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The European Central Bank’s Outright Monetary Transactions (OMTs) framework has helped address severe market distortions and improved the effectiveness of monetary policy. Initial progress on banking union—the Single Supervisory Mechanism (SSM) agreement, the European Stability Mechanism (ESM) framework for direct bank recapitalisation, and the Bank Recovery and Resolution directive (BRRD)—has demonstrated the commitment to improving European Monetary Union (EMU) architecture. Other critical steps to address the crisis have included: the completion of the European Stability Mechansim (ESM) firewall; the extension of official loan maturities to programme countries, and the agreements on Greece and Cyprus. These actions—along with reductions in external imbalances and progress by national governments in restoring the health of public finances—have boosted confidence in the long-term viability of the monetary union.
But the recovery remains elusive. Financial markets are still fragmented along national borders, and the cost of borrowing for the private sector is high in the periphery, particularly for smaller enterprises. Ailing banks continue to hold back the flow of credit. In the face of high private debt and continued uncertainty, households and firms are postponing spending. Needed fiscal consolidation is also weighing on growth. As a consequence, euro area GDP is expected to contract by 0.6 per cent for a second consecutive year in 2013, before expanding modestly by 0.9 per cent in 2014. Headline inflation is expected to remain subdued, highlighting risks of underlying deflationary pressures. And with unemployment, especially among the youth—at record levels, there is a risk of long-term damage to potential growth and to political support for reforms, including for further progress on EMU architecture. In turn, lack of reforms would undermine growth and job prospects
Risks to growth remain tilted to the downside. Because policy space is limited, public debt ratios are very high (and still rising), and economic slack is already substantial, further negative shocks—domestic or external shocks—could severely impact growth. The recent turbulence in global markets has tightened financial conditions in the euro area, although the recent introduction of forward guidance by the ECB has had a mitigating effect. Continued turbulence—related, for example, to expectations of earlier-than-anticipated exit from unconventional monetary policy in the US—could aggravate fragmentation and complicate the conduct of monetary policy. Incomplete or stalled policy commitments at the national or euro area level could also reignite financial market stresses. Over the medium term, there is a high risk of stagnation, especially in the periphery.
Executive Board Assessment
Executive Directors commended euro area authorities for the actions taken at both the regional and national levels, which have stabilised financial markets and reduced tail risks related to a euro break up. They acknowledged, in particular, progress toward building a banking union, enhancing the firewall, and strengthening fiscal governance. Directors noted that these efforts have reinforced the authorities’ commitment to preserve the integrity of monetary union.
Directors observed, however, that despite the policy actions on many fronts, growth remains elusive and high unemployment persists, especially among youth. At the same time, household and corporate indebtedness remains elevated in a number of countries, holding back domestic demand. Given narrowing policy space and still-fragile and fragmented banking sectors, these developments have increased the risks of stagnation, social and political tensions, and spillovers to the global economy.
Against this backdrop, Directors considered it imperative to revive growth and create jobs through a comprehensive strategy aimed at repairing bank balance sheets, making further progress on banking union, and supporting demand, while advancing structural reforms. They stressed that unwavering political backing for institutional reforms remains critical and in the interests of all EMU members.
Directors recognised that the first priority is to restore sound bank balance sheets to revive credit. Immediate steps include full recognition of losses, recapitalisation of weak but viable banks, and closure or restructuring of non-viable banks. In this context, Directors supported plans to conduct a comprehensive balance sheet assessment followed by stress tests to assess the potential capital needs of the banking sector, complemented with a clear strategy for addressing capital shortfalls. They pointed to the benefits of involving an independent third party in ensuring the transparency and credibility of the exercise. Directors also emphasised the importance of a credible backstop, including through direct recapitalisation by the ESM, and looked forward to early agreement on this matter.
Directors urged further progress toward a fuller banking union to help reduce fragmentation. Stepped-up efforts are needed to adopt the enabling legislation for the Single Supervisory Mechanism, agree on the Bank Recovery and Resolution Directive, and make progress on the Deposit Guarantee Scheme Directive. Directors stressed the importance of establishing a strong, centralised Single Resolution Mechanism, with the independent power to trigger resolution and make decisions on burden sharing.
Directors generally considered that, given weak growth and subdued inflation, further monetary support, including through policy rate cuts by the ECB, would likely be necessary, especially if conditions worsen substantially. Directors also saw a role for explicit forward guidance in anchoring expectations, while additional unconventional support from the ECB, including that targeted at lending to small- and medium-size enterprises, could help repair monetary transmission, preventing a further credit contraction as measures to restore banking system health are being implemented.
Directors agreed on the need for a flexible, differentiated pace of fiscal adjustment within a credible medium-term framework. In this regard, they welcomed the recent extension for some countries to meet fiscal deficit targets. Directors noted nevertheless that additional flexibility may still be needed in some cases, especially if that available fiscal space is used to implement deeper structural reforms or recapitalise viable banks. In the longer run, it would be desirable to facilitate greater fiscal risk sharing.
Directors urged further structural reforms at all levels, with a view to enhancing the growth potential and further rebalancing demand within the euro area. In particular, a targeted implementation of the Services Directive would remove barriers to protected professions, promote cross-border competition, and raise productivity. Within countries, labor market reforms should continue to remove rigidities, raise participation, and, where necessary, promote more flexible bargaining arrangements.
Transcript of a conference call