Foreword

2015 was a year of recovery for the euro area economy. Inflation, however, remained on a downward path. Against this backdrop, a key theme for the euro area in 2015 was strengthening confidence. Confidence among consumers to boost spending. Confidence among firms to resume hiring and investing. And confidence among banks to increase lending. This was essential to nurture the recovery and underpin the return of inflation towards our objective of below, but close to, 2%.

As the year progressed, we did indeed see confidence firming. Domestic demand replaced external demand as the motor of growth on the back of rising consumer confidence. Credit dynamics began recovering for the euro area as a whole. Employment continued to pick up. And fears of deflation, which had stalked the euro area in early 2015, were dispelled entirely.

As we describe in this year’s Annual Report, the ECB contributed to that improving environment in two main ways.

The first and most important was through our monetary policy decisions. We took action decisively throughout the year to ward off threats to price stability and ensure the anchoring of inflation expectations. That began in January, with our decision to expand our asset purchase programme (APP). It continued with the various adjustments to the programme throughout the year, such as the expansion of the list of issuers whose securities are eligible for purchase. And it concluded with our decisions in December to cut our deposit facility rate further into negative territory and to recalibrate our asset purchases.

These measures proved effective. Financing conditions eased considerably, with bank lending rates falling by around 80 basis points in the euro area from mid-2014 onwards – a pass-through equivalent to a one-off rate cut of 100 basis points in normal times. Growth and inflation benefited too. According to Eurosystem staff assessments, without the APP – including the December package – inflation would have been negative in 2015, more than half of a percentage point lower in 2016, and around half of a percentage point lower in 2017. The APP will raise euro area GDP by around 1.5 percentage points in the period 2015-18.

We recalibrated our policy at the end of the year due to new headwinds from the global economy, which tilted the inflation outlook to the downside. Those headwinds intensified in early 2016, requiring a further expansion of our policy stance. In March 2016 the Governing Council decided to expand the APP in both size and composition (including for the first time corporate bonds), to cut the deposit facility rate further, to introduce a new series of targeted longer-term refinancing operations with powerful incentives for banks to lend, and to strengthen its forward guidance. These decisions reaffirmed that, even when faced with global disinflationary forces, the ECB does not surrender to excessively low inflation.

The ECB’s second contribution to confidence in 2015 was to address threats to the integrity of the euro area. These mainly concerned events in Greece in the first half of the year. Uncertainty about the commitment of the new government to its macroeconomic adjustment programme led to both banks and the government losing market access, and to depositors stepping up withdrawals of their money from banks. The Eurosystem provided a lifeline to the Greek banking system through its emergency liquidity assistance (ELA).

The ECB acted in full independence according to its rules. That meant, on the one hand, ensuring that we did not provide any monetary financing to the Greek government and that we only lent to banks which were solvent and had sufficient collateral, and on the other, ensuring that decisions with far-reaching implications for the euro area were taken by the legitimate political authorities. The approach we followed was fully within our mandate: it respected the commitment to the single currency contained in the Treaty, but we implemented that commitment within the limits of our Statute.

Although tail risks were finally averted thanks to the agreement between Greece and the other euro area countries on a third programme, this episode highlighted the fragility of the euro area and reaffirmed the need to complete our Monetary Union. To that end, as one of the so-called “Five Presidents”, in June 2015 I contributed to a report making concrete suggestions for further reform of the euro area’s institutional architecture. If we are to achieve a more robust union – and to avoid overburdening the central bank – those suggestions must ultimately be turned into actions.

Finally, in 2015 the ECB also strengthened confidence in its own decision-making processes by enhancing its transparency and governance. In January we began publishing the accounts of our monetary policy meetings, which has given the outside world a clearer insight into our deliberations. We also started publishing ELA decisions and the amounts concerned, data on TARGET2 balances, and the calendars of the Executive Board members. In a time of unconventional monetary policy, these steps forward in transparency are essential to ensure our full accountability to the public.

Our governance was improved too through a project aimed at optimising how the ECB functions as we expand into new tasks and confront new challenges. In 2015 we began implementing several of its recommendations, notably appointing for the first time a Chief Services Officer to support the internal organisation of the bank.

2016 will be a no less challenging year for the ECB. We face uncertainty about the outlook for the global economy. We face continued disinflationary forces. And we face questions about the direction of Europe and its resilience to new shocks. In that environment, our commitment to our mandate will continue to be an anchor of confidence for the people of Europe.

Frankfurt am Main, April 2016

Mario Draghi President

The euro area economy, the ECB’s monetary policy and the European financial sector in 2015

The euro area economy: the low inflation, low interest rate environment

The global macroeconomic environment

The euro area economy was affected in particular by three key features of the international environment in 2015: a growing divergence in economic activity between advanced and emerging market economies; historically weak global trade developments; and low global inflationary pressures on the back of further declining energy prices and still abundant spare capacity.

Global economic growth remained modest

The world economy continued along its gradual recovery path in 2015, although global economic growth moderated slightly from the previous year. The marginal acceleration in economic activity in advanced economies was more than offset by the slowdown in emerging economies, with considerable heterogeneity across countries and regions. Following strong recessions in some emerging economies in the first half of the year, global GDP growth remained modest by historical standards (see Chart 1).

Economic activity in advanced economies remained resilient throughout the year against the backdrop of still accommodative financing conditions, improving labour markets, low oil prices and diminishing headwinds from private sector deleveraging and fiscal consolidation. By contrast, the pace of economic growth slowed markedly in emerging market economies in the light of heightened uncertainty, structural impediments (e.g. related to infrastructure bottlenecks, poor business environments and a lack of competition in labour and product markets) and tightening external financing conditions. In particular, lower commodity prices led to a sharp slowdown in commodity-exporting economies, while growth remained more resilient in commodity-importing countries. The decline in commodity prices, however, had an overall positive effect on global demand, as oil-importing countries tend to have a higher propensity to spend than oil-exporting countries, but in some cases the positive impact on consumption was weaker than expected.

Chart 1 Main developments in selected economies (annual percentage changes; quarterly data; monthly data) -10 -5 0 5 10 15 2009 2010 2011 2012 2013 2014 2015 euro area United States United Kingdom China Japan world excl. euro area a) Output growth euro area United States United Kingdom China Japan OECD total b) Inflation rates -4 -2 0 2 4 6 8 2009 2010 2011 2012 2013 2014 2015 Sources: Eurostat and national data.

Notes: GDP figures are seasonally adjusted. HICP for the euro area and for the United Kingdom; CPI for the United States, China and Japan.

Global financing conditions remained generally accommodative. The Federal Reserve System deferred the start of its monetary policy normalisation until the end of 2015, while both the Bank of Japan and the ECB continued to follow expansionary monetary policies. The Bank of England left its monetary policy unchanged. Financial market volatility and risk aversion remained relatively low for most of the year. In the third quarter of the year, however, a sharp correction in equity prices in Chinese stock markets led to a marked increase in volatility. While the spillover effects to the real economy were limited, the prospect of a growing divergence in the monetary policy stance of major advanced economies and market concerns about the resilience of economic growth in emerging economies led to considerable exchange rate depreciations and capital outflows in a number of emerging market economies, particularly those with significant domestic and external imbalances (see also Box 1).

Historically weak world trade developments

Following three years of weak trade growth, the growth rate of global imports of goods and services declined even further in the first half of the year, before gradually recovering towards the year-end from very low levels. Overall, the volume of world imports grew by only 1.7% year on year in 2015, compared with 3.5% in 2014. As in the case of GDP growth developments, emerging market economies were the main driver behind the global trade weakness, although some advanced economies temporarily experienced extremely weak trade growth as well.

Global import growth has been below its long-term average since the second half of 2011. Although this weakness is due in part to the subdued global recovery and is thus to some extent a cyclical phenomenon, the elasticity of world trade – i.e. the responsiveness of global import growth to GDP growth – has also been extraordinarily weak in the past four years. While trade increased at almost twice the rate of global GDP in the 25 years prior to 2007, its growth rate has fallen below that of GDP in recent years.

Possible reasons for the persistent weakness in global trade are manifold. On the one hand, cyclical factors include not only the generally sluggish recovery of global economic activity, but also the changed demand composition of global GDP, as import-intensive demand components (such as investment) have been particularly weak. On the other hand, structural factors may also play a significant role, including shifts in activity towards sectors (such as services) and regions (emerging market economies, in particular China) with lower underlying trade elasticities and changes in the participation in global value chains.

Low energy prices weighed on global inflation

The sharp fall in commodity prices – particularly energy prices – in the second half of 2014 contributed significantly to a decrease in global headline inflation in 2015 (see Chart 2). Annual inflation in the OECD area declined to 0.6% (down from 1.7% in 2014), while core annual OECD inflation (excluding food and energy) decreased only marginally, from 1.8% in 2014 to 1.7% in 2015 (see Chart 1).

Chart 2 Commodity prices (daily data) 30 50 70 90 110 130 150 2009 2010 2011 2012 2013 2014 2015 food and tropical beverages (USD; index: 2010 = 100) Brent crude oil (USD/barrel) non-ferrous metals (USD; index: 2010 = 100) Sources: Bloomberg and Hamburg Institute of International Economics.

While remaining low overall, oil prices showed considerable volatility throughout 2015. This followed a continuous decline from around USD 112 per barrel in June 2014 to USD 46 in mid-January 2015. After a temporary uptick until May 2015, oil prices declined in the second half of the year, continuing to reflect an oversupplied global oil market. The OPEC members maintained their production at near-record rates, although non-OPEC production growth was reduced somewhat in the second half of the year. In particular, lower prices and reduced investment triggered a slowing in the still resilient US shale oil production, leading to some moderation in the supply overhang. Crude oil demand picked up during 2015 on the back of lower prices, but remained too weak to keep pace with oil supply.

Non-oil commodity prices continued to decline on the back of both supply and demand factors. Lower global demand – particularly from China, which is the main source of demand for a number of metal commodities – added to the downward pressure on non-oil commodity prices. Lower food prices mainly reflected increased supply. Overall, in US dollar terms, food prices decreased by 18%, while the metal price index dropped by 17% in 2015.

Moreover, slowly closing output gaps in advanced economies and widening ones in several emerging market economies resulted in abundant spare capacity at the global level, which put further downward pressure on global inflation. At the individual country level, inflation was also strongly influenced by exchange rate movements. While the appreciation of the US dollar and the pound sterling at the beginning of the year led to additional downward pressure on inflation in the respective countries, some emerging market economies, such as Russia, Brazil and Turkey, faced upward price pressures stemming from a considerable depreciation of their currencies.

Heterogeneous growth developments in major economies

In the United States, economic activity remained resilient, with real GDP growth at 2.4% on average in 2015, unchanged from the previous year. After some weakness at the beginning of the year owing to temporary factors such as bad weather conditions and port traffic disruptions, GDP growth in the second and third quarters was fairly robust and mainly driven by final domestic demand, while net exports contributed negatively. Economic activity then decelerated again in the fourth quarter. Private consumption expenditure remained buoyant against the background of still accommodative financing conditions, lower oil prices, strengthened household balance sheets and improved consumer confidence. The underlying labour market momentum also remained robust, with a further decrease in the unemployment rate to 5.0% at the end of the year. In the light of the sharp decline in energy prices and the appreciation of the US dollar since the second half of 2014, inflation remained extremely low during the whole of 2015. Annual CPI inflation stood at 0.1% on average, down from 1.6% in 2014, while core CPI inflation (excluding food and energy) remained broadly unchanged at 1.8%.

Monetary policy stayed highly accommodative for most of 2015. Interest rate projections by the Federal Open Market Committee (FOMC) and federal funds futures moved down over time, as expectations regarding a rise in monetary policy interest rates shifted further into the future. In December 2015 the FOMC decided to raise the federal funds target range to 0.25-0.50%, which was its first rate hike in more than nine years. The fiscal stance was broadly neutral in the fiscal year 2015, with the fiscal deficit decreasing slightly to 2.5% of GDP, which was the lowest ratio since 2007.

In Japan, real GDP growth was relatively volatile during the year. Following the strong increase at the start of the year, economic activity temporarily weakened in the second quarter before returning to positive, albeit subdued, growth in the second half of the year. The recovery occurred against the background of a rebound in private consumption and exports. On average, real GDP expanded by 0.7% in 2015, which was a slight acceleration from 2014, when Japan passed through a strong recession owing to a hike in VAT rates. The fading base effects of this tax increase also led to a slowdown in inflation to 0.8% on average (down from 2.7% in 2014). Thus, despite the continuing quantitative and qualitative monetary easing programme implemented by the Bank of Japan, inflation is still well below its target of 2%, although core inflation showed some signs of acceleration towards the end of the year.

In the United Kingdom, economic activity slowed moderately in 2015. Annual GDP growth decelerated to 2.2% in 2015 from almost 3% in 2014, according to preliminary estimates. In particular, housing investment growth decelerated from the very fast pace of growth recorded in the previous year. Low inflation contributed to the increase in the real disposable income of households, thereby supporting private consumption and GDP growth. Compared with the previous year, the labour market continued to strengthen and the unemployment rate declined to around 5% by the end of 2015. Further progress was made with fiscal consolidation, and the general government deficit is estimated to have fallen to around 4½% of GDP in 2015. Inflation declined compared with one year before, hovering around the level of 0% throughout the year, on the back of low energy and food prices as well as the appreciation of the pound sterling. During 2015 the Bank of England’s Monetary Policy Committee maintained an accommodative monetary policy stance, keeping the policy rate at 0.5% and the size of the asset purchase programme at GBP 375 billion.

In China, the gradual slowdown of the economy continued against the backdrop of slower investment growth and weaker exports. Annual GDP growth decreased to 6.8% in 2015 from 7.3% in the previous year. Over the summer Chinese stock markets corrected sharply after posting very strong gains in the preceding months, raising concerns about financial stability and economic growth prospects in China and other emerging economies. The macroeconomic and financial stability impact of the stock market correction was, however, fairly limited. Faced with declining CPI inflation (down from 2.0% in 2014 to 1.5% in 2015) and in order to contribute to a stabilisation of growth, the People’s Bank of China continued the policy loosening that it had started in November 2014, with several additional cuts of benchmark and reserve requirement rates during 2015. Additionally, further reforms were introduced to strengthen the role played by market forces in the determination of the exchange rate, which led to a depreciation of the renminbi – and other emerging market currencies – against the US dollar and renewed stock market volatility in the weeks following the decision. Regarding fiscal policy, public infrastructure spending was raised in order to support total investment.

The euro continued to weaken

In the course of 2015 the exchange rate of the euro weakened in nominal effective terms. Developments in the euro exchange rate continued to reflect to a large extent the different cyclical positions and monetary policy stances across major economies. These developments were characterised by four distinct phases. In the first quarter of 2015 the euro depreciated markedly ahead of the announcement of the expanded asset purchase programme by the ECB. The euro then stabilised in the second quarter, notwithstanding occasional bouts of volatility related to developments in the negotiations between Greece and its international creditors, as well as to changes in market expectations about the timing of a possible increase in the Federal Reserve’s policy rates in the United States. Over the summer the euro appreciated markedly in an environment of heightened risk aversion globally and uncertainties about developments in China and emerging economies more generally. In the fourth quarter the euro depreciated again overall on the back of renewed expectations of a growing divergence in monetary policy stances on either side of the Atlantic.

Chart 3 Euro exchange rate (daily data) 100 105 110 115 120 125 130 1.00 1.10 1.20 1.30 1.40 1.50 1.60 2009 2010 2011 2012 2013 2014 2015 USD/EUR (left-hand scale) nominal effective exchange rate of the euro (right-hand scale) Source: ECB.

Note: Nominal effective exchange rate against 38 major trading partners.

The nominal effective exchange rate of the euro (as measured against 38 major trading partners) declined by more than 3% in annual terms (see Chart 3). Bilaterally, the euro weakened strongly against the US dollar (-11.0%). In line with this, the euro continued to weaken against currencies that use the US dollar as an anchor, such as the Chinese renminbi (-6.5%). The euro also depreciated against the pound sterling (-5.9%) and the Japanese yen (-10.3%). By contrast, the euro appreciated markedly against the Brazilian real (+29.2%) and the South African rand (+18.9%).

Turning to those European currencies that have close links to the euro, the Danish krone is currently the only currency in the European exchange rate mechanism II (ERM II), after Lithuania joined the euro area on 1 January 2015. The Danish krone traded close to its central rate within ERM II, while Danmarks Nationalbank lowered its policy rates on four occasions in January and February 2015. Following the announcement of the Swiss National Bank on 15 January 2015 that it would discontinue its minimum exchange rate target of 1.20 Swiss francs per euro, the euro depreciated sharply against the Swiss franc, to trade somewhat above parity thereafter. The Bulgarian lev remained fixed to the euro, while the euro weakened modestly against some of the currencies of EU Member States with floating exchange rate regimes, including the Czech koruna (-2.6%), the Polish zloty (-0.2%), the Swedish krona (-2.2%) and the Croatian kuna (-0.3%).

Box 1 Financial stress in emerging market economies Concerns about the economic growth prospects of China and emerging market economies more generally as well as rising expectations of monetary policy normalisation in the United States led to a period of heightened volatility in emerging economies’ financial markets in 2015. Several countries were subject to marked capital outflows from domestic bond and equity markets, coupled with a rise in corporate and sovereign bond spreads and substantial depreciation pressures on their domestic currency. In an attempt to lean against these headwinds, various central banks engaged in large-scale interventions in foreign exchange markets by selling foreign currency reserves. Tensions culminated in late August 2015, when a sharp correction of Chinese stock markets led to a marked increase in global risk aversion with significant repercussions on global, including euro area, financial markets. Financial stress in major emerging market economies peaked in the third quarter of 2015, at a level which was very high also from a longer-term perspective. Chart A shows an aggregate indicator of financial stress in emerging market economies that combines information on portfolio flows, exchange rate developments, movements in domestic bond spreads and changes in foreign exchange reserve holdings. This indicator peaked in September 2015, reaching the second-highest levels seen over the past ten years and also surpassing the elevated levels reached during the “taper tantrum” episode in mid-2013. Only the immediate aftershock of the global financial crisis in late 2008 gave rise to higher levels of stress. In terms of the individual components of the aggregate indicator, the high levels of stress over 2015 were mostly driven by exchange rate developments and, to a lesser extent, by declines in foreign official reserves. After the fall in the Chinese stock market in late August 2015, emerging market economies also registered strong equity outflows, which contributed to the peak in financial stress in September 2015. Chart A Financial stress in major emerging market economies (monthly data) -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2005 2007 2009 2011 2013 2015 indicator of financial stress in emerging market economies Sources: Haver, Institute of International Finance and ECB calculations.

Notes: The indicator of financial stress in emerging market economies combines information from different financial market time series: (1) portfolio flows into bond and equity markets (Institute of International Finance); (2) bilateral nominal exchange rate developments against the US dollar (Federal Reserve Board); (3) changes in domestic bond market spreads vis-à-vis US bond yields (JP Morgan’s Emerging Market Bond Index); and (4) changes in foreign exchange reserve holdings (IMF International Financial Statistics). The indicator shown corresponds to a three-month moving average of the first principal component, which explains around 50% of the total variation of the original dataset. Positive/negative values of the indicator indicate stress levels above/below the long-run average. The country sample comprises Brazil, China, India, Indonesia, Mexico, South Africa, South Korea, Thailand and Turkey. Data are monthly and cover the period from January 2005. The latest observation is for December 2015. While rising expectations of US monetary policy normalisation contributed to the heightened volatility in financial markets in 2015, they were probably not the main trigger. US rate hike expectations brought about a broad-based US dollar appreciation in 2015 and increased volatility in foreign exchange markets. At the same time, the December 2015 rate increase was well anticipated by the markets and had been largely priced in since the beginning of the year. Furthermore, in contrast to the taper tantrum episode, ten-year US Treasury yields did not show a clear upward trend in 2015 and the term premium remained very compressed. The acute financial volatility in emerging market economies during 2015 stemmed to a greater extent from concerns about the implications of slowing growth in China and the commodity price slump. For example, following the correction in the Chinese stock market in August 2015, some net commodity-exporting emerging market economies experienced sharp depreciations of their currencies. The currencies of the economies with strong trade links to China also reacted strongly, including those of Chile, Indonesia, Malaysia and Thailand. At the same time, existing vulnerabilities and concerns about lower growth prospects also contributed to financial market stress. Most emerging market economies have experienced a moderation in growth in recent years, driven by both cyclical factors and structural impediments, and are facing lower growth prospects in the years ahead. Moreover, some of the economies which were already deemed fragile by financial markets during the 2013 taper tantrum have remained so. Brazil, Indonesia and South Africa continued to run twin deficits (fiscal and current account), as they had at the start of 2013, with Brazil and South Africa also suffering from high inflation and weakening growth. Turkey also continued to exhibit significant external imbalances, along with high inflation and credit growth. The commodity price slump has negatively affected net commodity exporters, including Russia and Brazil. In Russia, the ongoing slowdown has been exacerbated by economic sanctions and low oil prices, which pushed the economy into a sharp recession. By contrast, India has managed to correct some of its vulnerabilities compared with 2013, lowering both the inflation rate and the current account deficit, as the authorities introduced a range of stabilisation and growth-enhancing measures. Chart B Changes in the credit-to-GDP ratio and debt service ratio (Q1 2010 - Q2 2015; percentage points of GDP; percentage points) change in credit-to-GDP ratio (left-hand scale) change in debt service ratio (right-hand scale) -2 0 2 4 6 8 10 12 -10 0 10 20 30 40 50 60 CN TH BR RU MY KR TR ID ZA MX IN Sources: Bank for International Settlements and ECB calculations.

Notes: Credit refers to total credit to the non-financial sector provided by domestic banks, all other sectors of the economy and non-residents; in terms of financial instruments, it covers “core debt”, defined as loans, debt securities and currency and deposits. The debt service ratio reflects the share of income used to service debt in the non-financial private sector. A list of country abbreviations can be found at the end of this report. Rapid credit growth has also made many emerging market economies susceptible to tightening global financing conditions. Loose global financing conditions have contributed to fast credit expansion in many of these countries over recent years (see Chart B). In China, where fast-rising credit has supported strong investment, credit to the non-financial private sector reached around 200% of GDP in 2015. Despite low interest rates, rising debt levels have pushed up debt service ratios for households and firms in many emerging markets, signalling increased risks to financial stability, particularly if the tightening of global financing conditions were to raise interest rates further. Moreover, in recent years several emerging market economies have significantly increased external financing in US dollars, which makes them vulnerable to a further US dollar appreciation. Overall, the financial stress in 2015 highlighted existing vulnerabilities in some emerging market economies and the need to address them, especially in the context of the likely tightening of global financing conditions and the lower growth prospects of these countries.

Financial developments

Euro area financial dynamics in 2015 were shaped to a large extent by the monetary policy decisions of the ECB, and in particular the asset purchase programme (APP). As a consequence, money market rates, government bond yields and the cost of external financing for non-financial corporations all continued their declines to new historical lows. Households also saw a further improvement in their financial conditions.

Euro area money market rates declined amid rising levels of excess liquidity

Money market rates continued to decline in 2015, initially reflecting the continued pass-through of the negative deposit facility rate, first introduced in June 2014. The initial strategies by investors to avoid negative interest rates through a search for yield at somewhat longer maturities, the purchase of high-quality securities and, to a lesser extent, the taking-on of more credit risk were progressively exhausted as pricing adjusted. In addition, market frictions associated with the transition to negative rates faded gradually.

Chart 4 Money market rates and excess liquidity (EUR billions; percentages per annum; daily data) -0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0 100 200 300 400 500 600 700 Jan. excess liquidity (left-hand scale) EONIA three-month EURIBOR six-month EURIBOR Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. 2016 2015 Sources: ECB and Bloomberg.

Note: The latest observations are for 11 January 2016.

Liquidity injections by means of non-standard monetary policy measures put additional downward pressure on money market rates. In particular, the APP and the targeted longer-term refinancing operations (TLTROs) were the main drivers of rising excess liquidity. With excess liquidity rising above €650 billion at the end of the year, rates turned increasingly negative (see Chart 4) and activity declined in certain segments of the euro area money market.

In the period preceding the December 2015 Governing Council meeting, money market rates decreased even further, reflecting market expectations of additional monetary easing. On 3 December 2015 the Governing Council decided to cut the deposit facility rate to -30 basis points and extended the APP at least until March 2017. As a result, money market yield curves gradually shifted further downwards.

Overall, despite some initial concerns, the transition of a broad set of reference rates to negative levels went smoothly, including the transmission to longer maturities such as the six-month EURIBOR. The three-month EURIBOR and six-month EURIBOR turned negative in April and November respectively, and stood at -13 basis points and -4 basis points respectively at end-2015.

Government bond yields reached historical lows

The euro area government bond market was strongly influenced by the public sector purchase programme (PSPP) (see Chart 5).[1] First, as a result of the announcement and implementation of the PSPP, long-term yields on AAA-rated debt continued the decline that started in 2014 to reach new historical lows in the spring. Thereafter, yields increased up to mid-2015 owing to positive surprises regarding the euro area’s economic outlook, technical market factors and a learning process in which the market adapted to the implementation of the PSPP. In the second half of 2015 yields resumed their decline as continued downside risks to the inflation outlook prompted further monetary policy accommodation by the ECB, including an extension of the APP. Overall, the average euro area ten-year yield over the year reached a historical low of 0.6%. This is notably lower than the averages recorded in previous years and is also significantly lower than the average of 2.1% recorded in the United States. It was, however, higher than the 0.4% observed in Japan.

Developments in intra-euro area government bond spreads were relatively muted year on year, but showed some heterogeneity across countries. At the same time, spreads remained at levels comparable to those before the start of the sovereign debt crisis.

Chart 5 Long-term government bond yields (percentages per annum; daily data) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 2009 2010 2011 2012 2013 2014 2015 euro area United States Japan Sources: EuroMTS, ECB, Bloomberg and Thomson Reuters.

Notes: Long-term government bond yields refer to ten-year bonds or to the closest available bond maturity. The euro area government bond yield is based on the ECB’s data on AAA-rated bonds, which include bonds of Austria, Finland, Germany and the Netherlands.

Chart 6 Major stock market indices (index: 1 January 2009 = 100; daily data) 50 70 90 110 130 150 170 190 210 230 250 2009 2010 2011 2012 2013 2014 2015 euro area United States Japan Source: Thomson Reuters.

Note: The indices used are the Dow Jones EURO STOXX broad index for the euro area, the Standard & Poor’s 500 index for the United States and the Nikkei 225 index for Japan.

Equities rose amid heightened volatility

Euro area equity markets were also affected by the PSPP. Initially, equity prices increased substantially in anticipation of and following the announcement of the PSPP, as declining bond yields provided strong support for euro area stocks through lower discount rates and a rebalancing by investors of their portfolios towards riskier assets. As a consequence, the EURO STOXX index had gained almost a quarter in value by the spring (see Chart 6). However, in the middle of 2015 volatility rose and stock prices declined, reflecting uncertainty surrounding events in Greece and the sharp declines in Chinese equity prices, which – coupled with a rapid fall in oil prices – raised concerns about the global economic outlook. Nevertheless, euro area equity markets increased in the autumn – in part because these concerns prompted expectations of monetary accommodation by major central banks, including the ECB – and ended the year up by around 8%.

Nominal cost of external financing for non-financial corporations also reached a historical low

By reducing the costs of market-based debt and equity, the announcement of the PSPP also helped to bring the overall nominal cost of external financing for non-financial corporations (NFCs) to a new historical low in February 2015 (see Chart 7). In particular, the easing of banks’ financing conditions as a result of both the PSPP and the TLTROs helped to further reduce the cost of bank lending for NFCs. Owing to the more bank-based nature of financial intermediation in the euro area, the reduction in the cost of bank financing played an important role in reducing the overall nominal cost of external financing. It compensated for the increase in the cost of market-based debt in the second half of the year and the spike in the cost of equity associated with the stock market developments in mid-2015. Importantly, the heterogeneity of external funding costs across euro area countries declined further during 2015 as the pass-through of increased monetary policy accommodation by the ECB strengthened in those countries that were most affected by the crisis.

Chart 7 Overall nominal cost of external financing for non­financial corporations in the euro area (percentages per annum; three-month moving averages) 1 2 3 4 5 6 7 8 9 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 overall cost of financing cost of market-based debt short-term cost of lending indicator long-term cost of lending indicator cost of equity Sources: ECB, Merrill Lynch, Thomson Reuters and ECB calculations.

Notes: The overall cost of financing for non-financial corporations is calculated as a weighted average of the cost of bank lending, the cost of market-based debt and the cost of equity, based on their respective amounts outstanding derived from the euro area accounts. The cost of equity is measured by a three-stage dividend discount model using information from the Datastream non-financial stock market index. The latest observations are for November 2015.

Increased flow of external financing

The low financing costs (both nominal and real), coupled with improved access to funding and a strengthening economy, led to a significant increase in the use of external financing by NFCs in the first three quarters of 2015 (see Chart 8). The key drivers behind the overall increase were bank loans, the issuance of unquoted shares and trade credit, while ongoing strong growth in retained earnings most likely dampened securities issuance somewhat. Significantly, 2015 was the first time in four years that NFCs increased their use of bank loans, reflecting both a strengthening of credit supply and a continued improvement in credit demand. Credit supply picked up owing to the easing of banks’ financing conditions and the improvement in the risk-return profile of loans relative to other assets.[2] Credit demand was supported, in turn, by the ongoing declines in the cost of lending amid a strengthening economic outlook. In addition to bank loans, the issuance of debt securities and quoted shares went up sharply between January and April 2015 following the announcement of the PSPP, but moderated in the second half of the year as market-based financing became more costly.

Chart 8 Changes in the sources of external financing of non-financial corporations in the euro area (four-quarter sums; EUR billions) -500 -250 0 250 500 750 1,000 2009 2010 2011 2012 2013 2014 2015 MFI loans debt securities quoted shares loans from non-MFIs loans from rest of the world unquoted shares and other equity trade credit other total Sources: Eurostat and ECB.Notes: MFI loans and loans from non-MFIs (other financial intermediaries, insurance corporations and pension funds) are corrected for loan sales and securitisations. “Other” is the difference between the total and the instruments included in the chart. It includes inter-company loans. The latest observation is for the third quarter of 2015.

Household net worth continued to increase

The low level of interest rates and the related high level of asset prices, which was also reflected in house price dynamics, increased the net worth of euro area households in 2015 (see Chart 9).

Chart 9 Change in the net worth of households (four-quarter sums; percentages of gross disposable income) -40 -30 -20 -10 0 10 20 30 2009 2010 2011 2012 2013 2014 2015 change in net worth change in net worth due to net saving 1) other flows in financial assets and liabilities 2) other flows in non-financial assets 3) Sources: Eurostat and ECB.

Notes: Data on non-financial assets are ECB estimates. The latest observation is for the second quarter of 2015.1) This item comprises net saving, net capital transfers received and the discrepancy between the non-financial and the financial accounts.2) Mainly holding gains and losses on shares and other equity.3) Mainly holding gains and losses on real estate (including land).

The financing costs of euro area households remained near record lows in all lending categories, but continued to vary across countries and loan types. Bank borrowing by the household sector recovered at a moderate pace.

Box 2 Why are interest rates so low? Nominal euro area interest rates are now at historical lows, with the interest rate on the main refinancing operations close to 0% and the deposit facility rate in negative territory. Over the past year and a half the euro area yield curve has moved downwards and become flatter (see Chart A). As these developments across advanced economies are, by any standards, highly unusual, it is important to understand why interest rates are so low. The very low interest rates are only partly the choice of the central bank. They also reflect global and euro area-specific factors, some of which are of a long-term, secular nature, while others are associated with the legacy of the financial crisis.[3] While monetary policy cannot address these longer-term forces weighing on the economy, it does need to respond to the disinflationary pressures that they create. If consistent with its mandate, the central bank may also respond to the additional weakness in aggregate demand stemming from the crisis. This is achieved by bringing the interest rate as close as possible to what is known as the “equilibrium” interest rate. This is the interest rate at which resources are fully employed in the economy and inflation is stable around the level most consistent with the price stability objective of the central bank. Given the severity of the crisis, this could not be attained through conventional monetary policy alone and a set of non-standard measures was required. Looking ahead, delivering price stability will create the conditions for interest rates to increase once more and gradually converge towards more normal levels. Chart A Synthetic euro area government bond yield curve and the overnight index swap curve (basis points) -0.5 0.0 0.5 1.0 1.5 2.0 2.5 1 2 3 4 5 6 7 8 9 10 Maturity (years) govenment bond yields (12 February 2016) government bond yields (4 June 2014) overnight index swaps (12 February 2016) overnight index swaps (4 June 2014) Source: ECB. Against this background, this box reviews the determinants of low interest rates in the euro area and discusses some of the implications for banks and savers. While monetary policy accommodation is clearly warranted in support of the recovery and inflation and is proving to be effective, as evidenced by the reduction in bank lending rates and the better availability of credit for firms and households, low interest rates may have implications for those who are more dependent on interest income, such as holders of savings accounts. Moreover, low interest rates can have undesired side-effects, such as stimulating excessive risk-taking in financial markets. Therefore, it is important to understand the underlying causes of persistently low interest rates, not least as these can be linked to factors that are outside the control of monetary policy. Determinants of low interest rates As a way to better understand the different drivers of low interest rates, it is useful to break down long-term nominal yields into four components: expected inflation over the term of the asset; the expected path of short-term real rates; the inflation risk premium and the real term premium, which together represent the compensation required by investors for holding long-term bonds as opposed to rolling over short-term securities. In sum, all these components have contributed to the very low long-term rates observed today. From a long-term perspective, nominal yields on long-term bonds have been on a declining trend in all major advanced economies since the 1980s. This in part reflects the improvements in monetary policy frameworks adopted by central banks which have brought down long-term inflation expectations and compressed inflation premia, both of which have contributed to lower nominal yields. The decline in nominal long-term rates is also explained by the real component, with forward real interest rates in negative territory far into the future (see Chart B). As the forward real interest rate encompasses the expected real rate and the real term premium, it has been shown that the expected real interest rate at horizons sufficiently far away from the present,after the forward premium is removed, is a proxy for the equilibrium real interest rate.[4] Chart B Market-implied path of the one-year real rate in the euro area (percentages per annum) -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 2006 2008 2010 2012 2014 2016 2018 2020 2022 one-year spot real overnight index swap swap-implied real overnight index swap (12 February 2016) swap-implied real overnight index swap (7 May 2014) Source: ECB. Part of the decline in global real interest rates can be accounted for by long-run forces; the other part is due to more cyclical dynamics. If the textbook Solow growth model is used to organise the different forces driving real interest rates in the long run, these forces ultimately pertain to productivity and population growth and savings behaviour. The intuition is that these forces determine investment and therefore the demand for loanable funds, which have to be matched by savings. Seen over the long term, growth in total factor productivity as well as population has been slowing in the euro area for decades. It is also possible that the global propensity to save has increased. On top of the gravitational pull of these long-term forces, there are additional factors weighing on real interest rates that are more directly linked with the global financial crisis. Notably, the euro area is still working its way through a “balance sheet recession”, where a severe debt overhang creates the conditions for a sharp downturn, which in turn necessitates substantial deleveraging and prolongs the length of the slump. The final component affecting long-term interest rates is the term premium. Here too longer-term forces have combined with more cyclical dynamics connected to the financial crisis to push nominal interest rates down. Term premia in the euro area have been compressed on account of the Eurosystem’s securities purchases as well as factors such as the supply of and demand for safe assets at the global level. Overall, low interest rates are ultimately a consequence of weak long-term trends, coupled with the cyclical consequences of a complex financial crisis and an extraordinarily protracted macroeconomic slump. Forecasting the persistence of these influences is fraught with considerable uncertainty. While the longer-term forces behind the drawn-out decline in real rates are outside the scope of monetary policy, it is the mandate of a central bank to ensure that inflation returns to and stabilises around the central bank’s objective, which in turn will help put the economy on a sustainable growth trajectory where cyclical slack is reabsorbed. Currently, this mandate motivates policies which can exert downward pressure on interest rates across the term structure so that borrowing conditions are kept at levels that are sufficiently accommodative to ensure that economic conditions and inflation normalise within a medium-term horizon. The evidence indeed suggests that the ECB’s measures, by keeping current and anticipated short-term rates anchored at their effective lower bound and by compressing the real term premium component of long-term rates, are working their way through the financial system. Bank lending rates charged to households and non-financial corporations have continued to decline, while credit growth is recovering gradually, albeit remaining weak (see Section 1.5 of this chapter). Accordingly, the prevailing accommodative monetary policy stance of the ECB is a necessary and effective means to ensure price stability over the medium term. Given that the Treaty on the Functioning of the European Union establishes price stability as the overriding objective of monetary policy in the euro area, the ECB’s current monetary policy stance is fully consistent with its mandate.

Box 3 What do low interest rates mean for banks and savers? It is important to monitor whether the ECB’s accommodative monetary policy stance gives rise to adverse side-effects for banks and savers. While the price stability mandate, as enshrined in the Treaty on the Functioning of the European Union, is not to be traded off against other policy considerations, the risk of side-effects can be mitigated by devising appropriate safeguards and highlighting areas where other policy domains should step up efforts to address underlying weaknesses in the euro area economy and financial system. Common concerns regarding potential side-effects of the ECB’s accommodative monetary policy stance and the low interest rate environment relate to the impact on bank profitability and on the remuneration of savings. One potentially adverse impact on the financial sector is often associated with the effect that a low interest rate environment – and notably central bank asset purchases and the flattening of the yield curve that they promote – can exert on bank profitability. In other words, banks’ traditional business model of maturity transformation (funding the acquisition of long-term assets by issuing short-term liabilities) may be hampered by downward pressure on their intermediation margins. Moreover, the negative deposit facility rate may further reduce the profitability of banks that deposit large amounts of excess liquidity with the Eurosystem. While these effects are indeed observable, one should not lose sight of other countervailing, beneficial effects associated with asset purchase programmes and accommodative monetary policy instruments more broadly. By supporting economic activity, these instruments improve the capacity of borrowers to honour their commitments, leading to positive effects on bank balance sheets through a marked improvement in the quality of bank assets and a decline in banks’ provisioning needs. Moreover, the general increase in asset prices triggered by the accommodative monetary policy leads to valuation gains for these assets on bank balance sheets. Judging by information from the euro area bank lending survey, there are currently no indications that the adverse effects of the accommodative stance on bank profitability dominate at the euro area level. In fact, over the months following the start of purchases under the asset purchase programme (APP), a positive net percentage of banks reported an increase in profitability as a result of the APP. While the ultimate effect of the APP on bank profitability may differ across countries, depending on the structural features of the respective banking system, this evidence overall warrants a positive assessment. The second concern relates to the decline in the remuneration that households can earn on their savings, especially those held as bank deposits.[5] Indeed, there is a tight link between such remuneration and the prevailing monetary policy stance. As a consequence, nominal rates on many types of savings in the euro area are currently very low by historical standards. However, as explained previously, the low interest rate environment is actually a reflection of prevailing macroeconomic and structural conditions. Therefore, the low remuneration of savings is a symptom rather than a cause of the sluggish recovery. Departing from the current accommodative monetary policy stance would further curtail economic dynamism, discourage borrowing (for example, by firms aiming to finance profitable investment projects) and ultimately contribute to prolonging the period of low interest rates. Ultimately, it is crucial to address the fundamental forces which are responsible for the currently low level of the equilibrium real interest rate. This has to be done primarily with effective structural policies which have the ability to raise productivity and to improve economic growth in a sustainable manner. Moreover, fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules. Finally, to remove remaining obstacles to high and sustainable growth, there is a clear need to address the institutional incompleteness of EMU along the dimensions laid out in the Five Presidents’ Report.

Economic activity

Despite a weakening of the external environment, euro area economic activity remained robust on the back of improvements in domestic demand. As a result, the gradual recovery in the euro area that started in the second quarter of 2013 continued throughout 2015. Average annual growth stood at 1.5% in 2015 (see Chart 10), which is the highest rate since 2011. The gradual improvements in growth mainly reflected robust private consumption, which was relatively broad-based across euro area countries (see also Box 4). Net trade also made a slight positive contribution to growth, mainly due to gains in export market shares following the sizeable depreciation of the euro that started in the middle of 2014. However, investment growth remained weak and was held back by the relatively slow progress in the implementation of structural reforms in some countries and the necessary balance sheet adjustments in a number of sectors.

Chart 10 Euro area real GDP (year-on-year percentage changes; year-on-year percentage point contributions) -6 -4 -2 0 2 4 2009 2010 2011 2012 2013 2014 2015 real GDP consumption investment net exports changes in inventories Sources: Eurostat and ECB calculations.

The euro area economic recovery continued in 2015 despite a weaker global growth outlook

The increase in average annual growth in 2015 was supported by the very accommodative monetary policy stance of the ECB, which was transmitted to the economy through an easing of financing conditions, improved market sentiment, very low interest rates and the euro depreciation. The decline in oil prices and the gradual improvements in euro area labour markets provided further impetus to growth in 2015.

In addition to supporting consumer sentiment, the various monetary policy measures implemented over recent years, including the expanded asset purchase programme at the beginning of 2015, boosted business confidence, as financial conditions, including those for small and medium-sized enterprises, improved. This was beneficial to investment, which contributed more to growth on average in 2015 than in 2014 and 2013, reflecting improvements in firms’ profits, less constrained demand and increasing capacity utilisation. However, while investment strengthened at the beginning of 2015, it remained around 15% below its pre-crisis level.

Domestic demand within the euro area improved during 2015 and was on average the strongest it had been since 2007. The household saving ratio was broadly stable during 2015 and thus supported consumption dynamics. Government consumption contributed positively to economic growth in 2015. A dampening effect on domestic demand stemmed from public and private sector indebtedness, which remained at high levels in some countries. Moreover, slow progress in implementing structural reforms continued to be a drag on growth.

Economic growth dynamics in 2015 were dampened by a weak external environment (see Section 1.1 of Chapter 1). While the slowdown of emerging market economies generated headwinds for euro area export growth, the sizeable depreciation of the effective exchange rate of the euro that started in the middle of 2014 benefited exports and led to gains in euro area export market shares. The relatively strong export performance was underpinned by a shift in the geographical composition of exports, whereby advanced economies such as the United States increasingly took in euro area exports. In addition, intra-euro area trade recovered further in 2015, mirroring the positive developments in euro area domestic demand. Growth rates for both exports and imports were higher in 2015 than in the previous three years. Overall, net trade is likely to have made a slightly positive contribution to growth in 2015.

Chart 11 Euro area real gross value added by economic activity (index: Q1 2009 = 100) 80 85 90 95 100 105 110 115 2009 2010 2011 2012 2013 2014 2015 total gross value added services construction industry excluding contruction Sources: Eurostat and ECB calculations.

From a sectoral perspective, the recovery in 2015 was relatively broad-based (see Chart 11). Total gross value added almost reached its pre-crisis peak in the third quarter of 2015, having been on a recovery path over the past three years. Growth of value added in services continued to outpace that in industry (excluding construction) as well as construction and stood about 3% above its pre-crisis peak in the third quarter of 2015. Value added in industry excluding construction remained below its pre-crisis level, but continued to recover gradually. Conversely, value added in construction displayed a small decline in 2015 and remained far below the pre-crisis peaks seen in 2008.

Labour markets continued to gradually improve

Labour markets recovered further in 2015 (see Chart 12). The rise in the number of persons employed which started in mid-2013 continued in 2015. In the third quarter of the year the number of persons employed in the euro area stood 1.1% above the level seen in the corresponding quarter of 2014, but remained some 2% below its pre-crisis peak. The rise in employment in 2015 mainly reflected improvements in Spain and Germany, but there were encouraging signs that other, previously vulnerable countries also contributed to the rise.

Chart 12 Labour market indicators (quarter-on-quarter growth rate; percentage of the labour force; seasonally adjusted) 7 7.5 8 8.5 9 9.5 10 10.5 11 11.5 12 12.5 -1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 1.2 2009 2010 2011 2012 2013 2014 2015 unemployment rate (right-hand scale) employment (left-hand scale) Source: Eurostat.

Looking at the breakdown by sector, employment increased mainly in the services sector, while the number of persons employed in industry excluding construction increased only moderately and employment in construction declined. In 2015 total hours worked increased slightly less than headcount employment. Annual productivity growth per person employed remained low, averaging around 0.5% per quarter over the first three quarters of 2015, compared with an annual rise of 0.3% in 2014.

The unemployment rate continued to decline in 2015 and stood at 10.5% in the fourth quarter of 2015, which was the lowest rate since the beginning of 2012. The decline in unemployment, which started in the first half of 2013, has been broad-based across gender and age groups. For 2015 as a whole, the unemployment rate averaged 10.9%, compared with 11.6% in 2014 and 12% in 2013.

However, while the euro area unemployment rate has declined substantially since the middle of 2013, broader measures of labour market slack – which take account of those involuntarily working part-time and those who have withdrawn from the labour market – remain elevated. With more than seven million people currently working part-time involuntarily owing to a lack of full-time work and around seven million discouraged workers (i.e. those who have given up looking for work and have withdrawn from the labour market), the euro area labour market still exhibits significant slack.

Box 4 The role of private consumption in the economic recovery Private consumption has been the main driver of the recovery in the euro area. Against a background of weak investment, fiscal consolidation and moderate growth in trade, private consumption has been recovering steadily since early 2013. In the four quarters up to the third quarter of 2015 its contribution to GDP growth was approaching its pre-crisis average contribution, which was not the case for investment (see Chart A). The recent recovery in consumption has gone hand in hand with steady improvements in labour markets. The increase in consumer confidence since early 2013 reflects robust growth in real disposable income, which, in turn, has benefited from steady improvements in labour markets (see Chart B). The unemployment rate declined by 1.6 percentage points over this period, but it remains well above the pre-crisis trough (3.3 percentage points higher in the fourth quarter of 2015 than in the first quarter of 2008). Looking at the individual euro area countries, recent consumption growth has been relatively high in countries where labour markets have strongly improved. In particular in Spain, Ireland and Portugal, the recovery of the labour market has been remarkable, coinciding with a significant increase in disposable income and consumption. Chart A Average quarterly contribution of the main GDP components to GDP growth (average quarter-on-quarter contribution; percentage points) -0.1 0 0.1 0.2 0.3 private consumption investment net exports government consumption changes in inventories Q2 1996 - Q1 2008 Q2 2013 - Q2 2014 Q3 2014 - Q3 2015 Sources: Eurostat and ECB calculations. Chart B Consumer confidence and the change in the unemployment rate (percentages; percentage points) -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 -35 -30 -25 -20 -15 -10 -5 0 2008 2009 2010 2011 2012 2013 2014 2015 consumer confidence (left-hand scale) 12-month change in unemployment rate (right-hand scale) Sources: Eurostat and ECB calculations. Lower energy prices have also played a non-negligible role in the recent recovery of consumption. Since the beginning of 2013 households’ purchasing power as measured by real disposable income has increased by around 3%. Around one-third of that increase was due to lower energy prices.[6] Moreover, gains in purchasing power owing to lower energy prices seem to have had a stronger than usual effect on consumption during the ongoing recovery. Part of the gain in real disposable income resulting from a fall in commodity prices is typically saved for a few quarters. Indeed, the saving rate usually increases after a drop in oil prices, and decreases after a rise. This was also the case during the financial crisis, when sharp decreases in oil prices were accompanied by a sizeable rise in the saving rate (see Chart C). By contrast, the saving rate has remained broadly stable over recent quarters. The muted response of the saving rate to lower energy prices is in line with an unwinding of pent-up consumption demand, for instance the demand for durables, which fell by more than the demand for non-durables and services during the crisis (see Chart D). Pent-up demand is often observed for durable goods immediately following a recession, when consumers have held off on purchases owing to the uncertain economic climate. The longer households postpone their durable purchases, the stronger are both the desire and the need to replace them once the recovery sets in. Thus, pent-up demand may accelerate the economic recovery immediately after an economic downturn. Chart C Saving rate and the price of crude oil (percentages; euro per barrel) 0 15 30 45 60 75 90 105 120 11 11.5 12 12.5 13 13.5 14 14.5 15 2000 2003 2006 2009 2012 2015 saving rate (left-hand scale) oil price in euro (right-hand scale) Sources: Eurostat and IMF.

Note: The saving rate is the ratio of gross savings of households and non-profit institutions serving households to the annual moving sum of their gross disposable income. Chart D Consumption of durables and non-durables and services in the euro area (annual percentage changes) -6 -4 -2 0 2 4 6 8 2005 2007 2009 2011 2013 2015 total private consumption durables non-durables and services Sources: Eurostat and ECB calculations.

Notes: Since Eurostat only publishes a breakdown of private consumption into durable and non-durable goods for some euro area countries, euro area aggregates are approximated using data for 17 countries (i.e. all euro area countries except Belgium and Ireland). The latest observation is for the second quarter of 2015. The recent pick-up in durable goods consumption may therefore reflect the build-up of pent-up demand during the crisis (see Chart D). From 2007 to 2013 the share of durable goods in total consumption declined in the euro area as a whole. This drop was much larger in the countries most affected by the crisis. Conversely, since 2013 durable goods as a share of total consumption have picked up faster in those countries. Looking ahead, the upward effect of pent-up demand on consumption growth is likely to disappear as soon as households have restored their stock of durable goods. As the bulk of the increase in real income seems to have come from improvements in the labour market, consumption will prove resilient, to the extent that labour markets continue to improve. Even when the support from lower oil prices and pent-up demand for durable goods fades, a continued improvement of the labour market will continue to support the recovery in private consumption.

Price and cost developments

Throughout 2015 headline inflation in the euro area, as measured by the Harmonised Index of Consumer Prices (HICP), was very low or even negative, against the background of continued low commodity prices. HICP inflation excluding energy and food initially picked up from its historical low in the first half of the year, but remained broadly stable at around 0.9% in the second half of the year.

Headline inflation declined further in 2015

In 2015 headline HICP inflation in the euro area was 0.0% on average, down from 0.4% in 2014 and 1.4% in 2013. The pattern of HICP inflation was mostly driven by energy price developments (see Chart 13). Headline inflation entered negative territory twice – first in early 2015 and then again in the autumn. Towards the end of the year headline inflation returned to slightly positive rates.

Chart 13 HICP inflation and contributions by components (annual percentage changes and percentage point contributions) -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 2009 2010 2011 2012 2013 2014 2015 2016 total HICP energy processed food unprocessed food HICP excluding energy and food Sources: Eurostat and ECB calculations.

Underlying inflation, as measured by the HICP excluding energy and food, increased from its historical low of 0.6% at the beginning of 2015 (see Box 5). In the second half of the year it remained broadly stable at around 0.9%, with the annual average being 0.8% (see Chart 14). External factors, including the lagged effects of the appreciation of the euro until May 2014 and the indirect effects of the declines in oil and other commodity prices, exerted downward pressure on underlying HICP inflation throughout the year. On the domestic side, subdued wage growth and firms’ low pricing power in a highly competitive environment also contributed to the low levels of underlying inflation.

Chart14 HICP inflation excluding energy and food and contributions by components (annual percentage changes and percentage point contributions) -0.25 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2009 2010 2011 2012 2013 2014 2015 2016 total HICP excluding energy and food non-energy industrial goods services Sources: Eurostat and ECB calculations.

Looking at the main components of the HICP in more detail, the energy component exerted continuous downward pressure on headline HICP throughout 2015. Energy inflation was negative in every month of 2015, owing mainly to developments in oil prices in euro terms.

Food price inflation has been on an upward trend since the start of 2015, mainly driven by unprocessed food inflation. The steep rise in unprocessed food inflation in the autumn reflected the impact of unusually hot weather in the summer on fruit and vegetable prices. Processed food inflation remained broadly stable during the year.

The annual rate of change in non-energy industrial goods prices recovered from very low levels in 2014 and early 2015. This upward movement was mainly driven by durable goods prices and, to a lesser extent, by prices for semi-durables, while non-durable goods inflation remained broadly stable. The upward trend mainly reflected the impact of the depreciation of the euro since May 2014. Looking back over a longer period, non-energy industrial goods inflation has continued to be dampened by the rapid fall in the prices of high-tech goods, which are subject to strong competition among retailers at both the national and the international level.

Import prices were the main source of upward pipeline price pressures, reflecting the depreciation of the euro. Import prices for non-food consumer goods continued to post solid annual growth rates throughout the year. On the domestic side, pipeline pressures on consumer prices for non-energy industrial goods remained subdued, as evidenced in particular by producer price inflation in the non-food consumer goods industries hovering at levels just above zero throughout the year. Producer prices in the intermediate goods industries, as well as the euro prices of crude oil and other commodities, suggest that pressures were also subdued at the earlier stages of the price chain mainly on account of weak prices for energy and non-energy commodity inputs (see Chart 15).

Chart 15 Breakdown of industrial producer prices (annual percentage changes) -25 -20 -15 -10 -5 0 5 10 15 20 25 -10 -8 -6 -4 -2 0 2 4 6 8 10 2009 2010 2011 2012 2013 2014 2015 total industry excluding construction (left-hand scale) intermediate goods (left-hand scale) consumer goods including food (left-hand scale) consumer goods excluding food (left-hand scale) energy (right-hand scale) Sources: Eurostat and ECB calculations.

Chart 16 Breakdown of the GDP deflator (annual percentage changes and percentage point contributions) -2 -1 0 1 2 3 4 2009 2010 2011 2012 2013 2014 2015 GDP deflator compensation per employee productivity unit profits unit taxes Sources: Eurostat and ECB calculations.

Services price inflation remained broadly stable within a range from 1.0% to 1.3% in 2015, reflecting still sizeable slack in the euro area product and labour markets. Items in the services component of the HICP tend to be produced domestically, which means that services prices are more closely linked to developments in domestic demand and labour costs.

Domestic cost pressures remained subdued

Domestic cost pressures stemming from labour costs remained subdued in the first three quarters of 2015 (see Chart 16). The large amount of economic and labour market slack in the euro area continued to constrain labour cost pressures and pricing power. In addition, structural reforms in labour and product markets in recent years have resulted in higher downward wage and price flexibility in some euro area countries. The fact that the real purchasing power of wages is higher given lower inflation also kept a lid on wage pressures.

Growth in compensation per employee in the euro area stood at 1.1% (year on year) in the third quarter of 2015, and the average of 1.2% for the first three quarters of 2015 implies a lower reading than for 2014. The annual rate of growth in unit labour costs stayed at low levels, perceptibly below 1%. This mainly reflected the decline in the growth of compensation per employee, while productivity growth accelerated initially in the first half of 2015 before also decreasing slightly.

Domestic cost pressures stemming from profit developments strengthened in 2015. The annual growth in profits (measured in terms of the gross operating surplus) continued to increase in the first three quarters of 2015, reflecting the economic recovery, moderate wage costs and terms of trade improvements related to weak import price developments. As a result, profits per unit of output were the main driver of the increase in the annual rate of change in the GDP deflator in 2015.

Long-term inflation expectations recovered

Survey-based and market-based long-term inflation expectations recovered, after having reached historically low levels at the beginning of 2015. The Survey of Professional Forecasters for the fourth quarter of 2015 showed five-year-ahead inflation expectations of 1.9%, while the level of longer-term inflation expectations in the October 2015 Consensus Economics survey was also 1.9%. Market-based long-term inflation expectations remained lower than survey-based expectations throughout the year, with some of the difference possibly stemming from inflation risk premia.

Box 5 Tracking developments in underlying inflation At the end of 2014 the question of when and how viably the inflation cycle would turn upwards was important in relation to the macroeconomic outlook. This box reviews the evolution of different measures of underlying inflation, i.e. the more persistent as opposed to transitory components of inflation,[7] and the signals they provided for a turning point.[8] Permanent exclusion-based measures of underlying inflation discount different types of transitory influence. A widely used measure is the Harmonised Index of Consumer Prices (HICP) excluding energy and food, which looks beyond the volatility inherent in energy and food prices owing to their exposure to commodity price shocks and, in the case of unprocessed food, weather influences. However, this sub-index can still include substantial transitory influences. One example is calendar effects, which come to the fore in particular in prices of travel-related items or items affected by seasonal sales such as clothing and footwear. Another example is one-off changes in indirect taxation or administered prices whose impact on the price level drops out of the annual rate of change after one year. Chart A Permanent exclusion-based measures of underlying inflation (annual percentage changes) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 2009 2010 2011 2012 2013 2014 2015 2016 HICP excluding food and energy HICP excluding food, energy, taxes and administered prices HICP excluding food, energy and volatile items Sources: Eurostat and ECB calculations.

Note: Volatile items include transport by air, accommodation, package holidays and clothing and footwear. The various exclusion-based measures under review implied a different timing of the turning point. Looking at developments over the last two years, HICP inflation excluding energy, food, taxes and administered prices reached a trough in May 2014. However, the signal for a more persistent upward movement remained blurred until the turn of the year 2014-15, when the HICP excluding food and energy also reached its trough (see Chart A). The underlying inflation measure which, in addition to energy and food, also excludes volatile seasonal items is much smoother and, after bottoming out in November 2014, provided relatively consistent signals for an upturn during the first half of 2015. However, all measures witnessed some loss of upward momentum after the summer months, which thus raised doubts about whether a turning point had actually been reached. Statistical exclusion-based measures provided a similar message. These measures reduce the volatility in HICP inflation data by excluding in each month the items with the highest and lowest annual rates of change. Two such examples are the 30% trimmed mean[9] and the weighted median. The 30% trimmed mean came out of its trough in January 2015, while the median reached its low point in March 2015 (see Chart B). The upward movement in these two measures was somewhat weaker than in the case of the permanent exclusion-based measures. Chart B Statistical exclusion-based measures of underlying inflation (annual percentage changes) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 2009 2010 2011 2012 2013 2014 2015 2016 HICP excluding food and energy trimmed mean (30%) median Sources: Eurostat and ECB calculations. Measures of underlying inflation based on econometric techniques confirmed the signals. One such measure is based on a dynamic factor model, which captures the common and persistent factor in inflation rates across countries and HICP items. This measure had reached its low point in December 2014, increased substantially up to May 2015, but then – like the median – lost some ground over the summer months and remained stable until the end of the year (see Chart C). Another measure takes into account only those items in the HICP excluding food and energy for which the output gap has had predictive power in the past. This is motivated by the economic reasoning that underlying inflation pressures should increase when economic slack starts to decline. The measure based on sensitivity to the output gap seems to have reached its turning point in March 2015. Chart C Measures of underlying inflation based on econometric techniques (annual percentage changes) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 2009 2010 2011 2012 2013 2014 2015 2016 HICP excluding food and energy measure based on sensitivity to output gap dynamic factor model measure Sources: Eurostat and ECB calculations.

: The super-core index (yellow line, three-month moving average) is constructed using those sub-items in the HICP excluding energy and food, for which the output gap has predictive power in an out-of-sample forecast exercise. The U2 core index (orange line) is based on a dynamic factor model using detailed HICP items for 12 countries. Overall, the signals provided by all of these indicators in real time implied some uncertainty with respect to the precise timing of the turning point and the strength of the upturn in price dynamics. In retrospect, looking at the different measures confirms that underlying inflation increased compared with early 2015. However, the loss of further upward momentum in the second half of the year suggests that confirmation of a definite turning point is yet to come.

Money and credit developments

In an environment characterised by subdued inflation rates and low policy interest rates, the ECB adopted additional non-standard monetary policy measures. Three developments in 2015 stood out: money growth remained robust, credit growth recovered gradually but remained weak, and lending rates declined significantly.

Money growth remained robust

In 2015 broad money growth first accelerated and, from April, remained robust (see Chart 17). In December 2015 annual M3 growth stood at 4.7%, compared with 3.8% at the end of 2014. Two factors were important drivers of monetary developments in the euro area: (i) the strong growth of the narrow monetary aggregate M1, in particular overnight deposits, which benefited from the low opportunity cost of holding the most liquid instruments; and (ii) the ECB’s non-standard measures, specifically the targeted longer-term refinancing operations (TLTROs) announced in June 2014 and the expanded asset purchase programme (APP) announced in January 2015.

Chart 17 M3 and loans to the private sector (annual percentage changes; adjusted for seasonal and calendar effects) -4 -2 0 2 4 6 8 2009 2010 2011 2012 2013 2014 2015 M3 (annual growth rate) M3 (annualised six-month growth rate) loans to the private sector (annual growth rate) loans to the private sector (annualised six-month growth rate) Source: ECB.

As regards the main components of M3, the very low key ECB interest rates and money market interest rates contributed to the strong growth of narrow money (i.e. M1), which stood at 10.7% in December 2015, compared with 8.1% in December 2014. M1 benefited from the elevated growth of overnight deposits held by both households and non-financial corporations (NFCs). The low remuneration of less liquid monetary assets contributed to the ongoing contraction of short-term deposits other than overnight deposits (i.e. M2 minus M1), which remained a drag on M3 growth. The growth rate of marketable instruments (i.e. M3 minus M2), which have a small weight in M3, turned positive. This development reflected in particular a recovery in the holdings of money market fund shares/units, as their relative rate of return (compared with the one-month EURIBOR) was positive.

Money creation was driven by domestic sources

Chart 18 Counterparts of M3 (annual percentage changes, percentage point contributions) M3 domestic counterparts other than credit to general government credit to general government by other MFIs debt securities held by the Eurosystem external counterparts (net external assets) -4 -2 0 2 4 6 8 2013 2014 2015 Source: ECB.

An assessment of the counterparts of M3 (see Chart 18) shows that domestic sources of money creation dominated during 2015. In an environment of low interest rates, M3 dynamics were driven by shifts away from longer-term financial liabilities and by the increasing contribution of credit from MFIs. The annual rate of change in MFI longer-term financial liabilities (excluding capital and reserves) held by the money-holding sector decreased further in the course of the year, to stand at -6.7% in December, compared with -5.3% at the end of 2014. This development reflected the relatively flat yield curve, the substitution by MFIs of longer-term debt securities with funds from TLTROs and the purchase of covered bonds by the Eurosystem via the third covered bond purchase programme. To the extent that resident non-MFIs were sellers of those bonds, this increased the money stock.

Eurosystem purchases of government bonds in the context of the public sector purchase programme was an important source of money creation (see Chart 18, in particular the item “debt securities held by the Eurosystem”). Within domestic counterparts other than credit to general government, credit to the private sector, which was the main drag on money growth in previous years, gradually increased in 2015. Despite a sizeable current account surplus, the net external asset position of euro area MFIs (which is the mirror image of the net external liability position of euro area non-MFIs settled via banks) declined in 2015. This position had been a major source of money creation in previous years. This development mainly reflected net portfolio outflows from the euro area in the context of the APP, which also favoured portfolio rebalancing towards non-euro area investment instruments.

Credit growth recovered gradually, but remained weak

The gradual recovery of credit growth reflected developments in loans to the private sector (see Chart 17). The annual growth rate of MFI credit to euro area residents increased throughout 2015, to stand at 2.3% in December, up from -0.2% in December 2014. An improvement in credit dynamics was noticeable for both households and NFCs. While the annual growth rate of loans to households increased further, the annual growth rate of loans to NFCs only turned positive in mid-2015. The improvement in credit dynamics was facilitated by significant declines in bank lending rates supported by a further reduction in bank funding costs, which was related to the ECB’s non-standard monetary policy measures.

Moreover, as indicated by the euro area bank lending survey, changes in both credit standards and loan demand have supported a recovery in loan growth. This survey identified the low general level of interest rates, increased financing needs for fixed investment and housing market prospects as important drivers of increasing loan demand. In this context, the APP had a net easing impact on credit standards and particularly on credit terms and conditions. Banks also reported that the additional liquidity from the APP and the TLTROs was used to grant loans, as well as to replace funding from other sources. Despite these improvements, loan dynamics remain weak and continue to reflect factors such as subdued economic conditions and the consolidation of bank balance sheets. Moreover, in some parts of the euro area tight lending conditions are still weighing on loan supply.

Bank lending rates charged to households and non-financial corporations declined significantly

The ECB’s accommodative monetary policy stance, a strengthened balance sheet situation and receding fragmentation in financial markets in general have supported a decrease in banks’ composite funding costs, which stabilised close to their historical lows. Since June 2014 banks have been passing on the decline in their funding costs in the form of lower lending rates (see Chart 19), which reached historical lows in the second half of 2015. Between the beginning of June 2014 and December 2015, composite bank lending rates for NFCs declined by around 87 basis points and those for households by around 69 basis points. In addition, bank lending rates for both NFCs and households continued to show reduced dispersion across countries.

Chart 19 Composite bank lending rates for non-financial corporations and households (percentages per annum) 2 3 4 5 6 2009 2010 2011 2012 2013 2014 2015 non-financial corporations households for house purchase Source: ECB.

Note: The indicator for the composite bank lending rate is calculated by aggregating short and long-term rates using a 24-month moving average of new business volumes.

Fiscal policy and structural reforms

The euro area fiscal deficit continued to decline in 2015, mainly on the back of favourable cyclical developments and lower interest costs, while the euro area fiscal stance was broadly neutral. For the first time in eight years, the ratio of general government debt to GDP fell, but debt levels remain high. To ensure sustainable public finances, further fiscal efforts are required. However, in order to support the economic recovery, consolidation should be growth-friendly. Growth would also benefit from the faster implementation of structural reforms, the pace of which remained slow in 2015, despite efforts at the European level. A stronger push in the implementation of reforms in the business and regulatory environment and in product and labour markets is necessary to support the recovery, to foster convergence towards the best performers and to increase growth potential.

Fiscal deficits continued to decline in 2015

The euro area fiscal deficit continued to decline in 2015, although at a slower pace than in the previous year (see Chart 20). According to the December 2015 Eurosystem staff macroeconomic projections, the euro area general government fiscal deficit declined from 2.6% of GDP in 2014 to 2.0% of GDP in 2015. This is broadly in line with the European Commission’s winter 2016 economic forecast. The decline in the 2015 deficit was mainly driven by favourable cyclical developments and lower interest costs. The windfall resulting from lower than initially budgeted interest expenditures amounted to around 0.2% of GDP in 2015 for the euro area. Many countries used part of these savings to increase primary spending rather than to reduce debt as recommended by the ECOFIN Council in its 2015 country-specific recommendations (CSRs). In a few countries, the unwinding of one-off factors in 2015, related to, among other things, financial sector support provided in 2014, also contributed to a budgetary improvement.

Chart 20 Budget balance and fiscal stance (as a percentage of GDP) -8 -6 -4 -2 0 2 4 -4 -3 -2 -1 0 1 2 2009 2010 2011 2012 2013 2014 2015 change in cyclically adjusted primary balance (left-hand scale) 1) budget balance (right-hand scale) Sources: Eurostat and December 2015 Eurosystem staff macroeconomic projections.1) Change in the cyclically adjusted primary balance net of the budgetary impact from government assistance to the financial sector.

The primary structural balance is projected to have deteriorated slightly in 2015. Consolidation measures, mostly in the form of indirect tax hikes, were outweighed by fiscal stimulus packages, which were adopted in a number of countries in support of economic growth and employment. Overall, this resulted in a broadly neutral fiscal policy stance in the euro area in 2015, as measured by the change in the cyclically adjusted primary balance net of government assistance to the financial sector (see Chart 20).

The immediate budgetary impact of the inflow of refugees varied considerably across countries, depending on the respective size of the inflows, whether the refugees just passed through a country or whether it was their final destination, and differences in social entitlements as well as legal provisions governing access to the labour market. In 2015 the refugee-related fiscal costs amounted to around 0.2% of GDP in the countries most affected by the refugee flows.[10]

Government balances converged further

Compared with the peak of the crisis, fiscal positions have improved in all euro area countries, largely on the back of significant structural adjustments in the years 2010-13. Government balances across euro area countries converged further, with the majority of countries now recording deficits below the 3% of GDP reference value. Progress in fiscal consolidation was evident from the increasing number of countries exiting their excessive deficit procedures (EDPs). In 2015 the EDP was abrogated for Malta. Moreover, Ireland and Slovenia are expected to have achieved a correction of their excessive deficits in a timely manner by their 2015 EDP deadline, and Cyprus may have achieved the correction one year ahead of its 2016 deadline. In Portugal, the 3% deficit target is likely to have been exceeded in 2015 owing to financial sector support. In 2016 France, Spain and Greece are expected to remain subject to the EDP.

The government debt-to-GDP ratio started to decline

After having peaked in 2014, euro area general government debt (as a percentage of GDP) fell for the first time since the outbreak of the financial crisis. According to the December 2015 Eurosystem staff macroeconomic projections, it stood at 91% of GDP in 2015, down from 92% in 2014, with the reduction being supported by favourable developments in the interest rate-growth differential and small primary surpluses (see Chart 21). In addition, negative deficit-debt adjustments, reflecting, among other things, privatisation receipts, contributed to the improvement. In a few countries, however, the debt ratio increased further.

Chart 21 Drivers of general government debt (as a percentage of GDP) -2 -1 0 1 2 3 4 5 6 7 8 9 10 2009 2010 2011 2012 2013 2014 2015 change in debt-to-GDP ratio primary deficit/surplus deficit-debt adjustment interest rate-growth differential Sources: Eurostat and December 2015 Eurosystem staff macroeconomic projections.

However, government debt levels remain high in a number of euro area countries. Containing risks to debt sustainability is all the more important in view of the substantial long-term challenges resulting from an ageing population and rising health and long-term care costs. In fact, the European Commission’s 2015 Ageing Report projects that total ageing-related costs will increase from 26.8% of GDP in 2013 to 28.3% of GDP in 2060. The increase is mainly driven by demographic factors, which are expected to result in almost a doubling of the old-age dependency ratio, i.e. the share of persons aged 65 or above relative to the working age population (aged 15-64), to above 50% by 2060. To put the ageing costs into perspective, it should be noted that these projections are subject to substantial adverse risks, as they are based in part on very favourable underlying economic and demographic assumptions.[11] In its 2015 Fiscal Sustainability Report, the European Commission confirmed that fiscal sustainability risks are substantial in a number of euro area countries over the medium and long term, assuming no further changes in policies. Moreover, the analysis underscores the importance of full compliance with the Stability and Growth Pact (SGP) to stabilise or even reduce the debt ratios of those countries with currently high debt levels.

More fiscal effort is needed in several countries

During 2015 a number of governments faced the challenge of carefully calibrating their fiscal policy stance in order to find a balance between reducing their high debt levels and not impairing the economic recovery, while staying in full compliance with the requirements of the SGP. For a number of euro area countries, large consolidation gaps with respect to the SGP requirements were identified in 2015 and further ahead, thereby calling for additional fiscal efforts. The European Commission published its assessment of the 2016 draft budgetary plans against the SGP requirements on 17 November 2015.[12] It found that out of 16 budgetary plans only five (i.e. those of Germany, Estonia, Luxembourg, the Netherlands and Slovakia) were fully compliant with the SGP. Seven (those of Belgium, Ireland, France, Latvia, Malta, Slovenia and Finland) were regarded as “broadly compliant”, as the headline deficit targets were likely to be met while the expected structural effort fell short of requirements, and four (those of Spain, Italy, Lithuania and Austria) were seen as being at “risk of non-compliance” with the SGP.

On 23 November the Eurogroup urged the countries at risk of non-compliance to take the additional measures needed to address the risks identified by the Commission.

It is important that fiscal consolidation is growth-friendly. On the expenditure side, spending reviews are a promising avenue for identifying entitlements that do not necessarily result in welfare increases. On the revenue side, improving the growth-friendliness of the tax system and limiting tax evasion are important reform areas in a number of countries. In particular, reducing the labour tax wedge can have positive growth and employment effects.

The implementation of structural reforms remained slow in 2015

While the economic recovery proceeded at different rates across euro area countries, efforts to support the supply side and increase economic resilience were generally limited in 2015. The pace of implementation of structural reforms remained slow, as was the case in 2014. This occurred despite the changes introduced in the 2015 European Semester, which aimed to increase ownership of reforms and support implementation efforts. Across policy areas, efforts focused on strengthening framework conditions (in particular via improvements in insolvency frameworks), making active labour market policies more effective and reducing the tax wedge on labour. Less effort was dedicated to reducing protection and increasing competition in sheltered services sectors, to improving public administration and to increasing wage flexibility.

Table 1 illustrates the progress achieved in the implementation of the 2015 CSRs. It shows that only limited progress has been made in the implementation of a large number of the recommendations. Across the euro area countries, implementation has been particularly weak, with limited progress being made in most areas in Germany, Lithuania, Luxembourg, the Netherlands, Austria and Slovakia. Among the euro area countries with excessive imbalances, as identified by the European Commission in 2015, Italy recorded a somewhat higher implementation rate than Portugal and France.

Table 1 European Commission assessment of the implementation of the 2015 country-specific recommendations Reform recommendations BE DE EE ES FR IE IT LV LT LU MT NL AT PT SI SK FI 2 3 4 5 6 1 = substantial progress = some progress = limited progress = no progress = fully addressed Source: European Commission, 2016 Country Reports.

Notes: The following categories are used to assess progress in implementing the 2015 CSRs: No progress: the Member State has neither announced nor adopted any measures to address the CSR. This category also applies if a Member State has commissioned a study to evaluate possible measures. Limited progress: the Member State has announced some measures to address the CSR, but these measures appear insufficient and/or their adoption/implementation is at risk. Some progress: the Member State has announced or adopted measures to address the CSR. These measures are promising, but not all of them have been implemented yet and implementation is not certain in all cases. Substantial progress: the Member State has adopted measures, most of which have been implemented. These measures go a long way towards addressing the CSR. Fully addressed: the Member State has adopted and implemented measures that address the CSR appropriately. The grey areas refer to reforms related to SGP compliance, which were not assessed in the Country Reports. Cyprus and Greece were not included in the European Semester in 2015 because they were engaged in macroeconomic adjustment programmes and thus did not receive CSRs.

Stronger implementation of structural reforms needed to permanently boost GDP growth

Against the background of slow reform implementation, some euro area countries still lag considerably behind the best performers in terms of structures that increase resilience and affect the long-term growth outlook. This is true with regard to the business and regulatory environment, as well as product and labour markets. These lags highlight potential that could be tapped through the implementation of structural reforms. Given that many economies are some way from following best practice, the gains from structural reforms could be large. For example, in the World Bank Group’s publication “Doing Business”, only one euro area country appears among the ten best performers. The deceleration in reform implementation in 2014 and 2015 emphasises the need for a stronger reform push to sustain the cyclical recovery and to lift growth potential. This push could be supported by stronger governance over structural reforms and by a stronger commitment by the euro area countries to take advantage of the low interest rate environment to bring about real structural change in their economies.

Low productivity growth, high unemployment rates and, in some countries, large stock imbalances such as high debt levels and negative net foreign assets pose risks to a sustainable economic recovery and call for policy action (see, for example, Chart 22). The available estimates from various international institutions (e.g. the European Commission, the IMF and the OECD) suggest that total factor productivity growth will remain below 1% in the next three to five years in most euro area countries. If structural reforms are credible, carefully chosen and well-designed, their positive effects can be felt quickly (e.g. via a boost to confidence) and thus support the recovery.[13] In many countries, reforms are still needed in product and labour markets as well as in the business and regulatory environment.

Chart 22 Average potential growth versus public and private debt (x-axis: public and private sector consolidated debt, Q2 2015, percentage of GDP; y-axis: average potential output growth, 2016-17) IE GR PT CY ES IT SI DE FR AT NL BE FI SK LU EE MT LV LT -3 -2 -1 0 1 2 3 4 5 0 100 200 300 400 500 Sources: Eurostat and European Commission.

Past experience shows that challenges to reform implementation vary across policy areas. This may be one of the reaso