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IMF Executive Board Discusses Euro Area Policies

Author(s):
International Monetary Fund
Published Date:
August 2005
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Background

The area’s low-flying recovery continues to struggle against the background of strong global growth. After losing momentum in the second half of 2004, real GDP rebounded in the first quarter of 2005, recording 2 percent growth (on an annual basis). However, domestic demand unexpectedly stalled, after showing encouraging gains at the end of last year. Lacking more vibrant domestic demand, as both households and corporations have been slow to step up spending, the economy has been more vulnerable to external shocks. Sharply rising oil prices and sustained euro appreciation in recent years have dampened growth, partly offsetting the impact of buoyant world trade on the area’s external sector.

Headline inflation has moderated to 1.9 percent in mid-2005, after escalating energy prices and administered price increases had pushed up inflation to 2½ percent last year. Underlying inflation remains low at about 1½ percent. A key factor behind subdued inflation has been modest wage growth and the absence of “second-round” effects. Reflecting this and some cyclical rebound in labor productivity, unit labor costs have been declining in real terms.

With favorable labor costs and low interest rates, euro-area corporations have improved profitability and strengthened their balance sheets. Low investment-output ratios and relaxed financing conditions should boost investment activity. But firms, thus far, remain in a defensive posture, more content to consolidate balance sheets or payout dividends than to seek out new financing, invest in new capital, or hire new workers.

Reticent private consumption has been a key missing link to a self-sustaining recovery. Households have been hesitant to spend owing to uncertain job prospects, modest wage earnings, and unfavorable price shocks. Low interest rates have fueled demand for housing and rising real estate values, but this has not translated strongly into higher consumption expenditures.

Financial conditions remain accommodative. In particular, monetary policy continues to be supportive of the recovery, with policy rates at low levels and unchanged since June 2003. Benign global market conditions have also helped ease long-term interest rates near historical lows. The euro has retreated from its recent highs against the dollar and multilaterally, but persistent global current account imbalances still constitute a key risk for further euro appreciation in light of recent history and the single currency’s expanding international role.

Fiscal policy in the euro area has been broadly neutral, with structural balances moving sideways and overall fiscal balances weakening—reflecting the operation of automatic stabilizers. Fiscal deficits, on staff projections, in five countries (France, Germany, Greece, Italy and Portugal) are expected to breach the Stability and Growth Pact’s (SGP) 3 percent of GDP limit in 2005-6, some by wide margins. Moreover, public finances have not made progress toward the area’s medium-term fiscal policy requirements of attaining close to balance or surplus in preparation for the looming demographic shock at the end of the decade.

Against this background, the staff projects real GDP to grow by about 1⅓ percent this year and 2 percent next year, underpinned by a resumption in final domestic demand growth. Downside risks include further hikes in oil prices, possible euro appreciation pressures owing to global current account imbalances and continued reluctance by households and corporations to step up spending. At present exchange rates and oil prices, inflationary pressures appear set to ease, with headline inflation expected to fall to 1¾ percent in 2006, in an environment of maintained wage setting discipline, and continued slack in goods and labor markets.

Executive Board Assessment

While expressing disappointment with the struggling recovery and continuing high unemployment, Executive Directors noted that the economic fundamentals in the euro area have continued to strengthen, reflecting significant structural reforms in several member states. In particular, past labor market reforms and continued wage moderation have further improved labor market resiliency, while corporate profitability has strengthened. At the same time, Directors observed that the burden of accumulated rigidities, and aging, continue to weigh heavily on the euro area, and fiscal policies fall well short of the area’s fiscal consolidation requirements. Furthermore, business and consumer confidence remains low, reflecting the still significant economic challenges facing the euro area.

Against this background, Directors called for a more decisive and consistent pursuit of forward-looking policies aimed at strengthening fiscal adjustment and structural reform, while harnessing the complementarities within and between fiscal adjustment and structural reform. In this regard, they considered that Europe’s restructured policy frameworks chart the right course, and the increased weight they place on ownership will be helpful for strengthening public trust and confidence. At the same time, now more than ever, effective implementation will call for the leadership and determination of both national capitals and the European Council.

Directors considered that the fundamentals remain in place for the modest recovery to resume in the second half of 2005, but with downside risks continuing to prevail. 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. Nevertheless, the outlook is uncertain, and the risks lie mainly on the downside, including from further sharp increases in oil prices, multilateral euro appreciation in the context of unwinding global imbalances, a reversal in the benign global financial conditions, and a potentially sluggish investment recovery in the face of weak business confidence.

Directors agreed that the European Central Bank’s monetary policy stance remains broadly appropriate. While headline inflation is still hovering around 2 percent, underlying inflation pressures remain subdued. With the latest activity indicators not painting a consistent picture of the future course of the recovery, Directors agreed that a wait-and-see attitude remains appropriate. However, many Directors stressed that, absent new information on prices or wages, a cut in interest rates would be appropriate if evidence of a fading recovery continues to accumulate over the coming months. These Directors felt that a rate cut would also be warranted if the euro appreciates significantly on a multilateral basis. Some Directors, however, questioned the case for a rate cut, pointing to the upside risks to headline inflation and the predominantly structural nature of the area’s sluggish activity. Given the considerable uncertainty surrounding the economic outlook, Directors encouraged the European Central Bank (ECB) to remain vigilant, and to stand ready to respond flexibly, as warranted.

Directors underscored the need to prepare the euro area’s public finances for the looming demographic shock. This will require steady progress toward achieving underlying fiscal balance by 2010, when population aging is set to accelerate. Many Directors advocated policies that consistently correct current and intertemporal fiscal deficits to anchor consumer confidence. This will require sustained fiscal adjustment of about ½ percent of GDP annually over the medium term—complemented by further structural reforms that address fiscal liabilities and strengthen the tax base. Fiscal adjustment is also needed to achieve adequate safety margins below the 3 percent Maastricht deficit ceiling and restore the credibility of the Stability and Growth Pact. Directors reiterated the crucial importance of achieving these objectives, especially in view of the limited progress that has been made in shoring up the area’s public finances over the past five years and the modest objectives for the medium term. Given the constraints imposed by the single monetary policy, a few Directors thought that fiscal policy should continue to have some role in smoothing out cyclical fluctuations, taking account of country-specific circumstances.

Directors welcomed the renewed agreement on the Stability and Growth Pact but underscored that its credibility depends on effective implementation. The reforms that allow for a greater sensitivity to economic circumstances under the Pact’s dissuasive arm, and call for minimum annual adjustment under the preventive arm, are improvements over the old framework. Nonetheless, many Directors cautioned that potentially open-ended tradeoffs between fiscal adjustment and structural reform and the restrictive definition of “good times” could be used to justify insufficient consolidation during upswings. A transparent, evenhanded, and sufficiently ambitious implementation of the reformed framework will thus be essential for Europe to address successfully its fiscal policy challenges.

Directors agreed that actions to boost potential growth and employment are crucial, and called for particular attention to the appropriate sequencing of product, service, labor, and financial market reforms. Key actions include reforming entitlement systems, boosting labor utilization, deregulating and strengthening competition, completing the internal market, and integrating national financial systems. In this regard, the new integrated guidelines under the revamped Lisbon Strategy were welcomed, as they should aid in the formulation of consistent National Action Plans. Directors observed, however, that with the agenda-setting shifting away from the center, the prospects for reform will hinge on the leadership and determination of national governments. In this regard, Directors acknowledged that national governments may be concerned about pressing ahead with structural reforms that may temporarily weaken demand. They nevertheless stressed that pursuit of clear and credible policy objectives that leverage the complementarities between product and labor market reforms should help boost investment without imparting undue effects on domestic confidence and consumer spending.

Many Directors considered that growth-enhancing structural reforms will be helpful in underpinning an orderly unwinding of global current account imbalances. While recognizing that global imbalances are attributable to a complex combination of factors, they noted that structural reforms needed from the euro area’s own perspective—namely to unlock the area’s productive potential, boost its demand, reduce its vulnerabilities, and enhance confidence—would also aid the global economy. However, some Directors believed that, while structural reforms will be crucial to raise the area’s growth potential, their effects on the euro area’s saving-investment balance remain ambiguous.

Directors agreed that the experience with the Stability and Growth Pact and the Lisbon agenda points to the importance of garnering domestic support for strong, forward-looking policies. They considered that debating Stability Programs and National Action Plans in parliaments would be important steps toward increasing transparency, informing the public, and building ownership. Many Directors believed that achieving these objectives would also be aided—especially in countries facing large consolidation and reform agendas—by developing independent, non-partisan institutions that are tuned to country-specific needs and inform the public about the larger strategic economic issues they confront, engage in the policy debate, and assess policies and their implementation. The policy mandate, however, should remain in the hands of elected representatives. Some Directors noted, however, that similar institutions already exist in several countries and that additional focus on them might detract attention from policy implementation. Directors agreed that intensive, peer-driven multilateral surveillance of policies remains essential.

Directors welcomed the progress that has been made through the Financial Services Action Plan and the so-called Lamfalussy process in laying the foundation for further integration of financial markets and convergence of supervisory practices in Europe. The onus now is on all member states to take a pan-European view to make this process work effectively, and on the Commission to enforce existing rules, including through competition policy. Directors agreed that growing cross-border activities of major, complex financial groups are placing an increasing burden on national supervisors. Many Directors also thought that a more integrated approach to supervision, including provision of up-to-date information on key groups through an existing area-wide structure, deserves consideration. A few Directors, however, felt that entertaining such moves at this stage is premature, with implementation of the Plan still incomplete.

On trade policy, Directors welcomed the EU’s continued commitment to playing a leading role in forging agreement on the Doha Development Agenda. They underscored the importance and the multilateral benefits from greater access to the EU’s agricultural markets. Many Directors regretted the recent moves to limit imports of textiles, clothing, and footwear.

Directors stressed that effective area-wide surveillance calls for improvements in the quality, availability, and timeliness of statistics, and strengthened statistical institutes. While the availability of statistics is broadly adequate, better fiscal data remain a key priority for a number of countries.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

Euro Area: Selected Economic Indicators
2000200120022003200420051/
In percent
Real Economy
Change in Real GDP3.81.81.00.72.01.3
Domestic demand2.91.00.41.21.91.3
Consumer prices 2/2.12.32.32.12.12.1
Unemployment rate 2/3/8.27.88.38.78.98.9
In percent of GDP
Public Finance
General government balance 4/-0.9-1.8-2.5-2.8-2.7-3.0
General government debt70.068.968.870.170.672.2
In percent
Money and Interest Rates
Change in M3 (end of year)4.18.07.07.16.66.75/
Money market rate (3 month money)4.44.23.32.42.12.16/
Government bond yield (10 year bonds)5.55.04.94.24.23.36/
In percent of GDP
Balance of payments
Current account balance 7/-1.20.00.90.30.60.4
Trade balance 7/8/0.11.11.81.41.40.89/
Official Reserves (US$ billion) 10/242.3235.0247.0222.7211.3200.06/
In percent
Exchange rates
Nominal effective rate (2000=100)1001011041161201216/
Real effective rate (2000=100) 11/100991021131151166/
Sources: Eurostat; European Central Bank; and IMF Staff, World Economic Outlook.

WEO, June 2005.

Period average; harmonized definition.

In percent of labor force.

Excluding UMTS license receipts.

April 2005.

May 2005.

Excluding intra-euro area trade.

Data for goods.

2005:Q1.

End-of year. Total reserves minus gold (Eurosystem definition).

Based on normalized unit labor costs.

Sources: Eurostat; European Central Bank; and IMF Staff, World Economic Outlook.

WEO, June 2005.

Period average; harmonized definition.

In percent of labor force.

Excluding UMTS license receipts.

April 2005.

May 2005.

Excluding intra-euro area trade.

Data for goods.

2005:Q1.

End-of year. Total reserves minus gold (Eurosystem definition).

Based on normalized unit labor costs.

1Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities.

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