## 1. The COVID-19 Crisis and Its Potential Impact on Regional Disparities and Inequality ## Source details **Canonical URL:** [1. The COVID-19 Crisis and Its Potential Impact on Regional Disparities and Inequality](https://www.imf.org/-/media/files/publications/cr/2020/english/1eurea2020001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2020/english/1eurea2020001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2020/english/1eurea2020001.pdf.json) --- ### Context and initial impact - Pre-COVID: banks reduced NPLs and increased capital buffers; fiscal space varied; real GDP growth decelerated in 2018–19; inflation persistently undershot the ECB’s medium-term aim. - Pandemic timeline and output: - First reported case in January; first wave contained by lockdowns; reopening led to renewed exponential increases and reinstated lockdowns. - Euro area real GDP: -3½ percent (q/q) in 2020Q1; -12 percent (q/q) in 2020Q2; flash + nearly 13 percent (q/q) in 2020Q3. - Output remained 4½ percent below pre-pandemic level after Q3 rebound. - Demand composition of contraction: mainly private consumption, plus sizable decline in gross fixed capital formation and lower net exports. - Labor market and short-time work: - Widespread short-time work programs limited job destruction. - Euro area unemployment: increased to 8.4 percent (October, seasonally adjusted) in 2020 (up 1 percentage point). - U.S. unemployment rose by about 3½ percentage points over the pandemic. - Participation rate declined. - High-frequency indicators: - Composite PMI in contractionary territory (November); services deteriorated; manufacturing expanded slower. - Retail sales rebounded above pre-crisis levels; mobility declined after renewed lockdowns. - Inflation: - Headline inflation: 1.4 percent (y/y) in December 2019 → 0.1 percent in May → -0.3 percent (November). - Core inflation (HICP excluding energy and unprocessed food): weakened to 0.4 percent in recent months. - Market-based long-term inflation expectations partly recovered but remain below historic averages. ### Policy response — fiscal, EU, and ECB - National fiscal responses: - Automatic stabilizers ≈ 5 percent of GDP. - Discretionary above-the-line measures: over 5 percent of euro area GDP overall; country range 3.1 percent (Finland) to 9.4 percent (Germany). - Commitments could exceed 20 percent of euro area GDP if all guarantees were called. - EU-level support: - March: greater flexibility in EU funds, activation of escape clause, temporary state-aid allowance. - May: financing support >4 percent of EU27 GDP. - €87 billion in SURE loans approved for short-time work schemes. - July: European Council agreement on €750 billion NGEU (grants and loans). - ECB and financial-sector measures: - APP topped up by €120 billion in 2020; PEPP introduced initially with €750 billion. - PEPP later augmented to €1.35 trillion; minimum expected horizon for net purchases extended to mid-2021. - June TLTRO: 742 banks participated for over €1.3 trillion, €548 billion fresh liquidity; September allotment net uptake €158 billion. - ECB Banking Supervision permitted use of buffers and applied restrictions on dividends and buybacks. - Financial markets: - Financial stress initially rose to GFC-like levels; accommodative policies restored confidence and risky asset prices. - Spreads narrowed between hardest-hit countries and Germany. - Corporate credit growth and net issuance rose substantially in 2020H1; consumer credit largely stagnated. - Late-2020 tightening of credit conditions as mobility restrictions tightened. ### External sector: recent developments - 2019 current account surplus: 2.3 percent of GDP (down from 2.9 percent in 2018). - 2020Q3: current account narrowed as services receipts (notably tourism) collapsed; income balance fell slightly; goods balance improved as imports weakened more than exports. - REER appreciation and strong fiscal stimulus may have moderated the current account in 2020Q3. - Preliminary 2020 indication: overall external position broadly in line with medium-term fundamentals (high uncertainty). ### Near-term outlook and risks - Recovery conditional on pandemic dynamics and medium-term challenges: - Staff expects lower growth through 2021Q1, rebound timing uncertain. - Assumes effective vaccine/therapies not widely available until summer 2021. - Contact-intensive sectors (retail, accommodation and food services) likely face persistent negative demand shocks. - Long-term scarring from bankruptcies and capital destruction to weigh on growth. - Staff projection (near term): - Real GDP to fall by about 8 percent in 2020. - Private domestic demand will not fully recover; private investment expected to remain muted. - Sluggish global demand to weigh on exports/imports; end-2021 real GDP projected to remain below end-2019 level. - Key risks: - Insufficient fiscal support, delays in NGEU implementation, premature withdrawal of support. - Major resurgences or delays in vaccine development/distribution. - Widespread outbreaks in trading partners reducing external demand. - Longer crisis could increase scarring and social discontent. ### Distributional and regional impacts - Pandemic expected to exacerbate regional disparities and inequality: - Post-GFC disparities driven by employment and productivity divergences likely amplified. - Highly affected-sector workers (often young, low liquidity buffers) disproportionately impacted. - Poorer regions with higher shares of non-teleworkable jobs likely to see increased income gaps. - Cross-country heterogeneity: - Among DEU, ESP, FRA, ITA, gap in share of highly affected workers between top 10 percent and bottom 10 percent of income distribution: almost 20 percentage points in Italy and Spain; <5 percentage points in Germany and France. - Intergenerational inequality: young workers concentrated in highly affected, non-teleworkable sectors and lower quintiles of income/wealth. --- ### Projections and key macro indicators (WEO, October 2020 aggregation and staff tables) - Real GDP growth: 2019: 1.3; 2020: -8.3; 2021: 5.2; 2022: 3.1; 2023: 2.2; 2024: 1.7; 2025: 1.4 - Contributions to growth (ppt) — Private consumption (2019–2025): 0.7, -5.0, 2.9, 1.7, 1.0, 0.8, 0.7 - Current account (%GDP): 2.3, 1.9, 2.4, 2.5, 2.5, 2.6, 2.5 (2019–2025) - Unemployment rate: 7.6, 8.9, 9.1, 8.4, 7.9, 7.7, 7.6 (2019–2025) - Potential GDP growth: 1.3, -3.2, 3.1, 1.4, 1.2, 1.3, 1.2 (2019–2025) - Output gap: 0.2, -5.1, -3.2, -1.6, -0.6, -0.2, 0.0 (2019–2025) - Inflation: 1.2, 0.4, 0.9, 1.2, 1.4, 1.6, 1.7 (2019–2025) - Graphic note: Output loss in 2025: -3.2% --- ### Corporate sector vulnerability (Box 2 key results) - IMF staff simulations for nearly 2 million companies in 13 euro area countries indicate: - Remaining liquidity and equity gaps after policy support could reach 4.7 and 2.4 percent of GDP, respectively. - Share of illiquid firms could rise by 5 percentage points to 21 percent; insolvent firms by 8 percentage points to 19 percent. - Liquidity risks easier to address than solvency; most gaps originate from SMEs. - Sectors most at risk: food and accommodation, construction, trade. ### Banking sector and financial stability - Bank implications: - Over 60 percent of banks’ corporate exposures are to highly affected sectors (notably real estate and trade). - More than half of bank lending is to households, especially mortgages. - Staff analysis (end-2019 bank-level and 2020 EBA data): - Under October WEO path, aggregate capital-to-asset ratio would almost fully recover by end-2021 after initial drop; two banks remain below 3 percent threshold even after moratoria and guarantees. - Debt moratoria and guarantees provide a cushion ≈ 1.2 percentage points. - Illustrative downside scenario (GDP growth -0.9 and -2.7 percentage points below baseline in 2020 and 2021): capital-to-asset ratio declines by additional 0.2 percentage point in 2020 and barely improves in 2021; six banks fall below threshold. - Bank lending capacity after provisioning (staff): about €0.3 and €0.9 trillion to households and nonfinancial corporates, respectively (equivalent to 4 and 9 percent of current stock of loans). ### NPLs, AMCs, and crisis management - Recommendations: - Rapidly close gaps in crisis management framework, harmonize emergency liquidity arrangements, make SRB powers more usable, introduce ESM treaty reform and common SRF backstop. - Consider network of national AMCs with common NPL data templates, transaction platforms, valuation methodologies; pan‑European AMC politically and operationally challenging. - Swift balance-sheet repair, normalize prudential standards, strengthen insolvency regimes, use out-of-court restructuring, and implement European Restructuring and Insolvency Directive. --- ### NGEU: structure, allocations, and simulated macro impact ### Package structure and headline allocations - European Commission to borrow €750 billion to finance €390 billion in grants and €360 billion in loans. - Main component: Recovery and Resilience Facility (RRF) disbursing loans and bulk of grants (€312.5 billion). - Repayment foreseen over 2028–58 from new EU revenues or additional country contributions. - Implementation details, including repayment modalities, remain to be clarified. ### Allocation principles and country examples - Allocation over entire period: proportional to population and inversely proportional to per capita income. - 2021–22 (70 percent of funds): also considers 2015–19 unemployment rate. - 2023 (30 percent): reflect economic impact of crisis. - Country-level grant shares (percent of 2019 GDP) under assumptions: - Croatia, Bulgaria, Greece: between 8½ and 11 percent of 2019 GDP. - Italy: 3.7 percent of GDP. - Spain: 4.8 percent of GDP. ### Macro simulations and results (EUROMOD assumptions) - Assumptions: two thirds of grants translate into additional public spending, one third finance already-planned spending, spread over 2021–24; monetary policy accommodative. - RRF grants potential impact: - Increase EU27 real GDP by over 1½ percent in 2023 relative to counterfactual without grants. - Counterfactual EU27 real GDP estimated 1½ percentage points lower than in model simulations by 2023—or ¾ of a percentage point lower than October 2020 WEO projections (which already incorporate some grant impact). - Debt dynamics: - Aggregate EU27 national government debt ratios forecast to decline starting in 2021 (excluding EU-issued NGEU debt). - Including EU-issued debt, aggregate ratio starts declining in 2022 and falls by less. ### Policy guidance for NGEU and national fiscal priorities - Near-term NGEU priority: accelerate green and digital transformations. - European Council agreed 30 percent of combined EU budget and NGEU (~€555 billion over 2021–27) to support climate measures. - RRF: at least 37 percent to climate change and 20 percent to digitalization; countries should aim to exceed these targets. - Emission reduction strategy: public investment, stronger carbon pricing, expanding ETS, complementary nonprice policies, transfers to protect lower-income households. - National fiscal sequencing: - Continue supportive fiscal policies prioritizing health containment, support to households and viable firms, and productive public investment. - Pace of withdrawing support should be state contingent. - High-debt countries: - Avoid withdrawing support too quickly; full use of EU financing and ECB accommodation important. - Costs of tightening too soon outweigh costs of slightly higher debt for a few years. --- ### Monetary policy stance, strategy review, and asset purchases ### Near-term stance and tools - PEPP: flexible tool; can be expanded in size and duration to counter market fragmentation and medium-term inflation gaps. - Deposit rate: reduced by 10 bps to -0.5 percent (September 2019). - Additional rate cuts technically feasible but likely limited effect on lending given credit risk and profitability concerns. - Complementary measures: adjust tiering multiplier; continue targeted/untargeted LTROs; forceful forward guidance. ### Asset purchases and communication - Expansion of asset purchases should remain main tool to offset disinflationary pressures. - Communication priorities: - Explain proportionality assessments and capital key deviations. - Clarify exit and reinvestment strategies. - Considerations if inflation deteriorates materially: - Substantial additional accommodation; consider new tools. - Yield curve control (YCC) faces legal and operational complexities. ### Alternative monetary frameworks (ZLB context) - Simulations under a binding ZLB show: - AIT and PLT can improve conditional outlooks if fully credible and well communicated. - Permanent adoption of AIT/PLT raises unconditional output gap volatility and deeper recessions (PLT notably). - Table 2 (exact regime statistics) — selected entries (regime = Inflation Mean; Output gap Mean; P(pi<0); P(r<=0)): - Symmetric ZLB: Inflation Mean: 1.96; Output gap Mean: -0.23; P(pi<0): 2.62; P(r<=0): 5.38 - Lower Target, ZLB: Inflation Mean: 1.44; Output gap Mean: -0.37; P(pi<0): 8.19; P(r<=0): 8.48 - AIT, ZLB: Inflation Mean: 1.98; Output gap Mean: -0.11; P(pi<0): 1.34; P(r<=0): 4.17 - PLT, ZLB: Inflation Mean: 2.00; Output gap Mean: -0.22; P(pi<0): 0.07; P(r<=0): 15.50 - Findings: - Lowering symmetric inflation target to 1.5 percent increases deflation risk and output shortfalls. - A “target band” for inflation triggers larger fluctuations than a point-target regime. - UMP deployment: - UMP tools (negative rates to -1, forward guidance, asset purchases) improve modal outlooks and lower deflation and downside activity risks. - State-contingent large-scale asset purchases reduce downside risk. ### ECB strategy review - Review scheduled to conclude by mid-2021; staff suggests a clear, well-communicated symmetric point inflation target would be desirable. - Flexible average inflation targeting could help re-anchor expectations but may raise output volatility and have financial stability implications. --- ### Key policy recommendations and priorities (staff appraisal and summary) - Finalize and operationalize NGEU/RRF rapidly; link funds to progress on country-specific reform recommendations. - Maintain national fiscal support while recovery is fragile; keep escape clause activated and reform EU fiscal rules. - Continue bold monetary accommodation; asset purchases should remain primary tool; consider further instruments if inflation outlook weakens. - Codify a symmetric point inflation target or explore AIT in ECB strategy review. - Maintain targeted financial sector support while rebuilding buffers; use stress tests to identify capital shortfalls and prepare for precautionary recapitalizations. - Strengthen insolvency regimes, out-of-court restructuring capacity; develop markets for distressed assets and consider networks of national AMCs. - Complete Banking Union and Capital Markets Union priorities; finalize ESM treaty reform and SRF backstop. - Phase out job retention schemes as recovery allows; reallocate support to facilitate labor mobility, reskilling, and targeted firm support. - Target policies to mitigate regional disparities, inequality, and poverty with special focus on young and disadvantaged groups. - Uphold and modernize the multilateral rules-based trading system; carefully design any EU carbon border adjustment mechanism to avoid trade retaliation. --- *Italic line: Source: IMF staff compilation from the Euro Area Policies chapter (PDF content unit 1eurea2020001).* ### 1. The COVID-19 Crisis and Its Potential Impact on Regional Disparities and Inequality _________ 13 ### 1. The COVID-19 Crisis and Its Potential Impact on Regional Disparities and Inequality _________ 13 ### Context: Pre-COVID landscape - Euro area resilience improved before the pandemic, with banks reducing nonperforming loans (NPLs) and increasing capital buffers. - Fiscal policy space varied significantly across countries; high-debt countries made limited or no progress in rebuilding fiscal buffers. - Progress on increasing public and private cross-border risk sharing and completing the banking union stalled due to lack of political support. - Real GDP growth decelerated in 2018 and 2019; the economy was estimated to have been operating around potential with the employment rate at an all-time high. - Inflation persistently undershot the ECB’s medium-term aim. - Deep structural issues: low investment, uneven structural reforms, large productivity and competitiveness gaps, high structural unemployment, and lingering poverty in some countries; low productivity growth in lower-income countries reversed income convergence and contributed to subdued potential growth. ### The initial impact of the pandemic and policy response - Pandemic dynamics and containment measures: - First reported case in January; first wave contained by unprecedented lockdown measures; reopening led to renewed exponential increases in infections and reinstated lockdowns. - Mortality, although increasing, remained below April levels. - Real GDP and demand shocks: - Euro area real GDP plummeted by 3½ percent (q/q) in 2020Q1. - Euro area real GDP fell by 12 percent (q/q) in 2020Q2 as mobility substantially dropped. - Flash estimates for 2020Q3 point to a record rebound of nearly 13 percent (q/q). - Despite the rebound, output remains 4½ percent below its pre-pandemic level. - Contraction driven mainly by private consumption, plus sizable decline in gross fixed capital formation and lower net exports. - Labor market and short-time work programs: - Widespread use of short-time work programs helped adjust hours worked without large job destruction. - Euro area unemployment rate increased by one percentage point to 8.4 percent (October, seasonally adjusted) in 2020. - By comparison, the U.S. unemployment rate increased by about 3½ percentage points during the pandemic. - Participation rate declined, reflecting labor market stress and exit of discouraged workers. - High-frequency indicators and momentum: - Composite PMI shifted into contractionary territory (November); services deteriorated, manufacturing continued to expand at a slower pace. - Retail sales rebounded above pre-crisis levels, but mobility indicators declined after re-imposition of lockdowns. - Economic sentiment weakened; consumer confidence deteriorated in October and November. - Inflation and expectations: - Headline inflation declined from 1.4 percent (y/y) in December 2019 to 0.1 percent in May. - Headline inflation descended into negative territory at -0.3 percent (November). - Core inflation (HICP excluding energy and unprocessed food) weakened to 0.4 percent in recent months. - Market-based long-term inflation expectations partly recovered but remain well below historic averages. ### Fiscal, EU, and ECB policy responses - National fiscal responses: - Automatic stabilizers worth about 5 percent of GDP. - Discretionary fiscal response: above-the-line measures worth over 5 percent of euro area GDP overall, ranging from 3.1 percent of GDP in Finland to 9.4 percent of GDP in Germany. - Measures included increased health spending, expanded or new short-time work schemes, temporary tax cuts and/or deferrals, financial support to firms, and guarantees for bank lending to businesses. - Commitments could exceed 20 percent of euro area GDP if all guarantees were called. - Take-up rates of financial support have been lower in some countries that announced large packages (e.g., Germany). - EU-level support: - March: greater flexibility in use of EU funds (Coronavirus Response Investment Initiative Plus), activation of the escape clause in fiscal rules, temporary allowance of state aid to firms. - May: package of financing support worth over 4 percent of EU27 GDP. - €87 billion in SURE loans approved to support countries’ short-time work schemes. - July: European Council reached agreement on the €750 billion Next Generation EU (NGEU) package to provide grants and loans over the next few years. - ECB and financial-sector measures: - ECB topped up the APP by €120 billion in 2020 and introduced PEPP with an initial envelope of €750 billion. - PEPP later augmented to €1.35 trillion and minimum expected horizon for net purchases extended by half a year to mid-2021. - PEPP’s flexible design allowed purchases at shorter maturities and lower credit quality than under APP. - ECB relaxed collateral requirements and provided substantial liquidity via targeted and untargeted LTROs. - June targeted LTRO (TLTRO) registered 742 banks participating for a total of over €1.3 trillion, of which €548 billion was fresh liquidity; September allotment net uptake was €158 billion. - ECB Banking Supervision allowed use of capital conservation buffers, temporary operation below Pillar 2 guidance and liquidity coverage ratio, flexibility in classification and provisioning of loans backed by public support, and relaxation of countercyclical capital buffers; restrictions on dividend distribution and share buybacks were applied. - Financial market developments: - Initial increase in financial stress to GFC-like levels; accommodative policy measures restored confidence and risky asset prices largely recovered. - Spreads between hardest-hit euro area countries and Germany narrowed significantly. - Corporate credit growth and net issuance of debt increased substantially in 2020H1; consumer credit largely stagnated. - As governments tightened mobility restrictions during the second wave, market sentiment deteriorated with incipient tightening of credit conditions in 2020Q3 and early signs of slowing credit growth. ### External sector and current account - 2019 current account surplus: 2.3 percent of GDP, down from 2.9 percent in 2018, due to lower services and investment income offsetting a stronger goods balance. - By 2020Q3 the current account narrowed further as services receipts collapsed (notably tourism) and the income balance fell slightly; weakness in imports exceeded that in exports, slightly improving the goods balance. - Recent REER appreciation and strong fiscal stimulus may have contributed to further moderation of the current account in 2020Q3. - Developments in 2020 suggest a shift toward the overall external position being broadly in line with medium-term fundamentals and desirable policies (highly uncertain given incomplete 2020 data). ### Outlook and risks - Recovery contingent on pandemic dynamics and medium-term challenges: - Staff expects lower growth through 2021Q1 followed by a rebound of uncertain timing thereafter. - An effective vaccine or therapies/treatments are assumed not to be widely available until the summer of 2021. - Renewed outbreaks are expected to be accompanied by ramped-up testing and local lockdowns. - Contact-intensive sectors (retail, accommodation and food services) likely to suffer persistent negative demand shocks with social distancing embedded in business models. - Long-term scarring from higher bankruptcies and destruction of physical and human capital likely to weigh on near- and medium-term growth. - Near-term outlook (2020–21): - Staff projects real GDP to fall by about 8 percent this year. - Private domestic demand, which sharply contracted in the first half of 2020, will not fully recover and private investment is expected to remain muted amid elevated uncertainty. - Sluggish global demand projected to weigh on export-oriented economies, with both imports and exports recovering only slightly in 2021. - At the end of 2021, real GDP is projected to remain below its end-2019 level. *International Monetary Fund — Chapter: "1. The COVID-19 Crisis and Its Potential Impact on Regional Disparities and Inequality" (source PDF).* ### 17. Notwithstanding the waning of temporary supply-side effects, inflation is expected to ### 1eurea2020001 - 17. Notwithstanding the waning of temporary supply-side effects, inflation is expected to ### Inflation outlook (near term) - Average headline inflation in 2020 is projected to fall to just above zero in 2020 due to: - Collapse in aggregate demand exceeding the fall in potential output, producing a sizable output gap and downward pressures on prices. - Drag from negative energy price growth and other temporary factors (e.g., the German VAT cut). - Average core inflation is projected to hit an historically low level of below one percent in 2020. - In 2021: - Headline inflation is expected to recover gradually as some temporary disinflationary effects fade. - Average core inflation is projected to remain broadly unchanged due to the high degree of inflation persistence in the euro area. ### Medium-term prospects - The gradual recovery is expected to leave permanent output losses relative to the pre-crisis trajectory, with inflation remaining low. - Key dynamics: - Sluggish growth in private consumption and investment from 2022 onward will drag on the recovery. - Contribution of net exports to growth projected to remain broadly neutral over the medium term despite a modest recovery of exports. - Reflecting long-term scarring effects on potential growth, output is expected to remain well below its pre-COVID trend throughout the medium term. - Given a high degree of inflation persistence and a flat Phillips curve, inflation will only gradually pick up with the recovery and is forecast to remain well below the ECB’s medium-term aim throughout most of the projection horizon. ### Distributional impacts and regional disparities - The pandemic is expected to exacerbate regional disparities and inequality in the euro area: - Post-GFC disparities increased across countries and regions mainly due to divergences in employment rates and productivity; the current crisis likely amplifies these patterns. - Workers in highly affected sectors (more likely to be young and lack liquidity buffers) are disproportionately impacted. - Poorer regions—already facing structural challenges—are likely to see income gaps further increase given their higher share of non-teleworkable jobs. - Box highlights: - Laggard regions characterized by higher shares of contact-intensive sectors, large dependency on SMEs, lower productivity, and lower shares of teleworkable employment. - The pandemic may exacerbate intergenerational inequality: young workers more likely employed in highly affected and non-teleworkable sectors, and concentrated in lower quintiles of income and wealth distributions. - Disproportionality across countries: among DEU, ESP, FRA, ITA the gap in the share of highly affected workers between the top 10 percent and the bottom 10 percent in the income distribution reaches almost 20 percentage points in Italy and Spain but less than 5 percentage points in Germany and France. ### Risks to the outlook (substantial known and unknown risks) - Risks are sizable and depend materially on the policy response; finding balance between containment and recovery-support measures is extremely challenging given epidemiological uncertainty. - Key risk factors: - Insufficient fiscal support, delays in implementing the NGEU recovery package, or withdrawing support too early would weaken the recovery. - Major resurgences of infections or delays in vaccine/therapy development/distribution would result in deeper scarring, slower recovery, and further output loss. - A widespread outbreak in key trading partners would significantly lower external demand and undermine growth. - Longer and deeper crisis could exacerbate scarring and lead to social discontent, especially if vulnerable groups are left behind. - Sector- and agent-specific downside scenarios: - Households: If crisis drags on, more layoffs and a substantial increase in unemployment are inevitable; absent reallocation policies, labor market hysteresis could drag productivity for years and increase poverty and inequality; household income losses could lead to mortgage defaults, foreclosures, and downward pressures on residential property prices. - Nonfinancial corporate sector: With prolonged crisis and support expiring, liquidity problems could morph into credit defaults; delayed insolvency proceedings and inefficient bankruptcy procedures in some countries will stifle recovery; higher corporate debt raises exposure to market volatility and adverse macro-financial feedback loops. - Banks: Deterioration in asset quality from rising bankruptcies, mortgage defaults, and falling property prices could cause capital shortfalls and higher risk aversion, impairing lending; structurally low profitability and a slow recovery will constrain banks' ability to rebuild capital buffers or raise fresh capital. ### Fiscal vulnerabilities - The crisis has exacerbated fiscal vulnerabilities: - Debt levels have risen considerably in all euro area countries and are expected to remain above or close to 2019 levels for the foreseeable future in most countries. - Government loan guarantees and other liquidity support have created potentially sizable contingent liabilities—averaging around 20 percent of GDP in euro area countries with government debt already above 100 percent of GDP. - Current favorable financing conditions help governments finance large deficits and rollover needs this year and next, but budget plans were drafted without accounting for a major second wave, suggesting deficits in 2021 will be higher than forecast in October, further eroding fiscal space. - Larger public debt increases will leave highly indebted sovereigns more vulnerable; large changes in market perceptions could threaten the ability of high-debt countries to roll over and service public debt. - If a prolonged crisis undermines banking sector solvency, pressure to bail out banks could precipitate a spike in sovereign borrowing costs for some countries. ### Brexit, trade tensions, and external risks - Brexit and trade tensions remain significant risks to the recovery: - Gaps remain between the U.K. and EU27 on their future relationship; proposed unilateral modification of the Withdrawal Agreement increased perceived likelihood of a no-deal Brexit with potential sharp trade disruptions when the transition period expires at the end of 2020. - Temporary equivalence grants EU-based financial institutions continued access to U.K. market infrastructures for clearing and settlement services until mid-2022 and mid-2021, respectively; no agreement on regulatory equivalence remains. - Trade tensions with the United States and potential tensions with China pose additional risks even if some tensions abate. - Staff analysis (conditional on specific assumptions) suggests a no-deal Brexit (default to WTO rules) would result in an EU output loss (relative to the baseline) of 0.5 percent within three years and 0.3 percent over the longer term. ### Corporate sector vulnerability and policy role (Box 2) - Firms have weathered the shock relatively well so far due to exceptional policy support; rating downgrades and defaults have risen but less than during the global financial crisis. - Policy responses varied across countries: wage subsidies, debt moratoria, tax deferrals, grants, equity injections, and widespread bank loan guarantees (more than half of total policy support in the euro area). - Staff simulations (based on October 2020 WEO projections and announced policies) for nearly 2 million companies in 13 euro area countries indicate: - Remaining liquidity and equity gaps after policy support could reach 4.7 and 2.4 percent of GDP, respectively. - Share of illiquid and insolvent firms could rise by 5 and 8 percentage points to 21 and 19 percent, respectively—significantly higher without policy support. - Liquidity risks may be easier to address than solvency ones; solvency gaps would remain large due to the COVID-related surge in leverage. - Most liquidity and solvency gaps originate from SMEs; sectors most at risk include food and accommodation, construction, and trade. ### Upside scenarios - Early access to effective and widely available vaccines and therapies and/or faster-than-expected adjustment to the virus are key upside risks: - Rapid confirmation of promising vaccine developments would likely instill confidence and result in faster-than-expected re-openings. - Quick business and consumer adjustment to a “new normal” would limit scarring and adverse productivity impacts even absent immediate vaccines or therapies. - Authorities noted upside from medical breakthroughs, ambitious and swift implementation of the NGEU/RRF funds, and a possible EU–U.K. trade agreement. ### Authorities' views - Authorities broadly agreed the pandemic is the main source of uncertainty with the second wave weighing on near-term activity and expected a pickup in activity only next year as containment measures are lifted. - Authorities expect the recovery to remain incomplete until end-2022 and to vary widely across countries. - On inflation: authorities expected downward pressures to prevail, with inflation in negative territory until early 2021 before gradually increasing; they did not see a high risk of deflationary pressures but expressed concern about duration of temporary disinflationary factors and renewed lockdowns' impact on demand. - Authorities saw important downside risks (prolonged health crisis, possible bank-sovereign-corporate feedback loops) and upside risks (medical breakthroughs, swift NGEU/RRF implementation, EU–U.K. trade agreement). Brexit-related financial stability risks appeared contained given preparations by banks, insurers, and asset managers. ### Projections and key statistics (World Economic Outlook, October 2020) - Real GDP growth: - 2019: 1.3 - 2020: -8.3 - 2021: 5.2 - 2022: 3.1 - 2023: 2.2 - 2024: 1.7 - 2025: 1.4 - Contributions to growth (ppt): - Private consumption: 0.7, -5.0, 2.9, 1.7, 1.0, 0.8, 0.7 (2019–2025) - Public consumption: 0.4, 0.4, 0.2, 0.1, 0.2, 0.2, 0.2 (2019–2025) - Gross fixed investment: 1.2, -2.6, 1.6, 1.1, 0.7, 0.5, 0.4 (2019–2025) - Net exports: -0.5, -1.0, 0.5, 0.3, 0.2, 0.1, 0.1 (2019–2025) - Current account (%GDP): 2.3, 1.9, 2.4, 2.5, 2.5, 2.6, 2.5 (2019–2025) - Unemployment rate: 7.6, 8.9, 9.1, 8.4, 7.9, 7.7, 7.6 (2019–2025) - Potential GDP growth: 1.3, -3.2, 3.1, 1.4, 1.2, 1.3, 1.2 (2019–2025) - Output gap: 0.2, -5.1, -3.2, -1.6, -0.6, -0.2, 0.0 (2019–2025) - Inflation: 1.2, 0.4, 0.9, 1.2, 1.4, 1.6, 1.7 (2019–2025) - Graphic note: Ouput loss in 2025: -3.2% *Source: IMF, World Economic Outlook, October 2020; IMF staff analysis as presented in the chapter.* ### 28. The historic NGEU recovery package could provide a meaningful boost to euro area ### 28. The historic NGEU recovery package could provide a meaningful boost to euro area growth, especially in some of the countries hardest hit by the pandemic ### NGEU package: structure and headline allocations - European Commission to borrow €750 billion to finance €390 billion in grants and €360 billion in loans to members. - Main component: Recovery and Resilience Facility (RRF), which will disburse all the loans and the bulk of the grants (€312.5 billion). - Remaining grants will top up other programs in the 2021–27 EU budget. - Repayment of European Commission borrowing foreseen over 2028–58, either with new EU revenues (a recycled plastic packaging waste tax, a carbon border adjustment tax, a digital levy, an emissions trading scheme, or a financial transactions tax) or by additional country contributions. - Many implementation details remain to be clarified, including how the debt incurred by the European Commission will be repaid. ### Allocation and simulated economic impact (Box 3) - Allocation principles: - Over the entire period, a country’s allocation proportional to population size and inversely proportional to per capita income. - During 2021–22, allocation of 70 percent of the funds will also consider the unemployment rate in 2015–19. - In 2023, allocation for 30 percent of the funds will reflect the economic impact of the crisis. - Country-level grant shares (percent of 2019 GDP) under these assumptions: - Croatia, Bulgaria, and Greece estimated to receive between 8½ and 11 percent of their 2019 GDP. - Italy: 3.7 percent of GDP. - Spain: 4.8 percent of GDP. - Macro simulations using IMF’s EUROMOD model (Andrle and others, 2015): - Assumes two thirds of grants translate into additional public spending and one third finance already-planned spending, spread over 2021–24. - Assumes monetary policy remains accommodative over the simulation horizon. - RRF grants have the potential to increase EU27 real GDP by over 1½ percent in 2023 relative to a counterfactual without the grants. - The counterfactual scenario estimates EU27 real GDP would be 1½ percentage points lower than in the model simulations—or ¾ of a percentage point lower than the October 2020 WEO projections that already incorporate some impact of the grants—by 2023. - Debt dynamics in simulations: - Aggregate of EU27 national government debt ratios forecast to decline starting in 2021 (excluding EU-issued debt for NGEU). - If EU-issued debt to finance NGEU grants is included, aggregate ratio only starts to decline in 2022 and falls by less. - Debt ratio is higher in the counterfactual, reflecting the denominator effect of lower GDP and correspondingly lower tax revenues more than offsetting the lower public spending. - Simulation caveats: - The assumption on the additionality of spending financed by grants may prove optimistic. - Other factors affecting impact: amount of slack, composition and quality of public spending, level of uncertainty, timing of spending. - Simulations do not account for structural reforms linked to the grants; ambitious reforms could boost output further. ### Policy guidance: use of NGEU and national fiscal policy priorities - Near-term priority for NGEU funds: - Accelerate Europe’s green and digital transformations to support aggregate demand and deliver medium-term productivity improvements. - European Council agreed 30 percent of the combined EU budget and NGEU package, or up to €555 billion over 2021–27, should support measures including mitigating climate change. - RRF would allocate at least 37 percent of its spending envelope to climate change and 20 percent to digitalization; countries should aim to exceed these targets. - Achieving emission reduction goals requires a combination of: - Public investment, more robust carbon pricing, and more ambitious implementation than currently envisaged. - Expanding the Emissions Trading System (ETS) to other sectors and setting a sufficiently binding carbon price floor for the ETS. - Complementary nonprice policies and fiscal support (e.g., tighter vehicle emission standards, binding efficiency targets for buildings, feebates, means-tested low-interest loans/grants for renovations, greening Common Agricultural Policy payments). - Protect lower-income households and countries more affected by a rising carbon price via transfers. - Consideration of a carbon border adjustment mechanism (CBA) to address emissions leakages. - National fiscal stance and sequencing: - Draft budgetary plans suggest fiscal policies will remain supportive next year, but may not fully reflect needed support given the pandemic’s resurgence. - With the resurgence, national fiscal policies should provide more broad-based support for longer than initially envisioned, prioritizing: - Containing the pandemic (health system capacity, testing, contact tracing, PPE, medical supplies). - Continued support to households and viable firms (short-time work schemes, liquidity and equity support, temporary tax cuts or payment deferrals). - Once recovery is established, adopt measures to facilitate reallocation of labor and capital (targeted hiring subsidies, wage-loss insurance, enhanced training and job search programs). - Pace of withdrawing support should be state contingent and reversed if indicators weaken. - Fiscal policy should support aggregate demand via productive public investment. - Risks and guidance for high-debt countries: - Countries should not withdraw fiscal support too quickly, though pressure will be higher on high-debt countries. - Full use of EU financing (SURE, ESM Pandemic Crisis Support (PCS), NGEU grants and loans) and continued ECB accommodation important to sustain needed fiscal support during recovery. - In current circumstances, costs of tightening too soon outweigh costs of maintaining slightly higher debt levels for a few more years. - Using stimulus to tackle structural challenges: - Near term: focus significant share of stimulus on public investment, particularly climate mitigation/adaptation. - Medium term: raise carbon taxes in nearly all countries and use revenues for public investment, R&D, and targeted transfers to ameliorate growth and distributional effects. - Incentivize investments delivering high-speed internet in rural/underserved areas. - Target education and job training to build digital and green economy skills. - Medium-term fiscal composition changes: - Make fiscal policy more growth friendly and inclusive on both spending and tax sides to boost medium-term potential growth and reduce inequality. - Examples: ensure withdrawal of means-tested benefits as income rises; reduce labor tax wedges for low-income and marginally attached workers. - Recognize that some countries’ debt ratios will rise to very risky levels and will need gradual but steady fiscal adjustment to restore space for future shocks. - Downside scenario: - If outlook deteriorates materially, fiscal support for workers and firms would need extending, increasing cumulative fiscal impact; contingent liabilities from guarantees could be realized. - Countries with fiscal space should bear this burden given accommodative monetary policy; high-debt countries may face adverse market reactions and knock-on effects on banks. - If ESM PCS and RRF loans are exhausted, further EU financing support could be needed in a severe downturn. - Prolonged crisis could increase divergence across countries due to differences in fiscal space and state aid. ### EU fiscal rules and governance - Escape clause: - Activation of the escape clause was warranted and should be extended until the recovery is firmly established. - The escape clause suspends requirements of the fiscal rules with respect to structural fiscal adjustment toward medium-term objectives, but does not suspend requirement to open excessive deficit procedures (EDPs) for breaches of the deficit criterion. - All euro area countries will have deficits in excess of 3 percent of GDP this year, and most will exceed that threshold next year, suggesting many could be subject to EDPs. - Reform opportunity: - A fundamental reform of the EU fiscal rules would be desirable: simplify rules and make them easier to communicate and enforce. - Commission’s fiscal rule review (started early 2020) was delayed by the crisis and is expected to conclude in 2021. - Political obstacles mean prospects for comprehensive reform in the near term are dim, despite argument that it would be timely to rethink economic governance before the escape clause is lifted. ### Authorities’ views and alignment with staff - European Commission largely agreed with staff’s fiscal advice: - Continue well targeted and temporary fiscal support; avoid creating permanent entitlements or withdrawing support too early/quickly. - Favorable financing conditions supported by positive perception of NGEU and monetary easing reduce risk of early withdrawal. - Reforms and investments financed by NGEU will support the recovery; NGEU grants should be well spent on productive investments and programs, coupled with structural reforms. - Commission did not see need for additional EU financing at this stage and argued untapped financing already available was sufficiently sizable if downside risks materialize. - Climate policy alignment: - Staff-advocated policies to address climate change align with Commission’s vision; extending the ETS and greater carbon pricing recognized as needed. - Commission currently looking at a carbon border adjustment mechanism to address emission leakages. ### Monetary policy: stance and near-term needs - Monetary policy response so far has been appropriately bold; further support needed given the second wave. - ECB has countered tightening in financial conditions and maintained an accommodative stance; estimated shadow rate well below median estimate of the natural rate. - With recovery disrupted and output projected to remain below potential over the medium term, further monetary accommodation needed to counteract disinflationary impact and lift inflation expectations. - ECB Governing Council’s commitment to recalibrate instruments once December Eurosystem staff macroeconomic projections are available is welcomed. *Source: IMF EURO AREA POLICIES chapter excerpt.* ### 44. An expansion of asset purchases should remain the main tool to offset further ### An expansion of asset purchases should remain the main tool to offset further disinflationary pressures, but effective communication is critical ### Monetary policy stance and asset purchases - PEPP can be further expanded, both in size and duration, to counter possible market fragmentation and larger medium-term inflation gaps. - An extended period of asset purchases may face implementation challenges (e.g., recent German Constitutional Court ruling on aspects of the ECB’s public sector purchase program (PSPP)). - The Court emphasized the centrality of the ECB’s self-imposed safeguards for price formation—including the capital key and minimum standards of credit quality. - Communication priorities: - Explain proportionality assessments that consider the full range of possible effects from asset purchases. - Clarify the rationale for any capital key deviations and expected convergence back to the key. - Set out the planned exit from asset purchases and reinvestment strategies. ### Interest rates and conventional tools - The ECB reduced the deposit rate by 10 bps to -0.5 percent in September 2019—the first policy rate cut since 2016. - Additional rate cuts are technically feasible (the reversal rate has likely not been reached) but would likely have limited effect on bank lending given higher credit risk and potentially lower profitability. - Complementary measures to mitigate adverse lending-channel effects: - Adjust the tiering multiplier. - Continue providing targeted and untargeted LTROs with effective funding costs below the deposit rate. - Back these by forceful forward guidance on the policy rate path and the APP, including reinvestment of principal from maturing securities. ### Weighing benefits and side effects of accommodative policy - Benefits of accommodative monetary policy continue to outweigh possible adverse side effects, though close monitoring is needed. - Risks from prolonged unconventional monetary policy (UMP) include inflating asset prices and increasing banks’ risk taking. - Pre-crisis financial stability risks were building in some areas, requiring continued monitoring and proactive macroprudential tools. - Evidence cited (Lenza and Slacalek, 2018) suggests distributional effects of UMP were negligible pre-crisis; UMP could help reduce inequality post-crisis by supporting sizable employment gains. ### If inflation outlook deteriorates materially - Substantial additional monetary accommodation via existing and new tools would be needed if the inflation outlook were materially downgraded. - The risk of prolonged low inflation or deflation is nonnegligible; even under the October WEO projections the euro area deflation index shows a moderate probability of headline inflation remaining in negative territory for several quarters. - To prevent prolonged deflation or sharp deterioration, the ECB would need to further ramp up support, including considering new policy tools. - Introducing yield curve control (YCC) is noted as likely to face considerable legal and operational complexities given the implicit commitment to unlimited sovereign purchases and targeting yield curves of 19 member states or the euro swaps curve. ### Direct support to nonfinancial corporates (if transmission is impaired) - Possible ECB interventions if bank lending weakens: - Fully or partly finance a special purpose vehicle (SPV) to deliver temporary bridge financing to viable firms facing liquidity shortages. - Purchase loans originated by eligible lenders (drawing lessons from the U.S. Main Street Lending Program). - Facilities must include appropriate screening and thresholds to avoid lending to “zombie firms.” - Expanding PEPP eligible assets to include high-yield corporate bonds, “fallen angels”, or equity ETFs could be considered, but may: - Generate losses. - Have limited effectiveness given European firms’ heavy reliance on bank financing. - The European Investment Bank (EIB) could take the lead in setting up, financing, and managing an SPV and potentially provide credit protection on pools of bank loans to SMEs. ### ECB strategy review and longer-term framework - The ECB’s planned review of the monetary policy framework is scheduled to be concluded by mid-2021; it will assess monetary policy objectives and instruments, inflation measurement, and long-term issues such as digitalization, climate change, and automation. - Context: declining neutral rates and extended inflation undershoot relative to the “below, but close to, 2 percent” aim. - Preliminary staff analysis: - A clear, well-communicated symmetric point inflation target would be desirable. - A symmetric point target outperforms an asymmetric objective in an environment of secular decline in real rates and weak sensitivity of inflation to activity (Annex II). - Adopting a lower inflation target or an inflation range would be undesirable due to higher deflation risks. - Flexible average inflation targeting (allowing overshooting after extended undershoot) could help re-anchor expectations, but long-term benefits are uncertain because it may raise output volatility and have implications for financial stability. - A continued medium-term orientation would allow consideration of broader objectives (employment, financial stability) within the price stability mandate. ### Authorities’ views - The ECB broadly agreed that a highly accommodative stance is necessary in light of the second wave of COVID-19. - The ECB stands ready to assess incoming information with new macroeconomic projections in December and recalibrate its toolkit as appropriate. - In the meantime, the ECB will continue to use the PEPP flexibly across asset classes, time, and jurisdictions. - On financial stability and negative rates: - Risks appear limited. - Macroprudential policies are first-line defense; no signs of excessive risk taking or stretched housing valuations at this stage. - Policy innovations—tiering reserves and the TLTRO—along with higher credit growth have mitigated negative-rate impacts on bank profitability. - The ECB sees the strategy review as important and guided by the Treaty mandate and single market characteristics; it emphasizes a clearly codified symmetric aim. ### Financial sector policies — safeguarding stability and supporting lending - Pandemic-related capital relief and conservation measures helped maintain credit flows. - Release of capital buffers of more than €120 billion expanded banks’ lending headroom. - After accounting for potential loan losses based on the October WEO projections (Box 4), banks’ capacity for net lending would still amount to about €0.3 and €0.9 trillion to households and nonfinancial corporates, respectively (equivalent to 4 and 9 percent of the current stock of loans). - As borrower-support measures expire and default risk increases, banks have started to tighten lending conditions, especially in countries with legacy NPLs. - ECB Bank Lending Survey: banks have raised underwriting standards as higher risk perceptions and balance sheet constraints outweigh lower funding costs. - Banks in vulnerable countries report net tightening from higher NPL ratios and have increased loan loss provisions on precautionary grounds. ### Bank capital, stresses, and scenarios (Box 4 and related) - COVID-19 has intensified profitability challenges; banks likely to: - Raise provisions for higher loan losses and lower collateral. - Write off rising nonperforming loans due to corporate insolvencies. - Face lower income from nonlending activities. - Over 60 percent of banks’ corporate exposures are to highly affected sectors (especially real estate and trade). - More than half of bank lending is to households, especially via mortgages. - Staff analysis (using end-2019 bank-level data and 2020 EBA Transparency Exercise) finds: - Under October WEO projected path, aggregate capital-to-asset ratio would almost fully recover by end-2021 after an initial drop; two banks remain below the indicative threshold of 3 percent even after debt moratoria and credit guarantees. - Debt moratoria and credit guarantees provide a cushion of about 1.2 percentage points. - Under an illustrative downside scenario (GDP growth -0.9 and -2.7 percent below the baseline in 2020 and 2021, respectively), the capital-to-asset ratio declines by an additional 0.2 percentage point in 2020 and barely improves in 2021—even with current policy measures in place (six banks fall below the threshold). - These results align with the ECB’s July 2020 COVID-19 Vulnerability Analysis: banks stable under baseline but several would need action under a severe scenario. ### Recovery, prudential normalization, and resolution - A slower recovery could cause sizable capital shortfalls, increasing bank credit losses and reducing lending capacity. - Some banks could raise capital at manageable costs; others require viability assessment, ideally via the ECB’s annual bank capital planning review. - Unwinding capital relief requires balance: - Maintain restrictions on dividends and buybacks until recovery is well underway. - Gradually rebuild capital and liquidity buffers to sustain lending capacity. - Keep borrower-support measures available until recovery is underway but tighten eligibility over time to target illiquid but solvent firms and vulnerable households. - Target moratoria and extend only if needed to prevent widespread insolvencies and without distorting banks’ classification and provisioning. - Swift balance sheet repair is critical: - Normalize prudential standards and clearly communicate them to incentivize timely recognition of problem assets. - Supervisors should enhance monitoring and ensure banks can resolve NPLs with credible, longer-horizon reduction strategies. - Banks with capital shortfalls should present capital restoration plans. - Strengthen insolvency regimes and supplement court capacity with intensive use of out-of-court restructuring. - Swift implementation of the European Restructuring and Insolvency Directive and agreement on extra-judicial collateral enforcement would increase national systems’ efficiency. ### Asset management companies (AMCs) - National AMCs: European Commission blueprint provides roadmap, but large deterioration in credit quality may make them unattractive where fiscal space is scarce. - A pan-European AMC could overcome funding limits in fiscally constrained countries and deepen the distressed-debt market, but differing insolvency and collateral frameworks and issues around asset purchases, funding, and mutualization of losses make agreement unlikely. - A network of nationally established AMCs, relying on common NPL data templates, transaction platforms, and valuation methodologies, could be more politically acceptable and facilitate cross-country transactions. *Source: IMF staff analysis in the IMF Regional Economic Outlook — Europe (excerpt).* ### 60. Addressing structurally low profitability in the banking system could help facilitate ### Addressing structurally low profitability in the banking system could help facilitate ### Banking profitability, business models, and consolidation - Structurally low profitability and rising impairments and provisioning requirements weigh on returns on equity (RoE). - An increasing number of banks are reporting earnings below their cost of capital. - Investments in digital technologies to reduce structural margin and cost pressures add to short-term expenses. - Supervisors need to intensify assessments of business model sustainability and cost-reduction plans. - Absent bold actions to cut operating costs, RoE is likely to remain subdued over the medium term, especially given the prolonged scarring effects of the crisis. - Increased consolidation through mergers and acquisitions could improve banks’ efficiency and profitability. - The ECB is proactively assessing banks’ forward-looking profitability projections, cost-reduction efforts, and broader viability of business models, and has issued guidance on its supervisory approach to banks’ consolidation plans. ### Crisis management framework reforms (building on 2018 FSAP recommendations) - Rapidly close existing gaps in the crisis management framework; key reforms recommended include: - (i) greater harmonization and centralization of emergency liquidity arrangements; - (ii) making the powers of the Single Resolution Board more usable for smaller banks and in systemic crises, including: introducing a systemic exemption to burden-sharing rules; adjusting interpretation of the “public interest test;” and introducing an EU level administrative bank liquidation tool to address situations in which banks may fail the public interest test but still be too large for national insolvency proceedings; - (iii) providing an operational financial backstop for the Single Resolution Fund (SRF) by finalizing the European Stability Mechanism (ESM) treaty reform. - On November 30, the Eurogroup agreed to proceed with the ESM reform and introduce a common backstop for the SRF by early 2022, pending ratification of the amended ESM treaty by member state parliaments. - The SRB has provided relief to the sector through the gradual buildup of the MREL capacity; work remains on liquidity in resolution and ensuring funding in resolution from private sources. ### Financial sector architecture reforms to prevent fragmentation - Banking Union / EDIS: - Potential consensus on the design of the European Deposit Insurance Scheme (EDIS) offers opportunity to remove remaining obstacles. - Interim report (June 2019) of the High-Level Working Group proposes concrete steps toward implementing EDIS. - Current proposal centers on a hybrid model: existing national deposit guarantee schemes reinsured by a central fund. - Implementation of the EDIS co-insurance would allow risk-sharing to evolve in parallel to risk reduction and should be implemented swiftly. - Discussions resumed on a hybrid model for EDIS and its interaction with crisis management and depositor protection frameworks in the context of the announced legislative package for 2021Q4. - Capital Markets Union (CMU): - New 2020 CMU action plan (published by the European Commission in September) identified steps to “reboot” capital market integration: fostering access to comparable company data through a single pan-European portal; facilitating company listings; developing adequate pension products; centralizing supervisory power in some areas; ensuring converging outcomes in national insolvency proceedings. - Fast implementation would ease access to market-based finance, lessen firms’ reliance on bank borrowing, increase private risk sharing, and strengthen resilience to shocks. - AML/CFT: - European Commission plans to establish a single AML/CFT rule book and expressed support for a single supervisor. - Full transposition by member States of the 5th AML Directive’s provisions on central bank account mechanisms and publicly available beneficial ownership registers with high-quality data should strengthen safeguards. - Authorities support creating a single oversight body for AML/CFT but recommend a separate institution given the ECB’s mandate limitation to prudential supervision of credit institutions. ### Prudential measures for nonbank financial institutions - Nonbank financial institutions provide sizable funding to firms and banks but many fall outside macroprudential surveillance perimeter. - Rising share of illiquid asset holdings makes investment funds, especially those exposed to real estate and alternative assets, more vulnerable to redemption pressures as risk sentiment changes. - Supervisory fragmentation prevents timely identification of liquidity risks and proper activation of liquidity management tools. - Some long-term institutional investors have become more active in repo markets to leverage returns, raising susceptibility to adverse financial conditions. - In absence of a comprehensive safety net for nonbank financial institutions, risks should be carefully monitored, including exposures to lower-grade corporate debt and real estate. - Recommendations (from 2018 FSAP and staff): - Borrower-based tools could be legislated where currently unavailable and national macroprudential supervisors should have authority to use these tools for all financial institutions. - Efforts should continue to reduce data gaps in measurement of the other financial institutions sector. - For investment funds, ESMA should be given more authority to bring about supervisory convergence on liquidity management tools and greater coordination across national supervisors on use of leverage restrictions. ### Authorities’ views and supervisory responses - Authorities view the banking sector impact as limited so far but are concerned that new lockdowns could adversely affect credit conditions. - Authorities share staff’s view that banks remain resilient based on October WEO projections given continued borrower-support and effective capital-conservation, but worry that deteriorating asset quality and persistent profitability challenges could weigh on lending capacity if capital buffers are not sufficiently used. - ECB intensified supervision, noted risk of larger bank credit losses if recovery is sluggish, and argued that supportive measures should become more targeted with clear communication on capital requirements applicability. - ECB deemed phase-out of flexibility in loan classification necessary to restore asset quality transparency, despite risks of forcing some banks to raise new capital. - To prevent renewed NPL build-up, authorities are working with member states on a comprehensive strategy: reform insolvency and debt recovery frameworks, develop markets for distressed assets, facilitate cross-border NPL transactions, widen investor base through data standardization and transparency, and develop NPL transaction platforms; could involve creating a network of national AMCs or a pan-European institution. - Authorities noted crisis-generated political momentum for advancing financial sector architecture and crisis management reforms; Commission to reflect on resolution toolbox for medium-sized banks. ### Structural policies: resource allocation, productivity, labor, and inclusion - The crisis is likely to have persistent effects on economic structures; social distancing and behavioral changes may persist, reducing demand in contact-intensive sectors and constraining operations. - Scale and uncertainty of COVID-19 argue for carefully expanding solvency support: - Transition from general lifelines to supporting firms with good post-pandemic viability prospects while facilitating exit of unviable companies. - Government support should be selective and provided to firms with solid pre-crisis average profitability or turnover ratios whose operations were impaired by health risks or social distancing. - Support should be targeted, temporary, and existing shareholders should bear much of the burden. - For systemic firms providing critical services or whose bankruptcies could trigger large spillovers, public support should be subject to strict conditions to guard against distorting competition. - At European level, a solvency support instrument could play a critical role in maintaining Single Market integrity given differing national capacities to inject equity. - Expected high pressure on courts underscores need for well-functioning corporate bankruptcy frameworks and expedited out-of-court restructurings, streamlining procedures and strengthening judicial capacity. - Labor policies: - Job retention schemes prevented massive job losses but will need gradual phasing out as restrictions lift and be complemented by measures to support workers and facilitate reallocation. - Strengthen mean-tested social assistance to ease passage into work while maintaining sufficient support. - Adjust job retention schemes with clear phasing-out mechanisms and promote training to reskill and upskill. - Strengthen incentives for job search and reduce hiring costs for viable firms (e.g., targeted hiring subsidies). - Pandemic likely accelerates automation; consider a fundamental rethink of labor market policies to respond to sectoral demand shifts. - Distributional effects and place-based policies: - Pandemic likely to disproportionately affect poorer regions and exacerbate inequality; targeted policies needed to safeguard vulnerable regions and groups, especially the young and disadvantaged. - Priority to strengthen social safety nets (e.g., for workers on temporary contracts and the self-employed) and reforms focused on retraining and reskilling. - Support adaptability to social distancing and teleworking via higher investment in digitalization (broadband roll-out in rural areas, expand digital public services). - Carefully calibrated place-based policies may be appropriate, including infrastructure and possibly social safety nets; staff analysis suggests spatial targeting of means-tested programs can reduce income inequality without increasing fiscal costs. - Use of EU funds: - EU funds should incentivize reforms addressing long-standing structural impediments and rekindle reform momentum, especially where productivity has lagged. - Reforms needed to enable green and digital transformations and facilitate entry of viable and innovative firms while allowing exit of unviable ones, including via improved insolvency regimes. - Deepening the Single Market for services at EU level would help raise productivity. *Source: IMF staff analysis as presented in the provided chapter content.* ### 73. Safeguarding the economic gains from trade liberalization is critical in an environment ### 1eurea2020001 - 73. Safeguarding the economic gains from trade liberalization is critical in an environment ### Trade policy and multilateral rules - Staff supports continued efforts to uphold and modernize the multilateral rules-based global trading system, including by operationalizing the multi-party interim appeal arrangement as a stop-gap solution to the blockage of the World Trade Organization (WTO) Appellate Body. - Joint efforts from the EU and its global trading partners are crucial to the success of needed WTO reforms. - The EU has taken actions aimed at complying with the WTO ruling in the Airbus case and has expressed a commitment to a negotiated settlement in the long-running Airbus and Boeing disputes with the U.S. - Any EU carbon border adjustment (CBA) mechanism needs to be carefully designed to avoid discrimination against foreign producers and products, which could lead to retaliation by trading partners and destabilize both global trade and climate policy. - The recent launch of a major trade policy review in response to the new global challenges and lessons learned from the pandemic is welcome. - The recent proposal to address foreign industrial subsidies is described as well-calibrated, but the EU should also continue to work toward a global solution. - The EU framework, including state-aid rules, prevents distortionary subsides by EU countries but does not capture subsides by third countries. - The EC White Paper proposes a new framework to address distortionary subsidies in the single market by third countries; the proposal needs guarding against potential capture by interventionist or protectionist interests within the EU. - Shaping EU policy could influence the search for global solutions, which are critical to reducing tensions and promoting a more open trading environment. ### Authorities’ views on crisis support, inequality, and trade - Authorities saw a continuing need for general lifelines to workers and companies given the protracted nature of the crisis and a high degree of uncertainty. - Job retention schemes were viewed as important for employment stabilization given the elevated pandemic-related uncertainty and high hiring and firing costs in Europe, though they could impede needed reallocation. - Reskilling through training programs was highlighted as necessary once containment measures are lifted. - For companies, liquidity needs could potentially morph into solvency shortfalls, including for some companies that were profitable before the pandemic; authorities argued for maintaining broad support in the near term given difficulty of effective targeting under elevated uncertainty and significant policy implementation hurdles. - Some programs at national and EU levels were noted as equipped with private sector risk-sharing mechanisms that helped passively target support to viable firms. - The common set of tools and conditions attached under EU state aid rules helped mitigate the risk of distorting competition in the Single Market; EU-level instruments would help balance support among member states with differing fiscal firepower. - Authorities agreed actions are needed to tackle the impact of the pandemic on inequality and poverty. - The crisis is likely to disproportionately affect young and disadvantaged groups; recent policy support at national and EU levels has helped alleviate negative impacts on inequality. - EU structural funds, together with additional resources from the NGEU, could help address inequality across regions. - Authorities emphasized advancing national-level reforms to support recovery and transition; the RRF is expected to play an important role. - RRF aspects seen as positive: green and digital focus; skew towards countries hardest-hit by the pandemic; expectation it will provide impetus for member states to implement reforms in line with past CSRs. - Authorities remain committed to free trade and a rules-based global trading system. - Intention to continue working with trading partners to advance needed WTO reforms. - Reiterated importance of complying with WTO rules for resolving trade disputes and introducing instruments for climate change mitigation. - Proposed rules for governing foreign subsidies are seen as a mechanism to ensure a level playing field in the Single Market and help garner public support for globalization. - Ongoing trade policy review aims at identifying strategic priorities for EU trade policy for the coming decade, centered on achieving strategic autonomy while preserving an open EU. ### Staff appraisal — macroeconomic outlook and policy priorities - Macroeconomic shock and recent dynamics - "The COVID-19 pandemic is leading to severe socio-economic dislocations and hardship despite an unprecedented policy response." - "Euro area real GDP suffered an historic decline in 2020H1." - A forceful ECB monetary policy response and unprecedented fiscal stimulus, along with financial sector and other measures at both national and EU levels, supported a strong rebound in economic activity in 2020Q3. - The ongoing second wave will delay the recovery; the 2020Q3 outturn looks certain to be followed by weaker activity in 2020Q4, and—barring a sudden change in pandemic dynamics—weak growth in 2021Q1. - Risks and external position - Uncertainty over the near and medium-term outlook remains extremely high; risks dominated by pandemic dynamics and skewed to the downside through early 2021. - Recent promising vaccine news provides a significant upside further out; rapid and widespread delivery of safe and effective vaccines would likely instill confidence and spur a faster recovery. - A prolonged health crisis and slower recovery would imply more scarring and divergence, tighter financial conditions, and increasing private and public vulnerabilities. - Ongoing negotiations regarding the UK’s future relationship with the EU27 and potential escalation of trade tensions add to uncertainty. - "The 2019 external position was assessed as moderately stronger than the level implied by fundamentals and desired policies, but the current account surplus has narrowed considerably since then." - Preliminary 2020 indication: shift to being broadly in line with medium-term fundamentals and desirable policies (subject to high uncertainty). - NGEU and fiscal policy - "The historic NGEU recovery package sends a strong signal of European solidarity and could provide a meaningful boost to euro area growth if it is implemented effectively." - NGEU should be finalized and operationalized as soon as possible; further delays would damage euro area recovery prospects. - Effectiveness depends on quality, efficiency and additionality of national government spending it will finance. - Linking funds to progress on implementing the EU’s country-specific reform recommendations should help ensure NGEU serves as a catalyst rather than a substitute for structural reform. - Positive experience with the recovery fund could help build political support for a permanent central fiscal capacity. - NGEU emphasis on green and digital transitions is welcome, though more ambitious carbon pricing and public investment policies than currently envisaged will likely be needed to meet EU emission reduction goals. - National fiscal policies should provide the first line of defense with the escape clause from EU fiscal rules remaining activated until recovery is on a firm footing; the rules themselves should be fundamentally reformed. - Monetary and financial sector policy - Monetary policy response has been appropriately bold, but further support is needed to counter disinflation risks. - ECB Governing Council commitment to recalibrate policy instruments once the December round of the Eurosystem staff macroeconomic projections are available is welcome. - Asset purchases should remain a go-to instrument; other options include a policy rate cut and further relaxation of the terms of the targeted and untargeted LTROs. - A marked deterioration in the inflation outlook would require substantial further accommodation where new policy instruments—for example, providing direct support to nonfinancial corporates—could be considered. - The ECB’s recent emphasis on its aim being symmetric should be clearly codified and articulated around a specific point inflation target during its ongoing strategy review. - A clear and well-communicated symmetric point inflation target has significant benefits compared with an asymmetric target. - Adopting a lower inflation target or an inflation range would be undesirable as it would carry higher deflation risks. - A flexible average inflation target could be explored to better anchor inflation expectations given the prolonged inflation undershoot. - A continued medium-term orientation would still allow the ECB to consider broader objectives such as employment and financial stability within its price stability mandate. - Financial sector measures have supported credit growth and prevented widespread insolvencies, but unwinding them requires careful balancing. - Capital relief and conservation measures, including restrictions on bank dividend payouts and share buybacks, should be maintained until the recovery is well underway; capital and liquidity buffers should be rebuilt gradually. - Borrower support should become more targeted over time and extended only if needed to prevent widespread insolvencies and without distorting loan classification and provisioning requirements. - The ECB’s next system-wide stress test could be used to identify potential capital shortfalls in a downside scenario to help secure potentially needed support via precautionary recapitalizations. - Swift balance sheet repair is critical to maintaining confidence and supporting intermediation. - Supervisors should ensure banks have credible medium-term strategies for NPL reduction. - Insolvency regimes should be strengthened and court capacity supplemented by intensive use of out-of-court restructuring. - National AMCs could help deepen distressed debt markets, especially if linked in a network. - Financial sector architecture and structural policies - Urgent tasks: completing the banking union, further advancing the capital markets union, finalizing the ESM treaty reform (following the recent Eurogroup agreement), strengthening the SRB’s powers, and ensuring greater harmonization and centralization of emergency liquidity arrangements. - Commission plans to establish a single AML/CFT rule book are welcome. - Prudential measures toolbox should be strengthened to address vulnerabilities in nonbank financial institutions. - Structural policies should remain agile: phase out job retention schemes as recovery takes hold and complement them with measures to facilitate worker movement to viable firms (strengthening social safety nets, promoting job search, enhancing training programs, providing targeted hiring subsidies). - Transition business support from general lifelines to firms with good post-pandemic viability prospects; an EU-level solvency support instrument could help maintain the integrity of the Single Market. - Inequality, regional disparities, and poverty - Mitigating the pandemic’s impact on regional disparities, inequality, and poverty should be a key policy priority. - The pandemic disproportionately affects poorer regions with pre-existing structural impediments and exacerbates inequality; targeted policies and place-based approaches with attention to young and disadvantaged groups are recommended. ### Key policy recommendations and priorities - Uphold and modernize the multilateral rules-based global trading system; operationalize the multi-party interim appeal arrangement for the WTO Appellate Body blockage. - Work with global partners toward a global solution for foreign industrial subsidies while guarding EU proposals against capture by interventionist or protectionist interests. - Carefully design any EU carbon border adjustment mechanism to avoid discrimination and retaliation that could destabilize trade and climate policy. - Finalize and operationalize the NGEU rapidly; link funds to progress on country-specific reform recommendations to ensure catalytic reform effects. - Maintain national fiscal support until recovery is firmly underway; keep the EU fiscal rules escape clause activated and fundamentally reform the rules to reflect post-pandemic realities. - Continue bold monetary accommodation; consider asset purchases, policy rate cuts, LTRO term relaxations, and new instruments if inflation deteriorates. - Codify a symmetric point inflation target (or explore a flexible average inflation target) in the ECB strategy review. - Maintain targeted financial sector support while rebuilding buffers; use stress tests to identify capital shortfalls and prepare for precautionary recapitalizations if needed. - Strengthen insolvency regimes, out-of-court restructuring capacity, and consider national AMCs linked in a network. - Complete banking union and capital markets union priorities; finalize ESM treaty reform; strengthen SRB powers and emergency liquidity centralization. - Phase out job retention schemes as recovery takes hold and reallocate support to facilitate labor mobility, reskilling, and targeted firm support; consider an EU solvency support instrument to preserve Single Market integrity. - Target policies to mitigate regional disparities, inequality, and poverty, with special focus on young and disadvantaged groups. *Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1eurea2020001.pdf* ### 92. It is proposed that the next consultation on euro area policies in the context of the ### 1eurea2020001 - 92. It is proposed that the next consultation on euro area policies in the context of the ### Projections and Key Macroeconomic Indicators - Real GDP projections (2017–2025): 2.6 1.9 1.3 -8.3 5.2 3.1 2.2 1.7 1.4 - Private consumption (2017–2025): 1.8 1.5 1.3 -9.2 5.5 3.2 1.9 1.5 1.3 - Public consumption (2017–2025): 1.1 1.2 1.9 2.2 0.9 0.3 1.2 1.1 1.1 - Gross fixed investment (2017–2025): 3.8 3.2 5.8 -12.0 7.6 5.0 3.4 2.4 1.7 - Final domestic demand (2017–2025): 2.1 1.8 2.4 -7.4 4.9 2.9 2.1 1.6 1.3 - Stockbuilding contribution (2017–2025): 0.2 0.1 -0.5 -0.2 0.0 0.0 0.0 0.0 0.0 - Domestic demand (2017–2025): 2.3 1.9 1.9 -7.5 4.8 2.9 2.1 1.6 1.3 - Foreign balance contribution (2017–2025): 0.4 0.1 -0.5 -1.0 0.5 0.3 0.2 0.1 0.1 - Exports (2017–2025): 5.5 3.6 2.5 -12.9 8.3 5.8 4.3 3.6 3.3 - Imports (2017–2025): 5.2 3.7 3.9 -11.6 7.8 5.7 4.2 3.6 3.3 Resource utilization and labor market - Potential GDP (2017–2025): 1.5 1.3 1.3 -3.2 3.1 1.4 1.2 1.3 1.2 - Output gap (2017–2025): -0.4 0.2 0.2 -5.1 -3.2 -1.6 -0.6 -0.2 0.0 - Employment (2017–2025): 1.6 1.6 1.2 -1.7 0.6 1.1 0.6 0.4 0.2 - Unemployment rate (2017–2025): 9.1 8.2 7.6 8.9 9.1 8.4 7.9 7.7 7.6 Prices - GDP deflator (2017–2025): 1.1 1.4 1.7 1.6 1.2 1.3 1.4 1.6 1.8 - Consumer prices (2017–2025): 1.5 1.8 1.2 0.4 0.9 1.2 1.4 1.6 1.7 Public finance (percent of GDP) - General government balance (2017–2025): -0.9 -0.5 -0.6 -10.1 -5.0 -2.7 -2.1 -1.8 -1.8 - General government structural balance (2017–2025): -0.6 -0.5 -0.6 -5.3 -3.1 -1.8 -1.8 -1.7 -1.8 - General government gross debt (2017–2025): 87.7 85.8 84.0 101.1 100.0 98.4 97.0 95.6 94.3 External sector - Current account balance (2017–2025): 3.1 2.9 2.3 1.9 2.4 2.5 2.5 2.6 2.5 Interest rates and exchange rates (end of period, latest monthly data for 2020) - EURIBOR 3-month offered rate (2017–2020): -0.3 -0.3 -0.4 -0.5 - 10-year government benchmark bond yield (2017–2020): 0.9 1.2 0.4 0.0 - U.S. dollar per euro (end of period): 1.18 1.14 1.11 1.18 - Nominal effective rate (2005=100): 106.1 107.8 105.7 113.9 - Real effective rate (2005=100, ULC based): 87.2 86.8 85.4 89.3 Notes - Projections are based on aggregation of WEO Oct 2020 projections. - Contributions to growth, intra-euro area trade included in exports/imports. - Public finance and external sector figures are in percent of GDP where noted. ### Key Monetary and Financial Measures (policy actions in 2020) Key Monetary Policy Measures - March: Additional asset purchases of €120 billion until end-2020 under the existing program (APP). - March: Introduction of a pandemic emergency purchase program (PEPP) with an envelope of €750 billion until end-2020 with a minimum maturity of 70 days and flexible allocation across time, assets, and countries. - March: CSPP eligibility extended to nonfinancial commercial paper (all commercial papers of sufficient credit quality eligible). - March: Additional full-allotment auctions under LTROs at 25 bps below the deposit rate until next TLTRO auction in June; TLTRO-III terms made more favorable (up to 50 bps below the deposit rate). - March: Relaxation of collateral standards for Eurosystem refinancing operations (MROs, LTROs, TLTROs). Borrowing rates for TLTRO-III were lowered to between -25 and -75 bps and later further reduced to between -50 and -100 bps below the average MRO depending on banks’ lending performance. Borrowing allowances were raised. - March: Reactivation of the U.S. dollar liquidity swap line arrangement with the U.S. Federal Reserve (and other major central banks). Frequency of 7-day USD operations reduced to three times per week in June, then once per week in September. - April: Relaxation of collateral standards by (i) widening ACC framework to include public sector-guaranteed loans to SMEs, self-employed individuals, and households; (ii) adopting a general reduction of collateral valuation haircuts (-20 percent) together with a temporary reduction of the same amount (until the end of the PEPP); and (iii) accepting Greek sovereign debt instruments as collateral in Eurosystem credit operation. - April: Grandfathering (until September 2021) of eligibility for marketable assets and issuers’ collateral that were investment grade on April 7, 2020 in case their rating falls below the minimum credit quality requirement. - April: Introduction of PELTROs (pandemic emergency longer-term refinancing operations), offered monthly at 25 bps below the average MRO, maturing between July and September 2021. - June: PEPP envelope increased to €1,350 billion and purchases extended to June 2021 with reinvestment until at least end-2022. - June: Establishment of a Eurosystem repo facility for central banks (EUREP) to provide precautionary euro repo lines to non-euro central banks. Key Financial Policy Measures - March: ECB Banking Supervision allowed significant institutions to operate temporarily below the Pillar 2 Guidance (P2G), the capital conservation buffer, and the liquidity coverage ratio (LCR). New rules on composition of capital to meet Pillar 2 Requirement (P2R) were front-loaded to release additional capital. - March: Temporary flexibility in classification requirements and expectations on loss provisioning for loans covered by public guarantees and crisis-related public moratoria. - March: ECB Banking Supervision asked banks not to pay dividends or buy back shares aimed at remunerating shareholders at least until October 1, 2020 (later extended to January 1, 2021). - April: Temporary capital relief for market risk by adjusting the prudential floor to banks’ current minimum capital requirement; lower qualitative multiplier to smooth procyclical impact. - April–June: European Commission proposed and EU adopted a “banking package” providing targeted exceptional legislative changes to CRR 2, including a two-year extension of transitional arrangements for IFRS9, more favorable treatment for SME and infrastructure lending, and delayed recognition of valuation losses from some sovereign exposures. - July: European Commission proposed a Capital Markets Recovery Package to encourage investment, allow rapid re-capitalization of companies, and increase banks' financing capacity. - July: ECB Banking Supervision committed to allowing banks to operate below the P2G and combined buffer requirement until at least end-2022, and below the minimum LCR until at least end-2021. - September: ECB Banking Supervision allowed banks under direct supervision to exclude cash holdings and central bank reserves from leverage ratio calculation until end-June 2021. ### External Sector Assessment — Findings and Policy Implications Overall assessment - 2019 external position: moderately stronger than level implied by medium-term fundamentals and desirable policies. - 2020 outlook: CA projected to narrow to 1.9 percent of GDP due to collapse in services exports in first three quarters; preliminary shift in 2020 overall external position to broadly in line with fundamentals and desired policies, but high uncertainty. - Medium term: CA surplus projected to slightly increase relative to 2019 levels; high uncertainty remains. National imbalances existing prior to COVID-19 could remain sizable. Potential policy responses - Short-term: focus on containing COVID-19, provide relief to households and firms to reduce scarring. - Monetary policy: remain accommodative until inflation durably converges to ECB’s medium-term price stability objective. - Structural: countries with excess CA surpluses should strengthen investment and potential growth; countries with weak external positions should undertake reforms to raise productivity and enhance competitiveness as pandemic recedes. - Area-wide: banking and capital markets union and fiscal capacity for macroeconomic stabilization could reinvigorate investment and reduce aggregate CA surplus. Foreign asset and liability position - NIIP trajectory: NIIP recovered from about –23 percent of GDP at end-2009 to about -0.5 percent at end-2019, driven by stronger CA balances and modest nominal GDP growth. - 2019 gross foreign positions: assets about 247 percent of GDP; liabilities about 247½ percent of GDP. - 2019 NIIP: –0.5 percent of GDP; Gross Assets: 246.9; Debt Assets: 95.1; Gross Liab.: 247.4; Debt Liab.: 95.7 - Assessment: NIIP-to-GDP ratio expected to rise moderately with continued CA surpluses; euro area expected to soon become net external creditor; overall NIIP financing vulnerabilities appear low, but large net external debtor countries (e.g., Portugal and Spain) bear greater sudden-stop risk. Current account - Background: CA at 2.3 percent in 2019, lower than 2018; services and investment income weaknesses offset stronger goods balance. - 2020: CA surplus declined through first three quarters mainly due to lower services balance and net investment income; goods balance slightly improved. - Model estimates: EBA model CA norm 1 percent of GDP vs cyclically adjusted CA 2.4 percent → EBA gap 1.4 percent of GDP. - IMF staff assessment: Staff CA gap for 2019 is 1.3 percent of GDP with a range of 0.5 to 2.1 percent of GDP; staff adjustments consider net external liability reductions and measurement issues in Ireland and the Netherlands. - 2019 indicators: Actual CA: 2.3; Cycl. Adj. CA: 2.4; EBA CA Norm: 1; EBA CA Gap: 1.4; Staff Adj.: –0.1; Staff CA Gap: 1.3 Real exchange rate - 2019 movements: CPI-based REER depreciated by 3.1 percent; nominal depreciation 1.5 percent; ULC-based REER depreciated by 2.3 percent; other REERs (extra-euro-area partners) depreciated by 1.6 percent on average. - Early 2020: REER depreciated until February, then appreciated sharply through September by about 6½ percent from end-2019. - Model assessments: EBA REER index model suggests an overvaluation of 4.2 percent; EBA REER-level model implies an undervaluation of 0.7 percent. - IMF staff REER gap (based on CA gap and elasticity 0.35): real exchange rate undervalued by 3.6 percent in 2019; staff-assessed REER gap range: –5.9 to 0, midpoint –3.0. - Cross-country heterogeneity: REER gaps range from undervaluation of 11 percent in Germany to overvaluations of 0 to 9 percent in several small to mid-sized members. Capital and financial accounts - 2019: net capital outflows mirrored CA surplus, driven by other investment outflows as banks reduced external liabilities. - First three quarters of 2020: lower net capital outflows, smaller net inflows of other investments, higher net portfolio investment in domestic securities. - Assessment: Gross external indebtedness of euro area residents decreased by 1.3 percent of GDP as higher external long-term sovereign debt was more than offset by lower other investment liabilities of banks and interoffice FDI debt. FX intervention and reserves - Background: euro has status of global reserve currency. - Assessment: Reserves held by euro area economies typically low relative to standard metrics, but currency is free floating. Notes - A complete analysis to be provided in the 2021 External Sector Report (ESR). - 2019 CA revised down from 2.7 percent of GDP to 2.3 percent of GDP in November 2020 due to intra-EA statistical discrepancy adjustments; assessment unchanged. ### Risk Assessment Matrix — Key Risks, Likelihoods, Impacts, and Policy Responses Unexpected (downside) shift in the Covid-19 pandemic - Likelihood: High - Expected impact: High (delayed recovery, scarring, higher unemployment, corporate stress, bank asset quality deterioration, capital shortfalls) - Policy responses: - Develop comprehensive containment strategies and support healthcare. - Support recovery by alleviating funding tightening, preventing liquidity problems from becoming mass defaults; provide direct support to households and firms, especially SMEs. - Maintain accommodative monetary stance, expand tools, explore additional options. - Develop NPL strategies to repair private sector balance sheets. - Boost EU policy response and address pre-existing structural issues at the national level. Widespread social discontent and political instability - Likelihood: High - Expected impact: High (economic disruptions, weakened policymaking, increased infection risk) - Policy responses: - Target vulnerable populations with adequate healthcare and social assistance including unemployment benefits. - Use active labor market policies to facilitate worker reallocation and limit labor market hysteresis. Accelerating de-globalization - Likelihood: High - Expected impact: High (reduced trade, lower potential growth, trade disruptions) - Policy responses: - Work with partners bilaterally and through WTO to address distortive policies. - Strengthen EU collaboration on medical supplies. Disorderly Brexit - Likelihood: High - Expected impact: High (no-deal disruptions, border delays, tariff/nontariff cost increases, financial market disruptions) - Policy responses: - Contingency planning and collaboration between U.K. and EU authorities to reduce cliff-edge effects. A shift in market sentiment - Likelihood: Medium - Expected impact: High (tightened financial conditions, insolvencies, bank balance sheet deterioration, potential sovereign downgrades) - Policy responses: - Maintain accommodative monetary stance and explore additional policy options. - Expand EU financing support in size and scope to restore confidence. - High-debt countries should announce credible medium-term consolidation plans. 1/ Risk Assessment Matrix explanatory note: likelihood categories—“Low” <10 percent, “Medium” 10–30 percent, “High” ≥30 percent. *Italic line: Source: IMF staff compilation from the provided Euro Area Policies chapter content.* ### Annex I. Climate Change Policies in the EU ### Annex I. Climate Change Policies in the EU ### Overview and targets - The EU is a global leader in climate change mitigation with total emissions currently about ¼ below their 1990 level. - Policy objectives: - Achieve a 55 percent reduction in 2030 emissions below 1990 levels. - Reach net zero emissions by 2050. - Achieving these targets will require much stronger policy action, including robust EU-wide carbon pricing complemented by national and sector-specific non-price measures. - Recommendation: Boost “green” investments in the near-term while gradually increasing the carbon price over time to accelerate a job-rich recovery and ameliorate transition costs. ### Main policy instruments: ETS and ESR - Emissions Trading System (ETS): - A cap-and-trade system covering emissions by large companies in energy, industry, and aviation, which account for about 45 percent of total EU greenhouse gas (GHG) emissions. - Benefits: ensures a given level of abatement and provides a price on emissions to encourage reductions. - Challenges: - Limited sectoral coverage: transport and buildings (the two most important sectors not covered by the ETS) account for about 35 percent of emissions. - A significant, but over time decreasing, amount of free emission allowances reduces the effectiveness of the price signal and ETS revenues. - Historically low and volatile carbon price undermining green investment incentives; price increased since the introduction of a market stability reserve (MSR) in January 2019. - Effort Sharing Regulation (ESR): - Covers the other 55 percent of emissions, defining national emission reduction targets for non-ETS sectors (excluding land use, land use change, and forestry and fisheries). - Countries meet ESR targets through a combination of carbon pricing and non-price measures. ### EU Green Deal financing and mechanisms - The Commission aims to mobilize €1 trillion in public and private investments over the next decade to help achieve the 2030 and 2050 targets. - Key funding sources include: - The EU budget and the Next Generation EU package. - Guarantees to the European Investment Bank and other development banks (through the InvestEU program). - National co-financing and ETS revenues. - Includes a Just Transmission Mechanism of €143 billion to help regions most affected by the transition. - The RRF of the Next Generation EU package requires member states to allocate at least 37 percent of its spending envelope to addressing climate change. - Consideration of a carbon border adjustment (CBA) mechanism for certain sectors to reduce competitiveness concerns and emissions leakage. ### Carbon pricing strategy and complementary fiscal/regulatory tools - Staff analysis: more comprehensive and predictable carbon pricing should be the centerpiece of climate policy. - Policy alternatives: - A uniform EU carbon tax (political and legal hurdles noted). - Expanding the ETS to other major emitting sectors and setting a carbon price floor for the ETS. - Introducing a CBA mechanism to address emissions leakage, especially in manufacturing (implementation challenges noted). - Other fiscal and regulatory instruments may be preferable in certain countries or sectors depending on circumstances. ### Sector-specific non-price measures - Transport and manufacturing: - Consider including transport in the ETS and raising fuel taxes and road usage charges to reflect congestion and air pollution externalities. - Complement with tighter emissions standards for vehicles, incentives for clean vehicles (differentiated road charges, “feebates”), and accelerated investment depreciation. - Reference: EU’s 2019 CO2 emission performance standards for new passenger cars and vans. - Residential buildings: - Renovation of existing housing stock is required to meet emission trajectories; new construction will take too long. - Market failures constrain renovation scale and pace (liquidity constraints, owner-renter cost mismatches, limited information). - Recommendations: harmonize energy efficiency ratings (e.g., energy performance certificates), introduce binding energy efficiency improvement targets, design energy-dependent property taxes, and consider “on-bill financing.” - Reference: European Commission’s Renovation Wave Strategy aims to at least double renovation rates in the next ten years. - Agriculture: - Main abatement channels: better soil management, reduced livestock emissions, and significant carbon sequestration potential. - Leverage the 2021-27 EU planning period to improve the Common Agricultural Policy (CAP) incentives: broaden “green payments,” introduce payments for carbon sequestration, and allocate more payments to land use benefiting biodiversity. - Complement with demand-side measures (e.g., remove preferential VAT rates, introduce GHG emissions footprint labels on food) consistent with the EU’s Farm to Fork Strategy. ### Public investment, financing timing, and revenue use - Public investment and financial support: - Direct capital spending toward network infrastructure (power grids for cleaner energy, electrification), electric vehicle charging stations, and low-emission public transportation. - Promote early-stage technologies (hydrogen generation, carbon capture and storage) and new energy storage forms. - Provide targeted financial support for building efficiency and heating electrification via government subsidies and means-tested grants; complement market-based mechanisms like “energy efficiency mortgages.” - Given low borrowing costs, frontloading such investments is beneficial even before sufficient carbon pricing revenues accrue; caveat: if carbon prices increase too rapidly, revenues to fund green investment risk being lower than expected. - Use of carbon pricing revenues: - Mitigate impacts on vulnerable and heavily affected groups and increase political acceptability of higher carbon prices. - Options: - Cut labor and other distortionary taxes to offset aggregate income effects. - Increase transfers to groups negatively impacted by higher carbon prices. - Simulation result: in wealthier EU countries, transfers of around 0.5 percent of GDP would be sufficient to compensate poorer households for a €100-per-ton carbon price increase; transfers likely need to be higher in poorer EU countries where lower-income households spend a larger share of income on energy. - Even without transfers, health and environmental benefits from lower pollution and avoided damages likely exceed costs of higher carbon prices. ### Equity across EU countries and the Just Transition - Distributional concerns: - Central and Eastern European countries typically have higher emissions per unit of output and would face a greater tax burden from higher carbon prices. - Simulations suggest Central and Eastern European countries could experience income losses (in percent terms) 2–3 times higher than Western European countries if carbon prices rose enough to achieve a 50 percent reduction in EU emissions by 2030. - These countries are also more likely to benefit from improved air quality. - Policy response: transfers between EU countries can equalize income impacts of mitigation policies without raising the overall EU income cost and with modest additional costs for Western European countries. - The general EU budget and the Just Transition Mechanism can play significant roles in implementing such transfers. ### Recovery and resilience plans (RRPs) and implementation priorities - RRPs present an opportunity to accelerate the shift to a greener, more sustainable, and fairer economy. - European Council commitment: spend 30 percent of available resources under the multiannual financial framework and the Next Generation EU package on climate action. - Each member state must allocate at least 37 percent of RRP expenditure to climate. - Expected EU higher climate expenditure to generate €285 billion for investment in climate-friendly projects. - Complementary measures: - National fiscal stimulus measures directed to climate-friendly investments (green infrastructure, R&D). - Subsidies and guarantees to encourage private demand and investment in low-carbon technologies. - Mandatory non-financial disclosure standards consistent with the forthcoming EU Taxonomy on Sustainable Activities to crowd in private investment and better measure climate-related risks. - Policy sequencing: frontload investments to reduce emissions while progressively increasing the price of carbon over time to accelerate recovery and ameliorate transition costs. *Source: Annex I. Climate Change Policies in the EU* ### 1.8 percent). ### Alternative Monetary Policy Strategies at the Zero Lower Bound ### Comparison of symmetric vs. asymmetric regimes and ZLB considerations - Simulations assume the zero lower bound (ZLB) was a binding constraint. - If an effective lower bound constraint were imposed, a symmetric target regime would be even more advantageous because the asymmetric regime is associated with lower inflation and output gaps on average, making it more likely the economy will be pushed into a recession in which the ZLB binds in response to adverse shocks. ### Average Inflation Targeting (AIT) and Price Level Targeting (PLT) — definitions and intended effects - AIT: ECB adopts a five-year window and considers an average inflation rate during the past five years in the policy rule rather than current inflation only. - PLT: central bank replaces the inflation term in the rule with the price level gap, where the price level gap equals the actual price level minus the target price level (a linear trend with a slope of 2 percent at an annualized rate). - Both AIT and PLT allow inflation to overshoot the central bank’s inflation target on the transition path back to steady state when inflation has been below target for a protracted period. ### Simulation setup and conditional outlooks without unconventional monetary policy (UMP) - Forecast distributions are generated under alternative fully credible monetary regimes using IMF WEO projections as initial conditions for 2020Q2, assuming no UMP tools and a hard ZLB constraint. - First column of Figure 1 uses the estimated historical rule; second and third columns report AIT and PLT rules. - Key qualitative result: AIT and especially PLT are associated with noticeable improvements in the outlook if fully credible and well communicated, allowing the central bank to provide more stimulus today and in the future and to endogenize and communicate forward guidance of future policy rates. ### Unconditional simulation results and drawbacks of permanent adoption - Adopting AIT and PLT on a permanent basis may not be desirable based on unconditional simulations (not conditioned on the current low inflation high output gap environment): - AIT and PLT trigger notably higher output gap volatility. - PLT particularly generates deeper recessions. - Intuition: committing to reverse a runup in inflation (e.g., due to a markup shock) entails a sharp and persistent tightening, with costly implications for output relative to allowing “bygones be bygones.” - These results hold under both rational and behavioral expectations formation and even when frameworks are asymmetric and applied only when the policy rate is at its effective lower bound with UMP deployment. ### Table 2 — Unconditional distribution under alternative monetary policy regimes (exact figures) - Regimes shown: Symmetric ZLB; Lower Target, ZLB; AIT, ZLB; PLT, ZLB. - Table 2 values (columns correspond to: Inflation Mean; Inflation Std; P(pi<0); P(pi>2); P(pi>3); Output gap Mean; Output gap Std; Mean (y gap <-5th); Nominal policy rate Mean; Nominal policy rate Std; P(r<=0)): - Symmetric ZLB - Inflation Mean: 1.96 - Inflation Std: 0.95 - P(pi<0): 2.62 - P(pi>2): 44.80 - P(pi>3): 11.74 - Output gap Mean: -0.23 - Output gap Std: 2.31 - Mean (y gap <-5th): -5.46 - Nominal policy rate Mean: 2.71 - Nominal policy rate Std: 1.71 - P(r<=0): 5.38 - Lower Target, ZLB - Inflation Mean: 1.44 - Inflation Std: 0.96 - P(pi<0): 8.19 - P(pi>2): 24.72 - P(pi>3): 4.30 - Output gap Mean: -0.37 - Output gap Std: 2.45 - Mean (y gap <-5th): -6.08 - Nominal policy rate Mean: 2.30 - Nominal policy rate Std: 1.64 - P(r<=0): 8.48 - AIT, ZLB - Inflation Mean: 1.98 - Inflation Std: 0.86 - P(pi<0): 1.34 - P(pi>2): 45.28 - P(pi>3): 10.49 - Output gap Mean: -0.11 - Output gap Std: 2.45 - Mean (y gap <-5th): -5.16 - Nominal policy rate Mean: 2.67 - Nominal policy rate Std: 1.55 - P(r<=0): 4.17 - PLT, ZLB - Inflation Mean: 2.00 - Inflation Std: 0.62 - P(pi<0): 0.07 - P(pi>2): 46.21 - P(pi>3): 4.71 - Output gap Mean: -0.22 - Output gap Std: 3.99 - Mean (y gap <-5th): -9.10 - Nominal policy rate Mean: 2.81 - Nominal policy rate Std: 2.30 - P(r<=0): 15.50 - Additional reported findings: - Lowering the symmetric inflation target to 1.5 percent increases deflation risks notably and causes output to operate further below potential on average. - Using a “target band” for inflation (policy less responsive when inflation between 1.5 and 2.5 percent) triggers larger fluctuations in inflation and output gap relative to a point-target regime, although inflation will be close to 2 percent on average over a longer time period. - Specific note in text: “Specifically, the standard deviation of inflation increases from around 1 in the first row in Table 2 to about 1¼ and the unconditional deflation risk increases from around 2.5 to 19 percent.” ### Effects of deploying unconventional monetary policy (UMP) tools - Figure 2 distributions assume ECB deploys UMP tools. - Deployment of UMP tools is associated with a noticeable improvement in the outlook under the estimated rule: improves the modal outlook and lowers deflation risk and downside risk to economic activity. - For AIT and PLT regimes, improvement is notable, especially for AIT. - State-contingent large-scale asset purchases play an important role in reducing downside risk and improving modal projections. - UMP tools allowed in simulations include: - a) negative interest rate policy (allowing policy rate to be cut to -1); - b) forward guidance (lower for longer interest rate policy based on a shadow rate concept including no response to output growth in the interest rate rule); - c) asset purchases to lower the term-premium and corporate spreads. - Note: the results suggest unconditional volatilities are very similar under UMP and ZLB. ### Annex III — An NPL strategy for Europe to deal with the COVID-19 fallout (overview) - A comprehensive strategy with a phased approach is recommended to deal with expected rises in defaults and insolvencies. Policymakers implemented wide-ranging measures to alleviate cash-flow pressures; policy should pivot to priorities during the reopening phase and the recovery phase. - Experience shows vigorous supervisory actions to repair balance sheets are critical to maintain confidence and support intermediation. ### Policies for the Reopening Phase — priorities and actions - Resume supervisory and insolvency actions put on hold while maintaining policy support and prudential standards for loan classification and provisioning. - Three focus areas: - Supervisory and prudential measures: - Encourage banks to use capital and liquidity buffers to cushion NPLs and support credit extension. - Provide supervisory guidance on classification and provisioning for restructured loans if necessary in view of potential new official measures. - Encourage banks to restructure loans to help borrowers manage pandemic impacts and minimize bank losses. - Debt enforcement and insolvency measures: - Extend moratoria only if necessary; prefer targeted and timebound moratoria. - Facilitate restructuring to reduce debt burden or adjust repayment schedules. - Concentrate legal and financial resources on sectors and companies with better recovery prospects using transparent triaging criteria. - Some EU countries could benefit from financial assistance to set up specialized courts and train insolvency professionals via structural funds. - Groundwork for structural improvements: - Put in place efficient out-of-court workouts with separate tracks for corporates, SMEs, and households, and fast-track court procedures to support debt restructuring. - Timely implementation of EU Directive (2019/1023) on Restructuring and Insolvency to offer better toolbox to deal with enterprise distress. - Build blocks for robust debt enforcement systems and efficient corporate insolvency regimes where necessary. ### Policies for the Recovery Phase — three pillars and measures - Once recovery is firm, make full use of prudential and resolution tools and embark on structural improvements based on three pillars: 1) supervisory and prudential measures; 2) insolvency reforms; 3) development of institutions to deal with NPLs. - Supervisory and prudential measures (recommended actions): - Require banks to gradually rebuild capital and liquidity buffers. - Follow up closely to swiftly recognize loan losses while encouraging robust provisioning, write-offs, and income recognition. - Improve NPL reporting standards for consistent and comparable reporting and transparent disclosure of banks’ NPL management performance. - Ask banks to develop credible action plans to reduce NPLs within a specific timeframe and adopt comprehensive NPL management strategies. - Ensure an adequate and conservative approach to collateral valuation (real estate), adopting minimum valuation rules and guidance for immovable property used as loan collateral. - Deal expeditiously with weak banks experiencing significant credit losses and require credible plans to restore capital. - Debt enforcement and insolvency measures (recommended actions): - Restructure debt of firms facing structural challenges when business model adjustments can restore viability; resolve and facilitate orderly exit of nonviable firms. - Address weak insolvency and debt enforcement regimes that obstruct meaningful restructuring. - Potential EU-level action to develop common and higher standards to address deficiencies in national insolvency frameworks. - Three avenues for EU-level action: - Data collection: use EU Justice Scoreboard and Directive reporting requirements to collect information on debt enforcement and corporate insolvency cases to assess effectiveness and identify gaps. - Core principles: improve triggers for insolvency proceedings, effects of a stay, rules on set-off, and enforcement of immovable collateral. - Monitoring progress: institute systematic monitoring of countries’ progress in observing core standards and follow up on benchmarking exercises. ### Deepening markets for distressed assets, NPL securitization, and AMCs - European distressed debt markets have deepened recently with more NPL deals and diverse portfolios attracting investors; investors have improved market infrastructure with servicers and servicing platforms. - Information asymmetries and data disparities impede NPL sales; simplification and widespread use of the EBA pre-trade data template would enhance data quality and comparability and reduce bid-ask pricing gaps. - Efforts to foster NPL securitizations can deepen distressed debt markets; recent measures in the Capital Markets Recovery Package include amendments to address disincentives for NPL securitizations. - New public guarantee schemes for NPL securitizations (akin to Italian GACS and Greek HAPS) would complement EC package; EIB could expand counter-guarantees to public guarantee schemes for NPL securitizations to encourage countries with limited fiscal space. - National asset management companies (AMCs) could deepen markets; advantages include: - economies of scale; - greater bargaining power; - increasing specialization; - better valuation, credit discipline, and price discovery. - Potential drawbacks of AMCs include: - large liabilities associated with asset transfers to AMCs; - weakening debt recovery and risk management in banks; - deterioration of payment discipline; - political pressure; - dependence on government resources or guarantees. *Source: IMF — excerpt from chapter on monetary policy regimes and Annex III on NPL strategy.* ### 10. Flexibility with state aid and banking rules might be needed to allow for temporary ### 10. Flexibility with state aid and banking rules might be needed to allow for temporary government support to banks through AMCs without the bail-in of investors ### State aid flexibility and scope of national AMCs - The Impaired Asset Communication (European Commission, 2009) defines transfer prices for NPLs to AMCs with and without state aid; together with the Restructuring and the Banking Communications (European Commission, 2009 and 2013) and the Bank Recovery and Resolution Directive (European Parliament/European Council, 2014), these rules have effectively limited national AMCs to: - (i) bank resolutions, with national AMCs as asset separation tools (ASTs); - (ii) insolvency proceedings under national laws, with national AMCs facilitating the exit of non-viable banks; and - (iii) precautionary recapitalizations. - The AMC Blueprint (European Commission, 2018) provides a roadmap to establish national AMCs consistent with banking and state aid rules. - The temporary state-aid framework has incorporated flexibility for extraordinary public support to banks—including through AMCs—which could be extended beyond end-2020. - Under public guarantee schemes, banks can offload NPLs at transfer prices into special purpose vehicles (SPVs) for sale to markets and acquire public guarantees for investment-grade rated senior tranches. No State aid is involved if fees paid by banks for public guarantees cover expected costs. Recent examples cited are the Italian Garanzia Cartolarizzazione Sofferenze (GACS) and the Greek Hercules Asset Protection Scheme (HAPS), set up in 2016 and 2019, respectively. ### Capital structure and moral hazard considerations - The Blueprint favors a capital structure based on senior guaranteed securities exchanged for impaired assets. - To address moral hazard, the Blueprint recommends that banks should hold equity stakes in AMCs on a qualified mandatory basis. - Total equity in AMCs would need to: - cover initial losses from booking NPLs at a lower fair value than the transfer price (or the real economic value); and - provide a buffer against unexpected losses from loan workouts. - Materially addressing moral hazard would require banks to acquire enough of an equity stake to prevent taxpayers being called upon to bail out AMCs; however, this would also prevent national AMCs from being consolidated in the fiscal accounts. - Equity-linked instruments such as with-profit participation notes could be explored to mitigate moral hazard and incentivize banks to share both losses and profits in AMCs. ### Pan‑European AMC vs. network of national AMCs - A pan-European AMC could help overcome funding limitations in fiscally constrained countries given a large expected deterioration in credit quality, but faces significant political and operational challenges: - Transferred distressed portfolios would likely involve large firms and commercial real estate across countries with different legal, insolvency, and collateral enforcement frameworks. - If the crisis results in large heterogeneous portfolios of retail and SME NPLs, a pan-European AMC would not be the most adequate resolution tool. - Political challenges related to funding and potential mutualization of losses might limit scope. - An alternative is a network of nationally established AMCs relying on common NPL data templates, transaction platforms, and valuation methodologies; this could be more politically acceptable while facilitating cross-country transactions. ### Selected statistical developments and recent data relevant to the policy context - European statistical governance: the ESS (Eurostat and NSIs) and the ESCB (ECB and NCBs) develop and disseminate European statistics under separate legal frameworks and cooperate closely. - COVID-19 related statistical actions: - Eurostat published guidance and methodological notes. - On April 15, 2020, the ECB released a communication to reporting agents on statistical collection in the context of COVID-19 and a regulation on extension of certain reporting deadlines. - The ESS and ESCB developed a joint template to identify the impact of COVID-19 related government policy measures on government revenue, expenditure and debt; Eurostat is developing guidance on their statistical treatment. - Transition and data standards: - All temporary derogations from ESA 2010 data transmission requirements expired on January 1, 2020; all member states should ensure full and timely data transmissions at legal deadlines in 2020. - By September 2020, 13 euro area countries (and 18 EU member states overall) had adhered to the SDDS Plus. - Ongoing statistical enhancement areas include climate-change statistics, national accounts improvements, Commercial Real Estate indicators, Government Finance Statistics (GFS), non-bank financial sector data, external statistics consistency, modernization of intra-EU trade in goods statistics (micro-data exchange starting in 2022), monetary and financial statistics (including €STR and MMSR), registers (EuroGroups Register and RIAD), and analytical credit datasets (AnaCredit). - Recent macroeconomic data and short-term developments (supplement to staff report): - The strong rebound in real GDP in 2020Q3 was 12.5 percent (q/q), largely driven by household consumption, with a total contribution of about 7 percentage points; investment, net exports, and public consumption also contributed positively. - Employment and working hours rebounded in 2020Q3 by 1.0 and 14.8 percent (q/q), respectively. - For 2020Q4, industrial production (SA, excl. construction) rose by 2.1 percent (m/m) in October. - The number of new reported infections in the euro area was halved to about 80,000 per day in mid-December relative to early-November; however, containment measures continued and mobility indicators remained well below summer months, suggesting output is likely to contract in 2020Q4. *Source: IMF staff report supplement as contained in the provided PDF content.* ### 2. The ECB Governing Council’s decision on December 10 to extend the ### 2. The ECB Governing Council’s decision on December 10 to extend the duration and scale up the volume of several monetary policy instruments was welcome. ### Monetary policy recalibration and instruments - The Pandemic Emergency Purchase Program (PEPP) was increased by €500 billion to €1,850 billion and its duration extended by nine months to at least the end of March 2022 (from June 2021). - Maturing securities under PEPP will be reinvested until at least end-2023 (previously, end-2022). - Targeted longer-term refinancing operations (TLTRO-III) parameters were modified: - The period over which banks can secure favorable terms was extended through June 2022. - Borrowing limits were increased. - Three additional operations will be conducted between June and December 2021. - The April 2020 collateral easing measures were extended to June 2022. - Four additional pandemic emergency longer-term refinancing operations (PELTROs) will be added in 2021 to act as a liquidity backstop. - The Eurosystem repo facility for central banks (EUREP) and all temporary swap and repo lines with non-euro area central banks have been extended to March 2022. - Staff view: recalibration is consistent with calls for continued monetary accommodation; further accommodation could be necessary if downside risks materialize. ### Bank dividend distribution - On December 15, the ECB lifted its restriction on banks’ distribution of dividends in 2021. - Background and conditions: - Nine months after the ECB ordered banks to cease all dividends and share buybacks in March to conserve €30 billion of capital, the ECB decided to allow the region’s strongest banks to resume dividend payments within strict limits if their capital buffers are sufficient to absorb expected loan losses. ### EU budget, recovery package, and Next Generation EU (NGEU) - EU leaders reached a compromise to finalize the agreement on the EU budget and recovery package on December 11. - Resolution of the rule-of-law mechanism dispute: - Agreement to exclusively rely on rulings of the European Court of Justice before triggering sanctions. - The European Council and European Parliament now need to take steps to adopt the relevant legislation, including the Own-Resources Decision, which must be ratified by member states’ parliaments. - Staff and authorities view NGEU as historic and important; call for swift adoption and effective implementation, including the Recovery and Resilience Facility (RRF). - Authorities note the general escape clause will remain active in 2021 and the European Commission will reassess in spring 2021. ### European Stability Mechanism (ESM) reforms and Banking Union - Leaders agreed on ESM treaty reforms, notably a common backstop for the Single Resolution Fund (SRF). - The backstop will take the form of a credit line from the ESM and will replace the Direct Recapitalization Instrument. - Expected to be operational at the beginning of 2022, contingent on ratification of the revised ESM treaty by all 19 member states’ parliaments. - Progress noted on Banking Union, Capital Markets Union (CMU), and Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT). - Authorities agree more progress is required to complete the Banking Union and to improve crisis management frameworks. - The European Commission intends to propose an AML legislative package in the first quarter of 2021. ### EU–U.K. negotiations and Northern Ireland Protocol - Negotiations on a post-Brexit trade deal are ongoing; remaining issues include: - Level playing field provisions, - A fisheries agreement on access to waters and quota shares, - Governance. - Agreement in principle on implementing the Northern Ireland Protocol (December 2020) covers: - Implementation of customs controls, - Application of state aid rules, - Exemptions for certain goods and activities, - Dispute resolution. - The U.K. government indicated it will drop clauses in the draft Internal Market Bill that could have been subject to legal challenge. ### Economic outlook and risks - Authorities share staff’s overall assessment of the euro area outlook: rebound interrupted in autumn; recovery expected to restart early next year. - GDP projections (European Commission autumn forecast): - Real GDP in the euro area is set to decline sharply in 2020 by 7.8 percent (European Commission) versus IMF projection of -8.3 percent. - Rebound by 4.2 percent in 2021 and by 3.0 percent in 2022. - Key risks: - Downside: evolution of the COVID-19 pandemic (infection and hospitalisation rates, effectiveness of vaccination campaigns), duration and stringency of government interventions, persistence of pandemic-induced behavioral changes. - Upside: fast and effective vaccine roll-out, additional medical advances, conclusion of a trade agreement with the U.K. - Concern that the crisis could increase medium-term divergences across euro area countries driven by: - Intensity and duration of the shock, - Relative size of contact-intensive sectors (e.g., tourism, business travel and hospitality), - Differences in fiscal space. - Labor market impacts: disproportionate effects on women, youth, and vulnerable workers; risk of permanent negative effects on potential growth and income gaps through reduced human and physical capital accumulation. ### Monetary policy and inflation outlook - Headline inflation has turned negative, initially mainly due to a significant fall in energy price inflation and policy measures, including a temporary reduction in value-added taxes in Germany. - Downward pressures on prices are expected to dominate due to weak demand, labour market slack and recent appreciation of the euro, offsetting supply-side disruptions. - Inflation path: - Gradual rise from start of 2021 as temporary factors wane and energy price base effects fade, but headline inflation expected to remain below the ECB’s medium-term objective and core inflation subdued. - ECB interventions: - Substantial purchases under PEPP and Asset Purchase Programme. - TLTROs at very favourable conditions to support bank lending. - Authorities request clarification that recommendations for additional monetary accommodation in the Report reflect the situation before the December Governing Council meeting. ### Fiscal policy - Authorities largely concur with staff’s fiscal advice: - Fiscal stance forecast to be highly expansionary in 2020 and supportive in 2021 at euro area and national level, excluding emergency measures. - Member States should continue coordinating actions; fiscal policies should remain supportive throughout 2021 while the health emergency persists. - Emergency measures should be phased out when epidemiological and economic conditions allow, while addressing social and labour-market impacts. - Policy priorities: - Pursue prudent medium-term fiscal positions and ensure debt sustainability while enhancing investment. - Implement credible medium-term fiscal strategies. - Increase public investment and foster private investment to support a fair and inclusive recovery consistent with green and digital transitions. - Emphasize good-quality budgetary measures, public financial management and public procurement frameworks. - Authorities note staff’s call for greater fiscal support if outlook deteriorates markedly; sizable policy support already available at EU level through agreed instruments. ### Structural policies and labor market measures - Use EU funds to incentivise reforms addressing long-standing structural impediments; swift adoption and effective implementation of national reforms aligned with the RRF to foster resilience and convergence. - Support for pivoting towards targeted support for firms with good post-pandemic viability when conditions allow; recognize difficulty of targeting and the need for prudence to avoid converting liquidity problems into insolvencies. - Importance of effective insolvency frameworks to support viable firms and orderly exit of non-viable firms. - Existing EU instruments for firm support noted (e.g., Temporary Framework for state aid and InvestEU); authorities take note of staff’s call for an EU-level solvency support instrument. - Short-time work schemes and SURE have been important in protecting jobs; need for active labour market policies and support for job transitions toward green and digital economy once recovery is established. - Broader reform needs: Single Market functioning, growth-friendly business environment, efficient public administration, education and training, re- and up-skilling, employment prospects for vulnerable groups, closing gender gaps. ### External sector policies - Staff assessment: euro area external position in 2019 was moderately stronger than level suggested by medium-term fundamentals and desirable policies. - Current account surplus projected to narrow in 2020, bringing it closer to the level justified by fundamentals. - Given economic uncertainty, a more comprehensive assessment of external balances for 2020 is deferred. - Report notes further appreciation of the euro in recent months; staff’s External Balance Assessment suggested the euro was very slightly undervalued in 2019, but authorities broadly agree that the euro cannot be considered undervalued in 2020. ### Financial sector policies and risks - Banking sector progress in solvency and liquidity helped during the crisis onset, but risks remain: - Potential rises in non-performing loans. - Consideration of structural measures to avert or mitigate NPL increases. - European Commission ready to support Member States in setting up national AMCs where appropriate. - Bank profitability has fallen further due to cyclical and structural factors; repair of bank balance sheets is necessary and should avoid premature tightening of lending conditions. - Non-bank financial sector: - Parts (money market funds and some investment funds) experienced stress in March market turmoil; stability returned after extraordinary monetary interventions. - Persistent structural vulnerabilities warrant further analysis, close monitoring and resilience enhancements reflecting macroprudential perspectives. - European Commission reviewing the Alternative Investment Fund Directive to identify gaps in information or prudential tools. - Action Plan on CMU should provide strategic guidance to advance CMU and unlock integrated European capital markets. *Statement by Mika Pösö, Executive Director for the Nordic-Baltic Constituency on behalf of the Euro Area Authorities — December 18, 2020* --- _Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1eurea2020001.pdf_