Despite much fanfare, the European Commission recommends much of the same for the eurozone

The Commission has today released its country-specific recommendations on economic policy. Below, we highlight the most important suggestions made to some of the key eurozone countries.

SPAIN

• According to the European Commission, Spain should “improve the efficiency and quality of public expenditure at all levels of government”. Clearly, this is easier said than done, given the well-known problems the Spanish government is having in trying to rein in regional spending.
• The European Commission also seems to suggest that the 2012 labour market reform – one of the flagship measures adopted by Mariano Rajoy’s government – may need tweaks. In particular, Spain should reform its active labour market policies.
• Spain should also push ahead with the liberalisation of closed professions and improve the business environment in general – for instance by cutting the amount of paperwork, a notorious issue in the country.
• Spain should “further limit the application of VAT rates”. This might be controversial, as the Spanish government has said several times it is opposed to further VAT hikes.
• According to the Commission, the reform of Spain’s pension system should be finalised by the end of the year.

FRANCE

The recommendations for France include quite a few suggestions which may be hard to digest for François Hollande’s socialist government.

• France should do more to cut labour costs, in particular by reducing social security contributions for employers.
• The European Commission says France should adopt new measures by the end of the year to “bring its pension system into balance in a sustainable manner no later than 2020.” The Commission suggests various ways of doing this, including “adapting indexation rules” (remove/reform the link between inflation and pensions increases, in plain English) and raise the retirement age. This is unlikely to go down well in Paris.
• France should improve the business environment and help its firms become more competitive;
• France’s unemployment benefit system should be “urgently” reformed, so that it is sustainable but also “provides adequate incentives to return to work”.
• France should do more to tackle labour market segmentation, and remove “unjustified restrictions in the access to and exercise of professional services.”

ITALY

As we noted several times, Mario Monti’s technocratic government did a good job in cutting Italy’s deficit – less so in implementing structural reforms. Here is what the European Commission would like Italy to do:

• Make sure that the reforms initiated by Monti's government are properly implemented (some of them require enacting legislation).
• Push ahead with labour market reform. Wages should be better aligned to productivity, and more should be done to bring young people and women into work.
• The tax burden should move from labour and capital to consumption, property and the environment. Sure enough, this is going to be controversial, given that the new Italian government is trying to avoid a VAT increase scheduled by its predecessor for 1 July 2013 and is also considering scrapping a property tax on first homes.
• Continue with liberalisation of the services market and opening up of closed professions – which seems to be an issue affecting all the Mediterranean eurozone countries.
• Needless to say, all this has to happen without breaching the EU’s deficit limit of 3% of GDP and in parallel to a reduction of Italy’s gigantic public debt (forecast to be over 132% of GDP in 2014).

SLOVENIA

• As we have previously warned, the Commission flags up the risk of the heavily indebted corporate sector and how this in closely intertwined with the fate of shaky banks.
• Of the largest domestic banks the Commission warns, “Their dependence on the state for capital is a substantial threat to the economy” and that “Further recapitalisations are foreseen in the stability programme”. The Commission does not give an estimate of the recap needs but it’s clear there is concern that it could impact the Slovenian economic situation. To this end it also called for an independent review of the Slovenian banking sector.
• Government growth forecasts are seen to be overly optimistic, particularly next year's, this could be further hampered by the banking sector.
• Significant push needed on cutting wages and increasing productivity, true in most places but especially on Slovenia when costs have been on a rapid rise in recent years.
• Need to push on with privatisations and come up with a clear policy framework to do so. More structure needed, particularly if investors are to be convinced.
• “Further reform efforts are required to improve the sustainability of pension expenditure in the long-term, including through aligning the statutory retirement age with gains in life expectancy and by further restricting early retirement.” – numerous concerns expressed about long term liabilities of the state.

GERMANY

• “Germany should do more to open up their services sector by removing unjustified restrictions and barriers to entry, thereby leading to lower price levels, making services more affordable for lower income groups.” – particularly calls for the opening up of public procurement, professional services and retail services.
• “Sustain conditions that enable wage growth to support domestic demand.” – although it sounds innocuous this could be very controversial in Germany. It essentially seems to endorse the calls for Germany to spend more and allow inflation to help rebalance the eurozone. Germans fear of inflation is well known but they also fear a decrease in the competitiveness.

BELGIUM

Some press reports were (perhaps a bit hurriedly, given how the EU works) suggesting that Belgium could today become the first eurozone country to face sanctions for missing its deficit targets. But EU Economic and Monetary Affairs Commissioner Olli Rehn just told journalists in Brussels that “it would be neither fair or legally sound to apply fines retroactively”, so Elio Di Rupo & co. have been let off the hook for now. These are the key recommendations:

• Transpose the ‘balanced budget rule’ enshrined in the fiscal treaty into national law; 
•  Step up efforts to “close the gap between the effective and statutory retirement age”. In other words, the European Commission thinks there are too many early retirements in Belgium at the moment. On pensions, Belgium should also “accelerate the adoption of a decision to link the statutory retirement age to life expectancy” – which could mean further retirement age increases in future; 
•  Less taxes on labour and better alignment of wages to productivity to restore competitiveness; 
• Remove barriers in the services sector. 

So, for all the talk of this being the ‘end of austerity’ or ‘austerity in retreat’, is much really changing? Sure, there is some tinkering with timelines for deficit reduction (Spain, France and others have been given more time to cut public deficit), but ultimately the eurozone is still going along the same policy path - just slightly more slowly. Cases in point are the countries above, since the clear themes running through all of them are the need for structural reform, welfare reform, fiscal consolidation and liberalising the economy. These are things which have long been advocated and are clearly necessary. The question remains whether they can all be done at the same time by a group of countries which are closely interlinked, and many of which are currently in recession.

Is the IMF turning bearish on Spain?

It’s been a busy week for the IMF, releasing their latest iterations of the World Economic Outlook, Global Financial Stability Report and the Fiscal Monitor. We’ve been poring over the reports and will continue to do so (see here for some initial thoughts on the WEO). One forecast in particular caught our eye – Spain's.

The IMF seems to have turned significantly more pessimistic on the prospect of a Spanish recovery. The charts below provide a comparison with the previous WEO forecasts (highlighting how these forecasts tend to be overly optimistic) - which very much confirms what we have noted before about the real risks in Spain.

The latest projections for the Spanish deficit (the dark blue line in the above chart) definitely represent a break from previous forecasts. In particular, the forecast for 2014 is 2.3% of GDP higher than in October. The IMF says this is:

“Reflecting the worse unemployment outlook and the lack of specified medium-term measures.”

Translation: the government does not have the necessary budget cuts and reforms in place to meet its desired deficit path – step it up Rajoy.

Such an increase manifests itself in the debt level projections as well. Worryingly, these no longer peak in 2015/16 and level off thereafter. Instead, Spanish debt to GDP is forecast to reach 111% in 2018 and looks set to keep growing rather than peaking and levelling off.

Effectively, this graph also highlights how the forecasts have progressed as the crisis in Spain has evolved from from financial, to a sovereign liquidity crisis and now into a sovereign solvency one. As the IMF notes, sustaining this will be tough:

“[Countries such as Spain] would need to maintain large primary surpluses over the medium term. In the absence of entitlement reforms, projected increases in age-related spending mean that additional measures will still be needed over time, however, to keep the primary surplus constant.”

Translation: Spain needs to run large primary surpluses for a long time, but in the face of increasing welfare and pension spending, this will need to come from a series of additional and painful cuts.

So the IMF does not paint a pretty picture for Spain. Longer and deeper recession, larger deficits at a time when it needs to be moving to surplus and increasing debt, in turn raising questions about the country's solvency. Let’s not forget, that’s before bringing the bust banking sector into the discussion. Plenty for Rajoy to get on with then…

Update 16:20 18/04/13:
Christine Lagarde has reportedly suggested that Spain should be allowed to ease its austerity programme. Lagarde argues that, although Spain needs fiscal consolidation, it does not need to be front loaded. Such an argument is not going to sit well with the eurozone and will increase the tensions within the Troika (some of which were outlined in this FT article earlier today). As the graph below shows such an approach may not fit well with the IMF own growth forecasts. Even with a 7% deficit, growth next year in Spain will be 0.7% according to the IMF. How much more would need to be spent to get to a respectable 1.5% GDP growth? Double the deficit?

Maybe not something this extreme but with debt already heading towards an unsustainble path it's not clear that there is much scope for further spending, while markets may put pressure back onto Spain once again. This raises the prospect of a further bailout or transfers from other eurozone states, but as we pointed out at length yesterday, Lagarde is talking about something very different than removing austerity in that case.

Tackling the slow, painful decline: A bad day of economic data for the eurozone

Some have said the worst of the eurozone crisis is over – this morning’s economic data did not provide much support to their argument.

 

Top of the list are the growth figures for the eurozone in Q4 2012 – as a whole the bloc contracted by a massive 0.6%. Maybe not a huge surprise but still worse than most expected. Furthermore, there were few glimmers of hope. 

As the graph above shows, Germany posted a contraction of 0.6%, Italy 0.9% and Portugal a massive 1.8% (more on this in a minute). France’s 0.3% contraction looked relatively mild, although it confirmed that the French economy saw zero growth in 2012 – it also put pay to any hopes of the French government achieving its growth projections for 2013 or its deficit target (see here for more on this). For all of these countries, this was the worst quarterly growth performance in almost four years (2009Q1).

The Italian statistics agency confirmed that growth for 2012 was -2.2%, a timely reminder of Italy’s real problem – an endemic and chronic lack of economic growth. The absence of any credible policy for correcting this in the current electoral campaign should be of grave concern to all of Europe.

Portugal was undoubtedly the stand out performer, but not in a good way. The 1.8% contraction in the final quarter brought the annual real terms contraction in 2012 to 3.2%. This result, along with the German contraction (which was put down to a collapse in European demand for German exports), highlights the substantial risk of expecting export lead recoveries to materialise when the entire eurozone is in a recession. The stumbling growth in the US and China at the end of 2012 likely created a further drag.

In fact, the only countries to provide any strongly positive data were the smaller central and eastern European economies – particularly Estonia, Latvia and Lithuania. Some would highlight that these are the countries that have already completed a significant round of structural reforms and internal devaluation. In any case, they are far from large enough to help pull the rest of the eurozone out of its current slump.

Meanwhile, the Greek statistics agency Elstat also released its figures for Greek unemployment in November 2012. Overall unemployment reached 27%. As we have noted many times before, this far outstrips the EU/IMF/ECB troika estimate for the end of 2012 which was 24.4% (this is even after it was revised upwards significantly in the IMF’s January report on Greece).

More worryingly though, youth unemployment has reached a whopping 61.7%. Think about that figure - it's absolutely extraordinary, especially when compared to the fact that it was only 28% three years ago. We can’t help but wonder how long such high levels of unemployment can be sustained before the political and economic impact becomes too heavy for the state to carry alone (i.e. before Greece demands further eurozone funding and concessions on its reform programme). Again, the risk is that the very fabric of Greek society could start disintegrating under such sustained pressure.

There has been plenty of optimism around the eurozone recently, some of it warranted and we should relish this. But this data should be a timely reminder of, arguably, the biggest challenge of them all for the eurozone: how to reverse the trend of slow, grinding decline.

If EU leaders thought for one minute that there were room for complacency, they can think again.