Towards the 'new normal' Financial and economic challenges in post-crisis European Union recovery

Servaas DEROOSE

Deputy Director-General European Commission, DG Economic and Financial Affairs

European Ideas Network (EIN) Summer University

Copenhagen, 2 October 2015

Outline

1. Economic outlook

2. Policy strategy

3. The way forward for EMU deepening

2

3

Economic outlook (ST)

• Cyclical recovery is underway: is this time different?

• Several tailwinds, but impact uncertain and temporary

o ECB actions, including quantitative easing

o Low oil price

o Weak euro

o Neutral fiscal stance

o Lagged impact of structural reforms in some vulnerable countries

• Risks to the short-term outlook tilted to the downside

o Weakness in emerging markets/Asia

o Market volatility and changes in asset valuation

o Greece: no contagion but work ahead

o Geo-political risks

o New elements: Refugee inflows and VW emissions scandal

4

Economic outlook (MT)

• Medium-term prospects: Not out of the woods yet

o Economic activity still below pre-crisis level

o Downward revisions to potential growth

o Falling behind major competitors

• Pre-crisis structural impediments to growth and jobs

o Unfavourable demographics

o Weak productivity growth

o High unemployment

o Rigid product and labour markets

5

Economic outlook (MT)

• Legacy of the crisis

o Investment gap

o Deleveraging private and public debt

o Bank capitalisation and high non-performing loans

o Still high unemployment, increasingly youth and long-term

o Ongoing sectoral adjustment in countries that e.g. underwent housing boom-bust

o Protracted low inflation

o Halt/reversal in convergence process

o Elevated uncertainty and depressed animal spirtis

o Rising inequality

o Citizens' declining systemic trust

6

Policy strategy

• Turning green shoots into a sustained, balanced recovery: A concerted four pillar policy response

o Continuing demand support

Maintain accommodative monetary stance; quid broadening/extending QE

Deficit-neutral, targeted fiscal expansion: strengthening automatic stabilisers / automating discretionary fiscal policies; tax shift;

Expediting investment: Juncker plan

o Cleaning up bank balance sheets

Strengthening prudential supervision

Addressing high level of NPLs

Discouraging ring-fencing

o Incentivizing structural reforms

Use of SGP flexibility

Benchmarking

o Completing EMU

7

Completing EMU

• Rationale

o Despite significant progress, EMU architecture remains incomplete

o Doubts about long-term viability; undermining economic recovery

• Sequencing logic

o Front-loading private sector risk sharing (BU; CMU)

o Linking public sector risk sharing to progress on pooling sovereignty

o Moving from rules to institutions

8

Completing EMU

• Stage I (to 30 June 2017)

o Complete Banking Union (add EDIS) and launch Capital Market Union

o Create European Fiscal Board

o Set up European system of Competitiveness authorities

o Streamline and reinforce European Semester

o Consolidate external representation of the euro area

• Stage II

o Fiscal capacity to better cushion asymmetric shocks

o Euro Area Treasury

o Common high-level standards to formalise convergence process

o Strengthen democratic accountability

9

Background

Oil price decline, QE and euro depreciation are driving euro-area growth

10

Euro-area real GDP growth in 2015 (%)

2015 Spring forecast 1.5

Potential growth 0.8

Oil price decline 0.5

Quantitative easing 0.4

Euro depreciation 0.4

EU-Russia sanctions -0.2

Residual -0.4

Recovery perspectives

Recoveries after major recessions and after the global financial crisis

11

12

Private and public debt

13

The investment gap in the EU is sizeable

14

3,039

2,527 2,543

2,528

2,567

2,640 2,717

3,021

2,657

2,714

2,659 2,647

230

370

Gap compared to sustainable trend

2,869

"Sustainable" trend of investment assuming a share in GDP of 21-22%

2,416

2,606

Real gross fixed capital formation EU-28, in 2013 prices, EUR bn

Source: European Commission

Slump in investment Total investment in levels Index, 2007Q4=100

Source: European Commission, Autumn Forecast 2014 15

EU INVESTMENT TRIANGLE

Strong boost to strategic investments

Better access to investment finance

for SMEs and mid-cap companies

Strategic use of EU budget

Better use of the European Structural and

Investment Funds

MOBILISING FINANCE FOR INVESTMENT

Project pipeline preparation and selection

Technical assistance at all levels

Strong cooperation between National

Promotional Banks and the EIB

Follow-up at global, EU, national and regional

level, including outreach activities

MAKING FINANCE REACH THE REAL ECONOMY

Predictability and quality of regulation

Quality of national expenditure, tax systems

and public administration

New sources of long-term financing

for the economy

Removing non-financial, regulatory barriers

in key sectors within our Single Market

IMPROVED INVESTMENT ENVIRONMENT

16

Structure and Investment target

European Fund for Strategic Investments (EFSI)

21bn

16bn 5bn

Infrastructure and

innovation window(through EIB)

SME

window(through EIF)

5bn16bn

European Union budget EIB

Own

resources

guarantee

11bn 5bn 2.5bn

Debt

portfolio

Equity-type

portfolio

Fully guaranteed

by EUFrom EIB

2.5bn

Total EIB/EIF financing

Total investment mobilised

49bn 12bn

240bn 75bn

17

GDP effects of closing half the gap with best practice

Potentially large GDP effects if each MS closes half the gap vis-à-vis best performers:

• GDP after 5 years: EU +3½%

< SE +1% ; EL +5% >

• GDP after 10 years: EU +6½%

< SE +2% ; EL +10% >

Effects take time to materialise

• - Effects of tax shift relatively fast

• - Labour market reforms slower

• - Innovation and education slowest

Source: Varga and in 't Veld (2014) 18

Banks ran into trouble Non-performing loans % total gross loans

19

From boom to bust Unemployment rate % civilian labor force

20

21

Strong nominal convergence pre-EMU; limited further progress due to weak market pressure and policy complacency

HICP inflation

(dispersion)

10-year govt. bond yield (dispersion)

Public gross debt / GDP

(dispersion)

0

1

2

3

4

5

6

1995 2000 2005 2010

EA-11

Current EA-19

EA changing

composition

20

25

30

35

40

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing composition

Note: Dispersion measured as an unweighted standard deviation. "*" indicates projected values. HICP inflation measured as y-o-y growth rate of the HICP index. 10-year nominal govt. bond yield. Public gross debt in line with EDP definition based on ESA 2010.

Source: Ameco.

0

1

2

3

4

5

6

7

8

1995 2000 2005 2010 2015*

EA-11

Current EA-19

EA changing

composition

22

Real convergence: Catching-up process mostly driven by 'new' euro area Member States

Note: Countries which were in 1999 (left chart) and in 2008 (right chart) not members of the euro area are highlighted in red.

The black regression line is based on the full sample of countries, the blue one excludes the 'new' euro area Member States, which are highlighted in red.

Source: Eurostat.

GDP per capita (in PPS) before and after the start of the financial crisis

AT

BE

EE

FI

FR DE

EL IE

IT

LU

NL PT

SK

SI

ES CY

LV

LT

MT

0

2

4

6

8

10

12

0 10 20 30 40 50

GD

P p

er

capita in P

PS

(avera

ge g

row

th 1

999-2

007)

GDP per capita in thousands PPS (1999)

excl. 'new' EA MS

all countries

AT BE

EE

FI

FR

DE

EL

IE

IT LU NL PT

SK

SI ES CY

LV LT

MT

-4

-3

-2

-1

0

1

2

3

4

5

0 20 40 60 80

GD

P p

er

capita in P

PS

(avera

ge g

row

th 2

008-1

3)

GDP per capita in thousands PPS (2008)

excl. 'new' EA MS

all countries

23

Heterogeneity can be costly, but it can

be overcome by appropriate adjustment mechanisms

Insufficient real convergence: a problem?

Reduce heterogeneity by reinforcing single market integration, risk-sharing financial market integration and cross-border labour mobility, whilst allowing for

system competition and national idiosyncracies

Ensure adequate adjustment mechanisms which make heterogeneous economies resilient to shocks (asymmetric/common) and respond effectively to

internal and external imbalances

Economic argument

Political-economy argument

A monetary union of heterogeneous

economies depends on political

cohesion and identity

Monetary unions with heterogeneous economies can be sustainable as long as a certain degree of

political cohesion and identity exists, e.g. US, Belgium, Germany

If political cohesion is defined in terms of convergence of economic welfare levels and in the absence of large transfers, the sustainability

of heterogeneous monetary unions is less clear.

Preventing a meltdown Asset purchases Lending to banks

ECB refinancing operations in euro area

24

24

QE impact

Signalling effect on inflation expectations and confidence

Portfolio balance effect, crowing investors out into riskier asset classes and driving down risk and term premia

Exchange rate channel, resulting from increasing monetary policy divergence with the US

Credit channel, increasing banks' incentives and ability to extend credit

TRANSMISSION CHANNELS

25

Liquidity trap: increasing money supply may have limited effect on prices and output at the zero lower bound

Increased search for yield may push asset valuations to fundamentally unjustified levels; interaction with macro-prudential tools untested

QE exit remains unchartered territory

CB profitability/capital position may suffer when increasing short-term rates amid excess liquidity

UNCERTAINTIES AND RISKS

Fiscal responsibility remains key as government debt is high and fiscal adjustment needs are large

S1 indicator: required fiscal adjustment by 2020 to reach a 60%

debt-to-GDP ratio in 2030

Government debt (% of GDP)

Structural balance and medium-term objectives, 2014

(% of GDP)

26 Source: European Commission

-5

-4

-3

-2

-1

0

1

2

3

UK

HR IE BG FR PL

MT

HU BE SI ES SK LT RO LV SE PT

AT FI IT CY EE CZ

NL

DK

DE

LU EL

structural balance MTO 0

20

40

60

80

100

120

140

160

180

EE LU BG

RO LV SE LT DK CZ PL

SK FI NL

MT

DE

HU

HR SI AT

UK FR ES BE

CY IE PT IT EL

2009 2014-2009

-5

-3

-1

1

3

5

7

9

LV EE DK

LU SK SE LT HU DE

RO CZ PL

MT

NL

AT

BG EA EU ES SI IT FI PT IE UK FR HR BE

Autumn2010

Winter2015

Preventive arm Corrective arm

Investment Allowed deviation from the MTO or the adjustment path towards it

EFSI contribution SGP-neutral

Structural reform Allowed deviation from the MTO or the adjustment path towards it

Whether to open or not an EDP (relevant factors) -Deficit (if breach is close and temporary) -Debt EDP recommendation -Setting the deadline and length of poss. Extension

Cyclical conditions

Modulation of fiscal effort with economic conditions (and sustainability risks)

Effective action methodology

Severe economic downturn clause: redefining fiscal effort

Using SGP flexibility to promote investment and structural reforms

27

• Effect of fiscal policy on monetary policy Risk of overburdening monetary policy in the short run by lack

of demand support

Risk of overburdening monetary policy in the long run via pressure for debt monetisation

• Effect of monetary policy on fiscal policy Interest rate falls impact national budgets differently

according to the debt structure in terms of maturity

Propensity of governments to use lower interest rate payment as a windfall to relax fiscal discipline.

Lesson from the crisis: fiscal policy with constrained monetary policy

28

Lesson from the crisis: stabilisation vs sustainability

• The large increase in public debt reduces fiscal space even if the increase in debt is the consequence of the crisis

• Fiscal multipliers may be higher under financial constraints, but risk of loss of market access

• A clever balancing-act is required between stabilisation ans sustainability

29

Five Presidents' Report: 3 stages, 4 unions

Economic Union

Financial Union

Fiscal Union

"Political Union"

Stage 1

• "Deepening by doing"

• by 30 June 2017

Stage 2 • "Completing EMU"

Stage 3

• "Final stage"

•At the latest by 2025

30