Mahmood Pradhan, Deputy Director, European Department, International Monetary Fund
Outlook for the EU 27 economies and financial sector
Malta, 5 April 2017
Good afternoon to all, and thank you very much for inviting me to talk about the EU.
What I am going to talk about today is primarily focused on some of the challenges of the euro area, but I will also touch on the EU 27. I will try to draw some common themes that I think are also present in the non-euro area EU members.
I would like to take stock of where we are in the euro area, following an extended period of not only very low growth, but substantial changes in the architecture and the governance framework of EMU. And there are undoubtedly more changes to come, particularly in the landscape for the financial sector.
While we should all celebrate a convincing and firming recovery in the euro area, especially after double-dip recessions, I want to draw your attention to what we should also worry about – in particular, the lack of policy space to deal with downside risks, and I want to focus particularly on this challenge. In a similar vein, while we should acknowledge the substantial progress in strengthening the architecture of the euro area – and the Prime Minister just referred to some of these accomplishments, which are very notable accomplishments – we might want to ask if more architecture can address the lack of real economic convergence among member states, and the persistent macroeconomic imbalances within the region, as the Prime Minister also mentioned. Finally, I will be a bit brave in this audience and delve into your domain, which is Europe’s financial sector. That is going through a major transformation shaped not only by changes in the regulatory environment, and the potential changes that could be triggered by the UK leaving the EU, but also because of the more fundamental challenge posed by overcapacity and low profitability in the banking sector.
Let me, then, start with the economic recovery. After the 2012/13 recession, growth only picked up very slowly compared to the immediate aftermath of the 2008/09 recession, when it jumped to over 2% in 2010. With 2016 coming in at about 1.7% for the euro area, we have now had two years of relatively solid growth. This is still lower than what would be necessary to deal with some of the legacies of the crisis, particularly public and private sector debt overhangs, and I will come back to this. Despite the euro area’s large current account surplus, recent growth is primarily driven by domestic demand, which is encouraging as it tends to be less volatile than external demand. The recovery has been underpinned by strongly accommodative monetary policy, a mildly expansionary fiscal stance in the last two years, and stronger job creation. Headline inflation is also picking up, but the average is still far below the ECB’s medium-term price stability objective, and underlying inflation remains persistently weak. This reflects the still large negative outlook gaps in some countries, and the impact of past import price deflation.
To summarise,the IMF’s forecasts suggest that growth will hold up at around current levels for this year and next year. With regard to inflation, we should see some pickup in 2017. Our forecast last year, in January, was 1.4%. We should see a substantial pickup in headline inflation to 1.7 percent for 2017, and 1.4 percent in 2018. Our baseline view is that the ECB will achieve its price stability objectives sometime between 2020 and 2021. In the rest of the EU – and here I am primarily talking about the new member states in the EU, to the east of the euro area – the good news is that the output gaps are largely closed. They have largely recovered from the crisis. The outlook for external demand – and external demand is quite important in this area – and greater absorption of EU structural funds both suggest that they should be doing reasonably well. To put EU structural funds in perspective, if they fully absorb the EU structural funds in the next 10 years, that should give them a rise in GDP of about 18 percentage points. This is substantial. I will come back to convergence issues for these countries.
Let me come back now to the euro area, and talk about where we go from here. We are much less sanguine about the medium-term outlook, especially because of the many risks and the very thin policy buffers. Let me lay out a few things on the horizon that should concern us. Firstly, Europe’s adverse demographic trends will be compounded by the unsolved legacy issues, such as substantial debt overhangs in some countries and higher structural unemployment in many countries. Secondly, high-debt countries will face higher borrowing costs, perhaps sharply higher, when monetary accommodation is eventually reduced. Thirdly, there is uncertainty about the stance of US policy and its external orientation. Fourthly, this year several member states have elections and some voters have already expressed scepticism about the benefits of integration. Political discord could lead to dramatic policy shifts with important economic implications. Fifthly, the process of disentangling the UK from the EU could take a toll on confidence. Negotiations between the EU and the UK on issues such as passporting and third-party equivalence could substantially change the distribution of financial market activities across Europe. At both the national and supranational levels, Europe needs to be ready to take on a heavier burden of financial market oversight. These are the risks on the horizon, perhaps also posed as challenges.
Let me turn to what I have already referred to twice, the policy buffers. External imbalances have improved, as many net external creditor countries have switched from current account deficits to surpluses, lowering their vulnerability to sudden external financing stops. However, the very large surpluses of net external creditor countries persist. This is the adjustment mechanism that the Prime Minister talked about earlier. Competitiveness gaps between these two groups of countries – the external creditors and the debtor countries – remain very wide. Partly because of this, there has been very little convergence in real per-capita incomes. Among the 12 original adopters of the euro, since its beginning, convergence has stalled and since the crisis there has in fact been divergence. This is worrying. Without further convergence, the monetary union will remain vulnerable to periodic bouts of political and economic instability. If we were to look at the whole club, the 19 euro area member countries, adding the seven which joined later, their convergence record to the average of euro area per capita GDP levels is substantially better, but we should worry about convergence among the 12 original adopters.
To foster convergence, all countries will need to contribute. Germany and the Netherlands, for example, as well as other large net credit countries will need to generate more domestic demand to reduce their excessively large current account surpluses. Italy and other net external debtor countries need to move much faster in implementing structural reforms to improve business conditions and raise productivity. Let me say a little bit, while I am talking about convergence, about the rest of the EU, the non-euro area. Here convergence has slowed substantially. Between 1995 and 2007, per capita incomes in that region rose by just over 4% per annum. But between 2007 and 2016, per capita GDP rose by only 1.5% per annum. This suggests that the process of convergence has slowed in the east as well.
Let me turn to the role of structural reforms to promote convergence. In our view, structural reforms at the national level are the only way to lift potential growth, close competitiveness gaps, and foster convergence. Without these, economic convergence within the euro area will remain elusive. Changes in architecture, such as completing the banking union, or somewhat more fiscal integration, can help make the environment more favourable, but improved architecture alone will not raise productivity and potential growth. In our view, also, countries should take advantage of the current low rate environment to forcefully enact needed reforms, before the eventual monetary policy normalisation raises financing risks for the high-debt countries. Unfortunately, progress thus far on structural reforms has not been encouraging, and that is putting it mildly, with some countries even reversing previous reform commitments. Member countries have also been relatively poor at consistently implementing the European Commission’s country specific recommendations.
More on policy space now. Turning to fiscal policy, in aggregate fiscal space in the euro area is relatively constrained and unevenly distributed due to high debt burdens in many countries. The few countries with fiscal space, such as Germany and the Netherlands, should, in our view, boost domestic demand and raise potential growth. This would also encourage external rebalancing and reduce their large current account surpluses. At the same time, high debt countries with little or no fiscal space need to rebuild buffers and save the windfall interest savings from monetary accommodation. Regardless of fiscal space, all countries can and should work towards a more growth-friendly composition of taxation and spending.
Given the uneven distribution of fiscal space, there is a compelling case for a central fiscal capacity to offset large, adverse country-specific shocks. However, building trust and political support for such a centralised capacity will require much stronger compliance from member states and credible enforcement of the current framework. It is regrettable that, thus far, compliance has been lax, and enforcement has also been weak.
Let me turn, now, to monetary policy, which we argue should remain accommodative for as long as it takes. Subdued underlying inflation and negative output gaps in many countries argue for maintaining the current very substantial monetary accommodation over an extended period. Negative output gaps are still substantial in many countries, such as in France where it is about 2%, and Italy where it is over 2%. Euro area core inflation has been stuck at about 1% for the past three years, and shows little sign of moving. Similarly, market expectations for medium-term inflation remain low at about 1.5%. Looking ahead, the ECB should look through any temporary inflation movements to ensure a durable and self-sustained return of area-wide inflation to its medium term price stability objective. Importantly, for some countries like Germany, where output gaps are mostly closed, this will mean inflation above the ECB’s 2% objective, possibly for a prolonged period. This is the only way the ECB can meet its mandate. Inflation in some countries has to be above the average, for the average to be around 2%.
Finally, let me turn to the financial sector, and say something on banks and the Capital MarketsUnion. The stock of non-performing loans has declined from its peak. That is good news. However, the pace of reduction is still too low, given the large remaining stock. NPLs have fallen by about €150 billion in the last two years, but some €1 trillion of NPLs remain. These are concentrated in three or four countries. If we look further east, at Hungary, Poland, the Czech Republic, Bulgaria and Romania, with one or two exceptions, we have seen much more progress in that region on reducing NPLs post the global financial crisis. The SSM took an important first step in issuing its comprehensive new guidance on NPL management. Its second step must be stricter monitoring of banks’ NPL reduction targets, backed by the imposition of additional bank-specific capital requirements, wherever needed. Even with that, supervisory efforts alone will not be enough. There needs to be continuous effort to harmonise and modernise national corporate and household insolvency frameworks, and develop markets for distressed debt.
The challenges for European banks, however, extend beyond high NPLs. The banking system in Europe suffers from chronically low profitability and a cyclical recovery alone cannot overcome this problem. Banks will need to restructure and consolidate, including through discontinuing unprofitable business lines, further cost cutting, and reducing the number of branches: concerted action, essentially, to tackle overbanking. This is, by and large, a private sector led process, but supervisors can also play a role, by pushing problem banks to restructure or to be resolved.
Despite the banking union’s early promise for a truly integrated European banking market, ring-fencing of liquidity within national banking systems is still prevalent. The ECB and national authorities should work closely together to reduce this ring-fencing, because it is not allowing the banking union to deliver that early promise. I will not touch on some things we have said before and said repeatedly, such as that completing the banking union also requires establishing a common deposit insurance, together with the associated risk reduction and a common fiscal backstop.
The CMU action plan is critical to improving the functioning of the single market, and enhancing the EU’s resilience to shocks. Greater capital market integration would bolster national private risk sharing, which has so far been surprisingly limited in the euro area and the EU, compared to the levels of regional private risk sharing within other jurisdictions like the United States, Canada and even Germany. CMU could also help diversify financing sources for the real economy, away from its high reliance on banks. Key policy actions in this area include legislation on infrastructure creation to incentivise more venture capital, enhance SMEs’ access to finance, address the debt equity bias in corporate taxation, and harmonise corporate insolvency and foreclosure frameworks.
Let me finish by saying that I hope I have left you with an optimistic message. You must remember the ‘good news’ part of my introduction! We should celebrate the recovery. But let us also use this positive backdrop to push harder on the many remaining challenges. We should worry about the lack of policy space and the very uneven distribution of that policy space in the euro area. And most of all, longer term convergence of real income levels will come from stronger actions, especially on structural reforms, at the national level
Thank you very much for your time. I look forward to learning a lot more from the large number of experts gathered here over the next two days.
CMU – Capital Markets Union
ECB – European Central Bank
EU – European Union
GDP – gross domestic product
NPL – non-performing loans
SMEs – small and medium-sized enterprises
SSM – single supervisory mechanism
UK – United Kingdom