Euro Area At The Crossroads: No Time For Complacency

IMF News, July 8, 2016

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Publication date: July 8, 2016
Recovery: "The fragile recovery that started in the euro area in 2014 has strengthened on account of consumer spending as more people find jobs, lower oil prices, a neutral fiscal stance, and accommodative monetary policy."
Medium-term outlook: "Inflation remains too low, and weak investment, still high unemployment, and the aging of the population will continue to hurt productivity, raising the risk of stagnation."
Central judgment: "The euro area is at a critical juncture... Muddling through is increasingly untenable," said Mahmood Pradhan, mission chief for the euro area.

Rising political risk: "The subdued economic outlook is exacerbated by rising political risk in the euro area and the European Union (EU)."
Euroscepticism and political divisions hinder collective decision-making on common challenges (for example, the refugee surge and security concerns).
Specific geopolitical uncertainty: "The recent United Kingdom referendum is likely to lead to persistent uncertainty regarding its new status vis-à-vis the EU."
External risk: "A slowdown in global growth could also undermine the recovery and raise the likelihood of stagnation."

Collective action required: "Unless collective problems are resolved, the euro area is likely to suffer repeated bouts of economic and political instability leading to crises of confidence and economic setbacks."
Rebuild support for economic integration to "rebuild flagging faith in the monetary union."
Refugee policy: "Countries should rapidly integrate refugees into their labor markets, while the block should reform its common border and asylum policy to protect social cohesion and preserve the single market."

Main goal: "A big push on structural reforms to improve the business climate and employment" to counter risk of stagnation.
Specific reform priorities:
- "Easier access to the professional and retail service sectors."
- "More efficient public administrations."
- "Stronger insolvency regimes."
- "A fully functional single market in services, energy, transport, digital commerce, and free trade agreements."
Labor market policies:
- "Shrinking the cost of hiring workers and expanding cost effective active labor market policies can draw more workers into the workforce."
- Reduce "excessive protection for workers on regular contracts and overly generous financial disincentives for entering the labor market."
Accountability and governance:
- Base reform agenda on "benchmarks related to reform outcomes that are directly under the control of policymakers."
- "Even-handedly enforce the EU’s economic governance rules."

Constraint: "Laden with high public debt, most euro area countries can ill afford to provide the fiscal support that is necessary to boost demand."
Recommendations for national fiscal policy:
- Change "the composition of fiscal policy in a manner that supports growth."
- Use "the interest savings generated by easy monetary conditions to pay down their debt and rebuild buffers."
- Countries with budgetary space should "use it to boost investment and support reforms."
Role for the EU:
- Provide "new or additional funds to support common investment projects such as in energy transmission and refugee settlement" where national demand is low and fiscal room lacking.
- Over the longer run, the EU should "have the capacity to stabilize economic cycles."
Conditions and safeguards:
- Centralized support should be conditional on "stronger enforcement of the fiscal rules of the zone."
- Access "should therefore be conditional on compliance and the implementation of structural reforms."
- In the medium-term, "the fiscal framework should be simplified as it has become too complex following successive reforms."

Current policy: "The European Central Bank’s supportive monetary policy of bond purchases and negative interest rates has helped ease financial conditions and the supply of credit."
If inflation worsens: "But if inflation stays stubbornly low or dips further, additional monetary easing will be necessary, mainly through larger asset purchases."
Policy implication: Maintain accommodative monetary policy and be prepared to expand asset purchases if needed.

Banking challenges:
- "Banking sector profits have remained subdued, making it difficult to raise new capital."
- Need for faster removal of nonperforming loans: "Banks need to off-load bad loans at a faster pace in order to restore financial health and further expand credit."
Supervisory and structural measures:
- Encourage consolidation of the banking system.
- Set "ambitious targets for shedding bad assets" and apply "less national discretion in banking supervision."
- Improve bankruptcy frameworks and develop "a market for distressed debt."
Banking union completion:
- A "common deposit insurance scheme with a common fiscal backstop is essential to completing the banking union."
- Rapidly put in place "The European Deposit Insurance Scheme," accompanied by measures to reduce banking sector risks.
- Advance a Capital Markets Union to "help reduce overreliance on bank funding for capital and foster private sector risk sharing."

Source: Euro Area At The Crossroads: No Time For Complacency (July 8, 2016).