The Stability and Growth Pact – Status 2007

Marianne C. Koch, International Relations

INTRODUCTION AND SUMMARY

The Stability and Growth Pact is at the heart of the EU's budgetary surveillance of the member states. The surveillance spans the short term in the excessive deficit procedure, the medium term in the medium-term objectives, and the long term in the long-term fiscal sustainability analyses. This article describes the most important developments and tendencies in the EU's budgetary surveillance in 2006, focusing on the experience so far with the Stability and Growth Pact after the 2005 reform.

The European economies made strong economic progress in 2006. This has influenced the EU member states' budgetary positions, which in most cases improved considerably in 2006. The strong economic growth enabled a number of member states that are subject to the excessive deficit procedure to reduce their deficits to below the 3-per-cent limit in 2006. For four of these member states, the procedure is expected to be abrogated in 2007. The number of member states subject to the excessive deficit procedure is thus likely to be reduced substantially during 2007.

In the medium term, the structural adjustment in relation to the medium-term objectives was insufficient in 2006, especially in view of the economic situation. The planned structural adjustments up to 2009 are on a par with the adjustment realised during the previous upswing at the end of the 1990s. However, this should be viewed in conjunction with the lower levels of budget deficits in the period 2006-09 when cyclical effects are taken into account. Since the adjustments are solely planned adjustments, the objective of consolidation in good times, and the reformed Stability and Growth Pact as such, will only be put to the test in the coming years.

In a long-term perspective, demographic changes will put considerable strain on the government finances of many EU member states. The European Commission's quantification of the long-term sustainability of government finances has increased focus on the need for budget consolidation and structural reform of the labour market, and of pension and healthcare systems.

GOVERNMENT FINANCES IN 2006

The cyclical development was positive in 2006, and the EU's GDP growth of 3.0 per cent was the highest for six years. The economic development impacted on the government budgets of the EU member states, which generally improved in 2006. Overall, the EU's budget deficit was thus reduced to 1.7 per cent of GDP in 2006, from 2.4 per cent in 2005, while the euro area's budget deficit decreased from 2.5 per cent in 2005 to 1.6 per cent in 2006.

Growth took a more favourable course in 2006 than was expected at the beginning of the year. As a result, most member states achieved a more positive budgetary development than expected when they presented their stability and convergence programmes at the beginning of 2006, cf. Chart 1. A total of 22 member states achieved more favourable budgetary developments in 2006 than expected at the beginning of the year. For these member states, the improvement can predominantly be attributed to higher revenue in view of larger output growth than expected.

Romania and Hungary are the only member states with an actual deterioration in their budgetary situations compared to the expected level. The deterioration was strongest in Hungary, whose budget deficit increased by around 3 per cent of GDP to 9.2 per cent of GDP.^[1]

Romania joined the EU on 1 January 2007 and in 2006, Romania's budget deficit was 1.9 per cent of GDP, and its government debt equivalent to 12.4 per cent of GDP. Romania's government finances thus initially comply with the Treaty and the Stability and Growth Pact.^[2] This is also the case for the other new EU member state, Bulgaria, which in 2006 posted a budget surplus of 3.3 per cent of GDP and government debt of 22.8 per cent of GDP. Economic growth is very strong in both member states, although their level of prosperity is only around one third of the EU level. Catching up with the rest of the EU is therefore the primary medium-term objective of both member states.

The cyclical upswing in the EU is expected to continue unabated in 2007. The budget consolidation is expected to follow suit. In its spring forecast, the European Commission expects the budget deficit of the EU member states to decline further to 1.2 per cent of GDP in 2007, while the euro area's budget deficit is expected to be reduced to 1 per cent of GDP, cf. the Appendix Table.

THE EXCESSIVE DEFICIT PROCEDURE

The excessive deficit procedure is a key element of the Stability and Growth Pact, which is the framework for the budgetary surveillance of the EU member states. The Pact can be divided into a " corrective arm" and a " preventive arm" . The corrective arm consists primarily of the excessive deficit procedure, while the preventive arm focuses on the member states' medium-term budget adjustments, cf. below. The central element of the excessive deficit procedure is that a member state's budget deficit may not exceed the Treaty-bound limit of 3 per cent of GDP. If this limit is exceeded, the excessive deficit procedure is initiated for the member state, and the EU's fiscal surveillance is intensified until the member state succeeds in reducing its budget deficit to below the 3-per-cent limit.^[3]

In most of the ten member states that were subject to the excessive deficit procedure at the beginning of May, the upswing has resulted in lower budget deficits. A number of member states thus reduced their budget deficits to below the 3-per-cent limit in 2006, several of them earlier than expected. The number of member states subject to the excessive deficit procedure is expected to decline in the coming months. Only the budgetary positions of Hungary, Slovakia and Italy deteriorated in 2006. Since the increased budget deficits of both Slovakia and Italy can be attributed primarily to one-off effects, Hungary is the only member state in the group subject to the excessive deficit procedure whose government finances actually deteriorated in 2006.

Budget deficits reduced to below 3 per cent in several member states
A consequence of the surprisingly high growth in 2006 is that a number of member states have reduced their budget deficits to below the 3-per-cent limit. For the two member states, Cyprus and France, that had a deadline for correction of their budget deficits in 2005, the procedure was abrogated in respectively July 2006 and January 2007. A further five member states reduced their budget deficits to below the 3-per-cent limit in 2006. The combination of the current favourable cyclical position and several member states' deadline for correction in 2006/2007 means that the number of member states subject to the excessive deficit procedure can already be considerably reduced in 2007. This tendency is expected to continue in the coming years.

Cyprus reduced its budget deficit to 2.3 per cent of GDP in 2005, from 6.3 per cent of GDP in 2003. Since the measures implemented by Cyprus

were predominantly of a permanent nature, the Ecofin Council in July 2006 decided to abrogate the excessive deficit procedure for Cyprus.^[4] For France, stringent interpretation of the rules of the Stability and Growth Pact delayed abrogation, even though France reduced its budget deficit to 2.9 per cent of GDP in 2005.^[5] To some extent the consolidation could be attributed to one-off measures (0.6 per cent of GDP), and in its spring 2006 forecast the Commission expected the deficit to increase to 3.0 per cent in 2006. As a result, the abrogation of the excessive deficit procedure had to await clear signs of a sustainable reduction of the deficit. Since the Commission's autumn forecast from November 2006 showed a downward trend for the budget deficit up to 2008, in January 2007 France was removed from the excessive deficit procedure. The example of France confirms the stringent interpretation of the Stability and Growth Pact in that the excessive deficit procedure was applied for an extended period to a large member state with a prolonged and relatively difficult course^[6] in the procedure.

For a number of other member states the procedure is expected to be abrogated in the near term. Greece, Malta and the UK, that are subject to deadlines for correction of the budget deficit in 2006 and 2006/07, have reduced their budget deficits to below the 3-per-cent limit in 2006.

Germany and the Czech Republic are subject to deadlines for correction of their budget deficits in respectively 2007 and 2008. In 2006, both member states also reduced their budget deficits to below the 3-per-cent limit. Expectations of Germany's budget deficit in 2006 have been subject to ongoing downward adjustment. The most recent data showed a budget deficit of 1.7 per cent in 2006, which is well below the 3-per-cent limit. After a rather turbulent process, which started in 2003, the procedure is now already likely to be abrogated for Germany in 2007, which is one year ahead of the deadline. The abrogation of the excessive deficit procedure for first France, and in the near future, Germany is important to the credibility of the reformed Stability and Growth Pact. With a budget deficit of 2.9 per cent in 2006, the Czech Republic also reduced its budget deficit to below 3 per cent of GDP. The European Commission expects the Czech Republic's budget deficit to exceed the 3-per-cent limit again in 2007, however.

A record-high budget deficit in Hungary
In 2006, the strong deterioration in Hungary's budget balance was a notable exception from the positive budgetary course in the other EU member states. Hungary has been subject to the excessive deficit procedure since July 2004, i.e. immediately after it joined the EU. Nevertheless, the budgetary situation has deteriorated strongly in recent years, and Hungary's budget deficit of 9.2 per cent of GDP in 2006 was clearly the highest in the EU. Hungary had already received two recommendations to reduce its budget deficit by 2008,^[7] but during 2006 Hungary's attitude changed. Previously, Hungary in practice ignored the recommendations of the Ecofin Council, but in 2006, after receiving the third Council recommendation to correct its deficit, Hungary made a commitment to comply with the EU requirements.

Hungary's updated convergence programme from October 2006 contained an ambitious consolidation plan, including structural adjustment measures equivalent to almost 7 per cent of GDP in the period from 2006 to 2009. Hungary already initiated its consolidation process in the summer of 2006 with a reform package aimed at reducing the budget deficit by the equivalent of 1.5 per cent of GDP in 2006, and with considerable savings into 2007. Furthermore, an announced tax package including tax cuts was postponed, and a number of taxes, including VAT and corporation tax, were raised instead, while the basis for personal taxation was expanded.

Other member states subject to the excessive deficit procedure
Besides Hungary, only four other member states subject to the excessive deficit procedure posted budget deficits above the 3-per-cent limit in 2006. For Italy, Poland and Slovakia, the deadline for correction of their budget deficits is 2007, while Portugal's deadline is 2008. So far, the consolidation measures of Italy and Slovakia have been found adequate, and in its spring forecast the Commission expects the two member states' budget deficits to fall below the 3-per-cent limit in 2007. On the other hand, Poland's measures have been found to be insufficient to reduce the budget deficit.^[8] Poland's budget deficit amounted to 3.9 per cent of GDP in 2006. In 2007, the deficit is expected to remain above the 3-per-cent limit, at 3.4 per cent of GDP. However, Poland expects to meet the conditions for the Commission's application of a special rule on the compilation of costs in connection with pension reforms.^[9] In 2007, the pension share will amount to 1.2 per cent of GDP, but the Commission finds that it is too soon to determine whether Poland meets the conditions for incorporation of this in the assessment of the budget deficit. In the spring forecast from May, the Commission expects Poland's budget deficit to exceed 3 per cent of GDP also in 2008.

OBSERVANCE OF THE MEDIUM-TERM OBJECTIVES

The more long-term prevention of high budget deficits is at the core of the preventive arm of the Stability and Growth Pact. According to the preventive elements, EU member states should pursue a structural balance close to balance or in surplus in the medium term. The structural balance is the budget deficit excluding one-off and cyclical effects. The objective of the preventive arm is to help the member states to avoid exceeding the 3-per-cent limit. The member states thus have structural medium-term objectives for their budgets.

The 2005 reform of the Stability and Growth Pact^[10] introduced differentiation of these medium-term objectives, which are now determined by the individual member states on the basis of the member state's government debt and potential growth.^[11]

More stringent rules apply to euro area and ERM II member states. Such member states with low debt or high potential growth may have a structural medium-term budget-deficit objective of up to 1 per cent of GDP, while member states with high debt or low potential growth must still pursue the objective of balance or surplus in the medium term. Furthermore, according to the preventive arm of the Pact, member states that have not yet achieved their medium-term objectives must make annual structural adjustments – for euro area and ERM II member states equivalent to at least 0.5 percentage points. More extensive structural adjustment is furthermore expected in an upswing (" good times" ). In addition, the Pact stipulates that the member states must avoid conducting procyclical policies, i.e. expansionary fiscal policy in periods of high growth.

The key issues in relation to the preventive arm of the Stability and Growth Pact are thus whether the member states observe their individual medium-term objectives, and whether they take adequate structural adjustment measures in the event of non-observance of their medium-term objectives.

Medium-term objectives – determination and observance
Differentiation of medium-term objectives was a key element of the reform of the preventive arm of the Stability and Growth Pact. When member states determined their individual medium-term objectives for the first time in their updated stability and convergence programmes 2005/06, the medium-term objectives were set in accordance with the principles of the Pact. According to the Commission, in the determination of the medium-term objectives there was a tendency for the level of debt to be given relatively higher weight than the potential growth.^[12]

In the latest update, most member states held their medium-term objectives unchanged. Only Hungary and Finland made changes, and to more ambitious medium-term objectives. In 2005, eight member states already observed their structural balance objectives, and this number was unchanged in 2006. During the programme period, 18 member states plan to observe their medium-term objectives, but the Commission points to some uncertainty in the forecasts towards the end of the programme period for a number of member states.

Structural adjustment in "good times"
In 2006, a number of member states failed to observe their medium-term objectives, and are thus subject to the structural adjustment requirement. In view of the favourable economic development in 2006 for most EU member states, 2006 was an opportunity to make structural improvements to government finances. Overall, the Commission found the structural adjustment measures in 2006 to be insufficient, and not in compliance with the required adjustment in " good times" .

To achieve more specific conclusions regarding the member states' compliance with the structural adjustment requirement, the EU member states are divided into three groups: member states subject to the excessive deficit procedure; other member states not observing their medium-term objectives; and member states that observed their medium-term objectives in 2006. In the updated stability and convergence programmes 2006/07, the three country groups are on average far from achieving the adjustment of 0.5 percentage points in 2006 required of most member states, cf. Chart 3.

In 2006, the member states subject to the excessive deficit procedure^[13] implemented moderate structural adjustment measures, but as from 2007 on average plan structural improvements exceeding 0.5 percentage points. However, the aggregate structural adjustment by this group is strongly influenced by the deterioration in Hungary's structural balance in 2006, while Hungary's planned ambitious consolidation measures from 2007 have a positive impact on the group.

The other member states not observing their medium-term objectives are primarily euro area and ERM II member states.^[14] Deterioration in the structural budget balance by an average of 0.5 per cent of GDP in 2006 is therefore far from compliance with the rules of the Pact. Cyprus and France were the only member states in the group to have undertaken positive structural adjustment, while especially Luxembourg and Latvia, along with Lithuania and Austria, had the opposite effect on the group. However, the member states plan to implement some adjustment measures in 2007.

The member states that observe their medium-term objectives plan a considerable deterioration in their structural budget balance, especially in 2007. A number of these member states, including Bulgaria, Estonia, the Netherlands, Ireland and Sweden, are thus at risk of conducting procyclical policies as a result of their easing of fiscal policy during an upswing.

All groups will step up their structural adjustment, but full compliance with the minimum requirements of the Stability and Growth Pact by all of the groups is not expected until 2009. Acknowledging that, in the light of the favourable economic development, the planned measures could be more ambitious, the euro area member states have, via the Eurogroup, committed to a higher degree of compliance with the structural adjustment requirements in the coming years. At the same time, the euro area member states that have achieved their medium-term objectives have committed to avoiding macroeconomic imbalances. This should be viewed as an obligation to maintain sound government finances and avoid procyclical measures.

Experience with the reformed Pact – status
One intention of the reform of the Stability and Growth Pact was to increase focus on the preventive arm. The limited structural progress in 2006 does not necessarily mean that the reform has failed to function as intended. The economic outlook has improved throughout the year, which has impeded the advance planning of further consolidation measures. For example, in the autumn of 2005 the Commission assessed that, in view of weak economic growth, the EU member states would only be able to reduce their budget deficits a little in 2006.

In the period 1998-2001, with average growth of 2.9 per cent, the overall cyclically-adjusted budget deficit improved by 0.3 per cent of GDP. In the period 2006-09, with an average expected growth rate of around 2.6 per cent, the target adjustment is 0.24 per cent of GDP.^[15] The budgetary adjustments in the programme period are thus at the level of the adjustment during the previous upswing, but the level of the member states' corrected budget deficits in 2006 and over the programme period is considerably lower. Since the adjustments in 2006-09 are solely planned adjustments, the objective of consolidation in good times, and the reformed Stability and Growth Pact, will only be put to the test in coming years, when the favourable economic trends are expected to continue. The importance of the reformed Stability and Growth Pact should therefore not be disregarded on the basis of the relatively limited adjustment progress in 2006.

LONG-TERM FISCAL SUSTAINABILITY

The EU's fiscal surveillance also includes long-term assessment of the member states' economic policies. The EU member states face a considerable challenge in coming years, when changing demographic structures will put a strain on government finances, particularly in the pension and healthcare areas. The Commission's October 2006 report on fiscal sustainability in the EU member states estimated an increase in expenditure related to the ageing population by around 4 per cent of GDP up to 2050. According to the Commission, the budgetary development in 2006 did not change this overall conclusion. ^[16]

The surveillance of long-term fiscal sustainability is based on projections of the member states' age-related government expenditure and the fiscal-policy strategies presented in the stability and convergence programmes. Fiscal sustainability is traditionally assessed over an infinite horizon.^[17] However, this restricts the outlook for political purposes, where a finite horizon is more relevant, particularly in relation to the formulation of political recommendations. For sustainability analysis purposes, the EU has thus calculated a sustainability indicator based on compliance with the limit for government debt of 60 per cent of GDP by 2050.^[18]  

The member states' readiness to address the increased strain on government finances in the coming years varies considerably, as reflected in the Commission's classification of the member states into low-, medium- and high-risk groups, cf. Chart 4.

For just under half of the EU member states,^[19] significant adjustment by more than 2 per cent of GDP is required for compliance with the 60-per-cent limit in 2050. The situation is particularly serious in Hungary, but Portugal is also regarded as a member state with considerable sustainability difficulties. In both member states, government debt exceeding the 60-per-cent limit and a high budget deficit are straining current government finances. The age-related expenditure is also considerably above the EU average. In 2006, both Hungary and Portugal took steps to reduce the long-term costs. While Hungary's pension measures are of an introductory nature, the Commission finds that in the coming decades Portugal's pension reform will significantly reduce the age-related cost burden. Consequently, less adjustment is required in Portugal, but both member states still face substantial challenges, cf. Chart 4.

While the classification of Hungary and to a certain extent Portugal as high-risk member states is attributable both to their unfavourable initial budgetary position and the rising age-related expenditure, the budgetary outlook for Cyprus, Slovenia and the Czech Republic is characterised by high future age-related expenditure. Age-related expenditure in Luxembourg is also expected to increase considerably in the coming years. However, due to low government debt and large savings resources in the social security system, corresponding to 25 per cent of GDP, Luxembourg is to a certain extent prepared for the demographic changes. Luxembourg is therefore classified as a medium-risk member state in terms of fiscal sustainability.

The Nordic countries, together with Estonia, on the other hand, are characterised by sound government finances and are classified by the Commission as low-risk member states in terms of fiscal sustainability. Despite its rather unfavourable starting position, Poland is classified as a low-risk member state, because the Commission expects Poland's age-related expenditure to decline up to 2050 due to extensive pension reforms.

The remaining member states face relatively moderate sustainability problems, in most cases related to the combination of a less favourable starting position and a certain age-related strain on government finances in the longer term.