I N T E R N A T I O N A L M O N E T A R Y F U N D

Jeffrey FranksDirector, IMF Europe Office

International Monetary Fund

1

EURO AREA AT THE CROSSROADS:

ECONOMIC GOVERNANCE AND OPTIONS FOR A FISCAL CAPACITY

European Parliamentary Research Service, October 20, 2016

Based on IMF’s 2016 Euro Area Article IV Staff Report

European Department, International Monetary Fund 2

SUBDUED GROWTH IN ADVANCED ECONOMIES

Source: IMF World Economic Outlook, October 2016.

World U.S. U.K. JapanEuro Area DEU FRA ITA ESP

2016 3.1 1.6 1.8 0.5 1.7 1.7 1.3 0.8 3.1

Revision from July

2016 0.0 -0.6 0.1 0.3 0.1 0.1 -0.2 -0.1 0.5

2017 3.4 2.2 1.1 0.6 1.5 1.4 1.3 0.9 2.2

Revision from July

2016 0.0 -0.3 -0.2 0.5 0.1 0.2 0.1 -0.1 0.1

Real GDP Growth Projections (percentage change from a year earlier)

European Department, International Monetary Fund 3

GRADUAL RECOVERY IN EMERGING MARKETS

Source: IMF World Economic Outlook, October 2016.

World EMDCs Brazil Russia India China

2016 3.1 4.2 -3.3 -0.8 7.6 6.6

Revision from July 2016 0.0 0.1 0.0 0.4 0.2 0.0

2017 3.4 4.6 0.5 1.1 7.6 6.2

Revision from July 2016 0.0 0.0 0.0 0.1 0.2 0.0

Real GDP Growth Projections (percentage change from a year earlier)

European Department, International Monetary Fund 4

EURO AREA RECOVERY CONTINUES …

90

95

100

105

110

115Real GDP

(2008=100)

US

Euro area

Japan

UK

Source: Haver Analytics, and IMF staff calculations.

5European Department, International Monetary Fund

-2.0

-1.5

-1.0

-0.5

0.0

0.5

2012 2013 2014 2015 2016

Euro Area: Structural Balance Fiscal Impulse(Percent of potential GDP)

Source: IMF, World Economic Outlook (April 2016).

-10

-5

0

5

10

15

20-8

-6

-4

-2

0

2

4

2010Q1 2012Q1 2014Q1 2016Q1

Loans to NFCs (y/y change)

Change in credit standards (rhs)

Euro Area: Corporate Lending Conditions(Percent)

Easi

ngTi

ghte

ning

Source: Haver Analytics.

… SUPPORTED BY FISCAL AND MONETARY POLICIES

BUT MEDIUM-TERM OUTLOOK FOR GROWTH AND INFLATION REMAINS WEAK…

6European Department, International Monetary Fund

80

85

90

95

100

105

110

115

120

125

130

80

85

90

95

100

105

110

115

120

125

130

Q

1 ye

ar

2 ye

ars

3 ye

ars

4 ye

ars

5 ye

ars

6 ye

ars

7 ye

ars

8 ye

ars

9 ye

ars

10 y

ears

1974Q3 1980Q11992Q1 2008Q1

Euro Area: Real GDP Over Various Cycles(Index: business cycle peak Q = 100)

Sources: ECB; WEO and IMF staff calculations.

-6

-4

-2

0

2

4

6

8

10

12

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

Mar

-15

Mar

-16

Euro Area: Annual Inflation(percent)

HICP: Total

Min

Max

8 countries with negative inflation

12 countries with negative inflation

Sources: Eurostat and IMF staff calculations.

DUE TO CRISIS LEGACIES OF STILL HIGH UNEMPLOYMENT…

7European Department, International Monetary Fund

0

5

10

15

2008

2009

2010

2011

2012

2013

2014

2015

US EA

Sources: Haver and IMF staff calculations. Note: */ after adjusting for changes in labor force participation.

Unemployment Rate since the Financial Crisis(Percent) *

…AND SLOW PROGRESS IN DELEVERAGING…

8European Department, International Monetary Fund

0

20

40

60

0

2

4

6

8

1020

10

2011

2012

2013

2014

2015

*

2010

2011

2012

2013

2014

2015

*

Perc

ent o

f Gro

ss N

PL

Perc

ent o

f GD

P

Nonperforming Loans and Write-offs

Gross NPL Write-off ratio (rhs)

United States Euro area

Sources: Bloomberg, ECB, EBA Transparency Exercise (2015), U.S. Federal Reserve, IMF WEO, and IMF staff calculations. Note: */ as of end-Sept. 2015 for the United States and end-June 2015 for the Euro Area.

… WEIGHING ON INVESTMENT

9European Department, International Monetary Fund

80

85

90

95

100

105

110

Real Investment (2008=100)

US Euro area

Japan UK

Source: Haver Analytics, and IMF staff calculations.

LAGGING PRODUCTIVITY AND COMPETITIVENESS

10European Department, International Monetary Fund

70

75

80

85

90

95

100

105

110

2007 2008 2009 2010 2011 2012 2013 2014 2015

Service Sector Productivity,: US and Euro Area (Index 2007 = 100)

EA 11 (excl IRL and LUX) US

Source: Haver Analytics.

90

100

110

120

130

140

150

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

ULC-based REER vis-a-vis Germany (Index, 1999Q1=100)

EAFRAITAESPGRCPRT

Source: Haver Analytics.

European Department, International Monetary Fund 11

COLLECTIVE, COMPREHENSIVE ACTION NEEDEDTO BOLSTER GROWTH AND STRENGTHEN

THE UNION

Create better incentives for growth-friendly structural reforms

Strengthen fiscal framework while expanding centralized fiscal support

Continue monetary policy accommodation

Accelerate balance sheet repair and complete the banking union

Comprehensive, more balance mix

I N T E R N A T I O N A L M O N E T A R Y F U N D

12October 20, 2016

OPTIONS FOR A CENTRALIZED FISCAL CAPACITY

FOR THE EURO AREA

Based on Euro Area Policies 2016 Selected Issues Paper “Options for a Centralized Fiscal Capacity for the Euro Area”

European Department, International Monetary Fund

RATIONALE

13

Motivation

• Common insurance against country-specific shocks in a currency union

• Policy context:• Constrained monetary policy capacity (ZLB)

• Limited fiscal space

Objectives

• Fiscal stabilization in the event of area-wide and/or country-specific shocks

• Fiscal risk-sharing to limit contagion and mitigate need for crisis support

European Department, International Monetary Fund

HOW TO DESIGN CENTRALIZED FISCAL SUPPORT IN THE EURO AREA?

14

Three options

• Tax-transfer scheme

• Borrowing-lending scheme

• Small euro area budget

European Department, International Monetary Fund

OPTION 1: TAX-TRANSFER SCHEME

15

Central Fiscal

Capacity

Tax transfers Reallocation

Member states

Member states

Unemployment Insurance

Rainy Day Fund

or

Citizens

European Department, International Monetary Fund

TAX-TRANSFER SCHEME

16

Pros

• Enhances resilience to country-specific shocks

• Automatic and counter-cyclical

• Can be designed to be budget-neutral

• Can provide incentives for labor and labor taxation reforms

Cons

• Limited capacity to address area-wide shocks, especially if budget-neutral

• Unemployment insurance is a lagged response to shocks

• Potentially redistributional, depending on design

• Without conditionality, might give rise to moral hazard

European Department, International Monetary Fund

OPTION 2: BORROWING-LENDING SCHEME

17

Borrowing Lending

Bond Markets

Central Fiscal

Capacity

Private projects

Option 2: ESM+ Member states

EA chapter of EU

budget

gran

ts

Member states’ capital

European Department, International Monetary Fund

BORROWING-LENDING SCHEME

18

Pros

• Enhances resilience to both country-specific and area-wide shocks

• Creates new fiscal space (countries can borrow at lower rates)

• New safe asset

• Can incentivize sound policies if conditional on compliance with rules

Cons

• Political resistance to common borrowing, creates contingent liability

• Can crowd out national borrowing and raise interest rates for some countries

• Not automatic

• Without conditionality, might undermine fiscal discipline

European Department, International Monetary Fund

OPTION 3: A SMALL EURO AREA BUDGET

19

Central Fiscal

Capacity

Transfers Various functions

Member states

Member statesTargeted support

Common public goods

and/oror

Own resources

Citizens

+ potentialdebt issuance

European Department, International Monetary Fund

SMALL EURO AREA BUDGET

20

Pros

• Enhances resilience to both country-specific and area-wide shocks

• Can provide automatic stabilization

• Common borrowing creates additional fiscal space and a new safe asset

• Can be conditional on compliance with rules

Cons

• Political resistance to common taxation, borrowing and spending

• Can increase the overall tax burden and create contingent liability

• Potentially redistributional

• Can crowd out national borrowing

• Without conditionality, might undermine fiscal discipline

European Department, International Monetary Fund 21

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I N T E R N A T I O N A L M O N E T A R Y F U N D

22October 20, 2016

ReferencesBased on IMF’s 2016 Euro Area Article IV Staff Report http://www.imf.org/external/ns/cs.aspx?id=317“Building a Better Union: Incentivizing Structural Reforms in the Euro Area,” IMF Working Paper 15/201, September 2015 https://www.imf.org/external/pubs/cat/longres.aspx?sk=43278.0“Options for A Central Fiscal Capacity in the Euro Area,” 2016 IMF Euro Area Selected Issues Paper http://www.imf.org/external/ns/cs.aspx?id=317“A Strategy for Resolving Europe’s Problem Loans” http://www.imf.org/external/pubs/cat/longres.aspx?sk=43286 and “Tackling Small and Medium-Size Enterprise Loans in Europe,” IMF Staff Discussion Notes 15/19 and 15/04, 2015 https://www.imf.org/external/pubs/cat/longres.aspx?sk=42614.0“Comprehensive, Integrated Policies to Boost Euro Area Growth,” 2016 IMF Euro Area Selected Issues Paper http://www.imf.org/external/ns/cs.aspx?id=317