## 1eurea2023001 ## Source details **Canonical URL:** [1eurea2023001](https://www.imf.org/-/media/files/publications/cr/2023/english/1eurea2023001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2023/english/1eurea2023001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2023/english/1eurea2023001.pdf.json) --- ### Inflation, imported prices, profits, and wages - Main shocks and structural challenges - Two exceptionally large supply shocks: pandemic-related supply chain disruptions and a sharp curtailment of Russian energy flows after Russia’s invasion of Ukraine. - Natural gas and electricity prices peaked at over ten and seven times their early 2021 levels, respectively. - Structural challenges: incomplete EMU architecture, need to deliver on the green transition, permanently higher energy prices, energy security concerns, and growing geo-economic fragmentation. - Inflation and expectations - Headline inflation peaked in 2022Q4 and has fallen sharply as energy prices eased; sequential core inflation (3m/3m) has only just started to decrease. - Twelve-month core inflation was around 6.9 percent in May (headline excluding energy and unprocessed food) and 5.3 percent excluding also processed food. - Services are now the largest contributor to inflation. - Consumer inflation expectations for 12 months ahead dropped by almost 1 percentage point in April. - Market-based longer-term expectations: 5y5y inflation linked swaps reaching 2.6 percent. - ECB’s SPF and Consensus Forecasts: 2.1 percent and 2.0 percent, respectively. - Wages and real incomes - Nominal wage growth reached roughly 5 percent y/y by end-2022. - Real hourly compensation fell by about 5 percent in 2022. - Real compensation per hour and per employee are back at 2015 levels; real negotiated wages are 5 percent lower. - With nominal wage growth of around 5 percent and falling inflation, real wages stabilized in 2023Q1. - Wide dispersion across member states (Baltics ran highest nominal wage growth). - Contribution to inflation (Q1 2022–Q1 2023 averages) - Import prices accounted for 40 percent of average inflation. - Domestic profits were the counterpart for 45 percent of average inflation. - Labor costs accounted for 25 percent of average inflation; net taxes slightly deflationary. - As of Q1 2023: profits (GDP-deflator adjusted) about 1 percent above pre-pandemic trend; compensation of employees (GDP-deflator adjusted) about 2 percent below trend. ### Output, labor markets, and demand developments - Growth and activity - Growth: 3.5 percent in 2022. - Euro area GDP contracted 0.1 percent q/q in both 2022Q4 and 2023Q1 (mild technical recession). - Level of GDP in 2023Q1 about 1.4 percent below the level staff projected pre-pandemic. - Private consumption remained at its 2019 level. - High-frequency indicators point to a return to growth in Q2 driven by services. - Labor market tightness (2022) - Output gap and unemployment gap at tightest since early 2008. - Vacancy-to-unemployment ratio reached an all-time high in 2022Q3. - Area-wide unemployment rate at a historical low; employment and participation rates exceeded pre-pandemic trends. - Hours worked per employee incompletely recovered, prompting more hiring; capacity constraints in industry near 15-year tightness. ### Selected exact indicators and statistics - Growth: "3.5 percent in 2022." - GDP contractions: "contracted 0.1 percent q/q in both 2022Q4 and 2023Q1." - GDP gap vs pre-pandemic projection: "about 1.4 percent below the level staff projected pre-pandemic" (2023Q1). - Core inflation: "around 6.9 percent in May"; "5.3 percent excluding also processed food." - Nominal wage growth: "roughly 5 percent y/y" by end-2022. - Real compensation fall: "about 5 percent in 2022." - ECB rate moves: "cumulative increase of 400 basis points"; "deposit facility rate reached 3.5 percent in June." - APP reduction pace: "€15 billion per month on average—from March through end-June." - ECB balance sheet shrinkage: "18 percent since the start of the tightening cycle." - TLTRO share of liabilities: "about 7 percent of bank liabilities, on average, in 2022Q3." - Tier 1 capital ratio: "exceeded 15 percent" as of end-2022. - Leverage ratio: "about 5.5 percent" as of end-2022. - LCR: "165 percent" as of end-2022. - Loan-to-deposit ratio: "103 percent" at end-2022. - NSFR: "126 percent" at end-2022. - Return on equity: "7.7 percent" in 2022 (one percentage point higher than in 2021). - Market-based long-term expectation: "5y5y inflation linked swaps reaching 2.6 percent." ### Policy implications from wages and inflation dynamics - For inflation to converge to target over two years, recovery in real wages likely needs to be drawn-out and firms will need to absorb part of wage increases through a lower profit share. - Continued monitoring of wage dispersion is important for relative competitiveness and alignment of wage policies. --- ### ECB monetary policy stance, balance sheet actions, and QT - Policy rate and balance-sheet moves - ECB key policy rates started rising in July 2022; cumulative increase of 400 basis points led the deposit facility rate to reach 3.5 percent in June. - ECB began reducing APP securities holdings by "€15 billion per month on average—from March through end-June" and will discontinue all APP re-investments as of July 2023. - Winding down of TLTRO loans and overall ECB balance sheet shrinkage of "18 percent since the start of the tightening cycle." - PEPP flexible re-investment continues; Transmission Protection Instrument (TPI) introduced in July 2022. - IMF staff: "the steepest hiking cycle in the monetary union’s history." - Transmission and financial conditions - Financial conditions tightened in 2023 but at a slower pace than end-2022. - ECB bank surveys: significant decline in credit demand and continued tightening in credit standards since 2022Q2. - Bank lending growth moderated for households and corporates; insolvencies slightly above pre-pandemic levels. - Ex-ante real interest rates (2-year, 10-year) rose; Financial Conditions Index tightened (2015Q1-2023Q2 series referenced). - Quantitative Tightening (QT) guidance (Box 3) - Policy rates should remain the primary instrument; QT should reduce the Eurosystem’s footprint gradually and state-contingently. - QT should stay gradual and cautious; stopping APP reinvestments while continuing PEPP reinvestments judged appropriate. - Staff estimate: discontinuing APP reinvestments and current QT pace reduces APP portfolio by about €334 billion between June 2023 and May 2024 (~2.3 percent of euro area GDP). ### Term premia and balance-sheet impact - Staff estimate: a 12-18bp increase in the term premia and long-term bond yields, roughly equivalent to an annual increase in the policy rates of 15-22bps — a small fraction of the 400bp increase in the ECB’s deposit facility rate since July 2022. - Eurosystem footprint and safe-asset scarcity: - Sovereign free float cut in half since start of QE; free float reached 40 percent out of €10.3 trillion outstanding euro area sovereign bonds by end-2022. - Bunds’ free float fell threefold to 20 percent of issued stock by end-2022. - Applying literature elasticities to €4.9 trillion of QE purchases implies accommodation to 10-year yields between 176 and 265bp on average (state contingent). --- ### Banking sector buffers, vulnerabilities, and supervisory guidance - Resilience metrics (end-2022) - Aggregate Tier 1 capital ratio: exceeded 15 percent. - Leverage ratio: about 5.5 percent. - LCR: 165 percent. - Loan-to-deposit ratio: 103 percent. - NSFR: 126 percent. - Return on equity: 7.7 percent in 2022 (one percentage point higher than in 2021). - Key vulnerabilities and transmission channels - Asset valuation channel: higher rates reduce valuation of long-dated fixed-interest assets; unrealized valuation losses on HTM books could be around 1 percentage point of CET1 on average since mid-2021 (wide cross-country variation). - Funding costs: deposit rates rose little so far due to excess reserves; deposit costs expected to rise as TLTRO repayments drain liquidity. - Net interest margins (NIMs) increased since end-2021 but boost could be temporary. - Credit quality: Stage 2 loans share high and rising; insolvencies increasing; NPLs expected to rise (staff research: NPLs take, on average, three years to peak after a negative macro-financial shock). - Real estate exposure: higher rates soften residential and commercial prices, reducing collateral values. - Supervisory and macroprudential recommendations - Conduct bank IRRBB stress tests; monitor valuation of assets held to maturity. - Frequently stress test bank- and market-wide liquidity given TLTRO repayments and QT. - Conserve and build further bank capital; supervisory action to prevent extraordinary high dividend payments preferred to across-the-board dividend restrictions or windfall taxes. - Tighten CCyBs where banks have temporarily high profits; maintain borrower-based measures in leverage-prone markets; expand macroprudential toolkit where national measures lacking (caps on DTI/DSTI absent in 10 out of 20 euro area member states). - Require stress-testing of new mortgages at origination to higher interest rates and lower disposable incomes. ### CET1 scenarios and capital buffers - Under WEO baseline: aggregate CET1 increases from 14.6 percent in 2023 to 15.5 percent in 2025. - Moderate downturn: aggregate CET1 could fall by as much as 1.9 percentage points to 12.7 percent in 2023 and partially recover to 13.4 percent in 2025. - Adverse scenario: bottom 20 percent of banks could see CET1 decline by almost 2.7 percentage points to 11.5 percent in 2024. - Six banks would breach the bank-specific threshold for the Maximum Distributable Amount in 2024; one bank could see a capital shortfall relative to combined pillar 1 and conservation requirement of 7 percent. --- ### Nonbank financial intermediation (NBFI), money markets, and macroprudential tools - Money market and NBFI stress signals - Higher rates and risk premia increased volatility and margin calls on derivatives held by nonbanks. - Investment fund sector AUM rose from 18 trillion euro to 42 trillion euro between 2010 and 2022. - Some fund segments experienced significant outflows in 2022; redemptions and liquidations proceeded in an orderly fashion to date, but risks remain in less regulated and opaque NBFI segments. - NBFI policy recommendations - Implement macroprudential tools limiting leverage and liquidity mismatches; robust liquidity management tools for funds. - Consider leverage restrictions (Article 25 AIFMD), restrictions on derivatives, liquidity rules lengthening withdrawal notice periods, and liquidity buffers. - Use ex-post liquidity management tools (suspensions, swing pricing) as crisis management complements but not sole reliance. - Deepen ESMA role as EU coordinating body for nonbank financial stability; enhance data collection and close data gaps; strengthen cross-border coordination with non-EU jurisdictions (UK, US). - Investment fund examples and measures - End-2022: Ireland introduced 60 percent leverage limit in open-ended AIF funds investing in Irish CRE (first example in EU). - Belgium, Italy, the Netherlands, Poland permit only closed-ended real estate funds; Germany, Hungary, Portugal require minimum notification periods for redemptions. --- ### External sector, energy, and trade fragmentation - Current account and trade - Current account: moved to a deficit of 1 percent of GDP in 2022 from a surplus of 2.3 percent of GDP in 2021. - Early 2023: current account rebounded to a surplus of 2 percent of GDP as energy prices eased. - NEER and REER depreciated by 3.7 and 3 percent, respectively, in 2022. - Terms of trade deteriorated by 4.4 percent in 2022. - Russian pipeline flows accounted for around 6 percent of current EU consumption (figures discussed). - Energy sector indicators and potential output effects - Gas storage levels remained high, supported by LNG and lower demand. - Natural gas demand in industry fell around 25 percent in 2022. - IEA attribution: 50 percent of the 25 percent drop due to reduced output, 30 percent due to fuel switching, 20 percent due to efficiency gains — implying a five percent improvement in natural gas efficiency in industry in one year. - Model estimates: - Energy price shock reduced potential output in the euro area by 1 percentage point in the baseline (using energy price path of 15-20 percent above pre-pandemic levels by 2027-28). - This contrasts with over 2 percentage points impact from October 2022 WEO (70 percent above pre-pandemic levels by 2027-28). - A smoother increase to the same 2027 endpoint would have reduced potential output by only 0.5 percentage points. - Model-predicted energy efficiency gains of 5-10 percent by 2027-28 suggest the shock may benefit the green transition. --- ### Outlook, projections, and key indicators (Text Table 1 / Table 1 highlights) - Staff projections (real GDP growth, y/y percent change) - 2021 = 5.3; 2022 = 3.5; 2023 = 0.9; 2024 = 1.5; 2025 = 1.8; 2026 = 1.7; 2027 = 1.4; 2028 = 1.3 - Private consumption contributions (percentage points) - 2021 = 2.0; 2022 = 2.3; 2023 = 0.3; 2024 = 1.1; 2025 = 1.1; 2026 = 1.0; 2027 = 0.7; 2028 = 0.7 - Current account (% of GDP) - 2021 = 2.3; 2022 = -1.0; 2023 = 0.9; 2024 = 1.1; 2025 = 1.4; 2026 = 1.6; 2027 = 1.7; 2028 = 1.7 - Unemployment rate (%) - 2021 = 7.7; 2022 = 6.7; 2023 = 6.8; 2024 = 6.7; 2025 = 6.6; 2026 = 6.5; 2027 = 6.5; 2028 = 6.5 - Headline HICP - 2021 = 2.6; 2022 = 8.4; 2023 = 5.2; 2024 = 2.8; 2025 = 2.1; 2026 = 2.0; 2027 = 1.9; 2028 = 1.9 - Core HICP (ex energy and unprocessed food) - 2021 = 1.5; 2022 = 4.8; 2023 = 5.9; 2024 = 3.2; 2025 = 2.2; 2026 = 2.0; 2027 = 1.9; 2028 = 1.9 - Overall fiscal balance (% of GDP) - 2021 = -5.3; 2022 = -3.6; 2023 = -3.5; 2024 = -2.7; 2025 = -2.3; 2026 = -2.1; 2027 = -2.0; 2028 = -2.0 - Potential GDP growth - 2021 = 2.5; 2022 = 1.2; 2023 = 1.4; 2024 = 1.5; 2025 = 1.5; 2026 = 1.5; 2027 = 1.4; 2028 = 1.3 - Output gap (% of potential GDP) - 2021 = -2.1; 2022 = 0.0; 2023 = -0.4; 2024 = -0.5; 2025 = -0.2; 2026 = 0.0; 2027 = 0.1; 2028 = 0.1 --- ### Risks, scenarios, and policy guidance - Risk assessment - Uncertainty high; risks to growth skewed to the downside and risks to inflation skewed to the upside (upside inflation risks judged "less than before"). - Risk Assessment Matrix highlights global risks: Intensification of Regional Conflict (Likelihood: High; Impact: High), Abrupt Global Slowdown or Recession (Likelihood: Medium; Impact: High), Commodity Price Volatility (Likelihood: Medium; Impact: Medium), Deepening Geo-economic Fragmentation (Likelihood: High; Impact: Medium), Systemic Financial Instability (Likelihood: Medium; Impact: High). - Downside scenarios and recommended responses - Financial sector stress: enhance monitoring, disclosure, contingency planning; provide temporary liquidity support; orderly restructuring interventions; rapid macro policy adjustments if needed. - Adverse supply shocks / persistent inflation: monetary policy should tighten further even if tradeoffs worsen; maintain separation of tools (monetary for inflation, liquidity for stability); targeted fiscal support only in severe scenarios. - Sovereign market stress: flexibly reinvest maturing assets under PEPP or activate TPI; consider Outright Monetary Transactions and ESM adjustment programs if sovereign solvency concerns arise. - Monetary policy guidance (Section A) - Continue tightening; maintain a tightening bias and a flexible meeting-by-meeting (data-dependent) approach. - Staff estimate nominal neutral rate at 2-2 ¼ percent (based on real neutral ~0 and long-term inflation expectations). - Policy rates primary tool; QT gradual and state-contingent; temporary accounting losses for Eurosystem should not influence policy decisions. - Staff sees merit in further hikes beyond baseline to limit risks of inflation overshoots and expectation shifts. - Fiscal policy guidance - Baseline: fiscal policy projected to tighten moderately in 2023 and further in 2024. - Staff advice: tighten the cyclically-adjusted primary balance (CAPB) by about 1 percent of potential GDP in 2024 to avoid additional inflation pressures and rebuild fiscal space. - Policy recommendations: allow temporary energy support programs to expire; offset any new expansionary measures; save temporary windfalls from higher-than-expected inflation. - Quantified estimate: reducing government consumption by 1 percent of GDP annually in 2023–24 and by ½ percent in 2025 would lower inflation by 0.2 percentage points during the first two years and lower the interest rate path by around 40-50 basis points in 2023-25. --- ### Fiscal governance, EU reforms, and structural priorities - Economic governance reform - Commission proposal: risk-based approach with multi-year net primary expenditure paths; deliver declining debt-to-GDP ratios after four years for countries with debt above 60 percent; adjustment period extendable to seven years if reforms/investments committed. - Fund staff: welcome proposal but caution on extending adjustment periods without strict safeguards; recommend transparency and conservative GDP effect estimates for investments/reforms. - Recommendation: swift agreement so new framework anchors fiscal policies in 2025 and beyond. - Strengthening EU fiscal framework - Proposal for EU-wide fiscal capacity and independent European fiscal council (EFC) to improve provision of common public goods and credibility of technical DSA-based trajectories. - Minimum corporate profit tax: Council Directive (November 2022) commits member states to introduce by 2024 a minimum corporate profit tax of 15 percent for enterprise groups. - Fiscal targets and debt outlook - Public debt-to-GDP: 90 percent in 2022 (some 6 percentage points above 2019 levels). - Debt in 2025 projected to be 12 percentage points of GDP higher than the pre-pandemic projection for that year. - Medium-term deficits more than 1½ percent of GDP higher than pre-pandemic projections, with slightly less than half reflecting higher debt service. - Recommendation: rebuild fiscal space, front-loaded consolidation in high-debt countries; primary fiscal balances should reach a surplus by 2026 and improve through at least 2028. --- ### Green transition, energy security, and industrial policy - Investment and transition needs - Estimated additional investments of around €400 billion per year between 2021 and 2030 (figure noted as likely risen with inflation). - REPowerEU, ETS reform, ETS II, CBAM, and Green Deal Industrial Plan (GDIP) noted as central initiatives. - EU carbon prices settled at over €90 per ton of CO2. - Policy recommendations - Accelerate green transition to reduce vulnerabilities and close income gaps. - Consider an EU Climate Investment Fund to internalize cross-border externalities and allocate funds to highest-return carbon abatement. - Limit subsidies under relaxed state aid rules in scope, duration, and size; coordinate fiscal support across member states; pursue WTO-consistent multilateral approaches. - CBAM: implement consistent with WTO and, where feasible, based on actual embodied carbon rather than benchmarks; support least developed countries’ adjustment. - GDIP trade-offs - Positive: streamline permitting, skills, finance, and regulatory sandboxes. - Risks: relaxed state-aid rules may raise fiscal costs, create inefficiencies, distortions, and protectionist pressures — recommend careful targeting and coordination. --- ### Structural reforms, productivity, and NGEU - Productivity and NGEU - Long-standing productivity challenges; labor productivity on long downward trend relative to the US. - NGEU: financial support equivalent to 6 percent of 2020 GDP conditional on investment and reforms; ~40 percent to climate, ~20 percent to digitalization. - IMF staff estimate: if implemented as planned, European GDP boosted by around 1.5 percent by end of program in 2026. - Labor market and reallocation - Accelerating sectoral shifts require reskilling/upskilling, labor and product market flexibility, and targeted hiring subsidies where effective. - Integrate immigrants to alleviate fiscal pressure of aging populations. --- ### Statistics, data, and operational annexes - Eurostat and ECB contributions - 15 euro area countries (and 21 EU member states overall) had adhered to SDDS Plus by March 2023. - New climate-related statistical indicators and experimental indicators on sustainable finance and carbon footprints published; work on distributional accounts and financial accounts underway. - Centralised Securities Database (CSDB) and Money Market Statistical Reporting (MMSR) enhancements in progress. - IReF (Integrated Reporting Framework) design phase launched; expected target go-live in 2027 (subject to Regulation adoption). - Annex II: Eurosystem net income and fiscal implications - Baseline scenario: two years of loss-making for the Eurosystem; 0−5 years for top-five NCBs. - Fiscal impact of loss-making: about 0.1−0.2 percent of GDP per annum. - Policy conclusion: no state capital injections recommended; offset losses against future net income; adopt more-conservative profit distribution rules to smooth dividend volatility. - Annex V: Progress against IMF FSAP recommendations - Ongoing actions on supervision harmonization, fit-and-proper questionnaires, supervisory planning, NPL resolution, MREL buildup, early intervention, and liquidity-in-resolution workstreams. - CMDI reform and ESM treaty ratification highlighted as priorities to operationalize SRF backstop and strengthen crisis management. --- *Source: 1eurea2023001 - EURO AREA POLICIES (selected excerpts).* ### 1. Inflation, Imported Prices, Profits, and Wages _________________________________________________ 19 ### 1. Inflation, Imported Prices, Profits, and Wages ### Context and main shocks - The euro area faced two exceptionally large supply shocks: the pandemic-related supply chain disruptions followed by a sharp curtailment of Russian energy flows after Russia’s invasion of Ukraine. - Natural gas and electricity prices peaked at over ten and seven times their early 2021 levels, respectively. - Policy responses cushioned incomes and secured energy supply; immediate shocks are partially dissipating, but elevated and persistent inflation remains a drag on policy and the economy. - Structural challenges highlighted: incomplete architecture, the need to deliver on the green transition, permanently higher energy prices, energy security concerns, and growing geo-economic fragmentation. ### Output, labor markets, and demand developments - Growth of 3.5 percent in 2022, stronger than initially projected after the war due to a rebound in contact-intensive services and less contractionary fiscal policy driven by energy relief measures. - Euro area GDP contracted 0.1 percent q/q in both 2022Q4 and 2023Q1, constituting a mild technical recession. - The level of GDP in 2023Q1 was about 1.4 percent below the level staff projected pre-pandemic; private consumption remained at its 2019 level. - High-frequency indicators point to a return to growth in Q2, driven by the services sector. - Labor market tightness in 2022: output gap and unemployment gap at their tightest since early 2008; vacancy-to-unemployment ratio reached an all-time high in 2022Q3; area-wide unemployment rate at a historical low; employment and participation rates exceeded pre-pandemic trends. - Hours worked per employee remained incompletely recovered, prompting firms to hire more workers; expected capacity constraints in industry showed the second tightest reading in nearly 15 years. ### Inflation, expectations, and prices - Headline inflation peaked in 2022Q4 and has fallen sharply in recent months due to lower energy prices; sequential core inflation (3m/3m) has only just started to decrease. - Twelve-month core inflation (headline excluding energy and unprocessed food) was around 6.9 percent in May; 5.3 percent excluding also processed food. - Services are now the largest contributor to inflation. - Consumer inflation expectations for 12 months ahead dropped by almost 1 percentage point in April; near-term market-based expectations have trended downward. - Market-based longer-term expectations inched upward with 5y5y inflation linked swaps reaching 2.6 percent. - ECB’s SPF and Consensus Forecasts remained anchored at 2.1 percent and 2.0 percent, respectively. ### Wages and real incomes - Nominal wage growth reached roughly 5 percent y/y by end-2022, doubling the 2018-19 growth rate. - Real hourly compensation fell by about 5 percent in 2022, with losses accelerating through the year. - Real compensation per hour and per employee are back at 2015 levels; real negotiated wages are 5 percent lower. - With continued nominal wage growth of around 5 percent amid falling inflation, real wages stabilized in 2023Q1. - Wide dispersion in nominal wage developments across the euro area, reflecting differences in inflation (Baltics ran highest) and wage-setting practices, with implications for relative competitiveness. ### ECB monetary policy stance and balance sheet actions - ECB key policy rates started rising in July 2022; cumulative increase of 400 basis points led the deposit facility rate to reach 3.5 percent in June. - ECB began reducing securities holdings (acquired under APP) by €15 billion per month on average from March through end-June, equivalent to roughly half of APP maturing assets; it will discontinue all APP re-investments as of July 2023. - Winding down of TLTRO loans and overall ECB balance sheet shrinkage of 18 percent since the start of the tightening cycle. - PEPP flexible re-investment continues; in July 2022 the ECB introduced the Transmission Protection Instrument (TPI). - The ECB implemented the steepest hiking cycle in the monetary union’s history. ### Transmission of monetary policy and financial conditions - Financial conditions tightened in 2023 for the aggregate euro area but at a slower pace compared to end-2022. - ECB bank surveys show a significant decline in credit demand and continued tightening in credit standards since 2022Q2. - Bank lending growth moderated for households and corporates; insolvencies ticked up to slightly above pre-pandemic levels. - Ex-ante real interest rates (2-year, 10-year) rose (charts show positive values in 2022–2023 periods). - Financial Conditions Index tightened (Index, 2015Q1-2023Q2). ### Banking sector buffers, vulnerabilities, and indicators - As of end-2022: significant institutions’ aggregate Tier 1 capital ratio exceeded 15 percent; leverage ratio about 5.5 percent. - Risk-weighted capital metrics generally stronger than those at large US banks; leverage ratios comparable. - Liquidity coverage ratio (LCR) at 165 percent; liquidity buffers in foreign currencies are lower. - Aggregate loan-to-deposit ratio at 103 percent; net stable funding ratio (NSFR) at 126 percent at end-2022. - Return on equity in 2022 was 7.7 percent, one percentage point higher than in 2021. - EU applies Basel capital, liquidity coverage, and stable funding requirements to all banks. Vulnerabilities and transmission channels: - Asset valuation channel: higher interest rates reduce valuation of long-dated fixed-interest assets; unrealized valuation losses on held-to-maturity books could be around 1 percentage point of CET1 on average since mid-2021 (wide cross-country variation). - Funding costs: deposit rates have risen very little so far due to excess reserve balances; deposit costs expected to increase over time as TLTRO repayments drain liquidity; TLTROs represented about 7 percent of bank liabilities, on average, in 2022Q3. - Net interest margins (NIMs) increased since end-2021 as new loan rates rose faster than deposit rates; this NIM boost could be temporary as deposit rates eventually increase. - Credit quality: Stage 2 loans share is high and rising; insolvencies increasing; NPLs expected to rise from current all-time low levels (staff research suggests NPLs take, on average, three years to peak after a negative macro-financial shock). - Households with variable-rate mortgages face sharp rises in debt service, though default rates have not risen materially, supported by mortgage recourse and still-low unemployment. - Real estate exposure: higher rates are softening residential and commercial real estate prices, reducing collateral values, increasing provisioning needs, and amplifying credit slowdown. Selected exact indicators and statistics (as provided) - Growth: "3.5 percent in 2022." - GDP changes: "contracted 0.1 percent q/q in both 2022Q4 and 2023Q1." - GDP gap vs pre-pandemic projection: "about 1.4 percent below the level staff projected pre-pandemic" in 2023Q1. - Core inflation: "around 6.9 percent in May" (headline excluding energy and unprocessed food); "5.3 percent excluding also processed food." - Nominal wage growth: "roughly 5 percent y/y" by end-2022. - Real compensation fall: "about 5 percent in 2022." - ECB rate moves: "cumulative increase of 400 basis points"; "deposit facility rate reached 3.5 percent in June." - APP reduction pace: "€15 billion per month on average—from March through end-June." - ECB balance sheet shrinkage: "18 percent since the start of the tightening cycle." - TLTRO share of liabilities: "about 7 percent of bank liabilities, on average, in 2022Q3." - Tier 1 capital ratio: "exceeded 15 percent" as of end-2022. - Leverage ratio: "about 5.5 percent" as of end-2022. - LCR: "165 percent" as of end-2022. - Loan-to-deposit ratio: "103 percent" at end-2022. - NSFR: "126 percent" at end-2022. - Return on equity: "7.7 percent" in 2022 (one percentage point higher than in 2021). - Market-based long-term expectation: "5y5y inflation linked swaps reaching 2.6 percent." *Source: 1eurea2023001 - 1. Inflation, Imported Prices, Profits, and Wages* ### 10. Money market developments signal possible fragility in the nonbank financial ### 10. Money market developments signal possible fragility in the nonbank financial intermediation (NBFI) space ### Money markets and NBFI sector stress - Higher interest rates and risk premia increased volatility and led to more frequent margin calls on open derivatives positions held by nonbanks. - Investment fund sector assets under management grew from 18 trillion euro to 42 trillion euro between 2010 and 2022. - Some segments of the investment fund sector experienced significant outflows in 2022; EU pension funds and other NBFI entities liquidated parts of their portfolios throughout 2022. - To date, redemptions and liquidations have proceeded in an orderly fashion, but stress may arise in the less regulated and more opaque NBFI sector and potentially lead to larger market dysfunction. ### Financial market stress and fiscal developments - The aggregate euro area fiscal deficit fell to 3.6 percent in 2022 from 5.3 percent of GDP in 2021. - The consolidated euro area cyclically-adjusted primary balance improved by 0.7 percentage points to -2.1 percent of potential GDP in 2022 (compared to a projected improvement of 1.4 percentage points pre-war). - Public debt-to-GDP ratio was 90 percent of GDP in 2022, remaining some 6 percentage points above 2019 levels. - The improvement in the 2022 fiscal balance was nearly 1 percentage point of GDP smaller than projected pre-war due to governments’ energy support measures. - RRF grant disbursements cited: in 2021, €43 billion (0. 35 percent of GDP) were disbursed; in 2022, €44 billion (0.33 percent of GDP) were disbursed. ### External sector and energy-driven current account changes - Current account moved to a deficit of 1 percent of GDP in 2022 from a surplus of 2.3 percent of GDP in 2021, driven by a sizable increase in the value of energy imports and a modest deterioration in net exports of non-energy goods. - NEER and REER depreciated by 3.7 and 3 percent, respectively, in 2022. - Terms of trade deteriorated by 4.4 percent in 2022. - Early 2023 saw a sharp reversal: the current account rebounded to a surplus of 2 percent of GDP as energy prices eased. - Russian pipeline flows accounted for only around 6 percent of current EU consumption (as of figures discussed). - European crude oil and refined petroleum product imports from Russia had virtually ceased as of early 2023 because of the EU’s embargo (Annex VI referenced). ### Energy sector developments and indicators - Gas storage levels remained high, supported by increased LNG deliveries and lower demand. - Dutch Natural Gas Futures and other energy price indicators showed a sharp reversal in prices over months prior to publication. - Energy imports by origin and gas flows charts indicate diversification away from Russia, with LNG (excl. Russia), Norway, North Africa, Central Asia, and others contributing. ### Trade fragmentation and supply bottlenecks - Freight rates and delivery times had normalized as of early 2023, though volatility remained and wholesale energy prices remained below their peaks. - Export openness: exports account for 31 percent of GDP for the euro area. - The April 2023 WEO estimates that advanced economies’ real GDP per capita could fall by slightly less than 1 percent in a baseline fragmentation scenario; losses could approach 2 percent in case of more extreme geoeconomic fragmentation. ### Outlook and macroeconomic projections - Staff project the short-term interest rate to reach a peak of 3¾ percent in late 2023 and ease gradually from early-to-mid 2024 onwards. - Staff assume easing in the short-term rate to be more gradual than current market expectations. - Credit growth is set to moderate; lending standards are expected to become more restrictive. - Energy prices are projected to remain some 15-20 percent above pre-pandemic levels over the forecast horizon. - Baseline forecast: slow pickup in growth, with sequential growth (excluding Ireland) projected to continuously increase especially in 2024. - Current account projected to turn positive again in 2023 and recover toward a surplus of 1¾ percent in the medium-term. ### Inflation, wages, and distributional dynamics (Box 1) - Headline and core inflation projected to decline gradually, returning to target only in mid-2025. - Import prices accounted for 40 percent of average inflation over 2022Q1 – 2023Q1. - Domestic profits were the counterpart for 45 percent of average inflation over 2022Q1 – 2023Q1. - Labor costs accounted for 25 percent of average inflation over 2022Q1 – 2023Q1; net taxes were slightly deflationary. - As of Q1 2023, profits (adjusted for the GDP deflator) stood about 1 percent above their pre-pandemic trend; compensation of employees (adjusted for the GDP deflator) stood about 2 percent below trend. - Core inflation is expected to exceed headline inflation for several quarters before converging in mid-2024. - For inflation to converge to target over two years, recovery in real wages likely needs to be drawn-out and firms will need to absorb part of wage increases through a lower profit share. ### Energy efficiency, potential output, and long-term effects (Box 2) - Natural gas demand in industry fell around 25 percent in 2022 amid record high prices. - IEA analysis attribution: 50 percent of the 25 percent drop due to reduced output, 30 percent due to fuel switching, 20 percent due to efficiency gains — implying a five percent improvement in natural gas efficiency in industry in one year. - Model estimates: - Energy price shock reduced potential output in the euro area by 1 percentage point in the baseline (using latest staff projection of the energy price path of 15-20 percent above pre-pandemic levels by 2027-28). - This contrasts with over 2 percentage points impact from the October 2022 WEO (70 percent above pre-pandemic levels by 2027-28). - A smoother increase in energy prices to the same 2027 endpoint would have reduced potential output by only 0.5 percentage points. - Model-predicted energy efficiency gains of 5-10 percent by 2027-28 suggest the energy price shock will be beneficial for the green transition. ### Key projected indicators (Text Table 1 highlights) - Real GDP growth: 2021 = 5.3; 2022 = 3.5; 2023 = 0.9; 2024 = 1.5; 2025 = 1.8; 2026 = 1.7; 2027 = 1.4; 2028 = 1.3 - Private consumption contributions: 2021 = 2.0; 2022 = 2.3; 2023 = 0.3; 2024 = 1.1; 2025 = 1.1; 2026 = 1.0; 2027 = 0.7; 2028 = 0.7 - Current account (% of GDP): 2021 = 2.3; 2022 = -1.0; 2023 = 0.9; 2024 = 1.1; 2025 = 1.4; 2026 = 1.6; 2027 = 1.7; 2028 = 1.7 - Unemployment rate (%): 2021 = 7.7; 2022 = 6.7; 2023 = 6.8; 2024 = 6.7; 2025 = 6.6; 2026 = 6.5; 2027 = 6.5; 2028 = 6.5 - Headline HICP: 2021 = 2.6; 2022 = 8.4; 2023 = 5.2; 2024 = 2.8; 2025 = 2.1; 2026 = 2.0; 2027 = 1.9; 2028 = 1.9 - Core HICP (excludes energy and unprocessed food): 2021 = 1.5; 2022 = 4.8; 2023 = 5.9; 2024 = 3.2; 2025 = 2.2; 2026 = 2.0; 2027 = 1.9; 2028 = 1.9 - Overall fiscal balance (% of GDP): 2021 = -5.3; 2022 = -3.6; 2023 = -3.5; 2024 = -2.7; 2025 = -2.3; 2026 = -2.1; 2027 = -2.0; 2028 = -2.0 - Potential GDP growth: 2021 = 2.5; 2022 = 1.2; 2023 = 1.4; 2024 = 1.5; 2025 = 1.5; 2026 = 1.5; 2027 = 1.4; 2028 = 1.3 - Output gap (% of potential GDP): 2021 = -2.1; 2022 = 0.0; 2023 = -0.4; 2024 = -0.5; 2025 = -0.2; 2026 = 0.0; 2027 = 0.1; 2028 = 0.1 *Source: 1eurea2023001 - 10. Money market developments signal possible fragility in the nonbank financial intermediation (NBFI) space.* ### 18. Uncertainty continues to be high, with risks to growth skewed to the downside and ### 18. Uncertainty continues to be high, with risks to growth skewed to the downside and ### Uncertainty and overall risk assessment - Uncertainty remains high for both the short- and medium-term outlook as the euro area economy adjusts to recent shocks and a high interest rate environment. - Risks to growth are skewed to the downside and risks to inflation are skewed to the upside, though upside inflation risks are judged "less than before" (See Risk Assessment Matrix, Table 3). ### Low Growth — low Inflation: Financial sector and credit risks - Credit risk and spillovers: - Lenders are generally insulated from direct effects of RRE price declines because of the largely recourse nature of RRE lending in the euro area, but potential distress in CRE markets may spill over to banks directly and via exposures to real estate investment funds (REIFs). - Negative developments in the NBFI sector could spill over to banks through direct exposures and via stress in funding markets. - Deteriorating corporate credit quality could raise NPLs, erode banks’ capital, limit new lending, and weigh on investment and growth. - Liquidity and funding risks: - Wholesale deposits are more volatile than retail deposits or bonds; while the ratio of wholesale deposits to total liabilities has been stable on average, there is heterogeneity and some institutions experienced substantial growth in wholesale deposits since the pandemic. - Recent events in the U.S. and Switzerland demonstrate that liquidity risks driven by wholesale deposits can surface forcefully if triggered by concerns about banks’ risk management and business models. - Large TLTRO repayments are geographically concentrated (including in Italy), may lead to large funding needs for banks, tighten credit, and have broader repercussions for activity and financial stability. - Aggregate mitigant: - Strength of aggregate banking metrics in the euro area is an important mitigating factor, but stresses cannot be ruled out. - Sovereign bond market risks: - Abrupt shifts in market sentiment or fundamentals could lead to sharply higher sovereign spreads for some countries, exacerbating cross-country differences in interest rate transmission, hurting growth and public debt sustainability, and potentially triggering concerns about bank health given large holdings of domestic sovereign securities. - Sovereign bond holdings still make up about 10 percent of large banks’ total financial exposure, with Greek, Italian, and Portuguese banks having holdings that approach 20 percent of total financial exposure. Bank sovereign bond holdings exhibit home bias, as banks tend to allocate half or more of those to the bonds of their own sovereign. - External demand: - Weaker external demand, particularly from key trading partners such as China and the US, would negatively affect euro area growth prospects. - Excess capacity in China could ease prices of tradable goods including commodities, reducing policy tradeoffs in the euro area. ### Low Growth — high Inflation: supply shocks and wage dynamics - Energy/food shock scenario: - Escalation of Russia’s war in Ukraine could trigger a renewed energy crisis in Europe and push food prices up; a full Russian gas shutoff combined with higher Chinese demand and a cold 2023/24 winter could lead to a renewed spike in prices. - Russian pipeline gas currently accounts for only 6 percent of EU consumption, highly concentrated in a handful of countries. Including LNG deliveries, Russian gas accounts for around 10 percent of EU consumption. - Inflation persistence and wages: - Higher-than-expected persistence in inflation would require a tight policy stance for longer, weighing on domestic demand. - With labor markets remaining exceptionally tight, stronger-than-expected wage growth could pass through into core inflation, particularly if firms’ profit margins do not fall; inflation expectations could de-anchor and result in wage-price spirals. - Geoeconomic fragmentation: - Further intensification of geoeconomic fragmentation would be akin to an adverse supply shock, pushing up inflation, harming trade, weakening confidence, and undermining recovery with uneven sectoral effects. ### Upside risks to growth - Commodity/capacity scenarios: - If commodity prices drop below pre-pandemic levels and/or substantial excess capacity in key segments of the world economy emerges, faster disinflation could occur, enabling looser monetary policy and supporting a faster rebound in growth. - Domestic demand resilience: - Wholesale gas price declines passing through to consumer prices, resilient consumption amid a still high stock of excess household savings, and/or stronger-than-expected real disposable income could strengthen domestic demand. - Household balances: - Charting household indicators: "Excess saving (2015 eur billion, rhs)", "Real disposable income (index, 2015=100)", "Real final consumption expenditure (index, 2015=100)". ### Medium-to-long run structural uncertainties - Uncertainties include: - (i) Where energy prices, especially natural gas, ultimately settle over the medium-term; - (ii) How persistent the post-pandemic reduction in hours per employee will be, and whether the pre-existing trend toward fewer hours has durably accelerated; - (iii) How pervasive remote working will become and what demand and productivity shifts it will lead to. - Additional considerations: - Climate-related risks affect potential growth. - Neutral rates are expected to ultimately settle at low levels again (April 2023 WEO), but significant uncertainty surrounds the trajectory of the neutral interest rate going forward. ### Authorities’ views - General agreement with staff’s macroeconomic assessment; noted resilience to the war in Ukraine and the energy crisis due to agile policy response (diversification of energy sources, demand reduction, fiscal support). - Authorities expected gradual expansion in 2023 and 2024, with policy tightening weighing on demand. - On inflation: headline inflation is on a downward path and core inflation likely has peaked, but full disinflation is projected to be gradual given upward pressures including strengthening wage growth. - Authorities projected core inflation will gradually decline during the second half of 2023 and into 2024 as tighter financial conditions and lower energy prices feed through. - Projected wage growth in the euro area is expected to accelerate in 2023 and moderate in 2024, given recent contractual agreements concluded in late 2022 and early 2023. - Authorities concurred that risks to growth are tilted to the downside and risks to inflation remain skewed to the upside, highlighting risks from persistent core inflation, stronger-than-expected wage growth, sustained profit margins, renewed market stress, and lack of policy consistency (e.g., expansionary fiscal stance necessitating tighter monetary policy). - On external position: authorities agreed with staff that the sharp deterioration in the current account balance in 2022 is likely temporary and expected a gradual increase in the current account balance over the forecast horizon as terms of trade improve, external demand strengthens, and services sectors normalize. They noted external imbalances persist at country levels and emphasized national policies to address them. ### Policy discussions — objectives and conditional actions - Near-term priority: - Guide inflation back to target in a timely manner while preserving financial stability. - Under the baseline: - Monetary and fiscal policies should tighten further to reduce price pressures and rebuild fiscal policy space. - Financial stability actions if stress materializes: - Enhanced monitoring, disclosure, and contingency planning. - In a significant financial stress scenario: temporary liquidity support to financial markets and institutions, orderly restructuring interventions, and rapid adjustment in broader macroeconomic policies may be warranted. - Structural priorities: - Complete institutional architecture of the economic and monetary union, safeguard sustainable public finances, deliver on the green transition, and raise potential growth. ### A. Reducing inflation while preserving financial stability — Monetary policy guidance - Continued monetary policy tightening: - With persistently high headline and core inflation, monetary policy should continue to tighten. - Recent policy rate hikes have shifted market rates up, to above the estimated neutral rate, bringing the monetary policy stance into contractionary territory. - Staff estimates the nominal neutral rate at 2-2 ¼ percent based on a long-term average estimate of the real neutral rate of around zero and the current level of long-term inflation expectations. These estimates are surrounded by much uncertainty but are in line with market expectations, survey of analysts, and ECB staff estimates. - The policy interest rate path assumed in staff’s baseline (¶14) is projected to bring inflation to target by mid-2025, but uncertainty is high and risks are skewed to the upside. - Staff argues the economic losses from reacting too late are larger than those from reacting too forcefully early on; staff sees merit in further hikes of the key policy rates than assumed in the baseline to limit risks of meaningful inflation overshoots and upward shifts in inflation expectations. - A tightening bias, with stronger responses to upside than downside surprises on inflation, would be appropriate. - A flexible meeting-by-meeting approach to setting the interest rate path is recommended to respond swiftly to changes in the inflation outlook, financial conditions, or fiscal settings (¶46-47). - Policy rates as primary tool and role of Quantitative Tightening (QT): - Policy rates should remain the primary monetary policy tool; QT should aim to reduce the Eurosystem’s footprint in financial markets. - The accommodation provided by the ECB’s bond holdings is no longer needed. - Tightening should be primarily achieved through key policy rates rather than a reduction of the Eurosystem’s bond holdings because policy-rate first approach makes a return to the effective lower bound less likely and because transmission of policy rates is better understood and easier to communicate. - There is scope to use the current tightening cycle to reduce the Eurosystem’s footprint and ensure issuer limits do not become binding should large-scale asset purchases be needed again. - Temporary accounting losses for the Eurosystem from higher policy rates should have no bearing on monetary policy decision making (Annex II). - QT implementation guidance: - QT should stay gradual and cautious, consistent with a learning-by-doing approach to allow market participants to adjust expectations and minimize adverse impacts on financial stability (Box 3). - The ECB’s decision to stop reinvesting all APP maturing assets as of July 2023 while continuing to reinvest principal payments from maturing PEPP securities at least until end-2024 is judged appropriate. - A state-contingent approach to QT would provide flexibility to adjust course if financial conditions change sharply. ### Box 3 — The Potential Impact of Quantitative Tightening (key points) - Eurosystem footprint and scarcity: - The Eurosystem’s large asset holdings increased its footprint in financial markets and reduced availability of safe securities for collateralized lending. - The share of sovereign free float—securities held by entities other than central banks, insurance, and pension funds—was cut in half since the start of QE, reaching 40 percent out of the €10.3 trillion in outstanding euro area sovereign bonds by end 2022. - The Bunds’ free float fell threefold during the same period to 20 percent of the issued stock by end 2022. - Eurosystem refinancing operations (including TLTROs) contributed to pressure on public sector collateral availability. - Asset swap spreads confirm increased scarcity, particularly with PEPP introduction during 2020-22; TLTRO repayments and lower risk aversion have likely eased scarcity in recent months but spreads remain almost double the pre-QE average. - Estimated effects of fully unwinding APP: - Eser et al. (2019) and Altavilla et al. (2021) suggest yields fall, on average, 3.6 to 5.4bp per €100bn of asset purchases by the ECB; applying these elasticities to the stock of QE purchases (€4.9 trillion) implies the level of accommodation to 10-year GDP-weighted zero-coupon yields of the four largest euro area jurisdictions is on average between 176 and 265bp. Such effects are highly state contingent and can be much higher in periods of market stress. - Gradual and predictable QT: - A gradual and predictable QT path is likely to have a small impact on the monetary stance while reducing the footprint in financial markets over time. - The reduction of the APP portfolio by €15 billion a month until June 2023, followed by full redemption of maturing APP assets, will reduce the total portfolio by about €334 billion between June 2023 and May 2024 or around 2.3 percent of euro area GDP. *IMF staff summary based on the provided chapter excerpt.* ### 2023. This will translate into a 12-18bp increase in the term premia and long-term bond yields, roughly ### 1eurea2023001 - 2023. This will translate into a 12-18bp increase in the term premia and long-term bond yields, roughly ### Monetary policy stance, term premia, and balance sheet - Staff estimate: a 12-18bp increase in the term premia and long-term bond yields, roughly equivalent to an annual increase in the policy rates of 15-22bps. - Comparison: This increase is a small fraction of the 400bp increase in the ECB’s deposit facility rate since July 2022. - ECB approach: - Maintain the policy rate as the primary monetary stance tool. - Adopt a meeting-by-meeting (data-dependent) approach with a clear reaction function to set policy rates and determine the appropriate level and duration of restriction. - No pre-commitment to a particular near-term interest rate path given elevated uncertainty. - Balance sheet reduction: - Current pace viewed as appropriate by the ECB. - Market absorption during March and April was smooth when only about half of maturing assets on the APP portfolio were reinvested. - Discontinuing all APP reinvestments is likely to have a small impact on the monetary stance. - ECB favors a measured and predictable approach to balance sheet reduction and sees scope to continue for an extended period, while retaining flexibility (flexible reinvestment of PEPP maturing assets, TPI, altering speed of reduction in a severe scenario). ### Safe asset scarcity and market signals - Note on market signal: A positive difference between the area swap rate and the euro area government yields indicates that investors are prepared to pay a premium for government bonds, which signals scarcity. - Charts/data mentioned (preserved labels and units as in source): - Eurosystem other assets (EUR, tn, lhs) - Eurosystem total QE assets (EUR, tn, lhs) - Bond yields - asset swap spread (bp, 5 dma, rhs) - Eurosystem sovereign debt holdings (EUR, bn, lhs) - Free float, EA (percent, rhs) - Free float, DEU (percent, rhs) - Free float (broad measure) defined as holdings of sovereign bonds by price sensitive investors, excluding insurance and pension funds. ### Banking sector resilience and risks - Overall resilience: - Banking sector as a whole appears resilient to a further tightening of financial conditions, but pockets of vulnerability cannot be ruled out. - Supervisory priorities and actions: - Continue monitoring banks’ interest-rate risk and risk management strategies. - Conduct bank interest-rate-risk stress tests to assess valuation of assets held to maturity and resilience to further interest rate increases. - Monitor and more frequently stress test bank- and market-wide liquidity conditions to ensure higher interest rates, TLTRO repayments, and QT do not trigger systemic liquidity events. - Extend monitoring to less significant institutions given potential for systemic loss in confidence from stress in medium to small sized banks. - Be ready to provide liquidity to solvent banks via existing or new facilities to prevent liquidity problems becoming solvency issues. - Buffers and capital: - Under the WEO baseline scenario, staff estimates aggregate CET1 ratio of euro area banks increases from 14.6 percent in 2023 to 15.5 percent in 2025. - In a moderate downturn, aggregate CET1 could fall by as much as 1.9 percentage points to 12.7 percent in 2023 and partially recover to 13.4 percent in 2025. - Adverse scenario: bottom 20 percent of banks could see CET1 decline by almost 2.7 percentage points to 11.5 percent in 2024. - Six banks would breach the bank-specific threshold for the Maximum Distributable Amount in 2024, triggering restrictions on dividend payouts; only one bank could see a capital shortfall relative to the combined pillar 1 and conservation requirement of 7 percent. - Recommendation: conserve and build further bank capital; supervisory action to prevent extraordinary high dividend payments preferred over across-the-board dividend restrictions or windfall taxes. - Liquidity and TLTRO: - Charts/data referenced: Outstanding TLTRO loan / cash reserves ratio (lhs); Outstanding TLTRO loan (billions of euros, rhs); Liquidity and TLTRO Repayment by Country (Sep 2022). ### Macroprudential policy and real estate risks - Banks should proactively increase buffers for higher credit and market risk as financial conditions tighten. - Real estate and corporate risks: - Residential real estate prices: on average appreciated by more than 20 percent since the beginning of the pandemic (and by close to 40 to 50 percent in several countries); prices are correcting. - CRE markets: declining liquidity; falling transaction volumes; CRE price corrections may directly and indirectly affect banks. - Bank exposure to RRE cushioned by still-low unemployment and recourse clauses, but variable-rate mortgage households in distress could affect banks. - Authorities should monitor real estate markets, interest coverage ratios in corporate sector, households’ debt service capacity, and run frequent stress tests with up-to-date information. - Macroprudential recommendations: - Tighten countercyclical capital buffers (CCyBs) where banks have temporarily high profits, as a step toward positive neutral rates for the CCyB. - Maintain borrower-based measures to preserve resilience in leverage-prone markets. - Expand macroprudential toolkit where national regulators lack measures (e.g., caps on DTI/DSTI absent in 10 out of 20 euro area member states). - Require supervisors to have banks stress-test credit risk of new mortgages at origination to higher interest rates and lower disposable incomes. ### Nonbank financial intermediation (NBFI) and AML/CFT - NBFI vulnerabilities: - Life insurers: benefited from rising interest rates with robust profitability and solvency. - Nonlife insurers: adversely affected by valuation losses in fixed income assets and higher inflation. - Investment funds: experienced significant outflows. - Redemption or liquidity pressures in NBFI can affect wider financial system through funding links to banks and effects on real estate prices. - Policy recommendations for NBFI: - Wider implementation of macroprudential tools limiting leverage and liquidity mismatches, including robust liquidity management tools. - Closely monitor and reduce risk of activity migrating to less-regulated parts of the sector. - Enhance cooperation between national authorities and strengthen EU agencies to coordinate cross-border regulation (Annex IV). - Close data gaps on NBFI sector to enable effective regulation and supervision. - AML/CFT priorities: - Improve information sharing between prudential and AML/CFT supervisors. - Establish a single AML/CFT rulebook and supervisory authority (in strong cooperation with the SSM) to ensure consistency. - Maintain transparency of beneficial ownership, reconciling this with the 2022 Court of Justice of the European Union ruling on personal data protection and the 2018 EU Anti-Money Laundering Directive. - Adoption of the Regulation on Markets in Crypto-Assets (MiCA) to ensure crypto-asset service providers have robust AML/CFT controls. ### EU financial architecture, crisis management, and structural reforms - Crisis management: - Need to strengthen crisis management arrangements and rapid intervention tools. - Recent European Commission proposal on crisis management and deposit insurance aims to broaden central resolution powers to midsized and smaller banks and improve resolution funding arrangements. - Proposal does not address key rigidities like bail-in requirements in systemic situations; recommendation for more substantive reform including introducing a systemic risk exemption from minimum bail-in requirements. - Progress needed on ratification of the amended European Stability Mechanism (ESM) treaty to operationalize the ESM’s financial backstop to the Single Resolution Fund (SRF) and on a pooled European Deposit Insurance Fund. - BU and CMU: - Meaningful progress on the Banking Union (BU) and Capital Markets Union (CMU) would enhance cross-border risk sharing, deepen access to finance, and improve risk-sharing, supporting macroeconomic stability, growth, and convergence. - Commission’s CMU legislative package includes steps toward harmonizing insolvency processes across member states. - Basel III implementation: - Full implementation is essential. - EU provisional agreement contains deviations that, according to previous EBA estimates, would reduce expected increase in Tier 1 aggregate capital requirements by about 3 percentage points compared to faithful implementation of Basel III. - Diluting macroprudential standards is undesirable. - Authorities anticipate Basel III implementation will be fully legislated by end-2023; they view the counterparty risk deviation as material, deviations related to unrated corporates and mortgages as minor. - Overbanking: - Europe faces long-standing low profitability due to too many banks and branches. - Recommendations: ensure largest banks have sound business models, encourage cost efficiency and branch network trimming, facilitate exit of less efficient banks to improve profitability and financial stability. ### Authorities’ views and policy stance - Authorities’ assessment: - Bank capital, liquidity, and profitability remain strong; confident banking system can withstand the tightening cycle. - Banks benefited from limited pass-through of higher policy rates to deposit rates so far. - Forthcoming TLTRO repayments expected not to create excessive funding pressure given time to prepare, aggregate comfortable excess liquidity, and ability to tap bond markets. - Valuation losses from banks’ HTM portfolios viewed as modest and largely absorbable by higher net interest income. - Monitoring and reforms: - Authorities agree vulnerabilities warrant continued monitoring and support ongoing EBA-ECB stress tests. - Authorities monitor interest rate and liquidity risks through SSM exercises, quarterly reviews, and analysis of funding profiles. - Support rebuilding regulatory capital buffers to sufficient levels, including through a positive-neutral rate for the CCyB, while avoiding procyclical effects on credit growth. - View Commission’s CDMI proposal as integral to Banking Union architecture and favor its package approach; see limited political scope for systemic exemption for smaller banks. - Agree more work needed on NBFI regulation and coordination; ESMA reviewing AIMF and UCITS directives to refine liquidity requirements on funds prone to large redemptions. *Source: IMF staff report (excerpts as provided).* ### 45. The authorities agree that strengthening AML/CFT supervision remains a priority. In ### 1eurea2023001 - 45. The authorities agree that strengthening AML/CFT supervision remains a priority. In ### AML/CFT supervision - The ECB has significantly enhanced channels for collaboration with national AML/CFT authorities in the EU regarding ML/TF issues of banks under its supervision. - The creation of the Anti-Money-Laundering Authority (AMLA), currently undergoing the trialogue process, will allow AML/CFT supervision of banks, financial institutions, and likely crypto-asset service providers at the European level. ### A Restrictive Fiscal Policy Stance — baseline and rationale - Under the baseline, fiscal policy is projected to tighten moderately in 2023 and further in 2024. - The euro area aggregated cyclically-adjusted primary balance (CAPB) as a share of potential GDP is projected to improve by 0.4 percentage points in 2023—largely explained by the expiration of the "Super-bonus” program in Italy (with most other countries maintaining a neutral fiscal stance). - For 2024, under existing policies, the CAPB would improve by an additional 1 percent of potential GDP, of which around one-third is in high-debt countries. - Staff analysis: an improvement in the CAPB of around 1 percent of potential GDP in 2024—which would be achieved under current policies—would help avoid additional inflation pressures and rebuild fiscal space. - Policy guidance: - Allow temporary energy support programs to expire and avoid extending or replacing these with other spending programs. - Any new expansionary policy measures introduced during the preparation of the 2024 budget should be offset by other discretionary policy changes. - Temporary revenue windfalls from higher-than-expected inflation should be saved. - Aggregate recommendation: while an aggregate euro area fiscal tightening of 1 percent is broadly appropriate, individual countries may need more tightening than currently in the baseline to contain fiscal risk and build fiscal space. ### Reasons for a restrictive stance — benefits and country differentiation - A restrictive fiscal policy stance would: - Allow less monetary policy tightening and thus help reduce the risk of financial market disruptions; fiscal adjustment would differ across countries, with more effort appropriate where inflation is high. - Support debt reduction and restoration of fiscal space against future shocks and longer-term spending pressures, including pensions, health, energy security and the green transition. - For high-debt countries, ambitious consolidation is particularly essential—many have seen a persistent increase in their fiscal deficits. - Clear communication of the rationale for fiscal consolidation is necessary to secure broad support. - For high-debt countries, fiscal consolidation should be accompanied by strong growth-enhancing reforms. ### Key quantitative staff estimates and footnotes - Staff’s advice of tightening the CAPB by 1 percent of GDP in 2024 is in line with a euro area aggregation of the European Commission’s Country Specific Recommendations. - Staff estimates that a reduction of government consumption (relative to the January 2023 WEO baseline) by 1 percent of GDP annually in 2023 and 2024, and by ½ percent in 2025 would lower inflation by 0.2 percentage points during the first two years and consequently, lower the interest rate path by around 40-50 basis points in 2023-25. ### Better-targeted energy support and fiscal-equity-climate tradeoffs - Euro area countries announced on average the equivalent of 2.6 percent of GDP in energy support measures for 2022 and 2023, of which more than two thirds are untargeted. - The announced cost is substantially larger than that of fully compensating the bottom 40 percent of households for the increase in the cost of living from the energy price shock. - Policy options to improve targeting and outcomes: - Bonuses or rebates on energy bills (not linked to current volume of consumption) or block tariffs are simple options that would improve current policy design in many countries. - Better targeting strengthens incentives for energy conservation and helps reduce inflation. - Reclaiming relief from the better-off through income taxation would make support more progressive. ### Relieving supply constraints and labor supply - The fast expansion of LNG import capacity, including through floating terminals in Germany, was an important step to tackle the surge in natural gas prices. - Continued efforts to close remaining European infrastructure bottlenecks in line with the REPowerEU plan are important, while avoiding a buildup in medium-term excess capacity. - Policies encouraging labor supply are crucial to expanding supply amid tight labor markets. ### Authorities’ views on fiscal stance - Authorities view the aggregate fiscal stance projected for 2023 and 2024 as broadly appropriate, acknowledging high heterogeneity across countries. - They emphasize phasing out energy support measures by end-2023 as energy prices decline and initiating improvements in underlying fiscal positions to enhance medium-term fiscal sustainability. - Authorities noted windfall revenue gains from unexpected inflation and argued for using them to further improve fiscal balances. - A potential return of higher energy prices is a risk; targeted energy support measures can offset negative impacts. - The introduction of a minimum corporate profit tax could help toward fiscal consolidation in some member states. ### Policy response in adverse scenarios - Downside scenarios of intensified financial instability could include: - Weakening of banks’ asset quality and credit provision due to higher corporate insolvencies. - A sharp correction in real estate prices. - Loss of confidence in banks or a sharp increase in borrowing costs of high-debt countries from a sharp change in market sentiment or solvency concerns. - Localized or systemic liquidity stress acting as an amplifier. - Recommended responses: - Financial sector policies: prompt early interventions in troubled institutions, orderly resolution of unviable institutions, use liquidity support tools to avoid contagion and unwarranted insolvencies, temporary and targeted emergency liquidity assistance if needed, and release the CCyB in a downside scenario. - Monetary policy: maintain the separation principle; continue to use monetary policy to fight inflation and liquidity tools to ensure financial stability; adjust monetary stance if financial distress tightens credit and has disinflationary effects; in severe stress consider temporary halt to QT or postponement of TLTRO repayments; if sovereign markets are disrupted, flexibly reinvest maturing assets under PEPP or activate the TPI; address sovereign solvency concerns through Outright Monetary Transactions and the ESM’s macro-adjustment programs. - Fiscal policy: allow automatic stabilizers to operate; reserve discretionary support for severe scenarios and target it well. ### Further adverse supply shocks / persistent inflation - Further adverse supply shocks or more persistent inflation would require tighter monetary policy even if tradeoffs worsen. - Example risk: a full shutoff of Russian gas combined with a harsh winter could keep inflation elevated and imperil anchoring of inflation expectations; monetary policy would need to be tighter in 2023 and 2024. - With tighter monetary policy, monitor and address financial stability risks closely. - In such scenarios, maintain separation of tools, provide targeted liquidity support, and adjust monetary policy cautiously only once disinflationary effects are more certain. - Allow automatic fiscal stabilizers, but avoid large increases in structural deficits; countries with limited fiscal space should restrict overall fiscal balances and offset spending increases. ### Authorities’ views on toolkit and response capacity - Authorities believe they have appropriate tools to respond to adverse scenarios referenced by Fund staff (financial sector stress; adverse supply shocks/persistent inflation). - ECB staff: existing open market operations facilities (MRO and LTROs) provide effective instruments to meet short-term liquidity needs. - Fragmentation in monetary transmission from divergent sovereign spreads can be tackled through flexible reinvestment of maturing bonds in the PEPP portfolio or through the TPI. - ECB did not rule out altering the speed of balance sheet reduction in a highly severe scenario but reiterated primacy of key interest rates and measured, predictable passive balance-sheet rundown. - If turbulence stems from nonbank financial institutions, the ECB could consider appropriate responses to stem contagion but did not see a need for a dedicated standing liquidity facility for nonbanks. - In a severe downside scenario, well-targeted discretionary fiscal support could be deployed. ### Building resilience and countering fragmentation — overview - Permanent shifts from the pandemic, energy shock, and uncertain global environment increase urgency to bolster resilience by addressing long-lasting and interlinked structural challenges. - Key areas: strengthen fiscal sustainability via revamped fiscal governance, raise potential output through structural reforms, and deliver on ambitious green transition targets. ### Safeguarding fiscal sustainability — outlook and targets - Euro area public debt increased sharply in 2020 and, despite strong nominal GDP growth, is about 6 percentage points of GDP above 2019 levels at present. - The level of debt in 2025 is projected to be 12 percentage points of GDP higher than the pre-pandemic projection for that year. - Average euro area medium term fiscal deficits are now more than 1½ percent of GDP higher than projected prior to the pandemic, with slightly less than half reflecting higher debt service costs. - Fiscal space should be rebuilt over the medium term with more ambitious and front-loaded adjustment in high-debt countries. - Primary fiscal balances should reach a surplus by 2026 and improve further at least until 2028. - For some high-debt and deficit countries, improvements in the overall balance of between 0.5 and 1.0 percent of GDP annually for several years are needed to put debt on a firmly downward path. - Fiscal consolidation should curb expenditure growth while safeguarding growth-enhancing public investment. - Countries with medium-to-low debt and strong fiscal balances should allocate sufficient resources to growth-enhancing public investments and support to vulnerable households. ### Reform of the EU economic governance framework - Ongoing reform is an opportunity to promote sustainable public finances, enhance macroeconomic stabilization, and secure provision of common public goods. - Current framework criticisms: complex targets dependent on unobservable variables, limited account of country-specific circumstances, and limited scope for managing tradeoffs between containing fiscal risks and output stabilization; compliance has been uneven and not generated sufficient debt reduction in good times. - The Commission proposal (late April) aligns with Fund staff views: - Calls for a risk-based approach to determining consolidation paths focusing on medium-term fiscal plans operationalized through multi-year net primary expenditure paths. - Such paths are expected (via DSA) to deliver declining debt-to-GDP ratios after four years for countries with debt above 60 percent of GDP. - Adjustment period can be extended from four to seven years for countries that commit to reforms or public investments. - As a safeguard, the debt-to-GDP ratio is required to be below its initial level at the end of the adjustment period. - During the adjustment period, countries must keep net primary expenditure growth below medium-term GDP growth, on average. - The proposal calls for an expanded role for national fiscal councils. - Minimum annual reduction in the deficit of 0.5 percent of GDP must be maintained if the general government deficit exceeds the reference value of 3 percent of GDP during the adjustment period. - Fund staff view: - The proposal is welcome for facilitating risk-based adjustment while avoiding procyclicality and fostering ownership. - Net primary expenditures as operational targets eliminate incentives to substitute expenditure programs with tax expenditures and allow automatic stabilizers to operate. - Cautions: extending adjustment periods can incentivize reforms but risks non-delivery; predicting output impacts of investments/reforms is challenging and may be optimistic ex-post. - Mitigations: establish and enforce clear criteria for extending the adjustment period, rely on conservative GDP effect estimates, ensure complete transparency on technical aspects (e.g., cyclical unemployment expenditure and discretionary revenue measures). - It is vital that an agreement is reached soon so the new framework can anchor fiscal policies in 2025 and beyond. *Source: IMF staff analysis as presented in the provided content.* ### 60. The current proposal could be further strengthened by an EU-wide fiscal capacity and ### 1eurea2023001 - 60. The current proposal could be further strengthened by an EU-wide fiscal capacity and ### Strengthening EU fiscal framework and governance - Proposal: introduce an EU-wide fiscal capacity and an independent European fiscal council (EFC). - Rationale: - A central fiscal capacity could improve provision of common public goods (energy security, green transition) and strengthen macroeconomic stabilization. - An independent EFC could establish credibility and impartiality for a framework that relies on relatively complex DSA analysis to set the “technical trajectory” for fiscal aggregates. - National fiscal councils (NFCs) would benefit from an EFC acting as a node in a network of NFCs to promote good practices, standards, and provide an independent voice on risks and execution of the framework. - Authorities’ stance: - Agreed on the need for ambitious and differentiated medium-term fiscal consolidation to build fiscal space and improve long-term sustainability. - Stressed swift adoption and implementation of proposed economic governance reform with country-specific, risk-based adjustment paths and medium-term net primary expenditure paths as the primary operational target. - Noted challenges: assessment of long-term growth impact of public investments and structural reforms; favored qualitative evaluation using established methodology and highlighted safeguards in the framework. - If no agreement on legislative reform by end of 2023, a transitional arrangement consistent with current EU legislation should guide member state fiscal positions. ### Minimum corporate profit tax - Implementation: - Council Directive (November 2022) commits member states to introduce by 2024 a minimum corporate profit tax of 15 percent for enterprise groups. - Expected effects: - Mitigates incentives to compete through low corporate tax rates and preferential regimes. - Reduces profit-shifting opportunities within the EU. - Improves tax collections and supports needed fiscal consolidation across the euro area. ### Delivering the green transition and energy security - Context: - Russian invasion of Ukraine increases urgency to accelerate transition to reliable low-carbon energy sources. - Fit for 55 commits to reduce emissions by 55 percent by 2030 (relative to 1990 levels). - Investment needs: - Estimated additional investments of around €400 billion per year between 2021 and 2030 (figure noted as likely risen with inflation). - Recent developments and outcomes: - Despite increased coal and oil use last year, renewable capacity (especially wind and energy) expanded at a record pace; efficiency gains in residential housing and industry contributed to an estimated reduction of 2.5 percent in total EU carbon emissions in 2022 (IEA, 2023). - Energy shock likely favorable for green transition: boosts to energy efficiency, renewable electricity production more cost-attractive, and accelerated policy initiatives (REPowerEU, extension of CBAM and ETS, Green Deal Industrial Plan). - EU carbon prices have settled at over €90 per ton of CO2. ### EU Climate Investment Fund (CIF) - Proposed role: - Help ensure emissions reduction goals are achieved cost-effectively by internalizing cross-border externalities and allocating funds to countries/sectors with highest return on carbon abatement. - Support preservation of the EU single market amid potentially growing subsidies for clean technologies and uneven fiscal space. - Relieve constraints due to limited fiscal space in some countries while avoiding permanent cross-country transfers. - Authorities’ view: - Recognized potential value but highlighted political hurdles; current focus should be on implementing and absorbing existing instruments and financing initiatives toward 2030 Fit for 55 objectives. ### ETS reform, ETS II, and CBAM - ETS reform: - Sets an ambitious emission reduction goal of 62 percent by 2030 (relative to 2005 levels), up from current objective of 43 percent. - Envisages establishment of a new social Fund to support vulnerable households and a separate ETS II expected to be implemented in 2027 for fossil fuels used in buildings, road transport, and certain industrial sectors. - Aligning ETS and ETS II over the longer run would help reduce potential distortions across sectors. - CBAM: - Scope widened in December 2022 to cover a broader set of goods; applies to imports from non-EU countries except those covered by EU ETS. - Third countries may apply for exemptions if they have equivalent domestic carbon pricing. - Planned to permanently enter into force in 2026 and phased in gradually from 2023 as free allowance allocations are phased out. - Recommended implementation: consistent with WTO, and—where administratively feasible—based on actual embodied carbon content rather than benchmarks. - EU should support least developed countries’ adjustment to new environmental policies. ### Green Deal Industrial Plan (GDIP) and subsidies - Positive elements: - Streamlining regulatory and permitting processes, enhancing training, fostering green innovation, and creating regulatory sandboxes. - Risks: - Extends/expands relaxation of state-aid rules (through 2025 via the Temporary Crisis and Transition Framework), allowing subsidies/tax incentives and country-specific schemes to support production of critical materials and green products. - Potential adverse effects: higher fiscal costs, inefficiencies, distortions to EU single market, and protectionist provisions (domestic content requirements) that could disrupt global supply relationships. - Recommendations: - Limit subsidies under relaxed state aid rules in scope, duration, and size. - Coordinate fiscal support for clean tech sectors across member states, including under an EU-wide facility, to limit distortions. - Pursue a common multilateral approach—consistent with WTO—on appropriate use and design of subsidies, underpinned by analysis of cumulative effects on climate and economic outcomes. - Authorities’ view: - Emphasized GDIP’s importance for competitiveness and transition; noted temporary relaxation of state aid rules carries risks and is subject to enhanced scrutiny and evidence of material relocation risks. - Suggested a proposed European sovereignty fund could provide greater flexibility for countries with less fiscal space. ### Trade policy, multilateralism, and WTO - Current posture: - EU should remain open and minimize trade distortions amid weakening trade policies and high trade tensions. - New tools implemented or in development: Foreign Subsidy Regulation, EU FDI Screening Regulation, upgraded Export Control Regulation, Chips Act, Anti-Coercion Instrument, and a possible outbound investment mechanism. - Applications of these tools should be narrowly targeted and not used to provide competitive advantage to domestic industries. - WTO priorities and EU role: - EU leadership needed to complete new WTO-based agreements and reform WTO. - Prioritized actions: implement Services Domestic Regulation plurilateral agreement, conclude plurilateral agreements on Investment Facilitation and E-Commerce, restore WTO dispute settlement, and strengthen efforts on agricultural and industrial subsidy practices. - A February 2023 EU paper presented ideas to improve WTO’s “deliberative function” and to address subsidy issues examined by IMF, OECD, WB, and WTO (2022). - Authorities’ view: - Openness and multilateralism are central to Open Strategic Autonomy; CBAM to be phased in gradually during 2023-34 while helping trading partners prepare. - WTO reform and restoration of an effective dispute settlement system seen as urgent; progress sought on fisheries subsidies, reduction of trade-distorting agricultural support, plurilateral e-commerce and investment facilitation, and a work program on industrial subsidies. ### Productivity, growth, and Next Generation EU (NGEU) - Productivity trends: - Long-standing productivity challenges remain; euro area labor productivity on long downward trend relative to the United States. - Over 2020-2022, labor productivity grew broadly at the pre-pandemic rate in absolute terms but masked a near standstill in total factor productivity (TFP) and smaller positive contribution of labor composition; slightly larger contribution from capital. - NGEU role and impact: - NGEU provides financial support equivalent to 6 percent of 2020 GDP conditional on investment and reform projects. - Investment allocation: around 40 percent dedicated to climate change; around 20 percent to digitalization. - IMF staff estimates: if implemented as planned, overall European GDP would be boosted by around 1.5 percent by the end of the program in 2026. - RePowerEU incorporation into NRRPs could accelerate transition to green economy; shorter permitting times in REPowerEU are welcomed given delays to wind and solar deployment in some regions. *Source: IMF staff — EURO AREA POLICIES, selected excerpts.* ### Box 4. Euro Area: The Long-term Impact of the Energy Price Shock on Output and Income ### Box 4. Euro Area: The Long-term Impact of the Energy Price Shock on Output and Income Divergence ### Overview - The increase in energy prices following Russia’s invasion of Ukraine has been larger for Europe than for the rest of the world, and energy prices in Europe are projected to remain elevated relative to the pre-pandemic levels, implying a permanent change in terms of trade with implications for factor incomes, aggregate output, and income divergence within the EU. ### Model simulations and quantitative results - Simulations use a Global Computable General Equilibrium model of a stylized energy price shock entailing: - EU increases of about 160 percent in gas prices (55 percent in the rest of the world). - 30 percent increase in oil prices (same in the rest of the world). - Gas and oil exports from Russia to the EU are assumed to be cut by 90 percent, compared to 2017 levels. - Key simulation findings: - A permanent shock to oil and gas prices in the EU will result in a loss of income for all factors of production. - Real wages and return on capital will decline, with heterogeneity across sectors. - Services sectors, relying on domestic demand, are likely to be hurt more because they gain less from real exchange rate depreciation. - Unskilled workers and capital owners in energy exporting economies (EEE) would on average benefit from the price shock. - Input factor incomes in the rest of the world (ROW) would decline, but to a lesser extent than in the EU. - Aggregate EU real GDP level declines by about 1.5 percent—threefold the impact on the rest of the world. - Given different energy mixes and sectoral composition across EU countries, impacts vary significantly, widening income gaps; countries with lower real wages would experience larger declines, partly due to heavier reliance on fossil fuels. ### Policy implications from simulations - Accelerating the green transition would help member states reduce vulnerabilities in energy-intensive sectors and close income gaps. - Policies should account for heterogeneous sectoral and country-level impacts when designing support and transition measures. ### National Recovery and Resilience Plans (NRRPs) — execution and governance - As of early June, around €153 billion out of a total of about €500 billion has been disbursed. - Only a small number of countries have received their second payments; Spain is the only member state to receive a third payment. - About one-third of member states are facing delays on planned reforms and investments, including due to the tight economy and attendant labor shortages. - Recommended actions: - Accelerate efforts to meet targets and milestones set in NRRPs. - Ensure NGEU funds adhere to highest standards of transparency and accountability (e.g., disclosure of beneficial ownership information for awarded companies). - Leverage European Anti-Fraud Office and European Public Prosecutor Office roles in investigating any misuse of NGEU funds. ### Innovation, R&D, and capital markets - Europe has lagged most other major economies in R&D spending over the past decade; large corporate R&D spending is concentrated in automotive and pharmaceutical sectors, with software, technology hardware and electronics lagging. - Policy priorities: - Renewed emphasis on innovation to durably lift growth. - Progress on digitalization (training, skills, connectivity) to foster collaboration and overcome local skills shortages. - Increase incentives for R&D and promote innovation hubs to capture network externalities. - Progress on the capital markets union (CMU) to deepen capital markets and improve access to finance for young firms. ### Labor market, sectoral shifts, and reskilling - The euro area faces accelerating sectoral shifts because of digitalization, automation, and the green transition; pre-pandemic trend away from agriculture and industry toward services has continued and accelerated. - Example: between 2015 and 2020, transition to electric vehicles (less labor intensive) increased unemployment in German regions relying more on the auto sector. - Policy recommendations: - Facilitate sectoral reallocation through labor and product market flexibility and sound macroeconomic policies. - Use temporary and targeted hiring subsidies to incentivize worker mobility, while recognizing these are challenging to deploy effectively. - Ensure efficient reskilling and upskilling with strong focus on digital skills; expand educational and vocational programs for those struggling to transition. - Better integrate immigrants across the EU to deploy human capital productively and alleviate fiscal pressure from an aging population. ### Macro-financial and fiscal guidance - Outlook highlights: - Growth expected to pick up modestly through 2023 and 2024 but output likely to remain below the pre-war trend for an extended period. - Inflation projected to decline further and converge to target only in mid-2025. - Euro area current account expected to increase over the forecast horizon as the impact of the energy shock gradually dissipates. - Risks: - Downside risks to growth and upside risks to inflation (including financial turbulence, weaker external demand, sovereign stress, persistent supply shocks, geoeconomic fragmentation, stronger-than-expected wage growth). - Monetary policy: - Monetary policy should tighten further and keep a tightening bias; a more restrictive stance maintained over a sustained period will be needed to anchor inflation expectations. - Continue a flexible, data-dependent approach; use policy rate as primary tool and proceed gradually in trimming securities holdings. - Banking and financial sector: - Euro area banks have strong capital and liquidity positions, but funding costs are expected to increase with upcoming TLTRO repayments and rising competition for deposits. - Where banks have temporarily high profits, capital buffers should be increased. - Supervisors should monitor bank risk exposures and risk management strategies. - In NBFI sector, vulnerabilities from liquidity demand and derivatives positions suggest expanding macroprudential tools limiting leverage and liquidity mismatches and improving cross-jurisdictional regulatory cooperation. - Strengthening EU financial architecture: - Support review of CMDI to extend resolution framework and improve resolution funding arrangements. - More flexibility in deploying resolution funds would help contain systemic risk. - Fully ratifying the ESM treaty to create a backstop to the SRF and agreeing on a European deposit insurance scheme would deepen resilience. - Progress toward the CMU and full implementation of Basel III are essential. - Enhance financial integrity through a single AML/CFT rulebook and establishing an AML supervisory authority. - Fiscal policy: - A tightening in the euro area fiscal policy stance in 2024 compared to 2023—by about 1 percent of GDP, as current policies imply—would help reduce the risk of additional inflation pressures. - Importance of saving revenue windfalls and allowing energy support measures introduced over the past year to expire. - If energy prices rise significantly again, any new support should be targeted to the most vulnerable to maintain consolidation efforts and strengthen incentives for energy efficiency. - Economic governance: - Swift agreement on EU economic governance reform is a priority. - The Commission’s proposal promotes a differentiated, risk-based, medium-term fiscal adjustment using net primary expenditure as the operational target. - Cautious implementation and transparency on technical aspects (e.g., cyclical unemployment expenditure and discretionary revenue measures) are essential. - An independent European fiscal council could add credibility; an EU-wide fiscal capacity for macroeconomic stabilization and public goods would strengthen the framework. ### Green transition and GDIP - The energy crisis has accelerated green policy initiatives and reduced short-term energy security risks via European solidarity, diversification of supply, and demand adjustment. - Policy considerations: - Expansion of EU’s ETS is positive; in the longer run align carbon prices across sectors to reduce distortions in emission reduction incentives. - Widening the scope of CBAM will help support global emission reduction; implement CBAM in line with WTO rules and based on actual carbon content in traded products rather than benchmarks. - The GDIP can complement climate neutrality efforts by streamlining regulatory and permitting processes, enhancing skills, and fostering green innovation. - Caution on relaxation of state-aid rules: risks of high fiscal costs, economic inefficiencies, and distortions to the Single Market argue for subsidies limited in scope, duration, and size and for a common WTO-consistent approach to subsidies across key players. - Consider an EU Climate Investment Fund to improve provision of common public goods related to energy security and the green transition. - Foreign subsidies, investment screening, and export controls should be narrowly targeted; resist using such tools to provide competitive advantage to domestic industries. *Source: IMF staff calculations and analysis as presented in Box 4. Euro Area: The Long-term Impact of the Energy Price Shock on Output and Income Divergence.* ### 90. Ambitious actions to boost productivity are needed to increase growth in the euro ### 90. Ambitious actions to boost productivity are needed to increase growth in the euro area ### Growth and structural policy priorities - Ambitious actions to boost productivity are needed to increase growth in the euro area. - The NRRPs have the potential to boost growth by delivering structural reforms and investments, but greater flexibility in their implementation may be needed if countries have capacity constraints. - Reskilling and upskilling the workforce—focusing on digital skills—and improving labor market flexibility can promote a dynamic labor market. - Policies to better integrate immigrants can help alleviate fiscal pressure caused by an aging European population. - It is proposed that the next consultation on euro area polices in the context of the Article IV obligations of member countries follow standard 12-month cycle. ### Real sector developments (high-level findings) - The euro area economy contracted by 0.1 percent in both Q4 2022 and Q1 2023 due to weak domestic demand. - After lagging in 2021, the services sector rebounded more than industry from the pandemic shock. - While GDP stands 2.5 percent above the pre-pandemic level, private consumption is still at 2019 level. - Imports and exports remained at high levels in historical comparison. - Sentiment had reached a trough in Q4 of 2022. ### Inflation developments (high-level findings) - Headline inflation peaked in 2022Q4 and has fallen sharply in recent months. - All components of energy inflation turned negative as energy prices eased. - Relative price changes from the pre-pandemic period remain large across components (energy, unprocessed food, services, processed food, non-energy industrial goods). - Dispersion in inflation rates within the euro area is high; the dispersion chart shows wide cross-country variation (May-23 headline inflation values shown for member states). - The share of investors expecting above-target inflation declined sharply for the US and the euro area in early 2023. - Consumer expectations have fallen from their peak in late 2022 in line with the drop in headline inflation. ### Public sector accounts (high-level findings) - Public sector debt increased sharply at the onset of the pandemic, before falling somewhat in 2021-22. - There are large differences in debt accumulation across countries; changes in public debt between 2019 and 2022 vary widely by country (charted as percentage points of GDP). - The increase in debt was driven both by a drop in nominal GDP and the fiscal support programs that were launched. - Much pandemic-era support has been rolled back but partly replaced by energy support, leaving countries with a challenge to bring current expenditure back to pre-pandemic levels. - Revenue and expenditure dynamics (2012–2022) show social security benefits, interest expenditure, other current expenditure, and capital expenditure as components of government expenditure. ### External sector developments (high-level findings) - The current account fell into deficit in 2022 as the trade balance deteriorated sharply, driven by the energy balance. - Net trade in services strengthened relative to 2021, with travel normalizing from the pandemic shock. - Primary and secondary income balances were broadly unchanged. - The net international investment position continued to strengthen as it has pre-pandemic. - The exchange rate depreciated to its weakest reading since 2015 in 2022 but has since partially recovered. ### Key projections and headline numbers (from Table 1: Main Economic Indicators) - Real GDP: 2019 1.6; 2020 -6.1; 2021 5.3; 2022 3.5; 2023 0.9; 2024 1.5; 2025 1.8; 2026 1.7; 2027 1.4; 2028 1.3 (y/y percent change). - Private consumption: 2019 1.4; 2020 -7.7; 2021 3.7; 2022 4.5; 2023 0.5; 2024 2.1; 2025 2.0; 2026 1.8; 2027 1.4; 2028 1.3. - Gross public debt: 2019 83.7; 2020 96.8; 2021 95.1; 2022 91.2; 2023 89.4; 2024 88.2; 2025 87.1; 2026 86.3; 2027 85.6; 2028 85.1 (percent of GDP). - Consumer prices: 2019 1.2; 2020 0.3; 2021 2.6; 2022 8.4; 2023 5.2; 2024 2.8; 2025 2.1; 2026 2.0; 2027 1.9; 2028 1.9. - Overall fiscal balance: 2019 -0.6; 2020 -7.1; 2021 -5.3; 2022 -3.6; 2023 -3.5; 2024 -2.7; 2025 -2.3; 2026 -2.1; 2027 -2.0; 2028 -2.0 (percent of GDP). - Current account balance: 2019 2.2; 2020 1.6; 2021 2.3; 2022 -1.0; 2023 0.9; 2024 1.1; 2025 1.4; 2026 1.6; 2027 1.7; 2028 1.7 (percent of GDP). - Euro short-term rate (€STR): 2019 -0.5; 2020 -0.6; 2021 -0.6; 2022 1.6; 2023 3.1 (end of period). - U.S. dollar per euro (end of period): 2019 1.11; 2020 1.22; 2021 1.13; 2022 1.06; 2023 1.09 (end of period). ### External sector assessment and policy recommendations (from Table 2) - Overall assessment: The external position in 2022 was broadly in line with the level implied by medium-term fundamentals and desirable policies. - The CA balance decreased to –1.0 percent of GDP in 2022 from 2.3 percent of GDP in 2021, falling into deficit for the first time in more than a decade largely due to a sharp increase in energy import prices and the associated deterioration in the goods balance. - Over the medium term, the euro area’s CA balance is projected to recover gradually to a positive territory but remain below its historical average as energy prices are projected to remain elevated. - National external imbalances are expected to remain sizable. Potential policy responses (as stated) - With energy prices projected to remain elevated over the medium term, policies aimed at protecting vulnerable households and firms should become increasingly targeted. - Efforts to facilitate the green transition should be stepped up. - Avoid trade-distorting subsidy races and other trade-distorting measures, which would undermine resource allocation and productivity, and preserve the integrity of the EU Single Market. - Resolve trade and investment disagreements with other countries in a manner that supports an open, stable, and transparent global trading system. - Countries with excess CA surpluses should increase investment. - Countries with weak external positions should undertake reforms to raise productivity, reduce structural and youth unemployment, and commence growth-friendly fiscal consolidation. - Euro-area-wide initiatives to make the currency union more resilient (for example, completing the banking and capital markets unions and establishing the central fiscal capacity for macroeconomic stabilization) would deepen public and private sector risk sharing, supporting external stability of high-debt countries. ### External position metrics (2022, percent of GDP) - NIIP: 2.0 - Gross Assets: 250.7 - Debt Assets: 92.0 - Gross Liab.: 248.7 - Debt Liab.: 92.5 ### IMF staff assessments and technical notes - EBA model estimates a CA norm of –0.3 percent of GDP, against a cyclically adjusted CA of 0.1 percent of GDP, implying a gap of 0.5 percent of GDP; IMF staff analysis indicates a 0.1 percent of GDP higher CA norm than the EBA model and staff assesses the CA gap to be –0.1 percent of GDP in 2021, with a range of –0.7 to 0.6 percent of GDP. - CPI-based REER: the IMF staff assesses the REER gap to be 0.0 percent in 2022, with a range of –1.6 to 2.0 percent, based on the estimated CA-REER elasticity of –0.35. - Heterogeneity: REER gaps range from an undervaluation of 8 percent in Germany to an overvaluation of about 10 percent in Finland and Italy. The EBA REER index and level models suggest overvaluations of 7.6 percent and 8.0 percent, respectively. *Source: EURO AREA POLICIES, INTERNATIONAL MONETARY FUND (chapter content).* ### 0.1 percent of GDP in 2022, mirroring the CA deficit. ### 1eurea2023001 - 0.1 percent of GDP in 2022, mirroring the CA deficit. ### External Position and Reserves - Current account: "0.1 percent of GDP in 2022, mirroring the CA deficit." - Gross external indebtedness: "decreased by 11 percentage points of GDP in 2022 as lower external debt of governments, the Eurosystem, and the nonfinancial sector has offset higher debt of deposit-taking institutions." - FX intervention and reserves level - Background: "The euro has the status of a global reserve currency." - Assessment: "Reserves held by euro area economies are typically low relative to standard metrics, but the currency is free floating." ### Risk Assessment Matrix — Global Risks (summary of likelihood, expected impact, and policy responses) - Intensification of Regional Conflict - Likelihood: High - Expected impact: High - Key channels: disruption of trade (energy, food, tourism, critical supply chain components), remittances, refugee flows, FDI, financial flows, payment systems. - Policy responses: - "Accelerate energy transition." - "Extend energy subsidies, but improve targeting." - Abrupt Global Slowdown or Recession - Likelihood: Medium - Expected impact: High - Key channels: synchronized sharp growth downturn, trade and financial spillovers, market fragmentation; in Europe: intensified fallout from the war in Ukraine, worsening energy crisis, supply disruptions, monetary tightening, housing market corrections. - Policy responses: - "Slow or pause monetary policy tightening depending on the prospects for aggregate demand and price pressures." - "Allow automatic stabilizers to operate and provide fiscal support to vulnerable households." - "Promote high quality public investment in infrastructure and advance structural reforms." - "Enhance liquidity support to financial institutions and markets with strong coordination between the ECB and the national authorities on financial stability risks." - Commodity Price Volatility - Likelihood: Medium - Expected impact: Medium - Key channels: supply disruptions and demand fluctuations causing recurrent commodity price volatility, external and fiscal pressures, social and economic instability. - Policy responses: - "Maintain a flexible and data dependent monetary policy." - "Allow automatic stabilizers to operate and provide fiscal support to vulnerable households." - "Safeguard energy security by accelerating the green transition." - Deepening Geo-economic Fragmentation - Likelihood: High - Expected impact: Medium - Key channels: reconfiguration of trade and FDI, supply disruptions, technological and payments systems fragmentation, rising input costs, financial instability, lower potential growth. - Policy responses: - "Diversify energy production and secure supply chains to avoid shortages of critical raw materials." - "Tighten monetary policy stance as necessary to bring inflation to target." - "Allow automatic stabilizers to operate and provide fiscal support to vulnerable households." - Systemic Financial Instability - Likelihood: Medium - Expected impact: High - Key channels: sharp swings in real interest rates, risk premia, asset repricing triggering insolvencies in weak banks or non-bank financial institutions, markets dislocations, cross-border spillovers. - Policy responses: - "Enhance liquidity support to financial institutions and markets to avoid contagion and prevent liquidity shortages morph into insolvencies." - "Ensure strong coordination between the ECB and the national authorities on financial stability risks." - "Rely on bank resolution systems to address unsound banks." - "Activate EU support lines for high-debt countries under stress." - "Maintain tight monetary stance until inflation is firmly on a downward trajectory toward target." - "Allow automatic stabilizers to operate and provide temporary support to vulnerable households." ### Risk Assessment Matrix — Euro Area Risks (selected entries) - Social Discontent - Likelihood: High - Expected impact: Medium - Policy responses: - "Expand support to most vulnerable households" - "Active labor market policies can be used to facilitate reallocation of workers toward expanding sectors and limit labor market hysteresis." - Realization of Financial Sector Vulnerabilities - Likelihood: Medium - Expected impact: High - Policy responses: - "Enhance liquidity support to financial institutions and markets to avoid contagion and prevent liquidity shortages morph into insolvencies. Ensure strong coordination between the ECB and the national authorities on financial stability risks." - "Use countercyclical financial policy to support viable financial institutions." - "Rely on bank resolution systems to address unsound banks." - "Maintain tight monetary stance until inflation is firmly on a downward trajectory toward target." - "Allow automatic stabilizers to operate and provide temporary support to vulnerable households." - "Activate EU support lines for high-debt countries under stress." - More Persistent Inflation - Likelihood: High - Expected impact: High - Key triggers: "Full Russian gas shutoff combined with increased Chinese demand and a cold 2023/24 winter", "Reduction of Ukrainian grain exports due to a blockade of Black Sea shipping routes, or low harvest due to the war in Ukraine or bad weather." - Policy responses: - "Tighten monetary policy further to keep expectations anchored and prevent wage-price spirals." - "Allow automatic stabilizers to operate and provide fiscal support to vulnerable households." - A Shift in Market Sentiment Against some High-debt Euro Area Countries - Likelihood: Medium - Expected impact: High - Policy responses: - "Activate EU support lines for high-debt countries under stress." - "Maintain tight monetary stance until inflation is firmly on a downward trajectory toward target." - "Enhance liquidity support to financial institutions and markets with strong coordination between the ECB and the national authorities on financial stability risks." - Extreme Climate Events - Likelihood: High - Expected impact: High - Policy responses: - "Build fiscal space that can be activated to alleviate large discrete climate shocks." - "Establish a Central Fiscal Capacity with the remit to finance mitigation of extreme climate events." - Probability interpretation (staff’s subjective assessment): - "Low" is meant to indicate a probability below 10 percent. - "Medium" a probability between 10 and 30 percent. - "High" a probability higher than 30 percent. ### Annex I — A Roadmap for Monetary Policy (modeling, robust approach, and policy implications) - Information and uncertainty - Central banks use models with different assumptions on how backward or forward-looking wage and price setting can be; uncertainty about persistence of inflation and inflation expectations rises during regime shifts. - "In the current inflation episode, a lagged response of wages to higher prices is likely to prolong the period of above-target inflation, even if a wage-price spiral is avoided." - Robust approach to policy under persistence uncertainty - Exercise basis: Laureys, Meeks, and Wanengkirtyo’s (2021) medium-scale New Keynesian DSGE model with financial frictions, estimated for the euro area; introduces uncertainty about the degree to which wage and price inflation is persistent. - Central bank choice: assume persistence remains low (reference policy) or assume persistence has increased and apply a tighter policy (robust/tightening-biased rule). - Outcome summaries: - If persistence is low, a more forceful tightening than the reference rule yields "less of a deviation between actual and targeted inflation and a more negative output gap." - If persistence is high and the central bank uses the reference (low-persistence) policy, "inflation is higher under the low-persistence optimal rule than under the alternative high-persistence rule, with a small gain in terms of output gap." - Quantified costs and benefits of the robust rule - Using a quadratic loss function with equal weights for output gap and inflation: - "The total central bank loss ... is only 4.4 percent (1.04 times) higher when the central bank uses the policy rule with tightening bias instead of the reference one." - "In the worst-case scenario (i.e., when the central bank assumes persistence stays low when in fact it is high), losses associated with using the reference rule are 1.5 times as high as the losses experienced when using the robust rule." - "Introducing financial stress (in the form of higher lending spreads) does not change the results qualitatively as the benefit of a robust monetary policy response remains larger than its cost." - Robust policy implications for ECB policy rates and inflation - Baseline staff projection reference: policy path peaks at "about 3¾ percent in 2024Q1." - Under a policy rule with a tightening bias: - "The range of the policy interest rate paths could be higher than under the baseline." - "Under the robust policy, inflation would come down faster and reach the ECB’s target of 2 percent before the end of 2024." - Figure descriptions: reference and robust paths for the ECB’s deposit facility rate and HICP inflation show policy rates peaking sooner and with a higher terminal value under the robust rule, and HICP converging to target "much faster than under the baseline." *International Monetary Fund — Euro Area Policies (excerpts).* ### Annex II. Raising Rates with a Large Balance Sheet: The ### Annex II. Raising Rates with a Large Balance Sheet: The Eurosystem’s Net Income and its Fiscal Implications ### Loss dynamics and balance-sheet mechanics - Quantitative easing removed duration risk from the private sector’s balance sheet and created bank reserves on the liability side, effectively executing a fixed-for-floating rate swap that leaves the Eurosystem with large interest rate exposure during tightening. - Rising policy rates lift the remuneration of bank reserves while assets churn more slowly, producing a period of loss-making for the Eurosystem. - The loss-making outcome is described as a feature of balance sheet policies shaped by the inflation objective, not an unexpected failure. ### Staff analysis and projections of net income - The baseline scenario (using market rate paths and announced policies) indicates: - Two years of loss-making for the Eurosystem. - 0−5 years of loss-making for the “top-five” NCBs: Germany, France, Italy, Spain and the Netherlands. - Drivers and sensitivities identified by staff: - Home bias in NCBs’ bond holdings leads NCBs whose sovereigns enjoy lower market funding costs to see larger and more persistent losses. - Asset churn into higher-yielding securities has a strong positive effect on net income; faster quantitative tightening (QT) can reduce cumulative net income because savings from faster reserve reduction are exceeded by lost interest income from lower reinvestments. - Parallel upward shifts in yield curves are profit enhancing. - Lower banknote demand reduces net income (has the opposite effect to upward yield shifts). ### Fiscal implications and key statistics - Fiscal impact (even without capital injections) is estimated at about 0.1−0.2 percent of GDP per annum. - The temporary nature of loss-making implies no need for capital contributions from the state; losses can be offset against future net income following the US Federal Reserve’s approach. - More-conservative profit distributions in future cycles could mitigate on-off dividend patterns. - Loss-making must remain orthogonal to monetary policy decision-making; credibility rests on performance delivering the price stability mandate. ### Selected NCB average annual tax payments and transfers to state (Table AII.1: Percent of GDP, 2008–31) - Table header/context (as presented): - Period ofReplenishment - No. of yrs. - Old steady stateloss-making& resumption without tax or 1/transfer - 2008-22 2023-24 1/2025-31 - Reported NCB figures (as presented): - Bundesbank 0.08 0.00 0.03 11 - Banque de France 0.17 0.00 0.19 3 - Banca d'Italia 0.23 0.12 0.41 0 - Banco de España 0.21 0.00 0.26 2 - De Nederlandsche Bank 0.09 0.00 0.18 3 - Note accompanying table: "1/ P&L periods as applicable to Eurosystem as a whole; periods for individual NCBs vary." - Chart note and decomposition (as presented): "Eurosystem: Monthly Profit and Losses, 2022-2031 (€ billion)" with components listed as: On other assets; On QE portfolio; On bank reserves; Operational costs; On gov. & other deposits; Net profits on TLTROs. (Source: IMF staff estimates and projections.) ### Summary policy conclusions - No state capital contributions recommended given losses are temporary and recoupable; offsetting losses against future net income is suggested. - Fiscal impacts are material even without injections: about 0.1−0.2 percent of GDP per annum. - Adopt more-conservative profit distribution rules in future cycles to smooth dividend volatility. - Maintain strict separation between loss outcomes and monetary policy decisions; prioritize price stability as the ultimate credibility anchor. *Source: IMF staff estimates and projections.* ### 8. Several macroprudential tools can help manage systemic risk in investment funds. ### 8. Several macroprudential tools can help manage systemic risk in investment funds. ### Macroprudential tools and their effects - Leverage restrictions in line with Article 25 of AIFMD can limit build-up of systemic risk from leverage. - Restrictions on the use of derivatives can reduce risk transmission through complex exposures. - Liquidity rules that lengthen withdrawal notice periods can help investment funds stagger their liquidity needs and thus ameliorate the risk of forced liquidations. - Liquidity buffers help address short-term liquidity needs, but would have more limited benefits under persistent liquidity pressures as they become exhausted. - Ex-post “liquidity management tools” that rely on suspensions of withdrawals or swing (penalty) pricing of withdrawals can be useful in crisis management but should not be relied upon exclusively, as crises are usually easier to prevent than to resolve. - Considerations for these tools have been articulated, for example, in ECB (2018). ### Extant examples of macroprudential policies in the EU - Belgium, Italy, the Netherlands, and Poland permit only “closed-ended” real estate funds, where capital is not redeemable until the fund’s end of life. - Germany, Hungary, and Portugal require minimum notification periods to manage liquidity in real estate funds (ESRB, 2022). - At end-2022, Ireland has introduced a 60 percent leverage limit in open-ended AIF funds that invest in Irish commercial real estate—the first example in the EU of macroprudential leverage limits on investment funds under the AIFMD (CBI, 2022). - Evidence of distress redemption spikes in investment funds during periods of market volatility is well documented (for example in relation to the early stages of the COVID crisis in 2020) (Falato and others, 2021; Cappiello and others, 2021), motivating wider implementation of macroprudential policy tools for this sector. ### Implementation challenges at the national level - National competent authorities (NCAs) have historically focused on consumer protection and micro-prudential supervision and may have limited macro-prudential orientation and mandates. - NCAs often have limited track record of macroprudential expertise. - This situation calls for a careful review of the NCAs’ objectives and mandates to ensure they incorporate macroprudential policy responsibilities and are equipped with necessary tools, which should be harmonized on the EU level. - Additional investment in macroprudential analytical and applied expertise in NCAs may be appropriate. ### Cross-border coordination challenges - Funds are disproportionately domiciled in only several jurisdictions: 60 percent of total assets are in Ireland and Luxembourg, with another 30 percent in France, Germany, and the Netherlands. - Concentrated domiciliation can create specialization benefits in the corresponding NCAs, but may limit those NCAs’ ability to assess cross-border financial stability risks or to devise appropriate macroprudential measures without close consultation with NCAs of jurisdictions where the funds operate. - For banks, most cross-border macroprudential spillovers are induced by the largest institutions that benefit from single direct SSM supervision; no similar single direct supervision exists for investment funds. - Macroprudential policy coordination across the EU for nonbank entities remains less tested, although the ESRB has an extensive track record in fostering consistency of macroprudential policy stance across the EU. ### Institutional and policy recommendations for EU-level coordination - Deepen the role of European Securities and Markets Authority (ESMA) as the EU-level coordinating body and center of expertise for nonbank financial stability policy, operating in tandem with the ESRB. - ESMA should ensure robust communication channels on nonbank financial stability issues between the NCAs of jurisdictions where nonbanks are domiciled and the NCAs of jurisdictions where nonbanks operate. - Given the global nature of the nonbank space, enhance coordination between EU bodies and non-EU jurisdictions (notably UK and US) and agencies such as IOSCO. - Deeper progress on improving macroprudential regulation of nonbanks would be in line with the priority item of enhancing financial stability, including by developing the relevant macroprudential framework, incorporated in the Commission’s 2015 Capital Markets Union Action Plan. *Source: 1eurea2023001* ### Annex V. Progress Against IMF FSAP Recommendations ### Annex V. Progress Against IMF FSAP Recommendations ### Supervision - Recommendation: Reduce the fragmentation of national legal frameworks for bank supervision (EU) — Timing: MT - The Banking Package includes measures designed to ensure more consistent supervision across the EU. - Transposition of the Capital Requirements Directive (CRD) V is ongoing: all member states have completed transposition; the Commission will soon start the conformity assessments. - In the context of the Capital Requirements Regulation (CRR) CRD6 currently under discussion at the European level, the ECB issued an opinion calling for: - (i) harmonized provisions for the assessment of banks’ directors and key function holders (fit and proper assessments); - (ii) a common set of rules for branches of third-country banking groups operating in Member States will replace heterogeneous national approaches and strengthen the single market; - (iii3) further harmonization of national powers related to the acquisition of qualifying holdings, transfers of assets or liabilities, mergers or divisions, as well as to the sanctioning regime, to ensure the consistency and robustness of the framework. - ECB actions: - Adopted a single Fit and Proper questionnaire for all banks under its supervision to ensure a standard set of information in all SSM countries. - Published a Guide to fit and proper assessments. - Implemented the IMAS Portal for standardized fit and proper applications and Heimdall to automatically identify inconsistencies with the ECB methodology and flag them to supervisors. - Published a guide on banking consolidation and will publish a guide on qualifying holdings this year. A guide on licensing is under preparation and will be published next year. - Recommendation: Revise legal provisions to close regulatory gaps with international standards (EU) — Timing: MT - Addressed in the review of the CRD/CRR concluded in 2019 and in related additional regulatory legal texts (technical standards). - Examples include interest rate risk in the banking book (Basel Core Principle BCP23), capital adequacy (BCP 16), and liquidity risk (BCP 24), especially the 2018 amendments to the Liquidity Coverage Ratio. - EBA published two regulatory technical standards (RTS) and one set of guidelines (GLs) on IRRBB in October 2022. - The final elements of Basel 3 will be implemented in the ongoing review of the CRD/CRR expected to be concluded in Summer 2023 and in related additional regulatory legal texts (technical standards). - Recommendation: Improve planning of supervisory resources (SSM) — Timing: ST - ECB Banking Supervision reorganized in October 2020 to be more agile and integrated, creating business area D-SSR focused on strategy, risk analysis, and a second line of defense. - D-SSR/Strategic Planning Office responsibilities: - Set-up, implementation, and continuous improvement of the SSM planning process and its monitoring. - Development of a comprehensive overview of activities and resources vis-à-vis priorities. - Conduct organizational readiness exercises and propose allocation of the SSM resource pool. - Supervisory fees: - Resources for supervisory tasks are financed via supervisory fees borne by supervised entities. - Calculation of fees is based on total costs of the supervisory function separately identifiable within the ECB’s budget. - A cost calculation model uses the Eurosystem’s common cost methodology based on the actual expenses of the financial year. - Cost allocation is based on actual direct cost and allocation of actual indirect costs using cost metrics (allocation based on Eurosystem Functions Grid, ESFG). - In annual budget planning, ECB applies a lean process, provides early estimation of supervisory fees using assumptions including full consumption of allocated budget, with cost metric types based on latest available information (year-end metrics of the previous year). - Other actions taken: - Increasing focus on risk-based supervision in the Supervisory Examination Program (SEP) and via a risk tolerance framework. - Increasing Supervisory Board Steering Committee’s focus on digitalization, integration and simplification of SSM processes; set up a dedicated group with ECB and NCA staff. - Implemented simplification and digitalization of processes, releasing staff (examples: risk-based supervisory approach, streamlining supervisory IT system work modules, simplifying access rights management). - Promoting a common SSM culture, enhancing mobility across organizations, and pursuing coordinated planning through the SSM Integration Project. - Started SSM-Hub on securitization for ECB-NCA collaboration. - Revamped supervisory planning process to foster closer collaboration with NCAs; pilot scheme for in-site inspections with two centers of competence for business models and profitability and interest rate risk in the banking book. - Increased internal resources for on-site inspections while offsetting cost by reducing consultancy expenditures to internalize model investigations. - Set up a dedicated SupTech function and an expanding portfolio of IT- and AI-driven tools to gain efficiency and support supervisors’ judgement. - NCA leg of Joint Supervisory Teams (JSTs) staffing improvements: - Better alignment of resources in both NCA and ECB leg of JST with supervisory complexity of institution. - Refinement of quantitative criteria for identifying JST staffing shortages. - Annual dialogue for each JST on identified NCA staffing shortages with quantitative criteria and qualitative input; development of a targeted team profile. - Escalation process for NCA staffing shortages involving senior management of ECB vertical DGs and NCAs; issues addressed to NCA leadership if necessary. - Tools introduced in supervisory planning: - Organizational readiness assesses skills and FTEs commensurate with supervisory priorities. - Capability building addresses critical areas via action plans (training and development). - Overview of resources to monitor utilization in JSTs and on-site inspections. - Recommendation: Raise standards for handling of loan classification and provisioning (SSM) — Timing: ST - Improvements include: - Publication of the Addendum for new NPEs as of April 1, 2018. - SREP recommendations for the stock of NPEs as of March 31, 2018. - New automatic Pillar 1 backstop for NPEs from newly originated loans as part of the EU Banking Reform package approved in 2019. - At the onset of Covid-19, “dear CEO” letters communicated supervisory expectations on classification and provisioning; followed by assessments, specific recommendations, and off-site follow-up. - Deep dives on forbearance, UTP and IFRS9 implementation conducted over the last two years and ongoing. - Training provided to JSTs and dashboards for monitoring asset quality and provisioning were enhanced. - Recommendation: Improve coordination and information sharing regarding AML/CFT (ECB, national authorities) — Timing: ST - At end of 2018 ECB/SSM set up an AML Coordination Function (ALMCO) to: - Act as a central point of contact for SIs. - Set up a network for consistent SSM-wide prudential approach. - Act as an internal center of expertise on prudential issues. - In January 2019, the ECB signed an agreement for information exchange with nearly 50 national AML/CFT authorities as mandated by the 5th review of the AML Directive. - Following the ESA review, the EBA plays a coordinating role on AML/CFT supervision across sectors and the EU. - Steps taken to streamline information exchange with AML/CFT authorities include more delegations and participation of JSTs as observers in AML/CFT colleges (for around 65 significant institutions). - ECB/SSM implemented EBA regulatory framework changes (EBA cooperation Guidelines, EBA database on material weaknesses). - Based on recent external assessments (ECA report, SSM review by the EC), the information exchange process works well overall. - ML/TF risks have been better reflected in prudential supervision for the SREP (implementation of the SREP Guidelines), authorizations, and fit and proper assessments. - Recommendation: Transfer supervision of systemic investment firms and third country branches to the SSM (EU) — Timing: ST - Investment Firms: - Investment Firms Regulation (IFR, Regulation (EU) 2019/2033) and Investment Firms Directive (IFD, Directive (EU) 2019/2034) adopted November 27, 2019; in application since June 26, 2021. - IFR/IFD introduced a multi-tiered regime; largest/systemic investment firms (above €30 billion at solo- or group-level) engaging in specific activities are authorized as credit institutions and, if significant, fall under direct ECB supervision. - Class 1 investment firms authorized as credit institutions can be found in the list of supervised entities on the ECB Banking Supervision website. - A dedicated section for ECB’s new permanent tasks in relation to supervision of investment firms established within Directorate General Systemic and International Banks. - Third Country Branches (TCBs): - A multilateral memorandum of cooperation between the ECB and NCAs of SSM participating Member States on supervision of TCBs is being finalized and expected to be applied from the second half of 2023; it will allow exchange of information on TCBs and credit institution subsidiaries of third country groups active in more than one SSM participating Member State and/or supervised by different supervisors. - Ongoing review of CRD/CRR (CRD6) expected to be concluded in the summer of 2023 will introduce a common set of rules for branches of third-country banking groups operating in Member States to replace heterogeneous national approaches and strengthen the single market. - Supervision of branches will remain the responsibility of national competent authorities as branches can only operate in the Member States where they are registered. - CRD6 envisages further enhancement of supervisory cooperation by including TCBs with a larger EU footprint under EU supervisory colleges and may allow supervisors to require systemic TCBs to become subsidiaries on a case-by-case assessment. - Recommendation: Ensure the availability of a full set of borrower-based macroprudential instruments (EC, ESRB) — Timing: MT - ESRB amended its recommendation on closing real estate data gaps to establish harmonized framework for monitoring real estate markets across EU countries and conducted a detailed survey on availability and usability of borrower-based tools in EU countries. - The Commission continues researching options to ensure availability of borrower-based instruments in all member states via amendments to CRD/CRR or the Mortgage Credit Directive. - Member States have insisted activation and calibration must stay in national hands and exclude potential ECB action; a potential legislative proposal following the macroprudential review (CRD/CRR) in 2022 was postponed. ### Preparations for the U.K. Exit from the EU - Recommendation: Accelerate discussions on action to ensure continuity of service and data access (ECB, ESAs, SSM) — Timing: I - Conditional recognition to U.K.-based CCPs until June 2025. - ESMA reduced regulatory costs of moving uncleared derivative contracts to EU-27 counterparts and specified EU-27 dual-listed stocks that must trade in an EU-27 trading venue to meet share-trading obligation under MiFID II. - Cliff-edge effects from derecognition of UK CCPs were avoided by temporary recognition for clearing services in the EU. - Cooperative arrangements between the Eurosystem/ECB, the Bank of England and relevant UK CCPs were adapted due to the UK’s withdrawal. - Ongoing regulatory initiatives in the EU aim to reduce excessive reliance on UK CCPs. - In March 2019, ECB and BoE announced activation of the currency swap arrangement for possible provision of euro to U.K. banks and of GBP to euro area banks. - ECB Banking Supervision cooperates and exchanges confidential supervisory information with UK prudential authorities on the basis of the MoU concluded in 2019 for the period after Brexit. ### NPL Resolution - Recommendation: Prescribe rules for valuation of immovable loan collateral, including repossessed collateral (EU) — Timing: MT - The 2017 EBA guidelines on PD and LGD estimation require some level of prudence for LGD estimation to reflect that repossession value does not always reflect market value. - Banks must apply an appropriate haircut to the value of repossession to address uncertainty. - The Banking Package proposed in October 2021 contains requirements for determining the property value, a concept more prudent than market value, intended to remove divergence between jurisdictions using either market value or mortgage lending value. - Recommendation: Set consistent NPL definitions and reporting standards (EC, EBA, SSM) — Timing: ST - Regulation (EU) No 630/2019 amended Regulation (EU) No 575/2013 and introduced clear conditions for classification of NPEs, leveraging EBA Implementing Technical Standards on reporting and forbearance. - Recommendation: Establish minimum standards for insolvency and creditor rights regimes (EU) — Timing: MT - June 2019 Directive on Preventive Restructuring established minimum standards in areas including preventive debt restructuring mechanisms and debt discharge for entrepreneurs. - In December 2022, the Commission proposed a Directive harmonizing certain aspects of insolvency law covering transaction avoidance, asset tracing, pre-packs, directors’ duties, micro enterprises, creditors’ committees, and measures to enhance transparency. ### Crisis Management and Financial Safety Nets - Recommendation: Strengthen the early action framework and advance resolution preparation (SRB, SSM, EC, NRAs) — Timing: I - The ECB crisis management framework is regularly revisited and continuously improved, including: - 2018 refinement of escalation procedures with qualitative and quantitative indicators of deterioration of bank conditions. - 2021 incorporation of lessons learned from the application of the EAP and the COVID-19 experience, adjustment to new regulatory requirements (e.g., LR, MREL/TLAC), and reflection of changes through reorganization of ECB banking supervision. - The EAP has been effective for ensuring a risk-based escalation process, assessment of early intervention when triggered, and timely preparation of a failing-or-likely-to-fail (FOLTF) determination while ensuring necessary coordination internally and externally (namely with the SRB). - Single Resolution Mechanism (SRM) improvements: - Cooperation between SRB and SSM set up via an MoU signed in 2015 and revised in 2018 and 2022. - The 2022 revision (December 16, 2022) enhanced cooperation before and in crisis on different aspects. *Source: Annex V. Progress Against IMF FSAP Recommendations (excerpt).* ### 1. Early intervention (assessment on EI conditions and measures shared at the ### 1. Early intervention (assessment on EI conditions and measures shared at the same time of the ECB SB) ### Early intervention and cross-authority cooperation - Recommendation: Early intervention (assessment on EI conditions and measures shared at the same time of the ECB SB). - Recommendation: Moratorium — "ECB and SRB should agree on a consultation period on a case-by-case basis prior to the consultation." - Recommendation: Cooperation between JSTs and IRTs — "formal and informal interactions in the recovery and resolution planning phase and sufficiently in advance in crisis." - Recommendation: FOLTF — "ahead of a crisis and at the time of a specific crisis case, the ECB and SRB agree on timelines and steps for the ECB/SRB FOLTF assessment." - Recommendation: Cooperation in resolution — especially when the bridge institution is chosen and on the business reorganization plan. - Cooperation with NRAs: NRAs are invited to pro-actively notify the SRB on any Less Significant Institutions under their direct responsibility that show early signs of financial distress or demonstrate suspicious behavior (e.g., money laundering suspicion, negative media publicity). - CMDI reform (Commission proposal, April 2023) intended to further enhance crisis preparedness, notably the use of early intervention measures and cooperation between supervisors and resolution authorities in the run-up to a potential resolution. *Decision note:* Decision of the Single Resolution Board (SRB) of 17 December 2018 establishing the framework for the practical arrangements for the cooperation within the SRM between the Single Resolution Board and National Resolution Authorities, amending the SRB Decision of 28 June 2016. The text is published on the SRB website. ### Proceed quickly with the buildup of MREL and internal MREL (SRB) - Regulatory context: The regulatory framework for MREL was significantly revised in 2019 via amendments to the BRRD, the CRR, and the CRD. - SRB application: The SRB has applied the new regulatory package from 2020 by setting intermediate MREL targets to be complied with from 1 January 2022, and final MREL targets from 1 January 2024. - Status as of 2022Q4: "30 out of 80 resolution entities in the sample were in shortfall against their final MREL targets (when considering the Combined Buffer Requirement). However, 15 out of the 30 banks have a longer transitional period to meet their final target, ending, in most cases, in 2024-25." - GSIIs: "All EU GSIIs still comply with TLAC." ### Ensure availability of liquidity in resolution (SRB, EC, Eurosystem) - Timeline classification: ST (short term). - Background actions: Eurogroup mandated EWG and TFCA to work on solutions for limitations in the current framework (December 2018). TFCA discussed SRB issuing debt, SRB guarantees to ECB, public guarantees; work currently suspended. - SRB priority: SRB has prioritized liquidity in resolution for SRB banks to ensure banks can estimate liquidity needs, identify and mobilise collateral, measure and report their liquidity situation in resolution. - Acknowledged limitations: EU Institutions acknowledge limitations in the current framework regarding “liquidity in resolution” (LiR). - SRF role: SRB has stated publicly that the SRF can contribute to liquidity provisioning to institutions in resolution, but it should not be deemed the only solution given capacity constraints for large banks (based on the target size of the SRF – even with the Common Backstop by the ESM after final ratification). - Rationale: Knowledge of additional funding would facilitate the resolution outcome and strengthen market confidence; funding might not necessarily be used but its availability is important. ### Crisis Management and Financial Safety Nets - Designate and make operational the SRF backstop (EU, SRB, ESM) — ST: - Eurogroup decision (December 2018): ESM will serve as the SRF backstop. - Eurogroup agreement (November 2020): introduction of the backstop by the beginning of 2022 (instead of 2024). - Operational/legal status: all necessary operational steps and legal documents prepared; establishment embedded in revised ESM Treaty, entry into force pending ratification by all signatories. - Backstop amount and form: "The backstop will have the form of a revolving credit facility initially amounting to €68 billion." - Establish an EDIS with a backstop (EU) — ST: - Eurogroup (2022) focus: strengthen common framework for bank crisis management and national deposit guarantee schemes; setting up EDIS remains to be addressed. - CMDI review given short-term priority; Euro Summit statement of March 24, 2023, called for continued efforts to complete the Banking Union, following Eurogroup statement of June 16, 2022. - Ensure consistency of triggers for action (EC, ECB, SRB) — ST: - ECB Banking Supervision (2018) adopted a new definition of solvency for: (i) precautionary recapitalisation; (ii) state guarantees on newly issued liabilities; and (iii) state guarantees to back central bank liquidity facilities. - Methodology: forward-looking assessment of compliance with Pillar 1 and Pillar 2 capital requirements; ensures alignment with the FOLTF assessment (one of the three conditions for resolution). - CMDI proposal: clarifies continuum of possible crisis management tools, including precautionary recapitalization, preventive measures, and resolution. - Align state-aid loss-sharing requirements with BRRD/SRMR while introducing flexibility via financial stability exemption (EU) — ST: - Commission evaluation: state-aid framework for banks expected to be completed in the first quarter of 2024. - Potential review: outcome will inform potential review to ensure consistency with renewed CMDI framework and regulatory scenarios in renewed CMDI. - Further harmonize hierarchy of creditor claims in bank insolvency (EU) — MT: - CMDI reform proposes further harmonization of creditor claims regarding ranking of depositors in insolvency (all depositors ranking in a single tier). - Introduce an administrative liquidation tool for the SRB (EU) — ST: - CMDI review approach: extend application of the harmonized resolution framework to small and med-size banks. - Longer-term: Commission following expert fora (e.g., UNIDROIT) discussing design of a possible administrative liquidation tool. - Pare back state-aid oversight of the use of the SRF and deposit insurance funding on a least-cost basis (EC) — ST: - CMDI proposal envisages targeted simplification of the process for Commission and SRB in case of use of Fund or State aid, while maintaining assessment of compatibility with the single market. - DGS funds: remain national; further changes and more centralized process for use of SRF and other industry-funded safety nets in resolution only possible once a European Deposit Insurance Scheme (EDIS) is in place. - Buttress SRB independence and powers (SSM, EC) — I (Immediate): - Revised SSM-SRB MoU signed in 2022: "the Supervisory Board will invite the Chair of the SRB to participate as an observer in its meetings for items relating to the tasks and responsibilities of the SRB." - MoU: items could entail “upon agreement between the ECB and the SRB, any other item necessary for the performance of the tasks and responsibilities of the SRB.” - Practice: an SRB Board member is already being invited to attend SSM Supervisory Board meetings as an observer if a topic is relevant to SRB tasks. ### Liquidity Management and ECB/Eurosystem operational framework - Articulate an explicit financial stability mandate for the ECB/Eurosystem (ECB) — MT: - Legal basis: Article 127(5) TFEU provides: “The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.” See also Article 25 of the ESCB Statute. - Primary objective: maintain price stability; Strategy Review steps taken to integrate financial stability analysis into monetary policy-making while preserving focus on price stability. - Intensify “horizon scanning” involving supervisory and operational functions (ECB, SSM) — I: - ECB note: elements of horizon scanning already built into supervisory and monetary policy processes; additional elements will be considered in future work. - CCP arrangements: ongoing work regarding TARGET emergency credit facility harmonization across credit facilities available to CCPs (with and without a banking license), considering safeguards and enhancements of cooperation/information-exchanges with relevant CCP supervisors. - Non-euro area CCPs: internationally agreed “No Technical Obstacle” principles provide basis for arrangements between ECB and non-euro area central banks. - Further harmonize and ultimately centralize ELA arrangements (ECB) — ST: - ECB regularly reviews rules and procedures for provision of ELA; ELA agreement first published June 2017; last ELA review finalized in Q4 2020. - ELA framework evolution: more elements covered to ensure ELA by NCBs does not interfere with Eurosystem monetary policy. - Centralization: merits and feasibility need careful assessment given legal competences of the Eurosystem. - Manage transition from crisis-related policy settings and develop future operational framework (ECB) — MT: - Ongoing work on future monetary policy implementation framework; issues include potential return to pre-crisis status quo, permanence of some crisis tools, or a complete overhaul. - Review plan: ECB will review its operational framework for steering short-term interest rates by the end of 2023. - Future framework drivers: assessment of the optimal range of excess liquidity, corresponding size of the Eurosystem balance sheet and its composition; will inform the endpoint of the balance sheet normalization process. - Objective: ensure robustness across monetary policy configurations and environments (e.g., away from the effective lower bound (ELB) and in proximity to the ELB) and reflect the Monetary Policy Strategy Review’s confirmation of ECB policy rates as primary policy instruments. - Regulatory technical standards and guidance on IRRBB: - RTS specify (i) criteria to evaluate risks from potential changes in interest rates and (ii) modelling and parametric assumptions and supervisory shock scenarios complemented by an ITS on Pillar 3 disclosure of banks’ exposure to IRRBB, applicable since June 2022. - GLs provide criteria for identification, evaluation, management and mitigation of IRRBB in banks’ internal systems. *Timing legend:* I: Immediate, within one year; ST: short term, within 1 to 2 years; MT: medium term, within 2 to 5 years. ### Annex VI — EU’s Economic Sanctions on Russia (summary of measures) - Sanctions adopted in response to Russia’s war in Ukraine include: - Prohibition on exports of arms and a range of dual technology goods, including those related to quantum computing, advanced semiconductors, sensitive machinery, transportation, chemicals. - Prohibition on exports of goods for use in the oil industry; prohibition on new investments in the energy sector; prohibition on certain operations in the aviation sector; prohibition on certain freight and transportation operations; prohibition of exports of goods contributing to the enhancement of Russian industrial capacities. - Prohibition on imports of coal, iron and steel, cement, rubber products, wood, spirits, liquor, high-end seafood; prohibition on imports of seaborne crude oil and on providing oil transport services; prohibition on imports of gold. - Prohibition on public financing or financial assistance for trade with, or investment in Russia; prohibition on financing the Russian government and Central Bank as well as banning transactions related to the management of the Central Bank’s reserves and assets. - Prohibitions on a range of financial interactions, financial rating services and transactions with Russia, as well as prohibitions on the provision of banknotes and sale of securities; decoupling of certain Russian banks from the SWIFT messaging system; prohibition on providing high-value crypto services and trust services; prohibition on providing trusts and on accepting deposits. - Sanctions against individual persons and entities. - Sanctions were also imposed on Belarus; some measures constitute capital flow management measures for reasons of national or international security. ### Annex VII — Statistical Issues (key points) - European statistics responsibilities: developed, produced, and disseminated by the European Statistical System (ESS) and the European System of Central Banks (ESCB); ESS composed of Eurostat and NSIs; ESCB composed of ECB and NCBs; operate under separate legal frameworks and cooperate closely. - Recent statistical responsiveness: - European statisticians responded flexibly to Covid-19, the war in Ukraine and euro area inflation unprecedented since the introduction of the euro. - July 2022: ECB published an analysis concerning euro area linkages with Russia, based on balance of payments statistics. - October 2022: ECB started publishing a subset of bilateral external statistics of euro area countries vis-à-vis Russia (additional Tab “Focus on Russia” available in the dashboard of the Balance of payments and international investment position). - Eurostat published methodological guidance notes and clarifications on statistical effects of government measures to mitigate high energy prices; developed template to identify impact of energy-related government policy measures on government revenue, expenditure and debt, with guidance on statistical treatment; GFS data closely monitored. - For period 2020Q1 to 2022Q3 reference quarter, Eurostat collected and published metadata on timing and severity of COVID-19 impact on economy, estimation techniques used, and quality/reliability of estimates; explanatory metadata on government measures to alleviate high energy prices is progressively being published. - October 27, 2022: ECB Governing Council decided to recalibrate targeted lending operations to help restore price stability over the medium term; TLTRO III continues to be accompanied by additional data collection measures from the banking sector. - Data submission expectation: "All Member States should ensure full and timely data transmissions under the European System of National and Regional Accounts (ESA) 2010 at the legal deadlines - Eurostat continuously monitors progress and prepares an annual Quality report on national and regional accounts." *Source: IMF staff chapter text (1eurea2023001).* ### 2. Eurostat and the ECB actively contributed to the discussions on the recommendations ### 2. Eurostat and the ECB actively contributed to the discussions on the recommendations ### Contributions to international standards and data initiatives - Eurostat and the ECB actively contributed to the discussions on the recommendations for the new G20 Data Gaps Initiative (DGI-3) as members of the Inter-Agency Group on Economic and Financial Statistics and are cooperating closely on continuation of work in specific priority areas. - Eurostat and the ECB jointly support the Special Data Dissemination Standard Plus (SDDS Plus), the third and highest tier of the IMF’s Data Standards Initiatives. By March 2023, 15 euro area countries (and 21 EU member states overall) had already adhered to the SDDS Plus. ### Quality assurance and the Macroeconomic Imbalance Procedure (MIP) - According to the June 2022 ESS – ESCB quality assessment report on statistics underlying the MIP: - The COVID-19 outbreak had a certain impact on the ability of statistical authorities to collect and process data in the traditional manner. - The ESS and the ESCB managed statistical production and dissemination according to schedule and with sufficient quality standards. - Country visits resumed: one virtual visit took place in 2022 and two on-site visits planned for 2023. ### Ongoing work to improve timeliness, coverage, and quality (major themes and findings) - Climate change statistics - On 24 January 2023, the ECB published a first set of new climate-related statistical indicators to better assess the impact of climate-related risks on the financial sector and to monitor the development of sustainable and green finance, fulfilling another of the commitments of its climate action plan (announced in July 2021). - Experimental indicators on sustainable finance: overview of debt instruments labelled as “green”, “social”, “sustainability” or “sustainability-linked” by the issuer that are issued or held in the euro area. - Analytical indicators on carbon emissions financed by financial institutions: information on the carbon intensity of the securities and loan portfolios of financial institutions, and on the financial sector’s exposure to counterparties with carbon-intensive business models. - Analytical indicators on climate-related physical risks: analyse the impact of natural hazards, such as floods, wildfires or storms, on the performance of loans, bonds and equities portfolios. - The ESCB Statistics Committee’s (STC) Expert Group on the Climate-Change and Statistics continues into its third phase to develop indicators on (1) exposure of financial institutions to climate-related physical risks, and (2) carbon footprints of portfolios of financial institutions that are comparable across countries and over time. - The European Commission proposed expanding European Environmental Economic Accounts by adding new modules for forest accounts, environmental subsidies and ecosystem accounts. - National accounts - Eurostat and the ECB are active participants in the ongoing update of the System of National Accounts (SNA) and the Balance of Payments manual (BPM), with the joint international effort to complete these updates by 2025. Emerging phenomena posing challenges include digitalisation, globalisation, non-bank intermediation and sustainable finance. - Preliminary (T+30) GDP flash estimates for the EU and the euro area were introduced in April 2016; European employment flash estimates were introduced in November 2018. Eurostat and NSIs continued work to advance first releases of these indicators; national GDP estimates are being included in the preliminary flash GDP as more countries advance publication. - Regular reporting exercise on the quality of ESA 2010 data transmitted by EU member states continued; Eurostat’s assessment report on 2020 transmissions considered data coverage after all derogations expired. - To exploit data under ESA 2010 Transmission Programme, Eurostat and some member states extended production and publication of data. By end-2021, Eurostat published additional productivity indicators supported by a task force assessing labour, capital and multifactor productivity indicators. - Task force on fixed assets and estimation of consumption of fixed capital under ESA 2010 completed review of assumptions and recommendations for further harmonisation. - FIGARO (EU inter-country supply, use and input-output tables) for 2010-2020 were released in spring 2022 in current prices. - Recommendations to improve vertical consistency between financial and non-financial sector accounts were developed by ECB, Eurostat and national experts and published in March 2022; implementation is planned by the next coordinated benchmark revision in autumn 2024. Eurostat is offering financial support, in the form of grants, to countries for work to reduce vertical discrepancies. - In autumn 2021 Eurostat launched a new data collection round for experimental results on distribution for income and consumption; centralised and national estimates were published in June 2022. In June 2022 a new Task Force was launched to support compilation of household distributional accounts; around 14 Member States participate, with OECD, ECB, DG EMPL and DG ECFIN following the work. Eurostat is offering grants to support countries’ work on household distributional accounts. - Price statistics - In 2022 Eurostat issued guidelines on treatment in the HICP of government measures to compensate households for high energy prices to ensure harmonised approach across Member States. - Eurostat plans to publish a statistical working paper on inclusion of owner-occupied housing in the HICP, responding to ECB recommendations. - In October 2020 the first dissemination of quarterly house sales indices took place; data on value of house sales and number of transactions are now available for a majority of EU countries. - Government finance statistics (GFS) - Annual and quarterly GFS time series are available for all countries and data mapped to the GFSM 2014 are regularly provided to the IMF. - European GFS are consistent with data supplied under the Excessive Deficit Procedure, which undergoes strong verification. - Progress in availability was made on COFOG data, detailed annual non-financial data, financial instruments and breakdowns of government debt. Eurostat continues to publish data on contingent liabilities and non-performing loans of the government. - Availability of GFS data is expected to increase following implementation of the revised ESA 2010 transmission programme. - Financial accounts - As part of the mid-term review of the ESA 2010 transmission programme, countries will be obliged to partially transmit annual financial accounts data 4 months after the reference year, starting from 2025. - ESCB is improving availability of data for the non-bank financial sector to better capture effects of globalization, distribution of household wealth and indirect holdings of assets, and debt issuance of non-financial corporations via financing conduits. - Quarterly financial accounts published by the ECB include a new breakdown of other financial institutions into subsectors other financial intermediaries, financial auxiliaries and captive financial Institutions and money lenders since October 2022. The sub-sectors data is available for the euro area and the national data of EU countries. - ESCB users received first experimental results for the distributional wealth accounts for the euro area and selected countries at end-2021. Since then the ECB has been disseminating the data every quarter at T+5 months, and the compilation has been extended to include six additional euro area countries (i.e. 17 euro area countries in total). Work is progressing toward external publication by end-2023. - Work on households’ indirect holdings via investment funds and on linking securities issuance data of financing conduits wholly owned by non-financial corporations is progressing and scheduled to be finalised by 2023/2024. - External sector statistics - As of May 2022, statistical information on Special Purpose Entities (SPEs) is included in the amended ECB Guideline on External Statistics (ECB/2011/13). The first transmission of data relating to cross-border transactions and positions of euro area SPEs took place in March 2023 based on data for the fourth quarter of 2022. Back data from the first quarter of 2020 will be transmitted by September 2023. - The ESS and the ESCB continued efforts to reduce asymmetries, particularly intra-EU asymmetries on foreign direct investment (FDI). Quarterly “Asymmetry Resolution meetings” are taking place for major bilateral EU FDI asymmetries and countries are encouraged to use a dedicated tool (FDI network) to exchange information. - Exchange of micro-data on intra-EU exports between EU Member States started in 2022 to help modernize intra-EU trade in goods statistics and reduce reporting burden while maintaining quality; ongoing work addresses asymmetries between intra-EU exports and imports statistics. - Exchange of customs data between EU Member States also started in 2022 to improve quality of extra-EU trade in goods statistics. - Monetary and financial statistics - In October 2022 the ECB finalised its review of the ECB Regulation on infringement procedures in cases of non-compliance with statistical reporting requirements, establishing a harmonised framework for monitoring compliance across statistical domains and reporting frequencies. - ESCB's long-term approach to banks’ data reporting aims to increase efficiency and reduce banks’ reporting burden while maintaining high-quality data via two elements: - Integrated Reporting Framework (IReF) to integrate Eurosystem statistical reporting requirements addressed to banks. - Banks Integrated Reporting Dictionary (BIRD) to help banks organise information in internal systems and fulfil reporting requirements. - Two cost-benefit assessments related to IReF were published in December 2021 and September 2022; an additional exercise will follow by end-July 2023 to comprehensively match costs and benefits based on stakeholder feedback. - In December 2021 the ECB Governing Council approved launching the Design Phase of the IReF; the Investigation Phase is expected in 2023, to be followed by the Realisation Phase in 2025. Subject to adoption of the IReF Regulation by the Governing Council in 2025, the IReF is expected to go live in 2027 (BIRD remains voluntary and will not be legislated). - IReF is a first step toward a broader integrated reporting system for statistical, prudential and resolution data in the EU. EBA, ECB, SRB and the European Commission have started cooperating in an Informal Coordination Group; cooperation is expected to be formalised through a Joint Bank Reporting Committee (JBRC) as outlined in the EBA feasibility study published in December 2021. - IMF Statistics Department (STA) has collaborated with the ECB since 1998 on sharing, transformation, and dissemination of granular MFS data as part of the “Data Gateway” protocol. STA currently transforms ECB source data to standardized report forms (SRFs) – 1SR for central banks and 2SR for other depository corporations – and disseminates via the International Financial Statistics. - In the September 2021 meeting of the ECB’s Working Group on Monetary and Financial Statistics (WG MFS), STA and ECB agreed ECB will start reporting new SRFs aggregates to STA including SRF-4SR for other financial corporations. Transmission will start after finalisation of mapping of the new SRFs by the ECB and in collaboration with the IMF and WG MFS. - Registers and coverage - EuroGroups Register (EGR) includes more than 130,000 multinational enterprise groups active in the EU. - The ESCB’s Register of Institutions and Affiliates Data (RIAD) maintains over 10 million active entities. - Financial Soundness Indicators (FSIs) - For most Euro area and EU countries, FSIs are calculated based on underlying data reported in standard FSI forms, using the EBA Guidance Note on compiling IMF FSIs using EBA’s Implementing Technical Standards (ITS) data. - During 2022 STA collaborated with the EBA to review and update mapping in the Guidance Note and ensure consistency with the IMF’s 2019 FSIs Compilation Guide. The updated Guidance Note will be used by authorities in Euro area and EU countries for FSIs reporting to IMF. ### ECB projects to enhance statistics from granular databases - Money Market Statistical Reporting (MMSR) - ECB started publishing new statistics on overnight index swaps (OIS) in the euro money market based on MMSR data collected from 47 euro area banks. Data series include OIS spot and forward markets information about total and daily average nominal amount and the weighted average rate. - These new statistics complement data on unsecured and secured money market segments published since November 2017 and January 2019 respectively and aim to enhance market transparency and money market functioning. - Centralised Securities Database (CSDB) - New ECB Guideline on the CSDB and production of securities issues statistics defines amended requirements for CSDB data quality management and production of securities issues statistics. - Following adoption of the Guideline, the ECB started publishing new breakdowns for securities issues statistics by valuation method, maturity and interest rate type for all EU Member States. This CSDB micro-to-macro dataset allows micro data to be used to compile official macro statistics with significantly enhanced timeliness. - Securities holdings statistics - ECB extended publication of securities holdings statistics with new breakdowns by individual euro area country, and by holder and issuer sectors, providing a more timely and complete picture of financial markets and better monitoring of primary and secondary market activities. ### Analytical credit datasets (AnaCredit) - In October 2021, based on experience after more than two years of AnaCredit data reporting, the ECB amended the Guideline on procedures for collection of granular credit and credit risk data. - A concrete revision policy framework was established and clarifications provided on practical implementation of the AnaCredit feedback loop framework. - The framework allows participant Eurosystem NCBs to share with their reporting agents sub-sets of AnaCredit data collected by other participant NCBs to enhance national credit register data (which may not cover loans granted by banks resident abroad), enabling reporting agents to obtain a more complete overview of indebtedness of a debtor or prospective debtor. *Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1eurea2023001.pdf* ### 8. Technical work by Eurostat is also ongoing toward modernizing and harmonizing ### 8. Technical work by Eurostat is also ongoing toward modernizing and harmonizing ### Eurostat technical work - Ongoing technical work toward modernizing and harmonizing public sector accounting in the context of the European Public Sector Accounting Standards (EPSAS). - Focus areas: EPSAS reporting entity, potential future EPSAS structure, and innovation in public sector financial reporting. - Work continues toward laying the ground for a potential future proposal on EPSAS under the next Commission. ### Statement by Mr. Buissé on euro area (July 12, 2023) — overarching view - Submitted in capacity as President of EURIMF; reflects the common view of euro area Member States and relevant EU Institutions. - Authorities express gratitude for consultations with staff and broad agreement on: new and existing risks, high uncertainty, need for prudent fiscal policies aiming at medium-term debt sustainability, and continued efforts on the green transition, energy security, and boosting productivity and growth through reforms and investments. ### Economic outlook and risks - The authorities share staff's assessment: economy showing remarkable resilience in a challenging global context. - Energy crisis impact contained in part due to rapid diversification of supply and a sizeable fall in gas consumption. - Labour market: "record-strong"; unemployment rate hitting historical lows; participation and employment rates at record highs. - Lower energy prices reducing firms' input costs from peak levels; consumers seeing energy bills fall, but private consumption expected to remain subdued as household incomes lag inflation. - External position: deterioration in the current account balance in 2022 likely temporary; a gradual increase in the current account balance is expected over the forecast horizon as terms of trade improve, external demand strengthens, and services (particularly tourism) normalize. - Euro area aggregate current account likely to stay somewhat below pre-pandemic levels over the forecast horizon; dispersion in external positions of Member States will persist with high uncertainty. - Downside risks: geopolitical tensions, resurgence of inflation, renewed financial stress. - Persistent core inflation could restrain households' purchasing power and require a more restrictive monetary policy trajectory. - Renewed financial stress could trigger a surge in risk aversion, stress in debt markets, and tighter lending standards. - Expansionary fiscal stance might fuel inflation further, conflicting with monetary policy action. - Positive scenario: more benign energy price developments would lead to a faster decline in headline inflation with positive spillovers to domestic demand. ### Monetary policy and inflation outlook - Authorities share Fund’s assessment of recent inflation dynamics. - Headline inflation: declined from its peak in October 2022 but projected to remain too high for too long. - Decline so far reflected easing of shocks behind surge in inflation, notably supply bottlenecks and global commodity prices (particularly energy). - Indicators of underlying price pressure remain strong, with some tentative signs of softening. - Headline inflation expected to continue downward driven by unwinding energy and food inflation. - Core inflation expected to decline gradually as diminishing pipeline pressures are partly countered by increasing labour cost pressures. - Heterogeneity of inflation across the euro area noted. - Nominal wage growth expected to remain above historical averages, gradually compensating for loss in purchasing power. - No sign of a self-sustaining price-wage loop at this stage; firms’ profits may offer a buffer for wages to increase with limited second-round effects. - Inflation expectations have remained well-anchored; well-anchored expectations are crucial to underpin wage-formation processes and wage-price dynamics compatible with maintaining high employment. - ECB actions: raised key interest rates by 400 basis points since last July. - Reinvestments under the Eurosystem’s asset purchase programme (APP) discontinued as of July this year. - ECB will bring key interest rates to levels "sufficiently restrictive" to achieve a timely return of inflation to the two percent medium-term target and keep them at those levels as long as necessary, following a data-dependent approach. - "Barring a material change to the outlook, it is very likely that the ECB will continue to increase rates in July." ### Fiscal policy - Authorities broadly agree with Fund’s views: consistent fiscal and monetary policies will help tame inflation and allow Member States to rebuild fiscal buffers. - Recommendation: Member States should adopt prudent fiscal policies in 2023-24 to ensure medium-term fiscal sustainability and to support monetary policy in the presence of inflation challenges. - Euro area Member States will achieve the necessary overall restrictive fiscal stance in the euro area for 2024 by implementing the fiscal recommendations. - Emergency energy support measures should be wound down, using related savings to reduce government deficits, as soon as possible in 2023-24. - Fiscal policy must adapt to changing economic circumstances; Member States should preserve investment financed by national budgets and ensure effective absorption of RRF grants and other EU funds, given priorities like green and digital transitions and defence capabilities. - If energy prices spike again, any support measures should be targeted, preserve an overall prudent fiscal policy, and preserve incentives for energy savings. ### Economic Governance Review - On 26 April 2023, the Commission presented legislative proposals for comprehensive reform of the EU's economic governance rules. - The Council of the EU resolved to process possible next steps to conclude legislative work in 2023. - Commission proposals aim to ensure sound public finances and prepare the EU for future challenges; transparent and clear application is key. - Proposals address the role of national IFIs and explore strengthening the role of the independent European Fiscal Board while preserving the Commission's surveillance role. - The authorities note the Fund’s support for swift adoption of reformed fiscal rules. - The Commission's fiscal guidance proposed in May 2023 reflects elements consistent with existing legislation. ### Structural reforms - Authorities agree on need to accelerate the green transition and implement growth-enhancing structural reforms and investment. - Progress on RRPs noted but uneven across Member States; importance of accelerating implementation where needed, ensuring effective governance and adequate administrative capacity. - Key initiatives: REPowerEU, reformed ETS, and the Green Deal Industrial Plan (GDIP) for energy security, reduced dependencies, and greenhouse gas mitigation. - An EU Climate Investment Fund could help finance public investments with cross-border spillovers, but political hurdles may exist; focus should be on implementation and absorption of existing instruments to achieve 2030 Fit-for-55 objectives. - GDIP based on four pillars: predictable and simplified regulatory environment; speeding up access to finance; enhancing skills; open trade for resilient supply chains. - Temporary Crisis and Transition Framework for state aid adopted in GDIP context allows Member States flexibility under State aid rules to speed investment and financing for clean tech production. - Risk: uneven fiscal space across Member States may adversely affect level playing field within EU. - Aid to match that received by competitors outside EU subject to enhanced scrutiny and given only after evidence of material relocation risks, consistent with WTO commitment. - Commission proposed a Strategic Technologies for Europe Platform (STEP). - Trade policy: openness and rules-based multilateralism essential; de-risking through diversification aimed at strengthening resilience. - Carbon-border Adjustment Mechanism (CBAM): transitional reporting period October 2023-26 where only reporting requirements apply; gradual phase-in from 2026-34 as free allowances under EU ETS are phased out. - EU will help trading partners prepare to comply with CBAM to support global emission reduction efforts. - WTO reform is a core element of trade policy; next WTO Ministerial Conference is a critical opportunity to advance WTO reform, notably restoring a fully functioning WTO dispute settlement system. ### Financial sector - Banks: capital, liquidity, and profitability remain resilient. - Banks benefited from limited pass-through of higher policy rates to deposit rates, leading to higher profits from net interest income. - Unrealised valuation losses from banks’ securities portfolios at amortised cost, due to higher interest rates, are modest at aggregate level. - Ongoing EBA-ECB bank stress test will assess resilience under an adverse scenario considering a hypothetical aggravation of geopolitical tensions leading to stagflation. - Vulnerabilities from tighter financial conditions warrant continued monitoring. - NPLs continue to decline due to NPL reduction strategies; credit risk related to tighter financial conditions may materialize with a delay, exposing consumer, corporate and real estate loans to an economic slowdown. - Supervisors and macroprudential authorities are addressing vulnerabilities in real estate markets. - On 27 June 2023, EU co-legislators reached a provisional agreement on implementation of the final set of international Basel III standards to make EU banks more resilient and support Europe’s transition to climate neutrality; EU applies Basel standards also to small- and medium-sized banks. - Basel III package includes measures to keep EU prudential framework fit for purpose regarding sustainability risks, supervision (including third-country branches), and provides stronger tools for supervisors. - CMDI proposal intended as integral to Banking Union architecture to build crisis management framework for all bank types, including small and medium-sized banks; responds to Eurogroup agreement of June 2022 to strengthen crisis management and deposit guarantee schemes. - Successful CMDI review could pave way for possible further measures to strengthen and complete the Banking Union; Fund’s assessment on need for a European Deposit Insurance Scheme noted. - Non-bank financial intermediation (NBFI) requires close monitoring; further work may clarify use of regulatory tools for investment funds for macroprudential purposes and potential case for more centralized coordination of such tools in the EU. - Commission preparing a report on the functioning of the EU money market fund regulation based on ESMA input. ### Digital euro, Capital Markets Union, and AML/CFT - In June, Commission put forward a two-proposal ‘single currency package’ including a draft enabling framework for a possible future ‘digital euro’ and a proposal on legal tender and availability of physical euro cash. - Digital euro would operate as an additional form of currency; physical euro cash would continue to circulate. - It would be provided by banks and other payment service providers, cheaply available and seamlessly usable throughout the euro area; security, privacy, and inclusiveness would be key features. - Legislative process ongoing; ECB continuing investigation and development work; decision on issuing a digital euro expected to take a few years, based on legal framework being in place. - EU will keep exchanging with the Fund and international partners on the issue. - EU committed to deepen the Capital Markets Union; Commission reported on elements from its 2020 CMU action plan. - European Parliament, current and incoming Council Presidencies, and Commission pledged to finalise work on legislative proposals before European Parliament elections in 2024. - Five legislative proposals already agreed. - New rules on European long-term investment funds will apply from January 2024. - European Single Access Point platform expected to be operational from summer 2027. - Political agreement reached on CSDR, CRR/D and MIFIR recently, with some technical work remaining. - Strengthening AML/CFT supervision remains a priority: the AML package contains three pending acts to establish a single EU rulebook and set up an EU AML Authority. - Regulation providing for the travel rule for Crypto Assets Service Providers published in the Official Journal on 9 June 2023. *Source: Statement by Mr. Buissé on Euro Area, July 12, 2023; content unit 1eurea2023001 — "8. Technical work by Eurostat is also ongoing toward modernizing and harmonizing".* --- _Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1eurea2023001.pdf_