## _cr12181 ## Source details **Canonical URL:** [_cr12181](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12181.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12181.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12181.pdf.json) --- ### A deepening crisis — key findings - Market tensions have increased, raising doubts about the viability of the monetary union and driving sovereign borrowing costs and risk premiums very high in several countries. - Adverse bank-sovereign feedback loops have intensified: - Banks’ solvency concerns increased because of large sovereign exposures, particularly in periphery countries. - Some sovereigns are struggling to backstop weak banks on their own; depositor confidence is increasingly fragile. - Official financing—including programs and ECB liquidity support—has become more important, largely mirrored in widening Target 2 balances. - Single financial market fragmentation: - Despite low policy rates, credit conditions vary widely across euro area countries due to diverging perceptions of sovereign and banking risks and a drastic decline in interbank activity. - Financing conditions are least supportive in countries where the crisis is most acute. - Real economy feedback: - GDP was flat in Q1 2012, after contracting at an annualized rate of almost 1 percent in Q4 2011. - Euro area unemployment increased to over 11 percent in May, the highest level since the start of EMU. ### Weak outlook with substantial risks — projections and pressures - Growth projections and drivers: - After averaging 1.5 percent in 2011, euro area GDP growth is expected to be -0.3 and 0.7 percent in 2012 and 2013. - Trend growth is seen at about ¾ percent over the medium term (staff estimate). - Germany and France expected to post weak-but-positive growth in 2012. - Fiscal consolidation and composition: - On current policies, the euro area structural deficit is projected to narrow by about 1½ percent of GDP in 2012, ½ percent of GDP in 2013, and an additional ½ percent of GDP over 2014-17. - Projected consolidation over this and next year ranges from around 3½ percentage points or more of GDP in Portugal, Greece, Italy, and Spain, compared with ½ percentage point or less in Germany, Austria, and Finland. - Labor market and inflation: - Unemployment in 2012 expected to span from about 5 ½ percent in Germany to 24 percent in Spain. - Headline inflation expected to fall well below 2 percent in 2013 and remain there through 2014. - IMF GPM projections indicate about a 25 percent probability of below-zero inflation by early 2014. - Fiscal factors are masking downward price pressures in the periphery; staff estimates suggest fiscal factors contribute over 1 percentage point to inflation in Italy in 2012. - External environment: - Global outlook deterioration reduces export demand despite recent euro depreciation. - External imbalances within the euro area will narrow mainly through weak activity and import compression in the periphery. ### Risks — Risk Assessment Matrix (selected scenarios) - Scale: relative likelihood (Medium/Low) and impact if realized (High/Medium) - Strong intensification of euro area crisis: - Relative likelihood: Medium - Impact if realized: High — undermine market confidence, adversely affect growth prospects, raise unemployment, threaten sovereign debt trajectories, and possibly market access. - Country-specific policy and reform slippage: - Relative likelihood: Medium - Impact if realized: Medium/High — raise questions about political will to sustain EMU; undermine confidence; drive spreads into unsustainable levels; intensify cross-border contagion. - Failure of a SIFI: - Relative likelihood: Medium - Impact if realized: High — intensify cross-border bank deleveraging and generate strong contagion effects. - Oil price surge: - Relative likelihood: Low - Impact if realized: Medium — weaken economic activity and increase headline inflation. ### Global spillovers - Further intensification of the euro area crisis—modeled as a jump in sovereign and private yields—could have significant global effects, especially in neighboring EU and southeastern European countries. - Output losses across the euro area result in nearly equivalent losses in the UK and Eastern Europe, with peak output losses occurring within two years. - Extent of spillovers depends on policy responses within the euro area and globally, crisis duration, and pass-through of sovereign spreads to private borrowing costs. ### Policy implications and recommended directions - Root causes unaddressed: EMU lacks tools to break sovereign-bank-real economy feedback loops and lacks ambitious policies to restore strong and balanced growth. - Policy responses to date: - ECB reduced policy rates to historical lows and conducted special liquidity interventions, including LTROs. - Enlarged European and global firewall will provide more liquidity insurance to sovereigns; ongoing reform of fiscal governance aims to strengthen fiscal discipline. - National governments have embarked on fiscal consolidation. - June 28-29 summit: steps toward a single supervisory mechanism; possibility of using ESM resources to recapitalize banks directly; ESM assistance to Spain would not carry seniority status; willingness to consider secondary purchases of sovereign bonds by the EFSF/ESM; agreement on terms for a “Growth Compact” and request to pursue the “Four Presidents” proposals. - Summit assessment (if fully implemented): - Would help break adverse links between sovereigns and banks and create a banking union. - Establishing a single supervisory mechanism—with key decisions to be taken by end-2012—would enable the ESM to recapitalize banks directly. - Additional necessary elements: pan-European deposit insurance and a bank resolution mechanism with common backstops. - Implementation hurdles include ESM ratification by all members, timing of pan-euro supervision, unanimity requirements, and outstanding questions on terms for direct bank recapitalizations. --- ### A. The Case for Completing EMU — institutional gaps and adjustment constraints - EMU described as "in an uncomfortable and unsustainable halfway point": integrated enough for spillovers but lacking flexibility and policy tools. - Constraints on adjustment to country-specific shocks: - Low labor mobility due to housing market rigidities, non-transferable social benefits, absence of area-wide social safety net. - Limited wage and price flexibility. - Freely moving capital susceptible to sudden swings. - Key missing stabilizing tools: - Lack of a strong common financial stability framework. - Absence of sufficient instruments of fiscal risk sharing. - Without robust fiscal governance, incentives to keep sovereign debt low before a crisis are weak. - Conclusion: A credible roadmap toward a full banking union and fiscal integration will make short-term crisis measures more effective; structural reforms and macroeconomic policies are also needed. ### Box 2 — The Case for a Banking Union (findings and mechanisms) - Crisis evidence and fragmentation: - System de-integrated from area-wide to within-national-borders; sovereign bond and interbank markets affected by withdrawals of intra-euro area cross-border capital flows (Change in EA MFI Cross-border Claims, 2011 and 2012Q1). - Financial fragmentation impaired transmission channels of euro area monetary policy. - Downward spirals: - Bank funding stress affects loan pricing: a 150 bps increase in bank CDS spreads is associated with an increase in lending rates of 0.6 percentage points for corporate loans and 0.4 percentage points for mortgages. - Absence of an exchange rate amplifies adverse feedback on domestic demand. - How a banking union helps: - Sever adverse feedback loops between banks and sovereigns. - Provide incentives to end financial de-integration and restore transmission of monetary policy. - Proposed core elements: - Pan-European deposit guarantee scheme: eventually funded by an industry levy; needs ready recourse to additional funding from a common pool of government-provided resources or an ECB credit line. - Pan-European bank resolution mechanism: authority with powers to bail in private creditors; resolution backed by common fund financed by an industry levy with recourse to government-provided resources or the ECB. - Common supervision: ideally encompasses entire banking system; could first focus on cross-border banks and SIFIs. June 28-29 summit plan to establish a single supervisory mechanism—to be considered by the Council by end-2012—is cited as an important first step. - Intermediate steps: - Implement and accelerate EU framework for harmonized national bank resolution processes and deposit insurance, including strong bail-in powers. - Use EFSF/ESM framework for interim financing of common deposit insurance and resolution frameworks. - Strengthen coordination of macroprudential policies; support role for pan-European institutions such as the ESRB and EBA. ### Box 3 — The Case for a Fiscal Union (findings and mechanisms) - Fiscal integration rationale: - Provides tools to enhance adjustment to idiosyncratic shocks and deal with externalities. - Literature suggests about 10-20 percent of regional income shocks are absorbed through sharing arrangements in other currency areas. - Common tools of fiscal risk sharing: - Financial stability backstops (e.g., FDIC-like arrangements). - Transfer and tax schemes responding to cyclical regional developments. - Central provision of public goods financed through regional taxes. - Governance and moral hazard: - Requires strong governance arrangements limiting regional fiscal sovereignty and enforcing agreed standards; legally enforceable fiscal rules are commonly used. - Roadmap and staged approaches: - Political and legal constraints imply large-scale fiscal integration will take time. - Limited-but-scalable common debt as a starting point: common euro area debt securities initially restricted to shorter maturities and small size, conditional on centralized control; proposals discussed include "Eurobills" and "the redemption fund". --- ### The ECB can provide further defenses — impaired monetary transmission (Box 4) and options - Impaired transmission: - Since late 2010, retail lending rates began to rise while ECB policy rate remained low; the speed and long-run impact of ECB policy changes on retail rates have declined. - Panel estimation (100 euro area banks, Q1:2007–Q1:2012) finds: - Banks’ quarterly lending growth was significantly higher for larger, more profitable, more liquid and better capitalized banks. - Banks with higher loan/deposit ratio mismatch and higher CDS spreads lent significantly less. - Monetary policy options to defend against escalation: - Interest rate reductions: - Economic weakness and downside risks to inflation warrant further reductions in main policy rates; room is limited but reductions would have signaling effects and reduce indexed borrowing costs under existing LTROs. - Quantitative easing (QE): - Transparent QE with sizable sovereign bond purchases, possibly preannounced and defined equitably across the euro area by GDP weights. - QE could lower yields even in already “low yield” countries, including Germany. - More SMP purchases: - Additional and clearly communicated Securities Markets Programme purchases could ensure transmission where sovereign bond markets are stressed; SMP purchases have been relatively small compared with outstanding debt stock. - Further liquidity provision (LTROs and collateral adjustments): - Additional multi-year LTRO facilities, coupled with adjusted collateral requirements (broadened collateral base and/or lowering of haircuts), could address localized shortages; credit risk to the ECB manageable given strong balance sheet. - One disadvantage: LTROs tend to strengthen sovereign-bank links. ### LTROs, collateral capacity, and haircut issues (Box 5) - Past LTROs and collateral changes: - Through two three-year LTROs and collateral relaxation, the ECB allotted €1 trillion to euro area banks, with a net increase in liquidity of about €500 billion. - For the second LTRO the ECB expanded eligible collateral to include additional performing credit claims (i.e., bank loans). - System-wide collateral capacity and borrowing: - LTRO borrowings are around €1.1 trillion (end May). - Marketable collateral eligible for Eurosystem operations is about €13 trillion (not all held by banks). - Substantial non-marketable collateral evidenced by €3 trillion pre-pledged collateral (typically non-marketable). - This could allow borrowing of up to €2.4 trillion (assuming haircuts of 20 percent). - Remaining risks and national differences: - Some individual banks—mainly in the periphery—could be short of collateral; Greek and Irish banks already use national ELA with a wider collateral pool. - Phasing-out of ECB funding will likely prove problematic if market access does not improve; liquidity risk can become the biggest risk should ECB support not be renewed. - Collateral valuation and haircut policy concerns: - The ECB assesses collateral using market prices or “mark to model” and applies haircuts; this is pro-cyclical. - Historical comparison: ECB required a haircut of 20 percent (later reduced to 12 percent with weekly margining); the Swiss National Bank required a zero initial haircut but used daily variation margining. ### Seniority clarification and backstops - Clarifying the seniority status of the ECB’s sovereign bond holdings and of the ESM would make crisis responses more effective; clear commitment to accept equal status with private sector claims, as in the case of Spain, would enhance official sector crisis management effectiveness. - Policymakers must be ready to support the euro area banking system if the crisis escalates, including flexible use of the European firewall; EFSF/ESM facilities should be ratified quickly and empowered with flexibility and resources. - Clarity on common support—foremost by the ECB, possibly including announcing a pan-European deposit insurance scheme—may be necessary to support depositor confidence. ### Fiscal consolidation and growth-friendly design - Most euro area countries plan significant fiscal adjustment over the medium term. - Guidance: - Focus fiscal targets on structural, rather than nominal, deficits. - Exploit flexibility in the Fiscal Compact and anchor consolidation in fully-specified multi-year plans with measures identified in advance. - Challenge: implement consolidation without exacerbating adverse feedback loops. ### National actions to restore banking and confidence - Implement transparent and comprehensive strategies to recapitalize viable banks without delay. - Independent assessments of banks’ loan books, deal with legacy assets, strengthen supervision and regulatory frameworks. - Restore public finance health and implement structural measures (labor and product market reforms). --- ### Growth, structural reforms, and weak trend growth (key findings and recommendations) - Key findings: - Weak trend growth has made bank and sovereign problems difficult to resolve. - Risk of stagnation rising as unemployment increases and long-term unemployment threatens potential output. - Productivity growth has weakened; effective labor utilization relatively low. - Demographic pressures: low and declining population growth imply substantial increases in dependents-to-working-age ratio. - Structural reform areas: - Labor market institutions, product market reforms, tax reforms (shift from labor income to consumption taxes), and pension reforms. - Estimated gains: - Eliminating half of euro area countries’ gaps with OECD best practice in labor market, product market, tax, and pension policies could raise output by 5 percent over 5 years. - Spillovers could account for one quarter of total gains. - Short-run considerations: - Some reforms can have immediate effects (e.g., active labor market policies); full benefits take time. - Support for aggregate demand in the short run is crucial. --- ### Short-term activity indicators, inflation, and LTRO effects - Early 2012: tentative stabilization at low levels amid volatility; performance differed markedly across countries. - Inflation narrative: - "Inflation is coming down as base effects from past food and energy price increases disappear..." - Wage pressures remain contained; inflation expectations remain well-anchored though some market indicators signal much lower inflation ahead. - Selected indicators and exact figures cited: - M3 increasing at 4.5 % - Unemployment rate series for Euro area: 7.6 7.7 9.6 10.1 10.2 11.1 11.3 11.1 (series as presented). - LTROs and ECB balance sheet facts: - The 3-year LTROs were extreme in size and average allotment per bidder. - LTROs led to sizable expansion and maturity lengthening of the ECB balance sheet. - Bank reliance on ECB funding increased substantially in the periphery; LTROs created room for sovereign carry trade strategies and increased banks' sovereign bond holdings. - Asset encumbrance rose; policy concern that LTROs could be counterproductive by increasing asset encumbrance and creating collateral shortages. ### Staff projection — selected table entries (Euro Area: Main Economic Indicators, 2007-2014) - Real GDP (levels and projections as presented): 3.0 0.4 -4.3 1.9 1.5 -0.3 0.7 1.3 - Private consumption: 1.7 0.4 -1.2 0.9 0.2 -0.5 0.5 1.0 - Gross fixed investment: 4.7 -1.1 -12.1 -0.5 1.3 -2.4 1.1 1.8 - Potential GDP: 1.7 1.4 0.8 0.7 0.6 0.5 0.7 0.8 - Output gap: 2.7 1.6 -3.6 -2.4 -1.5 -2.3 -2.3 -1.9 - Unemployment rate: 7.6 7.7 9.6 10.1 10.2 11.1 11.3 11.1 - Consumer prices: 2.1 3.3 0.3 1.6 2.7 2.2 1.6 1.5 - General government balance (percent of GDP): -0.7 -2.1 -6.4 -6.2 -4.1 -3.2 -2.5 -2.0 - General government structural balance (percent of GDP): -2.3 -2.9 -4.4 -4.2 -3.1 -1.7 -1.1 -0.9 - General government gross debt (percent of GDP): 66.4 70.2 80.0 85.8 88.1 91.4 92.4 92.2 - LTRO borrowings are around €1.1 trillion (end May); ECB allotted €1 trillion to euro area banks through two three-year LTROs with net liquidity increase of about €500 billion. - Marketable collateral eligible for Eurosystem operations: about €13 trillion; pre-pledged non-marketable collateral: €3 trillion; potential borrowing up to €2.4 trillion (assuming haircuts of 20 percent). ### Balance of payments — selected levels (current account and components, billions of euros as presented) - Current account (levels): 20.9 60.8 10.9 -12.7 7.3 -143.4 -22.0 -6.9 -3.2 - Goods: 98.7 94.1 42.2 8.1 42.3 -21.8 31.2 15.0 4.9 - Services: 22.5 32.9 39.6 42.5 47.9 42.0 36.5 49.6 61.0 - Financial account: -14.0 -78.6 -35.2 -6.2 3.1 121.3 9.4 -2.7 -24.6 - GDP (billions of euros): 7,546.9 7,860.4 8,145.4 8,564.9 9,030.2 9,244.3 8,930.1 9,160.9 9,425.8 ### IMF policy recommendations for selected countries (high-level bullets) - Greece: specify remaining fiscal measures; finalize recapitalization strategy; fiscal institutional reforms; competitiveness-enhancing structural reforms. - Ireland: accommodate revenue shortfalls if growth weakens; specify measures for 2013-15 consolidation; strengthen banks’ capacity to manage distressed loans; implement Pathways to Work. - Portugal: adhere to programmed fiscal targets but avoid excessive structural adjustment; align bank deleveraging with available credit supply; strengthen supervision and resolution framework. - Italy: lower taxes supported by expenditure cuts; target overall structural surplus of 1 percent of GDP as new fiscal rule anchor; strengthen bank capital and liquidity buffers; publish stress tests. - Spain: make fiscal adjustment less front loaded; increase role of revenue measures, especially indirect taxes; communicate comprehensive bank strategy and manage legacy assets; implement approved labor market reforms. --- ### Data, statistical initiatives, and surveillance improvements - Macroeconomic Imbalances Procedure (scoreboard) indicators include: current account balance (percent of GDP), net international investment position (percent of GDP), export market shares, nominal unit labor costs, HICP-based real effective exchange rates, private sector debt (percent of GDP), general government debt (percent of GDP), private sector credit flow (percent of GDP), house prices relative to consumption deflator, and unemployment rate. - Property market data: - Eurostat releasing quarterly house price data; new regulation entering into force in autumn 2012 requiring data transmission at t+85 days. - Commercial Property Price Indices: data sparse and variable; a tender for an international Handbook on best practices organized. - BPM6 implementation: - Regulation introducing BPM6 should be adopted "in a matter of weeks." - 2014 deadline mandatory; no derogations envisaged. - Intrastat and bilateral micro-data exchange for FDI encouraged to improve data quality. - Directive on national fiscal frameworks calls for monthly data on government operations and balance sheet to be disseminated from 2014. *Source: _cr12181 (IMF staff report excerpts provided).* ### 1. Euro Area: Main Economic Indicators, 2007-2014 ...................................................................... ### 1. Euro Area: Main Economic Indicators, 2007-2014 ......................................................................................... ### A deepening crisis — key findings - Market tensions have increased further, raising doubts about the viability of the monetary union and driving sovereign borrowing costs and risk premiums to very high levels in several countries. - Adverse bank-sovereign feedback loops have intensified: - Banks’ solvency concerns increased because of large sovereign exposures, particularly in periphery countries. - Some sovereigns are struggling to backstop weak banks on their own; depositor confidence is increasingly fragile. - Official financing—including programs and ECB liquidity support—has become more important, largely mirrored in widening Target 2 balances. - The single financial market has become increasingly fragmented: - Despite low policy rates, credit conditions vary widely among euro area countries due to diverging perceptions of sovereign and banking risks and a drastic decline in interbank activity. - Financing conditions are least supportive in countries where the crisis is most acute. - Real economy weakness reinforces bank-sovereign feedback loops: - GDP was flat in Q1 2012, after contracting at an annualized rate of almost 1 percent in Q4 2011. - Tightening financing conditions, weak confidence, and fiscal consolidation held back private investment and consumption. - Euro area unemployment increased to over 11 percent in May, the highest level since the start of EMU. - Weak activity has added to budgetary pressures and deterioration in banks’ loan portfolios. ### Weak outlook with substantial risks — projections and pressures - Growth projections and drivers: - After averaging 1.5 percent in 2011, euro area GDP growth is expected to be -0.3 and 0.7 percent in 2012 and 2013. - Private domestic demand is expected to remain subdued while balance-sheet repair and heightened uncertainty dampen consumption and investment; periphery growth expected to be much lower than in the core. - Germany and France are expected to post weak-but-positive growth in 2012. - Trend growth is seen at about ¾ percent over the medium term (staff estimate). - Fiscal consolidation and composition: - On current policies, the euro area structural deficit is projected to narrow by about 1½ percent of GDP in 2012, ½ percent of GDP in 2013, and an additional ½ percent of GDP over 2014-17. - The pace of fiscal adjustment is accelerated in the periphery: projected consolidation over this and next year ranges from around 3½ percentage points or more of GDP in Portugal, Greece, Italy, and Spain, compared with ½ percentage point or less in Germany, Austria, and Finland. - Labor market and inflation: - Unemployment in 2012 is expected to span a wide range, from about 5 ½ percent in Germany to 24 percent in Spain; differences are expected to persist in staff projections. - Headline inflation is expected to fall well below 2 percent in 2013 and remain there through 2014. - IMF GPM projections indicate about a 25 percent probability of below-zero inflation by early 2014. - Fiscal factors are masking downward price pressures in the periphery (example: staff estimates suggest fiscal factors contribute over 1 percentage point to inflation in Italy in 2012). - External environment: - Global outlook deterioration reduces export demand despite recent euro depreciation. - External imbalances within the euro area will narrow mainly through weak activity and import compression in the periphery. ### Risks — Text Table 1 (Risk Assessment Matrix) - Scale: relative likelihood (Medium/Low) and impact if realized (High/Medium) - 1. Strong intensification of euro area crisis - Relative likelihood: Medium - Key channels: larger-than-envisaged bank deleveraging; fiscal consolidation depressing activity more than envisaged; stronger adverse feedback loops between sovereigns and banks; stagnation and long-term damage to potential output. - Impact if realized: High — undermine market confidence, adversely affect growth prospects, raise unemployment, threaten sovereign debt trajectories, and possibly market access. - 2. Country-specific policy and reform slippage - Relative likelihood: Medium - Key channels: fiscal adjustment plans may falter; bank recapitalization efforts may be protracted; structural reform implementation could stall; backlash in the core against continued support; sudden financial stress could trigger deposit flight. - Impact if realized: Medium/High — raise questions about political will to sustain EMU; undermine confidence; drive spreads into unsustainable levels; adversely affect growth and raise unemployment; intensify cross-border contagion. - 3. Failure of a SIFI - Relative likelihood: Medium - Key channels: sizable sovereign or funding shock could lead to a SIFI failure; ECB LTROs have addressed immediate funding pressures; completion of higher firewalls may provide added liquidity insurance. - Impact if realized: High — intensify cross-border bank deleveraging and generate strong contagion effects. - 4. Oil price surge - Relative likelihood: Low - Key channels: spike in oil prices linked to geo-political tensions. - Impact if realized: Medium — weaken economic activity and increase headline inflation. ### Global spillovers - Further intensification of the euro area crisis—modeled as a jump in sovereign and private yields—could have significant global effects. - Spillovers would be especially strong in neighboring EU and southeastern European countries. - Output losses across the euro area result in nearly equivalent losses in the UK and Eastern Europe, with peak output losses occurring within two years. - Extent of spillovers depends on policy responses within the euro area and globally, crisis duration, and pass-through of sovereign spreads to private borrowing costs. - Some banks in core euro area countries are sufficiently large and connected to generate significant spillovers through cross-border deleveraging and increased counterparty risks. ### Policy implications and recommended directions - Root causes remain un-addressed: EMU still lacks basic tools to break adverse sovereign-bank-real economy feedback loops and lacks ambitious policies to restore strong and balanced growth. - Policy responses to date: - ECB reduced policy rates to historical lows and conducted special liquidity interventions, including LTROs, to address immediate bank funding pressures. - Enlarged European and global firewall will provide more liquidity insurance to sovereigns; ongoing reform of fiscal governance aims to strengthen fiscal discipline. - National governments have embarked on fiscal consolidation reaffirming debt sustainability and deficit targets. - June 28-29 summit: agreed steps toward a single supervisory mechanism; possibility of using ESM resources to recapitalize banks directly; ESM assistance to Spain would not carry seniority status; willingness to consider secondary purchases of sovereign bonds by the EFSF/ESM; agreement on terms for a “Growth Compact” and request to pursue the “Four Presidents” proposals. - Assessment of summit initiatives (Box 1—summary): - If implemented in full, summit agreements will help break adverse links between sovereigns and banks and create a banking union. - Establishing a single supervisory mechanism—with key decisions to be taken by end-2012—would enable the ESM to recapitalize banks directly. - Additional necessary elements include pan-European deposit insurance and a bank resolution mechanism with common backstops to decisively break the sovereign-bank link. - These steps should be complemented by plans for fiscal integration as anticipated in the ‘Four Presidents’ report. - Implementation hurdles include ESM ratification by all members, uncertain timing of pan-euro supervision, need for unanimity on measures, and outstanding questions on terms for direct bank recapitalizations. *Source: _cr12181 - 1. Euro Area: Main Economic Indicators, 2007-2014 (IMF staff report content provided).* ### 12. But the crisis calls for a much stronger collective effort now to demonstrate ### 12. But the crisis calls for a much stronger collective effort now to demonstrate ### A. The Case for Completing EMU - The euro area is described as "in an uncomfortable and unsustainable halfway point"—sufficiently integrated for spillovers but lacking flexibility and policy tools to deal with them. - Constraints on economic adjustment to country-specific shocks: - Low labor mobility across countries due to institutional factors such as housing market rigidities, non-transferable social benefits, and the absence of an area-wide social safety net. - Limited wage and price flexibility, slowing correction of macroeconomic imbalances. - Freely moving capital is susceptible to sudden swings that can paralyze financial markets and threaten financial stability. - Key missing stabilizing tools: - Lack of a strong common financial stability framework makes banking problems hard to contain and resolve in an integrated market (see Box 2). - Absence of sufficient instruments of fiscal risk sharing leaves no common backstops to support banks or soften fiscal consequences of country-shocks before they spread beyond national borders. - Without robust fiscal governance, incentives to keep sovereign debt levels low before a crisis are weak (see Box 3). - Conclusion: A credible roadmap toward a full banking union and fiscal integration will make short-term crisis measures more effective; structural reforms and macroeconomic policies are also needed. ### Box 2 — The Case for a Banking Union (findings and mechanisms) - Crisis evidence and financial fragmentation: - Prior to the crisis, the euro area had achieved a high degree of financial integration; sovereign risks of periphery countries were de facto shared between core euro area and domestic investors. - Faced with funding freezes for large euro area banks and contagion of sovereign stress to Italy and Spain, the system has fragmented from area-wide to within-national-borders, de-integrating sovereign bond markets, interbank markets, lending and deposit markets. - Sovereign bond and interbank markets have been deeply affected by withdrawals of intra-euro area cross-border capital flows (Change in EA MFI Cross-border Claims, 2011 and 2012Q1). - Financial fragmentation impaired transmission channels of euro area monetary policy. - Downward spirals between sovereigns, banks and the real economy: - Concerns about bank solvency remain large where the domestic sovereign is weak; weak sovereigns are unable to backstop failed banks without jeopardizing solvency. - Bank funding stress materially affects loan pricing: a 150 bps increase in bank CDS spreads is associated with an increase in lending rates of 0.6 percentage points for corporate loans and 0.4 percentage points for mortgages. - Absence of an exchange rate amplifies adverse feedback on domestic demand. - How a banking union would help: - Sever adverse feedback loops between banks and sovereigns. - Provide incentives to end financial de-integration. - Stabilize financial systems, restore transmission of monetary policy, and help healthy firms obtain credit at reasonable cost regardless of sovereign strength. - Prepared by Thierry Tressel (see 2012 Selected Issues Paper for further details). ### Banking union: proposed core elements (policy recommendations) - Pan-European deposit guarantee scheme: - Increases depositor confidence and reduces banks’ dependence on sovereigns to limit deposit flight. - Eventually funded by an industry levy, but needs ready recourse to additional funding in times of stress from a common pool of government-provided resources or an ECB credit line. - Pan-European bank resolution mechanism: - An authority with powers to bail in private creditors and support resolution would facilitate orderly wind-downs and smooth deleveraging. - Resolution could be backed by a common fund financed by an industry levy with recourse to government-provided resources or the ECB. - Common supervision: - A common supervisory framework is essential to foster stability and deter fragmentation. - Ideally encompasses the entire banking system but could first focus on cross-border banks and large systemically-important financial institutions. - The June 28-29 summit plan to establish a single supervisory mechanism for euro area banks—to be considered by the Council by end-2012—is cited as an important first step; rapid decisions and implementation are emphasized. ### Intermediate steps toward a banking union (sequencing and instruments) - Implement and accelerate the recently proposed EU framework for harmonized national bank resolution processes and deposit insurance: - Could reduce taxpayer costs by giving resolution authorities strong powers, including the power to bail-in unsecured creditors, thereby reducing the 'too-big-to-fail' subsidy. - Use of EFSF/ESM framework for immediate financing of common deposit insurance and resolution frameworks: - EFSF/ESM resources could provide interim financing before industry contributions are available. - Use of EFSF/ESM resources could be linked to advances in area-wide supervision (similar to decision to consider direct bank recapitalization by the ESM). - Strengthen coordination of macroprudential policies: - The compromise draft of the CRDIV provides greater flexibility at the national level by allowing countries to impose stricter capital buffers—helpful balance between single rule book and national financial stability concerns. - A common approach to capital and liquidity requirements is essential, with a strong role for pan-European institutions such as the ESRB and EBA. ### Urgency for the euro area (institutional alignment) - Faster progress is more critical for the euro area than for the EU: - Deposits move more easily within a currency area; a euro area deposit guarantee covering all depository institutions would reassure retail depositors and avoid sudden depositor flight. - A euro area bank resolution authority would weaken bank-sovereign feedback loops within the currency union. - To align supervisory incentives, the ECB could play the role of common supervisor and could be given explicit responsibility for financial stability and full lender-of-last-resort functions, thereby eliminating bank-sovereign linkages present in the current Emergency Liquidity Assistance (ELA) scheme. ### Box 3 — The Case for a Fiscal Union (findings and mechanisms) - Fiscal integration rationale: - In a common currency area, fiscal integration provides critical tools to enhance adjustment to idiosyncratic shocks and deal with externalities. - The euro area has limited economic adjustment to country-specific shocks (low labor mobility, volatile intra-area capital flows, structural rigidities), and governance safeguards against excessive debt have disappointed. - Evidence from other currency areas: - Countries such as Brazil, Canada, Germany, Switzerland, and the U.S. offer ex ante insurance through formalized mechanisms. - Literature suggests, on average, about 10-20 percent of regional income shocks are absorbed through sharing arrangements, helping prevent contagion and reducing need for costly ex post bailouts. - Common tools of fiscal risk sharing: - Financial stability: Common frameworks with an area-wide backstop (e.g., FDIC in the U.S.) to ensure localized banking stresses do not become systemic (see Box 2). - Transfer and tax schemes: Transfers from the central government to regions and/or tax sharing arrangements account for a significant share of regional income in many currency areas and often respond to cyclical regional developments. - Public goods: Central provision of important public goods and services financed through regional taxes entails fiscal risk sharing when regions face downturns. - Governance and moral hazard: - Fiscal integration requires strong governance arrangements that limit regional fiscal sovereignty and ensure behavior consistent with agreed standards. - Where public goods are provided centrally, the center usually has tax authority over the entire region; where transfers are significant, the center often has rights to intervene in regional public finances. - Legally enforceable fiscal rules are commonly used to ensure regional fiscal sustainability. - Some currency areas use bailout mechanisms; others rely on credible no-bailout provisions supported by a minimum level of risk sharing. - Prepared by Fabian Bornhorst (see Selected Issues Paper for further details). ### Crisis dynamics and the need for both banking and fiscal union - Feedback loops and fragmentation: - The bank-sovereign feedback loop and market fragmentation have been accentuated during the crisis. - Transfer of banking liabilities to public balance sheets continues in several countries while worsening public finances cause direct losses on sovereign bonds. - ECB liquidity provision has in some cases led to further sovereign bond purchases by banks, deepening the sovereign-bank link. - Where perceptions of sovereign and banking risks rise, financing conditions deteriorate and accelerate re-fragmentation of the euro area financial market. - A banking union would help address these underlying problems by weakening the sovereign-bank nexus and reducing financial fragmentation. ### Fiscal union: links to banking union and governance steps - Complementarity: - Fiscal integration supports a banking union through common backstops for deposit insurance and bank resolution and by delegation of national sovereignty to the center via unified regulatory and supervisory frameworks. - Recent governance steps: - The Fiscal Compact and the proposed "Two Pack" are identified as important steps toward stronger governance. - The Compact re-commits signatories to fiscal discipline of the original Stability and Growth Pact (SGP) while offering some necessary short-term flexibility. - The "two pack" will reinforce the European Commission’s influence over national budgetary plans and oversight of budgetary execution, better aligning national fiscal policy with common objectives. - Ex ante fiscal risk sharing: - Some fiscal risk sharing is currently provided after crises through EFSM, EFSF, and ESM—this ex post approach can be expensive and create recurring market doubts about resource adequacy. - By contrast, ex ante risk sharing (common in Switzerland, the United States) provides transfers and central provision of public goods that smooth shocks more effectively. ### Roadmap and staged approaches to fiscal integration - Political and legal constraints: - Large-scale fiscal integration (large central resources) implies a form of political union requiring changes to the EU treaty and national constitutions; this will take time. - The process should start with a clear commitment to broad-based dialogue and deliver a schedule of discussion, decision, and implementation. - Limited-but-scalable common debt as a starting point: - Introduction of common euro area debt securities could be restricted initially to shorter maturities and small size, conditional on centralized control (e.g., veto powers over national deficits, pledging of national tax revenues). - Proposals discussed include "Eurobills" (close to this approach) and "the redemption fund" (also limited). - Common bond financing could be used to provide backstops for common frameworks within the banking union. *Source: IMF staff chapter excerpt from _cr12181 - 12. But the crisis calls for a much stronger collective effort now to demonstrate.* ### 23. The ECB can provide further defenses against an escalation of the crisis. These could ### _cr12181 - 23. The ECB can provide further defenses against an escalation of the crisis. These could ### Impaired monetary transmission (Box 4) - Since late 2010, retail lending rates began to rise while the ECB policy rate remained low; the speed of adjustment and the long-run impact of ECB policy rate changes on a variety of retail interest rates have declined across many euro area countries. - Drivers of weakened pass-through: - Increased sovereign stress: banks’ wholesale funding and lending rates are priced off (domestic) sovereign yields; the impact of ECB policy rate changes on domestic bond yields has weakened as markets differentiate between core and periphery countries. - Weak bank capital and liquidity: panel estimation for 100 euro area banks (Q1:2007–Q1:2012) finds: - Banks’ quarterly lending growth was significantly higher for larger, more profitable, more liquid and better capitalized banks. - Banks with higher loan/deposit ratio mismatch and higher CDS spreads lent significantly less. - Bank lending was substantially higher in countries with higher GDP growth and higher house prices. - Evidence that policy support helped: ECB policy rate reductions and larger liquidity provision were associated with higher bank lending; a higher ECB-EONIA spread was associated with lower bank lending. - Policy implication: improving bank soundness and relieving sovereign stress will help underpin lending in the euro area. ### Monetary policy options to defend against escalation - Interest rate reductions - Economic weakness and downside risks to inflation warrant further reductions in the main policy rates. - Room for reductions is limited, but reductions would deliver a strong signaling effect and provide some direct near-term support to weaker banks by reducing indexed borrowing costs under existing LTROs. - Quantitative easing (QE) - A transparent QE program encompassing sizable sovereign bond purchases, possibly preannounced over a given period, could achieve further monetary easing. - Buying a representative portfolio of long-term government bonds—e.g., defined equitably across the euro area by GDP weights—would provide added stability to stressed sovereign markets. - QE would likely contribute to lower yields in already “low yield” countries, including Germany. - More SMP purchases - Additional and clearly communicated Securities Markets Programme (SMP) purchases could ensure transmission of monetary easing where sovereign bond markets are subject to increased stress. - With the possible exception of Greece, SMP purchases have been relatively small compared with outstanding debt stock, increasing the scope for additional intervention. - A well-communicated re-activation of SMP purchases would likely carry strong signaling effects and might mitigate the need for very large purchases. - Lower yields would ease collateral constraints on official and interbank lending facilities. - Further liquidity provision (LTROs and collateral adjustments) - Additional multi-year LTRO facilities, coupled with adjusted collateral requirements (broadened collateral base and/or a lowering of haircuts), could address localized shortages. - The credit risk to the ECB from such operations would be manageable given its strong balance sheet and high levels of capital provisioning. - One disadvantage: LTROs tend to strengthen sovereign-bank links (see Box 5). ### LTROs, collateral capacity, and haircut issues (Box 5) - Past LTROs and collateral changes: - Through two three-year LTROs and a further relaxation in collateral rules, the ECB allotted €1 trillion to euro area banks, with a net increase in liquidity of about €500 billion. - For the second LTRO the ECB expanded eligible collateral to include additional performing credit claims (i.e., bank loans). - System-wide collateral capacity and borrowing: - LTRO borrowings are around €1.1 trillion (end May). - Marketable collateral eligible for Eurosystem operations is about €13 trillion (not all held by banks). - Substantial non-marketable collateral is evidenced by €3 trillion pre-pledged collateral (typically non-marketable). - This could allow borrowing of up to €2.4 trillion (assuming haircuts of 20 percent). - Remaining risks and national differences: - Some individual banks—mainly in the periphery—could be short of collateral; Greek and Irish banks already use national ELA with a wider collateral pool. - In Spain, assuming stability of domestic deposits, collateral and liquidity buffers appear sufficient at the system level, but posted collateral is vulnerable to ratings downgrades and margin calls while the capacity to generate new collateral is weakening. - Phasing-out of ECB funding will likely prove problematic if market access does not improve; liquidity risk can potentially become the biggest risk should ECB support not be renewed. - Collateral valuation and haircut policy concerns: - The ECB assesses collateral using market prices or “mark to model” and applies haircuts to allow for quick sale without loss; this is pro-cyclical. - A fire sale valuation approach in systemic liquidity crises would require large haircuts, but imposing large haircuts as part of LTROs can reduce liquidity and force asset sales at distressed prices—exactly what LTROs aim to prevent. - Historical comparison: ECB required a haircut of 20 percent (later reduced to 12 percent with weekly margining); the Swiss National Bank required a zero initial haircut but used daily variation margining. ### Seniority clarification and crisis management effectiveness - Clarifying the seniority status of the ECB’s sovereign bond holdings would make crisis response more effective; market concerns about subordination of private sovereign bond holdings need to be addressed. - Similar clarification should apply to the ESM; a clear commitment to accept equal status with private sector claims, as in the case of Spain, would enhance official sector crisis management effectiveness. ### Backstopping the banking system and use of the European firewall - Policymakers must be ready to support the euro area banking system if the crisis escalates, including flexible use of the European firewall. - Clarity on common support—foremost by the ECB, but possibly including announcing a pan-European deposit insurance scheme—may be necessary to support depositor confidence. - EFSF/ESM facilities should be ratified quickly and empowered with sufficient flexibility and resources to support banks of member states; the June 28-29 summit decision to consider direct bank recapitalization marks important progress. - Existing EFSF/ESM framework could provide financing for common deposit insurance and resolution frameworks in the short run. ### Fiscal consolidation and growth-friendly design - Most euro area countries plan significant fiscal adjustment over the medium term to reduce deficits and debt that have risen sharply. - Challenge: implement consolidation plans without exacerbating adverse feedback loops with the real economy. - Countries under market pressure must proceed rapidly; elsewhere adjustment should be at a steady underlying pace balancing deficit reduction and recovery support. - Policy guidance: - Focus fiscal targets on structural, rather than nominal, deficits to avoid automatic damaging rounds of cuts from unanticipated shocks. - Exploit flexibility in the Fiscal Compact and anchor consolidation in fully-specified multi-year plans with measures identified in advance to increase credibility and mitigate negative demand effects. ### National actions to restore banking and confidence - Timely and credible national actions remain integral: - Implement transparent and comprehensive strategies to recapitalize viable banks without delay. - Independent assessments of banks’ loan books, dealing with legacy assets, and strengthening supervision and regulatory frameworks are key to restore confidence. - Policy actions to restore public finance health and structural measures (labor and product market reforms) will support confidence and anchor medium-term expectations. ### External imbalances, current account, and exchange rate assessment - Euro area external position: - The current account balance of the Euro area was, on average, zero for 1999–2006; since 2008 the balance has dipped slightly. - The net foreign asset position deteriorated to nearly -17 percent of GDP but has since recovered to -12 percent of GDP. - Staff assessment and desirable adjustment: - The Euro area external position appears moderately weaker than implied by medium-term fundamentals and desired policies. - A modest improvement in the current account, in the order of 1 percentage point of GDP, would be desirable to ensure external sustainability. - The euro is assessed to be overvalued in real terms by 0 to 5 percent. - Note: since this analysis, the euro has depreciated by nearly 2 percent in real terms. - Large bilateral imbalances within the euro area: - From inception of the euro, current account deficits by individual member states cumulated to nearly 20 percent of euro area GDP in 2011, while surpluses cumulated to over 20 percent during the same period. - During the crisis, deficit economies’ external balances have narrowed—e.g., Greece to -10 percent, Ireland to balance—largely via falling imports from sharp declines in domestic demand. - Cost adjustment has been limited: unit labor costs of deficit economies such as Greece, Portugal, and Spain declined, on average, by 1 to 2½ percent per year in 2010–11. - Required real exchange rate adjustments for individual economies: - Italy: required adjustment in the order of 5 to 10 percent. - Spain: required adjustment in the order of 10 to 15 percent. ### Structural policies to address imbalances and raise trend growth - In deficit economies: - Improve competitiveness of tradable sectors via policies that reduce unit labor costs: labor market flexibility, reducing entry costs in product markets, raising labor productivity. - Address non-price competitiveness through microeconomic reforms to help small firms expand into foreign markets. - In surplus economies: - Product market reforms—especially in services—are a priority. - Improvements in disposable incomes in surplus economies could have beneficial spillovers to deficit economies via higher external demand. - Improvements in non-tradables productivity should be matched by nominal wage increases to facilitate relative price adjustment. - Short-run role for price adjustment: - Wage and asset price increases in the north would reduce high current account surpluses and facilitate relative price adjustment by the south. - Larger inflation differentials, for a given euro area inflation level, would reduce the risk of debt-deflation spirals in the south. *Prepared from the IMF chapter text.* ### 35. Weak trend growth has fuelled the crisis. An important reason why bank and sovereign ### _cr12181 - 35. Weak trend growth has fuelled the crisis. An important reason why bank and sovereign ### Key findings on growth and crisis dynamics - Weak trend growth has made bank and sovereign problems difficult to resolve due to fragile debt dynamics in an environment of low growth and poor growth prospects. - Private capital has fled some economies, reflecting increasing doubts about the ability of member states to service debt, and demand for official funding has increased. - The risk of stagnation is rising as unemployment increases and the proportion of youth and long-term unemployed grows, threatening potential output as new workers fail to enter the workforce and existing unemployed workers lose skills. - Productivity growth has weakened over time and effective labor utilization has been relatively low in the euro area. - Demographic pressures: low and declining population growth imply substantial increases within the space of a generation in the ratio of dependents to those of working age. ### Structural reform opportunities and quantitative impact - Four critical reform areas identified: - Changes to labor market institutions to improve labor market performance. - Product market reforms to raise competition and lower regulatory burdens. - Tax reforms to switch away from labor income to consumption tax revenues and smooth marginal taxes to raise labor participation. - Pension reforms to ease revenue burdens and encourage increased labor effort. - Estimated gains: - Eliminating half of euro area countries’ gaps with OECD best practice in labor market, product market, tax, and pension policies could raise output by 5 percent over 5 years. - Spillovers: estimates suggest spillovers could account for one quarter of the total gains in growth. ### Short-run considerations and demand support - Full effects of reforms are likely to take time to materialize; some reforms (e.g., active labor market policies such as retraining) can have immediate effects if implemented well. - Reasons for lags include time to implement reforms, costs of reallocating resources across sectors, and uncertainty deterring long-term commitments. - Reforms might have negative short-run employment effects, especially if labor market measures are not accompanied by product market reforms. - With large economic slack, some reforms might initially reduce disposable income if unemployment rises; therefore, support for aggregate demand in the short run is crucial (see ¶23 and ¶26 referenced in source). ### Authorities’ views (summary) - Broad agreement with staff on the scale of the crisis and need for clear statements on the long-run architecture of the monetary union. - Authorities (the ECB and European Commission) stressed importance of deeper monetary integration through a banking union and a credible architecture for more fiscal integration to stabilize the immediate crisis and anchor EMU viability. - Authorities noted a rebalancing of growth composition away from domestic demand toward net trade, driven mainly by import compression. - Authorities emphasized headwinds from private balance sheet deleveraging, credit supply constraints, fiscal consolidation, and weak confidence; they project a recovery in domestic demand from the middle of this year driven by improving real incomes and confidence, rising external demand, and lower global commodity prices. - On inflation: authorities (ECB) stressed near-term inflationary pressures from higher energy prices, a weaker euro, and indirect tax effects; they expect inflationary pressures to decline ahead but do not expect strong disinflationary pressures given still well-anchored inflation expectations. - Increased financial market fragmentation is impeding the effectiveness of monetary policy; divergences in liquidity conditions and market lending rates weaken the interest rate channel; limits to the effectiveness of additional unconventional measures were noted, though not excluded. - Fiscal policy: agreement that the 3 percent nominal deficit target was binding for several countries in the near-term; flexibility in SGP/Fiscal Compact should be exercised if slippages are due to negative growth surprises; emphasis on structural rather than nominal fiscal targets. - Broad agreement on urgent need for a banking union encompassing area-wide supervision, deposit insurance and resolution frameworks with common backstops; flexibility in the ESM treaty could be used to establish new financial instruments, including allowing the ESM to directly inject equity into banks. - A credible roadmap for fiscal integration with intermediate steps (e.g., strong implementation of the “two-pack” and some limited form of joint borrowing) would raise confidence; meaningful fiscal integration would entail a stronger center with enhanced fiscal responsibilities, sufficiently large resources, and democratic controls. ### Staff appraisal and policy recommendations - Current environment: financial and economic environment continues to deteriorate; investors are withholding funding from member states most in need, moving capital to safe havens and driving risk premiums to new records; demand is weakening and unemployment increasing across the euro area; lower growth and heightened market stress compound difficulties in reducing debt burdens. - Recent actions taken: - ECB lowered policy rates and conducted special liquidity interventions. - Larger European and global firewall will provide more liquidity insurance to sovereigns. - Ongoing reform of fiscal governance, especially adoption of the Fiscal Compact, will help strengthen budgetary discipline. - National governments have embarked on fiscal consolidation and reaffirmed commitment to debt sustainability and deficit targets. - The June 28-29 summit set in motion a process toward a single supervisory mechanism, with the possibility of using the ESM to recapitalize banks directly. - Need for stronger collective effort: downward spirals between sovereigns, banks, and the real economy are strong; liquidity operations’ effectiveness has diminished as bank solvency concerns increased; absent collective mechanisms to break adverse feedback loops, crisis has spilled across euro area countries; contagion from further intensification would be sizable globally and particularly large for neighboring EU economies. - Priority actions recommended: - A strong commitment toward a robust and complete monetary union with a credible path to a banking union and greater fiscal integration, better governance, and more risk sharing; this requires a clear timeline with concrete intermediate actions. - Immediate priority: a banking union for the euro area, going beyond current proposals: - Establish a deposit guarantee scheme with a common backstop at the regional level to break links between domestic banks and their sovereigns and support depositor confidence. - Create a common bank resolution authority backed by a common resolution fund to ensure burden sharing and limit fiscal costs. - Support these efforts with a single supervisory mechanism and a macro-prudential framework to forestall further financial fragmentation. - More fiscal integration with risk sharing supported by stronger central governance to reduce spillovers from country-specific shocks; process should start with a broad-based dialogue delivering a schedule for discussion, decision, and implementation. - Introduce a limited form of common debt with appropriate governance safeguards as an intermediate step toward fiscal integration and risk sharing: - Common debt securities could be restricted initially to shorter maturities and small size and be conditional on more centralized control (e.g., limited to countries that deliver on policy commitments; veto powers over national deficits; pledging of national tax revenues). - Common bonds/bills financing could be used to provide backstops for common frameworks within the banking union. - Structural reforms to restore growth: - Address long-standing structural rigidities to raise long-term growth prospects. - Labor market reforms to raise participation and address disparities confining “outsiders” to low-wage, temporary jobs. - Southern Europe: increase competitiveness in the tradables sector; targeted investment in infrastructure and human capital to support growth and employment. - Northern Europe: product market reforms to generate a more vibrant services sector and raise productivity. - Improve competitiveness within the euro area: - Services sector reforms in surplus economies to improve disposable incomes and increase external demand for deficit economies. - Lower unit labor costs in tradables sector for deficit countries via productivity-enhancing reforms (e.g., lowering barriers to entry, easing small firms’ expansion into foreign markets) and labor market measures aligning nominal wages with productivity growth. - Monetary policy should ensure overall inflation does not drop far below two percent for the euro area as a whole, while allowing larger inflation differentials between North and South. ### Global implications and call for action - The global economic outlook is weakening, partly reflecting the fragile situation in the euro area. - Given Europe’s important role in the global economy, euro area policymakers should strengthen the crisis response through further decisive and collective action. - Setting out a credible long-term vision for the monetary union and boosting the near-term crisis response will provide much needed support to the global economic recovery. *Source: _cr12181 (IMF staff report; extract provided in content unit)* ### 60. The staff proposes that the next consultation on euro area policies in the context of the ### _cr12181 - 60. The staff proposes that the next consultation on euro area policies in the context of the ### Short-term activity indicators and labor market - Early 2012: some short-term activity indicators showed tentative signs of stabilization at low levels amid considerable volatility; performance differed markedly across countries. - Indicators shown (indices and series referenced): - Industrial Production Excl. Construction (2006 = 100) — series for Euro area, Germany, France, Italy, Spain. - Business Confidence (ESI, long-term average = 100) — series for Euro area, Germany, France, Italy. - Unemployment Rate (Percent) — series for Euro area, Germany, France, Italy, Spain. - Household Confidence (Percentage points; balance of opinions) — series for Euro area, Germany, France, Italy, Spain. - PMI: Composite Output (SA, 50+=Expansion) — Euro area, Germany, France, Italy, Spain. - PMI: Composite New Orders (SA, 50+=Expansion) — Euro area, Germany, France, Italy, Spain. ### Inflation developments and underlying price pressures - Narrative findings: - "Inflation is coming down as base effects from past food and energy price increases disappear..." - "...and administered price and indirect tax increases do not translate into higher core inflation." - "As for underlying price pressures, firm input prices and profits have fallen over the past year..." - "And broad M3 money growth signals no imminent inflation risks." - "...and also wage pressures remain contained." - "Inflation expectations remain well-anchored, but some market indicators signal much lower inflation ahead." - "Eventually, LTROs could be countereffective as they increase asset encumbrance and create collateral shortages." - Selected indexed and percent series (as presented): - M3 increasing at 4.5 % - Labor Costs (Year-on-year percent change): Unit labour costs; Compensation per employee; Hourly labour costs; Negotiated wages (series 2001–2012 shown in figures). - Euro Area Inflation Indices (Jan.2010=100): Administered prices; Headline; Constant taxes; Core (series shown Jan-10 to Jan-12). - Market and Survey-based Inflation: 5-year forward 5 years ahead break-even inflation rate; Consensus 5-year inflation expectation; 5-year inflation rate expectation (series 2008–2012). ### Fiscal outlook and consolidation (Figures 3a and 3b) - Key assessments: - 2011 deficit and debt levels are well above targets: references to "60 percent of GDP Debt Limit" and "3 percent of GDP Deficit Limit". - Planned fiscal consolidation is substantial and largely frontloaded. - Planned consolidation allows debt ratio to peak earlier and at a lower level than in other economies. - Fiscal consolidation challenges shown across countries: required adjustments in cyclically-adjusted primary balance (CAPB); shrinking fiscal space in many countries; weak growth adding to the challenge. - Charts and relationships described: - Relationship between 5-Year Bond Yield and Required Adjustment in CAPB (R² = 0.6422). - Relationship between Real GDP growth 2011-12 and Required Adjustment in CAPB (R² = 0.234). - Countries illustrated with large required adjustments and frontloaded cumulative changes 2011-13 and 2013-17. ### LTROs, ECB balance sheet, and bank funding (Figure 4) - Effects and findings: - The 3-year LTROs were extreme in terms of size and average allotment per bidder. - LTROs led to a sizable expansion and maturity lengthening of the ECB balance sheet (longer-term refinancing operations vs. main (weekly) refinancing operations; SMP; CBPP). - Bank reliance on ECB funding: ECB funding dependence of periphery banks increased substantially (series for Greece, Ireland, Portugal, Spain, Italy vs. rest of euro area). - Created room for sovereign carry trade strategies; increased banks' sovereign bond holdings (percent of bank assets). - Asset encumbrance rose: "ECB LTRO; ECB (before LTRO); covered bonds; repo" — Asset Encumbrance 2007 and Feb.2012 (Percent of bank assets). - Policy concern: LTROs could be counterproductive by increasing asset encumbrance and creating collateral shortages. ### Staff projection (Table 1: Euro Area: Main Economic Indicators, 2007-2014) - Demand and Supply (growth contributions and levels presented as in source): - Real GDP: 3.00.4-4.31.91.5-0.30.71.3 - Private consumption: 1.70.4-1.20.90.2-0.50.51.0 - Public consumption: 2.22.32.50.50.0-0.7-0.40.2 - Gross fixed investment: 4.7-1.1-12.1-0.51.3-2.41.11.8 - Final domestic demand: 2.40.5-2.80.50.4-0.90.41.0 - Stockbuilding 1/: 0.4-0.1-1.00.70.1-0.5-0.10.0 - Domestic Demand: 2.80.3-3.71.20.4-1.30.41.0 - Foreign balance 1/: 0.20.1-0.60.71.11.00.30.3 - Exports 2/: 6.61.0-12.711.26.22.13.13.8 - Imports 2/: 6.20.9-11.79.63.8-0.22.73.3 - Resource Utilization: - Potential GDP: 1.71.40.80.70.60.50.70.8 - Output gap: 2.71.6-3.6-2.4-1.5-2.3-2.3-1.9 - Employment: 1.80.7-1.8-0.50.1-0.70.10.6 - Unemployment rate 3/: 7.67.79.610.110.211.111.311.1 - Prices: - GDP deflator: 2.42.00.90.71.31.91.41.5 - Consumer prices: 2.13.30.31.62.72.21.61.5 - Public Finance 4/ (percent of GDP): - General government balance: -0.7-2.1-6.4-6.2-4.1-3.2-2.5-2.0 - General government structural balance: -2.3-2.9-4.4-4.2-3.1-1.7-1.1-0.9 - General government gross debt: 66.470.280.085.888.191.492.492.2 - Interest Rates 3/ 5/: - EURIBOR 3-month offered rate: 4.34.61.20.81.40.7...... - 10-year government benchmark bond yield: 4.34.44.03.84.33.5...... - Exchange Rates 5/: - U.S. dollar per euro: 1.371.471.391.331.391.28...... - Nominal effective rate (2000=100): 103.7108.7110.9103.2104.299.3...... - Real effective rate (2000=100) 6/: 100.9103.4104.095.395.089.8...... - External Sector 4/ 7/: - Current account balance: 0.1-1.6-0.2-0.10.00.91.01.1 ### Balance of payments highlights (Table 2) - Current account (billions of euros) and percent of GDP breakdown (selected lines preserved as presented): - Current account (levels): 20.960.810.9-12.77.3-143.4-22.0-6.9-3.2 - Goods: 98.794.142.28.142.3-21.831.215.04.9 - Services: 22.532.939.642.547.942.036.549.661.0 - Income: -44.8-6.82.416.65.3-66.83.431.731.8 - Current transfers: -56.1-59.5-73.4-79.6-87.9-97.1-93.1-103.3-100.6 - Capital account: 12.216.612.09.64.810.06.56.410.8 - Financial account: -14.0-78.6-35.2-6.23.1121.39.4-2.7-24.6 - Direct investment: -9.7-79.4-203.9-159.6-90.4-231.2-105.1-113.8-151.0 - Portfolio investment: 54.444.1106.4186.0126.8261.4265.8165.1308.1 - Equity: 32.8-2.3103.789.2102.0-14.771.867.4189.5 - Debt instruments: 21.346.72.496.524.9276.3193.997.8118.9 - Financial derivatives: -13.7-8.3-17.3-0.7-67.0-84.619.918.4-20.8 - Other investment: -72.8-47.962.1-30.938.7178.8-175.7-61.7-150.8 - Reserve assets: 28.012.618.2-1.1-4.9-3.44.6-10.5-10.1 - Errors and omissions: -19.11.112.49.4-15.112.25.72.917.0 - Memorandum items: - GDP (billions of euros): 7,546.9 7,860.4 8,145.4 8,564.9 9,030.2 9,244.3 8,930.1 9,160.9 9,425.8 - Reserves of the eurosystem 1/ (billions of euros): 306.7281320.1325.8347.2374.2462.4591.2667.1 ### IMF policy recommendations for selected countries (Table 3) - Greece — Fiscal Policies and Reforms: - Specify and legislate remaining revenue and expenditure measures necessary to achieve the medium-term fiscal target. - Undertake fiscal institutional reforms to improve revenue collection and prevent expenditure arrears. - Greece — Financial Sector Reforms: - Finalize recapitalization strategy for viable banks and establish timeframe for capital raising. - Finalize plans to address state-owned banks in a least cost manner (while protecting depositors). - Greece — Structural Reforms: - Improve competitiveness through labor market reforms, product and service market liberalization, and business environment reforms. - Ireland — Fiscal Policies and Reforms: - Accommodate a revenue shortfall if growth weakens notably in 2012 to help protect the fragile recovery. - Specify measures to underpin the 2013-15 fiscal consolidation by Budget 2013, including targeting of social welfare. - Implement fiscal institutional reforms through the Fiscal Responsibility Bill and give a statutory basis to the medium-term expenditure ceilings. - Ireland — Financial Sector Reforms: - Implement PTSB restructuring carefully to put it on a sound footing, including through timely separation of certain legacy assets. - Strengthen banks’ capacity to manage distressed loans to help restore their viability and restart lending. - Prepare the new personal insolvency framework to address household debt distress while protecting debt service discipline. - Ireland — Structural Reforms: - Fully implement Pathways to Work strategy, increase resources for engaging with jobseekers, possibly through private employment services. - Implement asset sales in 2013 and reinvest a portion of proceeds, but strengthen competition enforcement. - Review structure of social payments to avoid unemployment traps, especially for the long-term unemployed. - Portugal — Fiscal Policies and Reforms: - Adhere to programmed fiscal targets, but avoid excessive structural adjustment in case of weaker growth and employment. - Ensure timely implementation of PFM reform agenda. - Reduce contingent liabilities through timely, planned SOE restructuring. - Portugal — Financial Sector Reforms: - Avert a credit crunch by ensuring alignment of bank deleveraging plans with available credit supply. - Strengthen the capital buffers of the largest banks in line with program targets. - Strengthen the supervision and resolution framework. - Portugal — Structural Reforms: - Ensure competitiveness gains through accelerated supply side reforms, notably the labor code and product market reforms. - Address structural weaknesses in wage setting mechanisms and the judicial system. - Italy — Fiscal Policies and Reforms: - Lower taxes supported by expenditure cuts to better distribute the burden of adjustment and help growth. - To build buffers, target an overall structural surplus of 1 percent of GDP as the anchor for the new fiscal rule; legislate medium-term expenditure cuts in next year’s budget to lock in gains. - Strengthen fiscal institutions by ensuring independence of fiscal council, adopting multi-year expenditure frameworks, and merging the various spending reviews into a central role in the budget process. - Italy — Financial Sector Reforms: - Strengthen capital and liquidity buffers by raising equity and/or disposing of noncore assets. - Conduct and publish stress tests on banks not covered by the EBA. - Encourage banks to devise strategies for selling, restructuring or writing down impaired loans. - Strengthen the crisis management framework in line with the forthcoming EU Directive. - Italy — Structural Reforms: - Raise productivity in services by accelerating reforms in energy, local public, and professional services sectors to reduce the cost of doing business and increase competition. - Curb state involvement in the economy. - Implement labor market reform to reduce duality, increase participation, and decentralize wage setting. - Promote SME growth by improving access to financing and reducing start-up costs and regulatory hurdles. - Spain — Fiscal Policies and Reforms: - Make the fiscal adjustment less front loaded and embed in a more prudent macro framework. - Increase role of revenue measures, especially indirect taxes. - Apply sanctions on regional government finances and improve their transparency. - Spain — Financial Sector Reforms: - Communicate comprehensive strategy, including triaging banks according to the independent valuations, and managing legacy assets. - Enhance crisis management and resolution framework. - Spain — Structural Reforms: - Implement approved labor market reforms and other planned structural reforms. ### Appendix I: Statistical issues - General: - Statistics for the EU and the euro area are collected by Eurostat from national statistical institutes; generally sufficient for macroeconomic surveillance. - The appendix summarizes ongoing developments and desirable improvements. - Code of Practice: - The Code of Practice for the European Statistical System has been revised to reaffirm principles from 2005 and reinforce statistical independence, statistical use of administrative data, and quality management. - Mapping of the revised code and other existing quality frameworks, including the Fund’s DQAF, with the new UN Generic National Quality Assurance Framework was presented at the UN Statistical Commission in 2012. - The UN Committee for the Coordination of Statistical Activities was invited to harmonize different quality assessment frameworks. - National Accounts initiatives: - NACE Rev. 2: Annual and quarterly euro area aggregates starting in 2000 were released in December 2011 (three months behind schedule due to late reporting by some countries). The legal deadline for reporting long time series 1995-2000 according to NACE rev2 is end-September 2012, which will allow EU/EA aggregates to be released by December 2012. Eurostat expects no significant changes in countries’ GDP under the new method. - ESA 2010: Countries are expected to adopt the new system by September 2014. Supporting legal framework under discussion; main challenges include timeliness improvements (from t+70 to t+60 days), backward calculation of time series, and transmission of supplementary tables on pension schemes based on SNA 2008 standards (resisted by some countries). - Data Gaps Initiative: Eurostat is collaborating with the Inter-Agency Group (IAG). IAG members agreed on a template for reporting quarterly financial and non-financial accounts by institutional sectors. Agreement with member countries is essential to enable provision at both annual and quarterly frequencies. *Italic: IMF staff report content as presented in the source document.* ### 3. The new Macroeconomic Imbalances Procedure has involved considerable data ### 3. The new Macroeconomic Imbalances Procedure has involved considerable data collection since last year’s consultation ### Data collection, scoreboard, and institutional collaboration - Eurostat and the national statistical institutes worked closely with the European Commission (DG ECFIN) and the ECB during 2011 to set up a scoreboard of indicators to assess internal and external imbalances (the Macroeconomic Imbalances Procedure). - Eurostat has created a new platform collecting all relevant indicators, which will be updated on an annual basis. - Remaining data work areas include: - house price developments; and - the compilation of private sector debt, where consistency issues exist in the recording of intra-company loans and the treatment of Special Purpose Entities (i.e., holding companies). - Indicators in the scoreboard comprise: - the current account balance (as percentage of GDP), - the net international investment position (as percentage of GDP), - export market shares (goods and services) measures in values, - nominal unit labor costs, - HICP-based real effective exchange rates relative to 35 industrial partners, - private sector debt (percent of GDP), - general government debt (percent of GDP), - private sector credit flow (percent of GDP), - house prices relative to consumption deflator, and - the unemployment rate. ### Property market data under the Principal European Economic Indicators (PEEIs) strategy - Residential property prices: - Eurostat is currently releasing quarterly house price data. - A new regulation entering into force in autumn 2012 will require data transmission at t+85 days. - Monthly data is unlikely to become available in the near future with full coverage. - Although comparability issues remain, harmonization at EU level has been steadily improving. - Recommendation: more should be done to flag countries whose coverage and/or methodology are not fully in line with the harmonized rules to help economic analysis. - Indicator on house sales: - Eurostat expects that a harmonized indicator can be obtained as a byproduct of improvements in transaction price quarterly indexes of residential properties. - Staff view: where house price indices are derived from a comprehensive and timely Land Registry, sales data could be a useful byproduct. - Commercial Property Price Indices (CPPIs): - Collaboration between international organizations (including the Fund) is underway to set standards for the compilation of CPPIs. - Eurostat, as lead agency, has organized a tender for developing an international Handbook on best practices for compiling such indices. - Current situation: data are sparse and of variable quality; given the importance of CPPIs, pursuing improved standards and coverage is warranted. ### HICP seasonal products treatment and impact disclosure - Agreement: more information should be provided to explain the impact of the new treatment of seasonal products on the HICP introduced last year. - Action taken: Eurostat has published an impact report (updated regularly) for each country. - Observation: for several countries the effects were quite marked. - Staff request: more information should be provided on the underlying reasons for changes, especially those due to the changes in methodology. ### Quarterly government finance statistics dissemination - Eurostat is working towards improved dissemination of quarterly government finance statistics, including: - improvement of timelines; and - production of a new press release on quarterly government debt and actions. - Outstanding issue: a few countries still restrict the dissemination of quarterly government finance statistics for the first quarters of the year because of quality concerns. - New element in the quarterly statistics: data on intergovernmental lending that will avoid double-counting through consolidation. ### Directive on national fiscal frameworks and public sector statistics - The Directive on national fiscal frameworks calls for the dissemination of monthly data on government operations and balance sheet. - This poses considerable challenges to government finance statistics compilers. - Data are expected to be disseminated from 2014. - Provision of additional data on public sector statistics is even more demanding. - Current analysis of public finances is limited to the general government sector, following the ESA 95 and Excessive Deficit Procedure concepts. - Given their magnitude in many countries, a fully-fledged register of debt and deficits of public corporations is essential to the assessment of fiscal risks. - Eurostat is working closely with member states to publish new chapters on the ESA 95 Manual on Government Deficit and Debt. *International Monetary Fund — excerpt from the chapter titled "The new Macroeconomic Imbalances Procedure has involved considerable data collection since last year’s consultation."* ### 8. Work continues to modernize Balance of Payments statistics: ### 8. Work continues to modernize Balance of Payments statistics ### BPM6 implementation - The Regulation introducing BPM6 should be adopted "in a matter of weeks." - Eurostat is engaged with countries to ensure the swift implementation of the new methodology. - The 2014 deadline is mandatory and no derogations are envisaged; countries should adhere to the deadline. ### Intrastat reporting - Easing the reporting burden for international trade statistics remains a priority. - Eurostat is encouraging countries to collect and exchange micro-export data with other trade partners. - Collecting and exchanging micro-export data would allow for more flexibility compared with the current system, which also requires the reporting of import data. ### Bilateral exchange of micro-data for FDI - The tool has proved useful to enhance data quality. - Eurostat and staff concurred that compulsory reporting would be required to perfect the system. ### Asymmetries in trade statistics - Asymmetries persist but they are limited and stable over time. - Eurostat engages with countries in regular “reconciliation rounds” that facilitate the exchange of micro data. - Due to technical limitations faced by some countries, the rounds are voluntary. - Eurostat’s efforts to develop tools to resolve this issue are welcome. *Source: _cr12181 - 8. Work continues to modernize Balance of Payments statistics* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12181.pdf_