## _cr11184

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---

### A. A Two‑Speed Recovery in the Euro Area
- Finding: The euro area recovery has surprised on the upside over the past year, driven by robust global demand and an inventory cycle turn; very strong first quarter growth was recorded.
- Finding: Sharp growth divergences persist across the area, producing a "two‑speed" recovery:
  - Majority of members: solid activity, healthier labor markets, relatively sound household and firm balance sheets.
  - Vulnerable group: Greece, Ireland, Portugal (sovereign debt crisis); Spain (legacy of real estate bubble); Italy (chronic underperformance).
- Box 1 projections and patterns:
  - 2011 growth projections range from nearly -4 percent in Greece and about -2 percent in Portugal to over 3 percent in Germany, Estonia, Finland, Luxembourg, and Slovakia.
  - Private consumption: recovering in Germany, France, and Italy; subdued in Spain; lagging in Greece, Ireland, and Portugal.
  - Investment: rebounding in Germany; beginning to recover in France and Italy; plunging in Spain; investment in Greece, Ireland, and Portugal expected to lag.
- External adjustment and risks:
  - Current account imbalances have been reduced since the crisis, mainly reflecting contraction in domestic demand in deficit countries.
  - In many deficit countries private capital inflows have largely been replaced with ECB and official financing, described as unsustainable.
  - Scenario: if crisis in the periphery is contained, modest growth and steady closure of the aggregate output gap over the next two years; if periphery trouble spills into the core, much larger spillovers and unpredictable outcomes.
- Policy guidance:
  - Minimize risk of periphery spillovers while accounting for cyclical developments.
  - Complete balance sheet adjustment, pursue sectoral restructuring, and address high debt and unemployment where relevant.
- Other notable points:
  - Firms are rebuilding profit margins but corporate investment remains far below pre‑crisis levels despite low funding costs in most countries.
  - Household consumption has recovered as precautionary savings unwind.
  - Bank deleveraging in response to illiquid private assets, funding strains, and regulatory changes is likely to dampen investment activity.

### B. Restoring Fiscal Health
- Finding: Public finances deteriorated sharply since 2007; the euro area aggregate budget deficit worsened and public debt reached record highs in many countries.
- Key figures and projections:
  - The 2010 fiscal deficit for the euro area remained at about 6 percent of GDP.
  - Staff projects the debt-to-GDP ratio to peak at slightly below 90 percent in 2012 and gradually decline thereafter.
- Consensus and policy recommendations:
  - Fiscal consolidation should continue as planned; Excessive Deficit Procedures (EDP) adjustments are substantial, mostly expenditure-based and frontloaded where funding pressures are most severe.
  - Faster growing economies should let automatic stabilizers work and reach their EDP targets earlier than planned.
  - Crisis countries may need to extend plans in line with program requirements; consolidation should continue across the region.
  - Long-run debt decline requires restoring competitiveness and reinvigorating growth; pursue strong and sustained fiscal consolidation; reform pension and health care systems.
  - New rules proposed to guide debt toward the 60 percent target and to control spending, accompanied by strengthened governance procedures.

### C. Inflation Outlook and Monetary Policy
- Headline inflation:
  - Headline inflation is expected to peak at elevated levels in 2011 and recede to slightly below 2 percent in 2012.
  - Forecast assumptions: energy and food prices stabilizing; inflation expectations remain well anchored.
  - Most forward-looking measures of inflation currently remain at around 2 percent; break-even inflation rates have risen amidst some volatility.
- Model results and policy reaction:
  - Time series bottom-up model: decline in inflation by late 2011 mainly owing to decline in energy price inflation; core inflation contained; uncertainty large toward end-2012 with estimates ranging between 1.1 and 2.2 percent.
  - Small DSGE model: projects inflation to be more sluggish but still above 2 percent by end-2012; DSGE model sees policy rates increase to about 3 percent in the baseline.
  - Larger-scale ECB staff model suggests inflation would be higher if monetary policy adjustment was delayed.
  - Baseline incorporates an upward adjustment of interest rates to keep expected and actual inflation below the 2 percent threshold by 2012.
- Drivers of underlying inflation pressures:
  - Industrial producer prices: intermediate goods prices have risen strongly, fueled by higher energy and commodity costs.
  - Wages: labor cost indicators largely steady; strong employment prospects in some countries and wage indexation could increase wage outcomes and, absent productivity gains, lead to price pressure.
  - Profits: profitability of nonfinancial firms recovering quickly but profit margins remain somewhat below historical averages.
  - Capacity utilization: recovered considerably since the recession; approaching historical average and exceeding historical levels in faster growing parts of the region.
  - Money and credit: ECB considers monetary expansion pace to be gradually increasing and monetary liquidity remains ample.
- Monetary stance and ECB actions:
  - Outlook calls for gradual withdrawal of monetary stimulus to prevent high headline inflation becoming entrenched and to forestall excessive risk taking.
  - ECB discontinued one-year refinancing operations; balance shrank from around 620 billion euro in May 2009 to currently around 450 billion euro.
  - ECB clarified it was not committed to a path of rising policy rates and would adjust as necessary to anchor inflation at below, but close to, 2 percent.
  - Staff view: gradual tightening suggested given moderate recovery and dissipating energy/food price pressures; impact of ECB rate hikes on banks varies by balance sheet elasticity and location.

### D. Sovereign Tensions, Risks and Spillovers
- Contagion channels and risks:
  - Direct exposures of banks to sovereigns and banks at risk of default; several French and German banks remain significantly exposed to credit risk in the periphery.
  - Sudden large credit losses may trigger bank runs absent adequate liquidity and recapitalization facilities.
  - A credit event could reveal counterparty risks if sellers of default protection cannot meet commitments.
  - Bank funding shocks and sharp falls in equity prices could accelerate deleveraging while macro policies have limited space to respond.
- Policy priorities to limit damage:
  - Seek orderly solutions for sovereign difficulties (particularly Greece): strong program implementation, sufficient privatization proceeds, adequate official financing supporting debt sustainability, and private‑sector‑based banking solutions (e.g., cross‑border takeovers).
  - Quickly scale up capacity and flexibility of the EFSF, allow EFSF interventions in secondary markets, and assist with financial system problems.
  - Complete discussion on private sector involvement both in specific programs and in the context of the ESM.
  - Ensure adequate bank recapitalization plans to mitigate contagion from sovereign tensions.
- Specific observations:
  - Banks in Greece, Ireland and Portugal significantly increased government debt exposure during 2010 and rely on ECB liquidity against declining‑quality collateral.
  - Markets price significant default risk for some member states.

### E. Banking Sector Weaknesses and Reform Priorities
- Systemic weaknesses:
  - Leverage remains high and dependence on wholesale funding remains elevated.
  - Considerable refinancing needs will compete with sovereign and corporate issuances.
  - Periphery banks vulnerable from large exposures to their governments and real estate and from high marginal wholesale funding costs.
  - Some member‑state banks exhibit weak governance, structurally low profitability, thin capital, and large shares of doubtful assets.
  - Core euro area banks are significantly exposed to program countries.
- Profitability and capital projections:
  - Staff projects profitability will improve slightly under the baseline WEO scenario but will stay far below pre‑crisis levels due to persistently high nonperforming loans.
  - Slightly less than half of the banks, accounting for 30 percent of banking sector assets included in the exercise, would remain unprofitable until 2015.
- Deleveraging and Basel III implications:
  - Fund estimates (BCBS MAG study): peak output loss from increasing capital requirements by 1 percentage point of risk weighted assets range from about 0.29 percent to 0.32 percent depending on country and speed of implementation.
  - Faster implementation (for example within 2 years instead of the 6 years currently envisaged) would make virtually no difference in terms of average output loss, suggesting fast equity issuance would not penalize economic growth materially.
- Policy recommendations and consensus:
  - Need for substantially more and higher quality bank capital and restructuring of weak institutions.
  - Banks should recapitalize well ahead of the Basel III timetable, with strong frontloading especially by second‑tier weak banks.
  - Stress tests should be credible, of higher quality, and followed by consistent follow‑up actions; staff concerned about incomplete treatment of sovereign risks in stress tests.
  - Staff urged authorities to raise capital as soon as possible; some countries are already doing so.

### F. Private Cross‑Border Solutions, Market Development and ECB Proposals
- Private solutions:
  - Priority to private sector solutions, including private capital raising and cross‑border mergers and acquisitions; apply or review Directives for Cross‑Border Acquisitions and Takeovers to overcome obstacles to free flow of equity capital.
  - Public support may still be necessary and should be coordinated across the EU.
- Market-based finance and securitization:
  - Re‑develop securitization markets, appropriately regulated and based on high quality standards, to complement credit supply as bank deleveraging proceeds.
  - Support development of market‑based alternatives for corporate finance to reduce dependency on the banking system.
- Staff proposal:
  - Establish a conditional term funding facility for private illiquid (but performing) assets, operated by the ECB with explicit backing of euro area sovereigns (e.g., via the EFSF) to protect ECB independence and relieve pressure while reinforcing root problem resolution.
  - ECB position: felt such a facility was beyond its remit.

### G. Securing EMU — Financial Sector Architecture and Macroprudential Policies
- Institutional building blocks:
  - ESRB and the European Supervisory Authorities (ESAs) have become operational and should be core of a coordinated EU financial stability framework.
- Key needs and reforms:
  - Improve collaboration among EU institutions, including data and information sharing, and relationship with national authorities.
  - ESRB should develop the EU macroprudential policy toolkit in collaboration with other EU institutions and national authorities.
  - Rapid progress toward a single rule book; CRD4 should implement Basel III swiftly and without exceptions.
  - Staff: set capital requirements at an ambitiously high common level (above Basel III) reflecting balance sheet uncertainties and interconnectedness.
  - Capital regulations must allow flexibility for macroprudential tools, including capital surcharges for systemically important financial institutions.
  - Staff suggestion: zero risk weight for sovereign bonds in bank capital requirements will need adjustment to reflect market perception of sovereign risk and ESM design.
- Supervisory and resolution framework:
  - Staff proposed a European Resolution Authority backed by common deposit guarantee and resolution funds—potentially financed by a levy on the industry—to improve ex‑post burden sharing and provide an EU‑centered backstop for liquidity and solvency support.
  - Authorities preferred resolution colleges and harmonization of national resolution tools and deposit guarantee schemes and envisaged a review in 2014; staff urged more rapid action.

### H. Advancing Policy Coordination and Governance of EMU
- Governance and fiscal integration:
  - Stronger economic governance and some delegation of sovereignty to the center needed for effective crisis management and resilient monetary union.
  - ESM as a first step: provide support for countries facing sovereign funding pressures; final design and coverage should encourage prudent national policies while preserving financial integration.
  - Financial support under ESM should not be conditional on debt restructuring and should be conducive to continuing private sector engagement.
  - ESM could evolve into a European debt management agency if political will allows limited fiscal integration including common bonds backed by enhanced euro area fiscal capacity.
- Euro Plus Pact and enforcement:
  - Pact commits Member States to concrete policy actions to improve competitiveness, employment, financial stability and fiscal sustainability; commitments should be more ambitious, concrete and time‑bound.
- Fiscal surveillance and SGP reforms:
  - New SGP rules to include amended EDP with numerical benchmarks for debt reduction in countries exceeding 60 percent of GDP and a cap on growth in public spending net of discretionary revenue measures.
  - Sanctions will start in the preventive arm of the SGP and be more progressive.
  - Concerns remain over qualified majority voting and possibilities to suspend sanctions or extend deadlines for countries under the EDP.
- Directive on National Fiscal Frameworks (NFFs):
  - Proposals include monthly cash based fiscal data publication, reconciliation methodology disclosure, expanded government perimeter, and disclosure of contingent liabilities.
  - Member states asked to report to ECOFIN on estimated fiscal impact of revised ESA by autumn 2011.

### I. Growth Agenda, Structural Reforms and Single Market Completion
- Growth and reform priorities:
  - Deepen financial integration and reduce public ownership and involvement in the banking sector; address "national champion" protection and lack of standardization of financial products.
  - Lower barriers to competition in network industries, retail trade and regulated professions; remove unnecessary procedures and costs on entrepreneurship.
  - Reform and harmonize bankruptcy proceedings to facilitate exit of inefficient firms; transpose Small Business Act principles for SMEs.
  - Ambitious liberalization of the 160‑odd professions covered by the Services Directive to raise efficiency and competitiveness, especially in the periphery.
- Labor markets and tax reform:
  - Address labor market segmentation, informal economy and inadequate wage flexibility; move towards a Single Labor Market.
  - Upgrade education systems to enhance productivity.
  - Consider a deficit‑neutral shift in taxes from labor to consumption (e.g., VAT), preferably coordinated across the euro area.
  - Promote competitive corporate tax rates and simplification/harmonization of tax codes.

### J. Macroeconomic Outlook and Policy Stance (Chapter 5 highlights)
- If contagion from the periphery can be contained:
  - Recovery is becoming less dependent on public sector support.
  - Pursuing fiscal consolidation as planned would enhance confidence, provided policy gaps are closed and automatic stabilizers are allowed to work.
  - Program countries may need to extend adjustment paths to minimize recessionary impact, subject to available financing.
  - With price pressures up but still moderate, monetary accommodation can be withdrawn "at a very gradual pace," while leaving some unconventional measures in place.
- Financial sector strengthening and crisis management:
  - Capital raising from private sources should move ahead immediately.
  - Follow‑up to stress tests should lift capital to levels that handle current uncertainty.
  - Any residual public support should be coordinated across the EU.
  - Consideration merited for a term funding facility for illiquid but performing private assets with explicit backing of euro area sovereigns (e.g., EFSF/ESM).
  - The missing piece is crisis management and resolution with a common backstop largely funded by the industry to protect taxpayers.
- Economic governance:
  - Strengthen SGP’s preventive and corrective arms, upgrade national fiscal frameworks, promote policy coordination under the European Semester, foster structural reform under the Euro Plus Pact, and detect/correct imbalances under the EIP.
  - These governance tools "will need to be made more binding and relevant for national decision making, with quasi‑automatic activation and tighter deadlines."

### K. Key Indicators and Projections (Table 1 and selected aggregates)
- Real GDP: 2005 1.7; 2006 3.1; 2007 2.9; 2008 0.4; 2009 -4.1; 2010 1.8; 2011 2.0; 2012 1.7
- Private consumption: 2005 1.8; 2006 2.1; 2007 1.7; 2008 0.4; 2009 -1.1; 2010 0.8; 2011 1.0; 2012 1.2
- Public consumption: 2005 1.6; 2006 2.2; 2007 2.2; 2008 2.3; 2009 2.5; 2010 0.7; 2011 -0.1; 2012 0.0
- Gross fixed investment: 2005 3.2; 2006 5.4; 2007 4.7; 2008 -0.8; 2009 -11.4; 2010 -0.8; 2011 3.7; 2012 2.8
- Output gap: 2005 -0.3; 2006 1.2; 2007 2.3; 2008 1.2; 2009 -3.5; 2010 -2.7; 2011 -1.9; 2012 -1.4
- Unemployment rate: 2005 9.1; 2006 8.4; 2007 7.6; 2008 7.7; 2009 9.5; 2010 10.1; 2011 10.0; 2012 9.6
- Consumer prices: 2005 2.2; 2006 2.2; 2007 2.1; 2008 3.3; 2009 0.3; 2010 1.6; 2011 2.6; 2012 1.8
- General government balance (percent of GDP): 2005 -2.5; 2006 -1.3; 2007 -0.6; 2008 -2.0; 2009 -6.3; 2010 -5.9; 2011 -4.2; 2012 -3.3
- General government gross debt (percent of GDP): 2005 70.1; 2006 68.5; 2007 66.3; 2008 69.9; 2009 79.4; 2010 85.5; 2011 87.8; 2012 88.3
- EURIBOR 3‑month offered rate examples: 2005 2.2; 2006 3.1; 2007 4.3; 2008 4.6; 2009 1.2; 2010 0.8; 2011 1.4
- 10‑year government benchmark bond yield examples: 2005 3.4; 2006 3.9; 2007 4.3; 2008 4.4; 2009 4.0; 2010 3.8; 2011 4.4
- U.S. dollar per euro: 2005 1.24; 2006 1.26; 2007 1.37; 2008 1.47; 2009 1.39; 2010 1.33; 2011 1.4
- Current account balance (percent of GDP): 2005 0.1; 2006 -0.1; 2007 0.1; 2008 -1.5; 2009 -0.3; 2010 -0.4; 2011 0.1; 2012 0.3

### L. Balance of Payments and Financial Flows (selected Table 2 items)
- Current account (billions of euros): 2003 20.9; 2004 60.8; 2005 10.9; 2006 -12.7; 2007 7.3; 2008 -142.4; 2009 -25.6; 2010 -36.7
- Financial account (billions of euros): 2003 -14.0; 2004 -78.6; 2005 -35.2; 2006 -6.2; 2007 3.1; 2008 141.5; 2009 9.9; 2010 34.3
- Portfolio investment (billions of euros): 2003 54.4; 2004 44.1; 2005 106.4; 2006 186.0; 2007 126.8; 2008 283.3; 2009 270.5; 2010 143.3
- GDP (billions of euros, memorandum): 2003 7,559.7; 2004 7,869.5; 2005 8,161.7; 2006 8,575.1; 2007 9,035.4; 2008 9,264.3; 2009 8,970.4; 2010 9,203.3
- Reserves of the eurosystem (end of period stocks, billions of euros): 2003 306.7; 2004 281.3; 2005 320.1; 2006 325.8; 2007 347.2; 2008 374.2; 2009 462.4; 2010 591.2

### M. Statistical Issues and Data Improvements (Appendix I)
- Information Gaps Initiative (IGI):
  - Eurostat and the ECB, as members of the Inter‑Agency Group (IAG), are collaborating with the IMF to advance the 20 recommendations endorsed by the G-20 in 2009.
  - Eurostat: support measurement of cross‑border exposures on corporate groups, develop a Euro Groups Register (EGR), support PEEI initiatives.
  - ECB: content with progress under the IGI; identified remaining macroprudential data challenges; working on a securities holding database planned to be completed within 2‑3 years.
- Public finance statistics—program country actions:
  - Greece: ELSTAT Memoranda of Understanding with 9 ministries/entities; collection of arrears data across central government units; monthly consolidated general government report; automatic sanctions for delays.
  - Ireland: Central Bank compiles statistics including positions vis‑à‑vis nonresidents with instrument, maturity and currency breakdowns.
  - Portugal: integrate SOEs, PPPs and social security decisions with fiscal implications within the budget process; monitor fiscal arrears more closely.
- Stock‑Flow Adjustment (SFA) euro area aggregate SFA figures:
  - Peaked at 3.2 percent of GDP in 2008.
  - 0.9 percent of GDP in 2009.
  - 1.9 percent of GDP in 2010.
- Price statistics improvements:
  - New rules on seasonal products (Regulation EC No 330/2009) took effect with January 2011 index; early indications suggest a moderate positive impact on euro area headline inflation (+ 0.1 percentage points on average for the EU during the first [two] quarters).
  - New minimum standards for HICP weighting (Regulation EC No 1114/2010) require implementation by January 2012.
  - Eurostat pursuing changes in monthly euro area inflation flash estimates with possible breakdown to four main components.
- House Price Indexes (HPI) and Owner‑Occupied Housing (OOH):
  - Pilot projects led to first experimental OOH data releases; Eurostat preparing legal act to continue beyond pilot phase; considering including quarterly House Price Indices in list of PEEIs.
- Structural Business Statistics (SBS) and Euro Groups Register (EGR):
  - MEETS actions include data warehouses, micro data linking tools, back casting, and improving collection of SME financing access data.
  - EGR partly outsourced to private providers to compile MNE statistics affected by globalization.
- Balance of Payments and ITS:
  - Users generally satisfied with ITS data; work to improve SME trade statistics and reconcile asymmetries; FDI network used to share confidential data on large FDI transactions.

*Source: IMF staff report chapter "1. A Two-Speed Recovery in the Euro Area" and accompanying chapters and appendix as provided in the supplied PDF content.*

### 1. A Two-Speed Recovery in the Euro Area .............................................................................4

### 1. A Two-Speed Recovery in the Euro Area

### A. Steadying the Recovery — Expansion in the Offing but Not Everywhere
- Finding: The euro area recovery has surprised on the upside over the past year, driven by robust global demand and an inventory cycle turn; very strong first quarter growth was recorded.
- Finding: Sharp growth divergences persist across the area, producing a "two-speed" recovery:
  - Majority of members: solid activity, healthier labor markets, relatively sound household and firm balance sheets.
  - Vulnerable group: Greece, Ireland, Portugal (sovereign debt crisis); Spain (legacy of real estate bubble); Italy (chronic underperformance).
- Box 1 — Two-Speed recovery projections and patterns:
  - 2011 growth projections range from nearly -4 percent in Greece and about -2 percent in Portugal to over 3 percent in Germany, Estonia, Finland, Luxembourg, and Slovakia.
  - Private consumption: recovering in Germany, France, and Italy; subdued in Spain; lagging in Greece, Ireland, and Portugal.
  - Investment: rebounding in Germany; beginning to recover in France and Italy; plunging in Spain; investment in Greece, Ireland, and Portugal expected to lag.
- Finding: Member states' current account imbalances have been reduced since the crisis, mainly reflecting contraction in domestic demand in deficit countries; in many deficit countries private capital inflows have largely been replaced with ECB and official financing, which is described as unsustainable.
- Risks and scenario:
  - Provided the crisis in the periphery is contained, outlook is for modest growth and the aggregate output gap is set to close steadily over the next two years.
  - Serious trouble in the periphery spilling into the core would upset this scenario, producing a very unpredictable outcome with significantly larger spillovers.
- Policy guidance:
  - Policies should be geared toward minimizing the risk of periphery spillovers while taking into account underlying cyclical developments.
  - Emphasize completing balance sheet adjustment, sectoral restructuring, and addressing high debt and unemployment where relevant.
- Other notable points:
  - Firms are rebuilding profit margins but corporate investment remains far below pre-crisis levels despite low funding costs in most countries.
  - Household consumption has recovered as precautionary savings unwind.
  - Bank deleveraging in response to illiquid private assets, funding strains, and regulatory changes is likely to dampen investment activity.

### B. Restoring Fiscal Health
- Finding: Public finances deteriorated sharply since 2007; the euro area aggregate budget deficit worsened and public debt reached record highs in many countries.
- Key figures and projections:
  - The 2010 fiscal deficit for the euro area remained at about 6 percent of GDP.
  - Staff projects the debt-to-GDP ratio to peak at slightly below 90 percent in 2012 and gradually decline thereafter.
- Consensus on policy:
  - Broad agreement that fiscal consolidation should continue as planned; targeted adjustment under Excessive Deficit Procedures (EDP) is substantial, mostly expenditure-based and frontloaded where funding pressures are most severe.
  - Authorities argued that maintaining easier fiscal policies in the core for the benefit of the periphery would be of little help due to small direct demand effects, offsetting interest rate effects, and contingent fiscal liabilities.
- Policy recommendations:
  - Implement announced consolidation plans and fill policy gaps; faster growing economies should let automatic stabilizers work and reach their EDP targets earlier than planned.
  - Crisis countries may need to extend plans in line with program requirements; consolidation should continue across the region.
  - Long-run decline in debt requires restoring competitiveness and reinvigorating growth; pursue strong and sustained fiscal consolidation; reform pension and health care systems.
  - New rules proposed to guide the path of debt toward the 60 percent target and to control spending, accompanied by strengthened governance procedures.

### C. Inflation and Monetary Policy
- Finding: Headline inflation accelerated sharply in early 2011, mostly driven by higher energy and food prices; since February, inflation has exceeded 2 percent.
- Finding: Underlying inflation measures have also picked up: core inflation, trimmed means, and other measures rose from around 1 percent for most of 2010 to higher levels in early 2011.
- Real GDP forecast comparisons (as presented):
  - 2011: ECB 1.9; European Commission 1.6; IMF 2.0; Consensus 1.7.
  - 2012: ECB 1.7; European Commission 1.8; IMF 1.7; Consensus 1.7.
- Drivers of underlying inflation pressures (as identified by authorities and staff):
  - Industrial producer prices: intermediate goods prices have risen strongly, fueled by higher energy and commodity costs.
  - Wages: labor cost indicators largely steady due to a weak area-wide labor market; however, strong employment prospects in some countries and wage indexation could soon increase wage outcomes and, if not matched by productivity gains, lead to price pressure.
  - Profits: profitability of nonfinancial firms has been recovering quickly but profit margins remain somewhat below historical averages, limiting ability to absorb higher input costs.
  - Capacity utilization: recovered considerably since the recession; approaching historical average and exceeding historical levels in faster growing parts of the region, potentially creating expectations of future cost and price increases.
  - Money and credit: ECB considers underlying pace of monetary expansion to be gradually increasing and cautions that monetary liquidity remains ample and may accommodate price pressures.
- Policy implications:
  - Monitor wage outcomes and productivity to guard against wage-price spirals.
  - Watch transmission of higher sovereign spreads into corporate funding costs that may dampen investment.
  - Consider monetary liquidity conditions in assessment of inflation risks.

*Source: IMF staff report chapter "1. A Two-Speed Recovery in the Euro Area" from the provided PDF content.*

### 15.      Against this background, headline inflation is expected to peak at elevated levels

### _cr11184 - 15.      Against this background, headline inflation is expected to peak at elevated levels

### Inflation outlook and forecasts
- Headline inflation is expected to peak at elevated levels in 2011 and recede to slightly below 2 percent in 2012.
- Forecast assumptions:
  - Energy and food prices will be stabilizing.
  - Inflation expectations will stay well anchored to keep underlying inflation in check.
- Current measures:
  - Most forward-looking measures of inflation currently remain at around 2 percent.
  - Break-even inflation rates have risen amidst some volatility.
- Model-based results:
  - A small DSGE model projects inflation to be more sluggish but still shows a downward pattern; in that DSGE forecast inflation remains significantly above 2 percent by end-2012.
  - A larger-scale ECB staff model suggests inflation would be higher if monetary policy adjustment was delayed.
- Policy-reaction assumed in baseline:
  - The baseline incorporates an upward adjustment of interest rates in order to keep expected and actual inflation below the 2 percent threshold by 2012.
  - The DSGE model sees policy rates increase to about 3 percent.

### Box 2 — Modeling details and uncertainty
- Two models used to forecast euro area inflation:
  - Time series “bottom-up” model forecasting major CPI subcomponents (food, energy, core).
  - Small structural DSGE model (inflation expectations-augmented Phillips curve; aggregate demand = output gap + real interest rate; policy reaction = Taylor rule with interest rates inertia).
- Bottom-up model findings:
  - Decline in inflation by late 2011 mainly owing to a decline in energy price inflation under the baseline.
  - Core inflation would remain contained and pass-through from energy prices to headline inflation would be limited.
  - Uncertainty large toward end-2012, with estimates ranging between 1.1 and 2.2 percent (upper bound close to the ECB target).
- DSGE model findings:
  - Inflation rises to a maximum by early 2012 before gradually declining by end-2012.
  - Model dynamics and stochastic shocks produce a slower downward trend and higher end-2012 inflation than the bottom-up model.

### Monetary policy stance and ECB actions
- Outlook calls for a gradual withdrawal of monetary stimulus to prevent high headline inflation from becoming entrenched and to forestall excessive risk taking.
- ECB operational stance and actions:
  - Exit from record-low interest rates seen as helpful to anchor inflation and reduce risk-taking.
  - The ECB discontinued one-year refinancing operations as reliance on the deposit facility fell, shrinking its balance from around 620 billion euro in May 2009 to currently around 450 billion euro.
  - The ECB clarified it was not committed to a path of rising policy rates and would adjust rates as necessary to anchor inflation and inflation expectations at below, but close to 2 percent.
- Staff view:
  - A gradual approach to monetary tightening is suggested given the moderate recovery and dissipating energy/food price pressures.
  - The impact of an ECB interest rate hike on banks varies with interest rate elasticity of the balance sheet and bank location; in some program countries the effect could be positive by allowing repricing of variable rate assets tied to the policy rate.
  - Staff analysis suggests the difference between the common interest rate and what standard macroeconomic policy rules would suggest for individual member countries is likely to remain small.

### Risks, sovereign tensions, and spillovers
- Solvency concerns in some member states persist and could spill over to the euro area core and threaten the recovery.
- Key contagion channels identified:
  - Direct exposure to sovereigns and banks at risk of default; several French and German banks remain significantly exposed to credit risk in the periphery.
  - Sudden large credit losses may trigger bank runs absent adequate liquidity and recapitalization facilities; strengthened commitments to deposit insurance and domestic guarantees would reduce market fears.
  - A credit event could reveal counterparty risks if sellers of default protection cannot meet commitments; default protection could also shield some investors with an uncertain net effect.
  - A bank funding shock and sharp fall in equity prices could accelerate deleveraging while macro policies have limited space to respond; credit backstops would help mitigate damaging credit crunch risk.
- Specific country and market observations:
  - Banks in Greece, Ireland and Portugal significantly increased government debt exposure during 2010 and rely on ECB liquidity against declining-quality collateral.
  - Markets price significant default risk for some member states.
- Policy priorities to limit further damage:
  - Seek an orderly solution for sovereign difficulties (particularly Greece): strong program implementation, sufficient privatization proceeds, adequate official financing supporting debt sustainability, and private-sector-based banking solutions (e.g., cross-border takeovers).
  - Quickly scale up capacity and flexibility of the EFSF, allow EFSF interventions in secondary markets, and assist with financial system problems.
  - Complete discussion on private sector involvement both in specific programs and in the context of the ESM.
  - Ensure adequate bank recapitalization plans to mitigate contagion from sovereign tensions.

### Banking sector weaknesses and reform priorities
- Systemic weaknesses:
  - Leverage remains high and dependence on wholesale funding remains elevated.
  - Considerable refinancing needs will compete with sovereign and corporate issuances over the next few years.
  - Periphery banks vulnerable from large exposures to their governments and real estate and from high marginal wholesale funding costs.
  - Some member-state banks exhibit weak governance, structurally low profitability, thin capital, and large shares of doubtful assets.
  - Core euro area banks are significantly exposed to program countries.
- Profitability and capital projections:
  - Staff projects profitability will improve slightly under the baseline WEO scenario but will stay far below pre-crisis levels due to persistently high nonperforming loans.
  - Slightly less than half of the banks, accounting for 30 percent of banking sector assets included in the exercise, would remain unprofitable until 2015.
- Deleveraging and Basel III implications:
  - Getting deleveraging right requires balancing stronger bank balance sheets with adequate credit supply to finance recovery; many SMEs continue to lack bank credit.
  - As Basel III is implemented, banks may pass on some costs, potentially raising lending rates and limiting credit supply, especially if deleveraging occurs via shrinking assets.
  - Building capital buffers faster and to higher levels than Basel III requires will come at moderate output costs:
    - Fund estimates based on BCBS MAG study: peak output loss from increasing capital requirements by 1 percentage point of risk weighted assets range from about 0.29 percent to 0.32 percent depending on country and speed of implementation.
    - Faster implementation (for example within 2 years instead of the 6 years currently envisaged) would make virtually no difference in terms of average output loss, suggesting fast equity issuance would not penalize economic growth materially.
- Policy recommendations and consensus:
  - Unequivocal need for substantially more and higher quality bank capital and restructuring of weak institutions.
  - Banks should recapitalize well ahead of the Basel III timetable, with strong frontloading especially by second-tier weak banks.
  - Authorities agreed overall capital needs were likely to be manageable, though program countries have run out of fiscal capacity.
  - Stress tests should be credible, of higher quality, and followed by consistent follow-up actions; staff expressed concern about incomplete treatment of sovereign risks in stress tests.
  - Staff urged authorities to raise capital as soon as possible; some countries are already doing so.

*Prepared by IMF staff as presented in the source content.*

### 28.      It will be important to look for private cross-border solutions to strengthen the

### It will be important to look for private cross-border solutions to strengthen the euro area’s financial system

### Private cross-border solutions and public support
- Clear priority should be given to private sector solutions, including private capital raising and cross-border mergers and acquisitions.
- Relevant Directives for Cross-Border Acquisitions and Takeovers should be applied, or reviewed if necessary, to overcome formal and informal national obstacles to the free flow of equity capital.
- Public support may nonetheless still be necessary and should be made available in a manner coordinated across the EU.

### Securitization, market-based corporate finance, and ECB proposals
- Re-developing the market for securitization, appropriately regulated and based on high quality standards, should complement credit supply as bank deleveraging proceeds.
- European regulators should actively support the development of market-based alternatives for corporate finance to reduce dependency of the euro area economy on the banking system.
- Many banks that depend heavily on ECB financing would have problems regaining market access in the near term.
- Staff proposal: establish a conditional term funding facility for private illiquid (but performing) assets, operated by the ECB with the explicit backing of euro area sovereigns (e.g., via the EFSF) to:
  - protect the ECB’s independence and flexibility,
  - reinforce the need to tackle banking problems at their root,
  - relieve pressure on the ECB in the context of private sector involvement in crisis countries.
- ECB position: felt that such a facility was beyond its remit.

### IV. Securing Economic and Monetary Union — overarching assessment
- Incomplete economic, financial and fiscal integration is casting a shadow on the future of EMU and weighing on the euro area’s growth potential.
- National policymakers need to move away from the illusion that a national approach to fiscal, financial, and structural issues preserves sovereignty in a monetary union.
- Staff view: ultimate need to deal with the financial system at the euro area rather than the national level and to put in place some form of ex ante fiscal risk sharing, conditional on prudent fiscal policies and in the context of a binding economic governance framework that removes remaining obstacles to the free flow of goods, labor, and capital.
- Without decisive breakthroughs on these fronts, the euro area is unlikely to live up to its potential.

### A. Financial Sector Reforms and Macroprudential Policies
- Establishing the credibility and effectiveness of the new EU financial sector architecture is a priority. The European Systemic Risk Board (ESRB) and the European Supervisory Authorities (ESAs) have become operational and should be the core of a more coordinated and integrated European financial stability framework.
- Key needs and gaps:
  - Improve collaboration among EU institutions, including data and information sharing, and the relationship with national authorities.
  - ESRB should move forcefully in developing the EU macroprudential policy toolkit in collaboration with other EU institutions and national authorities.
- Single rule book and capital requirements:
  - Rapid progress towards establishing the single rule book is needed; Capital Requirements Directive 4 (CRD4) should implement Basel III swiftly and without exceptions.
  - Commission and ECB: harmonize new rules at the EU level with scope for flexibility for macroprudential purposes.
  - Staff: capital requirements should be set at an ambitiously high common level (above Basel III) to reflect prevailing balance sheet uncertainties, high interconnectedness, and the lack of an effective resolution framework for cross-border banks.
  - Capital regulations must allow flexibility to introduce macroprudential tools, including adjusting capital and liquidity requirements, varying risk weights, and capital surcharges for systemically important financial institutions.
  - ESRB role: coordinate and calibrate macroprudential instruments, including home-host coordination and reciprocity, balancing rules and discretion.
  - Staff suggestion: the zero risk weight for sovereign bonds in bank capital requirements will need to be adjusted to reflect market perception of sovereign risk and the design of the ESM.
- Supervisory, resolution and stability framework:
  - Staff called for faster progress toward a unified European financial supervisory, resolution and stability framework.
  - European Banking Authority must become effective rapidly, including building a prudential database and data sharing with and among national authorities.
  - Staff proposal: establish a European Resolution Authority backed by common deposit guarantee and resolution funds—potentially financed by a levy on the industry—to improve ex-post burden sharing and provide an EU-centered backstop for liquidity and solvency support. At minimum, agree on such an end-goal now.
  - Benefits of such an approach: underpin cooperation in the new supervisory architecture, allow cross-border private sector solutions to banking problems, and end intertwining of sovereign and bank balance sheets while limiting taxpayer funds and minimizing market disruptions.
- Authorities’ reactions:
  - With supervision remaining national, authorities felt some staff proposals infeasible in the short run.
  - Authorities prefer setting up resolution colleges and harmonizing national resolution tools and deposit guarantee schemes, and envisaged a review of the entire framework in 2014.
  - Staff response: national approach has proven deficiencies; fixing weaknesses identified by the EFFE should not be delayed.

### B. Advancing Policy Coordination in the Euro Area
- Governance reforms envisaged will have to go further to establish an effective EMU.
- Effective crisis management and a resilient monetary union call for some delegation of countries’ sovereignty to the center, which would have an authoritative say in national policies and issue a reasonable amount of well-managed debt, supported by larger and credible revenues.
- ESM as a first step:
  - ESM will provide support for countries facing sovereign funding pressures.
  - Final design and coverage should encourage prudent national policies while preserving financial integration of EMU and attractiveness of sovereign debt instruments.
  - Financial support under ESM should not be conditional on debt restructuring and should be conducive to continuing private sector engagement.
  - ESM could evolve into a European debt management agency if political will allowed limited fiscal integration including common bonds backed by enhanced euro area fiscal capacity.
- Euro Plus Pact and enforcement:
  - The new Euro Plus Pact should accelerate economic integration: national leaders coordinate and commit to a limited set of national policies to promote competitiveness, employment, financial stability and fiscal sustainability.
  - Current measures do not live up to expectations; commitments should be more ambitious, concrete and time-bound.
  - Other EU enforcement instruments (e.g., employment guidelines, Services Directive) should be strengthened.
  - The new Excessive Imbalances Procedure (EIP) could help detect and correct policies giving rise to unsustainable imbalances.
- Fiscal surveillance and SGP reforms:
  - Successful fiscal consolidation requires more stringent budgetary surveillance at the EU level.
  - European semester establishes an ex ante peer review of member states’ plans prior to finalization of national budgets.
  - New SGP rules will include an amended EDP with numerical benchmarks for debt reduction in countries exceeding 60 percent of GDP and a cap on growth in public spending net of discretionary revenue measures to encourage saving revenue windfalls.
  - Sanctions will start already in the preventive arm of the SGP and be more progressive.
  - Concerns remain: standard decision-making with qualified majority voting in the Council still applies to initiation of the EDP and the possibility to suspend sanctions and extend deadlines for countries under the EDP.
- Directive on national fiscal frameworks:
  - Will encourage prudent national fiscal behavior by setting institutional incentives for responsible budgetary policy.
  - Proposal aims to make fiscal rules more binding, enhance medium-term orientation, improve fiscal transparency, and contemplates national councils for independent surveillance.
  - Could be made more effective by requiring systematic disclosure on state-owned corporations and public private partnerships, spelling out good practices for fiscal rules, escape clauses and budget control, and extending the list of fiscal risks beyond contingent liabilities.
  - Other critical elements: budgetary unity and top-down sequence in budget preparation.

### C. Governance reform themes (Box 4) — key institutional proposals and tradeoffs
- Historical tension between deeper integration and economic nationalism; Union has exclusive competence on external commercial policy and shared competence on single market, but fiscal, structural and macroprudential areas remain coordinating roles for the Union.
- Crisis prompted governance reforms that strengthen coordination while keeping national sovereignty mostly intact.
- Suggested improvements to fiscal surveillance and EIP effectiveness:
  - Introduce legal provisions requiring correction of past upward drifts in public expenditure.
  - Calibrate more ambitious and country differentiated Medium-Term Objectives (MTOs).
  - Initiate EDPs by reverse qualified majority (RQM), whereby the Commission’s recommendation prevails unless the Council decides otherwise by qualified majority.
  - Restrict sanction waivers and tighten legal deadlines for corrective action.
- EIP specifics to be effective:
  - Specify alert thresholds for key indicators (CAB and IIP at the very least).
  - Set binding deadlines throughout the EIP.
  - Use RQM in activation of the EIP and all relevant steps.
- Institutional options for deeper integration:
  - Shared competence over fiscal matters for sovereigns breaching the region’s rules, potentially establishing a euro area institution vested with powers to override national policies conflicting with the common interest.
  - Ex ante fiscal risk sharing conditional on more binding fiscal governance and delegation of some sovereignty to the center; a more complete euro area financial stability framework backed by a proper EU banking supervisory authority.
  - Euro area fiscal stabilization would require increased resources managed by the center and Eurobonds to ensure efficient inter-temporal allocation of fiscal capacity; Eurobond design should avoid moral hazard.
  - Enhanced flexibility in capital, labor and product markets needed to insure countries against protracted adjustment.
- Conclusion: A more resilient EMU likely requires curbing national government powers and amending the Treaty and Constitutional laws substantially; such curbs may be modest compared to the cost of crises caused by lack of integration.

### D. Growing Out of Crisis — growth agenda and reform priorities
- Overcoming the sovereign crisis requires unleashing growth potential and completing economic and financial integration.
- Past decade: Europe’s ambitious growth agenda failed and the income gap with the US and other advanced countries increased even before the crisis.
- Reforms should focus on:
  - Measures to deepen financial integration and reduce public ownership and involvement in the banking sector; address “national champion” protection and lack of standardization of financial products.
  - Lowering remaining barriers to competition in network industries, retail trade and regulated professions; removing unnecessary procedures and costs weighing on entrepreneurship; reform and harmonization of bankruptcy proceedings to facilitate exit of inefficient firms; for SMEs, transpose principles in the Small Business Act into national legislation.
  - An ambitious liberalization of the 160-odd professions covered by the Services Directive to raise efficiency and competitiveness, especially in the periphery.

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

### Chapter 5.

### Chapter 5

### Macroeconomic outlook and policy stance
- The handling of the sovereign crisis in the periphery will define the outlook and the future of the economic and monetary union.
- A dominating core is pulling ahead of a periphery facing: very high debt levels, severe competitiveness problems, and fragile banking systems.
- Policymakers face a fundamental choice: allow national domestic considerations to upset integration and monetary union, or forge ahead to strengthen EMU. The latter is described as "the only viable course of action."
- If contagion from the periphery can be contained:
  - The recovery is becoming less dependent on public sector support.
  - Pursuing fiscal consolidation as planned would enhance confidence, with positive spillovers to the rest of the world, provided policy gaps between announced targets and actual policies are closed and automatic stabilizers are allowed to work.
  - Program countries may need to extend their adjustment path to minimize the recessionary impact of their adjustment, subject to available financing.
  - With price pressures up but still moderate, monetary accommodation can be withdrawn "at a very gradual pace," while leaving some unconventional measures in place to attend to pockets of stress in the financial system.
- Rapid implementation of commitments to scale up the EFSF and a further extension of its potential uses is important to confirm that member countries "will do whatever it takes to safeguard the stability of the euro area."
- It is essential to use great care in communicating to markets the modality of private sector involvement, and avoid any impression that under the ESM, financial support will be conditional on debt restructuring.
- Consistent treatment of sovereign risk will require revisiting the capital risk weighting of sovereign debt in financial sector balance sheets.

### Financial sector strengthening and crisis management
- Strengthening the financial system to allow banks to deal with remaining uncertainties is an immediate priority.
- Capital raising from private sources should move ahead immediately.
- The follow up to the ongoing stress tests should lift capital to levels that can handle the current high degree of uncertainty and mitigate contagion from the sovereign crisis affecting some member states.
- Any residual public support that must be put in place should be coordinated across the EU.
- Consideration is merited for a term funding facility for illiquid, but still performing, private assets, with the explicit backing of the euro area sovereigns, e.g., through the EFSF/ESM.
- Capital market development should be embraced rather than resisted to reduce the dependence of the euro area economy on the banking system.
- The interconnectedness of the financial system argues for a rapid completion of the financial stability framework of the euro area, building on recent progress.
  - The missing piece is crisis management and resolution with a common backstop (largely funded by the industry to protect the taxpayer), which "needs to be put in place without delay."
  - Ambitious and common rules for regulation and supervision should be adopted without exception, to underpin the single financial market, while leaving sufficient room for macroprudential policies, coordinated by the ESRB.
  - A full fledged EU FSAP taking into account interconnectedness would be useful.

### Economic governance and EMU strengthening
- Stronger economic governance of the euro area is indispensable, combined with a greater degree of ex ante fiscal risk sharing.
- Ongoing efforts cited that need to be taken further include:
  - Strengthening the SGP’s preventive and corrective arms.
  - Upgrading national fiscal frameworks.
  - Promoting policy coordination under the European Semester.
  - Fostering structural reform under the Euro Plus Pact.
  - Detecting and correcting imbalances under the EIP.
- All these governance tools "will need to be made more binding and relevant for national decision making, with quasi-automatic activation and tighter deadlines."

### Structural reforms, single market, and competitiveness
- More economic and financial integration is essential for a dynamic and stable EMU and to boost potential growth; this calls for the completion of the single market.
- Labor, goods, and services, and especially equity capital need to flow freely across sectors and borders.
- A fully integrated economy "has no need for 'national champions,'" and calls for a consistent and broad application of relevant European regulations and Directives.
- Executing the structural reform agenda with more emphasis on ensuring contestability and competition will bolster growth prospects.
- Specific reform directions and measures noted earlier in the chapter:
  - Best liberalization practices can benefit from the peer review under the Mutual Evaluation Process and greater involvement of the European Court of Justice.
  - Improving enforcement of competition rules and strengthening the independence of national competition authorities.
  - Addressing labor market segmentation, informal economy and inadequate wage flexibility (especially in countries suffering from competitiveness problems) in a move towards a Single Labor Market.
  - Upgrading education systems to enhance productivity, especially in the periphery.
  - More flexible arrangements for part-time work to help raise employment rates, especially for women where they remain low.
  - Pension reforms could support higher employment rates for older people.
  - A deficit-neutral shift in taxes from labor to consumption (e.g., VAT), preferably coordinated across the euro area.
  - Competitive corporate tax rates and simplification and harmonization of tax codes and regulations should limit the burden on firms across the EU.
  - Further trade liberalization, the unwinding of sectoral subsidies and the end to disguised forms of protectionism are needed as well.

### Global implications
- Given the euro area’s role in the global economy, success in addressing the sovereign crisis in some member countries and raising growth has a significant impact elsewhere.
- A cohesive and cooperative approach containing the sovereign crises will limit global spillovers.
- Policies that lift the euro area’s growth potential would have positive, though modest, external spillovers.
- The EU’s support for a successful Doha round of trade liberalization remains essential.

*Source: Chapter 5.*

### 49.      The staff proposes that the next consultation on euro area policies in the context of

### _cr11184 - 49.      The staff proposes that the next consultation on euro area policies in the context of

### Consultation timing
- The staff proposes 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.

### Current crisis compared to past episodes (Figure 1) — growth and labor market
- Following an unusually deep downturn, the recovery is now tracking the pattern of past upturns, with growth rates of GDP, exports, consumption, and fixed investment broadly in line with past experiences.
- Substantial divergences persist across economies, with Greece, Ireland, and Portugal lagging the rest of the euro area in terms of GDP growth and labor market stabilization.
- Pre-crisis: 2006Q1-2008Q1; crisis: 2008Q2-2009Q1; post-crisis: 2009Q2-2010Q4.
- Historical data are from 1960Q2.

### Intra euro area imbalances (Figure 2) — current accounts, trade balances, saving/investment, competitiveness
- The growth in intra euro area current account imbalances has reversed since the crisis.
- Surpluses moderated in Germany and deficits shrank in Spain and program countries.
- Adjustment in intra euro area trade balances contributed to the reversal, except in Ireland.
- A rise in private saving and a drop in private investment in the periphery are associated with these developments.
- Policy-relevant observations:
  - "A reallocation from non-tradables to tradables in program countries will help prevent a resurgence of imbalances."
  - "Measures to reduce labor costs and improve competitiveness" are highlighted as needed.

### Deficit and debt developments, 2007–10 (Figure 3)
- Public finances have deteriorated sharply since 2007.
- Deterioration mainly due to adoption of discretionary fiscal measures.
- Debt levels increased in all countries, placing Euro Area indebtedness at historically high levels.
- General government gross debt rose to high levels by 2010 (Figure shows country-level debt increases; see Table 1 for aggregate indicators).

### Inflation, labor costs, unemployment and output gap (Figure 4)
- Headline HICP inflation is moving up while core inflation remains fairly stable.
- Food, oil and commodity prices explain most of the rise in headline inflation.
- Other measures of underlying inflation are on the rise as well.
- Wage pressures are thus far limited.
- Employment is set to rise and unemployment likely to fall, in line with a narrowing of various output gap measures.
- Output gap measures show narrowing across WEO, OECD, model-implied, and European Commission estimates.
- Unit labour costs, compensation per employee, hourly labour costs, and negotiated wages series indicate limited wage pressures to date.

### Monetary policy stance and conditions (Figure 5)
- The EONIA rate converges to the policy rate reflecting a normalization of markets.
- Gradual phasing-out of extraordinary support measures accompanied the normalization.
- Refinancing operations data highlight ongoing use of long-term and main refinancing operations and other operations (includes covered bonds, SMP purchases, margin calls, fine-tuning operations).
- Monetary conditions remain accommodative despite recent increases in short-term rates.
- Long-term inflation expectations, while up recently, remain close to 2 percent.
- Market and survey-based measures show:
  - 5-year forward 5 years ahead break-even inflation rate and 5-year inflation rate expectations near 2 percent.
  - Financial markets increasingly price in interest rate increases (Euribor forward and swap rates series).
- Policy rules and model estimates:
  - Policy rates implied by Taylor rules and DSGE-implied policy rate are displayed; Taylor-rule range based on various specifications.

### Monetary policy stress and two-speed recovery (Figure 6)
- The euro area periphery is lagging in the two-speed recovery and is projected to face relatively lower inflation rates ahead.
- Higher ECB interest rates might come earlier for the euro area periphery, although the level of monetary policy stress still remains low by historical and US standards.
- Monetary policy stress measures include:
  - Difference between actual ECB policy rate and Taylor-rule implied optimal country rates (with and without lower bound constraints).
  - Aggregated monetary policy stress measured as weighted standard deviation of monetary policy stress.
- Forecasts shown for inflation, monetary policy stress, and output gap for core and periphery (Greece, Ireland, and Portugal).

### Sovereign and banking sector risk spillovers (Figure 7)
- Periphery sovereign spreads increased until recently despite IMF/EU programs in place (10 Year Bond Spreads vis-a-vis Germany for GRC, IRL, PRT, ESP, ITA, and other countries).
- Banking sector risk measures remain elevated.
- Banking and sovereign stress are closely correlated (banking sector 5y CDS spread vs sovereign 5y CDS spread, daily data since January 2010).
- Decomposition of sovereign spreads (2010) attributes spreads to factors including Debt/GDP, ECB reliance, Current account, Global risk, Deficit/GDP, Inflation, Government bond market size, Bank sector EDF.
- Conclusion: sovereign stress in the periphery has its roots in fiscal and banking developments.

### Banking sector health, 2000–10 (Figure 8)
- Profitability improved but a weak tail of mainly smaller banks remains (Return on Assets distribution).
- In some cases, banks were shunned from wholesale markets and needed to rely on the ECB; reliance on ECB funding increased for several countries (Apr-10 vs Apr-11).
- Asset quality has suffered greatly; loan loss provisions rose as percent of assets.
- Net interest income held up well; net interest margin remained resilient through the crisis.
- Euro area banks made least progress in raising capital ratios and reducing reliance on wholesale funding compared with US and UK peers.
- Wholesale funding ratio versus capital buffers show euro area banks lagging in deleveraging/recapitalization.
- External equity issuance through 2010 remained relatively low for the Euro Area compared with United Kingdom and United States.

### National budgetary frameworks and fiscal outcomes (Figure 9)
- Fiscal rules, medium-term budgetary planning, and independent fiscal councils improved fiscal performance where they exist.
- The Quality of Fiscal Rules Index (bound between 0 and 4) and the Structural Balance (average over 2000-08) show that higher-quality rules associate with better fiscal outcomes.
- Countries with fiscal councils exhibited better average cyclically-adjusted balances and smaller changes in gross debt and expenditure over 2000-08.
- The Quality of Medium-Term Budgetary Frameworks index (bound between 0 and 2) correlates with structural balance and changes in gross debt.

### Main economic indicators and projections (Table 1)
- Real GDP: 2005 1.7; 2006 3.1; 2007 2.9; 2008 0.4; 2009 -4.1; 2010 1.8; 2011 2.0; 2012 1.7
- Private consumption: 2005 1.8; 2006 2.1; 2007 1.7; 2008 0.4; 2009 -1.1; 2010 0.8; 2011 1.0; 2012 1.2
- Public consumption: 2005 1.6; 2006 2.2; 2007 2.2; 2008 2.3; 2009 2.5; 2010 0.7; 2011 -0.1; 2012 0.0
- Gross fixed investment: 2005 3.2; 2006 5.4; 2007 4.7; 2008 -0.8; 2009 -11.4; 2010 -0.8; 2011 3.7; 2012 2.8
- Output gap: 2005 -0.3; 2006 1.2; 2007 2.3; 2008 1.2; 2009 -3.5; 2010 -2.7; 2011 -1.9; 2012 -1.4
- Unemployment rate: 2005 9.1; 2006 8.4; 2007 7.6; 2008 7.7; 2009 9.5; 2010 10.1; 2011 10.0; 2012 9.6
- Consumer prices: 2005 2.2; 2006 2.2; 2007 2.1; 2008 3.3; 2009 0.3; 2010 1.6; 2011 2.6; 2012 1.8
- General government balance (percent of GDP): 2005 -2.5; 2006 -1.3; 2007 -0.6; 2008 -2.0; 2009 -6.3; 2010 -5.9; 2011 -4.2; 2012 -3.3
- General government structural balance (percent of GDP): 2006 -2.7; 2007 -2.3; 2008 -2.1; 2009 -2.6; 2010 -4.3; 2011 -4.0; 2012 -3.0; (table layout constrains exact year alignment)
- General government gross debt (percent of GDP): 2005 70.1; 2006 68.5; 2007 66.3; 2008 69.9; 2009 79.4; 2010 85.5; 2011 87.8; 2012 88.3
- EURIBOR 3-month offered rate examples: 2005 2.2; 2006 3.1; 2007 4.3; 2008 4.6; 2009 1.2; 2010 0.8; 2011 1.4 (latest monthly available data for 2011)
- 10-year government benchmark bond yield examples: 2005 3.4; 2006 3.9; 2007 4.3; 2008 4.4; 2009 4.0; 2010 3.8; 2011 4.4 (latest monthly available data for 2011)
- U.S. dollar per euro: 2005 1.24; 2006 1.26; 2007 1.37; 2008 1.47; 2009 1.39; 2010 1.33; 2011 1.4 (latest monthly available data for 2011)
- Current account balance (percent of GDP, staff projection alignment shown): 2005 0.1; 2006 -0.1; 2007 0.1; 2008 -1.5; 2009 -0.3; 2010 -0.4; 2011 0.1; 2012 0.3

### Balance of payments highlights (Table 2)
- Current account (billions of euros): 2003 20.9; 2004 60.8; 2005 10.9; 2006 -12.7; 2007 7.3; 2008 -142.4; 2009 -25.6; 2010 -36.7
- Financial account (billions of euros): 2003 -14.0; 2004 -78.6; 2005 -35.2; 2006 -6.2; 2007 3.1; 2008 141.5; 2009 9.9; 2010 34.3
- Portfolio investment (billions of euros): 2003 54.4; 2004 44.1; 2005 106.4; 2006 186.0; 2007 126.8; 2008 283.3; 2009 270.5; 2010 143.3
- GDP (billions of euros, memorandum): 2003 7,559.7; 2004 7,869.5; 2005 8,161.7; 2006 8,575.1; 2007 9,035.4; 2008 9,264.3; 2009 8,970.4; 2010 9,203.3
- Reserves of the eurosystem (end of period stocks, billions of euros): 2003 306.7; 2004 281.3; 2005 320.1; 2006 325.8; 2007 347.2; 2008 374.2; 2009 462.4; 2010 591.2

*IMF staff calculations and figures as presented in the source document.*

### APPENDIX I. STATISTICAL ISSUES

### APPENDIX I. STATISTICAL ISSUES

### Information Gaps Initiative (IGI)
- Eurostat and the ECB, as members of the Inter-Agency Group (IAG), are collaborating with the IMF to take forward the 20 recommendations endorsed by the G-20 in 2009 to address key information gaps in economic and financial statistics.
- Eurostat efforts:
  - Support conceptual work on measuring cross-border exposures on corporate groups on a consolidated national basis.
  - Develop a Euro Groups Register (EGR).
  - Support PEEI-related initiatives (developed in collaboration with the UN and the IMF) to:
    - form an integrated view of business, growth and acceleration cycles;
    - refine turning point techniques;
    - construct a composite indicator for early warning purposes at the euro area level.
- ECB views and actions:
  - Generally content with progress under the IGI and IMF leadership on macroeconomic data collection and distribution.
  - Identified remaining challenges with macroprudential data: data sharing, confidentiality, and completing legal groundwork for non-bank institutions.
  - Working on a securities holding database for the euro area planned to be completed within 2-3 years.

### Public finance statistics — actions to tackle statistical issues in program countries
- Greece:
  - Measures in 2011 to prevent recurrence of data under- and misreporting include a Memoranda of Understanding of ELSTAT with 9 ministries and entities to improve compilation of ESA95 general government fiscal statistics.
  - Collection of data on arrears covering both current and investment expenditure across all central government units (including line ministries, social security funds, public hospitals, extra budgetary funds, and the largest local governments).
  - Monthly publication of a consolidated report for the general government.
  - Automatic sanctions for delays in reporting introduced to help ensure timely reports.
- Ireland:
  - Central Bank of Ireland now compiles statistics including positions vis-à-vis nonresidents with breakdown by type of financial instruments, maturity, and currency; and separate datasets for banks servicing the domestic market and those focusing on the nonresident market.
  - Data show that foreign exposure to the Irish banking system has fallen sharply.
- Portugal:
  - SOEs, PPPs, and social security decisions with fiscal implications to be integrated within the budget process.
  - Fiscal arrears will be monitored more closely.

### Public finance statistics — Directive on National Fiscal Frameworks (NFFs)
- Draft directive aims to align fiscal behavior with SGP commitments.
- Requirements proposed:
  - Publish cash based fiscal data at a monthly frequency (before the end of the following month) for all government levels except local entities.
  - Explain methodology used for reconciliation of cash and ESA-based data.
- Eurostat plans:
  - Eurostat does not plan to collect nor to disseminate cash-level data.
- Fiscal transparency enhancements:
  - Expand government perimeter to include all extra-budgetary funds and bodies.
  - Disclosure of data on contingent liabilities.
- Other actions:
  - Member states asked to report to the ECOFIN on the estimated fiscal impact of the revised ESA by autumn 2011.
  - Emphasis that member states must facilitate Eurostat’s verification of public financial data.

### Public finance statistics — Stock-Flow Adjustment (SFA)
- Eurostat regularly monitors factors contributing to changes in government debt other than government deficits.
- Recent SFA figures for the euro area aggregate:
  - Peaked at 3.2 percent of GDP in 2008.
  - 0.9 percent of GDP in 2009.
  - 1.9 percent of GDP in 2010.
- Concern noted that governments may resort to SFA transactions to ensure deficit compliance with EDP requirements; justifies proposal for incorporating SFA analysis in the revamped SGP.

### Public finances — Statistical consequences of the EFSF
- Eurostat, in cooperation with the Central Bank of Luxembourg and STATEC, is defining the content and structure of the template to estimate the impact of the EFSF on GFS and BoP payments statistics in euro area countries.
- Figures will be reported on a monthly basis, with the first release scheduled for July 2011.

### Pensions systems
- 2008-SNA requires comprehensive recording of all pension entitlements accrued by households regardless of type of social security arrangement to improve comparability of pension schemes.
- Pension tables are elaborated on a voluntary basis by eight euro area members.
- In absence of SNA specific guidelines, Eurostat holds regular seminars with the ECB, NCBs and NSIs to give methodological guidance and provide TA where needed.
- A fully-fledged release of data targeted by 2014 with the new ESA 2010 transmission program.

### Short-term business statistics (STS) and PEEIs
- Work with NSIs to improve STS indicators and PEEIs, including:
  - Implementation of ESS guidelines for seasonal adjustment.
  - Ensuring consistency between euro area GDP and the Industrial Production Index (IPI), and consistency of the latter with individual countries’ IPIs.
- Timeliness of STS statistics improved in recent years, particularly for PEEIs-related STS; some indicators still lag U.S. dissemination speed.

### Price statistics
- HICP improvements:
  - New rules (Regulation EC No 330/2009) on treatment of seasonal products took effect with the index of January 2011, requiring some NSIs to change calculation methods.
  - Implementation acts follow in member states until November 2011; Eurostat closely monitoring impact.
  - Early indications suggest a moderate positive impact on euro area headline inflation (+ 0.1 percentage points on average for the EU during the first [two] quarters), with relatively higher impact in Southern countries, mostly driven by food and clothing sub-components.
  - New minimum standards for the quality of HICP weighting (Regulation EC No 1114/2010) require additional NSI efforts during 2011 to ensure implementation by January 2012.
  - Eurostat pursuing changes in monthly euro area inflation flash estimates with possible breakdown to four main components: processed food, unprocessed food, non-energy industrial goods, and services.
- House Price Indexes (HPI) and Owner-Occupied Housing (OOH):
  - Eurostat leading work to improve real estate price information in context of IGI Recommendation #19.
  - OOH remains a high priority methodological development for the HICP.
  - Pilot projects by NSIs coordinated by Eurostat have led to release of first experimental data.
  - Eurostat preparing a legal act to ensure continuation beyond pilot phase.
  - Eurostat considering including quarterly House Price Indices in the list of PEEIs.
- Handbook of Residential Property Price Index (RPPI):
  - Lack of homogeneity in RPPI methodologies problematic; release of the Handbook should help promote more consistent practice.
  - Plans for a companion Handbook for Commercial Property Price Indices.

### Structural Business Statistics (SBS)
- Improvements under the Program for the Modernization of European Enterprise and Trade Statistics (MEETS) (Decision EC No 1297/2008) launched in 2008.
- 2011 actions focus on:
  - Constructing data warehouses.
  - Developing tools for micro data linking.
  - Back casting data (e.g., in business demography statistics).
  - Improving collection of data on access to financing by SMEs.
- Euro Groups Register (EGR):
  - Creation of a register for MNEs operating in the European market (EGR) has been partly outsourced to private providers.
  - EGR seen as promising tool for compilation of statistics affected by globalization (e.g., FDI, trade, and knowledge) which currently suffer fragmentation and inconsistency.

### Balance of Payments and International Trade Statistics (ITS)
- Users generally satisfied with ITS data (Quality Report, 2010).
- Ongoing work to improve statistics on SMEs involved in international trade, including use of VAT data to measure trade not covered by Intrastat reporting.
- Data for 2008 and 2009 to be disseminated in the coming months.
- Asymmetries:
  - Reconciliation exercises carried out during 2011 produced largely positive outcomes.
  - FDI network useful platform to share confidential data on large FDI transactions, helping identify asymmetries and improve data quality.

*Source: APPENDIX I. STATISTICAL ISSUES (IMF staff and Eurostat/ECB collaboration material as provided in the source content).*

### introduction of the so called European Semester, which aims at providing integrated and ex

### introduction of the so called European Semester, which aims at providing integrated and ex

### European Semester and integrated ex ante policy guidance
- Introduces the so called European Semester, which aims at providing integrated and ex ante economic policy guidance to the Member States, in time to be taken into account in the formulation of national budgets for the following year.
- The first set of integrated country-specific recommendations was adopted by the Council in July, on a recommendation from the Commission.
- The recommendations integrate fiscal and structural policy guidance and feature a much higher level of granularity and specificity than before in terms of recommended policy action.

### Political impetus: Euro Plus Pact
- The reform process has received an additional political impetus in the form of the Euro Plus Pact.
- With the Pact, the participating Member States committed at the highest political level to further strengthen the economic pillar of EMU and achieve a new quality of economic policy coordination.
- The Pact commits Member States to implementing a number of concrete policy actions which are key for improving competitiveness and avoiding harmful imbalances, thereby leading to a higher degree of convergence and preserving our social models.

### Structural reforms and the Single Market
- The authorities emphasise that the Single Market has been and continues to be the cornerstone of economic integration in the euro area and in the whole EU, and with the single currency the euro area forms the most economically integrated part of the world economy.
- The authorities agree that there is still more potential to be exploited.

### Single Market Act: objectives and areas of action
- The Commission has presented a Single Market Act with a view to taking the Single Market to a new stage by:
  - tapping the full potential of the services sector;
  - encouraging the uptake of a digital economy;
  - facilitating cross-border transactions;
  - improving access to finance, especially for SMEs and fast-growing innovative companies;
  - increasing workers' mobility by modernising the system for recognising professional qualifications;
  - modernising standard setting and intellectual property regimes;
  - creating cost-effective access to energy.
- In services, a special emphasis is put on the need to remove non-tariff barriers to trade and to the harmonisation of product regulations and technical standards.

### Services Directive and expected effects
- The major recent liberalisation effort in the services sectors is the implementation of the Services Directive.
- Although it is too soon for its full effects to have materialised, it is expected to have a major impact on trade and FDI flows and has already created a momentum for services liberalisation.

### Network industries and energy sector liberalisation
- In network industries, progress has been made in opening markets and ensuing increased competition and further liberalisation is ongoing.
- The liberalisation in telecoms has led to a fall in the market share of the incumbent and to a reduction in prices.
- In the electricity and gas sectors, the implementation of the Third energy package will further enhance competition and integration.

*Source: _cr11184 - introduction of the so called European Semester, which aims at providing integrated and ex*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11184.pdf_