Public Information Notice No. 10/91

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation on Euro Area Policies

July 21, 2010

On July 19, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation on Euro Area Policies.¹

Background

The euro area’s sovereign crisis was largely caused by unsustainable policies in some member countries, which came to a head in early May 2010. Facing increasing turmoil, the ECB stepped up liquidity and credit support aimed at avoiding market instability. New European financing instruments were created to assist EU members facing difficulties in accessing capital markets, but have thus far not been used.

Already prior to the sovereign crisis, the staff expected the euro area to be slow to recover, with headwinds from uncertainty about the strength of the financial system, ongoing deleveraging of private sector balance sheets, and time needed to improve competitiveness, and reallocate resources to tradable sectors in some countries. Furthermore, despite employment-support measures in many countries, uncertainty about job prospects has been weighing on household demand. High-frequency indicators are consistent with a relatively strong second quarter in 2010, driven by the global recovery in trade and manufacturing, and some slowing of momentum during the second half of 2010. Disinflationary pressures persist in the face of weak domestic demand, with the sizeable output gap shrinking only gradually. Staff projects inflation to remain well below 2 percent over the relevant policy horizon.

The aggregate fiscal position of the euro area has deteriorated sharply in 2009. Many member countries allowed automatic stabilizers full play and implemented fiscal stimulus measures aimed at supporting private consumption, limiting increases in unemployment, and raising public investment. These policies mitigated the impact of the crisis, but together with bank support came with a rise in average euro area government debt. Current deficit targets imply a neutral aggregate fiscal stance in 2010 and synchronized consolidations, gradually leading to deficits below the SGP limit by 2013 in most cases. However, additional efforts will be needed to stabilize debt dynamics over the long term.

Amid considerable volatility interbank bank CDS spreads remain somewhat elevated and some banks persistently rely on liquidity and other government support. Stress tests are underway with the aim to assess the resilience of the euro area’s financial system, increase transparency to reduce counterparty risks, and identify banks with capital needs.

Individual euro area member current account deficits and surpluses and their persistence since the advent of EMU has been partly reversed by the recent crisis, but remain significant. Equilibrium phenomena, such as different demographics and long-term growth dynamics justify some imbalance, but the major drivers were to be found in unsustainable credit and construction booms, a lack of fiscal restraint, and unsustainable wage developments.

The current crisis has triggered a debate about how to close the fundamental gaps in the euro area’s governance framework. The authorities have tabled several proposals to strengthen fiscal surveillance, focusing on more intrusive ex-ante surveillance, more effective sanctions, and minimum benchmarks for national frameworks. They have also proposed similar procedures to strengthen surveillance over internal imbalances. Meanwhile, member states are in the process of building up the EU’s financial stability architecture, focused on establishing new European supervisory institutions, including a systemic risk board, and harmonizing the approach to resolution.

Executive Board Assessment

Directors agreed with the thrust of the staff appraisal. Noting that the euro area is being affected by a sovereign debt crisis with repercussions well beyond its borders, Directors emphasized the need for strong policy implementation across fiscal, financial, and structural policy areas to support the recovery and limit adverse spillovers. They welcomed the far-reaching crisis response and underscored that, while the newly created tools should be used as needed, they should not be considered an alternative to the necessary policy corrections and structural reforms.

Directors observed that the heightened sovereign risks have imparted further downside risks to an already moderate and uneven recovery. Over the medium term, Directors saw fiscal consolidation and structural rigidities weighing on the recovery, only partly offset by the recent depreciation of the exchange rate to a level that is now close to its fundamental value.

Directors welcomed the measures currently being undertaken and the heightened intent to tackle structural issues. They saw three essential areas for policy actions to help establish a durable recovery:

• First, weaknesses in the banking system, with some banks overly reliant on liquidity or other government support, need to be addressed. Directors welcomed the authorities’ intention to use transparent stress tests with an expanded coverage in terms of institutions and risks to help restore confidence in the financial system. They underscored the need to make resources available to recapitalize viable institutions lacking market access and restructure others. A clarification of new capital and liquidity requirements for banks, consistent across countries and appropriately phased in, would be important.

• Second, Directors agreed that fiscal consolidation is essential, with its speed and scope tailored to each country’s circumstances. They highlighted the importance of the quality and composition of fiscal consolidation and noted that entitlement reforms will be particularly effective in helping ensure medium-term fiscal sustainability.

• Third, Directors encouraged the timely implementation of structural reforms, especially in the labor and product markets, to lift the euro area’s tepid growth potential.

Directors welcomed the ECB’s Securities Market Program and the reinstatement of some other non-standard measures to secure effective transmission of the monetary policy stance. Directors saw long-term inflation expectations well anchored, keeping risks to price stability at bay. Hence, they noted that the policy rate remains appropriately low.

Directors encouraged the authorities to strengthen economic governance of EMU to deliver the collective responsibility necessary for a well-functioning economic and monetary union, which would help prevent future crises. They welcomed the recent proposals by the authorities in areas including budgetary policies and competitiveness. Directors pointed to the need for better enforcement of budgetary discipline and the extension of effective surveillance over key structural reforms.

Directors encouraged further progress in building the EU’s financial stability architecture. They welcomed the steps taken toward a more harmonized regulation and supervision of the EU financial system. The establishment of a core set of effective resolution tools would raise the scope for coordination in the resolution of cross-border institutions.