Mission Concluding Statement 

Euro-Area -- Concluding Statement of the IMF Mission on Euro-Area Policies

May 30, 2006

1. Optimism about near-term prospects is returning and the opportunity to transform it into confidence in the area's fundamentals should not be missed. Decisive progress on growth and employment requires policies to do more to exploit the synergies between fiscal adjustment, welfare reform, and enhancing the efficiency of all markets, whether for labor, capital, goods or—but perhaps especially—services, including financial services.

Macroeconomic issues

2. The recovery is gaining traction, but prospects beyond 2006 remain in question. Business confidence and the rebound in corporate profitability is spreading to small and medium-sized enterprises; investment is picking up; and hiring expectations and consumer confidence are recovering. Supported by continued robust external demand and accommodative financial conditions, the baseline scenario is for real GDP growth to remain around 2 percent, its average since last summer. However, a sustained pick-up beyond this pace, while possible, appears unlikely given appreciable headwinds, including higher oil prices, a strengthening euro, and some weak fundamentals—the decade-long sluggishness of productivity and the decline in the area's population beginning in 2010.

3. External and one-off shocks will likely keep headline inflation above 2 percent for much of the period to end 2007, but inflation is projected to recede to below 2 percent thereafter. With unemployment still high, wages are expected to firm only very gradually. Domestic pressures on inflation, aside from tax and administered prices, should thus remain contained into 2007—in line with various measures of underlying inflation, which are running below 2 percent.

4. Risks to growth and inflation seem tilted to the upside in the near term and to the downside in 2007. Healthy corporate profitability and robust world growth this year could trigger a stronger response of investment and employment and amplify the response of headline inflation to exogenous shocks. Looking further ahead, downside risks to activity and prices increasingly predominate, relating mainly to unresolved global imbalances, flight from risk in capital markets, euro appreciation, rapid credit growth and potentially stretched asset valuations in parts of the area in a context of weak labor markets and global competitive pressures.

5. With inflation expected to revert to its benchmark only slowly and with the recovery gaining traction, some further withdrawal of monetary accommodation appears warranted. However, the conditions for continued and thus more substantial tightening do not seem in place: headline inflation is expected to shift back below 2 percent in 2008, inflation expectations remain well-anchored, and risks are weighted to the downside. Continued tightening would seem to require a quickening in the fundamentals of the recovery—notably, under present circumstances, in employment growth—or the emergence of second-round effects or of yet further shocks likely to prompt increased domestic inflationary pressures. Growing uncertainty in financial markets and an appreciating euro also argue for caution in raising rates, as does the uncertainty of the extent of policy accommodation because of falling potential growth and high saving.

Structural challenges

6. While many reforms have been undertaken over the past decade, the payoffs have been positive but not decisive. Labor markets and wage setting have become more prudent and flexible, prompting major employment gains since the mid-1990s and exceptional resiliency during the latest downturn. Similarly, pension reforms have effected major improvements in fiscal sustainability and in the participation rates of the cohorts most affected. In the same vein, some product and services markets have been liberalized, fostering commendable productivity performance in the deregulated transport and communications sectors, for instance. But labor utilization is still low, unemployment high, productivity growth decidedly disappointing, and long-term fiscal sustainability still an issue. Moreover, the underlying rigidities are widely viewed as contributing to the sustained divergences in intra-area growth trends and imbalances—divergences that have contributed to concerns about the entry of new members even though some of these seem well-positioned to instill a new dynamic to the euro area. Clearly, there is a need for more reforms.

7. The experience of Europe's more successful long-term reformers suggests that more decisive progress is less a matter of social choices than of pursuing functionally and intertemporally consistent and complementary fiscal and structural policies. In the main, fiscal adjustment in these countries centered on welfare reform and the government wage bill, using the ensuing labor supply and related revenue improvements to cut taxes and maintain the reform momentum. These steps were complemented by actions that enhanced both factor and product (goods and services) market flexibility and enabled a stronger translation of wage moderation into jobs and increased real incomes rather than rents. Importantly, reforms along these lines also proved to be compatible in some of the countries with broadly stable income distributions. While these strategies all took a long time, the main lesson would seem to be the importance of devising mutually reinforcing packages of fiscal and structural policies that can be sustained over the long term. By this standard, recent area-wide policy initiatives on both the fiscal and structural front offer some promise, but major challenges need to be faced if decisive progress is to be expected.

Fiscal adjustment

8. In this regard, the reformed Pact is showing more promise than widely expected. Helped by strengthening activity, but also by the application of the new rules, budgetary outcomes surprised on the upside in 2005. Moreover, the handling to date of the cases of excessive deficits suggests that the corrections will continue—as they of course must if the Pact's increased credibility is to be sustained. Concerning the less-binding preventive arm of the Pact, it is too early to tell, but it is reassuring to note that countries are aiming for balanced accounts in the medium term and that the macroeconomic and fiscal assumptions underlying stability plans have become more realistic.

9. The fiscal challenges going forward remain formidable, however. Both the Pact and the onset of population decline around 2010 point to the need for adjustment of at least ½ percent of GDP per annum over the next 4-5 years. Broader considerations of economic strategy together with the report of the Aging Working Group argue for this to be effected on the expenditure side, where little overall primary consolidation has been achieved over the past 5 years. Moreover, while recoveries ought to be the time to effect adjustment, experience points to an ingrained resistance to do so among euro-area members. It is therefore critical—both to the longer-term economic health of countries and the credibility of the Pact—that the Pact be used to help countries use the better-times that appear in the offing to achieve underlying balance. As the preventive arm of the Pact is fairly soft, however, continued adjustment would also seem to need the support of non-partisan governance mechanisms at the national level that strengthen forward-looking perspectives, e.g. by giving auditing institutions an ex ante mandate.

Product and labor market reform

10. A welcome and indeed potentially promising feature of the new Lisbon process is the primacy placed on integrated National Reform Programs. By building up national ownership, these plans could help the public to better understand the need for restructuring, such as through mergers and acquisitions, the creation of a single market for energy, and the Services Directive, to mention recent areas of slippage. However, while progress has been made in involving national parliaments and social partners in the preparation of these plans, much more needs to be done by countries for these plans to become a fulcrum of public debate and a stepping stone to more consistent policies at the country level. At the area-wide level, evaluating progress under these plans in a consistent and transparent manner within a common framework should also help foster policy design and implementation. Regarding the content of the programs, labor market reform must remain a top priority, but the programs could usefully place a higher emphasis on strengthening productivity. While programs emphasize R&D, they pay insufficient attention to strengthening competition and completing the internal market—particularly in segments of Europe's large but insular services sectors where economic rents seem rife.

Financial sector

11. The EU FSAP and Lamfalussy process are fostering the integration of Europe's financial markets, but the pace is too measured given the opportunity costs. Thus, while the framework is designed to remove national barriers and has partly succeeded, obstacles remain pervasive, as evident from the difficulties banks face when expanding across borders, the so-called national goldplating of EU Directives, and the segmented infrastructure of parts of the financial markets. Removing these cross-border barriers will require using all the tools available to competition policy and more forceful public intervention where stakeholders stymie the establishment of open, market-based solutions, notably at present in securities clearing and settlement systems. Progress in these areas is vital: the financial sector accounts for much of the area's lagging productivity performance; and its integration would foster progress in key areas, notably by helping alleviate regional imbalances, improving the pass-through of monetary policy, and leveraging the benefits of greater competition in product and services markets and of increased spending on R&D.

12. The financial stability framework is being progressively strengthened, but we remain concerned whether the oversight of cross-border transactions is keeping pace with integration on the ground. In our view, a clarification and integration of supervisory powers over complex groups--supported by legal and regulatory changes at the national level--will be necessary to improve the efficiency and effectiveness of financial stability policies, notably prudential policies and crisis management. While the issues are complex, postponing political decisions on key drivers, such as the fiscal dimensions of crisis resolution, could significantly slow the process of integration. In the meantime, the latest initiatives—mediation, delegation, supervisory disclosure, and harmonized reporting and sharing of supervisory data—are pragmatic steps forward that deserve strong support from national capitals. As in other areas, the key test will be their rapid implementation. In this regard, priority should be placed on improving time-critical information flows between Europe's supervisors, notably by establishing a central repository with up-to-date information on systemically-important financial institutions that could also serve as a platform to aid crisis coordination efforts.

International Economic Relations

13. While the external position of the euro area is broadly balanced and the euro is seen as falling within a fairly-valued range from a long-run multilateral perspective, stronger growth is needed to facilitate orderly adjustment to global imbalances and limit downside risks to the euro area. While this can be achieved through a variety of measures, the most effective in the current context would appear to be steps to strengthen competition in the services sector, which, besides boosting productivity, would help accelerate growth and demand.

14. More resolve is required by the EU and others to conclude the Doha Round, and stem proliferating bilateralism. The window of opportunity to reach a Doha agreement is rapidly closing, and a serious political commitment to liberalization, including of EU agriculture, is needed to break the logjam. In this regard, the prospective stepping-up of EU bilateral trade initiatives, adding to the proliferation of such initiatives by other countries, would contribute to undermining the multilateral fabric of world trade. Greater efforts should be made to agree common disciplines in this area. Finally, welcome progress has been made in defining the EU's ambitious agenda for delivering Aid for Trade. The Economic Partnership Agreements could represent a helpful context for such aid to the extent that they support more open and competitive markets in developing countries.