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Transcript of a Conference Call on the 2015 Article IV Consultation with the Euro Area

Washington, D.C. Monday, July 27, 2015

Mahmood Pradhan, Deputy Director, European Department, and Mission Chief for the Euro Area

Kenneth Kang, Assistant Director, Deputy Mission Chief for the Euro Area

Olga Stankova, Senior Press Officer, Communications Department

MS. STANKOVA: Good morning or good afternoon, everyone. Thank you for your joining the conference call on Euro Area Article IV consultation. You had an embargo access to a range of materials ahead of the call.

The conference call will be led by Mahmood Pradhan, Deputy Director of the European Department and mission chief for the euro area, and Kenneth Kang, Assistant Director in the European Department with responsibility for the euro area mission.

I will pass the microphone to Mahmood Pradhan, Deputy Director of the European Department, for his opening remarks.

MR. PRADHAN: Thank you, Olga. And thank you all very much for joining this call. Good morning or good afternoon, wherever you are. Let me start with a brief overview.

This year’s Article IV consultation and the report that you now have has focused on two broad areas: the near-term recovery and the still weak medium-term outlook and what euro area policymakers need to focus on to address that.

Despite the near-term recovery, which we think is cyclically driven and quite strong, we are worried about the medium-term outlook. Let me start with the near-term recovery.

We think it is aided by weaker oil prices, a weaker euro, a strong policy stimulus provided by the ECB’s expanded asset purchase program including quantitative easing. And finally, a better fiscal balance relative to previous years; that is, the fiscal stance for the euro area as a whole is broadly neutral.

In the near term we see these factors as continuing to support the recovery, and you’ll have seen our forecast for growth for this year and next year, 2016, where we expect these cyclical drivers to be in place.

We are particularly encouraged that the ECB has made it very clear that it will stay the course until the announced date of September 2016 in the current asset purchase program, which means in practice that they will see through any short term volatility in inflation, and any short term spikes.

That means that inflation needs to be on a sustained adjustment path towards its price stability objective. Given the current inflation trends we think it is likely that they will need to go beyond September 2016.

Let me now turn to what we see as some of the medium term challenges.

To start with, many of the crisis legacies including high debt in both the public sector and the private sector have not really been resolved. One area that this year’s report is very focused on is the level of non-performing loans in quite a few banks, and concentrated in some countries.

This is based on the findings of last year’s comprehensive assessment and the associated asset quality review. While the comprehensive assessment was very successful -- it led preemptively to banks raising capital -- it did reveal very high levels of NPLs. We have a few observations on this issue. First we start with the motivation. We think it is very likely that the level of NPLs is holding back the full impact of QE.

Quantitative easing would have a more powerful effect on credit growth if banks were in a healthier position. Our findings suggest that those banks which have high NPLs are less profitable and also are not able to extend credit.

So to have a proper credit recovery in the euro area, NPLs need to be addressed more forcefully. That would make QE more effective. Let me just say in our discussions with euro area authorities, we are very encouraged that this problem is fully recognized, and the Single Supervisory Mechanism of the ECB is in the process of addressing this.

NPLs can be addressed in various ways. Some of these measures require individual bank supervision to be more forceful, in terms of collateral valuation being more conservative, asking banks to reduce NPLs at a faster rate, and putting time limits on some of these NPLs, how long they can sit on their books.

And then outside of the SSM, we need other official agencies to be involved in two areas: one is to improve insolvency frameworks and out-of-court settlement procedures, which would help resolve these weak assets at a faster pace. Also, to develop a market for distressed assets would help take some of these assets off banks’ balance sheets.

Let me then move onto other areas. And here we have a view that monetary policy has been effective. It has averted the risk of deflation, which not too long ago we all worried about. But inflation remains low, demand remains low and we need other policies to kick in.

A better policy mix would have larger growth dividends, and be more effective. And what are the other elements of this better policy mix? First, structural reforms need to progress at a faster pace.

In this report, we have worked with euro area authorities to think of a better framework that incentivizes structural reforms. And here we have argued in favor of an outcome-based benchmark approach where we have benchmark indicators of how countries are doing.

There are some examples in the report, but these are just examples. This benchmarking approach has also been endorsed by the recent Five President’s report. So I think all of us are on the same page and wanting to see faster structural reforms and thinking about how we might get there.

We have also, in an associated paper with the Article IV, a staff discussion note on the fiscal framework arguing that a simpler fiscal framework would be more effective. It would be both more effective in terms of transparency and it would be easier to monitor and to enforce.

Such a simpler fiscal framework is centered around two pillars. One is a simple debt-to-GDP anchor and the second is a simple operational target, which would be a real expenditure growth rule.

Outside of this, we still continue to call for those countries that have fiscal space to use it so that the euro area as a whole can improve -- can add some fiscal stimulus to what we think may be an overburdened monetary policy. Now talking about this area, there are some countries that have fiscal space.

One associated issue that I’d like to mention is that quantitative easing has led to lower sovereign borrowing costs than would otherwise have been the case. This has led to what we call some windfall gains for countries.

We think some countries which are nearer their limits in terms of the SGP, and their medium term objectives on debt, some of these countries should use these fiscal gains, windfall gains to reduce their debt burden.

Those that are not near those limits, the SGP limits, should use this fiscal space for structural reforms and investments. And finally let me end with another remark on fiscal policy, which is that we would also like to see a better balance.

It’s not always about fiscal stimulus as in expanding the envelope, but it’s also about rebalancing expenditures and revenues towards what we think would be more growth friendly. So more for investment away from current expenditures, changes in tax structures which incentivize more employment, by reducing the labor tax wedge, and so reducing unemployment.

In summary, if there was a better policy mix to include all of the factors that I have just covered, we think the Euro area would have a stronger growth dividend. And that basically is a very short summary of the report.

I will stop there and very happy to take your questions. Olga, thank you very much.

MS. STANKOVA: Thank you, Mahmood for this opening statement and now we’ll take your questions.

QUESTIONER: Yeah, hi. Thank you for the conference. I have a question on Greece, actually. Can you tell us a little bit about how the current situation in Greece is affecting the whole Euro economy according to your reports? Thank you.

MR. PRADHAN: Thank you for that question. I will give you an answer in two parts. One is that the euro area’s policy toolkit, the instruments available for the euro area, we think are adequate to deal with the near term contagion, possible contagion from Greece.

What we’ve seen over the last month is relatively calm reactions. We have seen some volatility in parts of the market, in some sovereign debt markets and some equity markets. I’m happy to elaborate on that later. But generally speaking, we have been through a period which has been relatively calm.

I emphasize relatively. Now if you compare this episode that we’ve just been through with 2012, you’ll see what I mean. Then we suffered from a lot more volatility, a lot more spread widening. Now what’s the reason for that?

As I said, the instruments available are sufficiently strong to deal with near term financial contagion. In our view, this is well acknowledged in financial markets that there is a strong tool kit.

This includes all the things that the ECB can do, including the OMT framework, which the ECJ has given kind of blessings, or a green light. Now in the near term, that’s how we would see the impact on the euro area economy.

As you know, the direct exposure to Greece of other euro area economies is relatively small. As you also know, Greece is, from a trade perspective, a relatively small part of the euro area. So we do not expect any real contagion.

But -- and I emphasize this but -- over the medium term we think this actually does call for a stronger architecture in the euro area. And I want to be a little more specific on this form of architecture. I think it calls for completing the banking union, strengthening the parts of the banking union which are still not well established.

For example, the single resolution fund could be mutualized at a faster rate. We still need in our view a common fiscal backstop in the event of a large enough event in the banking sector in Europe.

And in this report you will see we also call for an easier way to enable direct recapitalization of banks than the current regime under the ESM. All of these things we think are part of strengthening the architecture in the medium term.

And then beyond that we have argued in this report that European governments, the euro area governments should also consider a faster move towards more risk sharing, more fiscal integration which would make the euro area more resilient to -- let me say “idiosyncratic events in particular countries.” Thank you.

QUESTIONER: Yes. Hello, thank you very much. A follow-up question on Greece. Could you talk specifically about the negotiation are now starting or about to start in Greece and their impact as far as this possible contagion?

Do you feel it’s key that an agreement be struck by August 20th to make sure that the markets remain calm and that there is no contagion? And how confident are you that these talks are going to be successful given the tensions that there were between the creditors and Greece in the past? Thank you very much.

MS. STANKOVA: You know, we would like to start by saying that we have a statement that we are giving to the press and that can be attributed to an IMF spokesperson “A technical team will start work in Athens on Monday to take stock of recent developments.”

We don’t really have at this time any details of those discussion and wouldn’t want to speculate about the outcome.

MR. PRADHAN: I mean all I would add, Alexandria, is that it is in the interest of all parties that negotiations proceed at a reasonably rapid pace and conclude in a fruitful way by some of the deadlines you mentioned. That’s all I can add. I’m not directly involved with the negotiations.

QUESTIONER: Hi, good morning. I’m just wondering about this idea of benchmarks for structural reforms. You’ve given a few examples of the time it takes to set up a company, enforce a contract, that kind of thing.

Would you and perhaps the OECD working together be averse to publishing your own list of indicators of that kind to give to somebody as sort of an international set of benchmarks to work off? Clearly you’ve come to the conclusion that the peer review mechanism and the alleged peer review mechanism, I saw that your opinion isn’t really up to much.

And I don’t really see why you would trust the same set of characters to come up with a very binding set of benchmarks for themselves, either. So why don’t you guys do it?

MR. PRADHAN: Thank you, Paul. Can I just start by saying what we are proposing here is an approach. And by that I mean when you come down to the specifics, yes, we have given some examples taken from the OECD.

But operationalizing any particular benchmark is something that requires more work. So we see our work as very much initiating a move towards a different approach, the OECD is well ahead in this game and has been doing it for some time, producing a number of indicators.

We do not have our own indicators, so we’re not in a position to publish when you ask would we be averse. Secondly, some of these indicators could be country specific. We have had a very favorable response or reaction, reception, to this approach from various people in Europe, including the European Commission.

And as I mentioned, the Five Presidents’ report also endorses it. It is for countries working with the Commission to come up with benchmarks or indicators that would work for them.

One common one that I think has already got a fair amount of acceptance across Europe, is the labor tax wage. You will see this in the selected issues paper that is attached to the staff report.

There are common sense ones that are in there, shown as examples. The number of days it takes to enforce a contract, it speaks to the efficiency of administrative and legal process, enforcing contracts.

But in short, we really don’t have our own list and we’re not at that stage yet. Thank you.

QUESTIONER: Yes, good morning. Thank you. Mahmood, I would like to ask to what extent are the structural imbalances, i.e. Germany’s 7.5 percent trade surplus, its five percent unemployment rate versus 13 percent elsewhere. To what extent are those distortions an ongoing problem that gives cause to the worry of the medium term that you referenced at the beginning?

MS. STANKOVA: If I may, again, about the fact that we will be using external sector report tomorrow where a number of issues will be covered.

MR. PRADHAN: I’m going to ask my colleague Ken Kang to answer this question. As Olga says, there is an external sector report to be published soon, which will have assessments of a large number of countries. But let me ask my colleague Ken Kang to speak on the structure and balances within the euro area that we speak about in this report.

MR. KANG: Thank you. I think you rightly point out in the report, we do have a discussion on the external imbalances, noting that although the aggregate external position has improved; the imbalances within the Euro zone still remain significant.

And we do think this is part of the comprehensive strategy for higher growth and particularly the domestic demand component of that growth within the euro zone. That strategy would basically mean the surplus countries undertaking reforms to lift investment and to raise productivity, and for the debtor countries to pursue reforms to enhance competitiveness. Basically the comprehensive strategy that we outline in the report combining monetary easing with fiscal support, structural reforms, and a cleanup of bank’s balance sheets will also help facilitate this external rebound.

And we do think it’s important because if you look at the distribution of the output gap, the distribution of activity across the euro zone, it is really more the debtor countries that need that assistance. And that assistance can very much come from surplus countries doing their part in the rebalancing exercise.

QUESTIONER: Good morning, (Inaudible). I also have a question on to what extent do you think the Greek (Inaudible) are a result of the architecture and the shortcomings of the Euro zone?

For example some economists focus on trading policies within the Euro zone and (Inaudible) country is like Greece can have an export led recovery. And (Inaudible) what would answer (Inaudible) of my question? But since you mentioned the dangers of (Inaudible), to what extent do you think that the (Inaudible) would (Inaudible) Euro zone by making it irrevocable in the eyes of investors?

MR. PRADHAN: Thank you. I’ll take your question in two parts. The first one, you refer to trade imbalances. Now all I can say on that is that the extent that the euro zone countries trade both with each other and with countries outside of the Euro zone varies quite a lot within the Euro area.

And these are to do with the structural nature or structural features of an economy. We have long argued that Greece could have a bigger trade sector, and this requires structural reforms, changes that would improve Greece’s competitiveness.

So trade imbalances are not kind of given -- in the longer term sense these can be changed. Countries can become more open. But as I said there’s a variation across the euro area, which is quite significant.

Your second part of your question, direct contagion; if I understood your question correctly, part of it I have answered before, which is that the euro area has available a significant number of instruments to fight near term contagion. But when you say a currency, whether the euro area as a block is revocable or irrevocable, that I think speaks to the point I made earlier.

In the medium term, the euro area needs to become more resilient; it needs to be building a stronger architecture. And I gave you some examples earlier of what could be done in near term, particularly the banking union.

And the reason I emphasize that was that it is important to continue to sever bank-sovereign links. That would make the Euro area more resilient, to reduce the links between member states and their banks. And that process has begun in quite a strong way with the single supervisory mechanism, the single resolution board which is about to start, the single resolution mechanism, the single resolution fund, et cetera.

There are a lot of building blocks in place. And in the report you will see we also mention common deposit insurance. Right now deposit insurance is harmonized by an EU directive.

We would argue that they need to go further toward the common deposit insurance. So the second part of your question I would say that there is more work to be done in the medium term. Thank you.

QUESTIONER: Yes, thank you. One quick question on logistics and the other one on substance. The logistical one is -- I joined in slightly late so I wasn’t 100 percent sure if this is all on the record; if we could just clarify that in your answer to the question.

But the other thing is in your opening remarks, just to get back to the issue of monetary policy; you talked about the likely need for QE to be extended beyond the September 2016 deadline or period that ECB currently envisages. And if I’m not mistaken, you also said that the ECB communicated to the staff that visited them that they agreed with that; that they agreed that they were likely to have to extend QE beyond September 2016.

I just want to double check that because if I’m not mistaken, I don’t think the ECB itself has communicated that publicly. It is said that September 2016 is the end. And I guess if you could just give us any sort of clarification of that and also just the feedback on that point you had when you’re dealing with the -- thanks.

MR. PRADHAN: Okay. Thank you. By the way, to answer your first question, yes, this is on record. Secondly, let me take your question on monetary policy in two parts. First, if you look at our inflation projections, we think that reaching that sustained adjustment path close to the price stability objective, will likely based on our current view take longer. In our view the ECB has said in its communication -- and we’re not talking here about any discussions just with us, but in its public communication, in our view it has said that it will continue this program at least until September 2016 or until inflation is on a sustained adjustment part.

So I’m not kind of reporting any private conversation here. The second part of your question, I think is similar, whether on QE -- I think the second part of your question -- please correct me if I’m wrong -- the second part of your question was whether this is a staff communication or whether this is public, right? Have I missed your second part? Sorry.

QUESTIONER: No, I’m not sure there even was a second part. I just wanted to make sure I -- I got you right on your -- again, in your report you said the ECB should stand ready to (Inaudible) or continue.

And just in your opening remarks you sounded to be -- that it was a little bit more that you were preparing, or you were ready or you predicted they would have to do this; something along those lines. Is there like a difference between the report itself and your opening remarks?

MR. PRADHAN: Yes, Peter; you’re right. Let me just kind of rephrase and clarify. We are not saying, and we have not said that the ECB will likely extend QE beyond September 2016. We’re not claiming the ECB communicated this to us.


MALE SPEAKER: What we’re saying is that -- two things; one, as I had mentioned earlier, our current assessment of inflation in terms of projections; so yes, inflation takes longer to get back to the price stability objective.

So that’s our view; that’s not something they have said. All I’m saying is they have said they will continue until at least until September 2016 or until there’s a sustained adjustment in the path of inflation.

QUESTIONER: Great. That’s all I wanted to clarify. Thank you.

MR. PRADHAN: Thank you.

MS. STANKOVA: All right. If no more questions then we will cancel the conference call. Thank you for joining. The call was on the record and the (Inaudible) will be listed on the call and the documents (Inaudible) currently posted on our website at 10:00 a.m. Eastern Standard Time.

MR. PRADHAN: Let me just say thank you from all of us. Thank you for taking the time. We appreciate it.