OREANDA-NEWS. On July 21, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Euro Area.

The cyclical recovery is firming and becoming broad based. Lower energy prices, supportive policies, stronger labor markets and a recovery in credit growth have boosted domestic demand, especially private consumption. The near-term outlook is favorable, with growth of 1.9 percent expected in 2017 and 1.7 percent in 2018. While headline inflation picked up in the first half of 2017 due to higher energy prices, core inflation has remained persistently low. As the base effect of higher energy prices dissipates, headline inflation is anticipated to slow from 1.6 percent this year to 1.5 percent in 2018, well below the ECB’s medium-term price stability objective.

The improving near-term outlook is clouded by significant downside risks, especially in the medium and long term, amidst thin policy buffers. Some high-debt countries could experience rising borrowing costs in the face of tighter global financial conditions or reduced monetary accommodation. Structural weaknesses in the European banking system in the form of weak profitability and pockets of high non-performing loans could trigger financial distress. Moreover, political support for further European integration may be eroded by persistent external imbalances and lack of real income convergence.

On current trends, the output gap is forecast to close by 2019. Over the medium term, growth is expected to stay around 1.5 percent per annum. This reflects a variety of factors including insufficient structural reforms aimed at boosting productivity, the remaining crisis legacies of impaired balance sheets and high unemployment, and demographic headwinds.

Executive Board Assessment

Executive Directors welcomed the broad-based recovery and decline in unemployment, driven by higher domestic demand and supported by continued accommodative monetary policy. Directors cautioned, however, that underlying inflation and wage growth remain subdued, while medium-term risks are tilted to the downside. Countries with high public debt levels have limited buffers and are vulnerable to a rise in borrowing costs. An external slowdown, due to a rise in global protectionism, for example, could weigh on the recovery, while the uncertainty related to Brexit negotiations could dampen investment and consumption in some countries. Directors concurred that the more favorable political and economic context provides an opportune moment to accelerate reforms at both the national and central levels and complete the euro area architecture.

Directors noted that stagnant productivity growth has impeded the adjustment process in the euro area and contributed to stalling income convergence among countries. They urged countries to press ahead with structural reforms to improve productivity. Such reforms can have a larger impact in countries with lower productivity levels, thereby promoting income convergence and reducing competitiveness gaps. Directors reiterated their call for stricter enforcement of the Macroeconomic Imbalances Procedure combined with incentives for structural reforms, such as targeted support from central funds and outcome based benchmarks.

Directors recognized the uneven distribution of fiscal space across countries, and the need for tailored fiscal strategies. They encouraged countries with fiscal space to use it to support public investment and structural reforms that boost potential growth, while countries without fiscal space should consolidate to put debt ratios on a downward path. All countries, regardless of fiscal space, should make fiscal policy more growth friendly. Directors stressed that countries need to respect the Stability and Growth Pact, which is crucial to ensure the credibility of the fiscal framework and also important to build support for a central fiscal capacity. Developing such a capacity could go hand in hand with reforms to simplify the fiscal framework and make enforcement more automatic.

Directors concurred that monetary policy should remain firmly accommodative until there is a sustained rise in the inflation path toward the ECB’s price stability objective. The ECB’s forward guidance should remain unchanged until justified by actual inflation or by substantial evidence that the inflation outlook has improved. Directors considered that countries with closed output gaps will need to tolerate inflation above the ECB’s objective for a prolonged period to achieve higher area wide average inflation.

Directors urged further efforts to address nonperforming loans and low bank profitability, which, in part, requires countries to continue reforming their insolvency frameworks. They encouraged the European Commission to provide a blueprint for national asset management companies and clarity on State Aid requirements, which could help develop markets for distressed debt. Restructuring and consolidation in the banking sector should be incentivized by a firm approach to closing failing banks. Directors noted that the upcoming review of the Bank Recovery and Resolution Directive presents an opportunity to address any impediments to bank resolution.

Directors considered completing the banking union-with common deposit insurance and a common fiscal backstop-as an essential complement to risk reduction in the banking sector. They also noted that ring fencing of capital and liquidity within countries runs counter to the concept of a banking union. Directors agreed that Brexit gives greater urgency to building a capital markets union and that supervisory capacity needs to be correspondingly upgraded.