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Statement by Johann Prader, Alternate Executive Director for Euro Area Executive Board Meeting

Author(s):
International Monetary Fund
Published Date:
August 2005
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As Austria has been representing the Presidency of the Eurogroup of euro area finance ministers since 1 July, 2005, my statement expresses the common views of the euro area Member States and the European Community in their respective fields of competence.

The authorities of the euro area Member States welcome the staff assessment of economic developments and prospects in the euro area. They broadly concur with the policy conclusions in the staff appraisal. Nevertheless, some differences of view can be observed, which are outlined in this statement. In addition, I will update the Board on recent economic developments and policy actions taken at the European level.

Short term economic outlook

After a soft patch in the second half of 2004, economic growth in the euro area gathered momentum in the first quarter of 2005. However, contrary to expectations, the acceleration of activity was entirely attributable to net trade, with domestic demand, particularly investment, showing broad-based weakness. Moreover, available survey data suggest that activity slowed again in the second quarter of 2005. Accordingly, domestic demand remains fragile and growth for the year as a whole is likely to turn out lower than earlier expected.

The authorities share the staff’s appraisal that, although the near-term outlook is uncertain, the fundamentals remain in place for the recovery to resume, and they view growth gradually returning to potential during the remainder of the year. Both hard data and surveys have recently improved, supporting this scenario. Monetary and financial conditions remain quite supportive, labor cost pressures are contained despite the oil-price hikes, and the recent weakening of the external value of the euro should provide further support to euro area exports. Moreover, there are early signs that the soft patch in the global economy may be ending and that world trade could pick again up during the second half of the year. Regarding the risks to the short term economic outlook, the authorities agree with the staff’s view that currently they lie mainly on the downside. These include indeed further increases in already persistently-high oil prices, the unwinding of global imbalances leading to a multilateral euro appreciation, and a sudden reversal of benign global financial conditions.

A further issue that has been discussed by the authorities of the euro area is the increased divergence in growth rates and in the composition of growth shown across Member States, particularly among the four largest euro area Member States. While growth differences are a natural and inevitable feature of any large monetary union, the gap between weak and strong growth performers in the euro area risks becoming entrenched over time, which might be indicative of underlying structural problems. The persistence of growth differences in the euro area thus underlines the need for some Member States to boost their adjustment mechanisms in the face of economic shocks with different impacts.

Monetary policy and the outlook for price stability

The euro area authorities welcome the conclusion reached in the staff report that the current stance of monetary policy is appropriate. The analysis in that report is broadly in line with the ECB Governing Council’s baseline assessment that there is no evidence of underlying domestic inflationary pressure building up in the euro area. The Governing Council has identified potential upward risks to price stability over medium to long-term horizons, pointing to a need for vigilance in order to maintain inflation expectations in line with price stability. In particular – and as recognized in the report – since the time of the Article IV discussions, oil price developments have evolved in a manner that implies the materialization of some previously identified upward risks to the inflation projections for the euro area.

As regards the economic analysis, annual HICP inflation remained at levels slightly above 2 percent in June, reflecting mainly recent developments in oil prices. However, wage increases should remain moderate because of weak labour markets. In addition, economic growth has remained subdued in recent quarters. At the same time, as already noted, there continues to be reason to expect a gradual improvement in economic activity in the euro area. On the domestic side, investment should benefit from the prevailing very favourable financing conditions, the robust growth of corporate earnings currently observed and ongoing improvements in corporate efficiency. Consumption should evolve broadly in line with expected developments in disposable income. On the external side, ongoing growth in global demand and improvements in euro area price competitiveness should support euro area exports.

The monetary analysis provides further insight into inflation prospects over medium to longer horizons. Monetary and credit growth in the euro area remains strong, mainly reflecting the stimulative impact of the low level of interest rates. In the context of the significant portfolio shifts between monetary and non-monetary assets in recent years, the signals for likely future price developments given by current monetary developments have become somewhat unreliable. Liquidity remains ample by all plausible measures, even when taking into account the fact that, as claimed by the IMF staff, part of the recent shifts in the evolution of velocity might be due to more structural factors. The combination of ample liquidity and strong credit growth could imply risks of strong asset price increases. Admittedly, the relationship between money, credit, asset prices and consumer prices is complex, but it would be imprudent for the ECB not to monitor these risks. Therefore, monetary developments continue to support the case for vigilance with regard to upward risks to price stability over medium to long-term horizons.

In sum, the economic analysis confirms that domestic inflationary pressures over the medium term remain contained in the euro area, although this scenario is surrounded by upside risks. Cross-checking the economic analysis with information from the monetary analysis justifies ongoing vigilance in order to anchor inflation expectations at levels in line with price stability.

Fiscal policy and SGP reform

The authorities of the euro area share the staff’s view that further consolidation efforts are needed in the area in the years to come. Although the euro area deficit has declined in 2004 after having increased for three consecutive years, more budgetary room is needed, inter alia because of the pressures associated with rising ageing-related expenditures that will materialize starting from the next decade. The euro area authorities judge the size of the annual consolidation effort as defined by the staff (0.5 per cent of GDP in cyclically adjusted terms net of one-off and temporary measures) as appropriate and recommend that a bigger effort is needed by the countries posting deficits in excess of the Maastricht 3 percent reference value.

The authorities recognize the need to complement fiscal consolidation by structural budgetary reforms aimed at addressing forthcoming pressures in age-related expenditure by redefining entitlements to key expenditure programs, encouraging labor force participation and improving the growth potential. In this respect, the greater emphasis given to debt sustainability is welcome. It is also important to avoid pro-cyclical fiscal policies during good times. However, it is also acknowledged that a trade-off between reforms and fiscal consolidation may occur in the short-run, especially if reforms produce a significant budgetary deterioration compensated by savings in the medium-to-long term. This may occur, for example, in the case of pension reforms replacing PAYG schemes with funded schemes recorded outside the government sector.

The judgment expressed by the Fund staff on the reform of the Stability and Growth Pact (SGP) is partly shared by euro area authorities, but with a different view concerning the new provisions on the preventive arm of the SGP. Overall, the euro area authorities concur that the way the new system will be implemented will determine the definitive judgment on the SGP reform. Regarding the reform of the dissuasive arm of the Pact, there is agreement that the possibility of better modulating the adjustment path of the Member States in the excessive deficit procedure (EDP) according to economic circumstances provides the ground for inducing a credible adjustment achieved via structural rather than one-off measures. Concerning the new provisions that define the Treaty’s reference to “other relevant factors”, there is acknowledgment that Member States continue to be committed to the Maastricht deficit and debt ceilings and that these provisions outline how to deal with the room for judgment in implementing the EDP. The euro area authorities consider instead that the concern expressed by the staff on the reform of the preventive arm of the SGP is exaggerated. Here, the focus on overall fiscal sustainability will clearly be enhanced. The amended regulation explicitly refers to a benchmark annual adjustment towards the medium term objective of 0.5 per cent of GDP net of one-offs. As a result of the SGP reform, countries are now required to report in their stability and convergence programs the reasons for the lack of adjustment towards the medium term objective. These reasons will be discussed within the Council, with a likely increase in peer pressure.

Lisbon Strategy

In the context of the need for economic reforms to boost potential growth and employment, the authorities welcome the staff’s attention for the reinvigorated Lisbon Strategy. In view of the disappointing progress made in achieving the Lisbon objectives set in 2000, the Strategy has recently been refocused toward its growth and employment objectives. The changes made in the Strategy attempted to address the main weaknesses, namely the slow implementation of reforms in Member States and a gradual loss of political focus. The renewed Lisbon Strategy aims to increase the consistency and focus of the reform agenda through the identification of three major priorities: knowledge and innovation; making the EU an attractive place to invest and work; and more and better jobs. While the staff does not contest these priorities, its recommendations for reforms focus primarily on labor and financial markets and completing the Internal Market. However, appropriate attention needs to be devoted as well to the generation and effective use of knowledge and innovation which is the key factor for boosting Europe’s competitiveness and long-run growth potential. In addition, one should not lose sight of the fact that growth and stability-oriented macroeconomic policies are necessary to reap the full benefits of reforms in terms of growth and employment.

Improvements in the implementation record of Lisbon reforms are to come through increased ownership of reforms by Member States and considerable simplification of the reporting and assessment process. The Integrated Guidelines Package is the first step in this process. It brings together, for the first time, the Broad Economic Policy Guidelines and the Employment Guidelines into an integrated package, and sets out broad priorities on the basis of which Member States will prepare their National Reform Programs. The continued use of multilateral surveillance for the BEPGs, supported by the active role of the Commission, should support Member States in addressing structural problems in a coherent manner and avoid the temptation to postpone politically sensitive reforms. It is certainly true that improved communication on the necessity and benefits of reforms is essential for a substantial breakthrough.

Financial market developments

The authorities concur with the staff’s balanced analysis of financial-sector developments both in terms of stability risks and the ongoing process of integration. As the recovery proceeded, the financial sector became progressively more resilient to possible adverse shocks. However, this favorable assessment must be qualified by reference to a range of stability risks linked to persistent imbalances elsewhere in the financial system. As indicated in the staff report, these stability risks relate mainly to external factors such as tensions in the international balance of payments, a possible mis-pricing of risk in asset markets and the nature of markets for newer and more complex financial products. At the same time, it is important not to underestimate the significance of some domestic developments, notably strong price pressures in some real estate markets but also expanding credit and high private-sector debt levels under conditions of sustained below-par economic growth. In light of the risks from many different sources, vigilance in the prudential supervision of financial intermediaries will be key in the period ahead.

Now that the Financial Services Action Plan (FSAP) is almost fully implemented at the EU level, the process of financial integration has reached an important juncture. The FSAP is the blueprint for a common regulatory framework and is a pre-condition for an effective internal market in financial services. One of the main challenges now for the Commission and the Member States is to ensure timely and consistent transposition of the various legislative measures in the FSAP to national law and, thereafter, to provide the mechanisms to ensure adequate enforcement. Even as the new regulatory framework is being put in place, the process of financial integration is increasingly evident in the actual functioning of the financial sector. While the pace of progress varies with the type of market (e.g. wholesale or retail) and the transaction (e.g. secured or unsecured), there is ample evidence of an acceleration in cross-border financial activity.

While the staff acknowledges that progress has been made in financial integration, it suggests that its pace may need to be accelerated so as to contribute more actively to ongoing efforts to boost overall economic performance. Staff concerns that institutional arrangements – particularly in the area of prudential supervision – may not be keeping sufficient pace to manage cross-border financial stability risk seem not fully justified. First, progress in financial integration is on schedule and is already delivering positive economic results. The next phase of integration will focus on consolidation, implementation and evaluation of existing legislation rather than introducing a broad new legislative programs. However, the momentum created by the FSAP should not be lost. The Commission has already identified several areas for possible action, such as the post-trading infrastructure for securities markets, the asset management industry and retail financial services. Second, the need to ensure adequate arrangements for crisis prevention and management in an integrated financial sector has been under consideration by the relevant EU authorities for several years. The result has been improved arrangements and structures among national supervisors, central banks and ministries on either a bilateral or multilateral basis, which would seem adequate to the task without the need, at this stage, to seek the more centralized solutions advocated by the staff

Trade policy issues

Finally, I would like to address the staff’s assessment of trade policy issues. In this field the Doha Development Agenda (DDA) remains the EU’s top priority. The EU aims for an ambitious outcome of the DDA which should deliver substantive trade liberalization and stronger multilateral rules, including on trade facilitation, while supporting sustainable development. The DDA is entering a critical stage with the Hong Kong Ministerial approaching. The EU has shown leadership in advancing the Round and is willing to continue to play a leading role. However, in order to secure an ambitious and fair outcome of the DDA others will have to take their responsibilities as well.

The EU attaches great importance to the development dimension of the DDA and strongly supports the view that an ambitious outcome is needed. An additional effort to address supply side constraints is needed in some countries to ensure that they will be able to take advantage of new and existing opportunities to trade. The EU and its Member States will therefore increase their efforts in the area of aid for trade. At the recent G8 meeting the President of the Commission, Barroso, pledged to increase EU Trade-Related Assistance to € 1 billion per year.

Another priority of EU trade policy is the Negotiation of Economic Partnership Agreements with six ACP regions which focus on trade as a tool for development. A main aspect of the talks is the promotion of economic integration as a stepping-stone towards integration into the world economy.

On textiles and clothing, the EU concluded recently a Memorandum of Understanding with China covering the import of 10 product categories for the period 2005-2007. This can be considered a satisfactory solution as it seeks to avoid repetitive recourse to safeguard action and, as such, an amicable solution to a difficult problem.

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