Source: EURLEX
Language: en
Format: md

*|*

# 52013SC0379

**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 /\* SWD/2013/0379 final \*/**

  

CONTENTS

Executive summary. 3

Introduction. 5

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

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

1.2........ Challenges. 6

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

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

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

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

              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.

·
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.

              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 EMU[1].  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 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. 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 Survey[2],
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.

 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
transition[3].

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 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 effort[4]. 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

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 - 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 growth[5]. 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 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 Ireland[6], 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
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

Source: Commission Services

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.

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 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 2014[7]. 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 2014[8]. 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 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 2060[9]. 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 2012[10]. 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.
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

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 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 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, %

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 sovereign funding cost and the leverage of the private sector but also by
the health characteristics of the national banking systems[11]. 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.

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 €117bn, an increase by +13.3%
year-on-year. For the euro area as a whole, the amount of bond issuance more
than offsets the decline in net lending flows over the same period which
amounts to -€70bn once adjusted by sales and 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.

Figure 8
Contribution to total NFCs' annual credit growth, January 2013

Source: ECB

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 pressures[13] 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.

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, 2012[14] and Commission, 2012[15]; 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.

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 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 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 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 2012[18]). 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

Source: Commission Services

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.

Figure 12 Real unit labour cost
dynamics and unemployment

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).

\* 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

[1]               COM(2012) 777 final.

[2]               COM(2012) 750 final.

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

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

[5]               Revised Regulation (EC) No
1466/97.

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

[7]               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

[8]               For details on the S2 indicator, see Chapter 1.3 of
the Fiscal Sustainability Report 2012.

[9]               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

[10]             See European Council conclusions of 21 July 2011.

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

[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.

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

[15]             European Commission (2012), 'Current Account Surpluses
in the EU,' European Economy, 9.

[16]             OECD (2012). Economic Policy Reforms 2012. Going for
Growth. Paris, OECD.

[17]             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.

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

[Top](#document1)