Update on economic and monetary developments

Summary

The ECB’s monetary policy measures have continued to secure the very supportive financing conditions that are necessary to make continuous progress towards a sustained convergence of inflation rates to levels below, but close to, 2% over the medium term. The incoming information confirms a continued strengthening of the economic expansion in the euro area, which has been broadening across sectors and regions.^[1] The risks to the growth outlook are broadly balanced. While the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with the Governing Council’s inflation aim, it has yet to translate into stronger inflation dynamics.

At the global level, available indicators point to sustained global growth during the second quarter of 2017. Global headline inflation has moderated, reflecting waning support from energy prices. Global financial conditions have remained overall supportive, despite increases in long-term interest rates in advanced economies.

Since the last Governing Council meeting in June, euro area long-term interest rates have risen, also on account of the improved growth prospects. Overall, the EONIA forward curve has moved upwards by around 15 basis points on average across maturities since early June. Euro area equity prices have declined for non-financial corporations but have increased for financial firms, while solid earnings expectations have continued to support prices in both sectors. Corporate bond yields have risen, as have risk-free interest rates, but corporate spreads have tightened, which is likely to reflect market expectations of solid economic growth in the euro area, among other things. The euro has appreciated in nominal effective terms.

Incoming data, notably survey results, continue to point to solid, broad-based growth in the euro area in the near term. The pass-through of the monetary policy measures is supporting domestic demand and has facilitated the deleveraging process. The recovery in investment continues to benefit from very favourable financing conditions and improvements in corporate profitability. Private consumption is supported by employment gains, which are also benefiting from past labour market reforms, and by increasing household wealth. Moreover, the global recovery should increasingly lend support to trade and euro area exports. However, economic growth prospects continue to be dampened by a slow pace of implementation of structural reforms, particularly in product markets, and by remaining balance sheet adjustment needs in a number of sectors, notwithstanding ongoing improvements. The risks surrounding the euro area growth outlook remain broadly balanced. On the one hand, the ongoing positive cyclical momentum could generate a stronger than expected economic upswing. On the other hand, downside risks primarily relating to global factors continue to exist.

Euro area annual HICP inflation was 1.3% in June, down from 1.4% in May, mainly due to lower energy price inflation. Looking ahead, on the basis of current futures prices for oil, headline inflation is likely to remain around current levels in the coming months. At the same time, measures of underlying inflation remain low and have yet to show convincing signs of a pick-up, as domestic cost pressures, including wage growth, are still subdued. Underlying inflation in the euro area is expected to rise only gradually over the medium term, supported by monetary policy measures, the continuing economic expansion and the corresponding gradual absorption of economic slack.

Broad money continued to expand at a robust pace, driven mainly by its most liquid components. In addition, the recovery in loans to the private sector observed since the beginning of 2014 is proceeding, supported by easing credit standards and increasing loan demand. Financing costs for euro area non-financial corporations and households remain favourable. The euro area bank lending survey for the second quarter of 2017 indicates that credit standards for loans to enterprises and loans to households for house purchase have further eased and that loan growth continues to be supported by increasing demand.

At its meeting on 20 July 2017, based on the regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged. The Governing Council continues to expect the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed that the net asset purchases, at the current monthly pace of €60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases are made alongside reinvestments of the principal payments from maturing securities purchased under the asset purchase programme.

Looking ahead, the Governing Council confirmed that a very substantial degree of monetary accommodation is needed for euro area inflation pressures to gradually build up and support headline inflation developments in the medium term. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the asset purchase programme in terms of size and/or duration.

External environment

Survey-based indicators point to sustained global growth. In the second quarter of 2017 the global composite output Purchasing Managers’ Index (PMI) (excluding the euro area) remained at levels similar to those recorded in the previous two quarters, close to long-run averages, suggesting a continuing steady expansion in global activity (see Chart 1). Among the major advanced economies, the PMI declined in the United States, while it picked up in the United Kingdom compared with the first quarter. Among emerging market economies, the PMI improved in India and Brazil, in the latter case pointing to an expansion for the first time in three years. The PMI decreased in China to stand just above the expansion threshold.

Global financial conditions remain overall supportive. Equity markets have moderated slightly in advanced economies over the past few weeks. Long‑term interest rates have risen slightly in a number of major advanced economies amid market expectations about a gradual lessening of monetary accommodation. Among emerging market economies, long-term interest rates have also risen. However, in China, interbank rates have moderated slightly in the past few weeks, after a period since the beginning of the year in which financial conditions had tightened as authorities sought to curb leverage in the financial system, particularly in small banks and non-bank institutions.

Global trade growth moderated in April. Following a boost at the turn of the year, global trade growth slowed in April (see Chart 2). The volume of merchandise imports decelerated strongly, in three-month-on-three-month terms, from 1.9% in March to 0.4% in April. The slowdown in merchandise trade was mainly driven by emerging market economies. Leading indicators continue, however, to signal positive prospects in the near term. In particular, the global PMI for new export orders increased to 52.6 in June. Moreover, industrial activity developments have recently remained relatively robust across regions, which should be supportive of trade.

Global inflation slowed in May. After a slight increase in April to 2.4%, annual consumer price inflation in the Organisation for Economic Co-operation and Development (OECD) area declined to 2.1% in May. This was largely due to a declining positive contribution of energy prices which more than offset the increasing contribution of food prices. Excluding food and energy, OECD annual inflation declined slightly to 1.8% in May.

Oil prices have fluctuated in recent weeks. After declining in the course of June, Brent crude oil prices have recovered more recently. The initial decrease appears to have reflected beliefs in the market that the decision by OPEC and non-OPEC producers to extend their global supply restraint until next spring would be insufficient to rebalance the oil market and sustain higher prices. More recently, oil prices have rebounded following news of a slowdown in the growth rate in the US rig count, as well as a reduction in OECD industry stocks by 6 million barrels in May.

Economic activity in the United States rebounded in the second quarter. Real GDP growth has improved in the second quarter compared with the previous quarter, with real consumer spending and inventories recovering from the very low outcomes in the first quarter. Moreover, the tightening labour market, solid increases in asset prices and the consumers’ confidence indexes support economic growth. Headline and core inflation softened in the last three months, mostly owing to temporary factors. Annual CPI inflation declined further in June to 1.6% while inflation excluding food and energy was stable at 1.7%. In recent months, core CPI has been dampened by a sharp drop in prices for mobile telephone services and a weaker shelter component. The Federal Reserve System increased interest rates at its June meeting. It also announced the intention to start normalising its balance sheet later this year. Specifically, the principal payments received from its security holdings will be reinvested only to the extent that they exceed gradually rising caps.

The expansion of economic activity in Japan continues. Real GDP increased by 0.3% quarter on quarter in the first quarter of 2017, revised down slightly from the previous estimate. Looking ahead, solid domestic demand should support activity, while exports are set to decelerate. Industrial production increased only moderately in the first two months of the second quarter, which could be linked to weaker export performance. The labour market remains tight. The unemployment rate stood at 3.1% in May 2017, and in the same month the job-offers-to-applicant ratio reached a level unseen since the early 1990s. However, wage growth has remained weak. Consumer price inflation has also been subdued. Annual headline consumer price inflation was 0.4% in May, while consumer price inflation excluding food and energy fell to −0.2%.

In the United Kingdom, economic activity has slowed down markedly. In the first quarter of 2017, real GDP increased by 0.2% quarter on quarter, down from 0.7% in the previous quarter. The slowdown was led by a decline in private consumption, as households started to feel the squeeze from rising inflation and falling real wages. Recent indicators overall suggest that the pace of economic expansion remained relatively muted in the second quarter of 2017. Although annual CPI inflation fell to 2.7% in June, inflation rates remain elevated because of upward pressure from the depreciation of the pound sterling since the UK referendum on membership of the European Union. On 19 June 2017, almost exactly one year after the referendum, the European Union and the United Kingdom started the “Brexit” negotiations in accordance with Article 50 of the Treaties.

Momentum in the Chinese economy remains robust. GDP expanded by 6.9% in year-on-year terms in the second quarter. Consumer price inflation remains moderate. At the same time, leverage in the economy continues to rise, notwithstanding measures undertaken by the authorities to address financial market risks.

Financial developments

Euro area government bond yields have generally risen since early June, however over the period under review – 8 June to 19 July 2017 – the increase in yields took place from the last week in June. This resulted from a revision by market participants of their expectations on future monetary policy, effectively confirming that the macroeconomic outlook was firming. Overall, the euro area ten‑year overnight index swap yield and euro area ten-year sovereign bond yields, as measured by their GDP-weighted average, increased by around 15 points (see Chart 3). Across countries, the increases in sovereign bond yields ranged from a few basis points to slightly over 20 basis points. Spreads vis-à-vis the rate on German ten-year bonds overall tended to tighten, especially in Greece, Italy, Spain and Portugal. In the United Kingdom sovereign bond yields rose roughly in line with those in the euro area countries, while increases were more limited in the United States and negligible in Japan. On account of the re‑pricing that took place in the euro area government bond market at around the end of June, bond price volatility increased temporarily but reverted in the course of July to below the levels prevailing in around early June. US bond price volatility overall also declined over the review period.

Yields on bonds issued by non-financial corporations (NFCs) rose during the period under review but more modestly than risk-free rates. As a result, their spreads over AAA-rated sovereign yields tightened. Overall, the decline in the corporate spreads in spite of rising yields may have occurred, among other factors, on account of the positive momentum recorded by the euro area business cycle, a development that has historically been associated with low levels of corporate defaults. On 19 July, investment grade NFC bond spreads (on average across the rating classes AAA, AA, A and BBB) were 9 basis points lower than in early June and around 35 basis points lower than in March 2016, when the Governing Council announced the launch of the corporate sector purchase programme (CSPP). Spreads on non-investment grade corporate debt and for debt issued by financial firms (which is ineligible for purchase under the CSPP) also declined during the period under review, by around 30 and 15 basis points, respectively. On 19 July such spreads were around 270 and 35 basis points lower than in March 2016. Corporate bond yield levels also rose in other main economic areas on the back of the rise in risk-free yields.

The EONIA was stable at around −36 basis points during the review period. Excess liquidity in the banking system was little changed at around €1,650 billion, with the elevated level continuing to be supported by securities purchases under the ECB’s asset purchase programme.

The EONIA forward curve shifted upwards by around 15 basis points on average across maturities over the review period. The upward movement of the curve took place entirely from late June. Overall, the increase in the EONIA forward rates peaked for maturities ranging between four and six years, at slightly below 25 basis points. Forward rates rose marginally for very long maturities and especially for maturities shorter than two years. The curve remains below zero for horizons prior to December 2019.

Broad indices of euro area equity prices have declined since early June. At the end of the period under review the equity prices of euro area NFCs were around 1.6% lower than in early June, while prices rose by 1.7% for financial corporations. On the one hand, expectations of solid growth in earnings continued to support euro area equity prices, in line with the broad-based improvement in the euro area macroeconomic environment (see Box 2). On the other hand, the recent increase in yields, and the associated higher discount rates applied to expected profits, exerted a downward pressure on stock prices. As for financial corporations, market participants may have interpreted the upward revision to interest rate expectations as a development supportive of higher interest rate margins and future profitability, thereby explaining the diverging behaviour of equity prices between financial and non-financial corporations. Over the review period, equity prices of NFCs declined in the United Kingdom, by 1.1%, while they rose in the United States and in Japan, by slightly above 1% and by 2% respectively. The equity prices of financial corporations rose in these advanced economies by comparatively more than in the euro area, with the exception of Japan where prices remained broadly stable. Since early June market expectations of equity price volatility in both the euro area and the United States have overall remained unchanged. As at 19 July such expectations stood on an annualised basis at around 11% and 7%, respectively, values that are comparatively low in historical perspective.

In foreign exchange markets, the euro broadly appreciated in effective terms. From 8 June, the euro appreciated vis-à-vis all major currencies, including the US dollar (by 2.7%), the pound sterling (by 2.0%), the Japanese yen (by 4.2%) and the Swiss franc (by 1.3%). The broad-based appreciation reflected the evolution of market expectations regarding the monetary policy stance of major economies and the continued recovery of the euro area economy. At the same time, the currencies of some central and eastern European non-euro area Member States appreciated slightly vis-à-vis the euro, including the Czech koruna (by 0.9%) and the Hungarian forint (by 0.5%) (see Chart 4).

Economic activity

The broad-based and resilient domestic demand-driven economic expansion in the euro area continues. Real GDP continued to increase in the first quarter of 2017 (see Chart 5), on the back of positive contributions from domestic demand and, to a lesser extent, changes in inventories. The latest economic indicators, both hard data and survey results, remain buoyant and point to ongoing robust growth in the second quarter of 2017, at around the same rates as in the previous two quarters.

Household spending continues to rise and remains an important driver of the ongoing economic expansion. However, the outcome for the first quarter of 2017 was relatively low, at least in comparison with consumption developments over the previous three years, and may reflect a number of temporary factors including higher oil prices. At the same time, the annual rate of increase in real household disposable income rose to 1.7% in the first quarter, up from 1.3% in the previous quarter. This rise mainly reflects a larger contribution from property income, which suggests that stronger corporate profitability may be starting to add to household income (e.g. as a result of higher dividends), further underpinning consumption growth. In the first quarter of 2017 the saving rate remained stable on an annual basis compared with the previous quarter, as annual growth in disposable income and consumption both rose at the same rate.

Euro area labour markets continue to improve, thereby boosting household income and spending. The most recent data show that quarter-on-quarter employment rose further, by 0.4%, in the first quarter of 2017, resulting in an annual increase of 1.5%. As a result, employment currently stands 4% above the last trough in the second quarter of 2013 and is now slightly above its pre-crisis peak in the first quarter of 2008. The unemployment rate in the euro area edged down to 9.3% in April 2017 and remained at that level in May, which is 2.8 percentage points below its post-crisis peak in April 2013 (see Chart 6). This decline has been broad-based across age and gender groups. Long-term unemployment (capturing those who have been unemployed for at least 12 months) also continues to decline, but remains well above its pre-crisis level. Survey information points to continued improvements in labour markets in the period ahead.

Consumption growth is expected to remain resilient. Recent data on retail trade and new passenger car registrations are in line with sustained growth in consumer spending in the second quarter of 2017, possibly at a somewhat faster pace than that observed in the first quarter. Further employment growth, as suggested by the latest survey indicators, should also continue to support aggregate income and thus consumer spending. In addition, consumer confidence improved markedly in the second quarter and has now, for the first time, surpassed its pre-crisis peak in May 2007. Finally, households’ net worth relative to disposable income continues to rise, owing largely to valuation gains on financial assets and real estate holdings. These developments suggest further support for underlying consumption dynamics.

Euro area business investment should continue to grow in the second quarter of 2017. In the second quarter improving conditions in the capital goods sector, such as increasing capacity utilisation, rising orders, stronger confidence and survey evidence suggesting fewer perceived limits to production, taken together, signal an acceleration in the current investment momentum. Data on industrial production of capital goods up to May also suggest rising business investment in the second quarter. With regard to construction investment, monthly construction production data point to growth in the second quarter of 2017. Furthermore, survey indicators on the demand situation and the assessment of order books in the sector, as well as building permits, are still in line with positive underlying dynamics in the short term.

Investment is expected to remain an important contributor to the medium-term growth outlook. Rising foreign and strong domestic demand, together with low financing costs (see also the box entitled “Lower interest rates and sectoral changes in interest income” in this issue of the Economic Bulletin) and waning financial and economic uncertainty, as well as robust corporate profit growth, should increasingly promote investment. In particular, corporate gross operating surplus growth strengthened markedly in the first quarter of 2017, according to the euro area sectoral accounts, and earnings expectations for listed companies in the euro area rose in the first half of 2017. With regard to construction investment, factors such as rising household disposable income and improving lending conditions should underpin demand in the sector.

Monthly trade data suggest that growth in euro area exports will continue in the near term. Total euro area exports rose by 1.2% in the first quarter, on account of strong goods exports which were supported by the rebound in global trade. Monthly trade in goods outcomes up to May suggest that growth in extra-euro area exports remained relatively strong in the second quarter of 2017 in line with developments in foreign demand. Exports (as measured by three-month-on-three-month percentage changes) seem to have been underpinned by demand mainly from Asia, whereas the United States and Latin America provided a negative contribution. Leading indicators such as surveys continue to signal ongoing improvements in foreign demand, and new manufacturing export orders have risen.

Overall, the latest economic indicators are, on balance, consistent with ongoing real GDP growth in the second quarter of 2017, at around the same rates as in the previous two quarters. Industrial production (excluding construction) recorded a further rise in May. As a result, average production in April and May stood 1.2% above its level in the first quarter of the year, when it edged up by 0.1% on a quarterly basis. More timely survey data are also in line with continued positive growth dynamics in the near term. In the second quarter of 2017 the composite output Purchasing Managers’ Index (PMI) averaged 56.6 compared with 55.6 in the first quarter, while the European Commission’s Economic Sentiment Indicator (ESI) rose to 110.0 from 108.0 in the first quarter (see Chart 5). Consequently, both the ESI and the PMI, which remain above their respective long-term averages, are approaching their pre-crisis peaks (recorded in 2007 and 2006 respectively).

Looking ahead, the ongoing economic expansion is expected to continue to firm and broaden. The pass-through of the monetary policy measures is supporting domestic demand and has facilitated the deleveraging process. The recovery in investment continues to benefit from very favourable financing conditions and improvements in corporate profitability. Private consumption is being supported by employment gains on the back of past labour market reforms and by increasing household wealth. Moreover, the global recovery should increasingly lend support to trade and euro area exports. However, economic growth prospects continue to be dampened by a slow pace of implementation of structural reforms, particularly in product markets, and by remaining balance sheet adjustment needs in a number of sectors, notwithstanding ongoing improvements. The results of the latest round of the ECB’s Survey of Professional Forecasters, conducted in early July, show that private sector GDP growth forecasts were revised upwards for 2017, 2018 and 2019 in comparison with the previous round conducted in early April.

The risks surrounding the euro area growth outlook remain broadly balanced. On the one hand, the current positive cyclical momentum increases the chances of a stronger than expected economic upswing. On the other hand, downside risks primarily relating to global factors continue to exist.

Prices and costs

Headline inflation fell slightly in June. Headline HICP inflation was 1.3% in June, after 1.4% in May (see Chart 7). This mainly reflected a decline in energy inflation and, to a smaller extent, food inflation, which was partly offset by an increase in HICP inflation excluding energy and food. The large decline in energy inflation in June reflected the impact of a decrease in oil prices between mid-May and mid-June, as well as a smaller base effect than in the previous month. For unprocessed food price inflation, the unwinding of the unusually large increases at the start of the year continued in June.

Underlying inflation has yet to show convincing signs of a sustained upward adjustment. Looking beyond the movements from one month to the next, measures of underlying inflation are somewhat higher than at the end of last year but remain overall subdued. HICP inflation excluding energy and food stood at 1.1% in June, after 0.9% in May and 1.2% in April. The June data saw the end of Easter-related calendar effects for this year. If, in addition to energy and food, the very volatile components clothing and footwear and travel-related items are excluded, HICP inflation shows only a modest uptick in recent months. Furthermore, most alternative measures of underlying inflation also do not indicate a pick-up yet. This may reflect in part the lagged downward indirect effects of past low oil prices but also, more fundamentally, continued weak domestic cost pressures.

Pricing pressures at the early stages of the supply chain have yet to transmit to consumer good producer prices. The strong pick-up in global non-energy producer price inflation beginning in mid-2016 contributed to some upward pressure on the annual inflation for import prices of non-food consumer goods over recent months. It also continues to filter through the early stages of the domestic pricing chain. This is reflected, for example, in continuing strong growth in import prices for intermediate goods. Intermediate goods are also the main driver of producer price inflation for total industry (excluding construction and energy) in the euro area, which stood at 2.4% in May 2017. However, domestic producer price inflation for non-food consumer goods remained at a subdued level, recording an increase of only 0.2% in May – unchanged from March and April. The upward pressures from the earlier stages of the domestic pricing chain hence still need to feed through to the later stages before they can ultimately feed into non-energy industrial goods inflation.

More generally, underlying domestic price pressures remained subdued. The annual rate of change in the GDP deflator, which can be interpreted as a broad measure of underlying domestic price developments, stood at 0.7% in the first quarter of 2017, down slightly from the previous quarter. The contribution of profits per unit of output to the growth in the GDP deflator has moderated further as the positive terms of trade effects related to earlier oil price declines have faded out and changed signs in the first quarter of 2017 when oil prices were substantially higher than one year earlier. By contrast, the contribution of unit labour costs has remained broadly unchanged as growth in compensation per employee and productivity growth have been broadly stable at low levels.

Wage growth remains low. Annual growth in compensation per employee was 1.2% in the first quarter of 2017, down from 1.4% in the final quarter of 2016 and still well below its average since 1999 of 2.1%. Factors that may have been weighing on wage growth include still significant slack in the labour market, weak productivity growth and the ongoing impact of labour market reforms implemented in some countries during the crisis. Additionally, the low inflation environment over the last years may still be contributing to lower wage growth through backward-looking formal and informal indexation mechanisms.

Longer-term market-based and survey-based inflation expectations have remained broadly stable (see Chart 8). Since mid-June, the five-year inflation-linked swap rate five years ahead has hovered around 1.6%. Medium to longer-term market-based inflation expectations remain well above the levels observed in mid-2016. The latest survey-based measures of long-term inflation expectations for the euro area from the July 2017 ECB Survey of Professional Forecasters continued to stand at 1.8%.^[2]

Residential property prices in the euro area accelerated further in the first quarter of 2017. According to the ECB’s residential property price indicator, prices for houses and flats in the euro area increased by 4.0%, on a year-on-year basis, in the first quarter of 2017, up from 3.7% in the last quarter of 2016, pointing to a further strengthening of the house price cycle.

Money and credit

Broad money continued to expand at a robust pace. The annual growth rate of M3 remained broadly stable in May 2017 (at 5.0%, after 4.9% in April) and has been hovering around 5.0% since mid-2015 (see Chart 9). The low opportunity cost of holding liquid deposits in an environment of very low interest rates and the impact of the ECB’s monetary policy measures continued to support M3 growth. Annual M1 growth remained solid at 9.3% (unchanged from April) and was again the main contributor to M3 growth.

Domestic counterparts of broad money remained the main driver of broad money growth. First, Eurosystem purchases of debt securities in the context of the public sector purchase programme (PSPP) continued to have a considerable positive impact on M3 growth (see the orange bars in Chart 9). Second, the gradual recovery in the growth of credit to the private sector and the significantly negative annual rate of change in monetary financial institutions’ (MFIs’) longer-term financial liabilities (excluding capital and reserves) exerted a positive impact on M3 growth (see the blue bars in Chart 9). The ongoing net redemption of longer-term debt securities by MFIs is partly explained by the flatness of the yield curve, which is linked to the ECB’s monetary policy measures and has made it less attractive for investors to hold long-term deposits and bank bonds. The availability of the targeted longer-term refinancing operations (TLTROs) as an alternative to longer-term market-based bank funding also played a role. By contrast, the contribution to M3 growth of credit to general government from MFIs excluding the Eurosystem remained negative (see the green bars in Chart 9).

The MFI sector’s net external asset position continued to exert downward pressure on annual M3 growth (see the yellow bars in Chart 9). This development in part reflects portfolio rebalancing away from euro area debt securities triggered by the ECB’s expanded asset purchase programme (APP), in particular sales of euro area government bonds by non-residents.

The recovery in loan growth is proceeding. The annual growth rate of MFI loans to the private sector (adjusted for sales, securitisation and notional cash pooling) was stable in May (see Chart 10). Across sectors, the annual growth rate of loans to non-financial corporations (NFCs) remained stable at 2.4% in May, while that of loans to households increased to 2.6% (from 2.4% in April). The significant decrease in bank lending rates seen across the euro area since summer 2014 (owing notably to the ECB’s non-standard monetary policy measures) and overall improvements in the supply of, and demand for, bank loans have supported the recovery in loan growth. In addition, banks have made progress in consolidating their balance sheets, although the level of non-performing loans remains high in some countries and may constrain bank lending.

The July 2017 euro area bank lending survey suggests that loan growth continued to be supported by easing credit standards and increasing loan demand by non-financial corporations and households. In the second quarter of 2017, credit standards for loans to enterprises and for loans to households for house purchase eased. Competitive pressure continued to be the main factor contributing to the easing of standards. Banks also reported increasing net loan demand across all loan categories. Merger and acquisition activity, fixed investment, the low general level of interest rates and favourable housing market prospects were important positive contributors to loan demand. The ECB’s TLTROs continued to have an easing impact mainly on credit terms and conditions according to reporting banks. 63% of the euro area banks surveyed reported that they participated in the fourth and final TLTRO-II operation, due mainly to profitability motives. Finally, euro area banks also reported that they have continued to adjust to regulatory or supervisory action in the first half of 2017 by further strengthening their capital positions.

The decline in bank lending rates has stabilised since the beginning of 2017, with rates remaining close to their historical lows. In May 2017 composite bank lending rates stood at 1.76% for NFC loans, matching the historical low observed in February 2017, and 1.87% for housing loans (see Chart 11). Composite lending rates for NFCs and households have decreased more than market reference rates since the announcement of the ECB’s credit easing measures in June 2014. Between May 2014 and May 2017, composite lending rates on loans to euro area NFCs and households fell by 117 and 104 basis points, respectively. The reduction in bank lending rates on NFC loans was especially strong in vulnerable countries, indicating a more homogeneous transmission of monetary policy to bank lending rates in the euro area. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area has narrowed considerably. This indicates that small and medium-sized enterprises have generally benefited to a greater extent from the decline in bank lending rates than large companies.

Net issuance of debt securities by euro area NFCs moderated in the second quarter of 2017. The latest ECB data show that net issuance of debt securities by NFCs slowed down in April and May 2017. Recent market data suggest that issuance activity strengthened in June. Net issuance of listed shares by NFCs remained subdued in the second quarter of 2017 and was dampened by significant share buy-backs in May.

Financing costs for euro area NFCs remain favourable. The overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, is estimated to have increased moderately to around 4.3% in June and the first half of July 2017. The cost of financing now stands some 30 basis points above its historical low of July 2016, but remains considerably lower than the level observed in summer 2014. The recent rise in the overall cost of financing mainly reflects an increase in the cost of equity. By contrast, the cost of debt, expressed as the weighted average of the cost of bank lending and the cost of market-based debt, has fluctuated around its historical low since August 2016.

Boxes

Convergence and adjustment in the Baltic States

The Baltic States have been able to maintain an impressive rate of convergence towards the average EU per capita income over the past 20 years. Despite the severity of the crisis, strong convergence resumed quickly after the major adjustment of imbalances in 2008-09. This box reviews the long-term performance of and recent challenges faced by Estonia, Latvia and Lithuania.

The Baltic States are very small. They jointly represent only 0.4% of euro area GDP and 1.8% of the euro area population. The three countries joined the EU in 2004 with per capita income of, on average, 44% of that of the euro area. Since they joined the EU, these three countries have each pursued a strongly free-market and pro-business economic agenda, but they accumulated severe imbalances in the period leading up to the outbreak of the financial crisis in 2008. The economic adjustment which followed the 2008 financial crisis was sudden and very fast. Estonia had already adopted the single currency in 2011, meeting all the Maastricht criteria, benefiting from a very sound fiscal position in spite of the severe macroeconomic adjustment that was taking place. Latvia and Lithuania joined the euro in 2014 and 2015, respectively.

The three countries are different in many ways, but share a number of key features: very high levels of trade and financial openness and very high labour mobility; high economic flexibility with wage bargaining mainly at firm level; relatively good institutional framework conditions; and low levels of public debt (see the table). Most of these features are generally considered supportive of real convergence. At the same time, the great openness of these countries has also been a source of macroeconomic vulnerability and specific policy challenges. In particular, managing the business cycle against the backdrop of volatile capital flows has proved challenging.

From a long-term perspective, the convergence performance of the Baltic States has been remarkable. The Baltic States are among the few euro area countries (along with Slovakia) in which real GDP per capita in purchasing power standard (PPS) terms has shown substantial convergence towards the EU average over the last 20 years. While in 1995 their average per capita income (in PPS) stood at only around 28% of the EU15 average, in 2015 it reached 66.5% (see Chart A). It is also noteworthy that all three Baltic States experienced deep declines in real GDP in 2008 and 2009, but enjoyed strong recoveries afterwards.

The long-term convergence performance of the Baltic States has exceeded what would have been expected based on their initial income level. The strong convergence performance of the Baltic States should be assessed against the background of their very low initial income level at the beginning of their transition to market economies in the mid-1990s. However, their performance has exceeded what could have been expected from an equation linking initial per capita income levels with growth over the period from 1999 to 2015. This is shown in Chart B, which suggests that the Baltic States, along with Slovakia, significantly overperformed when compared to the prediction of the simple catching-up model.

One of the possible reasons for the fairly strong convergence performance of the Baltic States is the strong improvement in institutional quality in these countries (Chart C). The Worldwide Governance Indicators of the World Bank, which is a composite indicator of institutional quality, suggests that institutional quality has improved markedly in the Baltic States – especially in Estonia – over the recent decades. The improvement in institutional quality was particularly fast in the years prior to EU accession. The harmonisation of regulations with the EU prior to EU accession (the adoption of the acquis communautaire) was probably an important factor in this.

The Baltic States were very vulnerable at the start of the global crisis in 2008. All three countries had very high current account deficits, close to or above 10% of GDP in 2007, reflecting an unsustainable domestic demand boom financed by capital inflows. These large external financing gaps made the Baltic States vulnerable to the sudden stop in capital flows at the end of 2008 and in 2009. These large external imbalances in part reflected a marked deterioration in cost competitiveness against the backdrop of very fast unit labour cost growth, reflecting fast wage growth (with real compensation per employee growing annually at an average rate of 15.8%, 25.2% and 15%, respectively, in Estonia, Latvia and Lithuania between 2004 and 2007). Vulnerabilities had also built up in the financial system. Financial deepening increased rapidly in the pre-crisis years in the Baltic States, albeit from a very low level. A number of macroprudential and monetary policy measures introduced before the crisis (in particular increases in the required reserve ratio) were insufficient to prevent imbalances from emerging. Moreover, the measures were partially circumvented by the foreign-owned banks operating in the country.

While the crisis hit the Baltic States hard, the adjustment of imbalances was very fast. The rapid adjustment in fiscal balances and private sector balance sheets implied that the Baltic States could avoid the accumulation of a large debt overhang. In addition, the fast reduction in unemployment helped to decrease the risk of hysteresis, thus avoiding lasting consequences for potential growth.

The current account adjustment in the Baltic States triggered by the sudden stop in capital flows was frontloaded. As shown in Chart D, by 2009 the current account balance had already turned positive in the Baltic States. The main driver of the adjustment of the external financing gap was a collapse in import absorption and an acceleration in exports in 2010 owing to the internal adjustment and trade links with fast-growing regions. During the crisis, while euro area countries with large current account deficits had access to ample central bank liquidity to replace private capital flows, the Baltic States had to go through a full-blown current account adjustment in the absence of financing sources over a short time interval. Only Latvia received balance of payments (BoP) assistance from the EU and the International Monetary Fund (IMF) to cover part of the external gap with public funds.

The external adjustment of the Baltic States was facilitated by painful but effective internal devaluation (Chart E). At the time of the sudden stop in capital inflows in 2008-09, all three countries needed a significant adjustment in their overvalued real exchange rate. For various reasons, they each opted for an internal devaluation strategy. The adjustment in unemployment was also relatively fast (Chart F). At its peak in 2010, unemployment reached 16.7%, 19.5% and 17.8%, respectively, in Estonia, Latvia and Lithuania, but it subsequently decreased significantly, and by 2015 it stood at 6.2% in Estonia, 9.9% in Latvia and 9.1% in Lithuania.

This relatively fast adjustment in the Baltic States was facilitated in part by a strong initial rebound in employment growth, supported by an adjustment in labour costs. In addition, significant emigration to Scandinavia and Western Europe played a key role. The impact of these migration flows is complex. While they helped to ease labour market pressures and contributed to the balance of payments via sizeable worker remittances, they also contributed to a drop in labour supply and adverse demographic changes. Since joining the EU in 2004, the populations of Estonia, Latvia and Lithuania have fallen by 3%, 12% and 14%, respectively, reflecting in particular the emigration of younger workers.

Looking forward, the Baltic States are faced with a number of economic challenges. These include the following: (1) preserving competitiveness against the backdrop of a strong increase in wages and slowing productivity growth; (2) avoiding the “middle income trap”; and (3) managing a volatile business cycle inside EMU.

(1) Over the past three years, unit labour costs have increased significantly in the Baltic States, signalling a gradual erosion of competitiveness. The key reasons are a significant deceleration in productivity growth, along with an acceleration in real compensation per employee growth. Tightening labour markets played a key role in the recent acceleration of wage growth in the Baltic States, with the unemployment rate in 2016 already at 6.8% in Estonia, 9.6% in Latvia and 7.9% in Lithuania. In the context of a relatively flexible labour market, the emergence of wage pressures under such circumstances is a sign that a large share of that unemployment is structural and there are skills mismatches in the economy. While migration was a useful adjustment channel during the recession years, continued net emigration in spite of the recovery has contributed to the labour market tightness. Overall, it appears, however, that the pace of wage growth is beyond what can be explained by labour market tightness alone. The wage dynamics in these countries were also influenced by sharp increases in minimum wages. Policies to address skills mismatches and foster productivity growth, along with efforts to ensure that wage growth is in line with productivity growth, would therefore appear very important.

(2) International experience suggests that countries that reach a middle income level, like the Baltic States, tend to find it difficult to converge further and achieve a high income level. A World Bank study suggests that out of 101 middle-income economies in 1960, only 13 had become high-income economies by 2008.^[3] In the middle income stage of development, typically the scope for a productivity boost from the inter-sectoral transfer of labour from agriculture to more productive sectors, such as manufacturing, is limited and productivity growth should increasingly stem from innovation-based activities. There are a number of factors that can decrease the chance of a country falling into the “middle income trap”, including strong institutions, a low old age dependency ratio, high investment share and diversified trade and output.^[4]

(3) It remains a key medium-term challenge for the Baltic States to manage business cycle fluctuations. One of the key lessons to be learned from the crisis is that a small open economy in the euro area subject to volatile capital flows needs to put even stronger emphasis on counter-cyclical polices than other euro area countries. Such considerations highlight the importance of the active use of counter-cyclical macroprudential policy tools to limit the accumulation of financial vulnerabilities over the cycle. At the same time, counter-cyclical fiscal policy is also important. This means that, during upswings, the Baltic States should build up appropriate fiscal reserves to account for potential higher volatility in economic growth. Policy-makers could then let automatic stabilisers work during downturns and avoid the need to pursue pro-cyclical fiscal tightening.

Recent drivers of euro area equity prices

Following the trough after the UK referendum on EU membership, equity markets in the euro area have recorded notable gains (see Chart A). Compared with early July 2016, the increase amounts to around 40% for banks and 20% for non-financial corporations.

Using a dividend discount model, this box analyses the driving forces behind the increase in equity prices since July 2016. Dividend discount models allow changes in equity prices to be broken down into contributions from three factors: (i) changes in expected future cash flows from equities in the form of dividends; (ii) changes in the long-term risk-free rate; and (iii) changes in the “equity risk premium”. The sum of the equity risk premium and the long-term risk-free rate forms the required rate of return on equity at which future dividends are discounted, with the equity risk premium denoting the risk compensation, or extra return, required by investors for holding equity instead of long-term bonds.

To the extent that expected dividends, long-term risk-free interest rates and equity prices can be observed via financial market data, the equity risk premium can be found by equating the discounted sum of future cash flows to the prevailing stock prices. The path of future expected dividends, however, is inherently unobservable and would need to be proxied on the basis of observable indicators combined with economically plausible assumptions.

The dividend discount model is implemented here by assuming that the expected dividend growth rate varies over the course of different phases and converges to a constant long-term value. In the three-stage model, three separate phases for the dividend growth rate are assumed: (i) an initial period during which dividends grow constantly at a rate of ; (ii) an intermediate period over which the initial growth rate converges linearly towards a long-term growth rate (); and (iii) a final indefinite period, where dividends grow at the constant annual long-term rate (). With the current dividend in place, this assumed sequence of growth rates identifies the complete evolution of expected future dividends.

Under these assumptions on future dividend growth rates, the equity premium can be readily obtained from observed dividend yields and the risk-free rate. It is calculated using the expression shown in the equation, which is an approximation of the three-stage dividend discount model, also known as the “H-model”^[5]. In the equation, denotes the required rate of return on a stock (or stock price index), the risk-free long-term rate, the equity risk premium, and the current dividend yield, while and are the two dividend growth parameters described above. The parameter is the length of the initial period (first stage) plus half the length of the intermediate period (second stage). For the implementation of the model, the initial (first stage) dividend growth rate () is approximated by I/B/E/S “long-term” earnings projections^[6] and the long-term growth rate () (third stage) by long-term year-on-year GDP growth expectations as reported by Consensus Economics. Stock prices and initial dividends are taken directly from financial markets, while the long-term risk-free rate is gauged to be the ten-year overnight index swap rate. The latter is subtracted from the required rate of return in order to calculate the equity risk premium. Changes to the equity price index can then be broken down into changes in growth expectations (as captured by changes in the g-parameters), changes in the long-term risk-free rate, or changes in the calculated equity premium.

In cumulative terms, the increase in equity prices between early July 2016 and January 2017 was mainly attributable to a fall in the equity risk premium (see Chart B). Chart B shows cumulative contributions to the change in euro area equity prices, with positive contributions from declines in the equity risk premium being especially visible around the time of the presidential election in the United States.^[7]

Since early 2017, however, improvements in earnings growth expectations for euro area firms have picked up significantly and become the major driver of the further rise in equity prices. This increase in earnings expectations has been in line with the overall improvement in the euro area macroeconomic environment, as also signalled by strong readings in, for example, the euro area Citi Economic Surprise Index or Purchasing Managers’ Indices. Over the entire period, the declines in the equity risk premium and subsequent improvements in earnings expectations together more than offset the increase in longer-term yields since autumn 2016.

From a historical perspective, the current estimate for the equity risk premium in the euro area is not low (see Chart C), indicating that equities are not particularly highly valued relative to bonds. The estimated euro area equity risk premium increased significantly to levels between 6% and 8% in the wake of the 2008 financial crisis. At the same time, the equity risk premium, just like any risk premium embedded in financial market prices, is an unobservable object. Hence, any measurement (including the one presented here) is to some extent uncertain and estimated levels of such premia should be interpreted with caution.

Lower interest rates and sectoral changes in interest income

This box describes the impact of the decline in interest rates on interest income across sectors since 2008. It focuses on interest-bearing assets and liabilities, such as deposits, debt securities and loans (Chart A).^[8]

Sectoral holdings of interest-bearing assets/liabilities and interest earnings/payments allow sector-specific implicit interest rates to be computed. Chart A shows the balance sheet of the total euro area economy and the interest earnings and payments of the total euro area economy.^[9] At the sectoral level (households, non-financial corporations (NFCs), financial corporations, government and the rest of the world), this information allows the calculation of sector-specific implicit interest rates on interest-bearing assets and liabilities. The implicit interest rate on assets, for example, is obtained by dividing interest earnings by the notional stock of assets, i.e. free of valuation effects. Notional stocks can be obtained by cumulating quarterly transactions over time. Owing to the way interest earnings and payments are measured in the sectoral accounts, the implicit interest rate is conceptually close to a bond yield at issuance.^[10] Chart B shows that the implicit interest rate for the euro area’s assets is closely related to the euro area overnight interest rate (EONIA) and the long-term government bond yield. Because monetary policy closely determines the current and expected overnight interest rate, the ECB’s policy ultimately also influences interest rates on interest-bearing assets at the sectoral level. However, the extent to which changes in the current and expected overnight interest rate are transmitted to sectoral interest rates will also depend on developments in sector-specific risk premiums and the average duration of outstanding interest-bearing assets.^[11]

The implicit interest rate can be used to compute the contribution from lower interest rates to the observed changes in net interest income since 2008. This is obtained by multiplying the implicit interest rate by the notional stock of assets at the start of the period. In this way, one can ensure that the change in interest earnings since the start of the period under consideration depends only on changes in the interest rate (“price effect”). A similar calculation is done on the liability side of the balance sheet. Changes in the stock of assets also affect the overall change in interest income (“quantity effect”). The latter is excluded from the analysis in order to be able to measure how changes in interest rates alone have redistributed interest income across sectors. The starting point of the analysis is the third quarter of 2008, which marks the beginning of the current easing phase.

For the euro area as a whole, the impact of lower interest rates on net interest income has been positive. Chart C shows the change in net interest income from lower interest rates between the third quarter of 2008 and the fourth quarter of 2016 for the euro area as a whole and for nine euro area countries.^[12] As households are also indirectly affected by lower interest rates via their investments in pension funds, their equity holdings in companies or as tax payers, it is worth looking at how the total economy has been affected with respect to the rest of the world. For the euro area as a whole, and for most euro area countries, the impact of lower interest rates on net interest income has been marginally positive at the total economy level. The sectoral analysis makes it clear that the size and composition of sectoral balance sheets are key factors in understanding the impact of lower interest rates on the total economy. Chart C shows that, for the euro area as a whole, the impact of lower interest rates on net interest income was positive for the NFC and government sectors, while it was negative for the financial sector. For the household sector, the impact was broadly neutral.

The direct impact of lower interest rates on the household sector has been more heterogeneous across countries. ^[13] Chart C shows that the household sector in Finland, the Netherlands and Spain has benefitted from lower interest rates, i.e. in these countries, net interest earnings attributable to falling interest rates increased. This is because the size of household debt has been particularly large in these countries compared to the size of assets held by households. Moreover, the prevalence of variable rate mortgages (e.g. in Spain) also increased the gains from lower interest rates. By contrast, in Belgium, Austria and Italy, households saw larger falls in net interest income. In these countries, households hold a relatively large share of their financial wealth in the form of interest-bearing assets. In Germany, France and Portugal, the change in net interest income of the household sector was negligible.^[14]

While the NFC and government sectors are among the largest beneficiaries of lower interest rates, the financial sector generally lost interest income. In the NFC sector, gains above 1% of GDP in net interest income from lower interest rates occurred in France, Finland, Italy and Spain. The government sector benefited most from lower interest rates in Belgium, France and Germany. In the countries that were hardest hit by the sovereign debt crisis, the government sector gained relatively less from the drop in interest rates, owing to the simultaneous increase in sovereign risk premiums. Finally, with the exception of Portugal, the financial sector has generally been losing interest income since the third quarter of 2008, most prominently in France. This is due to the fact that the financial sector (including monetary financial institutions, insurance corporations and pension funds, and other financial institutions) has on average more interest-bearing assets than interest-bearing liabilities. When interest rates on assets and liabilities decline to the same extent, this reduces the sector’s net interest income. Note, however, that interest income is not the only determinant of the profitability of the financial sector.^[15]

Over the previous business cycle, sectoral changes in net interest income were largely neutral. This box has focused on the impact of the falling interest rates since 2008. It may be useful to compare these results with the previous business cycle from 2002 to 2008, as seen in Chart B. Chart D shows that, over the period 2002-2008, the redistribution of interest income was, ultimately, largely neutral across sectors.^[16] It also shows that, during the previous easing phase (2002-2005), the direction of changes in interest income across sectors was very similar to the pattern of changes since 2008. During the period 2002-2008, household and total economy net interest income was broadly unchanged. In the tightening phase (2006-2008), financial corporations recovered most of their net interest income losses, while NFCs saw a reversal of their gains. The government sector continued to benefit even beyond the end of the tightening phase. This is explained by the secular downward trend in government bond yields (see also Chart B), which started in the mid-1980s and is unrelated to the cyclical changes in interest rates from 2002 to 2008.

How do professional forecasters assess the risks to inflation?

Perceptions of uncertainty and risks are an important element in assessing the economic outlook, adding to the information gained from point forecasts. Economic agents’ expectations of future inflation can affect subsequent economic developments, for example, through their influence on price-setting, consumption and investment decisions. For this reason, analysis of inflation expectations data, such as that in the ECB’s Survey of Professional Forecasters (SPF), plays an important role in the overall assessment of the inflation outlook. Such analysis has two dimensions: the point forecasts and the perception of risks around those point forecasts. The point forecasts for the next three years tell us professional forecasters’ central views on the evolution of the economy, given the shocks already observed or embodied in their technical assumptions (e.g. for the oil price). Longer-term point inflation expectations can be used to assess the perceived effectiveness of monetary policy. Risk perceptions, on the other hand, reveal useful information on the expected distribution of economic shocks and provide an additional dimension for assessing the strength of the longer-term inflation expectations anchor. This box focuses on how risk metrics can be derived from the SPF data, and what those risk metrics might imply.

The probability distributions reported in the SPF can be used to derive measures of risk and uncertainty. The SPF asks not just for point expectations, but also for participants’ assessment of the probabilities of different inflation outcomes in the future. While the point expectations reflect survey participants’ central estimates of future inflation, the probabilities participants assign to different future inflation outcomes reveal their assessments of uncertainty and risks.

Uncertainty, measured by the width of the reported distribution, increases with the forecast horizon (see Chart A). In part, this reflects the general observation that the more distant future is typically more uncertain than the near future. More fundamentally, that may be because the number of different factors which can influence the outcome increases with the horizon: the short term tends to be affected predominantly by oil price developments; in the medium term, the outlook for inflation and the risks around it become more closely connected to those for real economic growth; in the long term, the perceived strength of the nominal anchor provided by monetary policy becomes most relevant.^[17]

Overall inflation uncertainty has remained higher than it was before 2008, but the volatility of actual inflation has increased by more. The standard deviation of the aggregate longer-term probability distribution, which measures its width, increased in 2008 and 2009. This movement in the forward-looking uncertainty measure tracked the evolution of the backward-looking, realised volatility in inflation, as movements in oil and other global commodity prices drove quarterly HICP inflation from 2% up to 3.8% in the third quarter of 2008 and then down to −0.4% in the third quarter of 2009. Uncertainty around future inflation outcomes has since remained at that higher level, even though the more recent movements in inflation, down from 2.9% in the fourth quarter of 2011 to −0.3% in the first quarter of 2015, then back up to 1.8% in the first quarter of 2017, have pushed up realised volatility further (see Chart B). This might suggest that while SPF respondents acknowledge the possibility of extreme commodity price swings leading to volatility in inflation, they do not expect large movements in inflation, such as those experienced over 2015 and 2016, to be repeated.

The asymmetry of respondents’ probability distributions indicates how they perceive the balance of risks. Put simply, the balance of risks measures how, in the event that a forecast would turn out to be wrong, the forecaster considers it more likely to be wrong. For instance, a positive balance of risks indicates that the forecaster believes that, were their forecast to be wrong, it would more likely be because the outturn was above the forecast than below it.^[18] In terms of the expected probability distribution, a positive balance of risks signifies that more probability is assigned to outcomes above the central estimate than to outcomes below it.^[19]

There are different ways of measuring the balance of risks numerically, but all measures tend to move closely together. Alternative measures of asymmetry and alternative practical choices which must be made when calculating those measures from survey data lead to a range of calculated asymmetries, rather than a unique value.^[20] Furthermore, in the SPF the point forecasts are reported separately and can be compared with the probability distributions to provide an indication of the balance of risks. In the quarterly SPF reports, this is measured numerically as the mean of the aggregate probability distribution minus the average point forecast.^[21]

SPF respondents see the risks to their inflation projections as broadly balanced at short horizons, but still to the downside in the longer term. The point forecast for inflation in 2017 lies close to the centre of the corresponding probability distribution (shaded darkest in Chart A), which suggests that the risks around that expectation are thought to be broadly balanced. In contrast, at the longer-term horizon, more probability is assigned to inflation outcomes below the point forecast than above it, indicating that the balance of risks around the longer-term inflation expectation is to the downside. However, the longer-term balance of risks has been recovering since 2016, albeit gradually (see Chart C).

Overall, the risk information in the SPF supports the notion that longer-term HICP inflation expectations remain anchored. Longer-term inflation expectations have remained stable at 1.8% over the last two years, despite strong volatility in actual HICP outturns. Furthermore, the forward-looking measure of uncertainty has also remained stable, despite the actual volatility, and the downside balance of risks to longer-term inflation expectations has shown some modest improvement in the last few survey rounds. This could suggest that the risks of de-anchoring of longer-term inflation expectations are gradually receding.

The 2017 country-specific recommendations

Every year the European Commission issues country-specific recommendations (CSRs) for each EU Member State, ^[22] which contain the policy priorities for the following year. These recommendations are approved by the EU Council following endorsement by the Heads of State or Government of all EU Member States. The CSRs provide guidance tailored to individual Member States on how to enhance growth and resilience, while maintaining sound public finances.^[23] The CSRs are drawn up in line with the medium-term Integrated Guidelines on economic and employment policies of the Member States. They are a key element of the European Semester as they are the instrument through which national economic policies become “a matter of common concern”, as stipulated in Article 121 of the Treaty on the Functioning of the European Union. Timely implementation of these recommendations is critical to reduce vulnerabilities and boost medium-term growth, employment and productivity in the European Union. For euro area countries, they are also consistent with the objective of ensuring the smooth functioning of Economic and Monetary Union (EMU).

The CSRs are prepared by means of a comprehensive process which starts in the autumn of the preceding year. First, in November each year the Commission releases the Annual Growth Survey and the Alert Mechanism Report. While the Annual Growth Survey identifies the main policy priorities for the European Union as a whole, the Alert Mechanism Report assesses developments in Member States to establish whether there are potential or existing imbalances which need to be corrected by targeted policy actions. On the basis of these documents, the Council adopts the recommendations for the euro area early in the year, setting out the main areas for reform for EMU as a whole. On 22 February 2017 the Commission released the Country Reports for all EU Member States, which analyse progress made by each country on implementing reforms and identify imbalances and rigidities which require further policy actions, in the context of the in-depth review of the macroeconomic imbalances procedure. On the basis of the Country Reports, the Commission provided Member States with the draft 2017 CSRs on 22 May. Following discussions in the relevant EU committees, the Council adopted the final CSRs on 11 July.

The euro area recommendation this year focuses on ways to reduce imbalances, increase resilience and strengthen growth and employment in euro area countries. The euro area recommendation (adopted by the Council on 10 March) precedes the country-specific recommendations and is addressed to all euro area Member States jointly. More specifically, it calls on euro area countries to increase reform efforts towards improving productivity and the institutional and business environment, and removing bottlenecks to investment. The euro area recommendation also calls on governments to increase flexibility and security in labour markets, as well as to ensure fiscal sustainability and accelerate the work on completing EMU, in particular regarding banking union.

The 2017 CSRs broadly echo the emphasis of the euro area recommendation. Chart A shows a breakdown of the 2017 CSRs by reform area. It indicates, for example, that a significant proportion of the recommendations address bottlenecks in framework conditions (including all measures related to the regulatory environment, the judicial system, insolvency frameworks, housing policy and financial sector regulation). Addressing such bottlenecks should positively affect market entry, increase incentives for firms to invest and improve resource reallocation. A large proportion of the recommendations address fiscal-structural issues, such as increasing the long-term sustainability of public finances, reducing the tax burden on labour, and increasing the efficiency of public administration and state-owned enterprises.

The new recommendations should be seen in the context of the relatively weak implementation of CSRs in recent years. ^[24] The Commission found in February this year that for the overwhelming majority of the 2016 recommendations (more than 90%) there had been only “some”, “limited” or indeed “no” progress on implementation, while only a very small number of recommendations had been “substantially” or “fully” implemented. Despite specific monitoring by the European Commission, implementation was not higher for countries with excessive imbalances. This is consistent with past patterns of very low rates of “substantially” or “fully” implemented reforms. The weak implementation of CSRs is all the more concerning given the remaining rigidities and vulnerabilities in euro area countries. The high level of remaining vulnerabilities is, for instance, reflected in the Commission’s finding that the number of countries with excessive imbalances (Bulgaria, France, Croatia, Italy, Cyprus and Portugal) remains at an all-time high.^[25]

Although the degree of CSR implementation remains low, the 2017 CSRs have been streamlined further. The Commission had already reduced the 2015 and 2016 CSRs with a view to allowing Member States to focus on key macroeconomic and social priorities. Despite this, CSR implementation did not improve. In several cases, some recommendations have even been dropped, although the countries concerned have made no progress or only limited progress on implementation during the past year.

CSRs have also been streamlined for countries with excessive imbalances. The number of CSRs has been reduced for countries with excessive imbalances and in several cases the level of urgency has been reduced, insofar as the CSRs contain significantly fewer deadlines compared with last year’s recommendations. This comes despite the limited implementation of CSRs for countries with excessive imbalances.

Given the difficulties of strengthening reform implementation in the context of the preventive arm of the macroeconomic imbalance procedure, there seems to be a strong case for applying the corrective arm of this procedure for all countries with excessive imbalances. This tool, which has not been used so far, offers a well-defined process ensuring greater traction on reform implementation for the most vulnerable Member States.

As a result of the streamlining of CSRs, fewer recommendations have been issued compared with the previous year. In particular, there are fewer recommendations on framework conditions and still only a limited number on product markets (see Chart B). This is surprising since a lack of competition in product markets and sub-optimal conditions for business activity remain an issue in many sectors across Member States.^[26] In view of the continued emphasis on strengthening private investment and productivity, it will be important to ensure that greater focus is restored to product market reforms in Member States’ CSRs.

Continued monitoring of other reform areas which are no longer covered by the CSRs, but which are critical for the overall economic performance of Member States, remains essential. For the past three years the Commission has excluded from the CSRs certain policy areas which are covered by other monitoring channels.^[27] These include the energy sector (which is covered in the context of the energy union) and the monitoring and enforcement mechanisms related to the Single Market. It remains essential, however, to keep track of developments and policies in these areas under the European Semester to ensure that all significant economic policies implemented by Member States are assessed in a holistic manner.

Article

The composition of public finances in the euro area

In times of stretched public finances and low structural economic growth, a legacy of the recent crisis, it is essential that fiscal policies are designed to be as growth-friendly as possible. A key element in today’s policy debate is the composition of public budgets, i.e. the choice of fiscal instruments on the government revenue and expenditure side. This article sheds light on changes in the composition of public finances since the pre-crisis years and assesses their growth-friendliness. It illustrates how vulnerable public finances have led governments to adopt consolidation measures that impinge negatively on long-term growth. The article also suggests redirecting public funds from less productive spending items towards education and infrastructure, while shifting the tax burden away from distortionary taxes, in particular labour taxation, towards less distortionary consumption and property taxes.

1 Introduction

The current environment of low structural growth, high unemployment and high government debt levels has brought attention to the composition of governments’ expenditure and revenue. As a legacy of the recent economic and financial crisis, the euro area has experienced a long period of relatively subdued growth and unemployment levels have remained high. At the same time management of public finances is constrained by high stocks of debt. Euro area government debt, although declining, stands at 90% of GDP, which limits the scope for expansionary policies. Hence, the challenge is how to foster potential growth without compromising fiscal sustainability. Consequently, evidence that the composition of budgets matters for long-term economic growth is of particular relevance in these times of necessary fiscal retrenchment. Shifting expenditure to the most growth-enhancing categories or the tax burden to less distortive taxes can exert positive effects on output growth without burdening public budgets.

This article assesses the growth-friendliness of the composition of euro area government budgets since the pre-crisis years. The size of the government sector in the euro area is large by international standards and it has grown further during the financial crisis and the subsequent consolidation period. On average governments in the euro area spend almost 48% of GDP. In its analysis this article focuses on developments in budgetary composition during the boom leading to the financial crisis and the subsequent fiscal consolidation. A backward-looking perspective is helpful to identify changes in the growth-friendliness of budgets and in particular to assess whether recent consolidations have curbed growth prospects by relying too much on cuts in growth-enhancing spending or increases in particularly distortionary taxes.

The analysis suggests that there is scope for reforms to improve the growth-friendliness of the fiscal composition. Such reforms are changes to the budget composition that improve the national GDP per capita in the long run, but are budget neutral in the short run. These may constitute reallocation of expenditures from less growth-friendly to more growth-friendly categories, tax shifts from distortionary to less distortionary taxes, or simultaneous changes in expenditure and revenue shares. There have been repeated calls by the European Commission, the Eurogroup, the ECB^[28], the IMF and the OECD to increase the growth-friendliness of fiscal policies.

The composition of public budgets is also an important element of the wider discussion on the quality of public finances ^[29] . This has several dimensions, such as the size of the government, the level and sustainability of fiscal positions, the composition and efficiency of expenditure, the structure and efficiency of revenue systems and fiscal governance.

This article is structured as follows: Section 2 discusses the relative growth-friendliness of different expenditure and revenue categories based on a survey of the empirical literature; Section 3 analyses the composition of expenditure by function and the evolution of tax structures by type of tax base since the pre-crisis years; and Section 4 concludes.

2 The growth-friendliness of the composition of public finances: what does the literature tell us?

The empirical literature provides evidence that some expenditure and revenue categories are more relevant for supporting long-term growth than others. Based on the review of the literature, it is possible to identify some underlying patterns in the adequacy of different fiscal instruments in terms of their long-term impact on growth.^[30]

Expenditure on education and health is important for long-term growth prospects since it raises the level of human capital, while expenditure on infrastructure raises the level of physical capital. As shown in a survey article^[31], the recent literature generally finds robust empirical relationships between certain expenditure categories and economic growth. In particular, it finds robust positive long-run effects for productive expenditure categories, such as education and several types of investment. For example, one of these empirical analyses^[32] studies the long-run effect of changes in the shares of different expenditure categories on the growth rates of per capita GDP in a panel of OECD countries. It finds a significant positive effect for education spending, as well as spending on transport and communication. Moreover, the study finds some evidence supporting positive effects for housing and health and negative effects for social welfare spending. The main findings are in line with earlier findings^[33] showing that shifting expenditure to education spending has a robust effect on growth.

The empirical evidence relating to the impact of physical public investment on structural growth is mixed. The estimates from the empirical studies tend to find a positive relationship between public investment and growth, but the results are heterogeneous. A meta-analysis^[34] shows that, in most empirical studies, a positive effect of the share of productive government investment on economic growth is found. However, the estimates vary widely and some studies even find a negative relationship between public investment and growth. These conflicting results can be reconciled if one distinguishes productive from unproductive government investment. Government investment can be conducive to economic growth, particularly if it creates public capital that is complementary to private capital or that would otherwise be undersupplied in an economy. But its effect becomes negative if it crowds out private investment. The positive effect is particularly pronounced for investment in infrastructure, such as transport and communication or education.

There are studies that find a negative relationship between social spending and economic growth ^[35] , but overall the results are not very robust. A possible explanation is the distortionary effects of social spending on labour market activity. The magnitude of these effects depends not only on the amount spent, but also and to a large extent on the design of the social programmes.^[36] By focussing transfers on those in need and avoiding negative incentives for labour market participation, fiscal costs can be lowered while also reducing the possible growth-inhibiting effects of such policies.

On the revenue side, taxes on income are found to be more detrimental to growth than taxes on consumption and property. According to the literature survey, labour taxation is particularly detrimental to growth, as it distorts individuals’ labour supply decisions and firms’ incentives to hire workers. Corporate income taxes tend to reduce the incentives to invest and can induce capital outflows. By contrast, consumption taxes are considered to be relatively less distortionary as they do not affect intertemporal consumption decisions (i.e. consumption now and consumption in the future are taxed equally). Finally, capital taxes on immobile capital, such as property taxes, are assumed to have low distortionary effects.^[37] Recent empirical analyses^[38] find that increases in the taxation of personal income and corporate profits have a negative effect on long-term growth, while raising tax rates on consumption does not significantly affect the growth rate.

It is likely that the progressivity of labour taxes has an ambiguous effect on long-term growth. At the upper end of the income distribution, high effective marginal income tax rates reduce incentives to pursue more highly productive (and thus more highly rewarded) activities. At the lower end of the income distribution, high tax rates may discourage low-skilled workers and second earners from participating in the labour market. These groups can be assumed to be particularly responsive to cuts in labour tax rates. Some recent empirical papers confirm this notion, showing that labour tax reforms reducing the burden for low-income earners have a particularly positive effect on employment and, eventually, economic growth.^[39]

3 Evolution of the composition of public finances in the euro area

This section is structured as follows: Section 3.1 sets the overall scene by providing an overview of the cyclically adjusted primary balances, revenues and expenditures during the period under observation. The disaggregated composition of the various expenditure and revenue instruments underlying the overall changes is particularly important when assessing the growth-friendliness of the changes. Consequently, Sections 3.2 and 3.3 look at developments in various expenditure and revenue categories^[40] respectively.

3.1 Overall trends

Expenditure and revenue-to-GDP ratios have shown some volatility since the pre-crisis years, but have increased overall. Chart 1 illustrates the trends in the cyclically adjusted primary expenditure and revenue ratios at the euro area level during the period 2003-16. The expenditure share increased sharply with the start of the financial crisis in 2008, when many countries reacted with expansionary fiscal policies. After the peak of the financial crisis, expenditure shares declined, but stayed above the pre-crisis level. By contrast, revenue shares stayed relatively constant until 2010, but climbed significantly in the years afterwards, reflecting euro area countries’ policies of revenue-based fiscal consolidation in view of surging deficits and debt levels.

In more detail, the period 2003-16 can be divided into three distinctive periods of budgetary composition. Based on Chart 2, these developments can be summarised as follows:

• The first period covers the years leading up to and including the start of the financial crisis (2003-10). After the years 2003-05, which can be characterised as “normal” times with on average closed output gaps for the euro area aggregate, significant positive output gaps were recorded over the period 2006‑08, which were then followed by the financial crisis. The euro area cyclically adjusted revenue ratio remained stable over 2003-10, indicating that overall governments were not actively pursuing discretionary changes. The sharp GDP deterioration in 2008-09 was accompanied by a temporary fiscal stimulus, which is reflected in the deterioration in the cyclically adjusted primary balances. Governments largely responded with emergency-driven expenditure increases. In 2010 the euro area as a whole recorded the most negative cyclically adjusted primary balance of the period 2003-16.
• The second period was marked by strong consolidation efforts in most euro area countries to reverse the steep deterioration of public finances (2011-13). ^[41] As a consequence, 2013 was the last year in which the euro area as a whole recorded a significant improvement of the cyclically adjusted primary balance.
• Although consolidation continued in a few countries beyond 2013, most notably those countries with the highest adjustment needs, the subsequent period can be considered as the convergence to the new “normal” (2014-16). Output gaps were still negative but they were closing according to European Commission estimates.^[42] For the euro area as a whole the consolidation effort came to a standstill over this period.

In the run-up to the crisis, most euro area countries failed to take advantage of the favourable economic conditions to build sufficient fiscal buffers. At the end of 2007, the euro area aggregate cyclically adjusted balance was in significant deficit, amounting to −2.2% of GDP, despite the fact that the euro area output level was considerably above its potential.

The financial crisis and the largely expenditure-based expansionary fiscal stance during 2008-09 led to a sharp deterioration of fiscal positions in most euro area countries and the need for a large adjustment in subsequent years. The cyclically adjusted primary balance, as a measure of the fiscal stance, deteriorated by 3 percentage points of potential GDP over the period 2008-10 in the euro area. The dominant share of this deterioration can be attributed to increases in cyclically adjusted primary expenditures which recorded an increase of approximately 2.7 percentage points of potential GDP as seen in Charts 1 and 2.

In most countries a largely revenue-based consolidation process started in 2011 and lasted until 2013. However, despite the already large size of the government sector in many euro area countries and the fact that developments during 2008-10 warranted more of an expenditure-based consolidation, revenue increases clearly predominated over expenditure cuts. More specifically, approximately two-thirds of the 3.6 percentage points of potential GDP consolidation during 2011-13 was revenue-based.

The fiscal stance has been broadly neutral since 2014 as most countries have stopped any further fiscal consolidation. This also implies that the expenditure ratio and – even more so – the revenue ratio have remained at a higher level than before the start of the boom-bust cycle, as shown in Chart 1. In certain countries, most notably those countries under economic adjustment programmes, consolidation has continued beyond 2013.

3.2 Government expenditures

Expenditures on education and transport infrastructure, which are usually considered as the most growth-friendly, accounted for about one-fifth of total euro area government primary expenditures in 2015. In addition, health expenditure, which can also have beneficial growth effects, accounted for nearly one-fifth. Social protection, on the other hand, accounts for over two-fifths of total primary expenditure and is by far the largest budgetary component. Pension payments constitute around 60% of expenditure in this category.

Developments in expenditure categories show a stark change in behaviour during the period under study. Before the start of the consolidation, increases in government spending were recorded across almost all categories of expenditure with the largest increases being concentrated in pension and health expenditure, as illustrated in Chart 4 (blue bars). These increases may not be purely discretionary on account of ageing populations. There were also significant increases in the particularly growth-friendly category of infrastructure and production-related expenditure. During the consolidation period (yellow bars) reductions occurred in all categories with the exception of pension expenditure. The consolidation relied significantly on cuts in education and infrastructure expenditure. In the case of the latter, however, the ratio of expenditure as a percentage of potential GDP remained constant overall for the period 2003-15, with the significant reductions during the consolidation period offsetting increases recorded pre-consolidation and post-consolidation. In the case of education, reductions have continued in the post-consolidation period (red bars). By contrast, in the post-consolidation period, expenditures on pensions have continued increasing, while in the categories health and non-pension social payments increases have largely reversed the cuts of the consolidation period.

Looking at developments in individual countries, in the period before the consolidation, significant increases in particularly growth-enhancing expenditures (education and infrastructure) were recorded in the majority of the euro area countries. As illustrated in Chart 5 Greece, Luxembourg, Italy and Cyprus are the only countries that registered reductions in the aggregate of expenditures on education and infrastructure even before the crisis.

During the consolidation period, expenditure on education and infrastructure investment suffered the largest reductions in most countries. Expenditure reductions were registered in all euro area countries except Belgium and Slovenia. The reductions were particularly large in the countries with the strongest adjustment needs. Ireland, Greece, Portugal and Cyprus registered reductions up to 2013, while the reductions have continued beyond 2013 in Greece and Cyprus.

Expenditure on infrastructure and education registered increases in the years 2014-15 in many countries, thus partly reversing the reductions in the consolidation period. As illustrated in Chart 5, since 2013 expenditures that are particularly growth-enhancing have recovered overall, but in 2015 they were still below pre-consolidation period levels. Increases were recorded in over half of the euro area countries. Germany, despite the absence of pressing consolidation needs, has, however, slightly reduced the ratio of expenditures on education and infrastructure as a percentage of potential GDP. The increases observed in other countries are largely in the category of infrastructure expenditure. In the case of education, the drop in the expenditure as a percentage of potential GDP even continued in 2014-15 in the majority of the euro area countries. The decline, however, does not necessarily translate fully into reduced expenditure per student as there is a declining population share of the young generation.

It is also relevant to consider the efficiency of the growth-enhancing expenditures in terms of outcomes. It is remarkable that some of the countries with the biggest cuts in expenditures on education and infrastructure after the financial crisis were also those with the biggest increases during the boom period that preceded it. Consequently, the adjustments after 2009 also to some extent mirror unsustainable developments before the onset of the crisis in which some expenditure was not well targeted and had low efficiency.

Expenditure on pensions is the only category to register increases in most countries throughout 2003-15, including during the consolidation period. As shown in Chart 6, increases were particularly strong in Greece and Portugal before the onset of the consolidation, while Germany and Luxembourg were the only countries which recorded decreases. During the consolidation episodes, increases continued in the majority of countries, while significant reductions occurred in some of the programme countries. However, these reductions were smaller than the increases in the years before. Pension expenditures continued increasing in the majority of euro area countries after 2013, also reflecting a further rise in the share of older people in the population. This shows that the pressure from an ageing society will continue to limit governments’ room for manoeuvre in the coming years as further increases in the share of elderly people are projected.

Overall, expenditure in the most growth-friendly categories was reduced over the consolidation years, but pension expenditure increased steadily over the entire period. This finding is particularly relevant taking into account that pension expenditure amounts to more than a quarter of government expenditure in the euro area, while expenditures in the growth-friendly categories of education and transport represent less than a fifth.

3.3 Government revenues

Developments on the revenue side can be assessed across four broad categories of tax revenue, namely property taxation, taxes on consumption, labour taxation and taxation on firms. Chart 7 illustrates the shares for these broad tax revenue categories for the euro area as whole. Labour taxation, which is the summation of personal income taxation and social security contributions, accounted for over 60% of taxation revenue, while taxes on firms only amounted to 6%. The categories of property and consumption taxation that have been shown to be less distortionary accounted for close to a third of taxation revenue.

Before the consolidation period, increases in labour taxation were offset by reductions in the other tax categories. As illustrated in Chart 8, it is remarkable that taxation on firms, consumption and property were decreasing on average during the period 2003-10. One notable exception was Germany, where the revenue share from labour taxation decreased substantially and the revenue share from consumption taxes increased.

During the consolidation period governments relied significantly on more distortionary taxes, most notably labour taxation, for consolidation. As shown in Chart 8, the increases were mostly concentrated on labour taxation. In particular considerable increases were recorded in the countries that had high consolidation needs, such as Greece, Portugal and France. The increases in revenues from corporate taxation observed during the consolidation period reversed to a certain extent the lower reliance on these revenues in the period leading up to it.

Since 2013 revenue shares have shifted towards the less distortionary taxation categories. Reliance on property and consumption taxation has continued to increase, while taxation on firms has recorded a small decrease.

Both the relative share of labour taxation and the degree of tax progression are relevant for growth. As shown in Chart 9, many euro area countries resorted to hikes in labour taxes when the need for fiscal consolidation was particularly pressing. Chart 9 shows the changes in the tax wedge on labour (i.e. the ratio of personal income taxes and social security contributions to the corresponding total labour cost for the employer) for single earners receiving 67% and 167% of the mean national income, respectively. The graph demonstrates that most countries in the sample increased the tax burden on high-income earners, while four of them (most notably France and Italy) reduced the burden on low-income earners.

Corporate income tax rates were not increased significantly, either during the consolidation period or afterwards. Chart 10 shows the effective average tax rate (EATR)^[45], which represents the effective tax burden on profitable investment. It takes into account the current tax code of each country, in particular concerning statutory tax rates and the definition of the tax base. In the first period, we see a general trend towards reducing the tax burden on firms, possibly also reflecting intensifying tax competition. During the consolidation period and after 2015, only a few countries resorted to increases in corporate taxes to generate additional revenues. Overall, the effective tax burden for firms is now lower in most countries than it was before the boom.

For consumption taxes there is a pattern of increasing VAT rates. Chart 11 shows the changes in the standard rates of VAT, which are a good proxy for the tax burden on consumption given that VAT is the predominant source of revenue from indirect taxation. Almost all countries increased the tax burden on consumption. Rates were increased particularly strongly in the consolidation period (especially in countries undergoing adjustment programmes), but some countries also increased their VAT rates after the adjustment. Increases in consumption taxes also took place in many euro area countries in the form of a broadening of tax bases, as goods were shifted from reduced to standard rates, and in the form of higher excise tax rates.

Overall, while taxation in the most distortionary categories (e.g. labour taxation) increased over the consolidation period, since 2013 governments have relied more on less distortionary taxation. This finding is particularly relevant taking into account that labour taxation is the largest component of tax revenues. The European Commission^[46] developed a horizontal indicator-based assessment methodology to help identify the need and scope for shifting the tax burden from labour to other revenue categories that are less detrimental to growth. The analysis using data for the period 2011-13 demonstrates that around one-third of the EU Member States show a need and scope for growth-enhancing shifts of taxation from labour to other tax bases.

4 Summary and policy implications

Changes in euro area public finances over recent years illustrate the risks that fiscal vulnerabilities cast on the growth-friendliness of public revenues and expenditures. Overall, the composition of budgets has become less growth-friendly over time during the 2003-15 period analysed, mainly due to the policy response to the crisis (see Chart 12). During the pre-consolidation period (2003-10) expenditure increased across the board, with the largest peaks concentrated in pensions and health spending, which are considered to be less growth-friendly. In the consolidation period (2011-13), there was significant reliance on the more distortionary taxes for increasing revenues, most notably labour taxation, while expenditure cuts centred on the growth-friendly categories of education and infrastructure investment.^[47] However, it is encouraging to observe some tendencies towards improving the growth-friendliness of budgetary composition since 2013, with a tax shift towards less distortionary taxation and a partial recovery in certain growth-friendly expenditures.

Looking ahead, there is now a need to improve the composition of public budgets in line with the long-term growth objective. In particular, it should be possible to lower the tax burden in a budget neutral way. The revenue share of labour taxation has increased significantly during the consolidation period and cutting it should be quite beneficial for growth. Greater reliance could be placed on the less distortionary tax bases of consumption and property: shifting towards taxation of property can also be equity-friendly. Moreover, the most growth-friendly reforms to personal income taxes are those which reduce the burden of low-income earners and second earners, and the resulting higher labour participation of these two groups contributes to lower inequality in labour income. According to OECD data, in 2016 the average tax wedge for low-income earners amounted to 37.6% and was substantially higher than the OECD average (32.3%). On the expenditure side, particular care should be devoted to redirecting more resources towards the areas of health, education or infrastructure, as such spending has been shown to have positive long-term effects on growth, while cutting less productive spending. The long-term economic growth effect coincides with a reduction in the share of those who are at risk of being unemployed or precariously employed.

Country-specific factors have to be considered when designing policies for a more growth-friendly budgetary composition. The trends identified at the euro area level are heterogeneous across countries. All other things being equal, for a country which has a very high public expenditure share it should be relatively more worthwhile to cut expenditures and thus create fiscal space for reducing distortive taxes. By contrast, for a country with a small public sector it may be more appropriate to increase tax revenues from non-distortionary sources if there is a need to strengthen productive expenditure. To determine the growth-friendliness of public finances it is also important to look at microeconomic data and efficiency studies at country level. A weak tax administration induces evasion activities that are inefficient and leads to an unfair tax competition between informal firms and formally registered firms (IMF Fiscal Monitor, 2017). More efficient tax collection can also create fiscal room for reductions in distortionary tax rates. On the expenditure side, the efficiency of public spending is crucial to maximise the economic effect of spending using the available resources. In this regard, studies show a great heterogeneity of expenditure efficiency across euro area countries.