OECD Economic Surveys: Euro Area 2016 9264256350, 9789264256354

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OECD Economic Surveys EURO AREA JUNE 2016

OECD Economic Surveys: Euro Area 2016

This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area.

Please cite this publication as: OECD (2016), OECD Economic Surveys: Euro Area 2016, OECD Publishing, Paris. http://dx.doi.org/10.1787/eco_surveys-euz-2016-en

ISBN 978-92-64-25635-4 (print) ISBN 978-92-64-25636-1 (PDF) ISBN 978-92-64-25634-7 (epub)

Series: OECD Economic Surveys ISSN 0376-6438 (print) ISSN 1609-7513 (online)

OECD Economic Surveys: Euro Area ISSN 1995-3747 (print) ISSN 1999-0804 (online)

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

Photo credits: Cover © GregDale/GettyImages.

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TABLE OF CONTENTS

Table of contents Basic statistics of the euro area, 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7

Abbreviations and acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8

Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Monetary and financial policies to support the recovery . . . . . . . . . . . . . . . . . . . . . . Restoring credit growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Making public policy more supportive of inclusive growth . . . . . . . . . . . . . . . . . . . .

9 10 10 10

Assessment and recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Challenges facing Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fostering recovery and rebalancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Keeping monetary policy accommodative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Improving monetary transmission by resolving non-performing loans . . . . . . . . . Completing banking union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Making public finances more growth and equity-friendly . . . . . . . . . . . . . . . . . . . . .

13 14 17 22 27 29 31

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

Annex. Progress in structural reform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

Thematic chapter Chapter 1. Making public finances more growth and equity-friendly . . . . . . . . . . . . . . There is strong potential to improve growth and equity through better public finances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Improving fiscal governance to promote inclusive growth . . . . . . . . . . . . . . . . . . . . Policies towards more effective public investment . . . . . . . . . . . . . . . . . . . . . . . . . . . Recommendations to make public finances more growth and equity-friendly. . . . . . . . .

50 57 65 71

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

Tables 1. Macroeconomic indicators and projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1. Post-crisis fiscal consolidation episodes: Cumulative change in revenue and expenditure items. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Figures 1. GDP growth and long-term interest rate spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. Eurobarometer: Public opinion of the European Union . . . . . . . . . . . . . . . . . . . . . . 3. Unemployment dispersion in the euro area. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Investment is still far below 2007 levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. Well-being outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

49

22 55

14 15 15 16 16

3

TABLE OF CONTENTS

6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 1.1. 1.2. 1.3. 1.4. 1.5. 1.6. 1.7. 1.8. 1.9. 1.10. 1.11. 1.12. 1.13. 1.14. 1.15.

4

Activity has gradually recovered but sharp cross-country divergence remains . . Debt of non-financial corporations in the euro area. . . . . . . . . . . . . . . . . . . . . . . . . Indicators of external balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Export performance and competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Developments in unemployment and poverty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Central banks’ total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inflation developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit developments and financial fragmentation . . . . . . . . . . . . . . . . . . . . . . . . . . House prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-performing loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-performing loans net of provisions to capital . . . . . . . . . . . . . . . . . . . . . . . . . . Evolution of gross public debt in the euro area . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The fiscal stance in the euro area . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Post-crisis fiscal consolidation episodes: Composition and labour tax wedge developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intensity of budgetary reform in euro area countries. . . . . . . . . . . . . . . . . . . . . . . . European Union budget: Structure of expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . European structural and investment funds as a share of public investment . . . . Evolution of gross public debt in the euro area and the United States . . . . . . . . . The fiscal stance in the euro area and the United States . . . . . . . . . . . . . . . . . . . . . Post-crisis fiscal consolidation episodes: Change in the underlying primary balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiscal consolidation and debt dynamics: Projections and outcomes . . . . . . . . . . . Post-crisis fiscal consolidation episodes: Contributions from revenue and expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in the labour tax wedge over the post-crisis fiscal consolidation episode . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income redistribution due to fiscal variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiscal policy and cyclical conditions in the euro area . . . . . . . . . . . . . . . . . . . . . . . . Extension of deadlines for eliminating excessive deficits . . . . . . . . . . . . . . . . . . . . Intensity of budgetary reform in euro area countries. . . . . . . . . . . . . . . . . . . . . . . . Remit and resources of independent fiscal institutions: Selected features. . . . . . European Union budget: Structure of expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . European structural and investment fund allocations for 2014-20. . . . . . . . . . . . . European structural and investment funds as a share of public investment . . . . Share of sub-national governments in total public investment . . . . . . . . . . . . . . .

18 19 19 20 21 23 23 24 25 26 27 28 28 32 32 34 37 38 39 51 52 52 53 54 55 56 59 60 62 64 66 67 67 70

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

This Survey is published on the responsibility of the Economic and Development Review Committee of the OECD, which is charged with the examination of the economic situation of member countries. The economic situation and policies of the euro area were reviewed by the Committee on 3 May 2016. The draft report was then revised in the light of the discussions and given final approval as the agreed report of the whole Committee on 20 May 2016. The Secretariat’s draft report was prepared for the Committee by Álvaro Pina and Jan Stráský under the supervision of Pierre Beynet. Research assistance was provided by Desney Wilkinson-Erb and secretarial assistance was provided by Sylvie Ricordeau. The previous Survey of the euro area was issued in April 2014.

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BASIC STATISTICS OF THE EURO AREA,a 2015 (Numbers in parentheses refer to the OECD average)b LAND, PEOPLE AND ELECTORAL CYCLE Population (million) Under 15 (%) Over 65 (%) Foreign-born (%) Latest 5-year average growth (%)

338.5 15.3 19.6 11.7 0.2

Population density per km² (18.0) Life expectancy (years, 2014) (16.3) Men Women (0.6)

122.7 82.0 79.2 84.7

(35.1) (80.5) (77.8) (83.1)

1.6 24.4 73.9

(2.4) (26.7) (70.9)

ECONOMY Gross domestic product (GDP) In current prices (billion USD) In current prices (billion EUR) Latest 5-year average real growth (%) Per capita (000 USD PPP)

11.537 10.400 0.6 40.2

Value added shares (%, 2014) Primary sector Industry including construction (1.7) Services (40.2)

GENERAL GOVERNMENT Per cent of GDP Expenditure Revenue

48.6 46.6

(42.3) Gross financial debt (38.5)

90.7

EXTERNAL ACCOUNTS Exchange rate (EUR per USD) PPP exchange rate (USA = 1) In per cent of GDP Exports of goods and services (including intra EA) Imports of goods and services (including intra EA) Current account balance Net international investment position

0.901 0.764 45.7 41.3 3.2 -4.0

Main exports (% of total merchandise exports) Machinery and transport equipment Other manufactured goods (54.1) Chemicals and related products, n.e.s. (49.7) Main imports (% of total merchandise imports) (0.1) Machinery and transport equipment Other manufactured goods Mineral fuels, lubricants and related materials

44.6 25.0 18.4 33.7 26.9 16.5

LABOUR MARKET, SKILLS AND INNOVATION Employment rate for 15-64 year-olds (%) Men Women Participation rate for 15-64 year-olds (%) Average hours worked per year (2014)c

64.5 (66.2) Unemployment rate, Labour Force Survey (age 15 and over, %) 69.7 (74.1) Youth (age 15-24, %) 59.5 (58.5) Long-term unemployed (1 year and over, %) 72.4 (71.2) Tertiary educational attainment 25-64 year-olds (%) 1 567 (1 770) Gross domestic expenditure on R&D (% of GDP, 2014)

10.9 22.4 5.5 29.2 2.1

(6.8) (13.9) (2.5) (33.3) (2.4)

6.7

(9.6)

0.5

(0.5)

ENVIRONMENT Total primary energy supply per capita (toe, 2014) Renewables (%) Fine particulate matter concentration (PM2.5, µg/m3, 2013)

3.5 12.2 13.7

(4.1) CO2 emissions from fuel combustion per capita (tonnes, 2013) (9.1) Municipal waste per capita (tonnes, 2014) (13.8) SOCIETY

Income inequality (Gini coefficient, 2014) At risk of poverty rate (%, 2014) Public and private spending (% of GDP) Health care, current expenditure (2013)c Pensions (2011)c Education (primary, secondary, post sec. non tertiary, 2013)

0.310 (0.308) Education outcomes (PISA score, 2012) 10.7 Reading Mathematics 9.0 (8.9) Science 10.8 (8.7) Share of women in parliament (%, April 2016) 3.5 (3.7) Net official development assistance (% of GNI, 2014)

493 494 501 30.6 0.30

(496) (494) (501) (27.9) (0.37)

Better life index: www.oecdbetterlifeindex.org a) Average of euro area 18 or 19 countries unless otherwise indicated. b) Where the OECD aggregate is not provided in the source database, a simple OECD average of latest available data is calculated where data exist for at least 29 member countries. c) Average of the euro area member countries that are also members of the OECD (15 countries). Source: Calculations based on data extracted from the databases of the following organisations: Eurostat, OECD, International Energy Agency, World Bank, International Monetary Fund and Inter-Parliamentary Union.

ABBREVIATIONS AND ACRONYMS

Abbreviations and acronyms AMC APP BRRD CAP EBA ECB EDP EFSI EIB ERDF ESF ESIF EU EUR GDP IFRS IMF LTROs MTO NPLs QE R&D SGP SMEs SoEs SSM TLTROs USD

8

Asset management company Asset purchase programme Bank recovery and resolution directive Common agricultural policy European Banking Authority European Central Bank Excessive deficit procedure European fund for strategic investments European Investment Bank European regional development fund European social fund European structural and investment funds European Union Euro Gross domestic product International Financial Reporting Standards International Monetary Fund Long-term refinancing operations Medium-term objective Non-performing loans Quantitative easing Research and development Stability and Growth Pact Small and medium-sized enterprises State-owned entreprises Single supervisory mechanism Targeted long-term refinancing operations United States dollar

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

OECD Economic Surveys: Euro Area © OECD 2016

Executive summary ●

Monetary and financial policies to support the recovery

●

Restoring credit growth

●

Making public policy more supportive of inclusive growth

9

EXECUTIVE SUMMARY

Monetary and financial policies to support the recovery Euro area consumer prices Y-o-y % change 4

Total

Expectations¹

3 2 1 0 -1

2012

2013

2014

2015

2016

1. Expected average annual inflation based on the difference between 5 and 10-year inflation swaps. Source: Eurostat Database and Thomson Reuters Datastream Database. 1 2 http://dx.doi.org/10.1787/888933366894

Growth has picked up gradually over the past two years, supported by very accommodative monetary policy. The effect of fiscal policy on domestic demand has turned broadly neutral. But unemployment is still very high in many euro area countries, investment has been sluggish and credit remains weak. Inflation is well below target and market-based measures of inflation expectations have been drifting down. Tackling these interconnected problems requires resolute and co-ordinated action by euro area countries to support aggregate demand and strengthen the financial sector to unlock credit growth.

Restoring credit growth Credit to non-financial corporations January-March 2016

Annual % growth 5

0

-5

-10

Important building blocks of banking union are now in place. But collective action is needed to complete banking union by further harmonising bank regulation, reinforcing deposit insurance at the national and European levels, and creating a common fiscal backstop to the Single Resolution Fund. The dependence between national banks and their governments still poses a serious risk in the event of renewed turbulence.

SVN NLD IRL PRT GRC ESP ITA EA DEU FRA BEL

Source: ECB, Statistical Data Warehouse. 1 2 http://dx.doi.org/10.1787/888933366900

Making public policy more supportive of inclusive growth Euro area fiscal stance Change in the underlying primary balance

% potential GDP 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

2004

2006

2008

2010

2012

2014

In the wake of the global financial crisis, governments provided fiscal support and public debt rose sharply. Subsequent fiscal consolidation often resulted in deep cuts to public investment and increases in labour taxes, which weigh on future growth potential. Addressing these problems requires applying the flexibility embedded in the Stability and Growth Pact to support growth when appropriate, upgrading national budgetary frameworks and supporting private investment, including in the context of the Investment Plan for Europe.

Source: OECD Economic Outlook, Vol. 2016, No. 1. 1 2 http://dx.doi.org/10.1787/888933366912

10

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

EXECUTIVE SUMMARY

MAIN FINDINGS

KEY RECOMMENDATIONS Monetary and fiscal policies

Inflation remains well under the target of below, but close to, 2%. Inflation expectations are drifting down. Aggregate demand is still weak and unemployment remains very high. In high-debt, low-growth countries, the strict application of the debt reduction rule of the Stability and Growth Pact can require very large fiscal adjustments.

Commit to keep monetary policy accommodative until inflation is clearly rising to near the target. Countries with fiscal space should use budgetary support to raise growth. Ensure that the application of the debt reduction rule of the Stability and Growth Pact does not threaten the recovery.

Financial policies Non-performing loans (NPLs) are still very high in some When NPLs create a serious economic disturbance, countries, which hampers credit growth. speed up and facilitate the resolution of NPLs by not triggering bail-in procedures within the existing rules. Consider establishing asset management companies where needed, and possibly at the European level. Take supervisory measures to encourage banks to resolve NPLs, which might include raising capital surcharges for long-standing NPLs. National fiscal positions are vulnerable to national Reinforce national deposit insurance schemes and banking crises. implement a European Deposit Insurance Scheme, in tandem with continued risk reduction in the banking sector. To reduce links between national governments and their banks, create a common fiscal backstop to the Single Resolution Fund. Banking regulation remains fragmented along national Further harmonise banking regulation in Europe. borders, which is an obstacle to a level playing field. Making public finances more growth-friendly Investment in Europe remains weak.

As intended in the Investment Plan for Europe, the European Investment Bank should finance higher-risk projects that would not otherwise be carried out.

Countries should increase targeted public support to investment while enhancing the framework conditions for private investment. The composition of public spending and revenue has Allow longer initial deadlines for correcting excessive become less growth-friendly. deficits if countries implement major structural reforms in spending and tax policies which enhance potential growth and long-term sustainability. Reforms to national budgetary frameworks have not Adopt national expenditure rules and conduct spending been sufficient. reviews linked to budget preparation. Ensure that national independent fiscal institutions have resources to fulfil their mandate.

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

11

OECD Economic Surveys: Euro Area © OECD 2016

Assessment and recommendations ●

Challenges facing Europe

●

Fostering recovery and rebalancing

●

Keeping monetary policy accommodative

●

Improving monetary transmission by resolving non-performing loans

●

Completing banking union

●

Making public finances more growth and equity-friendly

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

13

ASSESSMENT AND RECOMMENDATIONS

Challenges facing Europe Europe has made important progress in harnessing and reinforcing its policies and institutions to recover from a double-dip recession and improve crisis management. Very supportive monetary policy has helped growth to pick up gradually over the past two years (Figure 1, Panel A), and contributed to reduce tensions in sovereign debt markets (Figure 1, Panel B). The effect of fiscal policy on demand has turned broadly neutral. Important building blocks of banking union, on both supervision and resolution fronts, have come into operation, improving the resilience of the European financial system. Confidence in the European project has recovered from its lows in 2013, although it is still well below what it was before the crisis (Figure 2). However, many legacies of the crisis are still unresolved, and major new problems have emerged. Unemployment is still high in many countries, and there is a wide dispersion across the euro area (Figure 3). Despite the somewhat stronger economy, inflation is close to zero, well below the European Central Bank (ECB) target of just under 2%. Unlike in the United States, investment is still far below 2007 levels, especially in those countries hit hardest by the crisis (Figure 4), mainly due to weak demand but also to high non-performing loans and, in many countries, high corporate indebtedness, which hamper credit (OECD, 2015a). Political tensions have flared up recently due to large inflows of refugees, and have put strains on border-free travel within the Schengen zone. The reintroduction of border controls in some Schengen zone countries is a setback for European integration.

Figure 1. GDP growth and long-term interest rate spreads

4

A. Real GDP growth in the euro area1 Percentage growth

25

3 20

2 1

B. Long-term interest rate spreads2 Percentage points Greece Ireland Italy Portugal Spain

15

0 -1

10 -2 -3

5

-4 -5

2007 2008 2009 2010 2011 2012 2013 2014 2015

0

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

1. Euro area member countries that are also members of the OECD (15 countries). 2. Ten-year government bond spreads relative to the German rate. Source: OECD (2016), OECD Economic Outlook: Statistics and Projections and Main Economic Indicators (databases). 1 2 http://dx.doi.org/10.1787/888933366926

14

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

ASSESSMENT AND RECOMMENDATIONS

Figure 2. Eurobarometer: Public opinion of the European Union Question responses,1 per cent

60

60 Total positive

Neutral

Total negative

50

50

40

40

30

30

20

20

10

10

0

2007

2008

2009

2010

2011

2012

2013

2014

2015

0

1. “In general, does the EU conjure up for you a very positive, fairly positive, neutral, fairly negative or very negative image?” Source: European Commission, “Public Opinion in the European Union”, Standard Eurobarometer, various editions. 1 2 http://dx.doi.org/10.1787/888933366545

Figure 3. Unemployment dispersion in the euro area Unemployment rates, per cent

25

25

Euro area¹ Average² - Greece, Portugal and Spain Average² - Austria, Germany and Luxembourg

20

20

15

15

10

10

5

5

0

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

0

1. Euro area 19 countries. 2. Unweighted average. Source: Eurostat (2016), “Employment and unemployment (LFS)”, Eurostat Database. 1 2 http://dx.doi.org/10.1787/888933366937

These challenges weigh on economic performance and, more broadly, on the quality of life of European citizens. Well-being in the euro area often displays large disparities across countries (Figure 5). These tend to be most acute in income, labour market outcomes and subjective well-being, all of which were deeply affected by the crisis. Furthermore, some countries often find themselves among the best or the worst performers in most dimensions of well-being (Figure 5). Improving well-being requires

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

15

ASSESSMENT AND RECOMMENDATIONS

Figure 4. Investment is still far below 2007 levels Real gross fixed capital formation, index Q4 2007 = 100

110

France

Germany

Italy

Spain

United States

Euro area¹

110

105

105

100

100

95

95

90

90

85

85

80

80

75

75

70

70

65

65

60

2007

2008

2009

2010

2011

2012

2013

2014

2015

60 2016

1. Euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933366942

Figure 5. Well-being outcomes1 Euro area, 2016

Euro area

Highest three results²

Lowest three results²

Income and wealth 10 Subjective well-being

8

Jobs and earnings

6 Personal security

Housing

4 2 0

Environmental quality

Work and life balance

Civic engagement and governance

Social connections

Health status

Education and skills

1. Euro area member countries that are also members of the OECD (15 countries). Each well-being dimension is measured by one to three indicators from the OECD Better Life indicator set. Normalised indicators are averaged with equal weights. Indicators are normalised to range between 10 (best) and 0 according to the following formula: ([indicator value – worst value]/[best value – worst value]) × 10. 2. Calculated as a simple average of the highest and lowest performers of the euro area cross-country distribution. Source: OECD Better Life Index, www.oecdbetterlifeindex.org. 1 2 http://dx.doi.org/10.1787/888933366951

stronger and more even growth and job creation across the euro area, but also reforms in specific policy areas, such as education and health, where the composition and efficiency of public spending plays a crucial role.

16

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

ASSESSMENT AND RECOMMENDATIONS

Building a better future calls for stronger collective action on several fronts. Despite recent progress, banking union remains incomplete, which hampers monetary policy transmission and capital market integration, and the resulting mutual dependence of national governments and national banks poses vulnerabilities during a crisis. Joint action is also needed to protect external borders and share the financial burden of the refugee inflow. Public investment remains depressed, due to strong and lopsided fiscal consolidations in the recent past, which have fallen heavily on capital spending, and insufficient consideration of cross-country spillovers. Business investment is further hampered by the high levels of corporate debt overhang, by remaining weaknesses in some national banking systems and by scant progress in goods and services markets integration after the crisis, not least through the persistence of high regulatory heterogeneity. In this context, the 2016 OECD Economic Survey of the euro area mainly focusses on fiscal and financial challenges, and the 2016 OECD Economic Survey of the European Union on structural reform priorities to complete the Single Market. The main messages of the euro area Survey are: ●

To deal with the problems they face, member states need to harness European institutions to develop and implement collective and co-operative solutions.

●

The euro area economy is gradually recovering, but investment remains weak and the wide disparity in economic performance and well-being is still a major concern.

●

Collectively strengthening aggregate demand and financial sector performance will be critical to ensuring that growth picks up and unemployment continues to decline.

Fostering recovery and rebalancing Growth has gathered pace since mid-2014, supported by successive rounds of monetary expansion (Figure 6). The sharp fall in global oil prices has raised household incomes and fiscal policy is no longer weighing on domestic demand. Exports grew robustly for several quarters, reflecting the euro depreciation and stronger activity in major markets, such as the United Kingdom and the United States. More recently, a stronger euro and the slowdown in emerging markets have made export growth decelerate markedly. Business investment has disappointed, largely due to weak growth expectations and, in some countries, credit constraints. Economic performance has been uneven from country to country. The sovereign debt crisis and the associated large fiscal and macroeconomic adjustment efforts by the countries hit hardest (e.g. Greece, Ireland, Italy, Portugal and Spain) led to very divergent output and unemployment developments across the euro area. This divergence has been modestly reversed over the past two years, with some of those countries recording above-average growth. Despite narrowing interest rate differentials and significant reductions in lending rates, credit and investment in most of those countries have remained hampered by high non-performing loans and corporate debt (Figure 7), and incomplete capital market integration. The exceptions have been Ireland, where large multinationals do not depend on domestic banks for financing, and Spain, which has made significant progress in cleaning up banks’ balance sheets. External positions are rebalancing, but the process has been asymmetric and incomplete, and has left the euro area as a whole with a large external surplus. Germany and the Netherlands have further increased their already significant surpluses. The countries hit hardest by the global financial and euro area crises have all eliminated

OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

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ASSESSMENT AND RECOMMENDATIONS

Figure 6. Activity has gradually recovered but sharp cross-country divergence remains A. Activity in the euro area1 % change over previous quarter, volume 2.5

B. Oil price and effective exchange rate USD/barrel 150

GDP Total investment Exports of goods and services

2.0

Oil spot price (Brent, left axis) Nominal effective exchange rate (right axis)

2010 = 100 120

125

115

100

110

75

105

50

100

25

95

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

2012

2013

2014

2015

2016

0

C. Unemployment rates Per cent

2012

2013

2014

2015

90 2016

D. Real GDP Index Q4 2007 = 100

30

115 2013

2015 110

25 105 20

100 95

15 90 10

85 80

5 75 0

DEU

IRL

FRA

EA¹

ITA

PRT

ESP

GRC

70

Germany Greece Ireland Italy Portugal Spain 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

1. Euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), OECD Economic Outlook: Statistics and Projections and Main Economic Indicators (databases); and Eurostat (2016), “Employment and unemployment (LFS)”, Eurostat Database. 1 2 http://dx.doi.org/10.1787/888933366963

significant current account deficits, although, in spite of structural improvement, this also reflects still weak domestic demand and, therefore, imports (Figure 8). The same countries also improved cost competitiveness (Figure 9), in the context of substantial output losses. Apart from Greece and Italy, export performance has improved as a result. However, a number of these countries continue to display poor net international investment positions, and improving them will require sustained GDP growth and current account surpluses in the medium and long run. Stronger wage and internal demand growth in surplus countries will ease further rebalancing and make it more symmetric, not least by reversing the persistent decline in their relative unit labour costs (Figure 9). Labour market developments have also varied markedly across countries. As euro area unemployment started to increase in 2008, so did its dispersion across countries, which has only fallen slightly recently (Figure 3). Moreover, especially in the countries hit hardest by the crisis, estimates of structural unemployment have risen (Ollivaud and Turner, 2014)

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Figure 7. Debt of non-financial corporations in the euro area1 As a percentage of GDP

450

450 2014

2008

400

400

350

350

300

300

250

250

200

200

150

150

100

100

50

50

0

GRC

SVK

DEU

AUT

ITA

SVN

FIN

EST

NLD

ESP

FRA

EA²

BEL

PRT

IRL

LUX

0

1. Debt is calculated as the sum of the following liability categories, whenever available/applicable: special drawing rights; currency and deposits; debt securities; loans; insurance, pension, and standardised guarantees; and other accounts payable. 2. Unweighted average of data for euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), “Financial Dashboard”, OECD National Accounts Statistics (database). 1 2 http://dx.doi.org/10.1787/888933366974

Figure 8. Indicators of external balance As a percentage of GDP

A. Current account balance

B. Net international investment position 75

12 2008

2015

2008

2015

50

8

25 4

0

0

-25

-4

-50 -75

-8 -100 -12 -16

-125 GRC

PRT

ESP

IRL

ITA

FRA

NLD

DEU

-150

PRT

IRL

ESP

GRC

ITA

FRA

NLD

DEU

Source: Eurostat (2016), “Balance of payments statistics and international investment positions (BPM6)”, Eurostat Database. 1 2 http://dx.doi.org/10.1787/888933366980

and the labour force has fallen as workers have become discouraged and, in some countries, have emigrated in search of better job opportunities (OECD, 2015b). Conversely, Germany has benefited from lower unemployment and an increased labour force. Unsurprisingly, poverty has tended to increase more in those countries with large hikes in joblessness (Figure 10). Furthermore, recent consolidation efforts in the countries most affected by the crisis have sometimes included deep cuts to unemployment benefits (see Chapter 1), which have likely worsened distributional impacts.

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Figure 9. Export performance and competitiveness Index, Q1 1999 = 100

A. Relative unit labour costs1 140

France Italy

140

Germany Spain

130

130

120

120

110

110

100

100

90

90

80

1999

2001

2003

2005

2007

2009

2011

2013

2015

80

Greece Portugal

1999

2001

2003

2005

Ireland Slovenia

2007

2009

2011

2013

2015

B. Export performance2 160

160 France Italy

150

Germany Spain

140

140

130

130

120

120

110

110

100

100

90

90

80

80

70

70

60

1999

2001

2003

2005

2007

2009

2011

2013

Greece Portugal

150

2015

60

1999

2001

2003

2005

Ireland Slovenia

2007

2009

2011

2013

2015

1. Real harmonised competitiveness indicator for unit labour costs in total economy. 2. Ratio between export volumes and export markets for total goods and services. Source: OECD (2016), OECD Economic Outlook: Statistics and Projections (database); and ECB (2016), Statistical Data Warehouse, European Central Bank. 1 2 http://dx.doi.org/10.1787/888933366617

Gross domestic product (GDP) growth for the euro area as a whole is projected to accelerate modestly to close to 2% (Table 1). Activity will continue to be supported by sustained monetary stimulus, a broadly neutral fiscal stance and lower oil prices. However, high private indebtedness will remain a drag on consumption and investment in many countries, and falling demand from emerging economies will weigh on exports. Unemployment will decline only gradually, and the stark differences across countries will persist. Inflation is projected to edge up to about 1% by 2017 as the effects of cheaper energy wane and cyclical slack gradually decreases. A stronger-than-projected slowdown in China and other emerging market economies would weaken demand in the euro area through several channels. Impacts through trade linkages alone would likely be small (about 0.1% of GDP per percentage point fall in Chinese

20

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ASSESSMENT AND RECOMMENDATIONS

Figure 10. Developments in unemployment and poverty Percentage points

B. Poverty rate1 Change 2009-14

A. Unemployment rate Change 2008-13 20

3.5 3.0

15

2.5 2.0

10

1.5 1.0

5

0.5 0.0

0

-0.5

SVN

EST

GRC

PRT

ESP

LUX

SVK

ITA

DEU

EA²

IRL

BEL

NLD

FRA

FIN

-1.5

AUT

ESP

GRC

IRL

PRT

ITA

SVN

EA²

SVK

EST

NLD

FIN

FRA

BEL

LUX

AUT

-5

DEU

-1.0

1. The poverty rate is the share of persons with disposable income (equivalised for family size) below 60% of national median disposable income. 2. Euro area 19 countries. Source: Eurostat (2016), “Income distribution and monetary poverty” and “Unemployment and employment (LFS)”, Eurostat Database. 1 2 http://dx.doi.org/10.1787/888933366993

domestic demand), as even the whole of Asia accounts for only 12% of euro area goods exports. However, repercussions on euro area GDP could increase by a factor of three if the demand slowdown in China led to adjustments in global financial markets, such as higher risk premia (OECD, 2015c). Through cheaper commodities and pressures for euro appreciation, a slowdown would also make it more difficult to steer euro area inflation towards 2%. While tail risks of financial stress have receded, the outcome of the upcoming referendum in the United Kingdom could have important implications for economic performance in both the United Kingdom and the rest of Europe (Kierzenkowski et al., 2016). The refugee crisis is already straining the Schengen agreement and might even affect the free flow of goods and, especially, labour in Europe. This could to some extent reduce the benefits of the single market and shake confidence in the European Union more generally. There is considerable uncertainty regarding the inflation projection, and a more long-lasting period of low inflation, or even falling prices, cannot be ruled out. This could make debt burdens more difficult to manage and, for the countries hit hardest by the crisis, further competitiveness gains harder to achieve, delaying the recovery. On the other hand, more rapid progress in fiscal and structural reforms would boost growth relative to the projection. Of particular importance are collective fiscal action within the Stability and Growth Pact rules to boost investment and growth, the banking union and further progress on the single market. A resolution of the refugee crisis would bolster confidence in the EU institutional framework and thereby improve growth prospects. Recent and potential future policy moves by the ECB may prove more effective in raising inflation towards its target than assumed. Similarly, cheap oil may have a stronger-than-expected impact on demand.

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Table 1. Macroeconomic indicators and projections Euro area,1 annual percentage change, volume (2011 prices) Projections 2013

Gross domestic product (GDP)

2014

2015 2016

2017

-0.3

1.0

1.6

1.6

1.7

-0.6

0.8

1.6

1.8

1.7

0.2

0.8

1.3

1.7

1.1

Gross fixed capital formation

-2.5

1.4

2.6

3.3

3.2

Final domestic demand

-0.8

0.9

1.8

2.1

1.9

0.2

0.0

0.0

0.1

0.0

-0.7

1.0

1.7

2.2

1.9

Exports of goods and services

2.2

4.1

5.2

3.0

4.1

Imports of goods and services

1.3

4.5

6.0

4.4

4.6

0.4

0.0

-0.1

-0.4

-0.1

Private consumption Government consumption

Stockbuilding2 Total domestic demand

Net exports2 Other indicators (growth rates, unless specified) Potential GDP Output gap3

0.6

0.7

0.8

0.9

1.0

-3.2

-2.9

-2.2

-1.5

-0.7

Employment

-0.6

0.6

1.0

1.3

1.0

Unemployment rate

11.9

11.5

10.8

10.2

9.8

GDP deflator

1.3

0.8

1.2

0.9

1.1

Consumer price index (harmonised)

1.3

0.4

0.0

0.2

1.2

Core consumer prices (harmonised)

1.1

0.8

0.8

0.9

1.1

Household saving ratio, net4

6.3

6.4

6.4

6.7

6.6

Current account balance5

2.9

3.1

3.8

3.8

3.6

General government fiscal balance5

-3.0

-2.6

-2.1

-1.8

-1.4

Underlying general government fiscal balance3

-1.0

-0.8

-0.8

-1.0

-1.0

1.3

1.4

1.3

0.9

0.7

General government gross debt (Maastricht)5

93.7

94.7

93.3

92.4

91.3

General government net debt5

Underlying general government primary fiscal balance3

66.1

72.5

72.0

72.0

71.5

Three-month money market rate, average

0.2

0.2

0.0

-0.2

-0.3

Ten-year government bond yield, average

2.9

2.0

1.1

0.9

0.8

105.2

112.1

110.5

109.6

108.5

Memorandum item Gross government debt5

1. Euro area member countries that are also members of the OECD (15 countries). 2. Contribution to changes in real GDP. 3. As a percentage of potential GDP. 4. As a percentage of household disposable income. 5. As a percentage of GDP. Source: OECD (2016), “OECD Economic Outlook No. 99”, OECD Economic Outlook: Statistics and Projections (database).

Keeping monetary policy accommodative Following the outset of the financial crisis in September 2008 and the ensuing long period of low growth, the European Central Bank (ECB) successively cut its policy rates – except during a short period in 2011 – to their lowest levels since it started operating: the deposit rate has been negative since mid-2014 (Figure 11, Panel A). However, if assessed through the evolution of the real short-term market interest rate, monetary policy became less accommodative in 2013-14 (Figure 11, Panel B). This is explained by the fall in inflation since late 2011 (see below). The use of unconventional monetary tools diminished in 2013 and 2014, as most commercial banks started reimbursing the loans they took under the long-term refinancing operations (LTROs). As a result, the Eurosystem balance sheet shrank significantly from 30% of GDP end-2012 to about 20% end-2014 (Figure 12). Persistent undershooting of

22

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ASSESSMENT AND RECOMMENDATIONS

Figure 11. Interest rate developments Per cent

B. Real short-term interest rate1

A. Key ECB interest rates 6

3

Deposit rate Marginal lending rate Main refinancing rate

5

2

4 1 3 0 2 -1

1

-2

0 -1

-3

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

1. Three-month rate deflated by the harmonised consumer price index. Source: ECB (2016), “Statistics Bulletin”, Statistical Data Warehouse, European Central Bank; and OECD (2016), OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933367000

Figure 12. Central banks’ total liabilities End of period data, as a percentage of GDP

90

90 Euro area¹

United States

Japan

United Kingdom

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10

0

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

0

1. Estimate for 2016 second quarter onwards based on monthly increases of EUR 80 billion. Source: Thomson Reuters (2016), Datastream Database; and OECD (2016), OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933367019

inflation led the Governing Council to reinvigorate the use of unconventional tools as of mid-2014, and most recently in March 2016. Measures have included a combination of conventional monetary policy easing, taking the deposit rate increasingly to negative territory, credit easing in the form of a series of targeted long-term refinancing operations (TLTROs), and quantitative easing through an asset purchase programme (APP) that initially comprised asset-backed securities and covered bonds and increased in scope to include sovereign bonds (from March 2015) and non-bank corporate bonds (from June 2016).

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ASSESSMENT AND RECOMMENDATIONS

The asset purchase programme consists of purchasing various eligible assets, both private (asset-backed securities, covered bonds and non-financial corporate bonds) and public (such as government, agencies and European institutions bonds, under the so-called public sector purchase programme), at an original pace of EUR 60 billion per month, making it an effective quantitative easing (QE) programme. The initial intention was to carry out purchases at least till September 2016, but on 3 December 2015 the Governing Council extended it to March 2017 or beyond, if necessary, and increased the pool of eligible assets, notably by including regional and local government debt. The size of monthly purchases was increased to EUR 80 billion in March 2016 and the pool of eligible assets was widened further to investment grade bonds issued by non-bank firms. The balance sheet of the ECB is expected to reach close to 40% of euro area GDP by March 2017 (Figure 12). The effectiveness and timing of quantitative easing policies has been highly debated (IMF, 2013). However, since the announcement of the programme to the end of the first quarter of 2015, the valuation of European stock exchanges increased by about 20% and the euro effective exchange rate depreciated by about 10% (Figure 13). In addition, the asset purchase programme has helped spreads of sovereign bonds in peripheral countries to remain low (despite some renewed financial market stress around Greece in 2015), which is facilitating the recovery in those countries. Based on a macroeconomic model simulation (NiGEM), a 10% depreciation of the euro could increase inflation by ¾ percentage point and growth by about 1¼ percentage points in the following year. Using the same model, the impact of an increase in stock prices of 20% would be more moderate, about ½ percentage point on activity and none on inflation. Despite quantitative easing, inflation (total and core) and swaps-based inflation expectations are now well below the inflation target of the ECB (Figure 14). Temporary factors, such as the significant drop in oil prices and cheaper imports, notably from China,

Figure 13. Financial indicators Index, 2010 = 100

150

150 Nominal effective exchange rate

Share price index¹

140

140

130

130

120

120

110

110

100

100

90 80

APP dates² 2012

2013

2014

2015

90 80 2016

1. Dow Jones EURO STOXX Broad Benchmark Index. 2. ECB announcement (22 January 2015), recalibration (3 December 2015) and expansion (10 March 2016) of the Asset Purchase Programme (APP). Source: OECD (2016), OECD Economic Outlook: Statistics and Projections and Main Economic Indicators (databases). 1 2 http://dx.doi.org/10.1787/888933367029

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ASSESSMENT AND RECOMMENDATIONS

Figure 14. Inflation developments Year-on-year percentage change

4.5

4.5 Total¹

Core¹

Expectations² 4.0

4.0 Expanded APP³ 22 January 2015

3.5

3.5

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

-0.5

-0.5

-1.0

2008

2009

2010

2011

2012

2013

2014

2015

2016

-1.0

1. Harmonised indices of consumer prices; core inflation excludes energy, food, alcohol and tobacco. 2. Expected average annual inflation based on the difference between 5-year and 10-year inflation swaps. 3. European Central Bank announcement of an expanded Asset Purchase Programme (APP). Source: Eurostat (2016), “Harmonised indices of consumer prices”, Eurostat Database; and Thomson Reuters (2016), Datastream Database. 1 2 http://dx.doi.org/10.1787/888933366894

help explain this low inflation rate, but only to a certain extent. For example, the steep fall in the price of Brent by almost USD 40 per barrel in 2015 would have reduced headline inflation by only about ¼ percentage point in 2015, based on a NiGEM simulation. The transmission of monetary policy has improved and interest rates of corporate loans have been converging in the past two years. However, for loans of smaller size, which matter more for small and medium-sized enterprises (SMEs), rates remain 1 or 2 percentage points higher in some countries (Figure 15, Panels A and B). While part of this differential reflects differences in macroeconomic risk among euro area countries, this could also indicate that firms with similar risk profile, and especially SMEs, tend to suffer from higher lending costs depending on the country in which they are located. This could be explained by the still fragile situation of many banks in some countries, which are plagued with high levels of non-performing loans (NPLs, see below). Banks with high levels of NPLs tend to lend less as they are less profitable, have weaker capital buffers and higher funding costs (Aiyar et al., 2015). As a result, credit is still falling, though more slowly, in most of those countries (Figure 15, Panel C). In a well-functioning single market, the impact of weak domestic banks or high sovereign risk premia should be minimal as creditworthy firms should be able to get financing from other banks or channels (Coeuré, 2015). With inflation still low, inflation expectations falling and slack still large, monetary policy needs to remain firmly committed to an expansionary stance. Based on current OECD projections, inflation is set to remain below the ECB target until end-2017. In this context, the ECB should explicitly commit to keep monetary policy accommodative (i.e. not increase interest rates or shrink its balance sheet) and treat risks to the achievement of its inflation target symmetrically. In fact, explicitly accepting that inflation could go beyond 2% over the next two years without triggering a tightening of monetary policy could make monetary policy more effective at influencing expectations, which is crucial when interest rates are at the zero lower bound (Ambler, 2009). Nor would it necessarily reduce credibility. OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

25

ASSESSMENT AND RECOMMENDATIONS

Figure 15. Credit developments and financial fragmentation Non-financial corporations

A. Interest rates on loans of up to and including EUR 1 million1 Per cent 9

France Italy

8

9

Germany Spain

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

2010

2011

2012

2013

2014

2015

Greece Portugal

8

2016

0

2010

2011

2012

Ireland Slovenia

2013

2014

2015

2016

1

B. Interest rates on loans of over EUR 1 million Per cent 9

France Italy

8

9

Germany Spain

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

2010

2011

2012

2013

2014

2015

Greece Portugal

8

2016

0

2010

2011

2012

Ireland Slovenia

2013

2014

2015

2016

C. Loans adjusted for sales and securitisation Year-on-year percentage change 10

France Italy

Germany Spain

10

5

5

0

0

-5

-5

-10

-10

-15

2010

2011

2012

2013

2014

2015

-15 2016

Greece Portugal

2010

2011

2012

Ireland Slovenia

2013

2014

2015

2016

1. New business loans with an initial rate fixation period of less than one year. Loans other than revolving loans and overdrafts, convenience and extended credit card debt. Source: ECB (2016), “Balance sheet items” and “MFI interest rate statistics”, Statistical Data Warehouse, European Central Bank. 1 2 http://dx.doi.org/10.1787/888933367037

The ECB should ease further if inflation remains below target for longer than expected, for instance in the event of negative economic shocks. The ECB could envisage additional rate cuts, notably the deposit rate as it is the most important policy rate in an environment of excess liquidity, although it would be necessary to carefully assess whether the risks of lowering bank profitability are still of second order compared to the need to sustain the recovery (Coeuré, 2014). Expanding the use of TLTRO is a key tool to reduce impairment in

26

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ASSESSMENT AND RECOMMENDATIONS

the transmission of monetary policy and to enhance the provision of credit. The impact of the APP could be strengthened further by increasing again the monthly purchases, which may require a new extension of eligible assets. Macroeconomic imbalances linked to the very expansionary monetary stance seem so far limited. There is no indication at this stage of asset price bubbles at the euro area level, notably in the housing sector (Figure 16). Nevertheless, macro-prudential tools should be strengthened to avoid the reappearance of bubbles, which could also apply to EU countries outside the euro area as they could face high capital flows resulting from quantitative easing policies (Rey, 2015). In the housing sector, for example, lower loan-to-value or loan-to-income criteria could be imposed.

Figure 16. House prices Euro area,1 index

Long-term average = 100

2010 = 100 125

125 Real house prices (left axis)

Price to income ratio (right axis)

Price to rent ratio (right axis)

120

120

115

115

110

110

105

105

100

100

95

95

90

2007

2008

2009

2010

2011

2012

2013

2014

2015

90

1. Euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), Analytical House Price Indicators (database). 1 2 http://dx.doi.org/10.1787/888933367049

Improving monetary transmission by resolving non-performing loans On the banking sector side, a more aggressive policy to resolve the high level of non-performing loans (NPLs) in several countries would improve banks’ financial situation, facilitating monetary policy transmission and, hence, credit expansion. NPLs are still very high in several countries (Figure 17). Comparing the level of NPLs is difficult, despite the introduction by the European Banking Authority (EBA) in October 2013 of a harmonised definition, as it has mainly applied to the larger banks so far (Aiyar et al., 2015). Swift resolution of NPLs, before the value of impaired loans or their collaterals becomes too low, is a key element needed to reallocate credit more productively to other firms. This is also a financial stability issue as banks in many euro area countries would suffer significant capital losses if the value of their collateral were to fall substantially (Figure 18). To that end, banks should be encouraged to provision more on a case-by-case basis. Since current International Financial Reporting Standards (IFRS) do not require “dynamic” provisioning (i.e. using a forward-looking model of expected losses) before 2018, the regulator could consider other options, such as imposing capital surcharges. Such additional capital requirements could be triggered once NPLs have passed a certain period,

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27

ASSESSMENT AND RECOMMENDATIONS

Figure 17. Non-performing loans Gross non-performing debt instruments as a percentage of total gross debt instruments

40

France Italy

35

40

Germany Spain

35

30

30

25

25

20

20

15

15

10

10

5

5

0

2010

2011

2012

2013

2014

Greece Netherlands

0

2015¹

2010

2011

Ireland Portugal

2012

2013

2014

2015¹

1. Average of first three quarters. Source: ECB (2016), “Monetary and financial statistics”, Statistical Data Warehouse, European Central Bank. 1 2 http://dx.doi.org/10.1787/888933367053

Figure 18. Non-performing loans net of provisions to capital As a percentage of capital, Q4 20151

ITA

IRL

GRC

EA²

NLD

PRT

ESP

DNK

BEL

SVN

CZE

DEU

HUN

-10

FRA

0 OECD

0 SVK

10

JPN

10

AUT

20

POL

20

AUS

30

USA

30

EST

40

SWE

40

NOR

50

FIN

50

GBR

60

CAN

60

TUR

70

KOR

70

ISR

80

CHE

80

LUX

90

MEX

90

-10

1. Data is end of period. 2013 for Finland and Luxembourg; 2014 for Germany, Korea and the United Kingdom; Q2 or Q3 2015 for Belgium, Italy, Japan and Switzerland. Aggregates are unweighted averages of the latest data available and OECD covers 31 countries. The precise definition and consolidation basis of non-performing loans may vary across countries. 2. Euro area 19 countries. Source: IMF (2016), Financial Soundness Indicators (FSI Database), International Monetary Fund. 1 2 http://dx.doi.org/10.1787/888933367060

for example through higher risk weights. Still another way to encourage provisioning could be to impose a progressive reduction of the value of loan collateral past a certain duration: this was applied by the Bank of Spain for NPLs more than two years old.

28

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In parallel to increasing the costs for banks to keep NPLs, policies should also create instruments for banks to recover the highest possible value from their impaired loans. One avenue is to improve insolvency procedures. In particular, they should be made faster in many euro area countries, for example by using out-of-court procedures: fast resolution is key to preserve the value of collateral, especially for firms whose collateral tends to depreciate rapidly through obsolescence. In some countries, legal procedures for banks to access collateral are unduly long. Setting up an asset management company (AMC) can be a very efficient tool to resolve NPLs: such companies bring better knowledge to value impaired assets, which allows banks, especially smaller ones, to get a better price. A company set at the European level would maximise economies of scale and diversify asset recovery risks. At the same time, potential cross-country risk sharing could be compensated by some financial sector conditionality applied to countries benefiting from the European AMC. An alternative option would be to continue setting up AMCs at the national level. However, public capital may be needed to facilitate private sector participation. Under the new bank recovery and resolution directive (BRRD), selling assets to the AMC above market price (which is considered state aid) triggers a bail-in of junior creditors, the implementation of a restructuring plan for the bank, and, since January 2016, possibly a bail-in of senior creditors as well. Some of these senior bonds have been sold by banks to retail customers, which creates a significant hurdle for governments in some countries to move in that direction. Given the systemic and financial stability considerations in countries where the NPL problem encompasses large swathes of the banking sector, bank-level resolution considerations should not dominate, even if banks having structural viability problems should be restructured. To facilitate the creation of AMCs, measures to treat NPLs on bank balance sheets within the existing rules without triggering bail-in and resolution procedures should be examined, including possible initiatives at the European level. A very high level of NPLs should be considered a serious economic disturbance and warrant such a waiver to bail-in and resolution procedures within the existing rules. Alternatively, a more lenient approach in the definition of the price level triggering state aid – and hence resolution – could be applied. Both approaches would have to be weighed carefully against moral hazard effects and the possible exacerbation of the sovereign-bank nexus. Currently, the European Commission considers that there is state aid – hence triggering resolution – for any purchase of the NPL by a state-supported AMC at a price above the estimated “market price” of the NPL. Alternatively, when market prices are uncertain and depressed by stressed conditions, resolution requirements could be applicable only for prices above a level half way between the “market price” and the “real economic value” (the latter being the ceiling above which purchases of NPLs by a state-supported AMC are prohibited). Member states benefitting from this exceptional treatment could in return be required to make their insolvency regimes more efficient, which would facilitate a faster recovery of collaterals and thus enable the AMCs to get a higher price for impaired assets.

Completing banking union Despite recent progress, banking union is still unfinished business. Additional, mutually-reinforcing steps in the areas of supervision, resolution and deposit insurance are required. By curbing the still large potential for negative feedback loops between banks and their sovereigns, completing the banking union would considerably ease crisis

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management. Together with steps to create a Capital Markets Union, it would also foster capital markets integration, with benefits for monetary policy transmission, private risk-sharing and rebalancing across the euro area. Furthermore, many of these channels, together with decreased uncertainty brought about by a more complete Economic and Monetary Union, would spur investment and demand in Europe. The Single Supervisory Mechanism (SSM), comprising the ECB and the competent national authorities, came into operation in November 2014. The ECB directly supervises about 130 large banks, which account for over 80% of euro area banking assets, and oversees the supervisory activities of the competent national authorities on other banks. However, the regulatory framework remains fragmented by numerous options and discretions in the way national supervisors or legislators implement the EU banking law, which inter alia creates obstacles to harmonised supervision and cross-border banking consolidation in Europe. Recent harmonisation work by the ECB is expected to tackle about 120 options and discretions in the supervisory remit through an ECB regulation plus guidance to supervisory teams for decisions on a case-by-case basis (ECB, 2015). A level playing field, however, also depends on national legislation, both in banking law and in related matters, such as insolvency regimes. Beyond harmonisation, the EU banking law treatment of sovereign exposures, now generally zero-risk weighted and exempted from large exposure limits, is under review. However, to avoid disruptions to sovereign debt markets and government financing, changes in regulation in this area should follow a co-ordinated approach at global level and require careful consideration of transition arrangements (ESRB, 2015). The Single Resolution Mechanism became fully operational in January 2016, as planned, with a resolution authority (the Single Resolution Board), a harmonised framework for resolution tools (the Bank Recovery and Resolution Directive) and dedicated financial resources (the Single Resolution Fund). Bailing in shareholders and creditors by at least 8% of total liabilities (including own funds) is in general a pre-condition for access to the Single Resolution Fund. Over an eight-year transition period, this Fund will be built up with risk-adjusted contributions from banks, and its national compartments will be gradually mutualised. By end-2023, it should reach 1% of covered deposits in participating member states (an estimated EUR 55 billion). During the transition period, national credit lines will back up national compartments. Further progress at both national and European levels is needed on deposit insurance. The 2014 Deposit Guarantee Schemes Directive further harmonised coverage, sped up pay-out to depositors and strengthened funding requirements for national schemes, which are in general to be built-up to a minimum 0.8% of insured deposits by 2024. However, due to different starting points, transposition delays (most countries missed the July 2015 deadline) and remaining options and discretions, actual funding levels still vary widely. While desirable in its own right, reinforcing national insurance schemes through full implementation of the 2014 directive would also help to pave the way for mutualised area-wide insurance by decreasing moral hazard concerns. Even when fully built-up, national deposit guarantee schemes will remain vulnerable to large national shocks, an issue that mutualisation would mitigate. A recent European Commission proposal for a European Deposit Insurance Scheme, to be phased in over 2017-24, is a welcome step (European Commission, 2015a, 2015b). Overall costs for banks would not change, as contributions to the European Deposit Insurance Scheme would gradually replace those to national schemes, and the funding target of 0.8% of

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covered deposits by 2024 would also remain unchanged. Moreover, bank contributions would better reflect risk, since they would be calculated relative to all other participating banks, rather than in relation to individual national banking systems. Equally welcome is the pre-condition of further harmonisation of national schemes, in aspects like target levels of funding and determination of risk-adjusted bank contributions. To complete the banking union, it is necessary to introduce a European fiscal backstop to the Single Resolution Fund and to the European Deposit Insurance Scheme, once it is implemented. Layers of defence have been put in place in recent years, such as higher capital requirements, enhanced supervision and bail-in provisions. Yet the Single Resolution Fund, small even when fully built-up, could be insufficient to cope with a large banking crisis (CEPS, 2014). The direct bank recapitalisation instrument of the European Stability Mechanism, operational since December 2014 and designed as a last-resort tool after Single Resolution Fund intervention, provides only a partial solution. Amounts dedicated to this instrument are also limited (EUR 60 billion) and eligibility criteria are restrictive (Juncker et al., 2015), as they require national co-financing and could include general economic policy conditionality. A common backstop could be implemented through a credit line from the European Stability Mechanism to the Single Resolution Fund, and would be fiscally neutral in the medium term as banks would reimburse any public funds used through ex post contributions to the Single Resolution Fund. By breaking the banks-sovereign nexus at national level, a European fiscal backstop would also ease acceptance of tighter supervisory harmonisation (Schoenmaker and Wolff, 2015).

Making public finances more growth and equity-friendly The crisis has taken a heavy toll on public finances, calling for reforms at European and national level Public finances matter for growth and equity through multiple channels. Ensuring debt sustainability and smoothing cyclical fluctuations tend to support growth in mutually reinforcing ways. High levels of debt can hamper the ability to stabilise the economy (Fall and Fournier, 2015). In turn, deep recessions can harm long-term growth and thus compound sustainability challenges through hysteresis effects. By increasing long-term unemployment, these effects will also likely worsen inequality. Certain changes in the composition of expenditure or revenue can significantly enhance growth (IMF, 2015a). Examples include a greater prioritisation of public investment or education, or a shift of taxation from labour to consumption and property (Johansson et al., 2008; Cournède et al., 2013). More qualitative fiscal-structural reforms, such as basebroadening in taxation to fund tax rate decreases or greater efficiency in spending, would also be growth-friendly. At the same time, some compositional changes may harm equity, but others, such as those favouring education and childcare spending, enhance it. Sustainability, cyclicality, composition and efficiency are hence interconnected dimensions of the overall quality of public finances. However, several of these dimensions have deteriorated since the global financial crisis. The increase in public debt was substantial (Figure 19), largely due to the recession and to specific events, such as banking sector rescues (Eyraud and Wu, 2015). High debt can weaken fiscal sustainability including by triggering shifts in market sentiment, which could make debt financing more difficult. Further, although without firm conclusions on the direction of causality (e.g. Panizza and Presbitero, 2014), high debt levels tend to be associated with lower GDP growth. Concerns about high and rising debt, together with market pressure in some instances, led to sharp OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

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Figure 19. Evolution of gross public debt in the euro area1 Maastricht definition, as a percentage of GDP

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Figure 20. The fiscal stance in the euro area1 Change in the underlying balance as a share of potential GDP, percentage points

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1. Euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933366912

fiscal consolidation in the euro area as a whole, especially in 2011 and 2012, and to a lesser extent 2013 (Figure 20). Consolidation partly reflected earlier commitments in the context of the 2008-09 co-ordinated fiscal stimulus package. Although estimates of the importance of spillovers vary across studies, fiscal consolidation in one country can have a sizeable negative growth impact on others, especially in bad times (Goujard, 2013; Carnot and Castro, 2015). As a result, the simultaneous fiscal adjustment across the euro area, including in core countries, is considered to have made the recession deeper and longer (Baldwin et al., 2015). This likely aggravated the debt-GDP ratio as growth was weaker.

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Furthermore, shifts in budget composition have generally hurt medium-term growth prospects, especially in the countries carrying out the largest fiscal adjustments. Spending restraint has fallen heavily on public investment (Figure 21). Several countries, especially those hit hardest by the crisis, also cut social protection expenditures on family and children, although this spending tends to be growth and equity-friendly. Developments in revenue composition have been less harmful, but still a matter of concern. Social contributions have tended to account for a modest share of the adjustment, which is welcome, but personal income taxes have increased significantly in many countries. These increases can potentially make income distribution less unequal but tend to penalise employment and growth. Worryingly, labour tax wedges in euro area countries, already high in international comparison, have tended to rise further, and those on low incomes have sometimes risen the most (Figure 21). A recent stock-taking of reforms shows that many euro area countries are planning or implementing labour tax reductions, though measures could be more ambitious (European Commission, 2015c). These developments in government revenue and spending have gone hand in hand with only a modest degree of implementation of fiscal-structural reforms that improve the composition or efficiency of public finances. Action in response to country-specific recommendations addressed to countries by the European institutions has on average been relatively low, and below-average in fiscal-structural policy areas (Deroose and Griesse, 2014). For instance, there has been limited progress in reducing taxes on labour and broadening tax bases. On the spending side, reforms to strengthen public administration governance and to improve cost-effectiveness and performance in key domains, such as education and health, have also tended to display below-average implementation. While most policy levers to improve the quality of public finances remain at the national level, European and national policies can be mutually reinforcing in two key areas: fiscal governance and public investment. Fiscal governance matters for virtually all dimensions of the quality of public finances. Especially since the crisis, numerical fiscal rules have striven to reconcile sustainability and stabilisation (Schaechter et al., 2012). Other desirable features of fiscal governance, such as a multi-year budget horizon and independent fiscal institutions, can enhance the effectiveness of numerical rules and yield benefits for the composition and efficiency of public finances. For instance, better budget institutions tend to lead to more growth-friendly fiscal consolidation (IMF, 2014; Gonçalves and Pina, 2016). Multi-year budget frameworks, as encouraged by recent Stability and Growth Pact (SGP) reforms, help optimise public investment (IMF, 2015b), which is one of the fiscal tools with the strongest impacts on growth. Collective action to increase public capital formation and leverage private investment is critical to overcome persistent investment weakness in Europe and spur growth both in the short and the medium run. Especially in the latter horizon, the Investment Plan for Europe, in articulation with national resources and with other instruments at EU level, such as regional policy funds, may play an important role.

Reforming European fiscal governance to promote collective and inclusive growth Fiscal policy remains a key competency at the national level. At the same time, national budgets are also subject to the requirements of the Stability and Growth Pact (SGP). The SGP has a dual structure, with a corrective arm and a preventive arm. The first, also called the Excessive Deficit Procedure (EDP), is based on ceilings for the nominal deficit and debt as a

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Figure 21. Post-crisis fiscal consolidation episodes: Composition and labour tax wedge developments1 A. Expenditure cuts Change in the underlying primary balance, % points of potential GDP2 15

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1. A fiscal consolidation episode is a period of consecutive years where the underlying primary balance is improving. A deterioration of this balance in an intermediate year is admissible, provided the balance improves in the sum of any two adjacent years. Episodes considered in the chart are those starting in 2009 or later. Due to data limitations on the composition of consolidation, the final year considered is 2013, though for some countries consolidation efforts have continued afterwards. 2. On both revenue and expenditure sides, increases or decreases in cyclically-adjusted budget items do not always relate to discretionary policy measures. For instance, tax elasticities can fluctuate for reasons not captured by the corrections performed for the economic cycle and for one-offs. 3. Income tax plus employee and employer contributions less cash benefits as a percentage of labour costs. Source: D. Gonçalves and Á. Pina (2016), “The composition of fiscal consolidation episodes: Impacts and determinants” and D. Bloch et al. (2016), “Trends in public finance: Insights from a new detailed dataset”, both OECD Economics Department Working Papers, forthcoming; and OECD (2016), “Taxing Wages: Comparative tables”, OECD Tax Statistics (database). 1 2 http://dx.doi.org/10.1787/888933367086

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ratio to GDP (3% and 60%, respectively). The preventive arm is based on the so-called medium-term objective (MTO), which provides a medium-term target for the structural budget balance of each country. Some 2011-13 reforms make better allowance for the fiscal and economic situation of the EU member states. At the same time, SGP rules have become complex due to the proliferation of different numerical targets, procedures, contingency provisions and compliance indicators across the two arms (OECD, 2014a; Eyraud and Wu, 2015). The SGP has nonetheless remained primarily focussed on individual national policies, with scope for further consideration of their aggregate area-wide impacts. Furthermore, despite strengthened enforcement provisions of the preventive arm, those of the EDP remain more visible, often making policymakers focus on the 3% of GDP deficit threshold, risking procyclical policy responses. With Treaty changes unlikely in the coming years (Juncker et al., 2015; European Commission, 2015d), the short-term challenge is to ensure a sound application of the current SGP rules. In particular, degrees of freedom afforded by the rules should be used by countries with fiscal space to contribute to a more supportive joint euro area fiscal stance. The preventive arm contains some welcome flexibility in the structural balance trajectory towards the MTO. The required annual fiscal adjustment depends on cyclical conditions (for instance, with no required adjustment in case of negative GDP growth). In some cases, there can be temporary deviations from the MTO or the consolidation plan towards it to accommodate the short-term fiscal costs of major structural reforms, including certain kinds of investment. Rule enforcement allows for some margins of tolerance, since a deviation from the MTO or the path towards it is regarded as significant only if it reaches at least 0.5% of GDP in one year, or 0.25% on average in two consecutive years. Further, countries may be allowed to temporarily deviate from the adjustment path towards the MTO in periods of severe area-wide economic downturn, a provision unused so far. As cyclical conditions improve and more countries leave the EDP, the need for fiscal adjustment under the preventive arm will increase. In this context, rules should be strictly enforced to help avoid a return to fiscal slippages in good times, as occurred before the global financial crisis (Eyraud and Wu, 2015; Carnot and Castro, 2015). In bad times, national fiscal policies should take account of cross-country spillovers (Goujard, 2013) and, within SGP rules, contribute to supporting euro area aggregate demand. In the current weak recovery, countries should use the flexibility afforded by preventive arm rules to temporarily slow down or halt consolidation efforts and, if room for manoeuvre under the SGP exists, adopt a temporary fiscal expansion. Public investment on trans-European networks should rank high among the priorities for using fiscal space. The recently announced European Fiscal Board may help to inform the debate on the appropriate area-wide fiscal stance and how it should translate into national fiscal stances. In the corrective arm, large adjustments induced by the debt reduction benchmark should be avoided. The benchmark requires that the excess of the debt ratio over 60% of GDP be reduced at an average 1/20th per year (with some transitional provisions). For highly indebted countries, these fiscal adjustments can be very large. Italy, for instance, would have needed a cumulative structural effort of around 3 per cent of GDP over 2013-15 (European Commission, 2015e). In the cases it has examined so far (Belgium and Italy), the Commission took account of expected compliance with preventive arm requirements and

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expected implementation of ambitious structural reforms, as well as of unfavourable economic conditions (especially low inflation), and decided not to open an EDP (European Commission, 2015e, 2015f). A similar approach should be taken in forthcoming cases, as other highly indebted countries leave the EDP and become subject to the debt reduction benchmark. In a future SGP revision, the appropriate speed of adjustment towards the 60% of GDP debt threshold should be reviewed (see below). It is also important to strengthen incentives for reform, including of national budget frameworks. The corrective arm requires an annual adjustment of at least 0.5% of GDP regardless of cyclical developments, which may imply a procyclical stance, and a deadline for eliminating the excessive deficit. Longer deadlines are the main provisions for flexibility. Largely due to the recession, only five euro area countries achieved compliance with the initial deadline in EDPs that started in 2009/10, and five others were granted two or more deadline extensions. Building on recent steps (European Commission, 2015g), the Commission could make greater use of longer initial deadlines (or deadline extensions, conditional on a satisfactory track record of fiscal adjustment) to provide incentives for fiscal-structural reforms. Greater emphasis should also be given to the quality of national budgetary frameworks (an aspect already contemplated in current legislation) when taking EDP steps. Over the medium term, SGP rules should be improved along two main dimensions. First, to reduce complexity and asymmetries in enforcement, the preventive and corrective arms could be more closely aligned and possibly merged, giving rise to a single set of targets, procedures and indicators. Second, the current multiplicity of numerical rules could be replaced by a single fiscal anchor underpinned by a single operational rule (Andrle et al., 2015). The natural anchor is the public debt-to-GDP ratio in each country, given its direct link to fiscal sustainability. These reforms would imply very substantial legislative changes, including to the Treaty. The spring 2017 White Paper envisaged in the Five Presidents’ Report (Juncker et al., 2015) offers an opportunity to start preparatory work.

Reinforcing national budgetary frameworks Budget frameworks at national level play a key role in improving the quality of public finances and the procedures and institutions involved in preparing, approving and executing budgets are highly country-specific. The SGP reform of 2011-13 required stronger national fiscal frameworks, including numerical fiscal rules, independent fiscal institutions and improved budget reporting and transparency. Important strides have been made in some areas, such as the coverage and timeliness of budget statistics and the creation of independent fiscal institutions. However, overall budget reform activity since late 2011, as assessed by the OECD, has been generally modest (Figure 22). Apart from the transposition of the MTO into national law, the adoption of national-level numerical rules, such as expenditure rules with a broad coverage, has been limited (Schaechter et al., 2012; Bova et al., 2015). In most countries, more micro-level reforms enabling systematic expenditure prioritisation or the efficient use of performance information in budgeting have also had low implementation. Adopting national expenditure rules and regularly conducting spending reviews would upgrade budget frameworks in mutually reinforcing ways. Expenditure rules offer a good balance between sustainability and stabilisation objectives, as automatic stabilisers are largely on the revenue side, and tend to perform well on other counts, such as simplicity and ease of communication (Andrle et al., 2015). In turn, through systematic

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Figure 22. Intensity of budgetary reform in euro area countries1 Since end 2011, number of countries

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scrutiny of baseline expenditure, spending reviews can improve prioritisation and help achieve efficiency gains (Robinson, 2014). Rule-based aggregate expenditure ceilings provide a medium-term anchor to the determination of annual spending allocations, and thus facilitate reforms to increase the efficiency of public spending at sectoral or programme level. When integrated into the regular process of budget preparation, spending reviews support adherence to aggregate spending ceilings. Monitoring of rule compliance, as well as of spending reviews’ follow-up recommendations and respective impacts, should be entrusted to an independent fiscal institution. Besides monitoring compliance with fiscal rules and preparing or endorsing macroeconomic forecasts, according to SGP requirements, the remit of national independent fiscal institutions could be usefully extended to estimating the costs of proposed policies, a common task among such institutions outside the European Union (Debrun and Kinda, 2014). This would contribute to a more informed public debate on spending and tax policies, potentially leading to a better design of such policies. Independent fiscal institutions should also be provided with the resources and conditions for a credible fulfilment of their mandate. Staff needs would generally increase if institutions were tasked with cost estimates, as this requires sector and programme-specific expertise. Safeguards on institutions’ budgets, such as multiannual funding commitments, are often lacking, but would enhance the independence of those bodies (OECD, 2014b). Less than half of EU independent fiscal institutions have full access to non-public budgetary information (European Commission, 2014). Finally, relations between the new advisory European Fiscal Board and national independent fiscal institutions should be organised in a mutually-reinforcing way, as planned, thus avoiding to undermine the scope of action and credibility of the latter.

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Leveraging the impact of EU investment policies Both European and national policy levers play a key role in ensuring enough and efficient spending on public investment. EU budget funds for investment and other growth-enhancing expenditure, such as on education and active labour market programmes, stand at 0.5% of EU GDP. This amount is arguably too low if account is taken of the potential for generating economies of scale and positive externalities, for example from research and development or infrastructure. However, even these limited resources can have a leveraged impact on the composition and efficiency of public finances if deployed in a way to crowd in national public funds and private investment, and foster greater investment productivity. At national level, better co-ordination of investment across levels of government and upgraded administrative capacity would increase investment efficiency. The structure of EU budget expenditure should be made more growth-friendly. Funds aimed at investment and growth account for close to half of the total (Figure 23, “Smart and inclusive growth”). Most of these resources fund European regional policy and are geographically allocated. In contrast, “Competitiveness for growth and jobs” programmes are directly managed at European level with no country-specific allocations. They include, among others, the research and innovation Horizon 2020 and the Connecting Europe Facility (targeted at the development of trans-European networks in transport, energy and digital services). Also, in the context of the Investment Plan for Europe, the European Fund for Strategic Investments supports projects across the EU with no geographic pre-allocation. In the short term, it is essential to preserve investment and growth allocations in the face of pressures on other fronts, such as the refugee crisis. In the longer term, post-2020 financial frameworks should continue to increase resources for growth-enhancing expenditure, funded by either reallocation of expenditure or an increase in the overall EU budget size.

Figure 23. European Union budget: Structure of expenditure As a percentage of total commitments appropriations for 2014-20

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It is important to ensure additionality in EU regional policy (i.e. that EU funding adds to, rather than replaces, national public spending) and that funds are spent efficiently. Monitoring and enforcement mechanisms for additionality have been reinforced only gradually, and remain weak: possible sanctions appear late in the process (not before 2022 for the 2014-20 period) and are relatively light. Furthermore, especially for euro area countries, the levels of gross fixed capital formation required for compliance with additionality look often unambitious, implying an increase in the share of European structural and investment funds (and thus a decrease in that of national funds) in total public investment (Figure 24). Current rules for additionality should be credibly enforced, starting with the 2018 mid-term verification, where increasing required investment levels could be considered. In future programming periods, more ambitious levels should likewise be envisaged, and possible sanctions brought to an earlier stage.

Figure 24. European structural and investment funds as a share of public investment1 Per cent

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1. Allocations for the European Regional Development Fund, European Social Fund and Cohesion Fund as a share of government gross fixed capital formation. 2. Share of European structural and investment fund (ESIF) allocations in public investment if the latter equals the agreed reference levels for additionality verification. The fact that part of ESIF allocations will not fund gross fixed capital formation but rather other spending items (e.g. certain transfers) helps explain why shares can exceed 100%. In Italy and Slovenia the national-wide additionality targets depicted are merely indicative, as additionality will be verified at a regional level. Source: Calculations based on allocation data from European Commission Decision documents C(2006) 3473, 3474, 3475 and later amendments, C(2014) 2082 final and “Available budget 2014-2020”, http://ec.europa.eu/regional_policy/en/funding/available-budget; gross fixed capital formation data from OECD (2015), OECD Economic Outlook: Statistics and Projections (database) and Long-term Baseline, internal database, Economics Department. 1 2 http://dx.doi.org/10.1787/888933367118

To support institutional quality and investment efficiency, conditionality requirements in EU regional policy have been generally reinforced in the 2014-20 period. Numerous ex ante conditionalities need to be met before the disbursement of funds, either of a general nature (such as compliance with public procurement rules) or of a thematic one (such as the existence of national strategies in specific sectors). In addition, macroeconomic conditionality aims to reinforce consistency between European structural and investment funding and key elements of EU economic governance. For instance, to better address country-specific recommendations, the Commission may request countries

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to reprogramme structural and investment funds, which could improve their alignment with relevant structural reforms. As in the case of ex ante conditionalities, preserving national ownership of reforms and other requirements will nonetheless be key. In other cases, however, macroeconomic conditionality may be counterproductive. For example, the Commission must propose a suspension of structural funds when the Council assesses that no effective action has been taken to correct an excessive deficit. Though modulated in the light of economic and social conditions, suspended amounts will be at least in the range of 0.25 to 0.5% of GDP (or 25% to 50% of annual structural and investment funding if lower). This suspension will be lifted and re-budgeted as soon as the member state has adopted the necessary corrective action. Nevertheless, under fiscal stress, these sanctions would likely worsen the composition of public expenditure by intensifying downward pressures on public investment and other growth-enhancing items, and should therefore in most cases be avoided. Announced in November 2014, the Investment Plan for Europe aims to generate at least EUR 315 billion (2.2% of 2015 EU GDP) of additional investment over three years, mainly from private sources and with a focus on strategic sectors, including infrastructure, innovation and SMEs. The Plan’s funding pillar (the European Fund for Strategic Investments, EFSI) allows the European Investment Bank (EIB) Group to finance projects that would not have been supported otherwise. The EFSI is endowed with a risk-absorbing capacity of EUR 21 billion: EUR 5 billion from EIB resources, and an EU guarantee of EUR 16 billion. This guarantee will be backed up by EU budget resources mainly reallocated from other growth-enhancing programmes (Horizon 2020 and the Connecting Europe Facility). Alternative reallocations, drawing on less growth-friendly expenditure, would have been preferable. Similarly, it is important to ensure that the amounts committed by several countries to provide co-financing to investments represent additional public support, rather than investment reallocation. EFSI-supported investment has so far provided negligible stimulus to activity, but it may have a positive medium-term impact: project approvals are proceeding in line with the target, with those approved by mid-May 2016 expected to trigger total investment of about EUR 100 billion in the coming years. The Plan also comprises a second pillar for technical assistance (through the European Investment Advisory Hub) and project promotion, and a third pillar for structural reforms to create an investment-friendly environment, which are discussed in the 2016 OECD Economic Survey of the European Union. A case in point, essential to unlock investment, is the reduction of regulatory heterogeneity across Europe. Given limited public resources, the medium-term success of the Plan will hinge on its ability to leverage private investment, for which the EIB Group’s lending behaviour and the quality of the projects presented will be key. The EUR 315 billion investment target presupposes a multiplier of 15: the EFSI guarantee should enable three times as much EIB Group funding, which will be used to finance an average 20% of the value of investment projects (the remainder coming from additional investors, with a large role played by the private sector). This requires selecting projects which are attractive for additional co-funding and (to avoid crowding-out) which would not otherwise be carried out. Crowding in private investment on the scale envisaged also requires that the EIB Group depart from its usual very prudent lending practices, characterised by a choice of low-risk projects and negligible levels of non-performing loans (Claeys, 2015). This implies accepting projects with higher risk than in the past, and financing on average a lower share of each (one-fifth, rather than the traditional one-third to one-half).

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ASSESSMENT AND RECOMMENDATIONS

Improving public investment governance At national level, stepping up efforts to co-ordinate investment among tiers of government is essential. Across the OECD, sub-national governments account for about 60% of total public investment, highlighting the need for vertical and horizontal co-ordination mechanisms (OECD, 2013). However, effective co-ordination is difficult: in a recent survey on infrastructure investment, more than three quarters of EU sub-national governments reported co-ordination challenges (OECD and Committee of Regions, 2015). Potential tools to foster co-ordination include bringing together different jurisdictions in dialogue fora with actual involvement in decision-making, co-financing and conditionality mechanisms, and the promotion of collaboration between sub-national governments through the removal of legal and regulatory barriers, possibly coupled with financial incentives. Better co-ordination among sub-national governments will also enhance their ability to promote sound investment projects under the Investment Plan for Europe. Public administration capacity is also essential for efficient investment, but is often inadequate, especially at sub-national level. There is wide variation in the perceived quality of sub-national governments across the European Union, as well as within some countries (Charron et al., 2012). Capacity challenges have been identified at various stages of the investment cycle, including long-term strategic planning, the ability to involve the private sector (for instance through public-private partnerships) and public procurement (OECD, 2013). Aware of these weaknesses, EU regional policy has included the enhancement of administrative capacity among its ex ante conditionalities for the 2014-20 period, with an accompanying increase in financial support for this purpose. A recent proposal for a Structural Reform Support Programme (European Commission, 2015h) will also support capacity building, namely through technical assistance. At the same time, the European Investment Advisory Hub has the potential to provide expertise to national authorities and co-ordinate the already existing technical assistance activities. National authorities should prioritise actions to preserve and develop administrative capacity at different levels of government in response to the main gaps detected. In times of fiscal restraint, these considerations should inform the design of fiscal consolidation.

Bibliography Aiyar, S. et al. (2015), “A strategy for resolving Europe’s problem loans”, IMF Staff Discussion Note, No. SDN/15/19, International Monetary Fund, Washington, DC. Ambler, S. (2009), “Price-level targeting and stabilisation policy: A survey”, Journal of Economic Surveys, Vol. 23, No. 5, pp. 974-997, Wiley, http://dx.doi.org/10.1111/j.1467-6419.2009.00601.x. Andrle, M. et al. (2015), “Reforming fiscal governance in the European Union”, IMF Staff Discussion Note, No. 15/09, International Monetary Fund, Washington, DC. Baldwin et al. (2015), “Rebooting the Eurozone: Step 1 – Agreeing a crisis narrative”, CEPR Policy Insight, No. 85, Centre for Economic Policy Research. Bova, E., T. Kinda, P. Muthoora and F. Toscani (2015), “Fiscal rules at a glance”, Background document updating IMF Working Paper, No. 12/273, April, International Monetary Fund, Washington, DC. Carnot, N. and F. Castro (2015), “The discretionary fiscal effort: An assessment of fiscal policy and its output effect”, European Economy – Economic Papers, No. 543, European Commission, http://dx.doi.org/ 10.2765/46021. CEPS (2014), ECB Banking Supervision and Beyond: Report of a CEPS Task Force, December, Centre for European Policy Studies, Brussels.

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Charron, N., V. Lapuente and L. Dijkstra (2012), “Regional governance matters: A study on regional variation in quality of government within the EU”, Working Papers, No. WP 01/2012, Directorate-General for Regional Policy, European Commission. Claeys, G. (2015), “‘Juncker plan’: The EIB in the driver’s seat”, Bruegel blog post, 30 June. Coeuré, B. (2015), “Completing the single market in capital”, Financial Stability Review, No. 19, April, Banque de France. Coeuré, B. (2014), “Life below zero: Learning about negative interest rates”, Speech, Frankfurt am Main, 9 September. Cournède, B., A. Goujard and Á. Pina (2013), “How to achieve growth- and equity-friendly fiscal consolidation?: A proposed methodology for instrument choice with an illustrative application to OECD Countries”, OECD Economics Department Working Papers, No. 1088, OECD Publishing, Paris, http://dx.doi.org/10.1787/5k407lwvzkkh-en. Debrun, X. and T. Kinda (2014), “Strengthening post-crisis fiscal credibility – Fiscal councils on the rise. A new dataset”, IMF Working Papers, No. WP/14/58, International Monetary Fund, Washington, DC. Deroose, S. and J. Griesse (2014), “Implementing economic reforms – Are EU Member States responding to European semester recommendations?”, ECFIN Economic Briefs, No. 37, European Commission, http://dx.doi.org/10.2765/73044. ECB (2015), “Public consultation on a draft Regulation and Guide of the European Central Bank on the exercise of options and discretions available in Union law”, Explanatory memorandum, European Central Bank, Frankfurt am Main. ESRB (2015), ESRB publishes report on the regulatory treatment of sovereign exposures, European Systemic Risk Board, www.esrb.europa.eu. European Commission (2015a), “Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) 806/2014 in order to establish a European Deposit Insurance Scheme”, COM(2015) 586 final. European Commission (2015b), “Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions, ‘Towards the completion of the Banking Union’”, COM(2015) 587 final. European Commission (2015c), “Communication from the Commission. 2016 Draft Budgetary Plans: Overall Assessment”, COM(2015) 800 final, 16 November. European Commission (2015d), “Communication from the Commission to the European Parliament, the Council and the European Central Bank. On steps towards Completing Economic and Monetary Union”, COM(2015) 600 final, 21 October. European Commission (2015e), “Report from the Commission. Italy. Report prepared in accordance with Article 126(3) of the Treaty”, COM(2015) 113 final, 27 February. European Commission (2015f), “Report from the Commission. Belgium. Report prepared in accordance with Article 126(3) of the Treaty”, COM(2015) 112 final, 27 February. European Commission (2015g), “Communication from the Commission to the European Parliament, the Council, the European Central Bank, the Economic and Social Committee, the Committee of the Regions and the European Investment Bank. Making the Best Use of the Flexibility within the Existing Rules of the Stability and Growth Pact”, COM(2015) 12 final provisional, 13 January. European Commission (2015h), “Proposal for a Regulation of the European Parliament and of the Council on the establishment of the Structural Reform Support Programme for the period 2017 to 2020 and amending Regulations (EU) No. 1303/2013 and (EU) No. 1305/2013”, COM(2015) 701 final. European Commission (2014), Report on Public Finances in EMU 2014, European Economy, No. 9. Eyraud, L. and T. Wu (2015), “Playing by the rules: Reforming fiscal governance in Europe”, IMF Working Papers, No. 15/67, International Monetary Fund, Washington, DC. Fall, F. and J.M. Fournier (2015), “Macroeconomic uncertainties, prudent debt targets and fiscal rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/5jrxv0bf2vmx-en. Gonçalves, D. and Á. Pina (2016), “The composition of fiscal consolidation episodes: Impacts and determinants”, OECD Economics Department Working Papers, OECD Publishing, Paris, forthcoming.

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Goujard, A. (2013), “Cross-country spillovers from fiscal consolidations”, OECD Economics Department Working Papers, No. 1099, OECD Publishing, Paris, http://dx.doi.org/10.1787/5k3txn1mbw8x-en. IMF (2015a), “Fiscal policy and long-term growth”, IMF Policy Papers, April, International Monetary Fund, Washington, DC. IMF (2015b), “Making public investment more efficient”, IMF Policy Papers, June, International Monetary Fund, Washington, DC. IMF (2014), “Budget institutions in G-20 countries: An update”, IMF Policy Paper, April, International Monetary Fund, Washington, DC. IMF (2013), “Unconventional monetary policies – Recent experience and prospects”, International Monetary Fund, Washington, DC. Johansson, Å. et al. (2008), “Taxation and economic growth”, OECD Economics Department Working Papers, No. 620, OECD Publishing, Paris, http://dx.doi.org/10.1787/241216205486. Juncker, J.C., D. Tusk, J. Dijsselbloem, M. Draghi and M. Schulz (2015), The Five Presidents’ Report: Completing Europe’s Economic and Monetary Union, European Commission, http://ec.europa.eu/ priorities/sites/beta-political/files/5-presidents-report_en.pdf. Kierzenkowski, R., N. Pain, E. Rusticelli and S. Zwart (2016), “The economic consequences of Brexit: A taxing decision”, OECD Economic Policy Papers, No. 16, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/5jm0lsvdkf6k-en. OECD (2015a), OECD Economic Outlook, Volume 2015 Issue 1, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/eco_outlook-v2015-1-en. OECD (2015b), International Migration Outlook 2015, OECD Publishing, Paris, http://dx.doi.org/10.1787/ migr_outlook-2015-en. OECD (2015c), OECD Economic Outlook, Volume 2015 Issue 2, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/eco_outlook-v2015-2-en. OECD (2014a), OECD Economic Surveys: Euro Area 2014, OECD Publishing, Paris, http://dx.doi.org/10.1787/ eco_surveys-euz-2014-en. OECD (2014b), “Recommendation of the Council on principles for independent fiscal institutions”, Public Governance and Territorial Development Directorate and OECD Senior Budget Officials (SBO), February, www.oecd.org/gov/budgeting/OECD-Recommendation-on-Principles-for-IndependentFiscal-Institutions.pdf. OECD (2013), Investing Together: Working Effectively across Levels of Government, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264197022-en. OECD and Committee of the Regions (2015), “Results of the OECD-CoR Consultation of Sub-national Governments. Infrastructure planning and investment across levels of government: Current challenges and possible solutions”, https://portal.cor.europa.eu/europe2020/pub/Documents/oecd-corjointreport.pdf. Ollivaud, P. and D. Turner (2014), “The effect of the global financial crisis on OECD potential output”, OECD Economics Department Working Papers, No. 1166, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/5jxwtl8h75bw-en. Panizza, U. and A. Presbitero (2014), “Public debt and economic growth: Is there a causal effect?”, Journal of Macroeconomics, Vol. 41, pp. 21-41, Elsevier, http://dx.doi.org/10.1016/j.jmacro.2014.03.009. Rey, H. (2015), “Dilemma not trilemma: The global financial cycle and monetary policy independence”, NBER Working Paper Series, No. 21162, National Bureau of Economic Research, Cambridge MA. Robinson, M. (2014), “Spending reviews”, OECD Journal on Budgeting, Vol. 13/2, OECD Publishing, Paris, http://dx.doi.org/10.1787/budget-13-5jz14bz8p2hd. Schaechter, A., T. Kinda, N. Budina and A. Weber (2012), “Fiscal rules in response to the crisis – Toward the ‘next-generation’ rules. A new dataset”, IMF Working Papers, No. WP/12/187, International Monetary Fund, Washington, DC. Schoenmaker, D. and G. Wolff (2015), “What options for European deposit insurance”, Bruegel, Blog Post, 8 October.

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ANNEX

Progress in structural reform

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Main recommendations

Action taken since the previous Survey (2014) A. Monetary policy

Keep the current expansionary monetary policy stance over an Monetary policy has become more supportive since mid-2014, through extended period, subject to the outlook for price developments over the policy rate cuts (which have taken the deposit rate increasingly to medium term. negative territory), a series of targeted long-term refinancing operations and expanded asset purchases. B. Banking regulation and banking union Ensure that the ongoing comprehensive assessment of banks – which consists of three complementary elements: a supervisory risk assessment, an asset quality review and a stress test – leads to a consistent overall evaluation of banks’ balance sheets.

The 2014 comprehensive assessment of banks’ balance sheets improved information on the health of the financial sector and led, in a number of cases, to bank recapitalisations, paving the way for the coming into operation of the Single Supervisory Mechanism.

Adopt a single resolution mechanism with predictable and swift The Single Resolution Mechanism became fully operational in decision-making that is politically accountable, and ensure that it is January 2016. Its ability to take decisions in emergency situations has operative soon after the Single Supervisory Mechanism is in place. The not been tested yet. agreement needs to ensure the effectiveness of the mechanism and its ability to quickly take decisions in emergency situations. Ensure legal certainty and equal treatment in the bail-in of bank creditors across states to avoid complicating resolution processes and a potential negative impact on bank funding. Ensure minimisation of national discretion in setting resolution conditions.

The Bank Recovery and Resolution Directive was adopted (May 2014) and has been transposed by most countries. However, transposition has had some delays and has resulted in substantial heterogeneity across countries in resolution settings.

For the national resolution funds to be set up under the Bank Recovery and Resolution Directive, ensure that burden-sharing arrangements for banks with cross-border activities are available. For the Single Resolution Fund, establish strong arrangements to ensure cross-border resolution financing as long as the resources of the national compartments of the Fund are not yet fully pooled. Move over time to full pooling of the Fund resources. Prefund the Resolution Fund or temporarily bridge funding gaps that might occur in the transition phase via a fiscal backstop and recuperate the finances needed by risk-based contributions from the banking sector.

As per an intergovernmental agreement (May 2014), the Single Resolution Fund will be built-up over 2016-23 with risk-adjusted contributions from banks, and its national compartments will be gradually mutualised. In December 2015 countries agreed to set up national credit lines backing the respective national compartments.

Complement the Resolution Fund by a common fiscal backstop that is No action taken. fiscally neutral over the medium term and recoups ex post any bridge financing via contributions from the financial sector. Possible changes in the treatment of sovereign bonds, notably the Preparatory work on different policy options for reforming the gradual phasing out in the long run of the zero-risk weighting, should regulatory treatment of sovereign exposures has continued. No be assessed with a specific attention to possible impacts on the decisions have been taken yet. stability of financial markets. Any decision would need to be taken in a co-ordinated manner at the international level. Diversify in the long run the banks’ exposure to the debt of a single sovereign. Assess the merits of leverage ratios, as a supplementary measure to risk-weighted ratios, for gauging the strength of bank balance sheets. C. Fiscal policy and the budgetary framework Continue fiscal consolidation, respecting the requirements of the The aggregate fiscal stance turned into broadly neutral in 2015 and is Stability and Growth Pact, as planned and allow the automatic expected to remain so in 2016, which is welcome, as it eliminated a stabilisers to operate fully. source of drag on domestic demand. Design fiscal consolidation to favour inclusive growth and employment. In most cases, fiscal consolidation strategies have not favoured growth, equity and employment. Public investment has not recovered from previous cuts. Though some countries reduced social contributions in 2015, this has only reversed a small part of previous increases in labour taxation. Ensure effective implementation of the strengthened EU and Fiscal Compact rules in national fiscal frameworks, including medium-term budgeting, identification of future spending and revenue pressures and risks, independent fiscal councils and effective mechanisms to correct deviations from fiscal targets.

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More countries have set up independent fiscal institutions and transposed the medium-term objective and the adjustment path towards it into national law. The coverage and timeliness of budget statistics have improved. Less progress has been made in adopting national expenditure rules and regularly conducting spending reviews.

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Thematic chapter

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OECD Economic Surveys: Euro Area © OECD 2016

Chapter 1

Making public finances more growth and equity-friendly

Across the euro area, the ability of public finances to support equitable growth has tended to deteriorate. Concerns about high and rising public debt, together with market pressure in some cases, led to sharp fiscal consolidation in 2011-13, against the backdrop of a weak economic situation at the time, which is considered to have made the recession deeper and longer. Consolidation has slowed down afterwards, but countries with fiscal space have made limited use of the leeway allowed under EU fiscal rules to support euro area aggregate demand. The expenditure composition has generally become less growth-friendly, with large cuts in public investment. On the revenue side, already high taxes on labour have tended to increase further. Structural reforms with direct positive implications for the composition or efficiency of public finances have stalled. While most policy levers to improve public finances remain at the country level, European and national policies can be mutually reinforcing in fiscal governance and public investment. To achieve a euro area fiscal stance that fosters the recovery, countries with fiscal space under the Stability and Growth Pact rules should use budgetary support to raise growth, and existing incentives and flexibility should be taken advantage of to pursue reforms of tax and spending policies. At the national level, it is essential to further upgrade budgetary frameworks, including through the adoption of expenditure rules and regular performance of spending reviews. To promote capital formation and make it more effective, EU budget resources for investment should be deployed in a way to crowd in national public funds and private financing, and foster greater investment productivity. At the national level, better co-ordination of investment across levels of government and upgraded administrative capacity would increase investment efficiency.

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

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There is strong potential to improve growth and equity through better public finances Public finances matter for growth and equity through multiple channels Fiscal policies and instruments can help to achieve major socio-economic goals, such as providing cyclical stabilisation, promoting long-term economic growth and addressing redistributive objectives. Sustainability, cyclicality, and composition and efficiency of taxation and spending are crucial, interconnected dimensions of public finances and affect growth and equity through a variety of channels. Ensuring debt sustainability and smoothing cyclical fluctuations tend to be mutually reinforcing. High levels of debt can hamper the ability to stabilise the economy (Fall and Fournier, 2015). In turn, deep recessions can harm long-term growth and thus compound sustainability challenges through hysteresis effects. Certain changes in the composition of expenditure, such as greater prioritisation of public investment or education, or of revenue, such as shifting taxation from labour to consumption and property, can also support growth (Johansson et al., 2008; Cournède et al., 2013). The same holds for reforms of a more qualitative nature, such as broadening tax bases or greater efficiency in spending. In advanced economies, reforms of the composition of public finances can lift gross domestic product (GDP) per capita growth by close to 1 percentage point over 5 to 10 years (IMF, 2015a). Among OECD countries, making the composition of expenditure converge to that of the best performers (for instance, by increasing the share of public investment) could yield even larger growth payoffs (Fournier and Johansson, 2016). Fiscal policy also affects income distribution. Effective cyclical stabilisation tends to decrease inequality by reducing the risk of long-term unemployment. The tax-spending mix of consolidation episodes also matters for inequality, with spending-based episodes generally more harmful than revenue-based ones (Woo et al., 2013). This creates potential trade-offs between equity and other objectives, since spending-based consolidations are often regarded as more favourable to long-term growth and more likely to stabilise debt (Molnar, 2012). At a more disaggregated level, some changes in budget composition may also pose growth-equity trade-offs, such as when shifting taxation from direct to indirect taxes, but others are beneficial on both counts, such as when increasing the share of education in public spending (Fournier and Johansson, 2016). Greater prioritisation of spending on health, childcare and active labour market policies, accompanied by steps to preserve or enhance efficiency levels in those areas, is also likely to benefit both growth and equity (Cournède et al., 2013; OECD, 2015a). Co-ordinated action by euro area countries, harnessing national and common institutions and policies, is needed to make fiscal policy more supportive of inclusive growth. Countries with fiscal space within the boundaries of the Stability and Growth Pact should take account of the positive spillover effects of domestic fiscal expansion onto other member states and contribute to aggregate demand in the euro area. Member states should also further improve their budgetary frameworks, including by adopting

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expenditure rules, conducting spending reviews and implementing the ensuing recommendations, and exploring the full potential of independent fiscal institutions. This would support debt sustainability and cyclical stabilisation objectives, and would also help the implementation of reforms in the composition and efficiency of taxation and public spending. To tackle persistent investment weakness in Europe, these reforms should include co-ordinated efforts to increase public investment and make it more efficient, and to create better financial and regulatory conditions for private investment.

The crisis has taken a heavy toll on public finances On several counts, euro area public finances worsened as a consequence of the global financial crisis. The increase in public debt was substantial and broadly comparable to that in the United States (Figure 1.1), largely due to the recession and to specific events, such as banking sector rescues (Eyraud and Wu, 2015). Support to the financial sector has also implied sizeable levels of contingent liabilities. High actual and contingent debt can weaken fiscal sustainability: it can notably trigger shifts in market sentiment, which could make debt financing more difficult. High debt levels also tend to be associated with lower growth, though no firm conclusions have been reached on the direction of causality in the empirical literature (e.g. Panizza and Presbitero, 2014).

Figure 1.1. Evolution of gross public debt in the euro area and the United States General government gross financial liabilities as a percentage of GDP

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1. Euro area member countries that are also members of the OECD (15 countries). 2. Projections. Source: OECD (2016), “OECD Economic Outlook No. 99”, OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933367129

Concerns about high and rising debt, together with market pressure in some instances, led to sharp fiscal consolidation, especially in 2011 and 2012, and to a lesser extent 2013 (Figure 1.2). All euro area countries, including those which are usually considered to have a solid fiscal position, have undertaken consolidation efforts, which in several cases were well above 1 percentage point of GDP per year (Figure 1.3). Fiscal consolidation in the United States in 2011-13 was even larger, but came after an equally larger fiscal stimulus in 2008-09 and was accompanied by a more supportive monetary policy and a faster resolution of non-performing loans. OECD ECONOMIC SURVEYS: EURO AREA © OECD 2016

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Figure 1.2. The fiscal stance in the euro area and the United States Change in the underlying balance as a share of potential GDP, percentage points

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Figure 1.3. Post-crisis fiscal consolidation episodes: Change in the underlying primary balance1 Percentage points of potential GDP

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1. A fiscal consolidation episode is a period of consecutive years where the underlying primary balance is improving. A deterioration of this balance in an intermediate year is admissible, provided the balance improves in the sum of any two adjacent years. Episodes considered in the chart are those starting in 2009 or later. Due to data limitations on the composition of consolidation, the final year considered is 2013, though for some countries consolidation efforts have continued afterwards. Source: D. Gonçalves and Á. Pina (2016), “The composition of fiscal consolidation episodes: Impacts and determinants” and D. Bloch et al. (2016), “Trends in public finance: Insights from a new detailed dataset”, both OECD Economics Department Working Papers, forthcoming. 1 2 http://dx.doi.org/10.1787/888933367149

Even though delivered on a scale broadly comparable to plans, fiscal consolidation had a smaller-than-expected payoff in terms of halting the debt build-up (Figure 1.4), largely because of weak growth. Although estimates of the magnitude of spillovers vary across studies, fiscal consolidation in one country can have a sizeable negative growth impact on others, especially in bad times (Goujard, 2013; Carnot and Castro, 2015). As a result, the

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Figure 1.4. Fiscal consolidation and debt dynamics: Projections and outcomes1 Change in percentage points of GDP2

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simultaneous fiscal adjustment across the euro area, including in core countries, is considered to have made the recession deeper and longer (Baldwin et al., 2015). Within individual countries, the impact of consolidation on output, which tends to be larger in downturns and for spending cuts, may also have been underestimated, though the evidence is not fully conclusive (Blanchard and Leigh, 2013; Pain et al., 2014). Furthermore, shifts in expenditure composition have generally been detrimental to equity and longer-term growth, especially in the countries carrying out the largest fiscal adjustments. Spending restraint has fallen heavily on public investment (Figure 1.5), which in the countries hit hardest by the crisis was often more than halved in nominal terms (Table 1.1), falling as a share of GDP to values below the euro area average. In those countries, public consumption, including for education and health care purposes (Table 1.1), was also substantially curbed. In contrast, pensions have tended to be spared. Though making modest contributions to overall consolidation, social protection spending on family and children (comprising cash transfers and in-kind services and benefits) has often taken deep cuts (again, mostly in countries making the largest consolidation efforts). Developments in revenue composition have been less harmful, but still a matter of concern. Often the largest stream of revenue, social contributions have tended to account for a modest share of the adjustment, especially in the countries worst hit by the crisis. This is welcome, given the potential negative impacts of social contributions hikes on both growth and equity (Cournède et al., 2013). The brunt of revenue increases has come from the two other largest items, consumption taxes (other than environmental ones) and especially personal income taxes (Figure 1.5). Hikes in the latter can make income distribution less unequal but tend to penalise employment and growth, especially when implemented through rate increases. Labour tax wedges in euro area countries, already high in international comparison, have tended to rise further (Figure 1.6). More recently, many euro

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Figure 1.5. Post-crisis fiscal consolidation episodes: Contributions from revenue and expenditure1 Percentage points of potential GDP

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-4

FIN

BEL

FRA

DEU

ITA

AUT

LUX

NLD

SVN

SVK

PRT

EST

ESP

IRL

GRC

-4

B. Revenue increases 8

8 Personal income taxes

7

Social security contributions

Consumption taxes³

Other

Total primary revenue

7

6

6

5

5

4

4

3

3

2

2

1

1

0

0

-1

-1

-2

IRL

DEU

EST

NLD

AUT

LUX

SVN

ITA

FIN

FRA

BEL

SVK

ESP

PRT

GRC

-2

1. Fiscal consolidation episodes are the same as those in Figure 1.3. On both revenue and expenditure sides, increases or decreases in cyclically-adjusted budget items do not always relate to discretionary policy measures. For instance, tax elasticities can fluctuate for reasons not captured by the corrections performed for the economic cycle and for one-offs. 2. Education, health, other wages and intermediate consumption. 3. Other than environmental taxes. Source: D. Gonçalves and Á. Pina (2016), “The composition of fiscal consolidation episodes: Impacts and determinants” and D. Bloch et al. (2016), “Trends in public finance: Insights from a new detailed dataset”, both OECD Economics Department Working Papers, forthcoming. 1 2 http://dx.doi.org/10.1787/888933367168

area countries are planning or implementing labour tax reductions, though measures could be more ambitious (European Commission, 2015a). Unlike on the spending side, some positive developments have taken place as regards smaller revenue items, such as property or green taxes (Table 1.1). Recurrent taxes on immovable property, which tend to be among the least distortive forms of taxation, have often been substantially increased. In some countries, revenue from environmental taxes has also outpaced total primary revenue.

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Table 1.1. Post-crisis fiscal consolidation episodes: Cumulative change in revenue and expenditure items1 Cyclically adjusted data in current prices, percentage change over the episode AUT

BEL

EST

FIN

FRA

DEU

Total primary revenue

15.6

20.1

22.6

16.2

12.4

11.6

9.1

4.6

8.4

19.5

Personal income taxes

14.3

19.6

5.2

17.3

23.7

19.7

42.1

17.7

10.9

23.3

Social security contributions

13.5

15.3

19.6

14.3

9.9

8.5

-7.2

4.2

1.7

19.5

Corporate income taxes

44.8

49.4

7.4

8.9

28.8

27.1

-25.8

-9.8

4.3

8.8

5.1

42.7

19.7

11.1

3.1

42.2

8.3

12.0

17.3

36.9

23.2

9.0

7.3

13.7

-8.5

7.3

15.7

46.4

20.3

12.0

Other property taxes

85.1

48.7

..

39.0

14.5

34.9

-5.4

9.7

Sales of goods and services

13.2

22.8

12.7

12.0

6.5

18.2

-27.5

Other primary revenue

39.2

32.7

25.2

3.4

2.5

0.7

Total primary expenditure

9.9

16.4

3.4

14.1

7.3

Education

8.2

18.7

-2.3

5.3

4.2

10.7

15.4

10.2

14.2

5.2

11.4

5.9

Pensions

15.5

20.9

Sickness and disability

13.0

Unemployment benefits

20.5

Family and children Subsidies

Environmental taxes Other consumption taxes Taxes on immovable property

Health Other wages and intermediate consumption

Public investment Other primary expenditure

GRC

PRT

SVK

7.6

10.9

24.3

7.6

13.2

-0.1

57.3

26.4

-2.6

21.2

11.3

2.4

22.9

2.1

-3.1

8.2

7.9

21.6

34.4

-30.5

0.0

17.5

13.6

1.5

-9.4

7.0

22.8

20.5

14.7

23.8

7.2

9.6

19.3

11.7

52.0

58.6 140.4

24.9

28.1

34.0

26.9

26.7

58.5

-41.9

23.6

-11.7

-6.9

-63.4

-14.3

4.8

8.3

9.7

29.0

-1.5

-1.7

43.2

33.4

4.7

8.6

-6.4

2.8

5.0

28.2

-17.2

24.5

26.5

-12.5

6.8

-28.2

-14.3

0.6

11.6

0.8

-8.8

5.5

-1.2

-12.0

8.5

-15.2

-16.3

-7.7

14.9

-0.2

-8.6

18.3

-1.1

-10.9

7.5

9.9

-42.5

-10.8

-0.5

8.8

4.5

-12.0

6.4

2.4

-11.2

10.8

6.2

8.0

-36.3

-11.8

-0.3

9.6

-1.4

-15.3

3.0

4.4

-7.0

14.9

26.7

10.7

4.8

-14.0

16.6

7.3

14.5

7.2

8.7

10.2

9.5

22.6

19.8

1.7

11.0

10.4

12.6

-32.6

-7.7

-1.5

12.8

-1.5

2.5

12.7

-4.1

-5.5

4.4

35.2

-1.9

9.7

-21.7

-61.5

28.2

26.9

-2.4

11.0

-7.2

9.4

40.9

-50.2

-2.2

15.3

0.9

10.3

8.3

3.3

-48.8

-17.5

-6.7

-7.4

-19.4

-32.6

-4.5

-9.5

-39.9

-6.1

27.9

1.7

1.8

-0.1

-17.8 733.8

-5.5

19.7

-9.5

-15.2

-20.4

-9.4

-43.0

-13.1

1.3

14.2

9.4

22.2

2.3

6.7

-49.6

-66.6

-23.8

-2.4

-7.9

-61.0

-4.1

-13.6

-58.7

17.7

15.0

-52.6

15.4

7.7

26.1

-19.2

-8.9

-1.3

45.3

10.1

58.5

3.3

-13.1

-10.4

5.6 357.2

IRL

ITA

LUX

NLD

SVN

ESP

1. The fiscal consolidation episodes are the same as those in Figure 1.3. This table shows the nominal change from the year prior to the start of the episode to the last year of the episode. On both revenue and expenditure sides, increases or decreases in cyclically-adjusted budget items do not always relate to discretionary policy measures. For instance, tax elasticities can fluctuate for reasons not captured by the corrections performed for the economic cycle and for one-offs. Source: D. Gonçalves and Á. Pina (2016), “The composition of fiscal consolidation episodes: Impacts and determinants” and D. Bloch et al. (2016), “Trends in public finance: Insights from a new detailed dataset”, both OECD Economics Department Working Papers, forthcoming.

Figure 1.6. Change in the labour tax wedge over the post-crisis fiscal consolidation episode1 For a single person with no children at different earning levels, percentage points

8

8 67% of average earnings

100% of average earnings

167% of average earnings

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

0

-1

-1

-2

AUT

BEL

EST

FIN

FRA

DEU

GRC

IRL

ITA

LUX

NLD

PRT

SVK

SVN

ESP

-2

1. The labour tax wedge is measured by income tax plus employee and employer contributions less cash benefits as a percentage of labour costs. Fiscal consolidation episodes (FCE) are the same as those in Figure 1.3 and the change in the labour tax wedge is measured from the year prior to the start of the FCE. Source: OECD (2016), “Taxing Wages: Comparative tables”, OECD Tax Statistics (database). 1 2 http://dx.doi.org/10.1787/888933367172

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Tax and benefit systems have generally mitigated the impact of rising inequality in market income (European Commission, 2015b), but available data suggests that this was mainly due to social transfers. In contrast, the redistributive role played by taxes somewhat decreased in several countries in recent consolidation episodes (Figure 1.7). Further, low incomes have sometimes recorded the highest increases in labour tax wedges (Figure 1.6).

Figure 1.7. Income redistribution due to fiscal variables Reduction in the Gini coefficient due to taxes and transfers, per cent

A. Shares of redistribution, 20121

B. Change over the fiscal consolidation episode2

60

8

ESP

GRC

IRL

PRT

BEL

Total

NLD

SVN

FIN

EST

Transfers

FRA

SVK

ITA

IRL

FIN

SVN

BEL

-4

AUT

0

FRA

-2

DEU

10

LUX

0

GRC

20

SVK

2

ITA

30

PRT

4

ESP

40

EST

6

NLD

50

DEU

Taxes

AUT

Transfers

LUX

Taxes

1. 2013 for Finland and the Netherlands. 2. Fiscal consolidation episodes (FCE) are the same as those in Figure 1.3. The change is measured from the year prior to the start of the FCE to the final year of the FCE (when these are missing, the closest available years are used). Source: OECD (2015), “Income distribution”, OECD Social and Welfare Statistics (database). 1 2 http://dx.doi.org/10.1787/888933367182

These developments in the composition of government revenue and spending have gone hand in hand with a modest degree of implementation of structural reforms with direct positive implications for the composition or efficiency of public finances. Action in response to country-specific recommendations, addressed to countries in the context of the European Semester, has on average been relatively low, and below-average in fiscal-structural policy areas (Deroose and Griesse, 2014). For instance, there has been relatively limited progress in reducing taxes on labour and broadening tax bases. On the spending side, reforms to strengthen public administration governance and to improve cost-effectiveness and performance in key domains, such as education and health, have also tended to display below-average implementation.

Reforms at both European and national levels are needed Most policy levers to make public finances more growth and equity-friendly remain essentially at the country level, despite an important role for European policies in addressing cross-country implications. On the spending side, examples include the organisation of education and healthcare, and the design of social protection systems. On the revenue side, the prime national policy lever is the structure of taxation.

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In other domains, European policies exert major impacts on public finances. National budgets, though remaining in the remit of national governments and parliaments, need to comply with the requirements of the Stability and Growth Pact (SGP). Likewise, national public investment strategies are subject to European rules (e.g. those of European regional policy) and have the potential for synergies with policies at the European Union (EU) level, such as the Investment Plan for Europe. This chapter focusses on two prime areas where European and national spheres interact and can be mutually-reinforcing: fiscal governance and public investment policies. Fiscal governance matters for multiple dimensions of public finance overall performance. Especially since the crisis, numerical fiscal rules have often been specified in a way to reconcile sustainability and stabilisation (Schaechter et al., 2012). Other desirable features of fiscal governance, such as a multi-year budget horizon and independent fiscal institutions, can enhance the effectiveness of numerical rules and yield benefits for the composition and efficiency of public finances. For instance, better budget institutions tend to lead to more growth-friendly fiscal consolidation (IMF, 2014a; Gonçalves and Pina, 2016), and multi-year budget frameworks help optimise public procurement and, in particular, public investment (OECD, 2015b; IMF, 2015b). Public investment is one of the fiscal tools with the strongest impacts on growth, both in the short and the long run, and impacts tend to increase with investment efficiency, in turn underpinned by good governance (IMF, 2015b). Short-run multipliers often exceed unity, especially if an expansion in public investment is co-ordinated across countries (OECD, 2015c). Due to increases in productive capacity, long-run output gains tend to be even higher (Bom and Ligthart, 2014). A key feature behind them is the ability of sound public investment projects to make the private sector more productive, and hence crowd-in private investment. Increasing investment, both public and private, has particular urgency in Europe, where capital formation is still well below pre-crisis levels.

Improving fiscal governance to promote inclusive growth Reforming European fiscal rules The SGP has since its inception a dual structure, with a corrective arm and a preventive arm. The first, also called the Excessive Deficit Procedure (EDP), is based on ceilings for the nominal deficit and debt as a ratio to GDP (3% and 60%, respectively). It has a stronger legal basis, since it is enshrined in the Treaty. The preventive arm is based on the so-called Medium-Term Objective (MTO), which provides a medium-term target for the structural budget balance of each country (i.e. the nominal balance netting out the cyclical component and one-off and other temporary measures). Some 2011-13 reforms make better allowance for the fiscal and economic situation of countries (e.g. by further modulating the pace of fiscal adjustment as a function of economic conditions). At the same time, SGP rules have become complex due to the proliferation of different numerical targets, procedures, contingency provisions and compliance indicators across the two arms (OECD, 2014a; Eyraud and Wu, 2015). The SGP has nonetheless remained primarily focussed on individual national policies, with scope for further consideration of their aggregate area-wide impacts. Furthermore, despite strengthened enforcement provisions of the preventive arm, those of the EDP remain more visible. As a result, policymakers often focus on the 3% of GDP deficit threshold, risking procyclical policy responses. With Treaty changes unlikely in the coming years (Juncker

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et al., 2015; European Commission, 2015c), the short-term challenge is to ensure a sound application of the current SGP rules. In particular, degrees of freedom afforded by the rules should be used by countries with fiscal space to contribute to a more supportive joint euro area fiscal stance.

The preventive arm: Ensuring an appropriate area-wide fiscal stance In setting the structural balance trajectory towards the medium-term objective (MTO), the preventive arm contains some welcome flexibility, on which the Commission has recently provided detailed guidance (European Commission, 2015d). The required annual fiscal adjustment depends on cyclical conditions, and can sometimes be waived, such as when real GDP growth is negative. In some cases, there can be temporary deviations from the MTO or the consolidation plan towards it to accommodate the short-term fiscal costs of major structural reforms, including certain kinds of investment. These provisions minimise the extent of pro-cyclical policies and may ease reform implementation (Beetsma and Debrun, 2004). Rule enforcement allows for some margins of tolerance, since a deviation from the MTO or the path towards it is regarded as significant (giving rise to a warning to the country concerned and to subsequent enforcement steps) only if it reaches at least 0.5% of GDP in one year, or 0.25% on average in two consecutive years. With negative GDP growth, coupling the no adjustment requirement with possible leeway on investment grounds and with the enforcement margin would allow some fiscal expansion, but care would be needed to avoid stretching the margin and thus undermining the credibility of the rules. If medium-term fiscal sustainability is preserved, countries may be allowed to temporarily deviate from the adjustment path towards the MTO in periods of severe area-wide economic downturn. This provision, introduced in 2011 following the co-ordinated expansion of 2008-09, has never been applied so far, and could offer a legal basis for countercyclical policies were the euro area to fall back into recession. As cyclical conditions improve and more countries leave the EDP, the need for fiscal adjustment under the preventive arm will increase. In good times, rules should be strictly enforced to help create fiscal space to deal with future downturns. Consolidation should have been done more vigorously in the years before the global financial crisis (Eyraud and Wu, 2015), when the euro area aggregate fiscal stance was essentially neutral (Figure 1.8; Carnot and Castro, 2015). In bad times, national fiscal policies should take account of cross-country spillovers (Goujard, 2013) and, within SGP rules, contribute to supporting euro area aggregate demand. In the current weak recovery, countries should take advantage of the flexibility afforded by preventive arm rules to temporarily slow down or halt consolidation efforts and, if fiscal space under SGP rules exists, adopt a temporary fiscal expansion. Adopting structural reforms in tax and spending policies to make public finances more growth-friendly and thus enhance long-term sustainability would be desirable in its own right and would also ease exploitation of the flexibility provisions. In this vein, priorities should include increasing public investment, especially on trans-European networks, and decreasing taxation on low wages. If the recovery weakens significantly and the risk of a new recession looms, more widespread temporary fiscal expansion under the clause for severe area-wide economic downturns should be considered. Countries where a temporary fiscal easing would not threaten debt sustainability would adopt an expansionary stance, modulated according to

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Figure 1.8. Fiscal policy and cyclical conditions in the euro area1 As a percentage of potential GDP

Change in the underlying primary balance (% points) 2.0

2.0 2012

1.5

1.5

1.0

1.0

2011 2013

0.5

0.5 2014

0.0

2006

2005 2004

2007

2010

2015 -0.5

0.0 -0.5

2008

-1.0

-1.0

2009 -1.5

-1.5 -4

-3

-2

-1

0

1

2

3

4 Output gap

1. Euro area member countries that are also members of the OECD (15 countries). Source: OECD (2016), OECD Economic Outlook: Statistics and Projections (database). 1 2 http://dx.doi.org/10.1787/888933367191

fiscal space, while others would aim at a broadly neutral policy stance. In line with its remit (European Commission, 2015e), the recently announced European Fiscal Board would be well placed to advise on the applicability of the clause for severe downturns and, more generally, on the appropriate area-wide fiscal stance and how it should translate into national fiscal stances. A bleaker macroeconomic outlook would only increase the urgency of growth-enhancing reforms in revenue and spending composition.

The corrective arm: Avoiding excessive adjustment and strengthening incentives for reform In the corrective arm, large adjustments induced by the debt reduction benchmark should be avoided. The benchmark requires that the excess of the debt ratio over 60% of GDP be reduced at an average 1/20th per year (assessed over three-year periods, and with transitional provisions for countries which were under an EDP in November 2011). For highly indebted countries, these fiscal adjustments can be very large, far exceeding preventive arm requirements. Italy, for instance, would have needed a cumulative structural effort of around 3 per cent of GDP over 2013-15 (European Commission, 2015f), broadly similar to the postcrisis effort (Figure 1.3), which would have threatened the recovery. In the cases it has examined so far (Belgium and Italy), the Commission took account of expected compliance with preventive arm requirements and expected implementation of ambitious structural reforms, as well as of unfavourable economic conditions (especially low inflation), and decided not to open an EDP (European Commission, 2015f, 2015g). A similar approach should be taken in forthcoming cases, as other highly indebted countries leave the EDP and become subject to the debt reduction benchmark. In a future SGP revision, the appropriate speed of adjustment towards the 60% of GDP debt threshold should be reviewed (see below).

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Compared to the preventive arm, flexibility under the corrective arm is far more limited. The corrective arm requires an annual structural balance adjustment of at least 0.5% of GDP, regardless of cyclical developments and structural reform implementation, and setting a deadline for eliminating the excessive deficit. The adjustment requirement may imply pro-cyclical policies and is only consistent with an ex ante deadline if output developments play out as forecast. Longer deadlines are the main provisions for flexibility, and deadline extensions have been used intensively (Figure 1.9). Though often justified in economic terms, extensions are still a second-best tool, as they potentially undermine the credibility of the SGP.

Figure 1.9. Extension of deadlines for eliminating excessive deficits1 7

7 Number of extensions

Number of additional years since initial deadline

6

6

5

5

4

4

3

3

2

2

1

1

0

Other EA²

Belgium

Netherlands

Slovenia

Ireland

Portugal

France

Spain

Greece

0

1. Council decision on existence of excessive deficit made in 2009 (2010 for Finland). 2. Austria, Finland, Germany, Italy and the Slovak Republic. Source: European Commission (2015), “Report on Public Finances in EMU 2015”, European Economy Institutional Papers, No. 014. 1 2 http://dx.doi.org/10.1787/888933367203

Under these constraints, it is important to strengthen incentives for reforms of spending and tax policies and of national budget frameworks. Building on recent steps (European Commission, 2015d), the Commission could make greater use of longer initial deadlines to provide incentives for major public finance reforms. Deadline extensions could also be granted for this purpose, conditional on satisfactory fiscal adjustment prior to that point. As envisaged, the reforms considered should go beyond those introducing a multi-pillar pension system, which have in practice enjoyed a privileged treatment since the 2005 revision of the SGP (Eyraud and Wu, 2015). Greater emphasis should also be given to the quality of national budgetary frameworks (an aspect already contemplated in current legislation) when taking EDP steps.

Simplifying the assessment of fiscal effort The concept of structural fiscal adjustment is a key tool for both the preventive and corrective arms, but has become a source of complexity. As it is difficult to agree on a unique definition of “structural”, alternative indicators to measure fiscal adjustment, aiming to complement the structural budget balance, have proliferated. As a result, progress towards the MTO is also reviewed in the light of the so-called expenditure benchmark, which sets a growth rate for a spending aggregate net of discretionary revenue measures (see below). As for the EDP, the assessment of effective action resorts, in more complex cases, to two different measures of adjusted fiscal effort, obtained through

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top-down and bottom-up approaches. Moving towards a single indicator across both SGP arms would help reduce complexity and increase transparency. Commendably, efforts to this end have recently been announced (European Commission, 2015c). If well designed, a single indicator along the lines of the expenditure benchmark could have the additional advantage of supporting national expenditure rules. The expenditure benchmark has some welcome features: it preserves national discretion over the size of government (for instance, expenditure is allowed to grow faster if accompanied by revenue-raising measures), and defines expenditure growth with reference to potential rather than actual GDP, which avoids pro-cyclicality. However, it is based on a complex spending aggregate, which nets out not only interest payments (a common exclusion) but also some components of unemployment benefits, public investment and other government expenditure. By comparison, countries like the Netherlands and Sweden, which were among the first to adopt expenditure rules, use spending aggregates with less exclusions. A simpler expenditure benchmark would ease medium-term expenditure programming at national level.

Avenues for medium-term SGP reform Over the medium term, SGP rules should be improved along two main axes. First, to reduce complexity and asymmetries in enforcement, the preventive and corrective arms could be more closely aligned and possibly merged, giving rise to a single set of targets, procedures and indicators. Second, the current multiplicity of numerical rules could be replaced by a single fiscal anchor underpinned by a single operational rule (Andrle et al., 2015). The natural anchor is the public debt-to-GDP ratio in each country, given its direct link to fiscal sustainability. The appropriate speed of debt reduction could take account of cyclical conditions in each country (as is now the case for fiscal adjustment under the preventive arm) as well as in the euro area as a whole. Countries would then specify their own operational rules (for instance, deficit or expenditure rules) which should include a debt correction mechanism, thus reinforcing national budget frameworks. These reforms would imply very substantial legislative changes, including to the Treaty. The spring 2017 White Paper envisaged in the Five Presidents’ Report (Juncker et al., 2015) offers an opportunity to start preparatory work.

Reinforcing national budgetary frameworks Budget frameworks at the national level play a key role in making public finances more supportive of equitable growth and the procedures and institutions involved in preparing, approving and executing budgets are highly country-specific. For instance, the effectiveness of numerical rules targeting broad public finance aggregates hinges on their alignment with the medium-term strategic priorities of government (OECD, 2015d), and is fostered by top-down budgeting, a multi-year horizon, and performance-informed allocations and management at programme level. The SGP reform of 2011-13 included several provisions to strengthen national fiscal frameworks. The Six-Pack Directive on budgetary frameworks (2011) and the Two Pack and Fiscal Compact (2013) set requirements in a broad range of areas, including numerical fiscal rules, independent fiscal institutions, medium-term budgetary frameworks and budget reporting and transparency. Important strides have been made in some areas, such as the coverage and timeliness of budget statistics and the creation of independent fiscal institutions in virtually all euro area countries. However, overall budget reform activity

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across the euro area since late 2011, as assessed by the OECD, has been generally modest (Figure 1.10). Though further progress primarily depends on national governments and parliaments, European institutions can foster reform by enforcing legal obligations, such as the correct transposition of relevant EU law, and through peer-pressure and a greater weight given to the quality of national frameworks when applying SGP rules.

Figure 1.10. Intensity of budgetary reform in euro area countries1 Since end 2011, number of countries

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

0

Intensive²

Moderate³

Not significant

1. The degree of budget reform intensity is based on a qualitative assessment, by reference to the principles set out in the OECD “Recommendation of the Council on Budgetary Governance” (18 February 2015) of answers provided by 28 OECD countries to a questionnaire on changes to institutional budgeting frameworks since the end of 2011. Reforms relating primarily to fiscal rules, independent fiscal institutions and parliamentary/civic participation have been discounted relative to those in other areas. Draft assessments were submitted to the Working Party of Senior Budget Officials for discussion in June 2015. 2. Intensive reform activity and/or broadly-based across various aspects of budgetary governance. 3. Moderate reform activity and/or focused on specific aspects of budgetary governance. Source: OECD (2015), The State of Public Finances 2015: Strategies for Budgetary Consolidation and Reform in OECD Countries. 1 2 http://dx.doi.org/10.1787/888933367092

National expenditure rules and spending reviews should be more widely used Limited budget reforms are apparent as regards fiscal rules. The 2011 Directive required country-specific numerical rules, and the Fiscal Compact required transposing the medium-term objective and the adjustment path towards it into national law. This last requirement helps to explain why in recent years progress in the adoption of national fiscal rules by euro area countries was strongest for budget balance rules. However, when rules of supranational origin are excluded, several euro area countries are still classified as not having any numerical fiscal rules in place at the level of central government, general government or the public sector (Schaechter et al., 2012; Bova et al., 2015). Modest progress is also apparent if one considers expenditure rules, for which there are no transposition requirements in the SGP: in 2014, only five euro area countries had in place expenditure rules covering more than half of general government finances, compared to four in 2010 (European Commission’s Fiscal Governance database). Expenditure rules strike a balance between sustainability and stabilisation objectives, especially when supplemented with a correction mechanism that reacts to deviations of debt from its target (Andrle et al., 2015). Automatic stabilisers, mostly on the revenue side, are largely allowed to operate. Relative to a structural balance rule, an expenditure rule is simpler, easier to communicate and less vulnerable to real-time measurement error, since potential output is difficult to estimate in real time and estimates have been subject to large ex post revisions. Last but not least, aggregate expenditure ceilings can provide a

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better anchor to the determination of annual spending allocations, and thus facilitate reforms, which are discussed next, to increase the efficiency of public spending at sectoral or programme level. Communication and transparency of the spending rule is important to its credibility, and in this light monitoring of compliance with the rule should be entrusted to an independent fiscal institution, as required by the SGP. Spending reviews have the potential to yield important gains as regards the composition and efficiency of government outlays. Through systematic scrutiny of baseline expenditure, prioritisation can be improved and spending reductions, if needed, can be made more sustainable, notably through efficiency gains (Robinson, 2014). Furthermore, when integrated into the regular process of budget preparation, spending reviews can support adherence to aggregate spending ceilings, and foster the development of performance-informed budgeting. Successful spending reviews are nonetheless a complex tool, requiring co-operation between finance and spending ministries and sustained high-level political commitment for recommendations to be translated into policy decisions. These difficulties help explain why successful implementation of spending reviews remains limited. Resort to this tool has rapidly increased in the wake of the global financial crisis, with about half of OECD countries (and, within these, a similar proportion of euro area members) reporting some sort of spending review in place in 2011 (OECD, 2011; Robinson, 2014). Nonetheless, publicly available information on these reviews, notably on implementation of recommendations and ensuing savings, is fragmented and heterogeneous, and independent monitoring remains relatively scarce (Vandierendonck, 2014), as does the reviews’ integration into the regular budget process. Countries should conduct spending reviews on a regular basis, ensuring a systematic link to budget preparation as well as independent monitoring of ensuing results. Peer-review exercises, such as those organised by the European Commission in 2014 (Vandierendonck, 2014), can be a valuable tool to promote the exchange of good practices.

Independent fiscal institutions should be given conditions to operate effectively Euro area countries are required by the SGP to have independent fiscal institutions that monitor compliance with fiscal rules, with a special emphasis on those enshrining the medium-term objective in national legislation. Independent institutions should also prepare or assess the macroeconomic forecasts used in annual and multi-year fiscal plans. These requirements are strongly reflected in the remit of existing institutions (Figure 1.11), more than half of which started activity after 2011. The tasks entrusted to national independent fiscal institutions could be usefully extended beyond those mandated by the SGP. An example is the quantification of budgetary and economic impacts of measures and reforms (costing of measures), as often done by similar institutions outside the EU (Figure 1.11). Like rule monitoring and forecast production or assessment, carrying out cost estimates of measures is also associated with lower primary deficits (Debrun and Kinda, 2014). Further, it would contribute to a more informed debate on, and potentially better design of, structural reforms with direct budget implications, thereby improving the composition and efficiency of public finances. It is also essential that independent fiscal institutions be provided with conditions for a credible fulfilment of their mandate, in terms of resources, access to information and the broader institutional environment. Institutions in euro area countries tend to compare

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Figure 1.11. Remit and resources of independent fiscal institutions: Selected features1 Per cent

Euro area

Non-European Union

Remit: inst. performing a given task Macroeconomic forecasts² Monitoring of fiscal rules Long-term sustainability analysis Costing of measures

Resources: institutions possessing3 Access to information Staff commensurate to tasks Safeguards on budget 0

10

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50

60

70

80

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1. Only one independent fiscal institution per country is counted in the few cases where more than one exists; a given item is considered to be verified if it holds for at least one of the national insititutions. Institutions considered are those having started activity up to 2014. The number of countries covered by zone are: 17 for the euro area and 12 for non-European Union. 2. Preparation or assessment. 3. Access to information covers the legal obligation to share information essential for the institution’s activity. For a detailed description of other features see Box 1 in IMF Working Paper, No. 14/58. Source: OECD calculations based on X. Debrun and T. Kinda (2014), “Strengthening post-crisis fiscal credibility – Fiscal councils on the rise. A new dataset”, IMF Working Papers, No. WP/14/58 and X. Debrun et al. (2013), “The Functions and Impact of Fiscal Councils”, IMF Policy Paper, 16 July, International Monetary Fund. 1 2 http://dx.doi.org/10.1787/888933367217

unfavourably in terms of having staff commensurate to tasks (Figure 1.11), and staff needs would generally increase if institutions were tasked with policy costing, as this requires sector and programme-specific expertise. Further, institutions in euro area countries often lack strong safeguards on their budget, such as multiannual funding commitments, which would further enhance the independence of those bodies (OECD, 2014b). Full and timely access to relevant information should also be ensured. Though a legal obligation to share information essential for the institutions’ activity is often in place, less than half of those institutions in EU countries enjoy full access to non-public budgetary information (European Commission, 2014). Finally, relations between the new advisory European Fiscal Board and national independent fiscal institutions should be organised in a mutually-reinforcing way, as planned, thus avoiding to undermine the scope of action and credibility of the latter.

Statistical information can be improved further Further progress in public sector statistics would reinforce risk analysis and management, which is a key input for assessing debt sustainability. High-quality budget reporting has been highlighted as an important principle of fiscal governance (IMF, 2014a; OECD, 2015d). So has sound fiscal risk analysis and management, which requires comprehensive information on public sector units and on contingent liabilities. Since 2011, considerable progress has been made. Eurostat’s auditing powers have been strengthened and the coverage and timeliness of general government accounts improved, with monthly cash-based or equivalent data now available (quarterly in the case of local government)

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and a more transparent transition from cash-based to accrual (national accounts) data. As for general government contingent liabilities and non-performing loans, annual reporting has been introduced, but further efforts are needed to improve detail, timeliness (quarterly releases would be desirable) and coverage. Coverage particularly needs to be improved in the case of liabilities of state-owned enterprises (SoEs), where data limitations sometimes reflect a still incomplete delimitation of the public sector (formed by the general government and SoEs), especially at the level of local government. It would also be helpful to have complete accounts (and not just debt) for the public sector as a whole, which would require separate identification of SoEs and private firms in national accounts.

Policies towards more effective public investment Both European and national policy levers play a key role in ensuring enough and efficient spending on public investment. The EU’s own budget funds for investment and other growth-enhancing expenditure, such as on education and active labour market programmes, stand at 0.5% of EU GDP. This amount is arguably too low if account is taken of the potential for generating economies of scale and positive externalities, for example from research and development (R&D) or infrastructure. However, even these limited resources can have a leveraged impact on the composition and efficiency of public finances if deployed in a way to crowd in national public funds and private investment, and foster greater investment productivity. At national level, better co-ordination of investment across levels of government and upgraded administrative capacity would increase investment efficiency.

Making EU budget expenditure more growth-friendly The structure of EU budget expenditure has become more growth-friendly over time, but there remains large scope for improvement. Funds aimed at investment and growth currently account for close to half of total EU-level spending (Figure 1.12, “Smart and inclusive growth”). Among these, geographically-allocated European regional policy has accounted for about one third of total spending since the turn of the century. “Competitiveness for growth and jobs” programmes are directly managed at European level (there are no country-specific allocations) and include the research and innovation Horizon 2020 and the Connecting Europe Facility (targeted at trans-European networks). Their weight in the budget has roughly doubled since the nineties but is still less than half the share of agricultural subsidies. Resource constraints were well illustrated by the unfortunate need to partly fund the Investment Plan for Europe (discussed below) with allocations taken from Horizon 2020 and the Connecting Europe Facility, streams of spending that are also critical for boosting European growth potential. In the short term, and in particular in the budget review foreseen for 2017, it is essential to preserve investment and growth allocations in the face of pressures on other fronts, such as the refugee crisis. Unlike spending allocated to countries, investment and R&D programmes managed at EU level become potential targets for savings. In the longer term, post-2020 financial frameworks should continue to increase resources for growth-enhancing expenditure. This can be funded by either reallocation of expenditure or an increase in the overall EU budget size, reversing the unprecedented reduction in real terms agreed for 2014-20.

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Figure 1.12. European Union budget: Structure of expenditure As a percentage of total commitments appropriations for 2014-20

Smart and inclusive growth Sustainable growth (mainly CAP)¹

Economic, social and territorial cohesion Competitiveness for growth and jobs Market-related expenditure and direct payments Other sustainable growth expenditure Administration Global Europe Security and citizenship 0

5

10

15

20

25

30

35

1. CAP: Common Agricultural Policy. Source: European Commission (2014), European Union: Public Finance, 5th Edition. 1 2 http://dx.doi.org/10.1787/888933367109

European regional policy: Making the best of conditionality requirements European regional policy can be a powerful tool to increase the quality of public finances in the less prosperous EU countries, where receipts of European structural and investment funds reach macroeconomic significance (Figure 1.13). Those funds can improve the composition of public spending, since they are targeted to growth and equity-friendly investments, such as on transport and network infrastructures, R&D, education or active labour market policies. Furthermore, support to and compliance with sound institutional frameworks will tend to enhance the efficiency of the expenditure concerned (Rodriguez-Pose and Garcilazo, 2013). To maximise the benefits, it is essential to ensure that EU funding adds to, rather than replaces, national public spending (the so-called additionality). In the 2014-20 period, compliance with additionality requires that countries achieve minimum levels of public investment. However, enforcement mechanisms have been reinforced only gradually, and remain weak. Possible sanctions appear late in the process (not before 2022 for the 2014-20 period) and are relatively light. For instance, if public investment falls short of the levels required for compliance by 20%, only a modest 1.7% of the structural funds received for the less developed regions of the country concerned may have to be given back. Furthermore, especially for euro area countries, the compliance levels look often unambitious: they imply an increase in the share of European funds in total public investment (Figure 1.14), and therefore a decline in the relative contribution of national funds. Current rules for additionality should be credibly enforced, starting with the 2018 mid-term verification, where increasing the investment levels required could be considered. In future programming periods, more ambitious levels should likewise be envisaged, and possible sanctions brought to an earlier stage. Compliance indicators could also be improved further. For 2014-20, gross fixed capital formation of general government, as defined in national accounts, has replaced previous ad hoc indicators, with gains in terms of simplification and transparency. However, given that a significant part of

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Figure 1.13. European structural and investment fund allocations for 2014-201 Average annual allocations as a percentage of real GDP

3.0

3.0

2.5

2.5

2.0

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LUX NLD DNK AUT SWE GBR BEL

IRL DEU FIN

FRA

ITA

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ESP GRC SVN PRT CZE POL SVK EST HUN

1. Allocations for the European Regional Development Fund, European Social Fund and Cohesion Fund. Source: OECD calculations based on European Commission (2014), “Annexes to the Commission implementing decision setting out the annual breakdown by Member State of global resources […]”, C(2014) 2082 final and OECD, Long-term Baseline, internal database, Economics Department. 1 2 http://dx.doi.org/10.1787/888933367220

Figure 1.14. European structural and investment funds as a share of public investment1 Per cent

140

140 2008-10

2011-13

2014-16

Additionality target²

120

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0

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1. Allocations for the European Regional Development Fund, European Social Fund and Cohesion Fund as a share of government gross fixed capital formation. 2. Share of European structural and investment fund (ESIF) allocations in public investment if the latter equals the agreed reference levels for additionality verification. The fact that part of ESIF allocations will not fund gross fixed capital formation but rather other spending items (e.g. certain transfers) helps explain why shares can exceed 100%. In Italy and Slovenia the national-wide additionality targets depicted are merely indicative, as additionality will be verified at a regional level. Source: Calculations based on allocation data from European Commission Decision documents C(2006) 3473, 3474, 3475 and later amendments, C(2014) 2082 final and “Available budget 2014-2020”, http://ec.europa.eu/regional_policy/en/funding/available-budget; gross fixed capital formation data from OECD (2015), OECD Economic Outlook: Statistics and Projections (database) and Long-term Baseline, internal database, Economics Department. 1 2 http://dx.doi.org/10.1787/888933367118

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expenditure supported by structural funds is not classified as gross fixed capital formation of general government, a broader set of indicators could be considered, while preserving the principle of relying on readily available, standardised data. To support institutional quality and investment efficiency, conditionality requirements have been generally reinforced in the 2014-20 period. Numerous ex ante conditionalities need to be met before the disbursement of funds, either of a general nature (such as compliance with public procurement rules) or of a thematic one (such as the existence of national strategies in specific sectors). Further, macroeconomic conditionality aims to reinforce consistency between European structural and investment funding and key elements of EU economic governance. For instance, to better address country-specific recommendations, the Commission may request countries to reprogramme structural and investment funds, and to propose a suspension of payments in the absence of a satisfactory national response. Untested so far, this conditionality could improve the alignment of funds with relevant structural reforms. However, as in the case of ex ante conditionalities, preserving national ownership of reforms and other requirements is essential. In other cases, however, macroeconomic conditionality may be counterproductive. For example, the Commission must propose a suspension of structural funds when the Council assesses that no effective action has been taken to correct an excessive deficit. Though modulated in the light of economic and social conditions, suspended amounts will be at least in the range of 0.25% to 0.5% of GDP (or 25% to 50% of annual structural and investment funding if lower). This suspension will be lifted and re-budgeted as soon as the member state has adopted the necessary corrective action. Nevertheless, under fiscal stress, these sanctions would likely worsen the composition of public expenditure by compounding downward pressures on public investment and other growth-enhancing items, and should therefore in most cases be avoided.

Leveraging private sector investment Announced in November 2014, the Investment Plan for Europe aims at generating at least EUR 315 billion (2.2% of 2015 EU GDP) of additional investment over three years, mainly from private sources and with a focus on infrastructure, innovation and small and medium-sized enterprises (SMEs). The Plan’s funding pillar, the European Fund for Strategic Investments (EFSI), allows the European Investment Bank (EIB) Group to finance projects that would not have been supported otherwise. The EFSI is endowed with a risk-absorbing capacity of EUR 21 billion: EUR 5 billion from EIB resources, and an EU guarantee of EUR 16 billion. Decisions on the use of this guarantee to support specific projects are made by an independent Investment Committee. No member state made financial contributions to the EFSI, but several have already committed to provide co-financing to investments, mainly via national promotional banks. It will be important to ensure that these commitments represent additional public investment. Under certain conditions, national authorities will also be able to combine European structural and investment funds with EFSI support to enhance risk-bearing capacity and thus the ability to attract private sector financing (European Commission, 2016). The Plan also comprises pillars of project promotion and technical assistance, and of structural reforms. The European Investment Project Portal will advertise potential investment opportunities submitted by public or private promoters, while the European Investment Advisory Hub, already operational, offers a single point of contact for technical assistance. Structural reforms to create an investment-friendly environment are discussed

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in the 2016 OECD Economic Survey of the European Union. A case in point, essential to unlock investment and complete the Single Market, is the reduction of regulatory heterogeneity across Europe. The amount of EFSI-supported investment carried out so far has been small, providing negligible short-run stimulus to activity. Project submission and approval has nonetheless been progressing in line with the target in recent months, and about EUR 12.8 billion of EIB Group resources have already been committed by mid-May 2016, which are expected to trigger total investment of around EUR 100 billion in the coming years. Given limited public resources, the medium-term success of the Plan will hinge on its ability to leverage private investment, for which the EIB Group’s lending behaviour and the quality of the projects presented will be key. The EUR 315 billion investment target presupposes a multiplier of 15: the EFSI guarantee should enable three times as much EIB Group funding, which will be used to finance an average 20% of investment projects (the remainder coming from additional investors, with a large role played by the private sector). This requires selecting projects which are attractive for additional co-funding and (to avoid crowding-out) which would not otherwise be carried out. Crowding in private investment on the scale envisaged also requires that the EIB Group depart from its usual very prudent lending practices, characterised by a choice of low-risk projects and negligible levels of non-performing loans (Claeys, 2015). This implies accepting projects with higher risk than in the past, and financing on average a lower share of each (one-fifth, in line with the envisaged multiplier, rather than the traditional one-third to one-half).

Improving public investment governance At national level, stepping up efforts to co-ordinate investment among tiers of government is essential. Across the OECD, sub-national governments account for about 60% of total public investment (Figure 1.15), highlighting the need for vertical and horizontal co-ordination mechanisms (OECD, 2013; OECD, 2014c). However, for reasons such as informational asymmetries, non-aligned objectives, poor capacity or inadequate funding arrangements, effective co-ordination is difficult. Among 15 dimensions of institutional quality for efficient public investment management, central-local co-ordination is the one where advanced economies tend to fare worst (IMF, 2015b). In a recent survey on infrastructure investment, more than three quarters of EU sub-national governments reported co-ordination challenges across the national and subnational levels. Challenges in horizontal co-ordination across jurisdictions are also prominent in the survey results (OECD and Committee of Regions, 2015). Potential tools to foster co-ordination include bringing together different jurisdictions in dialogue fora with actual involvement in decision-making, co-financing and conditionality mechanisms, and the promotion of collaboration between sub-national governments through the removal of legal and regulatory barriers, possibly coupled with financial incentives (OECD, 2013; OECD, 2015e). For the 2014-20 period, EU regional policy has developed tools to promote co-ordination, such as integrated territorial investments, which bring together different funding lines to implement an integrated strategy in a specific territory. Delegation of management tasks to local and regional authorities is allowed, and, in some cases, even mandatory. Better co-ordination among sub-national governments will also enhance their ability to promote sound investment projects under the Investment Plan for Europe.

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Figure 1.15. Share of sub-national governments in total public investment1 Per cent, 20152

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100 Local

State³

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CAN

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ESP

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1. Gross fixed capital formation. 2. 2014 for Australia, Canada, Israel, Japan, Korea, New Zealand, Switzerland and the United States; 2013 for Mexico; and 2011 for Turkey. 3. Includes local government for Australia and the United States. Source: OECD (2016), “General Government Accounts, SNA 2008”, OECD National Accounts Statistics (database). 1 2 http://dx.doi.org/10.1787/888933367237

Public administration capacity is also essential for efficient investment, but is often inadequate, especially at sub-national level and in particular in lagging regions. There is wide variation in the perceived quality of sub-national governments across the EU, and within some countries (Charron et al., 2012). Capacity challenges have been identified at various stages of the investment cycle, including long-term strategic planning, the ability to involve the private sector (for instance through public-private partnerships) and public procurement (OECD, 2013). Aware of these weaknesses, EU regional policy has included the enhancement of administrative capacity among its ex ante conditionalities for the 2014-20 period, with an accompanying increase in financial support for this purpose. A recent proposal for a Structural Reform Support Programme (European Commission, 2015h) will also support capacity building, namely through technical assistance. National authorities should prioritise actions to preserve and develop administrative capacity at different levels of government in response to the main gaps detected and with a special focus on the weakest regions. In times of fiscal restraint, these considerations should inform the design of fiscal consolidation.

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Recommendations to make public finances more growth and equity-friendly Improving fiscal governance and supporting the recovery Key recommendations ●

Countries with fiscal space should use budgetary support to raise growth.

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Ensure that the application of the debt reduction rule of the Stability and Growth Pact does not threaten the recovery.

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Allow longer initial deadlines for correcting excessive deficits if countries implement major structural reforms in spending and tax policies which enhance potential growth and long-term sustainability.

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Adopt national expenditure rules and conduct spending reviews linked to budget preparation.

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Ensure that national independent fiscal institutions have resources to fulfil their mandate.

Additional recommendations ●

Include in the remit of national independent fiscal institutions estimating the costs of proposed policies.

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To reduce complexity, adopt a single indicator to measure structural fiscal adjustment under different SGP rules and procedures. Ensure that the chosen indicator does not hamper medium-term expenditure programming at national level.

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Further improve the coverage and timeliness of statistical data on general government contingent liabilities, especially as regards state-owned enterprises.

Protecting public investment and increasing its efficiency Key recommendations ●

As intended in the Investment Plan for Europe, the European Investment Bank should finance higher-risk projects that would not otherwise be carried out.

●

Countries should increase targeted public support to investment while enhancing the framework conditions for private investment.

Additional recommendations ●

Preserve EU budget resources for investment and growth in the face of short-term pressures on other fronts. In the future, continue to increase growth-enhancing expenditure in the EU budget, if possible by granting higher resources to the European Union.

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Credibly enforce current rules to ensure that EU structural and investment funds add to, rather than replace, national public spending. In the future, make the rules stricter through more ambitious target levels of public investment and the possibility of earlier sanctions.

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Do not suspend EU structural and investment funds to a country under the Excessive Deficit Procedure, as suspension would likely compound downward pressures on public investment.

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At national level, step up efforts to better co-ordinate investment among different levels of government and upgrade the technical and strategic capacity of the public administration.

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