COMMISSION STAFF WORKING DOCUMENT Assessment of the 2013 national reform programmes and stability programmes for the EURO AREA Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on the implementation of the broad guidelines for the economic policies of the Member States whose currency is the euro
Date: 2013-05-29
Institutions: European Commission
Subjects: EU control, Euro Group (euro area), banking system, budgetary control, budgetary equilibrium, economic growth, economic reform, economic statistics, tax reform

EUROPEAN 
COMMISSION 

Brussels, 29.5.2013  
SWD(2013) 379 final 

COMMISSION STAFF WORKING DOCUMENT 

Assessment of the 2013 national reform programmes and stability programmes for the 
EURO AREA 

Accompanying the document 

Recommendation for a COUNCIL RECOMMENDATION  

on the implementation of the broad guidelines for the economic policies of the Member 
States whose currency is the euro  

{COM(2013) 379 final} 

EN 

   EN 

 
 
 
 
  
 
CONTENTS 

Executive summary .................................................................................................................... 3 

Introduction ................................................................................................................................ 5 

1. 

1.1. 

1.2. 

2. 

2.1. 

2.2. 

2.3. 

Economic developments and challenges...................................................................... 5 

Recent economic developments and outlook............................................................... 5 

Challenges .................................................................................................................... 6 

Assessment of the policy agenda ................................................................................. 8 

Fiscal policy and taxation............................................................................................. 8 

Financial sector .......................................................................................................... 15 

Structural measures promoting growth and competitiveness..................................... 23 

2 

 
 
 
EXECUTIVE SUMMARY 

ECONOMIC OUTLOOK 

The euro area is going through a protracted downturn and though market tensions have eased, 
the  outlook  for  growth  and  employment  remains  subdued  and  is  marked  by  persistent  cross-
country  differences.  Overall,  GDP  contracted  by  0.6%  in  2012.  According  to  the  Commission's 
spring 2013 economic forecast, GDP would fall by 0.4% in 2013, though by the end of this year, most 
of the Member States that are currently in recession are forecast to register positive quarterly growth 
again. Assuming that continued policy efforts prevent a renewed intensification of the sovereign debt 
crisis,  the  economy  is  expected  to  grow  by  1.2%  in  2014.  External  demand  is  set  to  remain  the 
predominant  growth  driver  in  2013,  while  bank,  corporate  and  household  deleveraging  continues  to 
weigh on domestic demand. Unemployment would peak at 12.3 % in the euro area in 2013.  

Significant progress has been made on fiscal consolidation in the euro area. The headline deficit 
is expected to fall from 3.7% of GDP in 2012 to below 3% of GDP in 2013 for the first time since 
2008.  However  the  debt-to-GDP  ratio  continued  to  rise  in  2012,  exceeding  90%  of  GDP  and  is 
expected to reach 95.5% in 2013 and stabilise at 96% in 2014.  

KEY ISSUES 

A  fragile  banking  system  and  weak  economic  activity  are  a  legacy  of  the  crisis  and,  combined 
with  pre-existing  structural  and  institutional  challenges,  have  created  periods  of  considerable 
upheaval  in  financial  markets  and  individual  Member  States.  With  a  number  of  vulnerable 
countries  having  to  make  sizeable  adjustments  and  requiring  external  financing,  the  fabric  of  the 
Economic and Monetary Union (EMU) has been severely tested.  

Faced  with  these  deep  challenges,  both  euro  area  Member  States  and  the  EU  institutions  have 
acted in a decisive way to combat the crisis, and progress has been made to implement the 2012 
euro  area  recommendations.  Member  States,  especially  those  under  stress,  have  continued  with 
fiscal consolidation and structural reforms, while at EU level, economic and budgetary governance has 
been  strengthened.  A  permanent  European  Stability  Mechanism  (ESM)  is  now  in  place  to  address 
financial crises in the euro area, the Single Supervisory Mechanism for banks has been approved, and 
the  ECB  has  taken  non-standard  measures,  such  as  the  announcement  of  the  Outright  Monetary 
Transactions policy.  

However,  the  implementation  of  specific  recommendations  for  individual  euro  area  Member 
States and the euro area as a whole is incomplete and the most important challenge still remains 
to create the conditions for higher growth and lower unemployment. To do this, public, banking 
and private sector debt must be reduced in a growth-friendly way, while reforms that contribute to the 
rebalancing must be accelerated – by both surplus and deficit countries. 

•  Rebalancing:  There  is  evidence  that  rebalancing  in  the  euro  area  is  underway.  The 
improvement in the net export performance of vulnerable countries is driven not only by a fall 
in domestic demand but also by an increase in their competitiveness. However, the correction 
of large imbalances, such as high public and private debt or a loss of competitiveness, takes 
time  and  requires  sustained  reforms  that  may  have  negative  consequences  for  growth  in  the 
short term. The challenge for euro area Member States; including the surplus countries, will be 
to  make  sure  these  fundamental  economic  reforms  create  investment  and  employment 
opportunities for the future. 

3 

 
 
•  Structural  reform:  Boosting  the  euro  area’s  growth  potential  calls  for  an  ambitious 
programme  of  reforms.  This  should  concentrate  on  opening  up  certain  sectors  to  more 
competition,  allowing  in  innovative  firms  while  lowering  prices  for  consumers.  Business-
friendly  regulation  –  for  example,  swift  and  fair  bankruptcy  procedures  –  would  clear  the 
market of less efficient firms. Reforming labour law – for example, changing contract law to 
make  it  easier  for  young  people  to  enter  the  jobs  market  –  has  benefits  for  employers  and 
employees.  

•  Fiscal policy: Member States have delivered significant consolidation in 2012 and the overall 
budget  deficit  in  the  euro area  is  expected  to  fall  below  3%  of  GDP  in  2013. Thanks  to  the 
large  efforts  in  the  past  two  years  fiscal  consolidation  can  proceed  on  a  more  graduallpace. 
Making  the  adjustment  as  growth-friendly  as  possible  will  be  essential. To  that  end,  a  more 
growth-friendly  mix  of  spending  and  taxation  in  the  budget,  better  fiscal  governance  and 
structural  measures  to  increase  the  growth  potential  will  help.  Consistent  implementation  of 
well-designed  fiscal  reforms  does  not  only  improve  public  finances,  it  also  helps  rebuild 
governments' creditworthiness and reduce overall market uncertainty.  

•  Financial sector: Bank lending to the real economy – particularly SMEs – has not picked up 
and  fragmentation  of  financial  markets  along  national  lines  did  not  disappear,  despite  the 
easing  of  tensions  on  financial  markets.  The  ratio  of  non-performing  loans  that  banks  are 
holding  is  increasing  and  the  aggregate  loan-to-deposit  ratio  of  euro  area  systemic  banks 
remains  high.  The  challenge  is  to  identify  and  eliminate  any  remaining  pockets  of 
vulnerability  on  bank  balance  sheets,  to  restore  the  internal  market  and  to  further  break  the 
link between banks and sovereigns.  

•  Economic  governance:  Since  the  eruption  of  the  crisis  the  framework  for  economic, 
budgetary and structural surveillance and coordination has been significantly reinforced. The 
challenge  is  now  that  the  EU  institutions,  including  the  Eurogroup,    use  this  improved 
framework to encourage Member States to implement country specific recommendations and 
take account of the strong spillovers between countries.  

4 

 
 
 
INTRODUCTION 

The repercussions of the global economic and financial crisis of 2008/9 are still being felt 
in the euro area. A fragile banking system and weak economic activity constitute the legacy 
from  the  crisis,  and  this  has  combined  with  longer-standing  structural  and  institutional 
challenges  unique  to  the  euro  area  to  create  periods  of  considerable  upheaval  in  financial 
markets  and  Member  State  economies.  With  a  number  of  vulnerable  countries  facing  very 
large  adjustment  needs,  but  also  sizeable  external  financing  requirements,  the  fabric  of 
Economic  and  Monetary  Union  (EMU)  has  been  severely  tested.  Faced  with  these  deep 
challenges, both Member States and EU institutions have acted in a decisive way to combat 
the economic and financial difficulties facing the euro area and to reform and strengthen the 
EMU governance arrangements. Shortcomings have been identified in the original design of 
EMU in the light of the crisis and these are being addressed through appropriate measures in 
the  areas  of  financial  supervision  and  economic  surveillance.  Furthermore,  the  institutional 
architecture  of  EMU  is  reinforced,  as  temporary  financial  firewalls  such  as  the  EFSF  and 
EFSM have been replaced by a permanent European Stability Mechanism. At the same time, 
the monetary policy framework of the ECB has adapted to the specific challenges of the crisis 
and  become  more  supportive  of  financial  stability,  notably  through  emergency  liquidity 
provision  and  the  possibility  of  targeted  asset  purchases.  This  has  resulted  in  a  significant 
reduction of tail risks and has stabilised financial markets.  

Despite  evident  progress,  the  euro  area  still  faces  significant  obstacles  on  its  path 
towards economic and financial recovery. Achieving a stable and complete EMU requires 
further  broad-based  integration  in  the  financial,  fiscal,  economic  and  political  domain,  as 
discussed in the Commission’s blueprint for a deep and genuine EMU1.  The 2012 country-
specific  recommendations  for  the  euro  area  already  identified  the  need  to  achieve  fiscal 
sustainability  and  foster  growth  as  central  challenges,  as  well  as  the  need  to  restore  the 
financial  sector  to  good  health  and  facilitate  the  adjustment  of  macroeconomic  imbalances. 
While  much  has  been  achieved  in  the  way  of  cementing  the  cohesiveness  of  the  euro  area 
since  these  recommendations  were  addressed  to  euro  area  Member  States  in  2012,  further 
action to address these policy issues is still needed. The 2013 Annual Growth Survey set out 
the five most pressing challenges for the EU as a whole: these are also priorities for the euro 
area. 

1. 

ECONOMIC DEVELOPMENTS AND CHALLENGES 

1.1. 

Recent economic developments and outlook  

The euro area is going through a protracted downturn. The clear easing of tail risks still 
contrasts with a relatively subdued outlook for growth and employment across the euro area. 
Given  the  need  for  balance-sheet  adjustment  in  the  public  and  private  sector  in  several 
Member  States,  economic  activity  is  expected  to  remain  subdued  throughout  the  forecast 
horizon and marked by persistent cross-country differences. 

GDP contracted by 0.6% in 2012. Assuming that continued policy effort will prevent a 
renewed intensification of the sovereign-debt crisis in the euro area and improvements 
on  financial  markets  are  sustained,  the  economy  is  expected  to  move  slowly  out  of 

1  

COM(2012) 777 final. 

5 

 
 
                                                 
recession. Recent readings of survey indicators point to a gradual stabilisation in the first half 
of this year and the beginning of the recovery only in the second half of 2013. On the back of 
a strong negative carry-over effect from 2012 and an expected weak first half of this year, real 
GDP is predicted to decline by  0.4% in  the euro  area in 2013. Looking ahead to 2014, real 
GDP is projected to expand by 1.2%, still affected by the need for balance-sheet adjustment in 
the public and private sector.  

On  the  back  of  a  global  economic  recovery,  external  demand  is  set  to  remain  the 
predominant  growth  driver  in  2013,  while  multiple  headwinds  continue  to  weigh  on 
domestic  demand.  Deleveraging  of  banks,  non-financial  firms  and  households  has  made 
some  progress,  but  is  expected  to  continue  weighing  on  domestic  demand  over  the  forecast 
horizon.  Elevated  uncertainty,  which  is  affecting  spending  and  investment  decisions,  is 
expected to fade gradually. Against this backdrop, a gradual increase in domestic demand is 
expected in the second half of this year.  

While  the  euro  area  as  a  whole  has  been  affected  by  the  economic  downturn, 
macroeconomic  conditions  differ  considerably  between  Member  States.  Given  the 
differences in labour and financial market situations in some Member States and the different 
needs for fiscal consolidation and private sector deleveraging, economic growth differentials 
in the euro area are expected to narrow only gradually. However, by the end of this year, most 
of the Member States that are currently in recession are forecast to register positive quarterly 
GDP growth again.   

1.2. 

Challenges  

Supporting growth to improve sustainability  

 The  necessary  adjustment  of  internal  and  external  imbalances  accumulated  by  euro 
area countries in the pre-crisis period is ongoing and will take time to run its course. The 
correction of large imbalances generally requires a sustained adjustment process with negative 
consequences for short-term growth, as it implies not only a demand restraining balance sheet 
adjustment of the different sectors of the economy, but also a change in the output structure 
towards  a  more  sustainable  pattern  of  specialisation.  On  the  internal  side,  private  sector 
balance sheet adjustment processes currently taking place in several Member States represent 
necessary corrections of strong prior credit growth. Non-financial private sector deleveraging 
involves  a  reduction  in  investment  and  an  increase  in  saving  rates,  driven  by  the  desire  of 
households and corporations to improve their net asset position by paying down existing debts 
and/or increasing asset holdings. The current situation is particularly challenging to the extent 
that high levels of debt are held not only to the financial and non-financial private sector but 
also the public sector in some euro area Member States, which necessitates an encompassing 
assessment  of  deleveraging  challenges  in  all  the  different  sectors  of  the  economy.  On  the 
external side, a rebalancing of euro area Member States' current account positions is on-going. 
This is driven in part by domestic demand compression in vulnerable countries, but also by 
competitiveness  improvements.  Although  these  developments  include  both  a  cyclical  and  a 
non-cyclical component, the latter appears to dominate in most countries. The challenge for 
euro  area  Member  States;  including  the  surplus  countries,  will  be  to  continue  facilitating 
external  rebalancing  processes  by  boosting  the  adjustment  capacity  of  their  economies  and 
enhancing  the  growth  potential  so  as  to  support  the  reallocation  of  factors  of  production  by 
creating investment and employment opportunities.   

The  challenge  of  boosting  the  euro  area’s  growth  potential  calls  for  an  ambitious 
programme  of  reforms,  which  increase  flexibility,  productivity  and  competitiveness. 

6 

 
Given the currently sizeable negative output gap in the euro area and the major increase in the 
number of unemployed during the crisis, such a programme plays a key role in making better 
use of Member States’ productive resources and alleviating the economic and social hardship 
caused by the rise in unemployment. Economic efficiency is increased, as this will facilitate a 
reallocation  of  workers  and  capital  towards  more  productive  and  sustainable  parts  of  the 
economy will increase national income and growth potential. Furthermore as unemployment 
progressively  affects  the  present  and  future  growth  potential,  removing  obstacles  to  labour 
markets  operating  efficiently  should  therefore  be  seen  as  a  central  challenge  at  the  current 
juncture.  In  addition,  labour  productivity  will  need  to  be  supported  to  enhance  longer-term 
growth  prospects  and  enhance  competitiveness  through  capital  investment  and  measures 
boosting total factor productivity. 

Improving fiscal positions in a growth-friendly manner 

Member  States  have  delivered  significant  consolidation  in  2012.  Some  Member  States 
have already corrected their excessive deficits, while others are forecast to do so in the near 
future. However, the debt ratio rose to 90% in the euro area as a whole in 2012. Therefore, the 
challenge  is  to  put  the  debt-to-GDP  ratio  on  a  steadily  declining  path  over  time.  In  this 
context,  it  is  important  to  continue  on  the  path  of  differentiated  and  growth-friendly  fiscal 
consolidation, as advocated in the Commission's Annual Growth Survey2, taking due account 
of  the  starting  position  of  each  country.  The  focus  should  be  on  an  overall  efficient  and 
growth-friendly  mix  of  expenditure  and  revenue  taking  into  account  the  country-specific 
characteristics.  Consistent  implementation  of  well-designed  fiscal  reforms  does  not  only 
improve  the  position  of  a  country's  public  finances  but  it  also  helps  rebuild  government's 
creditworthiness and reduce overall market uncertainty. This is especially true if fiscal plans 
are  demonstrably  growth-friendly,  are  clearly  anchored  in  a  multi-annual  budgetary 
framework and address the long-term sustainability of public finances. 

Safeguarding financial stability and improving credit flow to the real economy 

Improved funding conditions for banks are yet to feed through to a pick-up of credit for 
the  real  economy.  Significant  differences  persist  across  Member  States  as  regards  bank 
lending activity and the cost of funding to the private sector. Credit growth is currently held 
back  by  weak  credit  demand  and  supply.  On  the  demand  side,  the  challenge  is  to  restore 
confidence and repair the strained balance sheets in the non-financial private sector. On  the 
supply side, high lending rates are linked to the health of the banking sector with banks with a 
high ratio of non-performing loans, low profitability and/or a weak capital position charging 
high  lending  rates.  Moreover,  the  current  low-cost  funding  environment  and  the  persistent 
high  loan-to-deposit  ratios  indicate  that  there  is  a  risk  that  banks  start  engaging  in  loan 
forbearance which would freeze the credit supply further and could undermine confidence in 
the  sector  as  a  whole.  This  is  exacerbated  by  financial  market  fragmentation  along  national 
borders due to feedback loops between banks and sovereigns. Therefore, the challenge on the 
supply  side  lies  in  further  breaking  the  feedback  loops  between  banks  and  sovereigns  and 
restoring the internal market in the financial sector. One important element in this regard is to 
promote the repair of bank balance sheets so as to facilitate an orderly deleveraging of both 
the banking sector and the non-financial private sector while sustaining the flow of new credit 
for productive uses in the real economy and particularly SMEs. To this end, the transparency 
of bank balance sheets should be enhanced and any remaining pockets of vulnerability should 
be identified and repaired.  

2  

COM(2012) 750 final. 

7 

 
                                                 
 Making progress towards effective governance arrangements in the euro area 

A  new  governance  framework  has  come  into  force.    Since  the  eruption  of  the  crisis  the 
framework  for  economic,  budgetary  and  structural  surveillance  and  coordination  has  been 
significantly reinforced. The challenge is now to use this improved governance framework to 
reinforce the commitment of Member States to implement country specific recommendations 
and to assure a coherent aggregate policy stance which reflects the strong spillovers between 
countries whose currency is the euro.  

2. 

ASSESSMENT OF THE POLICY AGENDA 

2.1. 

Fiscal policy and taxation  

Budgetary developments and debt dynamics  

Significant  progress  has  been  made  on  fiscal  consolidation  in  the  euro  area.  The 
structural  deficit  for  the  euro  area  improved  by  1.4  percentage  points  (pps)  in  2012.  This 
testifies to the significant fiscal effort undertaken by euro area Member States over the year. 
Also,  the  headline  deficit  continued  to  improve  by  0.4  pps  and  fell  to  3.7%  of  GDP. 
According  to  the  spring  forecast,  the  overall  structural  balance  of  the  euro  area  should 
improve by 0.75 pps in 2013. This should lead to a further reduction in the nominal deficit, 
which should fall below 3% of GDP for the first time since 2008 and by more than half from 
its peak in 2009-10 when it exceeded 6% of GDP on the back of fiscal stimulus and support 
for the financial sector.   

However  the  debt-to-GDP  ratio  continued  to  rise  in  2012,  as  the  effects  of  the 
consolidation programmes on debt will become visible only with time. The debt ratio of 
the euro area as a whole exceeded 90% of GDP in 2012. According to the Commission spring 
forecast the pace of debt accumulation will slow down markedly this year, but the debt ratio 
will  continue  rising  and  will  reach  95.5%  of  GDP  in  2013.  Assuming  no  changes  in  fiscal 
policies, the debt ratio is forecast to stabilise at 96% in 2014. Member States fiscal plans as 
presented in Stability Programmes imply a similar debt pattern as forecast by the Commission 
with a slightly lower debt level in 2014. Provided that SCP plans are rigorously implemented, 
the debt ratio should decline further to just below 90% of GDP in 2016. Higher debt ratios can 
weigh  on  growth  via  the  higher  taxes  needed  to  pay  for  interest  charges  and  via  higher 
sovereign risk affecting private risk and borrowing costs for private agents. These factors are 
more relevant when debt is larger. Therefore, consolidation efforts should be complemented 
by structural reforms to enhance the growth potential which would allow bringing down the 
debt ratio more rapidly. The recent amendments to the SGP have created a debt benchmark, 
which operationalized the debt criterion of the Treaty. It requires the Member States to reduce 
their debt ratios at a pace that would ensure reaching the 60% of GDP threshold at most over 
a  20-years  horizon.  However,  Member  States  that  were  in  EDP  in  November  2011  were 
granted  a  3-year  transition  period  during  which  they  need  to  show  sufficient  compliance 
towards meeting the benchmark at the end of the transition3.  

The speed of consolidation over the period 2010 and 2013 for the euro area as a whole as 
well  as  the  differentiation  according  to  fiscal  space  was  broadly  appropriate.  Over  the 
period 2010 and 2013, the annual average improvement of structural balances in the euro area 

3  

i.e. at the time the revised Regulation (EC) No 1467/97 entered into force. 

8 

 
                                                 
is forecast to be 0.8% (see Figure 1). The largest adjustment was implemented in programme 
countries and countries facing market pressures such as Greece, Portugal, Italy and Spain or 
countries  with  high  deficits  in  2009  such  as  Slovakia  and  France.  In  Member  States  with  a 
larger fiscal space such as Finland and Luxembourg structural balances have not improved or 
only moderately. However, for a number of countries, but especially for those experiencing a 
marked  fiscal  tightening,  the  underlying  degree  of  policy  retrenchment  needed  to  deliver  a 
given improvement in the structural balance is currently higher than in normal circumstances. 
This  is  attributable  to  the  ongoing  rebalancing  towards  tradable  sectors  that  translate  into 
temporary tax-poor growth and downward changes in potential growth. By contrast, but in a 
less significant manner, the discretionary fiscal effort is currently suggestive of a looser policy 
than the change in the structural balance in Germany, Luxembourg, Malta and Sweden. For 
the  euro  area  as  a  whole,  the  degree  of  policy  retrenchment  is  currently  higher  than  what 
would  appear  from  the  structural  effort4.  Looking  at  the  structural  balances  in  a  dynamic 
perspective, the European Commission recommended an EU consolidation strategy based on 
the  principle  of  gradual  and  differentiated  adjustment.  Countries  with  high  debt  or  under 
market stress were recommended to start consolidation in 2010 and others only in 2011. As a 
result,  fiscal  policies  played  a  key  role  to  support  the  economy  and  to  avoid  financial 
meltdown in 2009. For the euro area as a whole the fiscal stance was neutral in 2010. In 2011, 
the consolidation pace picked up to 0.9%, to peak at 1.4% in 2012. For 2013, the Commission 
forecasts a decline to an aggregate consolidation effort of 0.75%.  

Figure 1: annual average structural effort over 2009-2013  

 Greece
 Portugal
 Slovakia
 Spain
 France
 Italy
 Euro area
 Ireland
 Netherlands
 Slovenia
 Cyprus
 Belgium
 Germany
 Austria
 Estonia
 Malta
 Luxembourg
 Finland

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

% of GDP

Source: Commission 2013 spring forecast  

The Stability and Growth Pact (SGP) is a flexible framework to guide the differentiated 
speed of fiscal adjustment and the recent improvements in the SGP will further enhance 
this role. While the nominal deficit and debt thresholds - respectively 3% and 60% of GDP - 

4  

See Box I.4 of the Spring Forecast of the European Commission. 

9 

 
 
                                                 
are the main anchors of the SGP in the corrective arm, the consolidation paths towards these 
targets is defined in structural terms, i.e. assuming away the impact of the business cycle on 
the headline deficit. Therefore, if a significant deterioration of the economic outlook leads to 
missing the nominal target in spite of implementing the required structural effort, the deadline 
for  correcting  the  excessive  deficit  could  be  postponed.  In  the  preventive  arm,  countries 
should  pursue  steady  adjustment  towards  their  Medium  Term  Objectives  (MTO)  with  the 
annual structural improvement of 0.5% as a benchmark, which can be modulated according to 
country-specific  fiscal  and  economic  situation,  based  on  the  criteria  specified  in  the  SGP. 
Also, the SGP rules allow a temporary deviation from the adjustment path towards the MTO 
due  to  the  implementation  of  major  structural  reforms  with  direct  long-term  positive 
budgetary effects, including by raising potential sustainable growth, and which therefore have 
a  verifiable  impact  on  the  long-term  sustainability  of  public  finances.    The  SGP  provisions 
have served as a basis for the Commission's calendar of convergence towards the MTOs. In 
order to give a more tangible guidance to Member States on their path towards the MTO, an 
expenditure benchmark was introduced, which complements the assessment of the structural 
balance and requires Member States to keep the growth of expenditure, net of discretionary 
revenue measures, aligned with the medium-term rate of their potential growth5. A Member 
State that has overachieved the MTO could temporarily let annual expenditure growth exceed 
a  reference  medium-term  rate  of  potential  GDP  growth  as  long  as,  taking  into  account  the 
possibility of significant revenue windfalls, the MTO is respected throughout the programme 
period. 

Based  on  the  Stability  Programmes,  the  structural  effort  in  the  euro  area  will  decline 
further  with  a  differentiation  of  consolidation  based  on  fiscal  space.  This  implies  also 
that the headwinds from consolidation are expected to ease in the euro area as a whole. 
Thanks to the already implemented consolidation efforts and a robust economic performance, 
Estonia,  Finland,  Germany  and  Luxembourg  have  achieved  their  MTO,  with  Germany 
achieving it with a wide margin, or are expected to do so over the forecast period. Therefore, 
there  is  no  more  need  for  short-term  consolidation  measures  and  countries  with  structural 
balances above their  MTO  can  let the net expenditure  grow  above  the  medium-term  rate  of 
potential growth as long as their MTO is preserved. The negative impact of consolidation on 
growth  in  these  countries  will  fall  away.  Also  Member  States,  which  have  corrected  their 
excessive  deficit,  such  as  Italy  or  Austria,  could  assure  a  more  gradual  adjustment  towards 
their  Medium  Term  Objectives,  in  line  with  the  calendar  of  convergence  proposed  by  the 
Commission.  As  countries  in  the  preventive  arm  represent  more  than  40%  of  the  euro  area 
GDP, the overall consolidation needs in the euro area, as well as the impact of consolidation 
on euro area growth, are diminishing.  

Nonetheless, there remain substantial consolidation needs in some euro area countries as 
there  are  still  a  number  of  countries  in  excessive  deficit  procedure  and  countries  in  the 
preventive  arm  need  to  make  progress  of  0.5%  as  a  benchmark  towards  the  MTO.    These 
consolidation efforts will weigh on economic growth with the size of the effects depending on 
many factors, such as the composition of consolidation, the state of the balance sheets of the 
private  sector  or  the  credibility  of  policies.  Euro  area  Member  States  which  are  not  under 
stress but are still in the excessive deficit procedure and fulfil the conditions for an extension 
of their deadline, should continue their fiscal efforts in line with the Council Recommendation 
addressed  to  them  but  with  more  attention  to  complementary  measures  to  reinforce  their 
growth potential and to correct their macro-economic imbalances. For a number of vulnerable 
countries  that  face  both  private  and  public  deleveraging  needs,  consolidation  can  have  a 

5  

Revised Regulation (EC) No 1466/97. 

10 

 
                                                 
higher short term effect on economic growth in particular if rigidities exist in their financial-, 
labour- and product markets. Trading off public against private deleveraging is no option for 
these  countries,  as  their  overall  external  position  is  often  negative,  requiring  a  significant 
adjustment of the nation as whole. This is bound to be painful whatever the exact distribution 
between public and private deleveraging. These countries do not have an alternative as they 
have lost access to financial markets or are at risk of losing it.   

Composition of public finance  

While  expenditure-led  consolidations  should  be  favoured,  the  focus  should  be  on  an 
overall efficient and growth-friendly mix of expenditure and revenue measures. Analysis 
of  past  episodes  of  consolidation  suggests  that  expenditure-based  consolidations  are  more 
likely to succeed. Also, given the relatively high tax burden in some of the euro area Member 
States, further tax increases could impact negatively on future growth and other more growth-
friendly  ways  of  revenue  raising,  such  as  broadening  the  tax  base,  should  be  considered 
instead.. Overall, in order to limit the short-term negative effects on growth, the composition 
of  consolidations  should  find  the  right  mix  of  growth-friendly  measures  on  the  expenditure 
side  and  the  revenue  side  taking  into  account  the  country-specific  economic  and  fiscal 
characteristics. 

Consolidation efforts in the euro area have been broadly balanced between the revenue 
and  expenditure  side.  Between  2009  and  2012  revenue  ratio  increased  in  the  euro  area  by 
1.3 percentage points to 46.2% of GDP, while expenditure ratio fell by the same amount to 
slightly  below  50%  of  GDP,  but  still  not  reversed  the  large  increase  recorded  in  2009  and 
remain above the level of 2008. In implementing their adjustment strategy countries such as 
Ireland6,  Greece,  Portugal  and  Spain  mostly  relied  on  expenditure  cuts.  On  the  contrary,  in 
countries  such  as  France,  Belgium,  Italy  and  Luxembourg  overall  fiscal  consolidation  has 
been revenue-based although revenue ratios are already relatively high in these countries. 

Expenditure cuts also affected growth friendly expenditure categories. Public investment 
was the most affected expenditure type (see Figure 2). Although investment projects are the 
easiest ones to target when making savings, it is unfortunate as investment is the most growth-
friendly  type  of  government  expenditure.  At  the  time  when  the  private  sector  postpones 
investment, there is a case for the public sector to step in, while looking for budgetary savings 
in  other  parts  of  the  budget.  In  order  to  alleviate  this  drawback,  the  Commission  has 
announced in the Blueprint for a deep and genuine EMU that it would explore further ways to 
accommodate investment programmes within the preventive arm of the SGP. Also, the public 
wage bill and public consumption have been reduced since the start of the fiscal adjustment in 
2010. Conversely, the relative share of social transfers increased. The large increase in social 
benefits has been related to the impact of the crisis on labour market and efforts by Member 
States  to  moderate  its  social  consequences.  These  insights  are  confirmed  by  analysis  of 
expenditure by functional type, which show significant increased government expenditure on 
social protection, which at least partly reflects the counter-cyclical nature of such spending - 
although  conclusions  here  should  be  careful  due  to  short  time  series  of  data  available. 
Education  expenditure  has  risen  slightly,  which  is  to  some  extent  reassuring  in  view  of  the 
link to the long-term growth potential. Overall, however, this picture shows that there is still 
scope to improve the composition of fiscal adjustment on the expenditure side. In some cases 
the size and speed of adjustment was dictated by the developments on financial markets and 

6  

Expenditure cuts are influenced by the public intervention in the financial sector. 

11 

 
  
                                                 
deteriorating  liquidity  position  of  the  government  and  did  not  leave  much  space  for 
optimising  policy  measures.  The  improvements  in  financial  markets  should  allow  more 
considerate  decisions  on  the  composition  of  the  budgets  going  forward.    In  other  Member 
States,  however,  there  is  also  the  need  to  resist  easy  and  temporary  solutions  for  budgetary 
savings and aim at increasing efficiently and effectiveness of public spending in view of both 
current  adjustment  needs  and  the  long-term  challenges.  Benchmarking  of  best  practices  and 
appropriate  cost-benefit  analysis  could  be  useful  techniques  to  enhance  the  efficiency  in 
government spending.  

Figure 2 Change in total expenditure mix, by economic (2010-2012) and functional type 
(2010-2011), percentage points  

Social protection

General public services

Health

Education

Public order and safety

Housing and community amenities

Environment protection

Defence

Recreation, culture and religion

Economic affairs

Source: Commission Services 

-1.5

-1

-0.5

0

0.5

1

A  majority  of  Euro  Area  Member  States  increased  taxation  across  the  board  in  2011-
2012 in the context of large fiscal consolidation needs. Broad based revenue measures were 
required in some Member States, which implies an increase of the tax burden also on labour 
and corporate income considered more detrimental for growth. They raised taxes on income 
and wealth, as well as indirect taxes on consumption. Personal income tax rates increased, in 
several  cases  in  the  form  of  general  surcharges  or  solidarity  contributions  for  high-income 
earners.  There  is  also  a  tendency  toward  moderate  increases  in  recurrent  property  taxation. 
Measures  affecting  the  corporate  income  tax  are  more  mixed,  reflecting  also  very  disparate 
starting conditions in the Euro Area: Several countries have reduced the corporate income tax 
rate while other Euro Area Member States have introduced special levies and surcharges on 
large companies in particular. In an effort to dampen negative effects of the crisis on private 
sector  investments,  several  Member  States  introduced  changes  to  the  corporate  tax  base  to 
further  incentivise  research  and  innovation  investments  and  entrepreneurial  activity.  In  the 
area of consumption taxes, both VAT rates and excise duties on energy, alcohol and tobacco 
have been increased in many Member States.  

12 

 
 
 
 
Figure  3:  Tax-to-GDP  ratio  and  tax  structure  in  Euro  area  Member  States,  2012  (per 
cent of GDP)  

Source: Commission Services 

The  shares  of  direct  and  indirect  taxes  in  GDP  are  expected  to  increase  in  parallel, 
leaving  the  overall  tax  structure  relatively  unchanged  in  the  short  term  (see  figure  3). 
Some countries made an effort to improve their tax structure: measures have been taken there 
to  shift  from  taxes  on  labour,  including  targeted  reduction  of  taxes  for  particular  labour 
market  groups  such  as  low  income  or  second  earners,  to  consumption,  environmental  or 
property taxes.  

Going  forward,  there  is  still  scope  for  many  euro  area  Member  States  to  improve  the 
structure of the tax systems further. In particular France, Belgium and Italy have scope to 
further  shift  taxes  away  from  labour.  Such  shifts  would  need  to  be  properly  sequenced  to 
avoid revenue losses in the short term.  In several countries, the possibility could be explored 
to  accompany  the  increase  in  consumption  taxes  with  a  more  pronounced  use  of  recurrent 
property  taxes  and  environmental  taxation  which  are  considered  less  detrimental  to  growth. 
Property taxes could usefully complement consumption taxes as a way to shift tax away from 
labour,  given  the  possibly  adverse  effect  of  consumption  tax  increase  on  the  poorest 
households and on tax fraud.  

Many  Member  States  have  room  to  make  the  tax  systems  more  growth  friendly  and 
raise additional revenue by broadening the tax bases. Hence, there is scope for reviewing 
tax expenditure in personal and corporate income taxation with a view increasing the overall 
efficiency  of  the  taxation  system.  Belgium,  France,  Italy  and  Spain,  in  particular,  would 
benefit  from  addressing  the  wide  range  of  tax  expenditures  in  their  tax  systems.  Room  also 
exists  for  improving  VAT  efficiency  through  a  broader  application  of  the  standard  rate  and 
further rises in reduced rates in around half of the euro area Member States.  

Finally, a majority of Member States could further improve the tax governance or/and 
further  reduce  their  debt  bias.  Tax  governance  should  continue  to  be  improved  in  about 
half of the euro area Member States. This relates to sustained efforts in the mid to long term to 

13 

 
 
 
enhance tax compliance and improve the efficiency of the tax administration. Italy, Malta and 
Spain  could  further  intensify  their  efforts  on  tackling  tax  fraud  and  undeclared  work,  while 
Slovakia would benefit from to further improving VAT collection and strengthen the capacity 
of the tax administration. Finally, further reform efforts to reduce the debt bias in housing and 
corporate taxation may still be needed in some countries to address current imbalances and to 
prevent the recurrence of financial risks in these sectors. The Netherlands has room to further 
address the tax bias in the financing of housing investments, while Malta, Spain, Luxembourg 
and France have scope to continue to address the debt bias in corporate taxation.  

Long-term fiscal sustainability  

Coping  with  long-term  expenditure  trends  influenced  by  population  ageing  is  an 
important  challenge.  Significant  progress  has  been  made  since  2009:  Fiscal  adjustment 
needs to assure long term sustainability declined from 5.8% in 2009 to 2.3% now for the euro 
area  as  a  whole.  To  reach  the  60%  debt-to-GDP  threshold  by  2030  in  the  euro  area  an 
additional  effort  of  2  percentage  points  of  GDP  is  needed  on  top  of  the  already  envisaged 
fiscal effort until 20147. Failing to do so would entail that government debt as a share of GDP 
would  start  to  rise  again  towards  2030  as  the  budgetary  impact  of  population  ageing  takes 
hold more firmly, and debt would be close to 90% of GDP in 2030. The situation is however 
quite different across the euro area Member States. Sustainability risks are particularly high in 
Belgium,  Spain,  Malta,  the  Netherlands,  Cyprus  and  Slovenia.  If  one  expands  the  time 
horizon  towards  2060,  sustainability  challenges  are  still  bigger,  as  pensions  expenditure 
would  be  projected  to  rise  from  more  than  12%  of  GDP  today  to  14%  in  2060.  Moreover, 
spending  on  health  care  and  long-term  care  is  projected  to  rise  from  9%  to  12%  in  2060. 
Hence,  in  the  very  long-term,  ageing-induced  fiscal  sustainability  challenges  remain 
important  in  most  countries,  with  the  risk  being  highest  in  Belgium,  Cyprus,  Luxembourg, 
Malta,  the  Netherlands,  Slovenia  and  Finland.  Greece  and  to  a  lesser  extent  Spain  have 
implemented sustainability-enhancing pension reforms and others such as Italy and Portugal 
where the sustainability risks appear to be contained in a long-term perspective, conditional 
upon  the  full  implementation  of  the  planned  ambitious  fiscal  consolidation  and  on 
maintaining  high  primary  balance  well  beyond  20148.  This  demonstrates  the  progress 
countries under stress have made to improve their long term sustainability.  

Progress  has  been  made  with  reforms  of  pension  systems,  less  so  with  health  care.  A 
majority of Member States have adapted pension systems with the aim of putting them on a 
more sustainable footing against the background of population ageing. Last year a number of 
euro  area  Member  States  have  made  pension  reforms  which  are  having  positive  budgetary 
impact in the long term such as the Netherlands and Slovakia, which introduced an automatic 
link  between  life  expectancy  and  the  statutory  retirement  age.    Nonetheless,  further  reform 
efforts  are  needed  to  align  retirement  age  with  life  expectancy,  restrict  access  to  early 
retirement schemes, and enable longer working lives but also in the fields of health care and 
long-term  care  policies.  In  the  care  policy  field,  the  challenge  is  to  balance  the  need  for 
universal  health  care  and  long-term  care  with  an  increasing  demand  related  to  ageing 
population, technological development and growing patient expectations in all age categories. 
Public health and long-term care expenditure accounted for close to 9% of GDP in 2010. It 
has seen a substantial increase in the recent decades in terms of spending as a share of GDP 

7  

8  

For  details  on  the  S1  indicator,  see  Chapter  1.3  of  the  Fiscal  Sustainability  Report  2012,    European 
Economy  8|2012  http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-
2012-8_en.pdf 
For details on the S2 indicator, see Chapter 1.3 of the Fiscal Sustainability Report 2012. 

14 

 
                                                 
and as a share of total government expenditure. This trend, amplified by population ageing, is 
expected  to  continue  in  the  coming  decades.  The  joint  impact  of  demographic  and  non-
demographic drivers is a projected increase in public spending in health and long-term care by 
2 ½ or even 3 ½ pp. of GDP by 20609. Overall, 70% of the projected increase in age-related 
public  expenditure  is  due  to  health  and  long-term  care  (the  other  areas  being  pensions, 
education and unemployment benefits). As such, health and long-term care expenditure trends 
are  a  continuous  challenge  to  sustainability  of  sound  public  finances.  Therefore,  sound 
reforms are thus needed to achieve both a more efficient use of limited public resources and 
the  provision  of  high  quality  health  care,  improving  the  cost-effectiveness  of  public  health 
care.  Increased  cost-effectiveness  of  healthcare  systems  may  reduce  or  further  postpone  the 
burden  of  diseases  and  disability,  and  may  as  such  may  have  a  positive  impact  on  labour 
participation,  

Fiscal Frameworks  

The  strengthening  of  fiscal  frameworks  continues  across  the  euro  area.  While  the 
Directive  on  national  budgetary  frameworks  has  to  be  transposed  by  the  end  of  2013,  euro 
area  Member  States  pledged  to  advance  this  process  to  end  201210.  Despite  substantial 
progress,  there  is  still  some  way  to  go.    Member  States  have  to  ensure  timely  and 
comprehensive  statistical  coverage  for  all  general  government  sub-sectors,  whereas 
forecasting  provisions  often  lack  transparency.  Progress  is  somewhat  more  advanced 
regarding numerical fiscal rules: a wide array of national instruments are either in place or are 
being  prepared  to  buttress  national  fiscal  policy-making.  Beyond  the  Directive  itself,  the 
framework for strengthened EU governance introduced with the other legislative texts of the 
‘six-pack’ reform of the Stability and Growth Pact has helped to place the issue of effective 
national  numerical  fiscal  rules  high  on  the  Member  States’  reform  agenda.  This  is  also 
supported  by  the  inter-governmental  TSCG  which  mandates  the  adoption  of  a  structural 
budget  balance  rule  enshrining  the  MTO  at  national  level  and  safeguarded  by  a  robust 
correction  mechanism.  In  addition,  the  more  recent  agreement  on  the  'two-pack'  legislation, 
targeted  specifically  at  euro  area  Member  States,  will  further  reinforce  domestic  fiscal 
frameworks  in  the  context  of  enhanced  surveillance  of  budgetary  processes;  this  will  in 
particular  feature  a  stronger  role  for  independent  fiscal  institutions.  Work  on  effective 
coordination  arrangements  for  sub-national  governments  is  being  carried  out  in  many  euro 
area  Member  States,  but  the  positive  intentions  need  to  be  turned  into  concrete  and 
enforceable  arrangements,  especially  in  decentralised  countries  such  as  Spain  and  Belgium. 
The  push  towards  robust  fiscal  processes  is  also  extending  over  a  multi-annual  perspective. 
Although many Member States report that Medium Term Budgetary Frameworks are in place 
or planned, efforts are still needed in order to fully comply with the Directive’s specifications. 
Having  an  effective  medium  term  fiscal  planning  reduces  policy  uncertainty  and  increases 
confidence.  

2.2. 

Financial sector 

Most  risk  indicators  related  to  EU  financial  markets  as  well  as  market  sentiment 
improved  in  the  second  half  of  2012  and  early  2013  as  the  intensity  of  self-fulfilling, 
negative  confidence  spirals  has  dissipated  due  to  decisive  policy  action  at  all  levels. 

9  

10  

According  to  the  Ageing  Working  Group  Reference  and  the  Ageing  Working  Group  Risk  scenarios, 
respectively, see Ageing Report 2012, available at: 
 http://ec.europa.eu/economy_finance/publications/european_economy/2012/2012-ageing-
report_en.htm 
See European Council conclusions of 21 July 2011. 

15 

 
                                                 
 
There was a broad based recovery of asset prices in most market segments.  The reinforcing 
upward  trends  in  risk  premia  previously  observed  regarding  sovereigns  and  banks  were 
reversed  (see  Figure  4).  The  decreasing  perception  of  riskiness  of  euro  area  sovereign  and 
bank  debt  have  been  reflected  in  the  decline  of  bond  yields  in  programme  and  vulnerable 
Member States and their spreads against the German Bund as well as the corresponding CDS 
spreads.  This  decreasing  risk  perception  has  also  been  observable  in  successful  primary 
sovereign bond auctions, both in terms of bids received relative to the amounts requested and 
yields realised. Some Member States were able to tap the sovereign bond market with very 
long-term issues, while Ireland and Portugal have effectively prepared the grounds for a full 
return to market financing.  Market sentiment has also been quite robust and tail  risks have 
diminished as weak economic data, the uncertainty in the immediate aftermath of the Italian 
elections  and  uncertainty  related  to  Cyprus  has  not  led  to  a  resurgence  in  the  tensions  that 
characterised  so  much  of  2012  although  these  events  led  to  a  deterioration  of  confidence 
indicators and an increase in sovereign spreads, although the latter have been declining again 
as of April.  

Figure  4  10-Year  Euro  area  government  bonds  spreads  to  Germany  and  spreads  of 
bonds issued by banks  

Many EU banks have also returned to debt market financing and, since autumn 2012, 
banks from vulnerable Member States have also been able to issue substantial amounts 
of debt securities although bank bond issuance dried up in the aftermath of the events 
in  Cyprus.  At  the  same  time,  the  retail  deposit  outflows  from  banks  in  several 
vulnerable  Member  States  stabilised.  As  a  consequence,  banks'  borrowing  from  central 
banks has been decreasing in most countries that were the most reliant upon it, as witnessed 
by the contraction in the Intra Euro-system balances (see Figure 5). Several banks have also 
started  to  redeem  part  of  the  fund  borrowed  on  the  occasion  of  the  two  ECB  LTROs.  The 
restitution is accounted for mostly by banks in the core, Germany and France in particular, 
but  that  also  banks  in  more  vulnerable  countries  are  contributing,  most  notably  Spain.  The 
management of LTRO re-absorption will be extremely delicate and should be carried out in a 
careful way, especially at a time when pressure on the banking sector has started to ease but 
conditions  are  not  yet  back  to  normal  and  the  risk  of  resuming  funding  difficulties  is  still 
present.  

Figure 5 Intra Euro-system Balances  

16 

 
 
 
 
The positive market sentiment was spurred by several European level policy measures 
that  impacted  the  markets  in  the  last  year.  Perceptions  about  euro  breakup  have  receded 
significantly starting in the last quarter of 2012. On the monetary side the ECB's announced a 
new  programme  aimed  at  restoring  the  transmission  of  monetary  policy  Outright  Monetary 
Transactions  (OMT)  in  September  2012.  The  OMT  would  come  with  strict  and  effective 
conditionality  attached  to  an  appropriate  European  Financial  Stability  Facility/European 
Stability  Mechanism  (EFSF/ESM)  programme.  The  OMT  was  successful  in  dispelling 
markets'  concerns  about  the  existence  of  any  euro  convertibility  risk  and  has  produced 
substantial moderating effects on sovereign bond yields, especially in Spain and Italy. On the 
regulatory front, progress in economic and fiscal governance as well as the agreement on the 
Single Supervisory  Mechanism  (SSM) also contributed to  the reduction  of  risk  premia.  The 
SSM should be fully operational by July 2014 radically changing the supervisory landscape in 
Europe.  The  SSM  will  ensure  a  harmonised  oversight  with  centralised  supervision  for  the 
most  significant  banks  only  and  those  receiving  public  support.  This  will  enhance  high-
quality  and  impartial  banking  supervision  across  the  board,  contributing  to  boost  the 
resilience of the banking system in the medium term and dissipate doubts about the quality of 
banks'  assets.  As  a  consequence,  the  SSM  will  contribute  to  restoring  confidence  in  the 
banking system and weaken the negative feedback loop between sovereigns and banks in the 
euro  area.  Taken  together,  important  progress  in  reducing  financial  risks  has  already  been 
achieved. Finally, with the permanent European Stability Mechanism becoming operational, 
the EU can rely on strong firewalls that can be put in place to avoid feedback loops and spill 
over effects between sovereigns and between sovereigns and their financial sector.  

However,  market  conditions  have  not  normalised  and  market  fragmentation  did  not 
disappear which means that funding strains for banks in vulnerable countries remains 
prevalent. The return to full financial integration depends crucially on the preservation 
of a positive and ambitious effort to reform the financial framework. The loss of investor 
confidence  observed  in  the  last  couple  of  months  could  reinforce  the  fragmentation  of  EU 
financial  markets  again.  At  the  current  juncture,  national  governments  concentrate  on  the 
domestic  effects  of  bank  failures  and  often  ignore  cross-border  externalities.  To  reap  the 

17 

 
 
 
benefits  of  the  single  market  as  well  as  financial  stability,  the  euro  area  needs  new 
supranational  institutions  that  facilitate  cross-border  banking.  The  possibility  of  direct 
recapitalisation of banks by the ESM, which should be available soon, will also play a role in 
the dilution of the bank-sovereign link, both in the transition phase and the steady state.  

The  crisis  has  showed  how  countries  in  a  monetary  union  are  vulnerable  to  sudden  to 
asymmetric shocks and therefore also to potentially disruptive reversals in capital flows 
in the absence of coordination of their economic policies  and real convergence of their 
business cycles. Some countries which had relatively higher inflation and interest rates before 
joining  the  monetary  union,  attracted  massive  capital  inflows  during  the  first  decade  of 
monetary unification and underwent since the beginning of the crisis equally massive private 
capital outflows, whose full effect has been partly cushioned  by the possibility for banks to 
access  central  bank  financing.  In  order  to  prevent  similar  threats  for  financial  stability  to 
materialise in the future, on the financial side, macro-prudential policy will have a crucial role 
to  play.  CRD4  and  CRR  already  envisage  many  new  macro  tools,  such  as  counter  cyclical 
capital buffers (CCB) and buffers for systemically important financial institutions (SIFIs) that 
could help prevent the build-up of a similar situation in the future, and the ECB and ESRB 
need to ensure that their use is coordinated and done in the most efficient way.  

Banks continued balance sheet repair. Euro area systemic banks also continued to reduce 
their  leverage  ratios  with  assets  23  times  higher  than  equity  in  2012.  This  ratio  has  come 
down  considerably  since  2008  when  assets  were  31  times  higher  than  banks’  equity.  This 
improvement has mainly come about by an increase in equity. Systemic banks in the euro area 
continued to increase their solvency with the average core tier 1 rising from 10 towards 11% 
in the three first quarters of 2012. The weak macro-economic environment and the sometimes 
high levels of non-financial private sector indebtedness suggests that banks in the euro area 
should  conserve  capital  buffers  built  up  as  a  result  of  the  EBA  recapitalisation  plan  and 
continue strengthening their equity buffers, where needed. The economic outlook weighs on 
bank profitability via rising non-performing loans and provisioning needs. Shoring up capital 
should  preferably  be  done  by  raising  new  equity,  or  by  reducing  dividends,  executive 
compensation  and  share  buybacks  in  favour  of  retained  earnings,  in  order  to  avoid  any 
unintended consequences on the credit flow.  To illustrate the need to raise equity further still, 
it should be noted that the total doubtful and non-performing loans not covered by reserves as 
a  percentage  of  total  own  funds  is  rising  steadily  in  a  number  of  countries  under  stress  and 
some other countries. In programme countries, thorough evaluations have ensured a high level 
of  capital  in  the  banks  to  be  able  to  complete  the  process  of  balance  sheet  repair.  Some  of 
those evaluations are now outdated and will need to be updated to take account of the most 
recent economic developments and to identify any remaining pockets of vulnerability and so 
reinforce the confidence in the sector as a whole. 

The  overall  pace  of  decline  in  loan-to-deposit  ratios  over  the  last  years  is  rather  slow 
compared  to  the  declines  of  bank  balance  sheets  observed  during  previous  banking 
crisis. In fact, on aggregate total assets in the euro area did not decline significantly since the 
beginning of the crisis. At the moment the pace can be compared to Japan, which experienced 
a  very  slow  deleveraging  process  of  its  financial  sector  since  1997  because  bad  assets 
remained too long on the balance sheets of the banks. This had a big influence on the overall 
poor  economic  performance  of  Japan  over  the  last  decades.  The  aggregate  loan-to-deposit 
ratio  of  euro  area  systemic  banks  was  still  120%  in  June  2012.  This  means  that  euro  area 
banks are reliant on wholesale funding and are vulnerable when these markets dry up. While 
increasing equity is definitely the economically preferred way to deleverage as the credit flow 
to the real economy is less affected, the current slow pace of asset adjustment and the current 
low-cost  funding  environment,  point  to  a  risk  of  loan  forbearance.  Therefore,  legal  and 

18 

 
judicial  obstacles  to  non-performing  loan  resolution  should  be  resolved.  Moreover,  it  is 
important that asset quality reviews that are held are based on a common set of definitions and 
methodology with credible backstops. This approach could enhance transparency of the bank 
balance sheet and so reinforce confidence in the sector as a whole.   

In  the  euro  area  as  a  whole,  the  MFI  lending  volume  to  non-financial  companies 
decreased  in  2012  with  -3.8%  whereas  the  lending  volume  to  households  remained 
stable.  Lending volumes in the countries under stress are even more subdued. Comparing the 
changes in bank lending volumes and bank lending rates gives some insight in the respective 
contributions by demand and supply to weak credit growth. In Italy – in particular for small 
firms – and Portugal, developments in bank lending conditions suggest a dominance of supply 
shocks  while  the  case  of  Ireland  suggests  a  dominant  demand  shock.  In  Spain,  a  situation 
consistent with a combined effect of negative demand and supply shocks emerges.   Demand 
for loans is subdued because of the macro-economic environment, deleveraging pressures in 
the  non-financial  private  sector  and  uncertainty  weighing  on  investment  decisions.    Supply 
factors are contributing as well. Access to finance is particularly problematic for SMEs and 
start-ups in several Member States. According to the most recent edition of the ECB SAFE 
survey, access to bank loans continued to deteriorate in the euro area and rejection rates when 
applying for a bank loan increased to 15%. Almost one out of five firms (18%) reported that 
access to finance is their main problem. Despite the significant improvement in the sovereign 
bond yields and decline in funding costs for banks in countries under stress, the retail lending 
rates charged by bank to non-financial corporations and households have not yet significantly 
fallen  and  companies  and  households  in  some  vulnerable  countries  are  still  charged 
significantly higher rates for borrowing than their peers in core countries (see Figure 6). This 
demonstrates that the Single Market for finance is currently significantly fragmented. 

Figure 6 Retail interest rates: Loans to NFCs with an initial rate of fixation of less than 
one year up to EUR 1 million, % 

8

7

6

5

4

3

2

1

NL
FR
EA

DE
AT

A

B

C

D

8

7

6

5

4

3

2

1

PT
ES
IE

EL
IT
EA

A

B

C

D

0
200 3

200 5

200 7

200 9

201 1

201 3

0
200 3

200 5

200 7

200 9

201 1

201 3

Source: ECB Notes: A: Crisis outbreak; B: Lehman Brothers; C: First Greek programme; D: Sovereign contagion. Last 
data: January 2013. 

Since the financing conditions of the sovereign are correlated to those of the banks and 
feedback  loops  exist  between  the  financing  conditions  of  sovereigns  and  the  respective 
private  sector,  a  more  contained  sovereign  risk  should  via  bank  intermediation  feed 
through in the cost of credit to the economy as a whole. Recent analysis suggests that the 
variation  in  lending  conditions  to  the  non-financial  private  sector  is  not  only  driven  by  the 

19 

 
 
 
sovereign  funding  cost  and  the  leverage  of  the  private  sector  but  also  by  the  health 
characteristics  of  the  national  banking  systems11.  The  quality  of  the  loan  portfolios,  the 
profitability and the size of capital buffers of the national banking system contributed to the 
dispersion of bank lending rates at the country level (see Figure 7). This suggests that at the 
current juncture, higher lending rates may reflect the need to partially offset current or future 
losses  suffered  on  impaired  assets.  Therefore,  further  bank  balance  sheet  repair  (see  above) 
should lead to a normalisation of lending conditions in countries under stress. On top of that, 
the Single Market should be enforced, also in the short term. 

11  

European  Commission  (2013),  ‘Drivers  of  diverging  financing  across  member  states’,  Quarterly 
Reporton the Euro Area, volume 12 issue 1. 

20 

 
                                                 
Figure 7 Correlation’s between composite MFI lending rate to the non-financial private 
sector and 10 year government bonds yields, non-performing loans, return on assets and 
tier 1 capital  

Source: ECB 

The  subdued  supply  of  bank  lending,  has  led  to  a  diversion  of  financing  to  market 
financing.  Over  the  last  12  months  corporate  bond  issuance  in  the  euro  area  amounted  to 
the  euro  area  as  a  whole,  the  amount  of 
€117bn,  an  increase  by  +13.3%  year-on-year.  For 
bond issuance more than offsets the decline in net lending flows over the same period which 
amounts  to  -€70bn  once  adjusted  by  sales  an d  securitisation.  When  summing  up  the  two 
sources  of  financing,  it  emerges  that  the  total  funding  to  the  non-financial  corporate  sector 
remained  positive  over  the  last  12  months  in  the  euro  area  (+€47bn).  However,  in  some 
countries  deep  declines  in  lending  volumes  have  not  been  made  up  by  an  increase  in  bond 
issuance (see Figure 8). This could be due to weak demand for credit and/or the fact that these 
bond  markets  are  not  well  developed.  Moreover,  SMEs  or  households  do  not  have  direct 
access to market financing.   

21 

 
 
-
1
0
%

-
0
5
%

0
0
%

0
5
%

1
0
%

1
5
%

2
0
%

S
o
u
r
c
e
:

E
C
B

Austria

Belgium

Cyprus

Germany

Estonia

Spain

Finland

France

Greece

Italy

Luxembourg

Malta

Netherlands

Portugal

Slovenia

Slovakia

Euro area

2
2

F
i
g
u
r
e
8
C
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t
r
i
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t
i
o
n
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l

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n
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a
l

c
r
e
d
i
t

g
r
o
w
t
h
,

J
a
n
u
a
r
y

2
0
1
3

B
a
n
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L
e
n
d
n
g

i

B
o
n
d

I
s
s
u
a
n
c
e

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
At  this  moment  when  lending  volumes  in  Europe  are  declining,  especially  in  the  long-
maturity  segment  of  the  business  and  in  the  more  vulnerable  countries,  the  paid-in 
capital of the EIB has been increased by EU Member States by 10 billion which would 
allow an increase in lending for the EU-27 as a whole by about 20 billion for each of the next 
three  years.  The  annual  lending  will  be  equally  distributed  for  strategic  infrastructure, 
research, development and innovation, climate action and SMEs. In the countries under stress 
the  EIB  has  developed  a  partnership  with  the  EU  where  the  EIB  lending  is  combined  with 
some  risk  sharing  by  the  EU  budget.  In  Greece  for  example,  the  EIB  installed  a  EUR  500 
million trade finance facility for the first time to support a trade volume of EUR 1.5 billion 
per year.   In Portugal the EIB signed an innovative Portfolio State Guarantee, which provides 
for a lending envelope of up to EUR 6 billion over the next years.  

A number of other initiatives could be considered to ease SMEs access to bank and non-
bank financing in the EU and the euro area.12 These include the development at EU and 
Member  State  level  of  measures  aimed  at  improving  the  framework  for  venture  capital, 
dedicated  markets  for  SMEs  and  SME  pooling,  new  securitisation  instruments  for  SMEs, 
setting  up  standards  for  credit  scoring  assessments  of  SMEs  and  promoting  non-traditional 
sources of finance such as leasing, supply chain finance or crowd funding.   

2.3. 

Structural measures promoting growth and competitiveness 

Deleveraging and rebalancing 

Deleveraging  in  the  non-financial  private  sector  is  ongoing,  notably  in  vulnerable 
Member States as shown in Figure 9, but there is still a long way to go. Large drops in 
firm  leverage  can  be  identified  in  Spain,  Estonia,  Greece  and  Malta,  and  in  households' 
leverage in Ireland, Estonia, Spain and Portugal. Significant increases on the other hand can 
be observed in France, Finland and Belgium (in both household and firm leverage). Countries 
more prone to face credit market pressures13 seem to share, however, a deleveraging process 
characterized  by  simultaneous  disrupted  credit  markets  and  economic  recession:  negative 
GDP  growth  and  negative  net  credit  flows.  Looking  ahead,  a  well-capitalised,  viable  and 
stable financial system appears to be of critical relevance to minimise any spread of contagion 
effects from private sector deleveraging to the rest of the economy and to guarantee adequate 
credit  provision  so  that  firms  and  households  willing  to  borrow  are  able  to  do  so  at  an 
adequate cost. The search for growth drivers is also of critical importance to the extent that 
those  drivers  are  able,  at  least  partially,  to  offset  the  transitory  fall  in  domestic  demand 
underlying the deleveraging in the private sector. This is of particular relevance in the current 
circumstances as the room for manoeuvre by the public sector to attenuate the negative impact 
on  economic  activity  is  extremely  limited  in  countries  whose  public  sector  is  also  highly 
indebted and for which sovereign yields have increased significantly during the crisis. 

12 See Green Paper on the Long Term Financing of the European Economy, COM(2013) 150 final 
13  

See "Assessing the private sector deleveraging dynamics", Quarterly report on the euro area, Volume 12 
Issue 1, March 2013. 

23 

 
 
 
 
 
                                                 
Figure 9 Decomposition of y-o-y changes debt-to-GDP ratio euro area countries  

Rebalancing in the euro area is progressing, although most of the adjustment has taken 
place  on  the  side  of  the  deficit  countries  (see,  for  example,  Buti  and  Turrini,  201214  and 
Commission,  201215;  see  Figure  10).    Faster  adjustment  in  deficit  than  in  surplus  countries 
implies  a  positive  bias  for  the  euro  area  saving-investment  balance.  This  achievement  is  in 
line  with  the  assessment  of  euro  area  structural  features  -  ageing,  high  income  per  capita 
levels, need for fiscal consolidation and private sector deleveraging in many Member States -, 
which also suggest a moderate surplus for the euro area. In the deficit countries, private sector 
deleveraging  and  fiscal  consolidation  has  led  to  a  compression  in  consumption  and 
investment,  and,  therefore,  imports  although  enhanced  competitiveness  is  also  an  important 
determinant  behind  the  improvement  of  exports.  The  external  balances  of  several  Member 
States in surplus have been declining in 2011 but have gone up again in 2012 and, according 
to the Spring Forecast, are expected to stabilise or decline very gradually in the years to come.  
The rise in the current account surplus last year might have been caused by safe haven-effects. 
In  contrast,  returning  confidence  in  foreign  financial  assets,  along  with  dissipating 
uncertainty,  should  contribute  to  reducing  the  surplus  by  bolstering  investment  and 
consumption. Moreover, low interest rates, relatively dynamic wage increases and relatively 
robust  labour  market  developments  should  continue  to  underpin  housing  investment  and 
private consumption. Nonetheless, there remain two main bottlenecks that hold back a more 
symmetric rebalancing process. The private sector of some of the surplus countries is heavily 
indebted with the on-going deleveraging weighing on domestic demand. Also, in a number of 
surplus  countries,  productivity  growth  in  the  services  sector  is  low  as  restrictive  regulation 
and a weak enforcement of competition in the services sector hold back investment, and the 
associated productivity gains.  

14  

15  

Buti,  M.  and  A.  Turrini  (2012),  'Slow  but  steady?  External  adjustment  within  the  Eurozone  starts 
working', VoxEU.org, 12 November. 
European Commission (2012), 'Current Account Surpluses in the EU,' European Economy, 9. 

24 

 
 
                                                 
Figure  10  Current  account  balance  in  the  euro  area  and  euro  area  surplus  and  deficit 
countries, current account by partner  

Source: Commission Services 

Source: Commission Services 

Going  forward,  the  adjustment  in  intra  euro  area  imbalances  seems  durable  as  it  is 
dominated by non-cyclical components. First, the dynamism in exports by deficit countries 
is expected to continue, as structural reforms and reduction in production costs progressively 
translate  in  competitiveness  gains.  Second,  a  substantial  part  of  the  contraction  in  domestic 
demand  in  vulnerable  countries  is  also  of  non-cyclical  nature,  to  the  extent  that  pre-crisis 
growth  in  domestic  demand  was  driven  by  excessive  credit  inflows,  unrealistic  income 
expectations and speculative frenzy in asset markets. The downside of the latter development 
lies  in  its  lasting  impact  on  potential  output,  as  vulnerable  economies  reallocate  their  factor 
endowments among sectors.  

Since 2009, the pre-crisis trend of strong increases in the prices of non-tradables, in the 
deficit  countries,  has  been  discontinued.  The  prices  of  non-tradables  lost  dynamism  or 
have  fallen  relative  to  export  prices.  The  reduction  in  domestic  demand  and  the  fall  in  the 
prices  of  non-tradables,  relative  to  tradables,  provide  an  incentive  for  firms  to  divert  their 
production capacity to exports and contributes to the reallocation of labour and capital from 
the  non-tradable  sectors  (like  construction  and  public  administration)  to  the  export-oriented 
industries. However, the pace of the intersectorial allocations depends heavily on the degree 
of domestic competition and on the existence/absence of barriers to the entry and exit of firms 
in the different sectors. Product market reforms (addressed below) have, therefore, a role in 
improving  competition  and  providing  the  appropriate  business  environment  for  these 
reallocations  to  happen.  Moreover  the  availability  of  financing  for  productive  investment  is 
also critical for a smooth adjustment in the productive structure of economies. 

Structural reforms in product and service markets 

Structural reforms in product and service markets play a crucial role not only by setting 
the  basis  for  long-term  sustainable  productivity  gains,  but  also  by  generating  positive 
effects already in the short term through a number of different channels. As pointed out 

25 

 
 
by OECD (2012)16, positive confidence and wealth effects could stem from expected changes 
in future incomes, driven by reforms. This, in turn, could foster private investment and ease 
financial  constraints,  via  improved  collateral.  A  positive  effect  on  interest  rate  spreads  on 
sovereign  debt,  to  the  benefit  of  indebted  countries,  could  also  be  achieved  if  structural 
reforms are perceived by financial markets as credible. In general, credibility is the keyword 
to prompt these short term effects: reforms should not remain on paper but need to be rapidly 
and  fully  implemented.  Next  to  these  confidence  effects,  structural  reforms  in  product  and 
services  markets,  by  improving  the  adjustment  capacity  and  flexibility  of  the  economy, 
facilitate  the  transmission  throughout  the  economy  of  measures  in  other  key  areas  such  as 
labour markets. In this context it is particularly important to identify a package of product and 
labour market reforms that is complementary.. Furthermore, in order to minimise the impact 
of private sector balance-sheet restructuring on economic activity and financial stability, the 
search for growth drivers is of critical importance to the extent that those drivers are able, at 
least  partially,  to  offset  the  transitory  fall  in  domestic  demand.  Finally,  structural  reforms 
assume  particular  relevance  by  guaranteeing  a  durable  rebalancing  process  but  also  by 
attenuating  the  negative  impact  of  deleveraging  and  ensuring  the  right  conditions  for 
sustainable economic growth.  

Structural  reforms  enhancing  competition  by  further  market  opening,  particularly  in 
the  services  sector  and  network  industries  are  of  particular  importance.  In  order  to 
increase firm-level and aggregate productivity growth, entry/exit barriers should be removed 
to improve competition and let more innovative firms enter the market. An environment fully 
supportive of a reallocation process would thus ensure that resources are channelled towards 
the most productive and innovative firms or sectors, while the least efficient ones reduce their 
size  and  eventually  exit.    Recent  evidence  (Andrews  and  Cingano,  2012)17  shows  that  this 
process  does  not  work  evenly  across  the  euro  area,  as  the  contribution  of  the  allocation  of 
employment across firms to labour productivity in manufacturing swings between around -5% 
in  Greece  and  +70%  in  Finland  (compared  to  a  baseline  scenario  where  employment  is 
allocated randomly). Significant margin for a productivity-enhancing reallocation of resources 
still  exists  in  some  Member  States  (especially  in  Southern  and  Continental  Europe).  In 
particular, removing unjustified restrictions to entry in sectors such as retail trade, regulated 
professions,  network  industries  and  business  services,  would  contribute  to  enhancing 
competition and would facilitate reallocation.  

Product  market  reforms,  by  fostering  competition  and  reducing  excessive  rents  in 
protected  sectors,  would  provide  incentives  to  increase  the  efficiency  of  production 
processes and of resource allocation. Under increased competition, prices and margins come 
under  pressure.  While  accelerating  reallocation  of  resources,  this  will  provide  incumbents 
with incentives to make their production processes more efficient, in order to defend market 
shares  and  profit  rates.  At  the  same  time,  increased  competition  can  foster  product  and 
process innovation (insofar as innovative firms are able to appropriate rents from innovation, 
which highlight the importance of a well-functioning intellectual property rights system) and, 
ultimately,  boost  productivity  growth.  Gains  from  more  efficient  production  are,  in  turn, 
spread  throughout  the  economy.  This  is  especially  true  in  sectors,  such  as  services  and 
network  industries,  whose  output  largely  contributes  as  intermediate  input  in  other  sectors. 
Reforms increasing productivity in the former sectors, which are typically non-tradable, might 
then  have  significant  spill-over  effects  on  productivity  in  tradable  sectors  (such  as 

16  
17  

OECD (2012). Economic Policy Reforms 2012. Going for Growth. Paris, OECD. 
Andrews, D. and F. Cingano (2012), “Public Policy and Resource Allocation: Evidence from Firms in 
OECD countries”, OECD Economics Department Working Papers, No.996, OECD, Paris. 

26 

 
                                                 
manufacturing),  to  the  benefit  of  deficit  countries.  An  ambitious  implementation  of  the 
Services  Directive,  for  which  the  transposition  record  seems  rather  mixed,  is  an  important 
element of this type of reforms.   

During  the  last  year  several  Member  States  in  the  euro  area  have  undertaken  key 
structural reforms in product and service markets. The reform effort has been substantial 
in  countries  under  financial  assistance  programmes  and/or  under  market  pressure  (i.e.,  the 
vulnerable  countries).  Liberalisation  measures  have  been  adopted,  although  to  a  different 
extent,  in  network  industries  (e.g.  in  Greece,  Italy,  Portugal  and  Spain)  and  other  service 
sectors  (e.g.  in  Greece,  Ireland,  Italy  and  Portugal).  Reforms  in  the  competition  framework 
(e.g., revision of the Competition law and increased resources for the Competition authorities) 
have been implemented in Austria, Belgium, Finland, Ireland, Luxembourg and Portugal. Still 
a strong reform effort is needed in this area, in particular as concerns the reduction of barriers 
in  professional  services.  In  Austria,  Belgium,  France,  Germany,  Italy  and  Slovenia,  the 
untapped potential from opening access to regulated professions is still considerable. Finally, 
reforms  of  the  housing  and  rental  markets  are  also  ongoing,  notably  in  Spain,  Portugal  and 
Ireland,  aiming,  inter  alia,  to  reduce  the  incentives  for  households  to  build  up  debt  and  to 
foster labour mobility. 

Improving  the  regulatory  environment  in  which  EU  industry  and  enterprises  operate, 
would lead to competitiveness gains and enhance firm's ability to grow and create jobs. 
Business  environment  conditions  can  contribute  to  the  smooth  exit  of  less  efficient  firms. 
Firms' exit would be favoured by business-friendly bankruptcy legislations, striking the right 
balance  between  protection  of  creditors  (aiming  at  increasing  their  recovery  rate)  and  the 
reduction of exit costs for entrepreneurs (allowing a fast discharge of their debt in view of a 
"second chance" for good business plans). Allowing for out-of-court settlements and ensuring 
reasonable time to complete legal procedures in the case of business failure are crucial to this 
aim.  In  addition,  companies  that  would  have  failed  under  normal  market  conditions  should 
not  be  kept  artificially  alive  in  order  not  to  put  a  break  to  the  needed  adjustment  of  the 
economy,  while  taking  into  account  the  social  impact  of  such  reallocation  process  by  well-
designed  accompanying  measures.  Improving  the  business  environment  would  also  imply 
taking  actions  to  increase  the  efficiency  and  transparency  of  the  public  administration, 
through  administrative  simplification  at  all  levels  of  government,  thereby  reducing 
administrative  burden,  and  adopting  measures  to  improve  the  efficiency  of  civil  justice.  By 
decreasing  costs,  time  and  uncertainty  of  doing  business,  measures  in  these  fields  could 
increase  the  efficiency  of  operating  firms,  translating  into  lower  prices  and  higher 
productivity, while creating favourable conditions to attract investment and promote the entry 
of  new  firms.  Reforms  aimed  at  reducing  administrative  burden,  modernising  public 
administrations  and  making  civil  justice  more  efficient  have  been  taken  recently  in  several 
euro area Member States, notably Greece, Italy, Portugal and Spain. However, these countries 
need  to  continue  their  efforts,  given  the  large  gap  with  respect  to  better  ranked  Member 
States.    Reforms  in  the  area  of  public  administration  and  business  environment  are  also 
recommended in countries such as Estonia, Finland, France, Slovakia and Slovenia. 

Labour markets  

Labour  cost  developments  have  been  broadly  supportive  of  the  rebalancing  of  current 
accounts in the euro area.  Where surplus countries growth of unit labour costs (ULC) and 
nominal  compensations  per  employees  has  increased  recently,  both  ULC  and  nominal 
compensations per employee started growing at lower pace in countries characterised by high 
current account deficits at the moment of the crisis (see Figure 11). Over 2007-2012, the fall 
in  unit  labour  costs  compared  with  competitors  (i.e.  the  ULC-based  real  effective  exchange 

27 

 
rate)  has  been  significant  for  vulnerable  countries  like  Ireland,  Greece,  Spain  and  Portugal, 
even if the process of rebalancing would require some further effort in Greece and, to a minor 
extent,  in  Portugal  (see  Buti  and  Turrini  201218).  Looking  forward,  the  process  of  wage 
adjustment  will  be  further  supported  by  ongoing  reforms,  especially  of  wage  setting,  in 
countries such as Greece and Spain. In Greece, for example, wage setting has become more 
decentralised,  the  favourability  clause  for  firm-level  collective  contracts  and  the  extension 
mechanism for sectoral collective contracts have been suspended and greater room created for 
work councils to conclude firm-level agreements. Similarly, in Spain, it has become easier to 
conclude firm-level agreements that derogate from sectoral contracts. Nevertheless, it should 
be also noted that the fall in nominal compensations was not always accompanied by a change 
in the  same direction of the consumer price index, whether because of limited pass-through 
from  the  labour  to  the  product  market  (due,  for  example,  to  not  insufficiently  competitive 
conditions on product markets) or growing non labour costs (i.e. taxes, capital costs, energy, 
see  also  box  above),  thereby  posing  a  constraint  on  the  potential  improvement  in  cost 
competitiveness. 

Figure 11 Unit labour costs and nominal compensation per employees in surplus deficit 
countries in the euro area 

5

4

3

2

1

0

-1

-2

-3

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Compensation - Surplus c.

Compensation - Deficit c.

ULC - Surplus c.

ULC - Deficit c.

Surplus countries: BE, DE,   LU, NL,  AT, FI.
Deficit countries: EE,  IE, EL, ES, FR, IT, CY, MT,  PT, SI, SK.

Source: Commission Services 

18  

Buti,  M.  and  A.  Turrini  (2012),  'Slow  but  steady?  External  adjustment  within  the  Eurozone  starts 
working', VoxEU.org, 12 November. 

28 

 
 
 
 
 
 
                                                 
Labour  cost  developments  are  also  indicative  of  an  initial  process  of  reallocation  of 
resources.  In  vulnerable  countries,  nominal  wages  in  the  non-tradable  sector  fell  somehow 
more  significantly  than  those  in  the  tradable  sector  (e.g.,  Buti  and  Turrini,  2012;  European 
Commission, 2012), a tendency that provides for the necessary conditions for labour moving 
towards the tradable sector. This reallocation is key for a sustainable improvement of external 
positions  in  countries  that  have  accumulated  largely  negative  net  investment  positions  over 
the  past  years.  However,  the  process  of  labour  reallocation  needs  to  be  supported  by  more 
fluid  labour  markets.  In  some  countries,  still  rigid  and  segmented  labour  markets  are  by 
themselves  obstacles  to  the  process  of  reallocation,  especially  of  the  re-employment  of 
workers that have been made redundant during the adjustment, who now face significant entry 
barriers  back  into  the  labour  market.  Reforms  enhancing  labour  market  adjustment  and 
reducing labour market segmentation have been recently enacted or are ongoing in many of 
the  euro  area  countries  that  were  characterised  by  less  flexible  regulatory  settings.  Exit 
flexibility  was  enhanced  in  countries  that  have  been  historically  characterised  by  stringent 
Employment  Protection  Legislation  (EPL).  Spain  adopted  reforms  in  2010  and  2011  on  the 
definition  of  fair  dismissal  and  the  size  of  severance  pay.  In  Italy,  the  June  2012  labour 
market reform aimed to improve exit flexibility by revising the rules on dismissals – namely 
by limiting the scope  for  reinstatement, capping back-wages due in  case of  unfair dismissal 
and  accelerating  the  dispute  settlement  process  –  while  better  regulating  flexibility  at  entry 
through  the  introduction  of  disincentives  against  temporary  and  atypical  contracts.  Slovenia 
has  approved  a  labour  market  reform  that  exempts  employers  from  having  to  look  for 
alternatives in case of dismissal. A reform that  partially  softens protection  for workers with 
permanent contracts, whilst providing for security along the lines of the flexicurity model is 
under way in France.  It is paramount to preserve the reform momentum on labour markets 
and  implement  the  enacted  reforms.  Furthermore,  this  momentum  can  be  added  to  by 
ambitious  implementation  of  measures  facilitating the  free movement of workers within the 
Internal Market.  

The  scope  of  the  correction  in  the  relative  prices  of  tradable  and  non-tradable  sectors 
depends on the degree of pass-through from labour costs to prices, and thus inter alia on 
the degree of competition and firms' market power in the different sectors. To the extent that 
euro area vulnerable economies  are price  takers in most international markets, the observed 
significant reduction in labour costs, will mostly translate into higher profits and margins for 
the firms in that sector and the impact on export prices may be relatively weak. The increase 
in margins, and therefore the incomplete pass-through, supports the rebalancing process as it 
incentivises  the  reallocation  of  resources  towards  the  tradables  industry  or  by  shifting 
production  capacity  (made  available  because  of  the  contraction  in  domestic  demand). 
Nevertheless,  on  the  non-tradables  sector,  the  incomplete  pass-through  is  a  potential  reason 
for concern as it may indicate lack of competition in specific sectors. A reduction in the prices 
of non-tradables as a reaction to reductions in labour costs increases the economic efficiency. 
By dampening the impact that the reduction in labour costs has on the real disposable income, 
it also reduces the social hardship and avoids a steeper fall in domestic demand. Moreover, a 
decline  in  prices  of  non-tradables  reduces  production  costs  in  the  exporting  firms  and 
therefore also contributes to the external rebalancing of the economy.  

29 

 
 
 
 
Figure 12 Real unit labour cost dynamics and unemployment 

)
2
1
-
0
1
0
2

e
g
n
a
h
c
%

(

t
s
o
C
r
u
o
b
a
L

t
i
n
U

l

a
e
R

4

2

0

-2

-4

-6

-8

-10

-12

-14

DE

LU

NL

0

AT

5

MT

SI
CY

BE

FR

IT
10
FI

20

25

EE

ES

15

SK

PT

IE

EL

Unemployment rate 2010

Source: Commission Services 

Real  wage  developments  are  also  contributing  to  reducing  unemployment  divergences. 
The  crisis  had  largely  asymmetric  effects  on  euro-area  Member  States’  output  and 
employment. The countries most hit were those with the most severe compression of domestic 
demand  linked  to  current  account  reversals.  Countries  with  large  current  account  deficits  at 
the start of the crisis tend now to have much higher unemployment (e.g. Greece, Spain). The 
fact that the dynamics of unit labour costs and wages is currently more subdued in this group 
of countries therefore bodes well not only for the rebalancing of external positions but also for 
reducing unemployment divergences within the euro area. As shown in Figure 12, countries 
with higher unemployment in 2010 are witnessing a slower growth in real unit labour costs, 
which points at real wages growing below labour productivity. This process should help the 
absorption  of  large  unemployment  pools  recorded  in  some  countries,  even  though  it  can  be 
questioned if the speed at which real wages are adjusting is commensurate with the size of the 
challenge in some countries. 

The risk exists that unemployment becomes increasingly structural. In the absence of an 
effective  and  quick  absorption  of  cyclical  unemployment,  hysteresis  effects,  whereby 
unemployment  becomes  entrenched  and  less  sensitive  to  wage  dynamics,  may  materialise. 
Structural unemployment has significantly increased in some euro area countries. This would 
imply a loss of human capital and a reduction of the potential contribution of labour to growth 
looking forward. Tackling the risk of hysteresis requires tax and benefit systems and Active 
Labour Market policies providing incentives for the jobless to take up work, and creating an 
efficient infrastructure for matching on the labour market (e.g. effective Public Employment 
Services,  adequate  opportunities  for  training  and  re-training).  Moreover,  the  use  of  well-
designed job subsidies could help supporting labour demand for worker categories at risk of 
long-term unemployment and exclusion from the labour force (e.g. youth or displaced older 
workers). 

30 

 
 
 
 
 
 
 
 
 
Growth and jobs

Competitiveness

Public Finances

GDP per 
capita in 
PPS

GDP 
growth 
forecast

Employ-
ment 
rate

Long-
term 
unemplo
y-ment* 

Youth 
unemp-
loyment 
(<25)* 

Labour-
force 
partici-
pation 
rate* 

Nominal unit labour costs* 

Whole 
economy

Services

Manufa
c-turing

Nominal 
compensation per 
employee 

Non 
Market 
Services 
***

Private 
Sector 
****

Current 
account 
balance* 

Level, 
EU27=1
00

Annual 
rate of 
change

Age 
group 15-
64

% of active 
population

%

Annual rate of change

% of 
GDP 

Market 
share of 
exports 
(goods + 
services
)*  

 % of 
world 
total - 5 
year 
change

 General 
govern-
ment

debt* 

General 
govern-
ment 
budget 
position
* 

Overall 
tax 
burden

Sustai-
nability 
indicator 
(S2)* 

Average 
exit age 
from the 
labour 
force* 

Life 
expecta
ncy* 

Private 
debt*

Financial Stability
Long 
term 
interest 
rate 
spread 
vis-à-vis 
German
y

Doubtful 
and Non-
performi
ng loans 
(All 
Banks)

Return 
on 
equity 
(All 
Banks)

% of GDP

Total 
taxes as 
% of 
GDP

High 
figure = 
weak 
sustain-
ability

2010 or 
latest 
available

At 60 
years

% of 
GDP

%

Percenta
ge points

%

2011

2013

2012

2012

2012

2012

2012

2012

2012

2012

2012

2012

2012

2012

2012

2011

2012

2011

119
121
67
129
79
98
108
100
94
271
85
131
129
77
84
73
114
108
100

0
0.4
3
1.1
-4.2
-1.5
-0.1
-1.3
-8.7
0.8
1.4
-0.8
0.6
-2.3
-2
1
0.3
-0.4
-0.1

BE
DE
EE
IE
EL
ES
FR
IT
CY
LU
MT
NL
AT
PT
SI
SK
FI
EA 
EU

61.8
72.8
67.1
58.8
51.3
55.4
63.9
56.8
64.6
65.8
59
75.1
72.5
61.8
64.1
59.7
69.4
63.8
64.2

3.4
2.5
5.5
9.1
14.4
11.1
4.1
5.7
3.6
1.6
3
1.8
1.1
7.7
4.3
9.4
1.6
5.3
4.6
* Variables mentioned in  the European Council conclusions of March 2011. 
** Income statement data for domestic medium and small banks and foreign-controlled institutions in Germany is not available. 
*** ISIC Rev. 3 Codes L-P. 
**** ISIC Rev. 3 Codes A-K 
Sources: Commission services, Commission Spring Forecast, Eurostat and ECB  

99.6
81.9
10.1
117.6
156.9
84.2
90.2
127
85.8
20.8
72.1
71.2
73.4
123.6
54.1
52.1
53
92.7
85.4

5.1
4.9
:
:
-16.7
0.1
:
:
2.2
:
:
1.7
3.1
:
1.4
-7.5
3
:
:

-15.6
-12.6
6.9
-15.6
-26.9
-14.1
-14.1
-23.3
-26.2
-19.7
2.7
-11.6
-20.4
-15.4
-19.5
4.8
-31.2

66.9
77.1
74.9
69.2
67.9
74.1
71
63.7
73.5
69.4
63.1
79.3
75.9
73.9
70.4
69.4
75.2
72
71.8

22
7.9
19.8
29.5
58.4
55.3
25.5
37.1
31.8
18.6
14.5
10
9
38
23.2
35
19.5
23.7
23.3

4.3
2.3
:
:
-4.4
-2.9
:
:
-0.3
:
:
1.3
5.2
:
1.1
-0.4
3.2
:
:

0.9
6.4
-3.1
5
-5.3
-0.9
-1.8
-0.5
-4.8
5.6
-0.8
8.2
3
-1.9
2.7
2
-1.6
1.8
0.9

3.7
2.9
5.6
0.2
-6.2
-3.4
1.7
2.3
-0.1
3.2
3.7
1.3
3.4
-3.8
0.7
0.1
3.6
1.4
1.8

3.1
2
:
:
-4.1
-2.3
:
:
1.3
:
6
1.2
2.9
:
-3.3
2.9
2.4
:
:

3.5
2.7
:
:
-4.7
0.5
:
:
1.8
:
1.1
1.1
3.1
:
0.4
1.6
3.5

:
:

-3.9
0.2
-0.3
-7.6
-10
-10.6
-4.8
-3
-6.3
-0.8
-3.3
-4.1
-2.5
-6.4
-4
-4.3
-1.9
-3.7
-4

46.7
40
33
30.4
34.9
32.4
45.9
42.8
35.2
38.1
35.1
39
43.7
36.1
37.5
28.8
43.6
40.8
40

7.4
1.4
1.2
:
:
4.8
1.6
-2.3
8.2
9.7
5.8
5.9
4.1
:
7.6
6.9
5.8
2.1
2.6

23.8
23.8
21.5
23.5
23.8
25.1
25.8
25.1
23.6
23.8
23.6
23.9
24.1
24.2
23.3
20.4
23.9

61.6
62.4
62.6
64.1
61.5
62.3
60.2
60.4
62.8
59.4
60.5
63.5
60.9
62.6
59.8
58.8
61.7
61.4 23.9 (2008
61.5

23.7

2011/20
12
241
128
133
310
130
218
160
129
289
326
210
225
161
256
128
76
179
:
:

Jun-12 Mar-12

Jun-12

4.6
1.9
4.1
:
15.6
6
4.6
10.2
13.9
:
1.6
2,6
4.3
6.5
:
3.8
0.8
:
:

0.9
:
:
2.5
10
3.6
0.7
3.3
5.7
0.2
2.2
0.3
0.4
4.8
3.7
2.6
0.3
1.7
1.6

3.2
4.5**
17.3
-14.2
:
-5.2
7.1
1.9
-40.4
8.7
5.7
5.7
8.3
0.9
-0.7
8.9
9.5
:
:

31