Structural Reforms in the Euro Zone: an IMF Perspective

IMF News, October 18, 2017

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Bibliographic details

• Published: October 18, 2017

Background and context

• Speech by Poul Thomsen, director of the IMF’s European Department, at the European Central Bank conference "Structural reforms in the euro area" on October 18, 2017.
• Central premise: the common currency was expected to harden budget constraints and catalyze reforms that would allow poorer member states to catch up with better performing economies; this hoped-for convergence did not materialize and, since the crisis, divergence has been observed.
• Key dataset and period referenced: analysis of 20 advanced European countries over 1980 to 2014; detailed analysis available in the IMF report on the 2017 Article IV consultation for the Euro Area from July.

Empirical findings on convergence and productivity

• Pre-euro adoption: steady convergence in GDP per capita among the twelve original members (including Greece).
• Post-euro adoption: convergence largely stopped; since the crisis, divergence has occurred.
• Main driver identified: persistent gaps in productivity growth across countries.
  • Countries with higher labor productivity at euro introduction continued to experience productivity rises.
  • Countries with low productivity in 1999 experienced labor productivity stagnation.
• Distributional effect of structural reforms:
  • Analysis shows that the less productive a country is, the bigger are the productivity gains from structural reforms.
  • Implication: structural reforms can foster convergence, benefiting lower-productivity countries more.

Patterns of reform implementation in the euro area

• Historical momentum:
  • Strongest reform momentum occurred in the years running up to euro adoption when comprehensive reforms were implemented.
  • After the euro’s introduction, reform efforts weakened.
• Institutional and financial factors contributing to weak reform momentum:
  • Institutional weaknesses: strong positive correlation between quality of institutions (World Bank governance indicator; World Economic Forum’s Global Competitiveness Index indicator for public institutions) and productivity levels across Euro area members. Weaker institutions facilitate vested-interest blockage of reforms.
  • Financial easing associated with Euro accession: lower real rates and capital inflows boosted employment and GDP growth but failed to promote productivity catch-up.

IMF program experience and implementation outcomes

• Evolution of IMF approach:
  • Post-Asian crisis streamlining reduced number of conditions; post-Global Financial crisis programs initially scaled back structural conditionality.
  • Euro zone programs, facing no recourse to devaluation and deep competitiveness problems, reintroduced structural conditionality beyond fiscal and financial sectors.
• Implementation statistics (across crisis programs per the 2015 Crisis Program Review):
  • "70 percent of benchmarks were met without delays."
  • Implementation rates for Ireland and Portugal are at or above this level.
  • Programs in Cyprus and Greece in 2010 and 2012 are below this level.
  • Broader structural reforms (labor and product market reforms) were more likely to be delayed, partially implemented, or not implemented than financial/fiscal measures.
  • Implementation delays on structural reform conditionality were "about 20 percent longer, on average, then for financial and fiscal conditionality."
• Conditionality volume and capacity:
  • Share of program conditions met without delay was negatively correlated with the number of conditions, suggesting implementation capacity can be overwhelmed by a high volume of conditions.
  • Example: standby arrangement recently approved for Greece had "7 prior actions" for the IMF while European partners had "140."

Lessons on sequencing, ownership, and sustainability

• Three core lessons broadly applicable beyond programs:

1. Implementation capacity matters:

• Differences in capacity help explain uneven implementation.
• Technical assistance can mitigate weak capacity but takes time.
• Program conditionality cannot substitute for weak institutions.

2. Sustaining reform momentum and sequencing:

• Payoffs depend on implementing reforms in sequence as part of reinforcing waves, complemented by sound macroeconomic policies.

3. Domestic ownership is essential:

• Ownership defined as the extent to which authorities, public opinion, and the political establishment agree on and welcome reforms.
• Reforms legislated mainly due to external pressure and without strong domestic ownership are less likely to succeed.
• In contrast, program conditions focused on stabilizing the financial system or reducing fiscal deficits were more successful at prompting corrective actions.

Evidence from Ex-Post Evaluations of large IMF programs

• Evaluation scope: Ex-Post Evaluations are carried out for programs with "exceptional access" (access above the Fund’s normal financing limits). Since the crisis, 23 such Evaluations have been completed.
• Outcomes identified:
  • "Nearly one-third of the programs went off track before they were completed." In every one of those cases, weak ownership is identified as a primary reason; failure to implement agreed structural reforms was a key sticking point.
  • "In another fifth of the Ex-Post Evaluations we see notable delays in meeting key program conditions or less than full implementation of reforms." In most of these cases, ownership waned over time due to reform fatigue, easing financial pressures, or political elections.
  • For the remainder (generally completed without major delays), strong ownership was cited as a key contributing factor to success.
• Implication for program design:
  • Frontloading reforms can be helpful when ownership and political will are strongest and before reform fatigue sets in.
  • Reform packages should be parsimonious and focused to avoid diluting ownership and overloading implementation capacity.

Political economy and country examples

• Comparative case evidence:
  • Greece vs. Portugal:
  • Portugal: parallel discussions with main opposition party ensured broad political support; when government changed months into the program, implementation continued seamlessly until stabilization.
  • Greece: the governing party faced stiff opposition resistance from the outset; the body politic never unified behind the program, undermining implementation.
• Broader examples of unifying national resolve cited: the Hartz reforms in Germany; the 2011-12 reforms in Spain; current reforms in France.

Policy recommendations and Euro Area–level options

• Design of structural conditionality:
  • Must be very well focused and parsimonious.
  • Should be carefully sequenced.
  • Results may take a long time to show.
• EU and Euro Area level support to facilitate member-state reforms:
  • Provide technical assistance and advice to address implementation capacity issues.
  • Consider a euro area central fiscal capacity with participation conditional on compliance with fiscal rules and progress on structural reforms as a possible incentive mechanism and to make reforms politically easier to sell domestically.
• Limits of central-level action:
  • Significant limitations exist on what Brussels can do to speed up reforms in member states.
  • Structural reforms will not stick without strong domestic ownership; reform momentum remains critically dependent on domestic political resolve and cannot be imposed from outside.
• Timing:
  • The current strong cyclical recovery provides the best possible economic environment for domestic policymakers to undertake reforms.

Source: Speech by Poul Thomsen, "Structural Reforms in the Euro Zone: an IMF Perspective", October 18, 2017.

References

• Poul M. Thomsen
• Greece and the IMF
• Portugal and the IMF
• Conditionality
• Speeches
• PRESS CENTER
• IMF Country Report No. 17/236
• Review of Recent Crisis Programs
• Crisis Program Review
• [Structural Reforms and Macroeconomic Performance: Initial

Considerations for the Fund](http://www.imf.org/en/Publications/Policy-Papers/Issues/2016/12/31/Structural-Reforms-and-Macroeconomic-Performance-Initial-Considerations-for-the-Fund-PP4995)

• Structural Reforms and Macroeconomic Performance: Country Cases
• https://www.imf.org/en/home