Prospects and challenges for

the Euro Area economy

Servaas DEROOSE

Deputy Director-General
European Commission, DG Economic and Financial Affairs

Think Tank Europe

Copenhagen, 28 April 2017
 Outline

1. Economic outlook: Brightening growth

prospects, propelled by improving
fundamentals and supportive policy mix

2. Challenges: Addressing long-standing

structural weaknesses and crisis legacies

3. Future of Europe: How could a sustainable

institutional architecture for EMU look like?

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 Sluggish post-crisis recovery
Real GDP, Euro Area Real GDP, advanced economies
(index, Y-7 = 100) (index 2008 = 100)

3
 Key drivers of the recovery

Waning initial favourable tailwinds

Improving fundamentals
o Job-rich recovery, fuelling private consumption
o Switch from balance sheet to macro deleveraging
in the private sector
o Safer and sounder banking sector
o Improved competitiveness

Continued supportive policy mix

4
 Highly accommodative monetary policy

Policy rates set by the ECB and US Fed ECB and Fed balance sheet expansion
(in %) (in % of annual nominal GDP)

6 40
ECB MRO rate

5 ECB deposit facility rate 35

US Fed target rate (upper 30

4
bound)
25
3

20
2
15
1 FED
10
ECB
0
5

-1 0
Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17

Source: Left side: IHS, last observation 24 April 2017; right side: Datastream, last observation 24 April 2017.

5
 Diverging views on the role of fiscal policy

Discretionary fiscal policy is fraught with problems

It should be limited to exceptional circumstances
Fiscal policies in EMU should focus on prudent medium-
term positions in each and every country

The macroeconomic role of fiscal policies is essential

in EMU
At country level, as individual Member States have lost
the channel of monetary policy
Aggregate fiscal stance important too, complements
monetary policy (at least in some circumstances)

6
What fiscal stance for the euro area?

7
 Differentiated fiscal space

Fiscal space and adjustment needs at country level

8
 Challenges
Pre-crisis structural
impediments to growth
o Population ageing
o Slow productivity growth
o High unemployment
o Rigid product and labour
markets
9
Crisis legacy
o Investment gap
o Low potential growth
o Persistently low inflation
o High debt (private/public)
o Weak banks (high NPL, low
profitability, high costs)
o Asymmetric rebalancing
o Halt/reversal convergence
process
o Rising inequality
o Citizens' declining systemic
trust
 Sluggish recovery of investment
Gross fixed capital formation Gross fixed capital formation
(in local currency, index 2008 = 100) breakdown, EA-19
(in % GDP)
120 25

110
20

100
15
90

10
80

70 5

60 0
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
EA-19 DK
US Crisis countries Construction Equipment Total
Non-crisis countries
Note: Crisis countries include Cyprus, Greece, Ireland, Portugal, Spain. Data for construction and equipment only
available until 2015.
Source: European Commission winter forecast 2017.
10
 Economic structures less resilient

Product market regulation Employment protection legislation

3
5

1998
1998
2008 4
2008
2013
2 2013
3

2
1

0 0
US LU DK NL IE FI AT DE BE IT FR ES PT EL US IE BE DK FI FR ES DE AT IT EL NL PT

Note: The graph shows OECD indicators measuring the degree of product and labour market regulation (the latter refers to
individual and collective dismissals). Indicators range on a scale from 0 (least restrictions) to 6 (most restrictions). Latest data
available 2013.
Source: OECD.
.
11
 Structural reforms fatigue
Implementation record of COM country-specific recommendations (CSRs)

Note: Implementation record is measured by a COM composite indicator ranging from 0 (no implementation) to 100 (full
implementation). The country-specific recommendations (CSRs) list key reform needs of Member States as part of the European
Semester.
12
 Secular decline in potential growth
Contributions to potential growth
(in ppt., unless otherwise indicated)

EA-19 EA-19 vs. US

3
forecast Contributions to potential
Potential growth (in pps.)
growth
2 (annual % Labour
change) (persons) Capital TFP

= 1.3 pp
1999-08 2.0 0.4 0.8 0.8
1
EA-19 2009-16 0.7 0.0 0.3 0.3

Diff. -1.3 -0.5 -0.5 -0.4

0
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 1999-08 2.6 0.2 1.1 1.3

Labour (total hours) Capital stock US 2009-16 1.4 0.4 0.5 0.5

-1 TFP Potential GDP growth

Diff. -1.2 0.1 -0.6 -0.7

Source: European Commission winter forecast 2017.

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 High public and private debt
Gross debt general government Private sector debt
(in % of GDP) (NFC and HH; in % of GDP)
140 400

120 350 NFC in 2015

HH in 2015
300 NFC and HH in 2010
100
NFC and HH in 2008

80 250
MIP
200 threshold
60
(133 %)
150
40

100
20

50
0
EA-19 ES IE PT IT
0
LU

LT
EA

LV
ES
BE

EL

EE
CY

IE

FI

FR

AT
IT

SI

SK
NL
PT

DE
MT
2007 2009 2012 2013 2014 2015 2017

Note: General government debt in line with Maastricht
definition. Red line shows the Maastricht reference value.
Source: European Commission winter forecast 2017.
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Note: The private sector debt is the stock of liabilities in the form of
loans and securities other than shares excluding financial deriva-
tives held by the sectors non-financial corporations and households
and non-profit institutions serving households. Transactions within
sectors are eliminated (consolidation).
Source: Commission services.
Limited fiscal buffers to cope with shocks
Fiscal adjustment required to reach a 60% public debt-to-GDP ratio by 2031
(in % of GDP)

8.0 6

6.0 4

4.0
2
2.0
0
0.0

-2.0 -2

-4.0 -4

-6.0
-6
-8.0 PT IT FR BE ES SI FI EA CY IE AT LT NL DE MT SK LV EE LU
IT PT FR ES BE SI FI EA CY LT IE AT DE NL MT SK LV LU DK EE
COM baseline WF 2017 SCP scenario
COM baseline Winter forecasts 2017 scenario SCP 2016 scenario

Note: COM baseline scenario comes from the winter forecast 2017. 2016 Stability and Convergence Programmes
(SCP). Dotted line indicates COM assessment of high/medium risk (above the dotted line/between the dotted and
zero line/below the zero line).
Source: Commission services.
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 High non-performing loans (NPL)
The evolution of the NPL ratio and real GDP NPL per Member State
growth, EU and EA (in % of GDP)
(2000 - 2015)
40 100
10 EU average 5
Provisions (accumulated impairment) (lhs)
EA average 90
Net non-performing debt instruments (lhs)

% of total non-performing debt

9 Real GDP growth EU (rhs) 4 35
Real GDP growth EA (rhs) Gross non-performing debt instruments (lhs)
8 3 80
Provisioning ratio (rhs)
30

% of total debt instruments

70

instruments
7 2
% of gross loans

y-o-y % change
25
6 1 60

5 0 20 50

4 -1 40
15

3 -2 30
10
2 -3 20
5
1 -4 10

0 -5 0 0
2000 2002 2004 2006 2008 2010 2012 2014
EL

HR
HU

ES

EE
FI
SI

FR
CY
IT

IE
RO
AT

SK
PL

BE

UK

SE
PT
BG

DK

MT
NL
DE
LT
LV

LU
Note: Data based on Worldbank, ECB, DG ECFIN
calculations. Note: ECB and DG ECFIN calculations.
Source: European Commission (2017): A macroeconomic Source: European Commission (2017): A macroeconomic
perspective on non-performing loans (NPLs), Quarterly perspective on non-performing loans (NPLs), Quarterly
Report on the Euro Area, 2017(1). Report on the Euro Area, 2017(1).
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 Sizeable heterogeneity in the Euro Area
Real GDP Unemployment rate
(in %) (in %)
140 30
IE
130
25
EL
120

110 20

100
15
90

80 10

70 EL
5
60
DE

50 0
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Note: Dark blue line shows the weighted EA-19 average; dotted line shows the simple un-weighted EA-12 average. Light blue
area defines the whole range of observed values (from maximum to minimum), while the darker blue area defines the area
between the first and second quartile based on un-weighted data for EA-19. Green line shows Denmark.
Source: European Commission winter forecast 2017.
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EMU today: an unsustainable equilibrium?

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 Two competing models for EMU
"Back-to-Maastricht"
o Stronger enforcement of EU
fiscal rules to rein debt and
deficits
o MIP focused on competitiveness
of lagging countries
o Banking Union does not need
common deposit insurance
o End to the risk-free status for
sovereign debt and establish
sovereign debt restructuring
mechanism
o More market discipline
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Fast forward to an
integrated EMU
o Distribution of fiscal efforts to
achieve an appropriate
aggregate fiscal stance
o Symmetric adjustment to help
weak countries and reduce
Euro area current account
surplus
o Full Banking Union to ensure
financial stability and private
risk sharing
o Fiscal capacity for public risk
sharing and eventually
sovereign debt mutualisation
o Euro area Treasury
Minimum governance requirements for a viable EMU
Possible
Included
Included w/o
in the
in 5PR? Treaty
Blueprint
change?

Monetary ECB as a lender of last resort

Establish a common European Deposit Insurance Scheme

Implement a common backstop to the SRF
Banking
Improve the effectiveness of direct bank recapitalisation in the ESM
Create a European safe asset

Restore a credible no bail-out clause

Create a centralised fiscal capacity
Fiscal
Establish a sovereign debt restructuring mechanism
Establish a debt redemption fund

Economic Foster convergence towards similarly resilient economic structure

Note: This assessment only serves for indicative purposes. Inspired by Baldwin and Giavazzi (2016): How to fix the Eurozone: Views of leading
economists, 12 February 2016, VoxEU.

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 European policy priorities

Unburdening the ECB

More balanced
Fiscal capacity and fiscal rules
policy mix
Private and public risk sharing

Productivity / TFP
Structural Reforms 2.0 Human capital
New welfare and financial systems

New European public goods

Rethinking EMU
Rebuilding trust to complete EMU
architecture
Vertical budget coherence

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