Mission Concluding Statement 

Euro Area: Staff Concluding Statement of the 2020 Mission on Common Policies for Member Countries

November 30, 2020

Washington, DC: The human and economic costs of the COVID-19 pandemic have been devastating in the euro area. The policy response by European authorities has been noteworthy for its speed, scope and scale. But the nascent recovery is under threat from the large ongoing second wave of the virus, and formidable policy challenges to counter the pandemic and facilitate a durable recovery lie ahead. Recent positive vaccine developments suggest light at the end of the tunnel.

Outlook and Risks

The COVID-19 pandemic is leading to severe socio-economic dislocations and hardship despite an unprecedented policy response . Euro area real GDP plummeted in the first half of the year. A forceful ECB monetary policy response, an unprecedented fiscal stimulus, and financial sector and other measures at both national and EU levels helped cushion the impact of the crisis and supported a strong rebound in the third quarter. While economic activity remains well below pre-crisis levels, unemployment has increased only modestly thanks to widespread use of job retention schemes. Headline inflation has descended into negative territory for the first time since 2016.

However, the second wave of the virus poses a considerable risk to the recovery . Rising infections and re-imposed lockdowns have damaged confidence and lowered mobility, and the better-than-expected growth outturn in 2020Q3 will likely be followed by weaker activity in 2020Q4. Unless pandemic dynamics change significantly in the coming months, growth in 2021Q1 is set to be weaker than forecast in the October 2020 World Economic Outlook.

The outlook is subject to extreme uncertainty . Risks are dominated by pandemic dynamics. They remain clearly to the downside through early 2021 given the ongoing second wave. But the recent promising news on vaccine development provide significant upside risk further out , as rapid and widespread delivery of safe and effective vaccines would likely spur a fast recovery. A prolonged health crisis and a slow recovery, however, would lead to tighter financial conditions and increased private and public sector vulnerabilities, while significant labor market hysteresis would increase inequality and poverty. Taken together, these “scarring” effects would also depress the growth potential of the euro area. The ongoing negotiations regarding the U.K.’s future relationship with the EU27 and a potential escalation of trade tensions add to the uncertainty.

Fiscal Policy

The historic Next Generation EU recovery package (NGEU) could provide a meaningful boost to euro area growth if it is implemented effectively . The agreement in July on the recovery package, which includes €390 billion in grants, sends a strong signal of European solidarity in facing this crisis. However, hurdles in finalizing the package and disbursing the funds need to be overcome, as further delays would damage euro area recovery prospects. We support the emphasis placed on accelerating green and digital transformations. To achieve the green transformation and meet the EU’s emission reduction goals, more ambitious implementation of robust carbon pricing and public investment policies than currently envisaged will be needed.

The overall growth impact of the NGEU will depend on the scale, quality and efficiency of the national government spending it supports, and on progress with structural reforms . In this regard, the degree of additionality, or the extent to which the NGEU funds lead to higher overall levels of spending rather than simply finance expenditure that was already planned, will be important. Moreover, linking the provision of funds to progress on implementing the EU’s country-specific recommendations should help reinvigorate countries’ reform efforts—which are crucial for strong and durable growth—ensuring that the NGEU serves as a catalyst rather than a substitute for necessary reforms. While the recovery fund does not create the central fiscal capacity that we have long argued should be a key component of the euro area’s architecture, a positive experience with the recovery fund could help build political support for the eventual introduction of such a capacity.

With the ongoing second wave, national fiscal policies will likely need to provide broad-based support for longer than initially envisioned . National fiscal policies have been a critical defense against the pandemic, markedly dampening its economic and social impact by providing critical lifelines for workers and firms. Withdrawing such support too soon would risk derailing the recovery. Notwithstanding this, going forward, further support should prioritize households affected by the crisis and firms that are most likely to prove viable after the pandemic abates. As containment measures are lifted, there will also be a need for broader aggregate demand support, particularly public investment to facilitate green and digital transformations. And as the recovery gains traction, the focus should gradually shift to facilitating reallocation of labor and capital, sustainably boosting inclusive growth, and reducing fiscal vulnerabilities.

Even greater fiscal support will be needed if the outlook materially deteriorates further . For some countries with already high debt levels, providing the necessary fiscal support alongside the realization of sizable contingent liabilities could risk adverse market reactions. NGEU loans and European Stability Mechanism precautionary credit lines—which have yet to be tapped—can help mitigate such pressures. In a severe downside scenario, augmentation or expansion of defenses may be needed.

The escape clause in the Stability and Growth Pact should be extended until the recovery is firmly established . This could also be an opportune time to reform the EU’s fiscal rules. With the normal operation of the rules suspended through 2021, EU leaders should task the Commission with proposing fundamental reforms to the rules as part of its review of the fiscal framework. Reforms should aim to simplify the current rules, making them easier to communicate and enforce.

Monetary Policy

Monetary policy has been appropriately bold, but further support is likely to be needed . The ECB’s monetary policy stance is already strongly accommodative, yet with the economic outlook deteriorating further, additional stimulus will be needed to facilitate a sustained increase in inflation. Expanding asset purchases will be the first line of defense, but other options—including further relaxation of Targeted Longer-Term Refinancing Operations’ terms and a deposit rate cut—should also be considered. In this regard, the ECB Governing Council’s commitment to recalibrate its policy instruments at its next meeting, once the December round of Eurosystem staff macroeconomic projections is available, is welcome.

Even greater accommodation would be needed to counter deflation risks and ensure smooth monetary transmission in a downside scenario . To counter these risks, the ECB would need to further ramp up support via existing and new policy instruments. In this regard, direct support to nonfinancial corporates could be considered if the lending channel were to become impaired.

The ECB’s strategy review of its monetary policy framework is timely . Our preliminary analysis suggests that a clear, transparent, and well-communicated symmetric inflation point target has significant benefits over an asymmetric target that puts more weight on reacting to overshooting the target than to undershooting it. Hence, we recommend formally codifying the Governing Council’s recent emphasis on the symmetry of the inflation aim and changing that aim to a specific point target. A flexible average inflation target could also be explored to better anchor inflation expectations in the context of an extended period of undershooting. A continued medium-term orientation would still allow the ECB to consider broader objectives such as employment and financial stability within its price stability mandate.

Financial Sector

Recent capital relief and conservation measures have supported credit growth, but more recently lending conditions have started to tighten . The banking system entered the crisis in stronger shape than at the outset of the Global Financial Crisis, and the release of capital buffers and dividend restrictions have complemented borrower support measures and significantly increased banks’ lending headroom. However, banks have already started tightening lending conditions as risk aversion rises and credit guarantees and moratoria expire. While bank capitalization is appropriately high, a broader deterioration of asset quality is likely to reduce banks’ lending capacity through its impact on profits and capital buffers.

A slower recovery could result in sizeable capital shortfalls . A sluggish pace of reopening would exacerbate pervasive liquidity problems and increase debt overhang, especially for borrowers in vulnerable sectors, resulting in potentially much larger credit losses to banks. Banks that face capital shortfalls should present realistic plans to restore capital. The system-wide stress test next year could be used to identify capital shortfalls under a downside scenario, helping secure potentially needed support via precautionary recapitalizations.

Supportive financial sector measures should be maintained until the recovery is well underway . These include banks refraining from dividend payouts and share buybacks. Capital and liquidity buffers should be rebuilt gradually to ensure banks’ continued lending capacity. Borrower support in the form of moratoria and credit guarantees would need to remain available if the recovery stalls, but should be more targeted and extended only if needed to prevent widespread insolvencies and without distorting classification and provisioning requirements of banks.

Swift balance sheet repair will be critical to maintain confidence and support intermediation, especially in a downside scenario . Supervisors should ensure that banks have credible NPL reduction strategies over the medium term. Insolvency regimes should be improved to address the potentially high caseload, and court capacity should be supplemented by out-of-court debt restructuring. Operational and political constraints likely rule out a pan-European AMC, but nationally established AMCs could be helpful in deepening distressed debt markets, especially if linked in a network.

Advancing financial sector architecture reforms and swiftly closing gaps in the crisis management framework are critical to strengthening resilience . Completing the banking union, further advancing the capital market union, finalizing the European Stability Mechanism treaty reform, and enhancing the powers of the Single Resolution Board for smaller banks and in systemic crises remain urgent tasks. The Commission’s plan to establish a single AML/CFT rule book is welcome. The prudential measures toolbox should be strengthened to address vulnerabilities in nonbank financial institutions.

Structural Reforms

Balancing policies to support viable firms in a post-pandemic world with those to facilitate structural transformation will not be easy . The unprecedented scale of the crisis and uncertainties around the recovery argue for carefully expanding solvency support. As the recovery takes hold, policies will need to gradually shift from general lifelines to supporting firms with good post-pandemic viability prospects, while facilitating the exit of unviable companies. Implementing such triage is inherently difficult given the uncertainty surrounding the post-pandemic landscape, however, likely justifying erring on the side of caution and preserving some firms that ultimately prove to be unviable. To limit the cost to the taxpayer and incentivize necessary reallocation, support should be targeted and temporary, with existing shareholders bearing much of the burden. At the EU level, a solvency support instrument could play a role in maintaining the integrity of the Single Market given countries’ differing capacities to provide equity to struggling firms, especially in a downside scenario.

Labor market policies should remain agile to help ease adjustment while supporting the recovery, and a more fundamental redesign may be warranted given ongoing structural transformation . Measures designed to cushion the immediate impact of the pandemic may not be suitable for supporting the recovery. For example, job retention schemes have been invaluable in protecting jobs and livelihoods during the pandemic, but once the recovery gets underway, these schemes should be gradually phased out and supplemented with measures to facilitate the movement of workers to jobs in expanding firms and industries. Specifically, measures promoting job search, enhancing training and reskilling programs, and providing carefully targeted hiring subsidies will likely be needed, alongside stronger social safety nets. More generally, the pandemic will likely accelerate the trend towards automation in the context of the appropriate push for green and digital transformations. To make sure people are not left behind as demand switches across sectors, a more fundamental rethink may be needed on how to adapt labor market policies to respond to such shifts.

Mitigating the adverse distributional effects of the pandemic should be a priority . The pandemic is disproportionately affecting poorer regions with pre-existing structural impediments and is exacerbating inequality along different dimensions. The benefits of the recovery may also prove unequally distributed. Targeted policies will be needed to safeguard vulnerable regions and prevent rising inequality, with special attention given to the young and to disadvantaged groups. In this regard, carefully calibrated place-based policies may also be appropriate.

Safeguarding the economic gains from trade liberalization is critical . Efforts to uphold and modernize the multilateral rules-based global trading system are welcome. The recent proposal to address foreign industrial subsidies is well calibrated, but the EU should continue to work toward global solutions, which are critical to reducing tensions and promoting a more open trading environment. Lastly, any EU carbon border adjustment mechanism needs to be carefully designed to avoid discrimination against foreign producers and products, helping reduce the risk of retaliation by trading partners.