COMMISSION STAFF WORKING DOCUMENT Assessment of the 2014 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: 2014-06-02
Institutions: European Commission
Subjects: budget deficit, economic convergence, economic growth, economic recovery, economic reform, economic stabilisation, euro area, financial control, job creation, stability programme, structural adjustment













EUR-Lex - 52014SC0401 - EN











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52014SC0401

COMMISSION STAFF WORKING DOCUMENT Assessment of the 2014 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 /* SWD/2014/0401 final */









Contents
Executive summary. 3
1............ Introduction. 5
2............ Assessment of euro area challenges and
policy agenda. 5
2.1......... Structural reform policy. 5
2.2......... Fiscal policy. 11
2.3.........  Financial sector policy. 15

Executive summary 

There are
genuine signs that a lasting recovery is now taking place in euro area.
Recovery, although fragile, is gradually gaining strength and spreading across
the EU. Growth turned positive in a large majority of Member States over the
course of last year and the outlook has improved even in the more vulnerable
ones. Real GDP growth in the euro area is projected to advance with moderate
momentum in 2014 before gaining further speed in 2015. Labour market conditions
have started to improve and unemployment should continue to decline albeit very
gradually in most Member States. The aggregate
fiscal picture for the euro area has continued to improve as the large
consolidation efforts implemented in difficult economic conditions in recent
years are now bearing fruit. 
However, high
public and private debts and related deleveraging pressures in a subdued
inflation environment, weak possibilities for productive investment under a
recovering and fragmented financial system and unacceptably high levels of
unemployment are a legacy of the crisis and create challenges for returning
from fragile recovery to strong and sustainable growth and jobs. In meeting
these challenges, the high level of interconnectivity and potentially large
spillovers between euro area Member States continues to put a specific
responsibility on them to take ambitious and coordinated action in those areas
of particular importance for a well-functioning EMU.
Both
euro area Member States and the EU institutions have made significant progress
to implement the 2013 euro area recommendations. Member States, especially
vulnerable ones, have continued with fiscal consolidation and structural
reforms, while at EU level significant steps have been taken to deepen the EMU,
notably in the area of Banking Union, and in the application of the
strengthened economic and budgetary governance framework. However, the
implementation of specific recommendations for individual euro area Member States
and the euro area as a whole is incomplete and challenges remain. For the euro
area Member States ambitious and coordinated action is needed in a number of
areas; 
·        
Structural reform policy; Rebalancing in
the euro area is ongoing, but has been asymmetric and there has not been
progress in adjustment of current account surpluses. Deleveraging
in the private sector has still a long way to go in many euro area Member
States.  And levels of unemployment remain elevated, in some euro area
Member States to unacceptably high levels. Given the high interconnectivity in
the euro area, ambitious structural reform action remains needed to ensure the
well-functioning of EMU, promote convergence and further mitigate risks for
stability, future growth potential and social cohesion in the euro area taking
the potentially large spillovers of such reforms into account.  . 
·        
Fiscal policy: thanks to the large
efforts in the past years fiscal consolidation can proceed on a more gradual
pace. However, continued effort is needed to decrease high debt levels and move
towards Medium Term Objectives. Making the adjustment as growth-friendly as
possible, which implies a more growth-friendly mix of spending and revenues and
increased efficiency of spending, is essential.  Euro area Member States have a
specific responsibility in this regard in the light of ensuring an appropriate
overall euro area policy stance and the potentially large spillovers between
euro area Member States related to the sustainability of public finances.  
·        
Financial sector: access to finance,
notably for SMEs remains challenging in many euro area Member States which
risks undermining the economic recovery as well as the proper functioning of
EMU. Risk of a funding gap for productive investment remains acute, against the
backdrop of continuing deleveraging pressures and still significant market
fragmentation which is hampering the proper functioning of EMU. Next to the
creation of banking union, a number of initiatives related to financing the
long term economy are needed. Further repairing banks' balance sheets and
continuing the strengthening of equity buffers, where needed, will further
contribute to repairing the credit channel. 

1.        
Introduction  

The
euro area's economic recovery, which began in the second quarter of 2013, is
expected to continue to spread across countries and gain strength while at the
same time becoming more balanced across growth drivers. As is typical following
deep financial crises, however, the recovery remains fragile. In this context,
the nature of the challenges the euro area faces is changing. Just a few years
ago, the main policy issues related to establishing budgetary credibility with
rampant deficits and swiftly increasing public debt; stopping the negative
feedback loops between sovereigns and the banking sector and fixing problems of
the real economy which was characterised by unsustainable current-account
deficits, worrying losses in competitiveness, increasing private debts, and
high housing prices. Ambitious policy action both on EU and Member States' level has moved the euro area beyond this. The main challenges of the euro area
now concern the lingering impact that deleveraging pressures in many countries
have on medium-term growth and unacceptably high levels of unemployment and
inequality; the sustainability of private and public debts in a context of
competitive disinflation; the need to provide credit to viable investments in
the vulnerable economies under a recovering financial system These
should not be seen in isolation but as a complex system of interacting economic
variables, underscoring the importance of a consistent and coordinated policy
mix of the national and euro area level policies.  
In
the following section the specific policy agenda for the euro area in ensuring
a well-functioning EMU is assessed with specific attention to the the issues of
structural reform, fiscal policy and policies related to the financial sector.

2.        
Assessment of euro area challenges and policy
agenda 


2.1.                
Structural reform policy 

The rebalancing
in the euro area is on-going and well advanced. Significant
adjustment has taken place in the countries in the euro area periphery, which
experienced high current account deficits prior to the start of the financial
crisis. These vulnerable countries as a group actually recorded a surplus of
around 1.3% of their GDP in 2013, which is expected to further increase to 2.0%
in 2015. A large share of this adjustment is non-cyclical and as such will not
dissipate once the overall economic situation improves. It has been driven by
both structural declines in domestic demand and, to an increasing extent, by
improved export performance. To the extent that the adjustment has been due to
lower domestic demand linked to the reductions in potential output, it bears
high economic and social costs. Given the high private and public indebtedness
in these countries and the related drag on domestic demand, future growth will
have to importantly rely on exports, which will help sustain sound external
positions. In this respect, most of the vulnerable countries have made
important progress towards recovering cost competitiveness loses that
accumulated prior to the crisis. 
The rebalancing
process is far from complete as the debt legacy is still looming.
Despite the adjustment in flows, the stocks of external debt are very high in
most of the vulnerable countries. In this context, the dichotomy between these
'debtor' countries and their euro area 'creditors' has replaced the traditional
one between 'deficit' and 'surplus' countries. The improvements in current
accounts have not led to proportional reductions in NIIP-to-GDP ratios due to
the dismal growth in nominal output and, in some cases, also sizeable negative
valuation effects (to the extent that such valuation effects reflect the
increase in the value of foreign liabilities, e.g., increased prices of
domestic equity owned by foreigners, they can be a symptom of confidence of
markets in the economies concerned). Figure 1 shows that indeed, the euro area
countries with the highest levels of net external liabilities are those, where
growth and/or inflation have been very low. This effectively impairs two of the
main channels, which have historically proven to be key in dealing with debt
overhangs. To reduce the very high levels of external indebtedness to more
sustainable levels, the improved current account balances thus need to be
sustained in the future and, in some case, further improvements might be
required. While all of the vulnerable countries now record current account
balances which are consistent with ensuring a stable path of their NIIP-to-GDP
ratios, reasonably fast reductions in these ratios would require, in some
cases, still higher trade and current account surpluses.
Moreover, the
adjustment has been asymmetric and there has not been progress in adjustment of
current account surpluses. As a result the euro
area current account shifted to a surplus of around 2.2% in 2013, and is
forecasted to increase slightly to 2.3% in 2014 and 2015 (see figure 2). The
risks arising from such a surplus are the strain on domestic demand and
therefore on the ability of the euro area to grow, but also the possibility of
a euro appreciation. Through its effect on external demand and price and cost
adjustment this  could erode peripheral countries’ efforts to regain
competitiveness, while, through its effect on disposable income, also making
disinflation more-broad based. 
 Figure 1: External indebtedness and nominal growth || Figure 2: Geographical decomposition of euro area current account balance 
 || 
 Note: IT, LV, LU (2013Q3), MT (2013Q2), FR (2012Q4); NIIP multiplied by (-1) Source: Eurostat, AMECO || Source: Eurostat   
The rising euro
area current account surplus is a sign of weak aggregate domestic demand.
As interest rates are close to the zero lower bound, monetary policy has
limited to no scope for boosting demand. Similarly, fiscal policy appears
equally constrained in most countries. Given also the limited scope for
increasing domestic demand in the periphery countries, higher domestic demand
on the part of the surplus countries is the only other way of closing the
output gap of the euro area as a whole. In addition, the shortfall of domestic
demand in the euro area as a whole tends to exert downward pressure on prices.
The 'lowflation' environment – with inflation rate below the ECB's definition
of price stability of below, but close to, 2 per cent – makes it much more
challenging for the periphery countries to achieve the necessary adjustment in
relative prices. In this respect, given nominal rigidities, a persistent very
low inflation might also be a hurdle to the necessary adjustments in real
wages, which has important consequences for employment and unemployment.
A more symmetric adjustment in the euro area would make the overall adjustment
smoother and less costly and also moderate the overall euro area surplus.
Deleveraging in
the non-financial private sector has still a long way to go in many European
countries. The high external debt in the
vulnerable countries is a reflection of high indebtedness of domestic sectors,
both private and public. At the current juncture, it is particularly the
deleveraging pressures in the private sector, affecting households as well as
businesses, that hold back consumption and investment. As figure 3 signals,
debt levels are very high in a number of euro area countries and in a number of
cases no reductions have been recorded since the onset of the crisis.
Particularly, deleveraging in the corporate sector was very slow and firm
indebtedness decreased only in a few countries. Even in cases where some
deleveraging has occurred, the size of the adjustment observed so far in the
debt-to-GDP ratio is only a limited share of the pre-crisis increase, which
would suggest that the reduction in outstanding stocks of private debt is still
in early stages. Despite the subdued growth in new credit, the sluggish or even
negative GDP growth was playing against the reduction in the indebtedness
ratios.
 Figure 3 Private sector indebtedness, NFCs (left) and Households (right), % of GDP 
 || 
3.                       
Source:
Eurostat. Note: consolidated figures presented for NFCs. Debt includes loans
and securities other than shares, excluding financial derivatives. LU excluded
in the figure on NFC indebtedness.
Unemployment
reached 12% in 2013, which reflects a 0.7 pps increase since 2012.
Unemployment rates increased strongly in 1/3 of Eurozone Members States,
including in a number of countries where rates were already very high. The
speed of adjustment is still slow and the share of long-term unemployment has
continued to rise, reaching 50% of total unemployment in 2013, enhancing the
risk of unemployment becoming increasingly structural. Real unit labour costs
have grown slower in countries with higher rates of unemployment, smoothening
job losses while aiming to contain unemployment divergences between euro area
countries. Nonetheless the risk persists that unemployment becomes less
responsive to wage dynamicsThe process of reallocation of resources has started
to take effect, as nominal wages in the non-tradable sector fell more
significantly as compared to the tradable sectors, a development indicative of
the conditions for labour to move away from the non-tradable towards the
tradable sector. This reallocation and labour mobility in general is indeed key
for a sustainable improvement of external positions in countries that have
accumulated largely negative net investment positions over the past year.
The social
situation in the euro area deteriorated throughout the crisis,
and almost all social indicators worsened in 2012 (i.e. reflecting 2011
income), except for the share of people living in very low work intensity
households. The situation has especially worsened further for the working age
population, most directly hit by the deterioration of labour market conditions.
The current levels are all above pre-crisis levels. The at-risk of poverty
level stands at 17%, severe material deprivation at 7.6%, the level of people
living in a very low work intensity households at 10.5%, the in-work poverty 
rate at 10.6%, and lastly, the poverty gap at 23.4%. Starting from 2010, those
countries most severely hit by the crisis have seen their severe material
deprivation rate increase steeply, while a number of Member States have kept
most of their poverty indicators stable. The potential effects of social
developments on long-term growth and public debt sustainability are multiple[1].
In fact, poverty matters for productivity via the access to education and
health services, while inequality has dynamic effects on growth through private
debt accumulation and consumption growth. Additionally, higher poverty and
unemployment rate can affect the 'reform fatigue', which can substantially
disturb the recovery needed in the EA and, in turn impact on the sustainability
of public finances in vulnerable countries.  
In mitigating
these challenges for the well-functioning of the euro area, ambitious
implementation of structural reforms
leading to a more flexible economy are key.
Structural reforms cannot only contribute to a durable rebalancing process, but
also attenuate the negative impact of households' deleveraging: stronger real
wage adjustment leads to a smoother reaction of employment and, consequently,
of real output, while a faster adjustment in prices allows for an also faster
adjustment in the real interest rate towards the equilibrium level. Reforms
are instrumental for restarting sustainable and inclusive growth and for
stimulating employment, which in turn contributes to
the sustainability of private and public debt, and protects welfare systems in
times of fiscal consolidation. 
Given the high
interconnectivity between euro area Member States there are potentially large
spillover effects related to the implementation of structural reforms.
Trade and competitiveness are among the main channels through which spillovers
are transmitted. Product, services and labour market reforms as well as certain
tax reforms may affect employment and growth in the implementing Member State,
and hence the demand for products and services from other Member States. Some reforms
may produce spillovers through financial markets when reforms increase the Member State's ability to withstand external shocks and limit the risk of contagion of risk
premiums in case of concerns with regard to debt sustainability. Furthermore,
in areas where structural reform is needed in a most or all euro area countries,
coordinated reform can help communicate the broader welfare effects of
structural reform, while benchmarking, mutual learning and the exchange of best
practices can provide additional benefits
Vulnerable
Member States have recently pushed through impressive structural reforms. These
achievements notwithstanding, further progress is needed to create investment
opportunities that will help in shifting resources towards the production of
tradable goods and services, raising external competitiveness and boosting
productivity. In member states in the core area,
reform efforts have generally been less ambitious so far. Appropriate
reforms in core countries and a greater symmetry in
the adjustment would thus be good for stimulating the domestic demand in the
creditor countries, as well as in the whole euro area, and facilitate the
efforts to restore competitiveness and to grow in the periphery. Policies that
contribute to an increase in investment in particular are critical as they
boost demand in the short term, and increase potential growth in the future. Here,
product market reforms aimed at improving competition in non-tradable sectors would
notably spur investment and facilitate the development of these sectors.
In general,
structural reform efforts on product market has been limited. There
has been only very limited progress in the implementation the recommended
measures in services, including reforms to remove unjustified restrictions to
the access to and the exercise of professions, and to reduce barriers to entry
in retail. Limited progress has been achieved in reforms of the business
environment (e.g. red tape, contract enforcement, starting a business, support
to SMEs, insolvency procedures, late payments). Some action has been taken to
enhance the competition framework but further actions should be taken in some
countries to strengthen the independence and effectiveness of the competition
authority. Further reforms are also needed in the area of R&D and
innovation and in network industries, especially in railway. 
There is scope
and a need in many Member States to improve the structure of taxation by
shifting taxes away from labour and corporate income towards less-detrimental
tax bases such as consumption, environment and recurrent property taxes.
The composition of taxes in the euro
area is too heavily geared towards taxation on labour. The tax wedge in the
euro area is above 45%, which is much higher than in non-European OECD members
(see table 1). 
Table 1.
Average tax wedge for a
single person at 100% of average earnings, no child (%)                
   || 2013   || Change 2013-2009 
 Euro area || 46.5 || -0.2 
 OECD – Average || 35.9 || 0.7 
 Australia || 27.4 || 0.7 
 Canada || 30.7 || 0.5 
 Japan || 31.6 || 2.5 
 New Zealand || 16.9 || -1.2 
 Sweden || 42.9 || -0.3 
 United States || 31.3 || 1.3 
 United Kingdom || 31.5 || -0.9 
OECD (2010), "Taxing Wages: Comparative
tables", OECD Tax Statistics (database). Average tax wedge Euro area
calculated as the weighted average of the 15 Euro Area Member States that are
member of the OECD.
The process of
reallocation of resources should be facilitated by fluid labour markets both on
  Member State and euro area level.
Reforms enhancing labour market adjustment have been implemented in a number of
euro area countries in the past years, such as introducing changes in the
definition of fair dismissals or in the size of severance payments, but also
reforms facilitating the exit flexibility by revising dismissal rules. Specific
measures that increase the disincentive against temporary and atypical
contracts have been introduced to reduce labour market segmentation, though the
latter remains a significant labour market challenge for the future. The administrative
burden or reallocation options in case of dismissal have also been reduced in
several countries. 
Reforms of
unemployment benefit systems should support transitions back to work,
primarily by adjusting the design of unemployment benefits over the unemployment
spell and in some cases by strengthening job-search
conditionalities. Incentive-friendly measures include reduction in the
maximum level of benefits, adaptation of the design of benefits over the
unemployment spell, cuts in benefit duration, and stricter eligibility
criteria.
Several Member
States have reinforced their system of ALMPs,
in particular through more tailor-made job search assistance coupled with a
tightening of requirements for the continued receipt of benefits. Next to
activation measures, in their efforts to address poverty, some countries are
also reforming their social assistance systems.  
2.2.            Fiscal
Policy
The aggregate
fiscal picture for the euro area has continued to improve:
the large consolidation efforts implemented in difficult economic conditions in
recent years are now bearing fruit, supported by improving economic conditions.
In fact the nominal deficit in 2014 is expected to fall below the 3% of GDP in
the euro area, for the first time since 2009, standing at 2.5%. Moreover,
public debt is expected to finally stabilize in 2014, although at a high level
of 96% of GDP in the euro area, ending a continuously growing trend in past
years. With that, both the debt and deficit projections for the euro area are
considerably more positive than for other major economies including the United States and Japan. The Commission Spring Economic Forecast shows that the pace of fiscal
consolidation in the euro area will be slower in 2014 than in previous year and
is expected to be below ¼ pp
of GDP. 
Fiscal
achievements have to be acknowledged, but efforts towards sustainable budgetary
positions should continue. Consolidation efforts
have been large over the past few years and have managed to reduce deficits and
halt the rise in debt. Also, the economic outlook has been ameliorating and
improving the prospects for deficit and debt ratios. From a procedural point of
view this has been visible in Member States correcting the excessive deficits
in a sustainable manner and exiting the EDP. However, still many Member States
have deficits above 3% reference value and debt levels above 60% and need to
continue their efforts to reduce deficits and put debts on a steady declining
path, in line with the debt reduction benchmark, introduced in the reformed
SGP. Also, many Member States, which have corrected their excessive deficits
have not reached sustainable budgetary positions as defined by the MTOs. 
Mistakes of the
pre-crisis years have to be avoided.
One of the major innovations to the EU fiscal framework introduced by the
Six-Pack was the strengthening of the preventive arm of the SGP. This has been
based on the lesson drawn from the crisis that the weak compliance with the SGP
preventive arm was one of the main reasons behind the deep fiscal deficits and
the surge in debt during the crisis, but in fact already the diagnosis
preceding the 2005 reform of the SGP indicated the non-compliance with the
preventive arm as one of the main sources of the ensuing fiscal problems. To
remedy the weaknesses, the Six-Pack has clarified the assessment of compliance
with the MTO or the adjustment path towards it and introduced sanctions for
euro area Member States in case of non-compliance. Also, to underpin the
importance of structurally balanced budgets, Member States have signed the TSCG
enforcing in the national legislation at constitutional or equivalent level the
requirement of compliance with the MTO. It is therefore of utmost importance
that Member States ensure full compliance with the preventive arm requirements.
Improving economic conditions should be taken as an opportunity to press ahead
on the adjustment path towards the MTO and to build fiscal buffers before
cyclical factors turn again. From this point of view the structural
consolidation effort of below ¼ pp of GDP in 2014 points to an
overall insufficient response to the euro area's fiscal challenges. This is
particularly the case taking into account that for the Member States still in
EDP in 2014, the average structural effort recommended for 2014 in EDP
recommendations equals 1% of GDP, while for the Member States in the preventive
arm the SGP requires 0.5% of GDP structural adjustment towards the MTO as a
benchmark and only four euro area countries have reached the MTO. This
conclusion however should be qualified, as the structural balance may
underestimate the underlying fiscal effort on grounds of a lower than normal
response of revenue to economic growth and the current subdued growth of
potential output in a medium term perspective. 
Since the inception of the Europe 2020 Strategy, the Commission
has consistently called on Member States to give priority to growth-enhancing
policies when consolidating their public budgets. Important elements of a growth-enhancing fiscal policy are the
differentiation of the fiscal consolidation effort, the long term
sustainability (both assessed above), the composition and structure of revenue
and expenditures and a sound fiscal framework. 
The overall
quality of expenditure results from the combination of two main aspects: (i)
the composition of expenditures and in
particular the weight of more growth-friendly spending items; and (ii) the
efficiency of expenditures, i.e. how well public resources are translated
into services to citizens and business. 
In terms of targeting
spending areas which should, in principle, positively affect growth, the
expenditure categories commonly focussed upon are public investment, education
and research and development (R&D).
Latest trends in expenditure composition in the euro area since the onset of
the economic and financial crisis highlight a generalised increase in the share
of social protection accompanied by a reduction in several other functions,
including education, as well as a widespread tendency to cut public investments,
which is often viewed as an easy target for consolidation. For example, the
average expenditure on capital formation in the euro stood at 2.1 % of GDP and
4.3% of total spending in 2013, down from 2.6% and 5.7% respectively in 2007
(see table 2).  
Table 2. Public
Investment (Gross Fixed Capital Formation) as % of GDP and total expenditure 
   || GCFC (% of GDP) ||   ||   || GCFC (% of total expenditure) ||   ||   
   || 2007 || 2014 || chng || 2007 || 2014 || chng 
 BE || 1.6 || 1.6 || 0.0 || 3.2 || 2.9 || -0.3 
 DE || 1.5 || 1.6 || 0.1 || 3.4 || 3.5 || 0.1 
 EE || 5.1 || 4.0 || -1.1 || 14.9 || 10.3 || -4.5 
 IE || 4.7 || 1.6 || -3.1 || 12.7 || 3.9 || -8.8 
 EL || 3.4 || 2.6 || -0.8 || 7.1 || 5.5 || -1.6 
 ES || 4.0 || 1.3 || -2.7 || 10.3 || 3.0 || -7.3 
 FR || 3.3 || 3.0 || -0.2 || 6.2 || 5.3 || -0.8 
 IT || 2.3 || 1.6 || -0.7 || 4.9 || 3.3 || -1.6 
 CY || 3.0 || 2.3 || -0.7 || 7.3 || 4.8 || -2.4 
 LV || 5.7 || 3.7 || -2.0 || 15.8 || 10.5 || -5.3 
 LU || 3.3 || 3.1 || -0.2 || 9.1 || 7.2 || -1.9 
 MT || 3.7 || 2.7 || -1.0 || 8.8 || 6.2 || -2.7 
 NL || 3.3 || 3.3 || 0.0 || 7.3 || 6.6 || -0.7 
 AT || 1.1 || 1.0 || -0.1 || 2.2 || 1.9 || -0.3 
 PT || 2.7 || 1.8 || -0.9 || 6.1 || 3.8 || -2.3 
 SI || 4.2 || 4.2 || 0.0 || 10.0 || 8.4 || -1.6 
 SK || 1.9 || 1.9 || 0.0 || 5.5 || 5.0 || -0.5 
 FI || 2.4 || 2.9 || 0.4 || 5.1 || 4.8 || -0.3 
 EA-18 || 2.6 || 2.0 || -0.6 || 5.7 || 4.1 || -1.5 
Source: Commission services (Ameco)
As
far as efficiency of expenditure is concerned there also remains ample scope
for improvement in the euro area. This is illustrated in the domain of social
expenditure. Figure 2 presents the correlation between the reduction of income
inequality and social expenditure. Although, reducing inequality is not the
only goal of social security expenditures, the figure suggests that it is
possible to improve public finances without increasing the income inequality
provided efficiency gains can be identified. 
Figure 1.
Correlation between the reduction of market income inequality and social
protection expenditure, 2000-11
Source:
Eurostat and the Standardised World Income Inequality Database. Note: the
reduction in market income inequality is the percent difference between the
Gini coefficient after taxes and transfers and the Gini coefficient before
taxes and transfers.
With regard to
fiscal frameworks, across the euro area progress has been made in the past
couple of years. This was spurred by the need to
display and adhere to stricter fiscal discipline accompanied by more stringent
requirements in European fiscal governance, illustrated for instance by the
entry into force of the Directive on national budgetary frameworks[2]
at the beginning of 2014 in the EU-28. This drive towards improved fiscal
governance is particularly acute in the Euro area, where additional commitments
have been made to support fiscal discipline. During 2013 the framework for the
euro area became operational with the entry into force of Two-pack[3]
(see above) and the “Fiscal Compact” [4],
which fully applies for all Euro Area Member States. 
2014 will be a critical
year in terms of compliance with new requirements on fiscal frameworks.
Subject to the combination of newly established legislative elements outlined
above, Euro Area Member States need to ensure compliance with all legal
provisions now fully in place as soon as possible; ongoing compliance
assessment for the transposition of the Directive and Fiscal Compact are
currently undertaken by the Commission. Major areas of attention for Euro Area
Member States in the coming months should be to ensure the effective setup and
functioning of fiscal rules, in particular structural budget balance rules, and
their monitoring by independent fiscal institutions; as well as the full
national integration of the new common budgetary timeline including Draft
Budgetary Plans and Medium-Term Fiscal Plans, based on forecasts produced or
endorsed independently.

2.3       Financial sector policy 

Heterogeneity of
lending conditions remains very high and contrasts with the reduced financial
fragmentation in other market segments
such as those for sovereign and corporate debt. Euro-area banks acknowledged in
the ECB Bank Lending Survey that the dissipation of sovereign debt tensions
contributed on average to an improvement in banks' funding conditions while the
impact of the easing of the sovereign debt crisis on banks' credit standards
remained muted. This suggests the banks are not yet translating the improved
funding conditions into better lending conditions.
Over the last couple of months, interest rates for
loans to enterprises in core countries like Germany and France have stopped falling while they have declined slightly in the most fragile countries like Greece and Portugal. However, differences in lending rates for enterprises between countries like Italy or Spain and Germany have not yet started to narrow in earnest. Also, credit
flows have remained subdued. The latest bank lending data confirms that the
economic recovery we are seeing at the moment is
essentially creditless. Credit flows to the private sector shrank over the last
few months on the back of still very weak lending volumes to the non-financial
corporate sector. Such credit constraints can put a brake on recovery, notably
in vulnerable countries and add to disinflationary pressures. 
The
weakness of lending to the real economy is attributable to demand and supply
side elements. On the supply side, the interplay
of a protracted economic weakness with legacy balance sheet issues, amid
continued corrections in residential and commercial property markets in some
countries, affects credit risk. This results in worsening credit quality and
increases in the Non-Performing Loan (NPL) ratios of euro area banks. Moreover,
according to some market participants, asset quality problems are more acute
than reported as banks exercise forbearance towards borrowers with low credit
quality. This in turn can reduce banks’ capacity to extend new loans to
productive firms as the high proportion of NPLs and loans involving forbearance
tie up capital and funding. The ongoing ECB asset quality review, followed by
an EU-wide stress test, is expected to  reveal any unrecognised losses in banks
and further foster the completion of the necessary balance sheet repair. On the
other hand, the ongoing private sector debt overhang and deleveraging, the weak
economic environment and the poor economic prospects in the euro area weigh on
borrowers' debt servicing capacity and credit demand. In some euro area
countries, the slow progress on corporate sector restructuring further dampen
the demand for new loans. 
Despite
the relatively difficult economic environment, euro area banks have continued
to strengthen their capital positions. As
a result, the Basel III Common Equity Tier 1 (CET1) ratios of euro area large
banks are broadly comparable with those of their global peers. Also, many large
banks that already report Basel III CET1 ratios reached or surpassed levels of
9% by September 2013. As a result, despite continued increases in loan-loss
provisions, capital ratios in euro area banks remain stable overall and are
even growing in many euro area Member States. Nonetheless coverage ratios
remain relatively low in some countries as increases in NPLs outpace the growth
in provisions. The improvements in euro area banks' capital ratios were
achieved through a combination of capital increases and reductions of
risk-weighted assets. Given the uncertainty of financial market participants
related to the calculations of risk-weighted assets, a simple leverage ratio is
increasingly used as a complementary indicator to gauge the strength of the
banking sector. On this metric, the progress of euro area banks is less
pronounced. 
Looking
forward, financial fragmentation could be further reduced if progress can be
made in addressing its underlying causes. In
this respect, various policy initiatives are under way to tackle this issue and
the fragility of the banking system. Banking Union initiatives remain critical
points on the EU's policy agenda. The Banking Union will create a more robust
financial sector in the euro area, making all banks safer in the first place by
crisis prevention, while the centralisation of supervision under the auspices
of the Single Supervisory Mechanism (SSM) will reduce the risks of supervisory
capture. If banks do face solvency, liquidity or viability challenges,
supervisors can intervene at an early stage to manage them and, if problems still
cannot be adequately addressed, a framework will now be in place that allows
for the orderly resolution of troubled institutions. 
The
ECB has made significant progress with taking over the responsibility for bank supervision
in the euro area.  In particular,
the ECB is carrying out a comprehensive assessment
of the largest banks in the euro area
(128 credit institutions across 18 Member States, covering approximately
85% of total euro-area banks' assets) with the aim to finalise it prior to
assuming its single-supervisor role in November 2014. This exercise involves a
risk assessment for each bank and an asset quality review (AQR) followed by a
stress test (ST), which will be held in all EU-28 Member States, performed in
close coordination with the EBA. Work on the AQR is well
underway. The methodology was published at the end of March and the AQR process
is expected to be finalised in July. The stress tests
preparations are also ongoing and the EBA has published the scenarios and
methodology on 29 April. The EBA and the ECB have announced in coordination the
key elements of the exercise, including the capital thresholds of 8% CET1 for
the baseline and 5.5% CET1 for the adverse scenario. Unlike in past exercises,
the supervisory decisions to address the outcomes of the stress tests and the
implications for banks' results will not be coordinated by the EBA; rather,
this task will be allocated to competent authorities including the ECB. A
number of elements confirm the credibility of the stress test especially taking
into account that the starting point is more credible and tougher given the
preceding AQR. Further elements confirming this include (i) the extension of
the horizon of the exercise from 2 to 3 years, (ii) better harmonised
definitions for important parameters such as NPLs and (iii) a common approach
for the treatment of sovereign bonds in the stress test without national
discretion. In addition, the level of transparency introduced in the exercise
and its comprehensiveness are reassuring for institutions and market
participants. Moreover, the very favourable market
conditions may also make it easier and cheaper for banks to raise capital or
dispose in better conditions of assets that may be penalised during the
exercise.
The
Single Resolution Mechanism (SRM) has been approved by the co-legislators in
April 2014. The SRM will apply to all banks in
the Euro Area and other Member States that opt to participate.
The decision-making procedures of the
SRM have been carefully calibrated so that it will be possible to decide on a
resolution case over a week-end. The SRM is built around a strong Single
Resolution Board and will involve permanent members as well as the Commission,
the Council, the ECB and the national resolution authorities. In most cases,
when a bank in the euro area or established in a Member State participating in
the Banking Union needs to be resolved, the ECB will notify the case to the
Board, the Commission, and the relevant national resolution authorities. In the
Banking Union, the national resolution funds are pooled together gradually in
the Single Resolution Fund to which all the banks in the banking union
countries will contribute as from 2016 and which will amount to EUR 55 billion
by 2024. However, The SRM Regulation does not establish
yet a common backstop to the fund, which will be constructed over the coming
years.
Access to
finance for SMEs remains challenging in many Member States which risks
undermining the economic recovery. At
the same time, investment needs for transport, energy and broadband
infrastructure networks are estimated at EUR 1 trillion over 2020. Risk of a
funding gap in Europe remains acute, against the backdrop of continuing
deleveraging pressures and still significant market fragmentation (see above).
Next to the creation of banking union, a number of initiatives related to
financing the long term economy have been taken or are planned.
There is a broad
agreement on the need to diversify financing sources as Europe is characterised
by a system dominated by bank intermediation.
European capital markets are relatively underdeveloped and currently
insufficient to fill the funding gap created by bank deleveraging. A number of
bottlenecks exist for capital-market financing to take off. Incentives for
institutional actors such as insurers to engage in long-term financing could be
adjusted. SMEs access to capital markets is currently held back by asymmetries
of information and the absence of a liquid securitisation market. To revive the
securitisation market it would be crucial to “differentiate” between good and
bad securitisation which should then allow improving the prudential framework
for the good one. In the market for  infrastructure financing, financial market
participants have often pointed to the lack of transparency on project
pipelines as an obstacle to more predictable financing, for example as concerns
public-private partnerships (PPP). The enhanced availability of information on
national infrastructure and investment plans and on projects promoted by national
authorities could attract capital markets to projects in Europe. Finally, a
number of cross-cutting factors related to corporate governance, accounting
issues and taxation and legal issues are also holding back market financing.
The Commission Communication on long-term financing adopted end March 2014
focuses on a concrete action plan with several actions to be undertaken already this year to address these issues.

[1] Darvas, Z. and G. Wolff (2014), 'Europe's social problem and its
implication for economic growth', Bruegel policy brief, issue 03.
[2] Council Directive 2011/85/EU on requirements for budgetary
frameworks of the Member States, part of the "6-pack"
[3] Regulation (EU) No 473/2013 on common provisions for monitoring and
assessing draft budgetary plans and ensuring the correction of excessive
deficit of the Member States in the euro area.
[4] The Fiscal Compact is the fiscal chapter of the Treaty on
Stability, Coordination and Governance in the Economic and Monetary Union
(TSCG)