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Brussels, 31 March 2009

Quarterly report on the euro area: Special report on competiveness divergence within the euro area

The present QREA provides a comprehensive review of developments in price competitiveness since the launch of the euro. Competitiveness imbalances have built up within the euro area, increasing the exposure of some Member States to the financial turmoil. While the economic crisis is projected to lead to some adjustment in external imbalances, re-balancing competitiveness within the euro area requires a better use of fiscal policies, more flexible product and labour markets, including increased competition in the services sector, to increase productivity and lower prices to the benefit of employment.

Euro-area activity contracted by 1.5% on a quarterly basis in the last quarter of 2008, as confirmed by Eurostat earlier this month. Except for inventories and government consumption, all GDP components were down, with investment exhibiting the sharpest drop (-3.7% q-o-q). The situation on the labour market deteriorated significantly, with 450,000 job losses in the fourth quarter and the unemployment rate at 8%. World trade is being severely hit by the collapse in global demand which is increasingly also affecting emerging economies.

On a more positive note, developments in energy and commodity prices are providing some support to households' purchasing power. Falling commodity and energy prices together with base effects have indeed led to a steep decline in inflation in the euro area, with headline HICP inflation coming down sharply to 1.2% in February. Lately, there have also been signs of stabilisation in some confidence indicators both for the euro area and the global economy. It is, however, too early to see the full effect of the significant stimulus measures put in place, including the free play of the powerful automatic stabilisers, the measures to stabilise the financial sector and the easing of the monetary policy.

After some improvement at the end of 2008, the crisis in financial markets intensified again at the beginning of 2009 as the deterioration in the real economy took its toll on financial market sentiment. This was reflected in falling stock prices, as well as widening credit and market spreads. Loans to the private sector have moderated considerably, reflecting sluggish household credit and first signs of deleveraging in the non-financial corporate sector. Although some markets have recently shown some signs of improvement, conditions in the financial sector remain extremely fragile.

The current economic crisis highlights the need for broader and more in-depth macroeconomic surveillance within the euro area. Significant competitiveness divergences have built up within the euro area, raising the exposure of some Member States to the global crisis and accentuating the need for adjustment. Following the broad agenda set out in the Commission Communication on EMU@10 of May 2008 (EMU@10 ), Eurogroup finance ministers agreed that competitiveness developments in the euro area are a matter of common concern and warrant broader surveillance.

The special report presented in this issue provides a comprehensive review and assessment of competitiveness developments since the launch of the euro. Over the past decade, some Member States have seen significant falls in their price and cost competitiveness vis-à-vis the rest of the euro area while others have registered sharp improvements. The diverging trend is also visible in steadily widening current account differences.

While some of these developments can be explained by benign factors, a significant part of the divergence also has more worrying causes. In particular, it can be related to the build-up of significant domestic imbalances in some Member States. These include cost pressures due to inappropriate wages behaviour, excessive domestic demand, high private sector and external debt and surges in house prices. For the countries concerned, some of the macroeconomic imbalances underlying the competitiveness problems have also increased the vulnerability to financial market conditions and have aggravated the exposure to the current crisis.

The economic downturn is projected to lead to some convergence in current accounts within the euro area in 2009 and 2010. However, the convergence is so far associated with only limited re-balancing of Member States' price and cost competitiveness. This suggests that the economic cost in terms of unemployment could be significant in the years to come, unless more decisive policy action is taken.

Policies should target improving the functioning of labour and product markets. Moreover, fiscal policy should avoid pro - cyclicality. The financing of current account deficits in catching-up economies needs to be better monitored and structural measures should help to avoid the build up of competitiveness imbalances. Overall, there is a need to take into account asset markets and private-sector balance sheets in competitiveness surveillance exercises.

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