Economic and monetary developments

Overview

At its monetary policy meeting on 14 December 2017, the Governing Council concluded that an ample degree of monetary accommodation is still needed to secure a return of inflation towards levels that are below, but close to, 2%. The information that has become available since the previous monetary policy meeting in late October, including the new Eurosystem staff projections, indicates a strong pace of economic expansion and a significant improvement in the growth outlook. The Governing Council assessed that the strong cyclical momentum and the significant reduction of economic slack give grounds for greater confidence that inflation will converge towards its aim. At the same time, domestic price pressures remain muted overall and have yet to show convincing signs of a sustained upward trend. The Governing Council therefore concluded that an ample degree of monetary stimulus remains necessary for underlying inflation pressures to continue to build up and support headline inflation developments over the medium term. This continued monetary support is provided by the additional net asset purchases that the Governing Council decided on at the October monetary policy meeting, by the sizeable stock of acquired assets and the forthcoming reinvestments, and by the forward guidance on interest rates.

Economic and monetary assessment at the time of the Governing Council meeting of 14 December 2017

The Governing Council’s economic assessment reflected that the euro area economic expansion continues to be solid and broad-based across countries and sectors. Real GDP growth is supported by growth in private consumption and investment as well as exports benefiting from the broad-based global recovery. The latest survey results and incoming data confirm robust growth momentum. The global economy is also continuing to expand at a solid rate, and the recovery shows signs of synchronisation globally.

Financing conditions in the euro area have remained very favourable. Euro area sovereign bond yields have declined slightly since 7 September. Corporate bond spreads have also fallen, while equity prices of euro area non-financial corporations (NFCs) have increased. At the same time, valuations of corporate bonds and equities have continued to be supported by the robust economic outlook. In foreign exchange markets, the euro has remained broadly unchanged in recent months.

Looking ahead, the December 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.4% in 2017, 2.3% in 2018, 1.9% in 2019 and 1.7% in 2020. Compared with the September 2017 ECB staff macroeconomic projections, the outlook for GDP growth has been revised upwards substantially. The ongoing economic expansion in the euro area is expected to continue to be supported by the ECB’s monetary policy measures. Furthermore, private expenditure and consumption growth are supported by lower deleveraging needs and improved labour market conditions. Improvements in corporate profitability and the very favourable financing conditions continue to promote the recovery in business investment, while euro area exporters are benefiting from the ongoing global economic expansion.

Euro area annual HICP inflation was 1.5% in November, up from 1.4% in October, according to Eurostat’s flash estimate. At the same time, measures of underlying inflation have moderated somewhat recently, in part owing to special factors. Looking ahead, on the basis of current futures prices for oil, annual rates of headline inflation are likely to moderate in the coming months, mainly reflecting base effects in energy prices, before increasing again. Underlying inflation is expected to rise gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion, the corresponding absorption of economic slack and rising wage growth.

This assessment is also broadly reflected in the December 2017 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.5% in 2017, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020. Compared with the September 2017 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised up, mainly reflecting higher oil and food prices.

The latest staff projections also foresee the euro area budget deficit declining further over the projection horizon, mainly as a result of improving cyclical conditions and decreasing interest payments. The aggregate fiscal stance for the euro area is projected to be broadly neutral. The euro area government debt-to-GDP ratio is expected to continue to decline, albeit from a still high level.

Complementing the economic assessment, the monetary analysis showed that money growth remained robust in October and during the third quarter of 2017. Broad money continued to expand at 5% in October, in line with the steady pace witnessed since mid-2015. The recovery in loan growth to the private sector has also continued. The annual flow of total external financing to NFCs is estimated to have strengthened in the third quarter of 2017, reflecting improvements in both bank lending and debt securities issuance.

Monetary policy decisions

Based on the regular economic and monetary analyses, the Governing Council confirmed the need for an ample degree of monetary accommodation to secure a sustained return of inflation rates towards levels that are below, but close to, 2%. The Governing Council decided to keep the key ECB interest rates unchanged and continues to expect them to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding non-standard monetary policy measures, the Governing Council confirmed its intention to continue to make net asset purchases under the asset purchase programme (APP), from January 2018 onwards at a monthly pace of €30 billion, until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. Moreover, the Governing Council reconfirmed that if the outlook became less favourable, or if financial conditions became inconsistent with further progress towards a sustained adjustment in the path of inflation, it would stand ready to increase the APP in terms of size and/or duration. The Governing Council also reiterated that the Eurosystem will reinvest the principal payments from maturing securities purchased under the APP for an extended period of time after the end of its net asset purchases, and in any case for as long as necessary.

External environment

The global economy is continuing to expand at a solid rate, with increasing signs of synchronisation. The outlook among advanced economies entails robust expansion, which slows down over the projection horizon as the upturn matures. Among emerging market economies, the outlook is supported by strengthening activity in commodity exporters. Global trade indicators point to a rebound in the third quarter. Global inflation is expected to rise slowly as spare capacity at the global level diminishes.

Global economic activity and trade

The sustained pace of expansion of the global economy has become more broad-based and extended into the second half of the year. The recovery shows signs of synchronisation globally, as the share of countries with growth in economic activity above the average of recent years has been increasing since the second half of 2016. Across advanced economies, US economic activity expanded at a solid pace in the third quarter, in spite of the impact of the recent hurricanes. Real GDP growth in Japan also remained robust, while activity in the United Kingdom was relatively muted, partly on account of the negative effect of the depreciation of the pound on real household income and consumption, which more than offset the gains in competitiveness and the positive impetus from the increasingly robust expansion in the euro area. Across emerging economies, activity has been supported by India and China, as well as by the recoveries in Brazil and Russia after their deep recessions, although some loss of dynamism is anticipated in the short term in the latter.

Survey-based indicators and sentiment surveys point to sustained global growth in the near term. The global composite output Purchasing Managers’ Index (PMI), excluding the euro area, remained at similar levels in the third quarter to those recorded in the previous two quarters, close to long-run averages, and pointing to a continued steady expansion in global activity (see Chart 1). Sentiment survey indicators have also risen over the past few months.

Monetary policies show some divergence, but overall global financial conditions remain supportive. Markets continue to expect a very gradual monetary tightening in the United States. The Federal Open Market Committee (FOMC) left policy rates unchanged at its September meeting, but decided to start reducing the Federal Reserve System’s balance sheet. In December, in line with market expectations, a rate hike took place. Expectations of tightening in the United Kingdom, confirmed by the rise in the official policy rate, continued to firm following the surge in inflation to above target levels and persistent upward price pressures following the recent depreciation of the pound. In Japan, the Bank of Japan maintained its accommodative stance. In China, in order to curb leverage in the financial system, the People’s Bank of China has allowed financial conditions to tighten since the beginning of the year, increasing its open-market interest rates and guiding interbank rates upwards. Other emerging market economies (EMEs), including India and some commodity exporters, lowered policy rates as inflationary pressures subsided and exchange rates firmed. Overall, financial market sentiment has remained strong in advanced economies, with gains in equity markets and a further decline in volatility. Among EMEs, interest rates have declined in various key economies, contributing to a modest easing in financial conditions, and capital inflows have risen strongly.

Looking ahead, economic activity is expected to remain broadly stable at the global level, but developments across countries and regions vary notably. The outlook among advanced economies is for a robust expansion, which slows down over the projection horizon as the recoveries – particularly in the United States and Japan – mature and output gaps gradually close, while growth in the United Kingdom is anticipated to remain muted. Among EMEs, the outlook is supported by the recovery in commodity exporters, particularly Brazil and Russia. In India and China, growth remains solid, but China is expected to transition to a lower growth trajectory in view of slowing potential growth. Overall, these trends broadly offset each other, leading to a stable global GDP growth outlook.

The growth potential has declined across most advanced and emerging economies in recent years and is expected to stabilise at below pre-crisis levels. In advanced economies, capital contributions have diminished as rates of investment have fallen in the wake of the financial crisis, driven by the ensuing weakened expectations of demand prospects together with tighter financial conditions and heightened uncertainty. Investment was also lower in emerging market economies, in particular in commodity-exporting countries. Waning support from demographics has added to the decline in growth potential in several countries.

In the United States, activity is expected to remain robust on the back of solid domestic demand. The recovery will continue on the back of solid growth in investment and consumption, as tight labour market conditions gradually feed into higher wage growth and favourable financial conditions boost wealth. Moreover, the strengthening of external demand and the recent depreciation of the US dollar also support the US outlook. The tax reform and the associated fiscal package are likely to provide some impetus from next year onwards. However, GDP growth is projected to decelerate gradually in the medium term, returning to its potential.

In the United Kingdom, real GDP growth is expected to remain relatively muted owing to high uncertainty. The recent slowdown in economic activity, led by private consumption as households began to feel the impact of rising inflation and shrinking real wage growth, is expected to extend over the coming quarters. Relatively subdued growth expectations reflect the ongoing impact of high uncertainty and the strong depreciation of the pound in the aftermath of the UK referendum on EU membership.

In Japan, economic expansion is expected to remain firm, supported by domestic and external factors. While waning fiscal support is likely to act as a drag on growth, economic activity is expected to be supported by firming foreign demand, private investment gains associated with high profits and increasing labour and capacity shortages, and favourable financing conditions. The planned VAT hike in October 2019 is, however, expected to have a negative impact on economic activity after its implementation.

In China, activity continues to expand at a robust pace, supported by resilient consumption and a still robust housing market. The near-term outlook is dominated by the authorities’ focus on stable growth, given the ongoing political transition, while the assumption over the medium term is that continued structural reforms will gradually be implemented, leading to an orderly slowdown.

Economic activity in central and eastern European countries is expected to accelerate in the near term, driven by a rebound in investment and strong private consumption. Domestic demand will continue to be the main driver of economic growth looking forward, on the back of improving labour markets and higher absorption of EU funds.

The large commodity-exporting countries are continuing their recovery following deep recessions. In Russia, leading indicators signal a softening of the recovery in the short term, but growth is expected to resume afterwards, supported by higher oil prices, a stronger rouble and declining inflation. Over the medium term, growth is expected to remain mild amid fiscal challenges weighing on the business environment and the lack of fixed investment and structural reforms undermining Russia’s supply capacity. In Brazil, although recurring political uncertainties are continuously weighing on business investment and consumer spending, loosening financial conditions alongside increasing monetary accommodation and improving terms of trade will support the economy over the medium term.

Global trade growth remained robust in the second quarter, and prospects remain positive in the near term. Global merchandise import growth momentum suggests continued robust global trade in the third quarter of the year (see Chart 2). The volume of merchandise imports increased by 1.6% in September (in three-month-on-three-month terms), mainly due to a sharp rebound in import growth in EMEs, particularly in Asia and Latin America. In advanced economies, by contrast, September data point to a negative reading for the United States and Japan, confirming the fall in imports (goods and services) in available national accounts releases. Leading indicators seem to confirm robust world trade dynamics, with PMI new export orders remaining at high levels at the start of the fourth quarter.

Looking further ahead, global trade is expected to continue expanding. The combination of strong trade indicators and surveys and the repeated surprises on the upside could suggest that there is more cyclical momentum in world trade than previously anticipated related to the cyclical upturn and the recovery in investment.

Overall, global growth is projected to remain broadly stable over the projection horizon. According to the December 2017 Eurosystem staff macroeconomic projections, world real GDP growth (excluding the euro area) is projected to increase from 3.7% in 2017 to 3.9% in 2018, before gradually returning to 3.7% in 2020. This development results from a gradual slowdown over the projection horizon for advanced economies, where the cycle is more mature, which is offset by increased dynamism in EMEs, particularly in Latin America. Growth in euro area foreign demand is forecast to expand by 5.5% in 2017, 4.4% in 2018, 3.8% in 2019 and 3.5% in 2020. Compared with the September 2017 projections, global GDP is only revised marginally upwards in 2017‑18. Growth in euro area foreign demand has been revised upwards over the whole projection horizon, reflecting data revisions and a more positive view on medium-term developments.

Risks to the outlook for global activity are on the upside in the short term, but remain skewed to the downside in the medium term. On the upside, there is a possibility that improved sentiment will translate into a faster-than-expected revival in activity. A larger than expected fiscal stimulus along the lines currently being discussed in the US Congress also presents a moderate upside risk to US and global growth. However, medium-term downside risks prevail, such as an increase in trade protectionism, a sudden tightening in global financial conditions (which could affect vulnerable EMEs in particular), disruptions associated with China’s reform and liberalisation process, and political and geopolitical uncertainties, including those related to the negotiations on the future relations between the United Kingdom and the European Union.

Global price developments

Global consumer price inflation declined slightly in October, as energy prices decelerated. After increasing during the previous few months, as the contribution of energy prices intensified, annual consumer price inflation in the OECD area declined in October, to 2.2% (see Chart 3). However, excluding food and energy, OECD annual inflation increased to 1.9%, after having remained stable at 1.8% for the previous five months.

Oil prices have continued to increase in recent weeks. Brent crude oil prices rose from USD 50 per barrel in mid-August to over USD 64 per barrel recently. Higher prices were supported by geopolitical tensions in the Middle East and recent developments in Venezuela, firming expectations of an extension of the OPEC/non-OPEC agreement on supply cuts beyond March 2018, confirmed by the actual extension on 30 November 2017 to the end of 2018, and robust oil demand. Oil futures suggest that oil prices will fall below current levels, to around USD 61 per barrel in 2018 and USD 58 per barrel in 2019. By contrast, non-energy commodity prices have fallen slightly in the last few weeks, although iron ore quotations increased. Box 1 analyses the drivers of metal prices in more detail, decomposing them into demand and supply effects.

Looking ahead, global inflation is expected to rise slowly. While the current oil futures curve anticipates a slight decline in oil prices over the projection horizon, pointing to a very limited contribution from energy prices to inflation, the slowly diminishing spare capacity at the global level is expected to support underlying inflation.

Financial developments

Euro area sovereign bond yields have declined slightly since the Governing Council’s monetary policy meeting on 7 September. Corporate bond spreads have also fallen, while equity prices of euro area non-financial corporations (NFCs) have increased as perceived geopolitical risks have waned. At the same time, valuations of corporate bonds and equities have continued to be supported by the robust economic outlook. In foreign exchange markets, the euro has remained broadly unchanged.

Long-term euro area government bond yields have declined slightly since early September. During the period under review (from 7 September to 13 December 2017), the ten-year sovereign bond yield in Germany increased by 2 basis points to 0.32% (see Chart 4). However, the GDP-weighted euro area ten-year sovereign bond yield decreased by 5 basis points to 0.88%, owing to idiosyncratic falls in the sovereign bond yields of some euro area countries. In the United States and the United Kingdom, long-term government bond yields increased by 30 basis points and 24 basis points, to 2.34% and 1.21% respectively. Developments in euro area long-term interest rates since early September have been muted overall and have not mirrored increases abroad, owing to market expectations for euro area monetary policy. In the United States, the rise was driven partly by the prospect of reforms to the federal tax code, while in the United Kingdom, a reassessment of the future path of monetary policy was a factor.

Sovereign bond spreads vis-à-vis risk-free overnight index swap (OIS) rates fell in a number of euro area countries. The declines ranged from 3 basis points in Germany to 20 basis points in Italy, and around 100 basis points in Portugal (see Chart 5). In the latter two countries, a more favourable assessment of the sovereign’s creditworthiness by some of the major rating agencies contributed to the compression in spreads in line with the overall improvement in the euro area macroeconomic environment. Furthermore, the idiosyncratic falls in Portugal and Italy were largely responsible for the decline in the GDP-weighted euro area ten-year sovereign bond yield, as shown in Chart 4.

The euro overnight index average (EONIA) forward curve was broadly unchanged. The EONIA forward curve shifted slightly upwards at short maturities and slightly downwards at longer maturities (see Chart 6). The fact that the curve remains in negative territory until around mid-2020 is consistent with market participants’ expectations of a negative rate on the ECB’s deposit facility for a prolonged period of time.

The EONIA stood at an average of -35 basis points. Owing to idiosyncratic factors, the EONIA rose to a high of -24 basis points at the end of November. Excess liquidity increased by about €121 billion, to around €1,898 billion, owing to ongoing purchases under the Eurosystem’s asset purchase programme. Liquidity conditions are discussed in more detail in Box 2.

Spreads on corporate bonds declined further during the period under review. On 7 December investment-grade NFC bond spreads (over the corresponding AAA-rated euro area average yield curve) were on average 16 basis points lower than in early September and around 80 basis points below their levels in March 2016, prior to the announcement of the corporate sector purchase programme. Spreads on non-investment-grade and financial sector debt also declined, falling by 11 basis points and 16 basis points respectively (see Chart 7). The low level and further compression of corporate bond spreads is consistent with a strengthening economic recovery.

Euro area equity prices increased. Equity prices of euro area NFCs and banks were around 4% higher at the end of the review period, owing partly to a reduction in perceived geopolitical risk (see Chart 8). Euro area equity prices are also still being underpinned by the robust economic outlook and the ensuing increase in earnings expectations. The equity prices of US NFCs and banks were 7% and 19% higher respectively at the end of the review period, also reflecting the favourable market perception of a US corporate tax reform. In the euro area, market expectations regarding equity price volatility decreased marginally, remaining at the low levels which have prevailed throughout 2017, while in the United States, they declined overall.

In foreign exchange markets, the euro has remained broadly unchanged. However, this is masking some uneven developments across currency pairs. Since peaking at the beginning of the review period, the euro has depreciated vis-à-vis the US dollar by 2.0% (see Chart 9), reflecting both expectations about future policies and related macroeconomic news. There was also a depreciation in the euro vis-à-vis the pound sterling (by 3.8%) and against the currencies of a number of emerging economies in Asia. The euro appreciated vis-à-vis the currencies of some emerging and advanced economies, including the Swiss franc (by 2.1%), the Japanese yen (by 2.0%) and the Chinese renminbi, and also appreciated against the currencies of most non-euro area EU Member States, apart from the Polish zloty and the Czech koruna, against which it depreciated by 0.7% and 1.8% respectively.

Economic activity

The euro area economic expansion continues to be solid and broad-based across countries and sectors. Real GDP growth is supported by growth in private consumption and investment as well as exports benefitting from the broad-based global recovery. The latest survey results and incoming data confirm robust growth momentum in the near term. Compared with the September 2017 ECB staff macroeconomic projections, the December 2017 Eurosystem staff macroeconomic projections revised the outlook for GDP growth upwards substantially. Euro area real GDP is foreseen to grow by 2.4% in 2017, 2.3% in 2018, 1.9% in 2019 and 1.7% in 2020.

The economic expansion in the euro area continues to be buoyant and is broad-based across countries and sectors. Real GDP increased by 0.6%, quarter on quarter, in the third quarter of 2017, following growth of 0.7% in the previous quarter (see Chart 10). The main driver continued to be domestic demand, notably fixed investment spending, and to a lesser extent net exports and changes in inventories. On the production side, activity was broad-based, with strong value added growth in industry (excluding construction) and slightly lower growth in the construction and services sectors.

Euro area labour markets continue to exhibit strong dynamics. Employment rose further, by 0.4%, quarter on quarter, in the third quarter of 2017, resulting in an annual increase of 1.7%. Employment currently stands 1.2% above the pre-crisis peak recorded in the first quarter of 2008. Total hours worked also continued to recover, although average hours worked per person employed have remained broadly stable. This is despite both full-time workers and part-time workers working more hours on average, as these increases were offset by the shift in the composition of employment towards a higher proportion of part-time workers.^[1] The unemployment rate in the euro area stood at 8.8% in October 2017, which is its lowest level since January 2009 (see Chart 11). The decline has been broad-based across age and gender groups. Long-term unemployment (i.e. the number of people who have been unemployed for at least 12 months expressed as a percentage of the labour force) has also continued to fall, but remains well above its pre-crisis level. Survey information points to continued improvements in labour market conditions in the period ahead. At the same time, there are increasing signs of labour shortages in some countries and sectors.

Improving labour markets continue to support income growth and consumer spending. Private consumption growth slowed slightly in the third quarter of 2017 to 0.3%, quarter on quarter, down from 0.5% in the previous quarter. This growth, particularly in durable goods, has been underpinned by the recovery in labour market conditions and rising real wages per employee. The ECB’s monetary policy measures, which have eased financing conditions, also remain supportive of household spending. The savings ratio has declined in the last few quarters, mainly reflecting both an improvement in households’ economic and financial situation, and the low interest rate environment, which is reducing their propensity to save. Consumer confidence rose further in November 2017 as a result of households’ being more optimistic about their future financial circumstances and the general situation in the euro area. As a consequence, consumer confidence is now close to its historical highs, signalling strong underlying consumption dynamics in the near term.

The recovery in housing markets is expected to continue to drive growth. Housing investment increased by 1.3% in the second quarter of 2017, reflecting a continuation of the recovery in the euro area as a whole and in many individual euro area countries. Since the onset of the euro area crisis, developments in housing investment and household indebtedness have moved in opposite directions. In 2008 household indebtedness started to rise, while housing investment began to decline. Since 2013 this trend has reversed, with the recovery in investment being accompanied by household deleveraging. These developments are in sharp contrast with those during the period prior to the crisis when both indebtedness and investment were on the rise (see Chart 12).

Housing investment and house prices continue to be bolstered by very favourable financing conditions, portfolio shifts to housing in the context of low yields on alternative long-term investment opportunities and rising income growth related to ongoing job creation. Recent indicators suggest that this positive momentum in housing investment is set to continue. Business confidence in the construction of buildings segment improved further in October and remains at levels last seen in 2008. Construction production also rose in the third quarter, in line with the positive growth in housing investment in the same quarter, albeit at a slower pace than earlier in the year. A further improvement in the European Commission’s construction confidence indicator for the buildings segment in October and November compared with the third quarter suggests that the positive growth will also continue in the fourth quarter.

Business investment grew at a steady pace in the third quarter of 2017 and the short-term outlook remains robust. Non-construction investment grew by 1.9%, quarter on quarter, in the third quarter, following growth of 3.9% in the previous quarter. In the fourth quarter evidence from the European Commission’s survey suggests that supply constraints are perceived to have increased further, pointing to a need to extend or rationalise the capital stock. Furthermore, sentiment in the capital goods producing sector remains strong, reflecting very favourable production expectations and order books. Finally, moderate debt financing growth, together with the pronounced recovery in stock prices observed in recent years, has brought the leverage ratio (debt to total assets) in the non-financial corporation (NFC) sector down to historical lows, which should free up firms’ resources for investment activities.

Business investment is expected to recover further in the medium term. The robust outlook for investment is supported by a number of factors. Capacity utilisation continues to rise, remaining above the average levels seen before the crisis, financing conditions are expected to stay very favourable and profit mark-ups are foreseen to increase in the context of an already cash-rich NFC sector. Moreover, deleveraging pressures are expected to diminish further as the economic expansion progresses in the context of a low interest rate environment, in turn shoring up business investment growth. However, expectations of still subdued potential output growth and limitations on banks’ intermediation capacity in some countries, as well as remaining structural barriers and a lack of workers with certain skills, may continue to weigh on the outlook for business investment.

Euro area exports continue to grow robustly. Monthly trade data point to strong momentum in extra-euro area exports in the third quarter, which posted a six-year record annual increase of 4.1% (taking into account observations for July and August) and are well above their post-crisis average level. This marks a continuation of the rebound that started in 2016. Favourable developments in foreign demand more than offset the adverse impact of the recent appreciation in the euro. Exports to non-EU countries, in particular China and the rest of Asia, are the main driver of the dynamics. Above-average new manufacturing orders and export market climate indicators suggest that the strong growth in exports will continue over the coming months and that the positive momentum in intermediate and capital goods (see Chart 13) may be related to a rebound in global investment. A pick-up in the latter may sustain exports in the medium term.

Overall, incoming data are generally pointing to unabated upside growth momentum in the fourth quarter of 2017 and around the turn of the year, with robust growth expected to continue in 2018. The European Commission’s Economic Sentiment Indicator (ESI) and the composite output Purchasing Managers’ Index (PMI) continued to rise in November, remaining well above their average levels. This suggests that growth in the fourth quarter of 2017 was at least as strong as in the previous quarter (see the box entitled “The recent strength of survey-based indicators: what does it tell us about the depth and breadth of real GDP growth?” in this issue of the Economic Bulletin).

The ongoing economic expansion in the euro area is projected to continue, supported by the ECB’s monetary policy measures, which are being passed through to the real economy. Lower deleveraging needs continue to contribute to private expenditure growth. Improved labour market conditions, low interest rates and very favourable financing conditions support private consumption growth. Improvements in corporate profitability and very favourable financing conditions continue to promote the recovery in business investment. At the same time, euro area exporters continue to benefit from the ongoing global economic expansion.

The December 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP increasing by 2.4% in 2017, 2.3% in 2018, 1.9% in 2019 and 1.7% in 2020 (see Chart 14). Compared with the September 2017 ECB staff macroeconomic projections, the outlook for real GDP growth has been revised upwards substantially. The risks surrounding the euro area growth outlook are broadly balanced.

Prices and costs

According to Eurostat’s flash estimate, euro area annual HICP inflation was 1.5% in November, up from 1.4% in October. At the same time, measures of underlying inflation have moderated somewhat recently, in part owing to special factors. Looking ahead, on the basis of current futures prices for oil, annual rates of headline inflation are likely to moderate in the coming months, mainly reflecting base effects in energy prices, before increasing again. Underlying inflation is expected to rise gradually over the medium term, supported by the ECB’s monetary policy measures, the continuing economic expansion, the corresponding absorption of economic slack and rising wage growth. This assessment is also broadly reflected in the December 2017 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.5% in 2017, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020. Compared with the September 2017 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised up, mainly reflecting higher oil and food prices.

Headline inflation increased slightly in November. According to Eurostat’s flash estimate, euro area annual HICP inflation rose to 1.5% in November, from 1.4% in October, returning to the level recorded in September (see Chart 15). The November increase reflects mainly higher energy price inflation, marginally offset by a small decrease in food price inflation. The increase in energy inflation was larger than anticipated, stemming from the latest substantial increases in oil prices.

Measures of underlying inflation have moderated somewhat recently, in part owing to special factors. HICP inflation excluding food and energy was 0.9% in November 2017, unchanged from October but down from 1.1% in September (see Chart 16). This overall decline since September was due in part to large declines in inflation for certain services items, including education fees in Italy and transport-related insurance in Germany. November’s HICP inflation excluding food and energy stood close to its levels at the turn of last year. Overall, measures of underlying inflation have not yet shown convincing signs of a sustained upward trend.

Global price pressures remain strong but have still not passed through to the later stages of the pricing chain in the euro area. Annual oil price inflation in euro terms has increased markedly over recent months and global non-energy price pressures have remained strong (see Chart 17). While these global upward pressures on euro area import prices have been mitigated by downward pressure from the impact of the euro’s appreciation over the summer, they continue to be reflected in the robust growth of import and producer prices for intermediate goods. Both grew at an annual rate of 3.5% in October. The pass-through to the later stages of the pricing chain, however, still appears to be weak, as annual producer price inflation for non-food consumer goods remained broadly stable at only 0.2% in October. One possible explanation for the weak inflation in producer prices for non-food consumer goods, despite robust price pressures at the earlier stages of the production and pricing chain, is that margins are being squeezed.

Wage growth has increased somewhat over recent quarters. Annual growth in compensation per employee rose from a low of 1.1% in the second quarter of 2016 to 1.7% in the third quarter of 2017. This increase was driven mainly by higher wage drift, which tends to react more quickly to cyclical developments than negotiated wages. Annual growth in negotiated wages per employee was 1.4% in the third quarter of 2017, unchanged from the previous quarter and equal to the average for 2016. Factors that may still be weighing on wage growth include still significant slack in the labour market, past low inflation, weak productivity growth and the ongoing impacts from labour market reforms implemented in some countries during the crisis.^[2]

Both market-based and survey-based measures of longer-term inflation expectations have remained stable. The five-year forward inflation rate five years ahead stood at 1.71% on 13 December 2017, slightly above the level observed at the beginning of September (see Chart 18). The forward profile of market-based measures of inflation expectations continues to point to a prolonged period of low inflation, with only a very gradual return to levels below, but close to, 2%. The probability of deflation implied by inflation options markets remains low and suggests that deflation risk remains contained. According to the ECB Survey of Professional Forecasters for the fourth quarter of 2017, measures of longer-term inflation expectations for the euro area stood at 1.9%.

Although downward energy-related base effects are expected to cause HICP inflation to decline slightly in the near term, it is expected to be on an upward path thereafter, reaching 1.7% in 2020. On the basis of the information available at end-November, the December 2017 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 1.5% in 2017, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020 (see Chart 19).^[3] Compared with the September 2017 ECB staff macroeconomic projections, the outlook for headline HICP inflation has been revised up, mainly reflecting higher oil and food prices.

HICP inflation excluding food and energy is expected to rise gradually over the medium term. HICP inflation excluding energy and food is projected to be 1.0% in 2017, 1.1% in 2018, 1.5% in 2019 and 1.8% in 2020. On the domestic cost side, important factors behind the gradual pick-up in underlying inflation are improvements in euro area labour market conditions and increasing labour supply shortages in some parts of the euro area, which are expected to drive an upturn in wage growth. Beyond this, the significant pick-up in headline inflation in 2017 compared with the previous three years can be expected to contribute to the increase in wage growth in euro area countries where wage formation processes include backward-looking indexation or expectation elements.

Money and credit

In the third quarter of 2017 and in October, broad money growth continued to expand at the robust pace generally witnessed since mid-2015. The recovery in loan growth to the private sector also continued. The annual flow of total external financing to non-financial corporations (NFCs) is estimated to have strengthened in the third quarter of 2017, reflecting improvements in both bank lending and debt securities issuance.

Growth in broad money remained robust at 4.9% on average in the third quarter of 2017 and stood at 5.0% in October, in line with the steady pace of monetary expansion since mid-2015 (see Chart 20). Money growth was supported by the low opportunity cost of holding the most liquid instruments in an environment of very low interest rates, as well as by the impact of the ECB’s monetary policy measures. The most liquid components remained the main contributor to broad money growth, with the annual growth rate of M1 standing at 9.4% in the third quarter of 2017 and in October (compared with 9.2% in the second quarter of 2017 and 9.8% in September).

Overnight deposits continued to be the main driver of M3 growth. Specifically, the annual growth rate of overnight deposits held by households and non-financial corporations remained strong in the third quarter of 2017 and in October. By contrast, the volatile annual growth rate of overnight deposits held by non-monetary financial institutions declined in October, triggering the slowdown in M1 growth over the month. The annual growth rate of currency in circulation remained broadly unchanged in the third quarter of 2017 and in October, indicating no strong tendency on the part of the money-holding sector to substitute deposits with cash in an environment of very low or negative interest rates. Short-term deposits other than overnight deposits (i.e. M2 minus M1) continued to have a negative impact on M3. The annual rate of change of marketable instruments (i.e. M3 minus M2) – a small component of M3 – turned negative in this period. This development was driven by a smaller, positive contribution of money market fund shares/units, indicating a decrease in the attractiveness of these instruments, and a further decline in monetary financial institutions’ (MFIs) issuance of short‑term debt securities.

Domestic sources of money creation were again the main driver of broad money growth (see Chart 21). From a counterpart perspective, the Eurosystem’s purchases of general government debt securities (see the red portion of the bars in Chart 21), conducted mainly in the context of the ECB’s public sector purchase programme (PSPP), contributed positively to M3 growth. The ongoing recovery in credit to the private sector (see the blue portion of the bars in Chart 21) also continued to support M3 growth. This includes both MFI loans to the private sector and MFI holdings of debt securities issued by the euro area private non-MFI sector. As such, it also covers the Eurosystem’s purchases of non-MFI debt securities under the corporate sector purchase programme (CSPP). The persistent contraction in MFIs’ longer-term financial liabilities (excluding capital and reserves) contributed positively to M3 growth (included alongside other counterparts in the dark green portion of the bars in Chart 21). The annual rate of change of such liabilities has been negative since the second quarter of 2012, partly owing to the impact of the ECB’s targeted longer-term refinancing operations (TLTRO-II), which may be acting as a substitute for longer-term market-based bank funding. Finally, government bond sales from euro area MFIs excluding the Eurosystem contributed to the negative annual growth of credit to general government by MFIs excluding the Eurosystem and thus dampened M3 growth (see the light green portion of the bars in Chart 21).

MFIs’ net external assets continued to weigh on annual M3 growth (see the yellow portion of the bars in Chart 21). While the annual flow of net external assets remained negative in the third quarter of 2017, capital outflows from the euro area, which are partly explained by PSPP-related sales of euro area government bonds by non-residents, have declined over recent months. This has mitigated the related downward pressure on M3 growth. The decline in the negative contribution from net external assets came to a halt in October. Non-residents, while remaining among the main sellers of securities eligible for the asset purchase programme (APP), may have moderated the rebalancing of their portfolios towards other euro area assets.

The recovery in the growth of loans to the private sector, observed since the beginning of 2014, has continued. The annual growth rate of MFI loans to the private sector (adjusted for loan sales, securitisation and notional cash pooling) was broadly stable in the third quarter of 2017 and increased in October (see Chart 20). Across sectors, the annual growth of loans to non‑financial corporations increased to 2.9% in October, from 2.3% in the third quarter (see Chart 22). The growth of loans to NFCs has recovered significantly from the trough in the first quarter of 2014 and the cross-country dispersion of NFC loan developments has declined overall. At the same time, heterogeneity in loan growth across the four largest euro area countries increased somewhat in October 2017. The annual growth rate of loans to households remained broadly stable, standing at 2.7% in October (see Chart 23). The significant decrease in bank lending rates seen across the euro area since summer 2014 (notably owing to the ECB’s non-standard monetary policy measures) and overall improvements in the supply of, and demand for, bank loans have supported these trends. In addition, banks have made progress in consolidating their balance sheets and reducing non-performing loans, although the level of non-performing loans remains high in some countries and may constrain financial intermediation.^[4]

Banks’ funding conditions declined further, falling to new historical lows. Banks’ composite cost of debt financing declined further in the third quarter of 2017 and remained at a historically low level in October (see Chart 24). The decrease in the third quarter was driven by developments in bank bond yields, while the cost of deposits remained stable. In October, both bank bond yields and the cost of deposits fell to new historical lows. The ECB’s accommodative monetary policy stance, the net redemption of MFIs’ longer-term financial liabilities, the strengthening of bank balance sheets and receding fragmentation across financial markets have all contributed to the favourable bank funding conditions.

Bank lending rates for NFCs remained at historically low levels (see Chart 25). The composite bank lending rate for NFCs declined further to a historical low in the third quarter of 2017, where it remained in October. As regards loans to households for house purchase, the moderate increase in the composite bank lending rate for this loan category up to August 2017, from a historical low of 1.78% in December 2016, softened in September and October 2017 (see Chart 26). Overall, composite bank lending rates for loans to NFCs and households have decreased by significantly more than market reference rates since the ECB’s credit easing measures were announced in June 2014. This signals an improvement in the pass-through of monetary policy measures to bank lending rates. The aforementioned decrease in banks’ composite funding costs has supported the decline in composite lending rates. Between May 2014 and October 2017, composite lending rates on loans to NFCs and on loans to households fell by 120 basis points and 103 basis points respectively. The reduction in bank lending rates on NFC loans was particularly strong in vulnerable euro area countries, supporting a more homogeneous transmission of monetary policy to such rates across countries. Over the same period, the spread between interest rates charged on very small loans (loans of up to €0.25 million) and those charged on large loans (loans of above €1 million) in the euro area narrowed considerably and stood close to its historical low in October 2017. This indicates that small and medium-sized enterprises have generally benefited to a greater extent from the decline in bank lending rates than large companies.

The annual flow of total external financing to euro area NFCs is estimated to have strengthened in the third quarter of 2017. This reflects improvements in both bank lending and debt securities issuance, which were dampened by special factors in the second quarter. Overall, the recovery in NFCs’ external financing, observed since early 2014, has been supported by the strengthening of economic activity, further declines in the cost of debt financing, the easing of bank lending conditions and larger numbers of mergers and acquisitions. At the same time, NFCs’ record high – and increasing – cash holdings have reduced the need for external financing.

Net issuance of debt securities by NFCs increased in the third quarter of 2017. The increase in net issuance was concentrated in July, while in August and September issuance was subdued. Market data point to robust gross debt issuance in October and November. Net issuance of listed shares by NFCs continued to be dampened by significant share buy-backs in some countries.

Financing costs for NFCs remain favourable. The overall nominal cost of external financing for NFCs, comprising bank lending, debt issuance in the market and equity finance, is estimated to have declined slightly further, to 4.3% in November 2017, after increasing moderately in June and July. Most of the decline since July 2017 is accounted for by the fall in the cost of equity. In addition, the cost of market-based debt is estimated to have fallen to a new historical low (see Section 2). The overall nominal cost of external financing now stands 30 basis points above its historical low of July 2016 but remains considerably lower than the level observed in summer 2014, immediately before markets started to price in expectations about the forthcoming APP.

Fiscal developments

In the December 2017 Eurosystem staff macroeconomic projections, the euro area budget deficit is foreseen to decline further over the projection horizon (2017-20), mainly as a result of improving cyclical conditions and decreasing interest payments. The aggregate fiscal stance for the euro area is projected to be broadly neutral. The euro area government debt-to-GDP ratio is expected to continue to decline, albeit from a still high level. In particular, countries with high debt levels require additional consolidation efforts to set their public debt ratio firmly on a downward path and to rebuild fiscal buffers.

The euro area general government budget deficit is projected to decline gradually over the projection horizon. Based on the December 2017 Eurosystem staff macroeconomic projections,^[5] the general government deficit ratio for the euro area is expected to fall from 1.5% of GDP in 2016 to 0.5% of GDP in 2020 (see Table 1). The expected improvement in the fiscal outlook, which is broadly unchanged from the September 2017 projections, is mainly driven by favourable cyclical conditions and declining interest payments. While the draft budgetary plans for 2018, which the euro area countries submitted in mid-October 2017, foresee additional consolidation efforts by some countries, this is not necessarily fully reflected in the projections, as they only include measures that have already been adopted or are close to being adopted by the respective parliaments. For further details on the draft budgetary plans, see the box entitled “An assessment of the review of draft budgetary plans based on the 2018 exercise” in this issue of the Economic Bulletin. The euro area fiscal stance is projected to be broadly neutral over the projection horizon.^[6]

Euro area government debt levels are expected to continue falling from their high levels. The euro area debt-to-GDP ratio, which peaked in 2014, is projected to decline from 88.9% of GDP in 2016 to 80.7% of GDP by the end of 2020. The decline is driven mainly by a positive and rising primary surplus and a favourable interest rate-growth rate differential, the latter reflecting the generally stable macroeconomic outlook. The debt ratio is slightly lower compared with the September 2017 exercise, mainly reflecting a more favourable interest-rate growth rate differential. Debt ratios are projected to improve in most euro area countries, while in a few countries the government debt ratio is expected to increase over the projection horizon. In the case of high-debt countries in particular, further consolidation efforts in full compliance with the Stability and Growth Pact are essential to set the public debt-to-GDP ratio firmly on a downward path. Rebuilding fiscal buffers would make countries less vulnerable to any renewed financial market instability or a rapid rebound in interest rates.

Boxes

What is driving metal prices?

Prepared by Irma Alonso Álvarez and Frauke Skudelny

Understanding the factors behind metal prices is important to the assessment of their implications for euro area prices. This box analyses the drivers of metal price developments since 1998, with a particular focus on the surge in metal prices between June and September 2017, a period in which aluminium, copper and iron ore prices simultaneously increased by around 10%.

While attracting less attention than oil prices, metal prices have also been fluctuating strongly since the end of 2003. Metal prices were relatively stable between 1995 and the end of 2003, then increased strongly until the middle of 2011 (apart from a dip during the global recession), then declined until early 2016, after which they started rising again (see Chart A). Prices were about 75% higher in September 2017 than in 1995, led by iron ore and copper, while aluminium prices remained more stable over this period.

Reflecting buoyant economic growth over the last decade, China has become a dominant player in terms of its share in the consumption of metals and, for some metals, also in terms of production (see Chart B). China consumes about 50 to 60% of world metals and accounts for around 50% of world aluminium production and 35% of world copper production. However, its share in iron ore consumption decreased from 70% in 2014 to 60% in 2015, reflecting a gradual economic rebalancing in China away from commodity-intensive activities and towards services. In addition, environmental concerns supported lower steel production in China, with a negative impact on demand for iron ore.

While demand factors have been a key determinant of metal price fluctuations over the last two decades, model-based estimates suggest that the recent surge in metal prices was also driven by supply factors. To disentangle the main factors behind the surge, a dynamic factor model on a large panel of energy and non-energy prices, as developed by Delle Chiaie, Ferrara and Giannone (2017),^[7] is used. This approach assumes that commodity-specific shocks, such as supply shocks in individual commodity markets, tend to be idiosyncratic and hence average out when considering a large cross-section of commodity prices. By contrast, sustained changes in the common component (the global factor) tend to be indicative of demand shifts driven by the global business cycle. The global (demand) factor captures a large share of metal price fluctuations and has been of great importance since the beginning of the 2000s, largely owing to the increasing importance of China (see Chart C). However, when looking at the more recent period, the simultaneous increase in all three metal prices by around 10% between June and September 2017 was mainly driven by the commodity-specific components, which should reflect supply factors as captured by idiosyncratic and block-specific contributions (see Chart D). Increasing global demand also played a role, although to a lesser extent than supply.

These results are consistent with developments in the metal markets over this period. Copper production declined in Chile and Peru owing to weather conditions and strikes in some mines, while supply shortfalls in Australia and Brazil supported higher iron ore quotations. Aluminium prices also increased on account of strong global demand and China’s policy of reducing overproduction and pollution through the shutdown of factories. Since the beginning of October 2017, metal prices have increased slightly (by around 2%), primarily owing to iron ore dynamics. Iron ore prices rose on account of increasing demand for high-grade iron ore in the aftermath of a restructuring of the steel industry in China, affected by the implementation of environmental reforms.

Despite recent increases in metal prices, most forecasts for copper, aluminium and iron ore predict a stabilisation or a decline in prices. While futures markets suggest a stabilisation of metal prices, Consensus Economics forecasts point to a decline, by around 7% by mid-2019, as increased demand is expected to be offset by increases in supply. World Bank projections indicate that the drop in metal prices will be somewhat stronger, with iron ore prices expected to decline by around 30% by late 2019. Copper and aluminium prices are also expected to fall, by around 11%. China will probably play an important role in the evolution of metal prices, as the tightening of metal markets is largely influenced by China’s environmental and safety policies and the growth in demand for metals, with a stronger effect on iron ore than on copper and aluminium. Upside risks to these forecasts include unexpected supply outages, while downside risks relate to slower-than-anticipated demand growth in China and an easing of production restrictions on China’s heavy industries.

Developments in metal prices play a role in the assessment of the outlook for euro area inflation and the risks to price stability in the medium term. Metal price fluctuations affect inflation mainly via their impact on the production and distribution chain, since the share of metal in consumption is rather small. Moreover, as they mostly affect industry, while having very little impact on services, their impact is more relevant for countries with a large industrial sector than for service-oriented economies. Compared to the impact of oil, the effect of metal prices on inflation is small, as they do not have a direct effect via HICP energy prices. Some estimates suggest that a 10% drop in industrial raw material prices results in 0.15% lower euro area HICP excluding energy and unprocessed food over a three-year horizon.^[8]

Liquidity conditions and monetary policy operations in the period from 26 July to 31 October 2017

Prepared by Iwona Durka and Pamina Karl

This box describes the ECB’s monetary policy operations during the fifth and sixth reserve maintenance periods of 2017, which ran from 26 July to 12 September 2017 and from 13 September to 31 October 2017 respectively. During this period, the interest rates on the main refinancing operations (MROs), the marginal lending facility and the deposit facility remained unchanged at 0.00%, 0.25% and -0.40% respectively.

In parallel, the Eurosystem continued to purchase public sector securities, covered bonds, asset-backed securities, and corporate sector securities as part of its asset purchase programme (APP), with a target of €60 billion of purchases on average per month. This pace will be maintained until December 2017, after which it will be reduced to €30 billion on average per month until September 2018, or beyond if necessary.

Liquidity needs

In the period under review, the average daily liquidity needs of the banking system, defined as the sum of net autonomous factors and reserve requirements, stood at €1,212.5 billion, an increase of €43.7 billion compared with the previous review period (i.e. the third and fourth maintenance periods of 2017). This increase in liquidity needs was attributable to an increase in average net autonomous factors, which rose by €43.9 billion to a record high of €1,090.2 billion during the period under review, while minimum reserve requirements decreased marginally by €0.2 billion to €122.2 billion.

The growth in aggregate net autonomous factors, which implies absorption of liquidity, mainly resulted from a decrease in the liquidity-providing factors. The main contribution came from net foreign assets, which fell by €33.0 billion to €637.0 billion on average in the period under review. Average net assets denominated in euro also decreased, by €26.3 billion compared with the previous review period, to €306.1 billion.

Liquidity-absorbing autonomous factors also decreased over the review period, counteracting to some extent developments in liquidity-providing autonomous factors. The main contribution came from other autonomous factors, which fell by €30.1 billion to €690.3 billion. Increases in banknotes in circulation and government deposits, by €11.5 billion and €3.4 billion respectively, had a counterbalancing effect on the level of liquidity-absorbing autonomous factors.

The volatility of autonomous factors remained elevated and broadly unchanged from the previous review period. The volatility primarily reflected fluctuations in government deposits and net assets denominated in euro.

Liquidity provided through monetary policy instruments

The average amount of liquidity provided through open market operations – both tender operations and APP purchases – increased by €152.3 billion to €2,966.5 billion (see Chart A). This increase was fully attributable to the APP, while demand in tender operations decreased marginally.

The average amount of liquidity provided through tender operations declined slightly over the review period, by €6.0 billion to €772.7 billion. This decrease was primarily due to a lower average level of liquidity provided through MROs, which fell by €5.4 billion. The average outstanding amount of TLTROs also decreased slightly, by €2.8 billion, as a consequence of voluntary early repayments of funds borrowed via those operations. By contrast, the average amount of liquidity provided through three-month LTROs increased by €2.3 billion.

Liquidity provided through the Eurosystem’s monetary policy portfolios increased by €158.3 billion to €2,193.8 billion, on average, on the back of the APP purchases. Average liquidity provided by the public sector purchase programme (PSPP), the third covered bond purchase programme, the asset-backed securities purchase programme and the corporate sector purchase programme rose on average by €139.9 billion, €8.4 billion, €0.6 billion and €18.0 billion respectively. The reduction in liquidity owing to redemptions of bonds held under the Securities Markets Programme and the previous two covered bond purchase programmes totalled €8.6 billion.

Excess liquidity

As a consequence of the developments detailed above, average excess liquidity in the period under review rose by €109.5 billion compared with the previous period, to €1,755.3 billion (see Chart A). As mentioned above, the increase largely reflects the liquidity provided through the APP with a monthly target of €60 billion, which was somewhat offset by an increase in liquidity needs coming from autonomous factors. A more detailed analysis of the period under review shows that excess liquidity increased in the fifth maintenance period, growing by €90.1 billion on account of the APP purchases and a decrease in liquidity-absorbing autonomous factors, mainly as a result of lower government deposits. The sixth maintenance period saw a smaller increase in excess liquidity of €47.1 billion, as the liquidity injected via the APP was offset to some extent by higher aggregate liquidity needs of the banking sector as a result of an increase in government deposits.

The increase in excess liquidity corresponded to higher average current account holdings, which rose by €74.0 billion to stand at €1,248.0 billion in the period under review, while the average recourse to the deposit facility increased by a further €35.2 billion to stand at €629.8 billion.

Interest rate developments

Overnight money market rates remained close to the deposit facility rate, even falling below it for specific collateral baskets in the secured segments. In the unsecured market, the euro overnight index average (EONIA) averaged -0.357%, compared to an average of -0.358% in the previous review period. The EONIA fluctuated within a narrow range, with a high of -0.345% on the last day of August 2017 and a low of -0.366% in mid-September 2017.

In the secured market, average overnight repo rates in the GC Pooling market declined slightly for both the standard collateral basket and the extended collateral basket relative to the previous review period. The overnight repo rate stood at -0.437% for the standard collateral basket, while for the extended collateral basket the average overnight repo stood at -0.402%.

The September 2017 quarter-end decline in the core repo rates, which was similar to that observed in June 2017, was relatively mild compared to the 2016 year-end decline and the March 2017 quarter-end decline. This suggests that market participants have adopted more efficient practices for collateral management. Moreover, this development also suggests positive effects from the cash-collateral facility for PSPP securities lending.

The recent strength of survey-based indicators: what does it tell us about the depth and breadth of real GDP growth?

Prepared by Gabe de Bondt and Magnus Forsells

Recent opinion surveys point to a solid increase in real GDP, which raises the question whether this strong growth dynamic can be expected to continue. For example, “soft” data from the two most prominent surveys for the euro area – the European Commission’s business and consumer surveys and the IHS Markit PMI (PMI refers to Purchasing Managers’ Index) – have lately shown a remarkable strength, which appears to indicate that the euro area economy is growing solidly. Both of these surveys are closely monitored by analysts and policymakers because they are considered a timely and often unique indicator of economic developments: survey results are released on a monthly basis (from the third week of the reference month onwards), while the preliminary flash GDP estimate is published only 30 days after the end of the reference quarter. This box focuses on a key data series from each survey, i.e. the Economic Sentiment Indicator (ESI) and the composite output PMI, as the two indicators involved are typically best correlated to developments in real GDP.

The ESI and the composite output PMI are both useful for gauging movements in real GDP, but feature methodological differences. The European Commission’s surveys have a broad coverage in terms of countries (all euro area countries are covered except Ireland), sectors, questions and sample size (it comprises 75,000 private sector companies and 26,000 consumers). A detailed picture of economic developments can thus be obtained. As part of these surveys, the ESI includes confidence indicators for five sectors, with each one encompassing an average of two to four sub-questions. Some of the questions are related to orders, expected production/demand or employment and, as such, are of a forward-looking nature. The weights underlying the ESI are fixed as follows: industry at 40%, services at 30%, consumer (household) at 20%, and both retail trade and construction at 5%.^[9] However, financial services are not included in the ESI. This is a shortcoming because the financial sector affects real GDP and developments in this sector can be very different to those in the rest of the economy, as seen during the financial crisis.

The composite output PMI is derived from replies to a question on month-on-month output changes with three possible responses: “up”, “unchanged” or “down”. It applies a weight of 65% for services-related activity (covers 2,000 private sector companies from the four largest euro area countries and Ireland), with the remaining 35% assigned to manufacturing output (covers 3,000 companies at the country level, including from the Netherlands, Austria and Greece). Important sectors are thus missing, e.g. public services and non-manufacturing industry (mainly construction).

The ESI and the composite output PMI suggest that the euro area economy continued to grow strongly in the fourth quarter of 2017. As illustrated in Chart A, the ESI is constructed to track contemporaneous movements in year-on-year real GDP.^[10] The close correlation between the ESI and year-on-year real GDP indicates a continued solid economic expansion in the fourth quarter. Part of the recently observed discrepancy between the ESI and year-on-year growth can be explained by the fact that the recent upswing in the ESI is largely related to the forward-looking components underlying it. Thus, the recent improvement in the ESI may also point to solid developments beyond the fourth quarter.

The composite output PMI is designed to track quarter-on-quarter changes in real GDP growth. A simple PMI-based GDP tracking rule is illustrated in Chart B, i.e. the quarter-on-quarter percentage change in real GDP equals 10% of the quarterly average composite output PMI from which 50 is subtracted. The link between quarterly changes in real GDP and the composite output PMI has at times tended to weaken, particularly during the first years of the financial crisis (2008/09). Nevertheless, since 2003 (the start of the release of a flash GDP estimate for the euro area) this simple tracking rule has been more accurate in predicting the final GDP data released for calendar years than the first GDP vintage in about half of the time covered. This rule indicates that, in the fourth quarter of 2017, real GDP grew broadly in line with our staff estimate for December 2017 on a quarterly basis.^[11]

The ESI suggests that there will be a continued, unabated increase in real GDP across the euro area over the near term, with most countries experiencing this trend. Given the extent of its coverage, the ESI is more suitable for taking a closer look at the country and sectoral dimensions. The latest ESI results, which are for November 2017 (see the red dots in Chart C), show that the indicator is above its long-term average (represented by the zero line) for all euro area countries except Greece. Moreover, in all countries, excluding the three Baltic States, Belgium, Slovakia and Greece, the ESI is currently more than one standard deviation above its average level. The ESI reached its historical maximum in Malta and Cyprus in November (as indicated by the position of the red dots at the top of the blue bars).

A broadly positive picture also emerges at the sectoral level, with high levels of confidence being registered in most sectors across the euro area. At the sectoral level, in November 2017 the confidence indicators underlying the ESI were at a record high for manufacturing and close to an all-time high for the household (consumer) sector, retail trade and construction (see Chart D). The latter sector, in particular, displayed a remarkable cyclical upswing. In contrast, the latest results for the services sector were comparatively weak, though still above its long-term average as well as the previous peak registered in 2011. These sectoral differences are economically important. For example, aggregating the European Commission’s services and industry confidence indicators – using the composite output PMI’s sectoral weights (65% for services and 35% for industry) – would yield a substantially lower estimate for year-on-year real GDP growth for the fourth quarter of this year than that implied by the ESI (illustrated in Chart A). Overall, the sectoral readings suggest that all sectors are currently contributing to growth, albeit to different degrees.

What can we learn from the ECB Survey of Professional Forecasters about perceptions of labour market dynamics in the euro area?

Prepared by Rupert de Vincent-Humphreys and Friderike Kuik

Over the last ten years labour markets in the euro area have been subject to a number of shocks, leading to large fluctuations in the unemployment rate and pay growth. In response to these developments, professional forecasters have been repeatedly adjusting their expectations for the unemployment rate and annual growth in compensation per employee (hereafter referred to as wage growth), both upwards and downwards. This box examines the revisions to the expectations reported in the ECB Survey of Professional Forecasters (SPF), and how those expectations compare with the actual data outturns.

Between 2008 and 2013 the economic setbacks associated with the financial and sovereign debt crises led participants in the SPF gradually to adjust their expectations for the unemployment rate upwards and those for wage growth downwards (see Charts A and B). This is in line with the traditional notion of unemployment as the driver of labour market slack and, in turn, quantity-price dynamics in the labour market: the more unemployed workers there are competing for jobs, the lower the wages that firms need to offer to recruit or retain workers. This co-movement was also visible in the opposite direction during the temporary recovery of 2010-11, when shorter-term wage growth expectations were revised upwards at the same time that labour market slack was projected to diminish (as indicated by the narrowing gap between shorter-term and longer-term unemployment rate expectations). In 2013, however, a different picture emerged, with expectations for both the unemployment rate and wage growth successively revised downwards.

Up until 2013, SPF projection errors tended to mirror those for unemployment: episodes of weaker-than-expected wage growth coincided with a higher-than-expected unemployment rate and vice versa (see Chart C). ^[12] After 2013, however, not only did the pattern of revisions to unemployment and wage growth forecasts change, but so did the pattern of projection errors. Both wage growth and the unemployment rate were jointly overestimated by the SPF over the period 2013-15, a constellation of errors which seems unusual relative to the survey’s earlier history. Moreover, this pattern was not only seen in the average forecasts reported by the SPF, but also for the large majority of individual forecasters. The whiskers on Chart C illustrate the spread of individual forecast errors (calculated as the interquartile range). Over the period 2013-15 these whiskers lie mostly below the zero line, which indicates that a large majority of respondents overestimated both wage growth and unemployment.

This historically unusual pattern of forecast errors since 2013 may suggest a structural break in labour market dynamics in the euro area. Specifically, the pattern suggests that even though the amount of slack in the labour market (as measured by unemployment) turned out to be less than expected, other factors were keeping wage growth subdued. Such factors could include: increased wage flexibility, in view of the depth of the crisis and following structural reforms in labour markets; a larger increase in low productivity jobs; and effects arising from the low inflation environment.^[13] This pattern may also signal that, at the current juncture, the unemployment rate underestimates the total amount of slack in the labour market. For example, an elevated proportion of part-time workers who want to increase their hours or of marginally attached workers may have allowed employment to expand without generating significant wage inflation. This is consistent with the findings of the survey for the second quarter of 2017: when posed a question on perceived risks to wage developments, respondents emphasised the uncertainty around the response of wages to slack, and the risk that wage growth could turn out weaker than expected, if marginally attached workers re-entered the labour market as the economic recovery progressed.

However, the influence of factors behind recent unusual labour market developments may already be waning. Expectations for wage growth have been picking up in 2017 at all forecast horizons. In particular, the latest SPF (for the fourth quarter of 2017) shows that expectations for wage growth in the longer term have now recovered over half of the decline experienced over the period 2013-16 (see Chart B). This in turn may suggest that the factors which have been holding down wage growth are now perceived to be weakening.

An assessment of the review of draft budgetary plans based on the 2018 exercise

Prepared by Stephan Haroutunian, Sebastian Hauptmeier and Nadine Leiner-Killinger

On 22 November 2017 the European Commission released its opinions on the draft budgetary plans of euro area governments for 2018, together with an analysis of the budgetary situation in the euro area as a whole. Each opinion includes an assessment of the compliance of the relevant plan with the Stability and Growth Pact (SGP). It also follows up on the guidance provided in the country-specific recommendations for fiscal policies under the 2017 European Semester, as adopted by the Economic and Financial Affairs Council on 11 July 2017.^[14]

In general, the draft budgetary plans envisage broadly neutral support of the euro area economy by fiscal policies, but with considerable divergence between countries. Some member countries have reached their medium-term budgetary objectives (MTOs) and several of them are using their room for manoeuvre under the EU’s fiscal rules. In contrast, structural efforts in a considerable number of member countries are falling short of SGP commitments, despite the solid and broad-based economic expansion in the euro area. In its statement on 4 December 2017 on the draft budgetary plans for 2018, the Eurogroup concluded that “a broadly neutral fiscal stance appears still appropriate at the aggregate euro area level in 2018”.^[15] This is also in keeping with the view that when the output gap is small, fine-tuning of support of the macroeconomy by fiscal policies is not warranted.^[16] The Eurogroup also noted that “at the same time, the improving economic conditions call for the need to rebuild fiscal buffers, while continuing to strengthen the economies’ growth potential”.

Based on its 2017 autumn economic forecast, the Commission finds that only six of the eighteen draft budgetary plans are fully compliant with the SGP. ^[17] This refers to the plans of Germany, Latvia, Lithuania, Luxembourg, the Netherlands and Finland (all under the SGP’s preventive arm), and is one more than the number of countries whose plans were found to be fully compliant last year. The Commission considers that the draft budgetary plans of a further six countries are only “broadly compliant” with the SGP.^[18] This refers to the plans of Estonia, Ireland, Cyprus, Malta and Slovakia under the preventive arm, and Spain under the corrective arm. While the headline deficit of Spain, which had submitted a draft budgetary plan on a no-policy-change basis, is forecast to fall below the 3% of GDP deficit reference value by the 2018 deadline under the excessive deficit procedure (EDP), this is associated with cumulated shortfalls in structural efforts relative to commitments under the SGP.^[19] The draft budgetary plans of the six remaining countries are considered to pose a “risk of non-compliance with the SGP”.^[20] This refers to the plans of France – with an EDP deadline in 2017 – under the SGP’s corrective arm, and, under its preventive arm, to Belgium, Italy, Austria, Portugal and Slovenia (Austria having submitted its plan on a no-policy-change basis in the absence of a sworn-in government).

Debt ratios are falling only slowly in countries with high government debt. Among the group of the six countries whose draft budgetary plans pose risks of non-compliance with the SGP, Belgium, France, Italy and Portugal are projected to record high government debt ratios of above 90% of GDP in 2018 (see the chart). With the exception of Portugal, these countries are not expected to reduce government debt towards the reference value of 60% of GDP in line with the SGP’s debt rule. In its statement on 4 December 2017, the Eurogroup noted that “a slow pace of debt reduction from high levels in a number of Member States remains a matter for concern”. In the case of Italy, the letter sent by the Commission on 22 November 2017 states that “insufficient progress towards compliance with the debt criterion” has been made, and that “Italy’s public debt remains a key vulnerability”.^[21] At the same time, the Commission has still not issued a report under Article 126(3) of the Treaty on the Functioning of the European Union (TFEU) based on notified data for 2016.

By way of applying discretion, the Commission recommends that the 2018 structural adjustment requirements under the Stability and Growth Pact for Italy and Slovenia be significantly reduced. ^[22] For countries with structural effort requirements in 2018 of 0.5% of GDP and higher, the recitals to the Council’s 2017 recommendations on the member states’ economic, employment and fiscal policies issued on 11 July 2017 indicated that upcoming assessments would “take due account of the goal of achieving a fiscal stance that contributes to both strengthening the ongoing recovery and ensuring the sustainability of […] public finances.” On this basis, the Commission recommends a reduction in the structural effort requirements applicable to Italy from 0.6% to 0.3% of GDP, and a reduction in those applicable to Slovenia from 1.0% to 0.6% of GDP.^[23] Generally, for the credibility of the SGP, predictability and transparency in the application of its fiscal rules are important.^[24] Notwithstanding the reduced requirements, neither country is forecast to comply fully with the SGP’s preventive arm next year, according to the Commission’s 2017 autumn forecast.

The exercise of reviewing draft budgetary plans appears to have lost effectiveness over time. Introduced in response to the crisis, the review of draft budgetary plans was intended to provide a means of identifying and preventing potential deviations from sound fiscal policies early in the budgetary process, i.e. before budgets are finalised. Where a risk of particularly serious non-compliance with the provisions of the SGP is identified – that is, where a plan in fact envisages structural efforts that fall clearly short of requirements – the Commission can ask the relevant member country to provide an updated budgetary plan. The Commission has not made any such requests since the start of the first review exercise in autumn 2013, stating that the “particularly serious non-compliance” criterion has not been satisfied in any particular case.^[25] However, the Commission has written to those countries planning considerable shortfalls relative to SGP requirements, requesting that additional measures be taken. Early in the history of the review exercise, particularly in 2014, certain countries publicly committed themselves to following up on such requests.^[26] By contrast, in the context of the current review, none of the countries planning for shortfalls in fiscal efforts in 2018 have responded by taking additional measures.^[27] Moreover, in previous years, certain countries whose draft budgetary plans had posed risks of non-compliance with the SGP based on the Commission’s forecast had committed to “implementing the measures necessary to ensure that the […] budget will be compliant with the SGP”, based on a quantification of consolidation gaps relative to SGP commitments.^[28] However, this year, in its statement on the draft budgetary plans for 2018, the Eurogroup merely invites the countries concerned “to consider in a timely manner the necessary measures to address the risks identified by the Commission to ensure that their 2018 budgets will be compliant with the SGP provisions.” It should also be noted that, unlike in previous years, no follow-up to the current review exercise based on the Commission’s winter forecast appears to be envisaged in the Eurogroup in early 2018. Since the start of the draft budgetary plan review exercise in autumn 2013, the proportion of countries that have submitted draft budgetary plans compliant with the SGP has remained unchanged at around one-third, despite the improving economic conditions.^[29]

Looking ahead, it is crucial that the draft budgetary plan review exercise is again made more effective. Generally, the extent to which the draft budgetary plan review has incentivised countries to include additional measures in their final budgets is difficult to assess.^[30] Governments may take additional measures during the finalisation of the budget or during its implementation throughout the year, without linking them specifically to the outcome of the review exercise. Moreover, the assessment of whether countries have complied with the SGP in a particular year is based on outturn data and is only taken around 18 months or more after the start of the draft budgetary plan review. By that time, changes in the estimates regarding a country’s position in the cycle, as well as amendments to the rules, may potentially result in a more favourable assessment of compliance with the SGP.^[31] One way in which a country’s compliance with the SGP can be improved is by requesting updated plans in all cases where significant deviations from requirements are envisaged. Enhancing the functioning of the draft budgetary plan review exercise is important, particularly in order to address budgetary imbalances in economically favourable times so as to have more fiscal space in a future cyclical downturn.

Articles

The oil market in the age of shale oil

Prepared by Irma Alonso Álvarez and Virginia Di Nino

US shale oil production has expanded greatly since 2011, and now rivals that of Russia and Saudi Arabia in terms of market share. However, major producers of conventional oil, and members of the Organization of Petroleum Exporting Countries (OPEC) in particular, have been slow to adapt their production policies. This article investigates the reasons for this delayed reaction and provides an assessment of the relative importance of supply and demand factors in driving oil price developments in the wake of the shale oil “revolution”. Shale oil is the key novel factor affecting the structure of the oil market and influencing OPEC’s decisions whether to target price stabilisation or market share. The prolonged period of oversupply and low oil prices between the end of 2014 and the third quarter of 2016 was a result of the interplay of these factors; the partial recovery in prices, which occurred in 2017, reflects a gradual rebalancing of the market following the global supply restraint agreed by OPEC and major non-OPEC producers. Analysts expect oil prices to remain in a range consistent with the production costs of the major marginal producers – currently assessed to be around USD 50 per barrel over the short term. However, according to their projections, and given current extraction technology, prices must rise to around USD 65-70 per barrel over the medium term if shale oil production is to continue expanding profitably at a robust pace.

1 Introduction

Commodities, and oil in particular, remain the most important source of volatility in consumer price inflation. This poses a challenge for projections, as oil prices account for most of the prediction errors in inflation rates. Understanding the drivers of oil price movements is fundamental to an assessment of their persistence and of the implications for inflation expectations, as well as, ultimately, to the ability to tailor the monetary policy response. The surge in shale oil production since 2011 is generally considered to have created a structural transformation of the oil market, however several questions remain open: to what extent has that transformation so far affected the supply and demand factors which drive the oil price; and what is its relevance over the longer term?

The shale oil revolution has attracted significant interest because it marks a historical and unexpected turning point in US energy production trends. After three decades of steady decline, US oil production provided the largest contribution to global supply growth in the period from 2012 to 2014, and today rivals that of Saudi Arabia and Russia in terms of its share of global oil production. Initially, shale oil was essentially a US phenomenon, as both technical and legislative issues limited its global impact. In particular, the oil streams in the US, Canadian and Mexican pipeline systems were only able to absorb flows from the periphery into the internal US states, and exports of US crude oil were banned by a law which had been introduced for national security reasons. Both of these factors led to an extraordinary build-up of inventory, depressing oil prices within the United States. Quality differentials for delivery in landlocked stocking points, such as the West Texas Intermediate (WTI) benchmark^[32] (the main benchmark used in the United States) were priced at an increasing discount. Prices for energy products became cheaper in the United States than in the rest of the world. However, the subsequent inversion of the oil streams in the pipelines and the creation of additional rail capacity in 2014, combined with the repeal of the export ban a year later, served to close the gap between US and international oil prices and bring US shale oil into the global arena. By this point, the US Energy Information Administration (US EIA) had made several positive reassessments of shale oil, in terms of both future quantities and life span, suggesting that permanent changes were occurring in the global oil market.

OPEC’s production decisions during the shale oil age – which began around 2011 – have been particularly influenced by the evolving supply conditions in the United States. In November 2014 production targets were abandoned in an attempt to regain market share; this aim was achieved, but at the cost of a drop in oil prices of more than half. Persistently low prices and producer nations’ impaired public finances prompted OPEC’s decision in November 2016 to change its policy again and restrain production, in an effort to rebalance the oil market which had been swamped with inventory. Had OPEC accepted the fact that in its role as swing supplier it was now competing with shale oil producers?

This article describes the evolution of the oil market during the shale oil age, the shifts in OPEC’s production strategies and the effects of both of these developments on oil prices. It is structured as follows: Sections 2 and 3 review oil price dynamics and market fundamentals both before and during the shale oil age, with a particular focus on the market shares of major oil producing countries (notably the United States) following the revolution set in motion by the shale oil industry. Box 1 provides details of the structural VAR (SVAR) model of the global oil market used to assess the relevance of supply and demand factors, in which two types of strategies are distinguished, depending on whether OPEC acts to protect its market share (the “strategic” approach) or to stabilise oil prices around a target value (the “accommodative” approach). Box 2 discusses the historical decomposition of the oil price, focusing on the period of shale oil production. Section 4 assesses the potential implications of shale oil for the global supply curve and the equilibrium price, based on micro-level evidence. Section 5 summarises the main themes of the article and concludes with perspectives over the medium and the long term.

2 A narrative of pre-shale oil price dynamics

Developments in the oil price in the years preceding the global financial crisis sowed the seeds for the shale oil revolution. The steep rise in price from USD 23 per barrel in 2003 to an all-time high of USD 145 per barrel on the eve of the global financial crisis was primarily a reflection of surging demand in major emerging economies such as China (see Charts 1 and 4). On the supply side, while non-OPEC producers were struggling to keep up with expanding consumption, OPEC’s preference – according to the empirical analysis – was to maintain a relatively tight market and exploit its renewed power to influence market equilibrium (see Chart 3).

Against this background, capital flowed to the shale oil industry to finance investments in research and development. Medium-sized energy companies, generally more financially constrained than the multinationals, took advantage of these capital inflows to further develop horizontal drilling and hydraulic fracturing techniques in the United States, making shale oil production viable and profitable. The development of shale oil production also benefited from the fact that resources were located in sparsely populated areas, and that in the United States land ownership rights include rights to sub-surface minerals and environmental regulation is less strict than in, for example, Europe.^[33] The extraction of oil and natural gas from shale rock formations has had a lasting effect on the US energy mix and markedly reduced the United States’ dependency on external energy; this has, in turn, helped reduce the perennial US trade deficit.

Over the same period (2003-2007), OPEC regained influence on the oil market by addressing increasing demand from fast-developing emerging economies and stepping in to compensate for significant and protracted disruptions in production. In particular, new lows in prices in the aftermath of the Asian financial crisis of 1997 had restrained field investments for years, and conventional production, which lacked spare capacity, was unable to expand and respond to the growing demand from China and other emerging economies. The gap between global demand and supply was exacerbated by two major disruptions: a drop of 60% in Venezuelan oil production^[34] caused by a protracted strike which took place at the national oil company, Petróleos de Venezuela, in late 2002 in an attempt to force the then-president to call early elections; and the Second Gulf War in 2003. Given the general market conditions, OPEC was able to maintain a relatively tight market balance in order to support high oil prices during this period prior to the global financial crisis (see Box 1).

The global financial crisis dramatically reduced economic activity and demand for crude oil and pushed prices below USD 40 per barrel in early 2009 (see Charts 3 and 4). The decline in annual consumption was particularly severe in the United States and more than offset the growth in demand in some emerging economies. However, prices rebounded ahead of firming improvements in global economic conditions, as a result of a very substantial production cut by OPEC of almost three million barrels per day that was not fully reversed until 2012. It can be seen that OPEC’s policies are motivated by a series of macro and micro factors as market conditions change; Box 1 details a possible empirical framework which may be established to partially evaluate these factors.

3 A narrative of oil price dynamics in the shale oil age

This section assesses the evolution of oil prices and major market fundamentals in the age of shale oil, taking 2011 as a reference date – the year when shale oil production started to expand at a faster pace. Three phases are considered: the period from January 2011 to mid-2014; from mid-2014 to October 2016 and from November 2016 to April 2017; each of which corresponds to a major change in OPEC’s position and in oil prices. During the first period, oil prices remained rather elevated owing to persistent geopolitical tensions and market segmentation, even though shale oil production was expanding. Prices dropped from around USD 120 per barrel to below USD 40 per barrel during the second period, and, more recently, prices have fluctuated within a range of values broadly compatible with marginal producers’ production costs.

3.1 The first period of the shale oil age: January 2011 to mid-2014

During the initial phase of expansion (January 2011 until mid-2014) shale oil production trebled and drove the US share of the market to 12%, up from 7% in 2011. Total US production expanded by 76% from almost 5.4 million barrels per day at the beginning of 2010 to around 9.5 million barrels per day at the end of 2014 (see Charts 5, 6 and 7). This increase was principally due to production from major shale rigs – such as those in the Eagle Ford and the Permian regions – which had more than doubled since 2011, while US conventional production remained stable.

However, OPEC’s share of overall production decreased only marginally, owing to declines in production by other major non-OPEC producers (Norway, the United Kingdom and Mexico). More significantly, Saudi Arabia expanded its production quota; in mid-2013 it exceeded the production share it had held prior to the global financial crisis. Acting as the OPEC swing producer, it compensated for production cuts in those Middle Eastern countries which were experiencing political instability and the effects of an international embargo (Libya and Iran, respectively).

In this initial phase, oil prices appear to have been supported more by positive developments in demand, while supply factors were relatively muted (see Charts 7, 8 and 9). The impact of shale oil producers was still fairly small, since they faced high production costs and rather limited production capacity. The first projections by the US EIA on shale oil production date back to 2011. Since then production has proved to be well above expectations, forcing the US EIA to regularly revise its forecasts upward. This is likely to have led to an OPEC strategy of “wait and see”, and a period in which it incrementally fine-tuned its supply to keep the market well balanced so that the prices remained above USD 100 per barrel, especially in Europe. This is consistent with a SVAR analysis which shows that oil prices were driven by stronger oil demand during this period (see Box 2).

Nevertheless, from the end of 2013 the pace of expansion of shale oil production picked up and proven reserves were heavily reappraised upwards from two billion barrels in 2011 to 11.6 billion barrels in 2015. ^[42] The extraordinary new capacity of shale oil production represented a fresh challenge to the prominence of OPEC’s role in the oil market. In 2014, other non-OPEC supply also rose by around one million barrels per day, reflecting solid production figures in Brazil, Canada and Russia. OPEC rapidly started to lose market share (−2 percentage points between mid-2011 and mid-2014) and became concerned about the prospects for its high-cost producers.

3.2 Two years targeting market share

During the period from mid-2014 until October 2016, OPEC switched to a strategy of targeting market share. The reassessment of potential shale oil production growth in June 2014 can be considered as a turning point for the oil market, as it indicated that operators had underestimated the relevance of shale oil production. During the first half of 2014 not only did the US EIA repeatedly adjust its projections upwards^[43], but more importantly, it extended its estimates of the life expectancy of shale oil production to 2030. In this context, OPEC realised that its loss of market share over the previous three years would not be regained without a change in strategy.

While it is generally the role of swing producers to counteract temporary shocks, shale oil had modified the market structure permanently. ^[44] At this point, shale oil producers were still facing high break-even prices although production capacity was growing. Therefore an OPEC production policy consistent with maintaining high oil prices would have favoured continued development in the shale oil industry and progress in fracking technology, and resulted in further pressure on OPEC’s market share. Supply growth from the United States and Russia was not offset by reductions in OPEC production, and global demand growth was showing signs of slowing down. This led the International Energy Agency (IEA) to revise its forecasts for 2014 and 2015 downwards, mainly due to weaker projections for Chinese and European oil demand growth.

On the back of these developments, OPEC took its decision in November 2014 to abandon production quotas. This attempt to regain market share was only partially successful. As a consequence of lower prices the investment plans of OPEC’s competitors were heavily curtailed – especially in shale oil and non-conventional fields – but competitors were not driven out of the market. On the contrary, they became more efficient over time. The supply glut continued to drive prices to a level as low as USD 30 per barrel in early 2016. Despite the low prices, shale oil rig counts resumed their growth in April 2016, and shale oil production proved to be more resilient than expected as producing companies were able to compress extraction costs. The shale oil industry survived through mergers and acquisitions, as highly indebted mid-sized firms were acquired by larger entities with greater financial resources and capable of operating in an environment of low oil prices. In the period from mid-2014 to April 2017, oil prices were driven mainly by supply dynamics. This is consistent with the results produced by applying the oil market model presented in Box 2.

3.3 Reversion to a policy of price stabilisation

Targeting market share was proving too expensive for the strained public finances of OPEC members ^[45] who agreed with major non-OPEC producers in November 2016 to adopt an approach of oil market rebalancing in order to support prices. Global supply was cut by 1.8 million barrels per day but prices only rose to around USD 50 per barrel. However, the involvement of Russia and other major non-OPEC producers helped to partially preserve OPEC’s role in the market; in September 2017 OPEC’s production still represented 42% of global supply. Yet US production regained, and then exceeded, its 2014 level, suggesting that major shale oil production companies, at least in the short run, were economically viable at a price of around USD 50 per barrel.

The decline in OPEC’s production was a reaction to the considerable fall in the production costs of high-cost shale oil producers. In particular, these producers introduced a series of technological improvements that raised their competitiveness. The life of shale oil rig wells was extended by using injection liquids that had novel chemical compositions and, in particular, by the widespread use of re-fracking techniques^[46]. Drilling closer to the “sweet spot”^[47] increased the recovery rate and contributed further to reductions in break-even prices. The resilience of shale oil producers to low prices exacerbated the excess supply and kept oil prices persistently below the levels justified by production costs. Prices that fluctuate around USD 50 per barrel seem to be more consistent with short- to medium-term equilibrium prices. In order to progress with the rebalancing of the oil market through global supply restraints, member countries who signed up to the November 2016 OPEC agreement have recently extended it until the end of 2018, with the possibility of a review in June of that year.

4 The relevance of shale oil in the medium term according to micro evidence

Shale oil will remain an important factor in oil production in the future. The hypothesis maintained throughout this analysis is that producers began to be perceived as effective competitors once their supply capacity expanded and their break-even prices fell. However, how relevant is shale oil production expected to be in the medium term? This section provides evidence, based on the latest projections from Rystad^[48], that shale oil will remain an important factor for at least two reasons: i) the additional efficiency gains it is expected to achieve, and ii) the rapid increase of investment flows into the industry which are expected over the coming years.

Technological progress has succeeded in consistently reducing the break-even production prices of shale oil. Based on data released by Rystad in August 2017, Chart 10 shows the potential production in millions of barrels per price range in 2017 and in 2020, for given current and prospective shale oil wells (based on current ongoing and exploration projects). The data can therefore be interpreted as inverse aggregate shale oil supply curves; the blue line plots the current supply and the yellow line plots the forecasted supply. Almost the entire supply from currently active rigs can be produced economically for prices in the range of USD 40-45 per barrel (see Chart 10); this is a reduction of 30% from the production costs of a few years ago.

The comparison of the two curves (2017 and 2020) in Chart 10 also shows that current production of existing wells is limited to six million barrels per day. However shale oil supply is expected to expand rapidly beyond that limit at prices above USD 40-45 per barrel in the future. In particular, the development of newly approved projects could – according to these estimations – sustain a supply of around nine million barrels per day (equivalent to an increase of more than 50% over three years) provided that oil prices rise above USD 65 per barrel, which corresponds to the break-even price of just a few years ago. A note of caution accompanies the 2020 supply curve: since currently viable wells will be largely exhausted within two years and they are operating at prices below USD 40-45 per barrel, the curve shows that production in three years is expected to be lower than today if prices remain within that range over the medium term (see Chart 15). Similar analyses, conducted on other on-shore (non-shale) and off-shore production, show instead unchanged inverse supply curves, revealing a constant cost/supply structure and confirming that additional supply in the future will also almost exclusively come from shale oil.

The development of capital investment in US shale oil production also provides evidence of the resilience of shale oil production over the coming years. Capital inflows into the industry are underway and are expected to become particularly pronounced in the medium term. As shown in Chart 11, capital investment in the next five years is expected to be stronger than in the past (growing at an average of 18% per year, compared with the five-year average of 14% for the period ending in 2014). Capital investment in wells, which includes construction and drilling costs (among other factors), will experience one of the largest rises – in line with expected increases in US shale oil production mainly in the Permian region (Midland and Delaware).

5 Conclusions

This article has reviewed the contribution made by market fundamentals to oil price dynamics in response to the emergence of a key novel factor – shale oil production. Empirical results from a SVAR model with sign restrictions suggest that, especially since 2014, shale oil has had an effect on developments in oil prices: directly, by contributing to global supply growth; and indirectly, by influencing OPEC production policies. OPEC was incentivised to pursue market share as shale oil production increased but was not competitive enough. However, as shale oil producers gained in competitiveness, OPEC preferred a policy of price stabilisation around a value compatible with the break-even cost of the marginal producers.

Micro evidence suggests that not only has shale oil modified other producers’ incentives and therefore the mechanism of price formation over recent years, but it will remain a crucial element of oil production, at least for the next 15 years. Rapidly increasing investment inflows are expected to maintain the robust pace of production growth, thereby highlighting the relevance of technological improvements in oil production. However, important questions remain open concerning, for example, the life expectancy of the shale oil revolution – particularly given the unlikelihood that it will expand beyond the geographical borders of the United States to any significant extent. Geological conditions, environmental concerns, water shortages and less efficient supply chains have so far prevented the widespread diffusion of shale oil technology elsewhere.

The impact of global value chains on the macroeconomic analysis of the euro area

Prepared by Vanessa Gunnella, Michael Fidora and Martin Schmitz

With the decline in transportation costs and the reduction of barriers to trade in the last decades, production processes have become more fragmented as firms locate their production and source their inputs across national borders. This has significantly increased trade in intermediate goods and services. Euro area countries, in particular, have been increasingly participating in cross-border production chains, both within the currency area and outside.

This article analyses how global value chains affect the euro area economy. In particular, accounting for the presence of global value chains has an impact on some key economic indicators. The rise in importance of the value-added concept as opposed to conventional gross trade and the increase in intermediate trade change the way macroeconomic indices are computed and interpreted. Moreover, firms’ and sectors’ participation in global value chains creates or strengthens cross-country linkages via trade in intermediate inputs, which has consequences for macroeconomic analysis, namely for real activity spillovers and the skill mix and compensation of the labour force.

1 Introduction

The last few decades have witnessed a rapid expansion of global value chains (GVCs). Firms have been locating their production and sourcing their inputs across national borders. As a result, production has been increasingly organised in several stages across different countries, implying that exports have a significant amount of imported inputs incorporated into them (the “import content of exports”). As a result, production processes have become internationally fragmented, trade in intermediate goods and services has substantially increased (around 60% of world trade is estimated to be in intermediate goods), and the gross value of exports has become much higher than the value added originating in each exporting country. Multilateral free trade negotiations and the subsequent reduction of tariffs and non-tariff barriers, the opening-up of emerging market economies (EMEs) to global trade, financial liberalisation, the internationalisation of business services and technological improvements are the most prominent factors that contributed to the expansion of cross-country supply chains until recently.

Euro area countries, in particular, have been increasingly participating in cross-border production chains, stimulated by a harmonised regulatory framework within the European Union (EU) and integration in a common currency area. As a result, the establishment of a regional production chain and trade in intermediate products with the rest of the world have been fostered. A comparison of countries’ GVC participation indices^[49] (Chart 1, panel a) shows that the euro area^[50] is more involved in global production chains than other large economies, such as the United States and China.

In the years following the Great Recession, which occurred in the period 2008-09, the pace of supply chain expansion slowed substantially. Panel a of Chart 1 shows that the halt in the expansion of global value chains has been a global phenomenon. It has been partly due to increasing labour costs in emerging markets, as well as the onshoring^[51] of multinational activities towards export markets (the “shortening of global value chains”, in which production is brought closer to demand markets). In addition, the introduction of protectionist non-tariff barriers (for instance through local content requirements and other regulations) has increased trade costs, thus weighing on the expansion of global value chains. Other contributing factors may have been a global demand shift towards services, which are less trade intensive than goods, as well as robotisation, which is encouraging renewed localisation of production in the advanced economies.^[52]

Euro area countries, however, have been less affected by GVC shortening than other countries (Chart 1, panel a). The process of shortening was particularly pronounced in China. While in 2014 (the last year for which data are available) the degree of participation of the United States in global value chains was comparable to that in 2008, in the euro area it was significantly higher and was driven by intra-euro area trade.

Since the beginning of the 21st century, euro area countries have also recorded a rise in the foreign value added embedded in their exports, that is, they have been increasingly using imported inputs in the production of their exports. In panel b of Chart 1, the evolution over time of the position of selected economies in the global value chain is plotted. The position index^[53] of the euro area has fallen further below zero in recent years, meaning that euro area firms are using more foreign inputs and supplying fewer intermediate products to other countries. Hence, they are located more “downstream” in global value chains. Large euro area countries are, in turn, located “upstream” with respect to both small euro area countries and central and eastern European (CEE) countries^[54]. This means that the last two country groupings use a relatively higher share of imported inputs in the production of their exports, often as a result of final assembly activities as part of the pan-European contribution to global value chains. Conversely, the United States is comparatively upstream as it provides intermediate products related to R&D, the financial sector and the commodity sectors to the rest of the world. Also, China^[55] has been moving significantly upstream when comparing 2007 with 2014.

Global value chains have an impact on some key economic indicators. The rise in importance of the value-added concept, as opposed to conventional gross trade, and the increase in intermediate trade have brought about some challenges with regard to the way macroeconomic indices are computed and interpreted. In Section 2, the implications of global value chains for the measurement and interpretation of three key indicators – real effective exchange rates, export market shares and the global demand elasticity of trade – will be analysed.

Firms’ and sectors’ participation in global value chains also creates or strengthens cross-country linkages via trade in intermediate inputs. This has important consequences for macroeconomic analysis. Specifically, in Section 3 the focus is on real spillovers, as well as the skill mix and compensation of the labour force.

2 Implications of global value chains for the measurement and interpretation of macroeconomic indicators

2.1 Global value chain-based real effective exchange rates

Real effective exchange rates (REERs) are a measure of the international price and cost competitiveness of a country. REERs are computed as a trade-weighted average of a country’s bilateral exchange rates vis-à-vis its most important trading partners, adjusted for price levels.^[60] As such, they are used in aggregate export and import flow models and as a synthetic indicator for the analysis of trade performance and balance of payments adjustments.

A challenge to the interpretation of conventional REERs is posed by the fact that imports are pervasively used to produce exports in today’s global economy. As a result, countries often compete against each other in specific stages of the value-added chain (e.g. two emerging economies may compete in the assembly of an iPhone). The conventional REER measures, however, assume that countries compete to sell products that they produce entirely at home, using only domestic inputs.

In particular, bilateral value-added trade patterns may differ significantly from gross trade patterns, which implies that gross value trade weights may over- or understate the degree of bilateral competition for value-added exports. To account for this effect, value-added real effective exchange rates (VAREERs) based on bilateral value-added trade data can be constructed. VAREERs thus take into account that gross trade flows of intermediate goods, for instance between neighbouring countries, may distort the extent to which value added in terms of final goods is traded between countries.

Moreover, as countries trade intermediate inputs intensively, this affects the impact of exchange rate changes on trade. An appreciation vis-à-vis a trading partner from which a country largely imports intermediate goods (e.g. components imported by China from Japan for iPhone assembly) may actually be beneficial for the competitiveness of that country as it reduces the cost of intermediate goods imports. To account for this effect, input-output real effective exchange rates (IOREERs) can be constructed. IOREERs identify an additional channel through which exchange rate movements affect price competitiveness. An appreciation not only increases the relative price of domestic goods and therefore worsens the country’s price competitiveness, it also has a counteracting effect on competitiveness as it reduces the cost of foreign inputs used in production.

REERs based on GVC weights therefore offer a complementary measure that enriches the interpretation of more traditional measures based on gross trade and used in the computation of the REERs disseminated by the ECB. ^[61] VAREERs are calculated by replacing conventional bilateral total gross trade weights with value-added weights. IOREERs, instead, take into account bilateral trade in intermediates and attach a lower weight to partners that provide a sizeable share of inputs in a country’s production in order to account for the fact that an appreciation vis-à-vis such trading partners may actually be beneficial to the competitiveness of the importing country as it reduces the cost of production.^[62]

Although GVC weights are highly correlated with gross trade weights, their absolute differences are non-negligible. Table 1 reports the correlation coefficients between GVC-based trade weights (i.e. the share of each trading partner in the total trade of any given country) and conventional trade weights. On first inspection, the different weights look highly correlated for the majority of countries, with the exception of some small countries (Lithuania, Luxembourg and Slovakia), which have a correlation coefficient below 0.8. However, despite the high degree of correlation, absolute differences between GVC weights and conventional trade weights are substantial. In order to illustrate this, Chart 2 shows for each country the average of the absolute percentage deviations of its trading partners’ value-added and input-output-based trade weights from conventional trade weights. It turns out that in most cases value-added and input-output-based trade weights on average deviate by around 50% from the conventional trade weights and, in some cases, the average absolute percentage deviation is even higher than 100%.

An interesting finding is that the GVC REERs show larger changes in price competitiveness for the euro area countries that were most affected by the crisis, thus suggesting that they might have been useful in the detection of pre-crisis country vulnerabilities. Across euro area countries, a comparison of the dynamics of GVC REERs with conventional REERs delivers broadly consistent messages. In the case of the euro area countries most affected by the crisis, however, the evolution of REERs (see the examples of Spain and Portugal in Chart 3) shows that both the VAREER and, to a larger extent, the IOREER measures point to stronger losses in competitiveness in the years preceding the crisis and, correspondingly, larger gains in the post-crisis period. In macroeconomic analysis it would thus be beneficial to look at GVC REERs, which could provide useful complementary insights into competitiveness developments.

2.2 Global value chains and export market shares

With GVC integration, gross exports might not gauge a country’s international contribution to trade in terms of value added. As intermediate inputs cross borders several times within production chains, tracing value-added flows can be crucial for the assessment of the effective contribution of a country to the world market. Input-output data can be used in order to gather information on countries’ value-added structures^[63] and can be complemented with trade price data in order to investigate the price and non-price factors behind the evolution of market shares.

Value-added and gross trade shares broadly deliver the same trends in market shares for the period 2000-14. Chart 4 compares changes in market shares of value added in exports of goods (called “value-added market shares” for simplicity) with conventional global market shares based on gross exports of goods.^[64] Both measures point to substantial gains in market shares for CEE euro area countries and corresponding losses for most non-CEE euro area countries. Less pronounced gains in terms of value added compared with gross trade in Slovenia and Slovakia can be explained by the outsourcing to these countries of the final assembly of motor vehicles by Germany, France and Italy. A similar trend is observed in the manufacturing of food products, chemical products and wood products outsourced from Finland, Sweden and Germany to Lithuania and Latvia. Estonia shares the above-mentioned tendencies of the other Baltic countries, while larger gains in terms of value added are driven by the reduced outsourcing of electronic production from Finland.^[65]

The decomposition of the determinants of the changes in global market shares suggests that the international fragmentation of production plays a non-negligible role in the shifts of market shares (Chart 5). Changes in global value-added market shares can be decomposed into shifts in production chains, the variation of price factors and the change of residual non-price factors which can be thought of as being related to product quality and consumers’ tastes.^[66] The decomposition is done at the very detailed product level which makes it possible to control for differences in market conditions. First, the elasticity of real trade flows to changes in relative prices is estimated for every product on every geographical market. Taken together with the information on the changes in unit values, it provides the contribution of price and cost factors at a disaggregated level. Then, the aggregate contribution of price competitiveness is obtained. To account for the fact that each product contains value added from various countries, the aggregation uses weights calculated from trade in value added (rather than gross trade, as in the conventional REER). Moreover, a specific term accounting for shifts in global value chains is introduced into the decomposition; it is calculated as the weighted growth in a country’s share in the production of all goods exported by all countries. The positive shift in production chains can be achieved either by a higher domestic content in a country’s own gross exports, or by a higher value-added share in third countries’ gross exports. Finally, the non-price competitiveness is measured as a residual term that is not explained by the above-mentioned factors.^[67]

Changes in GVC participation and outsourcing resulted in market share losses for non-CEE euro area countries (except for Portugal, Luxembourg, Malta and Cyprus) and gains for CEE euro area countries between 2000 and 2014 (Chart 5). At the same time, increases in quality and consumers’ preferences for CEE euro area countries’ products overcompensated for the losses in price competitiveness. Compared with gross export market shares, the decomposition considering value-added shares downplays the role of non-price competitiveness, since some part of quality gains and losses of the gross exports can be attributed to the outsourcing process.^[68] Thus, the analysis based on value-added shares enhances the role of cost and price factors.

In conclusion, using value-added flows instead of gross exports for the computation of global market shares improves the understanding of the drivers behind the external performances of euro area countries. Although both market shares follow similar trends, the decomposition of the value-added shares reveals the role of production outsourcing and provides a more precise contribution of price and non-price factors.

2.3 Global income elasticities of trade

While trade grew by twice as much as income over the period 1981-2007, the trade-to-GDP growth ratio fell to about unity in the period 2011-2014 (Chart 6). In particular, the drop in the ratio was driven by a collapse in trade flows following the Great Recession that was significantly stronger than the decline in global income.

The changing international fragmentation of production is one of the drivers of the trade growth dynamics in relation to income growth. Although (tariff and non-tariff-related) trade costs, trade openness and financial liberalisation have been important determinants of trade growth, the intensity of engagement in global value chains plays a key role in explaining the disproportionate growth of trade compared with income at the end of the last century and the unexpectedly sharp drop after the crisis. First, from a merely statistical point of view, the organisation of production chains implies that goods and services cross borders several times during the production process and are hence partly double-counted in customs trade flow statistics (see Figure A in Box 1). As a result, registered gross trade flows exceed the effective value added of trade flows (Chart 7). Second, trade in global value chains is mainly in durable goods, which are known to have a high income elasticity, explaining the steepness of the trade reaction in the global crisis. Third, supply chain effects might intensify negative demand shocks, as downstream firms would initially cut inventories, affecting input providers.

GVC participation helps to explain significant variations in the global trade-income elasticity. Regression results based on a standard import demand model^[69] augmented by a GVC participation index show that global value chains have a significant impact on import elasticities. Moreover, the decomposition of the income elasticity of trade for the period 1995-2011 shows that the contribution of global value chains has been about 40% on average.^[70] However, recent data on GVC integration indicate a flattening trend in recent years^[71] and this translates into a negative contribution of global value chains to the global income elasticity of trade for the period 2012-13 (Chart 8).

The results of this analysis suggest that GVC dynamics are relevant for medium-term trade projections. From a euro area policy perspective, the decline in GVC participation was one of the factors explaining recent downward revisions to the global income elasticity of trade.^[72] Going forward, a close monitoring of GVC dynamics is warranted to ensure consistent trade projections.

3 Other implications of cross-country production linkages for macroeconomic analysis

3.1 Sectoral spillovers via global production linkages

Production linkages are a potential channel for real economic activity spillovers. ^[73] Firms and sectors are increasingly sourcing or selling their inputs across borders and production processes are broken down in such a way that value is added in each step. This section utilises the World Input-Output Database to investigate empirically how production linkages give rise to real activity spillovers and to establish which characteristics of the network are relevant for the transmission of spillovers. Chart 9 reports correlation coefficients of sectors’ growth in real value added at a given distance^[74] in the input-output network. It shows that because sectors are more closely connected with each other through trade in intermediate inputs, their value-added growth is more correlated. As a recent strand of literature^[75] has shown, shocks to specific firms or sectors transmit through production networks and might potentially translate into aggregate macroeconomic disturbances.

The presence of hub sectors is relevant for the transmission of economic shocks as they connect otherwise unrelated entities through input-output linkages and could act as a conductor of shocks. In the World Input-Output Database^[76] the upstream hubs (i.e. sectors that supply inputs to other sectors) are mostly located in the United States, the United Kingdom, Germany and Russia, and operate in sectors such as computer activity, headquarter activity, R&D, finance and raw materials. As regards the downstream part of the value chain (i.e. sectors that purchase inputs from other sectors), the hubs are transport equipment, electronics, construction and basic metals in Germany, the United States and more recently China. Box 2 focuses on the spillover effects originating in some of these sectors.

Activity spills over via these sectors to many other trading partners. A panel econometric analysis of the WIOD data confirms that, on average, spillovers to a sector stemming from other upstream and downstream sectors involved in its production chains are significant.^[77]

Overall, this analysis suggests that there is significant scope for propagation of sectoral shocks through global supply chains. As hub sectors could potentially be the channel of transmission across countries and sectors, particular attention should be paid to their developments and their links with other sectors in the global economy.

3.2 The impact of global value chains on labour value added, hours worked and compensation

Between 1997 and 2011 unskilled labour’s value-added share in the euro area has substantially declined, whereas skilled labour’s share has increased. Aggregating sectoral data at the country level helps to disentangle the evolution of the labour value-added contribution for different skill groups within the euro area.^[81] The overall importance of labour in both euro area output and exports decreased slightly from 1997 to 2011. Among the five largest euro area economies, Germany is characterised by the highest shares of labour value added. Euro area exports contain significantly less labour value added than gross output, revealing that exporting firms rely more heavily on imported inputs and/or capital (Chart 10). With regard to the skill mix, skilled labour has captured a growing part of labour value added at the expense of unskilled labour.

Trade in global value chains changes the scope of tasks being performed in each industry, possibly affecting the skill mix and compensation within sectors. The changes to production processes and input choices related to international production segmentation in the past decades could have affected the level of employment and compensation per hour for different types of workers. Therefore, there is a need to assess the relationship between recent labour market developments and different measures of GVC participation across different sectors and for different skill groups.

Estimation results using within-sector changes show that participation in global value chains may be associated with a shift towards high-skilled labour. ^[82] A panel fixed-effects estimation shows that participation in global value chains is associated with a change in the skill composition within sectors characterised by a shift towards high-skilled workers (Chart 11, panel a).^[83] When disentangling the effect between backward and forward-looking participation indices, this effect is mainly driven by an increased usage of imported inputs.^[84] Such a job polarisation might be related to a combination of both offshoring and skill-biased technical change at the sectoral level.

Turning to wages, panel analysis shows that backward participation in global value chains is associated with an increase in hourly compensation for all skill groups (Chart 11, panel b). Both high and low-skilled workers experience an increase in their hourly compensation when the sector they are working in sees an increase in the foreign value added embedded in its exports (backward participation).^[85] This result is supported by existing studies that show that imported inputs generate important productivity effects, through channels involving learning, innovation, and variety or quality aspects.^[86] While an increased share of imported inputs in the production process might benefit total factor productivity and hence potential output,^[87] competitiveness would improve only when productivity increases faster than input costs (wages and the rental rate of capital). A number of firm-level studies find a positive net effect of imported inputs on external competitiveness, hence enabling entry into new export markets.^[88] Moreover, the strengthening of global value chains has the potential to weaken the elasticity of exports to the exchange rate, for example if exports are increasingly made of inputs bought in foreign currencies.^[89]

This analysis suggests that global value chains have an impact on labour market outcomes. A greater share of imported inputs in production may be associated with a shift towards high-skilled labour. Foreign inputs could raise wages for all skill groups. At the same time, global value chains may have positive welfare implications for the participating economies, namely technological advancement following the more efficient allocation of workers to high-skilled tasks which also implies higher wages in advanced economies, on the one hand, and increased salaries for workers in emerging economies, on the other.^[90]

4 Conclusions

Euro area countries are heavily involved in global production chains. This has an impact on some key macroeconomic indicators. It is therefore essential to consider global value chains when dealing with certain macroeconomic concepts. More specifically:

• Measures of competitiveness which account for the presence of global value chains, such as value-added and input-output REERs, portray different pictures regarding episodes of currency appreciation/depreciation compared with conventional REERs.
• Although shifts in production chains are not a major determinant of the change in global market shares of euro area countries, taking into account global value chains helps to understand the drivers of competitiveness.
• Developments in global value chains have played a role in the accelerating and then decelerating dynamics of the elasticity of trade to global demand over the past decades. To the extent that the high responsiveness of trade to income – which was observed before the crisis also as a result of the expansion of global value chains – is no longer observed in the future, a lower elasticity of trade to income could be regarded as the “new normal”.

Firms’ and sectors’ involvement in production chains creates cross-country interlinkages. This has a bearing on the analysis of macroeconomic spillovers:

• Real spillovers via input-output linkages occur and certain sectors may play a key role in their transmission. Moreover, production chains are a channel for foreign and domestic technological transfer to non-frontier firms, which takes place through the technology that is embedded in imported intermediate products.
• Finally, sectors increasing their involvement in global value chains tend to hire a higher share of high-skilled workers and show systematically higher wages for any given skill level. In particular, sectors located downstream in the value chain see a positive effect on wages from using more foreign inputs.

Statistics

http://www.ecb.europa.eu/pub/pdf/ecbu/EB_1708_Statistical_Annex_final.pdf

Abbreviations

Countries

Countries

BE Belgium

BG Bulgaria

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

IE Ireland

GR Greece

ES Spain

FR France

HR Croatia

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL Netherlands

AT Austria

PL Poland

PT Portugal

RO Romania

SI Slovenia

SK Slovakia

FI Finland

SE Sweden

UK United Kingdom

US United States

In accordance with EU practice, the EU Member States are listed in this report using the alphabetical order of the country names in the national languages.

Others

Conventions used in the tables

“-” data do not exist/data are not applicable

“.” data are not yet available