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Euro Area Policies: Staff Report

Author(s):
International Monetary Fund
Published Date:
August 2005
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I. Introduction

1. The past few years have been difficult ones for the euro area and, by extension, for Europe more generally. This became all too evident recently when the still elusive recovery, cutbacks in cherished welfare programs, fears of delocalization, and electoral calendars coalesced with other concerns to prompt French and Dutch referenda rejecting the EU constitution (Box 1) and an acrimonious European Council Summit on the EU budget. Although many-dimensional, these symptoms partly reflect a frustration with the size of the economic problems euro-area countries face and the sluggishness of the system in delivering suitable policy responses. In many quarters, perceptions of and patience with Europe reached new lows during this year’s Article IV consultations.

Box 1.The European Constitution

The proposed European Constitution resulted from a desire to improve the EU’s functioning, increase its democratic legitimacy, and consolidate, simplify, and replace existing treaties. Significant changes would include the increased use of majority voting and a modified voting system on the European Council—the present one, established in the Nice Treaty, would remain valid until 2009; the introduction of a President of the Council and a Union Minister for Foreign Affairs; a reinforced role for the European Parliament; and a smaller Commission. In the area of monetary policy, the Constitution preserves the existing institutional set-up, with only minor adaptations such as the formal recognition of the already existing Eurogroup and Eurosystem.

The Constitution enters into effect after all 25 EU member states have ratified it. As of June 6, 2005, ten member states had done so, while referenda in France and the Netherlands had resulted in rejections. Of the remaining countries, seven planned to hold referenda. While Luxembourg is going ahead with its referendum on July 10, 2005, others intend to reflect on the way forward and the original November 2006 ratification target date has effectively been dropped.

The implications of the French and Dutch referenda results are, as of now, difficult to discern. Since the Constitution leaves the monetary policy framework unaffected and does not directly affect economic fundamentals, it should not impede the functioning of the monetary union. The main risk is for policy paralysis in the longer run at the Commission/Council, if the EU’s governance structure remains unchanged.

2. While the impatience is understandable, the pessimism seems exaggerated. Repeated disappointments on both activity and inflation are raising questions about the health of the euro-area economy. However, both the policies and the economic fundamentals have gradually been laying the basis for a slow recovery. On the structural front, progress has been made in the past few years towards reducing rigidities and addressing the looming demographic shock (Box 2). Together with continued wage moderation, these policies should again lead to further improvements in the area’s employment performance. On the cyclical front, significant progress has been made toward adjusting away the balance sheet strains stemming from the 2000 bust, leading to a strengthening of investment and consumption in 2004. While this progress has been interrupted by the economic and political ructions of the first half of this year, the underlying thrust of policies and developments over the past few years leads staff to continue to expect a gradual, modest, but strengthening recovery, albeit amidst preponderantly downside risks stemming from confidence effects or international headwinds.

Box 2.Past Fund Policy Recommendations and Implementation

Monetary policy: Over the past few consultations, the Fund has argued that monetary policy should remain accommodative until a sustained recovery in domestic demand firmly takes hold. Policy rates have been on hold since June 2003. The ECB has generally stressed that the balance of risks for price stability was clearly toward the upside, while the Fund saw a more balanced distribution. In the event, headline inflation typically exceeded staff and ECB forecasts but underlying inflationary pressures remained contained.

Fiscal policy: The Fund has underscored that underlying (cyclically-adjusted) balance was an appropriate medium-term goal, especially in light of imminent population aging. Countries with weak underlying budgetary positions were to undertake high-quality fiscal adjustments of at least ½ percent of GDP a year (and more in good times), while letting fiscal stabilizers work fully around the consolidation path. In reality, while the stabilizers have been allowed to operate, adjustment has fallen well short of this target. The Fund also called for a new consensus on the SGP, embodying better incentives to adjust in good times and a clearer differentiation between policies and the economic environment in the application of the Excessive Deficit Procedure (EDP). A new agreement has emerged in the past year that addressed Fund concerns about the EDP, but that made the Pact less transparent and did not strengthen its preventive arm.

Structural policy: The Fund has argued that the area’s key challenge has been to raise longer-term growth, especially by bolstering incentives to work. While progress has been made in recent years—including entitlement and labor reforms in key countries—labor utilization remains low and limited headway has been made in further developing the internal market. In this vein, the Fund has argued that the Lisbon Strategy remains an appropriate vehicle to foster reforms, as long as it is appropriately prioritized and undergirded by credible peer pressure, including through the use of benchmarking. The European Council adopted a rejuvenated Lisbon Strategy, which went some way toward better prioritization and improved governance structures, but stopped short of endorsing benchmarking.

3. A more open question is whether policies will muster the decisiveness needed to address the area’s still formidable problems. Two considerations invite caution. First, policy decisiveness has been erratic, with the spate of structural reforms of the past few years possibly motivated as much by bad times as the need for a more forward-looking approach. In this regard, the fraying of the consensus on fiscal policies and the shift to water-treading policies in a number of countries does not bode well. Second, the stresses of the past few years have also led to a rebalancing—embodied in the reformed SGP and the revised Lisbon Strategy—in the respective roles of the center (“Brussels”) and the member states, with more of the responsibility and initiative placed on the latter, and with the Council in an intermediate position. Officials point to these arrangements as providing a more realistic and ultimately sounder basis for strengthened policies. Ownership considerations support this view. However, absent stronger policy leadership and surveillance at the national level, these may take time to materialize.

II. Background

A. Recent Developments

4. The low-flying recovery has hit a rough patch. Hard data paint a confusing picture of rising weaknesses. After showing promising gains during 2004, final domestic demand unexpectedly stalled in 2005:Q1. By contrast, after losing momentum last year, real GDP growth rebounded to 2 percent in Q1, primarily reflecting slowing imports. Initially on par with past recoveries, growth overall has slipped relative to previous upturns (Appendix I, Figures A1 and A2).

Euro Area: GDP and Final Domestic Demand(Q-o-q annualized rates in percent)
GDP growthFinal Domestic Demand (Contribution to growth)
2004:Q12.61.0
2004:Q21.71.1
2004:Q31.11.8
2004:Q40.62.3
2005:Q12.0-0.1
2005:Q21.11.6
2005:Q31.41.7
2005:Q41.72.1
Source: IMF, World Economic Outlook.
Source: IMF, World Economic Outlook.

The recovery has lost momentum.

5. A key reason for the area’s disappointing recovery has been a high oil price and an appreciated exchange rate (Figure A3). Oil price hikes since mid-2003 may have detracted about ½ percentage point from real GDP growth in 2004 and may do so again in 2005. In the meantime, the euro’s appreciation has softened the impulse from the global expansion, subtracting almost ½ percent from growth in 2004 (Figures A4 and A5).

Oil prices are weighing on the recovery…

…and the exchange rate is not offering support.

6. The fundamentals for a tepid recovery remain in place, particularly those surrounding improved labor market resiliency. Past labor market reforms and continued wage moderation have made it easier for employers to preserve payrolls and adjust hours worked to reduce costs and avoid the typical labor shedding seen in past cycles (Figure A6). With the recovery, total hours have begun to rebound. Employment growth though has been modest, but wage settlements should be conducive to new hiring.

7. Benefiting from restrained labor costs, businesses have raised profitability and improved balance sheets, setting the stage for stronger investment (Figure A7).2 With favorable labor costs, relaxed financing conditions, and buoyant external demand, firms—especially larger companies, many with overseas activities—have rebuilt profits despite euro appreciation and elevated oil prices. By and large, improved cash flows thus far have been channeled into balance sheet consolidation, dividend payouts, and replacing worn-out capital. Continued buoyant external demand, however, should eventually prompt a stronger response of investment and employment.

Investment has adjusted gradually…

…stagnating less than in earlier troughs.

1/ Aggregated data for Austria, Germany, Greece, Ireland, Italy, Portugal, and Spain.

8. The elements for a more vigorous, selfsustaining recovery have yet to come together, however, with household consumption a key missing link. Reticent consumption growth has moved in line with small gains in disposable income, limited by modest wage earnings and unfavorable price shocks (Figure A8). On the domestic front, these have included unusually large administered price hikes, which cut some 0.7 and 0.4 percentage point off real disposable incomes in 2004 and 2005, respectively. In tandem with increasingly uncertain benefit prospects, consumers have been disinclined to reduce saving rates, unlike in previous recoveries. Low interest rates have fueled demand for housing, but new home purchases and rising real estate values have not translated strongly into higher consumption expenditures, given relatively few avenues in Europe to tap into home equity. As energy price hikes slow and administered prices stabilize, headline inflation should gradually converge to underlying inflation—which is running around 1½ percent—and this should support real income growth. But more employment growth, which is being facilitated by wage settlements, and confidence are essential for consumption to propel activity.

Consumption is unusually sluggish…

…but resiliency of employment has improved.

Underlying inflationary pressures are subdued.

B. Structural Perspectives

9. Structural adjustment has delivered on some counts and should continue to do so in the future. Wage restraint and reforms of part-time and temporary work have enhanced cyclical resiliency and encouraged job-rich growth. Since the mid-1990s, employment has risen by some 12 million and been robust through the downturn, a performance that is comparable to that of the United States. More generally, past trend declines in labor utilization have been arrested and even begun to turn around. Indeed, since 2000 employment rates of those aged 55 to 64 years—a key source of problems in earlier decades—have risen by over 4 percentage points. Concurrently, wages are subdued, notwithstanding major shocks, testifying to improved labor market institutions relative to earlier decades. Furthermore, fiscal policy has generally performed better than during earlier recessions and entitlement reform has proceeded.

Labor utilization is responding to wage moderation and reforms…

10. Nonetheless, the challenges remain large. The demographic shock looms ever closer. Employment rates remain low and, although partly reflecting the necessary increase in the employment intensity of output, disappointing productivity trends need to be reversed. More proximately, there is a need to reduce the 9–11 percent unemployment rates in the large states, which have helped fuel discontent with center-led policies.

…but still has a long way to go.

Source: OECD; and IMF staff calculations.

1/ In 2003 PPP values per hour.

2/ Total hours worked per capita.

11. There is a risk that reform fatigue and discontent with Europe will delay the area’s continued adjustment over the medium run. The discontent finds expression in part in the view that the high unemployment rates in the larger countries reflect an increased divergence in countries’ performances, at the expense of the larger countries, as a result of monetary union. In fact, divergences have been declining (Box 3). The weak performances are instead rooted in uneven efforts to implement labor and product market reforms and delays in addressing asymmetric shocks and losses of competitiveness (broadly construed) that have induced longer-term swings in countries’ performances.

Box 3.Regional Divergences

Increasing concern has been voiced about divergences in economic performance between member states, based in part on evidence from highly volatile quarterly data. In fact, area-wide annual numbers show no evidence of increasing dispersion in real GDP growth and inflation since the introduction of the euro in 1999, and currently observed differences appear to reflect partly an ongoing process of income-level convergence. Temporarily diverging dynamics can be triggered by the different speeds with which financial, nominal, and real variables converge.

While temporarily diverging dynamics are a normal feature both of the convergence process and the functioning of a mature monetary union, they may entail risks if, for example, due to structural rigidities or inappropriate policies, real wages move significantly ahead of productivity. This appears to have been the case in some members, notably those with weaker productivity performances. Avoiding that losses in competitiveness become deeply ingrained and prompt long-term swings in performance requires strategies that exploit fully the complementarity between structural and fiscal policies.

Cyclical and trend components of economic growth rates show declining dispersion since 1999…

…and remaining differences reflect at least in part ongoing convergence in income and price levels.

Nevertheless, developments in competitiveness require monitoring.

Source: IMF, World Economic Outlook database; and Fund staff calculations.

1/ Standard deviation used as measure of dispersion.

2/ Excluding Luxembourg and Ireland; big-4 = Germany, France, Italy and Spain; real GDP per capita is on PPP basis; coefficient of variation used as measure of dispersion.

12. While there may be a pause in the pace of reforms, fundamental changes in the course of policies do not appear in the offing. Developments in area-wide spreads of government bond yields suggest that capital markets seem to share this assessment, including following the rejection of the draft EU Constitution by some electorates (Figure A9). Overall, staff sees potential output growth stuck at a low level of around 2 percent, with actual growth only modestly higher over the medium run to close an output gap of about 1½ percent of potential GDP.

III. Report on the Discussions

A. Near-term Prospects and Risks

13. The shared view was that the fog surrounding the state of the recovery has not been lifted and that recent data releases have heightened downside risks. The abrupt halt in domestic demand together with the acceleration in real GDP growth in 2005:Q1 is difficult to explain. Oil prices increased from about euro 30 to 40 per barrel during the first quarter, possibly affecting forward-looking investment and employment decisions. Also, bad weather depressed construction, although calendar effects have had an opposite effect on headline GDP. “Pipeline” effects of past real exchange rate appreciation together with a sudden, presumably temporary, slowdown in global trade in the first part of the year pointed to weakness in goods production through the second quarter.

14. Nevertheless, elements sufficient for a continuation of the gradual recovery seem to remain in place. With fiscal policies largely in water treading mode and interest rates at historical lows, macroeconomic policies and financial conditions are supportive. The recovery of hours worked should begin to translate into higher employment and, together with slowing administered prices, support household incomes. Also, the effect of past exchange rate appreciations should be waning. Crucially, world demand and trade are projected to strengthen again, following an oil price-related soft patch. Commission staff emphasized the toll of uncertainty—including that surrounding reforms and the political situation—on expectations and confidence (Figure 1). But absent evidence that the global recovery is veering off-track, Commission, ECB and Fund staff project similar central scenarios, i.e., where euro-area output regains momentum in the second half of this year—with 2005 real GDP growth around 1⅓ percent—and achieves growth at potential by 2006 (Table 1). Hard data released since the discussions point to resuming manufacturing and construction activity, while service sector indicators remain resilient, supporting the central scenario.

Figure 1.Euro Area: Leading Indicators

Sources: Eurostat, Reuters, IFO, INSEE, Banque Nationale de Belgique, and staff calculations.

1/ Year-on-year percent change, three-month moving average, right scale.

2/ Standardized over 1991-2004 period.

3/ Annualized quarter-on-quarter growth, right scale.

Table 1.Euro Area: Main Economic Indicators(Percentage change)
1999200020012002200320042005 1/2006 1/
Demand and Supply
Private consumption3.33.01.90.91.11.41.41.6
Public consumption1.91.42.22.61.31.51.21.8
Gross fixed investment6.15.20.2-2.30.41.92.13.1
Final domestic demand3.63.21.60.51.01.51.52.0
Stockbuilding 2/-0.1-0.3-0.6-0.20.20.4-0.2-0.1
Domestic Demand3.52.91.00.41.21.91.31.9
Foreign balance 2/-0.70.90.90.6-0.40.10.00.1
Exports 3/5.412.43.82.10.66.03.55.2
Imports 3/7.910.31.70.61.96.33.85.5
Real GDP2.73.81.81.00.72.01.31.9
Resource Utilization
Potential GDP2.12.22.22.12.01.91.81.8
Output gap 4/0.21.81.40.3-1.0-0.9-1.5-1.4
Employment1.82.21.30.50.20.90.70.9
Unemployment rate 5/9.28.27.88.38.78.98.98.6
Prices
GDP deflator1.51.62.42.52.01.81.71.8
Consumer prices1.12.12.32.32.12.12.11.7
Public Finance6/
General government balance 7/-1.3-0.9-1.8-2.5-2.8-2.7-3.0-3.1
General government structural balance-1.4-1.9-2.5-2.6-2.4-2.1-2.3-2.3
General government gross debt72.570.068.968.870.170.672.272.9
Interest Rates8/
Short-term deposit rate3.04.44.23.32.42.12.1
Long-term government bond yields4.75.55.04.94.24.23.3
Exchange Rates
U.S. dollar per euro 9/1.070.920.900.941.131.241.21
Nominal effective rate (2000=100) 8/111.5100.0101.2104.3116.1120.0121.1
Real effective rate (2000=100) 8/10/113.4100.099.2102.2112.8115.5115.5
External Sector6/11/
Current account balance-0.5-1.20.00.90.30.60.40.3
Trade balance 12/13/0.90.11.11.81.41.40.8
Memorandum items6/14/
Current account balance0.5-0.50.10.70.30.40.40.2
Trade balance 12/1.50.81.62.31.91.81.61.4

WEO, June 2005.

Contribution to growth.

Includes intra-euro area trade.

In percent of potential GDP.

In percent.

In percent of GDP.

Excludes UMTS revenues.

Data for 2005 are for May.

Data for 2005 are for June 28.

Based on normalized unit labor costs.

Based on ECB data, which exclude intra-euro area flows.

Data for goods.

Data for 2005 are for 2005Q1.

Calculated as the sum of individual countries’ balances.

WEO, June 2005.

Contribution to growth.

Includes intra-euro area trade.

In percent of potential GDP.

In percent.

In percent of GDP.

Excludes UMTS revenues.

Data for 2005 are for May.

Data for 2005 are for June 28.

Based on normalized unit labor costs.

Based on ECB data, which exclude intra-euro area flows.

Data for goods.

Data for 2005 are for 2005Q1.

Calculated as the sum of individual countries’ balances.

Policies were less expansionary but supportive in the euro area. 1/

1/ Comparative assessments of policy stances need to allow for the differences in the role of the automatic stabilizers (relatively large in the euro area), the volatility of output (relatively low), and potential growth (relatively weak and weakening). Adjusted for such factors, area-wide policies have been more supportive than often perceived.

15. Absent stronger internal dynamics, the area-wide recovery remains exposed to external shocks and weakening confidence. Principal among these are further oil price hikes and multilateral euro appreciation. The area’s current account has played a minor counterpart role to growing external imbalances elsewhere (Table 2); and the staff’s multilateral assessments suggest that the area’s real effective exchange rate is somewhat above but close to medium-term fundamentals. However, all agreed that, in light of recent history and the euro’s prominent and expanding international role (Figure 2), the risk of a major appreciation remained on the horizon. Since the discussions, risks for activity from the euro—which has depreciated by some 2½ percent in effective terms—have receded somewhat. However, risks from a stronger fall in confidence may have risen.

Table 2.Euro Area: Balance of Payments
200020012002200320042005Q1
(In billions euro)
Current account-82.1-3.364.620.445.35.0
Goods7.673.3128.5102.7103.514.7
Services-6.00.016.419.527.12.3
Income-32.5-25.4-31.9-45.9-29.6-2.6
Current transfers-50.8-51.6-48.6-56.2-55.7-9.4
Capital account11.86.410.213.317.11.0
Financial account70.6-43.8-43.9-5.824.335.5
Direct investment-16.0-122.00.65.4-47.8-25.3
Portfolio investment-99.671.9127.943.368.60.1
Equity-234.1130.947.350.548.0-7.6
Debt instruments134.4-59.080.5-6.321.57.9
Financial derivatives-10.0-0.8-10.9-12.2-2.0-9.6
Other investment181.9-10.5-159.0-72.5-6.665.3
Reserve assets14.718.0-2.230.012.44.8
Errors and omissions-0.640.8-30.6-27.7-87.1-41.4
(In percent of GDP)
Current account-1.20.00.90.30.60.3
Goods0.11.11.81.41.40.8
Services-0.10.00.20.30.40.1
Income-0.5-0.4-0.4-0.6-0.4-0.1
Current transfers-0.8-0.7-0.7-0.8-0.7-0.5
Capital account0.20.10.10.20.20.1
Financial account1.1-0.6-0.6-0.10.31.9
Direct investment-0.2-1.80.00.1-0.6-1.3
Portfolio investment-1.51.01.80.60.90.0
Equity-3.51.90.70.70.6-0.4
Debt instruments2.0-0.91.1-0.10.30.4
Financial derivatives-0.20.0-0.2-0.20.0-0.5
Other investment2.7-0.2-2.2-1.0-0.13.5
Reserve assets0.20.30.00.40.20.3
Errors and omissions0.00.6-0.4-0.4-1.1-2.2
Memorandum items:
GDP (in billions of euros)6,619.86,895.17,134.47,328.27,611.01,890.3
Reserves of the eurosystem 1/
(In billions of euros)391.2392.7366.1306.5

End of period stocks.

End of period stocks.

Figure 2.Euro Area: Exchange Rates

Sources: Revised Annual Report, IMF (2003); Bank of International Settlements; and ECB.

The outlook for oil prices is shifting rapidly.

B. Inflation and Monetary Policy

16. Although headline inflation has persisted at or above 2 percent, underlying inflationary pressures are easing (Figure 3). Large increases in oil and administered prices had pushed up HICP inflation to 2½ percent by mid-2004 and continue to affect prices in 2005. But with modest wage setting and some cyclical bounce in labor productivity, unit labor costs have decelerated sharply and “second-round effects” from higher oil prices have not materialized. In the context of a modest recovery and lingering weakness in labor markets, both ECB and IMF staff foresaw core inflation falling close to 1½ percent over the medium term, with ECB staff seeing a modest acceleration beginning in 2007. Headline inflation would still run around 2 percent in 2005 and moderate to 1¾ percent in 2006, excluding a one-off reduction in administered prices.3 Inflation expectations, particularly survey-based measures, have been broadly stable, and the more volatile market-based measures (i.e., break-even rates) have recently receded.

Figure 3.Euro Area: Inflationary Developments and Outlook

(In percent, unless otherwise noted)

Sources: Datastream; Eurostat; and staff calculations and forecasts.

1/ Survey of Professional Forecasters.

17. ECB officials nonetheless saw the distribution of risks to inflation as heavily skewed to the upside. They argued that indirect taxes, administered prices, and oil prices, which were essentially held constant in the projections, continued to pose upside risks for inflation. These had been the main factors behind the repeatedly optimistic forecasts and five years of at least 2 percent inflation. They remained major risks going forward, as suggested in particular by the persistently tight demand-supply balance in the oil market—a point that has again been borne out by price developments since the discussions. Second-round effects stemming from wage and price-setting might still emerge, particularly once the recovery gathered pace. Moreover, while survey- and market-based measures of inflationary expectations remained well anchored, they did not point to inflation falling substantially below 2 percent.

18. ECB officials viewed monetary and credit conditions as also pointing to upside risks to price stability (Figures 4 and A10). Policy rates had been on hold at 2 percent—well below the neutral rate—since June 2003 and the yield curve had flattened at the long end, providing supportive financial conditions for the recovery. However, low interest rates had also led to a rapid expansion of monetary aggregates, particularly the most liquid components. As a result, the ECB’s monetary analysis pointed to liquidity exceeding that consistent with price stability over the medium to longer term. Similarly, on credit developments, loans to households—mainly, mortgage lending—had seen brisk growth and credit to nonfinancial corporates had shown renewed strength recently. Indeed, as a result of strong credit growth the ECB saw a need to carefully monitor whether risks to price stability were building in the context of strong house price increases in some regions of the euro area.

Figure 4.Euro Area: Interest, Money, and Credit

(In percent, unless otherwise specified)

Sources: ECB; Datastream; Bloomberg; and staff calculations.

1/ Deviation (in percent) of the actual real stock of M3 from an estimate of the long-run real stock of M3, consistent with long-run inflation of 1.75 percent a year and assuming that the real money gap was zero in January 1999.

19. Viewing risks to price stability as heavily skewed to the upside, ECB officials felt that it was not appropriate to entertain interest rate cuts, although their language is widely perceived to have softened since the discussions. They noted that the highly accommodative policy stance would inevitably need to end. In the meantime, the ECB stood ready to raise rates rapidly in the event that inflationary expectations lost their anchor. They elaborated that their established credibility and readiness to act had delivered an enviable yield curve, with long-term interest rates having reached historical lows in all euro-area member countries. This achievement would be put at risk if rate cuts were to be considered at this stage. Since the discussions, however, ECB officials have no longer explicitly ruled out the option of cutting rates.

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

  • As regards the “economic” pillar, it agreed that one-off shocks had been a continuing problem and that the resulting persistent over-shooting of the inflation target gave rise to both upside risks and credibility issues that needed to be taken into account. By the same token, wage and underlying inflation had been ebbing down and were expected to remain below levels consistent with the ECB’s target even on a baseline that foresaw a recovery of activity. Moreover, second-round effects were notable mainly for their absence. This pointed to downside risks.
  • As regards the monetary analysis, staff viewed the risks as too uncertain and long-term to motivate a change in policy stance at this juncture. While liquidity was ample, and appropriately so, robust cautionary signs of building medium-term inflationary pressures were lacking (Box 4).4 Furthermore, except for a few outliers, rapid credit growth—mainly for mortgages—had been in line with financial “catch-up,” which might help explain the dichotomy between the pace of activity in the area’s real versus financial sector. Nonetheless, staff agreed that it would be imprudent to downplay concerns related to excessive house prices in some countries of the euro area. However, these could be addressed more effectively at the national level, for example, with fiscal measures or prudential monitoring, as evidence for area-wide excessive house prices was not strong. Beyond these measures, staff pointed to the benefits of further financial market integration for a more uniform passthrough of monetary policy to asset prices.5

Box 4.Evaluating Liquidity, Credit, and Inflation Risks After EMU

At the heart of ECB concerns over upside risks to inflation is “excess” liquidity. Historically, money growth in excess of real output growth has over predicted area-wide inflation, reflecting velocity’s secular decline.

Inflation v. Money Growth, 1970-2004

(5-year log changes)

Staff analysis suggests a variable trend decline in velocity. Shifts could reflect temporary or more lasting factors, including portfolio shifts in the wake of the equity bubble, and/or more fundamental changes related to the creation of a large monetary union and the euro’s expanding international role. This increases uncertainty surrounding the assessment of liquidity and its inflationary impact, compounding the inherent difficulties in drawing firm monetary lessons based on the history prior to EMU.

Euro Area M3 Velocity, 1980Q1-2004Q3

(in logarithms)

The ECB also worries that low interest rates are fueling asset price inflation. However, policy action faces hurdles related to reliably identifying financial bubbles; the complex links between credit, asset and consumer prices; and the accompanying spillovers for the real sector. While house prices have risen quite rapidly in some member countries, driven also by financial catch-up and a stronger pass-through of monetary policy to demand for mortgages and housing, evidence for area-wide “excess” is not strong.

Real House Prices

(Natural logarithm; 1985-2004 average =100)

Sources: BIS calculations based on national data (8 countries) through 1991; ECB data thereafter.

Credit developments reflect financial catch-up, with a few exceptions.

21. Overall, staff considered that keeping interest rates on hold was still appropriate but that the need for a rate cut may be materializing. Indeed, with inflation headed for rates below 2 percent and moderating further, a cut in interest rates would be appropriate if, contrary to projections, evidence for a fading recovery continued to accumulate. For the time being, however, the stickiness of overall inflation together with the uncertainty hanging over prospects meant that keeping interest rates on hold seemed appropriate.

22. With internal demand lacking vigor, external risks also argued for some insurance. Specifically, a sharp multilateral appreciation of the euro would open the case for monetary easing, other things being equal. If oil prices were to persist at heightened levels for the foreseeable future, maintaining a wait-and-see position on interest rates as insurance would be appropriate, according to Fund staff, insofar as second-round effects did not materialize. Since the discussions, however, the euro has depreciated by some 2½ percent in nominal effective terms; and oil prices have risen by about 10 percent. While these developments have little net effect on growth, they have a small positive impact on headline inflation.6

C. Fiscal Policy and SGP Reform

Fiscal Policy

23. Fiscal policies are falling well short of what is needed to meet the area’s fiscal consolidation requirements. Absent action, the increase in aging-related expenditure after the end of the current decade will push debt in many countries onto clearly unsustainable trajectories. Staff viewed these pressures as calling for budgets to attain underlying balance by 2010 in tandem with continued progress with entitlement reforms. With the area-wide structural deficit close to 2 percent of GDP, achieving this objective required structural adjustment (net of one-offs and other temporary measures) of ½ percent of GDP annually. In fact, no significant area-wide consolidation has been achieved since 2000, and budgets for 2005 and targets for 2006 foresee little consolidation—with the larger countries being most prone to inaction (Figure 5). On staff projections, almost half of the countries in the euro area—France, Germany, Italy, Greece, and Portugal—would post deficits in excess of 3 percent in 2005–06, some by significant margins. Looking forward, the key problem was how to overcome the political economy biases toward postponing adjustment until rising market pressures force abrupt, potentially unsettling, action. More immediately, adjustment was also needed to secure an adequate safety margin to avoid a repeat of the breaches of the Maastricht ceiling during the next downswing.

Figure 5.Euro Area: Fiscal Developments

(In percent of GDP, unless otherwise noted)

Sources: European Commission; IMF, World Economic Outlook; and IMF staff calculations.

1/ Excludes Belgium, Luxembourg, and Greece. Shaded areas are periods of cyclical upswings.

Euro Area Debt 1/

(In percent of GDP)

1/ Assumes no consolidation after 2004.

Source: European Commission.

24. Some national authorities questioned whether the staff’s views on fiscal policy would not undermine the support for structural reforms. These authorities argued that, while recent entitlement reforms had, as acknowledged by staff, significantly reduced intertemporal imbalances, they had also led to sagging confidence and weak growth, which would be exacerbated by fiscal adjustment. Staff argued that the euro area’s performance problems were pre-eminently long term and unlikely to be remedied by on-the-go fiscal fine tuning, particularly given the area’s underlying fiscal unsustainability and its historical difficulty in reversing expansionary policies. In the staff’s view, current uncertainties were mainly of a longer term character and due to the stop-and-go approach to structural reform and fiscal adjustment. Expectations would best be stabilized through the articulation and pursuit of a clear, consistent, and forward-looking strategy aimed at securing the longer-term sustainability of the social model.7 While such a strategy would not preclude some ebb and flow in the role of its various elements, the underlying long-term complementarity between the area’s structural and fiscal requirements limited the scope for such tradeoffs.

SGP Reform8

25. The authorities fleshed out an agreement on a reformed Stability Pact that is seen as restoring needed order and discipline to EMU’s fiscal anchor. The Pact fell into procedural limbo in November 2003 when a badly split Council decided to suspend the Excessive Deficit Procedures (EDP) against France and Germany. The new Pact has been endorsed by all 25 EU members. The dissuasive arm—charged with ensuring that countries respect the limits on deficits and debt laid down by the Maastricht Treaty (3 percent and 60 percent of GDP, respectively)—has more flexible deadlines and allows consideration of a range of country circumstances. The preventive arm—which encouraged member states to maintain budgets close to balance or in surplus (CBS)—would now set these medium-term objectives (MTOs) according to country conditions (i.e., potential growth and initial debt levels), up to a maximum deficit of 1 percent of GDP. The MTOs would subsequently be adjusted to incorporate implicit liabilities. National authorities and the Commission argued that these reforms improved the Pact’s grounding in sound economic principles, thereby strengthening its potential for contributing to fiscal adjustment. In that regard, a clear step forward is the agreement to exclude one-off measures from assessments of policies under the reformed Pact.

26. Views varied on the merits of introducing added flexibility into the dissuasive arm. Some of the changes to the EDP are in line with staff views, notably the tighter link between adjustment deadlines and economic developments and the specification of a “minimum” annual adjustment in excessive deficits of at least ½ percent of GDP, net of one-offs and other temporary measures. On the other hand, the allowance for greater recourse to an open-ended list of “other relevant factors” is problematic as it could allow countries to avoid taking needed corrective action. The ECB, which is generally concerned by the complexity and vagueness of the reforms, viewed “other relevant factors” as a potentially serious watering down of the EDP. In response, the Commission argued that these factors could be invoked only if a breach of the 3 percent reference ratio was “temporary” and the deficit remained “close to the reference value.”

27. Staff’s main concern is that the provisions of the preventive arm are such as to permit quite limited adjustment more or less indefinitely, including during upswings—the Achilles heel of the old Pact. This stems from two provisions. The first states that the benchmark adjustment of ½ percent per annum is to be expected only when the level of output is at (“slightly below” if growth is high) or above potential. This is not the case at the current juncture and would excuse little adjustment for the foreseeable future. More fundamentally, however, the technique used to measure potential is such that this test is rarely if ever met in real time. It was not met by any of the largest countries even at the top of the 2000 boom (Figure 6).9 This provision, which has the potential to vitiate the ½ percent adjustment benchmark, is exacerbated by a second that allows countries to deviate from their adjustment paths when they undertake major structural reforms. The provision would allow countries to scale back adjustment in proportion to the direct (through budgetary savings) or indirect (through raising potential growth) effects of reforms that improve long-term fiscal sustainability. Taken together, these provisions would seem to provide ample scope for sominded countries to delay adjustment—as well as for lengthy debates on country assessments. While the authorities acknowledged these problems, they pointed out that the provisions for adjustment of the reformed Pact, while weaker than earlier expectations, now had a regulatory basis.

Figure 6.Selected European Union Countries: Output Gap Estimates

(In percent of potential GDP)

Source: IMF, WEO.

28. The complexity of the reformed Pact means that its effectiveness and credibility as a fiscal anchor will largely hinge on its implementation. The Pact has up to now improved fiscal discipline in a number of countries, curbing runaway deficits and reducing procylicality. But the recent burgeoning of deficits and non-transparent actions—ranging from one-off measures, financial operations, and even misreporting—underscore the need to re-establish a credible fiscal framework under EMU to anchor policies and expectations. Agreement on a reformed SGP was therefore considered a welcome and necessary step forward. However, the reforms introduce less simple rules and new margins for discretion that could be misused. Staff thus argued that implementation, particularly by the Council, will be key, stressing the need for ambition relative to medium-term requirements, even-handedness in the application of the rules, and transparency under a more flexible but more complex Pact.

29. With softer limits on fiscal policy at the center, staff argued for stronger national institutions to assess policies, a proposal that was questioned by a number of national authorities. In the staff’s view, popular disaffection pointed to the need to deepen public understanding at the national level of the longer-term issues facing countries and of the role of policies in addressing them. Steps in this direction—largely bypassed by SGP reforms—included debating Stability Programs in parliaments alongside budgets and strengthening or establishing independent, non-partisan fiscal councils. Such councils could assess policies, provide more forward-looking perspectives, help rally popular support for adjustment, better identify policy failures, and mark up reputation costs.10 In so doing, they could provide some offset to the weaknesses of the disciplining devices of the center and contribute to the formulation of more realistic budgets. Several national authorities were not convinced, however, arguing that these councils already existed in various guises in several countries, that their effectiveness was not demonstrated, and that they could detract from policy implementation and muddy accountability. Staff acknowledged that requirements would depend on national institutional arrangements, and viewed steps in these directions as particularly important in countries with problems in policy implementation and where policies fell short of ensuring long-term sustainability.

D. Product and Factor Markets

30. The basic issue confronting the euro area is how to strengthen the pace and effectiveness of reforms. The Barroso Commission is pursuing a two-pronged approach. As regards the many reforms that depend primarily on the initiative of member states, the aim of the restructured Lisbon strategy is to shift the ownership and onus for the reforms onto the member states (no more “hiding behind Brussels”). An integrated policy framework would ensure more prioritization and coordination of the national reform efforts. This bottom-up approach is complemented and in a measure fostered by pressing center-led reforms that aim at strengthening product market competition and achieving integrated financial markets.

31. While the need for reforms was common ground, views differed on the extent to which they should be motivated by their contribution to resolving global imbalances. The Commission and ECB staff noted that the root causes of imbalances lied elsewhere in the world economy and thus believed that a convincing case for EU reform had to be motivated from a domestic perspective. The national authorities added that the effects of structural reforms on global imbalances were ambiguous, as they might raise both investment and saving. While agreeing that the net effect on current accounts was arguable, staff noted that after a lag reflecting confidence and other effects, structural reforms should boost domestic demand and growth. Hence, Europe—and at one removed the world economy—would be in a better position to withstand a market-driven, more abrupt resolution of the imbalances. Moreover, a cooperative approach to the resolution of global imbalances would help forestall abrupt scenarios.

Lisbon revisited

32. The Commission has made the implementation of a reinvigorated Lisbon Strategy its top priority. The original agenda—launched in March 2000 to make Europe the most dynamic, knowledge-based economy by 2010—has fallen short of galvanizing support for accelerating structural reforms. One key objective, raising the employment rate to 70 percent by 2010, is now out of reach. While most of the reforms in question are the prerogatives of governments, there is agreement that coordination at EU levels has also fallen short. The restructured strategy, endorsed by the European Council in March/June, features the following:

  • An integrated and focused agenda. The objective is to make Europe a more attractive place to work and invest, to spread knowledge and innovation, and to create more and better jobs. The new strategy aims to promote greater consistency in reform programs through the promulgation and adoption of EU-wide Integrated Guidelines for Growth and Employment (covering three years) that regroup a number of up to now separate reform tracks managed by different ministries. In particular, the new guidelines encompass the former Broad Economic Policy Guidelines and Employment Guidelines.
  • A shift in the procedural locus from Brussels to the national level. Governments are to prepare National Action Plans (NAPs) that fit within the Integrated Guidelines. These plans are to include concrete measures and timetables for their implementation, all under the aegis of a national “Mr./Ms. Lisbon,” who is to collaborate closely with all stakeholders, including national Parliaments. The objective is to strengthen national initiative and ownership.

33. Staff welcomed the emphasis on integrated guidelines and ownership, but questioned whether prioritization had gone far enough and sufficient weight been given to peer pressure.

  • On the positive side, the emphasis on integrating agendas was on the mark as more and more analyses pointed to the importance of devising packages of measures that reinforced each other. An instance in point is the synergy between wage moderation and product market reforms documented by staff (see Box 5). Similarly, shifting part of the agenda-setting from Brussels institutions to the national arena seemed necessary to build lasting popular support for the course of reform.

Box 5.Product Market Regulations and the Benefits of Wage Moderation

Decelerating labor costs have had a stronger effect on growth and unemployment in economies with less regulated product markets. Lower wages raise profitability, prompting more entry, output, and employment in less regulated and thus more competitive economies. This evidence underscores the complementarity of labor and product market reform and partly explains why some countries benefited less from wage moderation than others.

The low correlation between wage moderation and GDP growth…

… increases after controlling for product market regulations.

Note: Wage shocks in the business sector are log changes in compensation per hour divided by the PCE deflator, minus log changes of labor-saving technology, minus log changes of unemployment rate multiplied by the elasticity of wages with respect to unemployment (0.1). For further details see the Selected Issues paper chapter “Product Market Regulation and the Benefits of Wage Moderation.”Source: OECD Analytical Database; EC - AMECO database; and staff estimates.
  • On the other hand, prioritization still seemed insufficient. Increasing labor utilization, through sharpened incentives to work, and strengthening competition seemed the most effective levers at hand to boost the continent’s potential output. With over 20 broad guidelines, the new Strategy provided ample opportunities to avoid politically difficult avenues. A diffused approach carried the risk of again failing to clarify issues and galvanize support. The staff also questioned whether the European Council’s decision against benchmarking and naming/praising would not also weaken the impetus to reform. Commission staff explained that the framework did not preclude countries from orienting their reform program toward key national priorities. They also noted that the experience with naming/praising had been mixed, and that countries’ progress would continue to be monitored using a cross-country database of structural indicators. The staff encouraged this work, pointing to the positive experience with the indicators presented in the OECD’s PISA studies on education.

34. Turning to more center-led reforms, the Commission’s agenda to strengthen competition had suffered a setback when the EU Services Directive was sent back by the European Council for amendments, amid concerns that it would trigger social dumping. The Directive guarantees the freedom to establish and provide services across the entire EU membership. For services rendered by a provider from another member state, the “country of origin principle”—where home (and not host) country administrative and legal requirements need to be met—would apply, albeit with a number of derogations for specific sectors. The Commission believed fears of social dumping to be misplaced, in light of various derogations and safeguards. Given that the country-of-origin principle is grounded in the EU Treaty, the Commission was hopeful that this approach would be maintained.

Financial market developments

A more resilient system

35. The strength and resiliency of the financial system is improving (Table 3). ECB staff explained that banks had weathered the latest downturn better than the recession of the early 1990s. Bank profitability continued to recover in 2004, reaching its highest level since 2000, supported by continued cost cutting, strong revenues from mortgage lending, and lower loan loss provisioning (Figure 7). While pockets of fragility might still exist in the banking sectors of some member countries, the overall banking system should not stand in the way of a more robust recovery, a point which the staff shared. The insurance sector had also recovered, buoyed mainly by equity markets, although some vulnerabilities persisted among life insurers faced with very low returns on fixed-income assets. The improved performance of the financial sector reflected reduced public sector involvement, greater market-discipline and transparency, and better risk management.

Table 3.Euro Area: Macro-Prudential Indicators for the Banking Sector, 1999–2003(In percent, unless otherwise indicated)
Dec-99Dec-00Dec-01Dec-02Dec-03
Capital Adequacy
Regulatory capital to risk-weighted assets*11.0013.7811.3611.87
Regulatory Tier I capital to risk-weighted assets*7.249.018.358.71
Capital (net worth) to assets3.663.67
Asset composition and quality
Asset composition (in percent of total assets)
Cash and balances1.211.081.161.311.39
Treasury bills3.380.760.710.970.92
Loans to credit institutions14.3919.1318.1817.6817.53
Debt securities29.3923.4223.8419.2420.42
Issued by public bodies7.258.27
Issued by other borrowers11.9912.15
Loans to customers43.7346.5046.3749.0648.17
Shares and participating interest2.004.564.103.353.41
Tangible assets and intangibles1.241.171.131.381.36
Other assets4.063.284.406.776.59
NPLs to gross loans*3.603.443.39
NPLs net of provisions to capital*19.7717.74
Earnings and Profitability
ROA*0.190.290.220.300.31
ROE*1/11.547.515.747.627.87
Interest margin to gross income*54.4555.9459.1353.8953.47
Noninterest expenses to gross income*61.4768.6072.1166.8664.46
Personnel expenses to noninterest expenses53.3055.2451.1557.1457.63
Trading and fee income to total income37.0838.7534.9731.9632.72
Liquidity
Liquid asset ratio 1 (cash and T-bills)4.591.841.872.272.31
Liquid asset ratio 2 (ratio 1 + loans to credit institutions)18.9820.9720.0519.9519.84
Liquid asset ratio 3 (ratio 2 + debt sec. issued by public bodies)27.2028.11
Customer deposits to total (non-interbank) loans0.780.820.830.84
Sources: ECB (ESCB Banking Supervision Committee); and staff calculations.

Included in the “core set” of FSIs.

After tax and extraordinary items.

Sources: ECB (ESCB Banking Supervision Committee); and staff calculations.

Included in the “core set” of FSIs.

After tax and extraordinary items.

Figure 7.Euro Area: Banking Sector Developments

(100 Largest Banks; in percent, unless otherwise noted)

Sources: FitchIBCA database; Datastream; and Fund staff calculations.

36. Financial sector risks relate mainly to global imbalances and the potential for an unwinding of benign market conditions, rather than to domestic factors. On the domestic factors, ECB staff noted that household balance sheets expanded further in 2004, driven by rising house prices and mortgage debt. However, for the area as a whole and on reasonable swings in interest rates, this did not create undue credit risks for banks. On the corporate side, large firms had continued to improve their balance sheets, helped by rising profitability. Indeed, rating upgrades exceeded downgrades in 2004:Q4 for the first time since 1998:Q2. Nonetheless, sluggish domestic demand had left Europe’s small and mediumsized enterprises more vulnerable. The key concerns among the mission’s interlocutors on the external side were exchange rate volatility, a spike in long-term interest rates, and a sudden increase in the price of risk. These developments were seen as more likely to originate outside the euro area, and could cause losses among some financial institutions, notably those with exposures to hedge funds or over-the-counter derivatives markets. In this regard, the general lack of transparency regarding hedge fund activities and trading in derivatives were of concern to the mission’s interlocutors.

An evolving financial landscape

37. The authorities expect the current policy framework—the Financial Services Action Plan (FSAP) and the Lamfalussy process—to result in significant progress toward achieving an integrated market. They noted that the framework had delivered a flurry of Directives essential to integrating Europe’s financial markets. After their transposition at the national level through 2007, this would eventually yield major benefits on the ground. In their view, the FSAP and the Lamfalussy process have been the EU’s most successful recent center-led programs of structural reform, forging consensus among national regulators and supervisors and across the political spectrum, including in the European Parliament. The Commission’s priorities for the next five years are to (i) consolidate and streamline existing legislation and keep new legislative initiatives to a minimum; and (ii) ensure the effective transposition of European rules into national legislation and their enforcement by supervisory authorities. The new initiatives would include integrating clearing and settlement systems—widely perceived as a major hurdle toward the consolidation of Europe’s securities markets; introducing a new insurance solvency framework; and improving crossborder payment systems. The plans also call for pressing for more integration at the retail level through use of competition policy, notably to identify the entry barriers and other obstacles to the provision of crossborder financial services.

38. The staff questioned whether the process would yield sufficiently rapid progress toward financial integration. Staff agreed that significant progress had been made, both on the ground, as evidenced by the progress made in integrating many wholesale activities, and in establishing the procedures to achieve further integration. However, in its view, more would be needed to fully reap the dividends of EMU, notably in terms of achieving an efficient allocation of investible resources, a greater buffering of country-specific shocks via the financial system, and an efficient monetary transmission. In particular, to varying degrees, governments, regulators, and market players continue to safeguard vested interests—as evidenced by state ownership of banks, difficulties in executing crossborder mergers and acquisitions, differences in regulations and supervisory practices, and the slow integration of securities markets. In the same vein, business strategies—notably consolidation among banks—remained largely nationally oriented, which might be thwarting competition,11 and financial innovation (e.g., securitization) was in some respects being pressed at the national rather than area-wide level. At the same time, risk profiles of the EU’s large, publicly-traded financial institutions appeared to be converging around unimproved levels, albeit supported by improvements in risk management. This seemed to be part of growing crossborder activities, including increasingly among larger financial groups. In this overall setting, the ongoing evolutionary/organic approach to integration might not deliver quality regulation and supervision in a timely manner and entail high costs and risks. A more centralized approach to supervision, particularly for the systemically important financial groups, and regulation, building on existing arrangements, ought to be considered. A first step might be giving EU supervisory committees access to basic, up-to-date, institution-specific data (including information on strategies, risk profiles and the potential for contagion risks) covering the limited number of EU financial groups with major crossborder operations.12

39. The authorities considered concerns about the pace and effectiveness of integration premature. Thus far, progress had been on schedule, and financial institutions and their clients were increasingly taking a European-wide approach to their decisions. EU supervisory networks and committees already offered fairly centralized vehicles for rulemaking and coordination of supervision. Information exchange was also intensive between national supervisors of financial groups with large crossborder activities. The newly-agreed Memorandum of Understanding on cooperation in financial crises reinforced this. Further centralization of supervision, even if it was limited to the dozen or so largest financial conglomerates with pan-European businesses and built on existing arrangements, raised complex issues and was not called for at this stage.13 Inefficient legislation or regulation would be reviewed, as proposed in the Green Paper. And recent cross-border takeover proposals finally offered an opportunity to open up national markets for financial services, supported by EU competition policy. In sum, all the mission’s interlocutors were confident that the FSAP and Lamfalussy process could deliver an integrated market for Europe. The process would be re-assessed in 2007, by which time many of the newly adopted rules should have begun to deliver results.

E. Trade Policy

40. The Commission explained its strong preference for the multilateral approach to trade policy. Under the WTO’s Doha Round, it sought to create genuine new market access opportunities, significantly improve WTO rules in areas such as anti-dumping, and contribute to economic development. Commission officials perceived an emerging “political will” to conclude the negotiations successfully and did not expect bilateral trade tensions with the United States to slow the negotiations. Staff welcomed the EU’s role in keeping the Doha negotiations on track but encouraged more ambition in its agricultural market access offer. The Commission staff recognized that negotiations on regional trade agreements (RTAs) diverted attention and resources from the Doha Round and intended to refrain from new RTA negotiations while the Round continued. Staff welcomed EU support for negotiations aimed at enhancing transparency and strengthening WTO rules for regional trade agreements, including those among developing countries.

41. While the Commission recognized the benefits to developing countries from reducing their own trade barriers, they expected substantial Doha-Round commitments only from the more advanced developing countries. Staff saw further trade reform by developing countries as critical if they were to take full advantage of increased market access opportunities. Staff expressed hope that the EU’s Economic Partnership Agreements (EPAs) with ACP countries would rationalize complicated and often overlapping existing RTAs, especially in Africa. Staff also suggested that the developing countries would benefit more by undertaking multilateral (M.F.N.) liberalization than by extending reciprocal preferences for EU exports.

42. Officials expressed the view that the ability by the EU to manage the consequences of the rapid growth of textiles and clothing imports, especially from China, was necessary to maintain internal support for liberal trade policy. These had strongly affected production in some regions of the area and thus they had taken steps toward imposing temporary import safeguards under special provisions of China’s WTO accession protocol but insisted these would not lead to a reversal of earlier reforms. Staff encouraged the authorities to refrain from imposing safeguards, noting the 10-year adjustment period afforded to domestic firms and that any such measures diminished the credibility of future reforms. Since the discussions, China agreed with the Commission to limit, until end-2007, export growth to the EU of ten product categories accounting for half of EU imports of Chinese textiles and clothing. The EU has also launched an anti-dumping investigation on footwear imports from China.

F. Statistics

43. More comprehensive data on flows of funds, balance sheets, non-factor services and trade are needed (Appendix II). Problems have surfaced with the quality of budget statistics in some countries, resulting in significant upward revisions to historical deficit figures. Staff and officials concurred that efforts to improve statistical governance standards needed to be stepped up, including by granting greater independence to national statistical institutes and by endowing Eurostat with greater monitoring and auditing powers. Ongoing efforts to increase Eurostat’s resources are welcome, but may not suffice.

IV. Staff Appraisal

44. The euro area is in the midst of a difficult economic transition and it is essential that the authorities forge ahead decisively with the strategy to ready Europe’s social model for the demographic shock through higher growth. The broad outlines of the strategy have been there for over a decade: fiscal consolidation and entitlement reform; increased incentives on both the demand and, more recently, supply side of the labor market; and strengthened competition, whether via the internal market, enlargement or, indeed, elimination of exchange rates. Implementation has already yielded tangible results—the employment gains of the past decade—and more can be expected from recent structural reforms. However, a preoccupation with the short-term together with inconsistencies in implementation have generated uncertainties, including about basic directions. With the burden of accumulated rigidities and aging continuing to weigh heavily on performance and the sustainability of the social model, it is essential that policies become more forward-looking and consistent, harnessing the complementarities between and within fiscal adjustment and structural reform. In this regard, Europe’s restructured policy frameworks still chart the right course and the increased weight placed on ownership can help build public trust. However, implementation, now more than ever, depends on leadership in national capitals and the European Council.

45. Although the near-term economic outlook is uncertain, the fundamentals remain in place for the recovery to resume. Continued wage moderation, improved corporate balance sheets, accommodative financing conditions, and reaccelerating world demand point to renewed momentum during the second half of the year. But the situation is hard to read and the risks lie mainly on the downside, including further oil price spikes, multilateral euro appreciation in the context of unwinding global imbalances, and a sudden reversal in benign global financial conditions.

46. The monetary policy stance still remains appropriate, but a need for a rate cut may be materializing. Underlying inflation is running well below target and seems likely to continue to do so, but headline inflation is still hovering around 2 percent. Moreover, the latest activity indicators do not paint a consistent picture of the future course of the recovery. Overall, keeping policy rates on hold for the time being is appropriate. However, absent new information on inflation, if evidence continued to accumulate over the coming months that, contrary to projections, the recovery was fading, a cut in interest rates would be appropriate. A rate cut would also be warranted if the euro appreciated significantly on a multilateral basis.

47. Budgetary plans fall well short of meeting the key policy requirement for euro area public finances—to make steady progress toward achieving underlying balance by 2010. Balance is needed both in anticipation of population aging and to move decidedly below the 3 percent Maastricht deficit ceiling. Absent adjustment, the anticipated spike in aging-related expenditure would push public debt in many member states onto an unsustainable path. Accordingly, policies need to consistently redress current and intertemporal fiscal deficits to anchor consumer confidence. This will require structural reforms complemented by annual fiscal adjustment of ½ percent of GDP, net of one-offs and other temporary measures.

48. The SGP needs to regain credibility as EMU’s fiscal framework and this will require transparent, even-handed, and sufficiently ambitious implementation of the reformed framework. The Pact has generally managed to tame runaway deficits and procyclical fiscal policies that were once commonplace in many countries and should remain a cornerstone of EMU’s policy framework. But it has been increasingly undermined as more countries fail to undertake the requisite adjustment, either by allowing their deficits to breach the 3 percent limit or by resorting to one-off measures, creative accounting, or even misreporting to avoid doing so. The proposals that allow for a greater sensitivity to economic circumstances under the dissuasive arm and that call for ½ percent of GDP annual adjustment as a benchmark under the preventive arm are welcome. Nonetheless, because of various provisions, the reforms do not adequately strengthen the preventive arm, which is regrettable given that the failure to adjust during past upturns has been the Pact’s Achilles heel. Potentially open-ended trade-offs between fiscal adjustment and structural reforms, alongside the restrictive definition of “good times” for adjustment to occur, could set the stage for a repeat of past mistakes. Agreement on reform of the Pact is a welcome step forward, but its credibility depends on an even-handed, transparent, and disciplined implementation by the Council of the new commitments.

49. With agenda-setting shifting away from the center, the prospects for reform will hinge on the leadership and determination of national governments. Action is needed to boost potential growth and employment, and also in part for Europe to play its role in facilitating an orderly unwinding of global imbalances. In particular, countries need to focus on reforming entitlement systems, boosting labor utilization, completing the internal market, and integrating national financial systems. In this regard, the new integrated guidelines under the Lisbon Strategy should aid in the formulation of consistent national policy matrices. The longer-term macroeconomic divergences within the monetary union are rooted in swings in competitiveness (broadly construed), and solutions must ultimately be based on increasing flexibility and integration through structural reforms.

50. Garnering domestic support for strong, forward-looking policies in a more decentralized environment argues for strengthening domestic economic institutions. Debating Stability Programs and National Action Plans in parliaments is an important step toward increasing transparency and building ownership. These objectives would also be served—especially in countries facing large consolidation and reform agendas—by developing independent, non-partisan institutions that would inform the public about the larger strategic economic issues they confront and assess policies and their implementation. Such domestically-driven surveillance mechanisms will, however, still need to be complemented by intensive, peer-driven multilateral surveillance of policies, including well-grounded benchmarking.

51. The policy agenda on financial sector integration will increasingly need to emphasize the enforcement of existing rules, including competition policy. Much progress has been made under the FSAP and the Lamfalussy process in laying the foundation for further integration of financial markets and convergence of supervisory practices. Nevertheless, it remains to be seen whether this evolutionary approach will be able to overcome vested interests and deliver a high-quality, harmonized regulatory framework without acting as a brake on integration or exposing the system to unnecessary risk. The onus is now on member states to make the process work and on the Commission to enforce existing rules. Similarly, growing crossborder activities of major, complex financial groups are placing an increasing burden on national supervisors and a more formal approach to areawide collaboration, including provision of up-to-date information on key groups to an existing area-wide structure, deserves consideration.

52. On trade policy, the EU should continue to take the lead in fostering agreement on the Doha Development Agenda. In particular, the EU should offer greater access to its agricultural markets and limit the use of sensitive product exemptions from tariff reductions. Recent moves to limit imports of textiles, clothing, and footwear are unfortunate. On the multilateral stage, there is merit in continuing to stress strong WTO rules over regional trade agreements and working with developing countries in liberalizing their trade regimes on a most-favored-nation basis.

53. While broadly adequate, effective area-wide surveillance calls for improvements in the quality, availability, and timeliness of statistics. Better fiscal data are a key priority for a number of countries.

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

APPENDIX I

Figure A1.Euro Area: Cyclical Developments

(Annualized quarter-on-quarter percent change, unless otherwise specified)

Sources: Eurostat; Datastream; and IMF.

Figure A2.Euro Area: Comparison to Past Cycles

Source: ECB; IMF, World Economic Outlook; and Fund staff calculations.

1/ Includes inventories.

Figure A3.Euro Area: The Past Decade

Source: IMF, World Economic Outlook.

1/ Simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh, euro per barrel.

Figure A4.Euro Area: Export Performance

Sources: ECB; and Fund staff calculations.

Figure A5.Euro Area: External Developments

(In billions of U.S. dollars; unless otherwise specified)

Sources: ECB; WEO, IMF; and staff calculations.

1/ Calculated as residual (excludes global discrepancy).

2/ Excludes intra-area trade (ECB data).

Figure A6.Euro Area: Employment and Wages

(In percent, unless otherwise noted)

Sources: European Commission; ECB; Eurostat; and Datastream.

1/ Constructed with average hours in industry excluding construction.

Figure A7.Euro Area: Financial Markets and Corporates

(In percent, unless otherwise specified)

Sources: ECB; Federal Reserve; and staff estimates and forecasts.

1/ Spending on capital and financial assets not covered by internal funds.

2/ Defined as the ratio of corporate debt to internal funds.

Figure A8.Euro Area: Consumption and Savings

(In percent, unless otherwise noted)

Sources: ECB; European Commission; and IMF World Economic Outlook.

1/ Balance of opinion on financial and general economic situation.

Figure A9.Euro Area: 10-Year Government Bond Spreads from German Bund

(In percent)

Source: Bloomberg.

Figure A10.Euro Area: Monetary Policy Indicators

(In percent, unless otherwise specified)

Sources: ECB; Datastream; Bloomberg; and staff calculations.

1/ Deviation from 1990-2005 mean.

APPENDIX II Statistical Issues

Economic and financial data provided to the Fund are broadly adequate for the conduct of area-wide surveillance. Eurostat and the ECB share responsibility for the production of euro-area statistics, as outlined in a March 2003 Memorandum of Understanding. Since the start of EMU, significant progress has been made in improving the scope and timeliness of euro-area statistics. A plethora of economic time series covering history and current developments is now available on the Eurostat and ECB websites, flash estimates of the main economic indicators are published with short delays, and Eurostat compiles a comprehensive set of structural indicators to support the Lisbon Strategy. Nevertheless, considerable gaps remain, in particular on the national accounts by institutional sector, on labor markets, and on the flow of funds (see IMF Country Report No. 04/234), and further improvements are still needed for external trade.

  • EU member states are in the process of introducing two major changes in their national accounts: (i) the allocation of Financial Intermediation Services Indirectly Measured (FISIM) to consumption, net exports, and intermediate consumption, instead of only to the latter; and (ii) the use of chain-linking for the measurement of economic aggregates in volume terms. The expected effects of these changes include a modest upward revision of GDP levels, improved accuracy and international comparability of estimates of real growth, and the loss of additivity of volume data. While national authorities will implement these methodological changes at different times, euro-area aggregates will reflect them from the Q3:2005 statistical release onward. All EU countries have now implemented the European System of Accounts 1995 (ESA95). Euro-area quarterly statistics on national accounts by institutional sector integrating flow of funds and non-financial national accounts are being prepared by Eurostat and the ECB, with a view to publication from May 2007 onward. A revised Nomenclature Générale des Activités Economiques dans les Communautés Européennes (NACE) classification is planned for 2007, in the context of the UN’s revision of the International Standard Industrial Classification (ISIC). Dates for the subsequent implementation in national accounts and other statistical areas are currently under discussion with EU Member States.
  • Following several cases of misreporting, at the end of 2004 the Commission proposed a strategy to improve governance in the area of fiscal statistics. The implementation of the strategy is well underway: (i) a draft regulation is being considered allowing more in-depth monitoring visits to national statistical authorities by Eurostat and experts from other member states, in addition to current dialogue visits; (ii) Eurostat has allocated more resources to its services that work on national fiscal statistics—although the workload of these services has also increased as a result of EU enlargement; and (iii) a Code of Practice on European Statistics has been drafted to serve as a self-regulatory instrument to improve the independence, integrity and accountability of the national statistical authorities and Eurostat. Work on quarterly public finance statistics is ongoing, with partial publication expected from early-2006 onward.
  • Asymmetries in the intra EU trade data reported by the different member states remain an issue. Work is ongoing to reduce these asymmetries, to increase the consistency between balance of payments and national accounts data, and to improve the timeliness of aggregate euro-area external trade data.
  • Labor market surveys are now conducted every quarter in all EU countries, which will enable the publication of complete quarterly data for the euro area from 2006 onwards. The current estimated series for the labor cost index will be replaced with an improved final series in the near future, based on a harmonized reporting system that became operational in June 2005. Better information on hours worked in the services sector is not expected to become available soon, in part due to concerns over the reporting burden on enterprises. Limited statistics on job vacancies are available for the euro area, and work is ongoing to develop harmonized short-term and structural data in this field. Monthly unemployment statistics are constructed on the basis of quarterly labor force survey (LFS) data, supplemented with monthly data for some countries. Data for some countries are not entirely consistent with the ILO definition.
  • Efforts to harmonize and improve inflation statistics as measured by the HICP continue. Current priorities include quality adjustment and sampling, the development of a price index for newly-built houses (excluding land) on a net acquisition basis and of a self standing price index for (new and old) dwellings, as well as a number of further methodological improvements, such as a common base year and a harmonized price collection period. A pilot project is ongoing to construct an HICP at constant tax rates. Eurostat and the CBS are currently considering how the 2006 health care reform should be reflected in the Dutch HICP.
  • A limited set of financial soundness indicators for the euro area is published in the fall issue of the ECB’s Financial Stability Report. All euro-area countries are participating in the Coordinated Compilation Exercise for Financial Soundness Indicators, but the ECB’s consolidation approach and frequency of compilation are not in line with the Fund’s Compilation Guide on FSIs.
1Including trade policies of the European Union.
2Foreign direct investment (FDI) and “delocalization”—contrary to popular perceptions—appear not to have been a major source of diversion, although they may be forestalling higher wages.
3ECB projections of June 2, 2005, place average annual HICP inflation between 1.8– 2.2 (mid-point 2.0) percent in 2005 and between 0.9–2.1 (mid-point 1.5) percent in 2006. For 2006, this includes a one-off reduction resulting from a health care reform in the Netherlands that is projected to trim 0.2 percentage point from the area-wide price level.
4See the Selected Issues chapter titled “Declining Velocity in the Euro Area: Implications for the ECB’s Monetary Analysis.”
5For a discussion of developments in housing markets and policy issues see the Selected Issues chapter titled “House Prices and Monetary Policy in the Euro Area.”
6Accordingly, staff’s latest forecast places headline inflation at 1.7 percent for 2006, or 0.2 percentage point above the ECB’s forecast mid-point of June 2. A 10 percent rise in oil prices is estimated to lower growth by 0.1 percent and raise inflation by 0.2 percent; a 10 percent effective euro depreciation adds 0.4 percent to growth and 0.3 percent to inflation in the year ahead.
7For the general case against discretion, see for example, Fatás and Mihov (2003), “The Case for Restricting Fiscal Policy Discretion.”
8See Annex II of the Council Conclusions of March 22–23, 2005 (No. 7619/05), available at http://www.eu2005.lu/en/actualites/conseil/2005/03/23conseileuropen/index.html.
9See also ECB Monthly Bulletin February 2005.
10A forthcoming FAD Board paper titled “Promoting Fiscal Discipline: Is There a Role for Fiscal Agencies?” discusses the role of Independent Fiscal Authorities (IFA) and Fiscal Councils (FC) in promoting fiscal discipline. It argues that Fiscal Councils can be beneficial, particularly if they engage in normative assessments and recommendations (as opposed to providing purely objective analyses), and if policies can be gauged relative to pre-existing fiscal rules. Moreover, staff work shows that macroeconomic and budgetary forecasts generated by independent entities tend to be more accurate than those produced by authorities.
11On the state of competition in Europe’s financial sector, notably among banks, see the Selected Issues chapter titled “Banks and Markets in Europe and the United States.”
12See the Selected Issues chapter titled “European Financial Integration: Stability and Supervision.”
13The issues revolve around incentives and the lender of last resort function, solvency support, and winding up rules.

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