This first Annual Growth Survey is also transmitted to the European Parliament and to the other Institutions and national parliaments.

The Commission proposes that upcoming meetings of the European Council should review regularly its implementation, to identify gaps at Member State and EU level and agree rapidly on corrective measures. The proposals set out in this Communication would already enable the next meeting of the European Council to take concrete steps to maintain and accelerate the momentum of efforts to frontload and raise growth, and agree on the timetable for implementing the comprehensive response to the crisis. For the latter, the European Council has already agreed on two benchmarks: for finalising work on the permanent European Stability Mechanism (ESM) by March and the legislative package to enhance economic governance in the EU by June. In the meantime, the publication of the results of a new stress-test will give guidance on the strategy to be followed in completing the repair of the banking sector.

Based on the guidance of the European Council, Member States should present by mid-April their national commitments in their medium term budgetary strategies under the Stability or Convergence Programmes and set out in their National Reform Programmes the measures needed to reflect this comprehensive response to the crisis anchored in the Europe 2020 Strategy. Based on recommendations from the Commission, the Council will issue country-specific policy guidance before the summer that Member States should take into account when preparing their budgets for 2012 and in implementing their growth policies. In the spirit of the integrated approach to policy coordination, the Council will assess the fiscal and growth strategies together, looking at their ambition, consistency and their implications at the EU level including the interdependencies within the euro area.

In this first Annual Growth Survey the Commission has set out 10 actions for the EU in 2011/2012, anchored in the Europe 2020 strategy. It proposes that these form the basis of an agreement by the European Council that Member States should commit to the implementation of these 10 actions. Given the interdependencies of Member states, in particular in the Euro area, ex-ante coordination in the Council is the essential element of the European semester.

Trade is a strong driver of growth. There is a huge untapped potential for export of EU goods and services, but Europe's exports were hit hard by the collapse in global trade. The positive export performance of some Member States shows that success in global markets rests not only on price competitiveness but also on wider factors such as sector specialisation, innovation, and skills levels that enhance real competitiveness.

Such policies would also have a positive impact on budgetary consolidation, by generating higher tax revenues and lower public spending on social transfers, and will help reduce the risk of future macroeconomic imbalances. Structural reforms will generate gains already in the short term. Output as well as employment gains are driven by product market and labour market reforms.

The most urgent task in 2011/2012 is to prevent a vicious cycle of unsustainable debt, financial market disruption and low economic growth. The first priority of this Annual Growth Survey is to set budgetary policies on a sound footing through rigorous fiscal consolidation, and to restore the normal functioning of the financial sector. The second priority is a rapid reduction in unemployment through labour market reforms. But tackling these two priorities will be ineffective without a major effort to frontload growth at the same time.

Member States need to step up their energy efficiency policies. This will lead to significant savings and create jobs in the construction and services sectors.

Energy is a key variable for growth. For business, energy prices are a key cost element. For consumers, energy bills represent an important item of the household budget and a particular challenge for low income households. Current plans by Member States risk falling far short of the overall 20% energy efficiency target set in the Europe 2020 strategy. This would lead to lost opportunities for growth across many sectors and regions and loss of employment creating possibilities.

To facilitate access to finance for SMEs and innovative start-ups, the Commission will make proposals to enable venture capital funds established in one Member State to operate freely anywhere in the EU and to eliminate remaining tax obstacles to cross-border activities.

The Commission will make proposals for EU project bonds to help bring public and private financing together for priority investments notably in energy, transport and ICT and will also include these innovative financing instruments in its forthcoming proposals for the next Multi annual Financial Framework.

Although sensitive, work should be taken forward on taxation. This has an important economic potential to stimulate growth and job creation, reduce administrative burden and remove obstacles in the Single Market. Tax treatment disadvantaging cross-border trade or investment should be eliminated. In particular the Commission will propose in 2011 measures to modernise the VAT system, to introduce a common consolidated corporate tax base, and to develop a coordinated European approach to taxation of the financial sector. Progress on taxation also implies reducing taxes on labour to the minimum necessary and adapting the European framework for energy taxation in line with the EU energy and climate objectives.

In addition to continuing to press for the conclusion of the Doha Round, the Commission will advance negotiations on Free trade agreements with partners such as India, Canada and Mercosur, and step up regulatory convergence work with major partners and increase symmetry in access to public procurement markets in developed countries and large emerging market economies.

The Commission will propose in 2011 measures to rule out geographically based differentiation in e-commerce inside the Single Market. It will also propose a European framework for intellectual property, as this is a key factor for developing both e-commerce and digital industries.

Member States should identify and remove unjustified restrictions on professional services such as quotas and closed shops together with restrictions on the retail industry, such as disproportionate limitations on opening hours and zoning.

All Member States should fully implement the Services Directive. The Commission is evaluating its implementation, and the potential for further growth enhancing measures through a further opening of the service sector.

Barriers to market entry and obstacles to entrepreneurship remain acute in the single market. Cross-border services only represent 5% of GDP, less than a third of trade in goods and only 7% of consumers buy on-line because of the numerous restrictions which prevent the development of cross-border on-line sales.

The Single Market can be an important source of growth –as outlined already in the Communication on a Single Market Act- provided quick decisions are taken to remove remaining obstacles. To strengthen it, the Commission will therefore give priority in the Single Market Act to growth enhancing measures in 2011-2012 as illustrated below.

The EU will only meet its ambitious Europe 2020 targets for sustainable and inclusive growth if urgent structural reforms are frontloaded in services and product markets to improve the business environment. To remain competitive in a globalised economy Member States must urgently begin the deep structural reforms needed to enhance the excellence of our research and our capacity to innovate, turning ideas into products and services that meet the demand of high-growth markets, taking advantage of the technological capabilities of our industry and helping SMEs to grow and internationalise. The EU's reform agenda will also have to exploit new sources of growth by turning the limits of traditional resource-based development into new economic opportunities through increased resource efficiency. It must also exploit the EU's first mover advantage on competitive environmental goods and services.

In some Member States employment protection legislation creates labour market rigidity, and prevents increased participation in the labour market. Such employment protection legislation should be reformed to reduce over-protection of workers with permanent contracts, and provide protection to those left outside or at the margins of the job market. At the same time, reducing early school leaving and improving educational achievements is essential to help young people to have access to the labour market.

Member States should design benefits to reward return to work or incentives to go into self-employment for the unemployed through time-limited support, and conditionality linking training and job search more closely to benefits.

European welfare systems have worked to protect people during the crisis. However, once the recovery has gained ground, unemployment benefits should be reviewed to ensure that they provide incentives to work, avoid benefit dependency and support adaptability to the business cycle.

The Commission will review the Directive on pension funds and present new measures as follow up to the Green Paper on Pensions launched in 2010.

Member States that have not already done so should increase the retirement age and link it with life expectancy.

Tax benefit systems, flexible work arrangements and childcare facilities should be geared to facilitating the participation of second earners in the work force. Efforts need to be stepped up to reduce undeclared work both by strengthening the enforcement of existing rules and reviewing tax benefit systems.

The combination of high unemployment rates, low participation in the labour market and fewer hours worked compared to other parts of the world undermines the EU's economic performance. The participation rate of low income earners, young people and second earners is worryingly low. The most vulnerable face the risk of long term exclusion from employment. In response, training and job search should be tied more closely to benefits.

There is a risk of a return to growth without sufficiently dynamic job creation. Tackling unemployment and preventing long term exclusion from the labour market is essential. One of the five EU targets of the Europe 2020 strategy is to raise the employment rate to 75% by 2020. Current indications are that the EU will fall short of this target by 2-2.4% - a shortfall that can be made up through the adoption of measures to create jobs and increase labour participation. Given the ageing of the EU population and the relatively low utilisation of labour compared to other parts of the world reforms are needed to promote skills and to create incentives to work.

In accordance with the recently agreed Basel III framework, banks will be required to progressively strengthen their capital base so as to improve their capacity to withstand adverse shocks. The Commission is also working on a comprehensive bank crisis resolution framework. In addition, another more ambitious and stringent EU-wide stress test will be conducted in 2011.

Restructuring of banks, and particularly those which received significant amounts of state aid is essential to restore their long-term viability and ensure a properly functioning credit channel. Public financial support for the banking sector as a whole should be gradually withdrawn, taking into account the need to safeguard financial stability.

At EU level, the regulatory framework must be further reinforced, while the quality of supervision should be enhanced by the ESRB and European Supervisory Authorities, which have become operational at the beginning of 2011. Bank restructuring must be accelerated to safeguard financial stability and underpin the provision of credit to the real economy.

Member States with large current account surpluses should identify and tackle the sources of persistently weak domestic demand (including further liberalisation of the service sector and improving conditions for investment). However, where domestic demand still remains subdued due to a policy or market failure appropriate policies should be put in place.

Large and persistent macroeconomic imbalances are a major source of vulnerability, especially within the euro area. Many Member States need to tackle their lack of competitiveness with greater urgency.

Some Member States may need to increase taxes. Indirect taxes are more growth-friendly than direct taxes and broadening tax bases is preferable to increasing tax rates. Unjustified subsidies, e.g. environmentally harmful subsidies, should be eliminated.

Member States facing very large structural budget deficits, very high levels of public debt or high levels of financial distress need to frontload their efforts in 2011. Where economic growth or revenues turn out to be higher than expected, fiscal consolidation should be accelerated.

Member States in excessive deficit procedure should set out the expenditure path and the broad measures they intend to take in order to eliminate of their excessive deficits.

All Member States, especially those in excessive deficit procedure, should keep public expenditure growth firmly below the rate of medium term trend GDP growth, while prioritising sustainable growth friendly expenditure in areas such as research and innovation, education and energy. All Member States should demonstrate that their Stability or Convergence Programmes are based on prudent growth and revenue forecasts.

The most urgent task for the EU is to restore confidence by preventing a vicious cycle of unsustainable debt, disruption of financial markets and low economic growth. Public expenditure must be put on a sustainable track as a pre-requisite for future growth. Annual adjustments of the structural budget balance in the order of 0.5% of GDP will be clearly insufficient to bring debt ratios close to the 60% requirement. Therefore, stronger consolidation is needed and should be implemented on the basis of the reinforced fiscal rules proposed by the Commission.

A more detailed analysis underpinning the Commission's assessment is set out in 3 reports that accompany this Communication and include an assessment of the initial setting up of the Europe 2020 strategy at Member State level.

Moreover, progress in establishing a permanent mechanism for resolving sovereign crises is needed to provide certainty and stability in markets. The new European Stability Mechanism should complement in 2013 the new framework for reinforced economic governance, aiming at an effective and rigorous economic surveillance, including reviewing the effectiveness of current financial backstops.

But such a comprehensive response will have to include other elements, e.g. the review of the European Financial Stability Facility (EFSF). As regards the latter the Commission considers that the effective financing capacity of the EFSF must be reinforced and the scope of its activity widened. This Annual Growth Survey also constitutes a contribution to the comprehensive response of the euro area to the sovereign debt crisis.

This first Annual Growth Survey is designed to apply to the EU as a whole but will need to be tailored to the specific situation of each Member State. The proposed course of action is particularly relevant for the euro area which is currently affected by the sovereign debt crisis. Fiscal consolidation, structural reforms and growth enhancing measures are necessary ingredients for the comprehensive response the euro area must give to the crisis.

Given the urgency, the Commission has chosen to present 10 priority actions. The Commission will continue its work on a broad range of other policy areas, including trade and a host of internal policies. These are not developed here. In this Communication the Commission focuses on an integrated approach to recovery concentrating on key measures in the context of Europe 2020 and encompassing three main areas:

This Annual Growth Survey brings together the different actions which are essential to strengthen the recovery in the short-term, to keep pace with our main competitors and prepare the EU to move towards its Europe 2020 objectives.

In this context, the EU has also decided to change its economic governance. January 2011 launches the first European Semester of ex-ante policy co-ordination starting with this Annual Growth Survey which is anchored in the Europe 2020 strategy.

If fully implemented, this strategy will help the EU come out stronger from the crisis and turn the EU into a smart, sustainable and inclusive economy delivering high levels of employment, productivity, competitiveness and social cohesion. This will deliver the competitive social market economy of the twenty first century, boosting confidence of market actors, companies and citizens alike.

That is why the European Council adopted the Europe 2020 strategy with ambitious targets for a new growth path. The preliminary indications of Member States on their national targets in the five areas agreed under the Europe 2020 strategy clearly show the road that the EU has to travel to deliver its own ambitions.

To avoid stagnation, unsustainable debt trends, accumulated imbalances and ensure its competitiveness, Europe needs to accelerate the consolidation of its public finances, the reform of its financial sector and to frontload structural reforms now.

The crisis could have a lasting effect on potential growth. Medium term potential growth for Europe is projected to remain low and estimated at around 1.5% up to 2020 if no structural action is taken namely to resolve the labour productivity gap with our main competitors. Given its cyclical nature, recovery alone cannot provide the impetus for leading Europe back to the pre-crisis economic situation and absorb the deficit accumulated.

The economic crisis was a global crisis, but its impact is very different across the world. While unemployment and public deficits increased more sharply in the US than in the EU, the crisis has aggravated the labour productivity gap between the EU and the US. Price and cost competitiveness remain problematic. Emerging economies are returning to growth at a faster pace although some of them also face major economic challenges. Therefore, the EU needs to use this crisis to address decisively the issue of its global competitiveness.

The crisis has taken a heavy toll on Europe's societies, despite the cushioning provided by welfare systems. The rise of unemployment is a central problem. On aggregate, 9.6% of the working population is unemployed. In some countries, youth unemployment can be as high as 40%. Around 80 million people are estimated to live below the poverty line in Europe.

In spite of the prompt response given by the EU, the legacy of the crisis is far reaching. It has resulted in a large loss in economic activity, a substantial increase in unemployment, a steep fall in productivity, and badly weakened public finances. By the end of 2012, eleven Member States are expected still to remain at output levels below those preceding the crisis. In 2010, EU gross government debt rose, on aggregate, to around 85% of GDP in the euro area and to 80% EU-wide. The budgetary impact of the crisis will compound the effect of demographic change, which will add a fiscal burden of some 4.5% of GDP in the long term. Structural weaknesses that were not tackled before the crisis have become more apparent and urgent.

According to the latest forecasts, there are signs of economic recovery albeit still uneven. While financial markets remain volatile, the real economy has shown signs of improvement in some quarters, led by growing exports after the resumption of global trade. Nonetheless uncertainties remain. Periods of renewed confidence in the return to growth alternate with setbacks, also due to the risks associated with the sovereign debt market. European economies face major adjustments. The financial sector has not yet returned to normal conditions and there are situations of vulnerability to stress and dependency on state-support. Credit conditions are not yet back to normal and in a number of Member States household and corporate debts are still excessive.

This first Annual Growth Survey marks the start of a new cycle of economic governance in the EU and the first European semester of economic policy coordination. The EU has taken decisive action to deal with the crisis: as a result, the deterioration of public finances and the increase in unemployment have been less marked than in other parts of the world. The EU's high levels of social protection cushioned the worst impact of the crisis but because of its weak productivity growth, recovery is slower in Europe.

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS





EN EUROPEAN COMMISSION Brussels, 12.1.2011 COM(2011) 11 final

ANNEXE 2 ANNUAL GROWTH SURVEY



ANNEX 2

MACRO-ECONOMIC REPORT

ANNUAL GROWTH SURVEY



ANNEX 2

MACRO-ECONOMIC REPORT Member States' actions in 2011-2012 will be critical in averting a "lost-decade scenario". Policy priorities, timing and content will have to be set according to national circumstances and reflect inter alia the risks to fiscal sustainability and the need to correct excessive imbalances. The most urgent task is to break the vicious circle at work in some Member States of unsustainable debt, financial market disruption and low economic growth. While the draft National Reform Programmes submitted in November acknowledge the urgency of addressing the macro-economic challenges in an integrated way, they often fall short of proposing adequate policy responses. This supporting document therefore aims at pinpointing measures that have the highest potential of delivering positive macro-economic effects and that Member States could consider implementing in the coming two year. The first section sets the scene by looking at the imbalances and weaknesses that had emerged before the crisis and at the legacy of the worst economic crisis since the Great Depression in the 1930s. The second section focuses on the need to set public finances back on track. The third section makes the case for healing the financial sector swiftly. The last section highlights the urgency of structural reforms to correct macroeconomic imbalances and to fix the ailing growth drivers. 1.Europe going through particularly challenging times The European economy is slowly emerging from the deepest recession in decades. The economic crisis resulted in a large loss in economic activity in the EU, accompanied with millions of jobs lost and a high human cost. The structural weaknesses pre-dating the crisis which had not been tackled adequately became blatantly apparent. The EU suffered from structural weaknesses before the crisis. While the EU is a wealthy area, its economic growth in the past decade has been weak by international standards (see Graph 1). In terms of GDP per capita, the EU-27 is much richer than the G20 average, but remains well below many non-EU OECD countries and the OECD as a whole. At the same time, its growth performance since 2000 has been very disappointing, below all the developed economies bar Japan and clearly behind most emerging economies. This means that the gap with regard to other developed economies is increasing. As catching up cannot explain the difference, EU's weak growth performance must be related to structural weaknesses. When one goes beyond GDP-type indicators, this overall dull picture conceals some strength in terms of life standards, such as relatively low income inequality, high life expectancy and relatively high environmental performance (for instance as measured by CO2 emissions by unit of output). Various "bottlenecks" held back growth in the EU over the past decade. Standard growth accounting reveals that before the crisis (2001-07) labour productivity was the main driving force behind growth, while labour utilisation and the increase in working-age population only accounted for around one fourth of total growth; in particular, decreasing labour market participation of youth and prime-age men and a reduction in hours worked per persons were dragging growth down in the EU-27 (see Graph 2). The crisis darkened the picture further. It led to a contraction of GDP, with a sharp increase in unemployment and a significant drop in total factor productivity (TFP), mostly explained by the strong decrease in capacity utilisation. The EU and the euro area are clearly lagging behind the US and Japan as regards both TFP levels and labour utilisation; on the latter, the difference is especially profound at both ends of the age spectrum, as seen in the blatant difference in employment rates (see Graph 3). Graph 1: GDP level and growth GDP per capita in 2010 (% differential vis-à-vis EU-27 in PPS) Average economic growth in 2000-2010 Graph 2:Decomposition of GDP growth Graph 3: Employment rate Total employment over working age population 20-64 Graph 4: Real primary expenditure versus real GDP growth

Average growth rates 2003-2007 Note: Member States are ordered by the size of the excess of average real primary expenditure growth over average real GDP growth.



In the years preceding the crisis, several EU Member States deviated from the basic principles of prudent fiscal policy making. Significant revenue windfalls generated by the economic expansion in 2003-2007 were only partially used to accelerate fiscal adjustment. A non-negligible part went into additional spending: the growth rate of primary expenditure exceeded the average rate of economic growth in twelve EU Member States in the good times preceding the crisis (2003-2007), by a large margin in some cases (see Graph 4).The untenable nature of this policy choice became apparent with the onset of the crisis, when the collapse of government revenues suddenly revealed vulnerable underlying budgetary positions with, in many cases, little or no fiscal space left to respond to the economic contraction. Over the decade preceding the crisis, macroeconomic imbalances in the EU increased considerably as well. Some Member States saw the building-up of significant domestic imbalances. This was reflected in the strong divergence in current accounts and competitiveness developments, as seen in Graph 5 for the euro area. Moreover, some euro area Member States have experienced a worrying loss in export market shares. External imbalances were fed by inappropriate responses of wages to productivity developments, excessive credit growth in the private sector, housing price bubbles as well as structural weaknesses of domestic demand. Graph 5: Evolution of price competitiveness relative to the rest of the euro area (indices; 1998 = 100, increases represent losses in competitiveness)

Impact of crisis on the real economy and employment Graph 6: GDP and employment (2008Q1=100) Sources: Eurostat; ECFIN Autumn forecast Note: the profile for forecast employment – available on an annual basis only – has been interpolated linearly to deduce its quarterly profile. The deep contraction in GDP wiped out on average four years of growth. The loss in output in 2008 and 2009 sent the EU GDP back to 2006 level. The EU is expected to recover the output level seen in the first quarter of 2008 – before the crisis hit the real economy – in the second quarter of 2012 only, according to the Commission’s Autumn 2010 economic forecast (Graph 6). By the end of 2011, only ten Member States are projected to have returned to their output levels in 2008 or above. By the end of 2012, eleven Member States are still expected to remain at output levels below those preceding the crisis. Employment is projected still to fall short of its pre-crisis level at the end of 2012 (by over 1%). The crisis has taken a heavy toll on Europe's societies with a sharp rise in unemployment. The unemployed represented 7% of the labour force in the EU-27 in 2008. In 2010, they accounted for almost 10%, with the prospect of the unemployment rate remaining above 9% in 2012, as displayed in Graph 7. The unemployment rate is particularly high, exceeding 12%, in Estonia, Ireland, Greece, Slovakia, Latvia, Lithuania and Spain. Long-term unemployment – those unemployed for more than one year – has increased steeply and currently represents around 40% of total unemployment in the EU. This highlights the risk of durable exclusion from the labour market. The rate of unemployment is particularly high amongst the low-skilled, the migrants and the youth. Youth unemployment exceeds 20% in more than half of the EU Member States and reaches 42% in one country (Spain).



Graph 7: Actual and structural unemployment rates in the EU-27 (2008Q1=100) The crisis decreased potential growth further through the strong rise in structural unemployment and the sharp drop in the investment rate. Potential output growth in the EU-27 is expected to be particularly low (1.1%) over the forecasting horizon (2010-12), owing to both low productivity growth and low labour utilisation. The situation is expected to be even more lacklustre in the euro area, with broadly similar but more acute patterns. The lower use of labour is related to the significant rise in NAWRU (see Graph 7) but also to the further decline in average hours worked per worker and the contraction of working-age population. Potential growth will also be affected by slower capital accumulation resulting from historically low investment rates in the wake of the crisis, and by slow total factor productivity growth which is gradually recovering but only towards the already weak pre-crisis path. Fiscal imbalances aggravated, with a slow reduction of macro imbalances

Graph 8: Public debt level in 2008 and its forecast rise over 2008-2012 (% GDP) Sources: ECFIN Autumn forecast The crisis had a dramatic impact on public finances in the euro area and the EU. Within a short period of time, government debt-to-GDP ratios increased sharply in almost all Member States wiping out the moderate progress achieved in the pre-crisis years (see Graph 8). At the end of 2010 gross government debt is expected to have climbed to around 84% of GDP in the euro area and around 79% of GDP in the EU, some 20 percentage points above the 2007 levels. At current policies the upward trend is set to continue. The current sharp deterioration of public finances results from a decline in revenues and increased pressures on expenditure as well as discretionary fiscal stimuli. Government finances in some Member States had become dependent upon highly cyclical or temporary revenue sources. This contributed to the collapse in government revenues on the back of a sharp contraction in economic activity while government expenditures were broadly kept at previously planned levels. Member States allowed their automatic stabilisers to fully function, which helped to soften the impact of global crisis on real economy. However, as this was insufficient to stem the fall in demand and avert the risk of a meltdown of financial systems, most EU governments also implemented discretionary fiscal measures under the common framework of the European Economic Recovery Programme launched by the European Commission in December 2008. This recent added pressure on public finances comes on top of the negative public finance effects of demographic ageing. This process has been in the offing for a long time and, in the absence of reforms taken soon, will inexorably produce a significant budgetary burden in the long-term, which will further aggravate the already worrying fiscal situation. With unchanged policies, public support for the elderly in terms of provision of pensions and other old-age benefits (healthcare and long-term care) is projected to increase by some 4½ percentage points of GDP in the EU over the next 50 years. In around one third of the Member States, the increase in ageing-related government spending is likely to exceed 7 percentage points of GDP. The crisis has only partly, and temporarily, corrected the large macroeconomic imbalances prevailing in many Member States before its outbreak. As the current recession has compressed excessive demand and removed or mitigated some drivers of divergence (i.e. housing market bubbles and credit expansion), the current account deficits have decreased. However, current account imbalances remain significant, especially within the euro area, and are not expected to unwind quickly, as seen in Graph 9. Graph 10 shows that those EU Member States which recorded a large deficit (surplus) in the balance of goods and services at the onset of the crisis were generally still in deficit (surplus) two years later, when economic activity picked up. This partly reflects structural weaknesses, such as weaknesses in domestic demand (in surplus countries) and weak price and cost competitiveness, often combined with high debt levels (in deficit countries). Graph 9: Decomposition of the current account, euro area Graph 10: Balance of goods and services and its forecast change up to 2010 (positive values= surplus; negative values= deficit; % GDP) Sources: ECFIN Autumn forecast. Note: Euro area Member States are identified as surplus or deficit countries on the basis of their current account position in 2006.

The need for differentiated policy responses across Member States Graph 11: Differentiated starting conditions in 2010 Public deficit /net import of good and services** Public debt /external account deficit* Source: ECFIN Autumn forecast *External account deficit means net borrowing vis-à-vis the rest of the world (current account plus capital transactions). This concept shows the annual change in external indebtedness. ** Net imports of goods and services is also called 'deficit in the balance of goods and services', and is directly influenced by price competitiveness. The surplus for LU exceeds 30% of GDP, outside the boundaries of this chart. EU Member States experienced highly different fiscal and external conditions, which call for tailor-made policies. Graph 11 shows in a purely illustrative manner and using different indicators that some Member States face particularly pressing challenges in terms of adjusting their unsustainable public finances and correcting their external imbalances. A one-size-fits-all approach will not work, and Member States' priorities in 2011-2012 should be shaped inter alia by risks to fiscal sustainability and the need to correct imbalances. Member States with large fiscal and/or macroeconomic imbalances face a hard constraint on their policy options and should, as a matter of priority, correct existing imbalances. Member States without major macroeconomic problems or discernable risks should strive to improve longer-term growth drivers, while preventing the occurrence of future imbalances. 2.Reining in public debt through a rigorous and durable fiscal consolidation The need to consolidate now

Graph 12: Structural deficits and MTOs (% GDP) While the crisis has hit government budgets in all EU Member States, the actual state of public finances varies significantly across Member States. As displayed in Graph 12, the distance of the deficit – corrected for the business cycle and one-off measures, i.e. structural deficit – from the medium-term budgetary objective (MTO) is particularly large (more than five percentage points of GDP) in twelve Member States. Member States which followed a more cautious course of fiscal policy ahead of the unprecedented economic downturn are in a comparatively better situation. They had more fiscal space to lean against the headwinds of the recession and, as a result, have accumulated lower fiscal imbalances during the crisis. Withdrawing the discretionary fiscal stimulus implemented during the crisis will not be sufficient to restore long-term sustainability of public finances. The debt-to-GDP ratio will not only suffer from the accumulation of public deficits but also from the implicit liabilities foreseeable with population ageing and the expected slow medium-term growth in the euro area and the EU. Moreover, government debt ratios in the EU have now reached levels beyond which additional government borrowing acts as a drag on economic growth rather than stimulating it. Servicing high government debt levels requires higher potentially distortive taxes and crowds out productive government spending through higher interest expenditure or both. Further debt building is also likely to increase the risk premia on government bonds further, raising the debt servicing burden even more, generating an unsustainable dynamic and eventually casting doubt on governments' solvency in financial markets. The adjustment effort required to put public finances back to a sustainable path is very significant and should be complemented by growth policies. Simple simulations indicate that an annual improvement of the structural budget balance of 0.5% of GDP - the conventional benchmark under the provisions of the Stability and Growth Pact (SGP) - would clearly be insufficient in many EU Member States to bring the debt to GDP ratio close to the Treaty-based threshold of 60% of GDP in the foreseeable future (see Graph 13). Only fiscal corrections of 1% of GDP per year or more would put debt levels in percent of GDP on a firm downward path over the coming two decades. However, fiscal consolidation, while absolutely necessary, might not always be sufficient to reverse adverse debt dynamics quickly and durably. Stronger output growth is imperative to increase fiscal revenue and lower unemployment-related expenditures, while automatically reducing the level of debt expressed as a share of GDP. Graph 13: Public debt projection in the EU Percentage of GDP Note: the projections assume the given rate of consolidation for each Member State until it meets its medium-term budgetary objective (MTO). As a result, fiscal policy makers in the EU face a formidable double challenge: putting fiscal policy back on a sustainable path while protecting or supporting short-run economic growth and employment. Under current circumstances, there is reason to believe that getting public finances in order will have a positive impact on economic growth in the medium run. Delaying fiscal adjustment would only push out and compound the problem. It would seriously compromise our ability to actively shape our future, and heavily mortgage future generations. Although the degree of urgency is not the same in all Member States, consolidation remains a key policy priority for all. In 2010, fiscal policy continued to support aggregate demand in the EU and the euro area. As economic recovery is expected to gain gradually momentum in the coming years, it is time to switch the policy stance. Member States with very large structural budget deficits or very high public debt-to-GDP ratios should be frontloading their adjustment in 2011-12. This should be the case in particular for Member States facing high levels of financial distress: some Member States such as Greece and Ireland will accelerate their adjustment in both years, while Spain and Portugal will only do so in 2012. Key ingredients for a durable and growth-friendly consolidation History provides rich evidence on how to turn fiscal consolidation into a success in terms of both its lasting effect on public finances through time and the impact on economic growth. The lessons of the past concern five interrelated dimensions of fiscal policy making: the composition of fiscal adjustment, the credibility of the policy strategy, the institutional context, complementary policy initiatives and the burden sharing across society. (1)Composition of fiscal adjustment: The single most important factor discriminating between success and failure of fiscal consolidation is the composition of adjustment. Expenditure-based corrections, especially corrections of current primary expenditure, are more likely to produce a lasting improvement in public finances and a milder, under some circumstances even a positive, impact on short-run economic growth than revenue-based corrections. Curbing expenditure developments is less distortive for growth than raising the tax burden, which is already high in the EU though significant variation exists among the Member States. In terms of credibility, expenditure cuts demonstrate a stronger commitment of the government to pursuing consolidation efforts. Revenue increases and cuts of investment expenditure may be easier to implement politically, yet weigh on the medium- to long-run growth prospects of an economy and are often reversed over time. In many Member States expenditure control will have to be supplemented by revenue-raising measures. Due attention should also be given to the quality of taxation, by collecting revenues in an efficient way and minimising the negative impact on economic growth while taking equity considerations into account. Broadening tax bases, for example by removing environmentally harmful tax exemptions or tax credits, is preferable to increasing tax rates. Some existing tax expenditures may have no sound economic rationale or provide incentives not in line with their original aims. Tax on immovable property followed by consumption taxes, including environmentally related taxes, are least distortive, while personal income taxes and corporate income taxes could have a more harmful impact on growth. (2)Credibility of the policy strategy: Convincing and credible plans can generate expectations of lower real interest rates and lower future tax liabilities and, hence, have the potential of boosting consumption spending of private households and investment spending of firms. In practice, the credibility of a multi-annual adjustment plan can be bolstered by front-loading legislation setting out in a legally binding way a roadmap of successive measures that contribute to the planned multi-annual adjustment. (3)Fiscal institutions: The success of fiscal consolidation also depends on the government's capacity effectively to implement the agreed policy measures via adequate national fiscal frameworks. The quality of the institutional and procedural arrangements governing budgetary policies, such as fiscal rules and multi-annual fiscal frameworks, influences the ability of governments to draw up and effectively put into practice fiscal consolidation programmes without creating excessive political and economic frictions. (4)Flanking policies: Budgetary policies typically interact with other instruments of economic policy making. This is also the case for fiscal consolidation. The complementary implementation of structural reforms will raise the odds of achieving a lasting fiscal correction, which also protects economic growth in the short run. The channels through which structural reforms help fiscal consolidation are twofold: directly by capping or flattening existing expenditure trends and indirectly by improving the functioning of markets which, in the end, supports economic activity. In actual fact, it is the structural reform dimension which confers and ensures the lasting character of a fiscal adjustment. Some structural reforms, notably reforms of pension systems, could have a positive impact on public finances already in the medium term through curbing expenditures and increasing labour supply. (5)Socially-balanced fiscal adjustments: Ensuring sound public budgets is a necessary condition to avoid that public debt growing out of control puts in jeopardy our social security systems in the future. In order to achieve the necessary political acceptance, the burden of adjustment needs to be distributed fairly across the different layers of society. Adjustments skewed towards specific constituencies are likely to be reverted as the political composition of governments change endangering the sustainability of fiscal adjustment. Policy priorities

In order to address the challenges outlined above, action is needed in particular in the following areas in 2011-2012: At the EU level, the legislative proposals to strengthen economic governance should be adopted according to the fast-track agreement between the co-legislators. Consolidation in all EU Member States should imperatively start – or continue – in 2011. The planned pace of the fiscal consolidation should be ambitious, and will have to go well beyond the benchmark of 0.5% of GDP per annum in structural terms in most Member States. Member States facing very large structural budget deficits, very high levels of public debt or high levels of financial distress need to frontload their efforts in 2011. Where economic growth or revenues turn out to be higher than expected, fiscal consolidation should be accelerated. Member States in excessive deficit procedure should set out the expenditure path and the broad measures they intend to take in order to achieve the elimination of their excessive deficits. All Member States should primarily adjust government expenditure, while protecting growth friendly expenditure e.g. in the area of public infrastructure, education and research and innovation. All Member States, especially those in excessive deficit procedure, should pursue prudent fiscal policy by keeping public expenditure growth firmly below the rate of medium term trend GDP growth. This should be complemented by efforts to raise the cost-efficiency of public expenditures. Where adjustment needs are particularly pressing, expenditure should be reduced. All Member States need to demonstrate that their Stability or Convergence Programmes are based on prudent growth and revenue forecasts. When a contribution from taxes is necessary, economic distortions should be minimised. At any given level of the overall tax burden, tax systems should be reviewed to make them more employment, environment and growth-friendly, for example via "green tax reforms" which consist of increasing environmental taxes while reducing other more distortionary taxes. Broadening the tax base is preferable to raising tax rates. Pension reforms, aiming inter alia at raising the effective retirement age, should be enacted and implemented without delay. This will ensure the sustainability of public finances and lead to an increase in active population. Health care systems need to be rigorously monitored and, where needed, reformed to ensure greater cost-efficiency and sustainability, especially in regard to demographic ageing. Member States are encouraged to improve their domestic fiscal frameworks, in the area of national systems of public accounting and statistics, macroeconomic and budgetary forecasts, numerical fiscal rules, medium term budgetary frameworks, transparency of general government finances and comprehensive scope of budgetary frameworks. 3.Healing the financial sector swiftly to find the path to recovery Graph 14: Bank lending in the EU Source: ECB. There is a strong correlation between a healthy credit expansion and sustained economic development. Since the outbreak of the financial crisis, credit growth is subdued, notably in corporate lending, as banks have tightened credit standards and firms' demand for financing is low given the poor economic outlook. Since the beginning of 2010 a pick-up in lending is noticeable and coincides with a timid recovery (see Graph 14). The ECB Bank Lending Survey of October 2010 shows that banks have stopped tightening lending conditions for enterprises and an easing of standards is expected for households. However, the lending conditions are not consistent with a strong economic recovery, especially regarding the loans to non-financial corporations (see Annex table). Balance sheet repair in the banking sector is essential to improve cost efficiency, restore competitiveness and return to normal lending. Yet, banks' profitability outlook is uncertain amid a sluggish recovery, heavy exposures to the real estate sector and tensions in the sovereign debt market. The negative feedback-loop from the real economy to the financial sector has been reinforced in some Member States with high household and non-financial corporate sector indebtedness. As a result, the level of non-performing loans has increased considerably and may increase further in the near term (Graph 15). Recently the overall situation of the banking sector has shown tentative improvement, with higher profits and a strengthening of the capital buffers, though in some cases it reflects capital injections by the government. A swift exit from sizable public support to banks will remove possible distortions to competition in the financial industry. In more than half of the Member States government assistance exceeded 5% of GDP and included measures such as capital injections, liquidity interventions, asset relief and guarantees (see Graph 16). Exit strategies from public support to banks have been initiated while maintaining flexibility in order to address possible macro-financial stability concerns. Cross border effects of the public interventions have to be taken into account due to the high financial integration in the European Union as illustrated by the level of banking sector assets abroad which attains 50% of GDP for many Member States (see Graph 14). Graph 15: Non-performing loans in the EU Percentage of total loans Graph 16: Public interventions in the EU banking sector Source: ECB, IMF Source: Commission Services (January 2010). Confidence in the banking sector is a prerequisite for maintaining financial stability. One of the tools to maintain confidence on the speed of the exit strategies is the stress test exercise. The objective of the exercise is to assess the banking sector's resilience to low-probability but high-impact events. The sensitivity of the capital buffer is examined to adverse economic and financial conditions. Based on rigorous assumptions, the next EU-wide stress test exercise will be conducted in 2011. The results of the next exercise will be available in June 2011. A good cooperation among national supervisors and EU authorities is critical in this context as well as a clear and transparent communication of the results and their implications. Graph 17: Banking sector assets abroad Percentage of GDP Graph 18: Total banking sector assets Percentage of GDP Source: BIS, Eurostat Source: ECB The recent crisis has exposed a clear gap in the EU regulatory framework for the banking sector and strengthened the case for action at EU level. The interconnectedness of banks and financial institutions across EU Member States – and with non-EU countries – underscores the importance to monitor developments in the financial sector in an international context. The size of the banking sector assets measured as a percentage of GDP points to the particular vulnerability of some Member States in case of a systemic crisis and the blatant insufficiency of the fiscal means to deal with major financial disruptions (Graph 18). Accordingly, at the EU level the regulatory and supervisory framework has been strengthened and should be completed rapidly. In October 2010, the Commission outlined the aims of the legal framework for crisis management in the financial sector, which will be proposed in spring 2011. The overriding aim is to allow a bank to fail – irrespective of its size – while ensuring the continuity of essential banking services, minimising the impact of that failure on the financial system and avoiding costs to taxpayers. This is essential to avoid the 'moral hazard' that arises from the perception that some banks are too big to fail. Beyond equipping the authorities with common and effective tools and powers to tackle bank crisis, it is also essential to ensure a smooth cooperation among the Member States and the EU institutions both in advance of and during a crisis. A permanent "European Stability Mechanism" will be established by euro area Member States to safeguard the financial stability of the euro area as whole. It will replace the current European Stabilisation Mechanism, which consists of the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM), which will remain in force until June 2013.

Basel III rules impose tougher capital requirements on banks, which will enhance macro-financial stability. In September 2010, the Basel Committee on Banking Supervision announced a substantial strengthening of existing capital definitions. In general, banks' capital will be lower according to the new definition, which increases the gap with the regulatory requirements. In addition to stricter definitions, the minimum capital requirements will also be gradually increased. Policy priorities In order to address the challenges that were outlined above, action is needed in particular in the following areas in 2011-2012. In this, coordination at EU level is of paramount importance. Restructuring of banks, and particularly those which received significant amounts of State aid, is essential to restore their long-term viability and ensure a properly functioning credit channel. Bank restructuring will therefore safeguard financial stability and underpin the provision of credit to the real economy. Public financial support for the banking sector as a whole should be gradually withdrawn, taking into account the need to safeguard financial stability. Progress is needed in establishing a permanent mechanism for resolving sovereign debt crises so as to provide certainty and stability in financial markets. In 2013, the new European Stability Mechanism will provide stability in markets and complement the new framework for reinforced economic governance, aiming at an effective and rigorous economic surveillance, including reviewing the effectiveness of the current financial backstops. The implementation of financial reforms must continue, including a reinforcement of the regulatory and supervisory framework and addressing the market failures exposed by the crisis. At EU level, the regulatory framework must be further reinforced, while the quality of supervision should be enhanced by the ESRB and European Supervisory Authorities, which are operational as of the beginning of 2011. Banks will be required progressively to strengthen their capital base so as to improve their capacity to withstand adverse shocks. This is in accordance with the recently agreed Basel III framework. In addition, another more ambitious and stringent EU-wide stress test will be conducted in 2011 with a view to assessing the resilience of the banking sector. 4.Structural reforms to support growth and correct macroeconomic imbalances Structural reforms can serve two goals: restoring the main growth drivers, and preventing or correcting imbalances as a key framework condition for growth. These reforms can boost the use of labour and labour productivity. Structural reforms can also help restore competitiveness and reduce external imbalances in the short run by reducing price and wage rigidities.Facilitating the needed reallocation of labour and capital across sectors and firms is instrumental for both growth and the reduction of external imbalances. While many structural measures could support both growth and macroeconomic adjustment, some of them, such as educational policies, require more time to pay off and are better suited to unlock long-term growth drivers. Nevertheless, this does not mean that action to strengthen these policies should be deferred.



Accelerating reforms to raise growth and jobs In the absence of resolute policies, potential growth is likely to remain weak in the coming decade. Over the period 2011-20, the average potential growth rate is projected to be around 1½% in the EU-27 in absence of policy changes, as seen in Graph 19. This is significantly lower than the rates observed in the EU in the past two decades, which were, moreover, much lower than those recorded in the US. This is accounted for by the pronounced underutilisation of labour in the wake of the crisis, combined with the contraction of labour due to population ageing at the end of the period and fairly slow productivity growth in the EU-27. Most Member States have been strongly affected by the crisis, through both capital accumulation and labour utilisation, and are expected to record a reduction in their labour resources at the end of the decade owing to the population ageing. Graph 19: Potential output growth up to 2020 in the EU-27 Macroeconomic scenario based on the production function approach Source: ECFIN Autumn forecast Confirming past trends, the growth outlook is even worse in the euro area. Over the period 2001-2010, average potential growth was 1. 6% in the euro area, as compared with 1.8% in the EU-27 (Graph 20). The picture for output growth and productivity growth will be particularly gloomy for the euro area in the decade ahead, as both are expected to stand at around 1¼% on average. However, the projected use of labour is very similar to that expected for the EU as a whole.



Graph 20: Potential output growth up to 2020 in the euro area Macroeconomic scenario based on the production function approach