g., Greece); complete the single market in services, energy, digital commerce, and transport; pursue ambitious trade agreements while supporting adjustment and even distribution of gains. - Labor market reforms: reduce the labor tax wedge (e.g., Germany); improve active labor market policies (e.g., Italy and Spain); reform distortive unemployment benefits (e.g., France); address excessive job protection for permanent contracts (e.g., Portugal and Spain) while designing measures carefully in weak-growth contexts to minimize short-term costs. - The cyclical recovery and favorable financial conditions make this an opportune time to push ahead with reforms to raise productivity, revive income convergence, and narrow competitiveness gaps. *Source: cr17235 (IMF).* ### 25. Strong and credible reforms could be incentivized through, and their impact amplified ### 25. Strong and credible reforms could be incentivized through, and their impact amplified by, the judicious use of fiscal policy ### Fiscal policy to support structural reforms - Countries with fiscal space could accompany structural reforms with some upfront fiscal stimulus focused on: - shifting spending toward high-return investments, and - reducing the adjustment cost of reforms (example: Germany’s fiscal easing would also boost the effect of its recommended structural reforms). - Countries without fiscal space should sequence reforms carefully within a credible medium-term framework, prioritizing product market reforms as they entail few short-term costs (example: Italy, Spain and Portugal). - Short-term economic effects of employment protection and unemployment benefit reforms could be minimized through budget-neutral fiscal support as part of a broader reform package (example: combining job protection reforms with measures to facilitate the setting up of small businesses). - Reforms with permanent fiscal costs—such as labor tax cuts and higher spending on active labor market policies—should be implemented in a budget-neutral manner in all countries to avoid compromising fiscal sustainability. ### Use of EU-level instruments and incentives - EU instruments are currently not being used effectively: weak implementation of CSRs in most countries, including six countries identified with excessive imbalances under the Macroeconomic Imbalance Procedure, suggests weak effectiveness. - To build credibility, stronger enforcement of the governance framework is needed. - Complementary incentives at the EU level could include: - targeted support from European Structural and Investment (ESI) funds, - flexibility under the fiscal rules to reward strong reforms, and - outcome-based structural reform benchmarks. - Independent national productivity boards can help build greater national consensus and ownership for reforms. ### Authorities’ views on reforms and incentives - Authorities agreed structural reforms are critical to reverse declines in productivity growth. - Progress has occurred in some areas: financial services, labor taxation, and active labor market policies. - Considering a multi-annual horizon, the large majority of CSRs have seen progress, reflecting that some reforms take time to implement. - Measures to reduce labor market duality and improve the business climate have lagged due to resistance from vested interests and a fragile political environment. - Priority for countries, especially those without fiscal space: product market reforms to improve the investment climate and create more effective insolvency regimes and public administrations (few short-term costs, significant medium-term gains). - Ongoing incentives and support: - Technical assistance through the Structural Reform Support Service. - Flexibility under the Stability and Growth Pact (SGP) for structural reforms (recently for Finland and Lithuania). - Tighter links being established between CSRs and ESI funds. - Eurogroup benchmarks: one on the labor tax wedge helped implementation; a second benchmark—on pensions—was adopted by the Eurogroup in March 2017; additional benchmarks (e.g., on insolvency practices) are being developed. - In countries with excessive imbalances, the EC intends to continue “specific monitoring” in lieu of opening an Excessive Imbalance Procedure to foster ownership and traction; the ECB calls for full implementation of the Macroeconomic Imbalance Procedure. - Trade negotiations to be conducted in a more transparent manner with greater public consultation. - National productivity boards will need to play a vital role in building consensus for reforms. ### Euro area fiscal stance, buffers, and differentiated strategies - Aggregate fiscal stance of the euro area is expected to be mildly expansionary in 2017. - The structural fiscal balance is expected to ease by 0.3 percentage points of potential GDP. - Fiscal easing comes primarily from Germany, and to a lesser extent from Italy, France, Finland, and Portugal. - For 2018 and beyond: - Output gap projected to shrink to -0.2 percent of GDP in 2018, and to close in 2019, reducing the rationale for additional fiscal cyclical support at the euro area level. - Output gaps vary across countries: below -1 percent of GDP in France and Italy, and +0.8 percent of GDP in Germany. - Fiscal space in countries with large negative output gaps is constrained by high debt levels. - Distribution of fiscal space calls for differentiated strategies: - Countries with fiscal space should use it now to boost public investment and promote structural reforms to increase potential growth over the medium term; this would also boost domestic demand and inflation in the near term and reduce sizeable external surpluses. Positive cross-border growth spillovers could modestly support other countries’ reform efforts. - Germany’s projected fiscal easing goes in this direction, but remains well below staff’s recommendations. - The Netherlands fiscal stance is expected to be tighter than staff advise. - High-debt countries with relatively less fiscal space need to adjust now to rebuild buffers and reduce vulnerabilities. - Most high-debt countries have so far not saved the windfall interest reductions from monetary accommodation. - It is important to make decisive progress on fiscal adjustment before monetary accommodation is reduced to avoid dangerous debt dynamics as interest rates rise. - Delaying consolidation would imply larger and faster adjustment measures, which would be more damaging to growth than a more gradual approach. - Contrary to staff advice, most more highly indebted countries are expected to ease in 2017, including France, Italy and Portugal; in 2018, high-debt countries are expected to consolidate, though full details will not be available until draft budgets are published in October. ### Fiscal policy design and SGP flexibility - The SGP permits a one-time deviation of up to ½ percent of GDP from the required fiscal adjustment path to encourage major structural reforms (example: Italy availed of this flexibility in 2016). Credibility is central, and is best achieved through concrete upfront actions. - All countries should undertake growth-friendly fiscal rebalancing: - Revenue side: benefits may arise from shifting from personal income taxes to indirect taxes, including emissions taxes, and property taxes, as well as from base broadening while lowering marginal tax rates. - Spending side: shift outlays to investment from less productive areas such as poorly targeted transfers. - In downside scenarios: - Countries constrained by fiscal rules can use additional latitude provided in the SGP. - In case of country-specific shocks, automatic stabilizers should be allowed to operate. - For countries in the Excessive Deficit Procedure (EDP), deadlines to reduce the headline deficit can be extended. - For countries in the preventive arm, the required fiscal effort can be lowered if the output gap falls below 1½ percent of GDP. - In a severe, euro area-wide downturn, the escape clause should be invoked to suspend temporarily the fiscal adjustment that would otherwise be required. ### Expanded EU-financed investment (EFSI) and allocation - Plan to expand and extend the European Fund for Strategic Investment (EFSI) by €200 billion, for a total of at least €500 billion by 2020, is welcomed. - Accompanying measures envisaged: - ensure “additionality” so private financing for projects would not be displaced, - an enhanced investment advisory hub for greater geographic and sectoral diversification, - increase transparency of EFSI governance. - EFSI financing could prioritize projects of common interest (e.g., energy union, climate change), especially in countries with negative output gaps and high levels of debt where demand impact would be greatest. - EFSI-related investment shares and recipients (total financing approved through end-2016 was euro 163.9 billion; actual investments occur over a number of years): - Country Investment Share: Italy 17.5, Spain 14.0, UK 13.2, France 13.0, Multi-country 11.1, Germany 9.3, Estonia 3.0, Bulgaria 2.1, Portugal 1.8, Italy 1.7, Greece 1.7, Spain 2.1. - Country Investment/GDP (percent): Estonia 3.0, Bulgaria 2.1, Spain 2.1, Portugal 1.8, Italy 1.7, Greece 1.7. - In percent of GDP terms, Spain, Portugal, Italy and Greece are among the top six recipients of EFSI-related investment. ### Restoring credibility and reforming the fiscal framework - Compliance with and enforcement of the SGP have been weak, undermining its credibility and impeding further fiscal integration. - Enforcement has suffered from weak political will (example: decision not to sanction Portugal and Spain for failing to meet EDP targets in 2016). - Recent absence of quantitative fiscal targets in the CSRs for 2018 implies greater discretion for the EC in assessing compliance, weakening SGP credibility. - Steps to restore SGP credibility: - An independent European Fiscal Board: operational and charged with assessing aggregate fiscal stance and even-handedness in SGP application; must demonstrate independence through actions. - A simpler and more transparent fiscal framework: amend rules over the medium term to: - focus on a single fiscal anchor and a single operational target with well-considered escape clauses, - make enforcement more automatic, - create better incentives for compliance with the rules. ### Common stabilization function (CFC) and deeper fiscal integration - A common stabilization function would permit a more accommodative fiscal stance in a downturn while supporting fiscal discipline in good times. - A central fiscal capacity (CFC) could help incentivize compliance with fiscal rules if access is conditional on member states’ compliance. - Design possibilities for a CFC include: - a modest tax-transfer scheme with a “rainy day fund” built up in good times to provide macroeconomic stabilization to countries hit by shocks, and - a borrowing-lending scheme to help finance public investment. - A CFC would be essential to completing the EMU architecture; favorable political momentum and better SGP compliance should be utilized to build political support for further fiscal integration. *International Monetary Fund — EURO AREA POLICIES (excerpts from the cited chapter).* ### 35. Looking ahead, Brexit will require politically difficult decisions on the EU budget. The ### 35. Looking ahead, Brexit will require politically difficult decisions on the EU budget. The ### Brexit and the EU budget - The annual gross contribution of the UK to the EU budget has averaged about 13 percent of the total over 2013–15, with an annual net contribution of about €11 billion. - Maintaining (non-UK) spending at the current level would require higher contributions from richer EU members or a new source of revenue. - Cutting spending would imply lower agricultural and structural funds (about 75 percent of EU spending). - Recommendation: Priority should be given to preserving structural funds, which are a major income source for many Central and Eastern European countries and help promote convergence. ### Authorities’ views on fiscal stance and differentiation - The authorities consider that a broadly neutral fiscal stance remains appropriate for the euro area in 2018, given the remaining trade-off between sustainability and stabilization needs. - Fiscal indicators: a headline deficit of 1.5 percent of GDP in 2016. - Compliance and outcomes: - Only two euro area countries had deficits above 3 percent. - Eight countries have reached their Medium-Term Objectives for the structural balance. - Assessment: - While the recovery is steady with a closing output gap, labor market slack suggests scope for higher growth without triggering inflationary pressures. - Debt sustainability is mainly relevant from a country-specific perspective, with several countries facing elevated sustainability risks in the medium term. - Policy differentiation: - Countries with fiscal space should make use of it, including in Germany, where the fiscal stance could be more expansionary to support future growth. - Countries without fiscal space should take advantage of the current negative interest rate-growth differential to reduce excessive levels of debt and rebuild buffers. - In some cases (example cited: Italy), the EC highlighted the need to consider the impact of budgetary adjustment on the recovery and employment when assessing compliance with the rules, suggesting use of margins of appreciation. - The ECB cautioned that the window of opportunity for high-debt countries to act is shrinking fast and that complying with the rules would be the best way to establish credibility. ### Strengthening EMU and central fiscal capacity (CFC) - Rationale: A common stabilization function would complement national budget stabilizers and allow smoother aggregate fiscal policy for the euro area. - Political constraints: To have necessary political support, such a function should not lead to permanent transfers, though a borrowing capacity would be needed to allow sufficient stabilization. - Complementarities: The establishment of a CFC could be combined with other EMU deepening measures, such as the creation of safe assets. - Institutional implication: With a CFC to support stabilization needs, national fiscal rules could focus on sustainability. ### Maintaining an accommodative monetary stance - ECB actions and intent: - The ECB’s decision last December to extend the asset purchase program (APP) through end-2017, while reducing the monthly purchase amount, signals strong commitment to maintain accommodation until there is a sustained upward shift in the path of inflation. - The decision to relax the constraint against buying bonds whose yield is below the deposit rate has significantly expanded the pool of eligible assets for purchase. - Effects of monetary easing: - Asset purchases have supported portfolio rebalancing and compressed risk premia. - In the two years following August 2014 Jackson Hole speech, the euro area average term spread fell by around 80 basis points. - The 10-year bond yield spread (to German bunds) narrowed by around 40 basis points for both Italy and Spain. - Since last summer, the average term spread has risen to slightly above the level in August 2014. - Corporate bond issuance picked up after the March 2016 CSPP announcement, particularly among firms with investment grade; yields, especially for high-yield corporates, have declined markedly since then. - Bank lending volumes have improved and lending rates declined, with limited side-effects on bank profitability; TLTROs enabled participating banks to replace more costly funding and extend maturities. - Bank profitability remains stable as increasing lending volumes, lower wholesale funding costs, and revaluation gains offset compressed lending margins. - Inflation and policy guidance: - Subdued underlying inflation points to the need for monetary policy to remain strongly accommodative for an extended period. - The costs of a long period of inflation undershooting continue to exceed those of a temporary overshoot. - The recent removal of the easing bias in the ECB’s forward guidance on policy rates was warranted by the disappearance of deflation risk; any further change should be underpinned by a clear shift in the path of actual inflation or a much stronger assessment of the inflation outlook. - For sustained euro area inflation recovery, some countries must accept inflation above the ECB’s “below, but close to, 2 percent” objective; in countries where the output gap is closed and wage growth is subdued, authorities could encourage faster wage and price growth in their public communication. - As U.S. monetary policy normalizes, it will be important to guard against unwarranted tightening of financial conditions in the euro area. - Collateral scarcity and securities lending: - The gap between unsecured money market rates and German repo rates remains very wide despite some narrowing; the cash collateral facility introduced in December likely helped. - Two-year German bond (Schatz) yields have recently reached new lows, diverging from OIS rates. - Recommendation: Develop a common securities lending framework for national central banks—including by allowing for non-sovereign collateral, using standardized legal agreements, and harmonizing features like costs, maturity, haircuts, and roll-over capacity—to facilitate access to high-quality collateral and improve market functioning. - ECB views: - The ECB stressed its commitment to continued monetary accommodation, noting asset purchases and negative deposit rate collectively reduced borrowing costs for NFCs and households and encouraged portfolio rebalancing. - The ECB agreed on the need to maintain strong accommodation until there is a sustained adjustment in the path of inflation towards levels below but close to 2 percent. - The ECB concurred on the importance of an effective securities lending program across the Eurosystem to avoid collateral scarcity; the cash collateral scheme introduced in December was well received and used where scarcity is most binding, though securities lending programs face national risk-management constraints. ### Repairing banks’ balance sheets and completing the financial architecture - Banking sector performance: - Although revenues have fallen, they have been partly offset by lower funding costs, leaving net interest margin broadly flat. - The sector’s aggregate return-on-assets (ROA) remains above 2010 levels; costs-to-assets ratios remain stubbornly high. - Medium-sized banks, in particular, still struggle to improve their ROAs. - The overall low euro area ROA and a return on equity well below the cost of equity raise doubts about the sustainability of banks’ business models. - Large banks reliant on market funding are incentivized to drop unprofitable business lines, reduce costs, and consolidate. - For banks supervised by the SSM, almost half of their assets have ownership and governance structures with little exposure to market pressures and may require greater supervisory efforts to adapt and consolidate. - Non-performing loans (NPLs): - Over the last two years, NPLs in the euro area have been reduced by about €160 billion, but the stock remains high at about €1 trillion. - More than 90 percent of the reduction in NPLs is accounted for by larger banks, and over 60 percent has occurred in Spain and Ireland. - Italy has the largest stock of NPLs; progress has been slow, with NPLs falling by only about 5 percent relative to the 2015 peak level of €324 billion. - Household debt has been the predominant component of NPL reductions; corporate debt accounts for a small share of the reduction, implying corporate NPL stocks remain stubbornly high. - Prior staff analysis suggests high corporate debt can lower the sensitivity of firms’ investment to demand improvements. - Policy and supervisory recommendations: - The ECB’s new guidance on NPL management is a good step forward but needs strong follow-up with ambitious reduction targets and vigorous supervisory follow-up. - Member states should apply the framework, with due proportionality, to smaller banks not covered by the ECB guidance. - Measures to modernize and harmonize foreclosure and corporate insolvency frameworks across member countries would help lift NPL values by improving judicial efficiency and providing more certainty in defaults. - The Mortgage Credit Directive and the proposals in the draft business insolvency directive are noted as steps in the right direction. - Tackling NPLs efficaciously would also ameliorate the private sector debt overhang, which contributed to holding back the recovery in some countries. *International Monetary Fund, Euro Area Policies chapter excerpts.* ### 49. In parallel, further development of secondary distressed debt markets would help ### cr17235 - 49. In parallel, further development of secondary distressed debt markets would help ### Secondary distressed debt markets and AMCs - Further development of secondary distressed debt markets would help avoid fire-sales, giving banks better chances to recover more value in disposals. - An EU-wide NPL clearinghouse to facilitate information dissemination would be a useful initial step. - International experience suggests that in several countries a publicly-supported asset management company (AMC) has helped develop the secondary market. - In Europe, an AMC must be compliant with the state-aid framework and the Bank Recovery and Resolution Directive (BRRD). - The European Banking Authority (EBA) has recently proposed a model for a pan-European AMC that it argues would be consistent with the institutional framework. - The European institutions should clarify which features of the proposal comply with EU rules and which need modification. - Given heterogeneity in insolvency regimes and in distressed asset classes across countries, AMCs at the national level—guided by a “blueprint” established by the EC—are likely to be more useful than a pan-European AMC. ### Banking union, liquidity, and risk-weight integrity - The banking union remains incomplete; despite a single bank supervisor, cross-border liquidity has been falling, not rising, within the euro area. - Ring-fencing of intragroup bank capital and liquidity remains pervasive, contrary to the spirit of the banking union. - Completing the banking union by establishing a common deposit insurance scheme with a common fiscal backstop would: - foster the free flow of liquidity, and - provide reassurance to supervisors that the bank-sovereign link is severed. - To encourage more uniform treatment of risks by banks, authorities should finalize international standards ensuring the integrity of risk weights. - Further integration would be helped by: - corporate insolvency and foreclosure framework harmonization, - speedier implementation of the BRRD’s minimum requirement for own funds and eligible liabilities (MREL) and related resolution planning. - Consider easing the preconditions for using the European Stability Mechanism’s Direct Recapitalization Instrument for systemically important banks under stress. - Although not vested with AML/CFT powers, the ECB should continue cooperative efforts to ensure effective AML/CFT oversight, including regional harmonization of supervisory frameworks in line with international standards and possible memoranda of understanding with designated national authorities. ### Insurance and pensions sector vulnerabilities - Systemic risks from insurance and pensions are low overall, but life insurers in some countries need to change business models and consolidate to reduce vulnerabilities. - The confluence of guaranteed products and interest rate duration mismatches on assets and liabilities create challenges in the low interest rate environment. - The shortfall in own funds to cover capital requirements appears manageable at the euro area level (at about a quarter percentage point of GDP), but is higher for some countries with high public debt. - The shortfall does not account for possible adverse feedback loops due to insurers’ exposures to domestic banks and sovereigns in some countries. - Insurers need to diversify and consolidate further to withstand an environment of persistently low interest rates. ### Capital Markets Union (CMU) and financial integration - Faster progress on the CMU action plan would foster greater international private risk sharing, helping better insure against adverse country-specific shocks. - Greater harmonization of regulatory and supervisory regimes, and improved access to non-bank financing (e.g., venture capital), would provide greater investor certainty and diversify firms’ funding options. - Recent progress includes: - EU adoption of simple, transparent, and standardized (STS) securitization, - political agreement on a venture capital fund and regulation, - a revised prospectus regime to facilitate access to capital markets. - Pending improvements include securities ownership rules and corporate insolvency proceedings. - New action items from the CMU mid-term review (stronger supervisory powers for ESMA, potential revisions to prudential treatment of investment firms, measures to encourage FinTech and sustainable finance) should enhance Single Market functioning. - Completing the CMU action plan would improve EU resilience to shocks and facilitate efficient allocation of capital. ### Brexit and relocation of financial activity - Brexit is likely to transform the financial landscape, with some market activity migrating to EU-27. - With substantive withdrawal discussions due to start in June 2017, financial institutions are likely to adjust ahead of separation. - Migration of activities such as clearing and securities transactions to the EU-27 may raise transaction costs during the transition, though the impact is likely to be modest. - The EU will need to strengthen oversight and regulation to handle greater volumes of financial transactions and mitigate risks. - Authorities are preparing for substantial relocation of banking, asset management and clearing activities for EU-27 clients from the UK, assuming a hard Brexit. - London-based financial institutions are in touch with EU, euro area, and national authorities regarding licensing and locational choices. - Provision of financial services to the EU-27 is probably not expected to shrink, but costs associated with activities hitherto conducted in the UK might increase moderately, including perhaps higher capital and margin requirements for banking and euro clearing activities, respectively. - The SSM has clarified that all licensing decisions for banks in the euro area rest with them. The EC is considering more centralized supervision for investment funds and clearing activities. ### Macroprudential tools, housing, and credit dynamics - Credit and house price growth are moderate overall, but pockets of risks suggest countries need greater flexibility in activating macroprudential tools in a timely manner. - Although credit growth has picked up, credit gaps are negative in many countries. - Overvalued residential and commercial real estate prices in a few countries suggest the need for nimble application of macroprudential instruments. - Authorities should reduce the onerous process of notifications for increasing banks’ risk weights on mortgages to curb housing-related macroprudential risks; current procedures could go all the way to the European Council. - For SSM countries, the notification and decision-making process for the ECB’s top-up powers over capital-based tools generally require simplification. - Rapid growth in commercial real estate prices posed risks in a few countries, but risk monitoring is hampered by lack of data. - Use of borrower-level tools such as limits on loan-to-value (LTV) ratios is based on national laws with varying activation procedures. - Authorities suggested the European Systemic Risk Board could be a single point of notification to ease confusion. ### Authorities’ views (summarized) - Authorities agreed persistently low bank profitability is a pressing challenge; consolidation should be led by the private sector. - Merger activity has been subdued with almost no cross-border deals due to low growth and NPL valuation problems; national differences in taxation, labor laws, and merger approval processes may disincentivize consolidation. - Recent EC proposals to codify loss-absorbing capacity and provide greater flexibility for intragroup waivers of capital and liquidity requirements within the banking union should resolve some regulatory uncertainty. - The EC proposal for a common consolidated corporate tax base should help. - A forthcoming report by the EU Council’s Financial Services Committee (FSC) will provide clarity on State Aid interactions and options to facilitate speedier NPL resolution. - For insurance sector stress tests, shortfalls in own funds relative to capital requirements are mainly used by supervisors to assess business models; insurers could seek more diversity in business models. ### Staff appraisal — key judgments and recommendations - The broad-based euro area recovery is an opportune backdrop to deepen integration; dispersion of growth rates across countries is now as its lowest since euro introduction. - Risks to the forecast are more balanced near term but remain tilted to the downside over the longer horizon; high-debt countries have few buffers and are vulnerable to a rise in borrowing costs. - Stagnant productivity is holding back medium-term growth prospects and complicating adjustment within the monetary union; reforms at national level and stricter enforcement of the Macroeconomic Imbalance Procedure combined with incentives could help. - Fiscal policies should be tailored to country-specific circumstances: - Countries with fiscal space, such as Germany and the Netherlands, should use it to boost potential growth while encouraging healthier external rebalancing. - High-debt countries with relatively less fiscal space, like Italy, France and Portugal, should consolidate to put debt on a downward path and rebuild buffers. - The sum of staff’s country-specific fiscal advice amounts to a broadly neutral euro area aggregate fiscal stance in 2018. - All countries must respect the SGP while the euro area should use political momentum to advance proposals for a common stabilization fund (CFC); consideration should be given to simplifying the fiscal framework and making enforcement more automatic. - Monetary policy should remain accommodative until a sustained upward adjustment of euro area-wide inflation occurs; no change to ECB forward guidance or policies should be made unless strongly backed by actual inflation performance. - Further action is needed to address high NPL stocks in some countries and widespread low bank profitability: - Banks need to restructure and consolidate, incentivized by an uncompromising approach to bank closure where necessary. - The upcoming review of the BRRD should seek to remove impediments to bank resolution and liquidation. - Reforms of national insolvency frameworks must continue. - The EC could promulgate blueprints for national, public AMCs to stimulate distressed debt markets and speed up NPL disposals while providing clarity on State Aid requirements. - Completing the banking union is necessary to build a unified banking system; reducing ring-fencing of intragroup capital and liquidity, combined with a common deposit insurance scheme and common fiscal backstop, would facilitate greater cross-border activity. - The Brexit process strengthens the imperative to build a capital markets union; oversight and regulatory capacities should be strengthened accordingly. *International Monetary Fund staff summary of cr17235, chapter content.* ### 69. It is proposed that the next Article IV consultation on euro area policies take place on ### cr17235 - 69. It is proposed that the next Article IV consultation on euro area policies take place on ### Timing of Next Article IV Consultation - It is proposed that the next Article IV consultation on euro area policies take place on the standard 12-month cycle. ### Main Economic Indicators (selected series, 2014–22) - Real GDP (annual percent change): 1.2, 2.0, 1.8, 1.9, 1.7, 1.6, 1.6, 1.5, 1.5 - Private consumption (annual percent change): 0.8, 1.8, 2.1, 1.6, 1.5, 1.5, 1.5, 1.5, 1.4 - Public consumption (annual percent change): 0.7, 1.3, 1.8, 1.2, 0.9, 0.6, 0.7, 0.7, 0.7 - Gross fixed investment (annual percent change): 1.6, 3.2, 3.7, 3.1, 2.9, 2.7, 2.5, 2.4, 2.3 - Final domestic demand (annual percent change): 0.9, 2.0, 2.4, 1.8, 1.7, 1.6, 1.6, 1.5, 1.5 - Stockbuilding (contribution to growth): 0.4, -0.1, -0.1, 0.1, 0.0, 0.0, 0.0, 0.0, 0.0 - Exports (annual percent change, includes intra-euro area trade): 4.4, 6.2, 3.0, 4.1, 4.0, 4.0, 3.9, 3.8, 3.8 - Imports (annual percent change, includes intra-euro area trade): 4.9, 6.3, 4.1, 4.3, 4.2, 4.2, 4.1, 4.0, 4.0 - Potential GDP (annual percent change): 0.9, 1.4, 1.1, 1.2, 1.3, 1.3, 1.4, 1.4, 1.4 - Output gap (percent of potential GDP): -2.5, -2.0, -1.3, -0.7, -0.2, 0.0, 0.2, 0.3, 0.4 - Employment (annual percent change): 0.5, 1.0, 1.4, 1.3, 0.9, 0.6, 0.6, 0.5, 0.4 - Unemployment rate (percent): 11.6, 10.9, 10.0, 9.2, 8.8, 8.5, 8.2, 8.0, 7.8 - GDP deflator (annual percent change): 0.9, 1.2, 0.8, 1.0, 1.3, 1.5, 1.6, 1.6, 1.7 - Consumer prices (annual percent change): 0.4, 0.0, 0.2, 1.6, 1.5, 1.7, 1.8, 1.9, 1.9 - General government balance (percent of GDP): -2.6, -2.1, -1.5, -1.4, -1.1, -0.6, -0.4, -0.2, -0.1 - General government structural balance (percent of GDP): -1.1, -0.9, -0.8, -1.0, -0.9, -0.6, -0.5, -0.4, -0.3 - General government gross debt (percent of GDP): 94.4, 92.5, 91.4, 90.0, 88.5, 86.4, 84.0, 81.7, 79.3 - Current account balance (percent of GDP): 2.5, 3.2, 3.3, 2.9, 2.9, 2.8, 2.8, 2.7, 2.7 - Interest rates (end of period, selected): EURIBOR 3-month offered rate: 0.1, -0.1, -0.3, -0.3, ... - 10-year government benchmark bond yield (end of period): 1.5, 1.2, 1.3, 1.2, ... - Exchange rates (end of period, selected): U.S. dollar per euro: 1.23, 1.09, 1.05, 1.1, ... - Nominal effective rate (2005=100): 105.4, 101.2, 102.0, 104.2, ... - Real effective rate (2005=100, ULC based): 100.8, 91.6, 91.5, 91.3, ... Notes on projections and data: - Projections are based on aggregation of WEO projections submitted by IMF country teams. - Stockbuilding and foreign balance entries are contributions to growth. - Exports and imports series include intra-euro area trade. - Unemployment rate and interest rates are in percent; government fiscal series are percent of GDP. - External sector projections are based on member countries' current account aggregations excluding intra-euro flows and corrected for aggregation discrepancy over the projection period. - Latest monthly available data for 2017 used for certain series. ### External Sector Assessment — Key Findings - NIIP trajectory and gross positions: - The net international investment position (NIIP) of the euro area fell to about -18 percent of GDP by the end of 2008, improving to around -6 percent in 2016. - Gross positions in 2016: assets about 237 percent of GDP and liabilities about 243 percent of GDP. - Growth in both gross asset and liability positions remains low but relatively steady after sharply slowing in 2008. - Outlook and vulnerabilities: - Projections of continued current account surpluses suggest the NIIP-to-GDP ratio will continue to improve at a moderate pace, with the euro area expected to become a net external creditor within the next few years, absent large differences in valuation changes on gross external assets versus liabilities. - The region’s overall NIIP financing vulnerabilities appear low. - Large net external debtor countries still bear a greater risk of a sudden stop of gross inflows. - Overall Assessment summary: - The external position of the euro area in 2016 was broadly in line with the level implied by medium-term fundamentals and desirable policies. - In 2017, the current account surplus is projected to shrink very slightly as the region’s economic recovery continues. - Imbalances at the national level remain sizeable and progress in reducing them is slow. - Further adjustment is needed by net external creditors to strengthen domestic demand (reducing surpluses) and by net external debtors to raise productivity and competitiveness (raising surpluses or lowering deficits). - The euro area’s external position may be affected by the UK’s eventual exit from the EU and possible policy changes in the global policy mix, including in the United States; these will be assessed in future ESR reports as their precise nature becomes clear. ### Potential Policy Responses (as stated) - Continued monetary accommodation to increase demand and lift inflation closer to the ECB’s medium-term price stability objective, while facilitating relative price adjustments at the national level by enabling greater inflation differentials across monetary union members. - Country-level measures: - Strengthen private sector balance sheets. - Structural reforms to enhance productivity and improve competitiveness. - A more growth-friendly composition of national fiscal policies. - Fiscal stance guidance: - Countries with fiscal space should expand investment and promote structural reforms to raise their potential and reduce their current accounts. - Countries without fiscal space should continue consolidating to reduce their debt and increase their buffers, while undertaking desirable structural reforms. - Regional measures: - Expanding centralized investment schemes would support rebalancing. - A more balanced policy mix with the implementation of priority institutional and structural reforms at the country level would better boost domestic demand and rebuild policy buffers, helping to reduce external imbalances, including within the euro area. *Source: IMF staff analysis as presented in the provided chapter excerpt.* ### 2016. Nearly all euro area countries are now running current account surpluses (apart from Belgium, Cyprus, Finland, Fra ### 2016. Nearly all euro area countries are now running current account surpluses (apart from Belgium, Cyprus, Finland, France, Greece, and Lithuania) ### Current account: developments and assessment - Background findings: - Nearly all euro area countries are running current account surpluses in 2016, apart from Belgium, Cyprus, Finland, France, Greece, and Lithuania. - Lower commodity prices provided a broad-based boost to euro area current accounts. - Import compression in the immediate aftermath of the crisis and external competitiveness gains from price and wage adjustments strengthened current accounts of net external debtors (e.g., Spain and Portugal). - Continued growth of surpluses in large creditor countries (e.g., Germany and the Netherlands) reflects strong corporate and public saving and weak investment. - Assessment (EBA model and staff): - The EBA model estimates a CA gap of -0.2 percent of GDP for 2016, with a cyclically adjusted CA norm of 3.1 percent of GDP. - The elevated norm reflects in particular demographics (population aging) and its impact on desirable saving. - Heterogeneity in estimated gaps across countries largely offsets in aggregate, with positive estimated gaps in some countries (e.g., Germany, the Netherlands) roughly equaling the total of negative estimated gaps for other countries (e.g., France, Italy). - Taking into account uncertainties in model-based estimates and consistency with member country-level assessed CA gaps, staff assesses the euro area CA gap to be in the range of -0.5 to 1.0 percent of GDP for 2016, leaving the underlying CA broadly consistent with the level implied by medium-term fundamentals and desirable policies. - Technical notes: - The IMF EBA analysis for the euro area covers 11 euro area members: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain. - When applying GDP-weighted aggregation for the euro area, the CA is corrected for reporting discrepancies in intra-area transactions, as the CA of the entire euro area is about ½ percent of GDP less than the sum of the individual 11 countries' CA balances. ### Real exchange rate (REER): developments and assessment - Background findings: - The CPI-based REER appreciated by about 1.1 percent from 2015 to 2016, reflecting the gradual strengthening of the euro area’s recovery. - Weaker inflation in the euro area relative to its trading partners accounts for a real appreciation lower than the nominal appreciation of about 3.3 percent. - As of May 2017, the REER is down by about 1.0 percent relative to its 2016 average level, essentially unwinding the 2016 appreciation. - Assessment (models and staff): - The EBA index REER model points to an overvaluation of about 2.4 percent in 2016. - The level REER model suggests an undervaluation of about 4.5 percent in 2016. - On balance, staff assesses the euro area 2016 average real exchange rate to have been broadly aligned, between an undervaluation of 5 percent and an overvaluation of 3 percent. - There is large heterogeneity in REER gaps across member states: ranging from an undervaluation of 10-20 percent in Germany to overvaluations of 5–20 percent in a number of small to mid-sized euro area member states. - Policy implication: the differences in REER gaps highlight the need for net debtor countries to improve external competitiveness and for net creditor countries to boost domestic demand. ### Capital and financial accounts: flows and policy measures - Background findings: - Mirroring the 2016 CA surplus, the euro area experienced net capital outflows, largely driven by portfolio debt and FDI outflows. - Outflows were somewhat tempered by inflows into portfolio equity and loans and other bank-related instruments. - The geography of gross capital inflows shifted with the global financial and sovereign debt crises, with inflows from the core euro area economies into the rest of the euro area diminishing. - Assessment: - Capital outflows in portfolio debt and inflows into portfolio equity over the past couple years likely arose in large part from the ECB’s monetary accommodation through its asset purchase program, which has lowered yields on debt and spurred interest in equity. ### FX intervention and reserves level - Background findings: - The euro has the status of a global reserve currency. - Assessment: - Reserves held by euro area economies are typically low relative to standard metrics, but the currency is free floating. ### Risk Assessment Matrix: key risks, likelihoods, impacts, and policy responses - Retreat from cross-border integration - Likelihood: High - Expected Impact: High - Expected effects: Increased investor uncertainty; lower growth due to trade barriers; rise in euro skepticism. - Policy response highlights: - Strong collaboration to ensure smooth and predictable transition to a new economic relationship between the U.K. and the EU. - Continued support for trade liberalization and free-trade agreements. - Re-double efforts to secure the benefits of economic integration and cooperation across the EU. - Policy and geopolitical uncertainties - Likelihood: High - Expected Impact: High - Expected effects: Global spillovers from difficult-to-predict US policies, uncertainty regarding post-Brexit negotiations and elections; policy divergence with U.S. could lead to rising global imbalances and volatility. - Intensification of security dislocation and migrant flows - Likelihood: High - Expected Impact: High - Expected effects: Lack of refugee integration could raise unemployment, pressure national budgets, and risk social cohesion; border controls could restrict movement of goods, services and labor. - Policy responses: - Rapid integration of refugees into host country labor markets. - Temporary costs related to refugee expenditures should be accommodated within current fiscal targets on a case-by-case basis. - A new system to relocate refugees is needed to reduce the burden on frontline countries. - Significant further strengthening of interest rates - Likelihood: High - Expected Impact: High - Expected effects: Highly indebted countries could face higher borrowing costs; loss of market confidence; negative shocks to growth. - Policy responses: - Structural reforms, balance sheet repair and fiscal consolidation in high-debt countries to build buffers. - The ECB should stay the course on its asset purchase program and look through inflation movements while remaining focused on its euro area-wide medium-term price stability objective. - European bank distress - Likelihood: Medium - Expected Impact: Medium - Expected effects: Could reverberate through the financial sector and widen sovereign yield spreads. - Policy responses: - Supervisors should set ambitious targets for reducing the stock of impaired assets; follow ECB guidance on NPL management with strict supervisory monitoring. - Insolvency reform, development of distressed debt markets, cost-cutting, and banking consolidation. - The Single Resolution Fund (SRF) needs a common fiscal backstop. - Euro area insurance sector stress from low interest rates - Likelihood: Low - Expected Impact: Low - Expected effects: Stress on life insurer balance sheets; potential funding risk for domestic sovereigns in some countries. - Policy responses: - Restrict use of new guarantee-based products; review rates on existing products; transition to unit-linked instruments; review business models or consolidate through M&As. - Some insurers may need additional capital based on EONIA stress tests; transition to Solvency II requires periodic review and regular system-wide stress testing. - Structurally weak growth in key advanced economies relative to baseline - Likelihood: (implied) Medium-High for some scenarios - Expected Impact: High - Expected effects: Lower growth potential, higher output gaps, deterioration in public debt sustainability and private balance sheets. - Policy responses: - Accelerate structural reforms to spur investment, productivity and competitiveness; repair bank, corporate, and household balance sheets. - Use fiscal space within SGP framework and fiscal rebalancing to support demand and promote structural reforms; in an adverse scenario, invoke systemic escape clause in SGP to provide near-term demand support while strengthening medium-term fiscal commitments. - Continue accommodative monetary policy to raise inflation and support demand. - Significant slowdown in China and other large emerging market economies - Likelihood: Low-Medium - Expected Impact: Medium-High depending on scenario - Policy responses include accelerating reforms, using fiscal and monetary accommodation as appropriate. (Note: The Risk Assessment Matrix shows events that could materially alter the baseline path; “Low” indicates probability below 10 percent, “Medium” between 10 and 30 percent, and “High” 30 percent or more.) ### Structural reform plans and progress: selected country summaries and staff recommendations - France - Reform priorities: Reform government spending to reach medium-term fiscal objective; improve labor market functioning; increase competition in services; pursue business-friendly policies. - Recent progress: Pension reform in 2014–15; tax credit (CICE) introduced from 2013–14 and increased in 2017; Rebsamen, El Khomri, and Macron laws with various labor and competition measures. - Staff recommendations: - Limit general government spending growth to inflation, institutionalize spending reviews, further raise effective retirement age, tighten caps on local taxes and borrowing. - Improve targeting of social benefits, tighten eligibility for unemployment benefits and job search requirements, change minimum wage formula to limit indexation to inflation. - Reduce disincentives for SMEs to grow, enhance business simplification, align regulated savings rates to market rates, review tax incentives for savings and insurance products. - Germany - Reform priorities: Increase labor force participation of women, older workers, and refugees; facilitate immigration of qualified workers; increase productivity and competition, especially in services. - Recent progress: Extended child care provision; law reducing disincentives to work after pensionable age; measures to broaden access to training for refugees; action plan on professional regulations; measures to improve venture capital environment. - Staff recommendations: - Lower the tax wedge, improve child care provision, increase retirement ages, facilitate labor market integration of low-skilled migrants, further deregulate professional services, strengthen regulator’s powers in transport/postal services, continue focus on innovation and digital economy. - Greece - Reform priorities: Preserve and expand labor market flexibility; foster competition; improve business environment. - Recent progress: Some reforms (dockworkers, OTC trade of pharmaceuticals, Sunday trade liberalization) but reversal risks and many reforms pending. - Staff recommendations: - Preserve recent labor market reforms; adopt legislative changes to align collective dismissals and industrial actions with EU best practices; significantly accelerate opening up of regulated professions; implement pending OECD recommendations; accelerate overhaul of investment licensing system toward notification with ex-post verifications. - Italy - Reform priorities: Increase competition; raise public sector efficiency; labor market reform; civil justice and insolvency reform. - Recent progress: Draft Annual Competition Law remains under discussion; implementing decrees on public administration reform issued but some measures weakened or stalled; 2014 Jobs Act introduced new standard contract; progress on insolvency and enforcement measures. - Staff recommendations: - Strengthen competition law, ensure annual pro-competition law adoption, enhance competition in local services and professional sectors, enhance independence of competition authority. - Bold implementation of public administration reform, improve public sector skill mix and procurement, rationalize procurement and public enterprises, privatize where appropriate. - Align wages with productivity at firm level, implement remaining Jobs Act aspects, extend contract changes, promote out-of-court debt restructuring, improve civil justice efficiency, strengthen enterprise courts and court resources. - Portugal - Reform priorities: Alleviate impediments to external competitiveness and potential growth; improve functioning of labor and product markets; improve judicial sector efficiency. - Recent progress: Halted public transport concessions; renegotiated privatization of national airline TAP; one-time levy on GALP lowering gas prices by an estimated 7–12 percent; new Budgetary Framework Law adopted in 2015 (implementation delayed); National Reform Program 2017–21 focusing on public sector modernization. - Staff recommendations: - Revisit reforms that have not yielded expected results, fully implement initiated reforms, preserve recent labor market reforms, promote managerial skills, link minimum wage increases to productivity, upgrade public services quality, improve payment discipline of public sector entities. - Continue reducing energy costs and make no new investments in energy infrastructure until energy sector debt is paid off; strengthen market integration at the European level. - Commission an in-depth survey on judicial system efficiency by an outside firm. - Spain - Reform priorities: Address labor market duality; reduce high structural unemployment; boost productivity for SMEs; facilitate private sector deleveraging and strengthen SME access to finance. - Recent progress: Wage moderation continued; 2012 labor reform reduced severance payments and eased fair dismissals; implementation of Market Unity Law ongoing; elimination of several size-dependent tax incentives in 2015 CIT reform; efforts to increase market-based SME financing continue; “fresh start” reform implemented. - Staff recommendations: - Ensure wage growth in line with productivity and external competitiveness; ensure use of firm-level wage bargaining and opt outs, particularly by small firms; close protection gap between temporary and permanent contracts; reduce legal and administrative uncertainties in collective dismissals; enhance ALMPs. - Foster competition by implementing Market Unity Law and liberalizing professional services; eliminate unwarranted size-related obstacles to growth; support internationalization and innovation. - Strengthen SMEs access to finance, enhance market-based financing and financial reporting transparency, provide direct financing and guarantees through ICO; ensure fuller use of enhanced insolvency regime. ### Fiscal stance: Euro Area scorecard highlights and country indicators - The Scorecard table presents numerous indicators by country (2016 and 2016–17 values) including: Debt gap, Output gap, Change in unemployment, Real GDP growth, Stock-flow adjustments, 10-year bund spreads, Overall structural primary gaps, and signals for fiscal stance relative to thresholds. - Selected country datapoints (as presented in the table): - Euro area: -1.3 (Debt gap), 0.7 (Output gap 2016), 10.0 (Output gap 2016-17), 0.01 (Change in unemployment 2016), 1.89 (Real GDP growth 2016), 12.2 (10-year bund spreads 2016), ... -1.5 (Overall structural balance 2016), -0.8 (Change in structural balance 2016-17), -0.3 (Deviation from MTO 2016). - Germany: 0.3; 0.4; 4.2; 1.86; 83.3; 0.8; 0.7; No; -0.6; -1.1; ... 1.2; No. - France: -2.2; 0.4; 10.0; 1.29; 61.2; 31.8; -3.4; -1.9; Yes; -0.1; 0.5/0.8; -1.5; No. - Italy: -2.7; 1.0; 11.7; 0.91; 33; 1.9; 33.6; -2.4; -1.1; No; -0.2; 0.5; 0.6; -1.1; No. - Spain: -2.3; 1.7; 19.6; 3.29; 90.2; 124.3; -4.5; -3.0; Yes; 0.3; 0.5/0.5; -3.0; No. - Portugal: -2.7; 1.9; 11.1; 1.41; 302.5; 305.0; -2.0; -1.1; Yes; -0.3; 0.5; 0.6; -1.4; No. - Note on thresholds and coloring: table uses thresholds to signal fiscal stance (Strong tighten, Modest tighten, Neutral, Modest stimulus, Strong stimulus) across indicators; thresholds and coloring logic are defined in table footnotes. - Sources for table: Haver Analytics; WEO; EUR desks; EC Spring 2016 Country-Specific Recommendations (CSR) for 2017 (where indicated). *Source: INTERNATIONAL MONETARY FUND (excerpt from EURO AREA POLICIES chapter).* ### Appendix I. Progress Against IMF Recommendations ### Appendix I. Progress Against IMF Recommendations ### Structural Policies - Recommendation: Accelerate the implementation of structural reforms at the country level, to raise potential growth and narrow imbalances. - Action since 2016 Article IV: Compliance with the 2016 Country-Specific Recommendations (CSR) under the European Semester has been patchy. See Table 4 for country-specific information on reform progress. - Recommendation: A stronger governance framework, with CSRs linked to outcome-based benchmarks, could better incentivize reforms. - Action since 2016 Article IV: While considering progress toward correcting imbalances identified in the 2016 CSRs, the EC has once again used its discretionary powers to not to open the excessive imbalances procedure in several cases. Some progress on benchmarking. - Recommendation: At the regional level, further improvements to insolvency regimes; a greater push toward a single market in services, capital, transport, energy, and the digital economy; and ambitious free trade agreements would boost competitiveness and productivity. - Action since 2016 Article IV: - Some progress in implementing the 2015 Single Market strategy on services but other initiatives under discussion. - Legislation to remove geo-blocking is quite advanced. - The European Services e-card and minimum standards for corporate debt restructuring and insolvency could face protracted negotiations. - The Comprehensive Economic and Trade Agreement (CETA) was signed in 2016, but prospects for the Transatlantic Trade and Investment Partnership (TTIP) agreement have dimmed. ### Fiscal Policies - Recommendation: Countries with fiscal space should use it to promote public investment and structural reforms, while high-debt countries should use interest savings from QE to reduce debt. - Action since 2016 Article IV: Policy actions have been mixed. Some countries with fiscal space are easing their fiscal stance while others tighten. Some high-debt countries have made progress on fiscal adjustment, while others did not. - Recommendation: Centrally financed investment schemes could provide additional fiscal support. The European Fund for Strategic Investment (EFSI) could be enlarged. - Action since 2016 Article IV: The EC has proposed to expand the EFSI by around €200 billion and extend it to 2020. No progress has been made on developing other centrally financed investment schemes to provide additional fiscal support. - Recommendation: Stricter adherence to the fiscal rules is critical for rebuilding trust in the fiscal framework and backing more centralized initiatives; supported by simplifying the fiscal rules, making enforcement more automatic, and establishing an independent European Fiscal Board. - Action since 2016 Article IV: Compliance with the fiscal rules has been weak and enforcement has become increasingly discretionary, as exemplified by the lack of quantitative targets in CSRs. There are currently no proposals to reform the fiscal rules, though the European Fiscal Board has been established and begun operations. ### Monetary Policies - Recommendation: If the inflation outlook deteriorates or fails to converge more quickly to the anticipated adjustment path, further easing would be warranted, primarily from expanding asset purchases. - Action since 2016 Article IV: - In December 2016, the ECB extended the asset purchase program (APP) to end-2017 (from March 2017), or beyond, if necessary, and in any case until a sustained adjustment in the inflation path is achieved. - The monthly net asset purchases between April and December 2017 were set at €60 billion (down from €80 billion). - To facilitate a continued smooth implementation, parameters of the APP were adjusted as of January: - The maturity range of the public sector purchase program (PSPP) was broadened by decreasing the minimum remaining maturity for eligible securities for two years to one year. - Purchases of securities under the APP with a yield to maturity below the interest rate on the ECB’s deposit facility was permitted to the extent necessary. - Recommendation: Developing a common securities-lending framework for national central banks would facilitate access to high-quality collateral, improving market functioning and enhancing the effectiveness of monetary policy. - Action since 2016 Article IV: In December 2016, the ECB introduced cash collateral in the PSPP securities lending. The overall limit for securities lending against cash collateral was set at €50 billion for the Eurosystem. The cash collateral option will be offered at a rate equal to the lower of the rate of the deposit facility minus 30 basis points and the prevailing market repo rate. ### Financial Policies - Recommendation: A comprehensive approach to accelerating NPL resolutions is needed. The SSM should incentivize faster resolution through stricter supervision. Corporate insolvency and foreclosure frameworks should be strengthened and harmonized. Active markets in distressed assets should be promoted, including through AMCs. - Action since 2016 Article IV: - The SSM issued new guidance on NPLs, harmonizing and strengthening supervisory oversight of banks with large NPL stocks. - The EC advanced a proposal to harmonize some aspects of corporate insolvency and restructuring frameworks across member states. - Discussions on ways to further develop distressed debt markets are ongoing, with proposed options including an EU-wide NPL clearinghouse, national AMC blueprints, and a pan-European AMC (put forward by EBA). - Recommendation: Common deposit insurance and a common fiscal backstop are essential to completing the banking union. Greater risk-sharing should proceed hand-in-hand with measures to reduce banking sector risks. - Action since 2016 Article IV: There has been little progress on the banking union’s third pillar and a common fiscal backstop. Proposals to reduce banking sector risks and further harmonize have advanced, including: - Adoption of the leverage and net stable funding ratios as binding requirements. - A minimum, harmonized requirement for bail-inable liabilities. - A more harmonized bank creditor hierarchy. - Recommendation: Faster progress on capital markets union (CMU) would spur greater private risk-sharing and non-bank financing alternatives. - Action since 2016 Article IV: - The EU has adopted a framework for simple, transparent, and standardized securitization. - There is political agreement on a venture capital fund and regulation, and a revised prospectus regime to facilitate access to capital markets. - Improvements in other areas, such as securities ownership rules and corporate insolvency proceedings, are pending. - In the mid-term review of the CMU action plan, the EC presented new initiatives, including to strengthen the supervision of integrated capital markets. *International Monetary Fund—Appendix I. Progress Against IMF Recommendations* ### 5.11 The indicators measuring systemic risk in the EU financial system were revised in ### 5.11 The indicators measuring systemic risk in the EU financial system were revised in March 2017 ### Revision of the ESRB Risk Dashboard and statistical support - The Risk Dashboard of the European Systemic Risk Board (ESRB) is a quarterly publication comprising a set of quantitative and qualitative indicators measuring systemic risk in the EU financial system. - In compliance with its legal obligation of providing statistical support to the ESRB, the ECB assisted in the revision of the set of indicators to: - include new indicators on insurance corporations (based on the new Solvency II data); - include new indicators on central counterparties; and - discontinue four other indicators. - The ECB also provides statistical support to the ESRB through the Macroprudential Database, containing reliable and sound data for the identification, assessment and mitigation of systemic risks. - A public version of the Macroprudential Database, released in October 2015, contains around 270 indicators which are reviewed bi-annually. ### Enhanced external statistics for the euro area (EA) - In September 2016, the ECB started publishing monthly ECB and Eurosystem international reserves and foreign currency liquidity templates with a time lag of 15 days, advancing their publication by 15 calendar days. - Comprehensive quarterly balance of payments and international investment position of the EA have been published since April 2017 for all reference periods back to the first quarter of 1999. - Net external debt data for the EA with detail by sector and original maturity was also disseminated. ### New and extended supervisory and granular datasets - Supervisory Banking Statistics (started November 2016) - New dataset covering quarterly data on the financial health of significant banks directly supervised by the ECB. - Based on standardized information submitted pursuant to Commission Implementing Regulation (EU) No. 680/2014 and subsequent amendments. - Includes figures on balance sheet items, profitability, capital adequacy, risk exposure composition and asset quality. - Data are presented by country and along dimensions such as income sources, geographical diversification, size, sovereign exposures and overall assessment of banks’ riskiness. - Publication is completed by collection of solvency and leverage ratios as disclosed annually by significant banks pursuant with Part Eight of Regulation (EU) No 575/2013. - Further extensions (e.g., banks’ liquidity) are planned; the publication provides links to relevant Pillar 3 disclosures. - Money Market Statistical Reporting (MMSR) - Since July 1, 2016, the ECB receives transaction-by-transaction data from the 52 largest EA Monetary Financial Institutions (MFIs) covering secured, unsecured, foreign exchange swap and overnight index swaps transactions denominated in euro (volume and rates). - Reporting instructions are fully compliant with ISO 20022 standards. - Some aggregated indicators were scheduled to be released to the public in late 2017. - Securities holdings statistics - In August 2016, the ECB amended legal acts to collect additional accounting and credit risk attributes from banking groups. - As of 2018, the list of reporting banking groups will be extended to cover all significant groups directly supervised by the ECB. - Analytical credit datasets (AnaCredit Project) - In May 2016, the ECB adopted a legal act enabling the ESCB to collect granular information on credit granted from banks to financial and non-financial corporations and other legal persons based on a core set of harmonized concepts and definitions. - Aims to support monetary policy analysis and operations, risk management, financial stability surveillance, and macro-prudential policy. - The first reporting will take place in mid-November 2018 based on data as of September 2018. ### Household Finance and Consumption Survey (HFCS) — second wave results - Published in December 2016. - Covered more than 84,000 households in the EA (except Lithuania) as well as in Hungary and Poland. - Findings: - Between 2010 and 2014 the median net wealth of EA households decreased by 10 percent in real terms, mainly due to lower house prices. - Most inequality indicators, the Gini coefficient among them, only marginally increased. - Implication: the survey’s findings enable better understanding of how microeconomic heterogeneity can affect macroeconomic outcomes. ### Eurostat and EPSAS technical work on public sector accounting - Ongoing modernization and harmonization of public sector accounting standards in the context of EPSAS (European Public Sector Accounting Standards). - Four EPSAS Working Group meetings took place since September 2015. - Two-phase approach: - (1) increasing fiscal transparency in the short to medium term; - (2) working towards comparability in the medium to the longer term. - Current EPSAS work program comprises: - (a) developing the EPSAS framework (EPSAS governance, accounting principles and standards) and collecting information for impact considerations; - (b) supporting modernization of public accounting systems in EU member states; - (c) widening stakeholder engagement. - Elements of the EPSAS framework are under construction using small expert groups (“cells”). - Technical work completed recently includes first-time implementation guidance for accruals accounting and the “cell” on governance principles. - Ongoing technical work covers taxes, pensions, relief for smaller and less risky entities, heritage, infrastructure and military assets. ### Bank restructuring, resolution, liquidation cases and policy lessons (June–July 2017) - Recent cases: Banca Monte dei Paschi di Siena (Italy), Banco Popular Español (Spain), Banca Popolare di Vicenza and Veneto Banca (Italy). - Monte dei Paschi (MPS) - EU-wide stress tests in mid-2016 estimated a significant capital shortfall in an adverse scenario; the bank applied for precautionary recapitalization and received substantial liquidity support from Italian authorities in form of government guarantees for debt issuance. - ECB reconfirmed the bank met regulatory capital requirements on a point-in-time basis; Italian authorities requested approval to provide state aid via a precautionary recapitalization under the BRRD. - Atlante II committed to purchase most of the equity and mezzanine tranches of the bank’s securitized bad loan portfolio. - The European Commission’s Directorate General for Competition (DG-COMP) approved up to €5.4 billion of state aid in the context of a restructuring plan. - Banco Popular - Eurosystem approved substantial emergency liquidity assistance in early June 2017 in response to a deposit run; two working days later the bank was unable to post sufficient eligible collateral. - ECB in supervisory capacity deemed the bank failing or likely to fail on liquidity grounds. - The Single Resolution Board (SRB) determined limiting systemic risk warranted placing the bank into resolution under the BRRD and resolved the bank using the “sale of business tool.” - The action in Spain involved no state aid, with share capital and junior debt alone absorbing losses of €4 billion (equal to 2.7 percent of total liabilities at end-March 2017). - Banca Popolare di Vicenza and Veneto Banca - Had applied for precautionary recapitalization and benefited in early 2017 from substantial guarantees from the Italian state to support senior bond issuance. - ECB in late June deemed the two banks failing or likely to fail on capital grounds. - SRB determined the situation did not pose sufficient systemic risk to warrant resolution under the BRRD and passed the banks to Italian authorities for liquidation under national insolvency rules. - Italian authorities requested approval to provide state aid in liquidation on grounds of serious economic disturbance; DG-COMP agreed and approved up to about €17 billion of state aid to facilitate smooth market exit. - Loss sharing for Vicenza and Veneto: junior debt with a face value of about €1.2 billion (2.1 percent of end-March total liabilities) and share capital were written down to nil and left unfunded in the receiverships; separately, retail investors holding about €100 million were compensated. - Aggregate state aid and burden sharing observations - Actions in Italy involve state aid—up to €22½ billion or about 1⅓ percent of GDP, excluding previous guarantees on funding—under the 2013 Banking Communication. - For Monte dei Paschi: junior debt with a face value of €4.3 billion (2.9 percent of end-March total liabilities) is converted into equity, before provision of up to €1.5 billion of compensation to retail junior debtholders who were mis-sold. - The liquidation of Vicenza and Veneto with state aid likely left senior debtholders better off than they would have been in resolution under BRRD rules, where bail-in of at least 8 percent of total liabilities is a precondition for use of the Single Resolution Fund. ### Policy lessons, issues raised, and areas for reform - The review of the BRRD must clear hurdles to timely and efficient bank resolution and liquidation to: - address problems effectively and at least cost to taxpayers, the financial system, and the economy; - ensure early action and appropriate burden sharing, with state support limited to unambiguously systemic situations; - provide a robust safety net, including common deposit insurance and a fiscal backstop for the Single Resolution Fund. - Specific issues highlighted: - (i) improving interaction of emergency liquidity assistance or government guaranteed funding with assessments of whether a bank is “failing or likely to fail” on liquidity grounds; - (ii) need for accurate and timely information sharing on asset quality; - (iii) the lengthy procedures for precautionary recapitalization; - (iv) conflicting approaches to assessments of financial stability under the BRRD and serious economic disturbance under the TFEU; - (v) aspects of the 2013 Banking Communication, including its less demanding bail-in requirements (not mandatory for senior debt) than those for resolution under the BRRD (with the 8 percent threshold) and its section on state aid in liquidation. - These issues will be covered by the Financial Sector Assessment Program exercise for the euro area which is getting underway. *Prepared by European Department, July 18, 2017. Statement by Steffen Meyer, Executive Director for Germany, on behalf of the Euro Area Authorities, July 21, 2017.* ### 2018. The European Commission forecasts are broadly in line with those of the IMF, amidst ### cr17235 - 2018. The European Commission forecasts are broadly in line with those of the IMF, amidst ### Macro outlook and risks - The European Commission forecasts are broadly in line with those of the IMF amid a supportive policy mix, reduced uncertainty and an improved global outlook. - Risks are more balanced than before: - Internal: political uncertainty has receded markedly but crisis legacies remain significant in some countries, reducing their ability to withstand future shocks. - External: uncertain policy stance of key trading partners, the relationship with the United Kingdom once it exits the EU, and broader geopolitical and security developments. - Upside: positive momentum could lead to higher-than-expected growth. - Economic and confidence indicators have continued to firm up: - Improving household balance sheets and falling unemployment are expected to support consumption. - Expansion in investment looks set to continue, supported by the pick-up of construction from a very low level. - Optimism in surveys may reflect the brighter global environment and improved domestic political climate, though a stronger euro partly mitigates the export boost. ### External position and rebalancing - The authorities concur with staff that the euro area’s external position is broadly in line with medium-term fundamentals, but imbalances at the national level remain sizeable. - Adjustments have mainly occurred in countries with large net external liabilities: - Net external debtor countries that earlier had persistent current account deficits have maintained surpluses over the past four years, leading to a small improvement in their net foreign asset positions. - Persistent surpluses of large net external creditor countries have not shrunk significantly and in some cases have grown larger, due inter alia to high national saving and comparatively weak domestic investment. - Relative price adjustment at the national level would contribute to euro area rebalancing. - Absent adjustment, the net international investment positions of persistent surplus countries could grow over the medium term. ### Medium-term outlook, productivity and labour market - Delivering the right reforms at European and national levels is essential to increase productivity, resilience, and resume convergence. - Despite recovery in consumption, investment remains relatively weak, reducing future growth potential and contributing to the euro area’s current account surplus. - Banking sector weaknesses and large differences among countries could hamper a stronger recovery in investment. - Labour market: - Unemployment has been falling but remains relatively high in several member states. - Hours per worker have not recovered to pre-crisis levels as part-time employment has increased. - Despite closing output gaps, substantial slack remains; slow productivity growth is seen as preventing stronger wage growth. - Long-term unemployment remains a concern for potential growth and affected workers. ### Monetary policy and inflation outlook - The ECB's monetary policy measures have proven powerful in generating very favourable financing conditions that are supporting the ongoing economic expansion and the return of inflation towards levels below, but close to, 2 percent over the medium term. - Inflation developments continue to remain subdued: - Underlying inflation pressures remain low and should increase only gradually over the next two years, as the economic expansion has yet to translate into stronger inflation dynamics. - A very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term. - Strengthening economic growth must be supported by more decisive actions in other policy areas, including stepping up structural reforms and a more growth-friendly composition of public finances. ### Fiscal performance, governance and policy stance - Authorities broadly agree with staff that fiscal policies should reflect economic conditions and sustainability risks at Member State level, while ensuring effective co-ordination of economic policies in line with the Stability and Growth Pact. - Fiscal stance: - After strong consolidation during the crisis, the fiscal policy stance in the euro area turned broadly neutral in 2015–16 and is set to remain so in 2017, with a slight overall contraction due to lower debt servicing costs—according to the Commission 2017 spring forecast. - Fiscal stance in 2017 is expected to vary across Member States; based on the change in the structural primary balance, some countries are expected to have an expansionary stance, while only a limited number are expected to have a contractionary stance. - Challenges: - Fiscal sustainability risks remain in countries with high public debt, which may negatively impact growth in the medium term and increase vulnerability to adverse shocks. - Stability programmes submitted in April confirm most Member States plan to converge to their medium-term budgetary objectives, although some back-load consolidation as from 2018–19. - Authorities concur with staff recommendations of a broadly neutral fiscal stance for the euro area in 2018, balancing sustainability and support for investment. - Composition of public finances: - Member states that have outperformed their medium-term objectives are invited to continue prioritising investments to boost potential growth while preserving long-term sustainability. - Other countries should focus on rebuilding buffers and reducing vulnerabilities. - There is large scope in most euro area countries to reorient public expenditure towards more productive and socially efficient uses, improve the efficiency and growth friendliness of taxation and reduce the tax wedge on labour. - Governance and enforcement: - The Council and the Commission remain fully committed to the fiscal rules; predictable, transparent and consistent application of the Pact is crucial. - Consolidation results: 23 EU Member States were under the excessive deficit procedure (EDP) in 2009; this is now down to 4. - The aggregate headline deficit in the euro area fell to 1.5 percent of GDP last year while the debt-to-GDP ratio has consistently declined since 2014. - Consideration of a fiscal capacity at euro area level is part of a broader reflection on the future of Europe and strengthening the EMU; simplification of the fiscal rules can be seen as part of this process. - The European Commission published a reflection paper on the deepening of the Economic and Monetary Union on 31st May 2017. ### Balance sheet repair and financial architecture - Financial conditions have overall remained favourable amid supportive monetary policy and progress towards the Banking Union. - Credit and lending: - Banks used additional liquidity from the ECB's expanded asset purchase programme to grant loans. - Lending rates for both euro area households and non-financial corporates remained at record low levels. - Credit standards on loans to both sectors eased somewhat further, mostly driven by competitive pressure. - Residential mortgage credit growth has remained broadly stable at moderate levels, with heterogeneous developments across countries. - Corporate sector credit growth continued to recover. - Bank lending and firms’ access to finance surveys signalled improvements in the availability of external finance, including for SMEs. - Banking sector profitability remained low despite improvements: - Profitability outturns and expectations have improved, and broad dispersion of profitability among EU banks has somewhat narrowed, but challenges to reach adequate levels of profitability remain pressing. - Reducing overcapacity can be accomplished by banks internally or by (cross-border) mergers and acquisitions, resolutions or market exits. - Non-performing loans (NPLs) and repair: - Overall level of NPLs has declined, but dispersion among countries remains wide and the pace of NPL resolution remains steady but slow. - The ECB's Guidance to banks on NPLs (published at the end of March) should be used as an inspiration of best practices for significant banking institutions. - The Action Plan to Tackle NPLs in Europe endorsed by the ECOFIN Council in July stressed a comprehensive approach combining supervision, structural reforms (including insolvency and debt recovery frameworks), development of secondary markets for NPLs, and banking system restructuring. - The Commission launched a public consultation on how to spur development of secondary markets for NPLs to speed up disposals. - Banking Union and Capital Markets Union (CMU): - Authorities broadly share staff's views on completing the Banking Union with regard to risk reduction and risk sharing, including a European Deposit Insurance Scheme and making the common backstop for the Single Resolution Fund operational at the latest by the end of the Fund’s transitional period. - Further progress has been made towards establishing a Capital Market Union; nearly two thirds of the actions have already been delivered. - The July Council adopted conclusions on the Commission's review of the CMU action plan, aimed at securing the building block for a fully-fledged capital markets union by the end of 2019. - Pending improvements include securities ownership rules and corporate insolvency proceedings; new action items include enhanced supervisory powers for the European Supervisory Authorities (ESA), potential revisions to prudential treatment of investment firms, and measures to encourage FinTech and sustainable finance. ### Structural reforms at Member State level - Well-designed and sequenced structural reforms—if fully implemented—can have sizeable positive medium-term impacts on potential growth and the euro area's adjustment capacity. - Priorities: - Product market reforms should be prioritised as they entail few relevant short-term costs. - Labour market reforms need cautious sequencing and appropriate support. - All countries should prioritize reforms to improve the investment climate, including incentives to favour investment, effective insolvency regimes and public administrations. - Strengthening competition, improving price responsiveness and lowering entry barriers would positively impact investment. - Coordinated implementation of reforms by Member States can produce higher gains, especially with low inflation and interest rates when multipliers are high and potential spillovers are larger. - European Semester and Country-Specific Recommendations (CSRs): - EU Institutions continue to promote and monitor structural reforms via the European Semester. - Implementation of CSRs has been uneven across policy areas and countries; progress more notable in fiscal policy and fiscal governance, active labour market policies, taxation policies, social policies and financial services. - Considering a multi-annual horizon, the large majority of CSRs have seen good progress; long-term structural issues take time to show tangible results. - Measures to improve long-term sustainability of public finances, competition in services and the business environment have lagged behind. - Macroeconomic Imbalance Procedure (MIP): - Authorities believe MIP should be used to its full potential, with the corrective arm applied where appropriate. - MIP surveillance has improved policy dialogue, raised awareness about reform needs and created conditions for more effective surveillance, complemented by technical assistance, peer pressure and support. - Results have been evident for some countries identified with excessive imbalances (e.g., Spain, Slovenia, and Croatia). - A recent survey by the European Court of Auditors indicates Member States see the MIP as having a positive impact on policy implementation. - Convergence and benchmarking: - Higher economic and social convergence can be achieved through structural reforms, higher growth and actions to address inequality. - The crisis of 2007–08 marked the end of the convergence trend and the start of a divergence trend, which is only slowly being corrected. - Benchmarking (cross-examination against indicators) can identify needs, monitor progress, communicate results and increase ownership of reforms. - Some benchmarks have been agreed in areas of tax wedges and pensions; Commission is developing further benchmarks and exchanges of best practice. ### Deepening the Single Market and EMU framework - Authorities concur on the need to deepen the Single Market to unlock investment potential and raise productivity: - Commission initiatives include developing the Capital Markets Union, deepening market integration for services and products, completing the Energy Union and establishing a true Digital Single Market. - Work ongoing on enforcement of single market rules, business services cross-border provision, business restructuring and insolvency, and creating a simple, modern and fraud-proof VAT system. - Thorough implementation and enforcement of additional key measures in the 2015 Single Market Strategy would be positive for growth. - EU commitment to open and fair trade evidenced by the agreement of July 6th on principles of an Economic Partnership Agreement between the EU and Japan, the first international trade agreement to include a clear commitment to fight climate change and support the Paris goals. - Deepening of the EMU framework: - Current favourable environment should be used to address shortcomings in the EMU design and functioning and step-up EMU reform delivery. - Range of ideas, including those in the Commission reflection paper, will be explored to achieve a more complete and resilient architecture capable of delivering higher growth and stronger economic and social convergence. - Completing the Banking Union and the Capital Markets Union are key priorities. - Furthering principles of responsibility and solidarity, legitimacy and accountability rests on improving policies and their delivery at national and EU level. - Authorities welcome exchanges of views with the Fund on these issues during the next Article IV consultations. *Source: cr17235 - 2018. The European Commission forecasts are broadly in line with those of the IMF, amidst* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17235.pdf_