Concluding Statement of the IMF Mission on Euro-Area Policies
Context of the 2007 Article IV Consultation Discussions with the Euro-Area
May 30, 2007
1. Good economic times have returned on the heels of generally good policies, but policymakers now need to overcome tendencies toward good-times complacency. Fifty years after the signing of the Treaty of Rome, the envisioned Single Market still holds the key to growing prosperity. The achievements are major and justify optimism. So too does the progress that has been made in preparing for population aging, the key challenge facing welfare systems. Much of this has been accomplished during bad economic times, with policies often falling short of requirements during good times, leaving urgent work undone. The intentions are different this time around, and in line with Europe's economic governance framework (e.g., the Stability Pact and the Lisbon agenda). This is welcome. They must now be translated into action.
2. The euro-area economy is moving from recovery to upswing. Key fundamentals for continued solid growth are in place, including favorable profitability, financing conditions, and external demand; but also improved fiscal positions and, especially, buoyant employment growth fuelled by reforms to labor markets and welfare systems as well as immigration. Moreover, company balance sheets are more robust than during the previous boom. Additionally, the area's external position is balanced and the real effective exchange rate of the euro continues to trade within range of medium term equilibrium. Accordingly, the central scenario is for real GDP to grow at about 2½ percent in 2007 and to continue apace in 2008.
3. The risks to this outlook are relatively small and on the upside in the short run, but widen and shift to the downside further out. External risks are to the downside and growing over time, relating to oil prices, global current account imbalances, potential investor flight from risk, and US growth. Domestic risks are to the upside in the short run, and dominate. With strengthening employment prospects and emerging equipment capacity constraints, households might consume and businesses invest more than projected. Over the medium run, however, stretched housing markets in parts of the area raise some domestic concerns.
Inflation and monetary policy: removing policy accommodation
4. In this setting of above potential growth, inflation can be expected to firm gradually. Wage and unit labor cost growth remain subdued, and one-off factors boosting inflation this year should recede next year. However, available indicators point to increasing utilization of both capital and labor resources. Given the strong growth prospects, this points to some firming of price trends over the medium term, including in wage increases and unit labor costs. With allowance for the role of the one-off factors, we project inflation to remain around 2 percent over the next two years, with the risks over this horizon being broadly balanced.
5. Accordingly, some further monetary policy tightening is required, but how much is uncertain. While liquidity is growing at a brisk pace, its relationship with prices is uncertain over the policy horizon. In the meantime, the policy rate has come within range of neutral. The need for further action depends in part on uncertain supply-side developments, notably the nature of the incipient acceleration of productivity, which thus far has not moved much beyond cyclical norms, and the extent to which reforms and demographics have improved labor supply, as suggested by downside surprises on wages. On the demand side, action hinges on the evolving distribution of risks to activity further out, including those related to global imbalances and the exchange rate, which are presently seen on the downside.
Fiscal policy: adjusting during the upswing
6. Fiscal policy performances in 2006 were generally strong, and the announced intentions to reach medium-term "close to-balance or surplus" objectives (MTO) by 2010 at the latest are welcome. Fiscal positions have surprised on the upside, reflecting buoyant revenue that in many but unfortunately not all countries has been allocated to debt reduction. As the upswing unfolds, the temptation to slow down adjustment toward MTO and to spend revenue windfalls must be resisted. Indeed, fiscal positions today are not much better than at the previous cyclical peak and for some countries avoiding a repeat of past breaches of the 3 percent deficit limit is far from assured. Furthermore, the pressure from aging-related public expenditure, which is forecast to rise by at least 3¾ percent of GDP through 2050, will build soon after 2010.
7. Accordingly, countries that have not yet reached their MTO should adjust by at least ½ percent of GDP per year. The supporting measures ought to be cast in a medium-term budgetary framework aimed at improving incentives to work and invest. In this regard, the trend toward strengthening fiscal policy rules and governance mechanisms is welcome. This should help bring forward the credibility gains from adopting complementary fiscal and structural policies.
Structural reforms: raising living standards via increased market contestability
8. The fundamental structural challenge is to effect a joint acceleration of productivity and employment. While reforms to and adjustment in labor markets have led to a significant strengthening of employment performance, the area's productivity performance has been enduringly disappointing. This is mainly due to the weak performance of the sheltered nontradable services sectors rather than the tradable sectors, suggesting that the contestability of national services markets needs to be raised. The Services Directive is a significant step in this direction—provided its public interest provisions are not abused. To hasten its effect, its implementation should be monitored in a framework featuring interim progress reports. Deregulation and other steps to increase contestability also have to be extended to services sectors not covered by the Directive, and labor market reforms need to remain oriented toward strengthening participation and incentives to work.
9. The revamped Lisbon Strategy is picking up steam, but still has some way to go in fostering ownership, harnessing the national and area-wide synergies among reforms, and becoming more transparent. The return to issuing country-specific policy recommendations testifies to the renewal of the Lisbon Agenda, which is welcome. The National Reform Programs (NRP) are useful vehicles to foster greater internal coordination of nationally-driven reform programs as well as of the latter with Community-led initiatives. They are potentially especially helpful to current and prospective EMU members to help them jointly address their respective capacity to adjust to economic shocks. While there are some signs of progress, too many countries are still not using the NRP to that effect and too many NRP are too vaguely specified to be monitorable and hence as credible as they might be. The ongoing efforts to deepen the analysis of the bottlenecks to growth and improve the recording and quantification of reforms are essential to remedy this and strengthen peer review. Additionally, the country-specific recommendations ought to place greater emphasis on addressing NRP transparency and governance issues.
10. The structural reforms committed to under the Multilateral Consultation remain on track. These policies, while of benefit in the first instance to the growth performance of the euro area, are thereby also important to the avoidance of a disorderly adjustment to global imbalances. It is important that their implementation continues apace.
Financial markets: advancing integration while strengthening stability
11. Europe's productivity performance could get a major boost from the integration of the markets for financial services. To that end, retail financial services need to become more contestable and Europe's capital markets developed further. This requires a consistent cross-country implementation of the EU FSAP (notably MiFID) and the integration of both clearing and settlement systems and markets for collateral-based transactions as well as for various other investment vehicles (including retirement saving). In this regard, the complexity and far-reaching nature of MiFID and its potential to significantly alter financial markets in Europe represent a major challenge for European securities supervisors.
12. Europe's financial stability framework is running behind market developments and holding up financial integration. While significant steps have been taken and more are being considered, progress on the ground is being held back by the governance framework. The core problem is the tension between the impulse toward integration, on the one hand, and the preference for a decentralized approach, on the other, the whole within a framework of misaligned incentives. Specifically, under the EU's home-host supervision model, supervisors are accountable only to their national authorities, informational asymmetries between home and host supervisors are large, and actions by one supervisor have potentially large effects on the jurisdiction of another. Particularly when applied to large cross-border financial institutions (LCFI), this setting rules out efficient and effective crisis management and resolution, thus fostering moral hazard and posing unnecessary risks for national taxpayers. More proximately and immediately, the misaligned incentives that pervade the framework are also at the root of the frustratingly slow progress on the crisis prevention/supervision dimensions of the framework, e.g. on supervisory convergence—which is central to building an integrated market for financial services—and systematic information sharing.
13. An integration-compatible financial stability framework will need to be built upon a foundation of joint responsibility and joint accountability for LCFI. Practical steps toward aligning the incentives of supervisors should be taken now to foster progress on the stability framework. In this regard, the proposal to introduce a European orientation to the mandates of prudential authorities is welcome. For this to be effective, however, the mandate should include a charge to minimize the collective costs facing EU states from potential LCFI failures. Such a modified mandate, together with agreement on a compatible set of principles and procedures to guide crisis management and qualified majority voting for Level 3 committees, would offer the prospect of tangible progress going forward.
14. Given such a framework, existing practices and approaches would acquire new life and urgently required new initiatives would become more practicable. Revamped cross-border arrangements for supervisory cooperation and memoranda of understanding should become better able to keep pace with market developments and address the informational and accountability issues, including the need for more (and more standardized) ex ante cooperation and information sharing than is common. Such arrangements at the level of individual LCFI would need to be complemented by a system-wide arrangement that would need to include the ECB. This could be achieved through a joint database with up-to-date supervisory information on Europe's LCFI. More ambitiously, a joint accountability framework should also enable progress on other thorny issues, including deposit insurance, work on converging supervisory powers, developing and implementing convergent pre-crisis sanctions and tools, and analyzing and improving the operation of insolvency laws as applied to banks in an area-wide context. With many of these steps requiring a daunting degree of harmonization across national legislation, an alternative approach would be to put in place a specific EU-level prudential regime. Such a regime could be provided in the form of a European Banking Charter that is open to all banks but calibrated to attract LCFI, thus permitting market-driven optimization of prudential arrangements.
15. With trade having consistently been a boon to Europe's productivity performance, an ambitious conclusion to the Doha Round is very much in the EU's interest. A willingness to agree to additional liberalization, in particular in agriculture, is needed on the part of the EU for successful agreement, and the window of opportunity to reach such an agreement may well be closing. Bilateral agreements may provide benefits to their participants and may be able to secure liberalization in "new" areas that fall outside the scope of Doha Round negotiations. However, they are inferior to multilateral liberalization for both members and non-members; and their pursuit may divert political energy away from securing an ambitious Doha Round outcome. The EU should also take more account of the benefits consumers have from trade and exercise restraint in the use of contingent protection such as antidumping and special textile safeguards, even if these are compatible with WTO obligations.
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