## _cr05265

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### Executive Summary — macro outlook and recovery
- Recovery described as "low-flying" and has "hit a rough patch."
- Domestic demand "lacking vigor"; recovery faced headwinds including "high oil prices" and (until recently) a sustained appreciation of the exchange rate.
- Past structural reforms have improved employment performance and "are expected to continue to do so."
- Subdued wage growth and major price shocks have crimped real disposable incomes and consumption; recovery "heavily reliant on global demand."
- Staff baseline: a "gradual, modest, but strengthening recovery," with "preponderantly downside risks" from confidence effects or international headwinds.
- Monetary policy stance judged "appropriate, for now"; staff would consider a rate cut if, absent new inflation information, evidence accumulated that the recovery was fading.

### Consumption, saving, and house prices
- Real disposable incomes were "0.7 and 0.4 percentage point off" in 2004 and 2005, respectively.
- Consumers have not reduced saving rates despite the recovery because of increasingly uncertain benefit prospects.
- Low interest rates have fueled housing demand, but limited avenues to tap home equity have restrained consumption effects.
- Underlying inflation running around "1½ percent"; as energy price hikes slow and administered prices stabilize, headline inflation should gradually converge to underlying inflation, supporting real income growth.
- Conditions for consumption to propel activity:
  - More employment growth (facilitated by wage settlements).
  - Improved consumer confidence.

### Structural perspectives and medium-term outlook
- Structural gains:
  - Since the mid-1990s, employment has risen by "some 12 million."
  - Employment rates of those aged 55 to 64 years have risen by "over 4 percentage points" since 2000.
  - Wage restraint and reforms of part-time and temporary work enhanced cyclical resiliency.
- Remaining challenges:
  - Demographic shock looms closer.
  - Employment rates remain low; need to reduce "9–11 percent" unemployment rates in large states.
  - Disappointing productivity trends need reversal.
- Staff sees potential output growth stuck at around "2 percent," with an output gap of about "1½ percent of potential GDP."

### Near-term prospects, risks, and staff scenario
- Recent developments:
  - Final domestic demand unexpectedly stalled in 2005:Q1.
  - Real GDP growth rebounded to "2 percent" in Q1 2005, primarily reflecting slowing imports.
  - Oil price hikes since mid-2003 may have detracted about "½ percentage point" from real GDP growth in 2004 and may do so again in 2005.
  - The euro’s appreciation "subtracted almost ½ percent from growth in 2004."
- Factors supporting gradual recovery:
  - Fiscal policies largely in water-treading mode and interest rates at historical lows.
  - Recovery of hours worked expected to translate into higher employment.
  - Past exchange rate appreciations' effects should be waning.
  - World demand and trade projected to strengthen after an oil price-related soft patch.
- Staff central scenario:
  - Euro-area output regains momentum in the second half of this year, with 2005 real GDP growth around "1⅓ percent," and achieves growth at potential by 2006.
- Main external and confidence risks:
  - Further oil price hikes and multilateral euro appreciation.
  - Since discussions, the euro depreciated by "some 2½ percent" in effective terms, reducing some appreciation-related risks but possibly raising risks from a stronger fall in confidence.

### Inflation, monetary analysis, and policy stance
- Inflation developments:
  - Headline inflation persisted at or above "2 percent"; underlying inflationary pressures easing.
  - HICP inflation pushed to "2½ percent" by mid-2004 due to oil and administered prices.
  - Core inflation expected to fall close to "1½ percent" over the medium term; ECB staff saw a modest acceleration beginning in 2007.
  - Headline inflation projected to run around "2 percent" in 2005 and moderate to "1¾ percent" in 2006, excluding a one-off reduction in administered prices.
- ECB projections (June 2, 2005) highlighted:
  - Average annual HICP inflation between "1.8–2.2 (mid-point 2.0) percent" in 2005.
  - Average annual HICP inflation between "0.9–2.1 (mid-point 1.5) percent" in 2006; includes a Netherlands health care reform trimming "0.2 percentage point" from area-wide price level.
- Monetary analysis and liquidity:
  - Policy rates on hold at "2 percent" since June 2003; yield curve flattened at the long end.
  - Rapid expansion of monetary aggregates, especially most liquid components; ECB’s monetary analysis pointed to liquidity exceeding that consistent with price stability over the medium to longer term.
  - Loans to households—mainly mortgage lending—saw brisk growth; credit to nonfinancial corporates showed renewed strength.
- Staff view:
  - Risks from the monetary analysis too uncertain/long-term to motivate a change in stance now.
  - Keeping interest rates on hold appropriate, but a cut would be appropriate if evidence of a fading recovery accumulated while inflation remained low (staff forecast headline inflation at "1.7 percent" for 2006, "0.2 percentage point" above ECB mid-point of June 2).

### Monetary contingency quantifications
- Since discussions:
  - Euro depreciated by "some 2½ percent" in nominal effective terms.
  - Oil prices rose by "about 10 percent."
- Estimated impacts:
  - A "10 percent" rise in oil prices is estimated to lower growth by "0.1 percent" and raise inflation by "0.2 percent."
  - A "10 percent" effective euro depreciation adds "0.4 percent" to growth and "0.3 percent" to inflation in the year ahead.
- Net effect: little net effect on growth but a small positive impact on headline inflation.

### Fiscal policy, SGP reform, and fiscal risks
- Current assessment:
  - Fiscal policies "are falling well short of consolidation requirements" and the area is "insufficiently prepared for the looming demographic shock."
  - With area-wide structural deficit close to "2 percent of GDP," achieving underlying balance by 2010 requires structural adjustment (net of one-offs) of "½ percent of GDP annually."
  - No significant area-wide consolidation achieved since 2000; budgets for 2005 and targets for 2006 foresee little consolidation.
  - Staff projection: almost half of euro-area countries—France, Germany, Italy, Greece, and Portugal—would post deficits in excess of "3 percent" in 2005–06.
- SGP reform:
  - Reformed Pact endorsed by all 25 EU members; dissuasive arm allows more flexibility; preventive arm sets medium-term objectives (MTOs) up to a maximum deficit of "1 percent of GDP."
  - Staff welcomed some elements (e.g., specification of a "minimum" annual adjustment in excessive deficits of at least "½ percent of GDP, net of one-offs and other temporary measures") but warned that an open-ended list of "other relevant factors" could be misused to avoid corrective action.
  - Main staff concern: preventive arm provisions could permit limited adjustment indefinitely, including during upswings, because the benchmark adjustment of "½ percent per annum" applies rarely in real time and deviations allowed for major structural reforms could scale back adjustment.
- Implementation emphasis:
  - Effectiveness and credibility of reformed SGP hinge on implementation by the European Council.
  - Staff argued for stronger national institutions (e.g., independent fiscal councils) to assess policies, increase transparency, and build support for adjustment.

### Structural reform strategy and the Lisbon Strategy
- Lisbon restructured to focus on growth and employment; objective to make Europe more attractive to work and invest and to spread knowledge and innovation.
- Shifted procedural emphasis from Brussels to national level via National Action Plans (NAPs) and a national "Mr./Ms. Lisbon."
- Staff assessment:
  - Positive: integrated agenda and national ownership appropriate; complementarities (e.g., wage moderation and product market reforms) important.
  - Concerns: prioritization may be insufficient; the new Strategy contains "over 20 broad guidelines," risking dilution and avoidance of politically difficult reforms.
  - Staff welcomed emphasis on ownership but warned about "insufficient prioritization and incentives for implementation."
- Box 5 finding:
  - Decelerating labor costs have a stronger effect on growth and unemployment in economies with less regulated product markets; evidence underscores complementarity of labor and product market reform.

### Financial sector developments, integration, and supervision
- Banking sector:
  - Banks weathered the downturn better than in the early 1990s; profitability recovered in 2004 to its highest level since 2000.
  - Banks remain well-capitalized; indicators cited include Total capital ratio, Tier 1 ratio, Capital/assets ratio, Net interest revenue/average assets, Return on average assets, Cost-to-Income Ratio, loan loss provisions/total assets.
- Financial sector risks:
  - Largely linked to global imbalances and potential unwinding of benign market conditions: exchange rate volatility, spike in long-term interest rates, sudden increase in price of risk.
  - Domestic concerns: strong house price pressures in some countries and expanding mortgage debt.
  - Corporate sector: large firms improved balance sheets; SMEs more exposed by sluggish domestic demand.
- Financial integration and supervision:
  - Authorities optimistic FSAP and Lamfalussy process will deliver significant progress; priorities include consolidating existing legislation and ensuring effective transposition/enforcement.
  - Staff concerns: pace and effectiveness of integration may be insufficient; obstacles include state ownership of banks, differences in regulations/supervisory practices, slow securities market integration.
  - Staff recommendation: consider a more centralized approach to supervision for systemically important financial groups and give EU supervisory committees access to up-to-date institution-specific data as a first step.
  - Authorities considered further centralization premature and favored reassessment in 2007 after full transposition results.

### Trade policy positions
- Commission preference: a multilateral approach under the WTO’s Doha Round; the EU to offer greater agricultural market access and to avoid new RTA negotiations while Doha continues.
- Staff welcomed EU role but urged more ambition on agricultural offers and cautioned against safeguards that undermine liberal trade policy.
- Regarding textiles/clothing: China agreed with the Commission to limit, until end-2007, export growth to the EU of ten product categories; the EU launched an anti-dumping investigation on footwear imports from China.

### Statistics, data quality, and surveillance enhancements
- Data needs: more comprehensive data on flows of funds, balance sheets, non-factor services and trade; concerns about budget statistics quality causing upward revisions.
- Recommendations: improve statistical governance, grant greater independence to national statistical institutes, and endow Eurostat with greater monitoring and auditing powers.
- Planned improvements and timing:
  - Euro-area quarterly statistics by institutional sector integrating flow of funds and non-financial accounts to be published from May 2007 onward.
  - Quarterly LFS in all EU countries to enable complete quarterly labor data for euro area from 2006 onward.
  - HICP improvements, pilot HICP at constant tax rates, and treatment of Netherlands 2006 health care reform under consideration.
  - Financial soundness indicators and coordination work noted; partial publication of improved public finance statistics expected from early-2006 onward.

### Key macroeconomic projections and statistics (selected)
- Real GDP growth: 1999: "2.7"; 2000: "3.8"; 2001: "1.8"; 2002: "1.0"; 2003: "0.7"; 2004: "2.0"; 2005 (WEO June 2005 projection): "1.3"; 2006: "1.9".
- Output gap (percent of potential GDP): 1999: "0.2"; 2000: "1.8"; 2001: "1.4"; 2002: "0.3"; 2003: "-1.0"; 2004: "-0.9"; 2005: "-1.5"; 2006: "-1.4".
- Unemployment rate (percent): 1999: "9.2"; 2000: "8.2"; 2001: "7.8"; 2002: "8.3"; 2003: "8.7"; 2004: "8.9"; 2005: "8.9"; 2006: "8.6".
- Consumer prices (percent): 1999: "1.1"; 2000: "2.1"; 2001: "2.3"; 2002: "2.3"; 2003: "2.1"; 2004: "2.1"; 2005: "2.1"; 2006: "1.7".
- General government balance (percent of GDP): 1999: "-1.3"; 2000: "-0.9"; 2001: "-1.8"; 2002: "-2.5"; 2003: "-2.8"; 2004: "-2.7"; 2005: "-3.0"; 2006: "-3.1".
- General government structural balance (percent of GDP): 1999: "-1.4"; 2000: "-1.9"; 2001: "-2.5"; 2002: "-2.6"; 2003: "-2.4"; 2004: "-2.1"; 2005: "-2.3"; 2006: "-2.3".
- General government gross debt (percent of GDP): 1999: "72.5"; 2000: "70.0"; 2001: "68.9"; 2002: "68.8"; 2003: "70.1"; 2004: "70.6"; 2005: "72.2"; 2006: "72.9".
- Euro/U.S. dollar exchange rate (U.S. dollar per euro): 1999: "1.07"; 2000: "0.92"; 2001: "0.90"; 2002: "0.94"; 2003: "1.13"; 2004: "1.24"; 2005: "1.21" (data for 2005 are for June 28).
- GDP (in billions of euros, memorandum): 2000: "6,619.8"; 2001: "6,895.1"; 2002: "7,134.4"; 2003: "7,328.2"; 2004: "7,611.0"; 2005: "7,890.3".

### Executive Board and staff policy recommendations (summarized)
- Monetary policy:
  - Maintain current stance; be prepared to lower rates if the recovery fades absent offsetting inflation signals or if the euro appreciates significantly on a multilateral basis.
- Fiscal policy:
  - Urgent need to prepare public finances for demographic pressures; aim for underlying balance by 2010.
  - Suggested sustained fiscal adjustment of about "½ percent of GDP annually" (net of one-offs and temporary measures) over the medium term, with larger effort in countries posting deficits above the Maastricht "3 percent" ceiling.
- Stability and Growth Pact:
  - Welcome reformed Pact but emphasize credibility depends on effective, transparent, even-handed, and ambitious implementation; guard against flexible definitions that could justify insufficient consolidation.
- Structural reforms and Lisbon Strategy:
  - Reinvigorate implementation with prioritization, ownership, and stronger incentives; focus on boosting labor utilization, entitlement reform, competition and completion of the internal market.
- Financial integration and supervision:
  - Enforce existing rules, ensure timely transposition of FSAP measures, and consider stronger area-wide cooperation for supervision of systemically important crossborder financial groups.
- Trade:
  - Continue EU leadership in Doha; offer greater agricultural access and avoid protectionist safeguards that undermine liberalization.
- Statistics and surveillance:
  - Improve quality, availability, and timeliness of statistics; strengthen statistical governance and Eurostat’s monitoring role.

*Italic source: IMF staff report excerpt (content unit _cr05265) from the provided document.*

### Executive Summary ......................................................................................................

### _cr05265 - Executive Summary

### Key findings: macro outlook and recovery
- The euro-area recovery is described as "low-flying" and has "hit a rough patch."
- Domestic demand "lacking vigor" amid a difficult structural/cyclical transition; the recovery has run into headwinds including "high oil prices" and (until recently) a sustained appreciation of the exchange rate.
- Past structural reforms have improved employment performance and "are expected to continue to do so."
- Subdued wage growth and major price shocks have crimped real disposable incomes and consumption, leaving the recovery "heavily reliant on global demand."
- Elements sufficient for a continuation of a gradual recovery remain in place, but "repeatedly disappointing activity is taking a toll on adjustment efforts and the EU policy context."
- Staff continue to expect a "gradual, modest, but strengthening recovery," but with "preponderantly downside risks" from confidence effects or international headwinds.

### Recent developments (background)
- After gains in 2004, "final domestic demand unexpectedly stalled in 2005:Q1."
- Real GDP growth rebounded to "2 percent" in Q1 2005, primarily reflecting slowing imports.
- Oil price hikes since mid-2003 may have detracted about "½ percentage point" from real GDP growth in 2004 and may do so again in 2005.
- The euro’s appreciation "subtracted almost ½ percent from growth in 2004."
- Investment has "adjusted gradually" and is "stagnating less than in earlier troughs."
- Consumption is "unusually sluggish" and household consumption is identified as a "key missing link."
- Labor market resiliency has improved: past labor market reforms and wage moderation have made it easier for employers to preserve payrolls and adjust hours worked; total hours have begun to rebound while employment growth "has been modest."

### Monetary policy stance and risks
- Broad agreement on the economic outlook and risks; discussions focused on monetary policy stance, the Stability and Growth Pact (SGP), and structural reforms.
- The monetary policy stance is judged "appropriate, for now."
- The ECB emphasized that "the distribution of risks to price stability was heavily skewed to the upside."
- Staff argued that "the risks were more balanced" and that, while keeping rates on hold remained appropriate, "a rate cut would be needed if, absent new information on inflation, evidence accumulated that the recovery was fading."

### Fiscal policy, SGP reform, and fiscal risks
- Fiscal policies "are falling well short of consolidation requirements" and the area is "insufficiently prepared for the looming demographic shock."
- Past fiscal policy failures—"notably insufficient adjustment during economic upswings"—have strained the SGP.
- Staff welcomed "certain elements of flexibility in the SGP reforms," but regretted "the vagueness and open-endedness of others."
- Agreement that the effectiveness and credibility of the reformed SGP hinge largely on "its implementation by the European Council."
- Staff view this as underscoring "the need for stronger national institutions to assess policies," a proposal that was questioned by a number of national authorities.
- Staff recommendation (past stance summarized): countries with weak underlying budgetary positions were advised to undertake high-quality fiscal adjustments of at least "½ percent of GDP a year (and more in good times)."

### Structural policies and the Lisbon Strategy
- "Center-led structural reform programs have struggled to deliver."
- Commission, ECB and staff broadly agreed on the need for reforms, but differed on their potential contribution to resolving global imbalances.
- Staff welcomed the greater emphasis on ownership in the reinvigorated Lisbon strategy, but expressed concern about "insufficient prioritization and incentives for implementation."
- Staff questioned whether programs to integrate Europe’s financial markets would yield timely results; interlocutors considered concerns about further centralization of regulation and supervision "premature."
- Past Fund recommendations (summarized): the Fund argued that raising longer-term growth requires bolstering incentives to work; the Lisbon Strategy remains appropriate "as long as it is appropriately prioritized and undergirded by credible peer pressure, including through the use of benchmarking."

### Policy implications and priorities highlighted in discussions
- Maintain current monetary policy stance while monitoring incoming information on the recovery and inflation; be prepared to lower rates if the recovery fades absent offsetting inflation signals.
- Strengthen fiscal consolidation efforts to meet medium-term requirements and prepare for demographic pressures; improve national institutions for policy assessment.
- Ensure SGP reforms are implemented in a way that preserves credibility and clear incentives for adjustment; avoid vagueness and open-endedness in application.
- Reinvigorate structural reform implementation with clear prioritization and stronger incentives/ownership under the Lisbon Strategy; monitor progress on financial market integration initiatives.

*Source: _cr05265 - Executive Summary*

### 0.7 and 0.4 percentage point off real disposable

### _cr05265 - 0.7 and 0.4 percentage point off real disposable

### Consumption, Saving, and House Prices
- Real disposable incomes were "0.7 and 0.4 percentage point off" in 2004 and 2005, respectively.
- Consumers have been disinclined to reduce saving rates despite the recovery because of increasingly uncertain benefit prospects.
- Low interest rates have fueled demand for housing, but:
  - New home purchases and rising real estate values have not translated strongly into higher consumption expenditures, given relatively few avenues in Europe to tap into home equity.
- As energy price hikes slow and administered prices stabilize:
  - Headline inflation should gradually converge to underlying inflation, which is running around 1½ percent, supporting real income growth.
- Conditions required for consumption to propel activity:
  - More employment growth (being facilitated by wage settlements).
  - Improved consumer confidence.

### Structural Perspectives
- Structural adjustment achievements and trends:
  - Wage restraint and reforms of part-time and temporary work have enhanced cyclical resiliency and encouraged job-rich growth.
  - Since the mid-1990s, employment has risen by some 12 million and been robust through the downturn.
  - Since 2000 employment rates of those aged 55 to 64 years have risen by over 4 percentage points.
  - Wages remain subdued despite major shocks.
  - Fiscal policy has generally performed better than during earlier recessions and entitlement reform has proceeded.
- Remaining challenges:
  - The demographic shock looms closer.
  - Employment rates remain low; disappointing productivity trends need to be reversed.
  - Need to reduce the 9–11 percent unemployment rates in the large states.
- Risks to reform momentum and sources of divergence:
  - Reform fatigue and discontent could delay adjustment.
  - Divergences in countries’ performances have been declining; weak performances are rooted in uneven reform implementation and delays in addressing asymmetric shocks and competitiveness losses.
- Medium-term outlook:
  - Staff sees potential output growth stuck at a low level of around 2 percent, with actual growth only modestly higher over the medium run to close an output gap of about 1½ percent of potential GDP.

### Near-term Prospects and Risks
- Uncertainty around the recovery:
  - Recent data releases have heightened downside risks; abrupt halt in domestic demand and acceleration in real GDP growth in 2005:Q1 is difficult to explain.
  - Oil prices increased from about euro 30 to 40 per barrel during the first quarter, possibly affecting forward-looking investment and employment decisions.
  - Bad weather depressed construction; calendar effects had opposite effect on headline GDP.
  - Pipeline effects of past real exchange rate appreciation and a temporary slowdown in global trade pointed to weakness in goods production through the second quarter.
- Factors supporting gradual recovery:
  - Fiscal policies largely in water-treading mode and interest rates at historical lows.
  - Recovery of hours worked expected to translate into higher employment.
  - Slowing administered prices should support household incomes.
  - Past exchange rate appreciations' effects should be waning.
  - World demand and trade projected to strengthen again following an oil price-related soft patch.
- Staff and institutions’ central scenario:
  - Euro-area output regains momentum in the second half of this year, with 2005 real GDP growth around 1⅓ percent, and achieves growth at potential by 2006.
- Main external and confidence risks:
  - Further oil price hikes and multilateral euro appreciation.
  - Staff’s multilateral assessments suggest the area’s real effective exchange rate is somewhat above but close to medium-term fundamentals.
  - Since the discussions, the euro has depreciated by some 2½ percent in effective terms, reducing some appreciation-related risks but possibly raising risks from a stronger fall in confidence.

### Inflation and Monetary Policy
- Inflation developments:
  - Headline inflation has persisted at or above 2 percent; underlying inflationary pressures are easing.
  - Large increases in oil and administered prices had pushed HICP inflation to 2½ percent by mid-2004 and continue to affect prices in 2005.
  - With modest wage setting and some cyclical bounce in labor productivity, unit labor costs have decelerated sharply and second-round effects from higher oil prices have not materialized.
  - Core inflation is expected to fall close to 1½ percent over the medium term (ECB and IMF staff), with ECB staff seeing a modest acceleration beginning in 2007.
  - Headline inflation projected to run around 2 percent in 2005 and moderate to 1¾ percent in 2006, excluding a one-off reduction in administered prices.
- ECB projections (June 2, 2005) noted in the source:
  - Average annual HICP inflation between 1.8–2.2 (mid-point 2.0) percent in 2005.
  - Average annual HICP inflation between 0.9–2.1 (mid-point 1.5) percent in 2006.
  - For 2006, projections include a one-off reduction from a Netherlands health care reform projected to trim 0.2 percentage point from the area-wide price level.
- Risks and monetary stance:
  - ECB officials viewed risks to inflation as heavily skewed to the upside: indirect taxes, administered prices, and oil prices posed upside risks.
  - Policy rates had been on hold at 2 percent—since June 2003—and the yield curve had flattened at the long end.
  - Low interest rates led to a rapid expansion of monetary aggregates, particularly the most liquid components; the ECB’s monetary analysis pointed to liquidity exceeding that consistent with price stability over the medium to longer term.
  - Loans to households—mainly mortgage lending—had seen brisk growth; credit to nonfinancial corporates had shown renewed strength.
  - ECB saw a need to carefully monitor whether risks to price stability were building in the context of strong house price increases in some regions.
  - ECB officials felt it was not appropriate to entertain interest rate cuts given upside inflation risks and stood ready to raise rates rapidly if inflationary expectations lost their anchor; since the discussions, ECB officials have no longer explicitly ruled out the option of cutting rates.

*Source: IMF staff report content from _cr05265 - 0.7 and 0.4 percentage point off real disposable*

### 20.      Staff saw the risks to price stability as more balanced than suggested by the

### 20.      Staff saw the risks to price stability as more balanced than suggested by the ECB

### Price-stability assessment (economic pillar)
- One-off shocks have been a continuing problem and the resulting persistent over-shooting of the inflation target gave rise to both upside risks and credibility issues that needed to be taken into account.
- Wage and underlying inflation had been ebbing down and were expected to remain below levels consistent with the ECB’s target even on a baseline that foresaw a recovery of activity.
- Second-round effects were notable mainly for their absence, pointing to downside risks.

### Monetary analysis and liquidity, credit, and inflation risks (Box 4)
- Staff viewed risks from the monetary analysis as too uncertain and long-term to motivate a change in policy stance at this juncture.
- Liquidity was ample, and appropriately so; robust cautionary signs of building medium-term inflationary pressures were lacking.
- Rapid credit growth—mainly for mortgages—was, except for a few outliers, in line with financial “catch-up,” which might help explain the dichotomy between the pace of activity in the area’s real versus financial sector.
- Staff cautioned against downplaying concerns related to excessive house prices in some countries, but noted evidence for area-wide excessive house prices was not strong; such country-specific concerns could be addressed more effectively at the national level (for example, with fiscal measures or prudential monitoring).
- Staff pointed to the benefits of further financial market integration for a more uniform passthrough of monetary policy to asset prices.

Box 4 — key points
- Historically, money growth in excess of real output growth has overpredicted area-wide inflation, reflecting velocity’s secular decline.
- Staff analysis suggests a variable trend decline in velocity; shifts could reflect temporary or more lasting factors, including portfolio shifts after the equity bubble and/or changes related to EMU and the euro’s expanding international role—this increases uncertainty in assessing liquidity’s inflationary impact.
- The ECB worries that low interest rates are fueling asset price inflation, but policy faces hurdles: reliably identifying bubbles, complex links between credit/asset/consumer prices, and spillovers to the real sector.
- While house prices have risen quite rapidly in some member countries (driven also by financial catch-up and stronger pass-through of monetary policy to mortgages and housing), evidence for area-wide “excess” is not strong.

### Interest-rate stance and near-term outlook
- Overall, staff considered that keeping interest rates on hold was still appropriate but that the need for a rate cut may be materializing.
- With inflation headed for rates below 2 percent and moderating further, a cut in interest rates would be appropriate if evidence for a fading recovery continued to accumulate.
- For the time being, the stickiness of overall inflation together with uncertainty meant keeping interest rates on hold seemed appropriate.
- Staff’s latest forecast places headline inflation at 1.7 percent for 2006, or 0.2 percentage point above the ECB’s forecast mid-point of June 2.

### External risks and contingency considerations
- A sharp multilateral appreciation of the euro would open the case for monetary easing, other things being equal.
- If oil prices were to persist at heightened levels for the foreseeable future, maintaining a wait-and-see position on interest rates as insurance would be appropriate, insofar as second-round effects did not materialize.
- Since the discussions, the euro has depreciated by some 2½ percent in nominal effective terms; and oil prices have risen by about 10 percent.
- A 10 percent rise in oil prices is estimated to lower growth by 0.1 percent and raise inflation by 0.2 percent; a 10 percent effective euro depreciation adds 0.4 percent to growth and 0.3 percent to inflation in the year ahead.
- These developments have little net effect on growth but have a small positive impact on headline inflation.

### Fiscal policy: current assessment and required adjustment
- Fiscal policies are falling well short of what is needed to meet the area’s fiscal consolidation requirements.
- Absent action, the increase in aging-related expenditure after the end of the current decade will push debt in many countries onto clearly unsustainable trajectories.
- Staff viewed these pressures as calling for budgets to attain underlying balance by 2010 in tandem with continued progress with entitlement reforms.
- With the area-wide structural deficit close to 2 percent of GDP, achieving this objective required structural adjustment (net of one-offs and other temporary measures) of ½ percent of GDP annually.
- No significant area-wide consolidation has been achieved since 2000; budgets for 2005 and targets for 2006 foresee little consolidation—with the larger countries being most prone to inaction.
- On staff projections, almost half of the countries in the euro area—France, Germany, Italy, Greece, and Portugal—would post deficits in excess of 3 percent in 2005–06, some by significant margins.
- Key problem: overcoming political economy biases toward postponing adjustment until rising market pressures force abrupt action.
- Immediate need: secure an adequate safety margin to avoid a repeat of breaches of the Maastricht ceiling during the next downswing.

### Debate on fiscal adjustment vs. structural reform
- Some national authorities argued staff’s fiscal stance could undermine support for structural reforms, noting recent entitlement reforms reduced intertemporal imbalances but led to sagging confidence and weak growth.
- Staff argued euro area problems are long term and unlikely to be remedied by on-the-go fiscal fine-tuning, given underlying fiscal unsustainability and historical difficulty in reversing expansionary policies.
- Staff advocated articulating and pursuing a clear, consistent, and forward-looking strategy aimed at securing longer-term sustainability of the social model; the long-term complementarity between structural and fiscal requirements limits the scope for tradeoffs.

### Stability and Growth Pact (SGP) reform: overview and staff views
- Authorities agreed a reformed Stability Pact intended to restore order and discipline to EMU’s fiscal anchor; the Pact had been in procedural limbo since November 2003.
- The reformed Pact was endorsed by all 25 EU members.
- Dissuasive arm: more flexible deadlines and allows consideration of a range of country circumstances.
- Preventive arm: medium-term objectives (MTOs) set according to country conditions (potential growth and initial debt levels), up to a maximum deficit of 1 percent of GDP; MTOs would be adjusted to incorporate implicit liabilities.
- Agreement to exclude one-off measures from assessments under the reformed Pact seen as a clear step forward.

Staff concerns on reform specifics
- Some changes align with staff views: tighter link between adjustment deadlines and economic developments; specification of a “minimum” annual adjustment in excessive deficits of at least ½ percent of GDP, net of one-offs and other temporary measures.
- Problematic allowance: greater recourse to an open-ended list of “other relevant factors,” which could permit countries to avoid corrective action. The ECB viewed this as a potential watering down of the EDP; the Commission argued these factors could be invoked only if a breach of the 3 percent ratio was “temporary” and the deficit remained “close to the reference value.”
- Main staff concern: preventive arm provisions could permit quite limited adjustment more or less indefinitely, including during upswings, due to:
  - The benchmark adjustment of ½ percent per annum expected only when output is at (or “slightly below” if growth is high) or above potential—this test is rarely met in real time.
  - A provision allowing countries to deviate from adjustment paths when they undertake major structural reforms, scaling back adjustment in proportion to direct or indirect effects of reforms.
- Combined, these provisions could provide scope to delay adjustment and invite lengthy debates on assessments.

Implementation and national institutions
- The effectiveness and credibility of the reformed Pact will largely hinge on implementation, particularly by the Council.
- The Pact’s greater flexibility and complexity introduce new margins for discretion that could be misused; staff stressed the need for ambition relative to medium-term requirements, even-handedness in application, and transparency.
- With softer limits at the center, staff argued for stronger national institutions to assess policies (debating Stability Programs in parliaments alongside budgets; strengthening or establishing independent, non-partisan fiscal councils).
- Fiscal councils could assess policies, provide forward-looking perspectives, rally popular support for adjustment, identify policy failures, and increase reputation costs—offering some offset to weaknesses of central disciplining devices and contributing to more realistic budgets.
- Some national authorities questioned the need for such councils, arguing similar bodies exist in various guises and their effectiveness is not demonstrated.

### Product and factor markets; reform strategy
- The basic issue is how to strengthen the pace and effectiveness of reforms.
- The Barroso Commission pursues a two-pronged approach:
  - Shift ownership of many reforms onto member states via a restructured Lisbon strategy (bottom-up), ensuring prioritization and coordination of national reform efforts.
  - Complement bottom-up reforms with center-led reforms to strengthen product market competition and achieve integrated financial markets.
- Views differed on whether reforms should be motivated by addressing global imbalances; Commission and ECB staff favored a domestic motivation, while national authorities noted structural reforms’ ambiguous effects on saving and investment.
- Staff noted that after a lag, structural reforms should boost domestic demand and growth, improving Europe’s resilience to a market-driven resolution of global imbalances; a cooperative approach would help forestall abrupt scenarios.

*Italic line: IMF staff report excerpt (section 20–31) from the provided document.*

### 32.      The Commission has made the implementation of a reinvigorated Lisbon

### _cr05265 - 32.      The Commission has made the implementation of a reinvigorated Lisbon

### Lisbon Strategy: restructured priorities and process
- Objective of original agenda launched in March 2000: make Europe the most dynamic, knowledge-based economy by 2010.
- Key target now out of reach: raising the employment rate to 70 percent by 2010.
- Restructured strategy (endorsed by the European Council in March/June) features:
  - An integrated and focused agenda to make Europe a more attractive place to work and invest, to spread knowledge and innovation, and to create more and better jobs.
  - EU-wide Integrated Guidelines for Growth and Employment (covering three years) that regrouped previously separate reform tracks, encompassing the former Broad Economic Policy Guidelines and Employment Guidelines.
  - A procedural shift from Brussels to the national level: Governments to prepare National Action Plans (NAPs) fitting within the Integrated Guidelines, with concrete measures and timetables under a national “Mr./Ms. Lisbon” collaborating with stakeholders including national Parliaments to strengthen national initiative and ownership.

### Staff assessment of the restructured Lisbon Strategy
- Positive assessments:
  - Emphasis on integrating agendas is appropriate given analyses showing the importance of packages of reinforcing measures (example: complementarity between wage moderation and product market reforms).
  - Shifting part of agenda-setting to national arenas should help build lasting popular support for reform.
- Concerns and cautions:
  - Prioritization may still be insufficient; increasing labor utilization (through sharpened incentives to work) and strengthening competition appear the most effective levers to boost potential output.
  - The new Strategy contains over 20 broad guidelines, which may allow avoidance of politically difficult reforms and dilute focus.
  - European Council decision against benchmarking and naming/praising could weaken reform impetus, though countries’ progress will continue to be monitored using a cross-country database of structural indicators.
  - Staff encouraged continued use of indicators, citing the positive experience with OECD’s PISA studies on education.

### Box 5 — Product Market Regulations and the Benefits of Wage Moderation
- Finding: Decelerating labor costs have a stronger effect on growth and unemployment in economies with less regulated product markets: lower wages raise profitability, prompting more entry, output, and employment in less regulated, more competitive economies.
- Interpretation: Evidence underscores complementarity of labor and product market reform and partly explains cross-country differences in benefits from wage moderation.
- Note on methodology: Wage shocks in the business sector are log changes in compensation per hour divided by the PCE deflator, minus log changes of labor-saving technology, minus log changes of unemployment rate multiplied by the elasticity of wages with respect to unemployment (0.1).
- Empirical periods and indicators referenced: Growth in business GDP/population, 1983 to 2003.
- Regression results shown in figures: y = -0.10x + 1.85, R2 = 0.24; and y = -0.15x + 2.11, R2 = 0.04.
- Data sources cited: OECD Analytical Database; EC - AMECO database; and staff estimates.

### Single market and Services Directive
- Commission objective: strengthen competition via center-led reforms.
- Setback noted: EU Services Directive sent back by the European Council for amendments amid concerns it would trigger social dumping.
- Directive feature: guarantees freedom to establish and provide services across the EU; for services provided by a provider from another member state, the “country of origin principle” applies (home-country administrative and legal requirements), with derogations for specific sectors.
- Commission view: fears of social dumping misplaced in light of derogations and safeguards; country-of-origin principle grounded in the EU Treaty, commission hopeful principle will be maintained.

### Financial market developments — resilience and risks
- Overall assessment: strength and resiliency of the financial system is improving (see Table 3).
- Banking sector:
  - Banks weathered latest downturn better than the early 1990s recession.
  - Bank profitability recovered in 2004, reaching its highest level since 2000, supported by continued cost cutting, strong revenues from mortgage lending, and lower loan loss provisioning.
  - Pockets of fragility remain in banking sectors of some member countries, but the overall system should not impede a more robust recovery.
- Insurance sector: recovered, buoyed mainly by equity markets; vulnerabilities persist among life insurers facing very low returns on fixed-income assets.
- Drivers of improved performance: reduced public sector involvement, greater market-discipline and transparency, and better risk management.
- Figure 7 (Euro area, 100 Largest Banks) highlights (as presented):
  - Banks remain well-capitalized: Total capital ratio, Tier 1 ratio, Capital/assets ratio (sample sizes indicated: sample of 69 banks only; sample of 89 banks only; sample of 68 banks only).
  - Stable interest margins: Net interest revenue / average assets and Return on average assets (sample of 89 banks only).
  - Cost-to-Income Ratio and profitability improvements (100 banks; 89 banks only).
  - Decline in loan loss provisions / total assets (sample of 86 banks only).
  - DJ Euro STOXX Index for banks performance to Mar-2005 shown (Sept 13,2001 =100).

- Financial sector risks:
  - Largely related to global imbalances and potential unwinding of benign market conditions: exchange rate volatility, a spike in long-term interest rates, and a sudden increase in the price of risk.
  - Domestic factors: household balance sheets expanded further in 2004 due to rising house prices and mortgage debt, but for the area as a whole and on reasonable swings in interest rates this did not create undue credit risks for banks.
  - Corporate side: large firms improved balance sheets and profitability; rating upgrades exceeded downgrades in 2004:Q4 for the first time since 1998:Q2.
  - Vulnerabilities: Europe’s small and medium-sized enterprises left more exposed by sluggish domestic demand.
  - Concerns about institutions with exposures to hedge funds or over-the-counter derivatives due to lack of transparency.

### Financial integration, regulation, and supervision
- Authorities’ view:
  - Current framework (Financial Services Action Plan (FSAP) and Lamfalussy process) expected to yield significant progress toward an integrated market.
  - Framework has delivered many Directives; after transposition through 2007 this should yield major benefits.
  - Priorities for next five years: (i) consolidate and streamline existing legislation and keep new legislative initiatives to a minimum; and (ii) ensure effective transposition and enforcement by supervisory authorities.
  - New initiatives: integrate clearing and settlement systems; introduce a new insurance solvency framework; improve crossborder payment systems; press for more retail-level integration using competition policy to identify entry barriers to crossborder financial services.
- Staff concerns:
  - Pace and effectiveness of integration may be insufficient to fully reap EMU dividends: efficient allocation of investible resources, buffering of country-specific shocks, and efficient monetary transmission require deeper integration.
  - Ongoing obstacles: state ownership of banks; difficulties in executing crossborder mergers and acquisitions; differences in regulations and supervisory practices; slow integration of securities markets; nationally oriented consolidation strategies; financial innovation being pressed at national rather than area-wide level.
  - Risk profiles of large publicly-traded financial institutions converging around unimproved levels despite better risk management.
  - Recommendation: consider a more centralized approach to supervision, particularly for systemically important financial groups; as a first step give EU supervisory committees access to basic, up-to-date, institution-specific data (including strategies, risk profiles, potential for contagion risks) covering the limited number of EU financial groups with major crossborder operations.
- Authorities’ counterpoints:
  - Consider concerns premature; progress on schedule; institutions and clients increasingly take a European-wide approach.
  - EU supervisory networks and committees already provide centralized vehicles for rulemaking and coordination; intensive information exchange exists between national supervisors of large crossborder financial groups.
  - Newly-agreed Memorandum of Understanding on cooperation in financial crises reinforces cooperation.
  - Further centralization of supervision raises complex issues and is not called for at this stage; process to be reassessed in 2007 when many newly adopted rules should begin to deliver results.

### Trade policy positions and staff views
- Commission preference: multilateral approach under the WTO’s Doha Round to create new market access, improve WTO rules (e.g., anti-dumping), and contribute to economic development.
- Commission perception: emerging “political will” to conclude negotiations; did not expect bilateral trade tensions with the United States to slow negotiations.
- Staff recommendations:
  - Welcome EU role in keeping Doha on track but encourage more ambition in agricultural market access offer.
  - Welcome EU restraint from new RTA negotiations while the Doha Round continues; support for strengthening WTO rules on regional trade agreements.
- Developing countries:
  - Commission expects substantial Doha commitments mainly from more advanced developing countries.
  - Staff view: further trade reform by developing countries critical to fully exploit increased market access; suggested multilateral (M.F.N.) liberalization would benefit developing countries more than extending reciprocal preferences for EU exports.
- Textile/clothing import pressures:
  - Officials noted need to manage consequences of rapid growth of imports (especially from China) to maintain internal support for liberal trade policy.
  - Steps taken: temporary import safeguards under China’s WTO accession protocol; staff encouraged refraining from safeguards due to the 10-year adjustment period for domestic firms and adverse effects on credibility of reforms.
  - Since discussions: China agreed with the Commission to limit, until end-2007, export growth to the EU of ten product categories accounting for half of EU imports of Chinese textiles and clothing; the EU launched an anti-dumping investigation on footwear imports from China.

### Statistics and data quality
- Data needs: more comprehensive data on flows of funds, balance sheets, non-factor services and trade are needed (Appendix II).
- Concerns: problems with budget statistics quality in some countries leading to significant upward revisions to historical deficit figures.
- Recommendations: step up efforts to improve statistical governance standards, including granting greater independence to national statistical institutes and endowing Eurostat with greater monitoring and auditing powers.
- Note: ongoing efforts to increase Eurostat’s resources are welcome but may not suffice.

### Staff appraisal — overall policy direction and priorities
- Context: euro area undergoing a difficult economic transition; essential to ready Europe’s social model for the demographic shock through higher growth.
- Core strategic elements reiterated: fiscal consolidation and entitlement reform; increased incentives on demand and supply sides of the labor market; and strengthened competition via internal market, enlargement, or elimination of exchange rates.
- Achievements and outlook:
  - Implementation has yielded tangible results—employment gains of the past decade—and more can be expected from recent structural reforms.
  - However, short-term preoccupation and inconsistent implementation have generated uncertainties about basic directions.
  - With accumulated rigidities and aging weighing on performance and sustainability, policies must be more forward-looking and consistent, harnessing complementarities between fiscal adjustment and structural reform.
  - Europe’s restructured policy frameworks chart the right course; increased emphasis on ownership can help build public trust.
  - Crucial: implementation depends on leadership in national capitals and the European Council.

*Source: IMF staff report content as provided in the supplied PDF excerpt.*

### 45.      Although the near-term economic outlook is uncertain, the fundamentals remain

### _cr05265 - 45.      Although the near-term economic outlook is uncertain, the fundamentals remain

### Near-term economic outlook
- Continued wage moderation, improved corporate balance sheets, accommodative financing conditions, and reaccelerating world demand point to renewed momentum during the second half of the year.
- Risks lie mainly on the downside, including further oil price spikes, multilateral euro appreciation in the context of unwinding global imbalances, and a sudden reversal in benign global financial conditions.
- The situation is hard to read given mixed activity indicators.

### Monetary policy stance
- Underlying inflation is running well below target and seems likely to continue to do so, but headline inflation is still hovering around 2 percent.
- Overall, keeping policy rates on hold for the time being is appropriate.
- A need for a rate cut may be materializing if:
  - Evidence continued to accumulate over the coming months that, contrary to projections, the recovery was fading.
  - The euro appreciated significantly on a multilateral basis.
- If those conditions materialize, a cut in interest rates would be appropriate; absent new information on inflation, current stance should be maintained.

### Fiscal outlook and public finances
- Budgetary plans fall well short of making steady progress toward achieving underlying balance by 2010.
- Balance is needed both in anticipation of population aging and to move decidedly below the 3 percent Maastricht deficit ceiling.
- Absent adjustment, the anticipated spike in aging-related expenditure would push public debt in many member states onto an unsustainable path.
- Policies need to consistently redress current and intertemporal fiscal deficits to anchor consumer confidence.
- Required annual fiscal adjustment: ½ percent of GDP, net of one-offs and other temporary measures.
- Structural reforms must complement fiscal consolidation.

### Stability and Growth Pact (SGP) credibility
- The SGP has generally managed to tame runaway deficits and procyclical fiscal policies and should remain a cornerstone of EMU’s policy framework.
- The Pact has been undermined by countries failing to undertake requisite adjustment, either by:
  - Allowing deficits to breach the 3 percent limit.
  - Resorting to one-off measures, creative accounting, or even misreporting.
- Recent proposals:
  - Greater sensitivity to economic circumstances under the dissuasive arm.
  - Call for ½ percent of GDP annual adjustment as a benchmark under the preventive arm.
- Shortcomings of the reforms:
  - Do not adequately strengthen the preventive arm.
  - Potentially open-ended trade-offs between fiscal adjustment and structural reforms.
  - Restrictive definition of “good times” for adjustment.
- Credibility of reform depends on even-handed, transparent, and disciplined implementation by the Council of the new commitments.

### Structural reform agenda and governance
- Prospects for reform will hinge on the leadership and determination of national governments as agenda-setting shifts away from the center.
- Policy priorities:
  - Reform entitlement systems.
  - Boost labor utilization.
  - Complete the internal market.
  - Integrate national financial systems.
- The new integrated guidelines under the Lisbon Strategy should aid in formulating consistent national policy matrices.
- Long-term macroeconomic divergences within the monetary union are rooted in swings in competitiveness; solutions require increased flexibility and integration through structural reforms.

### Strengthening domestic institutions and surveillance
- Garnering domestic support for strong, forward-looking policies in a more decentralized environment argues for strengthening domestic economic institutions.
- Debating Stability Programs and National Action Plans in parliaments increases transparency and builds ownership.
- Countries facing large consolidation and reform agendas should develop independent, non-partisan institutions to:
  - Inform the public about larger strategic economic issues.
  - Assess policies and their implementation.
- Domestically-driven surveillance mechanisms should be complemented by intensive, peer-driven multilateral surveillance of policies, including well-grounded benchmarking.

### Financial sector integration and supervision
- Policy agenda should emphasize enforcement of existing rules, including competition policy.
- Progress made under the FSAP and the Lamfalussy process has laid foundations for further integration and supervisory convergence.
- Risks and challenges:
  - Evolutionary approach may not overcome vested interests or deliver a harmonized regulatory framework.
  - Need to avoid acting as a brake on integration or exposing the system to unnecessary risk.
- Responsibilities:
  - Member states must make the process work.
  - The Commission should enforce existing rules.
- Growing crossborder activities of major, complex financial groups increase burden on national supervisors.
- Consider a more formal area-wide collaboration, including provision of up-to-date information on key groups to an existing area-wide structure.

### Trade policy
- The EU should continue to lead in fostering agreement on the Doha Development Agenda.
- Recommendations:
  - Offer greater access to EU agricultural markets.
  - Limit use of sensitive product exemptions from tariff reductions.
- Recent moves to limit imports of textiles, clothing, and footwear are described as unfortunate.
- On the multilateral stage, emphasize strong WTO rules over regional trade agreements and work with developing countries to liberalize trade regimes on a most-favored-nation basis.

### Statistics and surveillance
- Effective area-wide surveillance calls for improvements in the quality, availability, and timeliness of statistics.
- Better fiscal data are a key priority for a number of countries.

*Source: _cr05265 - 45.      Although the near-term economic outlook is uncertain, the fundamentals remain*

### 54.      It is proposed that the next consultation on euro-area policies in the context of the

### _cr05265 - 54.      It is proposed that the next consultation on euro-area policies in the context of the

### Consultation timing
- It is proposed that the next consultation on euro-area policies in the context of the Article IV obligations of member countries follow the standard 12-month cycle.

### Key macroeconomic outcomes and projections (from tables and text)
- Real GDP growth: 1999–2004 and projections: 1999: 2.7; 2000: 3.8; 2001: 1.8; 2002: 1.0; 2003: 0.7; 2004: 2.0; 2005 (WEO June 2005 projection): 1.3; 2006: 1.9.
- Domestic demand (real): 1999: 3.5; 2000: 2.9; 2001: 1.0; 2002: 0.4; 2003: 1.2; 2004: 1.9; 2005: 1.3; 2006: 1.9.
- Private consumption (percent change): 1999: 3.3; 2000: 3.0; 2001: 1.9; 2002: 0.9; 2003: 1.1; 2004: 1.4; 2005: 1.4; 2006: 1.6.
- Gross fixed investment (percent change): 1999: 6.1; 2000: 5.2; 2001: 0.2; 2002: -2.3; 2003: 0.4; 2004: 1.9; 2005: 2.1; 2006: 3.1.
- Exports (includes intra-euro area trade; percent change): 1999: 5.4; 2000: 12.4; 2001: 3.8; 2002: 2.1; 2003: 0.6; 2004: 6.0; 2005: 3.5; 2006: 5.2.
- Imports (includes intra-euro area trade; percent change): 1999: 7.9; 2000: 10.3; 2001: 1.7; 2002: 0.6; 2003: 1.9; 2004: 6.3; 2005: 3.8; 2006: 5.5.
- Output gap (percent of potential GDP): 1999: 0.2; 2000: 1.8; 2001: 1.4; 2002: 0.3; 2003: -1.0; 2004: -0.9; 2005: -1.5; 2006: -1.4.
- Unemployment rate (percent): 1999: 9.2; 2000: 8.2; 2001: 7.8; 2002: 8.3; 2003: 8.7; 2004: 8.9; 2005: 8.9; 2006: 8.6.
- Consumer prices (percent): 1999: 1.1; 2000: 2.1; 2001: 2.3; 2002: 2.3; 2003: 2.1; 2004: 2.1; 2005: 2.1; 2006: 1.7.
- GDP deflator (percent): 1999: 1.5; 2000: 1.6; 2001: 2.4; 2002: 2.5; 2003: 2.0; 2004: 1.8; 2005: 1.7; 2006: 1.8.

### Public finances and fiscal outlook
- General government balance (percent of GDP, excludes UMTS revenues): 1999: -1.3; 2000: -0.9; 2001: -1.8; 2002: -2.5; 2003: -2.8; 2004: -2.7; 2005: -3.0; 2006: -3.1.
- General government structural balance (percent of GDP): 1999: -1.4; 2000: -1.9; 2001: -2.5; 2002: -2.6; 2003: -2.4; 2004: -2.1; 2005: -2.3; 2006: -2.3.
- General government gross debt (percent of GDP): 1999: 72.5; 2000: 70.0; 2001: 68.9; 2002: 68.8; 2003: 70.1; 2004: 70.6; 2005: 72.2; 2006: 72.9.
- Staff projection/assessment: fiscal deficits in five countries (France, Germany, Greece, Italy and Portugal) are expected to breach the SGP 3 percent of GDP limit in 2005–6.

### External sector and balance of payments (Table 2 highlights)
- Current account (in billions of euros): 2000: -8; 2001: 2.1; 2002: 3.3; 2003: 6.4; 2004: 20.4; 2005 Q1: 4.5.
- Current account (percent of GDP): 2000: -1.2; 2001: 0.0; 2002: 0.9; 2003: 0.3; 2004: 0.6; 2005 Q1: 0.3.
- Goods (in billions of euros): 2000: 7.6; 2001: 73.3; 2002: 128.5; 2003: 102.7; 2004: 103.5; 2005 Q1: 14.7.
- Trade balance (percent of GDP, goods): 2000: 0.1; 2001: 1.1; 2002: 1.1; 2003: 1.8; 2004: 1.4; 2005 Q1: 0.8.
- Financial account (in billions of euros): 2000: 70.6; 2001: -43.8; 2002: -43.9; 2003: -5.8; 2004: 24.3; 2005 Q1: 35.5.
- GDP (in billions of euros, memorandum): 2000: 6,619.8; 2001: 6,895.1; 2002: 7,134.4; 2003: 7,328.2; 2004: 7,611.0; 2005: 7,890.3.

### Financial conditions and corporate sector
- Short-term deposit rate (percent): 1999: 3.0; 2000: 4.4; 2001: 4.2; 2002: 3.3; 2003: 2.4; 2004: 2.1; 2005: 2.1 (data for 2005 are for May).
- Long-term government bond yields (percent): 1999: 4.7; 2000: 5.5; 2001: 5.0; 2002: 4.9; 2003: 4.2; 2004: 4.2; 2005: 3.3 (data for 2005 are for May).
- Euro/U.S. dollar exchange rate (U.S. dollar per euro): 1999: 1.07; 2000: 0.92; 2001: 0.90; 2002: 0.94; 2003: 1.13; 2004: 1.24; 2005: 1.21 (data for 2005 are for June 28).
- Corporate behaviour: improved profitability and stronger balance sheets, but firms remain defensive—consolidating balance sheets or paying dividends rather than investing or hiring.

### Prices, wages, and labor markets
- Headline inflation: moderated to 1.9 percent in mid-2005; headline inflation expected to fall to 1¾ percent in 2006 (staff projection).
- Underlying inflation: about 1½ percent.
- Unit labor costs: declining in real terms; wage growth described as modest.
- Employment (percent change): 1999: 1.8; 2000: 2.2; 2001: 1.3; 2002: 0.5; 2003: 0.2; 2004: 0.9; 2005: 0.7; 2006: 0.9.
- Labor market improvements noted from past reforms, but unemployment remains high (around 8.9 percent in 2004–05).

### Cyclical assessment and risks (from PIN and Executive Board)
- Recovery: described as "low-flying"; real GDP rebounded in 2005 Q1 to 2 percent (annualized) after loss of momentum in late 2004.
- Demand composition: domestic demand stalled; weak private consumption and hesitant corporate investment are key constraints.
- External pressures: sharply rising oil prices and sustained euro appreciation have dampened growth; buoyant world trade has supported external sector.
- Risks (explicitly identified): further hikes in oil prices; multilateral euro appreciation due to global current account imbalances; reversal of benign global financial conditions; sluggish investment recovery; downside risks predominate.
- Staff central projection: real GDP growth about 1⅓ percent in 2005 and 2 percent in 2006; headline inflation expected to fall to 1¾ percent in 2006 given maintained wage discipline and slack.

### Executive Board policy assessments and recommendations
- Monetary policy: ECB stance judged broadly appropriate; wait-and-see stance appropriate given uncertainty. Many Directors: a rate cut would be appropriate if evidence of a fading recovery continues or if the euro appreciates significantly on a multilateral basis. Some Directors cautioned against a cut citing upside inflation risks and structural sluggishness.
- Fiscal policy: Directors stressed urgent need to prepare public finances for demographic pressures and recommended steady progress toward underlying fiscal balance by 2010. Suggested sustained fiscal adjustment of about ½ percent of GDP annually over the medium term, complemented by structural reforms to address fiscal liabilities and strengthen the tax base.
- Stability and Growth Pact: welcomed reformed Pact but emphasized that credibility depends on effective, transparent, evenhanded, and ambitious implementation; cautioned against using flexible definitions to justify insufficient consolidation.
- Structural reform priorities: reform entitlement systems; boost labor utilization; deregulate and strengthen competition; complete the internal market; integrate national financial systems. Emphasized sequencing and complementarity between fiscal adjustment and structural reform, and the need for national leadership to implement reforms.
- Financial integration and supervision: welcomed Financial Services Action Plan and Lamfalussy process; urged member states to adopt a pan-European perspective and the Commission to enforce existing rules. Some Directors recommended consideration of a more integrated approach to supervision; others considered it premature.
- Trade policy: welcomed EU commitment to Doha; underscored benefits from greater access to EU agricultural markets; regretted recent moves to limit imports of textiles, clothing, and footwear.

### Statistical issues and data improvements (Appendix II)
- Overall: economic and financial data broadly adequate for area-wide surveillance; Eurostat and ECB share responsibility as per March 2003 Memorandum of Understanding.
- Ongoing and planned improvements:
  - National accounts changes: allocation of FISIM and use of chain-linking; euro-area aggregates to reflect changes from the Q3:2005 statistical release onward.
  - Euro-area quarterly statistics by institutional sector integrating flow of funds and non-financial national accounts being prepared for publication from May 2007 onward.
  - Revised NACE classification planned for 2007 in context of ISIC revision.
  - Commission strategy (post-misreporting): draft regulation for deeper monitoring visits; more resources allocated to national fiscal statistics; Code of Practice on European Statistics drafted.
  - Asymmetries in intra-EU trade data remain; work ongoing to reduce asymmetries and improve consistency between balance of payments and national accounts.
  - Labor market: quarterly LFS in all EU countries will enable complete quarterly data for euro area from 2006 onward; improvements to labor cost index reporting operational from June 2005; limited job vacancy statistics; monthly unemployment constructed from quarterly LFS with some inconsistencies relative to ILO definitions.
  - HICP improvements: work on quality adjustment, sampling, price index for newly-built houses (excluding land) on net acquisition basis, self-standing price index for dwellings, common base year, harmonized price collection period; pilot HICP at constant tax rates; Dutch HICP treatment of 2006 health care reform under consideration.
  - Financial soundness indicators: limited set published in ECB Financial Stability Report; Coordinated Compilation Exercise participation noted but ECB consolidation approach/frequency not aligned with IMF Compilation Guide on FSIs.
- Publication timing notes: quarterly public finance statistics work ongoing with partial publication expected from early-2006 onward.

### Memorandum and summary statistics (selected)
- Eurosystem reserves (in billions of euros, end-of-period stocks): 2000: 391.2; 2001: 392.7; 2002: 366.1; 2003: 306.5.
- Official reserves (U.S. dollar billion, end-of-year, Eurosystem definition, total reserves minus gold): 2000: 242.3; 2001: 235.0; 2002: 247.0; 2003: 222.7; 2004: 211.3; 2005: 200.0 (data for 2005 are for May).
- Nominal effective rate (2000=100): 1999: 111.5; 2000: 100.0; 2001: 101.2; 2002: 104.3; 2003: 116.1; 2004: 120; 2005: 121 (data for 2005 are for May).
- Real effective rate (2000=100, based on normalized unit labor costs): 1999: 113.4; 2000: 100; 2001: 99.2; 2002: 102.2; 2003: 112.8; 2004: 115.5; 2005: 115.5.

*Italic source: IMF staff report and Public Information Notice (PIN) No. 05/103, August 3, 2005, based on documents and tables in the provided content.*

### conclusions in the staff appraisal. Nevertheless, some differences of view can be observed,

### _cr05265 - conclusions in the staff appraisal. Nevertheless, some differences of view can be observed,

### Short term economic outlook
- After a soft patch in the second half of 2004, economic growth in the euro area gathered momentum in the first quarter of 2005, but the acceleration of activity was entirely attributable to net trade; domestic demand, particularly investment, showed broad-based weakness.
- Available survey data suggest activity slowed again in the second quarter of 2005.
- Domestic demand remains fragile and growth for the year as a whole is likely to turn out lower than earlier expected.
- Authorities share staff’s appraisal that fundamentals remain in place for the recovery to resume and view growth gradually returning to potential during the remainder of the year.
- Supporting factors cited by the authorities:
  - Recent improvements in hard data and surveys.
  - Monetary and financial conditions remain quite supportive.
  - Labor cost pressures are contained despite the oil-price hikes.
  - Recent weakening of the external value of the euro should provide further support to euro area exports.
  - Early signs that the soft patch in the global economy may be ending and that world trade could pick again up during the second half of the year.
- Downside risks identified (authorities agree with staff that risks currently lie mainly on the downside):
  - Further increases in already persistently-high oil prices.
  - The unwinding of global imbalances leading to a multilateral euro appreciation.
  - A sudden reversal of benign global financial conditions.
- Additional issue: increased divergence in growth rates and in the composition of growth across Member States, particularly among the four largest euro area Member States, which risks becoming entrenched and may indicate underlying structural problems.
- Policy implication: need for some Member States to boost their adjustment mechanisms in the face of economic shocks with different impacts.

### Monetary policy and the outlook for price stability
- Authorities welcome staff conclusion that the current stance of monetary policy is appropriate.
- ECB Governing Council’s baseline assessment: no evidence of underlying domestic inflationary pressure building up in the euro area.
- Governing Council identified potential upward risks to price stability over medium to long-term horizons and emphasizes the need for vigilance to maintain inflation expectations in line with price stability.
- Since Article IV discussions, oil price developments have evolved in a manner implying materialization of some previously identified upward risks to inflation projections for the euro area.
- Economic analysis highlights:
  - Annual HICP inflation remained at levels slightly above 2 percent in June, reflecting mainly recent developments in oil prices.
  - Wage increases should remain moderate because of weak labour markets.
  - Economic growth has remained subdued in recent quarters, but there is reason to expect gradual improvement in activity.
  - Investment should benefit from prevailing very favourable financing conditions, robust growth of corporate earnings, and ongoing improvements in corporate efficiency.
  - Consumption should evolve broadly in line with expected developments in disposable income.
  - Ongoing growth in global demand and improvements in euro area price competitiveness should support euro area exports.
- Monetary analysis insights:
  - Monetary and credit growth in the euro area remains strong, mainly reflecting the stimulative impact of the low level of interest rates.
  - Significant portfolio shifts between monetary and non-monetary assets have made signals for likely future price developments given by current monetary developments somewhat unreliable.
  - Liquidity remains ample by all plausible measures; part of recent shifts in velocity might be due to more structural factors (as claimed by IMF staff).
  - The combination of ample liquidity and strong credit growth could imply risks of strong asset price increases.
  - Relationship between money, credit, asset prices and consumer prices is complex; ECB should monitor these risks.
- Conclusion: domestic inflationary pressures over the medium term remain contained, although surrounded by upside risks; cross-checking economic and monetary analyses justifies ongoing vigilance to anchor inflation expectations at levels in line with price stability.

### Fiscal policy and SGP reform
- Authorities share staff’s view that further consolidation efforts are needed in the area in the years to come.
- Although the euro area deficit declined in 2004 after having increased for three consecutive years, more budgetary room is needed given pressures associated with rising ageing-related expenditures that will materialize starting from the next decade.
- Authorities judge the size of the annual consolidation effort as defined by staff (0.5 per cent of GDP in cyclically adjusted terms net of one-off and temporary measures) as appropriate and recommend that a bigger effort is needed by countries posting deficits in excess of the Maastricht 3 percent reference value.
- Need to complement fiscal consolidation by structural budgetary reforms aimed at:
  - Redefining entitlements to key expenditure programs.
  - Encouraging labor force participation.
  - Improving growth potential.
- Greater emphasis on debt sustainability is welcome.
- Importance of avoiding pro-cyclical fiscal policies during good times.
- Acknowledge trade-off between reforms and fiscal consolidation in the short-run, especially if reforms produce significant budgetary deterioration compensated by medium-to-long-term savings (example: pension reforms replacing PAYG schemes with funded schemes recorded outside the government sector).
- Views on SGP reform:
  - Judgment on Fund staff’s assessment is partly shared, but authorities have a different view concerning new provisions on the preventive arm of the SGP.
  - Overall, implementation will determine definitive judgment on SGP reform.
  - Agreement that better modulation of adjustment paths in the excessive deficit procedure (EDP) according to economic circumstances can induce credible adjustment via structural rather than one-off measures.
  - New provisions defining Treaty’s reference to “other relevant factors” are acknowledged; Member States remain committed to Maastricht deficit and debt ceilings and these provisions outline how to deal with room for judgment in implementing the EDP.
  - Authorities consider staff concern on reform of the preventive arm exaggerated; focus on overall fiscal sustainability will be enhanced.
  - Amended regulation explicitly refers to a benchmark annual adjustment towards the medium term objective of 0.5 per cent of GDP net of one-offs.
  - Countries are now required to report in their stability and convergence programs the reasons for lack of adjustment towards the medium term objective; these reasons will be discussed within the Council, likely increasing peer pressure.

### Lisbon Strategy
- Authorities welcome staff’s attention to the reinvigorated Lisbon Strategy to boost potential growth and employment.
- Noted disappointing progress toward Lisbon objectives set in 2000; Strategy refocused toward growth and employment objectives.
- Renewed Lisbon Strategy priorities: knowledge and innovation; making the EU an attractive place to invest and work; more and better jobs.
- Staff recommendations focus primarily on labor and financial markets and completing the Internal Market; authorities stress need for attention to generation and effective use of knowledge and innovation as key for competitiveness and long-run growth potential.
- Growth- and stability-oriented macroeconomic policies are necessary to reap full benefits of reforms in terms of growth and employment.
- Improvements in implementation expected through increased ownership by Member States and simplification of reporting and assessment.
- Integrated Guidelines Package brings together Broad Economic Policy Guidelines and Employment Guidelines and sets broad priorities for National Reform Programs.
- Continued multilateral surveillance for BEPGs, supported by active role of the Commission, should support coherent addressing of structural problems and avoid postponing politically sensitive reforms.
- Improved communication on the necessity and benefits of reforms is essential for substantial breakthrough.

### Financial market developments
- Authorities concur with staff’s balanced analysis of financial-sector developments in terms of stability risks and ongoing integration.
- As recovery proceeded, financial sector became progressively more resilient to possible adverse shocks, but favorable assessment qualified by stability risks linked to persistent imbalances elsewhere in the financial system.
- Stability risks relate mainly to external factors:
  - Tensions in the international balance of payments.
  - Possible mis-pricing of risk in asset markets.
  - Nature of markets for newer and more complex financial products.
- Domestic developments of significance:
  - Strong price pressures in some real estate markets.
  - Expanding credit and high private-sector debt levels under sustained below-par economic growth.
- Vigilance in prudential supervision of financial intermediaries will be key.
- FSAP implementation:
  - Financial Services Action Plan (FSAP) is almost fully implemented at the EU level; process of financial integration has reached an important juncture.
  - FSAP is the blueprint for a common regulatory framework and a pre-condition for an effective internal market in financial services.
  - Main challenge: ensure timely and consistent transposition of FSAP legislative measures into national law and provide mechanisms for adequate enforcement.
  - Financial integration increasingly evident in actual functioning of the financial sector; pace varies by market type and transaction but cross-border financial activity is accelerating.
- Response to staff’s view on pace of integration and supervisory arrangements:
  - Authorities contend staff’s concerns that institutional arrangements may not keep pace are not fully justified.
  - Progress in financial integration is on schedule and delivering positive economic results; next phase will focus on consolidation, implementation and evaluation of existing legislation rather than broad new legislative programs.
  - Commission has identified areas for possible action: post-trading infrastructure for securities markets, the asset management industry and retail financial services.
  - Need to ensure adequate arrangements for crisis prevention and management has been under consideration for several years; improved arrangements among national supervisors, central banks and ministries on bilateral or multilateral basis are judged adequate without need for more centralized solutions at this stage.

### Trade policy issues
- Doha Development Agenda (DDA) remains the EU’s top priority; EU aims for an ambitious outcome delivering substantive trade liberalization and stronger multilateral rules, including on trade facilitation, while supporting sustainable development.
- DDA entering a critical stage with the Hong Kong Ministerial approaching; EU has shown leadership and is willing to continue to play a leading role, but others must take responsibilities to secure an ambitious and fair outcome.
- EU attaches great importance to the development dimension of the DDA and supports the view that an ambitious outcome is needed.
- Additional effort to address supply side constraints is needed in some countries so they can take advantage of new and existing opportunities to trade; EU and Member States will increase efforts in aid for trade.
- At the recent G8 meeting the President of the Commission, Barroso, pledged to increase EU Trade-Related Assistance to € 1 billion per year.
- Negotiation of Economic Partnership Agreements with six ACP regions focuses on trade as a tool for development; promotion of economic integration as a stepping-stone towards integration into the world economy is a main aspect.
- On textiles and clothing, EU concluded a Memorandum of Understanding with China covering the import of 10 product categories for the period 2005-2007 as a satisfactory solution intended to avoid repetitive recourse to safeguard action.

*Document conclusions and views as presented in the staff appraisal conclusions section.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05265.pdf_