EUROPEAN COMMISSION Strasbourg, 22.11.2022 COM(2022) 781 final REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL AND THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE Alert Mechanism Report 2023









































Prepared in accordance with Article 3 and 4 of Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances



























{SWD(2022) 381 final}



Alert Mechanism Report 2023 Contents Executive summary 1. Macroeconomic context 2. Imbalances, risks and adjustment: main developments 2.1. External sector 2.2. Competitiveness 2.3. Non-financial corporations 2.4. Housing markets and household debt 2.5. Government sector 2.6. Financial sector 3. Country section Annex 1: Note to the tables of the Country section Annex 2: Forecasts and nowcasts of scoreboard indicators

Annex 3: MIP scoreboard



This Alert Mechanism Report (AMR) initiates the twelfth annual round of the Macroeconomic Imbalance Procedure (MIP). The procedure aims at detecting, preventing and correcting imbalances that are adversely affecting, or have the potential to adversely affect, the proper functioning of the economy of a Member State, or of the economic and monetary union, or of the Union as a whole, and at eliciting appropriate policy responses. The implementation of the MIP is embedded in the European Semester of economic policy coordination to ensure consistency with the analyses and recommendations made under other economic surveillance tools (Articles 1 and 2 of Regulation (EU) No 1176/2011). The AMR identifies Member States for which in-depth reviews (IDRs) should be undertaken to assess whether they are affected by imbalances in need of policy action (Article 5 of Regulation (EU) No 1176/2011). Taking into account discussions on the AMR with the European Parliament and within the Council and the Eurogroup, the Commission will then prepare IDRs for the Member States concerned. The IDRs will be published in spring 2023 and will provide the basis for the Commission assessment regarding the existence and severity of macroeconomic imbalances, and for the identification of policy gaps. The AMR also includes an analysis of the euro area-wide implications of the Member States macroeconomic imbalances. The AMR analysis is based on the economic reading of a scoreboard of selected indicators, which provides a filtering device for detecting prima facie evidence of possible risks and vulnerabilities. In accordance with Regulation (EU) No 1176/2011, the role of the Commission is to undertake an economic reading of the scoreboard values that enables a deeper understanding of the overall economic context and taking into account country-specific considerations. () The AMR builds also on analytical tools and assessment frameworks, and additional published data, notably in-year data. () Building on the approach taken in previous years, the first screening for imbalances in the AMR is forward looking with a view of detecting risks of emerging imbalances early on. This could entail opening IDRs when adverse trends indicate high risks of a build-up of imbalances. To that end, this report uses forecasts, nowcasts and projections to better gauge the possible evolution of risks for macroeconomic stability. Values of scoreboard variables for 2022 and subsequent years have been estimated using Commission forecast data and nowcasts are based on in-year data (see Annex 2 for details). There is substantial uncertainty underlying those forecasts and it is necessary to bear this in mind in order to uphold the principles of transparency about analysis and data used, and prudence on the conclusions. The current approach to the AMR is consistent with the Commission’s proposal on the future of the surveillance of macroeconomic imbalances put forward in the context of the economic governance review. () In particular, it aims at a stronger preventive role of the MIP in an environment characterised by new risks. The assessment of imbalances would be based more on evolution of risks and policy action. The reformed MIP would focus on macroeconomic issues affecting Member States and at the same time, give more visibility to the EU and euro area dimensions of imbalances. Executive summary This Alert Mechanism Report (AMR) considers the evolution of imbalances at a time when the EU economy is moving from a recovery from the COVID-19 pandemic to a strong slowdown in growth amid inflationary pressures. By early 2022, nearly all EU economies had made up for the GDP decline experienced in 2020 due to the outbreak of the pandemic and were growing strongly, despite some remaining supply side bottlenecks and rising labour shortages. Since the launch of Russia’s war of aggression against Ukraine in February 2022, sharp increases in energy costs have resulted in a strong deterioration in the outlook for the EU economy. The current outlook is marked by a combination of high inflation, and declining consumer and producer confidence. Uncertainty, linked to the possible depth and duration of the energy crisis is high. Economic activity is declining, and growth is forecast to turn negative in the final quarter of 2022. Financing conditions have visibly tightened, even more so outside the euro area, as monetary authorities take measures to address the inflationary pressures. Outside the EU, global conditions are marked by a slowdown in China and jitters in emerging markets. Prior to the deterioration in economic conditions, the deleveraging of some long-standing imbalances which had increased during the pandemic resumed, while house prices accelerated. With the recovery, the deleveraging of high private and public debt levels that had been underway for the last decade in a number of countries resumed in many cases, but from higher starting levels. External rebalancing was slowly returning. It had paused during the pandemic, as the current accounts deteriorated in a number of large net-debtor countries with substantial tourism sectors, while large current account surpluses persisted. Government debt, which had increased substantially with the COVID-19 crisis given the strong recession and the need to support the economy, was beginning to moderate as of 2021. House price growth accelerated during the pandemic and strong growth continued during the recovery. In some countries robust wage growth has added to concerns about cost competitiveness that had in some cases been building up in the pre-pandemic period. The economic reading of the scoreboard, which reflects outcomes for 2021, is based on the central scenario of the Commission autumn 2022 forecast and in-year economic developments. In addition to the central scenario, there are increased risks and vulnerabilities that relate the heightened uncertainty about economic developments at the present juncture, which are discussed below. The economic reading leads to the following thematic conclusions: ·In 2021, the current accounts of most Member States reverted to close to their 2019 pre-COVID crisis positions, despite a residual impact in some countries with large tourism sectors. The current accounts of most net-debtor countries remained below the levels conducive for their swift correction, while some large current account surpluses ticked up. The large external stock positions mainly narrowed, thanks to higher GDP growth, but remain substantial. Throughout 2022 there has been a strong reduction in current account balances, both deficits and surpluses, driven by much higher energy prices. In some cases, these are accompanied by a reduction in non-energy trade balances, with exchange rate effects playing a role. Fiscal measures to alleviate the impact of the energy crisis shift the relative contribution of the government and private sectors’ net lending and borrowing positions, and contribute to increased current account deficits and reduced surpluses. ·The evolution of unit labour costs has been difficult to interpret in recent years due to serious disruptions in the measurement of productivity, but they have been growing overall. Wages have increased strongly in some countries in 2021, which points to a risk of loss of cost competitiveness within the euro area, in particular in countries displaying sustained pressure already before the pandemic years. In some countries labour markets are particularly tight, which may be partly due to the specific impact of the pandemic. In 2022, wage increases have accelerated, unmatched by productivity, leading to further pressure on competitiveness; however, due to high inflation household real disposable income is falling. Inflation-based real effective exchange rates have so far not appreciated overall in the euro area, due to the depreciation of the single currency, but there is considerable variation across countries. The different impact of the energy price shock on price dynamics plays a role, driven by differences in the energy mix, structure of energy markets and government support. There is also marked variation in effective exchange rates based on core inflation, with countries with greater price pressures showing appreciation relative to the euro area in the course of the current year. For countries outside the euro area, there are both substantial depreciations and appreciations underway, partly reflecting different nominal exchange rate dynamics which in some, but not all, cases are driven by the monetary policy stance. ·In 2021, the euro area current account surplus increased to pre-pandemic levels. In-year data show a sharp decline underway in 2022, mostly driven by increased imports with energy imports being the most significant factor on account of marked price effects. As a result, the euro area current account is forecast to fall considerably in 2022, and to remain largely unchanged in 2023, despite real demand holding up. Changes in unit labour costs over the pandemic have resulted in a temporary stalling in the symmetric adjustment of external positions within the euro area cumulatively over 2020 and 2021. Increases have, on the whole, been broadly similar for countries with high positive and high net negative Net International Investment Positions. Starting in 2022, the symmetric adjustment should restart and continue over the forecast horizon, with unit labour costs growing most strongly in some surplus countries. ·Corporate indebtedness ratios decreased in 2021 as economic growth resumed. Corporates are marked by increased liquidity partly mitigating immediate risks associated to corporate debt stocks. Nevertheless, debt stocks remain sizeable in many Member States, and above pre-pandemic levels in some cases. A continuation of the reduction in corporate debt as a share of GDP is underway in 2022, as economic growth remains positive amid continued financing flows, but this is likely to be hampered by the difficult macroeconomic context. In some countries, increases in non-performing loans and business bankruptcies have begun in 2022. ·House prices accelerated in most Member States in 2021 following years of sustained growth. Price increased further in the first half of 2022, but are forecast to moderate. Household debt ratios resumed their downward trend in 2021, but remain high and above pre-pandemic levels in some countries. While it is forecast to continue to fall as a share of GDP in 2022, the interest burden on households is likely to increase. Outside the euro area, mortgage interest rates have increased significantly over the course of 2022, while in the euro area the increase of interest rates is more limited but expected to continue. ·Government debt-to-GDP ratios decreased in nearly all Member States in 2021, but remain considerably above their 2019 level in nearly all cases. Deficits remained high, but strong economic growth exerted a downward effect on the debt ratios. Government debt ratios overall declined in 2022 as a result of continued economic growth alongside a further reduction of deficits despite sizeable support packages for households and firms related to high energy prices. The outlook for 2023 is varied across countries, although with further declines in government debt ratios among the highest debt countries. New policy measures to alleviate the impact of the energy crisis may increase debt levels. Debt service costs have started to rise since 2021 amid a tightening of financial conditions after years of very supportive conditions. This has been most pronounced in the non-euro area countries, which have seen stronger rises in their sovereign bond yield spreads. ·The banking sector is well capitalised and proved to be resilient over the pandemic. The reduction of the legacy non-performing loans continued in 2021 and in-year in 2022, but the possibility of the development of feedback loops cannot be excluded. While bank profitability has recovered, it remains structurally weak and is expected to decline again despite increases in interest rate margins as the worsening economic outlook affects assets and credit risks. In 2021, credit provision continued even after expiry of public guarantees and some macroprudential tightening. Some increase of non-performing loans is expected amid some delayed impact of the withdrawal of support measures taken over the pandemic and the current worsening economic outlook. Given the economic environment, there are specific risks that could lead to more accentuated imbalances. More adverse scenarios than the one described above could emerge, resulting in either more acute or longer lasting developments that may hamper macroeconomic stability and the functioning of the economies more generally: ·A protracted energy crisis, with continued high energy costs, could lead to a larger and longer downturn, increasing debt stocks both directly and indirectly and leading to a series of knock-on effects through the impact on consumers, workers, firms and the banking sector. Continued high energy costs could result in persistent larger current account deficits for some countries, putting pressure on their external sustainability.

·The prospect of a stronger structural transformation away from high energy dependency on fossil energy, in particular from Russia, is positive but entails risks and adjustment costs. A shifting of value chains away from more affected European firms facing globally higher input prices, could dampen profitability and lead to increased bankruptcies of firms, clustered in affected sectors and regions, and a fall in export shares and potential growth in more exposed countries. ·The repricing of risk across the world could reverberate through financial markets, leading to instability and driving up borrowing costs for sovereigns and private borrowers, possibly in idiosyncratic ways. The worse economic conditions have increased vulnerabilities and risks associated with pre-existing imbalances. Despite the strong slowdown in activity underway, nominal GDP growth is forecast to help reducing debt ratios in both 2022 and 2023, mainly due to the impact of inflation. However, weaker economic activity and tighter financing conditions increase the risks associated with high debt levels. A rise in non-performing loans and bankruptcies is a risk for both the corporate and the household side. Firms face increases in production costs and may be limited in their ability to pass these on, with more vulnerable firms clustered sectorally and geographically. Households face reduced real disposable income in most countries, with wage increases being lower than inflation but higher than productivity growth. House price growth is undergoing a correction in many Member States, amid increasing mortgage interest rates and pressure on disposable income. Continued strong house price growth in some countries would pose a risk of a disorderly reversal, particularly where accompanied by mortgage loans at variable interest rates. Corporate and household stress could compound each other and spread throughout the economy, with consequences for the financial sector too. Additional measures to support vulnerable households and more exposed firms would shift part of the cost of the energy crisis on the government sector and add to government debt, which for those countries with high starting debt and deficit levels may be a particular challenge, calling for measures to be targeted and temporary and common European solutions. Concretely, the Commission will reassess the needs for RePowerEU. Moreover, higher interest rates and weaker or negative GDP growth hamper government debt deleveraging, especially for high debt countries. This can have a knock-on effect on other sectors, with a negative impact on growth. As the strong post-pandemic growth stalls, new imbalances may emerge, with a risk of divergent price effects resulting from the common supply shock. Despite the commodity price increases and gas supply risks being a common shock to the EU, there is considerable divergence in its impact. Although inflation is expected to gradually start falling, there may be a step change in the relative price and cost levels of different countries when it recedes. This could result in cost competitiveness losses that may be costly to unwind. This is particularly for euro area countries and where external deficits have emerged, although higher inflation in large current account surplus countries could facilitate euro area rebalancing. In some non-euro area countries, currency depreciations may preserve cost competitiveness by offsetting some strongly rising labour costs but could further fuel inflation. In turn it may lead to tighter financing conditions whereas depreciations also increase the costs of external borrowing and debt services. The euro area is showing some signs of rebalancing in the short term, but its overall performance going forward requires continued close coordination of policy responses Some rebalancing within the euro area is supported by stronger unit labour cost developments in some net-creditor countries. Recent current account dynamics, resulting from the adverse external shock, are also broadly supportive of a rebalancing, with net-creditor countries showing greater reductions in their large surpluses. Differences in the magnitude of policy interventions aimed at mitigating the impact of high energy prices, and which shift the burden of the energy crisis between the corporate, household, and public sectors, and the prevalence of untargeted price measures are a concern. The type and composition of these measures, in terms of how they affect energy demand and energy prices, as well as of their effects on companies and households, may entail spillovers for the rest of the euro area and jeopardise the level playing field. This calls for those measures to be targeted and temporary. Uncoordinated policy measures can result in increased divergence, impeding monetary transmission and amplifying the heterogeneous impact of the energy crisis. The analysis presented in this AMR points to the need to closely monitor developments and risks related to common trends, which affect both Member States with pre-existing imbalances and those with newly emerging vulnerabilities. The fallout from Russia’s war in Ukraine along with global supply side constraints and inflationary pressures constitute common shocks that may imply risks for macroeconomic stability and the functioning of the EU economy as a whole and the euro area in particular. Given their common nature, these need to be considered within a common framework to provide context to any differentiated country-specific analysis. As part of the analytical underpinning of the upcoming country-specific IDRs, the Commission services will carry out in-depth thematic assessments on three issues of key relevance at the current juncture. These assessments will cover issues that are common to a number of Member States. They will identify common factors relevant for the country-specific analysis and focus in more detail on the countries assessed in this AMR as the most affected by those issues. The assessments will also be presented to the Economic Policy Committee in early 2023, and the relevant Member States will be invited to provide input to inform a discussion. This will inform the country-specific IDRs in the spring package of the European Semester. The following thematic notes will be prepared: ·An in-depth thematic note on housing market developments will look at the risks and drivers associated with house price developments and mortgage markets and household debt. The note will focus on Czechia, Estonia, Germany, Hungary, Latvia, Lithuania, Luxembourg, the Netherlands, Portugal, Slovakia and Sweden. ·An in-depth thematic note on competitiveness dynamics will assess the extent and impact of the pass-through of energy costs to inflation, and the evolution of wages. This note will focus on Czechia, Estonia, Hungary, Latvia, Lithuania, Romania and Slovakia. ·An in-depth thematic note on external sustainability and balances will look at the reduction in trade balances within a horizontal approach. This note will focus on Cyprus, Greece, Germany, Hungary, Latvia, Lithuania, the Netherlands, Portugal, Romania and Slovakia. Building on the assessment in the AMR, the IDRs will also cover additional concerns and country-specific issues. That will include the impact of current developments on imbalances identified in the 2022 IDRs (Cyprus, France, Germany, Greece, Italy, the Netherlands, Portugal, Romania, Spain, and Sweden). This AMR concludes that IDRs are warranted for those Member States with existing excessive imbalances or imbalances. For Member States that have previously been identified as experiencing imbalances or excessive imbalances, the 2023 IDRs will assess if those imbalances are aggravating, under correction, or corrected, with the view to update existing assessments and assessing possible remaining policy needs. That will be case for Cyprus, France, Germany, Greece, Italy, the Netherlands, Portugal, Romania, Spain, and Sweden. In addition, IDRs will be undertaken for Member States with particular risks of newly emerging imbalances. The IDRs will be informed by the in-depth thematic assessment notes, which will form the background for the analysis. The AMR concludes that IDRs are also warranted for Czechia, Estonia, Hungary, Latvia, Lithuania, Luxembourg and Slovakia, which have not been subject to IDRs in the previous cycle, but which could potentially be subject to particular risks of macroeconomic imbalances. Graph 1: Number of Member States recording scoreboard variables beyond threshold Source: Eurostat and Commission services calculations (see Annex 2)

1. Macroeconomic context In the aftermath of Russia’s invasion of Ukraine, the EU economy finds itself at a turning point, moving from a recovery from the COVID-19 pandemic to a slowdown in growth amid inflationary pressures. By early 2022, nearly all EU economies had made up for the GDP decline experienced with the pandemic in 2020 and were growing strongly. With Russia’s invasion of Ukraine in February 2022, the outlook for the EU economy changed significantly. According to the Commission autumn 2022 forecasts, real growth in the EU is set to fall from 5.4% in 2021, to 3.3% in 2022 and 0.3% in 2023, with solid output growth in the first half of 2022 masking the in-year deterioration that is underway (Graph 1.1). () By September 2022, inflation reached a new record high of 10.9% on a year-on-year basis in the EU, compared to a pre-pandemic inflation rate below 2%. In the euro area alone, inflation reached an all-time high of 10.7% in October. EU countries relying more on gas as a source of energy are expected to be more impacted by the recent shock (Graph 1.2 b). Consumer and producer confidence has fallen amid high uncertainty. Financing conditions have visibly become more challenging, as monetary authorities have started to tighten policy to address the high inflationary pressures, which are expected to remain relatively elevated in 2023. Graph 1.1: GDP slowdown Source: Eurostat and Ameco. Countries ordered by real GDP growth forecast for 2023. Soaring energy prices have been the main driver of inflation, but a number of other factors have broadened overall price pressures. The rapid global recovery following the first wave of the pandemic drove up demand for and prices of energy and other commodities. This was the first stage of the energy-inflation surge. () In the EU, this was combined with demand pressure, stemming from pent-up consumption and the unwinding of the high household savings accumulated during the acute phase of the pandemic, which led to a rapid expansion of domestic demand when restrictions eased. () Fiscal stimulus also continued to support demand in the EU, beyond the acute early pandemic period. This demand pressure was accompanied by effective supply bottlenecks, which put upward pressure on the prices of manufacturing products. After Russia’s invasion of Ukraine in February 2022, the disruption of the supply of Russian gas to Europe sent energy prices soaring, making energy prices the main drivers of HICP inflation (Graph 1.2 a). Household income developments over the pandemic paved the way for a strong rebound once restrictions were lifted, and labour market conditions started to tighten in some countries and sectors. A range of policy measures including employment support measures protected household incomes in 2020 and 2021. As a result, real household disposable income grew between 2019 and 2021 in most EU countries, although with significant variation. In parallel, in many countries, households accumulated net savings over the pandemic with curtailed consumption opportunities playing a role. Higher increases in disposable income over 2021 have enabled households to withstand more broad-based increases in prices without a reduction in demand, which in turn has allowed some non-financial corporations to preserve or even boost profits in this period. () This effect is likely to recede as real gross disposable income is forecast to decline in most EU countries in 2022 (see Section 2.4). While unemployment was stabilised by policy measures, overall labour market slack increased over 2020. Since then, it has been falling with the recovery in demand and the steep increase in vacancies in 2021. () The longer-term trend reduction in working-age populations due to ageing and changes in migration trends may also have contributed to tighter labour markets in various EU countries. Labour market slack in the second quarter of 2022 was low in a number of EU countries reporting high core inflation (Graph 1.2 d). Despite extensive policy measures to contain energy prices, they are the source of major economic pressure and uncertainty. The rise in energy prices represents a terms of trade shock that imposes costs on the EU economy. Throughout the EU, governments have sought to limit the burden of higher energy prices to firms and households by redistributing the burden, but they cannot eliminate the overall economic impact. Measures vary significantly across countries, from price freezes and tax cuts to income support schemes, and further support is being considered. These measures cannot fully compensate for the full impact of the energy price increases on households and firms, which face much increased costs, although with large variation depending on their energy use and exposure to higher retail prices. Electricity price inflation itself has varied across the EU, not just due to government policies, but also as a result of the countries’ energy mix and contractual arrangements and the related pass-through of wholesale electricity prices to retail prices. It represents a major change in costs and relative prices that could result in significant and lasting structural shifts across sectors and countries, depending on its duration and intensity. High inflationary pressures have broadened beyond energy, bringing a risk that inflation divergences become entrenched. Core inflation has increased significantly in all EU and euro area countries in 2022, with some of the broadening reflecting the indirect effect of higher energy prices. There are large cross-country differences in 2022 core inflation, which ranges from 2.8% to 11.5% across EU countries, and from 2.8% to 9.8% within the euro area. The heterogeneity in the policy response to the energy price shock is reflected in various measures of inflation, including trade deflators and the GDP deflator. While the pass-through of energy inflation plays a role, other factors such as supply bottlenecks and residual pent-up demand are likely to be significant. Second-round effects stemming from an increase in wage costs are not yet visible, but may be developing in some EU countries. House prices have risen to very high levels, fuelled by longstanding supply constraints, and their continued rise, despite increasing financing costs, could be a further push on inflation over time. Supply chain bottlenecks may be easing but continue to constrain supply in a number of sectors. There are continuing pressures resulting from supply chain disruptions still in 2022, although these pressures may be easing in some sectors. () The January/February 2022 data for the Purchasing Managers’ Indices (PMIs) for suppliers’ delivery times (SDT) and dynamic factor analysis including other indicators (backlogs of work, the orders-to-inventories ratio, intermediate input prices and shipping costs) suggest that supply chain pressures, while still historically high, have peaked and started to ease in the EU. The October 2022 PMI continues to indicate a drop in delivery times and the falling in demand easing supply bottlenecks. () However, possible disruptions linked to the war in Ukraine might lead to a setback. Increasing energy prices combined with wider geopolitical tensions are causing significant disruptions in key sectors, such as energy intensive industries, and limiting their access to critical raw materials. Depending on supply chain participation, these developments can also lead to different core inflation developments across the EU. Despite increasing unit labour costs in a number of countries, nominal wages are overall not keeping up with inflation resulting in a reduction in purchasing power. In 2022 compensation per employee is expected to grow at 4.2% () in the euro area and labour productivity at 1.2% leading to an increase in unit labour costs of 3%. Unit labour costs developments have, however, varied across countries (Graph 1.2 e). Nominal wages are not expected to keep up with inflation. While this helps to protect firms from a further increase in production costs and preserves employment, it brings with it a loss of purchasing power for households. The loss of purchasing power affects demand and raises the risk of balance sheet stress for vulnerable households. Monetary policy has started to normalise, driving funding costs up and prompting asset price corrections. This July, the ECB followed its reduction in asset purchase volumes with a further step on its policy normalisation path, raising the three key policy rates by 50 basis points, signalling further normalisation and approving the Transmission Protection Instrument (TPI). Further rises in policy rates were effected in September and October. Higher funding costs for banks have passed partially through to higher bank lending rates, in particular for households, while asset prices in some cases have adjusted down. In the euro area, credit standards have tightened for all loan categories in the second quarter of 2022 and continued tightening in the third quarter, due to concerns regarding the risks faced by borrowers in an uncertain macroeconomic environment. Euro area government yields have been volatile and increased markedly in 2022, although the risk of significant nominal interest rate differentials between euro area countries is expected to be mitigated by the introduction of the TPI. Monetary conditions have also tightened in non-euro area Member States, as non-euro area EU central banks have tightened their policy stance amid high inflation, leading to an increase in financing costs for the government and the private sector. The euro nominal effective exchange rate has weakened and changes in EU non-euro area currencies have been mixed. The euro has experienced considerable volatility against the dollar in 2022 but the pressure has been for euro depreciation as the US central bank has tightened monetary policy faster than the ECB. The euro is also exposed to geopolitical and economic risks related to the war in Ukraine that are specific to the EU, while the dollar is benefiting from safe-haven flows, as it usually does in times of uncertainty. Given the different exposures of euro area Members States to extra-EU trade and financial flows, movements of the euro by itself represent asymmetric shocks possibly leading to different movements in nominal effective exchange rates (NEER), a fact that has been documented in the literature. () Among EU non-euro area currencies, the Czech koruna has experienced significant appreciation amid marked tightening of monetary policy coupled with exchange rate intervention (Graph 1.2 c). The Polish złoty and, especially, the Hungarian forint have been on a continued depreciating trend despite domestic monetary tightening. In March 2022, the currencies of both countries depreciated strongly amid increased uncertainty following the Russian aggression on Ukraine and tightening of global financial conditions. Croatia has acted to continue stabilising its currency relative to the euro, while Denmark has maintained its long-standing euro peg and Bulgaria operates a euro-anchored currency board. After more than two years of the kuna’s participation in ERM II without frictions, Croatia is set to join the euro area in January 2023. () The Swedish krona depreciated over last year despite ongoing monetary policy tightening. Graph 1.2: Macroeconomic context Source: Eurostat and Ameco Box 1.1: Employment and social developments Before Russia’s military aggression against Ukraine, a robust labour market recovery took place in the EU. The strong economic recovery that followed the COVID-19 recession was accompanied by strong job creation and a decline in unemployment (Graph 1.3 a). The EU unemployment rate (15-74 years old) reached 6.4% in end 2021 and continued to decline in 2022 reaching 6% in August and September, the lowest rates for more than two decades. The overall labour market conditions continued to improve into 2022 driven by the full opening of the economies, improvements of the epidemiological situation, the effect of pent-up demand, and the good tourism season following eased mobility. Yet employment in manufacturing continued to stagnate. On the back of a rapid increase in demand, labour shortages reached new highs and although shortages emerged in various sectors, they increased more in services than in manufacturing. Employment growth was close to 1½% with the EU employment rate (20-64 years old) reaching 74.1% in the fourth quarter of 2021, although it remained 2 percentage points (pps.) below its pre-pandemic levels in manufacturing. In contrast, job creation was quite robust in less contact intensive services (such as health, public administration, and ICT) and construction (Graph 1.3 b). The labour market is expected to slow down in view of the deteriorating economic outlook. In 2022, the labour market has remained resilient due to still positive effect of the recovery that followed the reopening of the economy after the lockdown. Yet the rise in energy prices represents a major risk also for the labour market going forward. While the higher cost of energy is strongly felt by the more energy-dependent sectors, it has knock-on effects on almost all sectors. The employment impact of a gas price shock might differ across countries depending on their competitiveness. Econometric estimates suggest that a 10% increase in natural gas prices may reduce output by 0.6% after two years, while employment would decline by 0.3% and real wages by 0.2%. () The impact on employment might be softened by a reduction of the hours worked per person employed. The contribution to the increase in unemployment might be larger for services than for manufacturing since labour hoarding is more common in the latter, while employment is more responsive over the business cycle in the former, which is has a relatively higher share of temporary workers. () ·Compared to the 2021 yearly figure, in the second quarter of 2022 the unemployment rate declined in all countries, notably in Greece (-2.5 pp), Spain (-2.3), Ireland (-1.9), Austria (-1.8), and Lithuania (-1.6 pp). The gap between the highest unemployment rate in Spain (12.5%) and the lowest in Czechia (2.4%) dropped to 10.1 pp, the lowest gap since October 2008. ·In 2021, in almost all Member States employment rates (20-64) swiftly rebounded and surpassed their pre-pandemic levels. Between 2020 and 2021, the largest increases were observed in Greece (4.3 pp), Ireland (2.8), Poland (2.7), Spain (2), and Luxembourg (2 pp). The employment rate declined only in Latvia (-1.6 pp). In the first half of 2022, the employment rate continued to increase in all countries, notably in Ireland (+3.6 pp on average in the first half of 2022 relative to the annual figure of 2021) and Greece (+3.8 pp on average in the first half of 2022 relative to the annual figure of 2021). ·In the second quarter of 2022, employment in manufacturing remained largely below its pre-pandemic levels in few Member States, including Bulgaria, Romania, Spain, Poland, Slovakia, and Germany. Graph 1.3: Employment, unemployment, and labour shortages Source: European Commission services

2. Imbalances, risks and adjustment: main developments 2.1. External sector The current accounts of most Member States displayed small or moderate changes in 2021, often only partially reversing the changes from a year ago. In particular, recovering travel balances contributed to a partial improvement of current accounts in some large net-debtor countries. Despite the improvement, in 2021 the current accounts of some of these EU countries remained in large deficit and with their net international investment positions (NIIPs) still deeply negative. At the same time, some large current account surpluses increased, coming in close to their 2019 levels after a small decline in 2020. Overall, the high current account surpluses of some countries continued to significantly exceed what can be explained by fundamentals. () Some other countries saw small reductions and in a few cases balances came in considerably below those recorded in 2019 (Graph 2.1.1 a). Current account balances are declining strongly in 2022, driven primarily by high energy prices (Graph 2.1.1 a). The two most important driving forces behind the changes in current accounts in 2021 and year to date in 2022 have been the lower energy trade balance () and, working in the opposite direction, the recovery in international travel. The recovery in tourism is mostly benefiting net-debtor countries, but remains partial; most countries with a strong reliance on tourism exports still display travel balances below their pre-pandemic level, although the data for the main tourist season are still to come for the third quarter of 2022. Moreover, the improvement in travel balances is often surpassed by the impact of high energy prices which affect nearly all countries (Graphs 2.1.3 d and e). For a number of countries, a noticeable deterioration of non-energy trade balances is also underway in 2022. In some cases, this is driven by resilient domestic demand. The overall effect is a strong decline in current accounts in 2022, with a number of countries with surpluses in previous years going into deficit. The forecast for 2023 indicates some mild increases in current accounts for many, but not all, EU countries, but often clearly smaller than the deteriorations recorded in 2022. Strong nominal GDP growth in 2021 helped to narrow both negative and positive net international investment positions. In 2021, the strong denominator effect thanks to a marked recovery in economic growth reduced, but did not always fully undo, the dispersion in NIIPs that had occurred in 2020 (Graph 2.1.1 b and Graph 2.1.3 a). That pattern has continued into 2022 with NIIPs-to-GDP ratios of large net-debtor countries often recording further sizeable improvements, although most of them remain below the NIIP prudential levels. () For most of these net-debtor countries, the recent current account outturns are below the levels conducive for the swift correction of their negative stocks, as captured by the current account required to reach a specific NIIP target, even if only slightly in case of Spain and Portugal (Graph 2.1.1 a and b). Conversely, the NIIPs of several net-creditor countries have remained considerably higher than suggested by economic fundamentals. From a sectoral perspective, household net lending positions are declining in 2022 as a result of the reduced purchasing power. In 2021, the net lending/borrowing positions in most Member States were characterised by net borrowing by governments and positive net lending by the private sector, both households and corporates (Graph 2.1.3 b). There was a slight reversal of the exceptional fiscal support pursued in 2020 to mitigate the pandemic crisis, broadly offsetting a small decline in the private sectors’ net lending positions. In 2022, fiscal support is expected to remain in place, even if most Member States are expected to continue recording further improved government net positions (Graph 2.1.3 c). At the same time, the decline in household net lending is expected to dominate, contributing to lower overall net borrowing/lending positions in most cases. Graph 2.1.1: Current account balances and net international investment positions (NIIPs) Source: Eurostat and Commission services calculations. Global monetary tightening, amid high inflation, as well as elevated geopolitical risks, could affect the external financing conditions of some non-euro area Member States. As set out in Section 1, both the pandemic and, more recently increased uncertainty following the Russia’s aggression of Ukraine, have resulted in changes to some non-euro area exchange rates, with the Polish złoty and the Hungarian forint depreciating. If external (re-)financing risks were to emerge, countries with substantial foreign exchange reserve stocks, as well as those recording solid surpluses in external flows, would be less exposed. External financing needs, including these of the government sector, play a role in this context (see Section 2.6 on the government sector). The euro area current account surplus is falling sharply in 2022. Energy costs are the key factor for the strong in-year reduction of the euro area current account (Graph 2.1.2 a). Since 2021, global supply problems have led to marked rises in import prices for goods beyond commodities. This is reflected in the euro area trade balance vis-à-vis China, which has declined by more than one percentage point of GDP compared to 2019. High inventory imports and import prices from China explain part of the strong decline in the trade surplus of Germany in particular. In addition, global demand for European exports is decelerating, as the slowdown in China and monetary tightening in the US have implications for demand not only in these two trading partners, but also in most emerging markets. As set out in Section 1, the euro has depreciated strongly, in particular vis-à-vis the US dollar. This weighs on the euro area trade balance as the share of dollar-denominated imports, particularly for energy goods, largely exceeds the dollar denomination of exports. However, income from dollar-denominated foreign assets as well as merchanting and revenue from the global commodity trade has somewhat cushioned the overall impact of the terms-of-trade shock on the external balance. The decline in the euro area trade balance in 2022 has been driven by the terms of trade shock, with real demand remaining strong. The terms of trade shock that has been underway in 2022 on account of much higher energy import prices and weaker euro has driven the decline in the euro area nominal trade balance – and by extension current account (Graph 2.1.2 b). When measured in real terms, i.e. at constant prices, the trade balance is forecast to strengthen somewhat in 2022, as real aggregate demand should grow slightly less than GDP. Real demand growth is forecast to outpace output growth in 2022 in large net-creditor countries and has reduced their contribution to the euro area current account surplus (Graph 2.1.2 b). This is forecast to persist in 2023. Several net-debtor countries improved their real trade balance by demand not keeping up with recovering GDP growth. It is the total of smaller countries that are driving the stability of the real trade balance in 2022, and counteracting the decline in the real balance of Germany, the largest contributor to the euro area. The forecast for 2023 is for an overall stability in the euro area trade balance, including its composition, but this is subject to much uncertainty. Supply chain bottlenecks and import prices are likely to ease somewhat in 2023 but should continue weighing on the euro area trade balance. Decelerating global demand will dampen export prospects but may provide some relief for commodity prices. As a result, the impact of terms of trade is forecast to lessen somewhat, providing a marginal improvement in the overall euro area trade balance. Instead, domestic demand growth remains a key factor for the dynamics of the euro area external balance in 2023. In terms of its composition, the readjustment away from the contribution of large net-creditor countries is forecast to persist. Graph 2.1.2: The euro area current account and trade balance Source: European Commission services At country level, the following developments are worth highlighting: ·In 2021, the current account balances, based on 3-year averages, of four Member States stood below the lower scoreboard threshold of -4% of GDP: Cyprus, Greece, Ireland, and Romania. At the same time, three Member States had averages above the upper threshold of 6% of GDP: Denmark, Germany, and the Netherlands. As for the NIIP readings, for ten Member States they were below the scoreboard threshold of -35% of GDP: Croatia, Cyprus, Greece, Hungary, Ireland, Poland, Portugal, Romania, Slovakia, and Spain. ·Current accounts of some large net-debtor countries, such as Cyprus, and especially Greece, remained in sizeable deficits, even though Cyprus has recorded moderate improvements. While the small surplus of Spain increased slightly, the moderate deficit of Portugal was largely unchanged in 2021. In these countries, apart from Spain, the current accounts remain below the levels suggested by economic fundamentals, even if by different margins. In the first two quarters of 2022, a further solid recovery of international travel, coupled with rising prices in the sector, is lending a strong support to their surpluses in travel balances, especially for Portugal and, to a slightly lesser extent, also for Cyprus, Greece, and Spain, with the main tourist season still to come in the third quarter of the year. However, bar Spain, for these countries a deterioration of their current account readings is expected for this year as a whole, chiefly reflecting worse energy balances. Their clearly negative NIIPs have been improving mostly due to the strong nominal economic growth, but the improvement was somewhat weakened by the negative valuation effects in the case of Greece.

·Current account deficits are very sizeable and at their highest levels in years in the case of Hungary and Romania. Romania’s current account deteriorated from an already elevated deficit and continues to worsen in 2022 with no expectation of a significant improvement next year. Hungary is also recording a noticeable deterioration, with only a mild improvement expected in 2023, showing one of the sharpest deteriorations in its energy balance. The depreciation of the Hungarian forint adds to concerns about its external sector developments. For both countries, NIIPs are clearly negative but inward foreign direct investments represent a considerable portion of that. This renders their NIIPs, excluding non-defaultable instruments (NENDI), more favourable. ·In Latvia, Malta, and Slovakia, the current accounts in 2021 were in non-negligible deficit. In many cases substantial deteriorations are projected for 2022 and 2023. In Czechia, Bulgaria, and Poland the mild current account deficits of 2021 are forecast to increase. The depreciation of the złoty adds to concerns about external sector developments in Poland. Belgium and Lithuania are forecast to move into noticeable deficit in 2022. Slovakia and Lithuania have recorded some of the greatest deteriorations in trade balances as a result of worsened energy balances. The deficit of Slovakia is expected to further expand exceeding its pre-pandemic level. For Poland and Slovakia, which have pronounced negative NIIPs, as well as for other Member States in central and eastern Europe, inward foreign direct investments represent a considerable portion of their external liabilities. Consequently, their NENDIs are more favourable. ·The large surpluses of Denmark, Germany, the Netherlands, and Sweden remain above their current account norms. While the current account surpluses increased in those countries, bar Sweden, in 2021, they are expected to record a marked decline in 2022. In particular, the current accounts of Germany, the Netherlands, and Sweden have been declining noticeably and, in excess of the worsening of the energy balance. The surplus of Denmark has been increasing in the first half of the year, but overall, a decline is forecast for 2022. The NIIPs of the Netherlands, Denmark, Germany, and Belgium are far above the levels suggested by economic fundamentals. Graph 2.1.3: External sector: selected graphs Source: European Commission services 2.2. Competitiveness Unit labour costs grew faster over 2020-21 than in the pre-pandemic period, and their growth rate is accelerating in 2022. A strong increase in unit labour costs had been observed in most Member States in 2020, driven by mechanical drops in measured productivity, as job retention schemes mitigated the fall in employment despite the markedly lower output. In 2021, this trend partly reversed as the recovery in productivity led to either unit labour costs declines, or to a visible deceleration in their growth, in nearly the entire EU (Graph 2.2.1 a). Unit labour costs are forecast to rise this year and next, substantially in some cases (Graph 2.2.1 b). The increase in unit labour costs is expected to be driven by strongly rising nominal compensation per employee that should considerably exceed real labour productivity growth in almost all EU countries (Graph 2.2.3 a and b) often against a backdrop of low and falling unemployment. In some cases, these effects may be the continuation of trends that led to concerns about potential overheating pressures before the COVID-19 crisis. As the economic momentum slows down, productivity gains will be lower and will dampen unit labour costs less than they have done recently. Real exchange rate dynamics have not yet been substantial overall, although there has been divergence, particularly outside the euro area. The changes in HICP-based real effective exchange rates (REER) remained contained in 2021, although small depreciations were observed in more countries than in 2020. The changes in HICP-based and GDP deflator-based REER over three years up to 2021 were also limited (Graph 2.2.3 c). In 2022, the nominal effective exchange rate (NEER) has so far depreciated in nearly all euro area Member States reflecting the depreciation of the euro, while changes in the HICP-based REER have remained moderate except for the few cases in which inflation was either much higher than elsewhere or where the NEER depreciated more sharply (Graph 2.2.3 e). In some non-euro area countries, in-year changes in the REER have been more marked. The GDP deflator-based REER does not show strong signs of deteriorating price competitiveness for most Member States although with some notable variation across countries (Graph 2.2.3 d). Going forward, challenges may emerge in intra-euro area REERs on account of divergence in inflation rates and differences in exposures to euro nominal exchange rate changes across the different euro area countries. More heterogeneity is expected across non-euro area countries, partly reflecting different nominal exchange rate dynamics. High and divergent inflation rates are a risk to competitiveness to the extent they become entrenched, with particular risks within the euro area. As set out in Section 1, inflation rates are not only high, but very divergent, including within the euro area. Overall, this divergence is rooted in varying energy-intensity across economies, and is affected by the scale and composition of government measures. Despite the fact that inflation is largely driven by the increase in energy costs, and is expected to fall, divergence in inflation rates brings a risk to competitiveness from two angles. First, energy prices may not return to their previous levels, but stabilise at higher levels. This would entail major costs for specific sectors, such as energy intensive industries. To the extent that these costs become permanent, countries with higher inflation due to the direct impact of energy costs would have permanently higher price levels. This relative increase could have a negative impact on their competitiveness and may lead to risk of relocation, ultimately resulting in a fall in export shares and potential growth in the more exposed countries. Over time, this may make a change in their business model necessary, and could involve costly structural shifts. Second, inflation differences can lead to increases in prices beyond energy. Cross-country differences relate not just to overall inflation rates but are also increasingly marked in core inflation. Box 2.2.1 discusses the risk that these may become entrenched and bring about further increases, including to wages. Such widening differentials can result in real appreciations, reducing competitiveness. The resulting relative changes to competitiveness could lead to a rebalancing in the euro area, if countries with pre-existing competitiveness weaknesses gain relative to their peers. However, at present, the most marked differences in inflation are not affecting large net creditors or net debtors, on the whole. Furthermore, heterogeneous inflation expectations in some cases might lead to increased vulnerabilities within the euro area, if too low expected real interest rates in some countries result in excessive debt accumulation. Outside the euro area, currency depreciations entail other risks, for instance in terms of external borrowing and debt service costs. The current context in which inflation differentials are rising is different than that of the run-up to the global financial crisis, but could still entail risks of macroeconomic imbalances. In the run up to the financial crisis, high inflation in some euro area countries resulted in a cycle where low real interest rates fed excessive demand and debt accumulation, fuelling real exchange rate appreciations. This time, however, the shock experienced is predominantly a contractionary cost-push energy shock, rather than an expansionary one. While this time high inflation in the most affected countries may work to keep real interest rates low and provide some cushioning of the more adverse impact on demand in the near term due to higher energy bill, the emergence of entrenched increases in prices or wages could complicate efforts to bring down inflation leading to competitiveness losses that may dampen economic growth going forward. Graph 2.2.1: Unit labour costs Source: Ameco; 2022 and 2023 data come from the European Commission autumn 2022 economic forecast. The data refer to the number of employees and of persons employed Export market share developments in 2021 reflect a partial reversal of the COVID-19 crisis effects but are likely to fall in the immediate future, amid the higher energy costs and a slowdown in trade. An effect of the pandemic was to reduce export market shares of economies with important international tourism sectors, several of which have more negative external positions, and to increase export market shares for several net-creditor countries relative to their pre-crisis levels. Export shares are forecast to fall in most EU countries in 2023, negatively affected by the particularly high energy cost increase in Europe, with some supply chain disruptions also playing a role. A stronger effect is forecast for some net-creditor countries with substantial manufacturing sectors. Changes in competitiveness have once again become generally conducive for more symmetric rebalancing of external positions within the euro area. (Graph 2.2.3 f). Developments in unit labour costs are somewhat more moderate in net-debtor countries than in net-creditor ones. However, developments in inflation, and particularly in core inflation, have been either broadly similar or sometimes more contained in net-creditor countries, which might dampen the rebalancing going forward, unless wage developments continue to diverge in view of differences in labour market slack. While, net-creditor countries generally tend to gain more from a depreciation of the euro given their higher share of extra-euro area trade, in this case export market shares dynamics point to external rebalancing as net-debtor countries are regaining some of the lost export market, while net-creditors’ shares are expected to decline going forward. At country level, the following competitiveness developments are worth highlighting: ·Unit labour cost growth, cumulated over the three years to 2021, was above the scoreboard threshold in 15 Member States: Austria, Bulgaria, Czechia, Estonia, Hungary, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Romania, Slovenia, Slovakia, and Spain. For the HICP-based REER, the three-year changes were more contained and no Member State exceeded the scoreboard thresholds. The five-year changes in export market shares were below the scoreboard threshold in France, Italy, and Spain in 2021. While a decline in France was mainly driven by the declining share of exports of goods, in Spain and Italy the fall was caused by decreasing export shares of services. In all three countries, the aforementioned declines were most pronounced during 2020 pandemic. ·Concerns about cost pressures have been significant in some countries over a number of years and are increasing, or not sufficiently abating, including in Bulgaria, Czechia, Estonia, Hungary, Latvia, Lithuania, Luxembourg, Romania, and Slovakia. They were typically already sizeable before the COVID-19 crisis, in most cases continued in 2021 and the first half of 2022 amid comparatively tight labour markets. Unit labour costs growth is forecast to remain high or to increase strongly again next year in most of these countries. Several of them face additional risks to their competitiveness, relating to the surge in inflation, which is much higher than in the rest of the EU and in the euro area peers. While for most of these countries the REER are forecast to depreciate in 2023, a mild appreciation is expected for Slovakia. ·Malta and Slovenia have displayed similar effects as the countries mentioned above in the pre-COVID-19 period, but concerns about competitiveness losses, if any, were more moderate in 2021 and are expected to remain small this year too. In Belgium and Poland, unit labour costs are forecast to increase strongly over this year and next. Conversely, unit labour cost increases have been, and are forecast to continue being, more muted in Italy, pointing to a small relative gain in competitiveness. ·Concerns about cost competitiveness have been receding in some large net-debtor countries, including Cyprus, Greece, Portugal, and Spain. In particular, unit labour costs have been growing slightly less than in trading partners and the rest of the euro area.

Box 2.2.1: Potential entrenchment of inflation and competitiveness losses High and divergent inflation, which has been observed across the EU since late 2021, can adversely affect competitiveness especially if persistent. If aggregate wage rises fully or partially compensate for the loss in purchasing power of workers, these wage increases will be reflected in higher unit labour costs unless they are offset by productivity increases. Such unit labour cost increases can then lead to second-round effects and risks of higher future inflation. () Divergences in competitiveness across euro area Member States can emerge if the inflation shock is very different across countries or if very different second round effects develop in the wake of that inflation shock. However, if demands for wage increases take into account that inflation is likely to recede, then the risk of a price-wage spiral remains limited. The Commission’s 2023 Euro Area Report discusses the role of inflation expectation in wage increases. () The soaring energy prices account for a large share of the price level increases in most Member States. However, if inflation has largely broadened beyond energy to other goods and services, living standards cannot be maintained unless income growth keeps up, even when energy prices fall. Energy and food components of the overall price indexes can be quite volatile, and are relatively unaffected by monetary policy decisions, as they are typically strongly influenced by international markets, at least beyond short term, i.e. in absence of regulatory or fiscal policy intervention. As a result, central banks use measures of core inflation to better capture the underlying inflation trend. () Unit labour costs for several EU countries, including Estonia, Latvia, Lithuania, and Luxembourg and two non-euro area Member States, Bulgaria and Poland, surged over the year up to the second quarter of 2022 (Graph 2.2.2 a). The jump was driven by very strong growth in compensation per employee, which exceeded or came very close to the 10% mark. Nonetheless in only four Member States the compensation per employee increased by more than prices, with the differential being especially large in Bulgaria. Productivity changes were insufficient to mitigate growth in unit labour costs, and in some cases they reinforced it. In Bulgaria and Luxembourg, unit labour costs increased by more than prices, while in Estonia, Latvia, Lithuania, and Poland their growth exceeded the core inflation. While the latter holds true also for Belgium, France, Italy, and Romania, their unit labour costs growth has been somewhat more contained. Those excesses of unit labour costs over prices growth create risks of further price hikes in order for firms to preserve price-cost margins. Divergent core inflation and unit labour cost developments could have considerable and more persistent consequences to some countries’ competitiveness, which is particularly relevant for the euro area countries. The change in core inflation-based REER (Graph 2.2.2 b) suggests non-negligible losses of competitiveness for Estonia, Lithuania, and Slovakia due to much higher core inflation than in the rest of the euro area. For the latter two countries this is compensated for by REER changes with respect to non-euro area countries. Conversely, the competitiveness of Germany, and to a lesser extent Finland, France and Italy, benefit from lower core inflation than in the rest of the euro area. REER depreciation with respect to non-euro area countries, observed broadly, contributes further to competitiveness gains of these countries. For some non-euro area countries nominal exchange rate movements strongly affected the REER. Most striking is the case of Hungary, where the strong nominal depreciation led to competitiveness gains despite comparatively high core inflation. Similar effects can be observed in Poland and Sweden. Conversely, Czechia experienced an appreciation in the (effective) nominal exchange rate, which along the relatively high core inflation rate has led to strong real appreciation. It should be noted that while currency devaluations may mitigate cost pressures, they may entail other risks such as higher debt service costs of foreign-currency denominated debt, both domestic and external. This may constrain the use of nominal devaluations as an instrument in mitigating the impact of increased costs on competitiveness. Graph 2.2.2: Unit labour cost, (core) inflation and competitiveness Source: Eurostat and Commission services calculations. Graph 2.2.3: Competitiveness: selected graphs Source: European Commission services 2.3. Non-financial corporations Non-financial corporate debt-to-GDP ratios remained sizeable in many countries in 2021, although they continued to decrease. Following the substantial deleveraging that took place over the last decade in many Member States, non-financial corporate (NFC) debt-to-GDP ratios in 2021 were below their pre-pandemic peak in most EU countries. Nonetheless, in 2021, debt ratios were above levels suggested by both economic fundamentals and by levels related to prudential concerns in almost half of the EU countries and in many countries above levels registered in 2019, before the COVID-19 pandemic started (Graph 2.3.1 a and b). () In 2021, the corporate debt-to-GDP ratio decreased in most Member States, largely due to the marked recovery in GDP growth (Graph 2.3.3 a). Net credit to NFCs was positive across the EU and started to pick up in most EU countries in 2021, including in a number of cases with high NFC debt, in light of the pickup in investment (Graph 2.3.3 c). The deleveraging process that restarted in 2021 continued into 2022, but going forward is likely to be hampered by the difficult macroeconomic context. The corporate debt-to-GDP ratio continued to decrease in almost all Member States in the first half of 2022, despite the increase in credit, which may also reflect rising liquidity needs. The effect of new net credit on corporate debt-to-GDP ratio was more than offset by real GDP growth and the sharp increase in inflation (Graph 2.3.3 b). Passive deleveraging is overall expected to continue, driven by rising inflation rather than real GDP growth, but there is a considerable risk that the decrease in debt ratios may slow or reverse. The increase in inflation may squeeze profit margins if increasing costs cannot be passed on to customers and reduce demand overall. The profit share of corporates started to moderate in the first half of 2022, but remains above its pre-COVID-19 level. In almost all euro area countries a high share of new lending to corporates with short maturities implies that tightening lending conditions and rising interest rates can affect corporates rather quickly. () In several non-euro area Member States, there was a notable increase in lending rates for corporates and besides a high share of corporate loans denominated in foreign currency represents source of additional vulnerabilities. Increasing concerns related to corporate non-performing loans and bankruptcies add to overall corporate and financial sector vulnerabilities after the COVID-19 shock. Some industries, such as accommodation and transport, have been strongly affected by the COVID-19 crisis. () Non-performing loans ratios and business bankruptcies have been declining in most Member States since 2020, even after debt repayments moratoria have been phased out. However, the share of vulnerable firms after COVID-19 is particularly high in some countries with a high share of non-performing loans (Graph 2.3.3 f). While the corporate non-performing loans ratio continued to decrease in most Member States still in the first half of 2022, in some they started to increase (Graph 2.3.3 e). Also, business bankruptcies started to rise in some Member States in the first half of 2022. In addition, while credit continues to increase strongly, credit standards are tightening substantially and are now at their highest levels since 2013 (Graphs 2.3.3 c and d). While liquidity buffers and net savings have increased in recent years, the difficult macroeconomic context, combined with structural transformations and supply chain disruptions, could lead to deteriorating balance sheets, squeezing profit margins and affecting debt servicing and corporate savings and investments (see Box 2.3.1). The energy crisis will affect some industries particularly strongly, through price increases and supply disruptions, and may have a lasting effect resulting in structural transformations. Energy-intensive industries are particularly exposed and may face pressure on their balance sheets. Structural transformations are being accelerated by the energy crisis. While it is expected that energy prices and supplies will normalise, there may be a permanent structural change, that can have widespread effects on the productive capacity and potential growth of more affected countries depending on their energy intensity and specialisation of production. The acute phase of the energy crisis may result in a closure of firms and/or a shift of demand to production from other – less affected – locations, resulting in a permanent off-shoring. The normalisation of prices, and wages, may be to a higher level, which could compound the costs associated with the energy transition, and overall may lead to a loss of competitiveness, particularly in some energy-intensive industries and with a differential impact across countries. Graph 2.3.1: Non-financial corporations' debt Source: Eurostat sectoral financial balance sheet accounts – loans (F4) plus debt securities (F3), Ameco and Commission services estimates. Policy interventions play an important role in protecting national economies from corporate stress, but a lack of coordination could raise concerns from a euro area and an internal market perspective. National policy interventions distribute the burden of the energy crisis between the corporate, household and public sectors more fairly. These will be particularly important in protecting exposed industries and avoid reductions in activity, closures, offshoring and loans defaults. Without such measures, corporate stress could be propagated throughout national economies. While there is no evidence so far, financial conditions and available fiscal space might eventually play a role in the possible scale and scope of national interventions and different approaches between countries may amplify the divergence of corporate liquidity or solvency risks, in particular in case the crisis would deepen or become protracted. This in turn would have an impact on prices, as differences in corporate investment and price setting behaviour could lead to divergences in demand growth and monetary policy transmission, given the existing and the emerging inflation and competitiveness differentials in the euro area. Further integration efforts can help to overcome this combination of challenges as well as reduce corporate vulnerabilities and divergence in growth and productivity. On the national side, appropriate insolvency regimes are important to minimise the long-term economic impact of any corporate insolvencies. At country level, the following developments are worth highlighting: ·Non-financial corporate debt is very high, beyond 100% of GDP, and above fundamental and prudential benchmarks in Sweden and Denmark, and there are additional signs of vulnerabilities. In Sweden, the corporate debt-to-GDP ratio is still above its pre-COVID-19 crisis peak and increasing. In Denmark, corporate deposits declined from an already low level. ·Belgium, Cyprus, Ireland, Luxembourg, and the Netherlands also have very high non-financial corporate debt-to-GDP ratios beyond 100% and above fundamental and prudential benchmarks. However, that is also due to a sizeable share of foreign direct investment loans and cross-border intracompany borrowing, which may partly limit vulnerabilities. ·High non-financial corporate debt-to-GDP ratios, above fundamental and prudential benchmarks, in France, Greece, Malta, and Portugal, are on a declining path. In France and Malta, the high level of debt is partly mitigated by sizeable liquidity buffers. In Austria, the corporate debt to GDP ratio is above the prudential threshold and credit growth has been strong. The COVID19 crisis disproportionately affected a number of industries, leaving corporate sectors vulnerable in countries such as Greece and Italy.

·The corporate debt-to-GDP ratio in Spain is above fundamental and prudential benchmarks. In Bulgaria, the corporate debt-to-GDP ratio is moderate, although beyond the fundamental benchmark and higher than in regional peers.



Box 2.3.1: Corporate savings and investment developments Corporate savings and investment developments can provide useful insights about corporate soundness and vulnerabilities associated to corporate debt stocks. An increase in corporate debt to finance investment is economically different to increases to cover unexpected costs, as additional borrowing to finance investment tends to increase productivity and production capacity and thus corporate soundness. At the same time, corporate vulnerabilities associated to high debt can be partly mitigated by increasing savings or deposits. This Box looks in more detail at the role of corporate savings and investment developments in mitigating corporate vulnerabilities in the context of the recovery from the COVID-19 pandemic and the recent economic slowdown. Corporate savings increased in many Member States since the COVID-19 pandemic (Graph 2.3.2 a). Many corporates built up precautionary savings at the onset of the COVID-19 pandemic to improve their liquidity position, partly facilitated by support measures. Corporate gross savings started to decline in the fourth quarter of 2021 and continued declining sharply in the first half of 2022 from one year earlier, but in most countries remain above the pre-COVID-19 level. However, corporate savings, in percentage of GDP, are forecast to increase in most Member States in 2022 overall (Graph 2.3.2 a). Deposits started to decline in the first half of 2022 in the majority of Member States, as many corporates require substantial liquidity to address the sharp rise in input costs, but remained above their 2019 level. The non-financial corporate profit share in the EU started to moderate in the first half of 2022, but remains above its level pre-COVID-19 level. Investment of corporates declined sharply with the COVID-19 crisis, but recovered in most countries in 2021. The recovery was strong, with corporate gross capital formation to GDP ratios in 2021 having exceeded their 2019 levels in 16 of the 24 Member States for which data are available, except Austria, Cyprus, Germany, Ireland, Luxembourg, the Netherlands, Slovakia, and Spain. In 2021, investment and net credit flows, both in percentage of GDP, increased in many Member States (Graph 2.3.2 b). This suggests that in some countries additional borrowing was used to finance investment. The need to finance fixed investments has become a considerably less important factor for loan demand in the course of 2022, according to the ECB’s Bank Lending Survey. In real terms, investment for the EU as a whole continued to slightly increase in the first half of 2022, but at a much lower pace than previously and it did not yet return to its 2019 level. Graph 2.3.2: Investment, credit and savings of non-financial corporates Source: Eurostat and Ameco Graph 2.3.3: Non-financial corporations: selected graphs Source: Ameco, Eurostat, ECB. 2.4. Housing markets and household debt House prices accelerated further in 2021 and are estimated to be overvalued by more than 10% in half of the EU countries. Since the COVID-19 pandemic outbreak, house price growth accelerated and prices were estimated to be overvalued by more than 10% in several Member States, and in many by over 20%, at the end of 2021 (Graph 2.4.1 a). () The acceleration of house prices is more evident in nominal terms but even deflated house prices, in a period of high inflation, accelerated in most countries. Supply constraints are still present in the housing market and together with high construction costs, contribute to higher house prices alongside strong demand. In the first half of 2022, house prices displayed record growth rates while in the short to medium term moderation is expected. Low mortgage rates and income growth were associated with the increase in both credit and house prices over the last decade, although since the pandemic outbreak the acceleration is too sizeable to be explained by these factors. The increase of interest rates is expected to foster some moderation in house prices and recent 2022 in-year data show that this is underway in many, but not all, EU countries. Mortgage rates remain considerably lower than inflation, yielding record negative real interest rates and an incentive to further real estate purchases, but the expected increase in the cost of new mortgages should moderate housing demand and house prices going forward. Likewise, the fall in purchasing power caused by higher inflation as well as the uncertainty about the strength of the economy and household incomes should also temper demand for housing and in that way also contribute to dampen house price growth. In some countries mortgage rates have already increased significantly while real incomes are declining or stagnant in most EU countries (Graph 2.4.1 b). Graph 2.4.1: House price developments and fundamentals Source: Eurostat, Ameco, ECB, European Commission autumn 2022 economic forecast, and Commission services estimates for estimated house price valuation gaps in 2021. After the increase in 2020, household debt-to-GDP ratios fell in 2021 in most EU countries, although net credit flows picked up. Household debt-to-GDP ratios decreased in 2021 relative to 2020 due to the increase in GDP but remained higher than in 2019 in several countries and are not expected to fundamentally change in 2022 (Graph 2.4.3 a and b). Net credit flows to households, however, were positive in almost all EU countries, increasing even where household debt is already high. Household debt appears high in close to half of the EU when compared with benchmarks that account for country-specific economic fundamentals and with thresholds that account for prudential concerns. () Bank credit developments in 2022 have been uneven across the EU, with credit growth decelerating especially in the non-euro area. Outside the euro area, mortgage interest rates increased significantly together with money market rates. This is particularly the case among countries facing a depreciation in their nominal exchange rate. In the euro area, developments are more uneven, but the cost of credit has also increased recently (Graph 2.4.1 b). Net bank credit flows decelerated only in a very limited number of euro area countries, while in non-euro area countries the deceleration is more visible (Graph 2.4.2 b). Going forward, there are risks associated with households’ abilities to meet mortgage payments. In most Member States, the share of loans with interest rates fixed for a period of up to five years is high, above 80% in eight EU countries and between 40% and 80% in another nine, making households in those countries more vulnerable to interest rate increases. Household incomes will be under pressure, with rising energy bills reducing available income for other expenditures. These two effects create a risk of balance sheet stress despite very low and even negative real interest rates. A deeper or longer lasting economic downturn with a negative impact on employment may trigger further loan repayment difficulties and forbearance. Risks to the economy from a substantial downward adjustment of house prices are somewhat mitigated by lower weights of the sector in the economy and by macroprudential measures, but cannot be discounted. In 2021, construction activity was higher in countries where house prices are overvalued the most but still below peak levels. This may reduce the impact of any downward adjustment on prices, as value added and employment would be less affected than before the global financial crisis, although household consumption growth could be reduced by wealth effects. In addition, any reduction in house prices is likely to be more muted, as the structural factors that have led to housing supply being constrained would remain in place. The macroprudential measures in place have also reduced the risks for the overall financial stability related to the housing market (see Box 2.4.1). Despite these mitigating factors, risks remain that could spill over into other sectors and create negative feedback loops exposing systemic weaknesses. Different housing market country dynamics compounded with the common monetary policy could lead to divergent trends within the euro area. Even if the risk of large house price corrections appears muted, there are challenges related with high levels of mortgage indebtedness, particularly when interest rates have low fixation period, mortgages have long maturities and house valuations are above fundamentals. The situation varies widely across the euro area members, which may raise some challenges against the backdrop of a common monetary policy. The current tightening of the monetary and financing conditions in the euro area may be insufficient to moderate the housing price in countries where house supply is very constrained. On the contrary, in countries with more flexible supply, tightening of financial conditions can drive house prices down with adverse impact in the construction sector. This may raise the stakes for country-specific policies, especially those related to housing taxation and household debt and repayments, as well as macroprudential measures and policies on the supply side. Graph 2.4.2: Household debt and bank loans to households Source: Eurostat, Ameco, ECB, European Commission autumn 2022 economic forecast, and Commission services estimates

At country level, the following housing market and household debt developments are worth highlighting: ·In 2021, deflated house prices growth surpassed the 6% scoreboard threshold in 14 Member States: Austria, Czechia, Denmark, Estonia, Germany, Greece, Hungary, Latvia, Lithuania, Luxembourg, the Netherlands, Portugal, Slovenia, and Sweden. In the second quarter of 2022, house prices were still accelerating and growing more than 20% in nominal terms from one year earlier in Czechia, Estonia, Lithuania, and Hungary; in other 12 Member States, Austria, Bulgaria, Croatia, Germany, Ireland, Latvia, Luxembourg, the Netherlands, Poland, Portugal, Slovakia, and Slovenia, price growth was between 10% and 20%. ·Member States with house prices are estimated to be overvalued by more than 20% include Austria, Belgium, Czechia, Denmark, Germany, Luxembourg, the Netherlands, Portugal, and Sweden. In France and Sweden, household debt is above prudential levels, credit to households is high and household debt is estimated to be higher at the end of 2022 than in 2019. While in the case of France, most mortgages are at fixed rates, in Sweden, over two thirds of mortgages have variable interest rates with a fixed period only up to one year, which exposes households more to the risks of increased mortgage payments due to higher interest rates. In Luxembourg, house prices overvaluation is the highest in the EU and household debt is very high in relation to household income; furthermore, credit is expanding fast. In Austria, Czechia, and Germany, household debt is below or in line with prudential levels but credit flows to households are elevated. Austria and Germany recently received recommendations from the ESRB on its residential real estate market. In Belgium household debt is above prudential levels, and in Portugal is above both prudential and fundamental levels. Also in Portugal, two thirds of mortgages have interest rates fixed for only up to one year, with the remaining mortgage mostly having rates fixed for a period between one and five years. ·In Estonia, France, Greece, Hungary, Latvia, Malta, Slovakia, and Spain, house prices were also overvalued in 2021 and increasing fast in the first half of 2022. In these countries, except Estonia and Latvia, also household debt is above the prudential threshold or increasing and approaching the benchmarks. In Slovakia, household debt has been increasing over time, it is higher than the fundamental benchmark and is forecast to cross the prudential threshold this year. ·In Bulgaria, Croatia, Ireland, Lithuania, Poland, and Slovenia nominal house prices are also increasing at a fast pace, above 10% from one year earlier in the first half of 2022. ·In Cyprus and Finland, house prices do not seem overvalued but there are issues relating to household debt. In Cyprus, household debt is decreasing and below the fundamental benchmark but estimated to be way above the prudential threshold. In Finland, household debt is also above fundamental and prudential levels. In both countries, more than 90% of mortgages have variable interest rates or are fixed for only up to one year.



Box 2.4.1: Assessment of residential real estate vulnerabilities by the ESRB The European Systemic Risk Board (ESRB) has assessed systematically medium-term residential real estate (RRE) vulnerabilities in the European Economic Area (EEA) countries since 2016 (). The ESRB has been active in assessing RRE vulnerabilities across the EEA and, after issuing a first set of warnings in 2016, it then issued a set of country-specific recommendations in 2019, along with further warnings on medium-term vulnerabilities in the RRE sector. The ESRB can issue warnings if it sees the need to flag vulnerabilities and trends that have the potential to disrupt financial stability, while recommendations are issued not only to flag financial stability risks but also to point to necessary remedial actions. The last assessment was published in February 2022. The February 2022 ESRB assessment concludes that RRE risks due to rapid house price growth and increasing household indebtedness have continued to increase in several countries. The key vulnerabilities highlighted by the ESRB assessment are of a medium-term nature and, depending on the country, relate to rapid house price growth and possible overvaluation of RRE (as the gap between house price growth and household disposable income widens), the level and dynamics of household indebtedness, the growth of housing credit and signs of a loosening of lending standards. The specific vulnerabilities vary from country to country, and the details for the more concerning cases can be found in the individual warnings and recommendations. Beyond macroprudential policy considerations, in a number of countries, some underlying vulnerabilities would be mitigated more efficiently with the help of reforms of housing and taxation policies. Table 2.4.1: Source: ESRB Following its assessment, the ESRB issued four country-specific warnings and two recommendations on medium-term RRE vulnerabilities to EU countries. Warnings were issued to four EU countries with newly identified vulnerabilities: Bulgaria, Croatia, Hungary, and Slovakia. Recommendations were issued to Austria and Germany, which had already received ESRB warnings in 2016 and 2019 respectively, and whose vulnerabilities have not been addressed sufficiently. RRE vulnerabilities have remained elevated in the countries that received ESRB recommendations in 2019. In Denmark, Finland, Luxembourg, the Netherlands and Sweden, vulnerabilities have persisted in spite of recent measures introduced to address them. In most of these cases, house prices have continued rising or have grown even faster than before, resulting in unchanged or increased house price overvaluation. The risks related to household indebtedness have also remained unchanged or increased in several countries. For the remaining EEA countries, either the ESRB has not identified a build-up of material vulnerabilities in the RRE sector, or such vulnerabilities have been identified but the current policy stance is assessed as sufficient to address them. Graph 2.4.3: Household debt and house prices: selected graphs Source: Ameco, Eurostat, ECB, Commission services 2.5. Government sector Government debt ratios decreased in most Member States in 2021 but remain well above pre-pandemic levels. In 2021, the debt-to-GDP ratio decreased in nearly all the EU countries, with the EU aggregate declining by some two percentage points. This decrease is the result of the recovery of nominal GDP after 2020 while favourable financing conditions continued. Conversely, fiscal deficits, while lower than in 2020, often remained sizeable, averaging 5.1% of GDP for the euro area and 4.6% of GDP for the EU as fiscal policies remained expansionary. In particular, fiscal deficits continued to reflect the impact of sizeable COVID-19 emergency temporary measures to support households and firms affected by the pandemic, which corresponded to around 3¼% of GDP for the EU aggregate. The government-to-GDP ratio is expected to decrease further in most of the EU countries in 2022. In most Member States, government debt is forecast to fall in 2022 by 3½ percentage points on aggregate, but to still remain higher than its 2019 levels, in some cases by close to 15 percentage points. The improvement is a result of continued nominal economic growth, which is higher than the implicit cost of debt, alongside a further reduction of deficits despite sizeable support packages for households and firms related to high energy prices, following two years of substantial fiscal support provided in the context of the COVID-19 pandemic. The declines in the debt ratio have been more sizeable in the most indebted countries as economic growth has a stronger deleveraging effect when debt-to-GDP ratios are larger. In some countries with low or moderate government debt ratios, these are expected to grow further.

The outlook for 2023 points to milder declines or a stabilisation of government debt ratios in most EU countries. In 2023, the weakening of economic activity is forecast to bring smaller reductions of the debt ratio whereas government deficits are expected to edge up on aggregate, with some differentiation across countries. Government debt ratios are forecast to reach their pre-COVID-19 readings by 2023 only in a minority of Member States (Graph 2.5.1). In the coming months there may be additional targeted measures to support vulnerable households and firms, which would shift part of the cost of the energy crisis on the government sector and add to government debt. In addition, further tightening of financing conditions or exchange rate movements may have an adverse impact on the fiscal performance, especially in the non-euro area countries, where the share of debt denominated in foreign currency is often significant. Higher inflation could act to reduce the debt burden insofar as it increases nominal GDP, but higher risk premia and weaker economic activity may contribute to increasing the government debt ratios and, in turn, pose challenges not just to fiscal sustainability, but also to other parts of the economy (see Box 2.5.1). Debt service costs may increase due to higher nominal interest rates. In real terms interest rates are currently forecast to remain negative in the euro area. Sovereign bond yields have been rising across the euro area in 2022, with spreads increasing somewhat as markets price in risk. Despite the tightening of monetary policy, real interest rates are still forecast to remain negative and euro area government bond yields remain among the lowest in the world. However, bond yields of Member States with large debts recorded somewhat stronger increases during the third quarter, but longer debt maturities help to cushion the impact. The possibility of a rise in interest rates and negative nominal GDP, which would be a situation that is more adverse than the current forecast, cannot be discounted. In this case, interest rates could exceed nominal GDP growth, raising pressure to improve fiscal positions in some high debt countries. The introduction of the Transmission Protection Instrument by the ECB in July 2022 to ensure orderly monetary transmission across all euro area Member States provides some insurance against a strong deterioration of financing conditions, as long as its conditions relating to economic policy are met. Non-euro area Member States face higher debt service costs due to widening sovereign bond yield spreads and exposure to debt denominated in foreign currencies. The global tightening of financing conditions has had a more pronounced impact outside the euro area. Sovereign bond yields are especially high in Hungary, Poland, and Romania. In addition, non-euro area countries have a significant share of government debt denominated in foreign currencies, especially Bulgaria () (74%), and Romania (52%), but also Hungary (22%), Poland (22%), and Sweden (17%). Graph 2.5.1: Government debt and deficit to GDP Source: Ameco and European Commission services At country level, the following government sector developments are worth highlighting: ·At the end of 2021, the government debt-to-GDP ratios were above 60% in Austria, Croatia, Finland, Germany, Hungary, Slovenia, and Slovakia, and above 100% in Greece, Italy, Portugal, Spain, France, Belgium, and Cyprus. The debt-to-GDP ratios decreased in all those Member States in 2021, except Germany and Slovakia, and are forecast to continue decreasing in most of them in 2022 and 2023. ·Greece has been identified as displaying high fiscal sustainability risks in the short term (see Box 2.5.1). Its government debt-to-GDP ratio is the highest in the EU and well above 100% and the fiscal deficit remains sizeable but is expected to decline markedly. Gross financing needs are expected to decrease over the next years. ·Over the medium-term, nine Member States are assessed as facing high fiscal sustainability risks, namely Belgium, France, Greece, Italy, Portugal, Romania, Slovakia, Slovenia, and Spain. Countries with the highest debt ratios are particularly vulnerable to changes in financing conditions. Under a scenario of a 1 pp. increase in the growth-interest differential, debt would raise by more than 10pp. of GDP by 2023 in Italy, Greece, Spain, and Portugal (see Box 2.5.1). ·Romania and Hungary are characterised by persistently high fiscal deficits and increasing bond yields, and debt denominated in foreign currencies is relevant for both countries, especially the former. In Hungary, the government debt is also above 60% of GDP and the government gross financing needs are high. In Romania, the government debt-to-GDP ratio is forecast to slightly decrease in light of expected better fiscal outturns.



Box 2.5.1: Change in financing conditions – an adverse scenario of ‘r-g’ The Commission assesses the short, medium- and long-term sustainability risks of Member States. It finds that short-term vulnerabilities are present for Greece due to both fiscal and macro-financial variables. () Over the medium-term, nine Member States are assessed as facing high fiscal sustainability risk, namely Belgium, France, Greece, Italy, Portugal, Romania, Slovakia, Slovenia, and Spain. The risks are a result of: ·high or increasing debt ratios, notably linked to a weak fiscal position, ·increased uncertainty around the baseline projections, ·vulnerability to adverse macro-financial scenarios, ·the size of the required fiscal adjustment to bring the debt-to-GDP ratio to 60% in the medium term, i.e. S1 indicator. Beyond the debt analysis and risk classification there are other factors that may affect fiscal sustainability. () On the downside, contingent liabilities that are high for the EU as a whole but also with large cross-country differences may have a significant impact on public debt and deficit. This applies also to the contingent liabilities’ risk coming from the banking sector. On the upside, fiscal sustainability risks are mitigated by lengthening debt maturity that has been observed in recent years or the impact of the RRF reforms and investment on GDP growth that is expected rather in the medium to long term. Uncertainty and changing economic environment may play a crucial role in fiscal sustainability. Financing conditions have been favourable over the past decade as the low interest rate surrounding resulted from ageing societies, lower productivity growth and monetary policy run by central banks. A negative ‘r-g’, where economic growth exceeds interest rates, mitigates fiscal challenges to some extent but does not eliminate them as the differential can be reversed as conditions change. This is precisely why the assessment of sustainability risks is of particular importance currently when r is increasing as g falls, due to the change in financing conditions and the weakening of the economic situation overall. Weaker growth outcomes or higher interest rates over the next decade could lead to higher debt ratios in the absence of policy action. The baseline fiscal sustainability analysis has been carried out with the assumption of favourable financing conditions. In addition, an adverse scenario has been designed to capture an increase or even a reversal in ‘r-g’. Under this scenario, in most EU countries the ‘r-g’ projection is expected to remain negative in 2032 but would be higher than assumed in the baseline scenario. As a result, the projected debt in the adverse scenario would be higher by 2032 compared to the baseline,. Graph 2.5.2: Government sector: selected graphs Source: European Commission services

2.6. Financial sector The EU banking sector showed resilience to the impact of the pandemic in 2021 but has remained challenged by structurally low profitability. The Common Equity Tier 1 (CET1) ratio remained high and stable in the last year (2021Q3 – 2022Q2) (Graph 2.6.1 a). The return on equity has recovered above pre-pandemic levels in amid higher operating income and lower provisions recorded over this period but profitability lingers as a structural challenge across the EU due to the overcapacity and low cost-efficiency. () The disposal of the legacy non-performing loans (NPLs) continued in 2021 and the first half of 2022, while there was no notable increase of new NPLs despite the gradual withdrawal of moratoria on loan repayments introduced after the COVID-19 pandemic outbreak (Graph 2.6.1 b). Credit provision to non-financial corporations continued despite gradual expiration of the government guarantees granted during the COVID-19 outbreak and, in some countries, macro-prudential tightening. Credit for household expanded steadily in 2021 against a backdrop of spiking housing prices across the EU (Graph 2.6.2 a). Credit conditions started to tighten in the second half of 2021 and lending rates increased alongside monetary tightening, especially in the non-euro area countries (Graphs 2.6.2 b and c). Going forward, the worsening econ