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Keynote address by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the ACI Financial Markets Association South Africa, Johannesburg, 6 September 2022. | Keynote address by Dr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the ACI Financial Markets Association South Africa Seeing like a central bank: the SARB, supply shocks, and the logic of higher interest rates in a world of low economic growth 6 September 2022 Introduction Good evening, ladies and gentlemen. The South African Reserve Bank (SARB) has increased the repurchase (repo) rate at each Monetary Policy Committee (MPC) meeting since November of last year; our most recent move was 75 basis points, to 5.5%. We are raising rates in the context of higher inflation, with headline inflation currently at 7.8% − well above the 6% upper bound of our target range. I hear many questions about why we are raising rates, seeing that inflation is driven primarily by supply shocks in the form of higher global food and oil prices, while demand pressures in the economy are limited. I hope to explain today how central bankers think about what tools they have at their disposal in these circumstances. In so doing, I would like to make two points. First, we are aware of the role of supply shocks in driving inflation, and we understand that monetary policy cannot cancel out something like a sudden food price shock. The task we set ourselves on the MPC is different. Our objective is to look past the immediate supply shock, focus on the period after it has subsided, and ensure inflation stabilises at that point. I will discuss what factors we consider in pursuit of that goal. Page 1 of 8 Second, we are starting from a point of very low interest rates. During the onset of the COVID-19 pandemic, we cut the repo rate to a record low of 3.5%. This was the right thing to do at the time, but rates could not stay that low forever. Economic conditions have changed since 2020. We therefore need to think about the appropriate level of interest rates, given how inflation and growth risks have evolved, particularly in the past few months. One issue that I hope gets clarified by the end of my talk is that one cannot just look at the change in our interest rates from one MPC meeting to another, in isolation. The level of the interest rate is also important in our thinking – and more specifically, the level relative to what economists call the ‘neutral rate’. Supply shocks and demand shocks in monetary theory Let me start with some theory about how monetary policy should respond to different sources of inflation. It is well known, by central bankers and academics alike, that monetary policy works best when managing demand-side inflation pressures. For instance, higher interest rates can cool off an overheating economy, aligning demand for goods and services with supply. However, we rarely find ourselves in this position in South Africa. Apart from the boom of the late 2000s, and arguably the period around the 2013 taper tantrum, the inflation-targeting era has not featured many episodes of overheating. Instead, we often have to think about managing sticky inflation as we confront multiple supply-side shocks in the context of subdued economic growth or slack in the economy. Very few countries, to my knowledge, currently face pure demand-side inflation. But there are, across the world, variations among different economies that have different implications for their monetary policy response. I would distinguish two sets of countries. In the first category, inflationary pressures reflect both demand and supply factors. I would say that the United States (US) and the United Kingdom (UK) currently fall in this category. In other words, one source of inflation is supply chain-related shortages, aggravated by increases in oil and food prices because of the Russian war against Ukraine. But, given the scale of monetary easing and significant fiscal stimulus in response to the COVID-19 pandemic, these economies have not only recovered from the pandemic but have seen Page 2 of 8 demand-side pressures, particularly in the goods market, relative to services. Demand-side pressures mean that monetary policy can play an important role in constraining demand, in interest rate-sensitive sectors, to bring inflation back to policy targets. In the second category, some countries are currently subject to supply-side shocks similar to those of the US and UK but with no significant demand-side pressures, other than a modest recovery from the pandemic. There is typically some evidence of higher inflation, frequently from a low base, but by and large there is still slack in the economy. This, I would argue, aptly describes a country like South Africa as well as a few other emerging markets. In these circumstances, the textbook says you should try to look through the first-round effects of the supply shock and focus on the second-round effects. The fundamental question is whether the effects of the shock will be temporary or persistent. Central banks should ignore temporary effects, but if they ignore persistent effects, that would be a policy mistake, creating substantially more inflation than can be explained by the supply shock itself. This point cannot be emphasised enough. The goal of ensuring that inflation does not go well beyond the inevitable price rise called for by the supply shock, through second-round effects, largely explains why the MPC has to respond despite low demand pressures. To take a simple example, imagine an economy where there is a small supply shock, such as a modest increase in world oil prices. The central bank observes inflation somewhat above target in the near term. However, other items in the inflation basket remain stable, so the price increase is confined to fuel and immediately related items such as transport. Firms, households and workers do not change their views of inflation, except for the near term. Wage settlement rates do not pick up and firms do not seem to be raising mark-ups. Financial markets do not start to price more inflation compensation into instruments such as government bonds. In these circumstances, it is an easy choice for the central bank to rely on its credibility and make no policy changes. Inflation will very likely return to target after a year without further action. Of course, not all policy decisions are so easy. They become harder when the shocks are large and persistent, or when there are multiple overlapping shocks. It is also not always straightforward to determine, given data lags, if inflationary pressures are broadening. There are no definitive sources you can trust for early warning. At the same time, it can be dangerous to wait too long for perfect information because delays can make the problem Page 3 of 8 worse. Furthermore, it is never clear how much credibility one has until you have lost it. These situations pose some of the most challenging balancing acts for monetary policy. What are the data telling us? Let me now put aside the textbook and talk about our real-world decisions. As we went into the July MPC, we were confronted with tighter global financial conditions or higher global funding costs for countries like South Africa. In addition, we faced lower global economic growth projections due to factors that included slower growth in China, the continuing war in Ukraine, necessary monetary policy tightening synchronised across the world, and the tapering of commodity prices. While growth globally has been revised downwards, inflation has been revised upwards in most countries and has turned out to be more persistent. Inflation is expected to be above targets in most advanced and emerging market economies, both this year and next year. South Africa has not escaped these trends. At our recent MPC meeting, apart from a marginal upward revision of growth for 2022, there was a downward revision for 2023 and 2024. At the same time, domestic inflation moved higher, primarily as a result of oil and food inflation. Headline inflation is now well above our 4.5% midpoint objective, and also outside the upper limit of our full 3−6% inflation target range. Our forecast indicates that we will be back below 6% around mid-2023, and we will reach the midpoint of our target only late in 2024. Core inflation, a measure which excludes food and energy, is just above the midpoint of our target range at 4.6%. However, it has been trending higher recently, and is expected to average well over 5% next year. This points to a broadening of inflationary pressures. Decomposing core inflation reveals a wide gap between core goods and services inflation, with the former sharply higher, largely reflecting imported inflation, while services price increases have remained relatively well contained. The trajectory of inflation expectations also provides evidence of potential second-round effects. When we look at different measures of inflation expectations, respondents – rationally – expect higher inflation this year. Unfortunately, respondents also expect inflation to stay higher in subsequent years than they did previously. For example, between the first Page 4 of 8 and second quarter of this year, the Bureau for Economic Research (BER) survey expectations for 2023 inflation have gone from 5.0% to 5.6%, and the 2024 expectations have gone from 5.0% to 5.4%. Less than a year ago, 2023 expectations were at 4.5%. 1 Given this evidence, it is not implausible to conclude that supply shock pressures are unlikely to go away by themselves. The difficult question, however, is just how persistent inflation will be. If expectations do not come back to our target, that means price setters will build in higher prices in their contracts. Similarly, demand for wages will go up, at least to maintain real living standards. What is critical for the MPC is to avoid this spiral, where prices go higher and higher just because everyone believes, for example, that the rand will be worth less and less in future. We need to assess how serious this spiral risk is, and then deliver a policy response strong enough to deal with this risk. There are two variables in this analysis − wages and the exchange rate − which are especially important, and I’d like to unpack these further. I will start with wages, or more generally, labour costs. These are important determinants of inflation as they are one of the biggest inputs to firms’ costs. That said, wages and inflation need not have a one-to-one relationship. If a firm has to pay more in wages, it can do several different things. In addition to raising prices, a firm can also reduce the number of workers it employs, perhaps buying more machinery so the remaining labour force is more productive, and the firms’ total wage bill is unchanged. This increases unemployment rather than inflation. A firm can also accept smaller profit margins, if it is profitable enough and if market conditions make it difficult to raise prices instead. But in difficult conditions, this jeopardises the survival of the firm. It is not the role of the MPC to dictate what wage earners should take home. This is a complex and firm-specific process, affected by factors such as productivity gains and firm profitability. But we do need to assess how broad labour income helps determine whether supply shocks, like the ones we are experiencing today, generate more inflation in the economy. 1 The 4.5% expectation is from the 2021Q3 survey. All these numbers represent the BER average of firms, analysts and unions. Page 5 of 8 One measure I consult closely, to help make this judgement, is unit labour costs (ULC), which is basically the total wage bill divided by gross domestic product (GDP). The growth rate of this measure shows how much nominal wages are rising for each unit of real economic output. This is a useful measure because it incorporates productivity effects and labour-shedding effects, unlike raw wage measures. The downside is that these statistics, like all labour market statistics, contain a lot of noise and are only available with a lag. These challenges are compounded by base effects from the COVID-19 shutdowns, which make the data more difficult to interpret. Nonetheless, the most recent annual numbers show that nominal ULCs came down from 2.8% in 2020 to 1.6% 2021 for the formal sector, excluding agriculture. Looking at the most recent quarterly numbers, this measure of ULC growth decreased to 3.6% for the first quarter of this year, down from 4.6% in the fourth quarter of last year. Alternative ULC measures show analogous trends. This suggests that wage pressure on inflation has been quite benign, to date, with ULC growth below the inflation rate. However, as we said in the MPC statement, there are still risks here that keep us alert. For instance, nominal wages are forecast to rise from 5.6% in 2022 to 7.3% in 2023. Furthermore, the latest Andrew Levy survey shows an acceleration in increases for collective bargaining agreements, and also a pick-up in wage-related strike action. Therefore, while we do not observe an actual wage-price spiral underway, to date, these recent developments warrant vigilance. Another variable of special interest for us is the exchange rate. The two big forces driving a weaker exchange rate for South Africa at the moment are weaker terms of trade as export commodity prices moderate, and higher policy rates in major economies – essentially a higher global risk-free rate. We have had very favourable commodity prices recently, and exceptionally low global rates. This helped us set very low interest rates. But now things are changing in the world, and South Africa, as a small open economy, has also had to adjust. Part of that adjustment has been a weaker exchange rate, which is why we have seen the rand at around R17 to the dollar lately, rather than R14 or so to the dollar, where we were a year ago. Another aspect of the problem, however, is a re-setting of global base rates. If we tried to make policy in a way that ignored higher global rates, we would see unpleasant Page 6 of 8 consequences, including through a weak rand, which would drive the costs of imported goods even higher. It would be a mistake to say we have to adopt tight policy to keep the rand strong. My point is more subtle: what counts as tight or loose policy is changing, as global rates rise. If we do not recalibrate our policy settings accordingly, we could wind up with destabilising policy, which would be bad for inflation and also bad for domestic demand. In a changing financial climate, as with other forms of climate change, adaptation is healthier than denial. Pulling all these factors together, I hope you will appreciate that there is more to our analysis than just assessing whether current inflation is driven by demand- or supply-side factors. We do not focus on current inflation; we focus on future inflation because monetary policy operates with a lag. And while we don’t see today’s elevated inflation going away next year, we also don’t yet see inflation running out of control. With that said, the supply shocks that are driving inflation are significant, and we are seeing increasing risks of potential secondround effects. This justifies a policy response, rather than no response. Calibrating the policy response Why hike in response to supply shocks, given the low growth environment? As I have explained, our assessment of inflation is quite nuanced. In matching this nuance, we do not perceive our choices as ‘hike’ or ‘don’t hike’. When we make repo decisions, rather than just deciding to go up or down, we think more about the level of the policy rate. More specifically, we consider the level of rates relative to a normal or neutral interest rate, defined as the rate which would neither slow down nor speed up the economy. We also think about these rates not just in nominal terms, but rather adjusted for inflation. Policymaking therefore centres on choosing a setting somewhere along a broad spectrum of real rates, with options ranging from very loose to very tight, and a wide range of choices between these extremes. This is the standard modern framework for monetary policy, as distilled, for instance, by scholars like Michael Woodford.2 As with the inflation analysis, using this framework is not simple and easy. We must estimate where neutral rates are, and there is no single best practice for adjusting the nominal rate for inflation. However, with a repo rate of 5.5% currently, and an inflation rate starting just The classic reference is Michael Woodford, Interest and prices, Princeton University Press: Princeton & Oxford, 2003. Page 7 of 8 over 7% and declining to just under 6% next year, we still clearly have a negative real policy rate. This rate was significantly more negative before the rate hike in July. Meanwhile, our estimated real neutral rate is in the region of 2%, so actual rates are still well below neutral. They would also be below neutral even with different, lower estimates of neutral. This means the policy stance is still supportive of growth. I’ve realised that most people do not use this model, so a 75 basis point hike reads as tight policy. But this is not a good description of actual policy. The fact that we have a gap between the standard practice of monetary economists and everyone else suggests we have a lot of work to do to improve our monetary policy communication. Conclusion To conclude, let me summarise the messages the MPC would like people to hear about monetary policy. We are not slamming the brakes on this economy, but we are easing off the accelerator, moving towards a more balanced or neutral interest rate setting. We do not want to slow the economy down too much, and we are cognisant of the many challenges facing domestic producers and consumers. At the same time, we also do not want to join the large group of countries in the world today which took low inflation for granted, kept policy too loose for too long and ended up way above their targets, to the great unhappiness of almost all citizens. It is a delicate balancing act, and as an independent central bank operating an inflation-targeting framework, we aim to deliver moderate interest rates and low and stable inflation over time in our policymaking decisions. Thank you. Page 8 of 8 | south african reserve bank | 2,022 | 10 |
Remarks by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Johannesburg Stock Exchange (JSE) and the New York Stock Exchange (NYSE) Market Close event, New York City, 10 October 2022. | Remarks by Lesetja Kganyago, Governor of the South African Reserve Bank, at the JSE/NYSE Market Close Event, New York, 10 October 2022 Good afternoon distinguished guests, investors, members of the media, South African delegates, and New York Stock Exchange representatives. It is a privilege to address you here today, following the signing of a new memorandum of understanding (MoU) between the Johannesburg Stock Exchange (JSE) and the New York Stock Exchange (NYSE). This new MoU will foster closer ties between the two markets, and is aimed at increasing economic partnerships and trade opportunities. It is encouraging that the JSE and NYSE will continue to explore new areas of cooperation and collaboration in strengthening their value propositions for their respective markets. South Africa shares significant economic interests with the United States (US). South Africa is the US’s largest African trading partner and has the most diversified and industrialised economy on the continent. Despite the rapid growth in Asian economies, the US remains one of South Africa’s top five main trading partners.1 In 2021, US exports to South Africa totalled US$5.5 billion − a 25.8% increase from 2020, while US imports from South Africa totalled US$15.7 billion − a 38.5% increase. There are approximately 600 US businesses operating in South Africa and many use South Details are available at http://www.dirco.gov.za/foreign/bilateral/usa.html Africa as their regional headquarters,2 and a springboard for greater opportunity on the African continent. These structural features of our economic relationship are stable and will certainly grow in the coming years. Nevertheless, the global economic environment is challenging and is likely to remain as such for the next year or so, as we all find our way out of the economic repercussions of the COVID-19 pandemic. Critical to shaping our path will be considered policies that seek to reduce volatility and uncertainty, and which aid the long-term investment that underpins sustainable economic growth. Let me focus briefly on the global economy and South Africa’s response. This is an unusually challenging time for the global macroeconomy. High inflation has now taken centre stage in the global debate on monetary policy, as prices continue to climb at rates last seen decades ago.3 We have seen major central banks raising interest rates at the fastest pace in a generation. The current inflation surge has its roots in the highly expansionary policy actions taken to minimise the adverse effects of the lockdowns. With the benefit of hindsight, these were too expansive and extended for too long. Coupled with supply chain disruptions due to COVID-19, and mobility restrictions, this caused a sharp increase in the demand for goods early in the recovery. Labour markets tightened as a result, while food and oil prices rose sharply. Price pressures have been worsened by Russia’s invasion of Ukraine, with the effects going beyond the direct impacts of the war on the prices of oil, food and industrial commodities. We are now looking at increased pressures for deglobalisation, at least some form of it, particularly supply chain realignments. Although there has been some cooling in energy and food prices over the past couple of weeks, and slower economic growth which could potentially further temper price pressures, the trajectory for inflation and its outlook remains highly uncertain. The Details are available at https://www.state.gov/u-s-relations-with-south-africa/ Inflation in major advanced economies has reached 8.3% in the US, 9.1% in the euro area and 9.9% in the United Kingdom. Data are all for August 2022, for consumer price inflation, year on year. broadening of inflationary pressures means that swift and decisive policy action has become imperative.4 Globally, central banks have responded.5 Like the global economy, the domestic economy has been hit by multiple and often overlapping shocks, some positive and some negative. For instance, the strong global growth in 2021 supported South Africa’s terms of trade, and thus its growth. Russia’s invasion of Ukraine provided impetus to South Africa’s commodity export prices, lifting growth in the first quarter of 2022. However, these positive global shocks are fading, shifting us back into more usual conditions. Our macroeconomic adjustment to the pandemic was greatly aided by low inflation and a strong terms of trade, which helped create the policy space to cut rates and provide fiscal support. Now, as the domestic recovery continues and global conditions suggest further easing of commodity prices, our external balances have begun to adjust back to deficits. This will bring into sharper focus the financing needs of the economy and the currency, both as a facilitator of economic adjustment and as a source of inflation risk.6 These changing global conditions impact on how we conduct monetary policy. From being in a position to cut rates deeply to support recovery, we are now in a very different environment. While it is the case that our inflation rate was fairly modest for a long time, it clearly has moved higher quickly, necessitating larger rate hikes to move out of an overly accommodative stance. The tightening of monetary conditions, from exceptionally easy to neutral, is matched by fiscal actions to achieve a primary surplus and reduce the rate of growth in the public debt. These consistent policy actions are critical to further de-risk the economy in these more challenging global conditions. Alongside a robust macroprudential regulatory environment, moving to a more neutral macroeconomic policy stance improves the risk-reward ratio for private sector investors, both foreign and domestic, 4 See Bank for International Settlements, Annual Economic Report, 2022. 5 The US Federal Reserve has raised the federal funds rate by a cumulative 300 basis points since March 2022. The European Central Bank has hiked rates by a cumulative 125 basis points since July 2022 and the Bank of England has also hiked aggressively in recent months. 6 The depreciation is largely on a bilateral basis, owing to the US dollar strength. On a nominal effective exchange rate (NEER) basis, the rand has only depreciated marginally. and will lead to stronger investment rates over time. Foreign and domestic capital have always played key roles in providing the financing of South Africa’s needs. In the years of the global financial crisis and in the early weeks of the pandemic, risk aversion resulted in the sale of rand assets by foreign investors. This was complemented by resident savers shifting out of their foreign asset holdings and back into rand assets. As the global and domestic economy become less risky in the coming months and years, the build-up of these financial positions will occur again. Foreign investors will re-enter South African markets (and other emerging markets) due to better real growth differentials and higher yields, while residents will rebuild diversified portfolios that include foreign assets. It is useful to remind ourselves that South Africa’s financial markets are deep and robust, and well integrated with world markets. Financial system assets are nearly 300% of GDP, roughly three times the emerging market average. We were reminded during the early days of the pandemic of the need for central banks to provide appropriate backstops to financial markets. We do not want to create a moral hazard, either in the public or private sectors, but we do want to step in where liquidity evaporates. As the Bank of England recently demonstrated, in a crisis a central bank has extraordinary abilities to stabilise conditions, buying time for markets to better read current conditions and to adjust. Strong countries have good emergency response systems, and in a real crisis the South African Reserve Bank was there to backstop the system and return it to normal functioning. Such extraordinary policy actions work best when the underlying financial structure is sound, in particular where the debt structure has a long maturity. This is an important reason why our yield curve is steep: long-term debt is genuinely being held, in volumes, by private investors, and it is priced accordingly. The point is: the news is in the price, and it is an attractive price. It is not an artificially low price, held down by policies that we cannot sustain or that are inconsistent with our economic conditions. There is another reason the prices of South African assets are attractive, and that is the exchange rate. As you know, in South Africa we have a free-floating exchange rate, and we are very tolerant of exchange rate fluctuations. This is because we have low levels of foreign exchange debt, and we have inflation expectations that do not react strongly to exchange rate movements. This means the currency is free to adjust to global conditions, and when it depreciates, as it has done recently, it makes South African assets very attractive in foreign currency terms. You could say this is a strategy of attracting the smart money: when the currency moves a lot the smartest people buy, and this helps reverse the outflows. Let me conclude with a reminder that appropriate policy targets, as well as policy consistency and complementarity are important characteristics of successful economies. Increasing debt levels and high inflation are features of bad policy, imbalance and instability, not of sustainable economic growth. We have moved firmly back into a trajectory focused on sustainable fiscal policy, and with monetary policy capable and willing to reduce inflation, the investment environment in the country will continue to improve. I have spoken recently about adjustments to our inflation target itself, which I believe would be in line with the original planning for our inflation-targeting framework and deliver better economic results. I hold firmly that a better inflation target is like the example of a US$100 bill lying on the sidewalk, waiting for us to believe our eyes and pick it up. These steps are not enough to achieve the stronger economic growth rates the country needs, but they are critical steps in moving forward. We can square the circle of policy complementarity by moving faster on the reform of the energy sector and other structural reforms that would make South Africa’s investment environment more attractive to domestic and foreign capital. Thank you. | south african reserve bank | 2,022 | 10 |
Public lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Wits School of Governance, Johannesburg, 1 November 2022. | Public lecture by Lesetja Kganyago, Governor of the South African Reserve Bank, at the Wits School of Governance Johannesburg, 1 November 2022 Keeping it simple: monetary policy, growth and jobs in South Africa Introduction Good morning, ladies and gentlemen. Central banks are important, long-standing expressions of a universal need for stability in social and economic affairs. Their goals centre on achieving some definition of price stability, and in more recent decades, their methods have fixed primarily on inflation targeting.1 Where they directly target inflation, central banks’ primary tool is the policy rate, normally defined as a very short-term or overnight borrowing rate. At this rate, banks can borrow from the central bank to address overnight needs for liquidity and this marginal borrowing rate sets the basis for all other lending rates in the economy. A secondary policy tool is a blend of communications about current economic conditions Quite a few central banks do things differently, using various kinds of fixed exchange rate systems. Usually, these systems are used because of high import levels and dominant trade relationships with large neighbouring economies. These latter central banks normally face very high levels of imported inflation – their own price levels are determined by price inflation coming from other often larger economies, with which they trade heavily. and the policy rate level. A third encompasses the requirements and flexibility of the policy framework – the target itself and how it is measured. In more recent years, and under the impact of deflationary conditions, a few advanced economy central banks have adapted their approaches with secondary targets, such as inflation averages over time and unemployment rates.2,3 Today, I want to spend some time unpacking why it is useful for the South African Reserve Bank (SARB), and most emerging economies generally, to target inflation, and why achieving that goal ensures that monetary policy includes economic growth and job creation. I will look at recent changes in policy targets for the moment, before returning to current conditions and the relevance of jobs and growth targets for monetary policy. Financial distress, deflation and policy exceptionalism It is useful to start with the global economic shocks of the past 15 years and their monetary policy implications. While the global financial crisis (GFC) and the COVID-19 pandemic had different origins, the economic policy responses to them were similar. Advanced economies reacted to both by dropping interest rates as far as possible and using quantitative easing (QE). During the GFC, QE programmes kept asset prices of various kinds higher than they would otherwise have been, preventing asset price deflation from causing even worse economic outcomes.4 During the pandemic, QE additionally supported spending, as mobility and many face-to-face economic transactions were curtailed, while also protecting financial institutions. Inflation averaging and jobs targets are ways of indirectly targeting levels of economic activity. Nominal gross domestic product or price level targeting are better known versions of such efforts. F Budianto, T Nakata and S Schmidt, ‘Average inflation targeting and the interest rate lower bound’, BIS Working Paper No. 852, April 2020. 3 P Karadi and A Nakov, ‘Effectiveness and addictiveness of quantitative easing’, Journal of Monetary Economics 117, 2021, pp 1096−1117. 4 In a few places, including Europe, quantitative easing also supported sovereign debt values and the financial systems that held much of that debt. Job protection was also a major focus for major central banks and job creation became a measure of their policy effectiveness. More liquidity would help keep interest rates low, enabling firms to keep paying wages and to restart the economy. What impact have these efforts made on policy frameworks? Certainly, where countries faced collapsing growth and weaker inflation together, they could all move policy in the same direction. However, when the GFC ended and the pandemic ended, not all faced the same policy trade-offs. The GFC ushered in an extended period of ongoing QE and low rates, but this was not true for most emerging market economies. The end of the pandemic has been different. It has thrown us all back into a pre-Great Moderation world in which inflation is super-sensitive to supply and demand shocks. In particular, and with the benefit of hindsight, the current global inflation finds much of its origin in a too aggressive use of QE and in negative real rates as the pandemic started to wind down and economic activity rose. As in emerging economies postGFC, many countries now, post-pandemic, find their output gaps to be badly measured and giving off incorrect signals about their policy stance. As, and if, the current surge in global inflation wanes, some advanced economies may very well return to lower inflation for structural and demographic reasons. These central banks may retain other metrics in their policy frameworks – such as economic growth rates or the prices of specific assets (e.g. house prices in New Zealand), or in the case of the United States (US), employment levels. But it is highly unlikely that emerging market economies will decide to change their policy frameworks. Many had reverted to much higher inflation even before the pandemic eased, while others, like South Africa, are now caught up in broader inflation. In that more normal context, the standard monetary policy approaches make as much of a positive impact on economic growth and jobs as they can. However, the real solutions to faster growth and job creation lie in other policy domains. Why the difference between advanced and emerging economies? Why might the rules governing objectives differ somewhat? The answer has to do with pure economic theory, actual experience, and with the different economic conditions − cyclical and structural − faced by different central banks. To begin, it should be clear that for quite some time, essentially since the early 2000s, central banks of advanced economies have faced stubbornly low inflation, despite low interest rates, for a range of structural reasons related primarily to demographics and high savings. So, when they took an accommodative stance to raise growth and employment levels during the Great Moderation of the 2000s and the period into the pandemic, inflation still remained modest. As the pandemic hit, because inflation remained low, there was as yet no contradiction between the inflation targets and boosting growth. Policy expansion could help get people who had dropped out of the labour market back in. Job creation was efficient. Expansionary stances worked well with strategies that lowered the cost to firms of retaining people in jobs. In South Africa’s case, the pandemic also facilitated expansionary policy, precisely because inflation had trended lower from 2017. This allowed us to lower policy rates sharply in 2020 to confront the shorter-term damage done to the economy. The repurchase (repo) rate averaged 6.7% between 2017 and early 2020, before dropping to 3.5% in March/April of that year. A deeper dive into jobs and growth targets As in advanced economies, our expansion did little to immediately bring back jobs. Many were lost as lockdowns were extended, while some new ones were created in various services linked to the shift in consumption patterns. Expansion did support the recovery of both pre-pandemic spending patterns and many of the jobs associated with them. Of course, there is also much further to go, as some sectors remain constrained. The open question is whether sustained expansion in an environment of high debt levels and rising inflation could live up to the hopes of those that argue for a ‘jobs’ mandate for monetary policy. The short answer is ‘no’, but let me explain why. Our basic problem is that while growth creates job, inflation does not. Not only does this fatally challenge the belief many hold in the existence of usable Phillips curves, but it also limits what macroeconomic policy can achieve in terms of job creation. As we have noted many times in the past, the solutions to our unemployment problem lie well outside the realm of monetary policy, and in fact the failure to employ those solutions directly limits the positive contribution monetary policy can play. Let’s look at what the historical data tell us about Phillips curves. correlations. We see two One is that as inflation rises, unemployment rates rise. This characterises the late 1990s and into the latter half of 2003. In 2002/03, for example, inflation reached double digits even while employment was falling – when unemployment breached 30%. From about 2003 to 2007, however, we see another correlation, where inflation falls and employment rises. After the GFC, from about 2011 to 2019, we see something different. Inflation first came off the highs of the GFC and then accelerated back up to around 6%. There was some initial recovery in jobs, but as time went on, the acceleration was increasingly located in the public sector rather than the private sector. Economic growth weakened quite sharply from 2013 to 2015 and then more gradually slowed through to the pandemic. From 2017 onwards, inflation decelerated and so did job creation. The GFC and the pandemic were relatively clear instances when policy could respond in textbook ways to support the economy and see-through inflation shocks. Before and after these crises, we see more transparently the longer-term relationships between inflation and job creation. First, inflation does not create jobs.5 And second, on balance, expansionary policy prompts more inflation than growth or job creation. 5 J Fedderke and Y Liu, ‘Inflation in South Africa: an assessment of alternative inflation models’, South African Journal of Economics 86(2), 2018, pp 197−230; B Botha, L Kuhn and D Steenkamp, ‘Is the Phillips curve framework still useful for understanding inflation dynamics in South Africa?’, South African Reserve Bank Working Paper Series, WP/20/07, 2020. This tells us that South Africa’s Phillips curve is near-vertical at a low rate of positive economic growth.6 This is strong evidence that the basic job creation mechanism is being impeded by things other than aggregate demand. This adverse relationship between policy expansion and inflation kicks in when employment levels rise above what is called the non-accelerating inflation rate of unemployment, or NAIRU. Evidence for South Africa shows that this happens when our unemployment rate is still very high. This is exacerbated by level changes in the NAIRU caused by structural impediments to job creation. For instance, load-shedding or higher transport costs indirectly increase the cost of creating jobs and push up the NAIRU.7 A range of long-standing factors contribute to our very high NAIRU. Perhaps the most important of these is where people live and the cost of supplying their labour, and the skills they have compared to their cost.8 Regulatory costs of our economy also feature in various ways, including housing, where businesses can ply their trade, and compliance − which is a much larger burden for small and medium-sized businesses compared to that of larger firms.9 Part of the difficulty is that we have done little to make it easier for less-skilled workers to find jobs, or to make it less costly to employ them.10 6 When vertical, any expansion in demand is constrained by supply – prices rise but not volumes and not volumes of jobs. 7 One older estimate of the NAIRU put it at about 25%. A Kabundi, E Schaling and M Some, ‘Estimating a time-varying Phillips curve for South Africa’, South African Reserve Bank Working Paper 16(05), May 2016. 8 M Leibbrandt and P Green, ‘REDI3x3 conference: Policies for inclusive growth’, February 2017. http://www.econ3x3.org/sites/default/files/articles/Leibbrandt%20%26%20Green%202017%20REDI% 20conference%20on%20inclusive%20growth%20FINAL_0.pdf 9 J R Magruder, ‘High unemployment yet few small firms: the role of centralised bargaining in South Africa’, American Economic Journal: Applied Economics 4(3), July 2012. 10 D Faulkner, C Loewald and K Makrelov, ‘Achieving higher growth and employment: policy options for South Africa’, ERSA Working Paper 334, 2013; C Koep, M Leibbrandt, H McEwan and I Woolard, ‘Employment and inequality outcomes in South Africa’, Southern Africa Labour and Development Research Unit and School of Economics: University of Cape Town, 2010. Another part of the failing job creation machine is simply weaker real economic growth compared to the 2000s, when job creation was quite strong. This should not, however, lead us down the path of grasping at another seemingly ‘easy’ answer. Higher inflation will not give us higher sustainable growth. Instead, higher inflation undermines short-run growth by increasing interest rates on borrowing, affecting consumers’ buying on credit and business owners who want to use credit to invest. Higher interest costs reduce short-run cash flow, reducing all future consumption spending. While surprise inflation reduces the real value of the existing stock of debt owed, the trade-off is lower economic growth in subsequent years. The short-run benefit of a surprise lower interest rate is transformed by higher inflation into a long-run cost to growth. When inflation is higher than that of our trading partners, we suffer a continuous loss of competitiveness. High inflation overall also generally means higher inflation for poorer and less-skilled South Africans than for the wealthy. This increases inequality further and worsens the already low standard of living for those households, making them costlier to employ. For a few years before the GFC in 2008, the relationship between growth and employment was better – if economic activity grew by 1%, employment grew by around 0.62%. But since then, up to 2018, each percentage point improvement in growth only gives us 0.37% more jobs. Our low employment problem overlaps entirely with our low growth problem. In this context, the best a central bank can do is stabilise unemployment at the rate consistent with price stability. If a central bank attempts to get unemployment below the NAIRU, the result will be larger quantities of inflation but only small and temporary quantities of jobs as the supply curve becomes more vertical. The same is true for economic growth.11 Assuming that most of our unemployment problem is structural, are we at least sure that the residual cyclical unemployment is being reduced by monetary policy? Is a dual mandate better at addressing these cyclical drivers? At the SARB, we use an alternative measure of economic activity to the NAIRU for understanding where the economy is relative to its tipping point into more inflation or into deflation. This is the output gap, or the distance between the possible, or potential, growth rate of the economy and the actual or realised rate of growth.12 Similar to the US Federal Reserve (Fed), we use a Taylor rule to help tell us what the interest rate level should be, given the output gap and the distance between the inflation rate we want (the target) and where it currently is. 13 The Taylor rule tells us that we should set an interest rate that includes how quickly or slowly the economy is growing, compared to the speed at which it could be growing. If the output gap is a good representative measure of the cyclical unemployment rate, then we are fully covered – the monetary policy equation we use to get to the interest rate includes, as best we can, the relationship between those rates and employment. If we look at how the Fed operates, we can take further comfort in our own framework. The Fed has an inflation target of 2%, averaged over time. This averaging introduces some flexibility to not respond to inflation shocks that are temporary, just as in our flexible inflation-targeting framework. But the Fed framework does not say that when unemployment rises it will aim for a higher inflation rate. In other words, the dual mandate recognises that in the long run, the highest cyclical employment rate is consistent with low inflation. In the policy debate at present in the US, there may be a rise in cyclical unemployment to get inflation back down and to achieve a lower sustainable unemployment rate. 11 See Kabundi, Schalling and Some (2016) and Botha et al. (2020). 12 The output gap is also measured in level terms, not only the rate of growth in gross domestic product. 13 See, for instance, S de Jager, M Johnston and R Steinbach, ‘A revised Quarterly Projection Model for South Africa’, South African Reserve Bank Working Paper 15(3), August 2015. https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/6839/WP1503.pdf We need also to be cautious in our current circumstances. With surging inflation in advanced economies, it is likely that the adjusted policy frameworks of recent times will shift back to simpler and clearer formulations. Three takeaways from this discussion stand out. One is that inflation-targeting central banks also consider real variables such as growth and unemployment when they make monetary policy decisions. Second, that central banks don’t drop targeting inflation, even if they have an employment mandate. It simply means they respect the NAIRU and discuss more directly its level and what can happen to inflation when the speed limit implied by it is exceeded. And third, that despite some policy innovation in recent times in some advanced economies, these may very well be scaled back to simpler frameworks. Finally, we need to recognise, for the sake of solving our low employment problem and to keep monetary policy focused on the right things, that many issues sharply limit the transmission from policy to job creation outcomes. One is the job intensity of growth which we discussed. Another is the supply of skills that are coming into the market, and their cost. Some might argue that in that case, it means that monetary policy should be pushed much further and harder to get the expected growth or jobs. Unfortunately, when inefficiencies and constraints exist, pushing harder on monetary policy is like pushing the accelerator to the floor on a curvy, icy road over a mountain pass. At present, many central banks are skidding on that ice, with global inflation sharply higher and persistent. Even our own relatively benign recent inflation experience has become much more challenging very quickly. Keeping it simple We have seen now that having two targets certainly does not mean double the benefit. Instead, it means that there are times and certain conditions when one policy tool helps to achieve both. It also means that under other conditions, one tool cannot achieve both, and much of the world has now entered this territory. When policy becomes overloaded with too many and contradictory objectives, then negative outcomes are more likely. As inflation rises and growth slows, a central bank that fails to respond to rising prices will face the prospect of compounding inflationary shocks. Currencies depreciate and investment falls. 14 So where, in all of this, does South Africa find itself? We have not reached the ‘end’ of our policy rate space. We do not have stubbornly low or close to zero inflation. We are experiencing rising inflation rates. Inflation expectations, for the most part, are proving to be more responsive to current inflation outcomes than we would like, and less anchored around the midpoint of our target. If the expectations that firms and households hold for future inflation stray from the inflation target, then higher nominal wages and consumer prices are likely to emerge. In other words, once inflation expectations rise, they become a self-fulfilling prophecy, and the central bank has a more difficult and longer-term problem on its hands. A more expansionary policy stance runs that risk by enabling first-round inflation to embed into second-round inflation. This implies that we need to continue the normalisation of interest rates, moving them closer to the level that is consistent with more stable inflation rates and sustainable economic growth. At present, our repo rate is at 6.25%, still below long-term levels, but rising to a more sustainable long-term level that is consistent with inflation stabilising at 4.5%. 14 Domestic savers seek protection also, shifting saving offshore and away from assets like sovereign debt, whose real value falls as inflation rises. When inflation rises too fast, it becomes more volatile, and veers quickly towards hyperinflation. High inflation increases inequality dramatically, undermines export industries, and with investment falling and local industries struggling, the marginal or less productive jobs are the first to be shed. Conclusion As we have discussed today, neither growth nor high inflation lead directly to job creation in our economy. Much of our employment challenge lies in encouraging the return of economic activity in sectors that have been hardest hit by the pandemic. And we will also need to recognise that some jobs may be permanently lost as firms do things differently and as consumption patterns shift. Other jobs will be gained, however, and permanently impacting on employment levels requires approaches that have nothing to do with monetary policy. Just adding jobs targets will not get us there, and indeed part of our inflation problem stems from efforts to achieve such targets at a global level. We should be careful not to add to our policy objectives in a way that surely would push us into sharply higher inflation. If these are the primary constraints to job creation defined by the literature, and monetary policy has no impact on them, then the claim that more expansionary policies will solve the unemployment problem is simply an empty promise, backed up by little more than ideology and wishful thinking. We have an unemployment problem that needs more credible solutions. Employment and growth are both limited by factors that are beyond the reach of the central bank’s toolset. The best chance we have with monetary policy to get faster, more job-rich growth is to maintain our focus on price stability with flexible inflation targeting − a proven framework. This enables the SARB to help maintain a stable environment that is conducive to economic growth, and because credibility is high, for it to create the necessary flexibility to ignore short-term inflation shocks. A credible monetary policy will also keep borrowing costs lower than they would otherwise be. This is a central benefit to long-term economic growth and job creation. When inflation rises and stays high, investment decisions are distorted towards short11 term investments that carry with them short-term jobs. For this reason, low inflation is a sound developmental policy. It encourages firms across the private and public sector to make long-term investment decisions that imply productivity growth over time. This is critical, indeed a prerequisite, for sustainable jobs and income growth. Consumption based on rising debt levels cannot be a sustainable growth and development strategy. Having faced the unique threat of the COVID-19 crisis, we confronted that challenge with relatively low stable inflation and policy rate space. We were able to soften the damage of the crisis with the policy rate, while still protecting the value of the rand, and in so doing, were able to play our part in maintaining macroeconomic stability. Now that the global economy is recovering and inflation in many countries, including our own, is rising, we have learned from experience that we must not be tempted to loosen our grip on inflation, or to fall behind our peers as rates are normalised – the consequences would be too costly. | south african reserve bank | 2,022 | 11 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Lebanese Chamber of Commerce, Pretoria, 7 March 2023. | Lesetja Kganyago: How the new global environment is influencing the state of South Africa's economy Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Lebanese Chamber of Commerce, Pretoria, 7 March 2023. *** Introduction Ladies and gentlemen, it is my pleasure to address you today at this event hosted by the Southern African Lebanese Chamber of Commerce. I commend the efforts of the Chamber to deepen economic ties between Lebanon and Southern Africa, especially the long-established and thriving Lebanese community in South Africa. Last year, trade between South Africa and Lebanon amounted to over R170 million. As we look into the future, I believe there is room to strengthen ties even more. The topic chosen for my address – how the global environment is influencing the state of South Africa's economy – could not be more topical. Since the spread of the COVID19 pandemic across the globe three years ago, the world economy has faced numerous shocks, which have compounded the domestic challenges faced by South Africa and complicated the task of central bankers, both here and in the rest of the world. COVID-19 and other macroeconomic shocks The major disruptions since the onset of the pandemic in early 2020 challenged the belief of many that the world had entered a long phase of low and stable inflation. We now know that the 'closing and reopening' of economies due to the pandemic would not occur without major supply and demand mismatches in most markets. Supply chains, stretched by the staggered reopening of economies, only proved as resilient as their weakest link, resulting in major delivery lags and higher costs in key industries. Labour supply did not adjust automatically when firms began to hire again, resulting in tight labour markets and, in some jurisdictions such as the United States or the United Kingdom, an unusually high level of unfilled vacancies relative to unemployment. There was no precedent in recent history that we could learn from relating to the policy responses required to manage the pandemic shock. Even after economies had reopened, fears of long-term scarring, including bankruptcies and permanent job losses, prompted coordinated responses from governments and central banks to uphold highly stimulative policies. In retrospect, we now know that such stimulus provided excess support to demand at a time when supply was struggling to adjust, which compounded inflation. The war in Ukraine, which exacerbated the shock to prices of oil, gas and some inputs into food production, such as fertilisers, added to the global inflation problem. Even a country like South Africa, where supply constraints did not originate, faced price pressures from more expensive imports, shortages of key inputs, elevated shipping 1/5 BIS - Central bankers' speeches costs and the depreciation of the rand as financial markets repriced the outlook for global interest rates. Worldwide inflation pressures have forced broad-based and, in many cases, unusually fast monetary policy normalisation. Where do we stand now? Thankfully, some of the shocks that caused the global inflation surge have begun to abate, albeit at a slow pace. Energy and agricultural commodity prices have fallen. Shipping costs have largely normalised; other input prices have slowed significantly too. Yet, in many countries, inflation remains far above target and is showing signs of persistence in several sectors. This is particularly the case in non-housing services, where prices are highly dependent on wage growth, but also in some consumer goods. In South Africa, headline inflation also remains above the upper end of the target band, though it has been gradually moderating since the latter part of 2022 – primarily driven by a decline in fuel prices from the peaks observed mid-2022. However, we are not completely out of the woods yet. Domestic fuel prices have been rising, albeit moderately, and there is a risk that we could see further increases in the coming months, largely as a result of exchange rate volatility. This shows that the domestic inflation outlook is still susceptible to global factors, exacerbated by domestic conditions, of course. In South Africa, food price inflation has yet to peak, despite the decelerating trend observed in global agricultural commodities. Domestic meat prices are still accelerating, reflective of lingering supply constraints in the beef market following last year's outbreak of foot and mouth disease. While these constraints are expected to gradually unwind over the near term, persisting electricity supply issues - and the need for costly energy alternatives - will keep raising input costs for food producers in industries such as poultry and dairy farming. These may be passed through to consumers. Although core inflation has come in lower than our expectations over the past two months, we still caution that it remains above the midpoint of the South African Reserve Bank's (SARB) target of 3-6%. In fact, our baseline view is that core inflation particularly core goods - is likely to remain sticky over the next few months, before starting to ease over the medium term. For now though, prices of exchange ratesensitive goods continue to accelerate. In the services sector, while some components have surprised on the downside over recent months, we may start to see the margins in some of these sectors, such as insurance and housing, also starting to pick up pace and, as such, exert upside pressure on overall inflation. As we have communicated before, the SARB will continue to monitor price developments and act to guide inflation back to the midpoint of the target band over the medium term. Elsewhere in the world, major central banks have repeatedly indicated that they have not yet completed their policy normalisation. They may need to keep policy in restrictive territory for an extended period until clear signs emerge that inflation is returning sustainably to target. Implications for growth 2/5 BIS - Central bankers' speeches The number and pace of rate hikes needed to fight global inflation suggests we are likely to see weaker world growth in 2023, even ashousehold cash buffers and corporate profitability have limited the downside risk, so far. The International Monetary Fund (IMF) forecasts global growth of 2.9% this year, after growth of 3.4% in 2022, and this means weaker demand for the exports of small, open economies such as South Africa. Implications for the domestic economy are twofold: first, directly through weaker growth, and second, through a possible deterioration in our external accounts. Amid weaker exports volumes, combined with South Africa's persistent and more intensive loadshedding as well as a deterioration of its ports and railway infrastructure, the SARB's gross domestic product (GDP) growth forecast for this year currently sits at 0.3%. Stats SA published the Q4 GDP report this morning and the outcome was much weaker than what we thought it would be. It seems like the adverse impact of these factors has already started materialising, placing further downside risk to our current forecast. 2022Q4 GDP came in at -1.3%, bringing growth for the year 2022 to 2.0% – below our estimate of 2.5% at the January MPC meeting. A deep dive into these numbers shows that the decline was broad-based over the quarter, with 7 out of the 10 sectors detracting from GDP growth. From the expenditure side, we note the pressures faced by households, where elevated inflation has necessitated higher interest rates. While the domestic labour market also continues to recover gradually, an environment of weak growth implies that we may start seeing renewed job losses. Furthermore, while nominal wages have shown a recovery, real incomes, however, remain constrained. Nonetheless, we do expect household spending to remain supportive of the little growth that is projected for the year. This view is also corroborated by today's GDP report, which continued to show positive growth in household consumption. Furthermore, although having moderated over recent quarters, growth in fixed investment showed some recovery in Q4 and is also expected to contribute positively going into 2023. From this it is clear that the outlook for even the relatively low growth rates we project over the medium term, remains highly uncertain – in light of our own domestic constraints. The outlook also hinges on how quickly South Africa's structural constraints can be addressed over the medium term. From an external accounts' perspective, South Africa has benefitted from the generally high commodity prices that have prevailed over the past two years. These, however, have been moderating since the second half of 2022, in line with the slowdown in global growth, with further declines in South Africa's commodity export prices expected in 2023. While the reopening of the Chinese economy led to renewed strength for key commodities such as iron ore, platinum, copper and steel at the beginning of the year, this may not be sustained. The recovery in China's economy should mostly be led by services, while the commodity-intensive construction sector is unlikely to rebound at a fast pace. 3/5 BIS - Central bankers' speeches At the same time, the persistence of domestic electricity supply constraints implies that more businesses and households may be investing in alternative energy solutions, thereby driving up imports. This, balanced against projections of lower export volumes, equates to a deteriorated current account balance over the short to medium term. The role of the financial channel Financial markets are another channel through which global conditions affect South Africa. Global growth, inflation and the pace of policy normalisation in advanced economies affect investor risk appetite, cross-border capital flows and, hence, the availability and cost of external funding. So far, considering the pace of policy normalisation in major economies and the extent to which 'safe assets' have re-priced, the shock has not been strong by historical standards. Capital outflows from emerging markets were moderate for most of 2022 and recovered in the fourth quarter as global conditions improved. Throughout 2022, the rand weakened by a mere 6.5% against the US dollar, initially helped by supportive terms of trade and South Africa's current account surplus. But 2023 may still hold challenges on the financial front. If, as developments in February suggest, investors become more worried about global rates having to stay higher for longer, they may again shun riskier assets, and that includes South African bonds and equities. A similar outcome may occur if the consequence of policy normalisation is a deeper economic contraction than what markets currently discount. In both cases, South Africa may face renewed capital outflows, and the deterioration in the current account over the past year means this could trigger new volatility in our asset prices. Furthermore, if global investors become more selective in their choice of assets, South Africa may suffer from its own idiosyncratic issues and various fiscal risks such as rising public sector wage costs and an increasing need for fiscal support for some of our stateowned companies. Following the outbreak of COVID-19, unprecedented fiscal support in many economies has once again put sovereign debt sustainability at the forefront of investors' concerns. Many emerging countries face a mix of elevated public debt from the pandemic as well as low growth. This, combined with the higher borrowing costs that currently prevail, means that attracting foreign capital can become more challenging. Concluding remarks It has been quite a journey since the outbreak of the pandemic. Lockdowns were instituted almost universally to stem the spread of the virus, while fiscal and monetary authorities around the world implemented unprecedented policy support for their economies. And as we navigated through those risk shocks and their inflationary impacts, the start of the war in Ukraine in early 2022 presented a new set of challenges for economic policy around the globe. The impacts of both these shocks continue to linger and present a conundrum, for monetary policy especially. The global economy appears to be experiencing stagflationary conditions – with high inflation and low growth. These conditions create 4/5 BIS - Central bankers' speeches some tension between anti-inflation policies and pro-growth policies. That notwithstanding, global central banks have communicated their resolve to bring inflation back to target, as low and stable inflation is a prerequisite for high and sustainable growth. Similarly, in South Africa, we are also faced with high inflation and weak growth, and face similar policy challenges. However, weak growth in our domestic context is aggravated by structural constraints such as inadequate electricity supply, making this an even more challenging task. The encouraging news is that we have started to see a disinflationary trend. Inflation remains quite elevated, and like our peers around the world, as the SARB, we remain committed to seeing inflation sustainably returning to target. Thank you. 5/5 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 3 |
Speech by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the Central Banking Conference, Cape Town, 14 March 2023. | Speech by Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the Central Banking Conference, Mount Nelson Hotel, Cape Town, 14 March 2023 The state of the South African economy and the role of monetary policy These are some of the most remarkable years in the history of the South African economy. Unfortunately, they are remarkable for the wrong reasons. Domestically, we are experiencing the lowest growth episode in modern South African history, marked most recently by the widespread failure of basic infrastructure, especially electricity. Externally, we have been buffeted by a series of extraordinary shocks: the COVID-19 pandemic, the war in Ukraine, and a global inflation surge. These circumstances have profoundly affected the lives of all South Africans. They have also confronted policymakers with difficult choices. Today, I want to outline how monetary policy has responded, and share with you the main uncertainties and debates we are grappling with today. I will start with the changing external environment. In 2020, the COVID-19 shock prompted an unprecedented drop in economic activity worldwide. We saw a broad decline in inflation which led to a huge wave of stimulus from fiscal and monetary authorities. In South Africa, this included lowering the repurchase (repo) rate to 3.5% ‒ its lowest level ever. Fortunately, global pandemics are rare events, but this meant no one had much experience on which to base forecasts. While policymakers emphasised this uncertainty clearly, we can still say actual outcomes surprised most of us. For example, in 2020 it did not seem like the major advanced economies would soon be confronting the highest inflation rates in a generation.1 Part of the challenge was that 1 For instance, inflation rates in the United States and the United Kingdom reached their highest levels since 1981. In France, inflation is at its highest levels since 1984. In Germany, inflation has reached its highest levels in the post-war period. the pandemic produced an unusual mix of supply and demand effects, which included supply chain disruptions and abrupt shifts in the composition of demand. On top of this came the Ukraine war, a further shock in none of our forecasts, which pushed up food and energy costs around the globe. The result for macroeconomic policymakers was that we had to pivot fast. In South Africa’s case, as inflation rebounded, economic output recovered to pre-COVID levels, and global rates soared. At a minimum we needed to have interest rates near their normal or longer-run levels, not at long-term lows. In this context, the South African Reserve Bank’s (SARB) Monetary Policy Committee (MPC) implemented a series of 75 basis point hikes, larger than those used in the previous hiking cycle, to get back to safety.2 Given that the full impact of monetary policy on inflation is not immediate but has a lag effect, we could not immediately bring inflation back to target in 2022. Instead, what we aimed to do was set policy so that inflation would normalise after the initial, deep shock had played out. As at the latest data, headline inflation is at 6.9%, with core or underlying inflation at 4.9%. The peak appears to have been in July last year when headline inflation hit 7.8%. To put that in context, we have been outside of our 3‒6% target range since May 2022. The last time we were close to the midpoint of that range, which is where we aim to stabilise inflation, was about a year before that.3 On current forecasts, we anticipate inflation will be back at the midpoint of our target range towards the end of this year. Similarly, the International Monetary Fund’s (IMF) forecasts, from the most recent World Economic Outlook, have end-of-period inflation for 2023 at 4.5%,4 which is the midpoint of our target range. To put that in perspective, the IMF does not see major advanced economies hitting their 2% targets over this 2 The hiking cycle began with 25 basis points in November 2021. There were further 25 basis point increases in January and March 2023, followed by 50 basis points in May. The July, September and November 2022 decisions were all for 75 basis points. In January 2023, the MPC raised rates by 25 basis points. 3 Headline inflation was 4.4% in April 2021, 5.2% in May 2021, 4.9% in June 2021 and 4.6% in July 2021. 4 The precise forecast is 4.526%. horizon, with year-end projections at 2.3% for the United States (US), which is quite close to target, but 5.4% for Germany and 6.3% for the United Kingdom. These projections are encouraging. After all, the key test of policy is not whether shocks happen, but whether inflation comes back to target after the initial effects of the shocks wear off. After that, the next test of policy is how difficult the adjustment process is for getting inflation back to target. One problem is that we could get more shocks. Food inflation has been coming in higher than expected, and it surprised us once again in the latest consumer price index (CPI) release from Statistics South Africa. There is a global dynamic to elevated food price inflation, but now we are also worrying about load-shedding driving up food prices, as electricity shortages start to disrupt the production and storage of food. The exchange rate outlook has also deteriorated recently. At the start of this year, markets were optimistic that US inflation was coming down, that the US dollar had peaked in late 2022, and that the US Federal Reserve (Fed) would be able to pause rate hikes soon and even think about cutting rates. Recent data have undermined this benign view. The US economy still appears to be running hot, and markets have rapidly priced in an extra half a percentage point of Fed hikes, relative to where we were earlier in 2022. This has helped weaken the rand from around R17 per dollar in January 2023 to over R18 to the dollar recently. Domestic factors also have not helped. The local news flow has been mostly rand negative, for instance around load-shedding. Local interest rates are also well below those in some peer economies, adding to a weaker currency. For example, Brazil’s policy rate is at 13.75%, Mexico’s is at 11% and Hungary’s is 13%. In a world where the dollar is weakening, the rand is likely to benefit along with other currencies. But February was not kind to the market consensus on a weaker dollar, and the rand outlook has correspondingly become more worrying, once again. A second problem is that South Africans might start seeing a higher level of inflation as normal. For a start, inflation expectations have risen. The fourth quarter survey of inflation expectations, published by the Bureau for Economic Research (BER), registered expectations of 6.1% inflation for 2023, up from 5.9%, and 5.6% for 2024, up from 5.3%. Over five years, expectations are at 5.5%, up from 5.4% previously. Of course, respondents are rational to see higher inflation at the moment, given elevated food and fuel prices. A bigger concern is that expectations for longer-term expectations are well above our 4.5% target, which may indicate that the initial supplyside shocks are feeding through into longer-run price and wage-setting behaviour – a phenomenon referred to as ‘second-round effects’. We are therefore monitoring expectations closely, to see if people recover their faith in our target or if we need to do more to stabilise longer-term expectations close to 4.5%. For a sense of underlying inflation pressure, another important area we look to is core inflation. This is a measure of inflation which excludes food and energy prices, which are often volatile. Core inflation has been lagging headline inflation, only moving above the midpoint of our target range during the second half of last year. We anticipate that the peak for core is still ahead of us, with the January MPC forecast projecting core inflation of 5.4% in the second quarter of this year. So far, most of the pressure in core inflation has been coming from imported goods, which are being repriced to reflect the weaker rand and higher global goods prices. Our forecast takes the view that core goods inflation peaked at the end of last year. A weaker rand could keep core goods inflation higher for longer. But the bigger concern may be that inflation pressure is shifting over to services. This category is around two-thirds of the core basket, and it contains many prices which are not adjusted frequently – for items such as housing rental or insurance contracts. This is the area where second-round effects, through wages5 and inflation expectations, are most likely to manifest. A year ago, services inflation was near the bottom of our target range, at 3.1%. The latest CPI release puts it at 4.3%.6 In our forecast, the peak is just over 5%. The disinflation trends we see in headline inflation is therefore not the narrative for services. That said, we have had a couple of better-than-expected outcomes for services inflation recently, and these allowed us to revise down our core forecast at the January 2023 MPC, even as we revised up headline inflation. Perhaps we can hope our core forecasts will be too high. Of course, if we do not see services coming down later this year, then we will have a problem. We are not going to be able to achieve our target over time if services inflation gets stuck in the top half of our target range. After all this inflation analysis, you may well be thinking: but what about growth? Here the outlook is not good at all. We are expecting growth rates of 0.3%, 0.7% and 1.0% over the next three years. These are disastrously low. Given population growth rates of around 1.2% annually, the implication is that living standards will continue to fall, as they have done on average since 2014. Our growth rate also compares very badly to the historical record. Since the 1960s,7 South Africa has, on average, managed to grow by about 2.8% a year. This is around four times the average growth rate both for our forecast and for the past 10 years. This feeble growth outlook is also related to other social ills, including our 33% unemployment rate.8 What does South Africa’s growth challenges mean for monetary policy? 5 For the November 2022 MPC forecast, average salaries were expected to be 5.3%, 6.7% and 5.4% for 2022, 2023 and 2024 respectively. For the January 2023 meeting, the respective figures were 5.2%, 6.9% and 5.5% for 2022, 2023 and 2024 respectively, and 4.7% for 2025 (with the additional year added to the forecast in January). 6 See the January 2023 CPI report published by Statistics South Africa. 7 This claim is based on data from the Penn World Tables, starting in 1961. 8 The official unemployment rate for the third quarter of 2022 was 32.7%; for the second quarter of 2022 it was 33.6%. When we at the SARB think about growth, we would of course like to have the highest growth rate possible. But there are many things that drive growth that central banks do not control ‒ and do not have mandates to tackle ‒ including technological innovation, education, natural resources, and yes, reliable electricity supply. In this sense, delivering growth is much more of a team sport than controlling inflation. Central banks can do much of the work of managing inflation by themselves, although as with any solo sport, such as golf or tennis, support teams make important contributions. Growth policy, however, is more like soccer or cricket, where individual heroes cannot do much if their team members are weak or absent. When a central bank is playing for the growth team, what it can affect is demand, which can be applied to reduce the volatility of output. More technically, as long as prices are fairly stable, changing a nominal variable such as interest rates can temporarily affect real variables, including quantities of goods and services. This is useful when demand is too weak, during downswing phases of business cycles. Where a central bank aims for a growth rate which requires more output than an economy can produce, however, the results are troublesome. For a small open economy such as South Africa, this typically means that we experience unsustainable imports, currency depreciation and rising inflation. In modern central banking practice, we formalise these intuitions using a concept called ‘potential growth’, which is an estimate of the amount an economy can produce at full capacity. To the extent an economy is not at potential, we say it has an output gap. If output is below potential, then the output gap is negative; if it is above potential, the gap is positive. For every MPC meeting, the forecast team prepares estimates of South Africa’s potential growth and the output gap. They are unobservable concepts and must be estimates using imperfect techniques, which makes them uncertain. So, when I look at these figures, and how they shape the forecast and the policy advice, I do not quibble about the exact numbers, but I think about what kind of problem these numbers describe, how this information squares with the other information available, and how policy should then respond. As of the January 2023 MPC forecast round, those numbers told an extraordinary story. I have already mentioned that our growth projections are very low, but our potential growth estimates are even lower. The team estimates potential growth at 0% this year, then 0.6% in 2024 and 1% in 2025. Because the economy performed better than expected last year, and because expected growth is above potential, the forecast now sees a small positive output gap developing this year. In other words, in the interpretation of our Quarterly Projection Model (QPM), we have an economy operating modestly above its potential. And this, in turn, supports policy advice to raise rates not only because inflation is above target, but also because growth is too high. In assessing this forecast story, I am struck by two plausible but competing interpretations. The first interpretation is that potential growth must be 0%, or worse, given the scale of supply-side dysfunction in the economy. After all, isn’t it hard enough for people just to achieve the output they delivered last year, let alone produce more? We know electricity shortages have intensified; we expect to have 250 days of load-shedding this year, from 157 days last year and 48 days in 2021. On top of that, the freight rail system has, for the most part, not been functioning optimally, removing another pillar of the economy’s productive potential. There are many other constraints in the economy that also suppress potential growth. For our forecast team, these are facts that must be faced squarely, and it’s better to accept them up front than gradually mark down the projections as disappointing data come in. Of course, it is reasonable to expect that South Africans will find ways to cope with these challenges, and that there will be policy steps to address them with time. For this reason, potential growth rises over the forecast period, reaching 1% in 2025. But the narrative for this year is that the economy does not have the supply-side capacity to produce more than it did last year. At the same time ‒ and this is the second interpretation ‒ is it possible for the economy to be at full potential when unemployment is over 30%? The Quarterly Employment Survey recorded 10.57 million formal jobs at the end of 2019, against 9.98 million now.9 Were all those workers unproductive, so that recovering those roughly half-amillion jobs would add nothing to output? Are all sectors in the economy at full capacity? Can potential realistically be at zero? These competing views are not wholly incompatible. They both capture important truths. The main point of the comparison is to illustrate how the economy is short of some inputs, like electricity, but there is slack in other areas, such as employment. In these conditions, what the MPC is trying to gauge is the space to satisfy additional demand and follow through on what that means for monetary policy. The difficult part, for the MPC, is judging how much we can do to help on the demand side when the supply side of the economy is in such a perilous state. In common with many other central banks, we are flexible inflation targeters. We aim to achieve our inflation targets while also considering growth; if inflation is above target but there is a negative output gap, then we can tolerate a somewhat slower disinflation path for the sake of supporting demand. No one really targets inflation exclusively, ignoring growth and employment, as great policy thinkers like Stanley Fischer have pointed out.10 There is always a balancing act. As you know, a balance rests on a fulcrum, which is the central point around which balance can be achieved. In monetary policy, this fulcrum is another one of those unobserved concepts, like potential growth; it is called the neutral rate. The neutral rate is the interest rate that neither speeds up nor slows down the economy; it is the level at which the policy rate will settle when inflation is at target and output is at potential. This is a concept many of our close watchers have questions about. 9 These data are not seasonally adjusted. Regardless of the exact quarter used, this series shows a clear and sustained downward shift in formal, non-agricultural employment since the onset of COVID19. The Quarterly Employment Survey (QES) is likely to be a more reliable indicator of changes in formal sector employment than the Quarterly Labour Force Survey (QLFS). 10 Speech by Stanley Fischer, ‘Central bank independence’, 9 November 2015. https://www.bis.org/review/r151109c.htm: “In practice, I doubt that any central bank targets inflation to the exclusion of all other outcomes. For example, the Bundesbank was generally thought to have a very strict focus on inflation in the years in which it had an independent monetary policy before the founding of the European Central Bank. But researchers who have studied the Bundesbank's policies of that period have concluded that it likely responded to deviations from target of both expected inflation and output growth.” In South Africa, we estimate this neutral rate to be 7% over time,11 of which 4.5% is compensation for inflation and 2.5% is the so-called neutral real interest rate ‒ the rate excluding inflation ‒ which economists abbreviate as r-star. In turn, that 2.5% is made up of half a percentage point which reflects the global real rate, which we derive from the longer-run real policy rate of the US, the euro area and Japan, plus 2 percentage points for the South African risk premium. As with potential growth, we cannot be sure that the neutral rate is exactly 7%. It is an unobservable concept and our tools for measuring it are imperfect. Nonetheless, a rate of around 7% is a reasonable place to start conversations about the policy stance. It suggests that current rates, at 7.25%, are in the region of the neutral rate, and it also illustrates how loose policy was back when we were at 3.5%. Of course, if the inflation-adjusted rate needs to be around 2.5%, then for policy to be neutral we need inflation to be around 4.5%. We aren’t there yet; as I noted earlier, inflation is still close to 7%. For this reason, the extent to which the policy rate will change from the current 7.25% will depend on whether we feel confident that disinflation is proceeding and we will get to 4.5% this year. If the disinflation story does not play out as expected, then we won’t get real rates where we need them. I have discussed the risks that could produce that outcome. Because we cannot stabilise prices with persistently low or negative real rates, in this scenario there will be more work to do with rate changes, and the trade-offs between output and inflation will be more difficult. There are clear risks of adverse developments, which could require further monetary policy action to contain inflation. And so, to conclude, while we hope for the soft landing, we are also prepared for worse outcomes. Thank you. 11 Neutral rates can change over time. Although the QPM steady state is 2.5%, the neutral rate was estimated at 2% for both 2020 and 2021, and 2.3% for 2022. Over the forecast period, the neutral rate is currently projected at 2.4%, 2.4% and 2.5% for 2023, 2024 and 2025 respectively. | south african reserve bank | 2,023 | 3 |
Introductory remarks by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Witwatersrand dialogue, Johannesburg, 16 March 2023. | Lesetja Kganyago: Introductory remarks - Witwatersrand dialogue Introductory remarks by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Witwatersrand dialogue, Johannesburg, 16 March 2023. *** It is a real pleasure to be at Wits again and in a discussion with Adam Tooze The major disruptions since the onset of the pandemic in early 2020 challenged the belief of many that the world had entered a long phase of low and stable inflation. Supply chains, stretched by the staggered reopening of economies, only proved as resilient as their weakest link, resulting in major delivery lags and higher costs in key industries. Labour supply did not adjust automatically when firms began to hire again, resulting in tight labour markets. There was no precedent in recent history that we can learn from relating to the policy responses required to the pandemic shock. Even after economies had re-opened, fears of long-term scarring, including bankruptcies and permanent job losses prompted coordinated responses from governments and central banks to uphold highly stimulative policies. In retrospect, we now know that such stimulus provided excess support to demand at a time when supply was struggling to adjust, compounding inflation. The war in Ukraine, which exacerbated the shock to prices of oil, gas and some inputs into food production like fertilizers, added to the global inflation problem. Even a country like South Africa, where supply constraints did not originate, faced price pressures from more expensive imports, shortages of key inputs, elevated shipping costs and the depreciation of the rand as financial markets repriced the outlook for global interest rates. Worldwide inflation pressures have forced monetary policy normalisation. Policy rates increased quickly as central banks realised that what was thought to be the transitory inflationary shocks are not so transitory and there are strong second round effects. Despite the increases, policy rates in many countries, including South Africa, remain below neutral interest rates and in some cases, they are negative. The Covid-19 crisis and the recovery period reminded us of lessons that we often forget such as: 1. Working together to address global problems leads to effective solutions. The hoarding of vaccines during the crisis meant there were numerous mutations of the Covid-19 virus. It is only once vaccination rates increased across countries that the Covid-19 pandemic was contained. Coordinated global responses accelerated the global recovery. 2. We need to have policy buffers. Having policy buffers to tackle Covid-19 type pandemics is difficult as they are rare events. The problem is that many countries had no monetary or fiscal space to tackle even small crisis. In South Africa, we had the space to provide a sizable monetary policy stimulus unlike central banks in 1/2 BIS - Central bankers' speeches advanced economies which were stuck at the zero lower bound. But we had limited fiscal space due to the fiscal decisions in the post Global Financial Crisis period. 3. Inflation is bad. Many governments, including ours, faced mass protests against high inflation (and not high interest rates) in the post crisis period. 4. Borrowing in foreign currency during good times should trigger consideration regarding the ability to pay during bad times. In addition, the cyclicality of commodity revenues makes them an inappropriate source of continuous funding to meet short-term obligations (interest payments on debt). There are many other repeated lessons. The post crisis period poses many challenges for central banks from dealing with fiscal dominance effects to tackling climate change related risks. Increasingly central banks are being asked to address problems that fall directly under the domain of government, without consideration under what conditions and how central banks are effective in achieving their goals. Credibility and independence are critical in achieving our objectives. Other critical elements include well defined and limited number of goals, effective tools to achieve these goals and finally, measurable success indicators and accountability. Central bank credibility is directly linked to achieving the goals and being accountable. If you want for the South African Reserve Bank to address the unemployment crisis, then you need to give us the tools to address things such as high firing and hiring costs or the large number of unskilled workers. You would need to take them from other government departments. For us to be successful, we need to act independently without considering political issues. How many politicians would be happy with that? How would you hold us accountable if you give us multiple goals? Another example is climate change. The three main drivers of the transition are relative price changes, technology developments and adoption, and infrastructure investment. The most effective tools to accelerate these drivers sit with government departments. People downplay the importance of financial and price stability for the effectiveness of structural policies. How much green investment do you think we will attract if our financial system is unstable, and we cannot guarantee real returns!? The focus of central banks should be to deliver on their core mandates and create the space for government policies to drive structural changes. 2/2 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 4 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Macro Week 2023, Peterson Institute for International Economics, Washington DC, 11 April 2023. | Globalised stagflation and the emerging market response An address by Lesetja Kganyago, Governor of the South African Reserve Bank, at the Peterson Institute for International Economics, Washington, 11 April 2023 Introduction Ladies and gentlemen, it is a great pleasure to be invited back to the Peterson Institute. While advanced economies dominate the newsprint, I want to speak today about how the global inflation problem impacts emerging economies, and South Africa specifically. A broad spectrum of emerging economies are experiencing inflation rates that are persistent and well above target. And yet, five years ago, many emerging and developing countries seemed on a steady path towards lower, and more stable inflation. Are emerging economies able to get back onto that path, given the challenges presented by the current global environment? The short answer to this must be ‘yes’, but we need to recognise that doing so will not be easy. Certainly, the headwinds to constructive policymaking have increased and global conditions are far from benign. The surge in global inflation and the many accompanying structural changes risk pushing emerging economies away from better policies. I believe there are some grounds for optimism, despite the headwinds. In particular, we can build on the experience we have gained in emerging market central banking and monetary policy in addressing stagflation. A key lesson from our collective experience has to do with how central banks can use transparency to improve the effectiveness of monetary policy. For advanced economies, arguably, the stagflation challenge demands better communications and clarity of policy. For emerging economies, many of which moved faster to tighten policy, central bank transparency can play a role in setting the tone for public policy more broadly, helping to ease or resolve our particular non-monetary constraints to better inflation outcomes. The South African approach has been to speak clearly to the monetary policy challenges we face and to highlight the constraints to better results, even if these lie outside the immediate span of monetary policy. This has not won us many friends, but it has helped to foster a better public discussion about the challenges holding back our economy. I want to spend some time today discussing the shift in global inflation from one paradigm to another, and then discuss how these challenges impact policymaking in emerging economies, with particular reference of course to South Africa. Genesis of a global inflation shock In late 2019, before the COVID-19 pandemic, inflation was expected to remain low, or even fall further. In October 2019, the International Monetary Fund (IMF) forecast inflation of 2.0% for advanced economies and 4.3% for emerging and developing economies. For the latter countries, this was more than 2 percentage points below the average of the previous decade. The COVID-19 shock reinforced expectations of more disinflation, and short-term inflation projections duly fell, alongside market-based measures of inflation expectations. Within two years, advanced economies experienced their highest inflation rates in decades, and very few emerging countries (with the notable exception of China) were left unscathed. Inflation has become both more persistent and broader-based, whether you look at the common component of individual price patterns or at diffusion indices.1 So, what happened? “Drivers of Post-pandemic Inflation in Selected Advanced Economies and Implications for the Outlook”, FedsNotes, Board of Governors of the Federal Reserve System, January 13, 2023 With hindsight, we know that the world-wide lockdowns and staggered reopenings that followed generated multiple supply-demand mismatches. Complex supply chains only proved as resilient as their weakest link, resulting in bottlenecks and rising delivery lags. Disruptions to global trade were global and dramatic.2 Restrictions on activity persisted and demand rotated towards consumer goods, a surprise that quickly depleted industrial and retail inventories. The reopening was long and drawn out. Firms struggled to re-hire employees laid off months earlier and labour force participation plummeted, eventually causing widespread labour shortages. Given this turmoil in the global economy, the Russian invasion of Ukraine was sure to roil markets and supply chains further, as unhelpful and tragic as it was incomprehensible. Not all these developments were outside the purview of policymakers. As the consensus saw risks skewed towards disinflation at the start of the pandemic, so policymakers responded forcefully to the shock. Policy rates were slashed, often to zero.3 Central banks, including in some emerging countries, purchased fixed-income securities. Governments boosted cash transfers to households and firms. Policymakers also drew lessons from the period following the Global Financial Crisis (GFC) and kept stimuli in place, well after economies had reopened.4 The impact on demand was massive and with supply still constrained, it compounded the growing inflation problem. With hindsight, this was a policy error.5 These policy responses also exacerbated the demand-supply imbalances in labour markets, adding another channel for inflation pressures. Ample cash transfers allowed “Growing challenge of empty container returns adds to US supply chain disruption”, Journal of Commerce, August 18, 2022 By March 2020, the US Fed Funds rate had been lowered to a range of 0–0.25% (a cumulative 150 basis points reduction since the start of that year). The Bank of England similarly lowered its policy rate by 65 basis points to 0.1% over the same period. Meanwhile, the European Central Bank and Bank of Japan maintained their policy rates at their long-standing levels of 0% and -10% respectively. Interest rate adjustments were also accompanied by large asset purchases. Economies implemented additional supplementary relief measures throughout 2021: The EU adopted a EUR672.5 bn Recovery and Resilience Facility (RRF) in February 2021; and the US, a USD 1.9 tr COVID relief bill in March 2021. Japan approved a USD490 bn stimulus package in November 2021. The GFC did not constrain supply in the same way as the pandemic, or for so long, so production could efficiently respond to sustained demand where it was offered. many workers to ‘pick and choose’ from offers, while hybrid work changed the geographical distribution of labour supply. At a time when shifting spending patterns altered the demand for labour, mismatches grew, putting upward pressure on wages. Perhaps the biggest single problem had to do with how all this stimulus was positioned as a ‘new’ policy that would be kept in place for an extended time. I would characterise this as an adverse, unintended consequence of policy commitment and credibility. Providing more certainty to markets than was possible, we central bankers positioned shifts in stance too often and fully as policy change, at the wrong time. When we overdraw these changes, our ability to change direction is compromised. When the data further puts our commitment into question, we get sharply higher uncertainty and volatility. Imbalances persist As we stand now, some of the supply/demand mismatches I just described have abated. Natural gas prices are back near pre-war levels. Global prices of food commodities have declined and shipping costs normalised. Supply bottlenecks have eased, and delivery lags are again in line with historical norms. Yet not all imbalances have been resolved. Three years since the pandemic started, labour markets remain tight, with unusually high levels of vacancies relative to (low) unemployment levels.6 Furthermore, while year-on-year rates of inflation have peaked in most economies, the latest readings in major countries have shown stronger shortterm momentum in consumer prices. Services prices and core goods prices are either sticky or have re-accelerated, and with wages continuing to rise, the inflation environment is much more complex today. This places existing forecasting and macroeconomic models at serious risk of underperforming. Outdated data in advanced economies is one challenge. Another is simply the sharp rise in uncertainty and how it impacts on important model variables, like inflation expectations. As Lord Mervyn King observed, given the uncertainty, the 6 This suggests persistent shifts in the supply of labour, with many workers either ‘opting out’ of employment, or taking early retirement, or waiting for better pay or working conditions – all factors putting upward pressure on wage inflation. model assumption that inflation expectations remain anchored to target is too strong.7 To complicate matters, our ability to derive useful conclusions from short-term data also requires humility. Short-term elasticities can be assumed to be in flux, but in what way? Is, for example, the pass-through of energy costs to final consumer prices stronger, faster, or more or less symmetric today than yesterday?8 Will falling energy prices have a measurable effect on wages that are rising for structural reasons? Our models tell us that declining real incomes significantly counters a surge in inflation. But the labour market behaviour causing that outcome has very likely changed. Economic policies and structural factors suggest stronger responses of nominal wages to inflation. Are the implied changes to our Phillips curves permanent or do we need to adjust to non-linearities and more microeconomic ways of analysing labour supply?9 Companies’ profit margins have also increased, suggesting greater capacity of firms to pass through costs to consumers.10 Various explanations for this have been posited, some less influenced by economics. Before we can get to firm conclusions about this, it seems useful to sort through the interactions between the many short-term demand and supply forces, simultaneously affected by lockdowns, supply constraints and technological change.11 It may also be the case that a switch has been flipped – the price-formation process has become dynamically less benign, as the Bank for International Settlements last year pointed out in its paper on regime shifts. Rather than understanding consumer prices as a fading reflection of relative price shocks, they may co-move in self- See for example “Central banks have ‘King Canute’ theory of inflation, says former Governor”, The Guardian, 23 November 2021. See “Monetary policy after the energy shock”, Fabio Panetta, Member of the Executive Board of the ECB, 16 February 2023, and Bloomberg Interview with Isabel Schnabel, Member of the Executive Board of the ECB, 15 February 2023. Recent experience of large positive employment gaps (negative unemployment gaps) raising inflation significantly provides strong evidence for a non-linear Phillips curve. Central banks should therefore consider incorporating downward wage and price rigidity and non-linear Phillips curves into their macroeconomic models. See “25 Years of Excess Unemployment in Advanced Economies: Lessons for Monetary Policy”, Joseph E. Gagnon and Madi Sarsenbayev, Peterson Institute for International Economics, Working Paper 22-17, October 2022 See Schnabel, 2023 (op. cit.) To give one example from South Africa, core goods prices are sharply higher on the back of imported automobile prices. Is this a permanent shift in pricing power on the part of manufacturers? reinforcing ways – less a wave in a pond and more a tsunami building up as it gathers energy.12 I am also not sure that we can simply say that labour market cost pressures are primarily a result of labour force participation rates that fell with the pandemic and will now rise again, easing wages. A case could be made that the drawing in of elderly workers in the pre-pandemic period reflected high demand and a shift away from a preference for leisure because, for various reasons, returns to work had risen and returns to savings had fallen, alongside other kinds of factors.13 As I turn to central bank policy more directly, our inflation dynamics discussion also suggests that we may need to unlearn some lessons about cyclical policy from the GFC period. Rising debt with inflation and interest rates weakens the utility of fiscal and monetary expansion to address any source of slowing growth. This idea of policy inefficiency is a mainstay of emerging market policy thinking, but less commonly articulated in advanced economies.14 This is not to say that central banks could have or should have stepped back from action in the pandemic, but it does prompt consideration of challenges to central bank policy in the wake of the pandemic. Inefficiencies in policy transmission and new trade-offs As inflation increased, central banks withdrew the stimulative policies put in place during the pandemic. However, it is less clear that we are now in unambiguously tight policy territory. Real rate levels are barely positive and still negative in much of the world, and easing inflation acts as less of a drag on economic activity. When we turn to nominal rates, we see they are acting on credit demand, in particular in important markets like housing. But their effects are less obvious in other areas, in part because of structural developments and more persistent relative price shocks stemming from climate change, technology and now geopolitics. Policy clarity is further “Inflation: A look under the Hood”, Bank for International Settlements, Annual Economic Report, 25 June Such as early retirement ages and preferences for work to provide meaning and belonging. “When is debt odious? A theory of repression and growth traps”, Viral Acharya, Raghuram Rajan and Jack Shim, NBER Working Paper Series, May 2020 undermined by the high degree of forecast uncertainty and the role of the unobservables. With so many structural changes occurring, potential GDP and neutral real interest rates are moving around. Such shocks will tend to muddy our sense of policy effectiveness and how we react in this environment. The possibility of over-tightening is clearly real, but central banks can also rectify their stance more quickly than in the event where they ‘under-tighten’. At this point in my story, it becomes hard to dodge the problems associated with financial institutions and financial stability more broadly. While most central banks will move quickly to cordon off financial stability concerns from monetary policy where a trade-off emerges, the neatness of this will always be suspect. There will always be a more or less constant second-guessing of the monetary stance where tightening needs to happen, leading to market volatility. More fundamentally, does the existence of such a trade-off undermine price stability? If our financial regulatory requirements imply savers’ deposits and investments at banks are at risk from market repricing, then do central banks have to permanently socialise losses just to keep the financial sector turning over? And with what long-term implications with respect to central bank finance, relationships with national treasuries and ultimately independence? South Africa in the emerging market universe Let me now turn to the situation of emerging countries. In a globalised world with long value chains, factors such as energy prices and shipping costs, shortages of semiconductors or storage capacity will affect a broad set of prices in many countries. Integration in global food markets impacts local food prices. Common global factors, such as food and energy, also increasingly determine services prices.15 As the dollar has strengthened, the inflationary impact of currency depreciation has resurfaced, a result of the reduced appetite for risk and the relative attractiveness of EM assets.16 Using principal component analysis, economists at UBS research recently identified that the share of price variance across countries explained by a global factor was at its strongest since 2007, not just for core goods (ex food and energy) but also for services. See “Global inflation is turning in all major subsectors”, Global Economic Perspectives, UBS, 17 February 2023 ”Dollar invoicing and the heterogeneity of exchange rate pass-through”, Emine Boz, Gita Gopinath and Mikkel Plagborg-Møller, American Economic Association, May 2019 As global price pressures rose, inflation expectations also increased, reflecting our local propensity to stagflation. However, not every EM central bank faced the same price pressures, nor needed to respond in the same fashion. If we compare the response of monetary policy in South Africa to that of its emerging market peers, we see that it falls “somewhere in the middle”. Our repurchase (repo) rate currently stands at 7.75%, representing a cumulative increase of 425 basis points since we began raising rates in November 2021, compared to the policy easing of 300 basis points in 2020 in response to the pandemic. Our inflation rate is 7.0% at present, or 5.2% when excluding food, petrol and energy. While both rates are still above the midpoint of our 3–6% target range, headline inflation is off its highs of a few months ago and compares favourably to our emerging market peers. Several factors probably explain why South Africa did not experience the same acceleration in prices as many other countries. First, budgetary stimulus in 2020 was relatively guarded, and successive budgets have strived for a primary surplus. Second, South Africa’s inflation target credibility helped to dampen the initial waves of global inflation, keeping inflation expectations muted for some time.17 Third, the depth of our domestic capital markets has limited exposure to swings in hard currency interest rates, while South Africa’s net international investment position has remained positive in rand terms, suggesting little needed change in what is a beneficial level of international financial integration. Alongside a current account surplus from a robust terms of trade, relatively low levels of external and foreign currencydenominated debt, the currency played its role as an ‘automatic stabiliser’ without triggering financial concerns. Over the ten-year period running up to May 2022, when inflation breached the upper end of the target, 83% of the time monthly inflation was within the target band. Implications for policy going forward With negative real policy rates and the accompanying commodity price boom, a large part of our recovery was demand driven. The terms of trade, fiscal expansion and the lower borrowing costs were, nonetheless, offset in part by higher household and corporate saving.18 Alongside very low potential growth, a function of energy constraints primarily, the output gap has been much smaller than expected and measured to be zero in recent quarters. The weak growth performance entails further risks in a world where globalisation is retreating, with real yields propped up by high borrowing demands and insufficient efforts to get growth moving. South Africa and other emerging economies need to work harder to attract capital. This is even more true in a world in which neutral real rates in advanced economies shift higher, a prospect that looks increasingly likely. In such conditions, emerging economies run a serious risk of becoming permanently more prone to currency depreciation and higher inflation. On its own, this prospect pulls up our neutral rates, and can only be combatted with more orthodox policy measures. Clearly, in South Africa, structural reforms and key deregulations of transport and electricity are critical. But so too is a shift in fiscal policy back to predictable, transparent rules. With the rise in debt created by our efforts to confront weakening growth and failures of state enterprises, there is little chance of improving credit quality without new rules and more strategic use of macroeconomic policy. A major benefit to fiscal policy and to stronger growth would be the implementation of a revised inflation target in South Africa. A lower target, sitting at 3%, would help dampen exchange rate volatility and sovereign risk, reduce the potential for upward drift in the real exchange rate, and materially lower debt service costs, primarily for the now over-indebted public sector.19 Offsetting effects occurred in respect to volumes of exports and imports, even as price effects were strongly positive. “Monetary Policy in South Africa: 2007–21”, Patrick Honohan and Athanasios Orphanides, World Institute for Development Economic Research (UNU-WIDER), Working Paper 2022–29 Concluding remarks In conclusion, we look forward to further easing in global inflation and falling inflation expectations, in particular in emerging economies where they have ratcheted higher over the past year. Compared to the high inflation era of the 1970s, central bankers are probably better equipped to deal with the problem. We have a better understanding of the role of expectations in shaping price patterns, and of the relative importance of supply versus demand factors as well as better statistical tools to measure them. The inflation targeting framework now used by most central banks has provided a more solid anchor than the more ‘ad hoc’ approaches of those earlier high-inflation decades. However, complacency is a subtle enemy in this particular policy effort. It is true that central bankers are better able to address inflation should it stay high, but doing so effectively requires much greater fiscal complementarity and for good communications to play a critical role in keeping expectations in check. From the side of central banks, the policy challenge in communications should be achievable, even though credibility in the markets has deteriorated. I am less sanguine about policy coordination, particularly with fiscal authorities, when demands on the public purse are so high and some long-term costs, such as from financial bailouts, remain hidden from view. Should coordination take place, the institutional setup should be such that the remit of each of the authorities is clearly spelt out and accountability maintained. Perhaps the weakest link in our analytical and policy frameworks remains our ability to identify, measure and adjust to structural changes, such as climate change, demographics and labour markets, technology and trade. These drive relative price adjustments and create persistence in inflation but defy easy analysis. Central banks globally need to have more respect for these determinants of inflation, and advanced economies should consider taking greater comfort from minor recessions, instead of prolonged periods of weak growth that bedevil larger emerging economies like mine. Together, cyclical and ongoing structural forces will present a rich and varied set of topics for central banks to focus on in coming years. Let’s ensure we remain up for the challenge. Thank you. | south african reserve bank | 2,023 | 4 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the American Chamber of Commerce, Pretoria, 5 April 2023. | Lesetja Kganyago: Monetary policy amidst high inflation Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the American Chamber of Commerce, Pretoria, 5 April 2023. *** Introduction Ladies and gentlemen, thank you for inviting me to address you today. As you know, South Africa and the United States (US) have a long history of economic cooperation, and American businesses have played an important role in the development of our economy. South Africa is the US's largest African trading partner and has the most diversified and industrialised economy on the continent. Last year alone, the US accounted for close to 9% of total exports and 7% came from imports. In 2021, US exports to South Africa totalled US$5.5 billion a 25.8% increase from 2020, while US imports from South Africa totalled US$15.7 billion a 38.5% increase. There are approximately 600 US businesses operating in South Africa and many use South Africa as their regional headquarters,1 and a springboard for greater opportunity on the African continent. Today I want to talk about monetary policy in the context of high inflation and an environment of low growth - conditions which are, unfortunately, normal for South Africa but now also feature globally. The challenge currently being faced by all central banks is how to steer monetary policy to get inflation down without plunging the economy into a recession, and doing so in a context in which key determinants of inflation and growth are outside our control. Getting policy correct in turn depends on how well we handle the analytical challenge of distinguishing between the supply and demand sources of our inflation and growth problems. Are the price pressures we see today related to specific shocks that will gradually fade, or are they more permanent? How are global shocks impacting a country like South Africa and how should policy respond to them? These are the questions I will try to unpack today. Where we stand now Higher energy and other commodity prices, supply bottlenecks as well as insufficient inventories are some of the factors that drove inflation sharply higher in 2021 and early 2022. In recent months, headline inflation has started to come down in most jurisdictions, largely reflecting lower energy prices. By contrast, core inflation rates remain sticky. The lagged effects of energy, food and other cost increases are still feeding through to wages, services prices and many final prices. 1/4 BIS - Central bankers' speeches Furthermore, in many countries, labour markets remain very tight, even as economic momentum has slowed. This has forced businesses to offer higher wage increases to attract or retain workers. Furthermore, indications of still-solid profit margins suggest that firms continue to have significant latitude to pass through costs to their customers. So, while inflation forecasts show a decline in inflation, both for headline and core inflation, the uncertainty about the trajectory is very high. Forecasters are unsure about the terminal level of inflation and how fast it will get there. For example, members of the Federal Open Market Committee (FOMC) foresee, on average, personal consumption expenditure inflation of 3.3% this year and 2.5% in 2024. Consequently, the world may, for a relatively long period, have interest rates that are high by the standards of the past 20 years. Banking strains and policy While it is clear that central banks prefer to address higher-than-desired inflation with interest rates, there is a possibility for financial stability concerns to cloud policymaking. Financial markets have adjusted their forecasts for rates in recent weeks as strains in financial institutions emerged. However, it is important to remember that while pockets of vulnerability exist in the global financial system and can be exposed by the recent quick shift to more elevated funding costs, global banks are by and large much better capitalised and more resilient to shocks than they were before the global financial crisis. This explains why, at least so far, central banks have been able to 'ring-fence' problem institutions and maintain confidence through targeted interventions, without compromising on the necessary steps required to bring inflation back to target. This separation of financial stability concerns and the policy steps needed to address inflation is a critical benchmark for policy effectiveness. Central banks need to emphasise how the determinants of the two problems differ, how policy in each domain can and should respond, and to maintain the trust of the markets and the public so that the correct steps are taken. How the world affects South Africa There are several channels through which the global developments I have just described influence South Africa's economy and markets and, in turn, the policy response of the South African Reserve Bank (SARB). First, higher global interest rates weigh on world growth, and hence the demand for South Africa's exports. The impact on our balance of payments and, in turn, the rand, can be compounded as slower global growth reduces the prices of our commodity exports. Second, global banking strains can also result in reduced lending to South Africa, as such pressures often prompt major financial institutions to pull back loans from 'riskier' destinations, especially emerging market countries. However, South African banks do not have large external liabilities, while the corporate sector is not heavily dependent on foreign bank financing. Hence, we are confident that this channel of contagion should remain relatively limited. 2/4 BIS - Central bankers' speeches Lasty, financial markets are probably a stronger channel through which global conditions affect South Africa. Portfolio flows have historically been a key source of funding for our current account, which is in a deficit most of the time, and these flows are highly sensitive to global financial conditions. South Africa's current rating status as well as the recent greylisting of the country by the Financial Action Task Force will continue to exert downside risks to the rand, which has already underperformed most of its emerging market peers in recent months. Domestic inflationary pressures As described earlier, the exchange rate remains under pressure due to idiosyncratic domestic factors as well as the evolving global situation, thus exerting upward inflationary pressures. This limits the benefits of slowing global inflation to domestic inflation. In fact, the SARB has revised its inflation projections upwards – headline inflation is now forecast to decelerate at a slower rate, averaging 6.0% in 2023 (5.4% previously) from 6.9% in 2022. This is, in the main, due to higher fuel and food price inflation – a direct consequence of a more depreciated exchange rate. Domestic food price inflation continues to rise despite normalising global agricultural commodity prices. Inflation pressures on food price inflation appear to be broad-based, with most components still at double-digit inflation rates. While these pressures are expected to ease over the forecast period, food price inflation usually spills over into wage costs and other constraints, such as electricity and logistics, which will continue to put upward pressure on prices and business input costs. Fuel inflation continues to decline, benefitting from the correction in oil prices on the back of slowing global demand. However, here again, the depreciation in the currency is limiting the extent of this benefit, and it is thus likely to keep headline inflation elevated. In addition to this, while core inflation surprised on the downside recently, the exchange rate-sensitive core goods continued to accelerate. Second-round effects are also starting to show up in services inflation, with categories such as restaurants and hotels as well as public transport rising significantly. Other key services components such as insurance and housing inflation are starting to normalise from their recent lows, with insurance inflation averaging 6.4% in the recent outcome (February) compared to 3.1% at the same time in the previous year. Inflation expectations, which have increased and remained above the target midpoint, are also key to the overall evolution of services inflation. They largely characterise wage negotiations and ultimately inform price formation in the economy. Monetary policy going forward In light of all this, the SARB has often been asked: What is your view on economic growth and what is your forecast for inflation? These are important questions for any central bank and we find ourselves faced with an important conundrum, that is, juggling high inflation against low growth. Like many of our global peers, we are cognisant of weak growth prospects. Our gross domestic product (GDP) projection for 2023 is 0.2%, on the back of the electricity supply deficit. By contrast, inflation remains elevated. Our primary goal as a central 3/4 BIS - Central bankers' speeches bank is to anchor inflation expectations and to reduce the extent to which higher inflation does spill over into pricing behaviour in the following year. Our role as central banks is to keep inflation expectations anchored to prevent wage spirals from generating permanently higher inflation. As discussed at our Monetary Policy Committee (MPC) meeting held at the end of March, the balance of risks to the inflation outlook are assessed to be on the upside. As we have conveyed on several platforms, we believe that we have taken the right decisions over the past few MPC cycles to ensure that we get inflation back to the midpoint of the target range, but this cannot preclude further steps if inflation and inflation expectations continue to surprise higher. At this stage, we do not know what the terminal interest rate level will be, but we hope that the way in which we explain our policy creates confidence that future inflation will come back to target. We continue to monitor data and developments and we stand ready to act, as and when warranted. Concluding remarks In conclusion, I think many of us will agree that the emerging financial vulnerabilities are introducing new headwinds for global financial markets. As such, global conditions are likely to remain volatile in the near term, with tightening financial conditions in the US as new weaknesses in financial institutions emerge and concerns of contagion intensify. On the upside, the banking sector, globally, is much better capitalised than it was in 2008 and has become more resilient to shocks. However, central banks have to guard against continued volatility in financial markets while ensuring that they keep to their mandate of price stability. Thank you. 1 Details are available at https://www.state.gov/u-s-relations-with-south-africa/ 4/4 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 4 |
Remarks by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the Market Practitiners Group Conference, Sandton, 19 April 2023. | Remarks by Dr Rashad Cassim Deputy Governor of the South African Reserve Bank, at the Market Practitioners Group Conference, The Galleria, Sandton 19 April 2023 1. Introduction Good morning, all, and welcome to the second Market Practitioners Group (MPG) conference. I joined this industry body just over a year ago, at a time when the MPG had already identified a successor rate to the Johannesburg Interbank Average Rate (Jibar), namely the South African Rand Overnight Index Average (ZARONIA). At the time, the MPG commenced the foundational work to ensure a smooth and effective transition away from the use of Jibar. Various milestones were reached over the past year, including the development of a mechanism to collect high-quality transaction data to calculate and distribute ZARONIA rates daily; refinement of the transition plan; publication of a white paper on market conventions for ZARONIA-based derivatives; and the inclusion of fallback rates in financial contracts. However, there is a still a great deal of work to do and the eight MPG workstreams are working full steam to take on board the issues that need to be resolved. The objective of this conference is to bring together all the pieces of work into a coherent strategy, and to give you a clear picture of what the MPG is aiming to achieve Page 1 of 12 and the direction in which we are moving. We hope that at the end of this conference, you have a good grasp of what your organisations will require to successfully adopt ZARONIA and transition away from Jibar. At the risk of covering ground familiar to many of you today, I will provide some background and context to our reference rate reform initiative and move on to discuss transition challenges. 2. Why bother with reference rate reform? The reform of key reference rates globally began in earnest after the Financial Stability Board’s (FSB) review of major interest rate benchmarks in 2013–2014, which was a response to concerns raised by a wide range of stakeholders regarding the reliability and robustness of certain interbank offered rates (IBORs)1. It had become clear that IBORs were susceptible to manipulation as their computation relied on indicative rates supplied by a panel of contributing banks. Furthermore, they had become irrelevant due to declining volumes of unsecured funding market activity. As many of you know, the relevant international standard setting bodies require a benchmark to be representative of the underlying interest rate that it seeks to measure. To illustrate, some analysts framed the weaknesses in the design of the London Interbank Offered Rate (Libor) as a case of ‘measurement error’2, pointing out that Libor tended to be less representative of actual interbank rates during times of stress as certain contributing banks, being weary of revealing information that might increase their borrowing costs, would submit biased quotes. Based on these findings, several jurisdictions convened national working groups to review their respective IBORs. There was widespread agreement that IBOR rates should be discontinued and replaced with more robust risk-free or near risk-free rates. Some regulatory authorities went a step further, such as the United Kingdom’s (UK) Financial Conduct Authority (FCA), which no longer compelled panel banks to FSB (2014), Reforming major interest rate benchmarks. Baba, Parker and Nagano (2008), The spillover of money market turbulence to FX swap and cross-currency swap markets – BIS Quarterly, March 2008 Page 2 of 12 continue their Libor submissions after December 2021, effectively heralding the end of Libor3. 3. Is it necessary to do away with Jibar? Considering the global effort to reform key reference rates, the South African Reserve Bank (SARB) evaluated the design of Jibar against the recommendations of the International Organization of Securities Commissions (IOSCO) Principles of Financial Benchmarks. This was necessary because Jibar, in particular three-month Jibar, is a widely used reference rate in financial contracts. The latest Jibar-related exposures survey results estimated that the total value of outstanding contracts that reset against the three-month Jibar rate exceed R30.6 trillion4. Jibar is also a key input in the determination of the Short-Term Fixed-Interest (STeFI) Index, which is a non-tradable index used to benchmark the performance of money market portfolios. Through this evaluation, the SARB found, like many other countries, Jibar exhibits some of the weaknesses that were observed in the design of certain IBORs. The benchmark is based on indicative rates from only five contributing banks, making it vulnerable to manipulation. However, unlike Libor, the indicative rates are quoted on active screens, and hence they are tradable for all transactions whose nominal falls between R20 million and R500 million5. While this feature lends more credibility to Jibar, on its own it is unlikely to be effective in minimising the risk of manipulation. Furthermore, the issuance of negotiable certificates of deposits (NCDs), which underpins the calculation of Jibar, has declined considerably over the years, especially for the three-month tenor, compromising the representativeness of the benchmark. Consequently, the SARB determined that Jibar’s design weaknesses will become less defendable in the long term, and therefore it would be prudent to plan for the Refer to the FCA announcement on the future cessation and loss of representativeness of the Libor benchmarks – 5 March 2021 The amount relates to exposures as at 31 December 2022. The Jibar Code of Conduct and Operating Rules (Code) initially stipulated that screen prices must be good for a range of transactions that fell between R20 million to R100 million. The upper limit of the range was subsequently increased to R500 million following a revision of the Code, which was prompted by the recommendations of the MPG’s Unsecured Reference Rate Workstream aimed at enhancing the credibility of Jibar. Page 3 of 12 discontinuation of the benchmark and for financial markets to transition away from it. In the interim, the SARB implemented the MPG’s proposed measures to strengthen Jibar by enhancing the transparency of market activity that underpins the benchmark and by introducing various provisions in the Jibar Code of Conduct and Operating Rules (Code). The SARB appointed Strate (Pty) Limited to be the publishing agent for all Jibar-related post-trade disclosures6. The revisions to the Code have been completed and adopted and continue to undergo regular reviews. 4. The alternative near risk-free rate, ZARONIA It may be comforting to know that ZARONIA has been in the making for about five years. The name of the benchmark was initially coined in the feedback to a 2018 consultation paper in which market participants suggested that the South African Benchmark Overnight Rate (Sabor) Money Market, a proposed reformed version of Sabor, be named ZONIA, supposedly given its likeness to the Sterling Overnight Index Average (SONIA), the UK’s near risk-free rate. Nonetheless, we settled on ZARonia, where the emphasis was placed on ZAR (i.e. the South African rand)7. The MPG selected ZARONIA following an in-depth assessment of several alternatives8, most of which were deemed insufficient against the criteria of reliability, robustness, frequency, availability and representativeness.9 Prior to making its final decision, the MPG assessed the suitability of ZARONIA as an alternative near riskfree rate based on three requirements, which I will now discuss. The first requirement is rather deceivingly simple. It demands that a selected near riskfree rate should be very close to being risk-free – meaning that the transactions underlying the ZARONIA rates should, to a large extent, not reflect the credit risk of https://www.resbank.co.za/en/home/what-we-do/statistics/johannesburg-interbank-averagerate#:~:text=The%20post%2Dtrade%20disclosures%20consist,of%20the%20transactions%20traded%20daily. Refer to the summary of market participants’ comments on the Consultation Paper (2018) contained in the Report on the stakeholder feedback on the reform of interest rate benchmarks in South Africa (recommendation 4). The position paper of the Risk-Free Reference Rates Workstream (2020) summarises the considerations and conclusions made on the foreign exchange-(FX) implied overnight (O/N) rate Sabor, Sabor MM (the reformed version of Sabor), SAFEX O/N rate, ZARIBOR and SASFR (referred to as ZASFR in the draft statement of methodology and policies governing the SARB-administered benchmarks) BIS (2013) – Towards better reference rate practices: a central bank perspective Page 4 of 12 the counterparties to the transaction. ZARONIA is a near risk-free rate, as it is the commercial banks’ cost of borrowing overnight, where credit, liquidity and other risks are minimal. A more appropriate way to assess whether the risk premium is minimal would require a comparison of ZARONIA with a secured overnight rate or an extrapolated curve of risk-free instruments. However, the most available secured overnight rate, the overnight repurchase (repo) rate, is fraught with difficulties due to thin trading activity and a high concentration of market players that cause the rate to be wider than expected. It is also difficult to extrapolate a reliable credit curve from the spread between Jibar and Treasury bills, as the latter tend to be relatively illiquid due to their use as high-quality liquid assets (HQLA). Nonetheless, a crude measure for the risk premium would be to look at the spread between ZARONIA and the SARB’s policy repo rate. It would be reasonable to expect that ZARONIA, as an unsecured rate, would be above the repo rate (secured rate) but remain very close to it. On average, the ZARONIA repo rate spread is about -15.5 basis points10, meaning that not only is ZARONIA close to the policy repo rate, but it is usually priced below the secured policy rate. The second requirement relates to the depth of the market underlying ZARONIA. The IOSCO Principles of Financial Benchmarks recommend that a benchmark rate should be anchored in actual transactions that reflect the activity of a deep and liquid market, including in periods of adverse market conditions. This would make the benchmark more robust to manipulation.11 ZARONIA is supported by a significant amount of unsecured overnight transactions, which average circa R350.4 billion daily. The last requirement is whether ZARONIA is ‘fit for purpose’. Two distinguished American academics, Darrell Duffie and Jeremy Stein (2015) highlight that reliable benchmarks should reduce search costs in over-the-counter markets and ensure that The average is based on published ZARONIA rates for the period between 1 November 2022 and 11 April 2023. FSB (2021), Interest rate benchmark reform Page 5 of 12 information asymmetry is largely eliminated.12 Remarkably, this postulation has held true for ZARONIA. Based on the back-testing exercise results, market participants had cautioned that ZARONIA may not be suitable for derivatives as the calculated rates exhibited high volatility, which would limit the predictability of the benchmark and impede its adoption. The SARB argued that the volatility was largely due to the opaqueness of the market for deposits. And hence it was expected that the volatility would decline considerably once the SARB started publishing the rate and market participants began referring to it in their pricing considerations. Certainly, the volatility of ZARONIA has been low since the SARB started publishing the rate on 2 November 2022. 5. On the Jibar transition The transition from Jibar to ZARONIA will require market participants to deal with the inherent differences in the make-up of each rate explicitly. Naturally, as an unsecured forward-looking term rate, Jibar contains a premium to compensate lenders for the risks they assume over an alternative overnight risk-free rate. The risk premium could be decomposed into elements pertaining to the borrowing banks’ characteristics, such as credit risk and funding risk, and elements that reflect market-wide conditions, including the term premium, market liquidity and factors related to the fixing process and the microstructure of the market.13 Finding the appropriate measure of this risk premium that could be added to ZARONIA will be important for financial contracts that will require a Jibar equivalent after it has been discontinued. Globally, many jurisdictions have adopted the International Swaps and Derivatives Association’s (ISDA) methodology for determining the risk premiums, commonly referred to as ‘adjustment spreads’, that should be added to the risk-free replacement rates for the IBORs. These adjustment spreads are calculated as the median over a five-year period of the historical differences between the IBOR in the relevant tenor and the relevant risk-free rate compounded over each corresponding period.14 Duffie and Stein (2015), Reforming Libor and other financial market benchmarks BIS (2008), What drives interbank rates? Evidence from the Libor panel Bloomberg Index Service Limited (BISL) calculates and distributes the official fallback rates, including the compounded RFR and adjustment spreads, for several currency IBORs in accordance with the ISDA methodology. BISL (2023) published the methodology in the IBOR Fallback Rate Adjustment Rule Book. Page 6 of 12 We have not yet finalised the issue of adjustment spreads in our jurisdiction. The MPG will examine whether ISDA’s approach is appropriate for the domestic cash and derivatives markets and consider whether the methodology needs to be adjusted to account for the recent change in the SARB’s monetary policy implementation framework (MPIF). This should only matter to the extent that the change in the new MPIF had a significant effect on the residual risk factors contained in the risk premium. Nonetheless, the MPG will make a determination on this in due course, as the adjusted ZARONIA rate will only be used as a replacement or fallback rate after the cessation of Jibar. Market participants should in the meantime aim to actively transition out of Jibar referencing contracts to minimise the stock of legacy contracts that will need to rely on the adjusted ZARONIA as a fallback rate. Market participants have become accustomed to using forward-looking term rates, where the interest rate is known in advance.15 While forward-looking term rates are helpful in ascertaining future cash flows and, in so doing, assist firms and investment funds to plan better, they also expose the investor to unanticipated changes to the short-term rates. As such, investors tend to require a term premium to account for this interest rate risk, which often results in volatility in times of greater uncertainty regarding the path of monetary policy. An overnight rate is advantageous in this regard as it should not contain much of this risk. Instead, it should change as the central bank changes its policy rate. Market participants who still require a term rate should consider using an average rate based on ZARONIA compounded in arrears. This requires a shift in the market’s convention from determining interest at the beginning of the accrual period to determining it at the end of the accrual period. As many of you know, we have set up various workstreams in gearing up for the transition. It is not possible here to do justice, to reflect on the rich work of all the workstreams, but I will give you a flavour of what is being discussed at least in one or two them. 15 This has been enforced by some regulations, such as section 8(4) of Board Notice 90, which is currently under review, which prevents money market portfolios from investing in securities whereby the interest amount is not known at the commencement of the contract. Page 7 of 12 The Derivatives Workstream has proposed market conventions for interest rate swaps, whose floating leg will use compounded ZARONIA period average rates that will be determined in accordance with the ISDA methodology. While the use of compounded risk-free rates is fairly common in global markets, it does present a significant change in our market. Firstly, the nature of ZARONIA as an overnight rate will enable the introduction of Overnight Index Swaps (OIS). In this regard, the Derivatives Workstream has proposed market conventions that largely align with international best practice. Secondly, as ZARONIA will track the evolution of actual interest rates, the need for hedging risk using Forward Rate Agreements (FRAs) will largely diminish. As a matter of interest, the decline of FRA trading was remarkable in the Libor transition, where the daily turnover of FRAs decreased from USD1.9 trillion in 2019 to USD0.5 trillion in 2022, a 19% decline in total over-the-counter (OTC) derivatives turnover. Much of the residual reflects exposure to USD-denominated turnover and other currencies that have not fully transitioned to risk-free rates. FRAs that are denominated in sterling, the Japanese yen and Swiss franc have virtually ceased trading, with their turnover having declined by more than 90%.16 Therefore, it is likely that we will see the domestic FRA market decline, and those that wish to speculate on future short rate movements will likely have to use forward-starting OISs as a replacement for FRAs.17 Given the progress made by the Derivatives Workstream we expect that the market should be able to start trading ZARONIA-based derivatives products soon after the end of the ZARONIA observation period. Nonetheless, we do not discount the amount of work that needs to finalised between now and then to enable this. The Cash Market Workstream has begun the work to determine how the loan and bond markets could adopt ZARONIA. The mandate for the workstream is twofold: (i) determine the segments of the market that will ‘need’ a forward-looking term rate; and (ii) propose market conventions for the loan and bond markets. Huang and Todorov (2022), The post-Libor world: a global view from the BIS derivatives statistics – BIS Review, December 2022 MPG (2023), Market conventions for ZARONIA-based derivatives Page 8 of 12 6. Do we really need a forward-looking term rate? Given the work done for the Libor transition, it was determined that risk-free rates compounded in arrears were appropriate and operationally achievable for most cash market segments. In the UK, overnight SONIA compounded in arrears was quickly adopted in floating rate bonds and securitisations. However, loan markets were slower to progress and they estimated that about 10% of the sterling Libor loan market by value would require alternative rates. The 10% largely comprised low-value loans made to a wide range of smaller borrowers, who could benefit from simplicity and payment certainty. The policy rate, and in some instances a forward-looking term rate, would be preferred for them. Otherwise, larger and more sophisticated corporates and specialist lending sectors tended to use SONIA compounded in arrears. The Working Group on Sterling Risk-Free Reference Rates identified certain barriers to the widespread adoption of the overnight SONIA compounded in arrears, which are instructive for the work programme of the MPG. The barriers included: • loan IT and treasury management systems that required reconfiguration to make them compatible with overnight rates that are compounded in arrears; • standardised legal documentation that facilitate syndicated lending and other loans; • the development of market conventions referencing the overnight risk-free rate; and • the development of new loan products that reference the policy rate or an alternative forward-looking term rate.18 It is essential to note that the work on finding a forward-looking term rate, or, in keeping with the reference rate reform parlance, a ZARONIA term rate, is still at an infant stage. Previous attempts at constructing a new term rate based on deposit transactions, as detailed in the SARB’s Consultation Paper (2018) and Technical Specification Paper (2020), failed due to design flaws and data insufficiency. Developing a ZARONIA term rate is dependent on the derivatives market building sufficient liquidity to underpin the Working Group on Sterling Risk-Free Rates (2020), Use cases of benchmark rates: compounded in arrears, terms rate and further alternatives Page 9 of 12 term rate. Consequently, we would encourage the market to adopt ZARONIA compounded in arrears as a primary vehicle for the Jibar transition and not wait for a ZARONIA term rate, unless necessary. 7. On the next steps We are almost halfway through the ZARONIA observation period, which will end on 31 October 2023. Market participants should use the remaining time to assess the implications of using the rate in financial contracts and issues that could potentially hinder their transition away from Jibar. The MPG structures provide a good platform for raising such issues, such as the industry task forces that are managed by the Transition Planning Workstream and the MPG Communications Workstream’s regular virtual forums, which provide updates on its work programme.19 The SARB would prefer a relatively short Jibar transition period. Therefore, market participants are encouraged to actively transition as soon as possible to avoid what was witnessed during the Libor transition. Despite repeated advice from regulators and national working groups, most market participants did not take any action to reduce their exposure until the ‘endgame’ for Libor was in sight.20 To illustrate, in 2018 the Alternative Reference Rates Committee21 (ARRC) estimated that there were about USD200 trillion financial contracts that referenced USD Libor outstanding and that 80% of those contracts would mature in the same year. Instead of the value of the outstanding contracts decreasing over the ensuing years, the contracts increased to approximately USD223 trillion.22 The stock of legacy Libor contracts would have been significantly less had market participants taken steps to actively transition from Libor and not wait for the FCA and Intercontinental Exchange (ICE) Benchmark Administration to make more definitive statements about the cessation of all Libor tenors. The MPG Communications Workstream’s action plan for year included indicative dates for the industry forums. The workstream partners with industry associations such as ACTSA, ASISA, and BASA to set an agenda that caters for the needs of their constituents. Refer to ISDA (2021), The Libor End Game ARRC is a group of private market participants convened by the Federal Reserve Board and New York Fed to ensure a successful transition from USD LIBOR to the alternative Secured Overnight Financing Rate or SOFR. Randal K. Quarles (2021), Keynote remarks at the SOFR Symposium: the final year Page 10 of 12 The exact date for the discontinuation of Jibar will be determined and communicated soon after ZARONIA becomes available for use; however, the SARB’s preference is for the transition period to be less than the five years it took for the Libor transition. This is premised on progress achieved thus far and our ability to leverage off the work that has been completed in other jurisdictions. It would be unwise to re-invent the wheel and develop unique solutions that do not conform to international best practice. It is essential that each firm plans properly and ensures that sub-business units and business functions are ready to action the plan accordingly. The checklist for the implementation of the Jibar transition and ZARONIA adoption23 should include: • establishing an enterprise-wide Jibar transition programme across functions and businesses to manage the transition risks associated with Jibar-related exposures; • quantifying and monitoring Jibar-related exposures throughout the transition; • developing a product strategy that includes creating ZARONIA-based products; • developing a plan to address the required changes to technological infrastructure, processes and people skills required for the Jibar transition and the use of ZARONIA-based products; • determining the financial accounting, taxation and regulation considerations; • determining the financial, customer and legal implications that will result from the transition and plan for the inclusion of fallbacks in financial contracts; • developing a communications strategy to proactively engage and educate internal and external stakeholders; and • establishing a governance framework with senior executives to oversee an enterprise-wide Jibar transition programme. 8. Conclusion The success of this transition is contingent on our attempt to consult as widely as possible with all market participants and other stakeholders to ensure that all potential risks are addressed. This conference is a reflection of how serious we are about the The checklist is adapted from the ARRC (2019 ), Practical Implementation Checklist for SOFR Adoption Page 11 of 12 responsibility of ensuring that the process of ultimately moving to ZARONIA is as seamless as can be. After all, this transition marks a significant turning point in the history of South Africa’s financial markets, given its impact on a broader set of financial products in various market segments. Certainly, the MPG has established various workstreams that will provide industrywide guidance and make recommendations on all the essential aspects of the Jibar transition and ZARONIA adoption, which will be made available on the MPG’s webpage. I thank you and wish you a productive conference further. --- End --- Page 12 of 12 | south african reserve bank | 2,023 | 4 |
Public lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the University of Johannesburg, Johannesburg, 10 May 2023. | Public lecture by Lesetja Kganyago, Governor of the South African Reserve Bank, at the University of Johannesburg, 10 May 2023 Challenges facing the global economy: a South African perspective Ladies and gentlemen, it is with great pleasure to be invited to address you today. The past few years have been a rollercoaster – evidenced by the numerous shocks that we have been faced with in a space of just three years. While the global economy at large continues to recover from the COVID-19 shock, and as we navigate what one could consider a new normal, there are important challenges that we continue to face as policymakers across the world. As such, the topic chosen for my address today – challenges facing the global economy from a South African perspective – could not be more fitting. This topic is particularly important for South Africa which, alongside other emerging market economies, has had its own idiosyncratic challenges being exacerbated by these global shocks. In light of this background, my speech today will focus on how inflation, growth and the monetary policy outlook have impacted our domestic economy. Before doing so, it is probably important that we do a quick recap of where we have come from. Global developments since the outbreak of the COVID-19 pandemic The major disruptions since the onset of the COVID-19 pandemic have been an important learning exercise for global economic policy. With no precedent in recent history to learn from, it has highlighted the importance of finding appropriate policy responses required to address the shock. The unusually large supply and demand imbalances we witnessed during and post the pandemic were a result of the sudden restrictions (and consequent relaxation) of economic activity as authorities around the world sought to contain the spread of the pandemic. You will remember that prior to the COVID-19 pandemic, global inflation was quite low, with many major central banks struggling to get inflation up to the 2% target. Soon after the pandemic hit, broad-based declines in inflation followed, which then, in response, induced a wave of fiscal and monetary stimulus. The South African Reserve Bank (SARB) itself reduced its repurchase ‒ or repo ‒ rate to an all-time low of 3.5% in July 2020. This stimulus provided by policymakers to mitigate the impacts of the pandemic, together with pent-up demand from the COVID-19 restrictions and the much slower reopening of the services sectors, boosted the demand for goods while supply remained constrained. This, in turn, fuelled what would eventually be the highest rates of global inflation in a generation.1 As the global economy was gradually recovering from the COVID-19 shock, another unexpected shock came early last year: Russia’s invasion of Ukraine which triggered a war that still rages on today. The war in Ukraine compounded the shock to the prices of oil, gas and some inputs into food production, such as fertilisers – further fuelling the global inflation problem. With the benefit of hindsight, we now know that the various stimulus efforts by policymakers contributed to the inflation problem we are currently sitting with. Nonetheless, the stimulus was much needed and supported demand conditions at a time when consumer confidence had been crushed by the lockdowns and furloughs. However, it is now clear that fiscal and monetary policy remained too loose for far too long. The ultra-low interest rates and generous transfers to World inflation calculated by Haver rose to a peak of 9.4% in September 2022 and was still in excess of 7% in March this year. households and businesses created excess demand ‒ in an environment where supply constraints have lowered potential output in most economies ‒ which, in turn, ignited the inflation problem we currently face. Subsequently, global inflation pressures have resulted in many central banks around the world embarking on unusually fast and synchronised monetary policy normalisation. The SARB itself implemented a series of 75 basis point hikes over the past year – faster than in prior tightening cycles. Since November 2021 to date, we have raised the repo rate by a cumulative 425 basis points. However, for context, the cumulative repo rate increases by the SARB have been below those implemented by some of our emerging market peers and, more importantly, the real repo rate is still below its estimated neutral level of 2.5%. Where are we now? It is encouraging to see that some of the shocks that drove the surge in global inflation have begun to ease. After peaking around the middle of 2022, global inflation moderated somewhat in the fourth quarter of 2022 and into the first quarter of 2023. However, although these developments have, overall, been positive, for many economies inflation still remains elevated and well above central bank targets. Importantly, inflation is showing signs of persistence in several sectors. The latest International Monetary Fund (IMF) World Economic Outlook projects global inflation at 7.0% this year, down from the 2022 average of 8.7%. Inflation is expected to further moderate to 4.9% in 2024. This decelerating trend is reflective of lower food and commodity prices, particularly oil, coupled with the gradual unwinding of supply constraints. Although demand pressures have begun easing somewhat in response to global monetary and fiscal policy normalisation, core inflation remains high and persistent, risking prolonged target breaches in most economies, which could lead to some de-anchoring of inflation expectations. Furthermore, the global growth outlook remains weak. Following the steady recovery in trading-partner growth in 2021 of 7.0%, growth slowed to an estimated 3.5% last year. Looking ahead, and in line with higher prevailing interest rates, the SARB expects trading-partner growth to average 2.0% this year, before rising gradually to 2.6% in 2024 and 3.1% in 2025.2 In addition to slow global growth, rising interest rates have also triggered banking sector stresses in the United States (US) and Europe – leading to tighter global credit conditions as markets and financial institutions readjust their portfolios. Consequently, uncertainty around the path for the US Federal Reserve’s (Fed) federal funds rate has increased over the near term. This has added to financial market volatility and the resulting ‘risk-off sentiment’ is impacting small open economies such as South Africa. These bank stresses have also added to global policy uncertainty as the size and duration of these effects are still playing out, as can be seen in the recent failure of First Republic Bank at the beginning of May 2023. The domestic inflation landscape When I mentioned earlier some of the positive global developments over recent months, one of them has been a reduction in delivery lags and supply bottlenecks, which has contributed favourably to the inflation dynamics of some countries. Unfortunately, this has yet to have a material impact on our domestic inflation, mainly due to idiosyncratic domestic factors. In fact, it is expected that our own domestic infrastructural bottlenecks will continue to exert upside pressure on the inflation outlook. In addition to the initial studies on the impact of load-shedding on growth, there is recognition and growing evidence that the country’s ongoing energy supply challenges are impacting on prices as well. The SARB now estimates that loadshedding will add 0.5 percentage points to headline inflation in 2023.3 This calculation has taken into account the cost of alternative energy sources such as solar or back-up power generators – costs which are assumed will likely be passed on to consumers. The SARB’s global growth forecasts are based on real GDP growth in South Africa’s major trading-partner countries. See Box 1 in the April 2023 Monetary Policy Review. Overall, South Africa is no different from most countries that have experienced a surge in price pressures. With our economy being an open economy, global price pressures were bound to, sooner or later, reach our shores. Higher global food and oil prices and, more generally, elevated global goods inflation, translated to inflationary pressures in the domestic economy ‒ partly transmitted via the weaker rand – a point I will revisit later. This pushed domestic headline inflation to a high of 7.8% in July 2022 ‒ a rate that was last reached almost 14 years ago. Parallel to the somewhat easing global price pressures, domestic headline inflation has gradually slowed and came in at 7.1% in March 2023. However, despite this moderation ‒ primarily driven by a decline in fuel prices from the peaks observed in mid-2022 ‒ inflation remains well above the SARB’s preferred midpoint of the 3‒ 6% target range. Inflation edged slightly higher in February and March 2023, after recording 6.9% in January, underpinned by rising food and core inflation. Nonetheless, we expect a return to the 4.5% midpoint – though only by the third quarter of 2025. In South Africa, food inflation has continued to surprise to the upside, despite the decelerating trend observed in global agricultural commodities. Domestic meat inflation remains elevated, reflective of lingering domestic supply constraints in the beef market after the outbreak of foot and mouth disease last year. The expectation is for market conditions to improve gradually over the near term. However, the ongoing electricity supply challenge is likely to have more of an impact on energysensitive markets, such as poultry and dairy farming. Another important factor that has impacted inflation in South African has been exchange rate weakness. The rand has been one of the worst-performing emerging market currencies this year and over the past 12 months.4 Idiosyncratic factors such as persistent load-shedding and the recent greylisting of the country by the Financial Action Task Force have kept investors wary. And, by extension, The rand has depreciated around 6.8% in the year to date and by 17.6% over the past year against the US dollar. the rand depreciation has negated the impact of lower global energy and food costs on domestic inflation. Of concern is that core inflation, which excludes the more volatile food and energy components from the consumer price index (CPI) basket, remains sticky. The pressure on core inflation has been mainly driven by repriced imported goods costs. But apart from higher imported goods costs, one needs to keep an eye on core services inflation. To date, services inflation has remained relatively subdued ‒ averaging around 3.9% in 2022. However, upside risks seem clear, especially in medical insurance as premiums move closer towards their longer-term average rates. In addition to this, the tightening rental housing market and high inflation expectations are expected to exert upside pressure on core inflation over the near term. Risks to services inflation also emanate from spillover effects from higher food and fuel inflation as well as possible higher wage increases given the adaptive nature of wage settlements in our economy. (We have already seen sharply higher wage settlements in the public sector.) We predict that core inflation will only decline to the target midpoint in the second quarter of 2025. Inflation has important distributional consequences, with the poor and those living on fixed incomes the most adversely impacted. The current inflation surge has been underpinned by high food and fuel price increases that more adversely affect the consumption baskets of poorer households. Statistics South Africa (Stats SA) data show inflation for the lowest expenditure deciles (deciles 1 and 2) at about 11% in March 2023, while that for expenditure deciles 9 and 10 is around 6.5%. Unlike high-income South Africans, low-income earners and the poor more generally cannot protect their incomes from erosion due to inflation, and this results in rising income inequality in our country. This is a critical reason for the SARB’s constitutional mandate to protect the purchasing power of the rand, as this mandate ensures that we can continue to work towards improving and advancing the economic well-being of all South Africans. Looking ahead, domestic headline inflation is projected to remain elevated, returning to the target range in the third quarter of this year and averaging 6.0% for the year. A more pronounced moderation in inflationary pressures is only expected in the latter years of the forecast horizon, with headline inflation projected to average 4.9% in 2024, before reaching the midpoint of the target range only in 2025. What this means for growth The SARB, like many other central banks elsewhere in the world, has to deal with the task of maintaining price stability. In South Africa we protect the value of the currency in the interest of balanced and sustainable growth, as stated in our constitutionally enshrined mandate. The challenging part now is that we must do this in a context where many of the drivers of both inflation and growth are outside of our control. Central banks have a very constrained policy toolkit to steer growth and can only effectively smooth business cycle fluctuations. By design, central banks are not capacitated to influence the long-run growth trajectory for the economy, as the decisions needed require governments to make policy trade-offs that entail winners and losers.5 Good decisions, of course, generate growth, making it possible for governments to compensate losers both as the economy itself gets much larger but also through direct transfers where required. Fighting inflation is much harder when the economy is already underperforming, as tighter financial conditions have the effect of cooling economic activity more broadly. Yet, if allowed to persist, high inflation will either fatally undermine the economy’s growth potential or raise the nearer-term costs of eventually bringing inflation back to target. As we have often said, the prevailing conditions, more than ever before, have brought the monetary policy conundrum to the fore. For instance, world growth is expected to be lower this year as the lagged impact of policy tightening weighs on real incomes and dampens demand.6 Demand for South African exports is likely to be weaker and this could be exacerbated by a decreasing trend in commodity prices, which had previously helped mitigate what otherwise would have been a much more dire fiscal situation over the past two or Even for central banks with a dual mandate (inflation and employment), government policy dictates the full employment level (trend growth) while the central bank sets policy to keep inflation and output consistent with the given inflation target and trend growth rate. The IMF’s April 2023 World Economic Outlook forecasts world output at 2.8% this year, down from 3.4% in 2022. It forecasts South Africa’s growth at 0.1% this year (compared with 2.0% in 2022 and a projection of 1.8% for 2024). so years.7 Together with increased alternative energy imports, this means that our terms of trade will deteriorate further. Following the robust growth rate of 4.9% recorded in 2021, the domestic economy slowed sharply to 2.0% in 2022. The SARB now forecasts growth of 0.2% this year, and to average 1.0% in the following two years – this is barely an expansion. In fact, this is a reflection of the headwinds that the domestic economy continues to face. The ongoing infrastructure challenges, especially for electricity, continue to impose a hard constraint on growth. The SARB estimates that load-shedding alone will reduce GDP growth by 2% this year, after knocking off 0.7 percentage from growth in the previous year. We trust that the government will remain committed to implementing structural reform measures, especially with regard to logistics and electricity. We believe that the implementation of much-needed structural reforms will unlock South Africa’s growth potential and, in turn, address the long-standing unemployment challenges of the country. Concluding remarks In conclusion, it is safe to say that the past few years have presented a new set of challenges for macroeconomic policymakers across the globe. Although the demand and supply mismatches we witnessed at the peak of the pandemic and when the Russia-Ukraine war broke out last year have eased significantly, imbalances continue to linger, and risks remain elevated. Despite the decelerating inflation trend over recent months, inflation remains above target in many jurisdictions, with core inflation showing signs of persistence ‒ this is despite sharp policy tightening by monetary policy authorities across the globe. South Africa’s experience has paralleled that of the global economy, with high inflation and slowing growth. However, domestic idiosyncrasies have played an Elevated commodity prices had also supported the rand which helped to keep imported inflation at bay through the early stages of the domestic economic recovery. outsized role in these developments over the past year, suggesting that we could have had somewhat lower inflation and stronger growth had structural policy settings been more favourable. Put differently, we are suffering from largely selfinflicted wounds. With headline inflation having remained above the target midpoint for an extended period, the SARB’s Monetary Policy Committee has had to act decisively to prevent inflation expectations from de-anchoring more permanently. Over the past 18 months, the repo rate has been raised by a cumulative 425 basis points, and now sits at 7.75%. Still, the real policy rate remains somewhat accommodative, being slightly below its estimated neutral rate of 2.5%. As we have reiterated before, we are constantly monitoring price developments and stand ready to act as necessary to fulfil our mandate. As an independent central bank operating a flexible inflation-targeting framework, the SARB’s primary goal is to guide inflation and inflation expectations closer to the midpoint of the target band. I believe that many of us here understand that low and stable inflation is a prerequisite for a conducive business environment and, in turn, for inclusive and sustainable economic growth. We remain committed to ensuring price stability. Thank you. | south african reserve bank | 2,023 | 6 |
Text of the 2023 Michel Camdessus Central Banking Lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the International Monetary Fund, Washington DC, 11 July 2023. | 2023 Michel Camdessus Central Banking Lecture by Lesetja Kganyago, Governor of the South African Reserve Bank, at the International Monetary Fund, Washington, DC, 11 July 2023 The contribution of capital flows to sustainable growth in emerging markets Thank you for the honour of inviting me to give this lecture. Considering the people who have previously spoken at this forum, considering the stature of the audience here today, and also considering the legacy of Michel Camdessus, who led the International Monetary Fund (IMF) for so long, it is a great privilege for me to be here. My subject today will be the role of capital flows in emerging market growth. I want to start with a problem that has often bothered me. As the South African central bank Governor, I regularly meet with global investors to discuss economic conditions and policy settings in my country. The fundamental goal of these engagements is to encourage investment. Then I return from these meetings, and we have policy sessions where staff want to talk about the dangers of capital flows. But the investors I just met are the people who are responsible for the capital flowing. So, I wonder – which part of my time am I wasting? Do we want these capital flows or not? This is a global discussion, and one that has evolved significantly over my time working in macroeconomic policy. Twenty or 30 years ago, the mainstream view was that financial globalisation was good. Global markets could provide more financing, at lower rates, than countries could achieve by relying on their own resources. They would allow for better risk sharing, and they would create better incentives to get policy right. The standard policy recommendation was that controls on capital flows should therefore be liberalised, and where they were being applied, this was probably to cover for some other policy error. 1 Nowadays, the mainstream view has shifted. The IMF encourages policymakers to keep capital flow measures in their toolkits, both for pre-emptive purposes and to address capital flow surges. 2 The guidance is nuanced, and there is still appreciation for the benefits of capital flows – but as Christine Lagarde put it a few years back, “[This] is not your grandmother’s IMF” 3, and there has clearly been a big shift in the policy advice. 4 Outside of the IMF, attitudes to capital flows have been more bluntly critical. One part of this is unhappiness with spillovers from United States monetary policy, sometimes when the stance is loose, as in the ‘currency wars’ era after the global financial crisis, and sometimes when financial conditions tighten, as they did in the 2013 taper tantrum and as they have been doing during the current period. Another is the geopolitical tensions that have made ‘deglobalisation’ a buzzword. There have also been shifts in the realm of ideas, with even some mainstream economists condemning most forms of capital flows. For instance, in October 2022, Arvind Subramanian published an oped arguing that, “capitalism must be saved from its financial rentiers, and financial deglobalisation is a good place to start”. 5 Altogether, the reputation of capital flows is at a low ebb. An interesting retrospective discussion on this may be found in David Lubin’s interview with Larry Summers, titled, ‘Thinking aloud on emerging markets: is the international monetary system bad for EM?’, 2 August 2022. ‘Review of the institutional view on the liberalization and management of capital flows’, IMF Policy Paper No.2022/008, March 2022. Available at: https://www.imf.org/en/Publications/PolicyPapers/Issues/2022/03/29/Review-of-The-Institutional-View-on-The-Liberalization-and-Managementof-Capital-Flows-515883 Christine Lagarde, Opening address to the Conference on ‘Challenges for Securing Growth and Shared Prosperity in Latin America’, 5 December 2014. Available at: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp120514 Note the title of an IMF blog post on this advice: Tobias Adrian et al., ‘Why the IMF is updating its view on capital flows’, 30 March 2022. Available at: https://www.imf.org/en/Blogs/Articles/2022/03/30/blog033122-why-the-imf-is-updating-its-view-oncapital-flows Arvind Subramanian, ‘The case for structural financial deglobalisation’, 28 October 2022. Available at: https://www.project-syndicate.org/commentary/financial-deglobalization-emerging-developingeconomies-federal-reserve-by-arvind-subramanian-2022-10 We should, nonetheless, respect the enormous opportunity presented by access to a global financial system. Indeed, taking a blue-sky approach, capital flows look much too small. There are studies of optimal current account deficits for small economies, and they yield extraordinary estimates, for instance that it would be optimal to run annual current account deficits up to 60% of gross domestic product (GDP). 6 Relatedly, if you think about it, it is strange that interest rates in developing countries are not orders of magnitude above those in rich countries. Even in middle-income countries, capital stocks are typically less than a third of those in the United States, on a per capita basis. 7 It would make sense to pay radically higher rates to attract more investment, which would then raise the productivity of labour. 8 Yet real rates are not so far removed from advanced country levels: over the past two decades, real policy rates in rich countries have averaged about -1%, compared to just under +1%, on average, for middle-income countries. 9 Obviously, these observations are not policy recommendations. They do not pass reality checks. But they can help us approach the question of capital flows and financial integration with a more open mind. Considering the empirical cases, critics of capital flows often point to the successes of Asian countries, most recently China. These fast-growing economies were typically Sebastian Edwards, ‘Does the current account deficit matter?’, in Sebastian Edwards and Jeffrey A Frankel (eds), Preventing currency crises in emerging markets, Chicago, IL: University of Chicago Press, January 2002. Available at: https://www.nber.org/system/files/chapters/c10633/c10633.pdf For 2019, a simple average of the capital stock per capita was 31.7% for a sample of middle-income emerging markets, as compared to the United States. The sample comprises Brazil (28.61%), China (33.64%), Indonesia (30.63%), India (11.76%), Turkey (55.06%), South Africa (23.01%) and Mexico (39.37%). These data are sourced from the Penn World Tables and refer to investment as a GDP concept, not financial wealth. This specific point was raised recently in a blog post by John Cochrane, ‘Bob Lucas and his papers’, 17 May 2023. Available at: https://johnhcochrane.blogspot.com/2023/05/bob-lucas-and-hispapers.html For the period 2003-2023, using policy rates less annual inflation rates from the IMF’s World Economic Outlook, the US real policy rate is -1.17%. The UK is -1.0%, while the euro area is at 0.87%. An average of Brazil, China, India, Indonesia, Mexico, South Africa and Turkey is 0.74%, with a high of 5.2% (Brazil) and a low of -3.36% (Turkey). South Africa is at 1.45%. capital exporters, despite starting off poorer and with smaller capital stocks than the economies in which they invested their surplus savings. These countries also suffered crises when they opened to financial flows in the 1990s, disrupting their remarkable development trajectories. Where are the poster children for proponents of capital flows? There are countries that have enviable growth records, and which have relied for many years on capital inflows. These include the United States, Canada, New Zealand, and perhaps the clearest case of all, Australia. 10 As one study from the Reserve Bank of Australia pointed out, “Sizeable current account deficits have been recorded in Australia in almost every decade for at least 150 years”. 11 These large and sustained capital inflows have allowed for a higher level of investment than could have been achieved with only local savings. And the success of the economic model is hard to dispute. Australia’s living standards have ranked among the highest in the world since the middle of the 19th century, and towards the start of the 20th century they were probably the highest of any country. 12 It is highly unlikely that Australia would have performed better in the absence of capital flows. Of course, we cannot read Australian economic history as one long vindication of free capital movements. Both the depression of the 1890s and the economic crisis of the 1920s had symptoms familiar from modern emerging market crises, including balance of payments pressures and foreign debt stress. We also cannot say Australia has always been happy with large current account deficits. In the late 1970s and early 1980s, these deficits were a major concern for policymakers, especially because they were being driven by fiscal policy and were draining foreign exchange reserves. For an analytical discussion of capital flows out of Britain in the late 19th and early 20th century, see Michael A Clemens and Jeffrey G Williamson, ‘Where did foreign capital go? Fundamentals, failures and the Lucas Paradox, 1870-1913’, NBER Working Paper No. 8028, December 2000. Available at: https://www.nber.org/system/files/working_papers/w8028/w8028.pdf Rochelle Belkar, Lynne Cockerell and Christopher Kent, ‘Current account deficits: the Australian debate’, Research Discussion Paper No. 2007-02, March 2007. Available at: https://www.rba.gov.au/publications/rdp/2007/pdf/rdp2007-02.pdf Ian W McLean, Why Australia prospered, Princeton, NJ: Princeton University Press, 2013. However, significant current account deficits persisted even after the floating of the Australian dollar and fiscal consolidation. 13 This gave rise to the so-called ‘consenting adults’ thesis, that current account deficits produced by private sector decisions could be optimal and sustainable, and policymakers would not have to worry about them. Reflecting on other country experiences, the simple fact that deficits were privately contracted seems insufficient. We know private sector flows can be dangerous: clear recent examples are Spain and Ireland’s experiences during the euro area crisis. It therefore seems relevant that foreign investors in Australia were willing to accumulate claims denominated in Australian dollars, and that the Australian dollar floated. Another crucial fact appears to be a bedrock of investor confidence, based on credible macroeconomic policies – including a reasonable degree of price stability – and a resilient financial system. One also senses some deeper mechanism here, which ensured capital was channelled into productive assets that generated good returns. Of course, this reflects more than the resource endowment, as we could name many countries with ample natural resources which have not absorbed capital flows productively. There has also been something else going on, since at least the 19th century, that has made capital in Australia productive, whereas that same capital deployed elsewhere would have produced boom-bust cycles and default. Part of this is a story about the quality of institutions as well as the human capital available and empowered to run them. 14 Another theme is the development of local capital and financial markets, and their capacity to turn capital to productive purposes. As I will discuss below, these capacities intersect with policy choices, with capital flows supporting or weakening the productive potential of an economy. At the end of the 1980s, Australia had a fiscal surplus of 1% of GDP and a current account deficit of 6% of GDP. The classic comparison is Argentina and Australia; see for instance Alexis Esposto and Fernando Tohmé, Drifting apart: the divergent development paths of Argentina and Australia. Germany: VDM Verlag: Saarbrücken, 2009. On the whole, the Australian case teaches us that a country can absorb large capital flows over very long periods of time, and use these to support high levels of prosperity. This contrasts starkly with the Asian examples, where a range of countries likewise achieved impressive gains in living standards, but mostly did so without foreign capital. Most of the world’s countries would be happy if they could be Asian tigers, and ecstatic if they could be Australia. But many of us have a long way to go. What attitude to capital flows would help us on our way? In South Africa, we have long favoured the Australian option. 15 Given ample investment opportunities and limited domestic savings, growth and capital inflows have typically been correlated. In 1985, when the apartheid government was hit with sanctions, access to capital flows was largely cut off. 16 Of course, this was not a developmental policy for South Africa; it was a punishment. When sanctions were lifted at the end of apartheid, we looked forward to restoring access to global financial markets. We also appreciated that the end of sanctions did not mean the taps were open. Foreign investors all loved South Africa, but they would not invest based on warm feelings. And there was going to be a limit on how much investment we could attract, even with good policies. With a low domestic savings rate, if the public and private sectors were both borrowing heavily, this meant we were going to hit a balance of payments constraint. Specifically, we anticipated an unsustainable current account deficit, which would weaken the rand and drive up inflation. Interest rates would then have to rise to rebalance savings and investment, slowing growth. This was the core problem statement of the macroeconomic strategy adopted by the Mandela government in 1996. The goal was to attract more foreign savings, apply some fiscal discipline to improve the country’s South African balance of payments data are available from 1960. The average current account balance for 1960-2021 is -1.05% of GDP. The broad pattern, however, is for substantial deficits during the boom phases (the 1960s and early 1970s, and the 2000s) and minimal deficits or surpluses during periods of economic stagnation. In the four years before 1985, the current account recorded an average deficit of 3.02% of GDP. In the four years from 1985, the current account recorded an average surplus of 3.75% of GDP. investment profile and reduce government’s demands for savings, thereby permitting lower interest rates to allow more private sector investment. In hindsight, I would say the strategy was mostly successful. We experienced some of the downsides of openness to capital flows. These included a huge depreciation of the rand in 2001, which only loosely reflected fundamentals, as well as a phase of currency strength during the mid-2000s, which may have affected export competitiveness. The stronger currency and low interest rates also fed dramatic house price appreciation and risky mortgage growth ‒ a dynamic arrested by the 2008 crisis. Despite those blemishes, it was still a success. Indeed, as time has gone by, it looks more and more like a golden age of South African macroeconomic policy. Living standards were rising and growth was outpacing the global average. 17 Our investment rate rose from around 15% of GDP at the end of apartheid, 18 to around 20% of GDP, even as the domestic savings rate remained low at about 15%. This naturally entailed significant net capital inflows, much of it through portfolio flows rather than foreign direct investment. These we de-risked, in large part, by committing to a free-floating currency and minimising foreign currency borrowing across the economy. It seems extremely unlikely that we could have had better results by closing ourselves to global capital. What causes me great concern, by contrast, is what happened next. The 15 years from 2009 onwards are almost a mirror image of the first 14 years of democracy. From 1994 onwards, we achieved steadily high investment and growth, interrupted by temporary setbacks; from 2009 onwards, we have had steadily lower investment and growth, punctuated by incomplete recoveries. The IMF’s projections have 2023 investment at 16% of GDP ‒ far below the ratio needed for adequate For a fuller discussion of macroeconomic performance in this period, see Lesetja Kganyago, Address at the Centre for Education in Economics (CEEF) Africa, ‘Reflections of macroeconomics policy since 1995: from NICE to VICE – and back again?’, 28 September 2022. Available at: https://www.resbank.co.za/content/dam/sarb/publications/speeches/speeches-bygovernors/2022/An%20address%20by%20Lesetja%20Kganyago%20Governor%20of%20the%20SA RB%20at%20CEEF%20Africa%20event%2028%20September%202022.pdf According to IMF World Economic Outlook data, it was 14.16% in 1993 and 16.47% in 1994. growth. And yet even this level of investment is posing a serious funding challenge because the domestic savings rate is just 13% of GDP ‒ the lowest level since at least 1980 ‒ and the investment case for external investors has weakened significantly. Growth is projected at a mere 0.1%. This is where the capital flow story comes in. For much of the decade after the global financial crisis to date, South Africa had ample access to foreign capital, helped by ultra-low interest rates in major economies. The average current account deficit, until the onset of COVID-19, was over 3% of GDP. The financing for this deficit mainly came from portfolio flows, as it did before the global financial crisis. However, the composition of investment for this period shifted markedly towards government debt, and away from private sector assets such as equities. During the boom of the 2000s, government and public corporations absorbed just 16% of portfolio flows. In the next decade, this rose to 78%. 19 Recalling the Australian case discussed earlier, what we see is that South Africa moved away from a ‘consenting adults’ arrangement, where a stable fiscal position and a current account deficit were driven by private sector decisions, to a classic twindeficit situation. This had three destabilising implications. First, the volumes of money available to South Africa after the global financial crisis undermined good policymaking. In the 1990s and 2000s financial markets helped with fiscal discipline; in the 2010s they enabled excess. The underlying problems were homegrown, but the ready availability of foreign savings after the global financial crisis made it harder to win policy battles. Investor scrutiny is good for policy: it obliges everyone to double-check the figures and cut back on things you do not really need. For the period 2002Q1 to 2008Q4, portfolio flows averaged 1.27% of GDP, of which general government comprised 0.197 percentage points (pp), public corporations 0.004pp and all other flows 1.066pp. From 2010Q1 to 2019Q4, total portfolio flows averaged 2.9% of GDP, comprising 2.02pp for government, 0.22pp for public corporations and 0.65pp for all other flows. But when you know the money is coming anyway, it becomes much harder to insist on policy rigour. Second, these flows permitted the build-up of a large sovereign debt position. Debt, famously, is a troublesome form of financing because the lender shares relatively little risk with the borrower – unlike, say equity investments, where unsuccessful projects directly affect share prices and dividends. 20 Sovereign debt is particularly problematic, because declining government creditworthiness also spills over to the credit profiles of firms and households. With time, it leads to higher taxes and lower public sector investment to accommodate higher interest payments. An unsustainable fiscal position can therefore become a drag on the whole economy. Third, capital flows eroded potential growth. We often talk about the importance of institutions to growth, but debt can be used to weaken institutions by funding systems of patronage and corruption, driving out skilled and diligent public servants. Many private sector firms will also follow the money, redirecting their efforts from productive enterprise. Through these two channels, capital flows helped subvert the market incentives and competent bureaucracies that power modern economies. Our macro framework delivered resilience through a floating exchange rate, low foreign currency debt exposures, and careful regulation of the financial sector. But resilience is not enough; if you are going to absorb capital flows, you also need to get allocation right. Huge non-resident flows into public sector debt can actually make this more difficult. Today, we face the consequences. With too much borrowing, not much domestic saving and limited non-resident appetite for our assets, interest rates must rise to restore balance. The alternative is an inflationary balance of payments problem, which is plainly against the South African Reserve Bank’s mandate. This does not make the Reserve Bank popular, but facts are facts. We have gotten ourselves back in the trap we escaped in the mid-1990s. For a discussion, see Adair Turner, Between debt and the devil, Princeton, NJ: Princeton University Press, 2016. Reflecting on this whole experience, it is easy to sympathise with Daron Acemoglu’s argument in a recent Project Syndicate piece, that South Africa shows how capital flows, instead of promoting good government and development, can ‘facilitate’ a “hollowing out [of a] country’s economy and institutions…”. 21 Nonetheless, I do not think we should jump from diagnosing bad consequences to urging a prohibitionist approach to capital flows, and giving up on the benefits. I would much prefer a risk management approach. A source of inspiration here is the airline industry, where regulators and companies work together to fly as many planes as possible, as safely as possible, rather than responding to the occasional accident by adopting a zero-tolerance attitude to risk, which would sharply reduce the number of flights and blow up costs. 22 I think this is the right way to approach capital flows. A great strength of the IMF’s ‘institutional view’ is that it acknowledges the benefits of capital flows upfront and then moves on to risk control, 23 using a toolkit of capital flow and macroprudential measures. 24 A shortcoming in using these tools, however, is their weakness where the problematic flows spill over into the public sector. And these cases are hardly outliers. Capital flows into sovereign debt have been a major source of crises since at least the 19th Daron Acemoglu, ‘The great debt cleanup’, 23 June 2020. Available at: https://www.projectsyndicate.org/commentary/plan-to-navigate-emerging-market-debts-by-daron-acemoglu-2020-06. The full quote is as follows: “Far from checking autocrats, international finance has been facilitating them. For example, in South Africa between 2009 and 2018, foreign funds continued pouring in even after it was obvious that then-President Jacob Zuma’s kleptocratic government was hollowing out the country’s economy and institutions. When Zuma was finally kicked out of power, it was because his own party, the African National Congress, took steps to remove him. The whip of international markets had little to do with it.” Jón Daníelsson, The illusion of control, New Haven and London: Yale University Press, 2022. See for instance p. 252: “What is lacking [in financial regulation] is risk culture. The financial authorities could do well by learning from their counterparts in other fields, like aviation. The airline industry is regulated with a view to simultaneously maximise the benefits to society and keep risk under control, and we see the outcome. The cost of flying is steadily falling while safety gets better every year. The central banks and regulators need such a risk culture.” For instance, see the comment: “The key challenge is macro risk management" in Tobias Adrian, ‘Policy responses to capital flows’, 11 October 2018. Available at: https://www.imf.org/en/News/Articles/2018/11/15/sp101118-policy-responses-to-capital-flows For an IMF taxonomy of capital flow measures (and other comparable measures), see https://www.imf.org/-/media/Files/Data/2020/update-of-imf-taxonomy-of-capital-flow-managementmeasures.ashx century. 25 The ongoing African ‘funding squeeze’ is fundamentally about government borrowing. 26 Nonetheless, the IMF’s 2022 review paper on capital flow measures says relatively little about fiscal policy. The word ‘fiscal’ appears only nine times in that document, compared to 119 instances of the word ‘bank’. The policy advice is simply that if fiscal policy is the problem, it should be adjusted. 27 Fair enough, but what if that does not happen? Do we have additional policy tools to manage these risks? One option is to adjust the regulatory treatment for government bond holdings, for instance by obliging banks to hold capital against them instead of treating them as riskless. But this would not directly affect non-resident investment decisions. A second tool is developing a proper sovereign bankruptcy procedure. 28 This would give lenders stronger incentives to scrutinise borrowers. Where debts become unsustainable, countries would also have a better option than prolonged debt distress which delivers restructuring only after years of misery. 29 Still, I have limited faith in the Consider, for instance, this summary: “Sovereign debt defaults and renegotiations have been the bread and butter of Latin American countries since the first defaults in the 1820s. During the first period of financial globalization (1820-1931) there are sixty seven defaults across all countries from the richest, like Argentina, to the poorest, like Bolivia.” Graciella Laura Kaminsky and Pablo VegaGarcía, ‘Varieties of sovereign crises: Latin America, 1830-1921’, April 2014. Available at: https://www.nber.org/system/files/working_papers/w20042/revisions/w20042.rev0.pdf The title of the IMF’s April 2023 Regional Economic Outlook for Sub-Saharan Africa is ‘The big funding squeeze’. Available at: https://www.imf.org/en/Publications/REO/SSA/Issues/2023/04/14/regional-economic-outlook-for-subsaharan-africa-april-2023 The nine references to ‘fiscal’ contrast with 119 instances of ‘bank’; 33 of ‘house’, ‘housing’ or ‘household’; and 28 for ‘corporate’ or ‘corporations’. Of the fiscal instances, three are versions of advice to ‘adjust fiscal policy’. There is one mention of fiscal revenues as a comparator for the size of banks’ external assets; one comment on capital flow measures generating fiscal revenue; and one reference to fiscal policy as an incentive, among others, for locals to borrow in foreign exchange. There is one discussion of themes which would count as macro-critical and therefore relevant for IMF surveillance, with fiscal policy included on that list. There is one mention in the context of the different tools in the integrated policy framework. The last use of ‘fiscal’ is in the reference section. Similarly, work done by the IMF in 2011 on the capital flows toolkit has six references to ‘fiscal’ and 139 to ‘bank’ – see Jonathan Ostry et al., ‘Managing capital inflows: what tools to use?’, IMF Staff Discussion Note. 11/06, 5 April 2011. Available at: https://www.imf.org/external/pubs/ft/sdn/2011/sdn1106.pdf This point was made strongly by IMF leadership over two decades ago – see Anne Krueger, ‘The evolution of emerging market capital flows: why we need to look again at sovereign debt restructuring’, 21 January 2002. The design of the mechanism might have been suboptimal, but the issue is still here with us. Available at: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp012102 David Malpass, ‘Remarks by World Bank Group President David Malpass at the Breaking the Impasse on Global Debt Restructurings Conference’, 26 April 2023. Available at: ability of lenders to exercise adequate caution in the boom phase of the cycle. And where government debt is an asset held throughout society, default is probably a cure worse than the disease. A more benign tool is foreign exchange reserves. Standard accounts traditionally emphasise the role of reserves in meeting balance of payment needs, 30 especially in the context of inflexible exchange rate arrangements. But foreign exchange reserves are arguably more important for risk management, especially now that floating exchange rates are normal practice. A new wave of research is now also making direct connections between foreign exchange reserves and sovereign debt vulnerability. 31 With floating exchange rates and reserves financed in local currency, negative shocks to the country generate positive valuation effects on foreign exchange reserves. 32 Central banks can therefore accumulate reserves to hedge the public sector balance sheet against adverse outcomes, driven by factors that include unsustainable fiscal policies. Furthermore, central bank independence provides a technology for protecting these assets from spending demands. 33 This reserve accumulation approach may well work better than trying to restrain surges with capital flow measures, in a general sense, with reserve growth during inflow phases and the option to release reserves during outflows. 34 And it is a particularly useful option where flows are going to government debt and regular capital flow measures are not viable. https://www.worldbank.org/en/news/speech/2023/04/26/malpass-president-breaking-impasse-globaldebt-restructurings-conference See, for instance, the discussion by the IMF, ‘Clarifying the concept of reserve assets and reserve currency’, BOPCOM‒15/14, 27‒29 October 2015. Available at: https://www.imf.org/external/pubs/ft/bop/2015/pdf/15-14.pdf Laura Alfaro and Fabio Kanczuk, ‘Debt redemption and reserve accumulation’, IMF Economic Review 67(2), June 2019. Available at: https://www.hbs.edu/ris/Publication%20Files/redempt180504_6.21.18_da35aab6-70e6-4893-b94c94ea6ac519c1.pdf César Sosa-Padilla and Federico Sturzenegger, ‘Does it matter how central banks accumulate reserves? Evidence from sovereign spreads’, NBER Working Paper No. 28973, June 2021. Available at: https://www.nber.org/papers/w28973 Agustin Samano ‘International reserves and central bank independence’, Policy Research Working Paper No. 9832, 2021. Available at: https://openknowledge.worldbank.org/handle/10986/36483 Olivier Jeanne and Damiano Sandri, ‘Global financial cycle and liquidity management’, BIS Working Papers No. 1069, January 2023. Available at: https://www.bis.org/publ/work1069.pdf In addition to these tools, we should consider our macro policy narratives. For a start, we need to rediscover the dangers of government borrowing. Responsible policymakers never forget that fiscal debt is risky. But the nature of policy discussions is that while many claims are valid, some points get more emphasis than others. In the past decade, one such point was that fiscal consolidation hurts growth and is therefore self-defeating. Another was that higher government debt levels were safer than previously thought. I have personally observed these claims justify sustained fiscal slippage in South Africa. If we had felt the urgency of debt sustainability more keenly, we would have had a wiser conversation. We need a more responsible set of narratives around fiscal risks. 35 We also need to think more clearly about allocative efficiency. One of the strongest lessons I have learnt as a policymaker is that poor countries are poor not simply because they do not have money, but because they do not use money effectively. Too often, there is a tendency to look at a problem, cost out a solution and focus on raising the cash. Implementation is just a black box. But good policymaking starts with implementation and the financing need should reflect what can be used efficiently. Indeed, one might cast the volatile and often damaging history of capital flows as a conflict between budget constraints and capacity constraints. Capital flows provide spending power and can radically shift the budget envelope, but implementation capacity is stickier, and budgets can easily overshoot capacity. This point is relevant, once again, in the global dialogue about climate change justice and the financing that should be directed from rich countries to poor ones. There is a strong focus on costing the climate change impact for poor countries and using those estimates to lobby for massive inflows. But we have seen many times that the sum of money is secondary to the quality of policies, the incentives they create and the This point is also well made by World Bank Chief Economist Indermit Gill in his foreword to the June 2023 Global Economic Prospects: “… long before the outbreak of the pandemic, governments across the world had developed an appetite for huge budget deficits. They turned a blind eye to the dangers of rising debt-to-GDP ratios. If a lost decade is to be avoided, these failures must be corrected—now, not later.” (The reference to “These failures” includes reduced support for free trade as well as large fiscal deficits.) Available at: https://openknowledge.worldbank.org/server/api/core/bitstreams/6e892b75-2594-4901-a03646d0dec1e753/content capacity of the institutions available to invest funds. The capital flow sceptics and the climate justice activists should exchange notes. Ladies and gentlemen, to conclude, I remain impressed by the power of global capital flows to support investment, reduce financing costs and accelerate convergence in developing economies – especially where domestic savings are below investment needs. Nonetheless, this is a force that is dangerous as well as useful and powerful. The South African case shows both sides of the coin: intelligent use of capital flows in one period, and abuse in the second. For countries where investment opportunities exceed local savings rates, doing without capital flows means giving up on significant growth. It is not an attractive strategy. A better one is to welcome capital flows, control risks and nurture institutions that can deliver productive investment choices. That applies to climate finance, too. We need to remain optimistic about capital flows and vigilant about the risks, rather than pessimistic about the flows and allergic to the risks, or naïve about the flows and blind to the risks. My hope is that when the next boom comes, we will have learnt lessons that make that boom as safe, as long and as large as possible. Thank you. | south african reserve bank | 2,023 | 7 |
Keynote address by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the CFA Society South Africa and Investec Breakfast Conversation, Pretoria, 10 May 2023. | Keynote address by Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the CFA Society South Africa & Investec Breakfast Conversation, Pretoria, 10 May 2023 South Africa’s new system for implementing monetary policy For most of my career at the SARB, as a member of the monetary policy committee, I have worked on interest rate decisions. But only recently have I taken on the financial markets portfolio, and with it oversight of how monetary policy is implemented, so that interest rates transmit to the economy. As it happens, this has been an interesting time to make that shift, because we have been making big changes to our monetary policy implementation framework.1 I would therefore like to centre this speech on monetary policy implementation. Later we can discuss the outlook for the economy, and the challenges facing monetary policy. But I hope it will be interesting for all of you as I reflect on the underlying plumbing of monetary policy, including the role of our balance sheet, the monetary base and money creation, and the payments system. The main aim of monetary policy implementation in South Africa, as in many other economies, is to keep short-term market rates close to the policy rate chosen by the MPC. What we are really doing is setting the return on the safest and most liquid rand asset – the yield on money – which our relatively large and sophisticated financial markets then factor into other asset prices, taking into account their different risk and liquidity characteristics. In this way, our control of a relatively small asset class allows us to have significant effects on much larger financial markets, and ultimately influence the real economy. What exactly is this money we control? If you look at the Reserve Bank’s balance sheet, you will find two things that can be called money. One is notes and coin. These are Reserve Bank liabilities which are carried around by the general public. Their total value is about R170 billion currently. Everyone is familiar with these, but they are not very important for monetary policy implementation. We provide notes and coin in whatever amount is demanded by the public, and pay no interest on these, so they are not a lever we use for controlling interest rates. Detailed information on the new framework is available at: https://www.resbank.co.za/en/home/what-wedo/financial-markets/monetary-policy-implementation-framework The other is electronic money, which is known as bank reserves or settlement balances. This is a form of money held exclusively in SAMOS, the South African Multiple Option Settlement System, which is the backbone of the national payments system. It is managed by the SARB. SAMOS accounts are held mainly by banks, 28 currently, who transact directly with the Reserve Bank. They use these reserves to settle payments between each other. The total supply of bank reserves is around R220 billion, of which about R140 billion is required reserves. This is the form of money used to implement monetary policy. This R220 billion is only a fraction of the total amount of money in the economy. If you turn to our Quarterly Bulletin, where you will find comprehensive statistics on monetary aggregates or money supply, you will see that M3 – which is a broad measure of money, including all bank deposits and money market shares – was R4.72 trillion at the end of 2022. The total supply of SARB money was therefore only about 8% of total money in the economy. How is it that most money is not SARB money? Why can anyone else can create money? Isn’t that counterfeiting? In fact, money creation is a normal characteristic of a banking system. Banks routinely create money through the process of making loans. It works in a very simple way.2 A bank takes in a deposit and that deposit meets the definition of money – for example, this is the money you have in the bank. But then the bank makes a loan, for instance to someone who borrows for a car or a house. And that loan also appears as a deposit at a bank, which is also money. In this way, the act of credit creation expands the money supply. The constraint on banks is that every deposit is a promise to pay in bank reserves, which are the liabilities of the central bank.3 Banks have no power to create these and can instead only access them on terms worked out by the central bank, through its monetary policy implementation framework. This creates a powerful constraint on banks. Whenever they create money, they are obliged to ensure these rands are always valued at par with bank reserves. This obligation is tested many times daily: every time a payment goes from one bank to another, this settlement is conducted through the SAMOS system using bank reserves. So, if bank A creates money by extending a loan to a household, and that household then buys something from someone who banks with Bank B, Bank A will have to transfer bank reserves to Bank B. If they don’t have the bank reserves to settle, this bank will be in great trouble. For this reason, while the SARB only creates a small fraction of the money in the economy, it sets the standard for what that money is worth. This is the basis for modern monetary policy implementation. Let’s now consider how monetary policy was implemented before our recent reform. Between 1998 and 2022, monetary policy in South Africa worked through a shortage or classical cash reserve system. Essentially, we created fixed demand for bank reserves by levying a reserve requirement on banks. We then drained cash so the market was short: the amount of money needed for the reserve requirement was larger than the amount available. In John Kenneth Galbraith’s memorable phrase, “The process by which banks create money is so simple that the mind is repelled.” For an accessible discussion of this process, see Pontus Rendahl & Lukas B. Freund. “Banks do not create money out of thin air”14 December 2019. Available at: https://cepr.org/voxeu/columns/banks-do-not-createmoney-out-thin-air This forced banks to come to the SARB to fund the missing balances, which we provided through weekly auctions where we charged the repo rate. In theory, and most often in practice too, the market ended up with exactly enough liquidity to satisfy reserve requirements, no more and no less. For excess reserves, which is any cash banks were not required to hold for regulatory purposes, the SARB would only pay a penalty deposit rate of repo minus 1%. This incentivized banks to minimise their holdings of banks reserves, lending out spare cash to other banks. With an efficient interbank market, at the end of each day banks would all be able to meet their reserve requirements precisely, with no surplus balances. This used to work quite smoothly and gave us reasonably effective monetary policy transmission. But the framework became increasingly difficult to operate over time, mainly due to the accumulation of foreign-exchange reserves, which were funded with the creation of new bank reserves. To maintain a shortage, we had to drain these, and we were worried that our draining tools wouldn’t be up to the task. In 2020 this risk manifested: we had a bond purchase programme to prevent severe market dysfunction; we opted to absorb the dollar flows from the IMF and other multilateral lenders into the foreign exchange reserves; we participated in the loan guarantee scheme. All these things increased SAMOS balances. We also faced a dilemma: in conditions of financial strain, our financial stability mandate inclined us to provide more liquidity, but our implementation framework still required us to create a shortage of liquidity. For the next two years, we muddled through. We tolerated a smaller shortage than before, in the region of R30 billion rather than R56 billion. To create this shortage, despite greater liquidity pressures, we had to use draining tools which were distortionary and expensive. For instance, we relied quite heavily on FX swaps, which contributed to high and volatile rates in the forward market, likely hampering investment by non-residents.4 The volumes of public sector funds we took into the SARB cost around 30 basis points over repo.5 In addition, we were concerned that our toolkit could fail if the supply of bank reserves increased further, in which case the shortage might have disappeared. In particular, we knew National Treasury might need its deposits at the SARB, of which R26 billion had been drawn during COVID, leaving just over R40 billion – more than the existing shortage. At the same time, we were fortunate that leading central banks had accumulated a wealth of experience in dealing with surplus liquidity. This meant we could draw on their experiences to design a framework better suited to South African conditions, rather than trying to invent something from scratch. What we came up with was in many ways the mirror image of the old framework. Whereas the old system depended on a shortage of bank reserves, the new one relies on a surplus, and where once the borrowing facility was the locus of policy transmission, so now this is a deposit For further details, see Box 5 of the April 2021 Monetary Policy Review, available at: https://www.resbank.co.za/content/dam/sarb/publications/monetary-policyreview/2021/MPRApr21Internet.pdf This refers to the CPD deposits taken on call at the SARB, rather than being placed with the market facility. This meant we could stop draining liquidity, unwind those operations and let banks hold extra cash instead, on which they could earn the policy rate. The logic of this system is that abundant liquidity puts downward pressure on rates. But the deposit facility forms a floor: it is not attractive to lend to anyone else, or buy assets, with an inferior return to what the SARB offers. For this reason, these frameworks are often called floor systems. For our MPIF, we adopted a version of a floor system called a tiered floor, which had been pioneered in New Zealand and Norway. Tiered floors put limits on how much banks can leave with the central bank and still earn the policy rate; if you exceed your quota, you earn a lower rate. The motivation for adding this feature is to prevent banks from hoarding reserves, maintaining a functioning interbank market. Unlike countries with pure floor systems, we have not expanded our balances sheet so much that there is an enormous excess of bank reserves. We therefore wanted banks to lend some of their surplus to other banks, so the supply would be sufficient even without circulation of bank reserves through the interbank market. The idea is that the implementation framework isn’t, by itself, forcing the SARB to expand its balance sheet.6 This new system was phased in between June and August last year. The transition to the new MPIF was generally smooth: we undertook extensive consultation with stakeholders before the transition, and we published a clear transition roadmap, which likely helped pre-empt problems and misunderstandings. Initially we moved to a surplus of around R50 billion. Recently National Treasury has drawn down those deposits I mentioned earlier, and this has shifted the surplus to around R80 billion. We have learnt from operating the system that it would likely function effectively with a surplus under R40 billion. Even when the surplus dipped to around those levels, on occasion, we did not see upward pressure on other market rates, and we did not see any more demand at our weekly repo auction. The reason for building a bigger surplus than this is simple: it is cheaper, simpler and less distortionary to pay repo on excess bank reserves, in quotas, than to manage this liquidity using other tools. The size of the surplus is therefore based first on what quantity is sufficient to keep rates near the floor, and second on what achieves efficient management of the SARB’s liability structure. At this point in time, it seems safe to say we have successfully implemented a floor or surplus system of monetary policy implementation in South Africa. This has a few interesting implications. One, to our knowledge, we are the first emerging market to implement a floor-type system. These structures are now widely used by advanced economies, but until now emerging markets have not joined the trend. During our reform, we faced many questions about whether floor systems are suitable for emerging markets. Now there is better evidence than before to A recent discussion of this principle is Claudio Borio. “Getting up from the floor” 10 March 2023. Available at: https://www.bis.org/speeches/sp230426.pdf say that they are: it is working in South Africa. This is useful information for peer countries who share our excess liquidity situation. Two, we have relaxed the trade-offs between our price and financial stability mandates. With floor systems, unlike scarce-reserve systems, you can operate the balance sheet as a separate tool to interest rates, something central bankers call the ‘decoupling principle’.7 For instance, you can inject liquidity during periods of financial stress, to stabilise that system, without compromising the freedom of the monetary policy committee to select an interest rate, which will be implemented using the interest-on-reserves tool.8 Next time we hit a crisis, we anticipate the financial system will start off more resilient, given a larger pre-existing liquidity supply. And if this proves inadequate, we have powerful tools to inject further liquidity. Three, we seem to be getting more complete monetary policy transmission. In the old system, we could see the interbank market was struggling to achieve an efficient allocation of reserves, from 2020 onwards, with increased use of our penalty rate standing facilities each day. For instance, large volumes of excess reserves, on average about R5 billion a day, were coming back to the SARB each night and earning repo less 1 percentage point, something the system was meant to discourage, and which hadn’t happened before the onset of COVID. Worse, rates were not transmitting smoothly from the interbank market into the financial system. I mentioned earlier the problem of high and volatile rates on FX swaps – rates which have now compressed much closer to the policy rate, with significantly lower volatility. Another example is the repo market, where firms raise cash using collateral such as government bonds. We used to observe borrowing costs that differed markedly for residents and nonresidents, with rates well above the policy rate even for short-term loans. Now we have seen these rates much closer to each other, and closer to our policy rate. To conclude, monetary policy implementation is generally one of those things that works best when most people don’t have to worry about it, like plumbing or electricity. Nonetheless, interest rates play a crucial role in all modern economies9; monetary policy is an important driver of these rates; and the process of policy transmission affects how these decisions reach into the economy, ultimately affecting all of us. I hope, therefore, it has been interesting and useful to you to reflect on our reforms in this area. Thank you. Jaime Caruana. “Unconventional monetary policies in time of crisis” SUERF Annual Lecture. 16 November 2009. Available at: https://www.bis.org/speeches/sp091118.htm Philip Turner. The New Monetary Policy Resolution: Advice and Dissent. NIESR Occasional Paper. No. LV. 2021. Available at: https://www.niesr.ac.uk/wp-content/uploads/2021/02/New-Monetary-Policy-Revolution.pdf A recent reiteration of this point is Jamie Dimon. “Chairman and CEO letter to shareholders” JP Morgan Chase and Co. Annual Report 2022. Available at: https://reports.jpmorganchase.com/investorrelations/2022/ar-ceo-letters.htm “Interest rates are extraordinarily important — they are the cosmological constant, or the mathematical certainty, that affect all things economic.” | south african reserve bank | 2,023 | 7 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Nelson Mandela Foundation, Johannesburg, 3 May 2023. | Lesetja Kganyago: Launch of South Africa's upgraded banknotes and fourth decimal coin series Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Nelson Mandela Foundation, Johannesburg, 3 May 2023. *** I would like to thank the Chief Executive of the Nelson Mandela Foundation, Sello Hatang, for co-hosting today's event, and to welcome the Deputy Minister of Finance, David Masondo; the Minister of Basic Education, Angie Motshekga; former Governor Tito Mboweni; former deputy governors; our esteemed guests and members of the media. Six days ago, on 27 April, South Africa celebrated 29 years of democracy. This year we mark the 10th anniversary of the passing of former president Nelson Mandela who signed the country's Constitution into law in 1996 in Sharpeville, Johannesburg. The Constitution bestows a great responsibility on the South African Reserve Bank (SARB) in building the country's economy. It reads: "The primary object of the South African Reserve Bank is protect the value of the currency in the interest of balanced and sustainable economic growth in the Republic". Moreover, "in pursuit of its primary object, [the SARB] must perform its functions independently and without fear, favour or prejudice. It also states that "there must be regular consultation between the Bank and the Cabinet member responsible for national financial matters". I am pleased to say that consultation between myself and the Finance Minister and our respective teams has been regular and meaningful. Consultation about the upgraded banknotes and fourth decimal coin series that we are introducing here today has also been fruitful and is the culmination of years of engagement with our key partners in the public and private sectors. These include the Department of Sport, Arts and Culture; the South African National Council for the Blind; the Society for the Blind; the Pan South African Language Board; the South African National Biodiversity Institute; and various industry bodies. These partnerships have contributed to ensuring that the features on our banknotes and coin are relevant and reflect our culture and heritage. Equally important are the South African Mint Company, where our coins are minted, and the South African Bank Note Company, where we print our banknotes. These subsidiaries of the SARB perform a critical function in the management of currency through its life cycle - from design to manufacturing, distribution and circulation, and finally destroying it once it has been taken out of circulation. Timeline of our currency in relation to Madiba It is fitting that we mark this occasion at the Nelson Mandela Foundation - an institution that is mandated to promote Nelson Mandela's lifelong vision of freedom and equality for all, and which signifies his role in embodying the values enshrined in our Constitution. 1/3 BIS - Central bankers' speeches A country's currency is a fundamental component of its national identity. Our banknotes and coin have lived through South Africa's rich and dark past. About 230 years ago, Dutch Governor Joachim van Plettenberg first introduced handwritten paper money in the Cape. There was no printing press in the Cape, and the money featured a government fiscal hand stamp showing its value and date of issue. It was only in 1803 that banknotes were printed, but there was not a central bank to oversee the printing and issuing of banknotes. When the SARB opened its doors over a century ago in 1921, an objective was to bring about order in the issuance and circulation of domestic currency. At the time, financial institutions issued their own currency, causing instability in the economy. The early currency, including the rix dollar and stiver denominations, played a significant role in the early economic development of our country. South Africa later used the British pound as its currency. In 1961, the rand - which was named after the Witwatersrand ridge on which Johannesburg is built and where most of South Africa's gold deposits were found - became legal tender, and South Africa moved away from using the pound. The rand's entry coincided with South Africa becoming a Republic. Since then, the design of our banknotes and coin have gone through shifts in denomination showing different industries, depicting South Africa's fauna and flora, and more recently Nelson Mandela. The 'Big 5' was debuted on our banknotes in 1992. The Big 5 theme was adopted after the unbanning of political parties and the release of political prisoners, reflecting what was considered as a design that would be acceptable to all South Africans. In 2012, the SARB issued the first Madiba banknotes, illustrating Madiba on the front of the banknotes and retaining our Big 5 animals on the back. We sadly lost Madiba the following year. In 2018, the SARB issued a set of commemorative circulation banknotes to celebrate Madiba's birthday and acknowledge his contribution to our democracy. These banknotes illustrate Madiba's journey from the rolling hills of the Eastern Cape featuring his birthplace in Mvezo on the R10, followed by the R20 that features his home in Soweto where his political life began, alongside other struggle icons. The R50 shows the site of his capture near Howick following 17 months in hiding. The R100 depicts Robben Island where he was incarcerated for 18 of his 27 years in prison. Inspired by his long walk to freedom, the R200 depicts the Union Buildings where he was inaugurated as President of South Africa. A commemorative circulation R5 coin was also issued featuring a portrait of Madiba. Now, in 2023, we continue to acknowledge his legacy, and his portrait is still proudly depicted on our banknotes. The changes (themes and security features of the banknotes) While the broader themes of our banknotes and coin remain familiar, important enhancements have been made. The preamble to the South African Constitution in micro-lettering, celebrating our constitutional democracy, and the South African flag have been added around the Madiba portrait. The Big 5 animals on the back of the banknotes are now depicted with their young, celebrating diversity of age. To further enhance security, the denomination animals are visible in various other areas of the banknotes, including the see-through perfect print registration feature and the watermark. The security thread as well as the 2/3 BIS - Central bankers' speeches spinning circle which is visible on the bottom right of the banknote change colour in tandem when the banknote is tilted. The banknote denomination colours have also been adjusted for vibrancy, and the tactile marks have been improved to support the visually impaired communities to differentiate between the various denominations by feel. The designs on the coin have been renewed from the last issuance in 1989. Each of the six coins in the coin series features an animal or plant. The 10c coin features the Cape honey bee; the 20c depicts the bitter aloe; the 50c illustrates the Knysna turaco; the R1 coin the king protea; and the R2 coin our national animal, the springbok. The southern right whale is shown on the R5 coin. The R5 coin includes a latent image that transforms from the word 'FIVE' to the word 'RAND' when tilting the coin, as well as the abbreviation 'SARB' in micro-lettering on the inner circle of the coin. While the national Coat of Arms and the 11 official languages of South Africa have been retained on all the coins, the R1 coin features the national flag instead of the Coat of Arms. I want to emphasise that the upgraded banknotes and coin will have the same value as the current banknotes and coin in circulation, and I want to encourage the public to transact with them. Cash plays a significant role in our lives; it is the responsibility of the SARB to ensure that the public is protected by regularly revisiting its technical and security features, and to produce currency that is in line with global best practice, is credible and trusted. The currency was last upgraded in 2018 when enhanced security features on the Nelson Mandela Centenary banknote series were added. Internationally, it is regarded as best practice for central banks to upgrade the security features on their banknotes every six to eight years. This is to combat counterfeiting, which diminishes the value of real money, robs countries worldwide of billions of their currency annually, and tarnishes the credibility of a currency, thereby impacting negatively on the growth of an economy. Banknotes and coin remain a critical payment instrument that provide South Africans access to formal and informal markets. Cash is familiar, inclusive and continues to be used across sectors of society. It is also considered to be a safe haven during times of crisis and is relied upon when other forms of payment are not as easily accessible. It is vital in the functioning of our economy. A public awareness campaign on the changes made to our currency is underway and will be in circulation from 4 May 2023. Denominations of both the banknotes and coin will be introduced incrementally. The changes to the banknotes and coin can also been seen on the SARB Currency App, which is free to download, and I urge you to do so. Our banknotes and coin echo our rich and complex tapestry of history, heritage, people and culture. When you transact with the upgraded banknotes and coin, take a moment to reflect on the beautiful designs and how interconnected we are as a society and people. 3/3 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 7 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the 103rd annual ordinary general meeting of the SARB shareholders, Pretoria, 28 July 2023. | Lesetja Kganyago: Overview of the South African economy Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the 103rd annual ordinary general meeting of the SARB shareholders, Pretoria, 28 July 2023. *** I am very pleased to be here with you, in person, for the first time since 2019, even if the world has changed significantly since the last time I stood before the shareholders of the South African Reserve Bank (SARB). We have survived the onslaught of COVID-19, but South Africa now faces multiple challenges of high inflation, low economic growth and a difficult external environment. Despite the easing supply chain pressures and lower commodity prices, globally inflation remains well above many central banks' targets and monetary policy remains tight. These conditions, including rising uncertainty and weak confidence, have been a drag on growth for many emerging market economies, including South Africa, whose postpandemic recovery has been comparatively weak. Electricity shortages, infrastructure challenges, high public debt levels and weak investment continue to weigh on growth over the medium term in South Africa. Lower commodity prices have supported disinflation, and headline inflation returned to the target range in mid-2023. However, inflation remains sticky and the risk to the medium-term inflation outlook remains to the upside. Monetary policy continues to remain focused on returning inflation to 4.5% over the medium term, yet this goal will be complicated by challenges such as the ongoing geopolitical tensions and climate change. Global conditions Early in the pandemic, aggressive fiscal and monetary easing was aimed at mitigating the economic effects of the pandemic. As economic activity slowly resumed, supply chains remained severely constrained, prompting a sharp increase in global prices. The inflationary impulse was worsened by Russia's invasion of Ukraine, which raised the prices of important commodities such as food and oil. In response to elevated inflation, most central banks raised policy rates. Global inflation peaked in the third quarter of last year and has since moderated into the third quarter of 2023. This deceleration almost entirely reflects lower food and oil prices, alongside less binding supply constraints and tighter macroeconomic policies. However, inflation remains above central bank targets, and in the advanced economies, core inflation remains uncomfortably high, reflecting sustained spending on services, tight labour markets and robust wage growth. 1/7 BIS - Central bankers' speeches While the rising interest rates triggered some banking sector volatility in the United States (US) and Eurozone, this appears to have diminished in recent months. These market-related stresses were not enough to derail the hiking cycles of the advanced economies, with the US Federal Reserve and European Central Bank hiking by an additional 75 and 100 basis points respectively since March 2023. The persistence of inflation despite the sustained interest rate hikes by some central banks suggests that global neutral interest rates have risen well above their pandemic levels. As we move towards 2024, central banks around the world will be watching carefully for additional evidence of changes in neutral real rates. With global financial conditions adjusting and risk-adjusted real interest rate differentials widening, portfolio flows will become less certain, affecting the availability and the cost of external funding. These rising credit costs will further impair the financing of large fiscal and current account deficits in many emerging market and developing economies (EMDEs), including South Africa. Many economies have experienced sustained increases in public debt levels, which, with higher inflation, create serious headwinds to economic growth. As exchange rates depreciate in response to the more adverse credit conditions, imported inflation tends to rise – a trend already seen in producer prices, fuel costs and food prices, among other items. EMDEs will need to consolidate their fiscal positions over the coming years helping indirectly to reduce exchange rate passthrough pressures and inflation and its wide-ranging economic costs. Domestic conditions South Africa's recovery from the COVID-19 pandemic was driven by demand expansion and a supply rebound following the easing of pandemic-induced restrictions. This generated a strong, but incomplete, recovery from the 6.0% contraction experienced during 2020. While growth rebounded by 4.9% in 2021, activity subsequently slowed to 2.0% in 2022, and by 2023 even lower growth was expected as the energy crisis facing the country worsened. The SARB forecasts gross domestic product (GDP) growth at 0.4% this year, and expects it to average about 1% over the next two years. South Africa's post-COVID-19 recovery reflects various domestic idiosyncrasies such as political unrest, disruptive strikes, extreme weather conditions and failing infrastructure. Although load-shedding entered the South African lexicon 15 years ago, it has intensified over the past two years, placing a binding constraint on growth. The SARB estimates that growth over the 2023–2025 period would be closer to 2% in the absence of load-shedding. South Africa's underwhelming economic performance is not new; the country's chronic low-growth problem predates the pandemic. In the five-year period before COVID-19, growth averaged just 1% – compared to the 3.5% growth achieved by a typical emerging market economy. One of the main challenges to achieving higher growth is weak investment levels. South African investment lingers close to 16% of GDP compared to the 25% level achieved by comparative peers. From a macroeconomic perspective, a key constraint to achieving higher investment levels in South Africa is persistent fiscal dissaving. High public debt levels raise the risk premium, pushing up the cost of borrowing to around 11% today. 2/7 BIS - Central bankers' speeches The low-investment problem is worsened by the composition of public spending, which is geared more towards current consumption than infrastructure. The reversal of the economy's terms of trade risks worsening the fiscal outlook. Between January 2020 and March 2022, the prices for South Africa's major commodities – such as gold, iron ore, platinum group metals and coal – doubled. Since then, however, these prices have been falling consistently and by as much as 23.8% over six months alone. As funding needs grow, and as domestic saving remains weak, the need for foreign savings has widened. The current account deficit is now expected to expand from 0.5% in 2022 to 3.3% by 2025. Headline inflation rose sharply this past year, surpassing the upper end of the 3–6% inflation target band in April 2022 and reaching a 13-year high of 7.8% in July 2022. Inflation has since moderated, albeit with some volatility, and finally returned to the target band in June 2023, when it reached 5.4%. The moderation can largely be attributed to lower global food and fuel prices in recent months, as well as lower imported inflation due to easing supply chain disruptions and easing demand conditions. A more pronounced moderation in inflation is expected in the latter years of the forecast horizon, with headline inflation expected to ease to an annual average of 5.0% in 2024 and 4.5% in 2025. The risks to inflation are still assessed to be on the upside. Rising services inflation and elevated administered price inflation continue to put upward pressure on prices. These pressures are exacerbated by elevated and rising inflation expectations by key pricesetters over the medium term. For example, the survey of inflation expectations by the Bureau for Economic Research shows that two-years-ahead expectations have steadily trended up from around 4.5% in 2021 to 6.3% and 5.9% for businesses and trade unions respectively. These elevated expectations by key price-setters risk feeding into the recent wage negotiations and embedding in higher core inflation. Facing this elevated and persistent inflation, the SARB's Monetary Policy Committee (MPC) stepped up the pace of repurchase (repo) rate normalisation over the past year, raising the repo rate by a cumulative 400 basis points since the May 2022 MPC meeting. This has brought the nominal repo rate to 8.25%. At these levels, monetary policy in South Africa is now considered restrictive. The MPC continues to assess the impact of previous interest rate hikes on the economy. Monetary policy operates with a lag of approximately 12–24 months, with peak impacts of rate hikes between three and five quarters ahead. To date, the rate hikes have had a moderately slowing effect on credit demand, which continues to rise even after adjusting for prices. Total loans and advances to the private sector are, so far this year, 2.0% higher than they were over the first half of 2022. Credit growth to corporates remains relatively robust at 3.5%, while credit to households has slowed to real growth of 0.5%. Households' credit demand is typically comprised of mortgages, which have slowed since the robust growth experienced during the COVID-19 era ultra-low interest rate 3/7 BIS - Central bankers' speeches environment. The rise in interest rates has pushed households' debt-service cost as a share of their annual disposable income back up to its 2010–2019 average of about 8.5%. The broader environment in which monetary policy is made presents additional challenges to central banks. Geopolitical tensions, changes to established global value chains and the intensifying problems of climate change are all likely to present challenges to long-term growth and relative price shocks. Russia's invasion of Ukraine has been an unpleasant reminder of how rising commodity prices spill over into imported inflation for various economies. These tensions continue to pose an upside risk to the inflationary outlook, which is exemplified by the recent collapse of the Black Sea grain deal. Ongoing volatility in global oil and food prices risks delaying inflation back to target for many countries. While pandemic-related shocks to global supply chains continue to ease and revert to more normal conditions, established global value chains will continue to adapt to a changing global trade, industrial and technology policy landscape. 'Nearshoring' will likely reverse the disinflationary impulse of globalisation, and is expected to put upward pressure on manufactured goods vis-à-vis services over the long term. The effects on emerging markets like South Africa will be significant, as deglobalisation lowers productivity growth, slows the diffusion of technology and makes it harder for economies to maintain competitiveness. Major climate events such as floods and droughts have an immediate impact on local food prices. South Africa has experienced numerous climate events, including the flooding in KwaZulu-Natal in 2022 and the Western Cape droughts of 2015–2018. The El Niño event of 2015/2016 pushed food inflation up to about 11% in 2016, and its reappearance later this year risks delaying the food disinflation process. Despite the challenges of forecasting and modelling, a repeat of the 2015/2016 drought (which is a once-in-20-years event) could increase food prices by as much as 10%. For now, however, such a risk lies outside of the SARB's baseline view. In a world this volatile, it has been more important than ever that the SARB hold fast to its mandate of ensuring price stability in the interest of balanced and sustainable economic growth. Monetary policy is focused on preventing second-round effects and the risk that inflation expectations de-anchor following inflation shocks. Though the MPC has paused the hiking cycle, it will act decisively to quell any inflationary pressures should they strengthen over the medium term. The priority remains that inflation reaches the midpoint of the 3–6% target band (4.5%) – and stays there – to best ensure balanced and sustainable economic growth in the interest of all South Africans. Financial stability The SARB's role does not end with monetary policy. Let me now turn to our other legislative mandate: that of securing financial stability. The South African financial system has remained resilient amid challenging global and domestic developments. However, that resilience has been tested by global monetary 4/7 BIS - Central bankers' speeches policy tightening, turmoil in the developed markets' banking sectors, volatile financial markets and downward revision to growth projections. Over the past year, the SARB has been highlighting the financial stability risks associated with ongoing electricity-supply shortages, an upward repricing in government debt, South Africa's greylisting by the Financial Action Task Force (FATF) and the impact of escalating geopolitical tensions, notably between Russia and Ukraine. The SARB has, however, marked some key milestones in the past year that will bolster confidence and trust in our financial system, starting with the establishment of the Corporation for Deposit Insurance (CODI) as a legal entity on 24 March 2023. As the newest subsidiary of the SARB, which will become fully operational in April 2024, CODI will protect covered depositors in the event of a bank failure. Alongside this, the SARB became the Resolution Authority for Designated Institutions on 1 June 2023, which will help protect the financial system in the event of failures of systemically important financial institutions. Prudential regulation Another cornerstone of financial stability is effective regulation of our financial institutions. Several local institutions facing particular circumstances were put under curatorship in the past year. South Africa's banking and insurance firms, as well as its market infrastructures, remain sound. In the wake of FATF greylisting the country, the Prudential Authority continues to work with other regulators and law enforcement agencies to address the remaining gaps in South Africa's oversight of money laundering, the financing of terrorism and proliferation financing. Operational matters At an operational level, the SARB met several milestones during this past year, which serves as a testament to our values of accountability, excellence and integrity. The SARB's role as the steward of our country's national payment system (NPS) is too often overlooked. The NPS is, however, a critical infrastructure of the economy, and the SARB works hard to modernise the NPS and make it more secure, more efficient and more accessible. In September 2022, we successfully migrated to the International Organization for Standardization's (ISO) financial messaging standard: ISO 20022. The adoption of ISO 20022 enables richer, better-quality data in payment processing and settlements, and is a significant step in the modernisation of our payments ecosystem. A key operational development during the year was the transition to a new monetary policy implementation framework (MPIF). Between 8 June 2022 and 24 August 2022, the SARB moved from a money market shortage to a money market surplus. At the same time, banks were provided with quotas, allowing them to earn the policy rate on overnight deposits of excess reserves. The new system, formally a 'tiered floor' framework, is now fully operational. The reform has made monetary policy implementation simpler and more robust, while also improving the liquidity of the banking sector. 5/7 BIS - Central bankers' speeches We have also successfully rolled out South Africa's upgraded banknotes and fourth decimal coin series – the first new series in 34 years. The upgraded currency continues to pay homage to our first democratically elected president Nelson Mandela, who signed into law the very Constitution that gives life to the SARB's mandate and protects our independence. The SARB consults extensively with expert organisations on the use of national symbols, languages and designs on our currency, including the Pan South African Language Board (PanSALB), which is the statutory authority on our 12 official languages. Having received complaints from members of the Vatsonga community over the spelling of the Xitsonga word for 'Reserve Bank', used on the upgraded R100 note, the SARB has reached out to PanSALB to revisit the matter, and we await feedback. More broadly, the SARB's recent campaign to educate the public on the new security and design features helps to cement public trust and confidence in our currency. In light of the ongoing power crisis in the country, the SARB is taking the necessary actions to minimise the impact of load-shedding on its operations and key financial system infrastructures. Staff matters The SARB's ability to achieve its strategic and operational milestones is only possible because of its staff. The SARB's employee value proposition is designed to attract and retain professionals of the highest calibre – with the skills and the commitment – to ensure that the SARB continues working for the economic well-being of all South Africans. Our Diversity & Inclusion (D&I) Programme, now in its third year, is helping us build a more diverse leadership pipeline and an organisation that embraces the unique lived experiences of its employees. The SARB continues to embed hybrid-working principles as the Head Office Renovation Project gathers pace. In this final phase of the D&I Programme, organisation-wide workshops are underway to tackle issues around generational diversity; racial, ethnic and cultural diversity; gender diversity; sexual orientation; and sexual harassment. As we know, diverse organisations are more resilient and more responsive, and better placed to serve the public. That spirit of public service extends to our engagements with stakeholders through our economic roundtables, publications, investor sessions, monetary policy and financial stability forums, as well as our corporate social investment (CSI) work. Our CSI efforts are geared towards broadening the understanding of monetary policy, growing the pool of skills in areas such as economics and finance, and supporting people from disadvantaged communities. This includes bursaries for 102 students from first-year to Master's level, and partnerships with four universities, to develop programmes that focus on monetary policy, financial stability and economic journalism. Conclusion 6/7 BIS - Central bankers' speeches As the SARB is approaching the final stretch of its Strategy 2025, I am pleased that significant progress has been made in its implementation. Despite the prevailing global and domestic economic conditions, we remain on course to deliver against our five strategic focus areas (SFAs) and the enablement functions that support our strategy. As I indicated earlier, high inflation remains a concern and played a significant role in the SARB's inability to achieve its target set out in its SFA 1: keeping inflation within the target range of 3–6%. Appropriate monetary policy actions have contributed to an easing of inflation, with the consumer price index at 5.4% in June 2023. This again underscores the SARB's commitment to price stability. Enhancing resilience to external shocks, the basis of SFA 4, also proved challenging in the face of high government debt levels. Despite the many challenges to central banking that have emerged in recent years, both globally and domestically, I am confident that we have the human capacity to analyse those challenges and to work together with our partners in the public and private sectors to increase the resilience of our economy and financial system to meet any challenges head-on. In this ongoing process, central banks need to remain focused on their core mandates as the best way to ensuring that the economy can grow. We must hold fast to our mandate of ensuring price stability in the interest of balanced and sustainable economic growth – and we must do so without fear, favour or prejudice. In doing so, we will ensure that the economy has a stable foundation – one that is resilient and flexible in addressing the many challenges we will undoubtedly continue to face. I would like to express a heartfelt 'thank you' to all the staff of the SARB and its subsidiaries because they have done, and continue to do, just that. Their commitment and dedication means that we can count a number of successes achieved during the past year, despite all the challenges. We can expect that the months ahead will test us in new ways. But with this team of dedicated individuals, I know we will uphold our century-long legacy of working for the good of South Africa. Thank you. 7/7 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 7 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the University of Limpopo, Polokwane, 5 September 2023. | An address by Lesetja Kganyago, Governor of the South African Reserve Bank, at the University of Limpopo, 05 September 2023 Dealing with the high cost of living: South Africa’s experience Introduction Ladies and gentlemen, it gives me great pleasure to be here in Limpopo and to address you today. This province is home to the baobab tree – a symbol of growth amid adversity, which bears a stark resemblance to the domestic economy’s resilience, despite its challenges. The province’s contribution to commodity exports has also helped South Africa withstand the headwinds to growth in recent years. Over the past three years, the global economy has endured multiple large and overlapping adverse supply shocks. This was at a time when the COVID-19-induced expansionary fiscal and monetary policies were firmly in place. This confluence of factors pushed global inflation to multi-decade highs, eroding real incomes and forcing consumers to make some difficult choices. Today, I want to talk about how the high cost of living has impacted households globally and relate it more specifically to how the typical South African consumer has fared. In doing so, I will discuss how the resilience of global demand has perpetuated high inflation; how global inflation has propagated into the domestic economy; and how we, as the South African Reserve Bank (SARB), have responded to this inflation scourge. Global backdrop To provide context, I will begin by providing the global backdrop. Global inflation averaged 8.7% in 2022 ‒ its highest level in four decades. The genesis of this inflation was a confluence of factors, including supply chain pressures occasioned by the COVID-19-induced lockdowns and higher international food and energy prices brought about by Russia’s war in Ukraine. Expansionary fiscal and monetary policies meant to cushion economies from the ravages of the COVID-19 pandemic inadvertently became accelerants to inflation as demand recovered faster amid constrained supply. Early in the recovery, consumption shifted to the less contact-intensive goods as mobility restrictions held back services consumption across the world. Goods consumption benefitted from pent-up demand due to lockdowns as well as from the savings accumulated during the pandemic. Unfortunately, constrained supply chains could not cope with the sudden pick-up in demand, and shortages of goods became the order of the day, which resulted in soaring goods prices globally. You may recall the shortage of microchips in 2021 which impacted the production of vehicles in our own economy. Initially, inflation was thought to be transitory, but it soon became clear it was anything but transitory. The sharply higher and more persistent inflation prompted global central banks to begin normalising policy rates, with institutions such as the United States (US) Federal Reserve at times hiking rates in successive steps of 75 basis points. With a synchronised global hiking cycle, and monetary policy moving to restrictive territory, expectations were for global growth to slow sharply in 2023, weighed down by high interest rates. In fact, many forecasters assessed a high likelihood of a recession in the major advanced economies this year. Ordinarily, sharply rising interest rates squeeze household and corporate incomes and thus reduce demand and investment, and hence quickly extinguish inflationary pressures. This is what many commentators, policymakers and analysts had expected early in the hiking cycle. Global growth, however, has proved resilient. Growth prospects have continued to improve, leading to an overall upgrade in the 2023 growth forecasts. The global economy is now forecast to expand by 3.0% this year, from 2.8% projected in April 2023.1 China’s strong rebound at the start of the year, following the country’s reversal of its zero-COVID policy, together with the easing global supply chain disruptions, provided a boost to global economic momentum. Demand, which had earlier shifted to the less contact-intensive goods consumption at the height of the pandemic, has rebalanced by rotating back to services as the COVID-19 pandemic has faded. Consequently, services-intensive economies, such as the US, have shown strong growth so far in 2023. One unexpected challenge brought about by the resilience in household spending is inflation persistence. The pass-through of high energy costs into broader prices in the economy ‒ the so-called second-round effects ‒ have also added to inflation persistence, particularly across Europe.2 Although global inflation peaked last year, its pace of decline has been much slower than expected, especially given the rapid pace of monetary policy normalisation by the major global central banks. Global headline inflation has fallen from a peak of 9.4% in the third quarter of 2022 to 5.7% in the second quarter of 2023. Much of the decline in headline inflation has been due to lower international food and oil prices, which have fallen considerably as the uncertainty occasioned by Russia’s war in Ukraine has abated, as well as the normalisation of supply chain pressures. Headline inflation is projected to average 6.8% in 2023 from 8.7% in 2022. Measures of underlying inflation have, however, remained persistently high in major advanced economies, with core inflation3 declining more slowly. The rotation of demand from goods back to services that I alluded to earlier has also seen goods inflation slow markedly, while pushing services inflation higher, meaning that the stickiness in core inflation is largely a services inflation story.4 Several factors, including still elevated excess savings and unusually tight labour markets, especially in advanced economies, have also continued to support consumer demand and have possibly delayed the impact of rate hikes on aggregate demand. 1 International Monetary Fund, World Economic Outlook, July 2023. 2 Consumers and businesses across major advanced economies have been grappling with rising costs, which saw headline inflation measures rising to historic highs last year. See World Bank, World Economic Prospects, July 2023. 3 Core inflation strips out the volatile components (food and energy) from headline inflation. 4 Among the services components, rental inflation in major advanced economies has perhaps contributed the most to the stickiness in core inflation. (Fortunately, we do not seem to have that problem here in South Africa, at least not for now.) Complicating the disinflation efforts is that labour markets in advanced economies have remained unusually tight, which is likely to strengthen workers’ bargaining power and drive real wage growth above productivity gains.5 Although longer-term inflation expectations have remained anchored, headline inflation is expected to remain above the 2.0% target beyond 2024 in most advanced economies. Inflation also remains elevated in most emerging market economies, including here at home, and is expected to decline only gradually towards central banks’ targets by 2025. Despite the recent moderation in headline inflation, risks to global inflation are assessed to be on the upside. Geopolitical tensions show no signs of abating, which will likely keep global food and energy markets tight, while the probability of El Niño weather conditions this year has risen sharply. Monetary policy is likely to remain focused on ensuring that inflation continues to retreat, implying that global policy rates could remain higher for longer. Now, let me turn my attention to developments in the domestic economy. How has the domestic economy fared? Like the rest of the world, South Africa has been grappling with persistently high inflation. South Africa has experienced a sustained inflation target breach, with headline inflation having remained above the midpoint of the target range for 27 consecutive months since May 2021. High inflation erodes the purchasing power of the rand and thus makes South Africans poorer. Over the past 18 months, South Africans, alongside their global counterparts, have endured a rise in the cost of living. This came at a time when South Africans had become accustomed to low and stable inflation. After hovering in the upper half of the target range for a year, South Africa’s inflation breached the upper limit of the SARB’s 3‒6% inflation target range in May 2022, and reaching a high of 7.8% in July 2022 before beginning its retreat. The trajectory of domestic headline inflation has been shaped primarily by fuel, food and electricity 5 This presents risks of wage-price spirals, particularly given demand resilience. prices. The first two have largely reflected global developments, beginning with the sharp rebound in the demand for goods amid supply bottlenecks, and later exacerbated by the Russia‒Ukraine war, which further strained global energy and food markets. Sharply rising food and fuel prices raise fundamental concerns from a distributional standpoint. To provide some perspective, fuel inflation in South Africa soared to 56.2% in July 2022, and pushed pump prices well above R25 per litre, with immediate knockon effects on transport and production costs for goods and services.6 Meanwhile, high electricity tariffs have further raised the cost of living for many South Africans. Food and transport inflation impact the poor the most, as their consumption baskets are weighted heavily by these items. Recent inflation data by Statistics South Africa shows inflation for the lowest income deciles (deciles 1 and 2) averaging 9.0% in July 2023, while that for income deciles 9 and 10 averaged at 4.3%.7 Low-income earners and the poor more generally are less able to protect their incomes from being eroded by inflation, and this contributes to rising inequality in our society. The authors of our Constitution understood the need to protect those who cannot protect themselves. The Constitution tasks the SARB with protecting the purchasing power of the rand, and we are committed to executing on this mandate. In light of the deteriorating domestic inflation environment, the SARB’s Monetary Policy Committee (MPC) raised the repurchase (repo) rate by a cumulative 475 basis points since the hiking cycle began in November 2021. At the current level of 8.25%, monetary policy in South Africa is now considered restrictive. While the MPC paused the hiking cycle in July, the committee will continue to assess inflation developments, and will act appropriately to steer inflation to the midpoint of the 3–6% target band (4.5%) to create an environment conducive to balanced and sustainable economic growth in the interest of all South Africans. Inflation outlook As food and fuel inflation have eased, mostly reflecting base effects, so has headline inflation, which recorded a low of 4.7% in July 2023. Going forward, we expect to see 6 Diesel is used in many production processes, including agriculture. 7 The Limpopo Province has not been spared. Inflation in the province rose sharply and peaked at 8.9% in July 2022, but unlike the rest of the country, inflation in the province declined markedly to 4.4% in July this year. further moderation in headline inflation on the back of further declines in fuel and food inflation as well as the cumulative effects of the repo rate increases to date. This should help ease the burden of high costs for both consumers and businesses. However, core inflation has exhibited signs of stickiness, much like we have seen at the global level. Core inflation was initially pushed up by markedly higher global goods inflation and exacerbated by the depreciation of the rand. Inflationary pressures have, however, broadened within the core basket, in part reflecting spillover and secondround effects from the high fuel and food price increases over the past year. Within the core basket, inflation has been driven mostly by core goods, and to a lesser extent, services.8 Housing ‒ the largest services component ‒ has experienced subdued inflation since the pandemic. This has helped to keep services inflation more muted and slowed the rise in core inflation. Core inflation is expected to average 4.9% this year. Risks to the domestic inflation outlook are on the upside. Although some food price components have eased over the past few months, domestic food price inflation is still elevated (10% in July 2023), while the risk of drier weather conditions in coming months has increased. Domestic food prices also remain at risk from exchange rate volatility as well as the impact of geopolitical developments, particularly following Russia’s decision to withdraw from the Black Sea Grain Initiative agreement. Similarly, global oil markets remain tight and sensitive to geopolitical tensions. Risks also emanate from the still elevated inflation expectations, which could feed into prices and wages, providing impetus to core inflation. Before I conclude, let me briefly touch on the recent performance of the South African economy. GDP performance Much like the global economy, the resilience of the domestic economy has surprised policymakers. After contracting by 6.0% in 2020, the domestic economy rebounded 8 The weaker rand exchange rate has had an impact on big-ticket imported goods such as vehicles, and alcoholic beverages and tobacco, which has kept inflation in exchange rate-sensitive core goods above 6.0% in the year to date. sharply, growing by 4.7% in 2021 and 1.9% in 2022. These growth rates were much stronger than we had expected and meant that the recovery to the pre-pandemic output level was achieved sooner than we had forecast. South Africa experienced large terms of trade gains as the global economy re-opened following the COVID-19 lockdowns, underpinned by buoyant global commodities demand while imports remained subdued. The strong domestic recovery also reflected a very supportive domestic macroeconomic environment, with massive fiscal support and multi-decade low interest rates.9 With output now back to its pre-pandemic level, South Africa’s medium-term economic outlook has weakened sharply again, this time on the back of extensive load-shedding. Expectations were broadly for the domestic economy to experience no growth in 2023 and only modest growth (1.0%) over the medium term. The domestic economy, however, is again likely to surprise to the upside this year with projected positive, albeit subdued, growth of 0.4%, following a better-than-expected growth outturn in the first quarter of 2023. Load-shedding continues to place increasing pressure on economic activity and will remain a drag on domestic growth in the near term. The SARB estimates that loadshedding will shave up to 2 percentage points off real gross domestic product (GDP) growth in 2023. This means our economy could have grown by at least 2.4% this year. Let me put the challenges of load-shedding into perspective. We have seen more loadshedding in the first six months of 2023 than for the whole of 2022.10 Load-shedding is having broader effects on the cost of doing business and ultimately the cost of living for all South Africans.11 Encouragingly, we are beginning to see some traction on reforms, particularly in the energy sector. While some strides have been made in removing structural barriers to entry for independent energy producers, the full benefits of these interventions will mostly materialise in the medium to long term. The SARB sees both potential growth 9 The budget deficit rose to 10% of GDP in 2020/21 ‒ one of the highest in emerging markets. The SARB lowered the repo rate to 3.50% during the pandemic ‒ its lowest level in over 50 years. 10 The cumulative electricity shed from the grid in the first six months of 2023 amounted to just over 15 000 GWh, which is significantly higher than the 11 770 GWh shed in the whole of 2022. Load-shedding is estimated to have contributed 0.5 percentage points to domestic inflation this year. and output growth slightly higher over the medium term.12 Meanwhile, private sector investment in alternative energy is providing a welcome boost to fixed capital formation and is supporting domestic economic activity, particularly in the construction industry. Investments in back-up energy solutions have cushioned business operations from the impacts of load-shedding and partly explain the resilience we see in the economy. Despite high inflation eroding real incomes, household spending has grown over the past year, although its contribution to overall economic growth has been declining. High inflation and rising interest rates, alongside slower employment recovery and declining real disposable income, continue to weigh on consumer confidence, raising the prospect of further slowdowns in household consumption growth.13, 14 Slower domestic growth ultimately reflects in weaker fiscal numbers, especially so given the reversal in revenue windfalls. The current trajectory of the fiscus is characterised by elevated budget deficits and rising public debt levels. This has contributed to a higher risk premium, driving up the cost of borrowing, and depreciating the rand exchange rate, thereby raising exchange rate pass-through inflation. Fiscal consolidation can significantly lower fiscal risk, and this should support macroeconomic stability and ultimately economic growth. Conclusion Finally, let me conclude by recommitting the SARB to the challenge posed by our Constitution. Our job is to contain inflation in the interests of balanced and sustainable growth. The SARB will continue to exercise its mandate to guide inflation and inflation expectations closer to the midpoint of the target band which, in turn, keeps demand and supply in the economy in balance. By so doing, we play our part in creating an environment conducive to inclusive and sustainable economic growth for the benefit of our people. It is important, however, to realise that economic growth and development really is a team sport, and as such, needs all the players to pull together Potential (real GDP) growth has been raised from -0.1% in 2023 to -0.8% and 1.0% in 2024 and 2025 respectively. 13 Consumer confidence declined sharply to -25 points in 2023Q2 from -8 points in 2023Q1. 14 According to the 2023Q2 Quarterly Labour Force Survey, an additional 784 000 (5.0%) people were employed during the quarter, when compared with the same period in 2022. This brings employment back to 2019 levels. Meanwhile, the official unemployment rate has declined from 33.9% in 2022Q2 to 32.6% in 2023Q2. The Limpopo Province is also facing the challenge of job creation, with unemployment in the province currently at 31.6%, slightly below the national average. and do their jobs well. So, while we work hard to lower inflation and interest rates to support a healthy balance of saving and investment, it is critical that the broader public sector identifies constraints to growth and job creation and focuses on relieving them. Thank you. | south african reserve bank | 2,023 | 9 |
Lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Nelson Mandela University, Gqeberha, 19 October 2023. | null | south african reserve bank | 2,023 | 10 |
Address by Ms Fundi Tshazibana, Deputy Governor of the South African Reserve Bank, at the South Africa Year Ahead Conference 2023, organised by the Bank of America Securities, Pretoria, 1 December 2023. | Fundi Tshazibana: Higher for longer Address by Ms Fundi Tshazibana, Deputy Governor of the South African Reserve Bank, at the South Africa Year Ahead Conference 2023, organised by the Bank of America Securities, Pretoria, 1 December 2023. *** Good morning Thank you for the invitation to speak at your annual Year Ahead conference. We live in very interesting and uncertain times. These past four years, we have learnt that what we may think the year ahead could look like, often does not hold true, often in the most surprising ways. The nature of the shocks we have experienced in recent years has resulted in an unusually high degree of convergence of global monetary policies in recent years. In other words, central banks have been running together in a pack. During the onset of the COVID-19 pandemic, most of us lowered rates sharply. Then, as inflation took off afterwards, we all raised them again. Nowadays, one could argue on the back of our communication, that central banks are in a third phase, which everyone is calling 'higher for longer'. I thought it would be useful today to discuss this concept of higher for longer - what it means, why so many central banks are using it, and how it applies to South Africa. There are two main reasons 'higher for longer' have been getting so much airtime, globally. The first is that markets, especially in the United States (US), placed increased focus on interest rate cuts. Even as the US Federal Reserve (Fed) raised rates steeply, starting in 2022, markets kept anticipating that this would trigger a recession and that the Fed would start cutting rates again. This was contrary to the Fed's own expectations for rates, as demonstrated, for instance, in the famous dot plot. And it was a problem because it meant financial conditions did not tighten as much as the Fed wanted: very short-term rates, which the Fed largely controls, were going up, but long-term rates were not rising nearly as much. This was weakening monetary policy transmission. Only in early 2023, did markets start accepting that rates would be higher for longer. 1/7 BIS - Central bankers' speeches The collapse of Silicon Valley Bank (SVB) triggered a last round of hopes for large, near-term cuts. But the financial stress from that episode was contained, and the US economy kept on growing. By mid-2023, the market had converged to the Fed's messaging, and 'higher for longer' became the new consensus. In these circumstances, we have seen the two-year Treasury bill rate rise to around 5% – it was just 3.8% after SVB collapsed, and 3% at the start of 2022. Similarly, the 10-year US Treasury rate, which is a crucial benchmark for the US economy and the world, briefly hit 5% in late October, and is now around 4.6%, up from just 3% at the start of 2022. Of course, long-term rates are not just determined by monetary policy expectations. Many explanations have been offered for the rise in the 10-year rate, but there is no expert consensus yet. However, for monetary policy, it is clear that there has been a broad tightening of financial conditions. And this has given the Fed space to leave rates unchanged at its past two meetings, after previously hiking for 11 meetings in a row. This brings us to the second reason central bankers have been emphasising 'higher for longer'. I should at this point highlight that although 'higher for longer' might sound like bad news, this is meant to be a reassuring message about why central banks could pause their hiking cycles. At the South African Reserve Bank's (SARB) 2023 Biennial Conference, held in late August, the Bank of England's Chief Economist, Huw Pill, captured this with a brilliant metaphor. He distinguished two monetary policy strategies – one that looks like the Matterhorn and one that looks like Table Mountain. The Matterhorn is a very steep mountain in the Alps, nearly 4.5 km high, and it looks like a pyramid. A Matterhorn monetary policy is one where you raise rates sky high, then quickly start cutting again. Table Mountain, of course, is not as high. It has an elevation of just over 1 km. But it stays that high for about 3 km. For monetary policy, a Table Mountain strategy means you do not hike as far, but rates remain elevated for an extended period. At our conference, Pill made three arguments in favour of the Table Mountain option. Let us see if you agree with him: Firstly, he suggested a less volatile rate cycle could mitigate financial stability risks. Secondly, he argued 'higher for longer' could also control underlying inflation pressures more effectively, for instance by better influencing slow-moving prices like wages. 2/7 BIS - Central bankers' speeches Thirdly, he also pointed out that in the United Kingdom (UK), many borrowing costs, such as mortgage rates, reset after a couple of years. This would put a lag on monetary policy transmission, meaning the Bank of England's Monetary Policy Committee would be able to pause rates and still expect the effects of past monetary tightening to intensify in the economy. Of course, different countries have different conditions. Accordingly, it is not clear that Matterhorn strategies are always better or worse than Table Mountain strategies. For example, there are several Latin American central banks that have been praised for their proactive responses to the recent global inflation surge. Their interest rate paths resemble the Matterhorn much more than Table Mountain. In Brazil, for instance, the policy rate went from 2% in 2021 to a peak of 13.75% by August 2022. It has since fallen by 150 basis points to 12.25%. Similarly, in Chile the policy rate was just half a percent in 2021. It peaked at 11.25% by mid-2022. It has so far fallen back by 225 basis points to 9%. But these are countries with worse inflation experiences, historically. They also experienced very severe inflation surges, with double-digit price growth during 2022. You can make a strong argument that Matterhorn strategies were appropriate in these contexts. South African conditions are different. Our policy stance has so far looked much more like Table Mountain: we climbed from 3.5% to 8.25%, and policy rates have been unchanged at 8.25% since May this year. Rates have clearly risen significantly, but much less than we saw in the Latin American cases. Relatedly, while we have seen cuts already in those countries, markets and analysts only anticipate shallow cuts in our repurchase (repo) rate, sometime around the second half of 2024. Barring any upside surprises, this has the appearance of a Table Mountain path. Is this the right strategy for South Africa? Firstly, it is important to note that we have not had the experience of the US or the UK where financial conditions have been slow to tighten. The South African private sector, especially households, mostly carries floating rate debt. When the SARB adjusts the repo rate, borrowing costs reset rapidly, typically within one month. 3/7 BIS - Central bankers' speeches We therefore see quick and clear monetary policy transmission, which carries over as expected to variables such as credit extension and core inflation. Therefore, the 'higher for longer' story for South Africa is not about delayed transmission or markets misreading our intentions. Secondly, the financial stability consideration has not played a big part in our thinking. No doubt, if there was a way to achieve our target that involves less stress on the system – households, firms and government – we would prefer that. But we have a resilient financial sector. Liquidations and insolvencies have been limited. There are some pockets of stress, and households are certainly feeling the squeeze, but we are not like advanced economies where rates are suddenly radically higher than they used to be. We are 200 basis point above where we were before COVID-19 struck – by contrast, both the US and the euro area have seen changes that are double that, about 400 basis points. Furthermore, having not had zero interest rates in South Africa, no one got used to treating debt like it was nearly free. Importantly, we also have a range of tools, beyond interest rates, to look after financial stability. Overall, we feel we can be resolute in using interest rates to stabilise inflation, without feeling hobbled by trade-offs between our mandates. Nonetheless, even if you cannot copy and paste the rationales from other economies to South Africa, there still seems to be a good case for keeping rates 'higher for longer' domestically. To anchor that claim with a number, in the 2010s, the repo rate averaged just over 6%. It seems unlikely we will be going back to those kinds of average rates over the next few years. Let me address the why. The starting point is the global story. As discussed, the era of ultra-low inflation rates and ultra-loose monetary policies in the advanced economies seems to be over. Where once global financial conditions were loose and it was relatively easy to attract foreign money, nowadays even the very safe and liquid assets generate attractive real returns. This means investors are no longer searching the world for a bit of extra yield; instead, it is the borrowers who must put in extra effort. 4/7 BIS - Central bankers' speeches South Africa is one of those borrowers. On top of that, our domestic policy settings are also calibrated to push up rates. This is not a statement about monetary policy; it is a statement about the environment in which we make monetary policy. Consider the following. Firstly, fundamentally, interest rates reconcile saving and investment. South African savings, as a share of gross domestic product (GDP), are at historic lows, under 14% of GDP. We have the lowest saving rate in the BRICS countries, and also the BRICS+, which includes the six new members joining next year. If you posed an exam question that asked: what would happen to interest rates in a country where savings decline while everything else stayed unchanged, the answer would be clear. Interest rates would be higher. Well, here we are, competing for a shrinking pool of resources. Where does this come from? As a country, we have long had a culture of low saving. What is new is the scale of our fiscal deficits. The average fiscal deficit from 2000 to 2020 was 2.5% of GDP. By contrast, Nation Treasury expects 4.9% for this financial year and 4.6% for the year after that. The International Monetary Fund (IMF) numbers suggest that we could do a lot worse, reaching a fiscal deficit of over 6% of GDP. What this tells us is that the biggest economic actor in the country decided to save less, or more precisely, to dissave more heavily – which means to borrow more. That reduced the pool of saving available for the rest of the economy. The result is upward pressure on interest rates. Of course, in a global economy you can draw on foreign savings to supplement local stocks. But as noted, global rates are higher and we are now perceived as a riskier borrower. The sovereign lost its last investment-grade credit rating in 2020. That affected the creditworthiness of all South African borrowers. We have a bigger risk premium to deal with than we used to, and we deal with it by paying up. In other words, the underlying drivers of interest rates are going up. To maintain the value of the currency – that is, to stabilise inflation – actual rates must rise too. 5/7 BIS - Central bankers' speeches The SARB is the messenger that conveys this information. It is the way of the world that the carriers of bad news get shot at. It is therefore no surprise that our rate increases have drawn some fire. Questions are often asked whether the SARB is helping this economy or not – with the emphasis on not. Our answer is clearly yes, we are helping. In the counterfactual where we tried to lower rates significantly in the face of these headwinds, the outcomes would be unsustainable and inflationary. This is not some hypothetical speculation; there are very visible examples of countries that did not get monetary policy tight enough and are paying a high price. Our mandate is clear: we have a duty to step in and ensure price stability. This equates to protecting the purchasing power of households, preserving the value of savings and the global competitiveness of South African businesses. And where this requires higher interest rates, plainly we need to deliver them - as we have done. But the more material question to ask is, does this economy not need lower rates? And the answer to that is, yes. We are in a suboptimal macroeconomic space, and if we could coordinate our way to a better set of macro settings, we could be better off. I would love to see rates being lower for longer, not higher for longer. And there are things we can do, as a country, to make that possible. It is not hard to imagine reforms that bring down the country risk premium. It is also not hard to imagine reforms that lower inflation. Reduced country risk would help the exchange rate. Lower administered price increases would directly reduce inflation. It is also helpful to think about a lower inflation target, like those of other well-run emerging markets. But I will leave this topic for another day. All these changes would give the SARB space for lower rates. And to the extent that some of these reforms temporarily weakened demand, that would bolster the case for lower rates. So, that is one problem with 'higher for longer' - it is the second-best outcome, not the first. It is what we must do in a situation where the SARB carries more of the burden of stabilising the macroeconomy. The first-best solution entails broader burden-sharing and therefore lower interest rates. The other problem with 'higher for longer' is that it sounds too much like a commitment. 6/7 BIS - Central bankers' speeches Over the past few years, central banks have experimented more widely with what is called 'forward guidance', and the results have not been pretty. The problem is, when you say something about the outlook for interest rates and then add all your caveats, people just hear the first part. They then get hurt when they act on the projections and do something else. Worse still, central banks can feel obliged to stick with their initial commitments, even in situations where the world changes for which different tactics are required. If we have learnt anything from the past four years, it is to expect surprises. We therefore need to retain optionality. The only hard promise we can make is that we will do what is needed to deliver on our mandate; we cannot pre-commit to a specific policy path. I therefore hope, when I say 'higher for longer', that I'm heard correctly. It is not a SARB promise. It is not even our preferred outcome. Instead, it is a useful way of describing the stresses in this economy – some of them from outside and some of them from within. It also conveys a viable strategy for controlling inflation despite those stresses. But higher for longer is not inevitable. We have to control inflation, but if we have different macro arrangements, that could be done more cheaply. Lower for longer is also possible, and I hope we get there. Thank you. 7/7 BIS - Central bankers' speeches | south african reserve bank | 2,023 | 12 |
Address by Ms Fundi Tshazibana, Deputy Governor of the South African Reserve Bank, at the Central Bank of Eswatini, Mbabane, 17 November 2023. | An address by Fundi Tshazibana, Deputy governor of the South African Reserve Bank, at the Central Bank of Eswatini, Mbabane, 17 November 2023 Global shifts and regional spillovers – how are we performing? Introduction Ladies and gentlemen, thank you for the opportunity to address you today at this event hosted by our colleagues at the Central Bank of Eswatini. The relationships between our respective central banks go back a long way – after all, the Common Monetary Area (CMA) of Southern Africa is the oldest existing currency union in the world, dating back to the beginning of the 20th century. The deep economic ties between the economies in the CMA, and our pegged exchange rates, underscore a high synchronisation in our economic cycles, especially in responding to the impact from global shocks, trends and spillovers to the African region – a central theme of my talk today. The past three to four years have seen many global shocks, and their ramifications continue to reverberate. In fact, we are still uncertain about the long-term effects these shocks will have on the world economy, trade and capital flows. While the COVID-19 pandemic may no longer be a major health concern, we still face a world of relative price shifts, high inflation, re-organisation of supply chains and increasing geopolitical risks. Encouragingly, both the global economy and our regional context have shown some resilience to these shocks. But some effects might come with a lag and complicate the task we, as central banks, face in maintaining price stability and financial stability. These are some of the issues I will try to address today. Some encouraging global developments We are all well aware of the inflation surge experienced globally in 2021 and 2022, driven by supply and demand mismatches that emerged as economies reopened in a staggered manner after the COVID-19-related lockdowns. During this period, advanced economies experienced inflation levels not seen since the early 1980s. To limit the permanent release of the inflation genie out of the bottle, advanced economy central banks had to act decisively by raising rates to levels last seen before the 2008 Global Financial Crisis.1 In emerging market and developing countries, most central banks had to tighten too, though the degree of the policy response varied considerably based on idiosyncratic factors. The good news is that in the past year or so, inflation rates have declined around the world. However, core inflation has remained rather sticky. This is the case with labourintensive services in advanced economies, against a background of still-tight labour markets. Nonetheless, services inflation is now falling in most countries. Favourable base effects in energy, food and the unwinding of supply chain bottlenecks have also tempered price increases in other consumer price index (CPI) components. Furthermore, longer-term inflation expectations, at least in major advanced economies, have remained reasonably well anchored, a testimony to central banks retaining their credibility. As a result, the monetary policy tightening episode appears largely complete. While central banks maintain vigilance against persistently high inflation, they demonstrate rising evidence of the transmission of earlier rate hikes to financial conditions and credit demand. Consequently, financial markets now see no probability of an additional hike in the United States (US) or eurozone. In the emerging economies, some of those central banks which had acted early and proactively to deal with inflation now have the flexibility to consider rate cuts. Another encouraging development is that disinflation is occurring alongside the surprising resilience of the global economy. The IMF’s October World Economic Outlook estimates that global growth will only slow to 3.0% this year, from 3.5% in 2022. In addition, Bloomberg consensus of economists now also expects world growth See ‘Inflation: A look under the hood’, Bank of International Settlements, Annual Economic Report 2022. of 2.8% in 2023, up from only 2.1% projected at the beginning of the year. In advanced economies, most private sector balance sheets were solid at the time when monetary policy was tightened. Cash buffers supported private spending, while in the US, corporate borrowers had ‘locked in’ low-cost medium-term financing when interest rates were at historic lows. This delayed the impact of higher rates on demand. Cross-border capital flows, while weak by historical standards over the past few quarters, have nonetheless displayed equal resilience in 2022‒23, considering the size of the repricing in advanced economies’ bond markets, usually a “bellwether” for global investor risk appetite. Over the past 12 months, portfolio flows to emerging markets over the past 12 months are only a 0.3 standard deviation below their average of the past 10 years.2 This is good news, considering that the 10-year US Treasury yields have risen by about 300 basis points since the beginning of 2022. Some of this better-than-expected news appears to have spilled over to the subSaharan Africa (SSA) region. In its October 2023 Regional Economic Outlook, the International Monetary Fund (IMF) projected a rebound in regional growth from 3.3% this year to 4.0% next year. Similarly, the IMF noted that median inflation for the region fell by 3 percentage points between March and July, and that most governments have started to consolidate fiscal policies, thus helping to stabilise debt-to-GDP ratios. In response to this improved environment, most SSA central banks have also paused their tightening cycles. We have also observed moderating inflation rates, as well as some resilience in economic activity, in CMA counties. In South Africa, inflation stood at 5.4% year on year in September, down from a peak of 7.9% in July last year. A similar pattern has been observed in other CMA countries, and indeed, my colleagues at the Central Bank of Eswatini recently revised down their 2023 inflation forecast from 5.55% to 4.93%. 3 Inflation also fell faster than expected in Lesotho, and in Namibia, with expectations of a further decline in 2024. The portfolio tracker data from the Institute of International Finance is used. See Monetary Policy Statement, Central Bank of Eswatini, 22 September 2023. At the same time, the South African economy performed better than expected in the first half of the year, leading the South African Reserve Bank (SARB) to revise its 2023 growth forecast upwards to 0.7%, from a low of 0.2% in March. Risks of negative spillovers remain elevated Despite these recent improvements, the global environment remains challenging. In the shorter term, higher advanced economy bond yields can still undermine, with a lag, cross-border capital flows. These are key to the funding of countries with external and public deficits, like most of us in the SSA region. History suggests that capital flows are more vulnerable, not only when nominal yields but also real yields are rising – as the latter typically reflect a re-pricing of the future path for policy rates, or higher term premiums for longer-dated maturities.4 This has been the case in the US these past two years, where the real 10-year yield rose from -1.0% at the beginning of 2022 to a peak of 2.5% by the end of October. Bloomberg columnist John Authers recently drew a parallel between 2023 and 1987, a year when rising real yields in the US co-existed with resilience in ‘riskier’ assets, especially equities, until the stock market crashed in October of that year.5 We do not want to be ‘prophets of doom’ and predict market corrections that may or may not happen, but in recent months, we have already seen declines in equity prices, as well as emerging market currencies and bond markets. Higher yields may still translate, with a lag, into a further correction in riskier assets, especially if economic activity in the US eventually slows, as most economists expect. The tragic events unfolding at present in the Middle East, less than two years after the start of the conflict in Ukraine which shows no sign of an immediate resolution, highlight the importance of geo-political risks. These can negatively affect the global economy via trade, commodity prices – especially oil – and higher asset price volatility. Beyond geo-political issues, climate change, and the potential it has to generate greater volatility in agricultural commodities and changes in resource allocation, The Federal Reserve Bank of New York, using the Adrian, Crump and Moench (2013) model, calculates that the term premium on the 10-year US Treasury yield has risen from -0.74% at the end of April 2023 to +0.42% at the end of October (https://www.newyorkfed.org/research/data_indicators/term-premia-tabs#/overview). J Authers, “No one wants to remember 1987. Then there’s 1916.”, Bloomberg, 4 October 2023. presents another risk to global inflation. In fact, as Christine Lagarde recently remarked, the world may have entered a period where supply shocks will become durably larger, and more frequent than in the past.6 These non-financial factors can have a direct impact on financial markets and capital flows, as investors may require a higher risk premium for holding riskier assets. They can also have an indirect impact, as more frequent and larger supply shocks have a larger probability of de-anchoring inflation expectations, forcing central banks to be more cautious and resulting in tighter policy over the economic cycle. This can enhance financial stability risk. Expectations that the era of low and stable interest rates would last influenced both the funding and investment models of many financial institutions, leading them to increase their exposure to interest risk. If higher yields for longer become the norm, many investment positions may be liquidated simultaneously, adding to asset price volatility.7 Negative spillovers from the global environment to our regional economies are not limited to financial flows. Merchandise trade flows also pose a risk to emerging market and developing country growth. Global trade in merchandise goods – after the postCOVID-19 rebound – appears to be in a recession phase.8 China's shift away from infrastructure and property investment, towards more household consumption and away from infrastructure and property investment poses a challenge for commodity exporters. As a result, African exports have been contracting since the second quarter of 2023. Beyond the current weakness in global export and import flows, the international trade system could suffer from geo-economic fragmentation in the medium term if geopolitical rivalries unravel the multilateral, rules-based system. Rival trade blocs that engage less which each other, be it with respect to trade, foreign direct investment or technology transfers. Recent research from the IMF suggests that the SSA region, See ‘Policymaking in an age of shifts and breaks’, speech by Christine Lagarde, President of the European Central Bank, at the annual Economic Policy Symposium ‘Structural Shifts in the Global Economy’ organised by the Federal Reserve Bank of Kansas City in Jackson Hole, 25 August 2023. International Monetary Fund, Global Financial Stability Report, October 2023. Data from the Netherlands Bureau for Economic Policy Analysis show that the volume of global trade contracted by 1.9% year on year, on average, in the first eight months of 2023. with its broad spectrum of export destimations, could experience the most significant output losses from such fragmentation.9 Regional vulnerabilities to global challenges Although the SSA region has displayed resilience to global shocks, these improvements are still fragile and insufficient to bolster the region’s attractiveness for external investment. First of all, inflation remains too high in many SSA economies. Among the 10 largest economies in the region, six still had double-digit year-on-year inflation rates as of September. Recent currency depreciation in many SSA countries (where a large part of the consumer goods basket is imported, and where inflation expectations are often poorly anchored) risks perpetuating high inflation, in terms triggering addition foreign exchange losses. Many countries in the SSA region tend to suffer from ‘twin deficits’ (fiscal and external) which raise the cost of debt servicing and refinancing at a time when global investors are more risk-averse, and more sensitive to deteriorating fiscal dynamics. According to the IMF, over half of the SSA countries are either at a high risk of debt distress or already in debt distress.10 No country in the region has been issuing Eurobonds since April 2022, suggesting that the refinancing of external debt could be particularly challenging in the next few years. Finally, economic performance in the SSA region remains uneven, and generally falls short of the performance seen two decades ago‒ a period when investment in the region increased steadily. South Africa is one of the laggards in the region – the SARB only expects growth to accelerate to 1.0% in 2024 amid continued constraints from insufficient electricity production and inefficient transport networks. Other CMA countries also look set to fall short of the regional average. More generally, the IMF notes a tendency for resource-intensive economies to underperform, highlighting the lingering problem of the SSA’s insufficient downstream integration into value chains. See International Monetary Fund, ‘Geoeconomic fragmentation: sub-Saharan Africa caught between the fault lines’, Regional Economic Outlook: sub-Saharan Africa Analytical Note, April 2023. International Monetary Fund, Regional Economic Outlook: sub-Saharan Africa, October 2023. How policy can best respond In response to these global challenges and regional vulnerabilities I have described, policymakers in our region, including us central bankers, still have work to do. Here is a list of the issues we should consider: • Policy response is not for central banks alone • Structural reforms are unavoidable • Controlling inflation is not negotiable • Close supervision of banks and non-banks is a must • And a credibility fiscal path is not only a necessary for fiscal sustainability but to bolster confidence, ensure financial stability to give some breathing room to monetary authorities High and volatile inflation discourages external capital inflows. It also discourages domestic fixed investment, erodes the purchasing power of the more vulnerable in society, and generally leads to a sup-optimal allocation of resources. This makes it essential for central banks to ensure that inflation returns swiftly to target, even when the causes of deviation are due to external factors, domestic supply shocks or necessary exchange rate adjustments. Market-determined exchange rates support foreign investment and enhance the allocation of resources in the longer run. Within the CMA, the rand is able to play its role of ‘shock absorber’ in episodes of capital outflows, and this helps reduce the length and size of such episodes. In the near term though, currency realignment is typically associated with an inflationary shock, and it is a central bank’s task to ensure that the shock does not become permanent. Credible monetary policy frameworks are required to help facilitate the eventual return to lower inflation rates. Arguably, both the spillovers from global shocks and the policy response required to deal with the inflationary consequences can increase the vulnerability of a country’s financial institutions. To avoid conflict between price and financial stability goals, central banks should act pre-emptively by monitoring the evolution of financial institutions’ balance sheets and take appropriate action in the case of excess risk concentration or growing forex or duration mismatches. In the context of escalating public debt levels, heightened exposures of both banks and non-bank financial intermediaries to the sovereign require close supervision. Fiscal policy can play a crucial role in limiting both price and financial stability risks, especially in those SSA countries which, like South Africa, have seen elevated deficits and rising debt ratios in recent years. A credible fiscal consolidation path can boost investor confidence, stabilise the currency and reduce the risk premia on government debt. Reforms that help in broadening the tax base, prioritising productive public investment and reducing wasteful expenditure, can all assist in fiscal consolidation, without causing significant real income losses. More generally, structural reforms that help foster stronger and more inclusive growth would facilitate the task of both monetary and fiscal policymakers. These can include the deepening of domestic capital markets to reduce reliance on external funding at a time when the cost and availability thereof have become more challenging. They can also entail steps that facilitate the diversification of African economies, the broadening of their export base, and their stronger integration into global supply chains. Reforming network industries, fostering skills development and training, and reducing barriers to entrepreneurships would all assist in that diversification. Concluding remarks As the year draws to a close, we can take comfort in the relative resilience of the global economy and financial systems. The global economy continued to expand in 2023, despite being buffeted by high inflation, rising interest rates and heightened geopolitical tensions. Credit continued to flow, albeit at a more moderate pace, and any corrections in asset prices occurred in an orderly fashion. Closer to home, we are encouraged by signs of declining inflation and improving growth prospects. Nevertheless, the road back to price stability remains lengthy and one that is likely to be fraught with more uncertainties than we were accustomed to before the pandemic. Consequently, global interest rates may become structurally more volatile, at a time when cross-border trade and financial linkages potentially realign alongside geostrategic considerations. It is our task as central bankers to be ready to respond to how these patterns affect price formation. We remain committed to fulfilling our mandate of price stability. Thank you. | south african reserve bank | 2,023 | 12 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the INCA Capacity Building Fund (ICBF) Summer School, Johannesburg, 5 February 2024. | An address by Lesetja Kganyago, Governor of the South African Reserve Bank, at the INCA Capacity Building Fund (ICBF) Summer School, Sandton, Johannesburg, 5 February 2024 Delivering on Mandates Good afternoon Thank you for having me on this panel and thank you more broadly for the opportunity to engage with you on the topic of building state capacity at the municipal level. I recently returned from the World Economic Forum in Davos, where people like me try to convince those looking for investment opportunities to choose South Africa. Davos is a very well-resourced town, and its local government runs smoothly, unlike most South African municipalities that are facing power outages, water shortages and long queues at municipal offices. At Davos, we talk about the big issues facing the global community. Local government does not feature much. But what happens at the local government level affects people’s lives just as much as the main Davos themes, like artificial intelligence (AI) and climate change. Furthermore, if we had a technology that improved local government capacity as drastically as AI has improved recently, I would say that would be a more important breakthrough than what we pondered at Davos. Of course, we do not have that technology. What we have is you, the officials who manage municipalities. Today’s objective is to discuss mandates with you, and to share our knowledge and experience in trying to deliver on our mandates, in the hope that there are some common lessons. A mandate defines an organisation’s mission. In government, it is one of the ways in which a community achieves its goals. There are different ways, of course, to achieve social objectives. The classic mechanism in modern democracies is to choose people who then make choices on a community’s behalf, and if they do not like those choices, then they choose someone else the next time. But there are many decisions in democracies that are not directly made by voted-in representatives. Rather, they are delegated to specialist organisations that have mandates. The South African Reserve bank (SARB) is one of those organisations. This model works well when that mandate is clear and you know what is expected of you. It works best with goals that are generally agreed to be desirable, and for which we have the relevant and effective tools. It is also a particularly good way of insulating decision making from short-term political pressures, which can get in the way of good outcomes.1 Let me illustrate these points with the example of central banking which, of course, is the example I know best. There is a broad global consensus on the model of central banking that we use in South Africa. In that model, a central bank is independent, but independence does not mean that the central bank can do whatever it pleases. The central bank is given independence to achieve specific mandates. Those mandates are things most people agree are in the interest of society. Our mandates, in common with many other central banks, are for price and financial stability. We have a toolkit to achieve these mandates. We can set interest rates and we can enact a range of regulations, supervise financial institutions and intervene in the financial market to counter dysfunction and instability. Central bank independence came about because we tried central bank dependence and it did not work. In countries where central banks are captives of the political process, they tend to be willing to fund whatever government wants, or to adjust monetary policy to suit election timetables. Ultimately, these come at a huge cost to the economy, paid with an inflation tax, which is levied disproportionately on the poor and vulnerable people in society. This discussion draws on Paul Tucker, Unelected Power, 2019. You also get central banks that let banks misbehave, take huge risks, then extract bailouts from the public purse to save the financial system. In the short term, central banks can make themselves popular by providing cheap money and encouraging credit sprees. Conversely, central banks can also make themselves deeply unpopular by interrupting the ruling party by insisting on protecting price and financial stability. But ordinary people want stability. They do not want the currency crashing; they do not want prices in the shops spiralling; and they do not want to worry if their money in the bank is safe. Simultaneously, most citizens do not have the time or the power to enact policies to protect price and financial stability. What they have is us. This is not to speak disparagingly of our stakeholders, but we cannot expect citizens to master these issues. They have their own priorities; they have their own projects. There is too much information for them to understand everything and it is not their job to do the things we are responsible for. This is a phenomenon economists call ‘rational ignorance’. Just like with smartphones or cars, you want to be able to leave the technical details to someone else and rely on the system to work. Of course, when it does not work, there is a reckoning. People complain, they take to the streets and they shout at you through the media. This can bring some accountability. And yet, unfortunately, there are ways to dodge criticism. You can always find reasons why you did not deliver. There is a sad history of central banks finding excuses for why they cannot protect the value of their currencies. They talk about how they do not control oil prices or food prices, or how they are being attacked by unethical speculators, or how the political mood of the country just makes inflation inevitable.2 However, even where these things are true, after a year or so you get two kinds of countries. You have countries that make excuses and you have countries that have price stability. There are people who get the job done and there are people who make excuses. They are rarely the same people. The people who stick to their mandates eventually get results. A classic example is Arthur Burns, ‘The anguish of central banking’, September 1987, available at: https://fraser.stlouisfed.org/files/docs/publications/FRB/pages/1985-1989/32252_1985-1989.pdf. For a discussion, see Lesetja Kganyago, ‘In the shadow of COVID: lessons from 20 years of inflation targeting’, 12 August 2020, available at: https://www.resbank.co.za/en/home/publications/publication-detailpages/speeches/speeches-by-governors/2020/565 Of course, there are some good excuses out there. Everyone makes mistakes, honest mistakes. We call these mistakes ‘excusable’ for a reason. But I have seen clearly, in the history of central banking, many unconvincing excuses. And the longer the excuses go on, the weaker they get. Reviewing this history, I think the practical policymaking lesson is that we need to practice error-tolerance and excuse-scepticism.3 Error-tolerance means you come forward, confess your mistakes honestly, discuss your plans for recovering the situation, and you get a fair hearing. Excuse-scepticism means you get a harsh reception when you say nothing is your fault and you cannot be held accountable, even though the mandate you were trusted with is not being delivered on. Quite a few central banks got it wrong in recent years. They did not see inflation coming and they did not understand it when it did. In emerging markets, we have taken some satisfaction in the verdict of many in the policy community4 that some of us did better here than the developed countries. But the big central banks are high-quality organisations and they demonstrate that quality, not by avoiding mistakes but by dealing with them and being honest about their errors. In the 1970s ‒ the last big global inflation surge ‒ central banks made many mistakes, gave many excuses and lost control of inflation. In the 2020s, I am confident we will do better, with far fewer excuses and much more success.5 We are going to deliver on our mandates. Of course, I am not a municipal manager. I doubt that my challenges, and the challenges of my profession, map directly to your challenges. That said, there is one area where our work overlaps, and that is the issue of inflation. At the SARB, our fundamental mission is to protect the buying power of the rand, and we specifically aim to protect it from increases in the cost of living, as measured by the consumer price index from Stats SA. If you go to that index, you see some significant components where prices are set at the municipal level. Think of water, think of rubbish collection, think of municipal rates. This discussion draws on Amy Edmondson. Right kind of wrong: The science of failing well. 2023 An example is https://www.piie.com/publications/working-papers/central-banks-and-policy-communicationhow-emerging-markets-have https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm Unfortunately, these prices are often rising by more than headline inflation. In the latest inflation report from Stats SA, for example, water inflation was 9.6%. Housing assessment or municipal rates was 8.4%. These numbers should be much closer to the midpoint of the SARB’s target of 4.5%. High municipal inflation eats away the incomes of our people, keeps our inflation rate elevated, and makes it harder for us to lower interest rates. It’s OK for prices to keep up with inflation; it’s not OK for some prices to always be rising by more than inflation. And we need you to take the lead to tackle this. Let me conclude by summarising the main points I have made today. • • • • It is important to understand mandates as part of the democratic process – a system for producing specific outcomes in the interest of society. This model works best when there are specific powers, requiring expert knowledge to achieve outcomes driven by a clear mandate that ensures transparency and accountability, and importantly, is devoid of short-term political considerations. It is important to have the courage to acknowledge mistakes and how you plan to fix them, rather than covering them up or making excuses. Ultimately, mandates represent a duty to South Africans who need us and trust us to deliver. For those of us who commit ourselves to delivering on these mandates, it can be difficult if you do not have the requisite skills and resources. But we have seen enormous commitment, creativity and perseverance across society to deliver on our mandates. We should all feel great pride in our work, serving the people of South Africa. Thank you. | south african reserve bank | 2,024 | 2 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the memorial service for the late Dr Sam Motsuenyane, Sandton, Johannesburg, 7 May 2024. | Lesetja Kganyago: Honouring the life and legacy of a doyen of black business Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the memorial service for the late Dr Sam Motsuenyane, Sandton, Johannesburg, 7 May 2024. *** Good afternoon, and let me once again share my deepest condolences to Mme Motsuenyane and the family, the Bakwena-ba-Modimosana farming clan and Dr Motsuenyane's many near and dear friends. There are so many black men and women in South Africa who can relay a story of when they first heard about the legendary Sam Motsuenyane – starting as far back as the 60s, 70s, 80s and, of course, the decades that followed. I mentioned those three decades specifically because, as a black person, and an African in particular, it was painfully difficult to start a business, to operate in a politically volatile and economically hostile environment. But Dr Motsuenyane took the courageous decision to defy the apartheid policies aimed at excluding him from the formal economy. And defy the odds, he surely did. I was a youngster when the tales of him and other doyens of black business were shared with me by our elders. There was such respect and pride when these stories were told of a man who was relentless in his drive for excellence, for success, for growth, for wealth creation, for economic development, and most importantly, for uplifting communities. For nearly eight decades, he worked tirelessly across so many areas – starting with the founding of Nafcoc in 1964, followed by a dream to establish a bank that would serve the unbanked and underserved African community. That perseverance and determination paid off. When I visited him in Winterveldt, he lamented the many members of his family and friends who told him to throw in the towel when it seemed they were not going to raise the capital needed to get a banking licence. But true entrepreneurs do not give up. Inspired by black business owners in the United States who had established their own bank, he and others set out to convince people from across the country to invest. Any amount, big or small, was welcomed as they moved one step closer to realising this dream. A genius strategic move sealed the deal. In 1972, he, together with a group of businesspeople, set out to meet Anthony Keith, the Chairperson of Barclays Bank in London. Their clarity of vision and commercially driven strategy led Barclays to not only invest in the bank, but also provide training to its executive and staff. With such a powerful endorsement, they were able to raise the rest of the money from individuals and businesses from across the black community. They secured the R1 million needed to apply for a banking licence. But the officials at the SARB did not make it easy for the first black-only consortium seeking to open a bank. Even with the backing from Barclays, they were sent from pillar to post in what can only be described as efforts to block this application. Again, there was no giving up on their part. And so, whatever the SARB requested, they provided, until finally, and after the requirements were met, the banking licence was issued in 1975. 1/3 BIS - Central bankers' speeches The story of African Bank has been one of highs and lows. He told me about their daily battles to manage customers, creditors, the regulator, suppliers, and their investors. He was at pains sharing the story about when the bank was placed into custodianship of then Trust Bank because they had broken exchange control rules. The bank had new shareholders and Nafcoc's influence had diminished significantly. Towards the end of his tenure as chairperson of the bank, he was no longer happy with the direction the institution was heading into, moving away from savings and focusing mostly on lending. It was his wish to claim the bank back and move it back towards its founding vision – to serve and provide financial services to the marginalised and underserved. It was for this reason that I opened a bank account with African Bank in Plein Street, Johannesburg, in the early 80s. It was an institution that I could relate to as a black South African, an institution that spoke to me in a manner that was respectful – it spoke to me, not about me. It was an institution I was proud to keep my savings at. Knowing what I know now about banking, especially if you have a savings account, I would not have opened that account. They were distributing marketing pamphlets in Hoek Street, incentivising customers to keep a minimum of R250 in their savings book for 12 months. At the end of 12 months they would add, I think, R50 to your balance. I took the bait, and it paid off. So there I was 12 months later with R300 in my savings account. The problem was that my father discovered that I had that amount in my account and decided to cut my weekly allowance. So much for creating a culture of savings. Dr Motsuenyane was a man who led from the front. After the 1994 elections, he served as Leader of the House in the Senate, now known as the Council of Provinces. He put black economic empowerment firmly on Parliament's agenda. This led to various pieces of legislation. His talents in public service, together with a penchant for diplomacy and patience, led to the next move. After two years as a senator, Tata Nelson Mandela asked him to serve as Ambassador to the Gulf States – Saudi Arabia, Oman, Bahrain, Kuwait and Yemen - a post he held until 2000. Farming and agriculture – an equally deep passion of his, led to the Winterveldt Citrus Project, which brought together farmers to provide fruit to retailers across the country. He spoke to me about farming in the same way he did about starting Nafcoc and African Bank - with passion and pride. When we met virtually during COVID-19, I was struck by his energy, and despite his age, he did not seem to be slowing down. Later, he wanted us to meet in person and wanted to come to the Reserve Bank offices. You can imagine my response – I told him that it was my duty to pay homage to him. That led to one of my most memorable experiences – spending time with Dr Sam Motsuenyane on his farm in Winterveldt. We spent the day talking about his love for agriculture, from cattle farming to his citrus farm, and his nursery that provided seedlings to other farms. But our conversation somehow kept circling back to African Bank. He told me that he had set aside his family money to buy shares in African Bank when it lists or sells shares. At some point, he asked me what my home totem was, and I told him, "Ke Mokwena wa meetse a pula". He stood up, shook my hand and said, "Le nna ke Mokwena". I knew the crocodiles had connected. 2/3 BIS - Central bankers' speeches Reflecting on such a wonderful human being, it was fitting that he was honoured with the National Order of the Baobab (Gold) in recognition of his role in fostering the development of black-owned businesses and economic liberation. He lived an exemplary life, one that was in true service of humankind. Robala ka khotso Mokwena! 3/3 BIS - Central bankers' speeches | south african reserve bank | 2,024 | 6 |
Keynote address (virtual) by Ms Fundi Tshazibana, Deputy Governor of the South African Reserve Bank, at the Toronto Centre Workshop "Blended Finance: Barriers, Opportunities and Implications for Financial Stability and Supervision", 25 June 2024. | Fundi Tshazibana: Scaling up blended finance - the role of financial regulators Keynote address (virtual) by Ms Fundi Tshazibana, Deputy Governor of the South African Reserve Bank, at the Toronto Centre Workshop "Blended Finance: Barriers, Opportunities and Implications for Financial Stability and Supervision", 25 June 2024. *** Good morning from London, where I am participating in the annual plenary meetings of the Network for Greening the Financial System (NGFS). I thank the Toronto Centre for inviting me to add the voice of the NGFS to the conversation that you are having on the barriers and opportunities presented by blended finance, and by implication for financial stability and supervision. The most recent analysis from the Climate Policy Initiative (2023)1 indicates an annual average climate finance gap of between US$8.1 and US$9 trillion. Of this amount, US$2 trillion is the estimated amount required for global investment in energy alone – this amount is projected to increase, with estimates suggesting that global investment needs to accelerate from current levels to well over US$4.5 trillion per year to transition energy systems. At the same time, we are faced with major obstacles to scaling up the financing of climate action. In the aftermath of the COVID-19 crisis, fiscal space has diminished in most countries. Deglobalisation and increased geopolitical fragmentation are likely to slow economic activity, making future funding more difficult. Ageing populations require additional fiscal support, even as the working-age populations in many economies fall. These pose significant risks to economic and financial stability. In this context, it is clear that unblocking constraints and scaling up the funding of climate mitigation and adaption requires more integrated approaches and instruments that take the present risk context into account. Blended finance has emerged as an important tool to reduce project risks and increase private sector financing, particularly in emerging and developing economies. Blended instruments aim to reduce the cost of borrowing, increase funding and extend the maturity of loans. The risk, however, does not disappear. It simply shifts from one balance sheet to another that is better positioned to absorb possible losses. Effectively supporting the development of blended instruments requires that we understand their risk-sharing mechanisms. As central banks, we are faced with three main questions: 1. How do we support the scaling up of blended finance? 2. How do we identify the risks embedded in different blended instruments? 3. How do we mitigate against them? Today I hope to provide some preliminary responses to these questions. I hope that you will spend time unpacking them in the remaining sessions of the conference. 1/4 BIS - Central bankers' speeches First: How do we support the scaling up of blended finance? The NGFS recently published several recommendations on how financial regulators and central banks can support the scaling up of blended instruments. These recommendations were based on several case studies which discussed recent experiences with blended finance instruments. Our assessment is that financial regulators and central banks can help with increasing blended finance only as part of a broader country approach to addressing obstacles to climate finance. Some of the obstacles to blended finance include the absence of project pipelines or macroeconomic instability due to fiscal crisis. These two obstacles require intervention from fiscal authorities and other parts of government. For some developing countries that are in debt destress, debt restructuring is required, indicating that the success of blended finance instruments in these countries is directly linked to the work of the Global Sovereign Debt Roundtable and mechanisms such as the G20 Common Framework for Debt Treatments. Examples of focus areas for central banks and regulators include addressing data gaps so that financial institutions can price risk appropriately, embedding climate considerations in governance and risk management practices, and understanding the risk profile of different instruments so that these can be treated appropriately in the microprudential framework. Data gaps remain a major obstacle to increasing climate financing. Financial regulators have an important role to play in addressing these gaps. Using appropriate taxonomy and disclosure rules in their regulatory and supervisory approaches can improve information flows and enhance the operations of financial markets. Embedding climate considerations in the governance and risk management practices of financial firms helps manage climate-related risks more effectively and improves the allocation of capital across the economy. The NGFS's work on transition planning provides important guidelines on how financial institutions can incorporate climate considerations in all aspects of their operations and manage climate-related risks during the transition. Another important area to support the scaling up of blended instruments is around their risk treatment in the regulatory and supervisory frameworks. Financial regulators face increasing pressure to reduce the risk weights associated with blended financial instruments. Lower weights can decrease capital costs and support the expansion of blended finance. This brings us to our second question. How do we identify the risks embedded in different blended instruments? In many cases, reducing the risk weights of blended instruments is justified. But is it justified in all cases? We face several challenges in our regulatory treatment of blended instrument. For example: 2/4 BIS - Central bankers' speeches 1. It is easy to understand the risk profile of some blended instruments such as guaranteed loans. But other blended instruments have more complex structures. It is difficult to create a universal framework for all blended instruments. 2. As I mentioned earlier, the risk does not disappear. It is shifted from one balance sheet to another. This other balance sheet sometimes sits in the domestic financial system and sometimes sits in another jurisdiction. For financial sector supervisors, this creates a significant level of complexity around how we think about the risk profile of blended finance. We need to understand the balance sheets of the institutions that we supervise but also of those institutions that provide risk insurance. Many of our tools such as risk ratings and internal capacity adequacy are based on historical data. Climate-related risks and those associated with new financial instruments require forward-looking analysis, which is often characterised by high levels of uncertainty. This often leads to a higher pricing of risk. Global standard-setting bodies recognise this challenge and have prioritised climaterelated risks in their work plans. Now to the last question. How do we mitigate against risks related to blended finance instruments? Many efforts to improve climate-related information flows in financial markets and enhance reporting by financial institutions can help with scaling up blended finance by helping central banks to better understand the risks associated with these instruments and mitigate them more effectively. This, however, is impossible without greater international cooperation as risks shift from one jurisdiction to another. Blended instruments will increase financial linkages and require a greater exchange of information across different jurisdictions. Financial sector regulators need to develop new skills and research capabilities to understand the various implications of the climate transition on the financial system. More importantly, we need to understand how the combination of different structural changes is likely to impact financial stability. For example, the rapid deployment of artificial intelligence (AI), in addition to the climate transition, is likely to have profound effects on the financial system and generate significant financial innovation. Scenario analysis and transition planning can help financial regulators in understanding future pathways and the associated risks. There have been advances and improvements but data quality and consistency need to be enhanced, particularly in emerging market and developing economies. In conclusion, we need a massive increase in financing for the climate transition but also to adjust to other structural challenges. Central banks and financial regulators have an important role in ensuring that the financial system is resilient to shocks and scales up fundings. However, our efforts to increase blended finance or the use of other financing tools depends critically on how our actions are coordinated within the broader policy environment. We not only need to unblock unnecessary regulatory obstacles to new finance instruments but also need to recognise that some of these instruments can pose risks to the financial system. 3/4 BIS - Central bankers' speeches I thank you again for the invitation and encourage you to reflect on these issues in the remaining sessions of the conference. All NGFS material is available on its website, including the paper on blended finance and recently released papers on climate disclosure for central banks, transition plans and recommendations on how central banks' portfolio managers should develop sustainable and responsible investment strategies. 1 https://www.climatepolicyinitiative.org/publication/global-landscape-of-climate-finance- 2023/ 4/4 BIS - Central bankers' speeches | south african reserve bank | 2,024 | 7 |
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the 104th annual ordinary general meeting of the SARB shareholders, Pretoria, 30 July 2024. | An address by Lesetja Kganyago, Governor of the South African Reserve Bank (SARB), at the 104th annual Ordinary General Meeting of the SARB shareholders South African Reserve Bank, Pretoria Tuesday, 30 July 2024 Good morning, ladies and gentlemen. Introduction After another momentous year, today we convene the South African Reserve Bank’s (SARB) annual Ordinary General Meeting (AGM). In April, we marked 30 years of South Africa’s still-young democracy. It has been an extraordinary three decades, with a global financial crisis rivalling that of 1929, a catastrophic health pandemic, as well as our own ongoing struggle to develop a new democratic dispensation to better address our legacy of inequality and poverty. Despite these many challenges, the recent national and provincial elections have underscored our resilience as a society, and a new government of national unity has been ushered in. While the SARB has been in existence for over a century, it is our democratic Constitution that sets its current mandate: to protect the value of the local currency in the interest of balanced and sustainable economic growth – and to do so without fear, favour or prejudice. Page 1 of 11 I am honoured to be part of a renewed leadership of the SARB, with Deputy Governors (DGs) Fundi Tshazibana and Rashad Cassim being reappointed, and Mampho Modise filling the vacant DG role. Our track record notwithstanding, we continue to face enormous challenges, but trust we will be supported by the dedicated staff of the SARB and its subsidiaries. With this in mind, I now turn to our economic outlook. A world economy in flux The global economy continues on a long recovery path from the pandemic. This path has been a troubled one, and despite better prospects in recent months, remains beset by risks and vulnerabilities built up during the pandemic. Inflation remains stubbornly high, and public debt levels globally are at record levels. Technological development carries both risks to cybersecurity and the hope of large and sustained boosts to global productivity. Meanwhile, 22 July appears to have been the hottest day on Earth in recent history.1 In short: we are entering an era of new economic challenges, even as the recent ones have yet to be overcome. There is little fiscal or monetary policy space available to deal with the risks that could emerge to financial stability, renewed inflation pressures or even the growing challenge of climate change. Inflation remains a major policy concern for central banks globally. Although global inflation declined from 8.7% in 2022 to 6.8% in 2023 and continues to ease in 20242, it remains high relative to the 2–3% inflation targets that many countries are trying to achieve. Restrictive monetary policy, along with the recovery in supply chains and other pandemic-related bottlenecks, has helped inflation to recede from its 2022 highs. 1 Recorded by the Copernicus Climate Change Service (C3S) data. 2 Forecasts from the International Monetary Fund (IMF) World Economic Outlook (WEO) Updates, January 2024 and April 2024. Page 2 of 11 However, global disinflation has slowed recently, as is well illustrated by consumer price inflation in the United States (US) still sitting at 3% relative to their 2% target. The slow pace of disinflation reflects a pattern of lower imported inflation but higher services inflation across most economies. In some, rising wages and sustained pentup demand for services have been key factors.3 In emerging markets specifically, fiscal challenges and sustained currency depreciations have played more of a role. Policy commitment to reduce inflation back to targets has been strongly signalled around the globe, and central banks have generally been cautious in their approach to policy. Deepening geo-economic fragmentation, higher temperatures and other supply-related risks raise concerns about the long-term prospects for inflation, and considerable effort is going into reassessments of neutral real rate levels. While inflation remains higher than desired, global economic activity has proven to be more resilient than expected. Global growth surprised higher at 3.3% in 2023, despite considerable divergence in growth across individual economies. Generally, however, global growth rates are expected to remain below pre-pandemic trends. This reflects the impact of protectionist measures on global trade, relatively tight financial conditions as well as uncertainty of future policy trajectories. Greater stability in global affairs and more sustainable fiscal policy settings across the G20 countries would help to dampen uncertainty and enable longer-term horizons for policymakers, firms and households. While lowering debt levels weigh on growth in the short term, the longer-term effects of falling borrowing costs act to improve growth prospects, supporting private investment and freeing up fiscal space. Lower inflation would also open monetary policy space and support easier credit conditions, complementing the fiscal actions. 3 Persistent services inflation, especially in the advanced economies, along with higher commodity prices, is expected to continue slowing the pace of disinflation in 2024 and 2025. See the July 2024 IMF WEO Update: The global economy in a sticky spot. Page 3 of 11 The SARB forecasts trading-partner growth to remain moderate in the medium term, hovering at around 3%. Domestic real economy developments Despite varied sectoral performances, output in the South African economy slowed to 0.7% in 2023 from 1.9% in 2022, and remains well below growth in peer emerging markets.4 Load-shedding and logistical challenges have been weighing heavily on economic activity, depressing the credit appetite of businesses and the spending of households. Despite such weak growth in output, however, employment levels have recovered the 2.2 million jobs lost during the height of the pandemic.5 As of the first quarter of this year, total employment surpassed its 2019 level. Nonetheless, job creation has been too slow and not enough to offset the growth in the labour force, leaving the unemployment rate elevated at 32.9% in the first quarter of this year. South Africa’s tailwind for growth coming from strong terms of trade continued to fade, despite still remaining at historically good levels. Exports also suffered over the past 12 months from energy and logistics challenges as much as price factors. Imports were also muted by logistics. As energy and logistics constraints continue to ease, the growth outlook will also improve.6 The domestic economy is expected to grow by 1.1% this year, rising to 1.7% by 2026, as both household spending and investment start to strengthen. Domestic inflation dynamics 4 IMF WEO Update, July 2024. Peer economies are expected to grow by 4%. 5 The global average elasticity of employment is roughly 0.5%. Ours is about 0.6% to 0.7%. See V Morén and … [Insert his/her initial(s).] Wändal, 2019, ‘The employment elasticity of economic growth’, University of Gothenburg, and also H E Bhorat, K Naidoo, M Oosthuizen and P Pillay, ‘Demographic, employment, and wage trends in SA’, WIDER Working Paper Series, 2015. 6 Load-shedding is expected to detract less (0.2 percentage points) from growth in 2024, compared to 1.5 percentage points in 2023. Page 4 of 11 As with the global trend of moderating inflation, South Africa’s headline inflation decelerated over the past year, falling from 6.9% in 2022 to average 6% in 2023. These annual averages, however, hide the ongoing volatility in the underlying components of inflation, in turn demonstrating the risks and uncertainty marking the disinflation path. Since September of last year, headline inflation has been fluctuating between 5% and 6%, with frequent monthly setbacks coming from fuel, food and services prices.7 In February, core inflation rose by 0.4 percentage points to 5%, propelled sharply higher by medical insurance inflation. Encouragingly, as of June, core inflation has moved to 4.5%. The SARB sees core inflation averaging 4.6% this year, from 4.8% last year. Inflation expectations eased in the first half of this year, but still remain well above the midpoint of the target band. While headline inflation came out between 5% and 6% for much of the past year, our current forecast shows it easing to 4.9% this year, pulled lower mainly by softening food and fuel inflation, and resting at the midpoint in 2025 and 2026. Even with some quantitative and qualitative adjustments to risk perceptions over time, the Monetary Policy Committee (MPC) has felt it appropriate to maintain the repurchase (repo) rate at 8.25% – a level set in May of 2023. Financial stability Turning to financial stability, the SARB continued to ensure that the financial system remains resilient, without any systemic threats to its functioning materialising during the 2023/24 financial year. This is despite the risks to the outlook that include sustained geopolitical tensions, sticky inflation and government debt levels that remain uncomfortably elevated, globally. These risks have coincided with an unprecedented number of national elections around the world, leading to some uncertainty and heightened market volatility. 7 Inflation moderated to 5.1% in December 2023, from 5.9% in October, before accelerating to 5.6% in February 2024. Headline inflation has moderated from February and remained unchanged at 5.2% in both April and May. Page 5 of 11 South Africa is still confronted with its government’s growing debt levels and everhigher debt-servicing costs, as well as domestic financial institutions’ high exposure to that debt. The SARB continues to monitor this sovereign-financial sector nexus closely. Although we are working hard to exit the Financial Action Task Force (FATF) grey list, the effects of being greylisted are being felt as foreign counterparties apply greater scrutiny to our domestic institutions. At the same time, the effects of climate change are becoming more frequent and more severe, as highlighted by the recent winter storms that lashed at least four provinces and necessitated the declaration of regional states of disaster. As part of its ongoing efforts to understand and mitigate the risks associated with climate change, the SARB conducted its first comprehensive stress test of South Africa’s major insurance companies during the 2023/24 period, which included a climate change component. Going forward, climate-related risk will increasingly feature as part of the SARB’s stress-testing scenarios. As of 1 July 2023, the SARB became a resolution authority, and is now obliged to develop resolution plans for systemically important banks and insurers, should they fail. Accompanying this was the launch of the Corporation for Deposit Insurance (CODI) – a new subsidiary of the SARB with its own Board of Directors and Investment Committee. CODI manages the country’s first deposit insurance scheme and cover qualifying depositors for up to R100 000 if their bank fails, is liquidated, or placed into resolution. These milestones will bolster trust and confidence in the financial system and strengthen its robustness. Prudential regulation Page 6 of 11 The regulatory and supervisory work of the Prudential Authority (PA) goes hand in hand with our financial stability efforts. When it comes to the banking sector, elevated levels of inflation and rising interest rates have been eroding the disposable income of households and the profitability of businesses, resulting in a rise in impaired advances for banks. The PA will continue to monitor banks’ credit risk management practices and encourage banks to ensure that prudent financial and risk management practices are in place to weather any storm that may arise. In its work to safeguard the interests of depositors and policy holders, the PA placed two institutions under judicial management, while it continues to monitor several institutions that are in various stages of resolution, because of financial and governance-related matters. These challenges aside, the PA has supported efforts to grow a more diverse financial industry, having licensed one bank during the period under review, with five more in progress. Four new insurers, being three life and one non-life, were registered, with a further 11 applications in progress, six of which are life insurers. Two cooperative financial institutions were also registered, with a further two in progress. The PA and the Financial Surveillance Department are driving the SARB’s efforts to get South Africa off the FATF grey list. FATF has identified 22 action items that South Africa must address to improve its anti-money laundering and combating the financing of terrorism (AML/CFT) regime. Currently, eight of the 22 items have been addressed or largely addressed, and 14 remain in progress. South Africa is left with two reporting cycles, in September 2024 and January 2025, in terms of the action plan. Although foreign counterparties have been applying greater scrutiny to our domestic institutions as a result of the FATF greylisting, the PA has found no immediate negative impact on correspondent banking relationships. It is nevertheless imperative that the action items are addressed timeously to avoid long-term negative effects on the economy. Operational matters Page 7 of 11 Moving to operational matters: during the year under review, the SARB saw the overhaul of its balance sheet with the introduction of new arrangements governing the Gold and Foreign Exchange Contingency Reserve Account (GFECRA). Announced in February 2024, the new GFECRA framework will allow government to access a portion of these funds to reduce debt issuance, while providing the SARB with a stronger capital position. In June, these arrangements were passed into law with the gazetting of the Gold and Foreign Exchange Contingency Reserve Account Defrayal Amendment Act. This was accompanied by the signing of the GFECRA settlement agreement between the SARB and the Minister of Finance. The agreement ensures that, among other conditions, the SARB’s solvency is not undermined by any GFECRA profits distribution. These distributions will be used to reduce government borrowing. There will be no sales of foreign exchange reserves if such reserves are below estimated adequacy levels. As of 1 July, R100 billion had been transferred to the SARB, and roughly threequarters of the R100 billion due to National Treasury this year has already been paid out. We expect to complete the transfers by mid-August. The SARB is the custodian of South Africa’s national payment system. In the past, payment systems were often viewed as the ‘boring plumbing’ underpinning a central bank’s work. But with the rapid advancements in financial technology (fintech), payment systems globally are instead becoming central to innovation, enabling more digital transaction offerings, reducing the reliance on cash, and providing new ways to drive financial inclusion and economic development. The recently published Digital Payments Roadmap outlines the key interventions that the SARB, together with public and private stakeholders, will implement to advance efforts to improve digital payments adoption by consumers. The SARB’s payments ecosystem modernisation programme will further support efforts to make domestic payments cheaper, faster, more reliable and more accessible to underserved communities. The programme includes the establishment of a new centralised public payments utility, and the renewal of the domestic settlement system Page 8 of 11 – being the South African Multiple Option Settlement (SAMOS) system. The SARB will also implement foundational enablers such as a digital financial identity for consumers. Alongside modernisation efforts, the SARB remains committed to ensuring that our existing payment and settlement services continue to serve the industry effectively and efficiently. To this end, in June, we successfully migrated the Southern African Development Community real-time gross settlement (SADC-RTGS) system to the ISO 20022 global financial messaging standard. ISO 20022 is an open standard for payments messaging that creates a common language and model for payments data across countries. The adoption of this new standard by the SADC-RTGS system and its participants comes well ahead of the global November 2025 deadline and will support payments innovation in the SADC region. In its day-to-day operations, the SARB procures a range of goods and services. Its procurement strategy is focused on fair, equitable, transparent, competitive and costeffective purchasing. Although the SARB is exempt from the Preferential Procurement Policy Framework Act 5 of 2000, it nevertheless applies preferential procurement principles in its sourcing and procurement activities. This year has been the first of a three-year broad-based black economic empowerment (B-BBEE) strategy, demonstrating our commitment to maintaining and improving spend with qualifying suppliers. The bulk of the SARB’s R4.7 billion in spending – or a little over 91% – went to local suppliers. Using the Generic Codes of Good Practice scorecard, the SARB achieved 21.6 out of a possible 27 points in terms of recognised B-BBEE spend. Information and technology infrastructure is critical to the functioning of the SARB. The rapid changes in how we use and process information affect every facet of our work. The proactive management of the SARB’s networks and systems has ensured that mission-critical business applications have remained up and running 99.9% of the time over the past year. Our systems’ resilience has been enhanced by, among other initiatives, the redesign of our data centres and network modernisation. We are also working to build a workforce of the future, strengthening our cyber team to build local and regional resilience to cyber incidents. Page 9 of 11 Our commitment to serving the economic well-being of all South Africans is also evidenced in our corporate social investment programme, which focuses primarily on education. At the heart of this work is our external bursary programme, which aims to develop human capital in the fields of monetary policy, financial stability, data science and economic journalism. In 2023, the SARB sponsored 110 students: 63 continuing bursars, 35 first-year bursars and 12 students studying towards their Master’s degree in data science. Eighty six percent are from previously disadvantaged backgrounds and 63% are female. Staff matters The importance of the SARB’s role in our economy demands the utmost from its staff members. Without their commitment and expertise, this central bank would not be able to achieve its strategic objectives or deliver on its mandate. To ensure that staff continue developing their professional skills, the SARB’s spend on training increased to almost 6% of total payroll in the 2023/24 financial year. More than half of the employees that received training (56%) were women. Diverse organisations which reflect the societies they operate in are typically more successful. Having rolled out the third phase of its Diversity and Inclusion (D&I) Programme, the SARB has incorporated a D&I accountability framework into its performance scorecard, ensuring it is embedding D&I into all that we do. At the same time, our staff experience is being steadily improved through the digitalisation of our people management systems. Conclusion The year ahead will throw new challenges the SARB’s way. Our international activities will receive particular focus as South Africa takes up the G20 Presidency. Together with National Treasury, the SARB is gearing up to co-chair the Finance Track from Page 10 of 11 December 2024. It will focus on, among other issues, global macroeconomic matters, climate change, cross-border payments and capital flows, and the financial inclusion agenda. Over the past year, the SARB has worked to ensure a coherent G20 agenda which is relevant for the country, the G20 members and the African continent. South Africa is the fourth country in the Global South to lead the G20 Presidency before it moves back to an advanced economy. On the regional front, we have prioritised a stragey focused on the integration of SADC member countries, in our role as Chair and Secretariat of the SADC Committee of Central Bank Governors. The year 2025 will also mark the culmination of the SARB’s five-year strategy cycle. The formulation of our new Strategy 2030 is currently underway. Whatever the outcome of this process, I can assure you that the SARB will remain in service to the country. We will continue to ensure the cost-effective availability and integrity of our currency. We will continue to ensure that the financial sector safeguards depositors and policy holders. We will continue to enhance South Africa’s resilience to external shocks. But above all, we will hold fast to our price and financial stability mandates. Thank you. Page 11 of 11 | south african reserve bank | 2,024 | 8 |
Opening remarks by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the Market Practitioners Group Conference, Sandton, Johannesburg, 21 August 2024. | Rashad Cassim: The upcoming Jibar transition Opening remarks by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the Market Practitioners Group Conference, Sandton, Johannesburg, 21 August 2024. *** Good morning, all. We appreciate that, of all the priorities competing for your time, you have chosen to attend this third Market Practitioners Group (MPG) Conference. Our subject is an important one: the upcoming transition of the Johannesburg Interbank Average Rate, commonly known as Jibar, to ZARONIA which is the South African Rand Overnight Index Average rate. For several years, the MPG and the South African Reserve Bank (SARB) have been building the foundations for reference rate reform. The designated successor to Jibar, ZARONIA is an overnight, wholesale deposit rate. It is near risk-free, and unlike Jibar, it is based on large volumes of actual transactions in the South African market, as opposed to a rate based on small volumes of quotes. The veracity of ZARONIA has been tested extensively through a year-long observation period, which concluded in November 2023. It is now being published daily on the South Arican Reserve Bank (SARB) website for use in financial contracts. Many of you may be aware that the MPG has published several white papers recommending market conventions for ZARONIA-based cash and derivatives products. Based on these developments, market infrastructure providers have implemented solutions to support market activity. Before I open to our panels of experts, I want to make three general points. Then, I will move on to highlight some operational and methodological challenges associated with the transition process. First, the SARB remains committed to discontinuing Jibar. Second, it is important for market participants to prioritise an active transition away from Jibar based contracts and not just adopt a wait-and-see approach. The best way to minimise transition risks is to minimise the stock of legacy contracts based on Jibar. Third, the most progressive way forward for market participants will be to take ownership of the transition, to establish transition programmes within your organisations and, to work out your own paths forward. Jibar cessation The latest results from the Jibar-related exposures survey indicate that the number of financial contracts referencing Jibar remains huge, with the total gross exposure 1/5 BIS - Central bankers' speeches estimated at over R57 trillion. Much of this exposure is attributable to derivatives contracts that reference the three-month Jibar, accounting for about 91%, while at the same time, the volume of three-month negotiable certificates of deposit (NCDs) that underpins the three-month Jibar remains very small, at just R10 billion. We clearly need a better benchmark, and that is why we are committed to the Jibar cessation. That said, the SARB's commitment to discontinuing Jibar should not be taken to mean that Jibar is non-representative. It is not the SARB's intention to trigger any precessation clauses at this stage, but rather to give the market the confidence it needs to engage with the transition effort in earnest. The MPG's recent 'Update on the Jibar transition plan' indicates that Jibar will cease towards the end of 2026.1 The SARB intends to announce the precise Jibar cessation date in December 2025. This leaves the market with just over two years to complete the Jibar transition. It is an ambitious timeline, but achievable. Managing legacy contracts Jibar and ZARONIA are structurally different. There are term and risk premia in Jibar that do not apply to an overnight cash rate like ZARONIA. Therefore, we will need quantitative techniques to achieve economic equivalence when switching from Jibar to ZARONIA. This will largely be achieved by adding an adjustment spread to ZARONIA. You may ask: How can we determine an appropriate adjustment spread? It is not a straightforward question to answer. We could employ quantitative models to identify the various premiums in Jibar, and then base the adjustment factor on these spreads. However, model results can be sensitive to assumptions, and the models themselves may not be widely understood, which could make it difficult to achieve consensus on what the appropriate adjustment spread should be. Alternatively, we could rely solely on observed data to compute the adjustment spread. This would require choosing an approach for instance, the historical mean or median, the spot spread, or a forward-looking approach. This would then inform the choice of the ZARONIA measure that will be used – that is, whether the adjustment spread incorporates compounded ZARONIA period averages, spot ZARONIA rates, or forwardlooking ZARONIA rates that incorporate market expectations. Clearly, the choice of the Jibar measure would need to align with the choice of the ZARONIA measure. Fortunately, the International Swaps and Derivatives Association (ISDA) has consulted widely on this issue, 2 and concluded that market participants would prefer the historical median approach, with an adjustment spread based on five years of data.3 This method would be robust against data outliers resulting from unusual market conditions, as well as potential manipulation. 4 Consequently, this method was adopted in cash and derivatives markets in the United States, United Kingdom and many jurisdictions that were impacted by the London Interbank Offered Rate (LIBOR) transition. 2/5 BIS - Central bankers' speeches Nonetheless, in South Africa, market participants are not only concerned about dealing with data outliers; they are also concerned about structural shifts in the behaviour of the Jibar, especially since the SARB's migration to a surplus system for implementing monetary policy in June 2022. It appears that this reform has squeezed liquidity premiums, in that the spread between ZARONIA and Jibar has narrowed somewhat. The MPG is currently finalising its work on the adjustment spread methodology to ensure that the chosen methodology considers all the idiosyncratic factors that would concern market participants. It is also important for market participants not to over-rely on fallbacks to facilitate legacy Jibar referencing contracts. The best way to minimise risks would be to actively migrate to ZARONIA referencing contracts as soon as practicable.5 There will nonetheless be instances where, despite best efforts, it may not be possible to transition or adjust certain contracts before Jibar ceases. These so-called tough legacy contracts will require regulatory measures to facilitate their transition. As such, it may be necessary for the MPG to consider a synthetic Jibar, similar in structure to the current forward-looking Jibar, to minimise the impact on systems and processes. Furthermore, the MPG, the SARB and the Financial Sector Conduct Authority will consult with National Treasury on the appropriate regulatory instruments for ensuring contract continuity and safe harbour provisions for the protection of contract parties, supervisors and the benchmark administrator. Building a new foundation Shortly after the MPG Conference in April 2023, the remaining US dollar LIBOR panels were discontinued. This concluded a massive decade-long global project to replace LIBOR.6 Reflecting on this effort, the co-chairs of the Financial Stability Board's Official Sector Steering Group, Nikhil Rathi and John C Williams, concluded that it had been like building a new foundation under an existing home – an undertaking of extreme difficulty, one many doubted would succeed, and which they did not wish to repeat.7 It is remarkable that we have had a largely smooth LIBOR transition, and local institutions should be commended for managing their LIBOR exposures effectively. However, in South Africa we are not yet at the stage where we can relax, enjoy our new foundation and promise ourselves that we never want to renovate again. We are only now embarking on a critical stage of the 'Jibar transition roadmap', 8 which requires market participants to start trading ZARONIA-based securities in earnest. A poorly coordinated transition, or delayed action by market participants, could result in market disruption and undesirable cliff effects. Consequently, market participants should consider a smooth Jibar transition as a strategic priority, both for their own organisations and the larger financial system. 3/5 BIS - Central bankers' speeches Last year, I asked market participants to consider elevating the Jibar transition discourse in their organisations and to establish transition programmes, with visibility at the executive board level. This work is ever more urgent today. Concluding remarks To conclude, global reference rate reforms were triggered by serious weaknesses in existing benchmarks. These included design failings, glaring cases of market manipulation, and structural shifts in the markets underpinning benchmarks. The responsible authorities had no choice but to reform. But reference rate transitions cannot succeed if market participants do not join in the journey. I hope you will look at this transition not as a chore or a burden to be taken on with great reluctance, but as an opportunity – an opportunity to build better markets as we navigate together to a new benchmark. There are uncertainties contained in the Jibar transition plan. None of the listed milestones and timelines are cast in stone. At best, they reflect the MPG's best estimates given the knowledge and information at hand. It is possible that some milestones may need to be shifted now and again. Nonetheless, the MPG will endeavour to manage the uncertainties and continue to engage all stakeholders and provide clarity where necessary. I hope you enjoy the rest of the conference. Thank you. 1 Market Practitioners Group, Transition Planning and Coordination Workstream, 'Update on the Jibar transition plan', 2024. https://www.resbank.co.za/content/dam/sarb /publications/financialmarkets/committees/mpg/mpg-ralated-documents/2024/update-onthe-Jibar-transition-plan.pdf (accessed 10 August 2024). 2 ISDA, 'Consultation on certain aspects of fallbacks for derivatives referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW', 2018. https://assets.isda.org/media/f253b540-193/42c13663-pdf/ (accessed 10 August 2024). 3 The Brattle Group, 'Summary of responses to the ISDA consultation on final parameters for the spread and term adjustments', 15 November 2019. https://assets. isda.org/media/3e16cdd2/d1b3283fpdf/ (accessed 10 August 2024). 4 Financial Conduct Authority (UK), 'Article 23D benchmarks regulation: Draft notice of requirements', 29 September 2021. https://www.fca.org.uk/publication/libor-notices /article-23d-benchmarksregulation-draft-requirements-notice.pdf (accessed 10 August 2024). 4/5 BIS - Central bankers' speeches 5 Financial Stability Board, 'FSB statement to support preparations for LIBOR cessation', 19 November 2021. https://www.fsb.org/2021/11/fsb-statement-to-supportpreparations-for-liborcessation/ (accessed 10 August 2024). 6 Financial Stability Board, 'Progress report on LIBOR and other benchmarks transition issues: Reaching the finishing line of LIBOR transition and securing robust reference rates for the future', 16 December 2022. https://www.fsb.org/wp-content/uploads /P161222.pdf (accessed 10 August 2024). 7 N Rathi and J C Williams, 'Innovating for the future, heeding lessons from the past', Federal Reserve Bank of New York, The Teller Window, 17 August 2023. https://tellerwindow.newyorkfed.org/2023/08/17/innovating-for-the-future-heedinglessons-from-thepast/ (accessed 10 august 2024). 8 Market Practitioners Group, Transition Planning and Coordination Workstream, 'Update on the Jibar transition plan', 2024. https://www.resbank.co.za/content/dam/sarb /publications/financialmarkets/committees/mpg/mpg-ralated-documents/2024/update-onthe-Jibar-transition-plan.pdf (accessed 10 August 2024). 5/5 BIS - Central bankers' speeches | south african reserve bank | 2,024 | 8 |
Guest lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the University of the Free State, Faculty of Economic and Management Sciences, Bloemfontein, 15 August 2024. | null | south african reserve bank | 2,024 | 8 |
Speaking notes by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the South African Reserve Bank's Payments Study Report Launch, Sandton, Johannesburg, 5 September 2024. | Rashad Cassim: South African Reserve Bank's Payments Study Report Launch Speaking notes by Mr Rashad Cassim, Deputy Governor of the South African Reserve Bank, at the South African Reserve Bank's Payments Study Report Launch, Sandton, Johannesburg, 5 September 2024. *** Good afternoon, all. Thank you for joining us today as we launch the South African Reserve Bank's (SARB) inaugural Payments Study Report. This study is one of our initiatives to better understand the payment system landscape in South Africa. It supports our current strategy, Vision 2025, which identified a need for the SARB to collect more payments information. In pursuing that goal, we knew we already had extensive information about the supply side of payments. We get this from operating SAMOS,1 the core interbank payment, real-time gross settlement system. We also receive data from other payment service providers. The Payments Study Report we are launching today, by contrast, is about the demand side of the payment system – the users thereof and their choice of payment methods, including their preferences, level of awareness, usage, reasons for adoption and barriers to entry. The study has two parts. One is a survey of about 45 minutes that just over 3 000 people completed. We call this the Survey of Consumer Payment Choice (SCPC). In the second part of the study, about 4 600 respondents tracked their payment behaviour and payment method usage over a three-month period, using actual payments in a set period of days. This we call the Diary of Consumer Payment Choice (DCPC). Here people documented, among other things, their preferred payment methods, the amounts paid and what the payments were for. The two surveys were conducted nationwide between April and December last year. They were designed to complement each other. Indeed, this two-survey approach has also been adopted by other central banks, for instance in Australia, Poland, Sweden and the United States (US). 2 And the results make for interesting reading. I do not want to steal the thunder of our next presenter, who will be walking us through the high-level results, but I was struck by several points. For instance, even though the usage of cash is not growing any more, it remains the most popular payment method. Debit card usage is second and credit cards a distant third. 1/3 BIS - Central bankers' speeches Furthermore, while credit cards are mostly used by richer households, which you would expect, there is a gap between reported usage in the two surveys. The consumer diaries show that credit card usage are much more frequent, relative to the consumer payment choice survey. This seems to be explained by people using a family member's credit card. Perhaps you too are familiar with this phenomenon of family members using your credit card. It is also interesting to see the detail of when people spend and what they buy. By number of transactions, the top-three payment groups are groceries, transport and data. I'm not sure I expected data to be so far up on the list. The busiest payment days are Fridays and Saturdays; the slowest are Tuesdays. This sort of information really reminds me that it is in payments where central banks are most involved in people's everyday lives, even though monetary policy and financial stability are the topics that grab the headlines. Let me now say a bit about how economists and payments specialists can use the information from this study in South Africa. Firstly, given the SARB's role in payment systems, understanding consumer preferences for different payment methods will help us meet these diverse needs. Specifically, the study will help guide our implementation of our Payments Ecosystem Modernisation programme and Digital Payments Roadmap initiative. Secondly, the SARB and other regulatory authorities should be able to identify the possible misconceptions about some of the products. For instance, we see in the survey that the main reason people do not use debit cards is, they say, that they don't make enough money to qualify for a card. It seems that they think the qualifying criteria are more stringent than they really are. Given this sort of information, we can help educate people so they can make more optimal choices, which supports our financial inclusion work. Thirdly, we hope external researchers will be able to make creative use of this information. To give a taste of what can be done with this data, let me just give one example from a US paper that is based on survey data.3 The authors estimated the costs of adoption and usage of different payment instruments. They further estimated counterfactuals: what would happen, for instance, if banks were to impose a new fee on the use of debit cards, because of regulations that make debit cards more expensive to use? That question is difficult to answer, but armed with the survey data, the authors found answers. In this case, they determined that in the US, people would use more cash and cheques, in both the long and short run. Credit cards were not affected as much. It is surprising that such a change would lead to an increased use of paper instruments. The researchers also found that the burden of this change would fall much more on lowincome consumers, a useful policy insight. I hope we will also get some good papers and some good insights out of this survey. 2/3 BIS - Central bankers' speeches To conclude, I would like to congratulate the cross-functional team, led by the National Payment System Department, that dedicated long hours to this study. I'm sure the team is relieved to at last launch the results – but this information is so important, their job is not done. We will be repeating these surveys in future. Thank you all. 1 South African Multiple Options System 2 The US survey is conducted by the Federal Reserve Bank of Atlanta 3 Koulayev, S., Rysman, M., Schuh, S. and Stavins, J. (2016). Explaining adoption and use of payment instruments by US consumers. RAND Journal of Economics, 47:293– 325. 3/3 BIS - Central bankers' speeches | south african reserve bank | 2,024 | 9 |
Special guest lecture by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Department of Economics, Stellenbosch University, Stellenbosch, 17 October 2024. | Special guest lecture by Lesetja Kganyago, Governor of the South African Reserve Bank, at the Department of Economics, Stellenbosch University, 17 October 2024 Lessons learnt: how the South African Reserve Bank moved inflation to 4.5%, and what it cost Good day. My subject today is lower inflation. It is a major global theme – we have experienced the biggest inflation surge in decades, and now policymakers are looking back at the lessons learnt. I want to reflect on those lessons. I also want to discuss the South African experience with lower inflation. For that, I will focus on our move to 4.5% as the midpoint objective of monetary policy − a change we introduced back in 2017. All of this is relevant to our ongoing discussion about the inflation target and the desirability of moving to a lower target, in line with our peers. The first lesson, from the global inflation surge, is that people really hate inflation. We always knew inflation was bad, and we always knew the public disliked it. Still, many economists have been surprised by the depths of public unhappiness with high inflation. This has been especially clear in advanced economies that had very low inflation over a sustained period, usually 2% or less. At those rates, most people did not have to worry about inflation. But after the COVID-19 pandemic, they suddenly experienced the kind of price increases usually found in poorer countries, and they hated it even more than expected. They objected when prices rose, and they were disappointed when they did not fall again afterwards.1 They felt their wages had not As Jared Bernstein put it, “A central banker wants inflation to get back to target. A shopper wants his or her old price back.” ‘Inflation’s (almost) roundtrip: What happened, how people experienced it, and what have we learned?’, Remarks by Council of Economic Advisers (CEA) Chair Jared Bernstein at the Economic Policy Institute, 30 July 2024. https://www.whitehouse.gov/cea/writtenmaterials/2024/07/30/inflations-almost-roundtrip-what-happened-how-people-experienced-it-andwhat-have-we-learned/ kept up with inflation.2 They objected that it would have been easier to cope with a recession.3 It is a strong reminder to central bankers that the public like price stability and dislike inflation. A second lesson is about the effectiveness of monetary policy – what works, and what doesn’t. Something that didn’t work was the ‘transitory’ argument, the claim made in 2021 that high inflation would be temporary, and there was no need for a monetary policy response. As Jerome Powell said in his Jackson Hole speech this year, “The good ship Transitory was a crowded one, with most mainstream analysts and advanced-economy central bankers on board.”4 You will notice he exempted emerging market central bankers, who were more used to severe supply-demand imbalances and their inflation consequences. The fact is, the good ship Transitory sank in the inflation storm of 2022 – but fortunately everyone on board escaped to another vessel, joining the emerging market central bankers with aggressive inflation-fighting policies.5 Another failed claim was the 2022 argument that inflation would come down only through a severe recession, with a big increase in unemployment. In fact, inflation in major economies, like the United States (US), fell from about 9% to just over 2%, with no recession and steady job growth.6 Looking at this record, you could say that central bankers either got it right or they got lucky.7 My sense is that they made their own luck. S Stantcheva, ‘Why do we dislike inflation?’, NBER Working Paper 32300, April 2024. https://www.nber.org/papers/w32300 S Keynes, ‘Is a recession worse than inflation?’, Financial Times, 14 June 2024: https://on.ft.com/3VGP6lQ J Powell, ‘Review and outlook’, Speech by Jerome Powell, Chair of the Board of Governors of the Federal Reserve System, at ‘Reassessing the Effectiveness and Transmission of Monetary Policy’, an economic symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 23 August 2024. https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm See, for example, Rich Miller, ‘Jerome Powell ditches “transitory” tag, paves way for rate hike’, 30 November 2021. https://www.bloomberg.com/news/articles/2021-11-30/powell-ditches-transitoryinflation-tag-paves-way-for-rate-hike ‘Has Team Transitory really won America’s inflation debate?’. The Economist, 10 January 2024. https://www.economist.com/finance-and-economics/2024/01/10/has-team-transitory-really-wonamericas-inflation-debate C Giles, ‘Were central bankers lucky or smart in reducing inflation?’, Financial Times, 2 July 2024. https://www.ft.com/content/bd22ac3c-4cf9-4eed-b8d8-ec20103dfb8f There is no question that supply-side factors helped. We had lower oil price inflation, lower food price inflation and better supply-chain functioning after the COVID-19 disruptions. But it is equally clear that the monetary policy response is part of the story. Forceful policy responses put the brakes on inflation. They also helped convince the public that central banks were committed to low inflation, and that high inflation was an aberration, not the new normal. In the language of the Bank for International Settlements, central banks managed to get back to a zone of stability, averting a switch to a high inflation regime.8 The lessons are, it was wrong to say we could have low inflation for free, that we could just look through shocks, keep rates low, and all would be fine. But it was also wrong to say that lowering inflation would require a recession and large-scale job losses: a soft landing was an attainable goal.9 What we have seen is a reminder that good monetary policy can deliver low inflation at a modest cost. It does that by safeguarding the low inflation regime, which has its own self-stabilising properties.10 Given how strongly people dislike inflation, this is clearly the space we want to occupy. Let me now turn to our own inflation experience. South Africa implemented inflation targeting nearly a quarter of a century ago, in 2000. Looking back, the framework has been generally successful.11 Both inflation and interest rates have been lower than they were before inflation targeting. Inflation has also been within the 3−6% target range, on average. However, this average has been on the high side of the target range. Since 2000, using the ‘targeted inflation’ measure, it has averaged 5.85%.12 We have also missed the target quite often, almost exclusively to the upside: we have been above the 6% upper bound of the target nearly 40% of the time, compared with only 1% of outcomes below the 3% lower bound.13 See Bank for International Settlements, Annual Economic Report, Chapter 2, 30 June 2024. https://www.bis.org/publ/arpdf/ar2024e.htm For a discussion of soft and hard landings, see Sam Boocker and David Wessel, ‘What is a soft landing?’, 14 September 2023. https://www.brookings.edu/articles/what-is-a-soft-landing/ C Borio et al., ‘The two-regime view of inflation’, BIS Papers No. 133, March 2023. https://www.bis.org/publ/bppdf/bispap133.pdf See National Treasury, Macroeconomic policy: a review of trends and choices, 2024 (especially pp. 30-32. https://www.treasury.gov.za/documents/national%20budget/2024/Macroeconomic%20Policy%20Revi ew.pdf The targeted measure of inflation was the consumer price index excluding mortgage costs (CPIX), which then shifted to the consumer price index (CPI). Over the past 10 years (120 months since July 2014) it has averaged 5.12%. Out of 294 months, 113 have had inflation above 6%, while 3 have been below 3%; 38.4% of the months have been above 6% compared with 1% below 3% (all during COVID-19). This reflects targeted inflation; CPI was below 3% for a period in the 2000s, but as this was not the targeted measure of inflation, it did not constitute target breaches. When we reflected on our record, soon after I was appointed as Governor, we identified three shortcomings. First, we were missing our target too frequently – even though 3−6% is one of the wider targets around, and therefore should have been relatively easy to hit most of the time.14 Second, our average inflation rate was high. Inflation was mostly near 6%. This did not amount to a crisis, and it was much better than the double-digit rates seen in the 1980s and 1990s. But it was not good. At 6% inflation, prices double in just over a decade and triple in two decades.15 No one could confuse that with price stability. Third, we realised that the economy had a structural growth problem. After the global financial crisis, South Africa’s growth slowdown was diagnosed as a weak demand problem. To deal with it, we tolerated higher inflation so that we could avoid rate increases and restore growth. It didn’t work. Growth never came back; we just ended up with high inflation.16 Accommodative monetary policy was the wrong medicine for the patient. These hard truths prompted us to try a new strategy. From 2017, we began emphasising that we wanted inflation in the middle of our target range, at 4.5%. We would not treat 3−6% as a ‘zone of indifference’, which in practice meant aiming for the top of the range and ignoring the bottom half. Rather, we were explicit that we wanted to be at the midpoint, over time. The range would be there to handle volatility, which is inevitable with inflation. But over time, the SARB would always be working to bring inflation back to 4.5%. To make this point clear, we put it in the Monetary Policy Committee statement and our Monetary Policy Review. We discussed it in speeches.17 We also adopted a new The standard deviation of CPI inflation, since 2000, has been 1.95 percentage points, implying that around 90% of observations should have been within a 3-percentage point range, with a normal distribution and a mean of 4.5%. As noted above, only around 60% of outcomes were within the target range. Starting at a price level of 100, at 6% inflation prices pass 200 in year 12 and 300 in year 19. Given compound interest, by year 31 the price level passes 600. For a fuller discussion, see L Kganyago, ‘South Africa’s growth performance and monetary policy’, an address by Lesetja Kganyago, Governor of the South African Reserve Bank, at the Bureau for Economic Research, Cape Town, 22 October 2015. https://www.resbank.co.za/en/home/publications/publication-detail-pages/speeches/speeches-bygovernors/2015/456 See, for example, L Kganyago, ‘South Africa’s macroeconomic adjustment and monetary policy’, an address by Lesetja Kganyago, Governor of the South African Reserve Bank, at the 5th SA Tomorrow Investor Conference, New York, 9 November 2017. See especially p. 5: “Bringing inflation to the midpoint and ultimately anchoring expectations there, instead of at 6%, is one of the SARB’s most important medium-term strategic goals.” flagship forecasting model, the Quarterly Projection Model, which included an explicit 4.5% objective and projected a path for the policy rate that would deliver on that goal. The new strategy worked. Over the next few years, we achieved lower inflation, and we also secured broad stakeholder understanding of our revised objective. Between 2017 and 2019, we recorded many more mentions of our 4.5% objective, for instance from experts and journalists, in analyst reports and news articles.18 No longer did anyone have to write scholarly papers to estimate our implicit target19; we communicated exactly what it was. And inflation slowed. In 2016, annual inflation was 6.3%. That fell to 5.3% in 2017, 4.6% in 2018 and 4.1% in 2019. By the time COVID-19 hit, the latest monthly inflation print we had in hand was 4.5%, exactly.20 Inflation expectations also declined significantly, from near the top of the target range to around the middle. For instance, at the start of 2017, two-year ahead survey expectations were at 6%.21 At the beginning of 2020, that measure was down to 4.8%, and by the end of the year it was 4.5%. We were clear that we wanted inflation at 4.5% − and we delivered. This experience demonstrated some lessons that remain important today. These are lessons about the costs of lower inflation, about structural factors like high administered prices, and about the role of monetary policy in shaping trend inflation. I’ll start with the influence of monetary policy over inflation. If you go and ask people what causes inflation, you often get answers about food or oil prices, and other such supply-side factors. Yet all countries face these shocks. Nonetheless, different countries have different inflation rates over time, sometimes very different rates. It is easy to understand moves in inflation caused by something like the petrol price. But over longer periods, such as 10 years, these factors mainly create volatility, https://www.resbank.co.za/en/home/publications/publication-detail-pages/speeches/speeches-bygovernors/2017/516.” South African Reserve Bank, Monetary Policy Review, October 2019. See Box 2, pp. 8-9. https://www.resbank.co.za/en/home/publications/publication-detail-pages/reviews/monetary-policyreview/2019/9526 See, for example, N Klein. ‘Estimating the implicit inflation target of the South African Reserve Bank’, IMF Working Paper No. 2012/177, 1 July 2012. https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Estimating-the-Implicit-Inflation-Target-ofthe-South-African-Reserve-Bank-26045 This reflects the January 2020 print. This refers to the survey of inflation expectations conducted by the Bureau for Economic Research nothing more. For the long-run price level, it is the central bank that must take most of the responsibility. Yet, because the inflation process is not always well understood, monetary policy is not held adequately accountable, and our stakeholders are not fully aware of what they can ask us. Let me give a simple example. In 2000, both Chile and South Africa adopted inflation targets. Chile went for 3% and we went for a range of 3−6%. Since then, our inflation has been higher than Chile’s by 1.8 percentage points, on average.22 Chilean inflation has been a bit under 4%, whereas ours, as mentioned earlier, has been close to 6%. This may not sound like much of a difference, but if you look at price levels, Chile’s prices are now 2.8 times what they were in 2000, while ours are 4.5 times higher. Both have increased a lot – but ours has increased much more. It was not that we faced a higher world oil price or a higher wheat price. And both countries had professional, independent central banks. The difference was that we had a higher inflation target. This comparison takes me to the subject of administered prices. In South Africa, we have a range of prices set by government, for services such as water and electricity. These items tend to have high inflation, well above our target. If you start talking about lowering the target, a standard objection is, ‘What about administered price inflation? You cannot control administered prices; if you aim for lower inflation, you will hurt the rest of the economy’. We heard this a lot back when we started aiming for 4.5%, and we also hear it now, in the ongoing discussion about moving to a lower target. Unpacking this issue, it is important to realise that high administered price inflation negatively impacts everyone, whether the target is 6% or 4.5% or 3%, or whatever it may be. What we are seeing with administered prices is known as a ‘relative price adjustment’. Essentially, these goods and services are becoming more expensive relative to others. When this increase stems from inefficiencies and the pricing power of monopolies, it is detrimental both to the economy and to consumers. This is an important part of the reason we have long called for lower administered price inflation. However, it does not mean that the administered price inflation problem is worse at a target of 4.5% than 6%. Similarly, raising the inflation target would not necessarily improve the situation. If you have a higher target, you would expect all prices to rise faster, across the economy. You would expect your currency to lose its buying power for global commodities, such as energy and food, faster. You would expect more currency This comparison uses International Monetary Fund data. The measure for South Africa is the CPI, not targeted inflation, so average inflation for 2020-23 was 5.54%; it would be higher using targeted inflation (5.85%). Average inflation for Chile was 3.78% for this period. depreciation, meaning your currency would become less valuable compared to others that hold their value better. In these circumstances, administered price inflation would likely increase. Price setters, still intent on making relative price adjustments, would still have the power to do so, and would simply implement even larger price increases. If this situation is turned around, it becomes clear how it is possible to achieve lower headline inflation even with high administered price inflation. The overall price level rises more slowly, the currency depreciates at a slower pace, and the rate of administered price inflation slows, even as the ‘wedge’ to other prices remains. This is what we observed after 2017. Headline inflation slowed, and so did inflation for administered prices. The gap between the two was largely unchanged. From 2010 to 2016 it was 2.4%; since 2017 it has been 2.3%.23 Of course, the administered price series is heavily influenced by global oil prices, which are not administered, or at least, not by South African authorities. Even excluding the fuel price component, administered price inflation was lower after 2017, whether looking at water, electricity, school fees or vehicle licences. On average, the difference closely matched the amount of total disinflation we achieved – 1.5 percentage points – with headline inflation slowing from around 6% to 4.5%. Does disinflation negatively impact the rest of the economy if administered price inflation is high? It is important to remember that administered prices make up about 16% of the consumer price index (CPI) basket.24 It is an important category but hardly a dominant one. If we want 4.5% inflation, and administered prices are stuck at 2.4 percentage points above headline inflation, as they have been, that means other prices can only rise by about 4%. For 3% inflation, the same calculation gives an inflation rate for other prices of about 2.5%. In other words, you do not have to push the rest of the economy into deflation, even if you have high administered prices. You just need everyone else to implement smaller increases. Of course, it is highly desirable to have lower administered prices. And it is easier to have lower inflation, and lower rates, where these categories are helping, and not hurting, the disinflation effort. But let us not pretend we must live with a relatively high inflation target just because of our administered price problem. It did not stop us from getting from 6% inflation to 4.5%. This brings me to another concern about lower inflation, that the short-term costs are high. The expectation is that with a lower target, the central bank will raise rates, Arguably, the disinflation was achieved after 2017 but before 2020. The gap is 2.6% for 2018 to date and 2.4% for 2019 to date. CPI excluding administered prices is 83.78% of the total basket. CPI for administered prices but excluding fuel and paraffin is 88.5% of the total basket. squeezing the economy. Unemployment will then rise, firms will be unable to raise prices because of weak demand, and so inflation slows. This trade-off between growth and inflation strikes some people as unacceptable, even when they understand that lower long-term inflation would be desirable. It is therefore interesting to consider what it cost us to get to 4.5% inflation. In the real world, it is difficult to test counterfactuals. We cannot go back in time and conduct an experiment where we kept on aiming for the top of our target range rather than the middle. We do, however, have a study where two economists constructed a counterfactual model.25 Their work compares actual outcomes with how the economy was likely to proceed without the 4.5% change. The results make for interesting reading. Perhaps the most striking is, they find no reduction in aggregate demand during the move to 4.5%. Growth in gross domestic product (GDP) is in line with the counterfactual. Unemployment is generally unaffected. Credit extension is higher. Their conclusion is that there was little or no cost to getting inflation to 4.5%. And the explanation they provide is that the SARB’s commitment to 4.5% was heard and understood. Inflation was not forced down by a recession; it was managed lower by clear and credible communication. This conclusion lines up with another study, by SARB economists, of sacrifice ratios in South Africa.26 A sacrifice ratio is the cost of reducing inflation, measured as the amount of GDP growth lost for each percentage point of lower inflation. For the period where we moved inflation to 4.5%, this study finds a negative sacrifice ratio, which means there was no cost. The authors also find that disinflation costs have generally been low in South Africa. This is, once again, contrary to the popular intuition that lower inflation is achieved by slower growth and higher unemployment. And once again, the key seems to be the SARB’s credibility and communication. If the public understands and believes the central bank’s objectives, disinflation can be achieved with little or no pain. Ladies and gentlemen, let me conclude with a summary of the lessons learnt, which should be informing our current conversations. E Pirozhkova and N Viegi, ‘Change of the SARB’s preferred inflation target in 2017: the conditional forecast story’, SARB Occasional Bulletin of Economic Notes No. 2401, April 2024. https://www.resbank.co.za/content/dam/sarb/publications/occasional-bulletin-of-economicnotes/2024/change-of-the-sarbs-preferred-inflation-target-in-2017-the-conditional-forecast-story-april2024-01.pdf C Loewald, K Makrelov and E Pirozhkova, ‘The short-term costs of reducing trend inflation in South Africa’, South African Reserve Bank Working Paper Series WP/22/08, 2 August 2022. https://www.resbank.co.za/content/dam/sarb/publications/working-papers/2022/WP%202208.pdf First, we have a relatively high inflation rate. We often speak as if this is a structural, inevitable thing, and not a policy choice. But the fact is, we could have a lower inflation target, like almost all our peers, and with it, lower inflation. If we achieved this, I think South Africans would enjoy the lower inflation experience, and will look back at the era of inflation generally over 5% as a period of great inconvenience and difficulty. People prefer price stability. We cannot honestly claim that we are delivering that.27 We can do better. Second, in discussing inflation in South Africa, analysts too often misrepresent the administered price problem. Yes, administered price inflation is too high, and damaging for the economy. Yes, if it were lower, that would help deliver lower inflation and lower interest rates. But administered prices are also responsive to economy-wide inflation, and they are not such a large part of the basket that disinflation can only be achieved by forcing everyone else into deflation. The conversation about lower inflation should not be held hostage by administered prices. Third, it is still often assumed that lower inflation means lower growth, despite rigorous studies showing that sacrifice ratios can be low. It is depressing enough that shortterm pain is considered such a decisive argument against long-term gain. But it is even worse that it is considered a winning argument, when it is not even clear there is shortterm pain. The studies of the move to 4.5% inflation certainly do not show high costs. They show a path to lower inflation that relies mainly on communication and credibility, rather than high rates. Overall, I think these three misconceptions leave us with a macroeconomic discussion that is too pessimistic and insufficiently ambitious. We have an opportunity to achieve permanently lower inflation and therefore permanently lower interest rates. Executed effectively, a lower target could be achieved at little cost – just as we moved to 4.5% at little cost. Ladies and gentlemen, this is a season of reform in South Africa. For any successful reform, you need to start with ambition and conviction, and then you need to follow that with great care and responsibility, to get the execution right. I hope with this lecture I have helped us find our ambition and conviction, so we can move on to excellence in delivery. Thank you. As Patrick Honohan and Athanasios Orphanides noted in their review of South African monetary policy, “Inflation at 4.5% is arguably still too high to be really thought of as price stability.” South Africa – Towards Inclusive Economic Development (SA-TIED), ‘Monetary policy in South Africa, 2007-21’, SA-TIED Working Paper No.208, March 2022. https://sa-tied.wider.unu.edu/sites/default/files/SATIED-WP208.pdf | south african reserve bank | 2,024 | 10 |
Tribute by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Memorial Service of the late former Finance Minister and Governor Tito Mboweni, Johannesburg, 7 November 2024. | Lesetja Kganyago: Tribute to the late former Finance Minister and Governor of the South African Reserve Bank, Tito Mboweni Tribute by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the Memorial Service of the late former Finance Minister and Governor Tito Mboweni, Johannesburg, 7 November 2024. *** Today we paying tribute to a man who had such a profound impact on the lives of the South Africans. It has been a tough time mourning my dear friend and carrying out my duties as Governor of the South African Reserve Bank (SARB) - an institution he held so dear as our famous Governor no. 8. Today we are here to celebrate a life well lived. Let me once again, on behalf of the SARB, thank the Mboweni family for sharing Tito with us. He had so much love for you and cherished you dearly. We will miss him dearly. When our paths first crossed in 1990, we were laying the foundations to transform our country into one that would finally be home to all its people. Tito, who had recently returned from exile, understood that true economic reform and transformation would be vital to this project - and that, if it did not have people at its centre, we would fail. He carried this conviction through his many roles at the SARB, in government and the private sector. I was fortunate enough to have my career run parallel to Tito's across so many years and watched as he lived out this ideal, shaping policy to build the South Africa we all longed for. He convinced me to do the same, starting from when he nudged me to quit accounting to pursue economics and play my part. Twenty four years after our first meeting, I stepped into the role he held from 1999 to 2009 - a job which might have looked very different had he not taken the mantle of the first black Governor of the SARB. When Tito became Governor, the country was already five years into its young democracy. But the SARB, like other state institutions, was very much shackled to our country's past. Its head office in Pretoria was viewed as one of the remaining outposts of white nationalism - and for good reason. About 88 % of the SARB's management was white, male and Afrikaans.1 Many meetings were unashamedly held only in Afrikaans. This lack of transformation irked Tito tremendously. In his first months on the 32nd floor he set his sights on reshaping the SARB's management, in the hope that the upper echelons of the central bank would be 50% black by 2005. 1/4 BIS - Central bankers' speeches This would be easier said than done and Tito publicly decried the institution's struggle to retain black talent. But his work ultimately did pay off. By the end of his second term, 60 % of SARB employees were black. Today this stands at over 84% and 63% of the SARB's senior leadership is black and female. Tito's time at the SARB was very much an extension of his broader ambition for South Africa's economy – a sense of purpose that was nurtured over many years and which he poured into his policy work. On a number of occasions I have spoken of the loss of Tito's beautiful policy brain. He has left a deep void in our personal lives, and the country as a whole. But we must take comfort in the fact that his legacy is felt across so many aspects of our economy, and more recently, in the kitchen. At the SARB, Tito fought fiercely to keep inflation from ravaging workers' wages and the spending power of pensioners and the unemployed. He did so by championing inflation targeting, which the SARB adopted a year into his tenure as Governor. This policy has ensured that double-digit inflation prints are relegated to history. Early in his first term, Tito also negotiated a memorandum of understanding (MoU) between the SARB and National Treasury, then led by Trevor Manuel as Finance Minister. This MoU entrenched the coordination of macroeconomic policy and has remained in place to this day – outlasting the tenures of these two titans of policy. Tito's work as Governor extended beyond South Africa's borders. When he assumed the role, he, like other central bankers at the time, was concerned about the effects of globalisation, which had left emerging markets vulnerable to financial turmoil.2 To maximise the benefits of building multilateral institutions, Tito sought to create greater economic integration within the South African Development Community (SADC) and to insulate the region's central banks against political interference. He was a staunch proponent of central bank independence, even before it was written into South Africa's Constitution. He created greater central bank transparency and accountability, establishing the Monetary Policy Committee (MPC) and the monetary policy forums to enhance public engagement and accountability. These efforts have gone a long way in bringing together policymakers and the people whose lives their decisions impact. His legacy lives on, and today we still meet South Africans across the country to explain our decisions and account for the work we do as enshrined in the Constitution. 2/4 BIS - Central bankers' speeches This is one of the lessons Tito impressed on me: Policy is about people. And when it comes to enacting policy, there is little room for errors - there is cause and effect. If you make the wrong policy decision, by the time you get an opportunity to reverse it, the cost may already have been massive. In the statement he delivered during his inauguration as Governor back in 1999, Tito assured the country that he and the SARB would not follow Icarus by flying too close to the sun. It was a fitting metaphor for the time. South Africa had entered the next phase of its democracy and there was a feeling that the optimism that characterised the previous years would need to be followed through with prudent governance. While he shared the ambition of his ANC comrades of building an inclusive economy, Tito understood that many victories in this regard would be won by the narrowest of margins. In the context of lean resources, there would always be trade-offs. This approach made him quite unpopular in certain circles, especially among those who believed he was toeing an old line. His predecessor, Chris Stals, had warned him that this was a hazard of the job before he hung up his hat, saying: If a Governor becomes popular in his own country, it may be time to retire.3 It is true that monetary policy is about discipline - about forcing the country to live within its means, as Chris put it. And in some ways, Tito had to be more hard-nosed than many would have wanted him to be. After all, by the time he arrived at the 32nd floor, the rand was in turmoil and borrowing costs were painfully high. Tito had to be a rock in a storm - and, as a policymaker, he faced wilder tempests than most. Another great test came when he was appointed Finance Minister. In this position he was confronted with the country's dire economic predicament, made worse by a decade of recklessness. To the dismay of many, he was unyielding in his application of fiscal prudence, adding to his unpopularity in some quarters. When he delivered his first budget speech as minister, Tito famously brought with him an aloe ferox, noting the plant's resilience in harsh conditions. He quipped that one of his predecessors - his friend, Trevor - handed out plums to Members of Parliament in 2003, a symbol of an economy that was bearing fruit. "We must take the bitter with the sweet", Tito said in his 2019 speech.4 And he was not afraid to administer bitter medicine, to make the tough calls that would carry the country through the crisis that arrived on our shores in March 2020. While his 3/4 BIS - Central bankers' speeches doggedness put him at odds with some his colleagues, Tito did not shy away from differences of opinion. He revelled in debate and would often draw his friends into heated conversations about policy. The last time we met to break bread was shortly after the election. The question that hung over the dinner table was what the new government would look like. Tito kept on coming back to the same issue: What would this new government actually mean for the future trajectory of policy - what would it mean for the South African economy and its people? Tito remained resolute that the people of this country should always trump political expediency - a trait he lived by throughout his life. As we confront the challenges of this new season of our democracy, our decisions and actions must be firmly rooted in the everyday lives of South Africans, a deeply held pursuit by Tito. We must hold ourselves and others accountable to putting humanity first as we endeavour to strengthen our country and its economy. That is what my friend, Tito, would have wanted. Rest in peace, Governor no. 8. 1 See https://omalley.nelsonmandela.org/index.php/site/q/03lv00017/04lv00344 /05lv01258/06lv01351.htm 2 See https://www.bis.org/review/r990812c.pdf 3 See https://www.resbank.co.za/en/home/publications/publication-detail-pages /speeches/speeches-by-governors/1999/229 4 See https://www.treasury.gov.za/documents/national%20budget/2019/speech/speech. pdf 4/4 BIS - Central bankers' speeches | south african reserve bank | 2,024 | 11 |
Address by the Governor of the Bank of Italy, Dott. Antonio Fazio, at the Annual Meeting of AIOTE/ASSOBAT/ATIC/FOREX held in Milan on 25/1/97. | Dott. Fazio examines the progress of the Italian economy in terms of stability and recovery Address by the Governor of the Bank of Italy, Dott. Antonio Fazio, at the Annual Meeting of AIOTE/ASSOBAT/ATIC/FOREX held in Milan on 25/1/97. Yesterday the effective exchange rate of the lira was 5 per cent higher than in December 1994. Compared with the low point reached in the March 1995 currency crisis, the lira has appreciated by 25 per cent. To find a period in which the lira recovered to such an extent and so fast, it is necessary to go back fifty years to 1947. Inflation, measured on the basis of the cost-of-living index, fell to less than 4 per cent on average in 1996; between June and December it was around 2 per cent on an annual basis. According to preliminary figures, inflation in January of this year was less than 2 per cent. The net external position of the Bank of Italy, excluding gold reserves, improved from $28 billion at 31 December 1993 to $45 billion at the end of last year. In 1994 purchases of foreign currency in the market, primarily in the first half of the year, amounted to $7 billion; in 1995 there were net sales totalling $7 billion. In 1996 purchases were renewed, at an accelerating pace from March onwards. Yesterday the foreign currency reserves of the Bank of Italy and the UIC amounted to $35 billion, after using $21 billion to repurchase official ecus and redeem foreign currency swaps and other short-term liabilities. Foreign exchange interventions have been carried out in such a way as to avoid interrupting the appreciation of the lira. Between 1 March and 22 November 1996 the effective exchange rate rose by 4.7 per cent; the lire needed to buy one German mark decreased from 1,056 to 998. The lira’s re-entry in the European Exchange Rate Mechanism on 25 November 1996 was at the central rate of 990 against the mark and 1,906 against the ecu. The new rate corresponds to a depreciation of 19 per cent compared with that obtaining before the September 1992 currency crisis. The lira re-entered the ERM after the performance of the economy and an appropriate combination of policies had re-equilibrated Italy’s external position, brought a sharp slowdown in inflation and improved the outlook for the public finances. The surplus on the current account of Italy’s balance of payments and the return to external equilibrium provide a solid foundation for the maintenance of the internal and external stability of the lira. 1. The balance of payments The actions to reduce the budget deficit, the new level of the exchange rate, wage moderation and the stabilisation of prices have produced a shift in the composition of demand since 1993 that has permitted growing surpluses on the external current account after a long series of deficits. The surplus in 1996 is estimated to have been around 70 trillion lire, or 3.7 per cent of GDP. The surplus on goods and services was on the order of 90 trillion and in absolute terms was the largest recorded by the leading industrial countries. The increase of 18 trillion lire compared with 1995 was due to the improvement in the terms of trade, estimated at 4.7 percentage points. Exports of goods and services, after rising in volume by 10 per cent on average in each of the three previous years, remained basically unchanged. Sales of goods and services to the other EU countries diminished-as a result of the weakness of demand, whereas exports to the emerging countries continued to increase at a good pace. The share of Italian exports in world trade declined compared with the previous year, partly owing to a loss of competitiveness but mainly because of the unfavourable cyclical situation in Europe, where more than half of Italy’s exports are directed. Imports dropped by 2 per cent in volume, compared with increases of 9 per cent in both 1994 and 1995 and a decrease of 8 per cent in 1993; they were affected by the weakness of domestic demand for consumer and investment goods. The competitiveness of Italian products has diminished compared with 1995, but still shows a large improvement on the period before the September 1992 currency crisis. Measured in terms of producer prices, the real exchange rate of the lira shows a gain of competitiveness of 10 per cent compared with the first half of 1992. In terms of labour costs, the gain is on the order of 18 per cent (Figure 1). The marked appreciation of the lira in 1996 made a decisive contribution to the stabilisation of domestic costs and prices. The effect of the good trade performance on the exchange rate and market interest rates was reinforced by that of the surplus on capital movements. Portfolio investment abroad continued regularly, generating an outflow of 53 trillion lire; foreign investment in Italy increased substantially to 122 trillion (Table 1). 2. Italy’s external position. The exchange rate of the lira At the end of 1992 the country’s net liabilities amounted to 11 per cent of GDP; at the end of 1996 the ratio was well below 4 per cent (Figure 2). The current account surpluses that are forecast will bring the net external position roughly into balance by the end of this year and then make Italy a net creditor. Part of the item “errors and omissions” consists of capital outflows that are not recorded in the capital account; accordingly, the country’s external position is almost certainly already in balance. In September 1996 non-residents’ holdings of Italian government securities denominated in lire and foreign currency totalled 350 trillion lire, as against 290 trillion at the end of 1995 and 100 trillion in December 1992. This progression is evidence of foreign investors’ growing interest in the Italian securities market, but it is also the result of a policy aimed at diversifying the sources of Treasury finance. It exposes the domestic market, albeit deep and efficient, and government funding to interest rate movements in international markets and to the evaluations and decisions of international investors. The growing volume of public debt placed abroad is matched by the steady and substantial improvement in the external balance of the private sector. Starting from a net external debtor position of around 90 trillion lire at the end of 1992, by September of last year households and enterprises had built up a net creditor position of around 200 trillion (Table 2). The 1992 currency crisis caught Italian households and enterprises severely off balance; the latter, in particular, had built up substantial foreign currency liabilities, trusting in the stability of the exchange rate, even though this confidence was at odds with the expectations implicit in the significantly lower cost of borrowing in foreign currency compared with that in lire. The depreciation of the lira resulted in Italian firms incurring heavy losses. In the last few months of 1992 they began to reduce their foreign currency liabilities and build up their foreign currency assets and continued to do so on a major scale in the following years. The private sector’s gross external liabilities, about three quarters of which consisted of borrowings by non-financial enterprises, remained virtually unchanged at around 450 trillion lire; their composition changed, however, as the foreign currency share fell sharply. On the other hand, the external assets of enterprises, households and other nonbank operators rose from 370 trillion lire at the end of 1992 to 650 trillion in September 1996, with a significant increase in the proportion denominated in foreign currency. The recovery of the lira began in the spring of 1995, partly in response to domestic agents’ perception of the return to a balanced external position in foreign currency (Figure 3). Compared with a net external debtor position in foreign currency of 52 trillion lire in 1992, at the end of 1995 households and enterprises had already built up a net creditor position of 118 trillion. In September 1996 this had risen to 126 trillion (Table 3). In 1996 a major contribution to the improvement in the exchange rate came from the net sales of foreign currency against lire by non-residents for portfolio investment purposes. In the 1992 currency crisis the official reserves, acquired in connection with short-term capital inflows, proved evanescent in defending the exchange rate. The central bank’s foreign currency reserves are now part of an external position that is balanced overall and in surplus for the private sector. The domestic savings accumulated in Italy over the years is now again equal to, and in prospect will exceed, the sum of the country’s capital stock, created through public and private investment, and its huge public debt, contracted principally to finance the current spending of the public sector. 3. The global market The growing international integration of the Italian economy has profoundly affected the composition of financial assets and liabilities. The share of foreign assets, which accounted for 9.7 per cent of internal sectors’ total assets at the end of 1989, has risen in the nineties and was equal to 14 per cent at the end of the second quarter of 1996 (Table 4). The proportion in Italy is now similar to that in France; in Germany it is higher, at around 20 per cent. Neither in these two countries nor in the other leading industrial countries has it changed significantly in the nineties. The ratio of residents’ foreign financial assets to GDP is around 50 per cent in Italy, 90 per cent in France and 80 per cent in Germany. The diversification of Italian saving through investment abroad will continue in line with the development of the financial system. The growth in Italy’s foreign assets in the last few years has been accompanied by a rapid increase in its foreign liabilities. The total financial assets of the leading industrial countries rose from 510 to 550 per cent of GDP between 1989 and 1994. Most saving and investment in these countries still has a domestic counterpart; the share of total financial assets with a foreign counterpart is around 10 per cent and equal to around 50 per cent of GDP (Table 5). The total of the six leading countries’ holdings of foreign bonds and shares is equal to some $4 trillion, or roughly one quarter of their GDP. International financial integration has led, especially in the nineties, to the emergence of a single, world market for currencies and securities linking all the leading national markets. In this global market the pricing and trading of financial instruments are affected by the underlying performance of the international economy as a whole. The pattern appears to depend above all on the tendency prevailing among instruments denominated in dollars. The influence exerted by US financial markets, and to an even greater extent by dollar-denominated instruments, predominates in the world economy. The financial assets and liabilities of the United States, including those with both domestic and foreign counterparts, account for nearly 40 per cent of the corresponding totals for the six leading industrial countries. Japan’s share is only slightly smaller, while Germany accounts for around 8 per cent of the total and Italy 4 per cent (Table 6). The close links with the dollar of the currencies of Latin America and many of the emerging South-East Asian countries increase the importance of the US currency in determining the international financial cycle. The correlation between the yields on medium and long-term securities across national markets appears to be close. Differentials tend to be larger during currency crises; when conditions are calmer and inflation rates converge, yields become more closely correlated and differentials smaller. The yields on short-term assets are controlled by national monetary policies. In recent years there has been a notable reduction in the power of central banks to control longterm yields directly. Superimposed on the underlying pattern of long-term rates in international markets there is a set of differentials that reflect the inflation expectations present in each country and the related medium-term expectations concerning the exchange rate. The response of long-term yields to a change in official rates depends on the conditions in the economy, the economic policies in force and, in particular, on the stance and firmness of monetary policy. The experience of the last few years in financially open economies with exchange rate flexibility between the major areas confirms the effectiveness of monetary policy in controlling inflation. This, in turn, exerts an influence on expectations and yield differentials, and thereby on the level of long-term interest rates. The mechanism is well known in monetary theory. To the extent that monetary control is effective, it is able to influence inflation expectations and thereby interest rate differentials and hence the nominal yields on long-term securities. At the beginning of 1995 we announced our intention of raising short-term rates with the aim of curbing, reversing, the increase in the very high yields on long-term securities (Figure 4). In the currency crisis of spring 1995 the yield differential between long-term Italian and German securities widened to 660 basis points. The budget adjustment measures adopted, the performance of the external accounts and the improvement in inflation expectations caused the gap to narrow over the rest of the year (Figure 5). In January of last year the yield differential with respect to Germany was still around 450 basis points; the more stable political climate and the further improvement in inflation expectations resulted in its narrowing to around 300 basis points at the end of May. The substantial budget adjustment announced in the autumn of last year, the approval of the Finance Law for 1997 and the further slowdown in inflation have reduced the differential to around 150 basis points. As things stand today a reduction in official rates by a country’s central bank is effective if it is ratification of more favourable inflation expectations. These, in turn, must be rooted in the performance of the public finances and costs. History shows many cases where the inconsistency of other policies with the objectives has resulted in longer-term rates rising instead of falling in the wake of an easing of monetary policy. 4. Market participants and the allocation of funds in the international market The growing openness of national financial systems has accelerated the development of the market for Eurocurrencies, especially that for cross-border deposits and loans. Institutional investors, banks and the other participants in the global market need liquid funds to carry out their financial transactions. Dollar deposits outside the United States are equal to 70 per cent of the US money stock. The ratio for the mark is slightly lower at 63 per cent; for the pound sterling and the French franc it is 13 and 16 per cent respectively. Following the complete liberalisation of Italian short-term capital movements, in the spring of 1990 the Eurolira market also began to expand rapidly. It is now larger than the corresponding markets for the Swiss franc, the French franc and the pound sterling (Table 7). At the end of the second quarter of 1996 the stock of Eurolire amounted to 340 trillion lire, or 30 per cent of the Italian money stock. London accounts for a major part of this market. The mass of lire traded in the international financial market reflects a demand for financial transactions that focuses mainly on the secondary market for Italian government securities, though the demand for Eurolira bonds and derivatives is growing. The rapid expansion of this market and the size it has grown to, despite the reduction in yield differentials, are evidence of market participants’ increased confidence in the lira. The last few years have seen the activity of institutional investors in the global market grow at a rapid pace. At the end of 1995 such intermediaries in the United States, Europe, Asia and Oceania with balance sheets of at least $10 billion had total assets of $21 trillion (Figure 6). These intermediated funds are equal to about one fifth of the estimated value of the six leading industrial countries’ total financial assets with domestic and foreign counterparts, and equal to three times the GDP of the United States and twenty times that of Italy. Institutional investors place the bulk of the funds they raise in their national markets; they are nonetheless of considerable importance in the international allocation of funds in view of how they make their investment choices and the scale of their investments. In Italy, as in other leading countries, a large part of the funds invested abroad by enterprises and especially households is channelled through such intermediaries. They reallocate their resources according to the importance of the various economies, taking account of exchange rate expectations, yields and risks. The proportion invested in each country is determined on the basis of portfolio optimisation criteria; the amounts involved are large enough to affect securities prices even in medium-sized financial markets At the end of 1995 European institutional investors had raised $7.5 trillion. They are estimated to have invested 78 per cent of their resources, or $6 trillion, in shares and bonds. Around $2 trillion, or roughly a quarter of the total volume of intermediated funds, was invested outside the intermediary’s home country (Figure 7). The funds raised by US institutional investors amounted to $8 trillion at the same date and they had invested 80 per cent of the total in shares and bonds, a figure close to that for European institutional investors. In view of the depth and diversification of the US market, the greater part of these intermediaries’ resources was invested in domestic securities; nonetheless, 11 per cent, or around $900 billion, was invested in shares and bonds in foreign markets. Although institutional investors in Asia and Oceania had also invested domestically most of the nearly $5 trillion of funds they had raised at the end of 1995, their international investments in shares and bonds are nonetheless estimated to have amounted to $400 billion. Taken together, these institutional investors held more than $15 trillion of domestic and foreign shares and bonds at the end of 1995, corresponding to around 35 per cent of the stocks of such instruments issued by the leading industrial countries. These intermediaries’ investments in shares and bonds issued outside their home countries exceeded $3 trillion. The configuration of exchange rates and interest rates generated in international markets interacts with the financial variables of national markets In addition to the fundamentals of each economy, an important role is played by all the information permitting the assessment of the authorities’ ability to implement policies aimed at achieving growth in conditions of stability. 5. The 1995 currency crisis and the control of inflation In the early months of 1995 the Mexican crisis and the weakening of the US dollar prompted substantial and sudden shifts of funds, out of the weaker currencies into those considered to be stronger. In addition to the US dollar, the Canadian dollar, the pound sterling, the Swedish krona and the Spanish peseta also weakened considerably. The lira was hit hard: between mid-February and mid-March it depreciated by 15 per cent. The identification of a currency as weak or strong is linked to the general conditions in the economy, notably as regards the state of the public finances, the external position and the solidity of the country’s institutions. In the background there are the stability of the currency’s purchasing power, competitiveness, the outlook for economic growth and the availability of saving and the uses to which it is put. In Italy wage moderation made it possible to avoid a cost-price spiral, but the increase in consumer prices and the depreciation of the lira caused a marked deterioration in expectations. Opinion surveys revealed that a surge in inflation was expected (Figure 8a). At the same time as supplementary budget measures were adopted in February 1995, we raised the official discount rate and the rate on fixed-term advances; in May we raised them again. Monetary growth was drastically curbed. At the General Meeting of the Bank’s shareholders on 31 May 1995 we announced the objective of slowing inflation in the second half of the year; we pointed out that it was both possible and essential to reduce inflation to less than 4 per cent on average in 1996. Towards the middle of the year inflation expectations began to improve significantly (Figure 8a). Market yields on government securities started to come down, especially for longer maturities; the lira strengthened, partly owing to the appreciation of the dollar. On 31 May 1996, in addition to confirming that the conditions existed for inflation to fall below 4 per cent in 1996, we stated that it would be possible to achieve a more ambitious target in 1997: an inflation rate of less than 3 per cent. Between May and December of last year the average monthly rate of inflation on an annual basis was close to 2 per cent. The survey of consumer price expectations carried out last September indicated a rate of inflation of between 3 and 3.5 per cent in the first quarter of 1997. The survey carried out in December indicated a rate of between 2.5 and 3 per cent for the first half of this year (Figure 8a). 6. The outlook After the breakdown of the gold exchange standard all countries’ currencies became of a purely fiat nature. This is a new epoch in monetary history. International capital movements tend to expand, with a multiplication of money and credit at the global level that makes it increasingly difficult for authorities to exercise quantitative control. The volume of funds traded, the rapidity with which they can be shifted and the sensitiveness of market participants to economic and metaeconomic information can generate tensions in financial markets and influence the quotations of currencies and securities, with significant effects on economic activity and prices, even in medium-sized economies. Greater monetary stability in Europe not only benefits individual economies but also contributes to the solidity of the international financial system. The weakness of the economic cycle and the curbing of inflation have led to a fall in interest rates. Easier monetary conditions have been a major factor underlying the rise in bond and share prices. Monetary stability, public finances in order and flexible productive structures and factor markets are necessary to protect individual economies from destabilising speculative movements, to enable them to share in the benefits of the global market and economic and financial integration in Europe. This is the context in which policies must be implemented to permit the full employment of all the available resources of labour, saving and physical capital. In the last four years Italy has made significant progress in re equilibrating its external position, curbing the budget deficit and controlling inflation. In 1996 the slowdown in inflation permitted a substantial fall in interest rates; the Treasury’s spending on this item declined in absolute terms, despite the increase of 6 per cent in the stock of debt. The improvement in the budget deficit suffered a setback, however. The overall borrowing requirement grew in absolute terms and remained unchanged in relation to GDP at 7.4 per cent. The supplementary budget measures adopted in the middle of the year failed to prevent a large overshoot on the order of 30 trillion lire compared with the original target set in September 1995. In the Forecasting and Planning Report published last September the Government increased the 1997 budget adjustment to 62.5 trillion lire, compared with 37.5 trillion envisaged in the Economic and Financial Planning Document. This is a demanding commitment that is already having beneficial effects on government securities prices and the financial markets. As I pointed out in my Parliamentary hearing on the Finance Law, the forecasts of the borrowing requirement in 1997 reflect highly favourable assessments concerning the primary surplus; these are only compensated for in part by the significantly better-than-forecast behaviour of interest rates. The lower level of the primary surplus in 1996, with a shortfall of around 20 trillion lire compared with last September’s estimates, will have repercussions on the results in 1997; these will also be affected by the cyclical slowdown that started at the beginning of 1996 and became more pronounced in the last part of the year. The adjustment of the budget deficit will have to be pursued by curbing the growth in expenditure. On the revenue side it will be necessary to reduce tax avoidance and evasion. Further fiscal tightening would have adverse effects on domestic demand and prices. In order to create confidence in a return to equilibrium in the medium term, budget adjustment measures will have to be of a structural nature. There is an urgent need to revive growth. Italy, like many other leading European countries, is far from making full use of its resources of saving, labour and entrepreneurial ability, with consequent economic and social costs. In cyclical terms the level of economic activity remains unsatisfactory. According to the latest forecasts, the growth in GDP in 1997 will be just over 1 per cent. The trade surplus will remain large, as will the surplus on the current account of the balance of payments, thereby contributing to a further improvement in the country’s external position and providing support for the lira. It will be necessary to modify the composition of public expenditure, by reducing that on current account, in order to release the resources needed to return public investment to a normal level. In the last few years this component has fallen by around one percentage point of GDP. Investment will need to be directed to the areas and sectors where the shortfall in public infrastructure is greatest, to the benefit of productivity and, above all, of employment. The latest reduction in official rates, following that enacted in 1996, was made possible by the improvement in both actual and expected inflation. Together with the ample availability of saving, it also creates the conditions for a higher level of private investment. The fall in market interest rates will be locked in only if permanent price stability is achieved. Monetary stability, consolidation of the public finances and economic growth are three closely interrelated objectives. The experience of recent years shows that failing to achieve even one of them necessarily jeopardises the other two. The establishment and maintenance of the virtuous circle is likely to be interrupted by the reappearance of inflationary pressures, which can be engendered by labour costs, pricing policies that are short-sighted and unresponsive to competitive stimuli, by an insufficient reduction or excessive expansion of the budget deficit. Monetary policy will remain firmly directed towards producing an expansion of money and credit that will permit balanced growth of the economy in conditions of broadly stable prices. The rise in the incomes of those already working must not hinder the creation of employment. A smaller absorption of saving by the public sector will make resources available for investment. These are the conditions for removing the most acute, most socially unacceptable, forms of unemployment, which have been aggravated by the events of the last few years. They will allow a host of young people with qualifications and a desire to contribute to the development of our economy and society to become active members of the labour force. Figure 1 NOMINAL AND REAL EXCHANGE RATES OF THE LIRA January 1992 - December 1996 1992 H1 = 100 Real effective exchange rate deflated using the index of unit labor costs (*) Real effective exchange rate deflated using the PPI (**) Nominal effective exchange rate (*) Quarterly data, partly estimated for the last two quarters. (**) Quarterly averages, partly estimated for the last quarter. Figure 2 ITALY'S CURRENT ACCOUNT BALANCE, NET EXTERNAL POSITION AND THE REAL EXCHANGE RATE OF THE LIRA AAA AAA AAA AAA AAA AAA AAAAA AA AA AA AA AA AA -3 -6 current account -9 net external position real exchange rate -12 (*) Partially estimated data. (1) As a percentage of GDP; left-hand scale. (2) 1987 = 100; right-hand scale. (*) Figure 3 NOMINAL EFFECTIVE EXCHANGE RATES IN SELECTED COUNTRIES 2 November 1994 - 23 January 1997; December 1994 = 100 Canada Spain United Kingdom Japan United States Germany France Italy Sweden Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Figure 4 SELECTED INTEREST RATES IN ITALY January 1995 - January 1997 daily data Overnight Discount rate 10-year BTP Rate on special advances Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Figure 5 INTEREST RATE DIFFERENTIALS BETWEEN ITALY AND GERMANY January 1995 - January 1997 daily data 3-month Eurolira/Euromark 10-year Btp/Bund Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Figure 6 FINANCIAL ASSETS OF MAJOR INTERNATIONAL INSTITUTIONAL INVESTORS (*) (amounts outstanding in billions of dollars) 10,000 Non-bank-related investors Bank-related investors 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 EUROPE UNITED STATES ASIA and OCEANIA GEOGRAPHICAL DISTRIBUTION OF THE FINANCIAL ASSETS OF MAJOR INTERNATIONAL INSTITUTIONAL INVESTORS (*) 24% 37% 40% EUROPE UNITED STATES ASIA and OCEANIA (*) End-1995 data for institutional investors with total assets of more than $10 billion. Figure 7a FINANCIAL ASSETS OF MAJOR INSTITUTIONAL INVESTORS BASED IN THE UNITED STATES (*) (breakdown by financial instrument) Other assets 19% Domestic equities 36% Foreign bonds 3% Domestic bonds 34% Foreign equities 8% Figure 7b FINANCIAL ASSETS OF MAJOR INSTITUTIONAL INVESTORS BASED IN EUROPE (*) (breakdown by financial instrument) Other assets 22% Domestic equities 20% Foreign bonds 12% Foreign equities 13% Domestic bonds 33% Figure 7c FINANCIAL ASSETS OF THE MAJOR INSTITUTIONAL INVESTORS BASED IN ASIA AND OCEANIA (*) (breakdown by financial instrument) Domestic equities 11% Other assets 46% Foreign equities 4% Domestic bonds 36% Foreign bonds 3% (*) Partly estimated end-1995 data for institutional investors with total assets of more than $10 billion. Figure 8 FORUM-ME SURVEY OF EXPECTATIONS REGARDING CONSUMER PRICE INFLATION (percentage changes on year-earlier quarter) 6.0 6.0 June 95 5.5 5.5 Dec. 94 Dec.95 5.0 5.0 Sep. 95 Sep. 94 Dec. 93 Mar. 96 Mar. 95 4.5 4.5 June 94 June 96 4.0 4.0 Mar. 94 3.5 3.0 2.5 3.5 Sep. 96 3.0 Dec. 96 I II III IV I II III IV I II III IV I II III IV 2.5 actual changes in the cost-of-living index forecasts one and two quarters ahead (old survey) forecasts one and two quarters ahead (new survey) Source: Based on Istat and Forum-Mondo Economico data. (1) The survey methodology was changed in March 1995. INFLATION (percentages) Istat cost-of-living index, seasonally adjusted -2 I II III IV I II III IV I II III IV Annualized rate of increase in the quarter. Annualized monthly rate of increase. Source: Based on Istat data. Partially estimated data for January 1997. I II III IV -2 Table 1a BALANCE OF PAYMENTS (net flows in billions of lire) 1996 (*) A. OVERALL BALANCE -32,548 2,206 3,309 2,910 19,602 B. CURRENT ACCOUNT -34,225 17,824 24,329 44,583 53,771 C. CAPITAL FLOWS C.1. BANK C.2. NON-BANK C.2.1. ITALIAN CAPITAL of which: a) portfolio investment b) loans C.2.2. FOREIGN CAPITAL of which: a) portfolio investment b) loans 10,317 12,187 -1,870 -44,911 -27,393 -6,255 43,041 28,681 9,215 14,799 -22,273 -6,563 -84,589 21,594 -58,102 99,388 -43,867 51,539 -9,955 -84,090 -32,924 10,095 -52,135 -11,865 -5,076 -13,548 -4,444 109,343 40,223 84,463 103,390 43,871 61,490 607 -14,279 9,656 -10,550 -43,511 32,961 -82,664 -53,479 -19,389 115,625 122,054 -8,510 D. ERRORS AND OMISSIONS -8,640 -30,417 -23,619 1,253 -35,110 (*) Provisional. From October 1996 onwards includes "Trade credits", which will subsequently be attributed to capital account, and "Errors and omissions", which will subsequently be shown as a separate item. From October 1996 onwards does not include "Trade credits". In 1996, total for the period from January to September. Table 1b NET EXTERNAL POSITION OF BANKS AND CENTRAL BANK (end-of-period stocks in billions of lire) A. BANKS' NET EXTERNAL POSITION A.1. IN FOREIGN CURRENCY A.2. IN LIRE 1996 (*) -191,158 -127,208 -153,247 -108,535 -53,365 -187,114 -160,649 -155,841 -130,513 -104,483 -4,044 33,441 2,594 21,978 51,118 B. NET EXTERNAL POSITION OF THE CENTRAL BANK B.1 OVERALL of which: official Ecus B.2 NET OF GOLD 67,299 1,925 37,355 83,937 7,382 47,027 91,436 7,554 50,098 91,476 9,377 51,219 106,773 16,323 68,407 Memorandum item: - central bank foreign currency swaps 30,316 33,500 31,461 42,168 14,947 (*) Provisional. Table 2 ITALY'S EXTERNAL POSITION BY INTERNAL SECTOR (end-of-period stocks in trillions of lire) (September) ASSETS State sector Central bank Banks Non-bank private sector of which:households and investment funds non-financial companies other companies unallocated items and discrepancies of which:households and investment funds non-financial companies LIABILITIES State sector Central bank Banks Non-bank private sector other companies unallocated items and discrepancies -164 -145 -118 -85 -73 -104 -10 -86 -216 -10 -241 -24 -306 -6 -354 NET POSITION State sector Central bank Banks Non-bank private sector of which:households and investment funds non-financial companies -188 -172 -135 -110 -113 other companies unallocated items and discrepancies -8 -30 -35 -24 Memorandum item: Balance-of-payments errors and omissions (1) The data on the overall external position and that of the banking system are derived from the balance of payments and those on the other items from the financial accounts (stocks are valued at current exchange rates and state sector liabilities are valued at market prices). The amounts under "unallocated items and discrepancies" include the statistical discrepancies between the two systems of accounts. The assets of the central bank and the liabilities of banks exclude foreign currency swaps. The assets and liabilities of banks exclude the components matched by domestic foreign currency positions, which are included directly in the figures for the State and private sectors. Table 3 FOREIGN CURRENCY POSITION OF THE ITALIAN NON-BANK PRIVATE SECTOR (billions of lire) 1. 2. September FOREIGN CURRENCY ASSETS 68,361 102,296 158,244 210,263 242,180 262,357 262,840 1.1. Deposits 1.1.1 Vis-à-vis non-residents 1.1.2 Vis-à-vis residents 6,273 6,000 8,802 2,802 6,000 17,605 6,605 11,000 25,907 10,907 15,000 32,222 17,222 15,000 39,804 20,804 19,000 45,182 26,560 18,622 1.2. Loans 1.2.1 Vis-à-vis non-residents 1.2.2 Vis-à-vis residents 5,839 5,839 6,235 6,235 8,710 8,710 8,815 8,815 13,313 9,313 4,000 14,935 9,935 5,000 16,132 10,917 5,215 1.3. Securities 1.3.1 Vis-à-vis non-residents non-residents 1.3.2 Certificates of deposit and bonds in foreign currency issued by resident banks 56,249 56,249 87,259 87,259 131,929 129,929 2,000 175,541 173,541 2,000 196,645 194,645 2,000 207,618 203,618 4,000 201,526 196,969 4,557 FOREIGN CURRENCY LIABILITIES 128,424 134,079 206,414 179,961 154,218 126,832 114,741 2.1. Loans 2.1.1 Vis-à-vis non-residents non-residents 2.1.2 Vis-à-vis residents 126,135 67,135 59,000 133,533 60,533 73,000 205,860 74,860 131,000 179,156 69,156 110,000 153,316 60,316 93,000 123,068 50,068 73,000 113,557 45,971 67,586 2.2. Securities 2.2.1 Vis-à-vis non-residents 2.2.2 Vis-à-vis residents 2,289 2,289 3,764 3,000 1,184 3. FORWARD TRANSACTIONS -5,000 -4,000 -4,000 -13,000 -20,000 -18,000 -21,768 4. FOREIGN CURRENCY POSITION (1. - 2. + 3.) -65,063 -35,783 -52,170 17,302 67,962 117,525 126,331 4.1 4.2 -7,063 -58,000 35,217 -71,000 69,830 -122,000 123,302 -106,000 159,962 -92,000 183,525 -66,000 187,742 -61,411 -16,630 -8,284 -8,640 -30,417 1,253 -35,110 -23,619 Vis-à-vis non-residents Vis-à-vis residents Memorandum item: "Errors and omissions" from the Balance of Payments (1) Net of government securities in ecus (CTEs and BTEs), trade credits and direct investment. (2) Provisional data. Table 4 FINANCIAL OPENNESS OF SELECTED LEADING INDUSTRIAL COUNTRIES FOREIGN ASSETS (as a percentage of internal sectors' total financial assets (2)) Years Italy France Germany UK US Japan 9.7 10.0 10.1 11.1 12.8 12.7 13.2 13.1 14.7 13.6 14.5 14.4 14.5 n.a. 20.9 19.7 19.4 19.6 20.5 20.6 n.a. 29.4 28.6 27.7 30.0 29.8 30.1 n.a. 5.1 5.3 5.0 4.6 4.5 4.6 n.a. 7.9 9.9 9.2 9.2 8.6 8.2 n.a. 1996 Q2 14.0 n.a. n.a. n.a. n.a. n.a. FOREIGN LIABILITIES (as a percentage of internal sectors' total financial liabilities (3)) Years Italy France Germany UK US Japan 11.8 12.3 12.6 14.3 15.3 15.8 15.7 14.2 15.6 14.4 15.1 14.7 14.7 n.a. 15.1 14.2 14.4 15.3 16.9 17.3 n.a. 29.4 29.9 28.6 31.0 30.6 31.2 n.a. 7.2 7.8 7.3 7.3 7.5 8.0 n.a. 6.5 8.1 7.3 6.6 6.0 5.6 n.a. 1996 Q2 15.8 n.a. n.a. n.a. n.a. n.a. (1) Canada is not included for lack of comparable data. (2) Net of bank loans to internal sectors. (3) Net of bank deposits of internal sectors. Sources: For Italy, financial accounts; for other countries, based on OECD data. Table 5 TOTAL FINANCIAL ASSETS AND LIABILITIES OF SELECTED LEADING INDUSTRIAL COUNTRIES (stocks in billions of dollars and percentages) FINANCIAL ASSETS 61,951 67,406 74,260 75,263 83,970 92,698 as a % of GDP 509.7 488.5 505.3 512.8 552.2 551.8 Of which: with domestic counterpart as a % of total financial assets as a % of GDP 55,728 90.0 458.5 59,912 88.9 434.2 66,477 89.5 452.3 67,448 89.6 459.6 75,305 89.7 495.2 83,197 89.8 495.3 with foreign counterpart as a % of total financial assets as a % of GDP 6,223 10.0 51.2 7,474 11.1 54.3 7,784 10.5 53.0 7,815 10.4 53.3 8,666 10.3 57.0 9,501 10.2 56.6 60,223 65,361 72,955 73,987 82,546 91,078 495.5 473.6 496.4 504.1 542.8 542.2 Of which: with domestic counterpart as a % of total financial assets as a % of GDP 54,118 89.9 445.3 57,926 88.6 419.8 65,200 89.4 443.6 66,118 89.4 450.5 73,816 89.4 485.4 81,422 89.4 484.7 with foreign counterpart as a % of total financial assets as a % of GDP 6,106 10.1 50.2 7,435 11.4 53.9 7,755 10.6 52.8 7,870 10.6 53.6 8,730 10.6 57.4 9,657 10.6 57.5 Memorandum item: Total GDP (current $) 12,154 13,800 14,698 14,677 15,208 16,792 FINANCIAL LIABILITIES as a % of GDP (1) Italy, France, Germany, United Kingdom, United States and Japan. Canada is not included for lack of comparable data. (2) Total financial assets/liabilities are the sum of assets/liabilities of the internal sectors of each country in current dollars; assets are net of bank loans to internal sectors; liabilities are net of internal sectors' bank deposits. GDP is the sum of national GDPs in current dollars. Sources: For Italy, financial accounts; for other countries, based on OECD and IMF data. Table 6 TOTAL FINANCIAL ASSETS AND LIABILITIES OF SELECTED LEADING INDUSTRIAL COUNTRIES (stocks in billions of dollars and percentages) 61,951 67,406 74,260 75,263 83,970 92,698 100.0 100.0 100.0 100.0 100.0 100.0 3,000 4.8 3,645 5.4 4,032 5.4 3,452 4.6 3,345 4.0 3,708 4.0 FRANCE 5,438 8.8 5,914 8.8 6,653 9.0 6,673 8.9 7,768 9.3 8,160 8.8 GERMANY 4,152 6.7 5,585 8.3 5,942 8.0 6,014 8.0 6,222 7.4 7,134 7.7 UNITED KINGDOM 5,227 8.4 6,151 9.1 6,422 8.6 5,929 7.9 6,881 8.2 7,290 7.9 UNITED STATES 23,720 38.3 25,260 37.5 27,776 37.4 30,149 40.1 32,854 39.1 34,660 37.4 JAPAN 20,414 33.0 20,852 30.9 23,436 31.6 23,047 30.6 26,900 32.0 31,747 34.2 60,223 65,361 72,955 73,987 82,546 91,078 100.0 100.0 100.0 100.0 100.0 100.0 2,857 4.7 3,556 5.4 4,018 5.5 3,490 4.7 3,326 4.0 3,650 4.0 FRANCE 5,502 9.1 6,030 9.2 6,801 9.3 6,994 9.5 8,066 9.8 8,339 9.2 GERMANY 3,910 6.5 5,228 8.0 5,717 7.8 5,795 7.8 6,186 7.5 7,219 7.9 UNITED KINGDOM 4,947 8.2 5,899 9.0 6,230 8.5 5,710 7.7 6,649 8.1 6,967 7.6 UNITED STATES 22,456 37.3 23,736 36.3 26,437 36.2 28,609 38.7 31,195 37.8 32,980 36.2 JAPAN 20,551 34.1 20,912 32.0 23,753 32.6 23,390 31.6 27,125 32.9 31,928 35.1 FINANCIAL ASSETS Of which: ITALY FINANCIAL LIABILITIES Of which: ITALY (1) Canada is not included for lack of comparable data. (2) Total financial assets/liabilities are the sum of assets/liabilities of the internal sectors of each country in current dollars; assets are net of bank loans to internal sectors; liabilities are net of internal sectors' bank deposits. GDP is the sum of national GDPs in current dollars. Sources: For Italy, financial accounts; for other countries, based on OECD and IMF data. Table 7 FOREIGN CURRENCY ASSETS AND LIABILITIES OF BANKS RESIDENT IN INDUSTRIAL COUNTRIES (*) (billions of dollars) ASSETS 1996 (**) $ % $ % $ % $ % $ % Belgian franc German mark Dutch guilder French franc Italian lira Japanese yen British pound Swiss franc Ecu US dollar 27.0 622.4 47.6 128.6 83.1 196.7 138.6 196.0 235.6 2,385.0 0.7 15.3 1.2 3.2 2.0 4.8 3.4 4.8 5.8 58.7 29.1 647.3 52.0 139.5 113.6 188.7 128.4 169.9 217.2 2,398.8 0.7 15.8 1.3 3.4 2.8 4.6 3.1 4.2 5.3 58.7 33.3 759.2 55.0 138.4 146.7 238.4 144.5 178.7 207.8 2,536.1 0.7 17.1 1.2 3.1 3.3 5.4 3.3 4.0 4.7 57.1 38.9 820.6 65.8 160.6 166.1 324.1 145.5 207.5 201.5 2,578.1 0.8 17.4 1.4 3.4 3.5 6.9 3.1 4.4 4.3 54.8 47.1 846.8 76.7 169.0 220.9 304.8 150.7 195.8 182.0 2,644.5 1.0 17.5 1.6 3.5 4.6 6.3 3.1 4.0 3.8 54.7 Total (*) 4,060.5 100.0 4,084.4 100.0 4,438.1 100.0 4,708.7 100.0 4,838.1 100.0 LIABILITIES 1996 (**) $ % $ % $ % $ % $ % Belgian franc German mark Dutch guilder French franc Italian lira Japanese yen British pound Swiss franc Ecu US dollar 34.9 685.6 55.9 150.6 68.3 193.8 151.9 200.6 232.7 2,320.4 0.9 16.7 1.4 3.7 1.7 4.7 3.7 4.9 5.7 56.7 41.7 715.2 61.6 178.1 97.7 195.5 145.4 181.6 214.9 2,259.2 1.0 17.5 1.5 4.4 2.4 4.8 3.6 4.4 5.3 55.2 47.8 830.2 68.6 155.1 132.5 240.6 160.9 198.4 207.1 2,472.3 1.1 18.4 1.5 3.4 2.9 5.3 3.6 4.4 4.6 54.8 50.7 883.0 79.4 200.2 161.3 285.0 162.0 249.1 189.6 2,511.5 1.1 18.5 1.7 4.2 3.4 6.0 3.4 5.2 4.0 52.6 58.0 865.8 86.2 191.7 214.5 299.0 161.4 236.0 176.3 2,501.5 1.2 18.1 1.8 4.0 4.5 6.2 3.4 4.9 3.7 52.2 Total (*) 4,094.7 100.0 4,091.0 100.0 4,513.4 100.0 4,771.9 100.0 4,790.4 100.0 (*) Data on other currencies and data not allocated due to unavailability of information are not included. (**) For 1996, end-of-June data. Source: Bank for International Settlements. | bank of italy | 1,997 | 2 |
Text of the remarks by Dott. Tommaso Padoa-Schioppa, a Deputy Director General of the Bank of Italy, at the Governors' Dinner held in Basle on 7/4/97. | Mr. Padoa-Schioppa reviews his experience in central banking over the last thirty years Text of the remarks by Dott. Tommaso Padoa-Schioppa, a Deputy Director General of the Bank of Italy, at the Governors' Dinner held in Basle on 7/4/97. 1. To have been invited to attend and address the Governor’s dinner is a very great honour for me as I step down from the chair of the Basle Committee and leave the community of central bankers. When Governor de Larosière proposed my name to succeed Gerry Corrigan, he admitted, so I have been told, that my curriculum vitae was not that of a full-time bank supervisor. Presenting this handicap as an advantage, he suggested that my previous involvement in a variety of central banking activities could be useful because of the growing interaction between monetary policy, payment systems and banking stability. You were generous enough to accept that view. That was an act of confidence. As words like confidence, trust and credibility are the very essence of the vocabulary of banking, I am deeply grateful for the confidence you granted me four years ago. 2. In view of my mixed background, I shall focus on central banking, rather than just banking supervision, and try to sum up what I have learned and what I have witnessed over the last thirty odd years: first about the tasks of central banking and then about the context in which such tasks are performed. 3. A person of my generation is inevitably struck by the difference between what he was taught at university in the sixties and the reality he faced in the two following decades. In the lecture room central banking had just one pole, monetary policy. In the real world I found it was triadic, as monetary policy was combined with involvement in the payment system and banking supervision. At the Bank of Italy, for instance, more than half the staff of just over 9,000 is devoted to the operation of the payment system (the note issue, clearing systems, Treasury inpayments and outpayments, interbank funds transfers, etc.); around 15 per cent is engaged in banking supervision; less than 5 per cent is concerned with monetary policy. Although not all central banks have primary responsibility for banking supervision, the three tasks are inextricably linked because there is a close relationship between them and the three practically indivisible functions of money as numeraire, means of payment and store of value. Dealing with the complexities of triadic central banking has been for me both a fascinating professional experience and an intellectual adventure bringing new insights nearly every day. 4. Not only was monetary policy the sole task highlighted when I was a student, but the word “monetary” was overshadowed by the word “policy”. Monetary policy had always existed, of course, but the rise of fiat money greatly increased the room for manoeuvre. The central banker came to be seen in the fifties and sixties as a demiurg able to choose between inflation and unemployment, and to do so almost on a quarter-by-quarter basis. So delicate and powerful was the policy choice entrusted to the central banker that he could not be left to make it alone. Few central banks were truly independent. The intellectual paradigm that followed the demise of the Gold Standard, with its emphasis on discretionary goal setting, implicitly suggested that elected politicians should have the last word. Future historians will perhaps see this view of the role of central banks as having characterized only two or three of the twenty or so decades of their modern history, which began when convertible paper superseded coins as the main means of payment. 5. After a long period of neglect, payment systems have gradually returned to the centre of the stage. When advances in data processing and telecommunications brought a new revolution, we suddenly realized how much our monetary institutions, practices and even theory owed to the previous revolution. Until the eighties the term “payment system” was almost completely absent from central bank reports. Today, there are many who argue that monetary policy functions would not have developed in the way they did without the first revolution in payment technology. The raison d’être for central bank involvement in payment systems is to avoid, or at any rate minimize, systemic risk, while fostering their efficiency through an appropriate blend of cooperation and competition in the industry. Is there also a policy, or even a political, dimension? Perhaps not. The issue of central bank independence would be a much less burning one if only payment system tasks were considered. And systemic risk itself could become much less important in the years to come with the shift from net to gross settlement that new technologies are making possible. It is possible that payment system issues will move to the back of the stage again once appropriate arrangements are in place to cope with the new technological environment. 6. Chronologically, if not logically, the task of supervising banks came after that of running the payment system and before the advent of fiat money and discretionary monetary policy. From a monetary angle, it was the consequence of the spread of deposit banking, which ultimately resulted in bank money accounting for the bulk of the money stock. Runs on deposits can be seen as collapses of confidence about the stability of the rate of exchange between a unit of central bank money and a unit of commercial bank money. Commercial banks had to have sound fundamentals if one-to-one convertibility was to be preserved hence, the need for bank supervision. In the short run interventions, i.e. lending of last resort, could be - and was - used to support the rate. But, as in the more familiar case of foreign exchange interventions, they were no substitute for sound policies; credit provided too easily and too generously could even generate the risk it was meant to avoid; today we call it moral hazard. The ambivalent relationship between supervising banks and lending to them (surveillance and conditional lending, in IMF language) explains why there is no clear-cut answer to the question whether the central bank or a separate agency should be responsible for supervision. Seven of the twelve Basle Committee countries have a separate agency, as against about 10 per cent of countries in the world as a whole. More importantly, even where this solution has been adopted, the centrality of the banking system, and of its money creation prerogatives, in the monetary policy transmission mechanism means that no central bank disregards the “state of health” of its banks or completely rules out lending of last resort in extreme circumstances. 7. The other, perhaps more important, change concerns the context of central banking. This can be seen in terms of both time and space. I began my career in a world of annual accounts and quarterly or monthly statistics, in which paper was the medium and mail the carrier. For the bulk of financial transactions the two parties, the intermediary, the currency of denomination, the relevant laws and courts, and the central bank all belonged to the same jurisdiction. And that jurisdiction was not only economic, as it included the political jurisdiction from which public institutions derive their legitimacy through the democratic process. This simple description never fully coincided with the state of the world, of course, but twenty-five years ago it was still a workable approximation. Today, that is no longer true. The advance of data processing and telecommunications technology has been the most powerful single driving force of this change. But the low cost of transportation, the evolution of economic ideas, the desire for closer and more peaceful relationships among nations have also been crucial. 8. The time dimension of our world has shifted from the long and medium waves of the year and the quarter to the short and micro waves of the day and the intra-day. The direct credit controls many of our countries still used ten or fifteen years ago called for compliance at the end of the month, as did most other prudential requirements. Payment finality at the close of the day, achieved through clearing and settlement in central bank money rather than correspondent banking, was considered sufficient. Monthly figures (not monthly averages of daily data) were judged adequate for the purpose of computing compulsory reserves. The exchange rate and other prices were “fixed” once a day. The reality of the monetary and financial world is becoming that of the intra-day, the micro wave; we are moving towards a continuous-time economy. We do not yet have markets for “one-hour money”, real-time accounting and reporting, and other similar devilries. But they will come. The Basle Committee has stated that “although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis. i.e., at the close of each business day”. Naturally, cost considerations will set a limit to the process, but the effects will be - and to some extent already are - sufficient to upset many of the operational and regulatory instruments on which central bankers rely. Indeed, market players have so far been much more at their ease in the new microcosm than public authorities. 9. As regards the space dimension, markets have grown bigger than jurisdictions. A single transaction is now likely to involve a multiplicity of “nationalities” in terms of currencies, players, authorities and legal systems. We used to regard the “State” as the universal container providing the grounds and the rules for the game played by profit-driven players. Today, we sometimes have the impression that no one is responsible for maintaining the grounds or making the rules and even that central banks are the balls some round, some oval - being hit or kicked around in a free-for-all of baseball, golf, cricket, soccer, rugby and American football. 10. Even the most independent, best equipped and highly reputed national central banks are hard put to perform their triadic task effectively in the new conditions of time and space. The new context has been created by the market, evolves in response to market forces and basically meets the needs of private interests. It is a creature of the market much more than of public authorities. Partly because of this evolution central banks and governments have become much more respectful of market forces, even humble. They are much more conscious that wealth and welfare are created primarily in and by the market. They know that this is a much more powerful beast than its would-be tamer. The effectiveness of both the instruments on which central bankers rely - banking operations and regulatory provisions - have been eroded by the innovation in market practices and the blurring of national frontiers. To some extent this is healthy. Market players are not there to serve us, we are here to serve the economy. Yet, this downsizing of our role should not be carried too far. There is still a public interest to be promoted that private actions cannot be counted upon to serve. There are still grounds for being proud to serve the public interest and for claiming that central banks should have the means to achieve their ends. The fact that markets are powerful, global and fast-moving, while central bank operations and regulations are national, intrusive and burdensome, does not mean the monetary system can do without a central bank or a bank regulator. 11. Basle, the BIS, the meetings of the community of central bankers, from the Governors down to junior officials, are where our profession has strived, largely successfully, to maintain the upper hand over the reality that calls for its public function. The task is being performed notwithstanding the wide diversity of national laws, traditions, operational practices and institutional constraints. I am a convinced institutionalist, because I believe that without a “Rule of Law” liberty and peace - the key prerequisites for economic activity - cannot survive for long. And my basic training, as well as much of my professional experience, have been in the European arena, which is a highly institutionalized cooperative system. In international monetary cooperation Basle stands at the “soft” end of the spectrum no legal basis, no written terms of reference, no extensive minutes. Mostly personal contacts and work based on the key words of banking and central banking: confidence, trust, credibility, confidentiality. 12. Although I started to attend BIS meetings well before this tower was constructed (in the old hotel building of the Centralbahnstrasse), it was only when you called me to the Basle Committee that I fully realized how strong this soft approach could be. Lawyers say that the Basle Committee “does not legally exist”. When I was appointed to its chair, my secretary had to take my word for it because she could not find any written evidence of the decision. Yet the Committee rules, once endorsed by you, are adopted by the markets, followed by national legislators and spread to all countries worldwide. When considering the working methods of the Basle Committee, I have often thought that international cooperation among central banks can be compared to Italo Calvino’s “Nonexistent Knight”. When Charlemagne, reviewing his paladins before the battle against the Infidels, reached the last knight, Agilulf, clad entirely in white armour, the cavalier refused to show his face to the emperor. The explanation he gave was simple: “Sire, because I do not exist”. Charlemagne insisted and when the knight finally raised his visor, the helmet was empty. “Well, well! Who’d have thought it!” exclaimed Charlemagne. “And how do you do your job, then, if you don’t exist?”. “By will power and faith in our holy cause!” said Agilulf. He fought with valour and bravery. His special status assisted him in the accomplishment of his duty and indeed he proved to be one of the best paladins. | bank of italy | 1,997 | 4 |
Address by the Director General of the Bank of Italy, Dott. Vincenzo Desario, before the conference on "Italian society at the turn of the millennium: opportunities and prospects of the non-profit and voluntary sector" held in Milan on 17/3/97. | Mr. Desario looks at the financial system and the non-profit sector with respect to ethics and solidarity in finance Address by the Director General of the Bank of Italy, Dott. Vincenzo Desario, before the conference on “Italian society at the turn of the millennium: opportunities and prospects of the non-profit and voluntary sector” held in Milan on 17/3/97. The importance of the non-profit and voluntary sector is now appreciable not only ethically and culturally, as a tendency whose expansion bears witness to the human and civic development of Italian society, but also on the economic plane. Everywhere, substantial budget deficits are forcing a retrenchment of public spending and more generally an attenuation of direct government involvement in the economy. It follows that non-profit and voluntary organizations may play an ever-larger role in reducing social disparities, devising modes of intervention appropriate to the continually changing forms in which inequality arises. In Italy the need for a larger and stronger non-profit and voluntary sector is especially great, owing to the necessity of fiscal adjustment and the inefficiency afflicting public services. My remarks today begin with some preliminary considerations on the relationships between ethics, solidarity and finance. I shall follow this with a description of the non-profit sector and some observations on banking foundations. Finally I shall examine the funding of the non-profit sector and its relations with the banking system. 1. Ethics, solidarity and finance The changes in Italy’s credit and financial system in recent years reflect the concern of law-makers and supervisors to foster market values and competition. The principles of transparency and fairness in relations between banks and customers not only are embedded in rules of conduct but have now been given the status of purposes of supervisory activity by Legislative Decree 415 of 23 July 1996 transposing the EU Investment Services Directive into Italian law. Reference to these principles is not merely ritual. It bids us to recognize that the operating environment has been radically transformed and now, even more than in the past, demands the firm commitment of intermediaries to comply with the letter and the spirit of the rules of good faith and fairness. These values are inextricably bound up with the relationship between bank and customer, which is based on trust. They make it easier to face the challenges of competition. They promote customer loyalty and enhance the bank’s reputation in the market. Trust is essential to the operation and growth of the economy. As the Nobel Laureate Kenneth Arrow has observed “Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time. It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.” 1 K.J. Arrow, "Gifts and Exchanges", Philosophy and Public Affairs ( 1972). The risk of a self-serving breach of trust by economic agents is one of the main sources of transaction costs, in that it necessitates performance bonds and monitoring the counterparty’s behaviour. The most effective way of reducing transaction costs is for market participants to adhere to the precept that it is one’s moral duty to respect others and not to betray their trust. Widely shared ethical precepts and moral conduct strengthen agents’ credibility and reliability, make it easier to reach new business agreements and ultimately increase the likelihood of success. In a market economy the credit system has the important function of selecting creditworthy projects, economic initiatives that can produce new benefits and increase overall social welfare. It is essential for every bank to screen borrowers by strictly professional standards based on technical assessment of projects’ risks and returns. Inefficient assessment of creditworthiness results in significant losses. In markets where there is little competition, poor asset quality is reflected in higher interest rates, with adverse repercussions on the economy as a whole. In more competitive markets, with their narrower spreads, loan losses can lead to bank failures. And this affects other outstanding loans, causes jobs to be lost and wipes out uninsured depositors’ savings, with the risk that the failure may spread. Customer confidence is the banking enterprise’s most valuable intangible asset. It is the prerequisite for building stronger and more durable customer relations that can be broadened from simple loan disbursement to the entire range of firms’ financial needs. With trust, there is a better likelihood that the relationship between bank and customer will be consolidated as a “repeated game” in which, as game theory teaches, the problems of opportunistic behaviour are overcome.2 This approach can be successful if the bank does not act in conflict of interest; if, that is, it safeguards the interests of the customer together with its own, recommending financing plans and instruments that are compatible with the customer’s projects, the state of the firm and the prospects of its market. In finance, solidarity can be expressed by paying more attention to the customer’s needs, viewed comprehensively, and assisting the customer in making financial choices that best serve the realization of corporate goals. Any short-term earnings loss will be offset by the future income the bank will obtain as a result of the continuity of the relationship and from additional corporate financial services. The principle of overcoming conflict of interest also informs proper and transparent relations with savers who entrust the bank with making an investment or managing their financial assets. The intermediary that reconciles its own interest with the customer’s, that makes customer assistance a conscious value of its corporate culture, perceiving it as a tool of competition, has a better chance of success in the financial markets. See, for example, K.G. Binmore, Game Theory and the Social Contract, II Just Playing (Cambridge, Mass., 1994). The rule that one who acts on behalf of another must protect the latter’s interest and not make undisclosed profits from this management activity is clearly ethical in origin. It was first stated, as regards the law of trusts, in the Middle Ages in sentences handed down by the Chancellor of the King of England; that is, by a judge, ordinarily also a bishop, who decided lawsuits mainly on the basis of ethical and religious canons. Effective, correct customer assistance is premised upon thorough knowledge of the customer. The “know your customer” rule has been reaffirmed recently by Italian financial legislation. Law 1/1991, as well as the more recent legislative decree transposing the EU Investment Services Directive, lays down that in carrying on securities activities the investment firm must “acquire prior information about the financial situation of customers that is relevant to the conduct of the activity.” This principle was made applicable to the entire banking and financial industry with the publication of the Bank of Italy’s anti-money-laundering “Decalogue”, which stresses that familiarity with the customer is essential not only for detecting suspect transactions but also for maintaining stable customer relations. Intermediaries have increasingly recognized the importance and the positive implications of this rule. Appreciable steps towards self-regulation have been taken, such as the code of conduct for banks, adopted in 1996, which sets standards of fairness in dealings with customers. When they enjoy real consensus, such initiatives are an especially effective tool for reinforcing and extending the rules of professional ethics, because they are not imposed from above but reflect the shared feelings of those involved. In the public interest and in conformity with the law, the supervisory authorities lay down prudential standards and rules of conduct covering all intermediaries. The authorities are careful not to impose costs that are not justified by greater benefits to the community as a whole. They are guided by the best practices of the market. They check that intermediaries act consistently with the principle of sound and prudent management. Management that is sound - i.e. in accordance with the rules derived from experience and the theory of enterprise (profitability), not subject to improper influences (independence) and based on correct business relations - and prudent - i.e. sensitive to risk - will have beneficial results in terms of the orderly and efficient operation of the economic and financial system. Sound and prudent management is an overarching criterion for supervisory activity. It sums up the values of stability, efficiency, integrity and proper functioning of the financial system. It is where systemic objectives and microeconomic goals meet. As a norm, it requires that intermediaries’ dealings with firms and households be constantly inspired by the canons of business and professional ethics, transparency, legality, fair competition. Sound and prudent management is at once a technical rule and an ethical canon. Safeguarding competition also carries a deep ethical significance. Abuse of a dominant position, price fixing, or collusive agreement on practices to the detriment of consumers allows intermediaries to reap unjustified profits and excludes those who cannot pay the fixed prices from enjoying the relevant services. Such practices generate both inefficiency and inequity. 2. The non-profit and voluntary sector An abiding school of thought embracing analysts of differing backgrounds holds that a democratic political system, if it is to be deeply rooted in the social fabric, must be articulated in a tightknit web of organizations positioned between the individual and the state: collective actors that enable citizens themselves to “become the state” by directly administering and providing socially useful services. As the French sociologist Emile Durkheim stressed, a nation can be said to exist only if between the state and private citizens there is a whole series of secondary groups close enough to individuals to draw them forcefully into their field of action and so involve them in the mainstream of social life.3 The grass-roots presence of associations, mutual societies, communities and clubs, networks of civic commitment, is seen by some scholars as a decisive factor in establishing a climate of reciprocal confidence and social cooperation, which is necessary to launch a virtuous circle of economic development.4 The non-profit sector is defined essentially by two traits: private ownership and control and a ban on distributing profits. The latter feature does not imply that a non-profit body cannot ever generate profits; what counts is that any net profits must be reinvested in the pursuit and expansion of the organization’s activity, to finance its mandated purposes. It may seem surprising that in a market economy one finds associations, clubs, mutual societies, leagues and private cooperatives providing services without distributing profits and almost always operating alongside other institutions, such as the family, the state, and business corporations. Yet historical experience teaches that the state-market dichotomy does not exhaust all the ramifications of a modern economic and social system. In economic theory the most widely accepted explanations for the existence of non-profit enterprises bear on market “failures”, which are generally related to information asymmetries, i.e. cases in which the independent contracting power of agents does not ensure sufficient transparency or comparability of services and products. Especially where service quality is difficult to ascertain, there is room for the rise and growth of non-profit enterprises. For the consumer, the ban on distributing profits is a signal that the provider will not raise the price of the service without just cause or reduce its quality. Similar assurance is offered to those who wish to make donations to non-profit agencies that assist the weak and the needy. The ban on distributing profits fosters and strengthens the bonds of trust between users, private donors and the service organization. It is a deterrent to the involvement of workers and managers who would be inclined to pursue their own individual interests, those who are less socially committed. E. Durkheim, The Division of Labour in Society (1893). R.D. Putnam, Making Democracy Work: Civic Traditions in Modern Italy (Princeton, N.J., Princeton University Press, 1993). The private non-profit organization has comparative advantages not only as against business corporations but also with respect to public provision of goods and services, especially those earmarked for particular segments of society. By virtue of more efficient collection and processing of “local” information, i.e. within circumscribed territories, non-profit agencies cater more effectively to the particular needs of specific social groups or sectors. These are services that require more of a grass-roots presence and a greater capacity to target action to non-standardized needs. The state retains a comparative advantage in the provision of undifferentiated public services, such as compulsory schooling, basic health care, and social security. The non-profit and voluntary sector can play a major role in supplementing public programmes and in broadening the area of social protection. It must become a mechanism for soliciting and raising additional private resources, over and above government appropriations for these purposes, in order to meet those needs that state action is inefficient in facing. Italy’s unbalanced economic development has been accompanied by phenomena of social distress and has not succeeded, to date, in narrowing regional disparities. The growth and spread of social solidarity, volunteer service and the entire non-profit sector is highly desirable to reinforce the pact of mutual support binding the national community at the institutional level and to make for fruitful, complementary relations between private and public social welfare activities. Delay in the development of the non-profit sector and excessive reduction of the social role of the state, albeit for budgetary reasons, could place the whole burden of assisting society’s most vulnerable members on the family. Owing to the changes in society, the family is no longer capable, unaided, of dealing with the complicated problems posed by the modern world. 3. The fight against usury: a case of complementarity between government and voluntary action Solidarity means disinterested assistance to those in need. The traditional ethical condemnation of lending at interest, found in the Old Testament and in Aristotle, can be traced back to the ethical principle of solidarity whereby one must help the needy person, not take advantage of his need. Leviticus reads: “And if thy brother be waxen poor, and fallen in decay with thee; then thou shalt relieve him; yea, though he be a stranger, or a sojourner; that he may live with thee. Take thou no usury of him, or increase.... Thou shalt not give him thy money upon usury, nor lend him thy victuals for increase.”5 The passage from condemnation of charging of interest to the needy to the outright condemnation of interest as such, found in other books of the Old Testament,6 is logical in the historical context of a static, agrarian economy in which recourse to credit is not a normal event for anyone engaging in economic activity but the last resort of victims of exceptional adversity. Even today, the exploitation of the weakness of those in need is an element in Leviticus 25, 35-37. See also Exodus 22, 25. For example, Ezekiel 18, 13. usury, an odious and socially destructive practice that has taken on alarming dimensions in recent years. The problem is delicate, complicated, and because of its emotional impact proper analysis of the issue requires an effort of intellectual lucidity to avoid the sort of crude judgments that surface from time to time in the discussion. The alleged inflexibility of legal intermediaries in granting loans is often cited as a contributing cause of usury. But banks operate with the funds of their depositors, which it is their duty to safeguard; accordingly they lend to those customers who are in a position to honour their obligations. By using the savings it has collected in the most efficient manner and protecting their value through sound and prudent management, the banking enterprise performs its important economic function, combining private profit-seeking with the general interest. It may be that some high-risk borrowers, at the margins of the credit market, find it hard to obtain “legal” credit. These borrowers, who tend to be small businesses even more commonly than households, may fall prey to usurers, through no fault of the legitimate intermediaries subject to supervision. Italy’s 1996 anti-usury law accords official recognition to the role played by the voluntary sector in sparing enterprises and households the risk of having to turn to usurers. The main instrument for combating usury is government grants to non-profit foundations and associations that already administer resources deriving from private donations, to be used as security for bank loans at moderate rates of interest to persons in financial difficulty. Italy counts a good number of associations engaged in the battle against usury. There are eight officially recognized foundations active in prevention and assistance to victims. Six operate in the central and southern regions, where usury is most widespread and perilous, owing to its links with organized crime. 4. The banking foundations As I mentioned, non-profit enterprises develop in sectors where pronounced informational asymmetries between customers and service providers lead the public to prefer services supplied by undertakings that do not distribute profits. Informational asymmetries are a distinguishing feature of the banking and financial sector. These two points may help to shed light on the creation of banks in the form of associations or foundations (savings banks first and foremost), which reached its peak during the nineteenth century. These institutions served to counter usury and to overcome the aversion of “first-generation” savers towards the banking system. The great banking crises of the thirties fortified the role of the public banks, which served to restore savers’ confidence in the banking system and allowed an orderly flow of financing to the economy. The development of the Italian economy and decades of financial stability safeguarded by an effective system of public supervision brought a considerable part of the population into contact with the banking system. The evolution of markets and their increasing openness brought the public banks’ entrepreneurial features increasingly to the fore, with a corresponding de-emphasis of their original social functions. The reform of the public banks that Parliament enacted at the beginning of the nineties in response to these tendencies sanctioned the passing of the public law model of banking; the law separated the institutions’ original social-welfare and charitable purposes from banking activity, assigning the former to the foundations and the latter to companies limited by shares The most compelling reason for the reform, at the urging of the supervisory authorities, was to allow the introduction of organizational and operational models able to ensure higher standards of competitiveness and efficiency. An important factor was the central role assigned to banks’ capital by the supervisory system then being forged at Community level; the limited scope for Italian public banks to raise funds directly in the equity market hindered their growth and ability to compete. The legislative solution adopted - the original institutions to remain in existence after transferring their banking activity to companies limited by shares - also sought to exploit the valuable social and civic function that most of the public credit institutions had historically performed. Initially, the reform legislation was basically neutral concerning the practical options for the banking foundations; it defined the spectrum of activities open to them, clearly drew the border between banks and foundations, and laid down what the latter could not do, namely manage banks. The remodeled foundations’ sizable endowments fueled expectations that they might satisfy the growing financial needs of the voluntary and non-profit sector. The banking foundations, it was felt, could fill the gap left by the shrinking of the welfare state; but in order to occupy a central position in the nonprofit sector, it was argued, they had to dispose of their equity interests in banks at once. However, realizing the full potential of the banking foundations requires that they cease being regarded as a pool of resources to be dipped into indiscriminately or as a body of assets whose composition can be altered in order to pursue the most diverse purposes. The foundations are non-profit operators themselves and can actively contribute to the non-profit sector’s development by identifying areas for intervention and nurturing socially useful initiatives. In deciding how to go about pursuing their objectives, the foundations can adopt a directly operational setup and manage one or more socially useful activities themselves, under arrangements already adopted elsewhere and not new to Italy. If they should decide instead to continue in the role of grant-making institutions, in order to make a truly effective contribution they must develop sufficient skills in selecting initiatives, monitoring the use of funds and assessing results. Grant-making plainly entails a degree of specialization, not only geographic but also by sector of socially useful activity. In effect, the data assembled by the Association of Italian Savings Banks (ACRI) via reclassification of the banking foundations’ annual accounts and a survey of the grants made by the 81 ex-savings bank foundations offers evidence of growing specialization. Sorting the foundations by sectoral concentration of grants shows that 60.5 per cent allocated over half of their funding to a single sector or more than sixth tenths to just two sectors in 1995. There is some tendency away from small grants, although these are still very common among the smaller foundations, and considerable growth in multi-year grants, whose share in total disbursements rose from 7.7 per cent in 1994 to 11.6 per cent in 1995. According to the ACRI report, disbursements amounted to 211 billion lire in 1995, equal to a little less than one third of the foundations’ net operating results and 7.8 per cent up on the 1994 figure of 196 billion. The banking foundations’ activities are hampered by their low return on assets. ACRI calculates that the ex-saving bank foundations’ overall ratio of net operating results to assets was 2 per cent in the 1994-95 financial year. This poor performance, though an improvement on 1.43 per cent in the previous financial year, reflects the modest return on holdings of bank shares, dividends from which account for 80 per cent of the result. Thus, the ability of the foundations to fulfil their institutional purposes depends largely on cyclical conditions in the banking industry. It is incumbent on the foundations to seek an optimal return on their capital, in order to preserve its real value and ensure the continuity of their activities. This will require greater asset diversification, a necessary condition for the foundations’ assuming a more fertile, autonomous role in the social sphere. Fostering such a role is the basic objective of the provisions for the revision of the civil-law and tax treatment of the banking foundations in the Government’s recent enabling bill, which are meant to encourage them to dispose of their bank shares. The proposed legislation would provide tax incentives for the operations connected with privatization; unlike earlier proposals, it sets no deadline for the sale of bank shares. The decision to encourage rather than order such disposals and to allow them to be spread out over time appears appropriate. It is compatible with the objective of respecting the decision-making autonomy of the parties involved and improving the profitability of banks so as to enhance the attractiveness of their shares. And it creates scope for the stock market to be able to absorb the shares of the banks, without excess supply depressing the placement price. The foundations will have a better chance to dispose of their bank equity with the necessary gradualness. The incentives for the sale of bank shares will facilitate the reorganization of the banking system and foster an increase in bank size, especially if the sales bring in authentic fresh capital. However, the breadth of the delegation of powers contemplated by the enabling bill and, above all, the diversity of its objectives are such that a well-defined legislative framework is not yet discernible. The parliamentary debate will have to fill in gaps and resolve uncertainties. The proposed establishment of a regulatory authority for non-profit institutions, including the banking foundations. deserves some comment. This authority would be assigned to oversee the legitimacy of the actions of the foundations’ governing bodies, their sound and prudent management, the return on assets, and their effective pursuit of the aims specified in the bylaws. Its powers would also include authorizing transformations and combinations, passing on amendments to bylaws, removing the governing bodies and dissolving foundations in the event of repeated management irregularities, setting a minimum proportion of income (not less than one half) that must be allocated to institutional purposes, and acting in lieu of the governing bodies for individual acts. Beyond a certain point, it is not easy to reconcile the intensity of the planned administrative controls with the degree of autonomy that recognition of the institutions’ private nature would imply. Nonetheless, the experience of foreign jurisdictions with longer traditions in this field shows that some form of supervision on the foundations and non-profit sector in general remains appropriate, especially as regards entitlement to favourable tax treatment. However, supervision should be calibrated so as to avoid stifling the initiative of the non-profit institutions, draining their capacity to act and ultimately reducing the benefits to civil society. 5. Financing the non-profit and voluntary sector There are four possible sources of funds for the non-profit sector: private donations, government transfers, debt capital and self-financing. Government contributions bulk large in Italy, whereas private donations are marginal. The relationship between the two is specular, and in fact in countries where private donations play a larger role they are encouraged by favourable tax treatment. Banks can help to increase the flow of private donations to non-profit enterprises by offering their customers specially designed financial instruments; for example, the so-called “ethical” funds and accounts that some financial intermediaries have promoted, whose rules require subscribers or depositors to assign all or part of their income from the investment to nonprofit institutions. These products can involve financing as well as donations; alongside the assignment of customer earnings or capital gains, there is often an obligation for the intermediary to invest the monies received only in undertakings that conform to certain ethical standards or pursue specific objectives. The organizational and opportunity costs of launching such initiatives are compensated for by the enhanced reputation and standing that the intermediary enjoys among socially aware customers. The specific advantage of banks’ interposition with regard to charitable donations stems from their placement power: branch networks, which give banks an edge in supplying their own financial products and those of others, also put them in a strong position to sell “ethical” products to their customers. Where profit-seeking intermediaries offer customers financial products earmarked to fund the non-profit sector, organizational and accounting controls are necessary to ensure transparency. Other conditions being equal, two factors may handicap non-profit undertakings in raising debt capital. First, the rule prohibiting distribution of profits may strike the prospective lender as likely to erode operating efficiency in the long run. Whereas for commercial enterprises the profit motive is the mainspring of survival and growth, for non-profit institutions there is a problem of ensuring that the altruistic drive does not flag over time. On the other hand, the ban on distributing profits is also a point of strength, since it allows non-profit enterprises to screen and select collaborators, workers and managers who share their altruistic objectives of service. - 10 - The second adverse factor is linked to the eventuality of the non-profit undertaking failing to repay the loan. In this event, a bank bringing action for forced recovery would run the risk of appearing to put its own interests before the social, humanitarian or charitable purposes of the distressed undertaking. Financial support can be provided to the non-profit and voluntary sector by intermediaries that exclusively, prevalently or even only occasionally engage in such lending (so-called “ethical” intermediation). The record shows a variety of such experiences in many countries. To cite a few significant examples, Ökobank in Germany, which focuses on environmental and peace issues, had 63,000 customers and 170 billion lire of deposits in 1993; in the Netherlands, Triodos Bank, of the eponymous association for social development and environmental protection, accounts for 2.5 per cent of the country’s total bank deposits; in Switzerland, the banner experience is that of Alternative Bank ABS, which in 1992 had around 106 billion lire of loans outstanding to local non-profit enterprises and associations for thirdworld development. Other intermediaries concentrate on fostering small business in the third world or in economically depressed areas of the industrialized countries. The best-known example is Grameen Bank of Bangladesh, which lends to farmers in the poorest rural areas. The key to its success is its technique of forming small groups of customers who take part in training workshops that also serve to select the creditworthy. The small loans disbursed to them are gradually scaled up if each member of the group meets the repayment terms. The bank’s high credit quality testifies to the efficacy both of the method used for assessing creditworthiness and of the system of cross-monitoring among members of a group. The high risk that nonetheless characterizes the bank’s activity made it advisable for it to fund its loans primarily with public contributions and the bank’s own resources, part of which was paid in by the beneficiaries of its lending. In the United States, a very interesting case is that of the Illinois Neighborhood Development Corporation, created by non-profit shareholders and licensed to engage in banking since the seventies. The bank initially operated in one of the worst slums of Chicago, the South Shore, and endeavoured to redevelop the area particularly by giving minority groups more access to credit. The programme’s success allowed it to be extended to other rundown, outlying neighbourhoods. Thanks to its skilled and highly-motivated staff, this bank has combined rigorous lending standards with a variety of assistance and promotional services, operating in compliance with the normal banking supervisory requirements. A complete review of the experiences in various countries would also have to include the cases of failure and those demonstrating the difficulty of transplanting successful initiatives to different social and institutional settings. For an “ethical” intermediary actually to achieve comparative advantages in financing the non-profit and voluntary sector, various conditions, not always easily satisfied, have to be met: a highly motivated staff, for one, and savers receptive to the ethical aims pursued and willing to support them over time with deposits. The affinity of ideals between the bank and the borrower must not tempt the former to relax its technical standards of customer selection or neglect to heed the principle of - 11 - operating profitability. Specialization in the non-profit and voluntary sector must be compatible with the key principle of the banking system. Operating losses could not only cause the bank to fail but also have adverse repercussions on similar initiatives. The success of such projects essentially depends on devising techniques to limit the credit risk while simultaneously upholding both the “mission” of funding the non-profit sector and the banking industry’s standards of competence and prudence. When a bank is to be established that intends to finance the non-profit sector by taking deposits from the public, the above prudential recommendations become especially cogent. History shows how high the social costs of bank failures can be, and how complex is recourse to the instruments that make up the system’s crisis “safety net”. *** Modern economic theory accepts the principle that a solid ethical commitment is also economically rational. The propagation of virtuous conduct is a value in and of itself, in that it lends strength and security to economic agents, averting costs and formalities that would otherwise be necessary. This reinforces the ties between ethics and finance, between ethics and business. Ethical and moral principles are increasingly taking root among economic agents, producing closer links between the social dimension and the markets. Modern society is very attentive and sensitive to these values. The demand for ethical conduct is ever broader and stronger. Establishing relations of trust with customers invigorates financial activity. The intermediary must adopt the principle of proper assistance to the customer, of serving the latter’s best interest. In a framework of competition between financial operators, this must be effected in conformity with the intrinsically ethical standard of sound and prudent management. When non-profit institutions are formally organized as enterprises, i.e. when they are based on the principle that revenues must cover costs, they can turn to the banking system and the capital markets for financing to supplement their endowments, private donations and public contributions. In countries where the non-profit sector has grown to significant dimensions, its enterprises compete with commercial firms in the product markets and in the market for financial resources. They obtain funds from commercial intermediaries on the basis of proven solvency and established reputation. In Italian law the formation and the range of business of an intermediary whose vocation is to finance the non-profit sector cannot deviate from the rules governing financial activities in general. These rules respond to needs and interests, including ethical interests, of the first order, which are expressed in the canon of sound and prudent management and the values of stability and efficiency. Only within this framework can financial institutions dedicated to lending to the non-profit sector succeed, enhancing the contribution of finance to the growth of solidarity and voluntary agencies. | bank of italy | 1,997 | 5 |
Address given by the Governor of the Bank of Italy, Dott. Antonio Fazio, at an international conference celebrating 50 years of Quarterly Review/Moneta e Credito in Rome, on 20/11/97. | Mr. Fazio considers the issue of efficiency and instability in global finance Address given by the Governor of the Bank of Italy, Dott. Antonio Fazio, at an international conference celebrating 50 years of Quarterly Review/Moneta e Credito in Rome, on 20/11/97. In the wake of the Great Depression and the Second World War, the new monetary system set up by the Bretton Woods agreements, together with the liberalisation and expansion of international trade, laid the foundations for a long period of economic growth and stability. From 1950 to 1973 the world economy grew at an annual rate of 4.9%; the industrial countries achieved 4.4%, Latin America, Asia and Oceania a higher rate. Inflation was a little above 3% in the industrial countries and less than 5% in the world as a whole. The economic devastation of the Great Depression had undermined the classical vision of the economy based on the hypothesis of equilibrium, in which the action of policy-makers was constrained by the rigid rules of the gold standard. Following Keynes, in the new monetary order economic policies were assigned a pre-eminent role in governing the cycle. Controls were imposed on capital movements to permit interest rates to be managed in pursuit of domestic objectives. The liberalisation of trade contrasted with a segmentation of the market for savings and financial assets on a national basis. Current account imbalances were to be promptly corrected by means of a fiscal policy serving to re-establish the equality between saving and investment. The system broke down in August 1971, with the suspension of the dollar’s convertibility into gold. The main cause of the crisis lay in the US budget and balance-of-payments deficits, which generated an overhang that was incompatible with the dollar’s role of anchor. Other factors included economic policies in most countries focused primarily on domestic growth and employment, the rise in public expenditure in relation to GDP, the emergence of international financial markets and increasingly large flows of hot money, which reduced the effectiveness of the restrictions on capital movements. In a situation where monetary policies were still concerned with the control of interest rates rather than credit flows and the quantity of money, floating rates ended up by fostering an increase in inflation in the industrial countries and in the rest of the world. Monetary growth in the leading industrial countries continued, at an annual rate of 13%. The oil crisis had an impact that was simultaneously inflationary and recessionary. The growth rate of the industrial countries slowed to around 2.5% in the years from 1973 to 1980, inflation accelerated to 10%. Except in Germany, where monetary policy was directed with greater determination to controlling inflation, the 1970s were marked by high negative real interest rates. The shift in US monetary policy introduced by Paul Volcker in 1979 gave priority to controlling the quantities of credit and money; interest rates rose sharply to well above the inflation rate. The upward movement spread to all the other leading countries. 1. Global finance During the 1980s flexibility of the exchange rates between the main economic regions of the world was accompanied by the dismantling of the barriers to capital movements. Growth in the industrial countries was no more rapid than in the previous decade; it slowed in the 1990s. The persistence of budget deficits and large external imbalances, the rapid advances in data processing and telecommunications, financial innovation and the activity of institutions that collect and invest savings on a world scale all contributed to the creation of a single, global market for currencies and finance. The harbinger of this development was the growth of the Eurodollar market, which had been boosted in the 1970s by the recycling of the surpluses of the oil-producing countries. The new conditions made it possible for countries to adopt a gradualist approach to correcting budget and, above all, external deficits; it was no longer necessary for saving to equal investment in any given period. The global market was fuelled by the steady accumulation of external debt by the United States and the build-up of a net credit position by Germany and Japan. In all the leading industrial countries except the United Kingdom public debt continued to rise in relation to GDP. Gross financial assets and liabilities continued to grow much more rapidly than economic activity. Between 1982 and 1995 the total liabilities of the six largest industrial countries rose from US$ 25 trillion to US$ 110 trillion and from four to six times their GDP. Over the same period the degree of financial integration increased; today, external liabilities are equal to 60% of GDP. The growth in foreign exchange trading proceeded apace. Favourable investment opportunities encouraged huge flows of capital into the emerging economies; high rates of economic growth were often coupled with large balance-of-payments deficits and stable exchange rates. Foreign investment in these markets increased from US$ 50 billion in 1990 to US$ 200 billion in 1995. In the OECD countries the assets managed by institutional investors rose over the same period from US$ 14 trillion to US$ 23 trillion and from 85 to 102% of the area’s GDP. These intermediaries manage portfolios that tend to be global and take on technically complex risks. They can modify the composition of their assets extremely rapidly even for the sake of making small gains; they exploit the arbitrage opportunities stemming from fiscal segmentation or price differences between different financial centres. 2. Efficiency and stability Savings are now freer to flow towards what investors consider the most profitable investment opportunities. This results in a more efficient allocation of the resources available, support for capital formation and better growth prospects, especially for backward economies. The increase in lending to the developing countries, where the return on capital is higher, is certainly evidence of the markets’ efficiency; on the other hand it brings with it the problem of the sustainability of these countries’ foreign debt and the associated risks for stability, including that of the international financial system. The Mexico crisis and that still open in South-East Asia, like the debt crisis of the early 1980s in Latin America, have shown that a large inflow of funds can temporarily prop up unsustainable economic conditions. Anchoring the national currency to strong currencies when economic policies are inadequate causes the real exchange rate to rise, creating the conditions for a crisis. Insufficient supervision of banks and markets is a contributory factor. The liquidity of markets, the belief that securities can be sold without incurring substantial losses can lead to an erroneous perception of the risk. Widespread expectations that the international organisations will intervene can accentuate behaviour on the part of intermediaries that is not consistent with the riskiness of investments. It is becoming increasingly important to ensure sound and orderly economic conditions and at the same time to strengthen and enhance the effectiveness of the supervision of intermediaries and markets at the supranational as well as the national level, with the aim of forestalling systemic crises. The restrictive monetary policies adopted in the industrial countries brought annual inflation down from 10% in the 1970s to 5.8% in the 1980s. In the 1990s the objectives have become more ambitious; inflation has fallen further, to an average of 3.1%. Prices have also slowed down considerably in the last three years in the countries of eastern Europe and above all in Latin America. Real interest rates rose substantially in the industrial countries in the 1980s and 1990s. They increased by around 6 percentage points in the early 1980s in response to the change in the focus of US monetary policy. Real long-term rates stood at about 5% in the first half of the 1980s. Today, excluding Japan, they still stand at around 4%, above the rate of economic growth. The high level of real interest rates is a reflection of the high returns that can be earned on investments in the emerging countries and the growing risks of a financial nature, which, even though they originate in national markets, affect the whole system. To an even greater extent, with the money supply constant or even slightly declining in relation to GDP as a consequence of rigorous monetary policies, real interest rates are influenced by the rapid growth in the volume of private and, above all, public sector securities. The ratio of the quantity of money to nominal output has held steady or fallen a little in the leading countries in the 1990s; in 1996 it stood at about 64%. After rising sharply in the 1980s, international liquidity as measured by cross-border deposits has remained virtually unchanged. For the private sector to acquire the growing stock of financial assets, real interest rates have to be high; the growth in public debt, due first and foremost to the imbalances in social security systems, is a source of pressure on real resources. The gap between interest rates and economic growth rates is a cause of rising unemployment. 3. Italy’s role in international finance In the course of the 1990s, with the complete liberalisation of capital movements, Italy has become a full participant in the international financial markets. Gross capital inflows and outflows have increased enormously. This process has sustained the accumulation of financial assets and encouraged residents to diversify their portfolios by type of instrument, country of issue and currency of denomination. Between 1990 and 1996 net portfolio investment abroad by the private sector amounted to 190 trillion lire, accounting for 9% of the growth in total financial assets. The share of foreign instruments in the total financial assets of the private sector rose from 6% at the end of 1989 to 14% at the end of 1996. The growing flow of savings invested abroad also reflects a domestic supply of financial instruments that is still not sufficiently diversified in terms of risks and returns. Italy’s participation in the global market of finance has encouraged foreign capital inflows, mainly directed towards the government securities market. At the end of last year non-residents held 370 trillion lire of Italian government securities or 20% of the total amount outstanding, compared with 4% at the end of the 1980s. When doubts have emerged about the soundness of economic policy, foreign capital inflows have ceased suddenly and given way to outflows, supplemented by substantial exports of Italian capital. In late 1992 and again in early 1995 non-residents disposed of very large quantities of Italian securities; at the same time residents’ purchases of foreign financial assets increased considerably. These outflows put the lira and securities prices under very heavy pressure. The reaffirmation of monetary policy’s counter-inflationary commitment, the continuation, albeit with pauses, of the efforts to adjust the public finances, and the policy of wage moderation were decisive in easing the pressure and restoring conditions for a stable inflow of capital from abroad. Looking ahead to a situation of recovery in economic activity and a reduction in the external current account surplus, the diversification of residents’ financial portfolios will not put pressure on the exchange rate if non-residents continue to buy large amounts of Italian securities. During the current year, characterised by favourable expectations regarding the Italian economy and the prospects for Economic and Monetary Union, non-residents’ purchases of government securities, totalling more than 80 trillion lire up to September, have contributed to the sharp contraction in the long-term interest rate differential between Italy and the countries with a longer record of price stability and a lower level of public debt. Exports of Italian capital have also increased, however. One of the reasons for the gradualness with which monetary policy has been eased has been to ensure favourable conditions for foreign investment in Italy, taking into account the continual, structural outflow of Italian capital. As Economic and Monetary Union draws closer and national monetary policy’s room for manoeuvre gradually narrows to the point of disappearing, the macroeconomic equilibrium of each country will come to depend increasingly on budgetary, incomes and structural policies. In the absence of changes in the relative values of currencies, imbalances will impinge on competitiveness, production and employment. Public spending in Italy is now equal to more than 50% of GDP. Reducing this ratio will make it possible to ease the burden of taxation and social security contributions. In order to enhance Italy’s competitiveness and reduce the cost of labour, it is also necessary to remove the obstacles hindering competition in the markets for goods and arrive at a more flexible use of labour. 4. Concluding remarks In addition to benefiting the participating countries, the creation of a stable monetary area in Europe will contribute to the stability of the real and financial macroeconomy at the world level. In recent years Europe has been beset by modest growth and insufficient use of available resources; between 1990 and 1996 employment declined by 2 million units. Adverse factors include inefficiencies in some parts of the productive system, market rigidities and excessively large budgets. The implementation of a closer economic union and the soundness of money and finance over time cannot be entrusted exclusively to monetary policy. They require conditions of greater economic efficiency and the harmonisation of institutional arrangements in the participating countries. A sound currency requires a dynamic economy. Money is largely the product of the credit granted to firms and the State. The stability of its value does not depend only on the quantity in circulation but also on the efficient use of credit. Economic convergence must therefore be pursued not only in the nominal variables but also in labour productivity, a level of taxation that will enhance international competitiveness, and an efficient use of the resources the public sector appropriates. These are the conditions for a monetary union to have the necessary stability and solidity. The global market for currencies and finance influences the performance of all economies. The conditions in that market increasingly appear as exogenous variables of decisive importance. The macroeconomic equilibria of individual economies have to be related to the level and movements of interest rates determined in it and to the exchange rates established there between the leading currencies. The external constraint is increasingly taking the form of the need for each country and economic region to be in overall balance, in terms of financial assets and liabilities, with respect to the rest of the world. The development of the global financial market in the last ten years parallels that of national financial markets in the later nineteenth century and the first half of this century. The increase in financial activity within each national market, the expansion of credit and the development of intermediaries all made a decisive contribution to investment, production and employment. But the need rapidly emerged for overall control of money creation and even earlier for a system of prudential supervision of intermediaries’ activities. Today’s central banks are the result. At the international level the expansion in the nominal amounts of credit and money has no longer been limited by the availability of primary liquidity since the link with gold was broken. The present configuration of the market has evolved spontaneously, largely in conditions of fierce competition. However, given the nature of the variables involved, it is unlikely that a Pareto-efficient equilibrium will be reached. Money produces credit and credit produces more money; it is necessary to govern the growth of these aggregates; an anchor is needed to stabilise their value in terms of goods. In the absence of binding rules and appropriate policies, national economies and the international economy are exposed to the risks of inflation and instability in intermediaries and markets. This inflationary drift is likely to lead to speculative bubbles, excessive increases in the value of real and financial assets. The international crises that occur from time to time diminish the value of financial wealth and curb inflationary pressures at the world level. With many economies suffering from stagnation and poor fundamentals, the low cost and rapid expansion of dollar financing in the early 1990s and the subsequent restriction, together with the more recent monetary expansion in Japan and loss of value of the yen, have probably contributed to the instability of the global market for finance. The efforts, redoubled in recent years, to achieve monetary stability in most of the industrial countries, the banking supervision started by the Group of Ten for developed countries, its extension to the emerging countries and the surveillance performed by the IMF are playing a role of great systemic importance. Faced with open and competitive markets, the strengthening of cooperation helps to forestall crises, increases the efficacy of corrective action. Effective action by central banks, supervisory authorities and the IMF is a first response to the new problems of monetary and financial stability raised by the globalisation of markets; it may require more certain and firmly based international institutional arrangements. | bank of italy | 1,997 | 12 |
Address by the Governor of the Bank of Italy, Dott. Antonio Fazio, at a conference jointly organised by AIOTE - ASSOBAT - ATIC - FOREX - AIAF and held in Naples on 24/1/98. | Mr. Fazio discusses Italy and Europe in a world of global finance Address by the Governor of the Bank of Italy, Dott. Antonio Fazio, at a conference jointly organised by AIOTE - ASSOBAT - ATIC - FOREX - AIAF and held in Naples on 24/1/98. The expansion of trade and the globalization of markets have maintained the rate of growth of the world economy at a high level in the last ten years. The pace has been particularly rapid in the countries where labour is most abundant and least costly and in the industrial countries whose economies are marked by a high degree of flexibility and rising productivity. The liberalization of trade in goods and services, the improvement in communications and the reduction in transport costs increase the efficiency of the allocation of resources in the world. The gains from trade, the new wealth created are unequally divided among the countries involved; they also result in a redistribution of productive capacity and an increase in specialization and concentration. The globalization of finance allows saving to be allocated and managed more efficiently at world level; it has made a significant contribution to sustaining productive investment in the fastest growing economies. In the six leading industrial countries the volume of financial assets rose between 1982 and 1995 from $30 trillion to $124 trillion and from four to six times their annual GDP at current prices. In the industrial countries the huge rise in public debt contributed to the increase in the supply of financial instruments. Stock markets have grown very rapidly in recent years, especially in the emerging countries. The activity of non-bank intermediaries operating on a global scale and investing primarily in shares and bonds and other widely traded assets has developed, rapidly reaching a very substantial volume. Financial intermediaries, including banks, tend to behave according to operating models that are based on the same theoretical paradigms; sometimes, however, by reacting uniformly to important new information or to changes in expectations concerning individual economies, they shift funds very rapidly from one economy to another; they can take positions with very-short time horizons in foreign exchange or securities of a size that heavily influences countries with less solid financial structures. 1. The Asian crisis Foreign investment in the emerging markets by banks and institutional and private investors rose from $50 billion in 1990 to $240 billion in 1996. In mid-1997 the foreign debts of eight emerging Asian economies, including Hong Kong, Singapore and China, amounted to $900 billion or about 40 per cent of the area’s GDP; some two thirds of the total was due to mature within one year. The crisis, which has affected five countries in particular -- Thailand, Indonesia, Malaysia, the Philippines and South Korea -- is basically the result of the persistence of large external current account deficits ranging from 3 to 6 per cent of GDP and the consequent rapid accumulation of foreign debt. These countries’ budgets are generally close to balance and their public debt is limited. The disequilibria are attributable to an excess of private and public sector investment in relation to the albeit high rate of saving. The returns on investment projects have not always been adequate in terms of profitability and exports, partly owing to inefficiencies in the allocation of credit. Competitiveness was eroded by the 40 per cent devaluation of the Chinese currency in 1994. Firms’ growing dependence on foreign loans, denominated mostly in dollars, the preponderantly short-term nature of the debt and shortcomings in the supervision of financial intermediaries made financial systems more fragile. The uncertain performance of the Japanese economy and financial system exerted a negative influence. The crisis started and spread when market participants came to recognize the difficulty of sustaining exchange rates in the face of the sharp and continuing appreciation of the dollar and expectations of increases in interest rates in the United States. The possibility emerged of heavy losses by firms; growth prospects were scaled back, with further adverse effects on stock markets. It is surprising, in this crisis as well, how fast the climate of opinion changed among investors; it suggests a formation of expectations based on the performance of the macro-economic variables only in the short run and on the attitudes of other market participants. The extrapolative nature of expectations compounds fluctuations in exchange rates and securities prices. Once again there was a failure to make a thorough analysis of the underlying conditions of each economy. To be sure, the shortness of the average maturity of the debt indicated uncertainty among investors regarding long-term growth prospects; nonetheless, until mid-1997 the flow of capital to the area remained substantial. Notwithstanding the interventions organized by the IMF, the crisis deepened in December and the early days of this year. The falls in share prices and exchange rates against the dollar in the five countries mentioned since early 1997 have reached respectively 40 and 50 per cent on average; expressed in dollars, share prices have fallen to less than one third of the initial level. The markets, and especially the stock markets, of Singapore, Taiwan and Hong Kong have been caught up in the crisis. Events in the markets and the poorer prospects for the economies of the countries hit by the crisis have adversely affected the already delicate balance of Japan’s capital market and the quality of its banking system’s assets. The Chinese economy has not been drawn into the crisis, owing to its initially strong competitive position, relatively underdeveloped financial system and the preference given to direct inward investment over portfolio investment. The volume of financing mobilized by the IMF, other international organizations and the nations working to cope with the crisis is without precedent. The World Bank and the Asian Development Bank have been called upon to contribute to objectives beyond the scope of their respective institutional mandates. Total disbursements of around $110 billion have either been made or are envisaged. Banks will have to help in containing the effects of the crisis by rolling over existing loans. The intensity of the crisis and the fear of systemic repercussions have produced a disarray in the measures and decisions adopted that suggests the present arrangements for international cooperation are inadequate in the face of the challenges posed by the globalization of markets. 2. International monetary developments The backdrop to the Asian crisis is the persistent problem of the uncertain performance of the Japanese economy and the excessive burden placed on monetary policy. This situation is an inheritance from the Mexican crisis in the early months of 1995, which led initially to an abnormal appreciation of the yen and to fears of a prolonged decline of the dollar. The lowering of interest rates in Japan to near zero led in the second half of 1995 to a fall on the order of 20 per cent in the effective exchange rate of the yen. The economy did not benefit sufficiently in terms of growth, while the imbalance associated with Japan’s large external credit position was aggravated. The weakness of the exchange rate tended to depress share prices, thereby contributing to the contraction in domestic bank credit. Fiscal policy, even after the recent announcement of a small reduction in taxation, continues to be directed towards the undeniably desirable objective of containing the public debt in the long term. A further reduction in the budget deficit is expected in 1998; there does not appear to be sufficient concern about the deflationary implications of this course in the short term. The measures now before the Japanese Parliament provide for a limited stimulus to domestic demand based on tax reductions that should amount to around half a percentage point of GDP. The package also includes a plan for shoring up and rescuing the financial and banking system involving very substantial resources, some $240 billion or 6 per cent of GDP. The long period of expansionary monetary policy in Japan, especially from the spring of 1995 onwards, has substantially increased the supply of yen and lowered the cost of yen financing. Japanese banks have considerably increased their supply of credit to international markets; their external liabilities have fallen substantially and they have become large net creditors. The expansion in the credit provided by the Japanese banking system has occurred in a period which has been marked by a very large US current account deficit, at present on the order of $180 billion a year, coupled with a persistently high level of direct investment abroad by American firms. The relatively slack economic conditions in most of the industrial countries made it easier to finance the external deficits of the countries affected by the crisis. In a context of low inflation, both actual and expected, the supply of money at very low interest rates has been reflected in long-term yields in Japan and the other leading markets. The yields on long-term Japanese securities fell to 2.1 per cent in 1997. Japanese overseas portfolio investment amounted to more than $80 billion in 1994 and 1995, twice the level of the preceding years; it rose further in 1996 and the early part of 1997; around one fifth of the outflow goes directly to the US market. Foreign investment in US securities amounted to more than $300 billion in 1996, an increase of 50 per cent on 1994 and 1995; compared with three years earlier it more than doubled. Annual disinvestment is on the order of $100 billion. The yield on ten-year US securities fell from 6.4 per cent in 1996 to 5.8 per cent at the end of 1997. The European financial system also received much larger portfolio investment inflows in 1996 and 1997 than in the preceding years. More than $200 billion flowed into Germany in 1996, compared with $125 billion in 1995 and $76 billion in 1994. In 1997 the yields on medium-term securities fell faster in Germany than in the United States, reaching 5.3 per cent. In some respects the abundance of liquidity in the international market appears to be a replay of the situation in the early 1990s, up to the beginning of 1994, following the prolonged US monetary expansion. The Federal Reserve held short-term rates close to 3 per cent for nearly two years. In these circumstances the yields on medium and long-term securities in the leading markets declined steadily and substantially until the last few months of 1993. Those on ten-year US Treasury bonds fell from 7 per cent at the beginning of 1992 to just over 5 per cent in October 1993; the yields on German securities fell from 8 per cent to below 6 per cent at the end of 1993. The yields on ten-year Italian Treasury paper fell from over 14 per cent in the autumn of 1992 to below 9 per cent in the early months of 1994, after reaching 15 per cent during the EMS crisis. From February 1994 onwards, in connection with the shift in the stance of US monetary policy, interest rates rose rapidly everywhere; securities prices fell to their level of two years earlier. After the Mexican crisis, medium-term interest rates declined gradually again in all the main markets from the spring of 1995 onwards. Monetary policy was tightened moderately during 1997 in all the industrial countries except Italy and Spain. The upward pressures on interest rates are now being neutralized by the need to facilitate the solution of the Asian crisis and the expectations of slower growth in the United States. The funds that have been withdrawn from the Asian economies have flowed to the financial markets of the industrial countries, above all that of the United States, providing support for share and bond prices and the exchange rate of the dollar. The yen has been constantly weak, but in general outside Asia the pattern of exchange rates has remained orderly. On several occasions during the 1990s the Japanese government announced plans for fiscal expansion. Although they were substantial, the composition of the measures, their temporary nature and incomplete implementation meant that they produced effects of limited size and duration. The Japanese economy appears to be dominated by negative expectations for the medium and long term connected with the prospective ageing of the population. The large fall in property and share prices at the beginning of the 1990s created difficulties for the banking system, which have now been aggravated by the crisis of South Korea and the countries of South-East Asia, which have close commercial, financial and entrepreneurial ties with Japan. The way to overcome the impasse -- given the size of the Japanese economy and its actual and potential strength in terms of productive capacity and saving -- appears to be to provide an effective stimulus to domestic demand. Monetary policy, with interest rates close to zero, appears to have shot its bolt. The plan now under discussion, if it is approved by Parliament in its entirety, appears to be on a sufficiently large scale as regards the rehabilitation of the financial system. By contrast, the stimulus for economic activity appears still to be small. More incisive budgetary measures, possibly with short time horizons, could improve the outlook for growth in Japan without having adverse long-term effects on its public finances. The levels reached by share prices in the economies affected by the crisis, in conjunction with the stabilization plans drawn up for some of them with the support of the IMF, mean that there are likely to be profitable investment opportunities. In the present phase the international economy is exposed to the risk of systemic instability, with consequent widespread deflationary effects. International portfolio investment flows have been of unprecedented size in the last few years; it is necessary at least to monitor them and to some extent to govern them. A recovery in domestic demand and an improvement in the prospects for growth in Japan would also underpin the yen; they would bring direct benefits for the Asian countries and indirect benefits for the world economy. There is an increasingly urgent need for a new comprehensive approach to these problems conforming with the configuration of global markets and today’s international financial system. 3. Europe in the global market Europe’s markets are increasingly integrated with the international market in finance. The international opening of the Italian and French financial systems has proceeded apace in the 1990s. Germany had already been playing an important role in international markets; at the same time the share of finance coming from abroad has steadily grown and the large net external credit position built up above all in the 1980s is tending to diminish. The international openness of the United Kingdom remains pronounced, reflecting the presence of the world’s leading financial centre. The recent monetary developments have had a significant effect on all the markets of continental Europe. The last three years have seen substantial flows of portfolio investment into Germany, France and Italy as well as smaller countries. The fall in long-term yields, which occurred simultaneously everywhere, has reflected the stability of prices and the reduction in government deficits within Europe; more immediately it is the consequence of the large inflows of funds that have been a feature of all the European markets. Policies must be designed to maintain in the European Union financial investments that tend to be of a temporary nature. The small inflow of direct investment into some continental European countries, coupled with growth in EU outward direct investment, is a cause for concern. There is a need to develop conditions of competitiveness and profitability in productive systems that will attract the funds of international investors on a permanent basis. The competitiveness of the financial industry in continental Europe is relatively low. Costs are high; the quality of the services provided is still inadequate. Small markets and the chronic weakness of some currencies have been a brake on the development of a more modern financial industry able to compete in the global market. In 1996 the current account of the European Union’s balance of payments showed a surplus of $86 billion or 1 per cent of the area’s GDP. From 1990 onwards the external accounts of the EU countries fluctuated between deficit and surplus against a background of rapid growth of the world economy and moderate growth of domestic demand within the area. The limited increase in output, the steady decline in industrial employment and the rise in unemployment are indicators of insufficient competitiveness with respect to the rest of the world. The markets for goods and above all the market for labour are more rigid in continental Europe; unit labour costs in industry are comparable with those of the United States and Japan, but much higher than those of newly industrialized countries in Asia, Latin America and eastern Europe. The tax burden, and especially that relative to employee workers, is high. Population ageing will profoundly alter the balance between the economically active and inactive members of society. The low level of economic growth depresses the propensity to invest. The prospect of economic and monetary union has forced European countries to take determined action to put their public finances back on a sound footing. To a large extent the effort required to adjust budget deficits has been made. A high degree of monetary stability has been restored. In several cases however, the tax burden has increased further. Monetary stability is the primary objective of the unification; it serves to create conditions conducive to investment and growth. The parameters for government deficits and public debts are playing a key role in achieving monetary stability in the area; they were nonetheless conceived in a context in which the implications of the globalization of commerce and finance were still not sufficiently clear; it is also necessary to try and reduce the burden on the economy of some items of the public finances and the ratio of taxes and social security contributions to GDP. To seek to enhance the Union’s competitiveness through the exchange rate would be in contrast with the objective of monetary stability. Competitiveness is in the first place a reflection of the share of resources absorbed -- directly in the form of wages, indirectly via some items of public expenditure -- by labour. It must therefore be enhanced through a cost of labour, a flexibility in its use and a level of direct and indirect taxation that are compatible with today’s greater international openness of the markets for goods, services and especially finance. Increasing the size and diversification of the capital market can make a decisive contribution to monetary stability and ultimately to the prosperity of the economy. Europe as a whole is a net creditor with respect to the rest of the world. The creation of a single financial market that is no longer segmented by different currencies, in a context of price stability and greater competitiveness, will offer considerable scope for growth in the issue and trading of corporate bonds and shares, and for the development of related capital market activities, benefiting enterprises and economic activity and supporting their extension to world markets. Looking ahead, the international monetary system will increasingly be divided into three large blocs: those of the dollar, the yen and the European currency. The currencies of smaller countries will tend to be grouped around, and refer to, the three of greatest importance. The strength of each currency will depend on the credibility of the monetary policies adopted. In the background there will be a tendency for the productivity and competitiveness of the real economy to take on renewed importance. It is necessary to foresee a recomposition of the area’s value added in the medium term at the expense of more traditional industries and to the benefit of more advanced services, especially financial services. Important opportunities are opening up for Italian and European operators that they must succeed in grasping by updating strategies and professional skills and by correctly assessing the related risks through the application of more advanced and complete models. 4. Italy Italy recorded another surplus on its external current account in 1997, of the order of 60 trillion lire or just over 3 per cent of GDP. Towards the end of the year the country’s net external position returned to near balance. Some 470 trillion lire of net government liabilities vis-à-vis non-residents (mostly short and medium-term lira paper purchased on the Italian market, but with about one fifth consisting of foreign currency bonds issued abroad) were matched by net assets of more than 350 trillion held by the non bank private sector, about 100 trillion held by the Bank of Italy and smaller amounts held by banks and other financial operators. The Bank of Italy’s gold reserves amount to 2,500 tonnes; in addition the central bank’s external position improved from 51 trillion lire at the end of 1995 to 96 trillion at the end of last year. Households and firms have converted Italy’s substantial current account surpluses into external financial assets. They first repaid foreign currency debts taken on in earlier years and then increased their holdings abroad. Their overall position in foreign currency improved from near balance in 1993 to a surplus of more than 200 trillion lire last September. Capital outflows in the form of portfolio investment increased from a monthly average of 4.5 trillion lire in 1996 to one of about 9 trillion last year. This reflects a propensity for portfolio diversification aimed at achieving a better combination of risk and return, a process that is structural and that is bound to become more pronounced over the next few years. Increasingly, these outflows are being channelled through Italian and foreign intermediaries specialized in asset management. Despite the large volume of capital outflows in 1997, the net supply of foreign currency in exchange for lire remained very substantially positive, enabling the Bank of Italy to achieve the build-up in its foreign exchange reserves referred to earlier at stable exchange rates. The supply of foreign currency derived not only from the trade surplus but also from a large volume of inward portfolio investment by institutional investors, banks and private operators. In response to more favourable domestic conditions and abundant international liquidity, the foreign investors continued to make very large purchases in 1997: 118 trillion lire, in line with the previous year. At the same time, the improved climate of confidence was reflected in a sharp reduction in the share of purchases foreign investors financed in lire in order to hedge the exchange risk. Net purchases of Italian government securities by non-residents exceeded issues by a wide margin. The economy’s regained credibility, the prospects for the consolidation of the public finances, low inflation and the upward trend in bond prices encouraged investment and accentuated the decline in yields on medium and long-term securities, which are now comparable to those in the markets with the most stable currencies. Italian savers directed the bulk of their investment to the various forms of managed savings; through this channel they increased their purchases of foreign assets and Italian shares. Problems may arise in this connection with respect to the risks that households and firms may sometimes run with this new configuration of their portfolios. The declining yields on Italian government paper and the lower liquidity of these alternative instruments also strengthened the demand for money, and in particular for current account deposits. The climate of confidence that has prevailed in the markets has also been reflected in the surge in share prices, which has continued even after the outbreak of the Asian crisis. Financial conditions facilitated major privatizations of public sector banks, coupled with their recapitalization, along lines we had frequently suggested. Economic activity remained weak in the first half of 1997, bearing out the forecasts we made at the end of 1996 and early last year. In 1997 the growth in GDP, which had been a disappointing 0.7 per cent in 1996, would have been just over 1 per cent. Incentives for the purchase of consumer durables stimulated economic activity despite the further fiscal tightening and permitted annual growth estimated at about 1.5 per cent. Investment in plant and machinery has shown signs of picking up, partly in response to favourable conditions in Europe; by contrast, the construction sector continues to stagnate. The situation with regard to employment is not improving, however; in fact, in the more depressed regions it is deteriorating further. Growth in consumer spending is still hesitant, owing to the uncertain prospects for employment and the slow increase in households’ income. Monetary policy has continued to be firmly directed to stabilizing inflation. Consumer price inflation fell below 1.5 per cent on a seasonally adjusted annual basis in the second half of 1996 and remained at that level until the summer of 1997. In the fourth quarter of last year it rose to around 2 per cent, reflecting the upturn in producer prices that had occurred in the second. The expectations regarding inflation have improved continuously and now indicate a rate of 2 per cent for 1998 and 1999. The lowering of official interest rates from the middle of 1996 onwards was calibrated in relation to actual and expected inflation and the outlook for the adjustment of the public finances, the condition for a lasting return to stability, with constant attention to the changes in residents’ portfolios and the inflows of foreign capital. We have kept the exchange rate consistent with the lira’s central parity, with no need for support intervention in the moments of tension of international origin or related to domestic political developments. The reduction in the official rates, the discount rate and the rate on advances, decided at the end of last year is helping to sustain conditions that, thanks in part to the good performance of exports, are likely to foster investment. The growth in GDP in 1998 could exceed 2 per cent. Italy is still faced with difficulties that will have to be overcome, thereby laying the foundations for improvements tomorrow; there is a need for behaviour and policies that will ensure the saving available is used to strengthen productive investment at home. Over the last five years direct investment by Italian firms expanded substantially; the inflow remained virtually unchanged; the balance showed a deficit of 30 trillion lire. The quest for higher profits in a climate of renewed confidence in stability and economic growth can be directed towards expanding the scale of production and investment, with a view to creating employment. Wage moderation must be maintained, thereby permitting a reduction in unit labour costs; the albeit limited pressure on prices -- particularly producer prices -- must not be allowed to increase. Last year saw substantial progress towards the consolidation of the public finances. On the basis of the latest data, general government net borrowing should be less than 3 per cent of GDP. A start has been made on reforms aimed at improving the working of the public administration and rationalizing the tax system. Cuts have been made in some expenditure items and transfers to non-state public bodies reduced. What is needed now is action of a structural nature to consolidate the results achieved. Public services must be made more efficient and provide effective support for productive activity. There is a manifest need for flexible formulas in the use of labour that will enhance its productivity. Unit labour costs must be brought down substantially in the less developed regions, where both youth unemployment and the underground economy are present on a large and growing scale and where the labour force participation rate, particularly among women, is very low. It is indispensable to eliminate the rigidities In the economic relations between employers and employees, which prevent wages and salaries and other contractual conditions from adjusting to the level of productivity and the demand for labour. Excessively high labour costs lead to forms of hidden employment; they prevent most young people from embarking on a career in the regular economy and, together with high tax rates, give rise to evasion of abnormal proportions. A lack of effective demand is increasingly evident. A low level of investment is common to all the European economies; it lies at the root of the decline in employment in certain sectors and the rise in unemployment. It is serious in the more depressed regions, particularly in southern Italy; together with high labour costs, the fall in private and public sector investment is adversely affecting the economic and productive fabric. Appropriate policies are required to restore higher rates of investment. Lower unit labour costs and increased competitiveness provide fertile ground for a recovery in investment. - 10 - I have spoken at length elsewhere of the potential and actual availability of private saving in Italy. I have endeavoured to show that a higher level of economic activity and faster growth, combined with monetary and wage stability, can accelerate progress towards the lasting adjustment of the public finances. The price stability that we have regained with a monetary policy that at times has had to be extremely rigorous, must be bolstered by a competitive and expanding real economy. By pursuing a stable policy from the summer of 1994 onwards we brought the rate of inflation back into line with that of the leading industrial countries. Wage moderation, the drastic reduction in the Treasury borrowing requirement in 1997 and the weakness of prices in international markets have helped considerably in the curbing of inflation; as a consequence, long-term interest rates have come down. These results, obtained through an unwavering commitment, have made a major contribution to the convergence of Italy’s economy towards those of our European partners with a more firmly established tradition of stability. The months from now until the decisions connected with the launch of Monetary Union, but also the second part of this year, will prove especially delicate for the entire system of European exchange rates. In these circumstances monetary policy, while it will continue to guarantee moderate medium-term inflation expectations, is now focused more on the stability of the exchange rate. If economic agents’ behaviour is consistent, Italy will be able to maintain the international position it has so arduously regained, to the benefit of present and future generations. | bank of italy | 1,998 | 2 |
Statement by the Governor of the Bank of Italy, Dott. Antonio Fazio, before the Treasury, Budget and Planning Committee of the Chamber of Deputies, in Rome on 12/2/98. | Mr. Fazio reports on the Bank of Italy and the European System of Central Banks Statement by the Governor of the Bank of Italy, Dott. Antonio Fazio, before the Treasury, Budget and Planning Committee of the Chamber of Deputies, in Rome on 12/2/98. The results the Italian economy has achieved in the past five years are attributable to the combined operation of fiscal and monetary policy and to wage moderation. In late 1992 and early 1993 the restrictive stance of monetary policy prevented expectations of rising prices, fuelled by the decline in the external value of the lira and the abrupt change in the exchange rate regime, from translating into actual inflation. A substantial contribution to this result came from low wage growth and budgetary measures that impinged on the structure of the main components of government spending. Conditions in the economy became difficult again during 1994: the state sector borrowing requirement was overshooting the targets and demand was growing rapidly, with the result that inflationary pressures developed. In December 1994 and the first few months of 1995 domestic political factors and the repercussions of the Mexican crisis on the foreign exchange and financial markets aggravated the situation. Official rates were raised three times: in August 1994, at the first manifestation of price tensions; in February 1995, in conjunction with supplementary fiscal measures; and in May of the same year, when doubts arose about the curbing of inflation. The monetary tightening, the fiscal measures of early 1995 and the stabilization of the exchange rate had a positive influence on inflation expectations and long-term interest rates. Monetary policy maintained a restrictive stance throughout 1995 and in the first half of 1996, with the aim of subduing inflation expectations and bringing the rate of increase in prices into line with that prevailing in the other leading industrial countries. In July 1996 a start was made on lowering the official rates. The reduction was prudent and calibrated above all in relation to the decline in expected and actual inflation. This approach resulted in a constant inflow of funds from abroad for purchases of government securities; by offsetting the large outflows of Italian capital generated by the need for portfolio diversification, these inflows contributed to the stability of the exchange rate of the lira. The progress achieved made it possible for the lira to rejoin the exchange rate mechanism of the EMS in November 1996. The caution employed in relaxing monetary conditions meant that Italy’s financial and foreign exchange markets were not affected more than marginally in 1997 by the tensions that emerged at the international level in connection with the crisis in East Asia and the vicissitudes of some important European countries or by those attributable to domestic political developments. Today the Bank of Italy’s reserves comprise more than 2,500 tonnes of gold and foreign assets, net of repurchase agreements, worth 82 trillion lire, compared with ó trillion in 1992. Underlying the lira’s solidity is the return to balance between Italy’s external assets and liabilities. At the end of 1992 Italy had external claims of 600 trillion lire and external liabilities amounting to 770 trillion. The net debt of 170 trillion was equal to 11 per cent of GDP. Thanks to the succession of surpluses recorded on the current account of the balance of payments, at the end of 1997 Italy’s overall net external position was once more broadly in balance. Last September some 470 trillion lire of government foreign debt, consisting mostly of government securities held by non-residents, were matched by net external assets of more than 350 trillion held by the non-bank private sector, about 100 trillion held by the Bank of Italy and smaller amounts held by banks and other financial operators. The Bank of Italy and the European System of Central Banks It has been agreed within the Community that the decisions concerning the start of monetary union – in particular, those involving the countries that will adopt the single currency from the start – will be taken in the early part of the month of May. With the introduction of the single currency, the task of formulating monetary policy will be transferred to the European System of Central Banks, comprising the central banks of all the participating countries and the European Central Bank. The Treaty establishing the European Community, as amended at Maastricht, provides a broad outline of the internal organization of the ESCB. The preparatory work carried out by the European Monetary Institute since the signing of the Treaty has focused on these aspects. The national central banks will be entrusted with the task of implementing within each country the monetary policy decided at the Community level. The central banks of the participating countries will continue to be responsible for all the functions they are entrusted with under national laws; in Italy these include banking supervision, the supervision of markets, the safeguarding of competition in the credit market and, jointly with the European Central Bank, oversight of the payments system. The systemic crises in foreign markets have strengthened the view that banking supervision complements monetary policy in determining conditions of stability in financial and credit markets. The primary objective of the common monetary policy is price stability. The mandate, clear and unequivocal, given to the European System of Central Banks is based on two tenets held by the drafters of the Treaty: that the stability of the value of money is a public good which does not hinder, but rather fosters, sustainable growth of the real economy; and that maintaining stability depends crucially on the operation of monetary policy. The European System of Central Banks will enjoy complete autonomy; it will regularly provide information on its activities and report on them to the other Community institutions. In particular, the European Central Bank will be required, pursuant to Article 109b of the Treaty and Article 15 of the Statute of the European System of Central Banks, to publish periodic reports on the activities of the ESCB, with a description of the current and future stance of monetary policy. The European Parliament will be able to debate these matters and invite the President and the other members of the Executive Board of the European Central Bank to be heard by its competent committees. In particular, the need for a “single” monetary policy will have to be reconciled with the principle of “subsidiarity”, which has also been embodied in the Statute of the ESCB and is intended to permit the highest possible degree of decentralization in operational terms. More specifically, provision is made for a division of tasks along the following lines: - - the decision-making powers in monetary policy matters, especially with regard to interest rates and compulsory reserves, will be centralized in the European Central Bank. The ECB will exercise these powers through the Governing Council, comprising the Governors of the national central banks and the Executive Board, composed of the President, the Vice-President and four other members. The Executive Board will be responsible for implementing the decisions of the Governing Council on a continuous basis; the operational implementation of monetary policy will be entrusted to the national central banks. Each national central bank will thus have two tasks: it will contribute, through its Governor, to the decisions of the Governing Council; and it will implement these decisions in its own country. Operations in the money and foreign exchange markets will normally be carried out by the national central banks. Within this framework, the Bank of Italy will continue to carry out all the operational functions that it currently performs. The procedures for conducting monetary control operations will be different in part from those used today; the draft legislative decree currently under discussion in Parliament is designed to permit the necessary changes. Legal convergence The Treaty requires each member state to make its national legislation, and especially the provisions concerning its central bank, compatible with the Treaty and the Statute of the European System of Central Banks. In particular, the Treaty requires each member state to ensure that its central bank is independent from the government and all other political bodies; the necessary reforms must be enacted before the introduction of the single currency. Within the general framework laid down in the Treaty, the European Monetary Institute and the Commission have done valuable work in analyzing and interpreting the relevant provisions and providing clear indications of the criteria to be followed in adapting national legislation to Community law, not least in view of the need for the latter’s uniform application throughout the European Union. The key requirements of central bank independence with a view to a country’s adoption of the single currency are: the task of pursuing price stability as the primary objective; complete autonomy in the management of the monetary instruments, interest rates and monetary and credit aggregates, for the purpose of defending the internal and external value of the currency. Some of the provisions of the draft legislative decree are aimed at strengthening the Bank of Italy’s independence, the essentials of which are in fact already provided for in Italian legislation. At a higher level there is the proposal of the Joint Parliamentary Committee on constitutional reform for the Bank of Italy to be given constitutional status by affirming the central bank’s independence and autonomy in the performance of its monetary and supervisory functions in the Constitution. The integration of the national central banks in the European System of Central Banks is to be achieved by linking the implementation at national level of measures concerning official interest rates, compulsory reserves and open-market operations with the decisions adopted by the European Central Bank. It is important to stress that, in conformity with the Statute of the European System of Central Banks, the participation of the Bank of Italy in the System will • not affect the performance of the other tasks that it is assigned under national legislation, especially those related to banking supervision. The draft legislative decree contains the provisions needed to ensure the compatibility of Italian legislation with the Treaty and the Statute of the European System of Central Banks. In addition to the competent Italian Parliamentary committees, it has been submitted, as required, to the European Monetary Institute for its opinion. The provisions guaranteeing the integration of the Bank of Italy in the ESCB will mostly come into force at the time the single currency is adopted. The Statute of the Bank of Italy will be modified in accordance with the legislative decree under discussion. The Bank’s Board of Directors has already approved the proposed amendments, which will be put to the Extraordinary General Meeting of Shareholders to be held on 19 March: they will be rendered compatible with the final text of the legislative decree. The amendments to the Bank’s Statutes will then follow the procedure laid down for their approval by the President of the Republic. * * * In Italy the monetary policy approach that has been followed in the last few years, and will be maintained in the coming years, is aimed at convincing market participants, workers and businessmen that increases in income can only be achieved by expanding economic activity. The action taken on the monetary front, of necessity extremely rigorous at times, has made a major contribution to the convergence of Italy’s economy towards those of European countries with a more firmly established tradition of stability. The decisions that will be taken by the European Central Bank will have maintaining price stability as their objective. Labour market, incomes and fiscal policies will increasingly be the only ones available to promote the competitiveness and profitability of Italy’s enterprises, and growth in production and employment. They will have to give renewed impetus to productive investment. The ample availability of savings, of which a large part is invested abroad at present, makes this possible. The revival of economic activity in Europe as a whole cannot be based on manoeuvres to enhance competitiveness through the exchange rate of the common currency; such action would be in conflict with the primary objective of monetary stability. This will have to be underpinned by a strong productive system, to be achieved by curbing budgets and taxes, boosting investment and making more flexible use of the factors of production. These are the indispensable conditions for achieving faster growth and creating new employment. | bank of italy | 1,998 | 2 |
Address by the Director General of the Bank of Italy, Dott. Vincenzo Desario, at the conference 'Asset management: insurance companies versus banks' held in Rome on 9/4/98. | Mr. Desario reports on growth prospects and implications for supervision of asset management Address by the Director General of the Bank of Italy, Dott. Vincenzo Desario, at the conference “Asset management: insurance companies versus banks” held in Rome on 9/4/98. 1. Introduction The growth of asset management has been a common feature of the financial systems of all the leading industrial countries. In Italy, the growth has been especially rapid in the last two years, under the influence of both cyclical and structural factors. The professional management of savings has always been a characteristic aspect of financial intermediation. Its scope was originally limited to the management of individual estates and the provision of financial advice. The mandate to engage in financial investment conferred by savers (asset management) does not place intermediaries under an obligation to repay the nominal value of the principal invested, nor does it guarantee the achievement of a given yield. The scope of the activity has become much broader; it now involves a wide range of different financial intermediaries and instruments and a much larger pool of investors. The sharp increase in financial flows has led intermediaries to operate in a variety of markets and expand the number of innovative products they offer. The ranks of those involved have grown: banks and insurance companies have been joined by investment houses and investment fund management companies, the savings of high-income customers by those of lower-income workers and pensioners, and individual investors by institutional investors. The operational overlap between different categories of intermediary and the substitutability of different types of instrument have increased. Competition has become fiercer at both the domestic and the international level. The need to achieve a critical mass in order to operate in a market where the geographical boundaries and the supply of products are changing rapidly has prompted reorganizations, concentrations and the formation of conglomerates. The expansion of asset management has been a major driving force in financial innovation and has contributed everywhere to the erosion of institutional segmentation and to the pressure to change the organization of controls. I shall look first at the evolution of asset management at the international level, before analyzing its development in Italy and the role of banks and other intermediaries. In view of the opportunities and risks that this development entails, I shall also address supervisory issues, the new legal framework established recently with the consolidated law on financial markets and the need for closer and more effective cooperation between authorities, both in Italy and in international fora. 2. Asset management in the industrial countries The rapidity of the growth of the international asset management industry is reflected in the share of the financial instruments it offers in households’ portfolios and the importance of institutional investors. Between 1982 and 1994 - a period for which comparable figures are available - there was a significant shift in the composition of households’ portfolios in all the leading OECD countries: while the share of financial assets held as bank deposits declined, that of products offered by insurance companies, investment funds and pension funds grew steadily. ˝ -2˝ Significant differences between countries nonetheless persist within this common trend. At the end of the period considered, the proportion of households’ financial portfolio consisting of managed assets was one-sixth in Italy and France, one-fourth in Germany and Japan, two-fifths in the United Kingdom and three-fifths in the United States. During the same period, the assets of institutional investors (insurance companies, investment funds and pension funds) increased in relation to the total volume of financial intermediation and gross domestic product. Differences in the role of institutional investors in the various countries are captured by the latter indicator: the assets under their management were equal to 30 per cent of GDP in Italy and Germany but amounted to more than 200 per cent of GDP in the United Kingdom and Japan (Table 1). The disparity in the size of the sector in the different countries does not prevent us from identifying a number of shared structural determinants of the growth in asset management. The first and most important is the gradual aging of the population, which fuels demand for pension-related financial instruments. The difficulties faced by public pension systems reinforce this trend: asset management has grown the most in countries whose pension systems are primarily based on private pension schemes; where public systems play a major role, the sector has developed later and grown more slowly. The tight limits on budget deficits imposed by the stability pact among the countries participating in the Economic and Monetary Union will accelerate recourse to private pension arrangements, giving additional impetus to the growth of institutional investors in Italy, France and Germany. The liberalization of capital movements at the end of the 1980s was an equally important propulsive factor. New opportunities to diversify financial investments were opened up to savers in countries that had previously imposed foreign exchange restrictions. It became possible to construct portfolios with the desired combination of risk and return; at the same time, it became more difficult to manage portfolios, increasing the importance of the services offered by specialized intermediaries. The decline in the rate of inflation in recent years, together with the restoration of macroeconomic stability, has been another factor contributing to the growth and has encouraged a shift in financial resources towards longer-term assets and, above all, the stock market. The spread of asset management has not had the same features everywhere. In the United States, the process has been accompanied by a considerable reduction in the role of banks; in the countries of continental Europe the latter have retained a significant position and in many cases have been the main actors in promoting the growth of the sector. In reality, the growth of asset management does not necessarily lead to banking disintermediation: the competition triggered by the changed preferences of savers, new technology and more refined financial instruments, and the evolution of the legal framework does not favour any one type of intermediary but rather modifies the characteristics of financial intermediation and financial products as we know them today. Asset management, defined as the all-inclusive professional management of savings, is destined to produce lasting changes in the structure of the financial system we have inherited, in three main directions: greater concentration in the production of asset management services, an expansion of financial assets in relation to real wealth, and an increase in the importance of the securities market. ˝ The search for optimal size in asset management activities, international diversification strategies and the need to create efficient integrated structures for the production and distribution of financial products have given rise to mergers between some of the world’s leading intermediaries. The growth in asset management has contributed to financial deepening in the leading industrial countries. Between 1982 and 1994 the ratio of gross financial assets to real wealth rose from 0.8 to 1.6 in the United States and from 1.5 to 2.5 in the United Kingdom. Institutional investors are channelling an increasingly large volume of funds towards the financial markets. The arbitrage activities they engage in and their ability to trade in highly volatile financial assets give breadth and depth to the securities market, reinforcing its role in the allocation of savings and the redistribution of risk. It is worth noting the introduction of derivative credit instruments and the growing recourse to techniques for securitizing of bank loans. The connection between the development of asset management and the growth of the stock market is shown by the fact that at the end of 1995 the shareholdings of UK pension funds were greater than the total capitalization of the Italian and German stock markets. In certain circumstances the behaviour of institutional investors could accentuate tensions in securities markets. In markets of insufficient depth, price fluctuations are likely to be amplified by the use of dynamic hedging techniques or the imitative behaviour of managers seeking to reduce the risk of performing less well than their competitors. 3. The growth of asset management in Italy In Italy, the spread of asset management products has increased appreciably in recent years, approaching the levels achieved in the other leading countries. Between 1990 and 1997 the aggregate comprising investment funds, portfolio management services, pension funds and life insurance companies’ technical reserves increased from 150 trillion lire to just under 1,000 trillion, rising from 8.5 to 33 per cent of total domestic financial assets (Table 2). The increase was especially large in 1997. Net fund-raising by investment funds tripled by comparison with 1996 and amounted to 143 trillion lire. In the first nine months of 1997, the net inflow of resources to portfolio management services nearly doubled to 64 trillion lire, while premiums paid in respect of life insurance policies grew more moderately, increasing by 44 per cent. The differences between the products offered by the various categories of intermediary have narrowed. About one-quarter of the funds raised by portfolio management services were reinvested in investment funds. In the insurance industry there has been strong growth in products with a more pronounced financial component, such as single premium policies, sales of which increased by 125 per cent in the first nine months of 1997. The impressive increase in asset management in 1997 was boosted by the decline in interest rates that accompanied the fall in inflation. Small investors entrusted professional managers with savings that had previously been invested in government securities as they sought to increase their returns, inter alia through capital gains. The shift from personal investment to asset management has led to a greater diversification of households’ and firms’ investment portfolios. Nonetheless, considering the total ˝ -4˝ assets held directly or indirectly by savers shows that the redistribution of final investment instruments is taking place gradually. In the past two years the substantial reduction in households’ demand for government securities has been largely offset by the increase in the subscriptions of investment funds. Only in part has it translated into purchases of listed shares and especially foreign securities. The preference for asset management is likely to be reinforced by the recent changes in the tax treatment of financial assets. The new procedures for the taxation of financial income, based on an all-inclusive approach, relieves investors in managed asset instruments from having to send in returns and requires the intermediaries providing the service to settle the related tax liabilities. The new rules also standardize the procedures for individual and collective instruments; a simplification that should enhance operational efficiency. The flow of funds to institutional investors and to the securities market requires an adequate response in terms of the supply of financial instruments. Greater recourse by firms to the market, through debt and equity issues, will enable the productive economy to benefit from Italy’s substantial saving capacity and give intermediaries an opportunity to expand their investment banking services. The supply policies of banks, especially the leading Italian banking groups, have played a key role. Capitalizing on professional asset management is now a central strategic objective; it is in line with customer preferences, helps offset the downward trend in interest income, increases productivity through a better utilization of labour, and consolidates the fiduciary relationship with savers. In 1996 managed asset services contributed substantially to banking groups’ profitability, producing gross revenue of more than 4 trillion lire or around one-third of pre-tax profit. In the same year banks and their subsidiaries handled 70.4 per cent of all managed assets in Italy, up from 63 per cent in 1992. Considering investment funds and portfolio management services only, at the end of 1997 the volume of assets managed directly or indirectly by banks amounted to four-fifths of the total. Banking groups have strengthened their central role in asset management; overall, there has been no significant impact on the volume of funds intermediated by the credit system. Over the past five years the fund-raising policies of the bank-controlled asset management companies have transformed the rankings in this sector; the number of bank-controlled companies in the top five has risen from two to four. Marketing capabilities and the fiduciary relationship with customers have given banks a competitive edge over other financial intermediaries. The expansion of the distribution network in years past through the progressive diversification of channels (branches, financial salesmen, marketing agreements) has produced very extensive coverage of the territory. A survey of the banking system conducted by the Bank of Italy found that at the end of 1995 portfolio management services were offered by more than 60 per cent of all banks, life insurance products by over 70 per cent, and investment fund units by 80 per cent. Insurance products are increasingly simple and standardized, which has facilitated their marketing via bank networks and financial salesmen. In the first nine months of 1997 the share of life insurance products sold through bank networks was 33 per cent, compared with 25 per cent in the same period of 1996; the share marketed through agents dropped from 42 to 36 per cent. ˝ 4. Banks and other intermediaries: competition and integration The Italian financial system was historically bank-oriented rather than market-oriented. It did not offer valid opportunities for portfolio diversification: the scope for investment was restricted to one instrument - bank deposits - offering modest yields and a nominal value that was stable over time. In the last fifteen years Italians’ high propensity to save, the increasing supply of government securities, the launch of investment funds and the liberalization of capital movements have enormously enlarged the role of the financial markets and the opportunities for diversification. There nonetheless remain risks for the economy as a whole that the markets do not help to control and which financial theory defines as “non-diversifiable”. Such risks are connected with the economic cycle or the alternation of periods of financial euphoria and panic, which tend to generate broad swings in asset prices and thus affect households’ wealth. In such circumstances, an important role is played by intermediaries that perform the function of converting risk via their balance sheets through the supply of such non-negotiable instruments as bank deposits and defined-benefit life insurance products. Financial innovation continuously redefines the interaction between markets and intermediaries. It is this process that determines the ability of the financial system to sustain the growth of the economy and offer instruments with adequate safeguards for households’ and firms’ savings. The growing competition between instruments, types of intermediary, and intermediaries and markets thus does not eliminate some of the features that distinguish the operations of banks, insurance companies and securities intermediaries. Banks necessarily have a large portion of their assets tied up in non-negotiable assets - loans. They retain a central role in the provision of payment services. They are the main channel for the transmission of monetary policy impulses, owing to the convertibility of deposits into legal tender. Insurance companies are characterized by the production of non-negotiable instruments that offer customers a guaranteed return even for the long term. Securities intermediaries are geared to efficient trading in securities. The liabilities they issue do not carry the obligation of redemption at face value and are not means of payment. The intensification of competition is a force for the increasing integration of specialized intermediaries within group structures. The reasons for integration are often to be found precisely in the field of asset management, where the overlapping between banking, insurance and securities business is most pronounced. Competition spurs the drive for ever greater size, permitting adequate diversification and the exploitation of economies of scale in the supply of individual and collective asset management services. The recent wave of mergers among the leading global intermediaries confirms the link between the enlargement of the market, the increase in competition and the effort to achieve critical mass. For instance, the merger between Union Bank of Switzerland and Swiss Bank Corporation, already the third and fifth-largest European banking groups at the end of 1996, created ˝ -6˝ an intermediary with some $680 billion of managed assets, nearly three times the total net assets of Italian investment funds. Competition and concentration are bound to intensify with economic and monetary union, which will eliminate the residual segmentations based on the currency of denomination of financial products. In the drive for efficiency, Italian intermediaries have also begun to centralize functions that were once performed by different operational units and not always integrated in operational or administrative terms. They are rationalizing the production and distribution of their different asset management services within group structures, but they have not yet attained the size needed in order to compete at the European level. Italian intermediaries can defend their position in the domestic market effectively, capitalizing on their customer relations and distribution capabilities. With respect to certain groups of investors, however, such as firms, foundations and wealthy individuals, the distribution network is of minor importance, and foreign intermediaries are likely to be increasingly effective competitors. Over the longer run, the spread of electronic sales networks and other marketing innovations will intensify competition in standardized products for the retail market as well. The acceleration of mergers and takeovers within the Italian banking industry and the growing recourse to forms of integration between credit and insurance institutions reflect the commitment to enhance the competitiveness of the financial system and to reposition the sector within the European market. Alongside the major intermediaries there is still room for local operators, but their success requires highly specialized production strategies, aimed at particular instruments and markets. Alternatively, these banks could concentrate on strengthening their distribution capabilities, perhaps through agreements with large-scale asset management institutions that do business in a number of different financial market centres, in order to obtain more sophisticated products and offer their customers a broader range of services. 5. The new regulation of asset management The erosion of the geographical and product barriers between markets, the creation of complex and internationally ramified groups, the increasing competition between different types of intermediaries and the growth of securities markets have enhanced the investment opportunities available to vast numbers of small investors; they have also called for a major effort to adapt the regulatory framework and the organization of supervision in order to protect the savings invested and the stability of intermediaries. The revision of the regulations governing the various financial sectors, partly in response to the process of harmonization within the European Community, has eliminated the competitive inequalities between different intermediaries operating in the same markets, created instruments for exercising control in order to counter the risks arising from the new forms of organization of financial activity. In Italy, the Consolidated Law on Financial Markets has responded to the problems posed by the new and diversified structure of supply by thoroughly overhauling the rules governing financial intermediaries and markets. ˝ The statutory innovations will allow Italian intermediaries to diversify and broaden the range of services they provide, adopt more flexible organizational structures and compete on an equal footing with foreign firms. The earlier legal framework restricted the scope for innovation, especially in the field of collective investment, where new types of investment funds could only be introduced by primary legislation. The extensive recourse made to secondary instead of primary legislation has removed the constraints on the diversification of products and services. In particular, the Ministry of Treasury is charged with the task of defining the principal characteristics of the various types of investment funds, with special reference to eligible assets (listed securities, unlisted securities, real estate, etc.), whether the fund is open or closed-end, and the nature of potential customers (small savers or institutional investors). The Bank of Italy is charged with regulating the management of investment funds’ portfolios. In addition to the earlier tasks associated with the prudential supervision of undertakings for collective investment in transferable securities (UCITS), it is now responsible for establishing the procedures and prohibitions for investment activity and for the limitation and diversification of risk. The most important innovation is the elimination of the separation between management on an individual basis and that on a collective basis with the creation of a single manager, the “asset management company”. Investment firms, banks and trust companies continue to be allowed to provide individual management services directly, while asset management companies are allowed to provide both individual and collective management services on an exclusive basis. The possibility of operating across the board will enable them to achieve higher levels of productive efficiency. The right to provide the two services jointly, which is consistent with the proposed Community directive currently under discussion on the collective management of assets, meets the needs of intermediaries and puts them in a better position to satisfy the preferences of their customers. At the same time, the prohibition on the supply of other services is an important defence against conflicts of interest. Major changes in the direction of greater flexibility have also been introduced at the organizational level. In particular: the management and promotion of funds may be separated and entrusted to different companies; managers may delegate investment activity within a set of criteria for the allocation of resources; and in the field of individual management services banks and investment firms may entrust the execution of management contracts to third parties, for part of the portfolio or even the entire portfolio, subject to written authorization by the customer. The granting of considerable autonomy in the organization of production reflects the belief that the supply of management services is a complex business with high fixed costs and large economies of scale. The importance of group structures in the financial industry and the related need to strengthen prudential controls suggested extending the scope of the rules on consolidated supervision to financial groups having at least one investment firm or asset management company. Responsibility for issuing the regulations lies primarily with the Bank of Italy, which is required to define such groups for supervisory purposes and draw up the prudential rules to be applied on a consolidated basis. The division of supervisory responsibilities according to purpose has been confirmed and further clarified for all intermediaries. Consob is entrusted with ensuring the transparency, ˝ -8˝ correctness and regularity of trading, while the Bank of Italy is responsible for the controls aimed at protecting investors and ensuring the capital adequacy and stability of intermediaries. Faced with the continuous and at times tumultuous development of financial markets, the debate on the optimal organization of supervisory controls sometimes appears to be conducted at an excessively abstract level. The experience of recent years shows that supervisory arrangements must be constantly adapted to the situations created by financial and technological innovation. The transfer of vast sums to the care of professional managers by small savers belonging to a wide range of social groups raises special issues with regard to financial stability. Naturally, there is no derogation from the principle that the result of delegated investment depends on the performance of the management scheme, which may involve both lower-than-expected rates of return and capital losses. Managers nonetheless have a special responsibility to safeguard the value of such savings. It is indispensable that management choices should correspond to the risk profiles accepted by investors and, more generally, that the rules on risk diversification should be observed. The prudential limits on operations established and monitored by the authorities become of great importance. The structural changes under way in the Italian financial system require the different supervisory regulators to intensify their coordination efforts. Effective cooperation among authorities enhances the effectiveness of controls, and the ability to forestall instability is the key to achieving the efficiency gains that the growth of financial markets makes possible. The consolidated law imposes an obligation on the authorities to collaborate, inter alia by exchanging information; they cannot invoke official secrecy in their dealings with each other. The importance of coordination is thus confirmed, in recognition of the dangers that inefficient cooperation is likely to entail for the integrity and efficiency of the financial system. At the same time collaboration must be informed by the principle of minimizing the costs borne by those subject to supervision. The globalization and increasing competition between financial centres that have accompanied the growth in asset management have also spurred a far-reaching reorganization of the securities markets. The consolidated law completes the innovations introduced by Legislative Decree 415/1996, which provided for the privatization of the stock exchange and the securities markets. The management of the markets is entrusted to limited companies that have private sector shareholders and self-regulatory powers in matters such as the admission of financial instruments and intermediaries to the market, as well as their exclusion and suspension. Consob is charged with the supervision of the regulated markets; the Bank of Italy has been given a primary role for the markets that are important for monetary policy purposes: the screen-based government securities market (MTS) and the interbank deposit market (MID). 6. International coordination The response to the growing integration of markets has been to complete the reform of financial regulations, with the creation of a system of controls that is basically neutral with respect to the nature of intermediaries and based on cooperation among supervisory authorities. The internationalization of finance results in cooperation among the authorities of different countries becoming of fundamental importance. The increasing openness of financial markets makes the exchange of information indispensable, requires a flexible interpretation of cooperation agreements and calls for the coordination of corrective measures. The links between ˝ supervisory bodies must be permanent, not restricted to crisis situations, and must involve both the authorities responsible for controlling intermediaries and those with powers over markets. The growth of asset management, where the activities typical of institutions engaged in banking, insurance and securities investment services intersect, has fostered the rise of financial conglomerates. The presence of these complex organizations creates new channels for the spread of possible crises; their international ramification and the existence of different types of intermediaries increase the difficulty of coordinating the supervisory bodies involved. Generally speaking, the emergence of a small group of very large global operators with substantial capital and highly diversified portfolios strengthens the financial system; the emergence of such a group nonetheless faces the international community with the problem of forestalling the possibility of an insolvency and defining instruments on an adequate scale for handling such an event. The supervision of financial conglomerates is hindered by the existence of unregulated entities, but problems also arise where all the components are subject to prudential controls. In the case of capital adequacy, it is necessary to avoid double and multiple gearing, which can result in the group as a whole failing to have adequate capital even though the individual units all satisfy their respective capital requirements. The ramification and strategies of groups can reduce the effectiveness of individual supervisory authorities’ prudential controls and make it less easy to overcome company crises. Risk control in the more complex financial conglomerates is often centralized in a single operating unit; the correspondence between company structures and lines of business ceases to exist; group activities are no longer covered by supervisory controls, which are divided by country, type of institution and product. Regulators are likely to encounter greater obstacles to the effective performance of their tasks because functions that are crucial to the sound and prudent management of the undertaking subject to supervision are carried on in a different jurisdiction. Awareness of these difficulties has led to an intensification of cooperative efforts in international fora. At the beginning of 1996 the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) set up the Joint Forum on financial conglomerates and charged it with the task of addressing the supervisory issues raised by these complex financial organizations. In particular, the Joint Forum has studied the practical means of facilitating the exchange of information among supervisory authorities, at both the national and the international levels, and has examined arrangements for facilitating the coordination of control activities both in ordinary circumstances and in crises. It has also drawn up a list of principles aimed at permitting more effective supervision of regulated institutions within financial conglomerates. The proposals put forward by the Joint Forum primarily concern the methods for evaluating the capital adequacy of conglomerates and verifying the integrity and experience requirements for corporate officers and significant shareholders. Common reporting formats have been prepared for use by authorities in order to improve their understanding and analysis of the structure and operations of conglomerates. The possibility has been examined of identifying one authority to act as coordinator with the aim of facilitating the exchange of information, permitting an overall assessment to be made ˝ - 10 ˝ of the riskiness and capital adequacy of groups, and improving the consistency of prudential controls and the timeliness of corrective measures. This hypothesis nonetheless requires that consideration be given not only to the benefits just mentioned but also to the danger that supervisory action will be made more complex and the safety net seen as having been extended to all the components of conglomerates, including those that are unregulated. As things stand today, coordination among supervisors has to rely on their practice of exchanging information, the knowledge each has of the others’ operating procedures and objectives, and trust in the opinions they express. Last February the documents prepared by the Joint Forum were distributed to supervisory authorities and market participants for them to put forward their observations and suggestions. It is important that financial industries, including Italy’s, analyze the proposals very carefully, in order to contribute to enhancing their effectiveness and utility, to the benefit ultimately of all market participants. 7. Conclusions The growth in asset management represents a major structural change and is common to all the leading industrial countries. In Italy, the growth of the industry has accelerated sharply in conjunction with the fall in interest rates over the last two years. The shifts in intermediaries’ strategies, the recomposition of their assets and the links created between the different types of intermediary suggest that the growth will not peter out once Italian interest rates come into line with those prevailing in the other countries that will be part of the European Monetary Union. The management of savings by institutional investors benefits from the development of the securities markets and, at the same time, contributes to their efficiency. It does not necessarily imply the disintermediation of banks. In Italy, the supply policies of the major banking groups have sustained the expansion of management services. The increasing competition, at the international as well as the domestic level, is stimulating the search for larger size through mergers and equity stakes that often give rise to financial conglomerates. The changes under way modify the exposure to systemic risk, the channels for the propagation of crises and the latter’s potential impact. The greater ramification of the financial market is likely to reduce the probability of a single intermediary’s difficulties spreading to the rest of the system. Nonetheless, the number and size of today’s financial markets and institutions mean that it may prove more difficult to limit the effects of a crisis where one does occur. Despite the progress made in adjusting the regulatory framework to the new reality of financial markets, supervisory authorities are faced with new challenges; the most important concerns the coordination of their action, both domestically and internationally. The crises that have occurred in the last few years show how fast tensions can be transmitted across countries, markets and intermediaries. Macroeconomic instability is likely to interact with elements of financial instability, spreading to the jurisdictions of several supervisory authorities, central banks and governments and involving international organizations. As globalization proceeds, the asymmetry between the integration of markets and the multiplicity of regulatory authorities increases the difficulty of carrying out supervision, calls for a parallel integration of supervisory action. Coordination and the timely exchange of information can increase the ability to forestall crises and help overcome them when they do occur. ˝ - 11 - The reform of the securities market and the opening of finance to international competition have broadened and strengthened the structure of Italy’s financial system and improved its allocative efficiency. Firms and households can turn to new intermediaries and new instruments. Firms can tap a wider range of sources of external finance, raise long-term debt and, above all, make greater use of equity capital. In this way they can achieve a more solid financial structure that is better able to sustain investment. Households have greater scope to diversify their financial portfolios with products that in the long run permit higher real rates of return. In today’s new conditions of monetary stability, the possibility of earning high returns at low risk that was a feature of the last twenty-odd years will no longer exist. In order to take full advantage of the opportunities offered by the development of the securities markets, intermediaries will have to make their investment choices keeping a close eye on economic fundamentals and firms’ capital solidity and earnings prospects. It is not only intermediaries who must be fully aware of the growing complexity of financial intermediation and of the related risks, but also the investors who entrust them with their savings. ˝ - 12 ˝ Table 1 Assets of institutional investors as a percentage of total financial intermediation Italy .................. as a percentage of GDP 4.0 12.4 14.9 17.1 6.0 19.5 22.3 29.8 France .............. 5.5 13.6 18.0 23.6 12.2 33.8 50.5 71.3 Germany .......... 12.2 14.3 14.6 15.3 22.6 28.8 33.9 36.4 Japan ................ 61.4 63.1 59.4 63.2 150.9 205.9 222.2 246.9 United States .... 50.4 56.2 61.8 69.2 89.8 127.5 148.9 188.1 United Kingdom 24.0 32.6 34.2 42.6 71.7 131.8 119.1 202.8 Source: OECD, financial accounts. Table 2 Assets under management in Italy (billions of lire - percentage) Investment funds 47,379 56,191 60,663 110,093 130,169 126,802 197,544 368,432 Portfolio management services1 65,022 92,824 105,329 142,929 180,959 192,438 260,584 372,456 39,604 49,718 62,402 70,893 69,276 84,693 94,867 107,951 Life insurance companies1,2 Pension funds n.a. 76,209 80,941 85,545 94,977 101,025 104,812 108,741 Total (a) 152,005 274,942 309,335 409,460 475,381 504,958 657,807 957,580 Domestic financial assets (b) 1,818,643 2,037,146 2,203,325 2,379,134 2,536,384 2,631,070 2,688,595 2,916,609 8.4 13.5 14.0 17.2 18.7 19.2 24.5 32.8 Memorandum item: a/b*100 Sources: Banca d’Italia, Abridged Annual Report and Economic Bulletin. The figures for 1997 are estimates. 2 Technical reserves excluding assets entrusted to portfolio management services. ˝ | bank of italy | 1,998 | 5 |
Speech by Sig. Pierluigi Ciocca, a Deputy Director General of the Bank of Italy, at a conference on 'La concentrazione nell'industria dei servizi finanziari:aspetti teorici ed esperienze internazionali' held at the Università Cattolica del Sacro Cuore in Milan on 12/11/98. | Mr. Ciocca discusses competition and mergers in the Italian financial system Speech by Sig. Pierluigi Ciocca, a Deputy Director General of the Bank of Italy, at a conference on “La concentrazione nell’industria dei servizi finanziari:aspetti teorici ed esperienze internazionali” held at the Università Cattolica del Sacro Cuore in Milan on 12/11/98. Introduction In the last twenty years there has been considerable consolidation in the credit field. The process began in the United States, where there have been more than 7,000 bank mergers since 1980. The United Kingdom was the first country in Europe to see significant merger activity, but it has spread to other countries, including Italy. The most frequently cited general cause of consolidation lies in the changes that have occurred in the external environment: advances in electronic data processing and telecommunications, provisions aimed at attenuating the institutional separation of intermediaries, and the contraction in the role of public pension systems. Among other things, these developments have fostered financial globalization, asset management services, the use of powerful IT systems, and a drastic reduction in data transmission and communication costs. The repercussions have not been restricted to international and wholesale markets but have also been felt in local and retail markets. Banks appear to have seen the larger scale of operations as offering the prospect of coping with these repercussions better. In Italy’s case, however, a key additional factor has been the increase in competition. The Italian banking system had entered the eighties with the low level of competition inherited from the past. The subsequent change was radical and the consequent narrowing of margins stimulated restructuring and consolidation. From the eighties onwards, the dictum of comparative statics “more concentration, less competition” has been replaced by the dynamic alternative “more competition, more mergers”. The premise, already tested in analyses carried out by the Bank of Italy, was that the Italian banking system — traditionally marked by a low degree of concentration and banks of limited average size with multiple branches — offered not only plenty of niches for small banks but also considerable scope for economies of scale. This potential is at last being realized, in the international context I have just described, under the pressure of the “novelty”, at least for Italian banking, represented by the growth in competition that the Bank of Italy has been pursuing. In my remarks I shall touch on three aspects of these complex processes, the outcome of which is still wide open: a) antitrust action can forestall the adverse effects of consolidation on competition and reinforce the beneficial effects; b) the Bank of Italy, both before and after 1990, has pursued a policy aimed at fostering the efficiency of the banking system through competition; c) more competition, consolidation and restructuring remain objectives to be pursued, even though they are only necessary, and not sufficient, conditions for increasing the competitiveness of the Italian banking system, which is still burdened by high operating costs. Mergers and the protection of competition A high degree of concentration and a small number of large banks that enjoy growing economies of scale represent a situation that needs to be watched carefully. It is necessary to ensure that mergers bring benefits for customers and not an increase in market power. The law recognizes the threat that concentration poses for competition. Nonetheless, the traditional attitude towards mergers has been attenuated, in view of the positive effects that they are capable of producing. In Italy, Article 6 of Law 287/1990 defines the scope of antitrust action. The ban on mergers applies to those that would create or strengthen a dominant position that is detrimental to competition. Antitrust law, in turn, can supplement the monitoring of mergers with a range of alternative instruments. Controlling a firm’s behaviour may prevent it from exploiting its position to discriminate against competitors. Controlling the agreements between competing firms may prevent such understandings from distorting the play of competition. In addition, there is the action — which does not derive directly from antitrust law in the strict sense of the term and which often falls within the scope of several institutions’ authority — aimed at ensuring the contestability of markets, at making it possible for other firms to enter the market and erode the dominant firm’s profits. Freedom to enter the market must be coupled with freedom to leave the market by keeping down the sunk costs of withdrawing, allowing inefficient firms to go to the wall, and making it effectively possible for entrepreneurs to sell all or part of their businesses. The provisions concerning the abuse of dominant positions and agreements detrimental to competition, together with control of the effective freedom to enter and leave the market, make it possible to take a fairly relaxed view of most mergers and acquisitions, bearing in mind that in particularly serious cases operations hindering competition may be prohibited at law. It should also be noted in this respect that the parties can be required to dispose of assets or to adopt other measures like to ensure sufficiently competitive conditions. This practice is widely followed in the banking sector: in the United States some recent mega-mergers have been waved through subject to the mandatory disposal of assets equivalent to between 5 and 13 per cent of the deposits acquired. The banking industry still has several distinctive features, especially as regards the taking of deposits and the granting of loans. One important sunk cost is related to the information content of the customer relationships on which lending decisions are based, an asset that is not easily marketable. Credit relationships involve an information asymmetry between borrowers and lenders that results in their not being completely fungible. Small banks that establish particularly close relationships with their borrowers enjoy an information advantage. This explains why it is difficult for banks to enter directly into geographical markets in which they were previously absent; indirect growth by acquiring existing banks or branches is often the easiest way to overcome this barrier and enter a retail market characterized by information asymmetries. At the same time this peculiarity is likely to act as an exit barrier, thereby reducing the incentive to enter the market and the potential competition. Sometimes the authorities themselves encourage mergers in order to remove inefficient banks from the market without their having to be put into liquidation, with all the costs the resulting termination of customer relationships entails. The scope for mergers is accordingly a condition for keeping down market entry and exit barriers and thereby reducing the probability of collusion. A market for the control and ownership of banks that works is a necessary condition for the efficiency of banking as a whole. Mergers also make the financial market’s assessment of banks more effective; larger credit institutions are encouraged to open up their ownership structure to third parties and the stock market in order to increase their ability to raise equity capital. On the liabilities side of banks’ balance sheets, the demand for deposits and accessory services is still linked to customers’ physical closeness to branches. The evaluation of mergers must therefore take into account not only imperfect contestability but also the evolution of local markets and the conditions effectively applied to customers. Lastly, credit intermediaries are multi-product enterprises and often operate in several markets. Mergers between diversified intermediaries will have a different impact on the ability to be present in the various markets — for loans, deposits, payment instruments, securities business, asset management, leasing, factoring, consumer credit and corporate finance, etc. When assessing mergers, account therefore needs to be taken not merely of the increase in the degree of concentration in one market, but also of how competitive conditions change in the other markets. The Bank of Italy and the promotion of competition From the end of the seventies onwards the action taken by the Bank of Italy has been aimed at increasing competition in the banking and financial system. The powers of authorization assigned by law to the Bank as the body responsible for supervision were exercised from the twenties onwards according to the principle of competition. In the “Branch Plan” drawn up in 1978 the Bank explicitly announced the objective of fostering competition in the banking industry: the opening of branches was envisaged primarily in the areas where the concentration of loans and deposits was highest, and not infrequently monopolistic. Thus the Bank of Italy placed competition at the centre of its policy aimed at increasing the efficiency and solidity of the banking and financial system well before it was granted formal antitrust powers in 1990. The precondition for the change in the Bank’s approach was the abandonment of the idea — widely held after the crisis of the thirties, not only in Italy and not only among central banks — that competition, or “excess” competition, caused banking instability and was antinomic with respect to stability. On the contrary, and especially in the conditions of international openness typical of the Italian economy in normal circumstances, an inefficient banking system is bound to be prone to systemic instability, even though oligopoly allows it to be profitable. A powerful stimulus to achieve profitability and hence a congruous capital base through efficiency could clearly be detected in the increase in competition in the domestic banking and financial markets. Increased competition therefore became the key intermediate objective, the fulcrum of the Bank of Italy’s monetary, exchange rate and supervisory policies. Without competition, in the long run there cannot be efficiency; without efficiency, in the long run there cannot be stability in the banking and financial industry. A further consideration, rooted in the economic theory upon which antitrust legislation is based, was that laisser faire and competition were not the same thing, that the former could override the latter (especially in an industry with economies of scale), and that deregulation was likely to be more effective if set within the framework of an economic and institutional policy aimed at protecting and strengthening competition and ultimately imposing it on producers who might well not like it. The attribution to the Bank of Italy of responsibility for implementing antitrust law in the banking field was thus not a break, an anomaly to be removed later. It was the natural, institutional, recognition of a state of affairs that had already existed for tens of years. Above all it sanctioned a principle that must be consolidated and applied more widely: not only are prudential supervision and the protection of competition not in conflict, but they are rigorously complementary. The declarations of intent, the strategic decisions, the single acts with which the Bank of Italy interpreted and applied these general criteria in practice have been many and spread over twenty years. They cannot all be listed here, but I shall briefly indicate the most important in a series of summary points: • the first, absolutely fundamental, step was taken at the beginning of the eighties with the reaffirmation of the notion of banks, both publicly and privately-owned, as enterprises. In the wake of the transposition of the EEC’s First Banking Directive of 1985, the issue was finally settled in a judgement handed down by the Court of Cassation in 1989. The transformation of publicly-owned banks into companies limited by shares followed, as provided for in Law 218 of 1990; • between 1985 and 1990, while the amendments to the law that would lead to the new Banking Law of 1993 were being enacted, administrative measures were adopted attenuating or eliminating the restrictions in fields such as branching, fund-raising and lending beyond the short term, and the creation of new banks. The growth of individual banks was increasingly related, by way of solvency and gearing ratios, to the amount of capital they were able to bring into play; • starting in the early eighties, the quantity, the quality and the diffusion of the information disclosed by banks to customers and the market were enhanced; • by the end of 1988 the shift from direct administrative instruments to indirect market instruments in implementing monetary policy had been completed; • in response to the need to place growing volumes of public debt with domestic investors, steps were taken to create efficient money and bond markets. The share of bank deposits in households’ financial assets fell from 53 per cent in 1979 to 34 per cent in 1990 and stands at 25 per cent today; • the removal of exchange controls was started in 1988 and completed in 1990, with the result that, for the first time in its history, Italy had a fully convertible currency and complete freedom of both short and long-term capital movements. All the indicators show that the degree of competition in the Italian banking system increased significantly in the eighties. Between 1979 and 1989 the average number of banks present in each province rose from 20 to 27. The concentration of the loan market fell by 15 per cent nationwide and by 20 per cent in the Centre and South. The differential between the average bank lending rate and the pre-tax yield on Treasury bills narrowed from 5 percentage points in 1980 to less than 1 point in 1989 and this happened in a period which saw the riskiness of bank credit increase slightly. The spread between lending and deposit rates also narrowed, declining initially from more than 9 percentage points in 1980 to less than 7 points in 1989. Inevitably, these developments resulted in the margins on credit business coming under pressure. In 1990 the law establishing the Competition Authority (Law 287/1990) made the Bank of Italy responsible for the antitrust function in the banking sector. The choice was made in view of the specific technical nature of banking and the complementary nature of prudential supervision and the protection of competition. In the United States, with its century-long tradition of antitrust legislation, the situation is similar since the Federal Reserve or the Office of the Comptroller of the Currency, according to the banks involved, are responsible for evaluating the anticompetitive effects of mergers. The Department of Justice cooperates with the regulatory authorities and in extreme cases may bring a legal action against an operation. In Europe, it is worth mentioning the case of the Netherlands, where, in establishing a Competition Authority at the beginning of this year, the law provisionally assigned the protection of competition in the banking and insurance industries to the respective supervisory authorities. Other antitrust authorities are also beginning to recognize the specificity of the banking sector and, as in Canada, have issued special instructions for the evaluation of bank mergers. The growth in competition has continued in the decade that is drawing to a close. Following the decision taken by the Bank of Italy in 1990 to liberalize banks’ branch networks by abandoning the system of “branch plans”, the number of branches increased as never before, rising by 10,000, or more than 60 per cent, to 25,600 in June of this year. At the end of 1989 there were 1,173 banks in Italy, of which 83 were medium-term credit institutions or sections. By the end of June the number had fallen by more than 20 per cent to 937, of which 120 belonged to banking groups. In recent years the process of consolidation has involved large commercial banks, partly in response to the prospect of an integrated European market with a single currency. The average number of banks present in each province has risen further to 30. During the nineties the differential between the average bank lending rate and the pre-tax yield on Treasury bills has tended to remain close to its level at the end of the eighties. But, partly owing to the rather weak performance of the economy, this decade has seen a sharp increase in the average riskiness of loans and a deterioration in the quality of banks’ assets. Hence, the stability of the differential between bank lending rates and the yield on government securities is further evidence of the increasing competition within the banking industry. The differences between the lending rates applied in the various parts of the country have also narrowed in the last four years after peaking in the second half of 1994. The difference between the rates on short-term lira loans in the North and the South is currently around 2 percentage points for non-financial companies and about 1.5 points for producer households. The gap is entirely attributable to the greater average riskiness of lending in the South and the longer time it takes to recover credits there. The ratio of bad debts to total loans disbursed to customers in the South is 22 per cent, as against 7 per cent for borrowers in the Centre and North. Analyses carried out at the Bank of Italy show that, after adjusting for the risks that materialized, the geographical differential disappeared in the early nineties. The spread between lending and deposit rates has narrowed further and now stands at 4.5 percentage points. The growth in competition has contributed to a substantial redistribution of banks’ shares of the loan market. The major changes that occurred after the ceiling on bank loans was removed were followed by further large shifts in the two years 1989-90 and from 1995 onwards. In the last three years the market shares that changed hands each year were equal to around 4 per cent of the total loan portfolio on average, excluding the amounts directly affected by mergers. The increase in competition has led to banks adopting more aggressive supply policies and growth strategies more closely attuned to demand. Mergers and acquisitions in the Italian banking system Between 1990 and 1997 the Bank of Italy, pursuant to the provisions of antitrust law applying to the banking sector, examined some 300 proposed mergers and acquisitions. The banks in play grew steadily larger. In the last four years the banks involved accounted for 7 per cent of the banking system’s total assets on average each year. The consolidation process has had a particularly pronounced impact on the southern banking system, partly as a result of the acquisition of the control of local banks in difficulty by banks situated in the Centre and North. In ten cases the Bank of Italy decided to examine proposed mergers in order to verify whether the operation was likely to create or strengthen a dominant position and prejudice competition. In four of these cases the go ahead was made conditional on measures aimed at protecting competition in the market in question. Another ten examinations concerned agreements suspected of being detrimental to competition. The investigation of industry-wide standard terms and of payment instruments were especially important in this respect. In its recently published findings on the rules governing the use of the PagoBANCOMAT card, the Bank of Italy identified several circumstances that were potentially anti-competitive and made its approval of the agreement conditional on a number of changes that will help to make the market more competitive. The Bank of Italy also investigated five alleged abuses of dominant positions. In four of these cases the banks were accused of using their exclusive right to provide tax-collection services to gain undue competitive advantages in neighbouring credit markets. In the fifth case the Bank took action to prevent the bank from exploiting its dominant position to expand its branch network abnormally with the aim of obstructing the entry or growth of competitors in the market in question. In addition to its normal examination activity, in 1996 the Bank of Italy investigated the possibility that banks were coordinating their pricing policies, but found no evidence of such practices. In 1997, in agreement with the Competition Authority, it conducted a general factfinding inquiry into the corporate services sector. In the nineties the consolidation of the Italian banking system has proceeded primarily by means of mergers and amalgamations, of which there had been 265 by the end of 1997. Acquisitions of the control of banks that subsequently continued to operate as separate entities also played an important role, with a total of 91 such takeovers. Even where these operations have not yet significantly reduced operating costs, they have allowed capital to be used more efficiently and brought tax benefits, increases in fee income and improvements in the quality of the acquired bank’s loan portfolio. Mergers between banks which are not present in the same markets, or with only limited overlap, increase competition. By contrast, the “market power” effect tends to prevail over the efficiency effect where the merging banks both have a large presence in the same market. These findings confirm the continued importance of the physical closeness of customers to their banks and the need for the attention that the competition authorities pay to local markets. Mergers inevitably impact the payment system and the stability of the banking sector. By diminishing the number of participants in the payment system, they tend to reduce the volume of transactions to be settled. The setting of operational and technological standards aimed at exploiting network economies may well be easier. On the other hand, larger banks are likely to cause more serious problems in the event of insolvency: the overall effect of mergers on the stability of the payments system will depend on how they affect the riskiness of the individual banks. Competition, consolidation and costs Competition, consolidation and reorganizations have helped to curb operating costs in relation to the total assets of the banking system. In the three years from 1995 to 1997 this ratio averaged 2.4 per cent, compared with 3 per cent in the second half of the eighties. Nonetheless, partly as a result of the rigidity of the Italian labour market, the competitive gap between Italian banks and their counterparts abroad, which is attributable primarily to the greater incidence of staff costs, has not narrowed in the nineties. In 1997 bank staff costs amounted to 43 per cent of gross income in Italy, compared with an average of 38 per cent in France, Germany and Spain. The agreements between employers and the trade unions to reduce the cost of labour, prompted by the Bank of Italy and promoted by the Government, have not yet been given effect in a new wage agreement linking earnings more closely to a bank’s performance. Significant cost savings, as well as increased revenues, can be achieved by modernizing structures, reorganizing production processes and developing innovative distribution networks. Other banking systems have invested a substantial volume of resources, deriving in part from savings in staff costs, in technological innovation, thereby acquiring competitive advantages on several fronts. The increase in competition in banking markets, further intensified by foreign intermediaries accustomed to operating on a larger scale and with smaller interest rate spreads, has sharply reduced the profitability of Italian banks’ traditional activities. The fall in net interest income, which began several years ago and will be accentuated by the introduction of the euro, has not been offset by a lasting increase in revenues from innovative activities: corporate advisory services and finance, the administration and management of households’ savings, and business in the international securities markets. In the first half of the eighties Italian banks’ return on equity was in excess of 14 per cent, in line with that of the other leading European banking systems. Since then it has fallen, reaching a low of around 1 per cent last year. Apart from the level of costs, the large loan losses incurred in the last few years have made a major contribution to the decline in profitability. The risk-asset ratio of the Italian banking system is 13 per cent, well above the requirement of 8 per cent established in the Basle Capital Accord. Only a very few banks are below this limit and the total shortfall is around 500 billion lire. The decline in profitability has nonetheless reduced the flow of internally-generated resources with which to finance growth and merger operations. The larger banks have suffered especially in this respect: at the end of last year they held less than one third of the free capital of the banking system, as against 80 per cent of its total assets. The lack of free capital, not tied up in tangible and financial fixed assets and available for acquisitions, will curtail the scope for modernizing the system and pursuing efficiency. The intermediate objective pursued over the last twenty years has been largely achieved; there is more competition, there have been numerous mergers and a start has been made on reorganization projects that promise to improve efficiency. Competition has produced its full effects on the prices of banking products and services, holding them down and making them more uniform. But other benefits have been, still are, slow in coming: lower costs, international competitiveness, profits and fresh capital generated by efficiency and the quality of services. The picture is thus chiaroscuro. Disappointment should only be felt by those who fail to recognize that competition fosters efficiency but cannot guarantee it where producers lack the ability to respond — à la Leibenstein — to the competitive stimulus. It is necessary to appreciate how much inertia has to be overcome in a complex process that is more cultural than juridical or institutional, in short the “passage” from oligopoly to competition of an industry that is based on information asymmetries, bilateral customer relationships and the reputation of producers. This journey was bound to be laborious and slow, especially in Italy’s case. The Italian banking system arrived at the world economic crisis of the seventies after two postwar decades in which its oligopolistic nature had become deeply rooted, while the economy had enjoyed an extraordinary boom. The model formulated by Donato Menichella and Raffaele Mattioli had “worked” in a certain sense; it had met, albeit with the inefficiencies that were the inevitable corollary, the demand for credit and money of the Italian economy in that buoyant phase. The subsequent resistance to change cannot be entirely attributed to the reluctance of any industry to face the forces of competition or to the natural tendency to continue to do things in the same way. To give way to counterfactual criticism based on hindsight — such as, the injection of competitive enzymes should have been much larger and more intense — would be not only sterile but also debatable in theory and risky in practice. It is analytically doubtful whether it would have been possible, given the context. It is sufficient to mention just one aspect referred to earlier: the uniform treatment of banks and enterprises and of banks in the public and private sectors became a part of Italian law — as a result of the judgement of 1989 — ten years after the supervisory authority had clearly stated the principle. The risk at the practical level is that at this point banking competition will be seen as a missed opportunity, and that this will lead to the idea of renouncing it in the future. The position of the Bank of Italy is to proceed, if possible with greater determination, on the road taken twenty years ago — not only because the single market, the euro and their rules leave no option, and not only because the law in force in Italy today mandates this course, but in the belief that the progress that has already been made is in the right direction, even though competition on its own, it is worth repeating, does not guarantee an optimal financial system. The Bank of Italy will devote more resources, a revised internal administrative structure focused on banking competition, and additional analyses serving to underpin new interventions to the task of fostering competition in the markets in which banks operate and the mergers they autonomously plan. Two changes that are already under way will also produce their effects. Mutually reinforcing, they should, together with competition in the markets for banking products, stimulate efforts to achieve the cost reductions and quality improvements that are necessary. The first change is the privatization of the banks that are still under public control, the second concerns the exit procedures aimed at preventing moral hazard and the neglect of costs. The transfer of the ownership of banks to the private sector is the precondition for control to be contested in the market. In the last few years the process of privatizing public banks has gathered pace, in parallel with the growth in mergers. Including the operations that are currently being organized, the share of the banking system’s assets in the hands of banks of which the state, local authorities or foundations own the majority of the capital will shortly fall to 20 per cent, as against 70 per cent ten years ago. BNL is about to be privatized. The Monte dei Paschi di Siena foundation, the only one that still owns all the capital of a major bank, has recently decided to place some of its capital in the market and to seek a stock exchange listing. The prospect of contestability opened up by bank privatizations has been strengthened by the changes to the legal framework introduced by the Consolidated Law on Financial Markets, which came into force in July of this year. The new rules serve to increase the disclosure of information, enhance the efficiency of the financial markets and the contestability of control — in the case of listed companies partly through the revision of the provisions governing takeovers. There are 25 commercial banks listed on the stock exchange; they account, directly and indirectly via listed and unlisted subsidiaries, for 50 per cent of the banking system’s total assets. In addition, there are 10 cooperative banks listed on the stock exchange, accounting for 10 per cent of total assets, and another 7 banks are listed on the ristretto market. Although the Community authorities recognize the specific features of the banking sector, their application of Article 92 of the Treaty to banks tends to be rigorous. The authorization of state aid to some large European banks has been made conditional on their disposing of assets, parts of the business and equity interests. The fact that bankers will be able to count less on public support means they will have to adopt even more stringent criteria of autonomous, sound and prudent management. The number of banks in distress that have been consolidated (by means of mergers, amalgamations and takeovers) or placed under special administration or in liquidation has increased in the nineties, in both absolute and relative terms. The ratio of the number of such banks to the total number rose from 1.5 per cent in 1990 to an average of 4.3 per cent in 1996 and 1997; the ratio of their assets to the total assets of the banking system rose from 0.2 per cent to nearly 6 per cent. The increase in the number of such interventions with respect to troubled banks has been partly due to the increased emphasis on the preventive nature of supervisory action. Since the action is taken when the troubled bank still has a net value, it is possible to look for market-based solutions and hence to reduce the burden borne by the deposit protection system or the public finances. The proportion of troubled banks subjected to restructuring that were liquidated rose from 6 to 16 per cent between 1990 and 1997. In terms of their assets, the ratio rose from just a few percentage points at the beginning of the decade to 11 per cent in 1997. The potential for the development of the financial sector, in both quantitative and qualitative terms, that the Italian economy requires and that it can achieve is considerable, probably greater than in most other European countries. The Bank of Italy remains committed to ensure, with the instruments the law provides, that this further development takes place in a competitive environment and in conditions of greater efficiency. | bank of italy | 1,998 | 11 |
Address by the Governor of the Bank of Italy, Dott Antonio Fazio, at a conference organised by AIAF-AIOTE-ASSOBAT-ATIC-FOREX in Verona on 30/1/99. | Mr Fazio considers the world economy and finance in 1999 Address by the Governor of the Bank of Italy, Dott. Antonio Fazio, at a conference organised by AIAF-AIOTE-ASSOBAT-ATIC-FOREX in Verona on 30/1/99. The effects of the collapse of the Asian currencies in 1997 spilled over to the world economy in 1998; the crisis spread to Russia and other East European countries and to Latin America. The crisis in Asia followed the sharp decline in domestic demand in Japan. The sudden change in expectations generated rapid capital outflows and currency depreciations that exceeded some 50% in Korea and Thailand and 40% in Malaysia and the Philippines. In 1998 the Korean and Thai currencies recouped half the value they had lost. The Indonesian rupiah lost half its value in 1997 and another 20% of its initial value in 1998. The economies of Latin America withstood the wave of instability from Asia in 1997 but in 1998 were caught up in the crisis following the devaluation of the rouble. The currencies of Brazil, Mexico, Venezuela and Chile came under strong downward pressure. The speculative attack of midJanuary 1999 initially focused on the Brazilian Real. Argentina has stuck to the exchange rate fixed with the dollar under the institutional arrangement adopted for the peso. Since the devaluation of 1994, China has maintained a close link with the US currency. The swings in share prices in the countries hit by the crisis have paralleled those in exchange rates but have generally been more pronounced. In Japan, the stock market fell by a quarter in the last two years and has fallen further in the last few weeks; the yen first weakened then strengthened considerably in the last part of 1998. Last year the Korean stock exchange gained as much as it had lost in 1997. The falls in the currencies and stock exchanges of Asia have been mirrored by rises in the US and European currencies and stock markets, fuelled in part by the outflow of funds from Asia. Despite its high initial level, the S&P index rose by 60% in the two years 1997–98. The gains on some European exchanges were even larger. The crisis in Latin America All the major countries of Latin America continued to run large current account deficits in 1998. Brazil’s deficit grew to 4.2% of GDP, and the pattern in Mexico, Argentina and Chile was similar, with the deficit rising to 3.5, 4.5 and 6.8% of GDP respectively. The ratio of Brazil’s net external debt to GDP is of the order of 25%. In Mexico, Venezuela and Chile, the ratio is close to 40%, in Argentina to 30%. The debts are mainly denominated in dollars. In the last few years these economies were marked by rapid rates of growth and lower inflation than in earlier decades. In several cases budget deficits were substantial. In some respects there was a repeat of the experience of the Asian countries. A prolonged period of growth was financed with imports of foreign capital, mostly at short term. In Asia, the capital inflows had financed investment that in many cases exceeded 30% of GDP in 1997. In Latin America, by contrast, foreign capital also financed the current expenditure of the private and public sectors; investment fell to around 20% of GDP. In summer 1998 the stock markets of Brazil, Mexico, Argentina and Chile had already turned bearish. Interest rates were raised steeply to defend the exchange rate. –2– The tensions subsequently abated, thanks in part to the reduction in US official interest rates and the approval of the stabilisation plan agreed by Brazil and the International Monetary Fund. It was possible for interest rates to come down and shares recouped some of the earlier losses. Confidence in the exchange rates and stock markets of Latin America and some Asian and East European countries was undermined in 1998 by the uncertainty surrounding the solution of Russia’s financial problems and the effectiveness of Brazil’s stabilisation policies. The sharp fall on the stock market at the beginning of this year and the collapse of the Real following the decision to allow it to float halved the dollar value of Brazilian shares. In the days that followed their prices rebounded, rising by 30% in a single day; subsequently, however, there have been further falls in the exchange rate and share prices have gyrated. The world economy The slowdown in effective demand that began in Asia in mid-1997 gradually affected the rest of the world. The Japanese economy, which had been recovering in 1996, grew by only 1.4% in 1997. Growth remained rapid in North America and the United Kingdom and satisfactory in the continental European countries. It was particularly slow in Italy: 0.7% in 1996 and 1.5% in 1997. The crisis that struck in Asia in mid-1997 did not prevent an appreciable increase in consumption, investment and GDP in the area for the year as a whole; the exception was Thailand, where strains in the external accounts had already emerged at the end of 1996. Growth in Latin America continued at a very rapid pace in 1997: 8.6% in Argentina and 7% in Mexico. In Brazil the loss of competitiveness and subsequently the tensions in the financial and foreign exchange markets slowed down growth. In 1997 world exports recorded a particularly large increase of 9.9%, compared with 7% in the previous year. The demand of the emerging economies, still buoyant, sustained the cycle in the Anglo-Saxon countries and continental Europe. The full force of the crisis was felt in 1998 when expansion in world trade fell to 3.3%. Growth turned sharply negative in Asia, with GDP contracting by 7% in Korea, 7.5% in Malaysia and 8% in Thailand. The fall in imports and to a lesser extent the rise in exports inverted the sign of external current account balances for the first time in many years and generated sizable surpluses. The crisis took on political and institutional overtones in Indonesia, where GDP is estimated to have contracted by 15%. On the basis of the data available, the Chinese economy appears to have suffered only a slowdown in growth; the deceleration in the Philippines was more pronounced. Throughout the area, economic activity tended to stagnate. Partly owing to the depressed conditions in the rest of Asia, the performance of the Japanese economy continued to deteriorate in 1998. Investment contracted further, by more than 10%. Signs of deflation became increasingly evident in prices, domestic demand and business expectations. In Latin America, too, domestic demand and economic activity gradually slowed down during 1998. The problems afflicting the Asian, Latin American and Russian economies and the improvement in their competitiveness as a result of currency devaluations adversely affected demand in the industrial countries. –3– The impact on domestic demand and growth was already visible in the exports of the G7 and euro area countries. Effective demand remained high in the United States, where the increase in domestic spending was easily financed with growing imports of saving from the rest of the world and the supply of dollars on the international market. US demand for goods helped attenuate the crisis in Asia; it has so far prevented the economies of Latin America from declining faster. Business confidence nonetheless waned; after rising by 20% in the first quarter and 13% in the second, investment slowed down further in the second half of the year. In Japan expectations regarding the economy had already turned down in mid-1997. In continental Europe, business expectations deteriorated steadily in 1998. The recovery of investment that had begun in the second quarter of 1997 continued until the early months of last year; it was brought to a halt in the spring by the persistence of the crisis in Asia and its propagation to the East European transition economies and Latin America. The growth in GDP also slowed sharply before recovering slightly. The climate of households’ confidence was less negative. According to the IMF, output in Germany, France and Italy was well its potential level from 1993 onwards. The current account of the balance of payments of the euro area continued to show a surplus of 0.8% of the area’s GDP. After rising substantially in 1997, the volume of exports slowed sharply during 1998; the volume of imports also declined markedly. The cyclical recovery expected in the second part of this year is still uncertain. The low level of interest rates does not appear sufficient to trigger a widespread increase in investment. There are still no signs in the area of expectations of a vigorous and sustained recovery in economic activity in the medium term. The uncertainty surrounding the recovery of international trade in 1999 is related to the prospect of only modest growth or even continued recession in the Asian countries affected by the crisis, the possibility of mounting difficulties in the transition economies and the halt in growth in Latin America. Notwithstanding the sharp deceleration in economic growth in some regions, the international trade imbalances that have contributed to the abnormal increase in world finance and to the recurrent crises of recent years have not yet been corrected. The decline in demand and economic activity in 1998 means that many Asian countries risk performing poorly again in 1999. They will continue to record large surpluses on their external current accounts. Growth in Latin America will continue, but much more slowly than last year; current accounts will remain in deficit. The euro area still has a current account surplus; the US deficit and Japanese surplus are still growing. The slowdown of the world economy is stretching into 1999. Unemployment in Japan, although extremely low in comparison with that of other industrial countries, is rising sharply. Economic activity was still weak at the end of 1998. The support provided by monetary policy ceased to be effective a good while ago. Monetary expansion is –4– nonetheless providing the liquidity needed by the banking system, where the quality of credit continues to decline. The rescue operation prepared by the Government provides an assurance of solvency. It is essential that the planned massive reflation by means of budgetary policy revive domestic demand and set the economy back on a growth path this year. It is essential, as indicated by the G7 finance ministers and central bank governors at their meeting in Washington last October, that the growth in the United States be accompanied by a substantial recovery of domestic demand in Europe. It was emphasised that, in order to create expectations favourable to a recovery of investment, farreaching structural reforms are needed in the labour market and public expenditure. The United States and Canada, Europe and Japan produce approximately half of gross world output. They have the resources, or can attract them from the rest of the world, to sustain domestic demand and strengthen economic activity. There are clear signs of a deficiency of demand, especially for investment goods, in Europe and Japan. Only a faster rate of economic expansion in the industrial countries can prevent the world economy from stagnating and ensure a return to growth. The growth of money and world finance In the mid-1980s the bonds circulating in the G10 countries, issued almost entirely by governments, amounted to $6.3 trillion, or 70% of these countries’ domestic product. In 1996 the stock of bonds had tripled to reach $21.7 trillion; output at current prices had doubled., the ratio had risen to 105%. The stock of shares increased faster; the value of bonds and shares rose from 116% of GDP in 1985 to 220% in 1996. The growth in the quantity of money also exceeded that in output; the reduction in the income velocity of circulation was concentrated in the second half of the 1980s. The rigorous monetary policies of the 1990s have kept the ratio of the quantity of money to GDP in the G10 countries unchanged at close to 60%. The picture changes, with a larger increase in liquidity, if account is taken of cross-border bank deposits. Interbank deposits and those held by nonbanks grew at an annual rate of 11%. According to data reported to the Bank for international Settlements, the former amounted to 21% of world GDP in 1996 and the latter to 6%. Derivative products have made a decisive contribution to the increase in the liquidity of the world economy since the early 1990s, when the growth in the quantity of money was brought under tighter control. Their notional value rose from 25% of world output in 1990 to more than 100% in 1996. The use of derivatives increases the volume of transactions in financial assets that can be carried out with the existing money balances: the demand for and supply of securities increases by a multiple of the available liquidity. Derivatives permit more efficient risk management; but, used improperly, they entail the risk of instability for market participants. One fundamental reason for the increase in the market value of shares has been the growth in the actual and potential liquidity of national and international financial markets. The reduction in long-term interest rates, fostered by low inflation and a curbing of budget deficits, can also be traced to the same cause. –5– The abundant supply of liquidity in the markets is the consequence of the US balance-of-payments deficit and the monetary expansion in Japan, which accelerated in mid-1995 in the wake of the Mexican crisis. Following the Asian crisis, large liquid balances were channelled into dollardenominated instruments and into the European markets. The Italian economy The exports of the United States, Japan and the United Kingdom declined in the first half of 1998. Those of the euro area countries continued to rise, although this was largely due to France and Germany, which recorded annualised increases of respectively 3.4 and 2.8% compared with the second half of 1997. In Italy, the volume of exports contracted in late 1997 and the first few months of 1998, followed by a temporary recovery. The trend at the end of the year appears to have been downward again. Imports did not decline until the second half of the year; prices fell significantly. The surplus on the current account of the balance of payments was to 2.2% of GDP, as against 3.2% in 1997. The recovery in investment that had begun in spring 1997 faltered in 1998. Investment in construction has continued its downward trend. The pick-up in household consumption has proceeded regularly but at a pace that remains modest. Industrial production remained broadly unchanged for most of the year. Preliminary estimates for January 1999 indicate that output will be at about the same level as in January 1998. Firms’ expectations of new orders deteriorated steadily for most of last year. Households’ confidence, though lower in the second half than in the first, remains relatively high. Thanks to the introduction and extension of forms of flexibility in labour practices, employment has staged a recovery; the number of part-time and fixed-term contracts has increased considerably. On the basis of labour force survey data, the number of people employed increased by 0.5% on average for the year in the Centre and North and by 0.6% in the South. The increase was accounted for mainly by the weakest groups, women and young people. Given Italy’s low participation rate, however, the number of job seekers has also increased. The unemployment rate in the Centre and North declined marginally in the 12 months to October, from 7.7 to 7.6%. In the South, unhappily, it increased further, from 22.6 to 23.2%; youth unemployment in the region rose to a new peak. The use of saving Saving is the raw material of investment and growth. The large quantity generated is not all put to use domestically; it is necessary to create the conditions for it to be turned into investment to the benefit of employment in Italy. Analysis of the balance between the formation and use of saving, in a period marked by high unemployment and sluggish investment, highlights the lack of domestic demand and, indirectly, the shortfall in competitiveness. A succession of current account surpluses in the six years from 1993 to 1998 enabled Italy to bring its net external position into balance. A high level of foreign debt is inappropriate for an advanced industrial economy and the primary cause of continuous weakening of the exchange rate and inflation. –6– The achievement of a sound external position was a necessary condition for stabilising the exchange rate and consolidating the value of the currency. In the private sector, the flow of saving declined further in relation to disposable income in 1998; its use in the domestic economy to the benefit of growth and employment remained inadequate. The external current account surplus amounted to 45 trillion lire in 1998; in absolute terms it was in line with the figure for 1995; it was one third less than in 1996 and 1997. A substantial part of the surplus is regularly reinvested abroad, passing through Italy’s financial accounts. The “errors and omissions” item of the balance of payments resulted in about half the current account surplus recorded in 1996 and 1997 not appearing in the national accounts. In 1998 revenues not officially brought into the country or not recorded in the financial accounts amounted to around 50 trillion lire; they cancelled out the entire current account surplus. Analysis of officially recorded cross-border capital movements also highlights a reduction in the surplus and the progressive emergence in 1998 of a deficit of foreign investment in the Italian financial market. Inward investment in Italian bonds and shares amounted to 61.5 trillion lire in 1995; in 1996, owing mainly to the increased liquidity of the international market, the inflow of funds rose to 125 trillion lire. It remained at about that level in 1997 and then rose to 165 trillion lire last year. Funds were attracted from abroad by the steady improvement in inflation and the consequent expectation of lower interest rates. These factors were consolidated and reinforced in 1998, inter alia by Italy’s imminent adoption of the single currency. Italian portfolio investment abroad has increased more rapidly. Portfolio investment outflows were substantially less than inflows in both 1995 and 1996. With the reduction in official and market interest rates, investment abroad increased; owing to the less favourable outlook for profits, inward investment tended to slow down. In 1997 there was still a net inflow of 7 trillion lire, but in 1998 there was a net outflow of 18 trillion lire. The proportion of foreign securities in Italians’ investment portfolios is still smaller than in other countries. The process of diversification is bound to continue. The volume of listed shares in the Italian market is comparatively small. The alignment of Italian interest rates with those prevailing abroad is beneficial for its effects on the real economy but tends to reduce the attractiveness of the national financial market for Italian and foreign investors alike. The presence of a large number of foreign intermediaries in Italy is highly positive considering the benefits they bring for Italian saving and their role in modernising the market. Accordingly, we have taken a favourable view of the entry of foreign intermediaries and the additional intensification of competition within Italy. However, in the absence of profitable domestic investment opportunities, the export of saving is also facilitated. The relative weakness from which the Italian banking system still suffers in terms of size and range of business is a handicap. In the context of the single currency the abundance of saving, which for many decades was one of the great strengths of the Italian economy, loses part of its value as a comparative advantage in fostering growth. The new situation created by greater openness to cross-border financial flows calls in the first place for a strengthening of the efficiency and competitiveness of the banking system. –7– The response must be prompt and adequate in order to grasp the opportunities for growth and to finance profitable projects in Italy. We have encouraged the privatisation of the banking system and the formation of groups large enough to compete more effectively in Europe. The competition for saving at the global level depends ultimately on growth and efficiency of the economy. Foreign direct investment in Italy amounted to respectively 5.5 and 6.3 trillion lire in 1996 and 1997; in 1998 it rose to 6.9 trillion lire. Direct outward investment by Italian firms was 10 trillion lire in 1996 and rose to 18 trillion lire in 1997. In 1998 it amounted to 30 trillion lire. The Italian economy attracts considerably less foreign direct investment than France, Spain or the United Kingdom. Only Germany is more or less on a par with Italy in this respect. In a developed economy, exports of capital by firms investing abroad are normal. In Italy, however, there are still large parts of the country where development is insufficient and unemployment very high. Some 10% of all the employment generated by Italian industry is created outside the country. Together with the weakness of investment activity, the situation of Italy’s external accounts I have described and, in particular, the balance on foreign direct investment all point to the necessity of improving the competitiveness of Italy’s productive system within the global and especially the European economy. Competitiveness With the complete international opening of trade and capital movements and the adoption of the single currency, competitiveness is directly reflected in employment and growth. In the new international and European context, the advantage of banking and financial systems and their ability to contribute to growth are in large part the result of the efficient use of the funds they raise. In an open system, however, what ultimately counts is the demand for funds; this in turn depends crucially on the conditions of employment of the factors of production, above all the profitability of the corporate sector. In Italy, high taxation and the high level of labour costs relative to productivity in some areas hold back growth in investment and employment; they contribute to the expansion of the black economy, which harms the public finances and the efficiency of the productive system, distorts competition and has pernicious effects on the orderly life of the community. Between 1990 and 1997 the ratio of total general government revenue to GDP rose by 6%. In 1997 the tax burden in Italy was almost 1% above the European average; it was 13 and 14.5% higher than in the United States and Japan respectively. In 1998 the tax burden decreased by 1% as the result of the expiry of some temporary measures and the reduction in the yield from taxes on financial income owing to the fall in interest rates. Public investment fell from 3.3 to 2.4% of GDP between 1990 and 1997. In a medium-term perspective, there are reforms, many of which have been initiated, that remain to be completed in order to curb current spending, above all on pensions and welfare, and to enhance the effectiveness of expenditure, especially for education and healthcare. –8– The efficiency of public services and the stock of infrastructure are not as high in Italy as they are in the industrial economies with which we compare ourselves. It is estimated that 9% of the workers in manufacturing industry are in an irregular position with respect to tax, social security and work safety rules. In the building industry the ratio rises to 34%. Irregular employment is much more widespread in the South, where in some sectors it reaches 50%. At the root of the grey economy are insufficient differentials in labour costs between areas and firms with very different levels of productivity and profitability; the phenomenon also leads to the evasion of taxes and social security contributions. Through the black economy, the market tends to achieve a de facto closer alignment between labour costs and productivity. The improvement of competitiveness is to be pursued by increasing the efficiency of the public sector. It is important to proceed with the full operational implementation of the legislative reforms enacted. Frequently, the limited project development capability of local authorities and the lack of coordination with central government are far from secondary causes of the slowdown in expenditure on public investment and the failure to use the funds and resources available. Outlook At the root of the instability and recurrent crises of the world economy is the very rapid, at times chaotic, growth of finance, inconsistent with the growth in productive activity. This has consequences for the stability of exchange rates, the purchasing power of currencies, interest rates and securities prices. It has adverse effects on the financial position of banks and intermediaries, the business cycle and employment. The development of the international monetary system and its current configuration are the product of market forces. The institutional context does not permit quantitative limits to be set on the growth of flows. Transparent and widely accepted prudential rules for the management of intermediaries are not always applied. The liberalisation of capital movements and finance has greatly contributed to the growth of worldwide investment and saving. The gains from the liberalisation of trade in goods and services are certain at the global level and not distributed too unevenly, thanks to the operation of relative prices in response to the availability of factors. With the expansion of purely fiduciary money, there are no binding limits to quantities; monetary and financial expansion can be very uneven across the world and create tension and instability. Monetary and financial instability is detrimental to the efficient allocation of saving and the regular growth of economic activity. It gives rise to inflation, sometimes to recession. It can lead to an excessive concentration of financial resources in some countries and areas and an inequitable distribution of wealth, possibly producing tension and political conflict. The experience of the decades since the collapse of the gold exchange standard has no precedent in history. The free circulation of capital under the gold standard took place in a context in which the growth of money and finance had an ultimate reference, a quantitative anchor in the gold reserves of governments and central banks. The Bretton Woods system, based on the reserve currency role of the dollar, considerably increased the scope for monetary expansion and multiplication. An ultimate quantitative limit still existed. Flows of bank capital were subject to rigid rules; the International Monetary Fund adopted forms of –9– control designed to ensure compliance with equilibrium conditions by each national monetary system. The absence from 1971 onwards of the link between gold and the international reserve currency and the elimination, partly in response to the ideology of liberalisation and the interests of multinational firms and banks, of every rule concerning the transnational expansion of credit and the transnational circulation of money meant that the growth of money and credit became theoretically unlimited. Initially, during the 1970s, this resulted in a long period of rapid inflation worldwide and high interest rates and, ultimately, in a severe slowdown in the industrial economies. The return to tighter monetary control in the 1980s, first in the leading industrial economy and then in the others, led to a gradual reduction in inflation, but at the cost of a further rise in interest rates and a prolonged drag on economic growth. International liquidity expansion continued, partly as a result of progressive liberalisation of shortterm capital movements. It was only in the 1990s that more vigorous and coordinated monetary control efforts by all the industrial countries made it possible to rein in the expansion of money, at the international as well as the national level, and curb inflation. The growth in the supply of securities continued, however; the complete liberalisation of capital flows encouraged the illusion of unlimited scope for financing public sector deficits and countries’ external imbalances. The market reacted to the monetary restriction by developing derivative products, which in practice act as an additional multiplier of the liquidity created by banking systems. Financial globalisation is not a zero-sum game; it brings major benefits for world economic development but it can also generate instability and substantial losses for smaller and weaker economies. It is necessary to proceed resolutely with the action initiated by the International Monetary Fund and the World Bank to relieve the heavily indebted poor countries of a burden contracted years ago in conditions of extreme need. The conditions exist for this relief to be completed by the end of 2000, fulfilling the hope expressed by the Roman Catholic Church, international organisations and prominent political personalities. On several occasions we have insisted in the appropriate official fora on the need for the activity of the International Monetary Fund to be refocused on the prevention of crises, over and above its valid performance of crisis management, albeit in the midst of difficulties and with some failures. Even though the external constraint is less immediately binding, in view of the greater scope for raising finance offered by the global market, it is necessary to place renewed emphasis on the external equilibrium of each country and each monetary system. The macroeconomic surveillance carried out by the International Monetary Fund under the gold exchange standard must be revived in the new institutional and market conditions. The main causes of the crisis in Asia in 1997 and of the more recent events in Latin America were the failure to satisfy the conditions of external equilibrium and excessively rigid exchange rates of local currencies. The crisis cannot be overcome without a recovery in the growth of the world economy supported by the domestic demand of the developed countries, as called for by the G7 at its meeting last October. – 10 – In that forum a start was also made on studies and actions aimed at reforming the working of the international monetary system. The creation of a European currency common to 11 countries is a major event for the stability of world finance. The ground was prepared for the single European currency by the stabilisation carried out by the participating countries in the 1990s. Inflation was tamed but the rigidities and competitive weaknesses of Europe’s economies also emerged clearly. The monetary stability that has been regained can and must provide the basis for a new phase of growth; appropriate economic policies and consistent behaviour by employers and workers can produce new confidence in the ability of Europe’s economies to achieve rapid and sustainable growth. Structural policies are required in all the countries of the area to reduce the rigidity of public expenditure on current account, allow an easing of the tax burden and introduce elements of flexibility in a labour market that still responds to the logic of closed economies. The measures are needed in order to bring down the high rate of unemployment and to give, through the vigour of the productive economy, greater force to the single European currency. Money is largely the product of credit granted to private productive activity. Its strength depends not only on the prudent management of interest rates and quantities but also on the prosperity of the economy and the quality of lending. Where currencies are firmly anchored to productive activity, the setting of objectives for exchange rates appears logically extraneous to the system. The halt in the growth of the emerging economies and financial instability have led to a worldwide slowdown in economic activity that is tending to carry over into 1999. In Italy, the structural problems of the public finances, the large public debt and the level of the competitiveness of the financial system and the economy influence investment and employment. The adjustment of the public finances, intensified from 1993 onwards, the cooperation between employers and the unions, and the restrictive stance of monetary policy from 1995 to 1997 made it possible to recoup the serious fall in the value of the lira and to root out both expectations of inflation and inflation. Italy’s re-entry into the ERM and the restrictive fiscal policy of the latter years have consolidated the results of the stabilisation. Partly owing to the efforts required to reduce the budget deficit, the Italian economy grew at an annual average rate of 1.2% in the period 1996–98, or about half as fast as the German and French economies. The problems in the world economy contributed to growth in 1998 being much slower than expected. There is the risk that the trends of demand and output in the last part of the year will lead to unsatisfactory results for 1999. The large volume of saving available, of which a part flows abroad in the absence of profitable investment opportunities within Italy, and the unemployed labour force reveal the plentiful availability of resources for a return to rapid growth. Expectations must be modified, the climate of confidence improved. – 11 – Determined progress must be made, by means of extraordinary measures where necessary, in the reform of the working of the machinery of government by improving the efficiency and efficacy of the procedures. The plans for reviving investment in the South must be implemented, construction sites must be opened. The level of transport and water supply infrastructure must be raised. The funds and credit available at Community level must be utilised to the full. The process will gain from improvements in the project development and decision-making capability of local authorities, in part as a result of advances along the federalist-oriented path indicated in the proposed reforms of the Constitution. The medium-term policy of achieving equilibrium in the size and composition of the budget must be perceived by the market and business as a certainty. Tax competition is bound to intensify in Europe in the coming years; it will result in investment tending to be concentrated where the tax regime and the social environment conditions are most favourable and the cost of labour lowest. In the context of Europe and the global economy, flexibility in the conditions governing the supply of labour is necessary in order to enhance competitiveness; it can help support and increase employment both in large firms and in small and medium-sized enterprises. The broad consensus on the two sides of industry on the definition of the recently signed social pact can provide the foundation for a new incomes policy, for a lasting reduction in unit labour costs where unemployment is highest and illegal work most common, to the point of becoming the norm. If flexibility brings increased and more stable employment, the dignity of workers is defended and the participation in productive activity widened. The lofty issues concerning the orientation and development of society lie within the sphere of politics. What is needed is an underlying stability in the country’s institutions and in society based on convictions that are shared by all. The objective of more rapid growth, increased employment and better prospects for the young is universally accepted. It can serve as a reference point, without detracting from the debate that is inherent to democracy, for strengthening the social and political fabric. * * * | bank of italy | 1,999 | 2 |
Address given by Mr Antonio Fazio, Governor of the Bank of Italy, at the Euromoney Conference, held in Rome on 23 November 1999. | Mr Fazio gives an address on the Italian capital markets and the need for new strategies in Euroland Address given by Mr Antonio Fazio, Governor of the Bank of Italy, at the Euromoney Conference, held in Rome on 23 November 1999. * * * Between 1985 and 1998 the stock of public and private-sector bonds issued in the Group of Ten countries rose from 90% to 130% of their combined GDP; the market value of listed shares rose from 30% to 100%. The use of derivatives grew even faster: between 1990 and 1997 the notional value of those traded in organized markets rose from 40% to 200% of GDP. The flow of loans granted to non-residents by banks of the countries reporting to the Bank for International Settlements amounted to $1,100 billion in 1997, or 5% of the reporting countries’ GDP. The integration of financial markets, the prospects for growth in the emerging countries and the transformation of the economies in transition have created the conditions for an increase in allocative efficiency at the global level. The constraint imposed by the scarcity of financial resources for investment has been eased, especially in the developing countries. The growing dissociation between the generation and use of savings may nonetheless increase the riskiness of investments. Strategies aimed at maximizing profits in the short run and herding have added to the volatility of prices. Large-scale recourse to derivatives, which are extremely useful in controlling financial risks, has aggravated the adverse effects of speculative behaviour in some instances. The new context calls for careful assessment of the adequacy of national economic policies and the efficiency of the financial system, as well as careful control of borrowers’ creditworthiness and the use to which they actually put the resources they raise. In recent years intermediaries sometimes persisted in directing large volumes of resources towards countries with serious imbalances. This behaviour generated tensions and in the end led to crises. Italy’s financial system is increasingly integrated into the global economy; the adoption of the single European currency has intensified the process of integration. The return to monetary stability has created macroeconomnic conditions conducive to the expansion of the securities market. The size gap with respect to the other leading industrial countries remains to be closed. Bonds The reduction at the global level in the volume of savings absorbed by public debt issues has freed resources for productive investment and contributed to the decline in interest rates. In Europe, the elimination of exchange risk has lent special vigour to the growth of the market in private-sector securities. The volume of corporate bond issues has grown enormously both in national markets and in the Euromarket. The larger average size of issues and the standardization of their features have fostered the growth of the secondary market. In 1998, with the approach of the euro, issues denominated in ecus once more became substantial while the share of dollar-denominated issues declined. In Italy, in the first ten months of 1999 virtually all bond issues were denominated in euros. In France and Germany, the euro’s share of corporate bond issues remained somewhat lower, at 86% and 73% respectively. In the same period, the volume of bonds issued in the Euromarket by German, French and Italian residents between January and October this year was considerably larger than that recorded in 1998. This reflects the interest of issuers in gaining visibility in this new segment. The tendency for companies to make very large issues was encouraged by investors’ preference for liquid assets. The volume of corporate bond issues by Italian firms has also been boosted by the need to finance takeovers of listed firms. The issues of Italian enterprises have mostly been made through financial subsidiaries. The additional scope provided by the adjustment of the public finances is greater in Italy than elsewhere. The growth prospects of the private-sector bond market are enhanced by the efficiency of the secondary market and the opening of new regulated wholesale and retail markets for private-sector securities. A further contribution to the development of this segment will come as banks increasingly securitize their loans. The money market is highly efficient. The possibility of screen-based trading enables the Italian interbank deposit market to play an important role in Europe. Italy’s screen-based secondary market in government securities, MTS, is one of the most advanced of its kind. Created to facilitate the management of the public debt, this market has grown without interruption and average daily turnover has risen from Lit300 trillion in 1988 to over Lit19,000 trillion in the first nine months of 1999. MTS bid-ask spreads are extremely narrow, averaging around 4 basis points in 1999. The operational efficiency of this market and its privatization have been conducive to its international opening: trading involves some 200 Italian and foreign intermediaries, including some with remote access. MTS has served as a model for other European countries’ government securities markets. Equities The capitalization of the Italian stock market rose from 18% of GDP in 1994 to 50% in 1999, as against 75% in France and 56% in Germany. The gap compared with the United Kingdom and the United States is very large. At the end of 1998 there were 223 listed companies in Italy, the same number as in 1994. The composition of the official list has improved: many of the private-sector companies that have turned to the market are industrial firms and do not belong to groups that were already present on the stock exchange. In the same period the number of listed domestic companies rose from 423 to 740 in Germany, from 489 to 754 in France, and from 2,070 to 2,399 in the United Kingdom. The development of the Italian stock market has been influenced by the large proportion of small firms and the still limited propensity of medium-sized and large companies to seek a listing. The rise in share prices since 1994 has been partly due to the fall in nominal and real interest rates. Privatizations have accounted for the greater part of the contribution new listings have made to the market’s growth. The success of the offerings of state-owned companies’ equity on the market testifies to Italian savers’ lively interest in equity investment. With domestic supply still limited, Italian savers’ demand for shares has also given rise to substantial investment in foreign securities. In 1998 purchases of foreign shares amounted to around ELOOLRQ in 1999 they have increased further, rising to around ELOOLRQ LQ WKH ILUVW QLQH PRQWKV Savings pooled in investment funds contributed substantially to the outflow of capital. Pension funds continue to be of limited importance in Italy, whereas they play a pre-eminent role in the countries with more highly developed financial systems. Their equity portfolios are equal to about one third of total market capitalization in the United States and the United Kingdom. The growth of the stock market in Italy over the last five years has benefited from legislative innovations and tax incentives. Far-reaching measures have improved the organization of the market, considerably increasing the liquidity and transparency of trading. In 1998 the ratio of market turnover to capitalization was close to 100%. The growth of derivative products contributed to the increase. Last year the Italian market in equity futures ranked second in Europe in terms of trading volume. The use of derivatives has enhanced the efficiency of spot prices, whose daily volatility has declined compared with the first half of the 1990s and is approaching the levels recorded in more mature markets. Borsa Italiana has reached an agreement permitting its participants access to other European financial centres; interconnection will enable each market to exploit to the full the benefits of the massive investment that has already been made in technology while maintaining a close relationship with domestic firms. Foreign investors hold just over 10% of listed Italian shares; they are more active in derivatives, where they are involved in one third of all trades. Compared with the leading stock markets, Italy’s includes a smaller proportion of non-financial companies. Although they account for more than 90% of the value added at factor cost of the private sector in Italy, their share of market capitalization was 54% at the end of 1998. Non-financial companies account for more than 70% of total market capitalization in Germany, more than 75% in the United Kingdom and more than 85% in France. By contrast, the propensity of banks to go public is higher in Italy than in other leading countries. Banks account for 27% of the stock market in Italy, compared with values of between 10% and 15% elsewhere. A contribution to increasing the number of listed Italian shares may come from the Euro-NM circuit, reserved for innovative small and medium-sized firms with high growth potential. A few months after its inauguration it has 330 securities, listed jointly on several European exchanges, and a total market capitalization of ELOOLRQ%RUVD,WDOLDQDMRLQHGWKHFLUFXLWLQ-XQHWKHILYH,WDOLDQFRPSDQLHVQRZ listed account for about 3% of the total capitalization. Conclusion The global financial market has seen a marked increase in the activity of institutional investors, able to deploy advanced techniques that reduce the costs and risks associated with their investments. Stronger competition sometimes prompts asset managers to pursue short-term objectives, thereby tending to accentuate the variance of securities prices around their long-term values. The disappearance of the segmentation caused by exchange risk will foster the creation of a Europe-wide stock market. Financial intermediaries can look forward to an increase in their volume business. Their task is to allocate the flows of savings between countries. In Italy, a substantial increase in the role of pension funds is needed. It is becoming increasingly important to monitor not only the performance of economies but also single sectors and investment projects. Careful selection in the allocation of resources fosters the expansion of the global economy. Italy is endowed with professional and entrepreneurial expertise, labour and savings allowing it to compete successfully with other economies in the new and more competitive European and global environment. The many small firms present in the Italian economy can be a strong point, in view of their ability to use new technology and adapt rapidly to changes in external conditions. However, the increase in competition requires a major expansion in innovative sectors, something that larger companies are better able to achieve. The financial system can make a fundamental contribution by making finance available to the most viable investment projects, helping to keep domestic savings in Italy and attracting resources from abroad. The restructuring of the credit system under way and the formation of major banking groups will support the activity of medium-sized and large firms and their growth. It is these firms, together with the multitude of highly flexible and productive small enterprises, that can make a decisive contribution to the achievement of higher levels of investment, to the introduction of advanced technology in companies’ modus operandi and production processes and to the growth of savings and employment. | bank of italy | 1,999 | 12 |
Address by Dott. Vincenzo Desario, Director General of the Bank of Italy at the 5th ABI Convention on the Development and Management of Loan Portfolios held in Cernobbio on 15 October 1999. | Mr Desario discusses new approaches to the international regulation of credit risk Address by Dott. Vincenzo Desario, Director General of the Bank of Italy at the 5th ABI Convention on the Development and Management of Loan Portfolios held in Cernobbio on 15 October 1999. * * * Introduction My thanks, first of all, to the Italian Banking Association for the invitation to give the opening address at this conference on new methods for developing and managing loan portfolios. The subject is highly topical. Today, as interest rates converge on the lowest levels since the Second World War, banks’ competitiveness depends more than ever on their ability to select customers and offer the most appropriate forms of credit, so as to curb credit risk and generate yields above the cost of funds. Analysis of the crises that have shaken many credit systems in recent years confirms that the main source of bank instability lies in their lending business; cyclical swings in the economy, sharp changes in asset values, high credit concentration, and inadequate procedures for evaluating and managing loans have been the main factors in most bank failures. Inquiry into the causes of instability has been followed by action to reinforce safeguards against crises, strengthen banks’ credit risk management systems, make market discipline more effective, and improve supervisory authorities’ prudential rules and analytical methods. The Italian banking system’s bad debts rose rapidly in the nineties, although in the last two years loan quality has Improved thanks to companies 1 better profit performance and financial restructuring. Innovative market techniques for credit risk management have recently been introduced and some banks have begun to use advanced statistical methods of risk measurement. 1. Bank credit and the market In 1999 the ratio of new bad debts to total lending has fallen to its lowest level in the decade. The improvement, which had already been perceptible for some time in industrial lending, has spread to construction and services. In August the stock of bad loans held by banks was 5 per cent lower than a year earlier. The reduction was achieved by means of substantial writeoffs and the disposal of uncollectible claims through securitization. Selling credit assets to the market allows banks to turn their portfolios over faster and broaden their borrower base, thereby using capital more efficiently and diversifying their sources of income to include fees for the services related to the complex procedures of securitization. In the United States the volume of credit securitization business has grown enormously. In 1998 net issues of such securities amounted to more than $300 billion, or 35 per cent of total issues of debt instruments. Their share of outstanding debt is now more than 20 per cent. In the US market, securitization has centred on loan assets of better-than-average quality, which has led to the issue of highly rated securities. In Italy, it has been used mainly to reduce the incidence of doubtful credits and thus improve the average quality of banks’ assets. Since 1994 some 8 trillion lire of bank loans have been securitized, of which only 400 billion consisted of performing loans. The passage in April of a law on securitization opens up business possibilities previously foreclosed by uncertainty about the legal framework. The prospects for growth depend strictly on banks’ ability and willingness to offer the market good quality claims and to develop the entire gamut of services and specializations required. Bank managements will have to acquire the specific know-how needed for the evaluation of the complex risk-return combinations involved. There is also growing recourse by some leading Italian banks to credit derivatives, which allow credit risk to be transferred while maintaining title to the underlying credit relationship. The possibility of isolating one or more aspects of the risk associated with credit business and transferring them to other parties via derivative contracts enables banks to keep only the components of risk that they consider they are best equipped to handle. This trend towards specialization explains the high degree of concentration in credit derivatives business. In June 1999 the top five US banks accounted for 80 per cent of the American market with positions totaling $258 billion. Italian banks’ credit derivatives business is mostly channeled through their foreign branches; not only does it respond to the need to diversify risk but it also allows them to penetrate new markets by acquiring positions with customers that it would otherwise have been difficult to establish business relations with. At the end of the second quarter of 1999 the notional value of Italian banks’ contracts in the United States amounted to $15.3 billion, or 6 per cent of the total market. The development of credit derivatives in the Italian market is likely to make it easier to implement policies aimed at correcting situations of excessively concentrated sectoral and geographical lending. 2. The experience with solvency ratios The capital adequacy rules introduced by the Basel Capital Accord of 1988 constitute the main point of reference for supervisory authorities everywhere. The basic elements of the Accord are still fully valid today: capital resources as the safeguard of banks’ stability, risk-weighted capital ratios, capital requirements for off-balance-sheet assets. Since the publication of the Core Principles of the Basel Committee on Banking Supervision, to which supervisory authorities everywhere were asked to adhere, at least 140 countries have adopted the Committee’s approach in their regulation of banking. The Capital Accord was intended to raise banks’ level of capitalization, following decades of decline in the main banking systems. It also aimed to enhance the entrepreneurial initiative of bankers within a framework of close correlation between risks and capital resources and, through common prudential rules, to promote conditions of competitive equality among internationally active banks. Drawing a balance sheet today, the results have been very largely positive. The degree of capitalization has risen almost everywhere, making banking systems more resilient. The average solvency ratio of international banks located in the G10 countries rose from 9.3 per cent in 1989 to 11.6 per cent in 1998. Over the same decade the average solvency ratio for individual banks in Italy rose from 11.7 to 13.4 per cent. The improvement in capital adequacy has been fostered by the forceful action of the supervisory authorities, which has led banks to expand their capital resources in parallel with the rapid growth in higher-risk assets. Uniform capital requirements have also attenuated competitive handicaps stemming from disparities in the strictness of national banking regulations. They do not appear to have resulted in significant changes in the competitive position of banks compared with other, less strictly regulated financial intermediaries. In some countries, including Italy, many non-bank intermediaries have been transformed into banks. Studies on the impact of capital ratios, conducted mainly in the United States, have found temporary slowdowns in some markets but not contractions in the supply of credit affecting the aggregate level of economic activity. Ten years of rapid financial innovation and progress in developing statistical methods for measuring banking risk have highlighted some of the limitations inherent in the specification of the capital requirements. The rigidity of the standards has not encouraged the adoption of techniques to reduce credit risk; it has induced practices for circumventing the rules. The current definition of the capital requirements cannot capture the variation in credit risk stemming from cyclical developments; nor does it take account of the correlation between the risks associated with various assets and hence of the benefits implicit in well diversified portfolios. The benefit accorded to financial techniques of risk-shifting, in terms of reduced capital ratios, is insufficient, while banks are increasingly taking measures to lessen capital requirements that do not actually diminish risk. The limited diversification of the risk weights applicable to assets makes it possible for banks to select higher risk-return combinations. 3. The evolution of prudential rules on credit risk The Basel Committee has focused on the need to strengthen the set of legal rules safeguarding bank stability by defining capital adequacy requirements in greater detail, improving the structures and methods for the management of credit risk, reinforcing the discipline exerted on banking enterprises by the financial markets. In June the Committee released a set of proposed revisions of the capital adequacy rules, asking for the comments of the banking industry with a view to their definitive formulation in the second half of next year. During the summer it distributed documents setting out best practices in credit risk management, disclosure requirements and supervisory activity. For the time the idea of determining the capital needed to face credit risk by means of internal models devised by banks themselves has been shelved, pending resolution of the problems with existing methods and in view of the costs associated with producing such models. For the future, such models represent an opportunity to be pursued, in view of the possibility they offer of measuring credit risk more exactly and more analytically and of factoring in the correlation between different risks. They generate estimates that gauge the capital needed to cover the largest loss that could occur in any given period of time and with any given probability. For lending to firms, the Committee’s proposed changes provide for two distinct methods of determining risk weights: the ratings of specialized agencies, which are only available for a limited number of borrowers, and internal ratings, which the banks can assign to all their customers. For the standard method, the Committee has established the requirements that agencies must meet for their ratings to be used in determining capital ratios for banks. The requirements refer to agencies’ credibility and independence as well as to the objectivity and transparency of their judgments. The criteria for supervisory authorities’ validation of internal rating systems have not yet been fixed. They will certainly include the completeness of the data, the methodological rigour of the procedures and provision for verification of the results. There remains the complicated problem of defining a common yardstick to which to relate the results of the various banks’ internal rating systems, in order to make sure that capital requirements are uniform. Another problem to be faced concerns the comparability of the criteria for weighting the risk on loans to companies with agency ratings and those with internal ratings. 4. Credit risk management and banks’ internal organization The adoption of internal ratings as the basis for calculating risk coefficients creates a direct link between the regulation of capital requirements and banks’ internal structures for formulating lending policies and for assessing, pricing and monitoring the risks involved in individual operations. The Basel Committee has established the guidelines banks are to follow when making arrangements for credit risk management. Banks’ directors play a fundamental role in ensuring both that lending policies are consistent with banks’ ability to handle credit risks and that periodic cheeks are carried out on the results achieved. Clear information on policy choices must be given to all bank structures involved in lending. To ensure that objectives are attained, banks’ top managers must ensure that precise instructions are circulated setting out the various levels of responsibility, establish operational limits and extend credit risk management systems to the whole range of bank assets. When granting loans, banks should evaluate all the information available in order to acquire a complete profile of borrowers, including their exposure to cyclical or sectoral events, group relationships, if any, the use to which loans are to be put and the sources of the funds that will permit repayment. The monitoring of loans should be assigned to qualified personnel working independently of the units responsible for granting credit. Internal rating systems call for close liaison with the crucial aspects of risk management, such as pricing, provisioning and deciding to review loans or ask for their repayment. Exhaustive and continually updated information on borrowers’ financial positions and on the value of collateral is fundamental. The flow of information provided to financial markets is essential to ensure that the discipline they can impose on banks’ managements is effective. The guidelines established by the Basel Committee for periodic reports to the market cover all aspects of credit risk management: accounting practices, provisioning policies, organization, customer assessment procedures, breakdown of the loan portfolio by class of borrower, doubtful debts, collateral, volumes of derivatives and securitized loans, commitments, expected and actual rates of return on loans. The measures to address credit risk are completed by the activities of supervisory authorities directed at ensuring the adequacy of each bank’s capital resources in relation to its risk profile and corporate strategies. It is up to supervisory authorities to evaluate whether banks’ internal procedures can perform the tasks of identifying, measuring and managing credit risk, to set higher capital ratios for banks with particularly high risk profiles, to ensure compliance with capital requirements and to take prompt action to prevent banks’ capital from falling below acceptable levels. The attention of the Bank of Italy has been directed towards banks’ organizational arrangements for some time; in 1988 banks were asked to complete a questionnaire on their internal structures, which provided additional information on their organizations and served as a useful reminder to the banking system of these issues. The importance of banks’ organizational arrangements is reflected in the regulatory framework. Exactly one year ago the Bank of Italy’s instructions to banks and banking groups introduced a comprehensive set of provisions aimed at encouraging effective and efficient internal control systems in proportion to each entity’s size and operational complexity. Banks were also asked to report on the systems they had adopted, their level of compliance with the new provisions, any critical factors brought to light and the remedial measures required. While respecting banks’ entrepreneurial independence, general principles have been established that are consistent with international guidelines; these include the separation between operational and control functions, a clear definition of the responsibilities of banks’ various units and special regulations to ensure prompt corrective measures. Particular attention has been dedicated to internal auditing, with a view to ensuring continuous cheeks on the effectiveness of controls and the preparation of proposals to improve risk management policies, instruments and procedures. 5. The thrust of current action Briefly, an internal rating system embraces all the elements needed to measure the probability that a borrower will become insolvent and the share of the loan that, in such case, will no longer be recoverable; together, these two factors give the expected loss for each borrower. While the probability of failure can be assessed in terms of the borrower’s specific features such as economic sector, financial structure and income prospects, the recovery rate for any credit line depends on factors such as the technical form of the loan, the collateral and the lender’s position in relation to the borrower’s other creditors. Statistical methods of calculating these two components of expected losses require sufficiently long time series on the frequencies of failures corresponding to each risk bucket and on the losses sustained for the various categories of loans and collateral. The issue is made even more complicated by the fact that both the probabilities of failure and recovery rates are affected by economic trends. A survey carried out by the Basel Committee of about thirty leading international banks showed that the problem is being addressed in ways that differ in many respects. Internal assessment procedures evaluate the quality of either borrowers or credit lines, and in some cases the two profiles are combined. Evaluations may be based entirely on statistical models, or be supplemented with the opinions of sectoral analysts and lending experts; in some cases limits are set on the scope for altering the results of statistical calculations by adding qualitative considerations. The various systems differ in terms of the variables used to approximate the probability of failure for individual borrowers, the time horizons considered and the use of sectoral analyses. For many banks the reliability of the procedures adopted is closely linked to their ability to capture promptly any changes in a borrower’s solvency position. Others, adopting a similar approach to that of rating agencies, prefer so-called “across-the-cycle” evaluations, which consider the borrower’s position in a hypothetical unfavourable phase of the economic cycle. A specific probability of failure can be assigned to each internal rating class either on the basis of the bank’s own experience or by using information published by rating agencies on the frequency of failures. Evaluations based on internal rating systems can be used by banks’ directors and top management in formulating lending strategies and setting limits to the autonomous granting of loans; they can also be used in loan pricing procedures and to ensure the prompt reporting of any deterioration in borrowers’ positions. The survey carried out in the G-10 countries included a number of Italian banks, mostly major ones, and revealed some characteristic features of the approaches adopted in constructing a borrower classification system. The business sector is broken down by size; for small and medium-sized firms the first level of screening for creditworthiness consists mainly of a statistical classification of borrowers based on data culled from balance sheets and the Central Credit Register. The results of these automatic procedures are generally modified, within set limits, by information concerning corporate management and organization. In assessing larger firms the statistically-based elements carry less weight. The recent start made on the systematic observation of the insolvency rates within each risk bucket and the losses sustained in connection with secondary lending conditions means that the accuracy of these procedures cannot be guaranteed, it is still too early to assess the ability of systems to capture changes in the quality of credit linked to trends in economic activity. Assessments of individual borrowers usually refer to a time horizon of one year, a practice that most foreign banks also follow. The models in use are not able to take systematic account of the different maturities of operations, while economic theory and experience both indicate that the maturity of loans can have a marked impact on the related credit risks. In their risk management procedures, Italian banks are increasingly resorting to models that measure expected losses; they use the results in deciding whether to grant loans and in reviewing credit lines. The distinction between the units that calculate ratings, those that are involved in marketing and those that perform control functions appears to be well drawn. Nonetheless, the integration of the customer-classification systems of the different components of banking groups is not entirely satisfactory. Medium-sized banks, of which one of the strengths has always been their specialized territorial knowledge and entrenchment in the local economic tissue, are also making important changes in their credit risk management procedures. By opening new branches and acquiring local banks, they have rapidly extended their activities to be present on an inter-regional or national basis. These banks have responded to the need for more effective and efficient loan selection procedures mainly by reviewing their organizational arrangements, improving their information systems and tightening their internal controls. Specialized operational units have been created according to types of customer, with the granting of large loans often being referred to “Committees” composed of particularly experienced head office personnel; procedures for assessing creditworthiness have been improved through the use of information technology to coordinate and accelerate the use of available information. The enlargement of distribution networks has proved a strong incentive to decentralizing decision-making for smaller loans. To meet the requirements of control, special organizational units have been created to provide centralized monitoring of loan positions; these maintain continuous contact with the central and branch units engaged in granting loans, mostly through the use of computerized procedures that identify possible anomalies in positions. The most dynamic banks have supplemented these procedures with profitability indicators for individual borrowers in order to improve their overall risk-return profiles. Some of the more progressive medium-sized banks use internal rating procedures to support their loan portfolio diversification policies and to establish consistent writedown and provisioning criteria. Personnel training and specialization programmes need to be intensified in order to foster the spread and acceptance of new methods. 6. Specialization profiles of Italian banks With the spread of innovative techniques of credit risk mitigation, loan portfolios will tend to be managed in more dynamic ways than traditionally, when the focus was on selecting borrowers and maintaining positions until their natural maturity. The forms of lending specialization that emerge clearly today in the Italian banking system are related primarily to the type of borrower, defined in terms of size and product sector. There are important changes under way in the composition of loan portfolios: one aspect common to the entire system is the rapid growth in loans to households, while the pattern of lending to the corporate sector is diversified. In the nineties loans to households have grown at an average annual rate of around 11 per cent, or about twice as fast as total lending, and they have risen from 13.8 to 18 per cent of total loans. With interest rates declining and productive activity growing only modestly, banks have grasped the opportunities offered by households’ increased demand for credit; at the end of 1998 more than 95 per cent of loans to households were held by the banking system, either directly or through subsidiary financial companies. Indicators such as shifts in the market shares of individual banks and the correlation with their interest rates show that competition is intense and growing, partly owing to the entrance into the Italian market of foreign intermediaries specialized in mortgage lending. The expansion in the volume of business with households has been helped by the spread of technical forms of lending whereby intermediaries rely to a great extent on credit scoring techniques to select borrowers. In the consumer credit field, which is characterized by a large number of small transactions, the need to make decisions rapidly and minimize costs encourage the use of automated procedures. In the case of loans for the purchase of consumer durable goods, the results of credit scoring models are frequently decisive in deciding whether to lend; in that of personal loans, which are usually for larger sums, branch personnel are allowed greater discretion; and, lastly, special agreements covering specific groups of borrowers or particular categories of goods are often important. In the case of mortgage loans, the assessment of the desirability of granting a loan hinges both on the current and future ability of the borrower to pay and on the effective value of the collateral. Improvements to the procedures for selecting and monitoring loans to households are possible and necessary. The proportion of bad debts is high; the impact on banks’ financial situations must be evaluated in the light of the growing share of such lending in their portfolios. Last June - despite frequent writeoffs of small positions, out-of-court settlements and disposals without recourse to non-bank companies - 9.4 per cent of household loans were classified as bad debts, as against 8 per cent for other loans. As regards loans to enterprises, there has been a shift in their composition: in the eighties the share of lending to small and medium-sized enterprises grew continuously throughout the banking system. Since the early nineties the share of the economic sectors in which small companies predominate, i.e. those for which the average loan was less than 500 million lire at the end of 1997, has fallen at banks involved in mergers and acquisitions but has continued to increase for the rest of the system. A similar pattern has already been analyzed in the US banking system, which has seen far-reaching consolidation in recent years; it merits special attention in view of the importance of small firms in Italy’s industrial fabric. The recent consolidation of the Italian banking system does not allow a definitive judgment to be passed on the process: the shift in the composition of loan portfolios could be the result both of differences in lending policies and of the need to reorganize lending at banks that are still being integrated; it undoubtedly reflects the need to reduce the riskiness of the loan portfolios of banks with poor records that have been taken over. The share of long-term credit to enterprises has not changed significantly. Repeated calls have been made for enterprises to make more use of medium and long-term financing, which requires banks to develop more detailed knowledge of borrowers, to make accurate assessments of their earnings prospects, and consider the shocks that they could be exposed to as a result of adverse developments in the economy or the financial market. In practice lending has continued to be primarily in the form of short-term loans. Last June such transactions accounted for 35 per cent of the total credit granted to non-financial companies, basically unchanged compared with the preceding years. With reference to the companies surveyed by the Company Accounts Data Service, lengthening of maturities is restricted mainly to companies in critical conditions that require their debt to be restructured. The tendency of credit to be short-term has often been seen as related to the practice of borrowing from several banks, which undermines the discipline the banking system can impose on borrowers compared with what is possible with relationship banking. The consolidation of the Italian banking system is leading to less fragmented credit relationships; it requires banks to adjust their policies and organizational arrangements with a view to establishing relationships with customers in which more attention is paid to their long-term needs and the development of suitable forms of corporate finance. Conclusions International experience clearly shows that the stability of banking systems depends above all on the solidity of the real economy and its ability to follow a path of sustained and balanced growth. International financial integration offers major opportunities to improve the allocation of savings on a world scale, accompanied, however, by the risk of unprecedentedly large and sudden systemic crises. Without detracting from the importance of economic and monetary policies or of the action of the bodies entrusted with safeguarding macrofinancial stability, the fundamental aspect consists in the steps banks take to strengthen their risk-management policies and procedures and to counter the pressure on their margins arising from the growth in competition in national and international markets. In Europe the presence of many large global firms of high standing, the dismantling of the barriers inherent in the denomination of securities in different currencies and the possibility of referring to a single yield curve will foster the development of the market for private sector securities. For large companies, whose operations cover several national markets and whose financial management involves several different currencies, the new single currency regime will reduce the need to do business with a plurality of banks. A reduction in the demand for credit from prime companies appears possible, the spread of private sector securities may cause problems for fund-raising. Though marked by national traits in legal and fiscal matters, the configuration of the financial system of the European Union will becorne more similar to that of the Anglo-Saxon systems. The profitability of traditional lending to enterprises is likely to come under pressure; the need to develop business with different categories of customers and to look for profit opportunities in foreign markets will involve both old and new credit risks. The changes under way make it necessary to grasp the growth opportunities offered by corporate finance services; this will give further impetus to the spread of financial techniques for the management of risk and to the growth of the securitization market. The ability to manage risks, above all credit risk, efficiently, will be a competitive strength of crucial importance; it requires intermediaries to adopt the innovations made possible by today’s statistical models and financial techniques, to integrate them into their internal organizations, and to develop the necessary professional skills. Active management of the loan portfolio, frequently indicated as the new frontier in lending, cannot be independent of the effectiveness of the traditional procedures, from the assessment of creditworthiness to the constant monitoring of loan performance. In a market such as Italy’s, in which very little recourse has been made to rating by specialized agencies, banks lacking an internal rating system sound enough to be approved by the supervisory authorities would find themselves at a competitive disadvantage. Businesses of high standing would stand to obtain better conditions from other banks able to apply capital charges more consistent with the riskiness of the financing. The revision of the capital adequacy framework is a major challenge for Italian banks. The decisions regarding the formulation of the systems for classifying credit risk will have to be taken according to the internationally agreed timetable, in the knowledge that the trend is towards greater use of internal models. The Italian banking system has a good knowledge of the world of small and medium-sized enterprises deriving from its close contact with local economies. In constructing systems for the management of credit risk, it can count on statistical sources that are not always available in other countries, such as the Company Accounts Data Service and the Central Credit Register. Banks are becoming increasingly aware of the challenge; they have the necessary capital, know-how and organizational ability. On the other side the limited availability of external ratings and the small size of the private capital market could prove a serious obstacle to Italian enterprises’ efforts to diversify their sources of financing and reduce their average cost of borrowing. One is struck, once again, by the competitive disadvantage at which the Italian economy stands owing to the smallness of the share and bond markets. The Bank of Italy is stimulating and supporting the efforts of the banking system to modernize its techniques for managing credit risk. It has taken steps to ensure the proposed new regulations are widely disseminated and has launched consultations with bankers aimed at jointly assessing the characteristics that internal ratings will need to have for prudential purposes. Discussions will also be held with banks as part of normal supervisory activity and the Bank will participate in the ad hoc working group set up by ABI, the Italian Bankers’ Association. In addition, the Bank of Italy will be making information available from its archives, above all those of the Central Credit Register, that will be of help in constructing systems for measuring expected losses on loan portfolios. The Supervision Department is doing research into techniques for measuring capital at risk on the basis of indicators for the companies surveyed by the Company Accounts Data Service or by using measures of sectoral and locational riskiness to approximate that of borrowers. The estimates of riskiness obtained in this way have been used in determining the share of bad debts deemed not to be recoverable. These studies are the natural follow-on of the work begun in the early nineties to establish statistical methods for measuring the fragility of non-financial companies on the basis of balance-sheet data; further improvements have been made recently by combining the estimates with indicators of difficulties in serving loans taken from the Central Credit Register and extending the analysis to a sample of rnore than 400,000 companies. The research under way is expected to produce results that will be of help in the analyses and tests that will have to be carried out for the validation of the internal rating systems banks adopt. Increasing the competitiveness of the Italian banking system, and of the economy as a whole, requires continuous improvements in the methods used for granting and managing credit, and the development of the corporate finance services needed to foster small and medium-sized enterprises’ access to the capital market. It is necessary to capitalize on Italian banks’ greatest strength: the wealth of information and relationships accumulated over the years in doing business with their customers and turn it to account in creating effective internal rating systems. I am sure that Italian banks, faced with this new challenge in the most typical of all banking activities, the management of credit, will succeed in developing the instruments and mind-set needed by companies operating in markets that have been opened up to competition by the efforts over the last ten years of Parliament, the regulatory authorities and intermediaries themselves. | bank of italy | 1,999 | 12 |
Speech by Mr. Antonio Fazio, Governor of the Bank of Italy, at the World Gold Council International Conference "The Euro, the Dollar and Gold", held in Rome on 17 November 2000. | Antonio Fazio: The relationships between currencies and gold Speech by Mr. Antonio Fazio, Governor of the Bank of Italy, at the World Gold Council International Conference “The Euro, the Dollar and Gold”, held in Rome on 17 November 2000. * * * 1. “If a gold standard had never existed, it might be necessary to invent something of the kind”. This quotation from a monograph by Dennis Robertson (Money, 1928, p 122) refers to one of the positive aspects of the gold standard: that of shielding central bankers from pressures to increase the money supply. After the First World War the return to gold was in fact the overriding objective of economic policymakers, in order to ensure monetary stability. The economic disequilibria produced by the war were so pronounced, however, that they made it hard to re-establish the gold standard. The cost, in terms of welfare, imposed by inflation, rising public debt and war reparations was so high that it prevented the rapid return to gold. The Genoa conference of April 1922 laid the foundations for an important innovation: the creation of the gold exchange standard, under which gold was flanked by convertible currencies and central banks were granted greater autonomy; this was to be used to stabilize the value of gold, through international cooperation. However, the new system did not enjoy the same credibility as the earlier regime and, at the same time, failed to leave the monetary authorities sufficient room for manoeuvre. Culturally still under the influence of the gold standard, the monetary authorities were in any case little inclined to cooperate and tended to accumulate gold reserves, thereby exerting powerful deflationary pressure on the economy. The monetary disorder of the thirties created the need for a new reform, which was implemented after the Second World War with the Bretton Woods agreements. The suspension of the dollar’s convertibility on 15 August 1971 officially cut the link between legal tender and gold - an epochal change after more than 2,500 years during which money had always been based explicitly or implicitly on a precious metal, prevalently gold. 2. The abandonment of a monetary system hinging directly or indirectly on gold was a consequence of the severe economic disequilibria that developed between the two world wars. The advances made in monetary theory also exerted a powerful influence. Ricardo provides us with a clear indication of the main objective of the gold standard: “To secure the public against any other variations in the value of currency than those to which the standard itself is subject, and, at the same time, to carry on the circulation with a medium the least expensive…”. He also noted that: “Experience, however, shews, that neither a State nor a Bank ever had the unrestricted power of issuing paper money, without abusing that power: in all States, therefore, the issue of paper money ought to be under some check and controul; and none seems so proper for that purpose, as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion.” The same concepts are to be found some hundred years later in Irving Fisher. The success of the gold standard was due, among other things, to the broad consensus on metallism and the classical model; one of the latter’s key features is the self-adjusting ability of the economy. The restoration rule, which required the gold parity to be re-established after a period of suspension due to exceptional circumstances, was an essential part of the gold standard. Short suspensions of convertibility made it possible to overcome temporary difficulties. The system allowed discretion to be exercised only within very rigid limits. Gold acted as an anchor both for the monetary system and for the economic system by making maintenance of the parity a constraint on economic policy. A commodity standard, however, is not without its weaknesses, owing to the impossibility of controlling the money stock in the face of exogenous fluctuations in the quantity of metal. Given the short-run non-neutrality of money, countries suffered substantial welfare costs in deflationary periods, as in the closing decades of the 19th century. During the heyday of the gold standard several proposals were put forward to overcome this difficulty: Jevons’s revival of the tabular standard, Marshall’s symmetallism and Fisher’s compensated dollar. Wicksell even suggested cutting the link with precious metals altogether, thus anticipating by a quarter of a century Keynes’s radical approach in the Tract on Monetary Reform (1923). England’s ephemeral return to gold in the first half of the 1920s and, just a few years later, the terrible impact of the Great Depression greatly affected economic and political thinking. The discussion on monetary reform ceased to be confined to the purely academic domain. The advocates of reform (including, albeit with different approaches, economists such as Keynes, Fisher, Hawtrey and Robertson) focused primarily on the “artificialness” of the value of gold: demand for the metal depended crucially, among other things, on the conventions that governed the monetary systems of the various countries. While Keynes held that gold had exhausted its monetary role, other economists, such as Fisher and Hawtrey, continued to assign it a leading part, although they envisaged that central banks would neutralize the variations in its value - with the result that gold itself would be anchored. Keynes’s once heterodox view became widely accepted, since the malfunctioning of the monetary system was seen as one of the main causes of the propagation of the Depression. On the eve of the Second World War, the need to reform the monetary system faced economists with an intellectual challenge. For the first time in history, experts designed a new monetary “order”, to use Professor Mundell’s expression. The Bretton Woods architects set themselves the objective of re-establishing a fixed exchange regime and allowing each country to pursue a full-employment policy by means of capital controls. Parity changes were to be permitted only in the event of “fundamental disequilibrium”, which was not defined. In practice the system turned into a fixed-rate dollar standard. The importance attributed to domestic targets in the economic policy of the United States undermined the coherence and operation of the system, thereby preparing the ground for the abandonment of the link with gold and the move to floating exchange rates. 3. In the decade immediately following the breakdown of the Bretton Woods regime, the world economy became prey to high and variable inflation. This tendency was subsequently halted when, after absorbing the effects of the real shocks of the seventies, monetary policies were directed with greater determination to restoring price stability. Floating exchange rates proved highly volatile. In the last 30 years the international monetary system has come to find itself in a position where the expansion of credit and the creation of money have not been constrained, at the global level, by binding rules. After the about-turn in the monetary policy of the Federal Reserve at the end of the seventies, the restrictions imposed on the stock of money in the leading countries put a brake on monetary growth. Nonetheless, the combination of fiat money and the possibility of short-term capital movements between the different parts of the world has led to a system which does not permit the expansion of credit to be closely controlled and which is inherently unstable. In this context price stability is ensured in the leading countries; to some extent their behaviour then influences that of the world economy. Economic theory has taught us, rigorously (consider, for example, the analysis put forward by Patinkin), that even with fiat money the price level can be determinate when the central bank exercises control over the nominal quantity of money. The creation of important monetary areas - that of the euro alongside those of the dollar and the yen contributes to the stability of the world economy, even though many countries remain outside these areas. The expansion of credit at the international level is closely connected with the operation and stability of banking systems and capital markets. Important steps are being taken to subject countries outside the main monetary areas to standards of banking supervision that help to ensure the orderly expansion of credit and money. 4. In the absence of rigorous control over the quantity of money at world level, the last two decades have seen crises that, despite their occurring in just a part of the globe, have triggered a combination of inflation and deflation, with the destruction of some of the savings accumulated in banking systems and slowdowns in the growth of economies. The crises have become more frequent in the last five years and their effects more far-reaching as a consequence of contagion. The enormous advances made in data processing and telecommunications have fostered a growth in international monetary flows and total financial assets that has far exceeded the expansion of the world economy. This has undoubtedly contributed to the growth in productive investment at the global level in a period marked by low inflation, attributable in part to the increased competition in trade in goods and services and especially raw materials. The last five years have been marked by very rapid growth in the stock of financial assets made up of public and private-sector securities and bank deposits. The expansion began in 1995 at the time of the decision to carry out massive interventions in the foreign exchange markets in order to correct the pricing distortions between the dollar and other weak currencies on the one hand and the yen and other strong currencies on the other. On that occasion sales of yen against dollars amounting to several tens of billions of dollars were made; at the same time, a policy was adopted aimed at reducing yen interest rates until they were close to zero. The expansion of yen-denominated liquidity enabled the dollar and other weak currencies, including the lira, the peseta and sterling, to strengthen. The global market saw the start of bond and share purchases by highly-leveraged intermediaries; the latter borrowed funds at low cost and then invested in financial markets, making substantial use of derivative instruments. The parallel growth of the New Economy in the United States, consisting essentially in an increase in the productivity of capital and labour connected with the large-scale application of information technology to production, led to a flow of capital to the United States and a continuous rise in share prices, which, in five years, roughly tripled. The ratio of financial wealth - shares, bonds and the money stock - to annual GDP at current prices rose from 240 to 360%. The growth of derivatives makes it possible to carry out transactions with very high leverage, increases the velocity of circulation of the money balances used for financial transactions. Interest rates and the cost of capital have decreased. The recovery of the world economy, under way since 1999, is connected with these developments. The American economy, performing as a high-growth component of the global economy, attracts capital while simultaneously helping to sustain economic activity in the rest of the world with its imports. The low cost of capital is helping the expansion of investment in Europe and other parts of the globe. These developments can be said to have constituted an application on an international scale of the process, theorized in the past by Tobin, of monetary expansion increasing the value of the existing capital stock and thereby stimulating investment. The process up to now has followed a virtuous course, without excessive inflationary pressures thanks to heightened competition and productivity gains in the United States. Its Achilles’ heel is the rise in the prices of raw materials and energy products. 5. The gold reserves of the central banks today amount to some 32,000 tons, about one quarter of the world stock. Like other real assets, gold can appreciate when there is widespread inflation, which remains a threat. Gold’s importance as a monetary anchor came to an end with the emergence of more rigorous monetary policies in the 1980s and especially the 1990s. But in periods of crisis gold can constitute a sort of reserve or guarantee “of last resort” for a country, as Italy demonstrated during the 1970s. This view appears to be shared by the central banks of the leading industrial countries; when they signed the September 1999 agreement, they stated that gold continued to have an important role to play in the management of global reserves. It is up to economists to analyze whether and to what extent, in an international monetary system that has surely not yet become fully consistent in many of its parts, reference to gold, which performed a monetary function for thousands of years, can still contribute, in the decades ahead, to preserving that fundamental condition for orderly economic activity - price stability. The experience of the period following the Second World War shows that macroeconomic stabilization has always provided the basis for the growth of the most successful economies. Conserving this stability and the soundness of economies’ fundamentals is one of the principal tasks of governments and central banks. | bank of italy | 2,000 | 12 |
Address by the Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF ¿ ASSIOM ¿ ATIC ¿ ACIFOREX, Trieste, 3 February 2001 | Antonio Fazio: Finance and recovery in the world economy Address by the Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF – ASSIOM – ATIC – ACIFOREX, Trieste, 3 February 2001. * * * Globally, the growth in the money supply and the value of financial assets reached a peak last spring. The NASDAQ index has subsequently fallen by one half; the S&P 500 index first stopped rising and then, in September, began to decline. The performance of technology shares in Europe has been similar to that of the US market. All the European stock exchange indexes peaked towards the middle of 2000; they have followed a downward trend since the last few months of last year. At the beginning of 2000 equities in all the main industrial countries except Japan appeared substantially overvalued in relation to the expected growth in earnings and the risk premium implicit in valuations. A year ago we called for a "virtuous" realignment of the financial market's valuation of firms with the performance of the real economy, to be achieved through robust economic growth. The increasing divergence in the second half of the nineties between stock market prices and the actual and expected expansion in output was due to the world money supply having grown faster than the economy and to the rise in the velocity of circulation of liquid balances owing to the rapid increase in financial derivatives. One of the features of the second half of the nineties was the pace of productivity gains in the United States deriving from the spread of new technologies; producer prices and world commodity prices remained stable. The monetary policies of the leading central banks and the interventions of the international institutions had to cope with the succession of financial crises in Mexico, Asia, Russia and Latin America. The spread of these crises was averted; the worst effects of exchange rate instability and bank failures were kept within limits. Monetary policies and the expansion in the assets of the financial intermediaries active in international markets brought a steady decline in bond yields; the excess of liquidity was reflected primarily in the rise in share prices. The abundance of funds and the ensuing large fall in the cost of capital fueled the prolonged expansion in US domestic demand and fostered the recovery in 1999 in output and investment in Asia, Europe and Latin America. The recovery increased the demand for oil and energy products. From the middle of 2000 onwards the ensuing rise in the oil price caused consumption to slow down in the industrial and oil-importing emerging countries. We had drawn attention to the danger of not taking advantage of the opportunity offered by the improvement in economic conditions to press ahead, in Italy and in Europe, with structural reforms so as to transform the cyclical recovery into a new phase of sustained growth. Recent economic developments In the United States economic activity accelerated in the second half of 1999; the expansion continued in the first half of 2000 at a pace well in excess of the economy's potential growth rate. Inflation picked up significantly. The tightening of monetary conditions begun in June 1999 was intensified during 2000. The federal funds target rate was raised by 1.75 percentage points between the middle of 1999 and the middle of 2000. As in the other industrial countries, economic activity slackened in the second half of 2000. In the first half the economy's growth rate was nearly 6 per cent; in the third quarter it fell to 2.2 per cent. The rate of expansion in private investment has fallen from 13 per cent in the first half of last year to 3 per cent. For the first time since the end of 1998 pre-tax corporate earnings have declined. In the last quarter of 2000 there was a further slowdown in economic growth: GDP growth on an annual basis dropped to 1.4 per cent, reflecting the slowdown in consumption and a contraction of nearly 2 per cent in investment. The economic recovery in Japan, which had been fueled in part by the expansion of public expenditure, proved uncertain. The positive performance of private investment, which expanded by 4.5 per cent in the first nine months of 2000 after contracting in 1999, contrasted with stagnant consumption. In the third quarter net foreign demand's contribution to growth turned negative as a consequence of the sharp slowdown in exports; sales of capital goods to emerging markets in the region contracted. There continue to be deflationary pressures on both consumer and producer prices. In the other Asian countries, and especially those most dependent on the international cycle, the rate of growth declined in the second half of 2000, although it remained relatively high. In Latin America the economies of the countries with the closest trade links with the United States performed well. Output in Mexico increased by 7 per cent in 2000, as against 3.7 per cent in 1999. Brazil recorded an increase of 4 per cent last year, up from 0.8 per cent the year before. In Argentina, by contrast, the economic situation deteriorated last summer; the appreciation of the dollar, to which the peso is rigidly pegged, resulted in a further loss of competitiveness in 2000, of about 5 per cent. In Europe the growth in exports, investment and sales of consumer durables had brought a sharp acceleration in production and job creation in the middle of 1999. The expansion, which was still strong in the first half of 2000, weakened over the summer. The upturn in inflation diminished households' disposable income. The repercussions of the rise in the price of oil were more severe in Italy than elsewhere. The impact on production of the slowdown in consumption was partly offset by an acceleration in investment and a build-up of stocks of finished products. The cyclical indicators for the fourth quarter of 2000 confirm the slowdown in growth in Europe and Italy compared with the first half of the year. The year-on-year increase in GIDP of the euro-area countries in 2000 is estimated to have been 3.4 per cent, one percentage point more than in 1999. The acceleration was due to the strong growth in world trade and a recovery in market shares. The growth in Italian exports continues to lag behind that in world trade. Inflation in the euro area averaged 2.3 per cent in 2000. The core rate, excluding energy and food products, was 1.3 per cent. In Italy the overall rate was 2.6 per cent and the core rate 2 per cent. The net outflow of private capital from Italy and Europe for direct and portfolio investment continued; it was greatest during the summer months. The capital exports of euro-area residents went primarily to the United States, thus helping to finance its substantial external current account deficit. Banking systems and financial markets With today's institutional arrangements, the currencies of the leading countries provide the basis for the multiplication of credit in international markets. The stock of money and liquid assets is difficult to control at world level; its expansion is limited only by the risks and the occurrence of instability in intermediaries or financial systems. In a crisis the costs imposed by the destruction of savings and the contraction of credit, with the economies directly involved bearing the brunt, are much greater than the benefits reaped in the expansionary phase. The use of derivatives has increased the scope for hedging, but it has also multiplied the volume of speculative positions. The increase over the last ten years in the size of intermediaries and their internationalization are a response to the increasingly keen competition in domestic and international markets. Advanced methods are required to manage the risks inherent in organizations which have become more complex and are operating in more open and unstable markets. Recent studies conducted under the aegis of the finance ministers and central bank governors of the Group of Ten indicate that a further increase in the size of intermediaries as a result of mergers and acquisitions would not necessarily enhance stability. Moreover, in domestic markets concentrations involving large banks may pose problems for competition, with adverse repercussions especially for individuals and small businesses. In the United States rapid economic growth, the development of the capital markets and extensive activity in foreign markets providing high returns have enabled banks to make substantial profits in recent years. Lending to all categories of borrowers has increased rapidly. Bankers appear to have shared the optimism prevailing in equity markets, leading in some cases to not entirely realistic estimates of customers' creditworthiness. Corporate indebtedness, the level of share prices and the sizable exposure to emerging countries may aggravate the difficulties of the economy. Banks have adopted more prudent credit policies in parallel with the slowdown in the United States and the international economy. The Federal Reserve's recent survey of leading banks has revealed a larger-than-expected deterioration in credit quality. The more selective approach to lending primarily concerns medium-sized and large firms and finance for mergers and acquisitions. The banks reported that they were also being more cautious in granting lines of credit to new customers. The fall in the prices of shares in high-tech. sectors has dried up a major source of fee income for intermediaries. The economic slowdown has also had repercussions on the bond market. The risk premium for bonds issued by firms with a high credit rating widened by about one percentage point in 2000 to 1.3 points; that for bonds with a low rating nearly doubled to 4.3 points. The premiums have narrowed following the reduction in official rates in January. Within the euro area, private enterprises intensified their borrowings on the international capital market in 2000. Corporate bond issues exceeded 350 billion euros; syndicated loans to the private sector increased to 230 billion euros. Recourse to the market was led by telecommunications companies. The growth of the bond market was accompanied by an appreciable widening of yield spreads with respect to government securities. For bonds issued by telecommunications companies, the risk premium had risen to 164 basis points at the end of 2000. In the Asian emerging countries, where technology companies account for a high proportion of market capitalization, share prices have fallen sharply since March 2000, by 40 per cent in Indonesia and Taiwan, 30 per cent in Korea and Malaysia, and 20 per cent in Thailand. The increase in corporate indebtedness and greater financial fragility of these countries have undermined the confidence of international investors. This has led to a substantial widening of the yield differentials between dollar-denominated bonds issued by these countries and US Treasuries. Equity markets have also declined sharply in Latin America, with falls of 20 per cent in Mexico and 30 per cent in Argentina. Financial market tensions in the latter heightened in the last two months of 2000. The yield differential between dollar-denominated Argentine government securities and US Treasuries has widened. Turkey has experienced serious episodes of financial instability in conjunction with the crisis of its banking system; there have been adverse repercussions on equity prices, interest rates and the exchange rate. The crisis was sparked when international banks cut back their lines of credit to Turkish banks, which were highly exposed to exchange rate risk. The turbulence in Argentina and Turkey subsided following support interventions coordinated by the International Monetary Fund and marked by the significant participation of the private sector. The Italian banking system has undergone a wave of mergers and far-reaching restructuring in the last ten years that, starting from a situation marked by low concentration and mainly small banks, has permitted the creation of groups better equipped to face international competition. The liberalization of banking activity and privatizations have helped to increase competition in domestic markets. The groups that have emerged have improved their profitability by expanding asset management business and reducing staff. It is now necessary for the leading groups to strengthen their organizational structures and make the improvements competition demands. They will need to simplify their group and productive structures, rationalize their distribution networks, integrate their information and riskmanagement systems, and expand their innovative lines of business, especially in services. In the last three years banks' profitability has already benefited from action to contain labour costs, the reduction in bad debts and higher revenues from asset management services. In the first half of 2000 banks' return on equity was 12.4 per cent on an annual basis. Figures for the first three quarters and preliminary data for the fourth confirm the promising outlook for the year as a whole. Lending continued to expand rapidly in 2000. Exposure to companies operating in high-tech sectors, at interest rates below the average for nonfinancial firms, more than doubled. Including banks' holdings of bonds and shares and the guarantees they have issued, the total exposure to these sectors is on the order of 83 trillion lire. The loans granted by the Italian banks that have financed such companies are equal to 30 per cent of their consolidated capital. The average solvency ratio for the Italian banking system in June 2000 was 10.5 per cent, basically unchanged compared with twelve months earlier. In December 1999 the average value of the ratio for internationally active Italian groups was 9.6 per cent, compared with 12 per cent for competitors in the Group of Ten countries. The introduction, with the 1988 Basle Capital Accord, of capital requirements related to risk assets fostered a strengthening of banks' capital bases. Although the Accord was initially aimed at internationally active banks, the simplicity of its rules has led to its adoption in more than 100 countries. Extensive revision of the original Accord by the supervisory authorities of the leading countries culminated on 16 January 2001 in the publication of a new capital framework for banks that will come into force in 2004. The new rules provide for new valuation methods and a more diversified classification of the risks assumed by banks. The capital requirement for credit risk will be based on the assessments of borrowers made by rating agencies or those produced by banks themselves on the basis of their own information. It will take greater account of banks' use of credit risk mitigation techniques. A new charge will be introduced for operational risk. Supervisors will ensure that banks have systems for managing and monitoring capital adequacy that are appropriate to their overall risk profile; this action will be complemented by market scrutiny on the basis of more extensive disclosure requirements for banks. The importance of large banks for the stability of the financial system means that they must set aside more capital than the minimum requirements under prudential rules. Especially for intermediaries that borrow in the international markets, high levels of capital strengthen market confidence, inter alia with beneficial effects on the cost of funds. The outlook for the world economy According to the IMF, the world economy's rate of growth could decline to 3.5 per cent this year, from 4.8 per cent in 2000. Current forecasts are considerably lower than those published last September. The very nature of the recovery that began in 1999 and the persistence of deep structural imbalances in some areas had suggested that the rapid pace of world economic expansion would probably not be sustainable. The plentiful supply of international liquidity made it possible to continue to finance the external imbalances of the United States and the Latin American countries while also fueling the growth of the world economy. However, the rapid increase in demand eventually pushed up energy prices, thereby contributing to the economic slowdown in the United States, Europe and several emerging countries. In Europe the recovery has been driven by exports. It is necessary to create conditions that will allow domestic demand to grow vigorously. The return towards more realistic share prices and the adoption of greater prudence in lending by the banking systems most exposed to the emerging countries heighten the need to make the adjustments whose urgency was not recognized in full owing to the cyclical upswing. In the world's leading economy the spread of innovation is still in progress. The potential growth in output remains high in the long term. After rising to 5 per cent in 2000, growth in GDP this year may not reach 2.5 per cent. In December the business confidence index fell for the third consecutive month; in January there was also a significant erosion of household confidence. Both the timing and the extent of the easing of monetary conditions at the beginning of January took the market by surprise; it has presumably served to avoid a collapse in share prices in the United States. The risk of recession has determined the decidedly expansionary stance of monetary policy. The additional half-point cut in official rates just a few days ago, the possibility of further reductions and especially the clearer intention of using fiscal policy are capable of reviving positive expectations and thus creating the conditions for an upturn. The sustained expansion in economic activity in the nineties helped to generate the budget surplus and reduce the public debt. In the 2000 fiscal year the federal budget surplus was equal to 2.4 per cent of GDP. There remains the need to ensure the orderly financing of America's external imbalance. Net inflows of foreign direct investment - more than $250 billion in the three-year period 1998-2000 - make a sudden massive outflow of capital unlikely and attenuate the risk of sharp fluctuations in the value of the dollar. A rapid recovery of the US economy is essential for the stability of the world's financial markets and the expansion of the global economy. In Japan the restructuring under way in the major industrial groups, aimed at cutting excess capacity, has permitted their return to profitability and a revival of investment, but it has failed to put the economy back on a path of rapid growth. Business confidence, which had been recovering strongly, worsened again in December. The high levels reached by the public debt and the budget deficit in 2000 leave little leeway for the use of budgetary policy to boost the economy. The scope for monetary policy support remains limited. GDP growth is likely to remain close to last year's low figure of 1.6 per cent. Measures to safeguard the stability of the banking system and improve the outlook for growth appear necessary and are under study. In the euro area the rate of GDP growth in 2001 is expected to be more than half a percentage point lower than in 2000. The outcome will depend on international cyclical developments. Domestic demand is becoming the crucial factor in sustaining growth. The budgetary measures adopted in several countries with a view to reducing the tax burden on a permanent basis are a step in the right direction only if they are accompanied by a curbing of current expenditure and a strengthening of capital expenditure. Budgetary balance and debt reduction, where appropriate, must be assured. Taking a broader view, an additional stimulus to growth in European countries will come, under appropriate conditions, from the enlargement of the Union to include central and eastern Europe and some Mediterranean countries. Over 100 million people would be involved, about one quarter of the area's present population. Average per capita income in the twelve candidate countries is very low, approximately 40 per cent of the average for the Union. Standards of living in these countries vary widely: whereas per capita income is between 20 and 30 per cent of the EU average in Bulgaria, Romania, Latvia and Lithuania, it is close to 70 per cent in Slovenia and is 80 per cent in Cyprus. All the candidate countries made progress during the nineties in bringing down inflation, which fell from the very high values of the beginning of the decade to 12 per cent in 2000. Commercial and financial ties with the EU countries have strengthened considerably. In 1999 the exports to the European Union of the twelve countries in question accounted for about 70 per cent of their total exports and consisted mostly of labour-intensive manufactures. In the same year net direct investment in these countries, mostly by EU countries, was equal to almost 5 per cent of their GIDP. Foreign investment has fostered the European Union's exports of technologically advanced products and services; at the same time it has helped the beneficiary countries to modernize their capital stock, introduce new technologies and develop management skills. The entry of these countries into the European Union will intensify the flows of immigrants. The failing birth rates in the countries currently making up the Union call for the entry of additional labour in the medium term. With the support of adequate integration policies, workers coming from the candidate countries, who are relatively well qualified, can be fully inserted into the productive structure and help to sustain growth. Structural reforms in Italy and other EU countries to increase technological innovation and shift production towards more advanced sectors will prevent "crowding out" and make it possible to reconcile the integration of the new members with increased prosperity throughout the Community. Conclusions The price-earnings ratio of the companies of the S&P 500 was 31 at the end of 1999; it declined to 25 in 2000. The expected real rate of return on investment in shares rose from 3.3 to 4 per cent. In Germany and France the price-earnings ratio dropped from 26 and 25 respectively in 1999 to 21 and 19 in 2000. In Italy the ratio dropped in the same period from 29 to 23. In all four markets the price-earnings ratios remain higher than the long-term values that prevailed up to 1995. They may reflect a reduction in the risk premium associated with equity investment. Other conditions being equal, the greater liquidity of share markets tends to attenuate the fluctuations in the value of individual shares and of portfolios. Savers can diversify their investments widely by using the services of professional asset managers. The depth and resiliency of the markets reduce the risk of loss on the sudden liquidation of portfolios. Recourse to professionals lowers the costs of investment selection and reassures savers. It is always necessary to correspond to this trust in terms of professional conduct and disclosure to investors. It is necessary to overcome the slowdown of the international economy and the risks of a worldwide recession. Adverse repercussions on the expected returns on investments must be avoided. The potential for growth remains high in the largest industrial economy, on whose performance the international cycle depends crucially. It is estimated at around 4 per cent. The diffusion of new forms of organization of production, made possible by information technology and by new technologies, have involved only a part of the economic system; the process can continue in the years ahead. The expansionary stance of monetary policy and the use of fiscal policy to support demand in the short term and foster investment in the longer run can restart the engine of growth. For the economies of Latin America, the contribution of North American demand and financing remains fundamental. In Japan, more resolute deregulation of the economy, the restructuring of production, a greater opening up to foreign businesses and trade with the new industrial economies of the region can increase productivity. Domestic demand, influenced by low demographic growth and the ageing of the population, needs to be supported. Intermediaries and large banks that operate in international markets are seeking new configurations following the strong growth of the nineties. The banking systems of the countries of the European Union are solid; after the rapid expansion in lending in the past years, a re-examination of the criteria for measuring risk and of the structure and level of capital is necessary. The potential growth rate of the European economy remains limited by the as yet scant application of new technologies and the slow progress of structural reforms. The expansion will continue, even if more slowly than in 2000, thereby contributing to the stability of the world economy. An increase in domestic demand can also come from more intense infrastructure investment. It is necessary to press ahead with the steps already taken to remove the rigidities and imbalances that are still present in the labour market, the social security systems and the structure of government budgets. Scope for sustained growth can come from the integration of the economies of central and eastern Europe. In Italy there is a wide gap between achievable and actual growth. In 2000 GDP is estimated to have expanded by 2.7 per cent. From the middle of the year onwards consumption was held back by the increase in energy prices; this reduced private sector disposable income significantly, by more than 1 per cent of GDR Inflation was marginally higher than in the other European countries, but the latest data suggest that a gap could re-open. Last year exports again expanded less than world trade and the exports of the other EU countries; the increase in sales within Europe was especially small. Non-price factors continue to influence Italy's export performance and to contribute to the rise in imports. The increase in employment has been considerable thanks to the innovations in the labour market and the upturn in economic activity. The size of the underground economy has remained basically unchanged and abnormally large by international standards. Further reform of ltaly's labour laws and the agreements between employers and trade unions will have to permit a more flexible adjustment of costs to reflect productivity and individual companies' situations, with account also being taken of the sectors and geographical areas in which they operate. The recent efforts to raise the volume of public works must be continued, both because of the contribution they make to domestic demand and employment and in order to reduce the infrastructure shortfall in large parts of the country and to increase the efficiency of the economy as a whole. This raises the issue of the need to improve the functionality of local authorities, to enhance their project development and execution capabilities. Changes must be made to the legal system in order to eliminate regulations and divisions of responsibility that make it hard to bring public works to the starting gate and then through to the finish line. The action already taken to improve the efficiency of government must be followed up. The improvement in the public finances was interrupted in 2000. The state sector borrowing requirement, net of settlements of past debts and privatization receipts, rose back to 2.2 per cent of GDP, from 1.5 per cent the year before. The overshoot with respect to the estimates included in the Economic and Financial Planning Document was equal to 1 per cent of GDP. In December the Government presented the update of the Stability Programme for Italy to the European Council and Commission. The target for net borrowing of 0.8 per cent of GDP in 2001 was confirmed. The results for the borrowing requirement for 2000 make that objective more difficult. Immediate and resolute action is necessary to ensure that it is achieved. The situation of the public finances must be checked month by month. Any overshoots must be corrected. Unfavourable trends in receipts will have to be offset with curbs on disbursements; careful controls on spending are essential in order to avoid having to introduce revenue-side measures. The growth in GDP in 2001 could be on the order of 2.5 per cent. The planned reduction in the tax burden will have beneficial effects on domestic demand and growth. Adjustments in the pension system are necessary in order to ensure its equilibrium in the medium term. More stringent budgetary rules need to be introduced for local authorities. The planned reduction in the tax burden over the coming years must be credible; it must become part of economic agents' expectations. Certainty of a reduction in taxation encourages investment and consumption, reduces the disincentives to work and increases our economy's potential rate of growth. We must put all the time available to us to good use; create the conditions for inserting the Italian economy into the world recovery; strengthen the country's economic and civil development and the prospects of wellbeing for the younger generations and for families. * * * | bank of italy | 2,001 | 2 |
Remarks by Mr Pierluigi Ciocca, Deputy Director General of the Bank of Italy, to the Conference on 'The new structures of financial markets: how should supervision be organized?' held in Bologna, 4 May 2001 | Pierluigi Ciocca: Supervision: one or more institutions? Remarks by Mr Pierluigi Ciocca, Deputy Director General of the Bank of Italy, to the Conference on “The new structures of financial markets: how should supervision be organized?” held in Bologna, 4 May 2001. * * * Introduction The question of the allocation of responsibilities in banking and financial supervision is not a purely economic question, nor can it be solved merely on the basis of economic theories. Until quite recently Milton Friedman was the only great economist to have addressed the issue, and even then as part of the broader problem of money and its management. Many other aspects are involved, however, including: • the “legal experience” of a country, and hence the constitutional and institutional framework within which the question is set; • how supervision has been and is performed, in terms of the resources, reputations and independence of the institutions concerned; • the opinion of the markets in the light of their changeable “conventions”. The foregoing considerations suggest that the question should be approached, if not pragmatically, at least with prudent humility. The subject does not offer academic recipes suited to every context. One may nonetheless have opinions, based on arguments that have been worked out to a greater or lesser extent. I shall set out my own here, in the most generalized form I can achieve. The international picture These considerations regarding method are matched by an empirical observation. In recent times there has been no clear tendency for any one solution to predominate. Basically, there are three alternatives: extreme centralization (rare), extreme decentralization (less rare) and intermediate solutions (the most common). The United States has remained faithful to a division of responsibilities in which the types of body entrusted with supervision are highly diversified, with 6 for banking supervision1 (with 357 local offices and around 15,000 employees) and another 6 for financial supervision2 (covering markets, insurance companies and pension funds with 137 local offices and some 8,000 employees). In addition, it is necessary to consider the self-regulatory bodies of the 9 most important financial markets. The overlapping of powers is accepted, desired, in view of the “dialectics”, the “competition”, it ensures between the various institutions and because it avoids monopoly. The number of persons engaged in supervision is huge. In the banking field it is about fifteen times the figure for the Bank of Italy (about 1,000), even though the US banking system (at current prices and exchange rates) is only five or six times as big as Italy’s, while the GDP ratio is seven to one (on a purchasing-power-parity basis). At the other extreme the United Kingdom is implementing the decision taken suddenly in May 1997 to bring all the supervisory powers — except that concerning “systemic stability”, which has been left in the hands of the central bank — together in a newly-created organization, the Financial Services Authority (FSA). Japan has adopted a similar solution. The FSA has a head office with a staff of 2,300 (of whom no less than 450 deal with authorizations and consumer relations), no special body for on-site examinations and an annual budget of just 500 billion lire. With these resources, the FSA is expected to supervise a financial industry that, in terms of volume of funds, is about one quarter that of the United States and three times as big as Italy’s. It is true that with 841 banks Italy has more than The Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Banking Department of each of the fifty states. The Securities and Exchange Commission, The Securities Commission of each state, the Commodity Futures Trading Commission, the National Association of Insurance Commissioners, each state for insurance matters, and the Pension and Welfare Benefits Administration of the Department of Labor. twice as many as the United Kingdom,3 but the combined human and financial resources of the various Italian supervisory authorities are not very different from those of the FSA (moreover, in addition to a body of inspectors, the Bank of Italy has a network of branches that monitor their “local” banks and markets). Although the United Kingdom and Japan are major economies, the similar architectures they have adopted for supervision have not established a trend, for several reasons. The choice was influenced by the failure of their earlier architectures, with serious and unexpected failures of individual intermediaries in London and the structural crisis of the whole financial industry in Japan. It was made when the central bank was relatively weak in both countries. It does not reflect the great difference between the two countries’ political and constitutional traditions. The solutions to be found in the euro area lie somewhere between the extremes represented by the United States, on the one hand, and the United Kingdom and Japan, on the other. The changes introduced recently in the Netherlands, Portugal and Belgium increased coordination among the existing authorities (including the central bank), which nonetheless remained separate entities with each having specific powers. In Germany, Ireland, Finland and Austria proposals aimed more specifically at consolidation are under discussion. In some cases they have met fierce opposition. The question has become the subject of widespread debate. Some commentators believe that the monetary unification of Europe must be matched by some concentration of supervisory tasks. Why centralize? There are basically two general reasons that may lead to the decision to centralize supervisory powers: • the possibility of obtaining an overall view, accompanied by economies of scale and hence lower costs for the intermediaries subject to supervision; • the changes in the operational and geographical boundaries between intermediaries, markets and financial instruments, owing, among other things, to the emergence of “large and complex financial institutions”. The importance of these reasons increases with the degree to which finance is — or the authorities wish it to be — concentrated in a single centre (London accounts for about one third of all UK employment in banking and finance and produces 16 per cent of the country’s GDP) and with the “smallness” and “openness” of the economy (on the assumption that international coordination is easier to achieve among a few supervisory authorities). Two qualifications should be noted in the case for centralization: • that it should not take place at the central bank, which is required to perform monetary policy tasks that are deemed to be in conflict with those of supervision; • that the promotion of competition in the banking and financial sector should not be combined with the protection of stability, since these two functions are also deemed to be incompatible. Why decentralize? On the other side there are several reasons for decentralizing supervision, for adopting a solution somewhere between monopoly and extreme fragmentation. Here are some: • the switch from some degree of decentralization — the most common solution — to a centralized configuration inevitably involves costs and risks during the transition period; • technical specialization in the exercise of supervision continues to have a value even when the internal boundaries within the world of finance are being eroded; banking risk, for example, continues to be different from insurance risk and from the risk affecting pension funds; In the United Kingdom there are 377 banking businesses subject to supervision by the FSA (186 UK incorporated banks, 67 building societies and 124 branches of non-EU banks; the 118 branches of EU banks are subject to home-country control). • contact with the intermediaries and markets subject to supervision — closest where supervision is carried out by means of a network of “local” offices, as in the United States and Italy — gives supervisory authorities access to information and a power to discourage improper conduct; • avoiding an accumulation of administrative power in an extremely delicate field limits the risk of its being abused or supervision being used, de jure or de facto, for political ends — the classical lesson of Montesquieu. • in performing supervision it is important not to confuse the spheres of technical discretion and formal control of the conduct of business. The last reason needs to be clarified a little. Disclosure, transparency and correctness fall largely, although not exclusively, within the second sphere. Ensuring their respect implies, first and foremost, that rules must be detailed in advance in legislation and then that they must be enforced. It consists in administrative activities that are concerned less with the exercise of a natural and necessary technical discretion than with the discharge of a responsibility oriented primarily towards the control of legitimacy. Competition, efficiency and proper risk control — i.e. stability — fall within the first sphere. The need to distinguish in a crisis between illiquidity and insolvency, assess the probability of contagion, and choose how and when to act so as to achieve maximum effectiveness and minimum moral hazard often requires supervisory discretion and hence the independence of the body responsible for carrying out what amounts to a form of economic policy. Independence is inherent in the management of money and credit, which is entrusted to central banks. They are accustomed to exercising this independence in accordance with priorities they establish on the basis of the resources available. Independence is the cornerstone of central banking. An additional reason for entrusting so-called stability-oriented supervision to the central bank is the scope for synergy between this function and the monetary policy function. Far from being incompatible, these two functions are complementary, in at least three respects: staff’s experience and professional skills in the monetary, banking and financial fields; the two-way flow of information; and the risks facing individual intermediaries and the system as a whole. One last consideration concerns stability-oriented supervision and antitrust action in the banking industry. There is absolutely no trade-off between these two activities. Competition is a necessary but far from sufficient condition for the solidity of the banking system. Without competition, there cannot be efficiency. Without efficiency, there cannot be stability — true and long-lasting stability, in contrast with the false and temporary stability produced where survival is guaranteed by the state. Defending and fostering competition are an integral, indispensable part of banking supervision. They must guide the use of the instruments of supervision, regardless of whether there is an antitrust law. This is the approach followed by the Bank of Italy, both before and after the approval of antitrust legislation in 1990. If the law entrusts the task of defending and fostering competition to the supervisory authority (as in the United States and in Italy since 1990), the latter’s position is strengthened. The need for and shortcomings of coordination A reasonable degree of decentralization implies coordination of the various supervisory authorities. The blurring of the segmentations within the world of finance and financial globalization call for forms of closer coordination. This need has, or is being, met. It is being met in Italy, autonomously and in response to specific statutory provisions, through coordination of the Bank of Italy, the companies and stock exchange commission (Consob), the supervisory authority for the insurance industry (Isvap), the supervisory authority for pension funds (Covip) and the antitrust authority. It is being met in Europe and at international level through formal and informal bilateral agreements and through participation in multilateral fora, including the newly established Financial Stability Forum (in both cases with reference to common standards, such as those developed by the Basel Banking Committee). Coordination nonetheless suffers from potential shortcomings, including the risk of confusion concerning responsibilities and the possibility of overarching that amounts to a surreptitious form of total centralization. Conclusions The present set-up in Italy is based on a reasonable allocation of supervisory responsibilities in terms of the aims to be pursued and the institutions to be supervised. The basic criterion is a division by goals — stability on the one hand, correctness on the other — supplemented by a division by category of institution (banks, markets, insurance companies and pension funds). These arrangements appear satisfactory in the light of the principles I have expounded. Above all, they appear satisfactory in the light of experience, amply documented in the reports and analyses published by the Bank of Italy and the other supervisory authorities. Thanks at least in part to their action and cooperation, the Italian financial system has improved considerably in the last twenty or even ten years: it is now more widely diversified; more competitive, more efficient and more stable; it is in a better position to meet the needs of the economy. “Better” does not mean “the best”, which, assuming it is definable, would require the contribution of supervision to be achievable. These are issues which go beyond the scope of my remarks and which I have addressed elsewhere.4 P. Ciocca, La nuova finanza in Italia. Una difficile metamorfosi (1980-2000), Bollati Boringhieri, Turin, 2000. | bank of italy | 2,001 | 5 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, on the occasion of the granting of the Keynes Sraffa Award, at The Italian Chamber of Commerce and Industry for the UK, London, 25 February 2003. | Antonio Fazio: Two great economists and the challenges we face today Address by Mr Antonio Fazio, Governor of the Bank of Italy, on the occasion of the granting of the Keynes Sraffa Award, at The Italian Chamber of Commerce and Industry for the UK, London, 25 February 2003. * * * John Maynard Keynes was the most influential economist of the twentieth century, a century in which the world economy made greater advances than in any other historical period. The world’s population grew much faster than in the preceding centuries; per capita output also rose at an unprecedented pace. The growth in population and per capita income accelerated in the second half of the century, not least owing to the absence of wars comparable to those fought in the first half. The overall improvement in living conditions was accompanied by a widening of the gaps between the economic welfare of countries and geographical areas, and above all by an increase in the perception of the disparities. I shall return to this point later. As a subject in its own right, political economy acquired form and substance between the seventeenth and eighteenth centuries. In this respect it is worth recalling: the fundamental contributions of Cantillon and Hume; the Physiocrats and Quesnay with his Tableau économique, the precursor of Leontief’s input-output analysis; Antonio Genovesi, who held the first chair of political economy in Europe at the University of Naples, with his Lezioni di economia civile, and Ferdinando Galiani, whose treatise Della moneta remains exemplary for its profundity and enduring relevance. Adam Smith’s The Wealth of Nations marked a decisive turning point. But economic analysis had already been developed, as a part of philosophy, by the Schoolmen. In the late Middle Ages, from the thirteenth century onwards, the great Italian, Spanish, French and Flemish moralists, in addressing the emergence of the urban economy and the growth in commerce and fairs after the manorial economy of the great Benedictine monasteries and the feudal estates, discussed the new developments with regard to trade, currencies, prices and the interest rate. Not far from here, in Oxford, the light of the Franciscan order, John Duns Scotus, developed a theory of prices that is based strictly on the cost and hence on the quantities of labour employed in producing goods. The underlying idea was constantly to search for and define the just price, in order to pursue commutative justice in exchanges, a concept that, together with distributive justice, was forcefully stressed by Thomas Aquinas as the basis of orderly life in the community. Later, the doctors of the Sorbonne and the great Italian universities also addressed the question of insurance. Taking a premium to insure goods against the risks of shipwreck and piracy was acceptable, but the insurers had to possess adequate capital, what we would call actuarial reserves today, with which to indemnify the insured in the event of claims. Fresh impetus was given to the study of economic phenomena by the monetary upheavals that followed the discovery of America. In the 1500s and the early 1600s, Molina, Lessius and Lugo put forward elegant analyses of the distinction between interest, considered a merely monetary phenomenon in line with Thomas Aquinas, and profits. In general it was censurable, usury, to charge interest on sums that were lent, because money was deemed unproductive; however, it was morally acceptable to receive compensation, a return or a share of the profits where the money lent gave rise, through commerce, to the creation of new wealth. The distinction between monetary interest and profits, the fruit of the use of money in commercial and productive enterprises, was lost for several centuries. After Wicksell it was rediscovered by Keynes, who made it a cornerstone of his General Theory. In the nineteenth century Ricardo and Malthus in England observed and theorized the expansion of industry and international trade, the growth of the population and its relationship with resources. Malthus also perceived the problem of effective demand. Marx, reinterpreting Hegel and Ricardo, drew on the development of mass production and capitalism and the tensions between workers and capitalists to form his palingenetic vision of the end of private property, the triumph of the proletariat, and communism. In continental Europe and Italy, Christian sociologists and economists - Ozanam, von Ketteler and Toniolo - analyzed the social and political consequences of the industrial revolution and the spread of mass production. They prepared the way for the social doctrine of the Catholic Church and Pope Leo XIII’s encyclical Rerum Novarum. In Germany the principles of the welfare state were outlined. In every epoch, the great economists understand the economic and social changes and upheavals of their times. They put forward new views of the forces that dominate the evolution of the economy. They study stylized facts, theorize them and reduce them to logical relationships and to models of how economic systems work, from which they draw indications for the conduct of business and for the action of the public authorities. Towards the end of the nineteenth century the role of credit and banking and, more generally, of finance emerged in all its importance. The separation, the real and logical distinction, between economic agents who save and those who use savings or make investments by borrowing capital has enormous implications not only for the expansion of economic activity but also for the stability of the growth process, both within individual economies and across economic systems. Keynes fully understood these changes and derived revolutionary economic theories from them, as well as setting out their far-reaching implications for policy. His genius is to be seen in the Economic Consequences of the Peace, which, it gives me pleasure to recall, was immediately translated into Italian by the Milanese publisher Treves. Keynes foresaw the devastating effects of the Treaty of Versailles on the European economy. He envisaged the losses suffered by Germany and Russia being a source of major political instability in Europe. He made a fierce attack on the work of President Wilson, the French president and the British prime minister. He examined the advisability of partially or completely cancelling war debts that had become unbearable for the smaller countries, and analyzed the dire consequences that application of the peace treaty would have for international trade and the prosperity of some regions. In the background, there seems to emerge a positive vision of economic relations among European countries along the general lines of what would take shape in the design of the European Community. In A Tract on Monetary Reform, which was also promptly translated into Italian by Piero Sraffa, Keynes delineated a new and different role for monetary policy. The objective of the banks of issue, which had developed predominantly in the nineteenth century and the early decades of the twentieth, was basically reduced to maintaining the gold parity. Stressing the powerful repercussions of inflation and deflation on the orderly working of the economy, prosperity, growth and employment, Keynes indicated the stabilization of the price level in terms of fiduciary money as the objective of monetary policy. He advocated the abandonment of the gold standard, which he called a “barbarous relic”. Several years later, in his criticism of Britain’s return to the gold standard, he reiterated his objections to restoring the pre-war parity, or at any rate to setting an exchange rate well above the one then obtaining. In The Economic Consequences of Mr. Churchill, a pamphlet he wrote in 1925, Keynes argued that restoring the pre-war parity would generate deflation, with adverse effects on income, a contraction in the volume of business and economic crisis. The only way to avoid these effects was to reduce wages and prices. His warning went unheeded. In the opinion of many scholars, the return of all the major countries to the gold standard with a marked revaluation of their currencies was the underlying cause of the Great Depression of the 1930s. In Italy, Mussolini’s “quota 90” policy for the lira, implemented in an authoritarian fashion in 1926 by the Finance Minister, Giuseppe Volpi, despite the misgivings of the Governor of the Bank of Italy, Bonaldo Stringher, appears to have been influenced by Keynes’s suggestions. In order to mitigate the deflationary effects, the revaluation of the lira to 90 against sterling, from a market rate that had reached nearly 150, was accompanied by an overall reduction in wages of 20 per cent. In the 1930s the Fascist regime also began a large programme of major public works that supported domestic demand. The Great Depression and the economic crisis that gripped Germany were the main cause, together with the country’s severe institutional difficulties, of the advent of Nazism. The hyperinflation of the early 1920s had been the consequence of the impossibility for the German economy to expand again under the heavy burden imposed by the peace treaty. The Second World War was not unrelated to the First, partly owing to the serious errors committed in the 1920s in international relations and monetary policies. The problem of unemployment emerged in all its drama. In the United States economic policy reacted with the New Deal and with a monetary policy appropriate to the new conditions. Economists laboriously rediscovered the problem of effective demand. The Polish economist Michael Kalecki is among those to be recalled in this regard. But it was Keynes who fully developed a new paradigm with which to grasp reality and make economic policy prescriptions. In his General Theory of Employment, Interest and Money, the classical vision in which supply generates demand in accordance with Say’s Law is criticized and the causal relationship is reversed: the level of economic activity depends on the demand for consumption and investment. The separation between the units where savings are formed and those where investment is decided, through banking and financial intermediation, renders investment independent of the availability of savings. In the absence of full employment, the expansion of public and private investment generates an increase in employment, consumption, production and, ultimately, savings that is sufficient to cover the new investment. The rediscovery of the distinction between the interest rate and the marginal rate of return on investment gave Keynes the theoretical model for determining the demand for capital goods on the part of firms. The equilibrium between saving and investment is re-established through changes in income, while the interest rate is determined in the money market. The model’s originality, the theoretical revolution, was grasped by economists. John Hicks offered an elegant interpretation of it in Mr. Keynes and the Classics. In 1944 Franco Modigliani extended the analysis of Keynesian theory and formalized it in Liquidity Preference and the Theory of Interest and Money. In the United States the new theory’s implications for the public finances were worked out by Alvin Hansen. The great effort to rebuild an international monetary order towards the end of the Second World War, culminating in the Bretton Woods agreements of 1944, again saw Keynes among its protagonists. Instead of his proposal based on the creation of an international currency, the bancor, the agreements mainly adopted the plan formulated by Harry Dexter White of the United States, based on the dollar, which was in turn linked to gold. America and the Federal Reserve came to play a role akin to that of a world central bank. The ascendancy of the dollar as the most important currency in international trade had major consequences for the US economy. Like all great thinkers, Keynes interpreted his times. His theories have had an immense influence on the economic policies of all the major countries up to today; they have also been subjected to stretched interpretations and used for shortsighted policies in the field of public finances. That public works could be used to alleviate unemployment was something rulers had always known. It will suffice to recall the examples of public spending in the Papal States and the Kingdom of Naples in Italy before national unification. One example of a programme designed to increase the level of effective demand was Roosevelt’s New Deal in the United States. In England, the Beveridge plan was influenced by the same philosophy. Post-war Italy’s on-the-job public works training scheme, the Vanoni plan and the programme of special measures for Southern Italy are other examples. Keynes’s original idea was to concentrate on public works and infrastructure, on expenditure intended to orient production and not on unproductive expenditure, although he later used the paradox of digging holes in the ground and then filling them in to explain the principle of effective demand. On the theoretical level, the Keynesian model is definitively established as an explanation of how an economy works. I was brought up on Keynesian theory by Modigliani and Samuelson at the Massachusetts Institute of Technology in the 1960s. Solow’s classes introduced me to the theory of growth. Those were the years of Kennedy’s New Frontier and the new economic policy. Keynesian theory was taught and applied, but Modigliani also encouraged me to look into the work of Friedman, who was refocusing attention on classical monetary theory. Friedman had restated the quantity theory of money in 1956. In his Presidential address to the American Economic Association in December 1967 he prefigured the explanation of the stagflation of the 1970s. He reasserted the need to control the quantity of money and not only interest rates. His ideas formed the basis for the monetary policies of the leading industrial countries in the 1980s and 1990s after the period of inflation that followed the cutting of the link with gold and the oil crises. An elegant and insightful synthesis of these two theories, the classical and the Keynesian, was developed by Patinkin in Money, Interest and Prices. In the Bank of Italy’s econometric model, which we began to build in 1963 and which is continuously updated and used to analyze the evolution of the Italian economy, the starting point is a Keynesian approach to the operation of the real sector of the economy; this is then integrated with an analysis of financial flows, à la Tobin. The stabilization of Italy’s economy in 1974 after the first oil shock, which involved limiting the volume of bank lending in order to control domestic demand, capital outflows and the exchange rate, was planned and estimated using the model. The outcome was more than satisfactory. The same model was the basis for deciding the massive fiscal adjustment undertaken in 1977 to improve the balance of payments and curb inflation. In both cases the measures were set out in agreements with the International Monetary Fund. For the stabilization programme of 1994-96 we relied on a stringent monetary policy. The objective was to subdue inflation, and the rate was rapidly reduced from almost double digits to around 2 per cent. Following the drastic monetary restriction, in roughly two years the lira appreciated by more than 25 per cent against the German mark. The growth in the money supply was virtually nil in the two years 1995-96. Initially, short-term interest rates had to be raised to an exceptionally high level by rationing central bank credit to banks. Inflationary expectations were stamped out; the lira appreciated and long-term interest rates fell from almost 14 per cent in early 1995 to 6 per cent within the space of two years. Although a Keynesian model was employed in order to analyze demand, output and employment, the monetary tightening proved effective in disinflating the economy. In some respects even the supply-side economics of the Reagan Administration in the 1980s, which was also a major factor in the strong performance of the US economy in the 1990s, can be interpreted as a stimulus to domestic demand based on a reduction of taxation and an increase in the budget deficit. The economic policy pursued by the United States in 2001 and 2002, consisting in large interest-rate reductions, tax cuts and increased public spending, also displays pronounced Keynesian traits. It was made possible by the existence of a budget surplus, the relatively low level of public debt, the strength of the dollar and the growth in productivity, itself ascribable to the flexibility of the labour market, which prevented inflationary repercussions. In several cyclical phases in recent decades, and to some extent at present as well, the interpretation of international economic developments has indicated an insufficient level of effective demand, especially of investment expenditure in the leading economies. Piero Sraffa developed his ideas largely in the intellectual milieu of Cambridge, to which Keynes brought him in 1927. The year before, the Economic Journal had published an essay of Sraffa’s that shook the foundations of Marshall’s model of perfect competition. Sraffa was a student of Einaudi’s. For many years he kept up an intellectual correspondence with such philosophers and political thinkers as Wittgenstein and Gramsci. But he was a scholar open to practical problems. We see this in his writings on money and banks in Italy in the stormy aftermath of the First World War, from which he drew some principles concerning the advisability of public involvement in banking supervision in periods of instability, in economies where finance was still developing. Until 1950 he worked on the critical edition of the works of Ricardo. Exhuming an approach that had been “submerged and forgotten since the advent of the ‘marginal’ theory”, Sraffa formulated a theory of prices and distribution on rigorous analytical foundations. The result was a critique of the neoclassical theory of value, which was the consensus doctrine of the day. His analysis contradicts the Marxian labour theory of value. Like Keynes, Sraffa distinguishes the share of output that remunerates capital from the interest rate. He mentions the possible influence of the rate set by the central bank on the rate of profit. Sraffa’s Production of Commodities by Means of Commodities was not published until 1960, after more than three decades of intense work to make sure of the logical and mathematical consistency of his theory. It was published in English and an Italian version was brought out almost simultaneously. The new theory triggered lively debate. One of Sraffa’s students, Luigi Pasinetti, crossed swords, successfully, with two eminent representatives of neoclassical economics, Solow and Samuelson, my own professors. Another of his students, Pierangelo Garegnani, continued to elaborate Sraffian capital theory. He is now working on the complete edition of Sraffa’s papers, still largely unpublished, with support from the Bank of Italy. In 1965-66, in his course on “Advanced Economic Theory”, Samuelson described Sraffa’s work with the greatest respect and linked it to the great school of thought beginning with Quesnay’s Tableau économique and continuing, three centuries later, with Leontief’s input-output tables and linear programming. Professor Samuelson reaffirmed this judgment in an article in the Corriere della Sera of 6 September 1983 on the occasion of Sraffa’s death, with the statement that if his work had been published a decade or two earlier it would have exerted a powerful influence on the subsequent development of economic theory by Leontief, von Neumann, Knight and Koopmans. Professor Pasinetti has extended Sraffa’s theoretical vision to the analysis of economic development. So far, to my knowledge, this has had limited application to current economic events. I should like, instead, to put forward the hypothesis that it can be of considerable help in understanding several important phenomena of our age. Sraffa’s model is an analytical interpretation of subsistence, of the conditions for the existence and survival of an economic system. The relationships between the quantities of commodities produced and used for production and prices must correspond to certain conditions connected with technical relationships. The model offers a new view, which also differs from classical economics, of the relative importance of different goods in the functioning of the economy. Some goods are essential for the production of the others; their disappearance would derail the economy. On the contrary, luxury goods only satisfy the needs of certain groups of consumers; their disappearance would have no significant repercussions on the economy, nor would it affect the distribution of income between wages and profits. The model shows very clearly that the value of non-reproducible goods of which a given amount is found in nature, such as land, depends on all the other relationships existing between the goods that are produced, which in turn are means of production. In the same way as for luxury goods, taxes on rents have no effect on prices or the distribution of income. The meaning of Sraffa’s laconic remark on the possible dependence of the rate of profit on the rate of interest may be less elusive today. With the globalization of financial markets, the rate of profit must be correlated with and is certainly powerfully influenced by the level of interest rates established in the international money market. Classical models can be extended along the lines developed by von Neumann to the link between the interest rate and the rate of growth. In a global economy with unrestricted international financial transactions, this has implications for the sustainability of growth in economies with a large foreign debt, the interest rate on which is determined exogenously by the level prevailing in international markets. It also has implications for the distribution of income between wages and profits within such economies. Finally, I would like to read Sraffa’s work in the light of an ideal connection with the profound thought of the medieval Schoolmen in their search for the just price. Given the rate of profit, commutative justice is established in the exchange of goods within the economy, based on the quantity of labour directly or indirectly embodied in them. Every worker’s purchasing power is determined exactly as a function of the structure of production, as defined by technical ratios. In other words, every worker’s purchasing power reflects the values of the goods that remunerate the effort required to produce them. In addition to commutative justice this also results in a sort of distributive justice as the foundation of society. Considerable progress has been made over the past two decades in the economic and institutional situation of the advanced and the developing countries, in global economic interdependence and in international economic cooperation. Observers and politicians are fully aware of the need to take up the challenge of a globalization process that, while greatly improving living conditions throughout the world, has also aggravated and above all highlighted the disparities between the supply of essential goods and the level of economic development in different countries and geographical areas. Financial globalization has progressed at a very fast pace in the past twenty years, thanks in part to the use of information technology. Today it can be said there is a single, worldwide money and financial market. The growth in world trade has mainly concerned industrial products. These developments in the exchange of goods, services and capital are a source of wealth for all who take part in them. Yet the liberalization and globalization of financial flows can be accompanied by outbreaks of instability that harm the weakest economies. In a system that rests basically on fiduciary money, the principles of free trade and comparative advantage typical of trade in manufactures have sometimes been extended unquestioningly to movements of financial capital. Past errors in fixing exchange rates and instituting specific monetary regimes have been repeated in new ways. Reflection on the mistakes made and the need to limit and rectify the adverse effects on the stability of intermediaries, to protect savings and to restore conditions for a recovery in output have prompted the monetary authorities of the industrial countries to establish more extensive and closer cooperation among themselves and with the developing countries. The Governor of the Bank of England, Sir Edward George, plays a leading role in this new phase of international monetary cooperation that we could say began with the meeting of the Group of Seven leading industrial countries in Toronto in February 1995, shortly after the Mexican crisis erupted. The international financial system’s ability to cope with the repercussions of the uncertainty that followed 11 September 2001, the difficulties created by the cyclical slowdown in the leading economies and the consequences of the discovery of serious irregularities in the management of major international economic and financial groups, without suffering serious damage, testifies to the positive results. To date, agricultural commodities and textiles have been excluded from the liberalization of trade. The leading industrial countries must make an effort to reduce the enormous subsidies to their agricultural sectors and remove the regulatory and tariff barriers to imports of agricultural products and textiles from the developing countries. By concentrating on the production of high-quality goods and opening up to imports of widelyconsumed goods from the developing countries, the wealthiest economies can make an important contribution to increasing world output and, above all, to ensuring it is more equitably distributed. The great economists are men of their times, but they also have the ability to shed light on the future. The twentieth century gave us examples of instability and of economic and political upheaval of extraordinary magnitude. At some crucial moments people feared for the very survival of our civilization, owing to the wide-scale use of weapons of mass destruction. The experience of the two world wars, with their legacy of death and destruction, must impel us to relegate war to the past as a means of solving international disputes. Great philosophers have taught us that peace lies at the core of the future of humanity. Closer cooperation between the advanced countries and the emerging economies can contribute to the progress of the world economy. It is necessary to rely on the decision-making power of the United Nations. It is necessary to oppose all the forms of violence that offend the dignity of the person, such as terrorism. It is necessary to strengthen, also in the light of ethical principles, the foundations of international law and institutions. For its part economic theory has made major advances. There is room to refine the analytical instruments that the great thinkers of the distant and recent past have handed down to us and adapt them to today’s situations. This is a task for universities, but also for the institutions that are continuously faced with new phenomena and problems. Further intellectual revolutions may not be indispensable; if they are, enlightened minds will put them forward. Fruitful results can still come from the analogical application of existing theories, formulated for essentially closed economies, to increasingly open and integrated economies. The institutional orders and policies adopted for national financial systems can provide guidance, taking account of the differences, for world finance. Theoretical models developed in the age of free banking can be applied to the analysis of international finance, in which the national monetary systems of individual countries play a role similar to that played by banks in national economies in the early decades of the 1900s. There exists a problem of controlling global liquidity, in addition to the stability of intermediaries. As rightly pointed out by Fausto Vicarelli, an economist who died prematurely some ten years ago, the basic characteristic of capitalism in the age of finance is instability. He considered the analysis of this phenomenon, and the consequent proposals for economic policy, to be one of Keynes’s most important contributions. Sraffa’s theory and the exhumation of classical doctrine, from Smith to Ricardo, not to mention the neoclassical models of growth, provide us with interpretations of the underlying relationships that link the variables of the economy. We know the mechanisms, but our grasp of what sets them in motion is often tenuous. Investment remains a fundamental variable for comprehending the evolution of an economy. Our knowledge remains incomplete, however, our forecasting power fragile. The current difficulties of the European economy and the uncertain outlook in Japan suffice to demonstrate this. The links between economics and the other social sciences must be rediscovered, beginning with the adjacent and most closely interrelated disciplines, such as demography. There remains the wider realm of the moral sciences. Economics is part of philosophy and politics. In his writings Professor Dahrendorf compels us to re-examine critically the relationship that has developed between freedom and society, between the market and regulation, between democracy and self-determination. Raising the issue of a new international order, he has affirmed that “democratizing international decision-making is the greatest challenge posed to our political imagination”. There is a need for a “strong philosophy” of which economic theory must be an organic part. Adam Smith was a professor of moral philosophy; The Wealth of Nations springs from a social and political vision. The development of marginal analysis and the theory of markets and the study of general equilibrium have made fundamental contributions to our understanding of the economic behaviour and facts that surround us and in which we are immersed. They are not sufficient. We must investigate the underlying determinants of economic phenomena. The advances by Keynes and Sraffa beyond microeconomic analysis, with one considering aggregate quantities and the other the value relationships between wages and goods, directly seek to understand the variables of greatest importance for the welfare of society. The ancient themes of commutative justice and distributive justice maintain all their relevance. Economic analysis must go back to investigating first principles, rediscovering the links with the other dimensions of society of which the economy is part. This can come about in empirical fashion, as often happens. But that is not sufficient. It is up to social scientists, to philosophers, to return to a more systematic study that will set our understanding and action in the field of economics on a firmer foundation. The century that has just begun, with society marked by uncertainty and based on knowledge, demands an even greater capacity for government and participation, nurtured by a higher cultural level. It is the way to invest in the future, preparing a better tomorrow for the younger generations. | bank of italy | 2,003 | 3 |
Welcoming address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Euro-Mediterranean Seminar, Eurosystem and Mediterranean country national central banks, organised by the Bank of Italy and the European Central Bank, Naples, 14-15 January 2004. | Antonio Fazio: Welcome address for the Euro-Mediterranean Seminar Welcoming address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Euro-Mediterranean Seminar, Eurosystem and Mediterranean country national central banks, organised by the Bank of Italy and the European Central Bank, Naples, 14-15 January 2004. * * * The twelve Mediterranean countries of Africa, the Middle East and Europe represented here by the governors of their respective central banks are members of the Euro-Mediterranean Partnership. They are Morocco, Algeria, Tunisia, Egypt, Israel, the Palestinian National Authority, Jordan, Lebanon, Syria, Turkey, Malta and Cyprus. They are joined by Libya in the capacity of observer. The partnership between the European Union and the Mediterranean countries began in 1995 with the Barcelona Conference; it should lead, in 2010, to the creation of an area of free trade in goods and services. The signatories to the agreement have undertaken, in particular, to allow the reciprocal establishment of enterprises and to promote flows of direct investment in the less advanced economies. The commitments entered into at Barcelona have been followed by bilateral Association Agreements between the European Union and nearly all the Mediterranean countries, including measures to liberalize trade in manufactures as agreed during the Uruguay Round. The gross domestic product of these Mediterranean countries is equal to 10 per cent of that of the euro area. They have a population of 250 million people, which is growing at an annual rate of 1.8 per cent; young people below 15 years of age are 33 per cent of the total. The European Union has a population of 380 million; the proportion of young people under 15 is only 17 per cent. The proportion of over-65 year-olds is 16 per cent and is destined to rise substantially in the decades to come. The present birth rate is extremely low, only slightly higher than the death rate. According to UN estimates, by 2015 Europe’s population will have grown by 5 million, that of the Mediterranean countries by 60 million. The per capita GDP of the twelve countries is showing a tendency to rise, albeit slowly; it still averages only 11 per cent of the figure for Europe. Some years ago the Bank of Italy began a study of the economies of North Africa and the Near East. The geographical proximity and already significant commercial ties with these countries, the migratory movements, and the prospect of financial integration prompted us, within the Eurosystem, to undertake a more systematic analysis of the scope for their development, which is of great importance for Europe as well. The exports of the twelve countries and Libya are equal to around $120 billion a year, 20 per cent of the area’s gross product. More than half go to the European Union; 50 per cent of the goods exported to Europe are manufactures, the remainder consists mostly of energy sources and to a smaller extent of other raw materials and food products. Over three quarters of the thirteen countries’ imports from Europe consist of manufactured products; these imports account for about half their total merchandise imports. Trade among the countries of the area is limited. There are intense migratory movements from these countries to Europe, owing to their closeness and, above all, as a consequence of the large differences in per capita incomes and living standards. In Italy, out of a total of about 1,400,000 immigrants, 160,000 come from Morocco, 50,000 from Tunisia, 25,000 from Egypt and 12,000 from Algeria. In Germany, out of a total of some 7,300,000 foreigners, about 2,000,000 come from Turkey. In France, out of a total of about 3,300,000 immigrants, more than 1,300,000 come from Morocco, Algeria, Turkey and Tunisia. Migratory flows will undoubtedly increase owing to the ageing of the European population and the limited supply of workers to do unskilled and low-paid jobs. A major social and political issue is how to control migration, to ensure that it will benefit rather than harm our economies, to guarantee that immigrants and their families are harmoniously inserted into our societies; and to avoid the rifts, the marginalization and the problems of law and order caused by unregulated flows. Voluntary organizations do commendable work in fostering the social integration of immigrants. Many attempts, some very recent, to enter countries illegally with the complicity of criminal organizations have ended tragically, with women and children among the victims. There is an increasingly urgent need to find suitable ways to regulate the phenomenon and prevent the suffering and loss of human lives, in combination with policies for the development of the countries of origin of the migratory flows. An important shortcoming of the bilateral agreements between the European Union and the Mediterranean countries is the failure to liberalize trade in agricultural products, where the Mediterranean countries have a significant comparative advantage, to the benefit not only of their economies but also of ours. Direct investment in the Mediterranean countries, the most effective way of disseminating technological know-how, has been on a limited scale up to now. At the end of 2002 it amounted to €103 billion, or less than 20 per cent of the GDP of the countries of the area. A quarter of this investment was by EU businesses, 2 per cent by Italian ones. Firms from Mediterranean countries play only a small role in Italy, almost exclusively in the energy and media sectors; there are a few cases of equity interests in Italian banks and industrial companies. Closer links exist with the productive sectors of other European countries, but they are still of marginal importance. The openness of the Mediterranean countries’ financial systems, centred on banks, is limited. In many countries banks are still largely owned by the state. The development of the financial system is hindered by shortcomings in the legal framework and the governance rules for firms and markets. The key feature of the Euro-Mediterranean Partnership is a new strategic approach on the part of the European Union to the problem of these countries’ development. No longer are they seen as single entities to trade with and provide with technical assistance through bilateral agreements, but as an area in which to promote the start of a process of faster growth through institutional and economic reforms and the coordination of private and public investment. To this end there needs to be a continuing financial commitment on the part of the European institutions but also more intense contacts and exchanges of experience between the institutions and operators of the Mediterranean countries on the one hand and their European counterparts on the other. The decision taken in Naples last December to establish a Euro-Mediterranean Foundation can reinforce the links between the countries involved through training programmes and initiatives aimed at fostering mutual understanding and a dialogue between cultures. In the last few years the drive to bring about a radical renewal of the Mediterranean economies has lost momentum, partly as a consequence of the prolonged stagnation of the world economy. Progress has been made, albeit to a varying extent, in all the Mediterranean countries in terms of institutional reforms, market building, liberalization programmes and reducing the role of the state in the economy; coordination of the action aimed at the integrated development of the area is still lacking. There are risks of marginalization with respect to a world economy that is changing rapidly. This seminar, organized by the European Central Bank and the Bank of Italy, can be a stimulus to renew the initiative. In three working sessions, reserved to the central banks, it will address a series of problems regarding economic integration, exchange rate management, and banking and financial systems. It is our hope and intention that the seminar will not remain an isolated event. The Bank of Italy, in close accord with the Eurosystem, is willing to offer the necessary support for the creation of an institutional framework for the start of a long-lasting collaboration. Meetings like the present one can be held periodically on specific topics of interest to the central banks. In classical antiquity the Mediterranean did not constitute a barrier between the populations living on its shores. Rather, it was a basin of communication for intense trade in commodities and goods, for cultural exchange, for often peaceful, sometimes belligerent relations. In the words of Fernand Braudel, “The Mediterranean is the world’s most ancient crossroads. For thousands of years everything has converged here, mixing, enriching its history: men, beasts of burden, machines, goods, ideas, religions, ways of life”. This ancient unity, the Greek koine and the Roman empire, were followed by centuries of troubles and division. The unity that wars had shattered was laboriously but admirably restored in the Middle Ages at the cultural level, with the contribution of great Arab and Jewish philosophers, with the recovery of ancient learning, with the synthesis of Scholasticism. Today, however, we come from a long period, many centuries, of division, conflict, and war between the peoples of the Mediterranean, of profound upheaval in Europe as well. In the last fifty years, after the Second World War, our continent has taken a great stride forward in its history; fifteen peoples who at times had fought each other fiercely over the centuries have decided to unite in taking a path of economic and civil advancement. These peoples will shortly become twenty-five. Today, we are taking the first small but sure steps towards building a new unity of intent in the quest for shared progress around the Mediterranean, sustained by the values and cultures of the peoples of Africa, the Near East and Europe and the desire to exchange goods and experiences. Peace and trade will necessarily bring prosperity. The importance of the financial dimension for economic development must emerge clearly from today’s seminar. Let us proceed with humility, but also with commitment, in the search for a common language and shared objectives. This invitation is addressed to those participating in the seminar, but also to the wider financial, economic and civic community which, responding to our call, has welcomed us to this ancient but also modern and beautiful city of Naples. | bank of italy | 2,004 | 2 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF - ASSIOM - ATIC Forex, Genoa, 14 February 2004. | Antonio Fazio: The international economy and Italy Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF - ASSIOM - ATIC Forex, Genoa, 14 February 2004. * 1. * * Recent economic developments At last year’s General Meeting of Shareholders on 31 May I brought my Concluding Remarks to a close with the prospect of a recovery in the world economy during the course of 2003, and more certainly in 2004. Expectations were that domestic demand and output in the United States would accelerate as early as the second half of 2003, driven by the monetary expansion, tax relief measures and weakening of the dollar. On this basis we suggested that Europe, and especially Italy, stood in need of an economic policy capable of putting the economy back onto a path of faster growth. The US economy grew at an annualized rate of 8 per cent in the third quarter of 2003 and 4 per cent in the last. The GDP of the European Union, calculated at the average exchange rates of 2003, is of the same magnitude as that of the United States; it grew by 1.1 per cent in 2002 and by 0.8 per cent in 2003. Output increased in absolute value in the United States in one quarter by as much as it did in the European Union in two years. Labour productivity in the United States rose by 9 per cent in the third quarter of 2003 and by 3 per cent in the fourth. The decline in unit labour costs and strong competition kept the rate of inflation low; excluding food and energy products, it amounted to 1.5 per cent, which was lower than in the European countries. Fearing the possibility of deflation, the Federal Reserve accentuated the expansionary stance of monetary policy. Fiscal policy pushed the federal deficit up to 3.5 per cent of GDP in 2003, and it is expected to rise to 4.5 per cent this year. The growth in output averaged 3.1 per cent in 2003, well above the forecasts made last spring. In Japan exports expanded strongly in the last part of 2002 and recorded a further substantial increase in 2003; last year GDP grew by 2.2 per cent. The reorganization of production in large manufacturing companies has improved profitability and reduced employment. Since the mid-nineties, some 2,700,000 jobs have been lost in manufacturing industry against a gain of 1,100,000 in the other sectors. The improvement in profitability in industry had beneficial effects on the banking system, which is currently engaged in securitizing large volumes of doubtful loans. Symptoms of deflation are still present. Monetary policy has been even more expansionary. With the lessening of global political tensions, economic activity has picked up and progressively gained strength in the emerging economies as well. After two years of sharp deceleration, in 2003 the rate of growth rebounded to almost 6 per cent. In the emerging Asian countries GDP growth was 7.5 per cent. In Latin America, the modest results achieved by Brazil and Mexico contrasted with the sharp recovery in Argentina. The rate of growth in the euro area was no more than 0.5 per cent. In 2003 the world economy is estimated to have grown by 3.7 per cent. For 2004 the International Monetary Fund forecasts GDP growth of 4.6 per cent in the United States, 2.2 per cent in Japan, 6 per cent in the emerging economies and 3.6 per cent in the main Latin American countries. In the twelve euro-area countries output is expected to grow by 2 per cent. The world economy is forecast to grow in 2004 by around 4.5 per cent. 2. Liquidity and the international financial markets In a context of low inflation and globally insufficient aggregate demand, markedly expansionary monetary conditions in the three major areas have driven interest rates down to historically low levels, fostered a faster expansion of credit and supported the recovery of the financial markets. During the nineties the money stock in the seven leading industrial countries was somewhere between 65 and 70 per cent of GDP. In the last five years it has risen steadily to reach nearly 80 per cent, an increase larger than that recorded in the previous twenty years. In the three major areas it was monetary base and the more liquid components of bank money that increased most. From the mid-nineties onwards the deposits of non-residents more than doubled, rising from around 3 per cent of GDP to nearly 8 per cent. Conversely, short-term interest rates in the United States, the euro area and Japan have fallen to their lowest levels since the end of the Second World War; net of inflation they are close to zero. Real long-term interest rates on government bonds, which had touched 5 per cent in 1995, gradually came down to fluctuate around 2 per cent at the end of last year. After nearly doubling between 1996 and 1999, the capitalization of equity markets then fell and in 2002 was close to the value recorded six years earlier. The decline in share prices continued until March 2003, they have since risen by 40 per cent in the United States and France, by more than 70 per cent in Germany and by 30 per cent in Italy. In Italy and France price-earnings ratios are broadly in line with their long-term values. In the United States stock prices are high in relation to profits and dividends, reflecting low interest rates and expectations of higher growth. After a pause in 2002, the notional value of derivative products recorded another very large increase in 2003. For the seven leading industrial countries the value of listed derivatives rose from 110 per cent of GDP to 180 per cent, almost three times as high as in the nineties. The restructuring and capital strengthening carried out in recent years by the banking systems of the leading industrial countries, prompted by the supervisory authorities, enabled them to take the fall in stock prices between 2000 and 2002 and the sharp slowdown of the world economy in their stride. Banks were able to cope with the difficult conditions in some countries and absorb the consequent losses. They provided support for the restructuring of important sectors of industry and thus prevented production crises and job losses from spreading. After slowing sharply between 2000 and 2002, bank credit began to expand more rapidly again. Last year outstanding loans in the leading industrial countries grew by 4.3 per cent. There has been an increase in loan securitizations in domestic and international markets that have lessened the concentration of risk by spreading it across the financial system. In the last ten years companies active in the main markets have increasingly raised funds through bond issues, to finance investments and expand their operations. In Europe a major factor in the growth of this market was the introduction of the single currency. The outstanding value of medium and long-term bonds issued by non-financial corporations in the seven leading industrial countries roughly doubled between 1995 and 2002, rising from $2,800 billion, or 14 per cent of GDP, to $5,000 billion, or 24 per cent of GDP. At the end of 2002 the corporate bonds outstanding in the United States amounted to more than $3,000 billion, in the United Kingdom to more than $500 billion and in France to more than $300 billion; in Italy they amounted to about $100 billion. The flow of net issues remained high in the first half of 2003 in the United States, France and Germany. The spreads on emerging countries’ dollar-denominated securities over US securities have nearly halved, falling from 8 to 4.2 percentage points between the middle of 2002 and the end of 2003, in concomitance with the resumption of the flow of funds towards these countries. 3. Investment and demand The ample supply of credit and the low cost of capital have fostered an acceleration in investment in the United States and the emerging economies. Wage moderation in all the developed countries, as well as in the emerging economies, has permitted a constant increase in the flow of self-financing. The production of goods and services continues to be reallocated from the developed countries to the emerging countries in order to take advantage of lower labour costs. In the fifteen countries of the European Union, between 1980 and 2001 the manufacturing sector’s contribution to total value added declined from 24 to 20 per cent. The contribution of private services to income formation rose from 41 to 48 per cent. In the United States, over the same period the contribution of manufacturing fell from 21 to 14 per cent; that of private services rose from 52 to 61 per cent. The large flows of direct investment by US firms in Mexico and other countries of Latin America and in China and other Asian countries relate in good part to relatively low-tech production; in the emerging economies mid-tech production is also gaining ground. Investment in services and high-tech production continues to be concentrated in the developed countries. In the United States the easy monetary conditions, coupled with rapid population growth resulting from natural demographic increase and substantial immigration, led to investment in housing recovering strongly in 2002; the growth accelerated in 2003. By contrast, business investment in plant continued to shrink, but there was a pronounced increase in firms’ spending on machinery and equipment, especially information technology. The composition of business investment is reflected in the trend in payroll employment, which in the manufacturing sector was 3.6 per cent lower in January than a year earlier while in services it was 0.4 per cent higher. On the other hand, hourly labour productivity has risen sharply. In two years, between the fourth quarter of 2001 and the fourth quarter of 2003, labour productivity in the US non-farm business sector increased by a total of nearly 10 per cent. Population growth, the high proportion of young people, tax relief and low interest rates have pushed up consumption demand, particularly for durable goods, which grew by 6.5 per cent in 2002 and 7.4 per cent in 2003. Business investment has been sustained by the substantial rise in firms’ profits and the improvement in their overall financial position. The financial situation of households has also turned better. In Japan, against the background of a recovery in global demand, continuing abundance of liquidity and, above all, productivity gains by firms, private investment began growing again in the second half of 2002; in the first three quarters of 2003 the average increase was 8 per cent on an annual basis. There was a strong upturn in exports. In France, Germany and Italy, notwithstanding plentiful liquidity and the historically low cost of money, business investment diminished. In Italy total investment, including private and public-sector construction, fell in the first half of last year by nearly 10 per cent on an annual basis. The capacity utilization rate is low in all the euro-area countries. Consumer confidence, which was also weak, showed a slight improvement in Europe in 2003. In the euro area, after declining by 2.9 per cent in 2002, investment fell further by 2.6 per cent on an annual basis in the first half of 2003. Exports, weighed down by the appreciation of the euro, fell by 3.9 per cent in the first half of the year. The decrease was 2.7 per cent in Germany, 5.8 per cent in France and more than 13 per cent in Italy. Euro-area resident households’ expenditure, which was stationary in 2002, showed signs of increasing in the early part of 2003 but then slowed down again in the course of the year. In the third quarter euro-area and Italian exports staged a recovery, in concomitance with the pick-up in activity in the United States, Japan and the major Asian economies. Merchandise exports of the leading industrial countries, which had stopped growing in the latter part of 2002 and the early months of 2003, began expanding again in the second half of the year in both the industrial countries and the emerging economies. The large external deficit of the United States has fueled the growth in the supply of dollardenominated assets on the international markets. Private capital flows to Latin America have resumed, while those to the emerging countries of Asia and the countries of central and eastern Europe have remained strong; the flow of direct investment from the industrial countries continues; investment and growth in the developing areas are gaining pace. 4. Sustainability of the recovery The business cycle and growth in the United States are decisive for the prospects of the world economy. In 2003 world GDP amounted to $35,600 billion, of which US economic output accounted for 30 per cent or just under $11,000 billion. Japan’s GDP was $4,200 billion; that of the euro area was $8,100 billion, or more than one fifth of world economic output. Italy, with annual output of $1,400 billion at last year’s average exchange rates, accounted for 4.1 per cent of the world economy, mainland China for 3.9 per cent. The other developing countries together accounted for 13 per cent of world output. The latest forecasts for the United States are for GDP growth of around 4.5 per cent in 2004 and 4 per cent in 2005. Inflation will remain low. The consequence is a positive forecast for the world economy in the next two years. The acceleration in economic activity, under way since the middle of 2003, and the continuation of rapid growth in 2004 and 2005 are based on the recouping off of an initial situation of production below capacity. The estimates of potential GDP growth in the United States for the next five years range between 3.2 and 3.5 per cent annually, depending on the source. All in all these are prudent forecasts, taking into account the productivity gains that have been achieved in the last three years, the growth of the population, the country’s endowment of human capital and the heavy investment in technology and information systems. Productivity performance is in a sense the key to an economy’s strength. However, the macroeconomic context in which the efficiency of the US productive system is set contains factors of risk for the sustainability of growth. The financial balance of the public sector, the linchpin of the policy of support for domestic demand, went from a surplus of around 1.3 per cent of GDP in 2000 to a deficit of 4.8 per cent in 2003. The improvement in the balance between saving and investment of households and firms, amounting to around 5 percentage points in the three years from 2001 to 2003, offset only part of the deterioration in public-sector saving. Over the same period the balance-of-payments deficit increased by about one percentage point of GDP. The sustainability of the public debt appears to hinge crucially on economic growth. On 2 February the Administration announced it was committed to reducing the federal deficit from the $521 billion projection for 2004 to $364 billion in 2005 and $237 billion in 2009. The intention is to lower the ratio of the deficit to GDP to 2 per cent. At the end of 2003 the amount of federal government debt held by the public was equal to 36 per cent of GDP. It should be recalled that the household saving rate is extremely low and household debt high in the United States by comparison with Europe and with Italy especially. The external deficit is equal to approximately 5 per cent of GDP. The net external investment position is now negative by one quarter of GDP. At the global level a significant statistical discrepancy is to be found between the US balance-ofpayments deficit on current account and the rest of the world’s surplus; it is equal to one third of the US deficit. The growth in US foreign debt greatly exceeds the increase in assets held by the rest of the world. The sustainability of the foreign debt and, consequently, of the exchange rate depends on the demand for financial claims denominated in dollars and on the share of 12 American real assets held by non-residents. There is probably a substantial volume of dollar-denominated financial assets owned by firms and individuals that are formally not resident in the United States but which are within the orbit of that country’s economic and political system. In a globalized financial system, the productivity of the US economy, the country’s political and military strength, the stability and prestige of its institutions, the efficiency and liquidity of its markets offer real and financial investments a promise of safe long-term yields. Large exports of capital from the United States and high direct investment in all the emerging economies led to a stock of foreign assets worth $6,474 billion at the end of 2002, 31 per cent of this consisted of direct investment and 21 per cent of shares. At the end of 2002 America’s gross foreign liabilities stood at $9,079 billion, of which 22 per cent consisted of direct investment, 13 per cent of shares and 34 per cent of private and public-sector bonds; interest payments averaged around 3 per cent. Given its share of world output and finance, the US economic and financial system extends beyond the nation’s borders. A pattern seen during the last century for other economically and financially hegemonic systems is being repeated. A similar tendency can be seen for Japan in relation to the emerging economies of Asia. In response to the concern lest a large external deficit influence the level of the exchange rate, on the occasion of the recent meeting of the Group of Seven in Boca Raton, Florida, the US Treasury Secretary reaffirmed the Administration’s commitment to policies conducive to a strong dollar whose value would nonetheless continue to be determined by market forces. The direct investment of the more advanced countries promotes economic activity and introduces new technologies in those where the cost of labour is very low. A valid economic and institutional framework and the provision of infrastructure can create the conditions in newly industrialized and emerging economies that will enable them to attract foreign investment and boost growth. The free movement of capital is a powerful force in the expansion of the world economy. Even though China, India and other newly industrialized countries in Asia still account for only a limited portion of world output, their economies are growing more than twice as fast as those of the more advanced countries and contribute significantly to the expansion of the global economy. Economic activity in Latin America has begun to expand again after the major crises of recent years. In Argentina maintaining the present favourable macroeconomic trend will depend on the efforts to honour the undertakings entered into with the International Monetary Fund, achieve a satisfactory restructuring of the country’s foreign debt and rehabilitate the banking system. Parts of Africa, still crushed by a heavy debt burden and a series of institutional and other local problems, remain excluded from the advance of the world economy. It is necessary to revive the debtrelief procedures of the Highly Indebted Poor Countries Initiative. Europe is not contributing to the growth of the world economy. A stronger performance on its part is also necessary to adjust the payments imbalances between the principal regions of the world. The continent’s demographic structure and the aging of the population appear to offer little incentive for investment. The potential growth rate of the European economies is estimated at around 2 per cent. In recent years the expansion of output has been less than 2 per cent. This year it is expected to come near it. Despite slow growth, the area still shows a small surplus on external current account of less than 0.5 per cent of GDP. Europe’s share of the volume of world exports has declined in the last few years. Since the start of 2002 it has suffered from the appreciation of the euro. Taking a longer-term view, it is the insufficient increase in productivity that is holding back competitiveness and growth. Price stability within the euro area is assured by the single monetary policy. Financial stability is guaranteed by controls and supervision at national level. To increase Europe’s growth potential, reforms along the lines of the commitments undertaken at the Lisbon European Council in 2000 are essential. Action to reduce the ratio of current public expenditure to GDP on a permanent basis is especially urgent. Measures to alter labour market arrangements are necessary. Immigration will tend to increase in the years to come as the European population ages. It must be strictly regulated, at European Union level as well. Effective policies of integration are needed to attenuate the sometimes severe repercussions on the existing social balance; they can offer an opportunity for human development to people whose homelands are beset by severe economic and social problems and contribute to the growth of our own economies. 5. Italy From 1989 to 1999 the Italian economy grew at an average annual rate of 1.5 per cent, compared with an average of 2.1 per cent in the fifteen countries of the European Union. For Italy, these were the years in which the external accounts were adjusted and the public sector deficit was sharply reduced. The country’s net external debt had risen gradually during the eighties, touching 11 per cent of GDP in 1992. After the devaluation of the lira in September of that year, accompanied by the containment of inflation through incomes policy and the tightening of credit, exports picked up strongly, fostering economic activity and helping to reduce the foreign debt. In October the yield on three-month Treasury bills reached 18 per cent. Trading of government securities on the secondary market continued without a break; a generalized crisis of Italy’s financial system was avoided. The Mexican crisis, which erupted in December 1994, spread to the main world markets in the early months of 1995. The flight into strong currencies led to a strengthening of the Deutschemark and large appreciation of the yen; the dollar depreciated sharply. The crisis overtook the lira along with other weak currencies; in March, in a matter of days the lira’s effective exchange rate fell by 10 per cent. Despite a surge in yields, the primary and secondary markets for government securities again continued to operate without interruption. Inflationary pressures built up again. The monetary restriction made it possible, within a year, to restore the lira’s exchange rate to its end-1994 level. Inflation was reduced to a level close to the rates in the other European countries. The abatement of inflation and the prospect of participation in the single currency led to lower interest rates on the public debt. Italy’s re-entry into the European Monetary System at the end of 1996 definitively stabilized the exchange rate and permitted a gradual relaxation of monetary conditions. The public finances benefited from the lower cost of debt. The ratio of tax and social security receipts to GDP was raised by about 5 percentage points between the second half of the eighties and the second half of the nineties. Public sector net borrowing was reduced below the 3 per cent limit in 1997. The restored stability of the exchange rate was not associated with acompatible trend in production costs. Partly owing to the limited growth of the economy, labour productivity in both industry and services did not rise in line with that of the other industrial countries. The export competitiveness of Italian products, which had improved in 1993-1996 as a result of the lira’s depreciation, began to deteriorate again. Between 1995 and 2001 labour productivity in Italy rose on average by 1 per cent a year; in manufacturing the average annual increase was 1.2 per cent. In Europe in the same period labour productivity rose by 1.4 per cent a year in the economy as a whole and 3.1 per cent in manufacturing. In the United States labour productivity in manufacturing grew by 3.7 per cent a year between 1995 and 2001. Italy’s share of world exports, which stood at 4.5 per cent in 1995 and 4.2 per cent in 1996, has contracted steadily over the past seven years, falling from 3.7 in 2000 to around 3.3 per cent in 2003. French exports represented 5.3 per cent of world trade in 1996 and were still at the same level in 2003. Germany’s share of world exports has risen from 10.3 per cent in 1996 to 12 per cent. Italy’s loss of market shares is due to the relative increase in production costs and the scant importance of exports of high-tech goods. The loss of competitiveness has had repercussions on industrial activity and economic growth. Between 1996 and 2003 industrial production expanded by 5 per cent in Italy, by 17 per cent in the euro area. The growth the Italian economy lost because of the decline in international trade competitiveness is estimated to have amounted to more than half a percentage point each year. Italian industry consists of a few large corporations and a myriad of small and medium-sized firms. The 1996 census found that three quarters of manufacturing employment was in firms with fewer than 250 employees: some 550,000 firms, or 99.7 per cent of all manufacturing companies in Italy. A significant part of this vast network of small and medium-sized enterprises is located in industrial districts, which taken together account for 41 per cent of industrial employment and 45 per cent of employment in manufacturing. For the most part, district firms are export-oriented. The organizational model of the districts, which combine cooperation with competition, overcomes some of the limits of small size and permits high levels of innovation and efficiency. This is the Italian economic engine that in decades past created wealth and jobs. However, the steady loss of competitiveness and the weakness of domestic demand are threatening the growth prospects of an increasing number of firms. Productivity and employment are slowing. Smallness is not conducive to research and development, which is indispensable for technological innovation and international opening, both crucial factors in competition between national economies. In the last decade Italian industry has also been impoverished by the loss of important branches of manufacturing. The Italian car industry has encountered serious problems. The market share of the largest group, after peaking at 60 per cent in the eighties, fell to 27 per cent in 2003; since the end of the 1980s its European market share has declined from 15 to 8 per cent. The main source of difficulty was a strategy of diversification that ultimately diverted resources away from R&D in the auto segment. Thanks to the support of the banking system the group is now on the road to recovery and disposing of assets not strategic to the core business. It has reduced its debt. The latest data indicate that its market share has risen to over 30 per cent. The recent performance of the Italian economy has also been affected by the problems at two major food-processing groups. The difficulties of Italian manufacturing industry go well beyond those of the automobile and foodprocessing sectors. Industrial activity in Europe, after reaching a low point in the second quarter of 2003, expanded sharply in the third quarter and again in the fourth. In Italy the decline between the middle of 2002 and the middle of 2003 was followed by a significant upturn in the third quarter and a small contraction in the fourth, in which GDP stagnated. In the euro area GDP grew by 0.3 per cent with respect to the third quarter. In January the confidence of households plunged in Italy. Provisional data show that industrial activity remains slack. 6. Economic policy Economic policy must restore expectations of growth, halt the slide in competitiveness and prevent new problems from affecting production. Partly owing to the difficult economic situation, the adjustment of the public accounts has relied largely on temporary measures. The public debt remains high by international standards. There is still a considerable discrepancy between the general government borrowing requirement on a cash basis and net borrowing on an accruals basis. For the years to come, the European Commission has signaled the risk that the deficit may go above 3 per cent of GDP and the need, in the absence of structural measures to cut current spending, to raise taxes. The possibility of reducing taxes depends on achieving faster economic growth. In the short term, support for domestic demand through public works programmes is necessary. The banking system, which has been greatly strengthened in the last decade by privatizations and extensive restructuring, is committed to sustaining firms that are sound and profitable but too small to confront today’s increasingly fierce international competition. The banks must help firms to grow to a size that permits them to improve product quality and increase efficiency. This year a very substantial effort will be required to finance major groups that need the resources to continue and expand their activity. The banks’ commitment to providing support for troubled industries, notwithstanding serious difficulties, is commendable. It is essential that the system should earn and enjoy the confidence of the public, the authorities, and political and institutional bodies. For half a century the savings entrusted to banks and channeled by them to firms have benefited de facto from an absolute guarantee. The cost to the public finances of banking instability and the inevitable difficulties of intermediaries has been far smaller in Italy than in the other industrial economies and in the developing countries. As in the other advanced financial systems, the direct financing of firms in the market has spread in recent years. The banks have performed the service of placing the securities issued by firms with other institutions and with private investors; the latter sometimes may not have been fully aware of the real risk of the investment. It is intermediaries’ duty to inform savers correctly and advise them wisely. We have called on them to examine the features of these instruments more carefully and to verify the full awareness on the part of households of the risks assumed, according to ethical and professional standards. Partly at our urging, banks are moving to satisfy those who have committed even modest savings to such investments without sufficient awareness. Cases of this kind must not recur. Trust must be restored in a component of the financial market that is crucial to the growth of firms. It must be reiterated that high yields are necessarily accompanied by high risks. At the end of 2002 the savings entrusted by households to the banks in the form of deposits and other funding instruments amounted to €760 billion. At the end of 2003 total funds raised stood at approximately €1,100 billion. The Bank of Italy protects savings and savers through the stability of intermediaries. It promotes the efficiency and competitiveness of the credit system and thereby favours the allocation of the funds raised for the growth of production and the formation of new savings. At the end of 2002 households’ portfolios contained a total of €290 billion of corporate shares and bonds. Corporate failures have direct repercussions on the savings of households, as well as on the banks. The Bank of Italy intervenes promptly with intermediaries so that loan losses are kept within the limits of banks’ capital and reserves and do not affect the savings entrusted to them. In an economy in which firms increasingly finance themselves in the market, the value of this component of savings depends in the first place on the stability of the firms themselves. The truthfulness and quality of firms’ financial reports and the other information they disclose to the public are fundamental. The system of internal and external corporate controls must be strengthened. We look upon the work of Parliament to improve and supplement the system of controls in the light of recent events with confidence and respect. The unitary oversight of the credit function must not be impaired. The independence of the institutions responsible for controls is of fundamental importance. Drawing on the experience of the most advanced financial systems, the instruments of intervention must be strengthened and more resources made available so that the supervisory authority for companies and the stock exchange can take timely action to limit the frequency, magnitude and effects of corporate failures. A large share of national savings is entrusted by citizens to the State. The security of the savings entrusted to the public sector is fully guaranteed by the State’s power to levy taxes. However, too high a level of public debt adversely affects the financing available for firms and for investment. By limiting growth, it prevents the formation of new savings. In the current situation of the Italian economy, it is essential to reduce the public debt in relation to GDP. The prospect of closer economic policy coordination within the Government will increase the efficacy of measures; it can favour more effective action on the public finances. The recovery of the world economy also offers Italy an opportunity to overcome the present phase of uncertainty. Capitalizing on the resources of enterprise, labour and technology that it commands or can command, the Italian economy must make a concrete start on structural action, the reforms needed for faster growth. An organic vision of the objectives and instruments, the start of the action plans can restore confidence among all economic agents: the financial system, firms, consumers and savers. Looking at the experience of the most advanced economies, it is necessary for Europe to relaunch programmes for infrastructure, innovation and research. The progress made in economic and institutional integration and the Union’s enlargement provide a solid foundation. In Italy as well we must move resolutely in the direction of faster growth, higher employment, security for the elderly and valid prospects for the young. It can be done. We must do it. | bank of italy | 2,004 | 2 |
Speech by Mr Antonio Fazio, Governor of the Bank of Italy, at the annual meeting of the Italian Bankers¿ Association, Rome, 8 July 2004. | Antonio Fazio: The banking industry and the prospects for the economy Speech by Mr Antonio Fazio, Governor of the Bank of Italy, at the annual meeting of the Italian Bankers’ Association, Rome, 8 July 2004. * * * The European banking market Over the past three years the European banking and financial system has managed to withstand, without repercussions for the cost of credit, the difficulties caused by the slowing of economic growth, fluctuations in share prices and the crises and collapse of major industrial groups. Monetary policy in the three main areas of the world has been markedly expansionary, while prices have remained largely stable. There has been a substantial increase in the monetary base; interest rates on loans have fallen to historical low levels. In the case of real-estate investment the abundance of credit has fostered price rises in excess of the increase in prices of current output; in some countries, property values have been inflated by speculation. The Federal Reserve’s recent increase in interest rates by 25 basis points marks the start of a move to bring the cost of money in the United States back to long-term equilibrium levels, against a background of robust economic growth. Even after the rate increase the yield curve has a sharp upward slope everywhere, in the United States, in Europe and in Japan, pointing to market expectations that interest rates will rise substantially in coming years. The rise in interest rates will affect public finances, particularly in the most heavily indebted countries. It re-emphasizes the need for firms to ensure that costs and combinations of factors of production can guarantee the development of their activity and the growth of the economy, even with real and nominal interest rates closer to normal levels. The return on savings invested in financial assets will increase. The resilience of the banking and financial systems in the face of destabilizing forces can partly be ascribed in Europe to the close collaboration between national supervisory authorities and the increasingly widespread adoption of harmonized rules. Substantial progress has been made in the past ten years in improving the regulatory framework and strengthening the operational infrastructure and by integrating payment systems at national and international level. The integration of the share and bond markets can benefit firms in terms of the range, quality and cost of the services provided to them, as well as households. Wholesale financial activities, interbank transactions, syndicated loans and business services are concentrated and tend to develop on international markets. According to a survey conducted within the ambit of the European System of Central Banks, the 41 largest European banking groups, including three from Italy, have establishments in an average of five member states outside their own. Mergers and acquisitions have created banking groups whose home market encompasses the whole of Europe. In Italy as well, foreign intermediaries hold substantial market shares in such fields as securities trading on electronic markets and business services, including the placement of corporate bonds. Success in the retail market, on the other hand, requires a knowledge of the social, economic and institutional characteristics of the place of business and experience in dealing with small firms and households. Collaboration arrangements with local banks and aggressive commercial policies can only substitute partially and temporarily for the informational advantages of local roots. In crossborder retail banking there have been few attempts to supply services without a permanent foothold in foreign markets; in practice the decision to do business in other countries has been accompanied by the acquisition of existing operators. The Financial Services Action Plan launched at Community level in 1999 is due to be completed by the end of 2005; it covers legislative measures applying to both the wholesale and the retail segments. Last April a directive on investment services was approved, abolishing the obligation to concentrate trades on regulated markets and providing for the protection of investors, and the directive on takeover bids, which lays the foundations for the development of a European market of corporate control. These directives supplement those, also recent, on the supervision of conglomerates operating in the banking, financial and insurance sectors and on the prevention of market abuse. The supervision of banking systems is institutionally embodied in national legislation. In order for it to be efficient and, above all, effective, it must be performed close to the intermediaries concerned. In January this year the London-based Committee of European Banking Supervisors began operation, alongside other similar committees set up for the markets in financial and insurance services. It is composed of representatives of the banking supervisory authorities and central banks of the European Union and its task is to provide technical advice to the Commission regarding legislative and regulatory proposals in the field of banking, as well as to promote the uniform application of Community directives and the convergence of supervisory practices in the member states. The internationalization of the Italian banking system Spurred by competition and privatizations, the Italian banking system has made significant advances in the last ten years with regard to the average size of intermediaries and the range of services offered. Efficiency has improved; efforts must continue, above all within recently formed groups, to increase the integration of operating structures and the effectiveness of risk-management systems. In the Anglo-Saxon countries there is clear evidence of a structural shift in banks’ business stemming from the greater development of these countries’ financial markets; the relationships between banks and firms are changing. As international competition grows more intense, these trends will also affect the Italian financial system. The new aspects of credit business and the new operational instruments will need to be assimilated by Italian bankers and adapted to the specific features of the Italian economic and institutional context; the supervisory authority is following developments closely. Mergers and acquisitions have narrowed the gap between Italian and foreign banks in terms of volumes of business. The gap reflects the less developed state of the Italian banking market. The ratio of credit to GDP is 85 per cent, a value comparable to that of France, less than those of Spain and Germany and the euro-area average, all well above 100 per cent. Lending to households is less developed in Italy, among other things because of the higher propensity to save. Most of households’ borrowing consists of home mortgages; credit for the purchase of consumer durables is nonetheless expanding, thanks in part to a more diversified and efficient supply. By contrast, lending to firms is comparable to the euro-area average in relation to GDP. Interest rates are in line with, and sometimes lower than, those in the other EU countries. Another factor tending to reduce banking intermediation is the high level of public debt and the substantial investment of households’ savings in public-sector securities. Although growing, the presence of Italian banks in foreign markets is still limited. According to the BIS, at the end of last year the Italian banking system’s assets abroad vis-àvis non-bank counterparties equaled 13 per cent of GDP. The levels reached by the French, Spanish and German banking systems are much higher, respectively 49, 36 and 72 per cent. The leading international banks are interested in the Italian market. German banks have $137 billion of claims on Italian residents, compared with Italian banks’ exposure of $33 billion to German residents; French banks have $114 billion of assets in respect of Italy, compared with Italian banks’ $28 billion in France. These figures are mainly a reflection of the important production and above all marketing presence of German and French firms in Italy. The expansion of credit must serve the needs and in fact follows that of production. We have called on the banking system to increase the support it provides for the internationalization of the Italian economy. The growth in Italian banks’ operations in foreign markets will be assisted by greater industrial and marketing penetration of Italian firms in those markets. In recent years the leading Italian banks have increased their presence appreciably in Central and Eastern Europe markets, among other things in order to grasp the opportunities for expansion in retail business in those countries and benefit from the prospects of economic growth following their entry into the European Union. They are countries where Italian firms are investing heavily, both to serve local demand and to take advantage of low production costs. In several of these economies Italian banks have acquired a significant market share, more than 20 per cent in some cases. Foreign intermediaries hold a larger portion of the capital of major banks in Italy than is the case in the other main euro-area countries and the Anglo-Saxon countries; the shareholdings involved are minority interests. The shareholdings attributable to institutional investors, and to pension funds in particular, are negligible. The banking systems of France and Germany are characterized by the large share of bank capital held by the State, the US system by the presence of large institutional investors. The capital and reserves of Italy’s major banks surpass the standards agreed at international level; however, they are still less than those of the largest intermediaries operating in the European market. Industrial companies are not substantial shareholders of the leading foreign intermediaries. The holding of substantial or even controlling interests by industrial companies calls for careful evaluation in our system too, in the light of its possible consequences for the allocation of credit in the event of production problems or falling prices in some sectors. The strengthening of the banking system’s capital base must come principally from self-financing, recourse to the financial market and, looking further ahead, greater participation by institutional investors. The new Capital Accord On 26 June the central banks and supervisory authorities of the Group of Ten countries approved the text of the new Accord on banks’ capital, prepared by the Basel Committee. The document represents the point of arrival of a complex process initiated in the second half of the 1990s in response to the recurrent financial crises in the global market, which hit Mexico, Thailand, Korea, Russia, Brazil and Argentina, and the parallel and partly related evolution of banking. The Accord identifies more efficient methods for determining the amount of capital required to cover the different forms of risk. Credit risk being equal, the amount of capital banks will be required to have should decrease by virtue of its more efficient allocation. However, the development of banks’ activity and the complexity of their transactions have considerably increased their exposure to operational and legal risks. The new Accord grants intermediaries complete freedom of initiative. The rules and risks have been defined, in analytical terms, borrowing from operational best practices. The models and parameters for the measurement of capital requirements and their application are developed by each individual intermediary. The supervisory authorities assess them for approval and then oversee compliance. In response to an initiative of the Bank of Italy, among others, the Accord provides for specific solutions designed to produce a better evaluation of credit risk for small loans. Intermediaries may use simplified methods for the calculation of requirements, similar to those now in force. Like the more complex methods, the simplified ones will on average involve a reduction in the amount of capital required, as a consequence of the more favourable treatment for small loans. It should also be recalled that the capital of many smaller Italian banks is above the required minimum today. The new Accord will be incorporated in a Community directive; it will be phased in between the end of 2006 and the end of the following year. Simulations performed on a large scale show that application of the Accord will not have restrictive effects on the supply of credit. Many large banks already set the terms and conditions of loans in line with those that will derive from the new Accord. Under the new system it is essential that firms supply complete information on their assets and liabilities and profits and losses and on the structure and extent of their activities. This will result in firms themselves having an incentive to promote transparency and complete compliance with the rules. The economic situation Economic activity is expanding vigorously at global level. It is being driven by the cyclical upswing in the United States, the other major countries of the Americas, Japan and other Asian economies. In the twelve countries of the euro area, GDP grew by 0.6 per cent in the first quarter of this year. Its growth over the whole year is likely to be 1.7 per cent. Industrial production is estimated to have increased by 2.5 per cent since the middle of 2003. In Italy, GDP rose by 0.4 per cent in the first quarter. Consumption showed a recovery, as did business investment, which had the fallen in the two previous years. Exports declined in spite of an acceleration in world demand. Agriculture and services drove the expansion in GDP. In the second quarter industrial production continued to decline. According to preliminary estimates, it fell by 1.4 per cent between the end of 2003 and June of this year. The trend of industrial output in Italy continues to diverge from that in the other European countries, particularly France and Germany. There has been a further loss of Italian manufacturing’s competitiveness both abroad and at home. Between 2001 and 2003 unit labour costs in industry rose in Italy by a total of 9.9 per cent. In Germany the increase over the same three years was 2 per cent, in France 1.6 per cent. The gap mainly reflects the performance of productivity. In contrast with the sharp drop in Italian exports, amounting to 3.4 per cent in 2002, 3.9 per cent in 2003 and 2.1 per cent in the first quarter of this year, the volume of French exports contracted slightly over the same period and German exports showed vigorous growth. According to preliminary estimates, GDP growth was slower in the second quarter than in the first, both in Europe and in Italy. In Italy, the behaviour of the main macroeconomic variables and business investment intentions point to an acceleration in activity in the second half of the year. Credit continued to grow at a rapid pace in the first half of this year. The rate of increase in lending to the building industry remains high. Consumer credit is tending to expand for structural reasons. Loans to firms are growing faster than GDP. The increase in lending in the twelve months ending in May was 3.7 per cent nationally and 6.5 per cent in the South. The restoration of a climate of complete confidence among banks, firms and savers is necessary in order to ensure firms the support of credit in the face of important due dates and to finance the hoped-for expansion of activity in the second half of this year and in 2005. Economic policy Major problems and tasks lie ahead for economic policy and for the adjustment of the public finances in particular. In the first half of this year the state sector borrowing requirement exceeded that of the first half of 2003 by more than €12 billion, or nearly one percentage point of GDP. The progressive deterioration in the accounts in the first six months of this year suggests that in the absence of corrective action general government net borrowing for the year as a whole will be 3.5 per cent of GDP, as I indicated at the Bank of Italy’s Annual General Meeting on 31 May. The adjustment package the Government is about to adopt, amounting to some €7.5 billion or 0.6 per cent of GDP, is intended to ensure compliance with the 3 per cent limit. In formulating the mid-year budget, the restrictive measures must not be allowed to have a negative impact on demand at a time when the economic recovery is still halting. It will be necessary to monitor the effectiveness of the measures, whose application is concentrated in the coming months. The evolution of the public finances must be carefully verified, among other things owing to the uncertain outlook for some receipts that are an integral part of the budget for 2004 adopted at the end of last year. The positive outcome of the Ecofin meeting prevented a worsening of expectations. With a view to the publication of the Economic and Financial Planning Document, the size of Italy’s public debt requires the formulation, in accordance with the political calendar of a policy for the public finances that can reconcile their consolidation with faster growth in the medium term. After the second half of the 1990s the public finances began to deteriorate again. In the last two years cyclical developments have also been a factor. In the last three years the containment of the budget deficit has been entrusted mainly to one-off measures, which are useful in a period of transition and sluggish economic growth; it is now necessary to return to a lasting structural reduction of the gap between expenditure and revenue. The primary surplus has progressively contracted; this year it is likely to be around 2 per cent of GDP, notably less than the value of 5.5 per cent set in order to participate in the Monetary Union and to ensure a significant rate of debt reduction in relation to GDP. The outlook for the public finances needs to be verified both for this year and for 2005. The expected rise in interest rates worldwide will influence interest expenditure. The downgrading of Italy’s rating by an international rating agency is confirmation of the difficulties facing the country. The structural curbing of current expenditure must reduce government borrowing and provide the resources for increased public investment. Reducing the burden of taxation must not lead to a rise in the deficit. The expansionary effect produced by the growth in disposable income would be outweighed by the negative effect deriving from the increase in the debt. Conditions in the trade unions, firms and banks appear to be conducive to a return to growth-oriented cooperation. To date the contribution from the implementation of public works has been limited; it must be boosted. The curb on public expenditure must not penalize firms in the weakest parts of the country. New prospects must be created for research, for the application of advanced technologies in production and for the development of alternative energy sources. It is necessary to increase confidence. This can be done by drawing up a credible and broadly supported economic policy to reduce the absorption of savings by the State, lower (in part through faster growth) the ratio of public debt to GDP, and charts a course for progress in the years to come. As I also noted on 31 May, the Italian economy’s loss of competitiveness is the consequence of long-term trends; partly owing to an especially difficult international environment, the deterioration has not been halted in the last few years. It is necessary to act on several fronts and set in motion an improvement of the factors underlying growth. It is necessary and possible to react, in Italy and at European level, so as to be able to participate in what promises to be a strong and prolonged recovery of the world economy. | bank of italy | 2,004 | 8 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, to the Otranto City Council, Castello Aragonese, 25 September 2004. | Antonio Fazio: A brief look at the economy in Southern Italy and accounting practices Address by Mr Antonio Fazio, Governor of the Bank of Italy, to the Otranto City Council, Castello Aragonese, 25 September 2004. * * * I would like to begin by thanking everyone for their warm welcome and the civil and religious authorities for honouring the institution I represent by their presence. It is indeed a pleasure to be here in your city, known in ancient times as Hydruntum, after the nearby river Idro. The monuments and the outline of the old town immediately evoke its magnificent history and the role it once played in the Salentine Peninsula, which for many centuries was Terra d’Otranto the ‘Land of Otranto’. The beatification of the Hydruntum martyrs recalls an episode firmly imprinted in the memory not only of this part of Italy: the valiant resistance of its citizens against a violent siege raised long ago in 1480, when 800 men paid with their lives for refusing to renounce their Christian faith; it brings to mind other tragic times in the history of our country. It leads us to reflect on the goals to which humankind aspires, and on the principles that we must, especially now, preserve and reinforce in the international order in defence of life, liberty and democracy. To ensure détente will prevail among nations and people will live together in peace; to foster the development of relations between different races, religions and lifestyles in the name of human dignity. 1. This is my first visit to Otranto, and I am struck by the picture I see. In addition to its rich artistic heritage, the city enjoys an enviable position, set as it is in lovely countryside, with the sea and a beautiful stretch of coast. Otranto has all the right qualities for a substantial growth of tourism. Its residents possess the spirit of initiative and organizational skills needed to capitalize on the available environmental and artistic resources and local produce and crafts, which are renowned for their excellence. In 2004 Otranto again came top of Legambiente’s ranking of Italian summer resorts published in the Italian Touring Club’s Blue Guide for the year. The current project to set up a marine park along the Otranto-Santa Maria di Leuca coast will also make an important contribution to environmental policy and benefit the local community. The city looks across the sea towards the East; it responds with equanimity and solidarity to the problems raised by the influx of immigrants who reach land in this area. Hospitality, open-minded acceptance, rules, controls, law and order, and far-sightedness are closely related aspects of the attitude towards immigrants in search of better living conditions and a more advanced social and human context. Today, more than ever before, globalization demands that we pay attention to events beyond our own borders, and not only in the economic field. Immigration can be a positive force, particularly in view of the demographic problems facing us, and we should keep an open attitude towards it, provided its negative aspects are tackled and its legality is assured by creating the conditions required for security. 2. This morning, in Lecce, I had time to consider the economic outlook for the regions of Southern Italy. Today’s guests include representatives of the business world and the professions. Firms, all firms, are indispensable and powerful forces of economic growth. A business culture, a drive to improve production techniques, innovate, and manufacture better goods with more value added are crucial for the progress of the productive fabric. Although the South of Italy has experienced periods of exceptionally fast economic and civil modernization in the past fifty years, it continues to be a national problem. The economy of the South has opportunities and potential. There must be a drive to accelerate the process and overcome dualism, with Italy’s public institutions, corporate sector and social partners all contributing. The South of Italy is hampered by poor infrastructure; this shortcoming, and particularly the lack of transport and service networks, affects production, which is thus less competitive than in the regions of the Centre and North. An additional boost for public works and infrastructure investment is likely to stimulate aggregate demand and create good prospects of recovery. An increase of productivity and competitiveness in the South of Italy necessitates an efficient and effective public administration and conditions of safety and legality. Moreover, a problem of solidarity exists between the regions of Italy with regard to making good use of the institutional and functional forms of decentralization. The available labour force, particularly of young people, and the cultural and environmental resources of the less developed regions constitute a “reserve” that can be tapped for growth, to the benefit of the whole of Italy’s economy and society. Technical and scientific capabilities are crucial for governing transformation and avoiding marginalization. Basic and applied research play a leading role in international competition, process and product innovation, and the introduction of new technologies. 3. Today’s guests include auditors and accountants. Members of these professions perform a complex task with great responsibilities. I have often stressed that accounting rules are indispensable in order to know and certify the truthfulness of economic and administrative facts, which are a fundamental aspect of the organization of society. The whole of civil life could not function in fact if people did not tell each other the truth. In Summa Theologiae Thomas Aquinas said that truth was one of the values underlying social coexistence. The same holds for the economy and business, which must rest on an order made up of relationships and rules that include accounting standards. In Italy great masters laid the foundations of the art of accounting. In the fifteenth century Luca Pacioli, adopting the practices long in use among Venetian merchants, developed the theory of “double entry” bookkeeping Goethe called “one of the most wonderful discoveries of the human mind”. Fabio Besta arranged these studies on a scientific basis, perfecting the tools available to make correct entries. These are the solid foundations on which we now work. As a consequence of the function they perform, accountants are expected to show professional autonomy, independence of judgement, and constant dedication, vis-à-vis clients, to transparency and honesty. Members of the profession now face new duties; they must cope with all the forthcoming changes in the methods of accounting for corporate facts; they must keep constantly abreast of developments and study the innovations in company and fiscal matters. The recent financial difficulties of several industrial firms have highlighted the crucial role of internal controls and of external audits to verify that accounts are properly kept, that transactions are correctly recorded, and that the financial statements conform with the book entries and the rules for valuing assets and liabilities and recording corporate facts. The bankruptcy laws are in urgent need of reform, which is now under study, to shorten procedures, offer greater certainty and broaden the scope for mutually agreed solutions and the survival of worthwhile economic projects in temporary difficulty. Firms, banks and the economy will benefit. In the financial sector, reliable judgements and proper conduct are equally important. Intermediaries are required to assess fully all the risks of their clients’ investment decisions and present them clearly. 4. The discipline of accounting is undergoing far-reaching review at the moment in response to the demand for standardization stemming from the growing international openness of our economies. According to the principles derived from the European framework of harmonized legislation, from 2005 onwards listed companies, and banks and financial corporations will have to draw up their financial statements in compliance with the International Accounting Standards. In Italy the process of adapting our legislation, including civil and tax law, is under way. The new Capital Accord for banks known as Basel 2 will entail changes in the way financial statements are presented. It will come into force between the end of 2006 and beginning of 2007 and will introduce more efficient methods of defining the capital employed to hedge different types of risk that reflect the best business practices at international level. I affirm once again that, on the basis of existing studies, we do not expect there to be adverse effects on corporate financing, particularly of small and medium-sized firms. In fact the adoption of the new system will certainly encourage banks to become more efficient, improve their ability to assess creditworthiness, and better satisfy the needs of the business sector. At the same time firms must provide banks with exhaustive information about their assets and revenues, and the structure and scope of their activities at home and abroad. All this indicates that accountants will be expected to perform an increasingly important role, and highlights the advisory nature of their work and its contribution to dynamism. They must always be guided by ethics and professionalism. *** A joint effort is needed, based on a climate of complete trust and cooperation between firms, banks and institutions, to help lay the foundations for economic recovery, foster a reversal of the current trend, and encourage new models of growth to emerge in Southern Italy as well. The people, the intelligence, the savings and the business ability to do so are all present. I wish to thank you once again and wish you pleasure and success in the performance of your work. | bank of italy | 2,004 | 10 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, to the ACRI (Association of Italian Savings Banks), Rome, 5 November 2004. | Antonio Fazio: Overview of global economic and financial developments in first half 2004 Address by Mr Antonio Fazio, Governor of the Bank of Italy, to the ACRI (Association of Italian Savings Banks), Rome, 5 November 2004. * 1. * * The international economy The recovery in economic activity, which began in the spring of 2003 in the United States and was sustained by the growth of the Asian economies, has gradually spread to Europe and Latin America. In the first half of 2004 the world economy continued to expand rapidly; in the second half the pace moderated, partly as a consequence of the rise in the price of oil. In the United States economic activity slowed in the second quarter, after expanding strongly in the first; the growth in household spending slowed to 1.6 per cent, but that in investment accelerated to 13.9 per cent. In the third quarter GDP grew by 3.7 per cent, fueled by a pick-up in consumption and the continuation of the expansionary phase of the investment cycle, which has now spread from IT products to include traditional capital goods. Payroll employment rose, at a monthly rate of 300,000 from March to May and of 100,000 from June to September. The economic expansion will remain strong in the last few months of this year and will carry over into next year. Core inflation, measured by the deflator of consumption excluding energy and fresh food products, has held steady since March at around 1.5 per cent on a twelve-month basis. In view of the progressive reduction in unutilized capacity, the Federal Reserve began to raise the federal funds rate at a measured pace, so that it now stands at 1.75 per cent. The budget deficit, after worsening progressively for three years, has stabilized in 2004, thanks to the growth of the economy. According to the estimates put out by the Congressional Budget Office, the federal deficit, including the social security balances, was 3.6 per cent of GDP in fiscal 2004, virtually unchanged compared with the previous fiscal year and 0.5 percentage points less than estimated in the spring. The deficit on the external current account was equal to 5.4 per cent of GDP in the first half of 2004. From March to September the dollar fluctuated between 1.20 and 1.24 against the euro; since the middle of October a further weakening of the US currency has taken it to 1.28 against the euro. Since February 2002, when the prolonged decline of the dollar began, US competitiveness - measured by the fall in the real effective exchange rate, that is with account taken of inflation differentials - has improved by 13 per cent. In Japan, exports continued to expand very fast in the first half of the year, at an annualized rate of nearly 19 per cent in real terms, despite the slowdown in those to Asia. Productive investment increased by 12 percent. The slowdown in GDP growth from 6.4 per cent in the first quarter to 1.3 percent in the second was partly due to the fall in public investment. The latent data available indicate that economic activity is likely to have remained weak in the third quarter. Growth continued at a rapid pace in China, India and the other emerging Asian economics. The recovery has spread to the countries of Latin America. In the last few weeks the persistence of international tensions has aggravated the threats to the continuation of the strong phase of global expansion. In real terms the price of oil has risen to 50 percent of the peak recorded during the upswing at the end of the 1970s; the latest figures available suggest that the rising trend may have come to a halt. 2. The state of the financial markets The yields on US government bonds rose between mid-March and mid-May, primarily in response to the faster-than-expected growth in economic activity, by 1.2 percentage points to 4.9 percent; they subsequently came down and are about 4 per cent today. In the euro area the yields on ten-year government bonds have also come down and are about 4 percent; in Japan they are about 1.5 per cent. The abundant liquidity of the financial markets is helping to keep interest rates down and at the same time to reduce the volatility of the prices of shares and bonds. The risk premiums on US corporate bonds have remained virtually unchanged, at a historically low level. Stock market indices have remained near the highs reached at the end of 2003; the price/earnings ratio has returned close to its long-term average value. The volatility of stock and bond prices has been extremely low. In an environment marked by abundant liquidity and low interest rates, major international intermediaries have reacted to the weakness of the demand for credit by increasing the share of investments in high-yield instruments, in order to improve the return on capital. They have increased the supply of derivative instruments that provide protection against possible variations in the value of financial assets and assumed the related risks. The increased supply is deemed to have caused a fall in the price, and hence in the volatility, of options, which has spread to the cash markets. In such a situation, a return to normal levels of volatility could bring substantial losses. In the emerging countries, after the rise in risk premiums that occurred in the spring as a consequence of expectations of an imminent increase in US interest rates, financial conditions have become easier everywhere; the recovery in exports has been a contributory factor. The low cost of financing has encouraged numerous emerging countries to bring forward bond issues and increase their amount. In the first half of 2004 the value of the gross issues of the emerging countries as a group was two thirds of the historically high value of nearly $100 billion recorded in the whole of 2003. 3. Economic developments in the euro area and ltaly The upturn in economic activity in the euro area has not been as buoyant as in the rest of the world. In the fast half of this year GDP expanded at an annual rate of 2.3 per cent. Between the first and second quarters there was a slight slowdown. Growth was sustained chiefly by household spending. Consumption expanded substantially in France; in Germany it continued to contract. Investment continued at a modest level, growing at an annual rate of 0.7 per cent. A pronounced acceleration in France contrasted with continuing contraction in Germany, once again determined by investment in construction. The area’s exports accelerated to an annual growth rate of 7 per cent in the first six months of the year, fueled by the powerful expansion of world trade and the stabilization of the effective exchange rate of the euro. This result reflects the good performance of German exports, which are highly competitive even at current exchange rates. The stimulus to economic activity was blunted by the substantial increase in imports. The contribution of net exports to GDP growth was negative in both France and Italy. Italian economic growth picked up slightly in the first halt but remained significantly below the area average. Italian GDP growth followed the area-wide trend in decelerating between the first and second quarters. The main impediment to Italian economic growth is weak export performance. After diminishing in the first quarter, foreign sales increased appreciably in the second; growth apparently continued in the third quarter, albeit at a slower pace. For the year, export growth is projected to be much less than the growth in world trade; Italy’s share of the world market is expected to decrease further. Italian export penetration has met with difficulties both in the euro area and in the rest of the world. The loss of market shares began to intensify in 2002. With deteriorating competitiveness and the unfavourable trend in exports, industrial production recorded no increase between the second quarter of 2003 and the third quarter of 2004; in the euro area as a whole it grew by 2.8 per cent. Compared with the average for 2000, in September industrial production was down in Italy by 2.8 per cent; in the euro area, it showed an increase of 2.5 per cent. In the fist half of this year Italian investment recouped the decline registered in 2003. The most substantial increase was in investment in machinery, equipment and transport equipment. Household expenditure increased at an annual rate of 1.6 per cent. This gain came entirely in the first quarter; in the second consumption showed a marginal decline, due to spending on services. Purchases of durable goods continued to grow strongly, in connection with easy credit terms and a modest recovery in households’ confidence. In the second quarter the twelve-month rate of consumer price inflation in Italy was around 2.3 percent. In the last few months it has fallen below the average for the other euro-area countries. The effects of higher oil prices on electricity and gas prices have yet to be felt. According to national accounts data, in the first half of the year the number of persons employed in Italy rose by 0.6 per cent on an annual basis. For the euro area as a whole the increase was scarcely 0.2 per cent. In recent years the increase in the number of persons employed, despite the stagnation of economic activity, has been driven by the greater flexibility of the labour market and the moderation of real wage growth. Nevertheless, in the first half of the year unit labour costs in the service sector grew more than two percentage points faster on an annual basis than the average for the main euro-area countries. In industry excluding construction the gap exceeded four points. The main factor was labour productivity, which evolved less favourably in Italy than in the other countries. The unemployment rate has continued to fall, but geographical disparities remain extremely great. 4. Looking ahead The expansion in the world economy in 2005 will not match the exceptional rate of growth estimated for the current year, of the order of 5 per cent. In September the International Monetary Fund forecast growth of 4 3 per cent next year. It may be lower than that in view of the uncertainties stemming from international political tensions and the rise in oil prices, although this appears to have run its course. In the United States output is expected to grow by 3 to 4 per cent, in line with its potential; in Asia growth should be between 6 and 7 per cent, and in Japan, between 2 and 2.5 per cent. The rapid expansion in world trade is expected to continue, although not as fast as this year. The euro-area economy will continue to grow in the last part of the year and in 2005. In view of recent trends, the expansion of the Italian economy appears uncertain. Industrial production has not yet shown any sign of recovery. Preliminary estimates indicate that in October the level was no higher than at the end of 2003. Gross domestic product rose by 0.5 per cent in the first quarter and 0.3 per cent in the second; the increase is expected to remain about the same in the third quarter. For the year as a whole the estimated increase is 1.2 per cent, which is well below the average for the other European countries. Household consumption is increasing in line with GDP. The sharp upturn in world trade concerns Italy’s exports as well; if the recovery observed in the second quarter continues, they may increase by as much as 5 per cent in volume in 2004. After falling sharply in 2003, investment is showing signs of recovery. According to a survey conducted by the Bank of Italy’s branches between 17 September and 7 October on 4,157 firms, including 3,094 in industry excluding construction and 1,063 providing non-financial services, capital spending in 2004 will be only slightly below the amount initially planned; the recovery in investment is expected to continue in 2005, both in the service sector and in industry. In the first nine months of the year, the majority of firms saw their turnover increase in nominal terms with respect to the year-earlier period; during the third quarter orders showed some improvement with respect to June; a large percentage of firms in industry and services expect demand to pick up further in the next six months. In view of the favourable performance of international trade, it is expected that output will be sustained by exports. Poor competitiveness on the domestic market will entail a sharp rise in imports; GDP growth will be faster than this year; however, on the basis of current trends, it will amount to less than 2 per cent. Estimates made with the Bank of Italy’s econometric model indicate that investment in machinery, equipment, and means of transport could expand by 3 to 4 per cent in real terms. 5. Economic policy The twelve-month inflation rate fell to 2 per cent in October, according to preliminary data. On a seasonally adjusted basis, the consumer price index registered a slight decrease with respect to September. This is a development whose interpretation is multifaceted. Undoubtedly, the weakness of demand played a part in the decrease. After the criticisms and discussion of the behaviour of the distributive trades on the occasion of the changeover to the euro, the sector needs to regain consumers’ confidence. A broadly shared determination to act in this direction can bring benefits for the level of economic activity and for the distributive sector itself. In a cyclical phase that remains uncertain but is showing signs of improving, it is crucial to launch policies designed to create the conditions for faster economic growth. It is indispensable to proceed with the adjustment of the public finances. Curbing the rate of growth of current expenditure is part of this strategy; the recoupment of tax bases is necessary in order to reduce the benefits accruing to tax evasion and avoidance. There is ample scope for increasing the efficiency of the public sector. Major advantages can come from further administrative simplification and a drastic reduction in authorization procedures. Structural measures can contain the rise in expenditure on health care, without affecting the quality and availability of services. In the medium term, the size and certainty of the expenditure savings connected with the changes in the pension system will have to be verified in depth. The process of decentralization of government powers must necessarily involve a transfer of personnel and administrative units. In a context of deficient infrastructural endowment, even in such essential services such as transport, water supply and the provision of energy at moderate costs, spending on public works in 2004 remained at the previous year’s levels in real terms. Extraordinary measures and adequate financing can accelerate the transition from the phase of decision-making to that of project execution. Arrangements to prevent or resolve conflicts of authority, together with innovative mechanisms of cooperation with the banking system, can help to get the projects effectively under way. Private enterprise can take on an important share of the cost of the investments, when these regard the provision of services remunerated by user charges. The intensification of activity in this sector enhances the competitiveness of the economy; it will yield immediate results in term of an increase in domestic demand. The policies of liberalization, of stimulating competition, must be strengthened. Tax reduction will have a positive effect on expectations and growth if it does not lead to an increase in the public sector’s deficit and debt. If, in other words, it is perceived as sustainable. It is necessary to move to lighten the fiscal burden for firms as well. Measures aimed at facilitating their expansion in size and encouraging technological innovation are indispensable in order to operate well in a system increasingly exposed to international competition. The situation of firms in the last three years has been affected by the uncertainty of the cyclical situation. Banks have continued to provide support in this difficult phase. In the context of the new collaborative relationships, they are committed to making it still easier for small firms and innovative enterprises to obtain access to credit, in part by offering a wider range of services. There can be no delay in an organic reform of bankruptcy law. Although the conditions for a complete overhaul in the near future may be lacking, some institutes can be reformed and new ones introduced. Legislation must be adopted to provide for timely management of corporate crises, outside the framework of bankruptcy procedures or before recourse to them becomes necessary. Reform of the law on revocations in bankruptcy is needed to ensure certainty in relationships between the company and its creditors, especially suppliers and banks, and to avoid the sudden interruption of financing to the firm, due in the first place to the legal aspects involving penal responsibility. We are in a difficult moment for our economy. In a situation of less-than-full employment of productive factors and low growth, the formation of saving in the economy and the amount of savings at households’ disposal depend on increasing investment and accelerating growth. The defence of savings, above all through the stability of intermediaries, and the allocation of these resources by the banking system to the benefit of the most valid and innovative firms through efficient disbursement are indispensable in order to raise the economy’s potential growth rate. Consistent action on the part of politicians, the social partners and firms themselves must strengthen the signs of recovery. The perception by firms and households of a will to proceed in this direction by making up the shortcomings and encouraging productivity and competitiveness can dispel pessimism, foster a more solid recovery of economic activity and investment and put our economy back on the track of growth. | bank of italy | 2,004 | 11 |
Presentation by Antonio Fazio, Governor of the Bank of Italy, at the Frankfurt European Banking Congress 2004, panel discussion on ¿Regulation and Supervision in Financial Markets¿, Frankfurt, 19 November 2004. | Antonio Fazio: Regulation and supervision in financial markets Presentation by Antonio Fazio, Governor of the Bank of Italy, at the Frankfurt European Banking Congress 2004, panel discussion on “Regulation and Supervision in Financial Markets”, Frankfurt, 19 November 2004. * 1. * * Development and integration of financial markets in the euro area The introduction of the single currency has given a decisive impetus to financial integration in Europe. The integration of the money market has been rendered possible by the creation of TARGET, the European payment system. The launch of the new-generation system based on a single platform is scheduled for 2007. The euro has had a particularly significant impact on the European market for private-sector bonds; there has been a considerable increase in the number of even medium-sized firms placing issues outside their home country. The home-bias of equity portfolios has diminished. In the main industrialized countries the medium-term growth in the quantity of money, and hence in the volume of bank deposits, is in line with that in nominal GDP. The faster rate of expansion in the aggregate volume of financial assets, that is the process of financial deepening, is the outcome of the direct relationship established on the financial markets between the firms and the public sector issuing securities, on the one hand, and the investors purchasing them, on the other. In Italy, between 1995 and 2003 the volume of funds raised directly on the financial markets by firms issuing shares, bonds and other instruments grew from 20 billion euros to 65 billion. The amount of households’ financial wealth consisting of corporate securities increased from 180 billion euros to 470 billion, that is from 19 to 36 per cent of GDP. Similar developments have taken place on other markets. The stability of the banking system, the protection of the savings it intermediates and their efficient allocation are entrusted to the banking supervisory authority, as well as to market discipline. In order to strengthen, in this new context, the safeguards for savings invested in securities, steps must be taken to ensure more effective controls on financial markets and firms issuing securities, if necessary by forging Europe-wide links. 2. Banks and financial markets During the 1990s the large-scale process of consolidation and consequent growth in the size of banks encouraged the spread of the universal bank, which combines retail and wholesale business and simultaneously performs both commercial and investment banking services. The banks themselves have greatly stepped up their role in the distribution of third-party financial products, insurance policies, investment funds and corporate bonds. Credit risks and market risks have diminished with their progressive transfer away from banks’ balance sheets, but other types of risks have emerged. The reputation of a bank is inevitably and increasingly affected by the quality of the products it supplies to its customers. There has also been an increase in both legal and operational risks. The banks’ increasing role in the distribution of third parties’ products makes it crucial to monitor for conflicts of interest. It is extremely important that conduct should be ethical. The integrity and completeness of the information provided to the public must be guaranteed and internal controls must be reinforced. Staff incentives must be designed to prevent the risk of improper conduct. 3. Supervision International cooperation between banking, insurance and financial market supervisory authorities is strengthening. In view of the close links between the systems of the major areas - in the first place those of central and western Europe and the United States, but also to an increasing extent those of eastern Europe and Asia - supervisory cooperation has spread to the global level. In Europe, the nationally based organization of banking supervision is in conformity with the cardinal principle of the single European market, founded on minimum harmonization and mutual recognition. Supervision on a national basis permits the authorities to operate near the entities subject to control. It favours a constant exchange of information and direct contact with intermediaries. This is particularly effective if it is also realized by means of a widespread presence in the territory and through on-site inspections. Banking supervision is rooted in the legal and administrative systems of each country, not least owing to the possible involvement of public money in crises. Europe has equipped itself with a well-structured system of multilateral cooperation and bilateral agreements between the national authorities responsible for supervising the banking and financial markets. Spurred by the guidelines set by the Ecofin Council meeting of Oviedo in 2002, in 2004 the application of the Lamfalussy reform was completed, extending to the banking and insurance sectors bodies and legislative procedures that had already been introduced in the securities field. The reform process sees national authorities and European institutions engaged in speeding up the approval of harmonized European regulation, ensuring its uniform application in national law and further strengthening cooperation among the supervisory authorities. 4. Derivatives In the last four years the cyclical slowdown of the global economy, stock market turbulence, the failure of large companies operating at international level and the default of sovereign states have subjected financial systems to strong pressures in both advanced and emerging economies. Banks have demonstrated a great capacity to absorb the destabilizing impulses. Both in Europe and in the United States, the ratio of losses on loans has been lower than that registered during the recession of the early 1990s. There have been no significant episodes of instability. The greater soundness and flexibility of the system derive above all from the reorganization and capital strengthening of intermediaries prompted in many countries by the public authorities since the second half of the 1990s. The strong expansion of the bond market, which has allowed firms to supplement bank loans with funds raised directly from savers, has contributed to the stability of the system. The shocks that have hit the international financial system have been absorbed thanks also to the development of the derivatives market. At the end of 2003 the notional value of over-the-counter derivatives was approximately 200 trillion dollars, nearly twice as much as at the end of 2001. Interest rate derivatives account for about three quarters of the entire derivatives market. In the last few years credit derivatives have grown especially fast; in the middle of this year the notional value of credit default swaps was of the order of 5.4 trillion dollars. The greater scope for managing risks has made it possible to avoid compounding the difficulties of the real economy and the international political tensions with financial instability. For these reasons as well, the recent phase of cyclical weakness has been shallower than in similar periods in the past. The use of derivatives is not without its own risks. In an environment characterized by abundant liquidity and low interest rates the sharp decline in volatility recorded in recent months on the financial markets of the leading countries is connected to some extent with the search for higher profitability by major international financial institutions through the purchase of high-yield instruments. Intermediaries appear to have increased the supply of derivative instruments that provide protection against possible changes in the value of financial assets, thereby lowering option prices and volatility, and to have taken on the related risks. To forestall the potential adverse effects of the growth of derivatives markets, a high level of professionalism on the part of market participants is indispensable. The role of regulatory authorities and central banks is of fundamental importance. Supervisory regulations and practices, accounting standards, and the information that intermediaries have to provide are continuously updated, both at national level and in the sphere of international cooperation, to keep up with the development of the markets and contain the systemic risks that are associated with the potential benefits offered by the growing use of derivatives. 5. Conclusions Efficient intermediaries, developed financial markets, capable of channeling funds towards firms with favourable growth prospects, improve the allocation of resources and stimulate investment and saving. But the very efficiency of the financial system, its stability depend ultimately on the strength of the real economy, on its ability to grow and compete. The economy of the euro area is afflicted by a loss of competitiveness that reflects structural weaknesses in several fields. Productivity growth is unsatisfactory. It is necessary to remove the factors of an institutional, legal and fiscal nature that hamper flexibility in the use of labour and capital. In Europe the efforts to consolidate the public finances must be continued, not least so as to loosen the constraints that are holding back economic activity. The action of the Eurosystem aimed at guaranteeing price stability provides an essential condition for a firmly-based economic recovery. | bank of italy | 2,004 | 12 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF - ASSIOM - ATIC FOREX, Modena, 12 February 2005. | Antonio Fazio: The outlook for the global economy and Italy Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the AIAF - ASSIOM - ATIC FOREX, Modena, 12 February 2005. * 1. * * The international economy NON PUBBLICARE PRIMA DELLE ORE 11,45 The world economy grew by 5 per cent in 2004, the largest increase in more than twenty years; domestic demand in the United States and a number of emerging Asian economies contributed to the expansion. World trade increased by 9 per cent. Growth remained weak in the euro area and came to a halt during the year in Japan. The rise in oil prices slowed economic activity marginally. The US economy grew at an average annual rate of 3.1 per cent in the period 2002-04. The increase in public spending, the tax relief measures and the large reduction in interest rates sustained household consumption and encouraged a revival of investment. Output grew in 2004 by 4.4 per cent. The improvement in labour productivity, up by 4.1 per cent on average for the year, curbed inflation and buoyed corporate profits. Payroll employment rose by 2,200,000 during the year, making good all the decline that had occurred between the beginning of 2001 and the middle of 2003. The growth in employment sustained consumption and compensated for the drying up of the effects of the tax cuts on disposable income; the liquidity provided by mortgage refinancing also decreased. The business sector’s expectations regarding the growth of the economy are revealed by the performance of investment. At the beginning of 2003 investment in high-tech capital goods had already reversed the downward trend of the previous two years, rising at an annualized rate of 17 per cent. In 2004, with profit margins widening and financial conditions favourable, purchases of machinery also picked up rapidly. Spending on machinery and software increased by 13 per cent, compared with 6 per cent in 2003. Household expenditure rose by 4.1 per cent on an annual basis in the second half of the year; the saving rate declined further. The increase in the consumer price deflator, excluding energy and food products, rose from 1.1 per cent at the end of 2003 to 1.5 per cent at the end of 2004. At each of the six meetings of the Federal Open Market Committee held between 30 June 2004 and 2 February of this year, the federal funds target rate was raised by 25 basis points, bringing it to 2.5 per cent. As the Federal Reserve has emphasized in its press releases, monetary conditions continue to be accommodative. The markets expect further increases in interest rates in the coming months, for a total of 50 basis points. The federal budget deficit rose to 3.5 per cent of GDP in 2003. In the fiscal year that ended last September the ratio was virtually unchanged. If no new measures are adopted, and including the additional funds being finalized to cover defence spending, the deficit is expected to decline to 3.3 per cent of GDP in 2005. The US President has announced that the objective of budget policy will be to halve the ratio of the deficit to GDP by 2009, mainly by curbing expenditure. He stated that the priorities for his new term of office included reforming the public pay-as-you-go pension system, which currently provides benefits to around 45 million people for an annual outlay of $500 billion, or less than 5 per cent of GDP. The aim of the proposed reform is to prevent the emergence of growing financial deficits from 2018 on; it hinges on the introduction of individual accounts which would progressively be credited with part of the contributions presently paid into the public system. Looking ahead, the imbalance in the US external accounts will be a drag on the American economy, and consequently on the world economy. The current account deficit continued to increase in 2004. The improvement in price competitiveness brought by the weakening of the dollar has had very little effect. In 2004 the deficit amounted to 5.5 per cent of GDP; in 2005 it will exceed 6 per cent. The net international investment position of the United States, which was practically in balance at the beginning of the 1990s, subsequently deteriorated, with net foreign debt rising to a quarter of GDP in 2004. The worsening of the external imbalance is basically linked to the growth gaps between the US economy on the one hand and the European and Japanese economies on the other. The Federal Reserve has announced that there have been no major difficulties in financing the current account deficit, but it has also stressed that the growth in net foreign liabilities cannot continue indefinitely at the present rate. In order to maintain a rapid pace of capital formation, the Federal Reserve has called for a reduction in the budget deficit and measures to increase household saving. In Japan, economic activity slackened in the course of 2004, after expanding by around 7 per cent on an annual basis in the first quarter. Exports, which had been growing rapidly since 2003, were flat in the second half of the year; private investment slumped. It is estimated that output picked up slightly in the fourth quarter. Growth over the year is expected to have been close to 3 per cent. In the euro area, the recovery is struggling to gather momentum. It is hampered by the rapid ageing of the population. Structural factors hinder an improvement in productivity. The scope for macroeconomic policies remains limited: in the case of monetary policy this is due to the low flexibility of the economy; in that of budget policy to the size of the deficits. Buoyed by international trade, euro-area output grew at an annualized rate of 2.2 per cent in the first half of 2004. The upturn in exports was accompanied by a gradual increase in purchases abroad, partly in response to the lagged effects of the euro’s appreciation. Following a renewed slackening of consumer and investment demand, output slowed in the third quarter; over the year as a whole it is estimated to have risen by 2 per cent. We have kept the rate on main refinancing operations in the euro area unchanged at 2 per cent in view of the expectations of a fall in inflation to below 2 per cent and the still uncertain recovery. Short-term interest rates have been close to zero in real terms since the start of 2004. The market expects them to remain below 1 per cent until the middle of this year. An important contribution to the growth of the world economy has come from the emerging economies of Asia. In 2004 the increase in GDP was around 7.5 per cent. In China it was 9.5 per cent; investment rose by 26 per cent in nominal terms; signs of overheating have emerged on the price front. Despite the substantial increase in imports, the trade surplus widened from $26 billion in 2003 to $32 billion last year. The authorities are still endeavouring to bring the rate of expansion in economic activity back to a sustainable path. In India economic activity continues to expand at a rapid pace; in 2004 GDP grew by 6.4 per cent. Latin America experienced growth of 5 per cent in 2004, compared with 1.8 per cent in 2003. The acceleration involved all the main countries; in Brazil, GDP grew by approximately 5 per cent. In Argentina, the recovery, which got under way two years ago, was driven by the strong expansion of domestic demand and the good performance of exports; in the last three years there has been a large trade surplus. In the first three quarters of 2004 the growth in GDP amounted to 8.8 per cent year on year. The peso’s exchange rate against the dollar, which at mid-2002 had weakened to nearly 4 to 1, subsequently staged a recovery and has stabilized at around 2.9 pesos to the dollar since 2003. Benefiting above all from the increase in revenue produced by the strengthening of economic activity, the primary surplus on the federal budget rose to 3.6 per cent of domestic output in the first nine months of 2004, from 2.8 per cent in the corresponding period of 2003. The problem of restructuring the debt remains open at international level. 2. The financial markets As we have pointed out for some time now, conditions of abundant liquidity prevail in the international markets. The credit and monetary expansion has been very robust in recent years in the United States and Japan and has spread to the emerging economies of Asia whose currencies have been managed with reference to the dollar. Since the beginning of 2002 the broad measure of the money supply has grown by 56 per cent in China, by about 20 per cent in South Korea, and by between 12 and 16 per cent in the other Asian countries. In Europe, the 12-month growth rate of the M3 money supply, after falling to 4.9 per cent in May 2004, rose to around 6 per cent in December as a consequence of the expansion in currency in circulation. The plentiful supply of credit at global level has had a limited impact on consumer price inflation, thanks to greater competition and the spread of products originating from countries where labour costs are extremely low and social protection is scanty. In the United States, large productivity gains have helped to contain inflation. Bond and share prices in the industrial and the emerging countries remained stable at the high levels of the start of 2004. By contrast, in most of the industrial countries house prices continued to rise. Yields on ten-year government bonds have stabilized since October at around 4 per cent in the United States and approximately 1.4 per cent in Japan. In the euro area, given the low inflation rate and the uncertainty about the strength of the recovery, longterm yields fell to 3.6 per cent in January of this year. The yield spread between the bonds of US companies with a high credit rating and ten-year Treasury paper was equal to 0.9 percentage points in January; the corresponding spread for the securities of riskier companies has stood at 2.8 points since last October. A factor helping to curb the cost of financing has been the strengthening of the profitability and balance sheets of the corporate sector as a whole, which is also reflected in the persistent reduction in defaults and the improvement in the balance between corporate rating upgrades and downgrades. In the euro area, the growth in lending to the private sector was 7 per cent in December compared with the end of the previous year; the increase was nil in Germany, 7 per cent in Italy. In Europe too, the spreads between non-financial-sector euro-denominated bonds and government securities are currently at very low levels. According to Moody’s, at the end of 2004 defaults in the international market were equal to 0.2 per cent of the total amount of issues outstanding, the lowest rate since 1997. There was a further improvement in the rating agencies’ assessments of the creditworthiness of issuers. Thanks to the good performance of profits, in the United States and the euro area the ratio of share prices to earnings, declining since March 2002, has fallen further and is basically back in line with the long-term levels. House prices have accelerated in many industrial countries since the end of the 1990s: between 1999 and 2003 they rose in the United States, France and Italy at average annual rates around 6 percentage points higher than the rise in consumer prices; in the United Kingdom and Spain, the increase in real terms was around 12 per cent. In 2004 property prices again rose sharply with respect to the previous year; in the third quarter their increase outpaced that in consumer prices by 19 percentage points in the United Kingdom, 10 points in the United States, and 13 points in France and Spain. In Italy house prices rose by 9 per cent in nominal terms in 2004, compared with 11 per cent the previous year; in Germany and Japan, continuing a trend under way since the early 1990s, they fell slightly again in 2004. In the main emerging countries, after the increase in risk premiums recorded last spring, there was a return to relaxed financial conditions; in mid-January 2005 the spreads stood at very low levels, reflecting the strengthening of economic activity, the good performance of exports and abundant liquidity. In general, current conditions in the international financial markets are characterized by low interest rates and risk premiums. The large expansion of derivative products in the course of the last two years has redistributed risk towards market participants better able to absorb it. The markets are not signaling risks of instability at global level. 3. Exchange rates and external imbalances According to the indicator calculated by the Federal Reserve, between February 2002 and January 2005 the effective exchange rate of the dollar fell by 15 per cent in both nominal and real terms. Over the same period the euro appreciated by 24 per cent in nominal terms and by 21 per cent in real terms. The yen strengthened by 7 per cent; in real terms it depreciated by 3 per cent. In 2004 the central banks of the Asian countries again intervened on the foreign exchange market with massive purchases of dollars. In Japan the official reserves rose to $850 billion, in China they grew by about $200 billion to exceed $600 billion; in the other Asian countries they now amount to $830 billion. Reserve assets, mostly denominated in dollars, are equal to about 18 per cent of GDP in Japan and to about 37 per cent in China. Generally low rates of inflation and the peg to the dollar have enabled some Asian countries to improve their competitiveness: since February 2002 the real effective exchange rates of the currencies of China, Hong Kong and Malaysia have fallen by between 9 and 17 per cent. The competitiveness of Thailand and Taiwan has remained unchanged, while that of South Korea and Singapore has deteriorated slightly. After the financial crisis of 1997 the reference to the dollar in the management of exchange rates resulted in only limited changes in competitiveness among the emerging and newly industrialized Asian countries, thereby encouraging the growth of regional trade, which has increased to about half the total. This integration reflects the spontaneous development of vertical integration of production within the region, in which each country tends to specialize in one phase of production. In the last ten years China’s share of international trade has increased significantly. It takes 13 per cent of Japan’s exports and 17 per cent of those of the other emerging Asian countries: it imports capital goods and components from Japan, South Korea and Taiwan. It exports manufactures, for some ten years now mainly to the markets of the industrial countries. As globalization proceeds, the emerging Asian economies, which have very low labour costs and faster productivity growth than the United States, cannot pursue policies aimed at stabilizing the exchange rate against the dollar for ever. Such policies risk boosting inflation and fueling excessive increases in the prices of financial and real assets. In 2004 the large external deficit of the United States had a counterpart in the substantial surpluses of the Asian countries, which totaled about $330 billion. The surplus of the euro area rose from $26 billion in 2003 to about $50 billion, or 0.5 per cent of GDP. At present the bulk of Asia’s current account surplus is generated by Japan, which in 2004 contributed $170 billion; another major contribution, of $90 billion, was made by the newly industrialized economies. According to the IMF, in 2004 the current account surpluses of China and the other Asian developing countries amounted to $38 billion and $30 billion, respectively. In the last few years India has recorded modest surpluses. Even though all the Asian countries have been running large current account surpluses, their net international investment positions differ. Japan has had a structural current account surplus from the postwar period onwards. China began to record current account surpluses in the early 1990s. In South Korea and other important emerging Asian countries surpluses are of more recent date. In the ten years prior to the crisis of 1997, the persistent deficits of the emerging Asian economies had resulted in their accumulating a high level of foreign debt. The crisis forced these countries to make an abrupt adjustment; a substantial current account surplus followed. Despite the subsequent rapid recovery of economic activity in the region, the surplus continued to grow, rising in the last three years from 2.4 to 3.7 per cent of GDP as a consequence of the upturn in world trade and the favourable competitive position. The differing net investment positions affect countries’ propensity to keep on accumulating dollars and, more generally, foreign exchange reserves. 4. Italy In the first nine months of 2004 GDP growth in Italy was 1.2 per cent on an annual basis, 0.7 percentage points less than in the rest of the euro area. The growth gap, which had been nearly closed in the course of the previous three years, thus widened again in concomitance with the less favourable performance of exports. In the first three quarters Italian exports grew by 3.3 per cent compared with the same period of 2003, approximately half the increase recorded by the other euro-area countries as a group. The balance-oftrade data indicate they slowed down in the final months of the year. Given the buoyant expansion of world trade, Italy’s share of world exports of goods is estimated to have fallen to around 2.9 per cent in volume terms. The loss of world trade shares that began in 1996, when Italy returned to the European exchange rate mechanism, has continued. The substantial stability of the currency has not been accompanied by structural reforms capable of increasing competitiveness as much as in the other industrial economies. Italian exports continue to be held back by the loss of price competitiveness, due largely to the poor performance of productivity. The deterioration in manufacturing efficiency by comparison with the leading industrial countries, under way since the mid-1990s, has been aggravated in recent years. Between 2000 and 2003, total factor productivity in industry fell by about 1 per cent a year. The competitiveness of Italian goods, as measured by unit labour costs, declined by nearly 15 per cent between the start of 2002 and the end of 2003, or 9 points more than the deterioration in Germany and France. In the first nine months of 2004, with nominal exchange rates essentially stable, Italian competitiveness continued to suffer from a faster rise in unit labour costs. Earnings per employee rose by 2.8 per cent in the entire economy and by 2.3 per cent in the non-farm private sector. But there was no adequate gain in productivity. The rise in unit labour costs in Italy thus exceeded that in France and Germany by 1.4 and 3.5 percentage points respectively. Italian household consumption rose by 1.2 per cent in the first quarter of 2004 with respect to the previous three months, but then remained almost flat for the next two quarters. Harmonized consumer price inflation was 2.3 per cent in Italy in 2004, as against 2.1 per cent in the euro area. According to the January Consensus Forecasts, inflation is expected to fall to 2.1 per cent this year in Italy and to 1.8 per cent in the area as a whole. Investment in machinery, equipment and transport equipment, which in the first half of 2004 recouped the contraction registered in 2003, turned downwards again in the third quarter, reflecting uncertainty over the recovery in economic activity. Investment in residential construction continued to expand. Public works activity slowed sharply in the second half of the year after a lively expansion in the first. The uncertain path of investment and the decline in industrial production have braked the expansion of employment. The more intensive utilization of labour in connection with wage moderation and with the greater flexibility produced by the reforms enacted since the early 1990s appears to have come to an end. In the third quarter the number of persons employed was 0.2 per cent higher than in the fourth quarter of 2003. In industry, following the moderate expansion recorded between 2000 and 2002, employment began to contract again in line with production. The unemployment rate fell in 2004, mainly owing to the decline in labour force participation. The diminution in the supply of labour interrupted the decade-long process of convergence towards the average European participation rate. There was a decline in labour force participation by young people in the South, especially women. More systematic action, including training programmes, is needed to raise labour market participation rates. Bank lending was 6.7 per cent greater in December than a year earlier. There was a slowdown in the North and Centre, while the growth in lending accelerated further in the South to 10.5 per cent. Credit to consumer households, essentially for the purchase of houses, increased by 16 per cent. The value of new bad loans remained limited. Qualitative and quantitative indicators show that credit supply conditions continue to be easy. Interest rates are still extremely low. Secondary market yields on Italian corporate Eurobonds are in line with those on the bonds of other international issuers. 5. The banking system and the corporate sector Since the early 1990s the Italian banking system has undergone a transformation on an historic scale. Initially, 68 per cent of total assets were held by banks controlled by the state or by foundations; today the figure is close to 10 per cent. Most of the banking groups are controlled by a core group of investors comprising intermediaries, foundations and, in some cases, firms with minority interests. Important international financial intermediaries are present in a higher proportion than in other European banking systems. Foreign banks and financial institutions currently hold an average of 17 per cent of the capital of the four largest banking groups; for the 10 largest groups, the share held by foreign intermediaries is 11 per cent. On the basis of BANKSCOPE data, foreign intermediaries hold 7 per cent of the capital of the four leading banking groups in Germany, 3 per cent in France and 2.6 per cent in Spain. In the privatization process, foundations’ and public entities’ sales of shareholdings were facilitated in the second half of the 1990s by buoyant share prices. In disposing of their holdings in banks, the foundations and public entities fostered the creation of stable core groups of controlling shareholders. Mergers and acquisitions have resulted in the number of banks operating in Italy falling from 970 in the mid-1990s to 785; 443 are mutual banks. Initially the market share of the four largest banking groups was 30 per cent; by June 2004 it had risen to 44 per cent. Some 80 per cent of total assets are held by groups headed by banks listed on the stock exchange. In the mid-1990s the return on equity of the Italian banking system was less than 2 per cent. Today, after rising to approximately 13 per cent in 2000, it is close to 11 per cent. All the indicators point to a considerable increase in banking competition; this is confirmed by the evolution of the structure of the market and interest rates, and by the redistribution of intermediaries’ market shares. In the regional loan markets there has been a marked decrease in the index of concentration. Compared with the mid-1990s, the average cost of short-term bank credit has fallen by more than 8 percentage points and is now in line with the euro-area average; the spread between short-term lending and deposit rates has narrowed from 6 to 4 percentage points. The Italian banking system is now in a position to compete in Europe. It is expanding its presence in Central and Eastern Europe. Italian banking groups are smaller than the major euro-area intermediaries; the indicators of operating profitability and efficiency are nonetheless better than the average for the banking systems of the area. The integration of the groups formed during the last ten years is at an advanced stage as regards corporate structure, operating procedures and information systems. Further combinations between large groups within the Italian banking system would entail serious problems in terms of the creation of dominant positions and a substantial reduction in competition in a number of regions and provinces. Account must also be taken of the uncertainty surrounding the productivity gains obtainable from the increase in size, owing to the organizational complexity of the entities that would be created. Combinations of regional and medium-sized banks are producing efficiency gains. There has been a revival of discussion on the possibility of additional mergers in Europe, where the size of banks is deemed inadequate compared with that of the major banks of the other main monetary areas. On the basis of the experience of recent years, the benefits of additional mergers are uncertain for large groups. At world level some of the largest banking groups have encountered serious difficulties. In other cases obstacles have emerged to the efficient control of operations in different lines of business and countries. In wholesale banking there is already a fully-fledged single market at international level. For financial services, the key factors are intermediaries’ technical skills and reputation and their links with countries with developed capital markets. In the Italian market, from the beginning of 2000 up to June of last year, foreign banks managed, through their branches, 30 per cent of the issues of securities by Italian and foreign non-financial companies and a quarter of the issues of international financial institutions. Foreign banks placed more than 70 per cent of the value of the roughly 200 issues of Eurobonds made by Italian firms. The leading international banks dominate M&A activity in the Italian market. As for retail banking, a dominant role in all the European countries is played by domestic intermediaries. These have detailed knowledge of the legal and institutional context and of the characteristics, needs and creditworthiness of customers, especially those of smaller size. A recent report prepared under the auspices of the G-10 Finance Ministers and Central Bank Governors shows that bank mergers and acquisitions mainly involve domestic intermediaries in all the leading economies. In Europe most of the few crossborder mergers that occurred were between intermediaries based in countries with institutional, cultural and linguistic affinities or involved a bank in financial distress. When intermediaries of different countries are combined, legal and institutional differences and cultural barriers may hamper the transfer of managerial skills from the acquiring bank to the bank acquired. In Italy the fruitfulness of collaboration with intermediaries of other countries is attested to by the extensive participation of foreign capital in the Italian banking system, by numerous cooperation agreements for the distribution of financial and credit products and by the significant role played by foreign intermediaries in wholesale banking. The Bank of Italy examines every proposal submitted to it for mergers or acquisitions of major equity interests to be carried out by Italian banks vis-à-vis Italian banks, by Italian banks vis-à-vis foreign banks and by foreign banks vis-à-vis Italian banks. It applies Italian and Community law; it performs its statutory mandate of ensuring the sound and prudent management of credit, protecting the stability of intermediaries and of the system as a whole, and promoting competition. In the last few years Italian banks have provided financial support to firms, including large ones and some involved in extensive restructuring. They have directed very large volumes of credit to small and medium-sized enterprises, which are an important part of the Italian economy. In the financing of such businesses, there has been a steady increase in the proportion of credit provided by banks rooted in the local economy. For Italian banks, reducing costs and improving internal organization remain key objectives. Product innovation and the reduction of unit costs must be to the benefit of firms and households. They must be turned into an improvement in the quality of the products supplied and be reflected in the prices of retail services, above all for payment services and asset management. In a period of low inflation it is only right for banks to limit the fees charged on retail services. Progress in this direction, correct and professional conduct strengthen the relationship of trust with customers and are conducive to the orderly growth of intermediation business. In collaboration with the Antitrust Authority, we have launched a fact-finding inquiry with the aim of ascertaining the existence, for some services, of strategies and costs that discourage customers from changing bank. Over the last ten years, the banking system has been marked by a process of consolidation and a progressive increase in the average size of individual intermediaries, whereas the industrial and service sectors have experienced further fragmentation, with inevitable adverse effects on the productivity and competitiveness of the whole economy. The number of large industrial groups, essential for the spread of new technologies, is limited. The system of industrial districts, which in past decades helped to generate the synergies and efficiencies typical of large groups within clusters of small firms, now seems less able on its own to sustain a further drive to improve competitiveness. The shortage of infrastructure and the cost of energy and services for firms are a drag at national level. Spending on research by both the public sector and the private sector is particularly low in Italy by comparison with the other advanced economies. The proportion of value added by high-technology sectors is very small. This affects Italian products’ penetration of international markets. Italy’s share of world exports of goods and services in volume terms was approximately 4.5 per cent in the mid-1990s; in 2004 it fell below 3 per cent. Industrial production follows the performance of exports. For several years now, as we have documented on other occasions, its growth in Italy has fallen appreciably short of that recorded both in the euro area as a whole and in the area’s two largest countries, Germany and France. In 2004 Italy’s index of industrial production showed a slight tendency to decline. To a degree, the transfer of traditional production to countries with low labour costs and rapidly expanding demand is normal. In Italy the phenomenon has intensified since the mid-1990s; the number of workers employed in foreign companies invested in or controlled by Italian firms has reached one fifth of the total number employed in domestic industry. In recent years, the prevalent reason for investment abroad appears to have been to cut costs; direct investment aimed at increasing firms’ presence in advanced markets has contracted sharply. The strategies that will enable the system to reap the maximum benefit from internationalization need to be identified; better knowledge and thorough analysis of the phenomenon are necessary. An economic policy that intends to revitalize Italian industry must necessarily come to grips with the problem of firm size, in part by encouraging mergers and acquisitions. There are difficulties, above all in connection with the ownership structure of Italian firms. The banking system, which possesses databases and extensive and detailed information on the structure and profitability of firms, can promote mergers and acquisitions, provide the financial assistance and services needed to make the productive system more solid. The Italian economy contains instances of excellence in innovative and creative ability, not just in the traditional branches of activity but also in high technology. These more dynamic units can act as poles of aggregation for less productive firms. It’s a challenge in which we cannot fail, in order to improve an important part of our economy. 6. The outlook The overall expansion of the world economy is set to continue this year. In the United States, GDP is expected to grow by about 3.5 per cent. Short-term interest rates were drastically reduced in the weak phase of economic activity. They are currently nil in real terms; increases are expected in the course of the year. The supply of dollar-denominated securities has been abundant in the past few years, reflecting the high public sector borrowing requirement and robust investment. From the low it touched in the closing days of last year, as of yesterday the dollar had recouped 6 per cent against the euro. Although, as mentioned earlier, the level and structure of yields do not signal risks, a growing imbalance between the demand for and the supply of savings in the largest industrial economy looms over the global financial system. A current account deficit in 2004 of $600 billion, a little more than 1.5 per cent of world GDP at current exchange rates, was absorbed with a depreciation of the dollar but without serious strains in the markets, in a year in which the world economy grew by 8 per cent in nominal terms and the demand for financial assets expanded even faster. The quantity of dollars as defined by M2 increased by 38 per cent between 1999 and 2004; over the same period the stock of public and private-sector bonds grew by 45 per cent. The sum of the two aggregates rose to 260 per cent of America’s GDP. For the euro, the money supply and the stock of bonds increased by 48 per cent over the same five years, and the volume of assets denominated in euros rose to 235 per cent of the area’s GDP. In Japan, the money supply and securities grew by 35 per cent; their ratio to GDP is far higher than in the other two main monetary areas. The expansion of the world money supply and, to an extent, that of private and public-sector bonds in relation to GDP have had bullish effects on share and especially property valuations. Consumer price inflation has been held in check by the increase in productivity and competition. The external current account deficit of the United States for the current year is expected to be of the order of $700 billion. The ability of the international markets to finance large imbalances between saving and investment in the major industrial countries has increased markedly in the last few years. The world economy will continue to absorb dollar-denominated financial assets; excessive repercussions on exchange rates and yield spreads can be avoided if the expansion of the quantity of dollars is not substantially greater than that of the other main currencies. Important factors, in this context, will be the overall balance sheet position of the private and public sectors in the three monetary areas, the growth expectations for the US economy, and the willingness of global financial intermediaries to increase the share of their dollar holdings further, while reducing that of other currencies and their domestic currency. A large loss of value by the dollar would be harmful for the orderly functioning of the financial system and the world economy. The increase in official interest rates should help to sustain the external value of the dollar during 2005. The resolve of the US administration, which it recently reaffirmed, to reduce the budget deficit substantially is crucial. But in a long-term perspective, a more balanced relationship between the major currencies cannot come about without a return to faster growth in Europe and Japan. In Japan, according to the estimates of the central bank, the increase in GDP will be approximately 2 per cent this year. In the emerging areas the pace of growth is likely to slow somewhat but will nevertheless remain very rapid. According to the IMF, growth will diminish to 3.6 per cent in Latin America, 7.5 per cent in China and 5.5 per cent in the other emerging Asian economies; at world level, the expansion in GDP is forecast at 4.3 per cent. In the euro area, the cyclical indicators weakened during the autumn. In November manufacturing output registered its second consecutive decline, reflecting the contraction in activity in Germany and Italy and stagnation in France. Indicators of the climate of confidence have not yet signaled a clear reversal of trend in the expectations of households and firms in the main countries, except in Germany, where the last few months have seen an improvement. The international organizations forecast area-wide growth to be approximately 2 per cent this year, about the same as in 2004. In Italy, GDP growth in 2004 is estimated to have been approximately 1.5 per cent. According to preliminary estimates, industrial production declined by 0.5 per cent in the fourth quarter, and appears to have contracted slightly again in January. During 2005 the expansion in output is expected to gain pace, as a consequence of an acceleration in exports and in the domestic components of demand. A policy aimed at raising the Italian economy’s growth potential appears increasingly necessary. Prerequisites for this are the structural adjustment of the public finances and the lowering of the ratio of debt to GDP. The Government is considering a set of measures to improve the economy’s competitiveness. Their prompt implementation is essential to bolster the still uncertain propensity of firms to invest. Factors of fundamental importance are the development of basic and applied research, in part through closer relationships between universities and firms, the transfer of matters from primary to secondary legislation, and the reduction in the number of authorization procedures. The prompt implementation of the public works plan requires mechanisms, including extraordinary instruments, to speed up procedures and execution. The reform of bankruptcy law, which can no longer be put off and should be implemented in the form of a decree-law or enabling law, will benefit the protection of businesses, workers, creditors and banks. The Italian banking system can sustain a higher rate of economic and investment growth. It will also benefit from a stronger economy. Its stability and efficiency are the guarantee for the savings entrusted to it and for their fruitful investment to the advantage of economic activity. With a united effort, we must establish the conditions for faster growth. Among the measures for competitiveness, special attention must be paid to the South, with its resources of labour, intelligence and initiative. Growth realizes the potential of labour flexibility through the employment it brings. Economic policy action, the response of the social partners and the institutions can create the climate of confidence that is necessary for enterprise and innovation. We must increase our commitment on behalf of those, especially young people, who are convinced that a better future can and must be built. | bank of italy | 2,005 | 2 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Accademia Nazionale dei Lincei International Conference, Rome, 18 February 2005. | Antonio Fazio: Franco Modigliani Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Accademia Nazionale dei Lincei International Conference, Rome, 18 February 2005. * 1. * * Some personal recollections Franco Modigliani occupies a central role in 20th century economic analysis. For his work on the theories of saving and finance he was awarded the Nobel Prize. He made considerable contributions on innumerable topics, as is borne out by the five volumes of his Collected Papers. His participation in the debate on Italian economic policy answered to the profound need of the man and the economist, who, after analyzing problems, threw into the search for solutions the whole weight of his civic passion, his commitment to the welfare of the community, of those he regarded as his fellow citizens. Discussions, whether with economic policymakers or with young people eager to learn from him, were always lively and directed to conclusions that were analytically well-founded and socially fair. I first met Franco Modigliani in 1957. During a trip to Italy, the first since the end of the war, he gave a lesson in Piazza Borghese to Professor Travaglini’s political economy students. We had studied Bresciani Turroni, including his attempts to make an empirical analysis of the demand for Egyptian cotton, and were tackling Value and Capital. I was struck by Franco’s description of the way the consumption function was estimated, in the United States, of course. Political economy did not end with sophisticated analyses of isoquants, the income effect and the substitution effect: it was a practical science. After graduating and spending some time in the Bank of Italy’s Economic Research Department on a scholarship, I was encouraged by Professor Cutilli to write to a number of American universities in order to specialize in monetary theory and econometrics. In the end I chose Northwestern, because Professor Modigliani taught there, and it was partly thanks to him that I was admitted. At the beginning of 1962 Franco announced to me that he was moving to the Massachusetts Institute of Technology and suggested I should follow him. I did, without hesitating. Under Paul Samuelson’s influence, MIT was already at the forefront of the academic world, for the originality of its research, the quality of its teaching staff, and the constant wrestling with practical problems; among the latter, I have pleasure in recalling Kennedy’s new economic policy, which was under discussion in the States at the time. Franco advised me to take Samuelson’s course in Advanced Monetary Theory, which was also taught by Albert Ando. These were the years of fierce debate between Keynesians and monetarists regarding the role of monetary policy in economic growth and in controlling inflation. Let me recount an anecdote. One day, someone came into the lecture hall with a large pile of Xerox copies, which he placed on the table: it was the typescript of Friedman and Schwartz’s Monetary History. Professor Samuelson remarked, ‘Milton, Milton! We set up the Fed to adjust the quantity of money to the needs of the economy’. In its simplicity this comment touched on one of the main points of the debate on the importance of the quantity of money. I also attended – how could I fail to – Solow’s lectures on economic growth, based on Denison’s Sources of Economic Growth in the U.S.; I had confirmation of their topical relevance when discussing total factor productivity in the United States and Europe with colleagues from the Federal Reserve. Professor Modigliani offered me the opportunity to attend a course in monetary theory ad personam. It consisted in a sort of two-man seminar, in which he assigned me reading to complete, which we would then analyze together. Inter alia, I was given the instruction that “…although I do not agree with a word of Milton Friedman’s conclusions regarding monetary policy, he is an author you must study, starting with his reformulation of the quantity theory of money”. Our discussions could last hours; if it was late in the afternoon, Professor Modigliani would sometimes take me to his home in Belmont to continue thrashing out various points over dinner; we would talk on into the evening, until Serena remonstrated and told him to drive his student home. Modigliani was working on a new version of his 1944 essay “Liquidity Preference” to correct a mistake he thought he had made in that article by expressing income and wage variables in nominal instead of real terms. I had also studied Patinkin in depth, and Modigliani explained an aspect that I had not understood: the application of Walras’ Law to macroeconomics. He “skewered” me again on this point some years later with a criticism of the early version of the model of the monetary sector of the Italian economy: I had included one market too many, a redundant one. After some sharp but unfailingly gallant exchanges he acknowledged, however, that I was right about the importance of the concept of monetary base, as distinct from money, as a central bank tool for controlling credit. Another field of research in which Franco sought to involve me concerned the relationship between demographic structure and formation of savings; we pursued a line of thought initiated by Giorgio Mortara, an author I had also studied for my thesis. I never had any doubt, thanks also to Guido Carli’s encouragement, that I wanted to work for Italy’s central bank. In recalling Franco Modigliani, I shall concentrate on some aspects of his thinking that have a major bearing on economic policy. His many important contributions to theory have already been discussed by the other economists of note taking part in this conference. 2. The role of money and the econometric model The complexity of macroeconomic theory, and of monetary theory in particular, is attested to by the heated controversies that have marked it in the course of time. I have recalled the monetarists and the Keynesians; much earlier there had been the protracted dispute between the Currency School and the Banking School, more recently the debate on the new classical macroeconomics. The contraposition between distinct strands of thought derives not only from alternative visions of the working of the economy but also from a different emphasis, as a result of a different assessment of their empirical importance, on certain aspects of the phenomena investigated. Antithetical economic policy ideas and suggestions may then emerge. In academic debate the different approaches proceed in parallel; often, the prevalence of one over another is connected with the occurrence of shocks strong enough to cause a change of paradigm. The Great Depression created a break in the secular progress of economic analysis. The classical model, dominant until then, proved inadequate in the face of a crisis of catastrophic dimensions. In a speech broadcast by radio on 21 November 1934 with the eloquent title “Poverty in Plenty: Is the Economic System Self-Adjusting?”, Keynes took up the question of the economic system’s intrinsic stability and answered it in the negative. While recognizing the validity of much of classical economics, Keynes called himself a “heretic” and proposed an alternative model. He identified an error in the prevailing theory: “There is, I am convinced, a fatal flaw in that part of the orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment; the flaw being largely due to the failure of the classical doctrine to develop a satisfactory theory of the rate of interest.” In the Keynesian tradition, the problem of the instability of capitalist systems, especially those in which financial intermediation is highly developed, was the subject of a penetrating essay by our friend Fausto Vicarelli, who died so prematurely. How many episodes of instability we have seen in the last ten or fifteen years, characterized by a rapid expansion of global finance. Episodes of instability that caused severe hardship and social malaise in the countries affected by the crises; efforts by all the components of society were necessary to overcome them. Starting out from The General Theory and his rereading of Hicks, Modigliani, in his article of 1944 and in his subsequent paper, “The Monetary Mechanism”, published in 1963, analyzed the implications for employment of the downward rigidity of wages. With the money supply constant in nominal terms, a diminution of aggregate demand entails a movement away from the full-employment equilibrium and hence the necessity for an activist monetary policy. Different aspects of the monetary and economic policy transmission mechanism, which Modigliani analyzed and which he discussed in our Economic Research Department with reference to Italian economic reality, are incorporated in the structure of the Bank’s econometric model. Modigliani let us have the benefit of his advice regularly during the 1960s and on numerous occasions in the following decades. We discussed the problems of growth, of employment and of investment, in general and in the Italian economy. The specification and estimation of the individual equations of the econometric model were also carefully considered. In this setting the lines of a wage policy that was later applied with good results took form with Ezio Tarantelli through studies of the labour market. The hallmark of the Bank’s econometric model was that it combined an extensive part referring to the real economy −employment, wages, investment, prices, effective demand −with a detailed analysis of financial flows. This second part stemmed from the theoretical contributions of Gurley and Shaw, from Tobin’s Manuscript and from Copeland’s studies on the flow of funds, a subject empirically developed for the Italian economy by Ercolani and Cotula. Modigliani was greatly interested in this structure of the model and threw himself into the discussions on the Italian financial system, which also engendered ideas for improving the structure of the markets. The Bank of Italy has constantly used the econometric model since then as a logical frame of reference and a tool for knowing some fundamental parameters of the Italian economy. We used the model in intense discussions with the International Monetary Fund in order to design and define the parameters of the policy to stabilize the Italian economy in 1974 in the wake of the first oil crisis. This had caused an enormous imbalance in the external accounts and a surge in inflation, which was followed by a wage explosion due in part to the indexation of wages to prices. The success of the policy of credit restriction was immediate, thanks also to the resoluteness with which Governor Guido Carli implemented it. Inappropriate budget policies created new imbalances in the following years. We used the model and its parameters again to define, under Governor Paolo Baffi, the stabilization policy of 1977-78 carried out by the government led by Giulio Andreotti. The budget correction amounted to 5 per cent of GDP. The positive effects on the external accounts came through within a year. Over a span of thirty years Franco Modigliani’s analyses, his diagnosis of the ills of our economy and the suggested cures, encompassed manifold subjects, from the labour market to the problems of retirement provision. He was motivated by the desire to penetrate the reality of the Italian economy in order to correct its malfunctions, increase efficiency and expand employment. His interventions, above partisan interests, were always highly appreciated by Governors Carli, Baffi and Ciampi. 3. Modigliani and economic policy In the 1960s, the dominance of Keynesian economics was uncontested. Milton Friedman proposed an alternative line of thought, but his ideas were not considered, save to dismiss them out of hand. But not by Franco Modigliani. In the 1970s the collapse of the Bretton Woods monetary order created the conditions for a worldwide inflationary drift. As a result of restrictive monetary policies, there was also a generalized slowdown in economic activity. Inflation refocused attention on Friedman’s ideas. In the United States the Federal Reserve had long restricted its monetary action to stabilizing interest rates – the policy of William McChesney Martin. In this way the rise in costs and prices was financed almost automatically. With the policy shift instituted by Paul Volcker in 1979, the Fed focused on controlling the quantity of money. For a short time administrative ceilings were also imposed on lending by Federal Reserve System member banks. Market interest rates soared. Inflation was curbed. The so-called monetarist counter-revolution, which blamed activist economic policy for destabilizing effects, sought to confine policymakers’ actions within the bounds of a set of “simple rules”. In reality, this prescription reflected the basic postulate of the economy’s automatic return to equilibrium, which, as Keynes had underscored, was the keystone of classical economic theory. In his presidential address to the American Economic Association in September 1976, Modigliani intervened in the debate between Keynesians and monetarists, with acute arguments defending the need for both fiscal and monetary countercyclical measures. Modigliani was sceptical about the hypothesis of rational expectations underpinning the alleged ineffectiveness of stabilization policies, because of the conflict with the empirical evidence. Deviations of unemployment from its natural rate were neither transient, nor small. The factors preventing the economy from returning to an equilibrium position within a relatively short time are incomplete information and institutional rigidities. The hypothesis of rational expectations may apply in the long run. Exogenous shocks necessitate stabilization measures. The postwar experience, he said, offered confirmation of this view, but overemphasis on fine-tuning was a mistake. Modigliani recoiled from partisan thinking and pinpointed the weaknesses of all the different models, including the Keynesian, which he criticized for failing to consider long-term effects. He once confided to me, “For decades we have focused exclusively on flows; in our analysis we need to go back to considering the role of stocks.” The ratio of wealth to disposable income in Italy today is about 8 to 1, the highest among the G-7 countries. The conclusion that stabilization policies are effective anticipated by a quartercentury the thesis sustained by Robert Lucas in his presidential address in January 2003. Lucas offered a positive judgment on the economic policies of the postwar period based on advances in macroeconomic theory, both Keynesian and monetarist. Countercyclical policies did stabilize the economy and prevent another large-scale depression, but more intensive recourse to these measures would not produce additional welfare gains; such gains can be attained by supply-side policies. In the classical tradition, Lucas stresses incomplete markets and the existence of rigidities and frictions that impede adjustment. On these points and on the compatibility of a theory of money and prices with an essentially Keynesian model, Patinkin’s analyses in “Price Flexibility and Full Employment” first and then his Money, Interest, and Prices tie in with specific passages in the last part of the General Theory and provide a synthesis that, to my mind, is still valid today. This was a lesson that served me in the mid-1990s, when I had to impose a highly restrictive monetary policy in Italy to support the exchange rate of the lira and curb inflation. In doing so, I had in mind an idea of the working of the economy in which the level of activity is determined essentially by effective demand. Perhaps, if monetarists today cannot but call themselves Keynesians, I should be tempted to assert that – as far as stocks and sound analysis are concerned – Keynesians must similarly own to being monetarists. Economic theory is a great help to central bankers. In practical action, however, we must not forget that the complexity of theory is such that it is not always possible to reach unequivocal conclusions or, as a consequence, unquestionably correct and effective policy prescriptions. One may be confronted with hypotheses that suggest completely different economic policy measures. It is important for policymakers to bear in mind the multiple facets of each problem, so as to choose the model that has the greatest explanatory power. History provides numerous examples of policy errors that were the consequence of an inadequate theoretical apparatus. It is sufficient to recall the monetary policies of the early 1930s and the dysfunctions of the gold exchange standard, which helped to spread the Great Depression, with dire consequences for the world economy. In the second place, it is necessary to have empirical knowledge of the phenomena to be acted on. We are regularly faced with discussions of topical problems based on abstract models unrelated to the real world. The search for solutions must begin from concrete situations. As Pareto suggested in his Manual, to approach the optimum one must also take account of non-economic factors and constraints. Insufficient understanding of the complex workings of a market economy affects our ability to operate and can produce erroneous solutions. Expectations play a decisive role in determining economic performance and the transmission of economic policy impulses. The lesson to be learned from Modigliani in this respect is important: he sought to grasp the essentials of the problems, independently of preconceived notions. Together with Emile Grunberg, he made a major contribution to our understanding of the role of expectations as early as 1954; this issue recurred frequently in his thinking. Governing an economy – through fiscal policy, monetary policy and structural reforms – is a complicated task. Today, more completely than in the past, we read the various signals coming from the economy, but even so their informational content is incomplete, not sufficient to plot a secure course. Our knowledge, at micro and macro level, of the behavioural functions of economic agents has improved. Yet like all the applied disciplines, economic policy remains an art. 4. Conclusions The international economy and national economies are dominated today by the phenomenon of globalization. It is the sign of the times. Globalization not only transforms economies and finance but it also impinges on social and cultural models; it raises the urgent question, especially at international level, of the institutions required to govern the phenomenon. To cope with the changes and anticipate the future, an approach is needed in which ever greater specialization is combined with elements of humanistic culture. In this context institutions such as this glorious Academy have a task to perform in the higher reaches of knowledge. The financial system has gained a sort of primacy and autonomy at global level. Within it are determined the levels and structure of interest rates, exchange rates, the cost of capital −here too Modigliani docet −on the equity markets. The global financial system receives impulses from the performance of the major economies and from central banks; by its nature it is always exposed to the risk of instability; its raison d’être lies in bringing together the capacity for saving of some sectors with the investment expenditure of others. In closed systems, the major actors were firms, households and the state; in the global system the imbalances between states and monetary areas come into play. The international financial system is also tending to adapt the characteristics and scope of its operations to the need to transfer resources from countries and economic areas with current account surpluses to those with deficits. Capital flows to where productivity and, hence, profits and returns are highest and security greatest. Basically, for closed systems −and the world is a closed system – this has already been theorized in the Turnpike Theorem. But the global system is a sort of free banking regime with no anchor. The central bank governors are striving to define rules for intermediaries in order to increase stability. Notwithstanding failures along the way, we appear able to succeed in this intent. The Basel rules, continual consultations and banking supervision in the individual countries make a fundamental contribution to stability. Derivatives, this new invention of finance, provide the lubricant; they reduce and redistribute the risks. Sometimes they are transformed into fuel, pushing the system beyond the limits of prudence. National economies are linked with the global system through trade, but today, much more than in the past, through finance as well. The efficiency and stability of national financial systems and their coordination with the global market are necessary for the vitality and proper working of an economy; they are not sufficient to ensure growth and prosperity. Policies must in the first place correct macroeconomic imbalances and hence promote the full utilization of productive factors; in open systems, they must foster competitiveness. From a broad perspective, competitiveness is simply the ability of an economy to supply, through its working, an adequate and growing flow of value added. Accordingly, it appears to me that in open systems competitiveness comes to coincide with potential growth. In Europe, and especially in Italy, the potential growth of GDP has diminished in recent years. The introduction of the euro has not been accompanied by reforms capable of accelerating growth. Monetary stability and low interest rates have brought benefits, but growth still has not ensued. The Lisbon Agenda, valid in its general formulation, must be applied with the support of the Union and the Member States in the individual economies by identifying the instruments for its implementation. To judge by its public statements, the European Commission is working on these issues. Demographic ageing −to whose implications for government budgets and macroeconomic equilibria, related in turn to those of individuals, Modigliani devoted so much attention −is looming over Europe, Italy and other advanced economies. The public pension and health systems, conquests of great social value of the past century, must continue to provide their benefits to future generations. A wisely regulated immigration policy can be a resource, as the experience of the most advanced economy demonstrates. It is a policy that has substantial effects on the social, institutional and legal plane; following thorough analysis based on solid principles, the problems must be addressed in ways that avoid extreme solutions. Our interests must be borne in mind, but also the expectations of those who leave their own country in search of dignified living conditions, the aspiration and right of every human person. It has been affirmed by a high authority that every person, upon coming into the world, becomes a citizen of the world community, with the right to partake of the goods that the system can offer. The economy is one aspect of a vaster civil society. Welfare, including economic wellbeing, is attained through analysis, determination, cooperation and enterprise that glimpses new horizons and works and struggles to reach them. Increased employment, the spread of work, is the goal that negates the idea of economics as the “dismal science”. It is crucial today in Italy to activate all the necessary means to reverse the trends, to catch the updraft of the recovery, to increase the propensity to invest, to trigger an expansionary drive. The solutions and the proposals must come, albeit in the necessary dialectical process, from the convergence of all the parties, institutional, economic and social. The prospects of an economy can be seen in the willingness of firms to venture and invest. The formation of capital, essential to raise potential growth, is tending to be dematerialized, to take on the form of knowledge, organization and the ability and quality of men of Smithian memory. We must recover the commitment to growth of every component of society and confidence in the future. Practice must be founded on good theory. Economists offer recommendations for which they are competent. Action and synthesis, in the concrete context of civil life, are up to politics. I think these reflections would not have displeased Franco Modigliani. He would certainly have offered criticisms and observations, suggested additions and changes. Fundamentally, however, it is his moral strength, his passion for the good of his fellow citizens, which he passed on to us with his teachings, that have inspired these reflections. | bank of italy | 2,005 | 2 |
Speech by Mr Pierluigi Ciocca, Deputy Director General of the Bank of Italy, at the 8th ABI Convention ¿Implementing Basel 2 and IAS: Tendencies, Problems, Solutions¿, Rome, 29 November 2004. | Pierluigi Ciocca: “Basel 2” and “IAS” - more competition, less risk Speech by Mr Pierluigi Ciocca, Deputy Director General of the Bank of Italy, at the 8th ABI Convention “Implementing Basel 2 and IAS: Tendencies, Problems, Solutions”, Rome, 29 November 2004. * * * My intention in these remarks is to set the issues raised by Basel 2 and IASwithin a common framework. I shall therefore not consider the technical details but three general aspects: a) the macroeconomic context in which the new methods will be inserted; b) the hoped-for effects on the financial system; c) their transposition by banks and the Italian legal system. a) The macroeconomic context The entry into force of the new International Accounting Standards and the “Basel 2” capital adequacy accord will be gradual, phased in between 2005 and 2007. Intermediaries and supervisors are making their preparations. The “context” thus consists in a set of present-day realities, plans, expectations and forecasts. The information now available suggests that the moment is propitious for the non-traumatic introduction of the new methods. The international economy is subject to the threat of military conflicts, oil shortages, high real-estate prices, the large foreign debt of the United States and a declining dollar. Yet overall the economic picture is the rosiest seen for a quarter of a century. The forecasting scenario for 2005-2006 remains one of inflation-free growth: annual GDP growth of 3 per cent in real terms and price inflation under 2 per cent in the OECD countries, and annual world trade growth of no less than 9 per cent. This essentially benign macroeconomic situation is accompanied by systemic financial stability. The Financial Stability Forum, in which I have had the honour of participating since its foundation in 1999, is the world’s leading financial supervisory body. The Forum sees the debt of firms and households as moderate or sustainable, intermediaries as profitable and well-capitalized, share prices as basically in line with fundamentals, and prudential standards as stronger virtually everywhere. By comparison with the past the indicators of stability are on average higher and have lower although not negligible dispersion. Italy is no exception as regards low inflation and the stability of the financial system as a whole. Unfortunately, however, it is an exception in its rate of economic growth. From 1992 to 2006 (forecast) the yearly growth rate will come in at a mediocre 1.4 per cent. Yet the cyclical upturn is basically in line with the −modest −expansion of potential output. Moreover, even an economy with slow growth in potential output can be financially efficient and stable. The Italian economy’s “growth problem” can be solved.1 We are not condemned to stagnation. We have a diagnosis. And most important, the therapy is clear.2 The State must restore the health of the public finances, take care of infrastructure, reduce taxes and rewrite economic law; firms must expand in size and improve in quality with investment and technical progress; banks must select and support the best firms; the trade unions must defend but also moderate wage growth. All are called on to accept competition, not to impede the reallocation of resources. Policies and conduct together – not just government policies, not just the conduct of firms, banks and workers – can bring the Italian economy’s long-run growth rate back up to 3 per cent. P. Ciocca, Il tempo dell’economia. Strutture, fatti, interpreti, Turin, Bollati Boringhieri, 2004, Chapter 14. P. Ciocca and G. M. Rey, “For the growth of the Italian economy”, Review of Economic Conditions in Italy, No. 2, 2004. b) The purposes of Basel 2 and IAS Taken together, Basel 2 and IAS can appreciably increase efficiency, and above all in this way enhance bank stability. How? In principle, through stepped-up competition between intermediaries and within the financial markets. Without competition there cannot be efficiency. Without efficiency, in the long run there cannot be stability. Without stability the drive for efficiency is more difficult, and the free play of competition is impeded. A policy of prudential supervision that – by choice or because obliged by law – ignored competition or, worse, thought it could be sacrificed in the name of stability would be selfcontradictory. I shall back up these propositions – of whose validity the Bank of Italy remains thoroughly and analytically convinced – with a theoretical consideration and empirical evidence. Simplifying, the theoretical consideration can be quickly set forth. By their nature or in response to the urgings of supervisors, banks are risk-averse. They are in equilibrium if lower returns correspond to lower risk. Competition erodes quasi-rents, the extra profits of oligopoly. Other things being equal, therefore, competition does not induce banks to take on greater risk. On the contrary, by eliminating the quasi-rent “subsidy” of their riskier assets, it recalls them to prudence. Supervisory action works in the same direction. On the theoretical plane there is no conflict between competition and banking stability. Accordingly, on the institutional plane there is no conflict in principle between supervision and antitrust action in banking where – as has been the case in the United States from the very beginning and in Italy since 1990 – the same institution is responsible for both. The empirical evidence is equally clear. Despite the protracted stagnation of the Italian economy following the dramatic foreign exchange crisis of 1992, in supervising and regulating the banking system the Bank of Italy observed increasingly intense competition and at the same time instability limited to individual banks. In most of the markets for banking products the microeconomic indicators of price and volume testify to heightened competition, the transition from the traditional state of little rivalry to one of sharply stepped-up competition.3 In the markets for corporate ownership and control, contestability in the banking sector has been boosted by the industry’s virtually total privatization and the increased share of overall banking business accounted for by listed banks. The Lerner Index of oligopoly was one fifth lower in banking in 2000-2001 than it had been on average in the 1980s; in the service sector as a whole it was a quarter higher; and in the industrial sector excluding construction it was unchanged at a lower level.44 On the average, as we can see from the tables and the figure, productivity in banking rose faster between 1990 and 2003 than it had in the 1980s, while the real cost of labour rose more slowly. Nevertheless, profitability declined, not because of larger loan write-downs but because of sharper competition. Meanwhile, since 1990 the number of banks has fallen by nearly 300 to 790, and 800 banks went out of business. Yet the present value of the total losses of the banks that failed or were taken over made good by other banks or by the State during this decade-and-a-half did not even amount to 1.5 per cent of a single year’s GDP. In the field of credit risk, regulations anticipated banking practice rather than following it as in the 1996 market risk amendment to the Basel accord. “Basel 2” fosters efficiency in banking. Banks, large or small, that use more accurate and effective methods of risk assessment and management are rewarded with lower capital requirements. In this sense the new accord introduces a “Darwinian” selection bias for the survival of the fittest banks. It will heighten competition and shift market shares. The same holds for the new International Accounting Standards, although for different reasons. They are designed to enhance disclosure and transparency. They make the accounts of banks and firms comparable internationally. Potentially, they allow for a more realistic representation of market risk (with the application of fair value accounting for all securities) and of credit risk (with the broad, harmonized notion of “impaired loan”, which includes overdue credits). Information and transparency will also intensify competition both between firms and between banks. P. Ciocca, The Italian Financial System Remodelled, Basingstoke, Palgrave Macmillan, 2005, especially Chapter 6. N. Cetorelli and R. Violi, Forme di mercato e grado di concorrenza nell’industria bancaria dell’area dell’euro, Quaderni di Ricerche, Ente Einaudi, No. 35, 2003, pp. 37-39 and Table 4, p. 55. Since advances in competition and efficiency are for these reasons correlated with advances in capital soundness, Basel 2 and IAS together will certainly also strengthen the overall stability of the financial system. Two qualifiers are needed here, however, one self-evident and the second more debatable. The first is that Basel 2 will contribute to banking stability above all, and directly, by guaranteeing that banks’ capital is better able to cover the risks incurred. Second, aside from differences of opinion over the informational content of measurements based on fair value, it can be feared that the International Accounting Standards, and in particular those concerning securities, will make for more volatile balance sheets and income statements. This may not necessarily happen, once the impact of the initial transition to the new accounting rules is past; but even if it does, we must not mistake volatility in the operating results of firms and banks for instability of banks’ balance-sheets. If “true” variability – or at any rate that which is relevant to the markets – is reflected better in items marked-to-market than valued at cost, then the banks will be called on to take precautions in managing, insuring against and sustaining risks. Prudential supervision itself will focus more sharply on the financial institutions supervised. In itself, better registration of “true” variability is not destabilizing; quite the contrary. In any case consideration is being given to the idea of applying prudential “filters” in calculating supervisory capital that can attenuate improper volatility in the accounts due to the repercussions of fair-value accounting. c) The transposition of the new methods The extent to which the aims are actually attained will depend on how well the banks make their preparations. But it will also depend on the adaptation of economic legislation. For banks the change will be profound, at once technical and cultural. From valuations and decisions still largely based on deterministic values, singlevalue variables and the simple “summing up” of individual items they will move towards widespread use of both objective and subjective probability distributions. The next step will be even more towards considering portfolios as a whole and taking account of the linkages between asset and liability values, the structure of the balance sheet and immunization strategies. It will be less and less common for overall risk to be calculated by adding up the risk of the individual components. Italian banks are readying themselves. The banking groups that will use advanced internal rating methods from the outset have initiated an especially intensive interaction with the supervisory department of the Bank of Italy. Basel 2 and IAS also constitute an additional reason for adapting Italian law to the needs of a modern “regulated market economy ”. Albeit in different ways and to a variable extent, three fields of economic legislation will be involved: company law, competition law and bankruptcy law. Italy’s recent company law reform is now filtering into the concrete reality of firms and banks. The legislation on banking has been coordinated with the Civil Code by Legislative Decree 37/2004. The implementing regulations will follow soon. The aspects on which the Bank of Italy has focused in helping banks to interpret the new company law are a more general notion of equity interest, adaptation of the requisites for bank officers and above all the duties and responsibilities of the board of directors and control bodies in the traditional and new models of governance. For Basel 2 and IAS to have the desired effects, the independence granted to directors – notably in the revised Articles 2381 and 2392 of the Civil Code – must be accompanied by strengthened internal and external controls on operations and accounts. In applying the legislation intended to safeguard and foster competition in banking, even greater advantage will be taken of the connection between antitrust action and prudential supervision. Credit remains the heart of banking. Competition in the credit market is increasingly vital. As the supervisory authority, the Bank of Italy will have a delicate dual task. It must validate the various internal models of risk control that the banks can use under Basel 2. It will also have to check how these models are used in decision-making and, together with Consob, how the International Accounting Standards are applied. As stochastic methods come into more widespread use, until the ways in which they are employed converge under the pressure of competition the credit “product” and its price will vary −from bank to bank and over time, and perhaps even for the same customer. In the product price/quality/quantity analysis performed for antitrust purposes, the benefits of assigning the antitrust powers to banking supervisors will increase. The supervisory authority is better informed because it has primary responsibility for the validation and checking of the banks’ risk models and accounting methods. Lastly, the urgent need for radical revision of bankruptcy procedures has become even more glaring. In a world in which corporate planning and decisionmaking are no longer deterministic but probabilistic, the old bankruptcy law, all black-and-white, without shades of grey (liquid-illiquid, solventinsolvent, revocable loans, impaired loans and bad debts) has become simply impracticable. Even the vested interests that have stymied all attempts at reform for years now will have to recognize the need to rewrite the bankruptcy procedures from top to bottom. Basel 2 and IAS encourage customized standards where abstract and general principles are hard to apply to concrete cases. This is consistent with the principle that the courts must weigh not so much the outcome of companies’ decisions as the process by which they are made. Both extremes must be avoided: having directors’ actions governed exclusively by established parameters on the one hand and placing excessive emphasis on the outcome, ex post facto, in judging their choices on the other. Ultimately, in any event, jurisprudence will be crucial. Long-term trends in the Italian banking industry Demographics Banks existing at 31.12.1990 1,064 Banks existing at 30.06.2004 Banks, that went out of business between 1.1.1991 and 30.6.2004 Profitability and productivity 1980-1990 1991-2003 (averages of annual data; percentages) Return on equity 11.3 6.0 Operating profit/total assets 1.70 1.39 Rate of change in per capita staff costs at constant prices 0.8 0.1 Rate of change in assets per employee at constant prices 1.0 4.0 Rate of change in gross income per employee at constant prices 1.1 2.2 Listed banks Number Market share (assets) 23% 30%, 80% Losses of banks that went out of business: 1990 - 2003 Nominal losses (millions of euros) 12,998 Present value as of 2003 (millions of euros) 17,465 Present value 2003 / GDP 2003 1.34 1) Directly and through unlisted subsidiaries. 2) Income statement losses between 1990 and 2003 of all the banks that stopped operating, that were merged with other banks, or control of which was acquired by other banks or banking groups. 3) Calculated using the average annual rate on Italian Treasury bills. 1980-1990 1991-2003 Operating profit 45.9 20.19 Net value adjustments, net non-recurring expense / income -23.2 -8.75 Pre-tax profit rate 22.7 11.4 Taxes -11.4 -5.4 Return on equity 11.3 6.0 Contribution to formation of the profit rate (as a percentage of capital and reserves) | bank of italy | 2,005 | 2 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the inaugural meeting of the Amintore Fanfani Foundation, Rome, 9 March 2005. | Antonio Fazio: Amintore Fanfani Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the inaugural meeting of the Amintore Fanfani Foundation, Rome, 9 March 2005. * * * 1. Amintore Fanfani was a protagonist of Italian institutional and political life; possessed of a strong will, he always acted in the light of an elevated and internally consistent view of society and domestic and international reality that was rich in historical references and ideals. This breadth of vision was apparent when one had the opportunity to talk with him on economic and social issues. His action was directed to achieving concrete results, with the definition of objectives and instruments able to impinge on reality. His declared aim, sometimes enounced amidst polemics and disagreements as to the means, was always that of serving the common good. His cursus honorum shows him to have emerged first as a scholar and teacher of economic history; subsequently, as a political leader, member of the Constituent Assembly, government minister and holder of high positions in State institutions. He was an architect of projects of social reform and promoter of international peace initiatives. I have personal memories of Fanfani, as well, since he was one of my professors at Rome University. His historiographical work traced the thinking that over the centuries investigated the evolution of the economy and contains reconstructions covering long periods. He showed great ability in setting the relationships linking the economy, institutions and society within a unitary framework. His background, the debate on reconstruction, after the enormous material, civil and moral damage inflicted by the Second World War, and his vision of how the economy should operate, necessarily in man’s interest, led him, especially as a government minister, to foster reforms that influenced the organization of the State and left their mark on Italy’s history. 2. In the Constituent Assembly Fanfani contributed to the search for agreement among the reforming forces − Catholic, leftist and liberal democratic − on a formula that is a synthesis of the fundamental features of the new State and the centrality of democracy. The first article of the Constitution states that the Republic is founded on labour, expression of the dignity of citizens, guarantee of everyone’s full participation in organized civil life, the means for all to exercise popular sovereignty, to the benefit of all. We have perhaps not yet reflected enough on the right to work; the political sphere and the economy must contribute to its realization; the former must preside over the latter’s autonomous operation. The right to work in many cases still has to be realized. The conditions for achieving a satisfactory level of employment vary with the changes in the economic context, the state of technology, the organization of society, and the relations between economies and States. The right to employment is realized in the first place through growth and development. In the 3rd Subcommittee of the Constituent Assembly, Fanfani was the rapporteur for matters concerning the social control of economic activity. The text, approved after a series of amendments, affirms the freedom of private initiative, but draws attention to its social function. While recognizing economic freedom, a proviso is introduced allowing the public authorities to set limits in order to protect the general interest. In recent years this principle has been widely debated; some have seen it as conflicting, in a changing economic reality, with the principle of competition, which in the meantime has become widely established in the legal order. But it needs to be reaffirmed that, even in the present context, the relationship between freedom of enterprise and public regulation and control remains valid, albeit to differing degrees. In the period of postwar reconstruction Fanfani, coming from the experience of the Great Depression, operated in a political and economic system characterized by an extensive presence of the State in the economy. It was certainly not a question of a planned economy; it was a conception of economic life that, based on social guidelines, lay somewhere between liberalism and statism. 3. After the catastrophe of the Second World War, state intervention in the economy played an essential role, mobilizing the nation’s best intellects and with the inefficiency that would later cripple it still far off. In the 1930s the public sector accounted for about 15 per cent of the economy in the industrial nations. The Depression that swept the private sector had a devastating impact, with major political repercussions, in the absence of the stabilizing effect of a substantial sector not subject to cyclical swings. In the 1950s the State’s share of the economy in all the economically advanced countries was near 30 per cent. By the 1980s it had reached and in several countries exceeded 50 per cent. Problems of efficiency and rigidity became increasingly evident. In the 1950s Amintore Fanfani fought to put the principles of the Constitution into practice and guarantee economic and social rights and freedoms: the right to work, to housing, to a more equitable distribution of wealth. On various fronts he furthered projects to improve the condition of Italy’s economy and increase the use of manpower: reforestation programmes, public works and energy policy. As Minister of Labour, Fanfani undertook the first public residential construction programme, the INA-Casa Plan, financed by worker and employer contributions supplemented by State resources and the intervention of the banking system. In a situation of high unemployment, this programme helped to create jobs. As Minister of Agriculture, he completed the land reform initiated by Antonio Segni, a reform of fundamental importance because it significantly affected not only economic but also political and social relations. During the 1950s and 1960s the Italian economy grew at remarkably rapid rates. Employment and labour productivity increased. There was substantial private investment alongside public investment. A whole set of institutional, financial and foreign policy instruments were created that enabled Italy to advance by leaps and bounds. The opening of the economy, investment in public works, the extraordinary programmes for Southern development, incentives for economic activity and the creation of new categories of banks were all factors that reinforced industry and enhanced competitiveness, creating a virtuous circle of unbroken expansion. These were also the years of postwar reorganization in banking, with the creation of new special credit institutions and the introduction of subsidized credit. Donato Menichella, who headed the Bank of Italy from 1948 to 1960, ensured monetary and financial stability, thereby creating conditions conducive to the long period of growth and Italy’s integration into the world economy. In this context he successfully combined a rigorous credit and monetary policy with the funding of rapidly expanding investment. He contributed decisively to the creation of the Southern Italy Development Fund, which was conceived to lay the institutional and structural foundations for economic growth. The Cabinets headed by Fanfani during those years helped to shape new patterns in the relations between business and labour. The convertibility of the lira was achieved in December 1958. The electricity industry was nationalized. Lower secondary schooling was made compulsory and standardized. Projects for the creation of regional governments were launched. It was above all in his fourth Cabinet, in office in 1962 and 1963, that Fanfani promoted a new policy which revived reform and initiated an as yet hesitant experimentation with non-mandatory medium-term economic planning. Thanks to rapid growth, by the end of the 1960s Italy was approaching full employment and had become one of the world’s leading industrial countries. The oil crisis of 1974 and the wage explosion of the following years slowed down economic growth worldwide and in Italy. Rapid inflation required drastic credit restriction. The balance-of-payments deficit, the devaluation of the lira, and the price-wage spiral, fueled in part by the wage escalator, further curbed growth and distorted the allocation of income. In the early 1980s, with Fanfani’s fifth Government, the wage escalator agreement was terminated and then revised as part of a process of disinflation in the framework of a policy of concertation with the social partners, based on the theoretical contribution of Ezio Tarantelli. This was the premise for a new approach to economic policy. His last term as prime minister saw the beginnings of foreign exchange liberalization in connection with Italy’s endorsement of the Single European Act. Serving three times as President of the Senate, from 1968 to 1973, 1976 to 1982 and 1985 to 1987, Fanfani stood out for his dedication, rigour and the absolute impartiality with which he fulfilled this mandate. In his career as a politician, Fanfani also fought some lost battles, as he himself readily acknowledged. It is still early for serene reflection on these defeats, on the core issues involved, without the distraction of the polemics and conflict by which they were marked. What can be underscored is his forthright advocacy of the independence of political action, which led him to inquire into the relationship between modernization, ethical principles and the essence of truth. 4. The bond between Fanfani and Giorgio La Pira, strengthened by their common vision of the values of man and their trust in dialogue, by their religious faith and their reference to Thomism and Maritain, led both to support courageous foreign policy initiatives for détente and peace. In 1975 La Pira telegraphed this message to Fanfani: “So many memories come to my heart and mind concerning your legislative and political interventions for a policy of reforms and renewal. But allow me to recall especially your role as a motor force of world politics for the liberation and social, political and economic development of the Third World countries and for peaceful coexistence, disarmament and peace in Europe, in Asia, in every continent.” The international stature Fanfani enjoyed in the different positions in which he represented Italy was due to his uncommon abilities, to his activity inspired by the ideals of peaceful coexistence, open to the creation of new opportunities for foreign policy, aimed at constructing relations of cooperation and solidarity among peoples. In his travels abroad and in international meetings he worked for the beginning of talks to halt the arms race, to establish more advanced relations with the Soviet Union, to promote a “thaw” between the opposing blocs, to develop fruitful relations with the countries of the Mediterranean area. On assuming the presidency of the United Nations General Assembly in 1965, Fanfani declared that it was necessary to make every effort to achieve the objective of “general and complete disarmament”, including a treaty that would commit all countries “to cooperate to halt nuclear weapons”. In a statement that is striking today for its relevance, he stressed how important it was that the action of the United Nations in defence of peace and justice be made effective through concrete agreements, over and above generic declarations of good will: “Specific pacts and the resolve to realize constructive agreements will be necessary. Otherwise we will have to admit that we do not intend . . . to make our Organization something more than a simple international forum, that is to say the engine of peace, the keeper of law and the guarantor of security for us all.” In Fanfani’s conception, social justice, democracy and protection of the environment were both a premise and an effect of the development of trade, of the spread of technologies, of the drive for growth. At a time when we had yet to witness the acceleration of globalization, he foresaw the risks as well as the opportunities inherent in the nascent phenomenon. Today, facing the transformations that globalization has brought, we are pondering the ways to govern it, to create a new international order and guarantee every nation a fair share in the potential benefits. The free market, fundamental for the efficiency of the economy, needs to be regulated if it is to operate in the interest of society. It requires rules, controls, the reign of legality and security, the sharing of principles and values. Not a Manager State but a State that effectively regulates and at the same time is able to ensure the provision of essential public goods directly or indirectly. These are goods of collective interest, such as good administration, justice, basic infrastructure and, at global level, goods of primary interest for humanity: the climate and the preservation of the environment. That a good is a public good does not necessarily imply that it is supplied by a public entity; what is fundamental is the use to which it is put, the function it serves. Very important work has been accomplished in recent years in numerous international fora and institutions to defend the essential interests of humanity, natural resources, the climate, international security. Its progress needs to be accelerated. What makes Amintore Fanfani’s work relevant today and prompts us to study its underlying thought is, above all, the perception of the close, organic links between all the factors of social, economic and political life at both national and international level. 5. In view of the complexity and originality of Fanfani’s work, the fields to be ploughed in the Foundation's research range from economic policy to foreign policy, from technological innovation to the transformation of markets and the globalization of the economy. Of the heritage he handed down together with La Pira, we have to rediscover and make actual the concern for The expectations of poor people, the ability to translate lofty visions of the dignity of man and society into the realm of practical action. In the years of Italy’s great economic and social transformation a generation of thinkers, entrepreneurs, labour leaders and statesmen charted the country’s course. The drive to come together and plan with a view to objectives of general interest was present in all the components of society and politics, even though they clashed fiercely on some basic decisions. The social partners likewise sensed the connection that the interests of a specific category must have with the general interest; a union plan for employment was drawn up. The economic policy choices effectively accelerated the course of developments. Among the personalities who took part in elaborating those guideline I should like once more to recall Donato Menichella, who enjoyed relations of mutual collaboration and respect with Fanfani, as did my other illustrious predecessors who followed him, Guido Carli, Paolo Baffi and Carlo Azeglio Ciampi. In the climate of rebirth, the emphasis laid on the role of the “public sector” reflected the need to plan, to have an overview of the evolution of economic and social life in which to insert the action of private-sector actors in a long-term perspective. It was a question of foreseeing, but also of fostering expectations and aspirations, the will to advance, to risk, to invest in the future, of giving young people a different future from the experience of those who had been young in the early part of the century. The eminent statesman’s sense of service drew sustenance from the force of his personality. Fundamental among his qualities was his ability to act on the basis of an organic, far-sighted vision and rigorous study of the problems, to grasp the course of history. The endowment of programmes and institutional instruments, the possibility of employing unutilized capacities, the start made at forging international links prepared, in the 1950s, the great burst of economic growth. Confidence, a desire to test oneself and to improve, and expectations of a different future were the major driving forces. The times are different now, but the ability to plan ahead and an organic vision are fundamental components of our action, the basis of shared choices, a precondition for carrying out specific initiatives. In these absolutely different conditions, we must rediscover the élan of those times. | bank of italy | 2,005 | 4 |
Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Italian Bankers' Association Annual Meeting, Rome, 13 July 2005. | Antonio Fazio: Economic developments and the banking system Address by Mr Antonio Fazio, Governor of the Bank of Italy, at the Italian Bankers’ Association Annual Meeting, Rome, 13 July 2005. * * * The expansion of economic activity in the euro area is proceeding slowly. In 2004 euro-area output rose by 2 per cent, compared with 5 per cent for the world economy; GDP growth was 2.3 per cent in France, 1.6 per cent in Germany and 1.2 per cent in Italy. Euro-area growth this year will be lower than in 2004. Germany’s economy is suffering from the weakness of domestic demand, Italy’s from a progressive loss of competitiveness. In the early months of this year the euro-area index of industrial production continued to waver. In the spring the cyclical indicators signaled the persistence of a very cautious attitude among firms and households. Incipient signs of recovery have appeared recently; in France and in Germany, the climate of confidence among industrial firms improved in June for the first time since the start of the year; the euro-area index based on surveys of purchasing managers has risen. The Italian economy faces the second half of the year starting out from conditions that are less favourable that those of the other main countries of the area. The fall in output in the fourth quarter of 2004 and again in the first three months of this year has made the fragility of our productive system more evident. By comparison with 2000, in January the negative gap between Italy’s index of industrial production and the euro-area average was equal to 8.1 percentage points, the widest in the last four years. The erosion of competitiveness in the international markets under way since the middle 1990s is continuing. Since 2000 Italian exports have contracted by 4.9 per cent, while the exports of the other euro-area countries have grown by 17.2 per cent. The problems of competitiveness have continued to weigh especially on firms in the Centre and North and on smaller firms. Price strains have not emerged. Inflation has benefited from wage moderation and the appreciation of the euro; it has also been influenced by the weakness of demand. Looking ahead, the rise in oil prices and the performance of the euro could have a negative impact. Household spending is being held down by uncertainty about the outlook for income and employment; the propensity to save has been rising since 2000. In the first quarter of this year investment in construction fell further. After declining in the second half of 2004, productive investment staged a slight recovery. In April industrial production picked up sharply from the low levels to which it had fallen in March; the estimates for the subsequent two months indicate that the index has fallen, but not enough to cancel out the April rise. The progressive decline of production levels in industry appears to have come to an end. After the pronounced fall recorded in the first quarter, GDP is expected to return to growth, albeit modest, in the second. The banking system Italian banks are continuing to ensure an ample supply of credit. Bank lending rates are very low. In May the cost of short-term credit for businesses was 4.9 per cent in nominal terms, and 1.2 per cent net of the change in producer prices. The overall effective interest rate on loans to households for house purchases was 3.8 per cent, or 1.9 per cent net of inflation. In the middle of the 1990s lending rates were above 10 per cent and more than 6 per cent in real terms. Despite growing concern about the evolution of the business cycle, the periodic surveys of the leading banking groups have not picked up signs of a tightening of credit disbursement standards. Lending is expanding rapidly. In the first few months of 2005, accommodating the strong demand of households and the more moderate demand of firms, it grew at a rate of more than 8 per cent, about two percentage points higher than the euro-area average. Fueled by low interest rates, the increase in credit to households has stabilized at around 15 per cent since mid-2004. A decisive factor in all the regions of Italy has been the expansion in loans for house purchases. In 2004 new mortgage loans amounting to €49 billion were granted; disbursements in the first quarter of this year were 11 per cent up on the corresponding period of 2004. Households’ access to credit is also facilitated by the marketing policies banks are pursuing; under the stimulus of competition, they have diversified supply, adapting it to the needs of customers. Fixed-rate mortgage lending is relatively underdeveloped by international standards: about 80 per cent of outstanding loans for the purchase of houses are at variable rates or rates renegotiable within one year. In addition to real-estate lending, consumer credit granted by banks and financial companies is also expanding rapidly. Italian households’ debt is very low by international standards. The risks to the financial system from the rapid growth in lending to households are limited. At the end of 2004 household debt was equal to 28 per cent of GDP in Italy, compared with a euro-area average of 55 per cent and about 90 per cent in the United States and the United Kingdom. Partly as a consequence of subdued investment, the financial conditions of firms have remained good on the whole. In 2004 firms’ operating profits were higher in relation to value added than during the cyclical downturn of the early 1990s. However, the data for the sample of around 40,000 non-financial corporations surveyed by the Company Accounts Data Service show a fall in profits in the period 2000-03, notably in the textile, clothing and transport equipment sectors. Firms’ interest expense has diminished thanks to the reduction in interest rates, due in part to the lengthening of the average maturity of corporate debt. Leverage is seven percentage points below the level of the 1990s; the average maturity of Italian firms’ bank debt is gradually approaching that prevailing in the other European countries. There continues to be rapid growth in financing to categories of firms that in the past encountered greater obstacles in gaining access to credit during cyclical downturns; credit to firms resident in the South of Italy increased by 8.5 per cent, two points more than the national average. In the period 1996-2004 the value of mergers and acquisitions between banks in Italy accounted for 27 per cent of the euro-area total, compared with the Italian banking system’s roughly 14 per cent share of euro-area bank assets. The far-reaching transformation of the banking system since the middle of the 1990s has had positive effects on operations. Since 2001 loan quality has remained unchanged despite the weakness of the economy. At about 1 per cent the ratio of new bad debts to outstanding loans is very low by comparison with the past. Households and firms have benefited from part of the banking system’s efficiency gains through more favourable rates on deposits and loans. In 2004 banks’ profits amounted to €11 billion, or 10.7 per cent of capital and reserves, compared with 6.7 per cent in 2003. Contributing to the improvement in the results for the year were the decline in value adjustments to loans and a significant increase in net non-recurring income. Operating costs diminished by 0.5 per cent with respect to 2003. The ratio between costs and revenues was in line with the European average. The growth in self-financing and capital increases have strengthened the banking system’s capital base. At the end of 2004 Italian banks’ supervisory capital amounted to €149 billion. The ratio of capital to risk assets was 11.6 per cent; the difference with respect to the average ratio for banks of the EU countries has narrowed in recent years to about one percentage point. For the largest banking groups, the ratio of supervisory capital to risk assets has increased significantly since 2001. Italy’s banking system, like those of the other advanced countries, is adapting to the principles of the new Basel rules on capital. In its supervisory capacity the Bank of Italy is evaluating whether banks’ risk management systems satisfy the quantitative and qualitative requirements established by the new rules. Evaluation and validation are carried out by means of examination of the statistical documentation submitted by banks, meetings with corporate officers and direct examination of the state of progress of the project and the organizational processes. At our request, the main banking groups performed simulations of the impact of the new international accounting standards on their balance sheets. On average for the system, the results indicate larger writedowns of bad and doubtful debts and capital gains on buildings and, to a lesser extent, shareholdings. The total capital of the groups concerned would not be significantly affected. This April the Bank of Italy began a survey extended to all banking groups, with the aim of estimating the impact of the new rules on supervisory capital, on the basis of a rigorous hypothesis regarding the prudential regulations that will enter into force at the end of the year. The supervisory action of the Bank of Italy is increasingly oriented towards forward-looking analysis whose compass includes an evaluation of the solidity of individual banks and of the system in the face of adverse events which, though highly improbable, are nonetheless possible. It proceeds through exercises designed to check the income and capital margins in case of increases in credit and market risks deriving from major negative shocks. Economic policy Public-sector net borrowing looks set to exceed 4 per cent of GDP this year. The negative performance of the public finances reflects the slow growth of the economy together with difficulties in implementing some of the planned budgetary measures. Owing in part to the lapsing of one-off measures, net borrowing in 2006 will be equal to about 5 per cent of GDP in the absence of corrective action; the primary surplus will fall to nil. The persistent contraction of the primary surplus affects the process of bringing down the ratio of debt to GDP. The structural situation of our public finances requires continual adjustment measures, which threaten to create distortions in the management of resources and to fuel uncertainty; the scope for stabilization policies is limited. Negative effects on the cost of the debt must be averted. It is important that the Government and Parliament decide, on the basis of the Economic and Financial Planning Document, measures for the next four years able to reduce current expenditure in relation to GDP, increase public investment and gradually diminish firms’ tax burden. As requested of Italy by the Council of Finance Ministers of the European Union, it is necessary to reduce the deficit below the threshold of 3 per cent by 2007. A return to higher rates of growth that are compatible with the available resources cannot be achieved without a renewed and effective commitment of economic policy to changing the structure of production. The reduction of the tax burden on businesses should facilitate the growth in size of firms, technological innovation and investment. The efforts to make the operation of public services more efficient and to create a more stable legislative framework need to be intensified. Competition must be strengthened. Firms must expand their scale of production, increase the professionalism of their managements, orient their specialization towards more dynamic and innovative sectors, and increase their presence in some technologically mature but high-quality segments of the international market. The financial system must assist firms in this difficult phase of transformation, directing resources towards the companies and projects with the greatest potential. The growth of pension funds will be of great importance for the financial market and for the supply of capital to the banking sector. The outlook Economic activity probably reached a low in the first quarter of this year. The figure for GDP is expected to show an increase, albeit modest, for the three months from April to June. It is necessary that the still hesitant recovery gain momentum in the second half of the year. If it does, we will be able to avoid a contraction in GDP this year with respect to 2004, and to achieve growth of more than 1 per cent in 2006. The performance of GDP this year and next must be along these lines in order to give substance and credibility to the scenario projected for the public finances. As we underscored on 31 May to the General Meeting of Shareholders of the Bank of Italy, investment is finding it hard to gain momentum, consumer demand remains weak, and the outlook for exports remains uncertain even in a favourable international context. There is a need for a commitment by the Government, the social partners and firms not to lose the opportunity to reverse our economy’s negative trend. Thanks to the progress made in the last decade, banks are in a position to finance the growth of production and investment. When the difficulties of businesses are cyclical and transitory, banks can, indeed must, contribute to safeguarding production capacity. Recourse to the Wage Supplementation Fund in industry covered a number of hours equivalent to about 26,000 full-time employees in the first half of 2001; it rose rapidly in 2003 to 48,000 employees. In the early months of this year it rose further, to 58,000 employees. Use of Wage Supplementation has increased especially in the machinery and textile sectors. Where it is possible and appropriate, banks must work for the restructuring and reorientation of production capacity and assist the business sector in the process of consolidation aimed at augmenting the average size of firms. A major banking merger at European level has as its protagonist an Italian bank that had previously completed its own restructuring and consolidation in the context of the general reorganization of banking that began in the middle of the 1990s. Market transactions are under way for the acquisition of control of two important banks. Once the authorization procedures are concluded, it will be the shareholders, the market, that decide the outcome of the initiatives, which envisage different paths, instruments and objectives. We are following the developments in scrupulous observance of the law and supervisory regulations, bearing in mind the general interest and reporting on the necessary procedures in the competent fora. In any event, the transactions will lead to significant further strengthening of our banking system. Banks are called upon to address the problems of customer relationships more effectively and systematically. Initiatives to contain the costs of services and the amount of fees are necessary and they must spread. The image banks project is fundamental for their reputations. As we recently had occasion to argue at length, the problem of the Italian economy lies primarily in the competitiveness of industry. But there is also a weakness of domestic demand. According to the Bank of Italy’s surveys, investment in public works in the first half of this year was at the same level as in the first half of 2004. The rise in the number of contracts and the opening of sites have yet to show up in an increase in investments actually implemented. According to the construction firms in the sample, the outlook for the second half of the year is uncertain. The efforts at both central and local government level must be intensified, and with urgency, to step up activity, to avert a slowing of investment that could jeopardize the recovery. According to the legislative innovations introduced by Parliament and those now being adopted, the implementation and management of public works does not necessarily have to be totally entrusted to government; it is possible and advisable to leave room for private enterprise, on the basis of rigorous and transparent criteria. The role assigned to banks is that of giving impetus to operations in the sector and carefully evaluating the quality of investment projects. There are signs that the world economy is slowing down with respect to its exceptional expansion last year, but growth remains robust. Its course must not be affected by the recurrence of terrorism. This requires a coordinated, effective response in the various fields, including at European level, and the continuation of the initiatives for détente and peaceful coexistence. The present phase of the cycle is a difficult one. A favourable opportunity for recovery could take shape and must be seized. It is necessary to restore a climate of confidence. This depends on what actions are taken but also on the manifestation of a harmonious will to act for our country’s economic and civil progress. | bank of italy | 2,005 | 8 |
Report by Mr Antonio Fazio, Governor of the Bank of Italy, to the Interministerial Committee for Credit and Savings, Rome, 26 August 2005. | Antonio Fazio: Update on the change in the control structure of some Italian banking groups Report by Mr Antonio Fazio, Governor of the Bank of Italy, to the Interministerial Committee for Credit and Savings, Rome, 26 August 2005. * 1. * * Introduction. Supervisory procedures and action in the case of transactions involving the capital of banks The controls on the ownership structures of banks contribute, together with the other instruments of prudential supervision, to the pursuit of the objectives of sound and prudent management of intermediaries and the stability, efficiency and competitiveness of the banking and financial system (Article 5 of the Consolidated Law on Banking). Effective performance of the controls has accompanied the international opening of the ownership of Italian banks, which is also significant in comparison with other European countries. The proportion of foreign-owned capital in the four major banking groups averages 16 per cent in Italy, 7 per cent in Germany, 3 per cent in France and 2.6 per cent in Spain. In Italy competition has increased; the range of services offered to customers has broadened; unit operating costs have been reduced. This process is still under way. Under Community and Italian law, the acquisition of shareholdings in banks above given thresholds, which start at 5 per cent, must be authorized by the Bank of Italy; moreover, holdings that allow the exercise of control must always be authorized (Article 19 of the Consolidated Law on Banking). All shareholders’ agreements leading to the coordinated exercise of voting rights at a bank must be notified to the Bank of Italy within five days. Voting rights that are the subject of unreported agreements may not be exercised. The evaluations conducted by the Bank of Italy are intended to prevent major shareholders from exercising their rights to the detriment of the sound and prudent management of the bank. To this end the Bank of Italy takes into account: (a) the characteristics of the parties intending to acquire the holdings; (b) the upper limit of 15 per cent on industrial and commercial companies’ holdings of a bank’s capital and (c) in the event of the acquisition of a controlling interest, the business plan pursued. If the acquirer is a bank, the evaluation also looks at the operation’s impact on the bank’s overall situation and organization and that of the entity created by the combination (Article 53 of the Consolidated Law on Banking). If the acquirer is an EU bank, Community law requires prior consultation with the supervisory authority of its country of origin, which is responsible for verifying its sound and prudent management. The sustainability of acquisitions is evaluated with reference to prudential regulations, which are based on common international principles; in this regard, capital adequacy with respect to the various forms of risk is of fundamental importance. In particular, the regulations state that banks’ capital, in the composition employed for supervisory purposes, must be equal to at least 8 per cent of their riskweighted assets.1 Banking groups are required to report their capital ratios to the Bank of Italy twice a year, with reference to the situation on 30 June and 31 December of each year; these official reports must be sent, respectively, by 25 October and 25 April following the reference date. In the case of banks belonging to banking groups, the minimum capital requirement is lowered to 7 percent (at the “individual” level), while the requirement for the group as a whole remains 8 per cent (at the “consolidated” level). Furthermore, the Bank of Italy also requires the main banking groups to aim for higher capital ratios than the regulatory limits: the so-called target ratios. 1/14 Compliance with the regulations is verified on the basis not only of statistical reports, but also of information and documents acquired by the Bank of Italy as part of its administrative activity and in the course of interviews with corporate officers. Supervisory inspections can be conducted to obtain further information regarding the management of the bank and the quality of the data transmitted. Community law and supervisory instructions do not exclude the possibility of deviations from regulatory requirements, but require that suitable measures be adopted promptly to restore compliance with the capital ratio. In the case of business combinations, the Bank of Italy examines the amount of capital available as well as the plans for raising any additional funds that might be needed. The evaluations are made on the basis of the latest balance sheet of the acquirer, audited, in the case of listed banks, by a leading firm of independent auditors; these evaluations are supplemented with information acquired in the course of ordinary supervisory activity and with additional information, data and simulations obtained during meetings with corporate officers or from other sources. In general it is not economically advantageous, in the early stages of planning, for the bank making the acquisition to obtain more funds than are necessary for ordinary operations, not least in view of the substantial progress the capital market has made in recent years; acquiring capital in advance would primarily affect the shareholders, by reducing the return on their capital. The authorizations contain mandatory provisions to coordinate the making of investments in shareholdings with the raising of capital. In order to provide safety margins with respect to the minimum ratios prescribed by the regulations, the Bank of Italy often requires contingency plans for raising further capital to be drawn up, ready for implementation in case of need. The Bank of Italy performs a different evaluation of mergers and acquisitions, entirely separate from the examination of the prudential aspects, by virtue of the powers as antitrust authority for the banking sector entrusted to it under Law 287/1990. I will not go into this aspect in detail because it has no bearing on the facts that are the focus of attention today; in the case of the Banca Nazionale del Lavoro, the opinion of the Antitrust Authority is pending.2 The procedures followed by the Bank of Italy in the conduct of its supervisory activity comply with the provisions of Law 241/1990, as amended, which regulate administrative proceedings, making a distinction between the examination stage and the decision-making stage. In the case of business combinations, the Bank of Italy examines the amount of capital available as well as the plans for raising any additional funds that might be needed. The evaluations are made on the basis of the latest balance sheet of the acquirer, audited, in the case of listed banks, by a leading firm of independent auditors; these evaluations are supplemented with information acquired in the course of ordinary supervisory activity and with additional information, data and simulations obtained during meetings with corporate officers or from other sources. In general it is not economically advantageous, in the early stages of planning, for the bank making the acquisition to obtain more funds than are necessary for ordinary operations, not least in view of the substantial progress the capital market has made in recent years; acquiring capital in advance would primarily affect the shareholders, by reducing the return on their capital. The authorizations contain mandatory provisions to coordinate the making of The Antitrust Authority recently asked the parties concerned to provide information about an existing consultation agreement relating to FINSOE, the company controlling UNIPOL, entered into by Monte dei Paschi di Siena, a shareholder in FINSOE, and Holmo Spa, which controls it. 2/14 investments in shareholdings with the raising of capital. In order to provide safety margins with respect to the minimum ratios prescribed by the regulations, the Bank of Italy often requires contingency plans for raising further capital to be drawn up, ready for implementation in case of need. The Bank of Italy performs a different evaluation of mergers and acquisitions, entirely separate from the examination of the prudential aspects, by virtue of the powers as antitrust authority for the banking sector entrusted to it under Law 287/1990. I will not go into this aspect in detail because it has no bearing on the facts that are the focus of attention today; in the case of the Banca Nazionale del Lavoro, the opinion of the Antitrust Authority is pending. The procedures followed by the Bank of Italy in the conduct of its supervisory activity comply with the provisions of Law 241/1990, as amended, which regulate administrative proceedings, making a distinction between the examination stage and the decision-making stage. In the interests of a desirable plurality of technical evaluations, these stages have always been characterized by a dialectical approach correlated with functional roles, professional capacities and related responsibilities. The internal regulations prescribe how these dialectical positions are synthesized and regulate the powers and duties of the people authorized to make decisions. 2. Transactions involving the capital of Banca Antoniana Popolare Veneta (Antonveneta) 2.1 Governance structure of Banca Antonveneta During 2004 relations between the members of the shareholders’ agreement governing Banca Antonveneta (ABN Amro, Lloyd Adriatico and some entrepreneurs) became increasingly strained, mainly because of the large number of participants and the diversity of their objectives; in December some of them announced their intention not to renew the agreements upon expiry. Given this situation, ABN Amro, which in June 2004 had expressed an interest in increasing its holding in Antonveneta, signified its willingness to find a solution for the bank’s governance that would safeguard its investment; on the other hand, Banca Popolare di Lodi (BPL) informed the Bank of Italy that it intended to put itself forward as reference shareholder in the search for new governance arrangements for Antonveneta. From the point of view of the Bank of Italy, the uncertainties surrounding the evolution of Banca Antonveneta’s ownership structure threatened to destabilize its management policies, thereby undermining the effectiveness of the ongoing internal reorganization and enhancement of the bank’s balance-sheet assets; this process had been initiated recently by the management in order to solve the considerable operating and organizational problems from which Antonveneta had been suffering for some time;the consolidated profit and loss account for 2003 closed with a loss of €842 million, partly as a result of substantial value adjustments to loans. In 2004 it showed a profit of €282 million. Against this background of uncertainty, ABN Amro and BPL were repeatedly urged to reach an agreement that would ensure the sound and prudent management of Banca Antonveneta. Contacts between the two parties in the early months of 2005 nonetheless failed to produce mutually acceptable solutions regarding either the governance of the bank or commercial agreements; on the contrary they led to an acceleration of plans by both parties to undertake transactions involving the capital of Banca Antonveneta. 3/14 2.2 BPL’s application to increase its shareholding to 14.9 per cent of Banca Antonveneta’s capital On 4 February BPL gave the Bank of Italy prior notification of a plan to acquire 14.9 per cent of Antonveneta’s capital. A formal application was sent on 11 February; the Bank of Italy granted authorization on 14 February, ten days after the notification. The capital needed to ensure the sustainability of the transaction was to come from an existing surplus of own funds and the forthcoming issue of a €300 million subordinated loan for which authorization had already been obtained. The plan drawn up by BPL to strengthen its capital base by issuing additional instruments was designed to maintain a high solvency ratio even after the investment. Since the issue of the capital instruments announced by BPL would take a few weeks, in the authorization measure the bank was invited to proceed gradually in acquiring the shareholdings; the document contained a further request that additional measures to strengthen capital be scheduled for the end of 2005 to take account of the effects of the application of the new International Accounting Standards. In the weeks after 14 February technical meetings were held to discuss the proposed issue of capital instruments with innovative features; the Bank of Italy requested additional documentation and after careful examination demanded changes to the transaction; consequently the preparation of the issue took longer than initially planned. 2.3 ABN Amro’s applications for authorization On 15 March 2005 ABN Amro informed the Bank of Italy, in its prior notification, that it was interested in acquiring control of Banca Antonveneta through a complete-acquisition tender offer. ABN Amro sent the official request for authorization, accompanied by the prescribed documentation, to the Bank of Italy on 30 March. In compliance with the requirements of European legislation and the supervisory Instructions, the Bank of Italy, after subjecting the documents to a preliminary examination, on 12 April applied to the Dutch supervisory authority for information regarding ABN Amro. On 12 April ABN Amro requested authorization to hold shares in excess of the thresholds of 15 and 20 per cent of capital, on the grounds that it wished to ensure the success of its bid. One complex point that arose in the course of the examination was the fact that ABN Amro was in possession of bonds convertible into Antonveneta shares; conversion of these bonds would have had major effects on the ownership structure and governance of Antonveneta. On 19 April, seven days after the formal application was made, the Bank of Italy authorized ABN Amro to increase its shareholding in Banca Antonveneta to 20 percent. At the time it was not possible to give permission to go beyond that threshold: authorization to do so would have placed the Dutch bank in a position to increase its holding to the next threshold prescribed by the regulations, 33 per cent; attainment of that threshold would have made a tender offer mandatory, whereas the application to gain control of Antonveneta by means of a voluntary tender offer was still being evaluated. On 20 April ABN Amro formally undertook not to exceed 30 per cent of Antonveneta’s capital, thereby making the potential bond conversion into the bank’s shares irrelevant for the purpose of calculating ABN Amro’s total shareholding. On 27 April the Bank of Italy authorized ABN Amro to acquire up to 30 per cent of Antonveneta’s capital. On 6 May, once the necessary analyses and verifications and the consultation with the Dutch authorities had been completed, ABN Amro was authorized to take control of Banca Antonveneta. The examination, which began with ABN Amro’s prior notification on 15 March, lasted 52 days; starting from the date of the formal application for authorization, which was 4/14 submitted on 30 March, the inquiry lasted 37 days; 17 days were taken up by the consultation with the Dutch authorities. The tender offer terminated on 22 July 2005, with the shares tendered amounting to just over 2 per cent of Antonveneta’s capital. ABN Amro publicly announced its intention to return the shares acquired during the tender offer and that it was not interested in remaining a minority shareholder in Banca Antonveneta. 2.4 BPL’s additional investment On 31 March BPL announced its intention to increase its shareholding in Antonveneta to 29.9 per cent and submitted a formal application for authorization on 4 April. During the technical meetings held to assess whether BPL had sufficient capital, the Bank of Italy asked the bank’s officers to explain how the capital requirements would be met. They replied that steps would be taken to match the disbursement with actions to strengthen the capital base; proposals included the use of securities lending and the pledges of shares in order to acquire voting rights of the order of 10 per cent of Antonveneta’s capital; the sale to foreign banks of minority shareholdings in companies controlled by the group for an overall value of around €1 billion; and additions to the subordinated loans already planned. Finally, in a longer term perspective, a substantial capital increase was envisaged to support the bank’s growth plans. The estimates submitted by BPL showed the investment to be sustainable. The cost of acquiring the entire 29.9 per cent share in Banca Antonveneta’s capital was estimated at around €2 billion, while the new capital resources that were the subject of the two applications for authorization amounted to €2,275 million, later raised to €2,380 million. At the end of the transaction the bank’s capital ratio would stand at 10.3 per cent. On 7 April authorization was granted, seven days after the start of the examination of the application. Even assuming unfavourable developments regarding certain variables, acquisition of the shareholding appeared compatible with the sound and prudent management of the BPL group. After obtaining authorization for the shareholding, BPL asked the Bank of Italy to approve the issue of the instruments to strengthen its capital base described in the application and to include them in the computation of supervisory capital. The Bank of Italy called for changes in the terms and conditions of the issues, so that they would have standard technical features; the authorizations were granted in measures adopted after examinations lasting up to one month. In the meantime the Bank of Italy held several technical meetings to keep abreast of developments in the capital strengthening plan and, in particular, the sale of minority holdings of companies belonging to the group. On 29 April BPL’s shareholding reached 29.5 per cent of Antonveneta’s capital. On 30 April the shareholders’ meeting of Banca Antonveneta renewed the governing bodies and appointed members put forward by BPL. Subsequently, according to the documents produced by BPL at the beginning of May, it was found that the acquisitions had been effected with less recourse to securities lending and pledges of shares than originally proposed; moreover, it appeared that the timetable for the sale of minority shareholdings had not been respected. As a consequence, from April of this year the capital ratios were briefly out of line, although the shortfall was subsequently removed. These circumstances have no bearing on the effects of the authorization already granted by the Bank of Italy, as confirmed by the recent decision of the Lazio Administrative Court dated 13-19 July and filed on 9 August, but they are relevant for sanctions. The relative investigations, which began immediately, concluded with a formal notice issued on 29 July to the members of BPL’s board of directors and board of auditors. 5/14 2.5 BPL’s takeover bids for Antonveneta On 22 April Banca Popolare di Lodi gave the Bank of Italy prior notification of a plan to acquire control of Banca Antonveneta by means of an exchange tender offer. The formal application was filed on 5 May. Preliminary estimates showed that BPL’s capital ratios after the acquisition would have been above the regulatory minimum regardless of the amount of shares tendered. Moreover, the planned capital increase of €1.5 billion would have further increased the capital surpluses. In April Consob, with which the Bank of Italy had begun cooperating in February with regard to the transactions involving Antonveneta’s capital, intensified its checks. Among other matters, Consob informed the Bank of Italy of the acquisition of Antonveneta shares by BPL on behalf of a number parties. Consob investigated this activity on the basis first of information requested from BPL and then of inspections and the Central Credit Register data it requested on two occasions from the Bank of Italy. The requests for Central Credit Register data were transmitted on 20 April and 4 May and satisfied by the Bank of Italy in six and two working days respectively. With a resolution dated 10 May Consob, proceeding on its own authority, found that an undeclared shareholders’ agreement existed between BPL and other Antonveneta shareholders for the concerted acquisition of Antonveneta shares and the exercise, individually or jointly, of a dominant influence over Antonveneta; the resolution also drew attention to the manner in which loans had been granted for the purchase of Antonveneta shares. The Bank of Italy promptly notified the suspension of voting rights to the persons indicated in the Consob resolution and initiated the administrative sanction procedure against them for violations of the provisions concerning the notification of shareholders’ agreements to the Bank of Italy and the authorization to acquire major shareholdings. Furthermore, judging that there had been instances of non-compliance with the rules on credit management, the Bank of Italy initiated an additional sanction procedure against BPL. The Consob resolution, which was transmitted to the Bank of Italy in a letter dated 11 May, substantially modified the information available to the Bank; the obligation to make a tender offer, with a further outlay of cash, altered the overall context of the supervisory evaluations. On 17 May BPL, conforming with the obligations resulting from Consob’s finding, applied to the Bank of Italy to authorize the mandatory cash tender offer as well and transformed the exchange tender offer for which it had applied for authorization on 5 May into a cash and exchange tender offer basically similar in content to the exchange tender offer. At the same time BPL executed a shareholders’ agreement among the persons indicated in the Consob resolution, which was notified pursuant to Article 20 of the Consolidated Law on Banking. On 2 June the shareholders’ meeting of Banca Popolare di Lodi approved a €1.5 billion capital increase; on the same occasion the name of the bank was changed to Banca Popolare Italiana (BPI). The offering terminated on 15 July with an acceptance rate of 99 per cent, which took the capital ratios well above the regulatory minimums. In view of the uncertainties regarding the transactions for the capital cover of the mandatory tender offer, on 8 June the Bank of Italy asked BPI to submit documents on the actions intended to ensure that the 8 per cent requirement would continue to be satisfied after the acquisition. In addition, the Bank formalized some especially stringent guidelines that BPI was to follow in order to ensure that the bank’s capital base could sustain the mandatory tender offer. BPI responded to the requests by providing updates and documents on the capital strengthening needed to sustain the acquisition of control of Banca Antonveneta. 6/14 Lastly, on 20 June the Bank of Italy initiated an inspection of a general nature at BPI, inter alia with the aim of checking, in connection with the acquisitions, the bank’s capital ratios, its credit disbursement and management procedures and its statistical reports. The first checks concerned the amount of BPI’s own funds. The latter initiative came after the start on 9 June of an inspection at Antonveneta to check whether the functioning of the bank’s ordinary operations had been impaired by the temporary uncertainty stemming from the precautionary suspension of the shareholders’ resolution of 30 April renewing Banca Antonveneta’s governing bodies, ordered by the Court of Padua on 21 May. The inspection ended on 24 June without significant findings. 2.6 The examination of BPI’s proposed tender offers. The examination, conducted according to the criteria and methods referred to above, focused principally on three aspects material to the granting of authorization to acquire control of Antonveneta: a) the BPI group’s capital adequacy; b) BPI’s “quality” as a shareholder, taking account of the above-mentioned Consob resolution and the consequent steps taken by the Bank of Italy; and c) the checks carried out by the Bank of Italy regarding the conduct in connection with the temporary shortfall of BPI’s capital ratio. On the last two points the Bank of Italy continued to avail itself of the advice of authoritative jurists who had collaborated with it from the start of the Antonveneta case. Recourse was made to outside experts in view of the complexity of the factors to be evaluated, the novelty of the case and the extremely specialized nature of the matter, including its practical application. Professors Agostino Gambino, Massimo Luciani, Fabio Merusi and Paolo FerroLuzzi collaborated; Professors Gambino and Luciani were part of the Bank of Italy’s defence team in the trial before the Lazio Administrative Court. The examination began by estimating the overall capital ratio at 30 June on the basis of the documentation and statements produced at the time by BPI. The ratio was found to be equal to 9.2 per cent on the more restrictive assumption that the shareholding already held would be consolidated using the equity method; if it were not consolidated, taking into account the intervening suspension of the voting rights attaching to it and the absence of BPI representatives on Antonveneta’s board of directors, BPI’s capital ratio would have been higher than 11 per cent. Considering the capital strengthening measures envisaged by BPI, and particularly the capital increase of €1.5 billion then under way, it was found that the bank’s capital base could sustain the transaction in the event of the tender offers succeeding. However, the examination also revealed uncertainties as regards the situation that would emerge with the year-end application of the International Accounting Standards, due to put options issued by BPI to third parties on shares of group companies and the commitment to purchase Antonveneta shares owned by the other parties to the shareholders’ agreement. As regards the conduct deemed material for the purpose of verifying compliance with the requirements for the quality of the shareholders and sound and prudent management, an initial phase of the examination found questionable conduct in business dealings by shareholders of Antonveneta, in relation to the facts brought to light by the Consob resolution of 10 May and the checks carried out by the Bank of Italy. For a fuller evaluation of the facts, the analysis of these aspects was usefully supplemented by the observations already made by the legal advisors; the results of a further consultation contributed significant elements for an appreciation of the case from the standpoint of the granting of authorization. The convergent opinions of the legal advisors, authoritative and expert in the matter, were considered to overcome the various doubts that had arisen in the first phase of the 7/14 examination and to provide a correct interpretation of the letter and the spirit of Italian and Community legislation. On 11 July 2005 the Bank of Italy authorized BPI to acquire control of Antonveneta, giving an ample account of the grounds for its decision in the authorization measure. The integration of the two banks as envisaged in the business plan presented positive aspects from the supervisory point of view, considering the significant synergies that would arise, partly as a consequence of the new group’s strong territorial roots. On the basis of the advisors’ opinion, the authorization measure recalled the necessary autonomy of the Bank of Italy’s evaluation of matters able to impair sound and prudent management with respect to the above-mentioned Consob resolution. It was observed that the law provides for the mandatory tender offer as an ex post remedy in favour of minority shareholders; accordingly, a comparison of the different interests led to the conclusion that the consequences of denial of authorization were so serious that such a course was possible only if the applicant bank was found to be manifestly unsuitable, to an extent that rendered the threat to the target bank’s stability obvious. In addition, separate evaluations were made of the conduct of the bank’s corporate officers and the “reliability” of the bank. According to the approach adopted, the conduct was punishable with administrative sanctions. The imposition of an administrative sanction does not affect the reliability of the bank, which is the effective applicant for authorization and its ability to ensure sound and prudent management is not in question. As regards the conduct in question, the sanction procedure had already been initiated by the Bank of Italy. Similar considerations hold for the temporary shortfall of the capital ratio, since, as noted earlier, this had been made good in full and the Bank of Italy had already initiated the administrative sanction procedure for violation of the rules on capital requirements. With regard to BPI’s prospective capital adequacy, account was taken of its formal commitments to meet any need for a further strengthening of its own funds and of the feasibility of the steps it envisaged. At all events the Bank of Italy expressly required BPI to: – launch the cash/cash and exchange tender offer once the conditions for the successful outcome of the capital increase then under way had been verified; – reformulate the shareholders’ agreement between BPI and the other shareholders of Antonveneta, so as to avert a negative impact on capital adequacy with the entry into force of the International Accounting Standards for supervisory purposes; – modify the agreements concluded with Société Genérale, Deutsche Bank and Dresdner Bank for the transfer to them of up to 30 per cent of the Antonveneta shares acquired in the cash tender offer for subsequent resale on the market and reduce the market risk borne by BPI; – take every step that might be necessary in the future to ensure compliance with the prudential rules. The examination began on 22 April with the prior notification transmitted by BPI and lasted 80 days. From the date the first formal application was submitted (5 May), it lasted 67 days, including the period in which the time limit was suspended. Meanwhile, the Bank of Italy and Consob continued to exchange information and documentation in the context of their ordinary cooperation. The Bank of Italy described in detail the fact-finding activities it had begun and the checks and inspections under way, notifying Consob of each decision it made concerning BPI’s acquisition of control of Antonveneta. 8/14 2. Actions under administrative law and the ruling of the Lazio Administrative Court Between April and June ABN Amro decided to apply for legal remedies, requesting, among other things, the annulment or revocation of the authorizations issued by the Bank of Italy to BPL (now BPI) whereby the latter had been progressively authorized to raise its holding in Banca Antonveneta to 29.9 per cent. These applications were examined by the Lazio Administrative Court, which on 28 April dismissed the applicant’s request for suspension of the authorizations and then issued its ruling on the merits of the case, dated 13-19 July and filed on 9 August. The Administrative Court recognized the full legitimacy of the acts of the Bank of Italy. The judges preliminarily excluded that BPL had been granted favoured treatment with the issue of its authorizations in less time than had been taken for ABN Amro, since the two applications involved different situations (BPL’s directed towards the acquisition of minority albeit qualifying holdings, ABN Ambro’s towards the acquisition of control), that merited distinct evaluations. In this regard, I recall that the examination for the granting of authorization to acquire control of Antonveneta lasted 52 days for ABN Ambro and 80 days for BPI. In stating the grounds for its ruling, the Administrative Court underscored that the go-ahead for the transaction was “formulated in such as way as to reconcile the preeminent needs of banking supervision with the characteristic dynamism of market transactions”, and affirmed that the authorization for BPI to increase its interest in Antonveneta up to 29.9 per cent came at the end of “an examination that appears to have been complete and appropriate” and that the Bank of Italy had evaluated the sustainability of the transaction from the “standpoint of sound and prudent management”. Furthermore, the Court confirmed the correctness of the conduct of the Bank of Italy, on the grounds that “the Bank of Italy is required to verify not so much the current amount of the applicant’s own funds in relation to the entire planned acquisition, as the adequacy and practical feasibility of the proposed plan for capital strengthening, thereby making a forecast, with a high degree of technical discretion, in which its institutional functions are ultimately manifested”. The Administrative Court also explicitly ruled that supervisory indications imparted at the time of granting an authorization are not conditions for the effectiveness of the authorization; they constitute accessory elements by way of guidance. Consequently, supervening developments do not impinge on the effects of the authorization measure or its legitimacy, but are relevant, on a different plane, for the Bank of Italy’s powers of control and sanction with regard to compliance with its prescriptive supervisory instructions. The Bank of Italy based its activity on these principles again in authorizing BPL to acquire control of Banca Antonveneta. 2.8 Events following the granting of authorization for BPI to acquire control Following the authorization measure of 11 July, Consob ascertained the existence of an undeclared agreement between BPI and Magiste International for the concerted purchase of Banca Antonveneta shares and the exercise, possibly on a joint basis, of a dominant influence over that bank, as well as the interposition of two foreign funds in some purchases of Antonveneta shares made prior to 30 April 2005. In this case too the Bank of Italy notified suspension of the voting rights and initiated the administrative sanction procedure under the Consolidated Law on Banking in connection with 9/14 the relevant matters indicated in the Consob resolutions, which included the management of BPI’s finance area. On 26 July the decree issued by the Milan public prosecutor’s office for the sequestration of the Antonveneta shares owned by the parties to the shareholders’ agreements, including BPI, was notified to the Bank of Italy. According to the investigators, some financial transactions carried out in order to comply with the capital ratios, particularly the sales of minority shareholdings, had been merely artificial. On 27 July Consob ordered the precautionary suspension of both the cash tender offer and the cash and exchange tender offer made by Banca Popolare Italiana.Moreover, the supervisory inspections begun at BPI on 20 June revealed credit derivative agreements with a maturity of one year entered into with the London branch of Deutsche Bank; according to the interim reports of 29 July and 8 August by the head of the inspection team, the transaction may have been executed without following normal internal procedures. In view of the links between the credit derivatives and the minority shareholdings sold, the effect of the disposals carried out to strengthen BPI’s capital base may be substantially annulled. At the Bank of Italy’ request the company’s governing bodies are making the necessary checks. On 30 July the Bank of Italy had already ordered the suspension for up to ninety days of BPI’s authorization to acquire control of Antonveneta, considering it necessary to make a further examination of the effects of subsequent developments on the evaluations included in the authorization measure of 11 July 2005. 2.9 The situation of BPI’s capital ratios The current situation of the BPI group, taking account of the recently executed capital increase of €1.5 billion, shows a substantial surplus of capital with respect to the minimum requirements. The surplus is estimated at €2.3 billion, with an overall capital ratio of 15.8 per cent. If on the basis of the further examinations now under way it should be necessary to sterilize the benefits to the capital ratios of the above-mentioned disposals of minority shareholdings, the surplus is estimated to be €1 billion and the overall capital ratio to be 11.3 per cent in the absence of corrective measures. If BPI were to sell the Antonveneta shares in its possession, this would lead to a substantial increase in the capital surplus, to €4.4 billion, and in the overall ratio, to 22.5 per cent; in the event that the effects of the above-mentioned disposals of shareholdings were sterilized, these figures would be €3 billion and 18 per cent respectively. A revival of the cash tender offer cannot be independent of the prompt execution of the further measures of capital strengthening already approved by the company’s governing bodies and authorized by the Bank of Italy (a capital increase of €300 million, a €400 million issue of preference shares and conversion of the €1,200 million convertible subordinated loan). The need for full compliance with the Bank of Italy’s guidance for dealing with the prospective impact of the application of the International Accounting Standards remains unaffected. The Bank of Italy is following the development of the situation and will adopt the measures falling within its sphere of competence, taking account of the decisions that will be made by the company’s governing bodies. 10/14 3. Transactions involving the capital of Banca Nazionale del Lavoro 3.1 Governance structure of Banca Nazionale del Lavoro. In April 2004 some BNL shareholders - Banco Bilbao Vizcaya Argentaria (BBVA), Assicurazioni Generali and Dorint-Della Valle - concluded a shareholders’ agreement concerning the management of the bank covering a total of 28.39 per cent of BNL’s share capital (the “pact”). In July 2004 other non-bank, non-financial shareholders of BNL entered into a rival shareholders’ agreement (the “counterpact”), which among other things regulated the way in which the voting rights attaching to their ordinary shares would be exercised; the share capital covered by the counterpact increased progressively from an initial 13.5 per cent to 27.7 per cent. Individually, the parties to the counterpact owned shareholdings that did not exceed 5 per cent. Consequently, their share purchases were not subject to prior authorization by the Bank of Italy and were in compliance with the ceiling designed to ensure separation between banking and commerce. This ceiling does not apply to shareholders’ pacts as such. The existence of two opposing pacts gave rise to a state of conflict within the body of shareholders and the board of directors of BNL, engendering uncertainty in the management and operation of the bank and impeding initiatives for its revival and growth. 3.2 Banco Bilbao Vizcaya Argentaria’s application for authorization to acquire control of BNL On 18 March 2005 BBVA gave the Bank of Italy prior notification of its intention to acquire a controlling interest in BNL by means of a voluntary exchange tender offer for all of BNL’s ordinary shares. On 13 May, after completing the required consultation procedure with the Bank of Spain and receiving clarifications from BBVA concerning the procedure for the exchange tender offer and its business plan for BNL, the Bank of Italy authorized BBVA to acquire, by means of an exchange tender offer, a holding of more than 50 per cent of BNL’s share capital. The application process lasted a total of 56 days, from the prior notification on 18 March to the authorization on 13 May. Counting from 29 March, the date on which the formal application for authorization was submitted, the process took 45 days, including a suspension of 19 days for consultation with the Spanish supervisory authority and for the acquisition of additional information from BBVA. In a note dated 30 May BBVA asked the Bank of Italy to modify the authorization issued on 13 May by eliminating the requirement to exceed the 50 per cent threshold. In a note dated 10 June the Bank of Italy responded that if as a result of the exchange tender offer BBVA were to acquire a holding of less than 50 per cent of BNL’s share capital, the Bank of Italy would evaluate the suitability of the new ownership structure to carry out the necessary reorganization. The major strategic and operational investments necessary to relaunch BNL require an ownership structure that can ensure stable management and effective policymaking, ultimately to safeguard the savings entrusted to the bank by its depositors. Similar considerations had in the meantime been set forth on 7 June in a note to the Minister for Community Policies in response to a specific request from the European Commission for clarifications concerning the 13 May authorization. Appreciation for the information provided by the Bank of Italy was expressed in a letter from the Competition Directorate-General on 13 July. 11/14 On 14 July the Bank of Italy granted the application that BBVA had made on 16 June to acquire up to 30 per cent of BNL’s share capital through its exchange tender offer, independently of acquisition of a majority holding. In response to BBVA’s further request for recognition of its de facto control of BNL if its holding exceeded the 30 per cent threshold, the Bank of Italy reaffirmed the need to await the outcome of the exchange tender offer in order to verify the Spanish bank’s actual exercise of control. The tender offer expired on 22 July. Acceptances amounted to around 1 per cent of BNL’s share capital. BBVA announced that it would not acquire the shares if they were not enough to attain the majority of BNL’s share capital, thus implicitly acknowledging the failure of the exchange tender offer. 3.3 UNIPOL’s initiative On 11 May and 30 June UNIPOL Assicurazioni and its parent company Holmo S.p.A. requested authorization to increase their holding of BNL shares first to 9.99 per cent and then to 14.99 per cent. The stated purpose of these purchases was to acquire a large, stable holding in order, among other things, to safeguard the investment in BNL Vita, an insurance joint venture controlled by UNIPOL and BNL. In relation to each application, the Bank of Italy asked ISVAP, the supervisory authority for the insurance industry, for information on the strength of the insurance group. On 25 May and again on 13 July ISVAP pronounced a judgement of “suitability”, attesting the sustainability of UNIPOL’s planned investment in financial and capital terms. Authorizations to increase the holding were issued on 27 May and 15 July. A copy of each decision was also transmitted to Consob. On 17 July 2005 the boards of directors of UNIPOL and its parent company Holmo resolved to acquire control of BNL. The explanation adduced for this initiative was the impossibility of reaching a satisfactory agreement with BBVA on the operation of BNL Vita and establishing forms of cooperation with the parties to the counterpact. In the course of the contacts following the prior notification of this intention the Bank of Italy had emphasized the desirability of extending the project to include banking or financial partners of high standing in a position to contribute to the growth of the volume of business. The acquisition of control is to be achieved by means of a mandatory tender offer for 59 per cent of BNL’s ordinary share capital following the conclusion on 18 July of a shareholders’ agreement, notified to the market on the same day, between UNIPOL and other BNL shareholders (some cooperatives, Banca Carige, Nomura and Hopa). The agreement, which covers 30.86 per cent of BNL’s share capital, makes a tender offer mandatory under Article 109 of the Consolidated Law on Finance. The offer is to be made exclusively by UNIPOL, with the other parties to the shareholders’ agreement jointly and severally liable. Other shareholders’ and bilateral agreements, also entered into on 18 July 2005, govern the acquisition and sale of BNL shares by the parties thereto. The agreement with Crédit Suisse First Boston International also outlines joint business and financial plans. On 4 August the UNIPOL insurance group submitted its formal request to the Bank of Italy for authorization to acquire control of BNL. As UNIPOL specified, the aim of the transaction is to create a highly integrated banking and insurance conglomerate of uniquely large size in the Italian financial market. The Bank of Italy requested the opinion of ISVAP concerning the civil law implications of the transaction and the operating and financial adequacy of the insurance group and its ability to create an organizational and operational framework meeting the needs of the reorganization and relaunching of BNL. The Bank of Italy informed UNIPOL that the time limit for responding to the request for authorization was suspended pending receipt of ISVAP’s opinion. The Bank’s relations with 12/14 ISVAP are conducted under the principle of cooperation laid down in Article 7 of the Consolidated Law on Banking. If the takeover succeeds, the provisions of Community law on the supplementary supervision of financial conglomerates, recently transposed into Italian law (Legislative Decree 142 of 30 May 2005), will apply. On 16 August UNIPOL submitted its draft offer document to Consob for the latter’s evaluation prior to clearance for publication and issued a press release summarizing the characteristics of the tender offer. On 19 August the Bank of Italy asked UNIPOL for supplementary information on its business plan, with reference among other things to the strategic and operating and financial aspects, the distribution networks, and the information procedures and systems. 4. The merger of Unicredit with the German bank HVB On 12 June 2005 the Boards of Directors of Unicredit and Bayerische Hypo- und Vereinsbank AG (HVB), with a preliminary notification to the Bank of Italy, approved the integration of the two groups. The plan envisages an exchange tender offer by Unicredit for all of HVB’s share capital. The Italian and German supervisory authorities, after a top-level meeting in Rome on 28 June, coordinated their respective procedures for authorization, which was granted on 21 July after a thorough technical investigation that in some parts included joint work by the two institutions. The exchange tender offer is expected to start at the end of August and close at the end of October. The HVB group consists of the German parent company (the country’s second largest bank in terms of assets) and a number of subsidiary banks, mostly located in Central and Eastern Europe; the most important are Bank Austria (the largest bank in Austria) and BPH (the fourth-largest bank in Poland). The combination would create one of the largest banking groups in the euro area. It would have total assets of €730 billion and yearly operating profits of around €8 billion. The new group would be highly diversified both geographically and by customer segment. Forty per cent of its credit risk would stem from exposures in Germany, 30 per cent in Italy, 15 per cent in Austria and 10 per cent in the Central and Eastern European countries. Since Unicredit already boasts a major presence in Central and Eastern Europe, the new group would have especially large market shares in Croatia (34 per cent), Bulgaria (24 per cent), Bosnia (22 per cent) and Poland (17 per cent). Thanks to the future synergies laid out in the operating and financial plan, it is expected that in 2007 the new group will have a gross operating profit of €11.8 billion and net profits of €6 billion. ROE would be 18 per cent. A specific agreement between the parties settles the principal questions regarding the management of the new group: the registered office and most of the administrative headquarters of the parent company will be in Italy; the chairman of the board of the parent company, with non-executive functions, will be the present chairman of the management board of HVB; the CEO will be the present CEO of Unicredito Italiano; and the chairman and the majority of the members of the HVB Supervisory Board will be designated by Unicredit. Under European law, the Bank of Italy will exercise consolidated supervision over the new group, in accordance with the guidelines issued recently by the Committee of European Banking Supervisors for cooperation between authorities in the supervision of international banking groups.3 CEBS CP 09, Guidelines for co-operation between consolidating supervisors and host supervisors, July 2005. 13/14 *** The description of the bids for control of Banca Antonveneta and Banca Nazionale del Lavoro presented to this Committee, which is the institutionally competent forum, has highlighted in particular the timing of the exercise of powers of authorization and control. The correctness of the decisions and conduct has to be gauged by their conformity with the law. No other parameters exist. Anything beyond this does not pertain to the set of factors to be taken into consideration, especially in an institutional forum such as this. The Bank of Italy has complied scrupulously with Community and Italian law and with the relevant regulatory and supervisory provisions. The ruling of the Lazio Administrative Court, with its description of the criteria that constantly guided the Bank’s action, fully recognizes this. Without in any way infringing on the powers or organs of the State, first and foremost Parliament, to which we pay the most respectful attention, we believe that detailed knowledge of the steps taken by the Bank of Italy will help to foster agreement on the consistency of the course that the Bank has followed. The Bank of Italy performs its activity of monitoring and oversight, always ready, when the conditions require, to activate its specific powers. 14/14 | bank of italy | 2,005 | 9 |
Address by Mario Draghi, Governor of the Bank of Italy, at the 12th Congress AIAF - ASSIOM - ATIC FOREX, Cagliari, 4 March 2006. | Mario Draghi: Financial market integration and the intermediation of savings Address by Mario Draghi, Governor of the Bank of Italy, at the 12th Congress AIAF - ASSIOM - ATIC FOREX, Cagliari, 4 March 2006. * * * 1. The world economy: expansion and imbalances The world economy is enjoying a period of strong and widespread expansion. Despite sharp increases in the prices of raw materials, inflationary pressures remain moderate. Yet in some respects it remains fragile. The expansion began in 2002 thanks to the recovery in the United States and the support from China’s booming economy. It gained strength from the middle of 2003 onwards, with the average annual rate of growth rising to nearly 5 per cent, and has spread gradually, if unevenly, to every region of the world, although in somewhat weaker form in Europe. In Italy, after stagnating in 2005, the economy now shows some signs of recovery. There is still uncertainty, however, about the extent and durability of the country’s economic growth, which continues to be weighed down by unresolved structural problems. World economic activity has benefited from the persistence of stable financial conditions that have been exceptionally propitious for investment. Apart from the expansionary stance of monetary and budgetary policies, other contributory factors have been the integration of financial markets, their development in emerging regions, the spread of more efficient instruments for the management of risk and the progress made in the fields of crisis prevention and financial supervision. The economic upswing has generated strong demand for oil, especially by China and the other emerging Asian economies. Despite increased supply, this demand has been met with difficulty and at rising prices. The price of oil has doubled in real terms since the spring of 2003. So far this pressure has not been passed on to core inflation, which has remained moderate everywhere, testifying to the credibility gained by monetary policy in the leading countries. This credibility is precious and needs to be preserved. It is the reason, especially in the euro area, why monetary conditions continue to be very relaxed: interest rates remain near the lowest levels ever. The monetary and credit aggregates continue to expand rapidly; the prices of real assets are high; no restrictive impulses are coming from the exchange rate. Keeping inflation expectations firmly anchored at a level consistent with price stability is essential for economic growth and the creation of jobs. The increase in the key rates decided on Thursday by the Governing Council of the ECB serves this purpose. Although the world economic expansion is widespread, it is accompanied by very large external imbalances. These are caused by the divergences in the growth of domestic demand between the main regions and the massive transfer of resources from oil-consuming to oil-producing countries. The US external deficit has been increasing since the middle of the 1990s, although the causes have changed over the years. Initially, it reflected the capital formation associated with the spread of new information technology. Boosted by increasingly good prospects of growth, consumption also rose faster than disposable income. The current account deficit was financed thanks to massive inflows of private capital, attracted by the high yields expected on the stock market, especially for high-tech securities, while the appreciation of the dollar further exacerbated the trade deficit. In 2001 the determinants of the current account deficit began to change. In the face of the risk of recession, monetary and fiscal policies were made expansionary. The saving rate continued to decline. Consumption was sustained by the rising value of property; households’ propensity to save turned negative in 2005. The federal budget balance deteriorated by 6 percentage points of GDP between 2000 and 2004 and will show another large deficit in 2006. The manner of financing the external deficit also changed. The inflow of private capital slowed between 2002 and 2004. The dollar came under downward pressure, despite much larger purchases by the monetary authorities of countries with current account surpluses. Such purchases are liable to undergo rapid change. In 2005 these countries reduced their accumulation of official reserves, only China recording a further massive increase. However, the widening of the short-term interest rate spread prompted renewed private sector investment in the dollar, which gained strength as a consequence. The appreciation of the dollar came to a halt last November. However, as things stand, the exchange rates between the major currencies are not conducive to adjustment of the external imbalances. High rates of growth have so far made it possible to postpone the adjustment, but these conditions cannot last indefinitely. In 2005 various conditions arose that could help initiate a process of adjustment. Domestic demand accelerated in Japan, and to a lesser extent in Europe as well. The reform of China’s foreign exchange system, although it has only produced a small appreciation of the renminbi so far, is a step in the right direction; a cooling of the US property market, of which there are signs, might slow the growth of private consumption. An adjustment of the underlying real imbalances is the best guarantee of orderly progress. For this to happen, the current trends need to be supported by a combination of more restrictive fiscal policy in the United States, greater exchange rate flexibility in the Asian economies, and structural reform in Europe. 2. International financial conditions On the international financial markets real interest rates and the volatility of financial assets are low. Relaxed and stable financial conditions foster economic growth, which in turn is conducive to such conditions. At the same time they may reflect a reduced perception of risk by market participants and encourage them to build up illiquid and highly risky positions. The low level of long-term interest rates is mainly the result of continuing expectations of moderate inflation, even over a very considerable time span. These expectations are based on the credibility of monetary policies. Investors accept modest returns in part because they have a perception of diminished risk, related to the limited volatility of securities prices and to conditions in the real economy. The expansionary cycle and wage moderation have sustained the growth in corporate profits, thereby improving the state of firms’ finances. The insolvency rate is well below the long-run average. The spread between corporate and public-sector bonds is now unprecedentedly narrow. Other contributory factors in keeping interest rates down have been the investment of current account surpluses by the Asian economies and the oilexporting countries and an increase in investments by pension funds. These flows have proved unresponsive to the tightening of monetary policy by the Federal Reserve and the ECB; its effect has been limited to the shorter term maturities. The yield curve has flattened, particularly in the United States. In view of the historically low level of interest rates on risk-free assets, there has been a surge in the demand for riskier securities by investors in search of higher returns. In this context, the reduction in risk premiums no longer reflects only a diminution of the underlying risks, but also agents’ reduced risk aversion. Nor can it be ruled out that the premiums asked to hedge risks underestimate their true magnitude. The favourable conditions on the financial markets delay the correction of real imbalances, masking the symptoms without removing the causes. The international markets have become more robust, contributing to an orderly reallocation of financial flows. The conditions are right for this to take place gradually, in a context of more balanced but strong global growth. However, geopolitical events, such as sharper internal and international tensions in the oil-producing countries or shocks due to individual corporate events or linked to single sectors of production, could trigger brusque changes in agents’ attitudes and a sudden reallocation of savings and investments, leading to wide swings in the prices of real and financial assets and in exchange rates. This possibility is small today but not entirely absent. The widespread use of derivative instruments may offer a better means of risk management, but it could also accelerate the propagation of extreme events. 3. Integrated, efficient and robust markets Efficient and well-regulated markets, apart from performing their normal function of allocating financial resources in the best way possible, are crucial to ensuring that the system is robust enough to withstand violent shocks, however unlikely. Policies designed to speed the integration of Europe’s financial markets and their infrastructure contribute to orderly and lasting economic growth. Market integration allows firms to exploit economies of scale by reducing the cost of access; it increases the opportunities for diversifying investments; it ensures more efficient allocation of resources; it improves the ability to absorb shocks; it strengthens the stability of the system. In Europe, market integration has been furthered by the single currency and the stability-oriented monetary policy. It has not gone far enough yet. Additional measures are needed to harmonize laws and regulations and adapt the infrastructure. The greatest progress has been made in the money market, thanks among other things to the development of the TARGET settlement system. In November 2007 this will be superseded by TARGET 2, which will bring further benefits to firms in terms of liquidity management. As you know, the Bank of Italy has been a key figure in the project, alongside the French and German central banks, and intends to maintain that role. In the case of government securities, common platforms such as MTS have gradually extended their operations, increasing the liquidity and efficiency of the European market. The equity market is still fragmented. There are evident advantages, typical of a network economy, in concentrating trades; the attraction of a stock market for issuers and brokers grows with the number of present and prospective participants. On the other hand, for the stock of smaller firms in particular, the information advantages of national markets lead to better liquidity conditions. Forms of horizontal consolidation and federation between national markets would achieve both benefits. Unrestricted and equal access to settlement systems and multiple links between the various markets would foster both competition and efficiency. Italy’s stock exchange faces the challenge of adapting to the new context. Our primary goal should be to ensure ease of access to European markets and infrastructure for our firms and intermediaries. We need to reflect together on the best way to achieve this. The integration of securities clearing and settlement systems has not yet reached a satisfactory level owing to differences in national infrastructures that predated the launch of the monetary union. The existence of numerous national systems, with their non-standard services, diverse market practices and different laws and tax rules, increases the risks and costs of settling cross-border transactions. Some specific barriers to integrating post-trading systems have been clearly identified. The removal of those created by differences in laws and regulations will require sometimes complex legislative intervention. The removal of strictly technical barriers and barriers created by market practices can be effected at the initiative of market operators themselves. There is no reason to wait. A set of European rules is already in place to promote market integration and transparency by regulating such matters as settlement finality, market abuse, collateral, prospectuses and takeover bids. The directive on markets in financial instruments issued in April 2004 will spur competition by abolishing the requirement to conduct all transactions on regulated markets, encourage the provision of crossborder financial services and strengthen investor protection. The complex process of implementing the directive must be speeded up, at both Community and national level. 4. The role of intermediaries in asset management The saving rate of the Italian economy, especially among households, is still high, despite a long-term downward trend. It is associated with a level of household wealth that is also high. Savings continue to be a fundamental resource for economic growth. Efficient management of the country’s savings is a competitive challenge and an opportunity for growth, both of the economy as a whole and of the financial industry. In Italy as elsewhere the composition of households’ financial wealth has shifted in the last few years, as a result of more active, diversified and efficient portfolio management. Between 1995 and 2004 the share of bank and postal deposits fell from more than 40 per cent to barely 25 per cent and that of publicsector securities from 23 to 7 per cent, while the incidence of private-sector bonds, equities and investment fund units increased. Fund units are now as important as in the other leading industrial countries. The share of insurance products and private pension funds is much smaller, however, essentially because of the broad coverage provided by the public pension system. The share of private-sector bonds, in particular bank bonds, is high, as they enjoy a more favourable tax regime than deposits. Full advantage is not being taken of the portfolio diversification that professional managers can provide. Banks continue to play a crucial role, both because the level of direct intermediation is still high and because the major banking groups include management companies that control almost the entire investment fund market. This market therefore contributes decisively to the size and profitability of banks, which accordingly have a strategic interest in increasing its competitiveness. Management companies distribute their products almost exclusively through the networks of the group they belong to. This vertically integrated model enabled the Italian investment fund industry to grow rapidly, households to rely on relationships of trust with their banks when turning to asset management services, and banks to diversify their sources of income. Asset management offers Italian banks considerable scope for expanding their business, increasing their profits and improving their stock market ratios. However, in a fast-changing competitive environment, this will require appropriate strategies for both products and customer relations. The reliance on a captive market and the small size of most asset managers are not conducive to innovation or economies of scale, which are crucial to competitiveness and profitability in this sector. Foreign competitors are gaining ground in the Italian market, especially as regards innovative products; more than 85 per cent of the exchange traded funds listed by Borsa Italiana are managed by foreign groups. The independence of asset managers whether it is the result of decisions regarding their ownership or of strict corporate governance rules is essential not only for their growth but also to resolve the conflicts of interest inherent in their relationships with their parent banks. 5. Financial regulation The large proportion of savings not entrusted to professional investors, the scale of households’ investment in financial products and the growing complexity of the financial instruments available require the authorities to refine supervisory regulations and practices constantly. The law on the protection of savings recently approved by Parliament strengthens some of the safeguards for investors. The division of responsibilities between the Bank of Italy and Consob has always been based on the distinction between safeguarding the stability of intermediaries on the one hand and protecting investors and supervising markets on the other. This distinction, essential for effective action and the clear attribution of responsibilities, requires cooperation among the authorities in drawing up rules, in verifying intermediaries’ compliance and in promoting investors’ financial education. The Bank of Italy stands ready to continue this cooperation. Regulation of the markets cannot eliminate risks for investors, nor should it; what it should do is facilitate their allocation by enhancing transparency and limiting and managing conflicts of interest, with a view to protecting the weakest investors. This is necessary on grounds of both efficiency and fairness. In preparing laws and regulations, every effort must be made, with the assistance of the operators involved, to strike a better balance between pursuing objectives and containing the costs borne by issuers, intermediaries and investors. Without breaching the key principle of the distinction between functions, the Bank of Italy verifies intermediaries’ compliance with the rules for the protection of savings. Irregular or over-aggressive conduct exposes intermediaries to legal and reputational risks, which need to be addressed by prudential supervision. The management of both old and new banking risks is now set to reap the benefits of the substantial investments that have been made by banks and regulatory authorities to bring the Basel Accord into operation. The new regime creates incentives for banks to direct their choices towards the objectives of prudential supervision, enhances the effectiveness of the rules and reduces their distortionary effects under a highly innovative approach. Based on the risk management techniques of the most sophisticated banks, it will promote competition and significantly improve the quality of most banks’ operations. The Accord could become the model for the regulation of investment firms and insurance companies as well. The convergence of the three sectors of financial intermediation should reduce the risk of regulatory arbitrage and rationalize the management of financial conglomerates. The supervisory review process, the second pillar of the Basel Accord, requires each bank to make its own assessment, which should also be forwardlooking, of the capital considered adequate in relation to its specific features, its risk exposures not considered for the minimum capital requirements and the quality of its organization. It is up to the supervisory authorities to examine, discuss and approve the systems adopted. Using the analysis of different scenarios and stress tests, this instrument can also serve to link supervisory authorities’ micro- and macro-prudential assessments, by exploiting the wealth of theoretical and empirical models available. But we must aim higher, taking the opportunity offered by the Basel 2 system to arrive at a significant simplification of today’s supervisory rules and practices. The law on the protection of savings expressly provides for the periodic review of legislation, to check its compliance with the principle of proportionality between the objectives and the costs borne by supervised entities, and for the assessment of the impact of each new provision. These are reasonable and useful criteria, to which we must add that of achieving a high degree of convergence among European countries on supervisory rules and practices, a goal whose importance increases with the number of banking groups operating in more than one national market. 6. The Italian banking system Good laws and efficient supervision are what public institutions can and must contribute to the strengthening of the Italian banking industry, to the benefit of the country’s economic growth. The Italian banking system has made significant progress in recent years. There has been a general increase in productivity. The quality of banks’ assets has improved considerably despite the weakness of the economy. The majority of banks have capital in excess of the minimum requirement. The leading groups have completed complex organizational integration and rationalization plans in the wake of mergers, with substantial cost reductions. The positive outlook depends on an improvement in net interest income, which is likely to follow as the European economy picks up, on continued growth in lending, especially corporate loans and consumer credit, and on realization of the major opportunities for synergy afforded by consolidation at the national level. The efficiency gains have been reflected in profitability and market sentiment, which has responded favourably to dividend policies. The smaller banks have consolidated their positions in local markets, exploiting their comparative advantage in lending to small and medium-sized enterprises. The European takeover-bid directive, which provides for minimum harmonization, leaves it up to national governments to decide on any further convergence of their laws and regulations and to set the course towards greater or lesser contestability of ownership. The present situation is unsatisfactory because it leaves open the possibility that cross-border consolidation will be undertaken not only on the basis of criteria of industrial and financial advantage but also for reasons of regulatory arbitrage. Opening the markets for credit and banking services to domestic and foreign competition in conditions of regulatory equality reconciles the private interests of shareholders with the general interest in an efficient allocation of resources. It is the most effective way to stimulate further gains in operational and allocative efficiency, innovation, cost reductions and improvements in the quality of the services supplied to firms and households. To exploit these opportunities, including by means of mergers and acquisitions, capital is available on a scale that was unthinkable until recently. Protectionism leading to worse regulatory arrangements than today’s would entail costs on a comparable scale. We must avoid such an outcome. Hopefully, a rational and constructive spirit will prevail and interest in a level playing field for financial markets quickly re-emerge in the deliberations of the Heads of State and Government and Finance Ministers of the European Union. 7. Closing remarks Italy continues to benefit little from the favourable developments in world trade and international finance. In 2005 GDP stagnated, exports continued to lose market share, the budget deficit widened. Since the 1990s the economy has been as if bogged down. Cyclical indicators and the short- and medium-term predictions of the main forecasting institutions now point to a pick-up in Italian GDP, but with growth still less than the potential, which is already lower than in the other major countries. The growth gap reflects Italian industry’s difficulty in competing. This is rooted in the lack of improvement in productivity. In other countries the revolution in production sparked by information and communications technology has produced its full effects: firms have adapted their human and organizational capital to the new technologies. Italy has been slow to seize the opportunities of this revolution. The gap is widest in total factor productivity. New players are coming onto the stage, formidable in Asia but also present in Latin America and Central and Eastern Europe. This has imparted an extraordinary impulse to world trade. It is a great opportunity for growth but also a major challenge, in the face of which Italy has stumbled. With the end of the illusory remedy of competitive devaluations, productivity growth is the only possible way to achieve prosperity, to create a solid, sustainable foundation for wage increases, and to ensure the development of the country, for ourselves and for future generations. The structural lags of the Italian economy are not the signs of inevitable decline. They are manifestations of problems that are profound and serious but that can be overcome. We need to devise lasting solutions and explain them clearly to the public. This week the European Central Bank raised its key rates by a quarter of a point. The time available for the adjustment of the public finances and a return to growth is running out. Savings, one of the strengths of our economy and our society, are an essential ingredient for growth. It is up to the financial system, markets and intermediaries, to channel them towards the most productive uses, acting in a fully competitive environment and in compliance with the rules. This is your – and our – responsibility. | bank of italy | 2,006 | 3 |
Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the ordinary general meeting of shareholders, Rome, 31 May 2006. | Mario Draghi: Overview of economic and financial developments in Italy Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the ordinary general meeting of shareholders, Rome, 31 May 2006. * * * Ladies and Gentlemen, As I take the floor for the first time before this annual meeting, allow me to begin by conveying my best wishes to the President of the Republic, Giorgio Napolitano, to whom I confirm the continuing institutional commitment of the Bank of Italy to serving the nation. In the same spirit of invaluable institutional continuity, I pay my respects to the Government that led Italy for the duration of a legislature and wish the Government that has just taken its place success in its endeavours. In December of last year Antonio Fazio resigned as Governor of the Bank of Italy. He had joined the Bank in 1965, become Head of the Research Department and then Central Manager for Economic Research. As Governor since May 1993, he directed the monetary policy that accompanied Italy’s entry to Economic and Monetary Union. His actions towards the end of his tenure are still open to judgement. To him I wish to express recognition that is not merely formal for having dedicated his entire professional life to the service of this institution. The end of last year brought with it the conclusion of a convulsive period of scandal and speculation, during which it had seemed that the market, the savings of Italians, and the destiny of companies in key sectors of the national economy were prey to the caprice, self-interest and schemes of a few individuals. The action of the judiciary prevented these schemes from succeeding. The outcome of the judicial proceedings now under way is awaited. Although the institutional integrity of its supervisory structure was unscathed, the Bank of Italy has been wounded. As President Carlo Azeglio Ciampi did me the honour of appointing me Governor, on the proposal of Prime Minister Silvio Berlusconi, it was and it is my responsibility to lead the Bank in the restoration of the prestige it has always enjoyed, and to guide its evolution in a national and international environment radically different from the one that has shaped its history. The field of action is vast: contributing substantively to the formulation and implementation of monetary policy in the euro area; expanding and strengthening banking supervision while adapting it to the new international rules; making the Bank once again the trusted, independent advisor to Parliament, the Government and the general public; and, internally, reconfiguring the central administration and branches, with a rethinking of their tasks and structure, and reconsidering the role of the Italian Foreign Exchange Office. These are the lines of action to be undertaken. In tackling the evolution of the Bank in these new circumstances, the contribution of the staff and of the trade union representatives is essential. In a few days’ time I shall set out these strategy guidelines to them in practical terms, confident that they will share my belief in their necessity. At its next meeting the Board of Directors will discuss the proposed amendments to the Statute of the Bank, in compliance with the new legislation. This begins the mandated procedure, which will culminate in examination by the Government and the issue of a decree by the President of the Republic. I know, to borrow an expression from Guido Carli, that my strength is not equal to the objectives. I would doubt ever being able to attain them if I could not count on the integrity, professional competence and sense of institutional responsibility of the entire staff of the Bank. But there is also something else on which I am certain I can rely: the rightful pride of this institution, which has always transformed difficulties into a spur to growth. In the Bank of Italy, which from Einaudi to Ciampi has provided the nation with Presidents of the Republic, Prime Ministers and cabinet Ministers, I have found an institution of excellence, where the nobility of public service is deeply felt. It is to that service that I, like other Governors before me, intend to dedicate my efforts. It is from this collective sentiment that I shall draw my strength. Returning to growth The cyclical recovery that is now beginning in Italy cannot by itself solve the growth problem that has afflicted the country for more than a decade, but it will facilitate the necessary structural changes. If slow growth persists for long, it stifles an economy’s ability to innovate, saps the aspirations of the young and portends regression. It is especially worrying in a country such as ours, with its adverse demographic trend and high public debt. Financial stability is a necessary condition for economic growth, but in Italy growth is in turn a prerequisite for financial stability. It is essential, while preserving the one, to rekindle the other. The international context In the last two years the world economy has grown at an average rate of 5 per cent, the euro-area economy at an average of 1.7 per cent. World trade has increased by just under 9 per cent. Increasing demand, supply bottlenecks and geopolitical tensions have driven up the prices of raw materials and energy. The latter have more than doubled in real terms in the last three years. Monetary policies are becoming less accommodating everywhere, though differences in the timing and intensity of the change reflect different cyclical conditions and inflationary risks. Fiscal policies have not yet taken advantage of global growth to make the adjustments to the public finances that are necessary to reduce imbalances and cope with the ageing of the population. A rise in interest rates tends to increase the cost of servicing the public debt. The higher the debt, the greater the effect; Italy is particularly exposed. Balance-of-payments disequilibria have become more pronounced. While current account surpluses are widely distributed, the deficit is concentrated in the United States, where it has reached nearly 2 per cent of world GDP, a record high. A rise in the US domestic saving rate, a recovery in growth in Europe and Japan and an acceleration in domestic demand in China and the oil-producing countries may lessen the danger that the inevitable correction of the disequilibria will come about by means of disorderly changes in exchange rates. The expansion in world liquidity and low interest rates contributed to the rise in the prices of financial assets and housing. Interest rate differentials and the volatility of the financial variables fell to historically low levels. The possibility that investors will underestimate risk is a potential source of instability. The volatility of exchange rates and securities prices has increased in recent weeks, triggering a rapid unwinding of carry trade positions that in its turn has affected exchange rates. These factors of fragility are counterbalanced by the credibility of monetary policies, which has subdued inflation expectations. The recent rise in energy prices has not affected core inflation, which has been contained partly by international competition. The talent, capital and technology now available in the financial markets have increased their ability to reallocate risk and strengthened their resilience to shocks. However, the rapid spread of derivatives may amplify the transmission of shocks, with systemic implications that have still not been fully quantified. Persistent disequilibria, high oil prices and the protracted, rapid growth in liquidity are a cause of concern to monetary authorities in view of their potential repercussions on inflation, the prices of financial assets and exchange rates. The distinctive features of the international scene today are the development and spread of new information technology and the rapid growth of the large emerging economies. The digital revolution that took place at the end of the last century has triggered an efficiency competition between national economies. It is essential to rise to the challenge. The emerging economies’ share of world exports of manufactures has risen to 30 per cent, and the proportion of their products with a medium or high intensity of capital and technology is increasing. Consumers in the advanced countries have derived large and immediate benefits. Producers can meet the fierce challenge from competitors with low labour costs if they seize the opportunities offered by the internationalization of production and the emergence of new markets. In a situation of continuing rapid growth in the world economy and world trade, we must be guided by the optimism of initiative, not by melancholy regret for a protectionism that has had its day. Italy’s productivity crisis Since the middle of the nineties output per hour worked has risen much less in Italy than elsewhere: on average, by over one percentage point less each year than in the OECD countries. The delay in adapting the technological and organizational capacities of firms and the economy in general has caused total factor productivity to decline, making Italy unique among industrialized countries. Improvements in efficiency are being impeded by the skewed size distribution of firms, which is scarcely compatible with the new paradigms of technology and competition. This is accompanied by sectoral specialization that is still excessively geared towards traditional products. Removing the obstacles to the expansion of firms is a prerequisite for seizing the opportunities offered by market globalization and for stimulating the widespread and systematic application of innovations in corporate organization, production processes and product ranges. This is the way to regain international competitiveness and to stimulate renewed growth. Defending competitiveness by devaluing the currency, which in any case gave only temporary relief from the effects of a productivity gap, is now impossible. The only options are increasing output per man-hour and containing nominal incomes. In the long run, only rising productivity generates economic well-being. This year the growth in gross domestic product could be close to 1.5 per cent, thanks to a recovery in exports and investment. The cyclical upturn may facilitate measures to encourage adjustment in the economy. Stability: a necessary condition for growth Macroeconomic policies contribute to stimulating renewed growth by ensuring a framework of stability. The common monetary policy has given the euro area price stability and protection from the volatility of the financial markets. Between 1999 and today, actual and expected consumer price inflation in the area has been barely above 2 per cent, albeit with significant rises in the prices of some items, in particular in sectors less exposed to competition. The price stability objective established by the Eurosystem anchors the expectations of producers, consumers and the social partners. Testifying to the credibility that the European Central Bank has acquired, short-term interest rates in the euro area reached their lowest level in fifty years. The convergence towards price stability has served the interests of all the participants in the monetary union, and continues to do so. The benefits of the euro are especially valuable in Italy. The decline in interest rates enabled firms to keep their financial costs low in relation to value added, even during a downturn in which corporate debt increased. The interest rate differential between Italian and German long-term government bonds had averaged 340 basis points between 1992 and 1998; between 1999 and 2005 it fell to just 25 basis points. Interest expenditure on new issues of public debt was drastically reduced. The benefits of the single currency for the public finances have been largely dissipated, however. The upward trend in rates now calls for urgent action on the structural determinants of public spending. The burden of the public debt must begin to diminish again. Its ratio to GDP increased by 2.5 percentage points last year to 106.4 per cent, despite asset disposals worth about one point. General government net borrowing rose to 4.1 per cent of GDP; it exceeded the limit set by the Treaty of Maastricht for the third consecutive year. The primary surplus has steadily declined, from 6.6 per cent of GDP in 1997 to 0.4 per cent last year. Net of privatization receipts and excluding the effect of oneoff measures, the borrowing requirement – on which the trend in the public debt depends – came close to 6 per cent of GDP. Net borrowing may again exceed 4 per cent of GDP in 2006; the debt ratio would rise further. To bring the public finance balances back to levels that permit a predictable, continuous and permanent reduction in the debt ratio, structural adjustments affecting the main expenditure items and all levels of government are necessary. In the light of current trends, a correction of around two percentage points of GDP is needed to achieve the net borrowing objective of 2.8 per cent of GDP set out in government programmes for 2007 and to begin to reduce the ratio of debt to GDP again. Additional resources would have to be found to fund any measures to ease the burden of taxation or boost public investment. Primary current expenditure, which has risen in real terms by 2.5 per cent per year over the past decade, has to be curbed. In addition to containment of the operating cost of government, there are two unavoidable priorities: tackling the problem of the average age at which people retire and making regional and local governments fully responsible for controlling their expenditure. Pension outlays amount to 15.4 per cent of gross domestic product. Almost one quarter of this consists of old-age and seniority pensions paid to persons under 65 years of age. The greatest number of workers retire when they meet the minimum pension requirements. In recent years, as a result of the reforms that tightened the eligibility requirements, the average age at retirement has been about 60 in Italy; it is 61 in Germany, 62 in the United Kingdom and over 65 in the United States. At age 60, women can expect to live another 25 years and men another 21. In the future, together with the development of supplementary pension schemes, only a significant rise in the average age at retirement can square the payment of adequate pensions with the financial sustainability of the contributions-based pension system. A lengthening of the working life will also help raise the labour force participation rate. Regional and local governments account for more than 40 per cent of total general government expenditure on labour costs; they make nearly 80 per cent of total public investment. Health care, which is a regional responsibility, constitutes more than 13 per cent of general government spending. The decentralization of government functions can improve the overall efficiency of the system only if a close link is created between spending and responsibility for its financing. The decentralization of spending has not yet been accompanied by sufficiently broad powers of taxation, transparent and systematic criteria for revenue equalization and effective constraints on borrowing. In order to contribute to stimulating renewed economic growth, not only must budget balance be restored but the composition of expenditure must also be modified. Savings on other items would release resources with which to improve infrastructure, strengthen social security, thus facilitating the operation of the labour market, and reduce the tax burden to enhance competitiveness. A lasting impact on the budget requires a decisive change in the laws and rules on expenditure. Otherwise, as experience has shown, even dramatic budget adjustments produce only short-lived results. Measures to stimulate renewed growth Heightened competition and a broadening of the scope for market mechanisms to operate are necessary for a revival in production and complementary to decisions regarding equity. Competition is the best agent of social justice in an economy, and in a society such as Italy’s in whose history the privileges of the few have commonly been rooted in the protection of the State. In recent years numerous areas of action have come to the attention of observers and economic policy-makers as crucial for restoring the growth of the economy: employment, education, services and the legal and administrative environment are issues of particular importance. Labour costs are affected directly or indirectly by the level of wages, by taxation and social security charges and by the rigidity of regulations. The coordination of wage bargaining at national level not only safeguards equity but also helps to ensure that wage trends in sectors where there is little competition and areas of the country with low unemployment do not become incompatible with price stability. The 1993 agreements between employers and trade unions assigned the distribution of productivity gains to decentralized bargaining. The adoption of employee-compensation schemes explicitly linked to the firm’s productivity is still very limited, however, and remains concentrated among large industrial enterprises. In 2005 State levies, in the form of taxes and social security contributions but not counting the regional tax on productive activities, amounted to 45.4 per cent of the cost of employing a typical worker in industry. The average in the OECD countries is 37.3 per cent. Too large a tax and contribution wedge distorts resource allocation and hampers growth. The budget constraints leave little room for financing a reduction. Shifting taxation from labour to consumption offers benefits in terms of resource allocation and certainty of coverage, but it has macroeconomic and distributive effects that need careful assessment, in conjunction with the social partners. Rigidity in the utilization of labour has implicit costs for business. It may be rooted in hiring procedures, in the deployment of human resources within the firm, or in termination procedures; the latter are made onerous, above all, by the length and cost of possible legal proceedings, which are uncertain and frequently very high. Some flexibility has been recovered during recent years with the spread of atypical employment contracts. If the labour market is well-regulated and typical contracts not overly rigid, atypical contracts will offer a useful range of options to firms and workers. However, if they become a surrogate for ordinarily flexible employment, they prevent many young people from planning for the future, reduce the incentives for firms to invest in training and curb macroeconomic productivity. Efficiency and equity require that market segmentation be lessened by establishing more uniform rules under which employment becomes more stable with the passage of time. In an age in which the economy must rapidly reallocate resources in the changed competitive environment, it is the worker rather than the job that must be protected by ensuring – subject to budget constraints – a decent and non-distorting level of unemployment benefits and real opportunities for training and career change. This is not enough, however. A return to productivity growth calls for innovation and investment in research and technology, and entrepreneurs with the courage and far-sightedness not to remain passive in the face of difficulties but to seize the opportunity to change the way their businesses operate. The stagnation in productivity is partly due to the shortage of human capital. The low level of employment among members of the most vital and promising segment of the working population is a serious waste: in Italy the employment rate for people in their twenties is 10 points lower than the average for the European Union. In the past ten years Italy has narrowed the gap with the other advanced countries as regards young people’s educational attainment, but the cumulative deficiencies will be reflected in the average educational level of Italians for a long time to come. In 2003 secondary-school and university graduates made up 34 and 10 per cent respectively of the age group from 25 to 64, compared with averages of 41 and 24 per cent in the OECD countries. The quality of academic results is also unsatisfactory in several respects. By the age of 15 Italian students are the equivalent of one school year behind in mathematics: according to an OECD survey, Italy ranks 26th out of 29 countries. This lack of educational effectiveness is compounded by a lack of equity: in terms of the variability of achievement levels among 15-year-olds, Italy is in 23rd position among the OECD countries; success in secondary school and at university is closely correlated with the socio-economic status of the student’s family. The seriousness of the problem is a compelling reason to examine the experience of other European countries, such as Sweden, Finland and the United Kingdom, which have experimented with ways of improving the performance of the education and research system by increasing competition among schools and universities; even more than additional expenditure, what is needed are new rules to reward teachers and researchers on merit. The productivity of the service sector is essential for economic growth. Services account for over 70 per cent of value added in the OECD countries; they are used in production by all the other branches of activity. Monopoly rents that keep prices high, impede innovation and productivity, and depress the economy’s competitiveness are more prevalent in the service sector. Utility companies in Italy were still entirely publicly owned until the middle of the nineties. The largescale privatization programme involving them helped to reduce the public debt in relation to GDP. The liberalization of these markets has not progressed to the same extent. The problems of network operation and expansion of the number of suppliers remain largely unresolved. Where local public services are concerned, even privatization has made little progress, and liberalization is practically non-existent; contracts can be let to public or mixed companies without a call for tenders. Local authorities still control many enterprises supplying public services. Sometimes they attempt to increase the range of services offered, triggering a return to public control. Obstacles to competition also stem from restrictive regulations, which in several branches of activity harm the majority of consumers and workers. In the retail sector the average number of employees is about half the euro-area average. The degree of fragmentation impinges on efficiency; it slows the adoption of new technologies, which are an important source of productivity growth in the sector in other countries. The reform law of 1998 liberalizing the establishment of small shops empowered the regional authorities to regulate the opening of larger outlets. Not all of the regions took this opportunity to liberalize. In the regions that applied the most restrictive standards this hindered productive efficiency and the spread of new technologies, to the detriment of consumers and even of employment growth in the sector. The European services directive currently in the process of being adopted can offer only modest stimulus to competition. The undertaking of more resolute liberalization policies is still left mainly to the discretion of national governments. Italy has everything to gain by moving resolutely in this direction. The legal and administrative system significantly affects the costs and competitiveness of businesses. In Italy it has long been indifferent to market considerations. In a World Bank classification of the bureaucratic and administrative formalities affecting businesses, Italy comes 70th, last but one among the OECD countries. From the middle of the nineties onwards, steps were taken to simplify administrative procedures and improve the system of regulation. They have been only partially successful. The discrepancy between measures as formally drafted and their practical application continues to be a general problem of the Italian system. The recent reform of bankruptcy law has introduced instruments to promote earlier detection of critical situations and the rapid reorganization of firms in temporary difficulty; it has streamlined and modernized liquidation procedures. However, the new legislation only applies to about half of all businesses; in particular, a large set of firms are not eligible for the cancellation of residual debts at the end of the procedure. The penal provisions, based on a punitive view of bankruptcy, remain unchanged. Much remains to be done in the general area of the application of the law, although this is not the place to suggest remedies, which can be sought in the experience of other countries. The reforms passed in the last fifteen years to speed up civil proceedings have not yielded the desired results. Civil actions still last far longer than in other European countries; debt recovery proceedings in Italy take five times the OECD average. International studies show that, in relation to the size of the population, the number of judges and officials in Italy and the amount of public spending on the justice system are comparable to the figures for other countries of similar size and legal tradition. In the tax field, action to improve the clarity of the rules and regulations and the way they are applied reduces litigation and guarantees firms a more certain framework in which to operate. Compliance with tax and social security obligations is discouraged by frequent recourse to amnesties and immunity from prosecution; between 1970 and 2004 only two fiscal years were not covered by provisions of this kind. The revival of domestic economic growth and the reduction of geographical disparities are complementary objectives. Measures that will have an impact on the structure of the economy, particularly on the growth in the size of firms and changes in their product specialization, serve both purposes. In fact, they bring greater benefits to the economy of the South, which suffers more acutely from the national ills, notably in public services and infrastructure but also in the enforcement of law and order. Specific policies offering incentives to firms may be helpful, but their usefulness must not be overrated. They involve administrative costs, possible distortions in the allocation of resources, and the risk that they will be abused, especially if they rely on discretionary mechanisms. Even the benefit of stimulating investment, despite being greater for firms in the South, is modest in relation to the resources employed. According to Bank of Italy surveys, one fifth of industrial firms in the South received public incentives in 2005, compared with nearly one quarter of those in the rest of Italy. In the case of firms in the South, the additional investment generated is less than 30 per cent of the funds distributed; in the Centre and North the corresponding figure is about 10 per cent. A scaling-down of the system of transfers to firms would release resources for other spending priorities and for reducing the tax burden and social security contributions. By contrast, an attempt to force the growth of the South financially by assigning inappropriate tasks to banks could once again lead to situations that have already proved harmful in the past both for the economy of the South and for the stability and efficiency of the banking system. The financial system in the South has made important strides in the last ten years, especially in the quality and efficiency of banking, thanks in part to the involvement of banks based in the Centre and North. On a risk-adjusted basis, the difference between the cost of credit in the South compared with that in the Centre and North has almost vanished. However, there is still a lag in the spread of more advanced financial instruments among households in the South, and even in the use of banking services. Banks and financial institutions have considerable growth potential in the South. A financial system serving development The capital markets Funds raised directly in the market by firms in the form of listed shares and bonds represent only 17 per cent of their financing in Italy, about a quarter less than in France and Germany; the figure is higher than 40 per cent in the United States and close to 50 per cent in the United Kingdom. In relation to the size of the economy, Italy’s stock exchange is much smaller than the average for the advanced countries. Development of the capital markets is necessary for the growth of firms, and vice versa. The markets play a crucial role in mobilizing financial resources. The total financial wealth of Italian households is large in relation to GDP and also by comparison with the other major European countries. Although the behaviour of savers has changed in the last few years, the diversification of households’ portfolios is still limited, to the detriment of the balance between returns on savings and protection from risk. Broader, efficient and well-regulated financial markets will make it possible to encourage current trends, benefiting households, firms and intermediaries themselves. In the life of a firm, admission to stock exchange listing is the first step towards a more solid financial structure, possibly paving the way for a leap in size, with a higher proportion of bond debt and often with a lower cost of bank credit. But fear of losing control of the firm and the costs connected with the transparency requirements for listed companies, including their tax implications, deter many entrepreneurs from seeking a listing. Regulation must seek to strike a balance between safeguarding investors and minimizing the costs for firms. It is up to the entrepreneur to assess the opportunities offered by stock exchange listing, which detracts nothing from his passion or creativity; on the contrary, in difficult moments of transition, it can represent a compromise between keeping all the capital in his own hands, thereby sacrificing the opportunities for growth, and relinquishing control entirely. Development of the markets requires rapid and effective protection of minority shareholders from opportunistic or non-transparent behaviour. Prevention must be able to rely not only on primary and secondary legislation and its application by the supervisory authorities, but also on the autonomous initiative of operators in the market: banks, rating agencies, investors. There is ample scope for selfregulation and shareholder activism. If this is not fully exploited in Italy, it is partly because institutional investors carry little weight. Their voice, which is strong and insistent elsewhere, is faint in Italy. Their presence contributes to the assessment of the quality of corporate management, the protection of minority shareholders and the correct handling of conflicts of interest; it deepens the market and increases its allocative efficiency; it facilitates the placement of equity capital and the spread of long-term financial liabilities. Where institutional investors play a more prominent role, the average size of the companies that seek a listing is smaller. Pension funds in particular have great potential for growth in Italy. In the most advanced financial systems they are among the main investors in listed shares. In the United States they hold about one fifth of the market capitalization, corresponding to roughly one third of GDP; in Italy the proportion is close to zero. The financial assets managed by Italian pension funds amount to 2.1 per cent of GDP, those of funds created after 1993 to 0.8 per cent. More rapid expansion is necessary. The income replacement delivered by the public pension system will decline in the decades ahead as a consequence of the reforms introduced in recent years. The rapid growth of supplementary pension schemes is essential to provide adequate incomes for future generations of retirees. In addition to workers’ contributions, it will be necessary to use the flow of resources now set aside for severance pay, which for the private sector amounts to approximately 1.5 per cent of GDP per year. The advantages for workers are likely to be considerable. Greater investment in equities would increase the return on retirement savings. Over the long run the rate of return on equities has been substantially higher than that on bonds and well above the nominal rate of growth in GDP; it has been far higher on average than that on accumulated severance pay. Hitherto, the accumulation of severance pay has represented a form of precautionary saving for workers, offering a modest but certain return, which in the event of loss of employment supplemented the often scant protection provided by the welfare system. Ways must be found to guarantee workers adequate flexibility in the use of the accumulated resources and an appropriate limitation of risk. As for firms, contributions relief such as that which has been announced would amply compensate for the loss of a source of finance at less than market rates. The development of supplementary pension schemes requires that full competition be promoted between all financial institutions and that workers be guaranteed full freedom of choice. Suitable fund size and greater transparency of terms and conditions must contribute to containing costs. At the same time, it is necessary to give workers clear information about the public pension that they will receive in the future. According to the Bank of Italy’s Survey of Household Income and Wealth, one third of the persons in employment are unable to judge whether their pension will be adequate. The experience of other countries suggests that the expansion of pension funds is also crucial for the development of intermediaries specialized in fostering the growth of small, innovative firms. Between 2000 and 2003 pension funds in the United States accounted for 42 per cent of the financial flows of venture capital firms, compared with 20 per cent in the euro area and 3 per cent in Italy. A deep and efficient stock market enables private-equity investors to dispose of their shareholdings by means of stock exchange listings, a method of disinvestment that makes the valuation process transparent while also offering entrepreneurs greater protection against the risk of losing control. The growth of specialized intermediaries, the greater involvement of institutional investors and the strengthening of the stock market are mutually reinforcing. More widespread use of investment funds would permit greater diversification of the risks in households’ portfolios and improve the functioning of the financial markets. The competitiveness of Italian funds is affected by tax disadvantages by comparison with foreign operators; it is in the interest of the development of the Italian financial industry that they be eliminated. The Bank of Italy will simplify the supervisory rules. The timetable for the launch of funds will be shortened by broadening the range of cases in which the approval of fund rules is rapid or automatic. Hedge funds and funds reserved to qualified investors, which have high minimum investment requirements, will be allowed the greatest possible operational autonomy. The growth of investment funds could also benefit from changes in the sector’s structure. The current governance arrangements for asset management companies are based on the integration of the production and distribution of financial products and on the central role of banking and insurance groups. Initially this model enabled the sector to grow rapidly, but today it threatens to segment the market, reduces its efficiency and restrains its further growth in quality and size, preventing full exploitation of the large economies of scale in asset management. In the past few years the Italian financial marketplace has achieved great progress in terms of trading volumes and transaction costs. The market’s liquidity and depth can increase further if implementation of the plans for federation with other European exchanges is accelerated, while safeguarding the informational advantages of the national market. The European directive on financial markets has created the conditions in which integration can strengthen competition between regulated markets and systems operated by intermediaries. However, the benefits may not materialize if barriers to access to clearing and settlement services persist and legislative and technical disparities remain. Further common rules could be formulated with the aim of preventing discrimination in access and creating a harmonized regulatory and supervisory framework that will ensure competition on an equal footing, investor protection and systemic stability. The banks The Italian banking system is sound. In the last few years loan quality has remained high, despite the weakness of the real economy; it has benefited not only from improvements in borrower selection techniques but also from the transfer of part of the credit risk away from banks’ balance sheets. The profitability of banking groups has improved: the return on equity has reached 12 per cent, two points higher than in 2004; for the leading groups it has risen by five points to 16.2 per cent. Further development of the banking sector, including in terms of banks’ size, can improve the financial system’s competitiveness and strengthen the economy. Small banks continue to play an indispensable role in financing local economies; the presence of sufficiently large intermediaries is necessary to ensure that more advanced services are widely available at low cost. The growth and internationalization of firms are facilitated by the growth and internationalization of banks. As well as engaging in traditional activities, banks now increasingly distribute a wide range of financial products. This alters the composition of the risks they face. Their good name, which depends on proper conduct and the quality of the products they sell, including those of third parties, becomes crucially important for their competitiveness and even for their stability. In addition to traditional credit and market risks, which have now been partly transferred to other intermediaries, banks now face reputational, legal and operational risks. In this context strict compliance with regulations, with appropriate operating standards and with deontological and ethical principles is a prerequisite for the sound and prudent management of intermediaries. The measures to foster corporate cultures based on rigorous observance of the rules, the correct handling of conflicts of interest and maintenance of customers’ trust must be strengthened. The Bank of Italy will issue instructions requiring banks to establish a compliance function to monitor observance of legal and self-regulatory rules. The code of ethics that the Board of Directors of the Bank of Italy approved this morning contains a provision to that effect for this institution. Effective governance arrangements are equally important. Especially where ownership is fragmented, self-referential forms of governance must be prevented from taking hold. The clear allocation of roles, the effective exercise of their powers by governing bodies, the existence of adequate checks and balances, and transparent conduct will ensure proper management with the well-informed assumption of business risks. Banks’ greater efficiency and the increase in competition are not yet sufficiently reflected in the prices or quality of some banking services. Bank charges for closing accounts are especially significant, because they may restrict customer mobility and thereby hinder competition. At the end of 2004, in consultation with the Antitrust Authority, the Bank of Italy initiated an enquiry into the procedures and charges for terminating the main retail banking and financial services. In the last two years some banks have eliminated their charges for closing accounts. In most European countries banks are not allowed to charge for this; in some, such as the United Kingdom and France, self-regulatory codes also lay down standards to ensure that accounts and the related services can actually be transferred within a given time. The extensive data collected in the course of the enquiry are described in the body of the Annual Report; the follow-up is now the responsibility of the Antitrust Authority. The new Basel Capital Accord introduces some highly innovative principles into the regulation of banking. Its transposition requires a far-reaching revision of supervisory rules. It will simplify prudential regulations, increase intermediaries’ freedom of action and enhance the flexibility of the banking system. The key criterion is the evaluation of the different forms of risk using common quantitative methods, together with a more accurate correlation between capital requirements and the size of the risks faced. The new rules for assessing the capital and organizational adequacy of banks are based on their own methodologies. The Bank of Italy’s task is to verify the reliability and rigour of the methods used and, if necessary, to require corrections and improvements. There will be a more intense interaction between the supervisory authority and the banks, but the regulatory formalities will be reduced. The widespread dissemination of the methods for calculating capital requirements developed by each of the leading banks has made adequate techniques available to a wide range of intermediaries, in some cases through participation in consortiums. However, the most advanced calculation methods will initially be used only by some of the major groups. The market will comprise banks applying credit assessment methodologies of varying complexity. The Bank of Italy is committed to checking that the use of different methods of customer selection does not lead to regulatory arbitrage or adverse selection. The risk-weighting system and the special treatment reserved for small loans mean that the new rules will not result in credit rationing or higher costs for smaller firms. By increasing the role of flexible and market-oriented supervisory instruments and reducing that of detailed administrative prescriptions, the new regulatory system enhances the role and effectiveness of on-site and prudential supervision. Again with the aim of directing finance toward stimulating renewed economic growth, the Bank of Italy intends to submit a proposal for revising the regulation of banks’ equity interests in non-financial corporations to the Interministerial Committee for Credit and Savings. The rules would be fully aligned with Community law by easing the present stringent constraints while introducing rigorous codes of corporate governance in order to safeguard intermediaries’ stability and ensure the transparent and correct handling of conflicts of interest. As regards the authorization of acquisitions of controlling interests in banks, the obligation to notify plans to the Bank of Italy before they have been submitted to the board of directors will be abolished. Driven by the single currency and progressive regulatory harmonization, the integration of European banking markets derives additional momentum from developments in the competitive environment. The growth of consumer credit and, more generally, of financial products for households contributes in this respect. Such products are becoming increasingly standardized in design and in the technology used, which encourages their large-scale distribution and enhances the value of existing distribution networks. Italy, where households have a low level of debt and still relatively undiversified financial assets, is an attractive market. In the last ten years the main European banking groups have become highly profitable, partly owing to the restructuring carried out in national markets. They now have the resources to extend their activity abroad significantly. The growth of the main Italian banks has narrowed the gap between them and their leading European counterparts, but has not eliminated it; the process must continue. It is well known that last year saw important acquisitions of two Italian banks by foreign banking groups and of foreign banks by an Italian group. This greatly increased the degree of internationalization of Italy’s banking system, bringing it into line with that of the other leading euro-area countries. Foreignowned banks’ share of the assets of banks established in Italy rose from 8 to 14 per cent; in France, Germany and Spain the corresponding figure is between 10 and 11 per cent, and in the Netherlands it is 14 per cent. The foreign assets of the largest five Italian banking groups rose from 11 to 41 per cent of their combined assets, a figure comparable to that in the other countries I have just mentioned. The increase was entirely due to a single acquisition. The spread of multinational banking groups in Europe requires supervision performed jointly by authorities from different countries, in accordance with principles established at European level, under which the supervisory authority of the parent company is responsible for coordination. Permanent structures, known as supervisory colleges, have been established to coordinate the supervision of multinational groups. The Bank of Italy has signed agreements with the German authorities and made contact with those of many other European countries with a view to establishing cooperation arrangements for Italian groups with a presence of systemic significance in other countries and vice versa. Cooperation also relates to the convergence of supervisory practices, to ensure that units of groups located in different countries receive uniform treatment. The law on the protection of savings passed in December 2005 is intended to strengthen the safeguards for savers and increase market transparency, with provisions that affect the regulation of market participants, relations between intermediaries and their customers and the arrangements for supervisory authorities. As regards the latter aspect, the reform is based on the principle of the purpose-based allocation of responsibilities. In accordance with this approach, antitrust activity in the banking sector has been transferred to the Antitrust Authority and new duties concerning the regulation and control of the supply of financial products by banks and insurance companies have been entrusted to Consob. The purpose-based model of supervision offers advantages in terms of the specialization of controls, the speed of decision-making and the transparent identification of the authorities’ responsibilities in relation to the purposes they are assigned and the exercise of the powers they are granted. The Bank of Italy had already concluded agreements with Isvap and Consob on the supervision of financial conglomerates and is now ready for any additional agreements that the new legal framework may require. For matters that fall under the jurisdiction of more than one authority, it is to be hoped that some of the technical solutions envisaged by the law will be simplified, especially as regards the artificial combination of the various authorizations involved in banking mergers into a single act. Cooperation among the authorities is essential for the more effective exercise of administrative discretion and to curb the costs borne by the entities subject to supervision. *** I began my remarks with the words “returning to growth”. This is Italy’s absolute priority for economic policy today, as was entering the monetary union ten years ago. While preserving the stability we acquired at so great a cost, we must find our way back to the path of growth. The actions to be undertaken, including the measures to redress the public finances that have now become imperative, must be evaluated first and foremost from this point of view. Such an objective can only be achieved if there is consensus on the goals for the future and agreement on action in the present. Let us draw encouragement from the knowledge that in the course of its history this country has successfully overcome far more dramatic challenges. | bank of italy | 2,006 | 6 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at an inquiry into matters relating to the implementation of Law 262/2005, before the Sixth Standing Committee of the Italian Senate, Rome, 26 September 2006. | Mario Draghi: Measures for the protection of savings and the regulation of financial markets Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at an inquiry into matters relating to the implementation of Law 262/2005, before the Sixth Standing Committee of the Italian Senate, Rome, 26 September 2006. * 1. * * Introduction The law on savings (Law no. 262 of 28 December 2005) is a sweeping reform with commendable objectives: to strengthen companies’ internal controls and public controls for the protection of savings, enhance the transparency of markets and foster cooperation between authorities by establishing rules to govern their coordination. Together with many appreciable, necessary changes, the new rules also have several problematic points, chiefly as regards the division of the regulatory framework between laws, administrative rules and self-regulation. The quality of financial regulation is gauged by its effectiveness in preventing improper conduct, protecting investors against uninformed risk-taking, and averting systemic crises. With today’s increasingly complex financial markets and financial products, it would be illusory to pursue these objectives by means of ever-more detailed and pervasive formal constraints and prohibitions. The fact is that constant financial innovation often results in the rapid obsolescence of formally rigorous and detailed rules crystallized in a law, thus imposing unwarranted costs on economic agents and undermining their competitiveness, with counterproductive effects for investor protection. It is important that the fundamental principles the law must establish should fully exploit the potential of mechanisms based on transparency and reputation, the application of self-regulatory codes, and flexible action by the supervisory authorities. The law on savings takes this course, but only up to a point. On the matter of conflicts of interest within financial intermediaries in particular, it introduces detailed and rigid prescriptions that are not always in line with the rules prevailing at European and international level, which make the most of the selfregulatory capacity of the markets and the flexibility and adaptability to concrete cases characteristic of secondary legislation issued by regulatory authorities. In the field of corporate governance as well, the reform appears to be torn between measures designed to strengthen internal arrangements and the role of self-discipline, and more dirigiste instruments based on meticulous prescriptions. In coordinating the new rules with existing codified laws and other sectoral legislation, the draft legislative decree under examination introduces many useful elements of rationalization and solves a number of problems. I shall offer some considerations in this regard later, after reporting on the steps the Bank of Italy has taken in recent months to apply the law on savings within its sphere of competence. I shall treat questions of corporate governance only in passing and concentrate instead on matters relating more directly to the responsibilities of the Bank of Italy. Here let me just mention some of the changes proposed in the draft decree that move in the direction indicated: revised rules on corporate disclosure by companies adhering to codes of conduct that would assign responsibility for the truthfulness of such statements to corporate bodies, without prejudice to Consob’s powers to publicize the codes; a new supervisory approach to stock option plans, confirming Consob’s duty of guaranteeing complete disclosure to the market of the working of the plans but eliminating overdetailed rules on matters properly left to the independent management of the company, such as the methods for setting prices and the deadlines for exercising the options; and finally, abolition of the secret ballot requirement for the election of corporate officers, a mandatory norm that is unparalleled in any other system, raises serious problems of opacity in decision-making by the shareholders’ meeting, and is not conducive to the transparency of the market for corporate control. It is necessary to move progressively towards a set of rules allowing sufficient scope for shareholders to perform the controls envisaged by internal corporate mechanisms in a fruitful fashion and make effective use of judicial remedies. This means bringing the efficiency of the civil courts up to a level that has so far proved hard to reach, despite the recent reform of civil procedure. In short, a proper balance between internal mechanisms and public regulation requires that there be effective protection of individuals’ contractual positions. Given the scope of delegated legislation, the draft decree could not deal with all the problems of the legislation on savings. Another opportunity to rationalize the rules, especially on securities, is offered by the transposition of the European directives on offering and listing prospectuses 1 and markets in financial instruments. 2 As for the protection of savings, it would appear advisable to start studying forms of crisis management cooperation between the technical authorities and the Government. 2. Implementation of the law on savings 2.1 Cooperation between authorities The law on savings confirms the independence of the supervisory authorities, reinforces the division of regulatory and control functions by purpose and emphasizes cooperation between the authorities, leaving it largely to their discretion to devise the best forms of collaboration and coordination. The Bank of Italy’s contacts with other authorities, frequent even before the new law, have been stepped up with a view to agreeing on how to implement the legislative changes. The reflections underlying the draft legislative decree on coordination are the fruit of a joint analysis on the part of the authorities, which participated in the working group chaired by Vice-Minister Pinza. Together with the Antitrust Authority, we identified the problems with the provision for a “single act” authorizing acquisitions of equity stakes in banks and agreed on appropriate correctives. The Bank’s former antitrust powers in banking were handed over without prejudice to proceedings already under way. A memorandum of understanding will be signed with Consob on the ways the Bank of Italy is to contribute to the examination of prospectuses for bank securities. Another memorandum, also nearing completion, will determine the technical procedures whereby Consob may access Central Credit Register data to verify possible abuses of market power without harm to the confidentiality of the service. 2.2 Bank of Italy administrative and regulatory procedures The law on savings lays down the principles that are to govern the supervisory authorities’ administrative and regulatory action, leaving implementation to regulations to be issued by the authorities themselves. The law provides expressly for individual proceedings to be subject to the standards of transparency and efficiency laid down by Law 241/1990 on administrative proceedings, insofar as these are compatible with the specificity of control activities. The Bank of Italy has adapted its earlier measures in this field to the new legislation and issued regulations establishing the time limits and persons responsible for administrative proceedings. Regulations governing access to documents and participation in administrative proceedings will follow. In implementing the principles of the law on savings, the Bank of Italy has also issued measures to separate, within the framework of the administrative sanction procedure, the investigative from the decision-making function. This was made necessary by the direct attribution to the Bank of the power to impose administrative sanctions for violations of the Consolidated Law on Banking. The law on savings also sets forth principles governing the procedures for approving regulatory and general acts. Their adoption must be preceded by consultations with the financial industry and consumers and by assessments of their impact on the existing regulatory framework, the activities of financial institutions, and the interests of customers. The reasons for measures must be stated and Directive 2003/71/EC. Directive 2004/39/EC. consideration given to the principle of proportionality. Regulations must be reviewed at least every three years. Even before the reform it was standard practice for the Bank of Italy to give the reasons for its regulatory measures and to hold consultations with the financial industry. The new law turns these practices into mandatory requirements, which the Bank will comply with fully. The quality of regulation is a factor in the efficiency of the financial system. The Bank of Italy is engaged in constant adaptation of its regulations to reduce the costs they entail and to adapt them effectively and promptly to the evolution of the market. The prudential regulation of banks and other intermediaries is undergoing far-reaching change, partly driven by convergence at international and EU level. 3 The Bank has issued public consultation documents setting out the regulatory options and policy guidelines for the implementation of the new prudential rules. The banking and financial industry is called on for comments, suggestions and proposals. More broadly, a programme of regulatory simplification has been launched to remove constraints and costly formalities that are no longer needed. Most recently the requirement to notify the Bank of Italy of transactions that would entail acquisition of control of a bank even before discussion of the operation by management bodies has been abolished. This change, in line with the standards of transparency confirmed by the reform, abrogates an obligation that the market perceived as an obstacle to domestic and cross-border banking concentrations. Planned concentrations are still subject to authorization, an instrument essential for the Bank of Italy to perform its duty of controlling the quality and soundness of all those intending to acquire control of a bank. 2.3 The institutional structure of the Bank of Italy The law on savings contains principles that bear on the institutional structure and functioning of the Bank of Italy and serve to protect the independence of the Bank and its governing bodies. 4 The implementation of some of these principles required revisions of the Bank’s Statute. On 27 July the Board of Directors approved the draft of a new Statute that incorporates the indications of the law. The text was sent to the European Central Bank, which on 25 August issued a broadly positive opinion, suggesting only limited changes. In order to take these suggestions into account, the text will now be submitted to the Board of Directors again and then to the extraordinary shareholders’ meeting. Subsequently, the law requires that the Statute be approved with a decree issued by the President of the Republic acting on a proposal from the Prime Minister in concert with the Minister for the Economy and Finance following a decision by the Council of Ministers. One of the major innovations introduced by Law 262/2005 is the principle of collegiality, whereby the Directorate is required to adopt measures of external significance that were previously within the scope of the Governor’s authority. The new rule was promptly applied in decision-making. Some delicate problems nevertheless emerged during the rule’s initial application, as the law lends itself to a diversity of interpretations. In transposing the principle of collegiality into the Statute, an effort has been made to define the scope of the measures to be adopted by the Directorate more precisely. Other changes concerned the procedural rules for appointing and removing the Governor and the other members of the Directorate and their term of office. These rules have been rewritten in full conformity with the new legislation and the principles of the European System of Central Banks. The law also required the Statute to be amended with regard to the powers of the Board of Directors, which was to be expressly entrusted with functions of supervision and control within the Bank. With the amendments accordingly made to the Statute, the system of controls will involve three actors: the Board of Directors is charged with overseeing operations in accordance with the responsibilities of the administrative body; the Board of Auditors is charged not only with ensuring conformity with the law but also with exercising accounting control; and, as required by the Statute of the ESCB, the Bank’s accounts will be examined by external auditors. The law also lays down that the Government is to issue a regulation revising the Bank of Italy’s ownership structure and governing the procedures for the transfer of those of its shares held by persons other than the State or other public entities. 5 The New Capital Accord (Basel 2) and Directives 2006/48/EC and 2006/49/EC on the business of credit institutions and the capital adequacy of investment firms and credit institutions, respectively. Article 19 of Law 262/2005. The ownership of the Bank of Italy has been a topic of debate and analysis of late. It is not up to the Bank of Italy to choose its owners, but it is appropriate to reflect on some general principles that should guide regulation of the ownership of a modern central bank, in the light of European rules, international standards and the experience of other major countries. This comparison shows a variety of arrangements. The model of exclusively public ownership, though widespread (France, Germany), is not the only solution; there are examples of public and privatesector shareholders both being present (Austria, Belgium) as well as the totally private ownership structure of the Federal Reserve System of the United States, where the capital of the central bank is held by the privately-owned banks belonging to the System. But the findings are far more uniform in other respects, reflecting common principles serving to safeguard the central bank’s institutional and operational independence. The owners must in no way interfere in the institutional functions. As for the monetary functions, the principles are codified in the Treaty. They include financial independence, meaning the possibility for the central bank to allocate sufficient resources to the performance of its tasks without being influenced by other public authorities. On more than one occasion the European Central Bank has drawn the attention of the national parliament to the need to establish adequate guarantees for the autonomy of the central bank in legislation on the ownership of the Bank of Italy. 6 The presence of multiple shareholders is important in the light of this principle. Under the new Statute 7 there must be a “balanced” distribution of shares among the shareholders and the power exercised in voting cannot exceed certain limits; the task of ascertaining whether potential purchasers satisfy the requirements is assigned to the Directorate and the Board of Directors, in conformity with the opinion of the ECB, as an additional guarantee of the Bank’s independence. An international consensus is also found in the approach taken to the area of banking and financial supervision. Here the independence rule must hold at two levels. The first, essential for every supervisory authority, is that of impermeability to the interests of the institutions subject to supervision. It is based on solid institutional safeguards. The argument, sometimes made, that there is a conflict of interest between some supervised entities (the shareholder banks) and the supervisor (the Bank of Italy) is without foundation. Not only does the Board of Directors, elected by the shareholders’ meeting, not have the power to intervene in questions of monetary policy, but it is also explicitly excluded by law 8 from all tasks relating to banking supervision. The law on savings (and the new Statute) assign these tasks to the Directorate. Pursuant to the law, the Governor is now appointed by the Government. 9 It should also be borne in mind that the votes any one shareholder may cast in a shareholders’ meeting are limited by the Statute 10 to a maximum of 50 (out of a total of 665 today), regardless of the number of shares held, in order to prevent individual shareholders from exerting a preponderant influence on the Bank’s decision-making even in the restricted scope of the matters in which the shareholders intervene. The other level regards the possible influence of politics on the technical decisions of banking supervision. The principle of the supervisory authority’s independence is affirmed by international organizations and is a value incorporated into the Bank’s de facto constitution. Clearly enunciated in the Core principles for effective banking supervision prepared by the Basel Committee on Banking Supervision, 11 it is now sanctioned in domestic legislation by Article 19.3 of the law on savings, which establishes the independence of the Bank of Italy’s governing bodies. Consistently, the Bank’s new Statute 12 prohibits the Bank’s decisionmaking bodies from accepting instructions from other public or private-sector entities. Article 19.10 of Law 262/2005. See, in particular, the opinions issued with regard to the law on savings (CON/2005/34 and CON/2005/58) and the Statute of the Bank of Italy (CON/2006/44). Article 3.2. Article 5.1 of Legislative Decree 691/1947 issued by the Provisional Head of State. Article 19.8 of Law 262/2005. Article 8 of the Statute now in force, Article 9.3 of the new Statute. See the recent consultation documents of April 2006. Article 1.2. The comparative picture, the approaches adopted in national and Community legislation, and the longstanding orientations of international organizations suggest the usefulness of reflecting further on the possible configurations of the Bank’s ownership and comparing the principles referred to above with the solution chosen by Law 262/2005. 3. Implementation of the enabling clause on legislative coordination The Bank of Italy participated in the work at the Ministry for the Economy and Finance to implement the mandate to coordinate the consolidated laws on banking and finance and other sectoral laws with the changes introduced by the law on savings. 13 The work was carried out in a climate of full cooperation among the authorities concerned and between them and the representatives of the Executive. The draft decree as a whole is consistent with a rational interpretation of the mandate: it accomplishes coordination between the new legislative text and pre-existing financial legislation and allows selective corrections to some critical aspects of the law on savings. To begin with, the text contains some provisions on the Interministerial Committee for Credit and Savings. It formalizes the practice, established in recent years, of involving the chairmen of the other financial sector authorities in the work of the Committee on the basis of an invitation decided by the Minister for the Economy and Finance from time to time for topics “relevant to the matters assigned to them by law and pertaining to aspects of the overall stability, transparency and efficiency of the financial system”. For the aspects directly bearing on the tasks of the Bank of Italy, the dropping of the rule that requires the Bank and the Antitrust Authority to adopt their respective measures authorizing bank acquisitions in a “single act” is commendable. Besides involving problems of implementation, the provision is asystemic and does not serve the objectives pursued. It would be superseded by one in which the two authorities are required to adopt their respective measures within 60 days of the time the application, accompanied by all the necessary documentation, is filed. The draft decree appropriately specifies that only acquisitions giving control of a bank fall within the scope of the new rule. Consistently with the new division of tasks, the Antitrust Authority, acting on a request from the Bank of Italy, may authorize agreements and concentrations that restrict competition, on grounds of the functionality of the payment system or the stability of the banks concerned. By enlarging the tasks with which the authorities are charged and rendering them more complex, the law on savings makes it necessary for the authorities to enjoy a form of legal protection for good-faith conduct in the exercise of their institutional functions, in order to safeguard the independent and impartial performance of supervision. The draft decree inserts into the part of Law 262/2005 governing administrative procedures a provision that limits the liability of the authorities (the Bank of Italy, Consob, Isvap and Covip), the members of their respective decision-making bodies and their employees to cases of bad faith or gross negligence. This rule is in line with the most advanced international standards 14 and with what the International Monetary Fund has suggested on more than one occasion. The draft decree addresses the question of conflicts of interest in banking and amends the provisions of the Consolidated Law on Banking concerned with connected lending 15 and the obligations of banks’ corporate officers. 16 On connected lending, the draft decree introduces general principles and eliminates excessively detailed prescriptions. Flexibility is restored to the prudential rules by referring to sources of secondary legislation and specific measures adopted by the credit authorities. The guidelines recently established by the Interministerial Committee for Credit and Savings in conformity with the indications of the law on savings establish a very stringent discipline, in view of both the broad definition of related parties and the quantitative limits set on risk assets. The amendments provided for in the draft decree will require the Committee to reexamine the matter. Work is already under way on the secondary Article 43 of Law 262/2005. Core principles for effective banking supervision, Basel Committee, 1997. Article 53 of Legislative Decree 385/1993 (the Consolidated Law on Banking). Article 136 of the Consolidated Law on Banking. legislation that the Bank of Italy must issue, based in part on solutions adopted in other leading countries. Great care is needed, not least in view of the potentially significant impact on the relationship between banking and industry. As for the obligations of banks’ corporate officers, problems emerged in applying the new rules as soon as the reform came into force. As is well known, under Article 136 of the Consolidated Law on Banking banks’ lending to their corporate officers and other business dealings with them are subject to a special procedure and non-compliance is a penal offence. The law on savings has extended the scope of the provision to such a broad range of “relevant” persons and made their identification so complex that they risk committing violations unwittingly. The problem is aggravated by the large number of intragroup transactions to which the provision applies, since for the most part they have no bearing on the provision’s objective. Although useful, the changes that the coordination decree would make to Article 136 do not solve all the problems this provision of the law on savings has created, especially as regards the broad range of persons falling within its scope. If the limits of the legislative mandate are deemed not to permit any other solution, addressing the question as soon as possible in a different legislative form should be considered. Rather than multiply constraints and prohibitions, it would be better to fully exploit the strengthening of transparency obligations as the means of limiting conflicts of interest. The draft decree also contains provisions intended to coordinate the innovations introduced by the law on savings concerning the transparency of financial products issued by banks with the Consolidated Law on Banking and the Consolidated Law on Finance. The law on savings establishes that all investment contracts, including those of banks (and insurance companies), fall within the scope of the Consolidated Law on Finance and are subject to Consob controls. The draft decree explicitly clarifies that such contracts are no longer covered by the Consolidated Law on Banking or subject to Bank of Italy controls; it also provides for the same rules to apply to “mixed” products with banking, securities and insurance components. On the other hand it clarifies that the “financial products” defined in the Consolidated Law on Finance do not include bank or postal deposits that are not represented by financial instruments, since such deposits normally serve a purpose other than investment. This eliminates interpretative doubts and the overlapping of some border areas. The draft decree also radically revises Article 129 of the Consolidated Law on Banking, which, as it stands, grants the Bank of Italy powers of prior control on issues of securities. The amendments eliminate the Bank of Italy’s ex ante control and introduce a system of ex post notifications intended to permit the monitoring of markets and financial instruments. The change is consistent with the purposebased allocation of tasks among the regulatory authorities and is therefore welcome. Lastly, the draft decree addresses the question of the circulation among the public of financial products originally placed with professional investors. The law on savings added a provision to the Consolidated Law on Finance 17 requiring professional investors who transfer financial products to the public either to make information available or to guarantee the issuer’s solvency. The aim of the provision is to protect investors more effectively and to prevent elusive and opportunistic behaviour on the part of intermediaries. The objective is commendable; if achieved, it will also help to safeguard the stability of intermediaries by reducing the reputational risks associated with improper behaviour towards clients. However, as currently formulated, the provision involves serious problems of interpretation and enforcement. The draft decree seeks to overcome the difficulties by introducing a different system for the protection of non-professional investors. It establishes that there is a public offering, and a consequent obligation to publish a prospectus, when financial products that were the subject of a placement reserved to professional investors are systematically sold on to nonprofessional clients in the twelve following months. Failure to comply with the rules would be punished by the annulment of the contracts and be subject to civil action. In view of the purpose of the provision, these sanctions should apply only to intermediaries that sell the products to small investors in the retail market; there is no reason to extend their application to other professional investors that had traded the securities among themselves benefiting from their exemption from information requirements. A revision of the Consolidated Law on Finance along these lines would be desirable. Article 100-bis. 4. Transposition of EU financial directives The matters covered by the law on savings will shortly be affected by the implementation of some important EU directives. The transposition of the directive on offering and listing prospectuses will be completed with the exercise of the delegated legislative powers provided for in the law on savings. The Bank of Italy has been consulted by the Ministry for the Economy and Finance on a preliminary draft of the legislative decree and has submitted some observations concerning matters bearing on the banking sector. In particular, it has drawn attention to the need for a more flexible regime for the exemption of bank securities, where many of the rules do not have to be laid down by law but could be left to Consob. The transposition of the MiFID directive could be an opportunity to re-examine the question of conflicts of interest in the securities industry. The law on savings has introduced solutions intended to prevent conflicts of interest by imposing stringent constraints on intermediaries’ organizational and operational freedom. 18 This choice diverges from the line followed by the Community. According to the MiFID directive, intermediaries are required to identify conflicts of interest themselves and adopt organizational arrangements capable of preventing them; the regulatory authorities are controlling the effectiveness of the measures adopted and establishing appropriate transparency obligations. The Minister for the Economy and Finance has recently consulted the Bank of Italy on draft criteria for the mandate to transpose the MiFID directive. The document envisages solutions consistent with the orientation of the Community. In line with the purpose-based allocation of functions, secondary legislation and controls concerning conflicts of interest would be entrusted to Consob. This will require close coordination with the Bank of Italy, which would remain responsible for all the prudential aspects concerning intermediaries’ organization and internal controls. 5. Configuration and coordination of the regulatory authorities The configuration of supervision defined by law essentially reflects a purpose-based allocation of tasks. The Bank of Italy is entrusted with ensuring the stability of the financial system and with the controls on intermediaries’ sound and prudent management, Consob with the controls on transparency and proper behaviour for the protection of investors. The law on savings removed some exceptions to this approach, for example by bringing financial products issued by banks within the scope of the rules on investment services and public offerings. The same logic governed the transfer to the Antitrust Authority of responsibility for safeguarding competition in the banking sector. The purpose-based criterion for the allocation of tasks meets the needs deriving from the growing integration of the different segments of the financial market and makes the identification of the responsibilities of each regulatory authority clearer. The law provides, pragmatically and flexibly, for the authorities themselves to manage the boundaries between their responsibilities and identify the necessary forms of coordination and information sharing. I have described the steps already taken in this respect and the initiatives under way. Apart from any technical improvements required, this model appears to be decidedly preferable to the creation of complex and rigid entities. It makes it possible to perform coordination more efficiently, to adapt the latter’s forms and content to the evolution of the market with the necessary rapidity, and not to impinge on the authorities technical independence. The introduction into the banking industry of the system for legislating and providing supervisory coordination and cooperation known as the Lamfalussy system, 19 with the creation of the European Banking Committee and the Committee of European Banking Supervisors, has eroded the scope for autonomous regulation by the member states and shifted both legislative choices and the process of establishing uniform supervisory practices to Community level. There thus appears to be a decline in the importance of the Interministerial Committee for Credit and Savings, whose function of providing legislative guidelines has shrunk considerably as a consequence of the integration of European financial regulation, not infrequently by way of maximum harmonization solutions, in both primary and secondary legislation. Articles 9 and 10 of Law 262/2005. Commission Decisions of 5 November 2003, 2004/5/EC and 2004/10/EC. On the other hand new coordination needs are emerging that involve the political as well as the technical sphere and make it desirable to find ways of linking up the Ministry for the Economy and Finance and the supervisory authorities. These needs primarily concern the prevention and management of financial crises with potentially systemic effects. The problem has not only a national but also a European dimension. The necessity of tackling it was referred to in the proposals put forward by the EU Economic and Financial Committee in March 2006 on the basis of the indications expressed by the informal Scheveningen ECOFIN meeting. The Minister for the Economy and Finance also mentioned this point when he reported to Parliament on the ministry’s policy guidelines. These matters need to be studied, including by reference to the best solutions adopted in other legal systems and the experience being gained with crisis simulations coordinated at European level. It is necessary to find forms and methods of coordination that distinguish properly between the responsibilities of the regulatory and political authorities. The former include the identification, on the basis of technical evaluations, of a state of crisis. On the other hand, the management of crises that have been declared, when they are of a systemic nature and have their origin in defaults, must necessarily involve not only the technical authorities but also the political authorities because they may require interventions that, directly or indirectly, have a cost for the public purse. Modern and efficient regulation provides protection for the weak and at the same time fosters competition. It is an essential instrument for promoting the growth of the economy. Partly in response to traumatic events, Parliament and the Government have laid the foundations for a far-reaching reform that will affect basic aspects of the framework of rules governing finance. The work must be completed. Legislation in the pipeline will provide an opportunity to do so. The Bank of Italy’s collaboration is unstinting. | bank of italy | 2,006 | 10 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the presentation of the book Luigi Einaudi: Selected Economic Essays, Italian Embassy, London, 17 October 2006. | Mario Draghi: Luigi Einaudi and economic freedom Address by Mr Mario Draghi, Governor of the Bank of Italy, at the presentation of the book Luigi Einaudi: Selected Economic Essays, Italian Embassy, London, 17 October 2006. * * * Ladies and gentlemen, Let me thank the Ente Einaudi for the taking the initiative of having a selection of Luigi Einaudi’s works translated and thus introduced to a non-Italian public. I should like to congratulate the editors – Riccardo Faucci, Luca Einaudi and Roberto Marchionatti – the translators and all other contributors for a job magnificently done. Luigi Einaudi had a long, very active life. When he published his first essay in 1893, Giuseppe Verdi had just completed his Falstaff; when he died, aged 87, Federico Fellini had just shocked Italians – and possibly even Britons – with La Dolce Vita. A key actor in Italian public life, he passionately believed in the interaction between Italian, European and American intellectual circles. He was friend to people like Hayek, Huizinga and Röpke; he was instrumental in getting many authors translated into Italian, among them Beveridge, and he carried on an intense activity as a consultant of the Rockefeller Foundation, with great benefit for many young Italians who could study in British and American universities, even during the Fascist time. During three decades he was The Economist’s correspondent from Italy, so that it was also through his eyes that politicians and business leaders of the world perceived Italian affairs. Einaudi is certainly difficult to sum up in a phrase. He was in turn economist, historian, journalist, wine maker, bibliophile, central banker, politician, statesman. He has left literally thousands of pieces of writing. If I have to single out the one reason why he made such a profound mark on the intellectual and political history of Italy, that is his faith in a fundamental idea: man is fallible; lawmakers and planners are no less fallible than other humans; legislative and administrative commands often fail to attain their goals or have unintended consequences; man must be free to experiment, to try new solutions for old problems. He extolled “the beauty of the struggle”: between people, ideas and market players, even between social classes; individual and collective effort and competition engender progress; excessive regulation, forced collectivism and decisions from above hinder it. All institutional arrangements that foster human creativity he would praise; but when confronted with arrangements, legal or otherwise, that block evolution, he would carefully, fastidiously analyse them, and then expose their failings. He advocated a legal system based on a few, simple laws and unbending application. Despite his intellectual authority, he did not always, or perhaps even often, succeed in persuading legislators and policymakers in his time. For most of his life his voice was that of a respected minority. Recognition usually came later. But the lesson has only been half-learnt and the issue is almost as alive now as it was in Einaudi’s time: the delusive quest for the perfect regulation and the perfect plan still goes on in much of Europe. A professor, but not an inhabitant of the ivory tower: to the very end of his life Einaudi was extremely curious about real economic and political life. To cite just a few topics from a much more extensive list, he collected information on, and wrote in newspapers about, union demands, capital taxation, agricultural prices, steel production, monetary policy, foreign trade, bank raiders. He always made a point of linking theory with facts. He was a clear, persuasive writer. Which is not just, I believe, a gift of nature, but mostly the result of caring about the subject one writes about. Though firm in his fundamental convictions about economic and political liberalism, he was not a doctrinaire; his position can be described as optimism, not naïveté, about the market. He often repeated that laissez faire is not a scientific principle, but just a convenient rule taught by experience. Certainly subsequent developments of welfare economics have made us more sensitive to externalities and to market failures than he ever was. However, he also was well aware of the importance of the legal framework and a proper regulation for the markets’ well functioning. He deeply believed in equality of opportunities, and accepted a degree of income redistribution. He observed that stumbling blocks to innovation (he called them “trincee”, trenches), while found everywhere, were especially plentiful in Italy: tariffs against foreign commodities, rules barring new competitors from entering established trades, laws that put obstacles in the way of new trades or commodities, cartel agreements among producers to limit competition and innovation: all to the detriment of the consumer. A recurring theme in his writings is the denunciation of private monopolies and of any attempts, by private firms, to restrict markets. However, in Italy he saw the state itself as the main source of market restrictions: the dominating positions of many firms were, more often than not, the product of laws and regulations. In 1947, as a member of the Constituent Assembly of the new Italian Republic (of which he was to become the first full President), he proposed an anti-monopoly clause for the Constitution: La legge non è strumento di formazione di monopoli economici; ed ove questi esistano li sottopone a pubblico controllo a mezzo di amministrazione pubblica delegata o diretta. [The law shall not be a means to form economic monopolies, and such monopolies as may exist shall be subjected to public control through delegated or direct public administration] His proposal was rejected on flimsy arguments, and antitrust legislation eventually came, well after Einaudi’s death. But the alliance between public bodies and private interests to carve out privileges has bedevilled Italy to this day. He applied his convictions about the power of market forces to the banking sector. In a 1935 article that is partly included in the selection, he showed his distrust for the views of a fictitious character, the “rationaliser”, who wanted to regulate from above the banking industry all the way down to dictating what the number of banks should be. He also had little sympathy for the many restrictions on banks’ activity (on area, sector, type of credit) which were not to disappear in Italy until the 1990s. On banking supervision he favoured a flexible approach and disliked rigid administrative rules: “If the regulation really regulates, it only prevents the good transactions and does not prohibit the bad”, he wrote. This resonates with certain main themes in the evolution of supervisory activity in recent times. Much impetus for market-oriented reforms in Italy eventually came from European institutions. Europe was, indeed, a recurring theme in his writings from very early days. He supported a European federation immediately after the First World War. From the columns of the Corriere della Sera he argued, under the pen-name “Junius”, that the League of Nations would be ineffective because it depended on the will of individual states, and advocated the creation of a federation of European nations. The articles went virtually unnoticed at the time. In the final years of the Second World War, he started to write again on the same theme. What should a European federation do? His views were ambivalent in a way reminiscent of today’s debate. Einaudi is absolutely clear about the urgent need for “unifying some economic matters”, among these money. “Devolution to the federation of the regulation of money and money surrogates appears to be uncontroversial”, he writes. (It took a mere 45 years for this “uncontroversial” item to materialise). He goes on to list the advantages of European monetary union in terms unmistakably similar to those used in the debate on the euro that took place almost half a century later. The main virtue of a monetary union lies in its doing away with the monetary sovereignty of national states, which “boiled down often to the right to falsify money” via inflation, or hyper-inflation. On the political aspects his views are less clear-cut. He does not want member states to renounce political independence, a step for which “our spirits are not prepared”. But following the tragic experience of war, he comes down squarely in favour of a fully unified “army, navy and air force”, and of clearly defined federal legislative and executive bodies. These are boldly integrationist views, even by today’s standards. In 1939 Einaudi’s thoughts on Europe came to the attention of two careful readers who would later play a key role in European federalism. Ernesto Rossi and Altiero Spinelli – the first a friend and student of Einaudi’s, the second a former Communist party member – had been imprisoned by the Fascist government for 10 years, and later exiled to the tiny Mediterranean island of Ventotene. Spinelli was at once fascinated by the “Junius” articles; Rossi managed to get through to him material on the debate on federalism in England, including works of Lionel Robbins. We may say that Einaudi contributed indirectly to the birth, in 1941, of the Manifesto di Ventotene, a cornerstone of the European political federalist movement. I cannot refrain from briefly recalling Einaudi’s role in ending post-war inflation and opening the way to a long period of sustained growth and stability. The monetary stabilisation of 1947 bore his mark and is an enduring legacy left by Einaudi as a policymaker. Economic historians still debate the respective roles that Einaudi himself and Donato Menichella, the then Director-General of the Bank of Italy, played in devising the stabilisation plan. Whatever the details, it is clear that Einaudi, as Governor of the Bank of Italy first, then as Budget Minister and deputy Prime Minister, took prime responsibility. Even if he had not had any policymaking role, Luigi Einaudi would be remembered as a communicator and educator. In fact, his very success as a policymaker owes much to his clear, effective way of speaking to the general public, at a time when this was very unusual. His frank and direct style of communication, his choice of explaining, in plain language, policy decisions in a special final chapter of the Bank’s annual report, were at the time a significant advance towards greater accountability of monetary policy. Sixty years ago Einaudi gave his last speech as the Governor of the Bank of Italy. In the new Italian democracy it was under his leadership that the Bank of Italy, already a well-respected institution, started shaping its special role in Italy, unique among central banks, a role upheld by all of Einaudi’s successors: that of a trusted, independent advisor to Parliament, the Government and the public opinion. | bank of italy | 2,006 | 10 |
Alfieri Lecture by Mr Mario Draghi, Governor of the Bank of Italy, at Florence University, Cesare Alfieri Faculty of Political Science, Florence, 11 October 2006. | Mario Draghi: International financial institutions in the world economy Alfieri Lecture by Mr Mario Draghi, Governor of the Bank of Italy, at Florence University, Cesare Alfieri Faculty of Political Science, Florence, 11 October 2006. * * * In the last five years the benefits deriving from the opening up of markets and the elimination of barriers to trade and to the international mobility of productive factors have become progressively greater. The world economy has expanded, per capita incomes have risen, inflation has settled to historically low levels, and the financial markets have been marked by abundant liquidity, low interest rates and limited asset-price volatility. In the first half of 2006 the world economy continued to grow at a fast pace; indeed, its further acceleration took the main public and private research institutes somewhat by surprise, prompting them to revise up their forecasts for the two years 2006-07, except for the United States. According to the International Monetary Fund’s current estimates, which are in line with those of other international organizations and private institutes, world GDP growth will be 5.1 per cent in 2006 and then decelerate slightly to 4.9 per cent in 2007. These are remarkable figures by historical standards; if the forecasts are borne out, the four years 2004-07 will be the period of greatest global expansion since the early 1970s. On the whole growth is becoming more evenly balanced among the different regions of the world: the slowing of the American economy is accompanied by a more vigorous recovery in the euro area and the continuation of growth in Japan and the main emerging countries, especially China and India. Global inflation was reduced by more than half in the second part of the 1990s and continued to decline in the subsequent years, falling to 3.8 per cent in 2006. The combination in recent years of high growth and low inflation is the product of numerous factors, starting with the quality and credibility of monetary policy. In turn the action of the central banks has been facilitated by globalization. In particular, the far-reaching transformation of China’s economy and the entry of that country into the world trading system have helped to moderate inflation by stimulating productivity gains in the advanced countries exposed to Chinese competition and by holding down the rates of increase in the prices of imported manufactures and in wages. On the financial markets, volatility has been much lower in the past few years than in the 1990s. The current phase is distinguished in particular by the simultaneous involvement of different instruments and markets, embracing equities, government and corporate bonds, short-term interest rates and exchange rates, and extending to both the industrialized and the emerging economies. The reduction in volatility is largely ascribable to structural developments in the financial markets. The increase in the share of assets managed by professionals such as institutional investors and hedge funds has increased their liquidity, while the rapid growth of the markets for the transfer of risk has allowed investors to cover their exposures and to allocate risks in a way that is probably more efficient than in the past. The quality of monetary policy has also made a positive contribution. Central banks today formulate their objectives more clearly and transparently, communicate them to the public more efficiently and implement monetary policy decisions with greater gradualness; these major changes have been rewarded by a stabilization of expectations regarding inflation and short-term interest rates, with positive effects on longer maturities as well. However, this favourable scenario is not without risks: pronounced balance-of payments disequilibria, high crude oil prices, signs of inflationary pressures in the advanced countries, the risk of an inversion of the benign conditions now prevailing on the international financial markets. The current account deficit of the United States has continued to expand and is set to exceed $800 billion this year; it could rise further in the coming months. The deficit has been accompanied by a further widening of the surplus of the major Asian countries and the formation of huge surpluses in the oil-exporting countries. The existence of pronounced current account imbalances does not necessarily imply a threat to the stability of the international economic and financial system. Deep, liquid and interconnected markets like today’s can easily permit these imbalances to be financed. The crucial problem is to understand whether the current trends are sustainable and whether the adjustment will take place in an orderly fashion. The studies and explanations presented to date help us to understand the origin and persistence of these imbalances but do not demonstrate that they can last forever. According to IMF estimates, the continuation of a US deficit at the present levels, equal to 2 per cent of world GDP, would imply a further increase in the share of world financial portfolios invested in US instruments. Until some time ago, the deficit was financed by building up external liabilities represented by direct investment and equity portfolio flows. More recently, purchases of debt securities have increased sharply; a significant role has been played by the investment in US securities of the reserve assets accumulated by the countries running a surplus. The factor income account of the US balance of payments, traditionally in surplus, changed sign for the first time this year. Although the most likely scenario remains a gradual correction of these imbalances, this assumes that international investors will be willing to continue to increase the share of US assets in their portfolios in the years to come. Otherwise, the correction would be more abrupt, with severe repercussions on the exchange rate of the dollar, interest rates and, ultimately, the growth of the world economy. The scale of the potential adjustment costs underlines the need for all the major actors of the world economy to take part in the effort to reduce current account imbalances. I shall return to this point in the final part of this talk, in connection with the role of the IMF. Since the beginning of the year the price of crude oil rose to a peak of more than $75 a barrel in August before falling sharply to around $60 the following month. The rise was not caused by a cutback in supply, which has in fact increased by 9 per cent in the past three years despite temporary reductions in extraction and refining as a result of hurricane Katrina and the geopolitical disturbances in the Middle East. Rather, the price increase has mainly been due to demand factors, notably the growing energy requirements associated with the rapid expansion of the global economy in recent years, especially in China and the other Asian countries. At a time of low margins of idle capacity and with no prospects of a substantial structural reduction in user countries’ oil dependency, there are no grounds for supposing that the situation will change in the short or medium term. The rise in oil prices entails a transfer of purchasing power from user to producer countries. For the latter, it is important to exploit the improved terms of trade not only to enlarge the oil industry’s productive capacity, but also to diversify the structure of supply. Using the increased revenues to raise national levels of consumption and investment, instead of merely recycling them through financial investments in the advanced countries, would help to mitigate the overall current account disequilibria. In the oil-importing countries, where unaccommodating monetary policies are geared to preventing secondary inflationary effects, real wages and producer prices need to remain suitably flexible if an increase in unemployment is to be avoided and the loss of output contained. On the other hand, the rise in the price of oil has caused a change in relative prices that should bring about a reduction in oil consumption and the use of alternative sources of energy. National governments should not discourage such a process. One important question is whether the present low volatility will reinforce or undermine financial stability. There is no one answer in this respect. On the one hand the factors mentioned earlier have undoubtedly improved the structure and operation of the markets, while on the other the limited volatility, combined as it is with exceptionally low interest rates, has prompted many investors to seek higher returns, which may have led them to take excessive risks. Another type of danger comes from the very sophistication of the markets: financial derivatives are likely to amplify the effect of disturbances in periods of stress, when market liquidity diminishes; similarly, hedge funds (although helping to increase market liquidity) are likely to accentuate the variability of asset prices. Finally, in a long-term perspective there remains the problem of deciding whether the reduction in volatility is a permanent phenomenon or not. Even if it were permanent, there are doubts whether investors would be able to cope with large and persistent disturbances, which cannot be ruled out a priori. If investors’ portfolio choices are based on market prices, which in turn incorporate the expectation of low volatility, these could be affected by sudden shifts in such expectations. To conclude, there is profound uncertainty about the nature of today’s financial volatility. In view of the seriousness of the international payments imbalances and the enormous cost of adjustment, the international financial institutions provide the natural fora in which to exchange information and initiate action. The objectives, levels and methods of international economic cooperation have been profoundly influenced by the development of closely integrated private financial markets. The scope of cooperation has broadened, spreading from the traditional field of macroeconomics and coordinated economic policies to the sphere of market structure, regulation, supervisory practices, standards and rules of conduct. The number of organizations and agencies dedicated to cooperation has increased, reflecting the need for a more efficient division of labour and variously involving features and elements proper to the private sector. Since its creation in 1944 the International Monetary Fund has enlarged its membership from the original 40 countries to the present 184, thereby becoming the world’s largest multilateral financial institution. Its traditional functions (of “surveillance”, lending and technical assistance) have undergone significant changes. The IMF’s financial function remains hinged on its original structure as a “credit cooperative”. Basically, the capital paid in by the member countries (their “quotas”) is used to grant loans to members with temporary balance-of-payments difficulties. Over the years, the stock of IMF loans to members has fluctuated widely around a trend that was rising until the beginning of the present decade. Peaks in disbursements bear witness to the crises that overtook various categories of member countries, their gravity increasing with the mobility of capital movements: first were the industrial countries, hit by the rise in oil prices of the 1970s; then came the emerging economies, which experienced foreign debt crises in the 1980s and, above all, disturbances to capital movements in the 1990s. “Surveillance” has undergone more radical changes. Until the 1970s the Fund had been the “guardian” of an international monetary system featuring fixed but adjustable exchange rates and relatively minor movements of capital. In that framework, surveillance was intended to identify economic policies that were consistent with the foreign exchange system and oversee the policies actually followed by the members, with quite broad powers of sanction in the event of failure to meet targets. After the collapse of the fixed-exchange-rate system, the Fund allowed member countries to choose what they considered the most appropriate exchange rate regime, retaining such generic obligations as “stability oriented” domestic policies and the undertaking not to “manipulate” the exchange rate to the disadvantage of trading partners. Notwithstanding these fairly weak legal foundations, the IMF succeeded in adapting its surveillance activity to the circumstances of the members and exerted substantial influence on their economic policies, especially in the emerging countries. In the light of the financial crises of the late 1990s and the heightened attention to the financial sector of the economy, surveillance was extended beyond the traditional area of macroeconomic policy to bear on the adoption of and compliance with standards and codes of conduct in banking supervision, market rules, and transparency of statistics. Today the Fund is grappling with an identity crisis, rooted in the sharp fall in the last three years in its traditional clients’ demand for credit. The stock of IMF loans has fallen to the level of the early 1980s. Paradoxically, this reflects a positive development, namely the robust health of the world economy and the absence of financial crises. In the last few years the emerging countries have built up foreign exchange reserves that now outweigh the funds of the IMF tenfold. There have been proposals, notably by the Asian countries, to use a part of these reserves to institute new “regional monetary funds” to provide loans in a similar way to the IMF. If this reduction in the amount of credit granted were to prove permanent, there would be no alternative to drastically scaling back the Fund’s financial function. “Surveillance” itself would have to be reformed, since the IMF’s influence over member countries derives in part from its role as potential supplier of finance. The diminution in the Fund’s lending is the result of both structural and cyclical factors. The structural factors include the prevalence of flexible exchange rate regimes, the improved quality of members’ economic policies and the ability of the private financial markets to satisfy the demand for credit. However, an end to the present positive phase cannot be ruled out. Sudden changes in exchange rates and interest rates or jumps in risk premiums could complicate the debt position of some of the emerging economies. It is thus not a question of removing the Fund from the roster of international financial institutions or reducing its role, but rather of making it better suited to the conditions of a complex, globalized economy. There must be fundamental reform in two areas: the Fund’s “mission” and its governance structure. The “surveillance” function has returned to being the fulcrum of IMF activity, especially as regards: (a) the exchange rates between the main economies, both advanced and emerging; and (b) the urgent need to curb balance-of-payments imbalances. On the latter front, the Fund recently began consultations with policy makers in the United States, Japan, the euro area, China and Saudi Arabia. The aim is to design measures to reduce the imbalances and work for their adoption, through internationally concerted efforts. As to the governance of the IMF, there is a perceived need to bring voting and decision-making power within the Fund more closely into line with the changed economic importance of the various member countries. In this year’s annual meetings in Singapore it was agreed to increase the quotas, and with them the voting rights, of the most seriously underrepresented countries: China, South Korea, Mexico and Turkey. It is expected that in the future other emerging countries will have their quotas and voting rights increased. The voice of the poorest countries in directing the affairs of the Fund will be safeguarded. The Financial Stability Forum (FSF), set up in 1999 at the initiative of the G7, provides a venue for informal discussion among the governments, central banks and national supervisory authorities responsible for financial stability of the seven leading countries, Australia, the Netherlands, Hong Kong and Singapore. In addition, meetings are attended by representatives of the international financial institutions (the IMF, the World Bank, the BIS and the OECD) and self-regulatory bodies in the banking, corporate, insurance and accounting fields. The Forum’s mandate is: a) to assess vulnerabilities affecting the international financial system; b) to identify and oversee action needed to address these; and c) to improve coordination and information exchange among the various authorities responsible for financial stability. Among the potential sources of vulnerability, the Forum has addressed the issues of the role of offshore financial centres, the operation of highly-leveraged financial institutions, the volume and variability of capital flows, the transfer of credit risk, reinsurance companies, corporate governance rules and, more recently, the activity of hedge funds. The Forum has also encouraged the adoption of standards and codes of conduct established at international level. As a general principle, the attention of the Forum is focused on the intermediaries and infrastructure of the financial sector rather than on individual countries and on structural, financial and regulatory problems rather than those of a cyclical, real or macroeconomic nature. Its ultimate aim is to prevent crises, not to forecast or manage them. Looking ahead, one cause for concern is the danger of the present period of low volatility in the markets coming to an end without financial institutions being adequately prepared. This is all the more likely at a time of transition such as the present: it is becoming increasingly difficult to incorporate the flow of financial innovations into complex risk management systems. It is therefore important for regulators to possess accurate and up-to-date information on the size and distribution of risks, the nature of the investors holding them, the structure and liquidity of markets, and the functioning of new financial products. In order to ensure that financial institutions have a better understanding of the new risks and are equipped to manage them efficiently, it is also necessary to verify the solidity of their internal control mechanisms and improve the collection of statistical information. This process entails costs, which could be considered excessive if problems proved to be episodic and on a limited scale. The FSF can make a decisive contribution to assessing the costs and benefits in close cooperation with the private sector. The acceleration of world economic growth in the last few years is part of a longer-term trend. The introduction of market mechanisms and the opening to international trade have driven the development of large countries: first Japan, South Korea and the Asian tigers; more recently, China and India. They have raised hundreds of millions of people, a significant share of mankind, from conditions of absolute poverty. For the process to continue, it is important that the opening to market mechanisms and international trade spread from the production and exchange of goods to those of services. Financial services offer an extraordinary potential for growth, with benefits for emerging countries that can hardly be overrated. The tumultuous growth of these countries requires a modern financial system that can channel their enormous savings and promote an efficient allocation of capital while raising the consumption of households and allowing them to make better provision for the future in the absence of effective social security cover. The creation of an appropriate institutional framework is a necessary condition for the development of modern financial systems. One of the lessons of the successes of globalization (and also of the failures, which have not been lacking, especially in Sub-Saharan Africa) is the role of good institutions: ensuring legal certainty, efficient justice and honest and effective administration is essential for the development of the economy in general. It is especially important for the financial sector, which cannot prosper without the support of fixed and accepted rules, appropriate standards of corporate behaviour, and sufficiently transparent and efficient markets. Ensuring the existence of these conditions is not an easy task. It is not only a question of good laws but also, and perhaps above all, of their being applied fully. In many emerging countries it requires a sea change in the culture of administration and in that of economic agents as well. The role played by the governments of these countries is therefore important, but so is that of the international financial institutions, in persuading, assisting and guiding through their example. | bank of italy | 2,006 | 11 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, on the occasion of the 2006 World Savings Day, at the Association of Italian Savings Banks (ACRI), Rome, 31 October 2006. | Mario Draghi: 2006 World Savings Day Address by Mr Mario Draghi, Governor of the Bank of Italy, on the occasion of the 2006 World Savings Day, at the Association of Italian Savings Banks (ACRI), Rome, 31 October 2006. * 1. * * Savings and investment Half a century ago, when Italy was moving towards prosperity, it was the parsimony of its population that financed economic growth. Right up to the mid-1970s, while expenditure on investment amounted to 26 per cent of gross national disposable income, private saving exceeded 30 per cent, with more than two-thirds of it due to households; their thrift was encouraged and upheld as a social virtue. Towards the end of the twentieth century, both expenditure on capital goods and private saving diminished to around 20 per cent of national income; household saving dropped below 9 per cent. Since then, Italian households have started to save again, partly in response to the public pension reforms of the 1990s; they continue to be among the thriftiest of the developed countries. With no more barriers to capital movements and a globalized financial market, savings worldwide are now in search of investment opportunities, wherever they may arise. The link between saving and investment is no longer related to national borders. Only a growing country will attract capital, from both within and without. Italy’s weak economic growth in the past ten years has been aggravated by inadequate investment, not so much in terms of quantity as of quality and composition. The technological component of real assets, human capital and organizational structure are of growing importance. If the present recovery is to last, economic policy and the financial system must support the restructuring of production, channelling savings towards innovative investment. 2. Returning to growth 2006 is about to become another year of record growth in world output. Since the summer there have been increasingly clear signs of slower growth in the United States, where the lengthy property boom appears to be coming to an end. World demand may be affected by the slowdown, but it continues to be fuelled by the exceptional growth of the Asian economies. Economic growth in the euro area is considerably stronger now than in the previous months. The momentum could be lessened over the next quarters by the decline in demand in the United States and the need for some of the main euro-area countries to consolidate their public finances. In Italy, too, GDP growth resumed at a rapid pace in the first half of this year. Industrial production recorded an estimated year-on-year rise of over 2 percentage points in the first ten months and is steadily picking up from the low point of early 2005. The substantial increase in indirect tax revenue is another indication of a cyclical upswing. Available indicators point to strong GDP growth in the third quarter as well. So far the recovery has drawn strength principally from exports and investment. Italian goods have penetrated further on foreign markets, including the fast growing markets of South-East Asia, thereby slowing the erosion of our market shares. Exports to China are soaring, not only those of traditional products but also of capital goods, suggesting an improvement in the competitiveness of some medium-to-high technology firms. The expansion in foreign demand has helped to rekindle investment in machinery and equipment, which has also been fostered by the shortage of spare capacity, ample availability of financial resources and persistently low interest rates. Domestic orders for capital goods have reached their highest level in five years. The Bank of Italy’s business surveys indicate that the trend will continue in the coming months. Although output growth has been stronger than expected, it is still slower than in the rest of Europe. Productivity in industry remained at a standstill in the first half of this year, while in France and Germany the quarterly increase was over 3 per cent. We need to step up the action, just initiated, to overcome the structural constraints impeding Italy’s growth. The aim of the budget for 2007 is to ensure financial stability in the years to come. It is to be hoped that the debate in Parliament will not attenuate the push for structural reform of the public finances. Achieving this objective is a prerequisite, but also a consequence, of economic growth. The best response to the rating agencies’ assessments is a country that is growing. The Government’s budget proposals include measures to help firms recover their competitiveness, such as the reduction in the tax component of labour costs. However, most of the policies to stimulate renewed economic growth remain outside the sphere of the budget because they are concerned with measures to change the rules of the economic game more than with changing the volume of public resources. Five months ago, in my Concluding Remarks, I listed several areas of action for structural policies. Common to all of them was the need to increase competitiveness, in the goods markets as in the markets for factors of production, by eliminating the protection of vested interests and the monopoly revenues that weigh on firms’ costs and households’ budgets. In the summer the Government took steps to open up further the market for private services. Various measures to revive the productive system are now set out in bills recently passed by the Council of Ministers. It is to be hoped that progress in this direction will continue, without deviating from the objective of improving competitiveness and efficiency at every point of the productive system. As far as incentives are concerned, automatic facilities for firms appear preferable as being less costly and distorting than discretionary measures, which rely on the public bodies concerned to select the sectors for promotion and choosing between different technologies and projects. Such a model requires a remarkable capacity for strategic evaluation. If that is lacking, there is a serious risk of scarce resources not being optimally allocated. To promote growth, improving the environment in which the productive system operates is more important than augmenting or refining the incentives offered to firms. The areas needing action are many and well known. They include simplifying the regulatory and tax system, introducing rewards for merit and mechanisms of competition within the educational and training system, reducing the cost and enhancing the effectiveness of business services and local public services, promoting competition in the production and distribution of those services everywhere possible, and acting to ensure that the legal order and governmental authorities are guided by the values of the market and efficiency rather than the deleterious standards of legal formality and bureaucratic power. 3. The financial system’s contribution to growth 3.1 The stock market and institutional investors Structural reform must also extend to the financial industry. The possibility of direct or indirect recourse to the capital market plays an essential role in facilitating the expansion of firms that have growth potential. Market access is assisted by the presence of a large stock exchange, a good number of institutional investors and a web of specialized intermediaries. Progress on all these fronts is needed. As we know, the Italian share market is smaller than those of the other advanced countries. Both the number of companies listed and the ratio of their total capitalization to GDP are not only far lower than in the United States and the United Kingdom but also below the euro-area average. As for specialized intermediaries, in 2005 total private-equity investment in Italy was half the European average in proportion to GDP. The resources invested in Italy go largely to buyouts. Only 15 per cent of Italian private-equity investment in 2005 went to venture-capital operations, compared with a European average of 27 per cent. And even of that, only a marginal portion, far smaller than in the other major European countries, went to start-ups. Investment in high-technology sectors is minimal. A good part of the capital is of foreign origin; the domestic component comes largely from banks, while the role of other investors, especially pension funds, is scant. As a rule, small firms with highly innovative projects are unable to raise funds directly in the capital market, nor can ordinary bank lending suffice. Even medium-sized companies with opportunities for growth are often incapable of attaining stock exchange listing. There is a need for intermediaries that are able to select risky but promising projects in which to invest, with the ultimate aim of placing the equity on the market. More generally, private equity is also helpful in other corporate transitions, such as generational change, management buy-outs, crises and restructuring. The expansion of the stock exchange and of specialized intermediaries can also be fostered by an enhanced presence of institutional investors, pension funds above all. In the countries where pension funds play a significant role, even relatively small firms tend to seek stock exchange listing. Institutional investors play an active role as minority shareholders, monitoring management’s performance. They reduce informational asymmetries and increase the volume of resources available on the market to finance enterprises. They are among the leading sources of venture capital and, more generally, of funds for intermediaries specialized in supplying risk capital to firms. The spread of private pension funds in Italy is essential to the equilibrium and the equity of the pension system. The rules governing the allocation of workers’ accruing severance pay entitlements will play a key role in shaping the funds’ development. While the amounts accumulated must be earmarked for retirement purposes, workers must be given full freedom of choice: free and fair competition between classes of asset managers and types of retirement scheme, at low cost to the saver, constitutes a guarantee for the robust, competitive development of the sector. Workers must be provided with clear and complete information on their pension situation and the alternatives available if they are to be in a position to make informed choices. The Finance Bill’s provision for the partial transfer to the social security administration of resources now going to firms’ severance pay funds must not conflict with the objective of developing supplementary pensions. 3.2 The shape of the banking system Banks were once virtually the sole agents for collecting savings in Italy and channelling these resources to firms. Overseeing their stability was tantamount to protecting households’ savings. Today, banks and the capital market perform complementary functions in sustaining the operation and growth of the economy, but small and medium-sized enterprises still depend decisively on bank credit. Helping such firms to grow is necessary to strengthen them for competition in an increasingly globalized market. When the technological and human factors and the market conditions are right, the careful and rigorous assessment of creditworthiness does not conflict with a lending policy designed to accompany firms’ growth in size. In the 1990s technological progress, privatization and deregulation triggered a wave of consolidation within the banking industry. In the last ten years the number of banks has diminished; mergers and acquisitions have involved institutions accounting for 80 per cent of total assets. And further significant concentrations are being discussed. Those who propose concentrations – board chairmen and directors – increasingly grasp the necessity and the benefits of consolidation and are showing an ability to transcend the localisms and personal interests that impede it. The Bank of Italy wants the stability and competitiveness of the banking system to emerge stronger still. In a financial system that is open to international competition, it encourages banks to continue on the path of consolidation on the basis of plans decided upon independently by the market. In bank mergers, rational governance arrangements in the new bank are essential to reap all the benefits of consolidation. Innovative corporate governance models may serve to facilitate concentrations; they must be organizationally effective and not jeopardize efficient decision-making. A fundamental contribution to the reorganization of the banking system has come from the banking foundations. The great majority of them have disposed of their controlling interests but they are still significant shareholders of banks, even if consolidation has nearly always diluted their holdings. Their conduct is directed today towards enhancing the value of capital invested, in keeping with their role of long-term investors; their interest lies in pursuing institutional objectives. It might be appropriate to reconsider the regulatory discriminations that limit their ability to acquire and manage bank shareholdings, such as the sterilization of voting rights in excess of 30 per cent. Consolidation has also involved cooperative banks, whose number has fallen from 95 to 36 in the last ten years. Based mainly in the most developed regions of Italy, they diversify the structure of the banking system, draw competitive advantages from their proximity to the productive system at local level, and play a significant role in the investment of households’ savings. There is scope for further concentrations permitting potential synergies to be exploited, without the new groups’ greater complexity compromising their mission of financing the local economy. Consolidation has accentuated the differences between cooperative banks. Alongside banks that preserve an exclusively local vocation, there have emerged groups of considerable size and national reach. A reflection is necessary on how to adapt the corporative governance rules typical of cooperative banks to the reality of each bank. Recent events have demonstrated the risks of instability that can derive from inadequate rules. The inflexible rule of one vote per head, limits on the collection of proxies and restrictions on individual shareholdings can result in a self-referential attitude of management, insufficient protection of shareholders and obstacles to capital strengthening. Parliament has examined various reform projects in recent years. Towards the end of the last Government’s term of office a broad consensus had been reached on a bill that would have eased the shareholding limits, especially for institutional investors, and strengthened the protection of shareholders of listed cooperative banks, while preserving the essential features of the cooperative form. The matter needs to be taken up again. The rules imposing rigid separation between banking and industry, particularly those setting strict quantitative limits on shareholding in banks by investors not belonging to the financial sector, constitute an isolated case in Europe and have to be assessed also for their compatibility with the legislative reform proposals now under discussion at Community level. The need for adequate safeguards is undiminished. It remains essential to ensure the autonomy of the bank vis-à-vis companies that, as a result of conflicts of interest, can unduly influence its decisions, distorting the allocation of loans and imperiling its very stability. But, as with other aspects of supervision, the instruments to be used change. They now consist first of all in governance rules that ensure transparency of decisions, checks and balances, the presence of independent directors, interaction between the different corporate functions and effective internal controls. Secondly, the rules that limit the concentration of risk, particularly vis-à-vis related parties, take on increasing importance. Likewise, with regard to the restrictions “downstream”, on shareholding by banks in firms, the experience acquired and the development of risk management and control techniques make it possible today to ease the existing limits, bringing Italian rules into line with Community provisions. The management of the conflicts of interest that arise in private-equity activity requires adequate transparency safeguards and decision-making guarantees, including the separate conduct of privateequity business by companies within banking groups, and rules on the spreading and diversification of risk. Replacing rigid regulatory constraints with flexible supervisory principles restores autonomy to banks and entrepreneurs and stimulates efficient decision-making. At the same time, this increases the responsibility of the supervisory authority, demands continual refinement of its technical apparatus and requires it to be fully transparent in accounting for its actions. 3.3 Banks: costs and transparency The efficiency gains deriving from concentrations must be transferred in full to households and firms. The costs of banking services for customers are still too high in Italy. Customer protection must be entrusted above all to instruments that guarantee complete information on terms and conditions and the application of a general canon of correctness in business relations. Ordinarily, competition is the most effective means of curbing the costs charged to customers. However, one set of costs - those directly or indirectly connected with closing bank accounts - hinder customer mobility and thus constitute in themselves an impediment to the free working of the mechanisms of competition. Such costs should be eliminated. The full portability of accounts, including accessory services, must also be ensured. The aim of the recent measure that provides for the closing of accounts without expense and other rules protecting bank customers are therefore commendable. However, the formulation of the measure, based on the dictation of economic clauses by statute, has engendered problems of interpretation, particularly as regards the obligation under certain circumstances to modify lending and deposit rates simultaneously and the exact identification of the items to be considered in the charges connected with closing accounts. A situation of uncertainty has been produced that creates operational problems for banks, keeps customers from taking full advantage of the new rights and may cause costly litigation. It would be better if the statutory provisions were limited to laying down general rules, referring their implementation to secondary legislation and self-regulation. Besides, it is in the banks’ own interest to strengthen the consumer safeguards they have already put in place as part of the sector’s self-regulation, by extending their scope and introducing effective mechanisms for settling disputes. In Italy there are already bodies for the out-of-court settlement of banking disputes. For banking business the law on the protection of savings has entrusted the Interministerial Committee for Credit and Savings with the task of regulating the procedures and decision-making bodies. Forms of direct involvement of the supervisory authority could be considered. Transparency and fairness in customer relations are an integral part of the sound and prudent management of banks. Every transgression creates legal and reputational risks. Banking relationships are based on trust; loss of trust can cause risks of instability, including at a systemic level. The Bank of Italy must verify that banks’ organization and internal controls provide adequate protection against risks deriving from business practices that are unfair to customers. Proposed rules on the compliance function have been sent to financial intermediaries and the public for consultation; the related regulations will be issued shortly. Transparency of banking business also requires that banks’ financial statements and other public information on their financial positions be comparable. There has been a significant increase in such comparability in Europe with the adoption of international accounting standards. Greater convergence is necessary with regard to the methods of classifying impaired loans. Adopting the strictest definition of defaulted loans - which includes overshoots and payments overdue by more than 90 days - the figures for Italian banks are high owing to the tolerance of late payments. Banks must further shorten their reaction times by speeding up the organizational and procedural interventions that have already reduced overshoots from 1.7 to 1 per cent of the total loans in the last twelve months. 3.4 Payment services Technological progress offers plenty of scope for increased competition and greater efficiency in the payment system. The spread of mobile telephony, which can be used to provide financial services, and of cards and equipment prepared by the suppliers of electronic payment services is conducive to the entry into the market of new operators and the growth of innovative payment mechanisms, especially for small amounts. The Bank of Italy has already authorized the purchase of products over the phone, when they are supplied by the operator of the service and it does not involve the creation of payment instruments for general use. But in view of the evolution of technology and the market the rules on the reserves for electronic money and the collection and transfer of funds will need to be re-examined, in line with the revision of the European rules now under way. Access to a variety of competing operators must be ensured, while maintaining the public’s trust in the payment system. 4. The Bank of Italy 4.1 Ownership structure In my recent testimony before Parliament concerning the law on the protection of savings, I drew attention to the need to reflect on the implementation of the provision calling for the redefinition of the Bank of Italy’s ownership structure and the transfer within three years of those of its shares held by persons other than the state or other public entities. As I pointed out, it is not up to the Bank of Italy to choose its owners; but it is in the Bank’s interest, indeed it is its duty, to call attention to any solutions that are likely to conflict with the safeguarding of its independence. A plurality of shareholders, a balanced distribution of shares, non-interference in the Bank’s institutional functions, a guarantee of its financial autonomy and, above all, consistency with Community law - an aspect to which the European Central Bank has drawn attention several times are the principles with which the central bank’s ownership structure and corporate governance must conform. In light of international standards and the experience of other countries, it may prove necessary to reflect on the choice made by the law and move towards a configuration of the Bank’s ownership that fully protects its independence, the guarantee of stability and a cornerstone of the European economic constitution. 4.2 Organizational developments A working document has been sent today to the trade unions present in the Bank of Italy on the overhaul of the Bank’s organization. The document identifies and details the medium-term strategic objectives for the performance of the Bank’s central banking functions, in harmony with the evolution of the Italian and European institutional framework. The measures outlined in the document aim to increase the Bank’s effectiveness and efficiency both at international level and in Italy, by concentrating its local structure in appropriately strengthened units at regional level. The new organizational structure - which also envisages the incorporation of the Italian Foreign Exchange Office (UIC) - must be able to respond to the challenges imposed by change and to offer staff greater participation in decision-making and operational processes and better opportunities of professional and cultural growth. The reorganization will call on the vast stock of professional skills available within the Bank. A path will be agreed with the trade unions that sets out the timetable and content of the changes and the manner of achieving the objectives of the reorganization. Clear objectives, gradual implementation and dialogue are what are needed for this to be completed in a reasonably short time and without trauma. The ability of the Bank of Italy to go on playing its role in Italy and the European System of Central Banks efficiently and authoritatively depends on the success of this project, which will require the joint efforts of all concerned. | bank of italy | 2,006 | 11 |
Lectio Magistralis by Mr Mario Draghi, Governor of the Bank of Italy, at the inauguration of the 100th academic year, University of Rome 'La Sapienza', Economic Faculty, Rome, 9 November 2006. | Mario Draghi: Education and economic growth Lectio Magistralis by Mr Mario Draghi, Governor of the Bank of Italy, at the inauguration of the 100th academic year, University of Rome “La Sapienza”, Economic Faculty, Rome, 9 November 2006. * 1. * * Education and development Italy set out on a path of rapid development after the Second World War and kept on it for more than a quarter-century. A substantial part of the country’s disadvantage with respect to those with higher levels of economic welfare was made good. Although it was marked by sometimes acute social tensions and distributive conflicts, growth benefited from several domestic and external factors that made for extremely large productivity gains. Increasing resources, which had been largely underutilized in the agricultural sector, were employed in the sectors with higher output per worker, completing the transition to an industrial economy. This unprecedented rapid and sustained growth was accompanied by a progressive rise in the educational level of the population that fitted nicely with the state of technological knowledge. Since the 1990s the inrush of the emerging economies on the international markets and the advent of the new information and communications technologies, biotechnologies and thin material technologies have radically altered the characteristics of global economic development. They have created new hierarchies, revolutionized production processes and, especially in the advanced countries, thoroughly modified the characteristics of the labour input demanded by firms. The ample strand of economic literature that investigates the connection between education and development has gained new vigour. Broadly speaking, the level of education carries decisive weight in explaining processes of economic growth from two fundamental angles. One concerns the improvement of knowledge applied to production: human capital formation fuels efficiency in production and drives up the remuneration of labour and the other factors of production. This engine of growth becomes still more important in phases characterized by rapid technical progress. In the 1960s Edmund Phelps observed that the acquisition of advanced knowledge was an essential condition for innovation and for adapting to new technologies. The endowment of human capital assumes a crucial value that transcends those who benefit from it in the first instance: it promotes the generation and diffusion of new ideas that impart impetus to technical progress; it improves earnings prospects and, closing the virtuous circle, increases the incentive for further investment in human capital. As a primary source of accumulation of this type of capital, the educational system produces major externalities that help raise the growth prospects of the entire economy. This is one of the most interesting insights of the “new” theories of endogenous growth. According to some estimates, the social returns to education are higher than the private returns; that is, they exceed the extra benefits enjoyed by the individual who has more and better education. But the externalities - and we come here to the second angle - are not limited to the sphere of production in the narrow sense; they also affect the social context and contribute to economic growth in this way as well. This aspect has been analyzed mainly in connection with the developing countries, but of course it applies to the advanced societies too. For some time economic thought - and not it alone - has underscored that the properties of efficiency of the markets in an economy cannot be considered ignoring “social capital”, defined as the body of institutions, social norms and trust and reciprocity in formal and informal networks of relations that foster collective action and are a resource for creating welfare. At aggregate level social capital, as distinct from human capital, with which it is nevertheless connected, is a factor of human, social and economic development. It is a system of shared values that guarantees the sense of responsibility for the commitments entered into by the parties in concluding a contract. These values constitute a trait of the national identity that is set in the long run through custom and principles handed down from generation to generation. The educational system can enrich this inheritance, enhancing opportunities and attenuating negative aspects. Social capital is an especially important factor for the development of the financial markets: the relationship of reciprocal trust between borrowers and creditors underpins the stability and correctness of business activity. The lack of it is, among other things, a barrier to the market entry of newly created firms. A high degree of schooling facilitates critical access to useful information for evaluating the advisability and risk of a financial contract; this results in lower costs for learning about and managing an investment and a greater incentive to participate in the financial markets. Education helps to relax the economic and cultural constraints that bind individuals to their environment of origin. It increases the probability that the most capable and deserving will rise to functions of command in the organization of productive factors. In this way too it exerts a positive influence on economic growth: good education boosts the efficiency of firms, creates the conditions for the competitive selection of the most innovative entrepreneurs - those most apt to drive economic growth - to unfold without being fettered by rights of caste and positions of rent. The thrust of these remarks on the link between education and development can also extend to demographic aspects. All else being equal, the diffusion of high levels of education is associated with better conditions of health and an increase in life expectancy, since it can lead to less risky behaviour and a greater ability to assimilate and act on information serving to prevent illness and gain access to available therapies. 2. Education and the Italian economy’s potential for growth Since the mid-1990s, the annual increase in labour productivity in Italy has been one percentage point less than the average for the OECD countries. This is the underlying cause of the present crisis affecting the country’s growth and competitiveness. The rapid rise in employment fostered in recent years by wage moderation, the regularization of many immigrant workers and labour market reforms has produced a natural, and expected, slowdown in the rate of productivity growth. On top of this, however, the overall efficiency of the economy has deteriorated, as evidenced by the recent decline in total factor productivity, the only instance in the industrialized world. The situation is rendered even more worrying by the demographic scenario for the next decades. According to current projections, and despite taking account of large migratory flows, the working-age population is set to decrease dramatically, and this will act as a further brake on the potential growth of the Italian economy. Only a substantial increase in labour market participation and a return to productivity growth can reverse these trends. Raising the population’s average level of education and improving its quality are prerequisites for the achievement of both objectives. Although significant progress has been made in the past decade, the labour market participation rate in Italy is still well below the European average, particularly among women, young people and the older age groups. A higher level of education tends to narrow these gaps. In the OECD countries, the average rate of employment for university-educated men aged 25 to 64 is 15 percentage points higher than that of their peers with only a lower-secondary-school qualification; for women, the difference is 30 points. The fact that people with higher levels of education are more likely to be in work reflects their increased propensity to participate in the labour market and, in the case of adults, the smaller risk of unemployment. The Bank of Italy’s Economic Research Department estimates that, all other things being equal, in Italy the probability of participating in the labour market increases by 2.4 percentage points with every year of school attendance. In the South, the figure rises to 3.2 points, reflecting a greater relative scarcity of skilled workers. All this highlights the important contribution towards overcoming the country’s geographical dualism that could be made by policies to raise educational levels in the South. A high level of education is also the best way to minimize the risks of fragmented career paths and of job loss, which have become more pressing than in the past with the spread of fixed-term employment contracts. The higher the professional qualification, the greater the incentive for firms to invest in stable and lasting employment and the greater the likelihood of workers finding another job quickly if the present one is unsatisfactory or threatened by adverse events. Higher levels of education bring gains in productivity. The relationship can be gauged roughly from the link between educational qualification and earnings, that is from the personal return on education. In the majority of OECD countries, people with a qualification equivalent to our specialist university degree earn at least 50 per cent more than workers with a secondary school diploma. The wage differentials between workers with a diploma and workers with only a lower secondary school certificate range from 15 to 30 per cent. In Italy individuals’ return on education is lower than the OECD average; nonetheless, the return on a given investment in education, even taking the associated costs fully into account, is much higher than for alternative investments. A poor level of education can affect the evolution of productivity through the inability to exploit the opportunities offered by rapid technical progress. It is only recently, and later in Italy than elsewhere, that the organization of production has begun to benefit from extensive use of information technology, for which better training is essential. Among the highly developed countries, Italy stands out for its anomalous and static model of specialization, in which the predominant industries are marked by a medium to low level of human-capital. It is a model that is consistent with a relatively small endowment of highly skilled manpower. In the new technological and competitive environment it drags our economy down, preventing it from penetrating today’s more dynamic innovative branches and exposing it to the fiercer competition from emerging countries. Another crucial condition for overcoming this static model is the presence of managerial skills capable of reshaping production processes, exploiting technologies, and reallocating resources. The widespread availability of these skills can be achieved through higher levels of education; inevitably this will be accompanied by greater contestability of firms’ ownership. 3. What kind of education? In the course of the twentieth century Italy’s schools and universities sustained the nation’s economic growth and civil progress. They became less elite and progressively opened themselves to the society at large. Giving an education to millions of previously excluded citizens reduced inequalities but at the same time made it more difficult to attain high standards of achievement. Over the decades, national school and university reform measures responded only partially to the emerging need to bring a growing student population up to higher levels of education, all the more essential today given the transformation of the labour market in the advanced countries. The education deficit remains worrisome, because of Italy’s lateness in commencing mass education and its more unfavourable demographic dynamics. Notwithstanding significant gains in young people’s level of educational attainment, in 2005 only 37.5 per cent of Italians aged 25 to 64 had upper secondary diplomas, nearly 8 percentage points below the OECD average. And the gap in the share of university graduates was wider still: scarcely 12 per cent in Italy, half the OECD average. Because of the faster aging of the Italian population, the share of young people is one of the lowest anywhere in the world. The consequence is that the gains made by the younger generations have only limited impact on the average level of educational attainment. Too many adolescents still abandon their studies, and those who stay in school have a harder time learning than their peers in the rest of Europe. In 2004 only 76 out of every 100 young people of graduation age got their upper secondary diplomas, one of the lowest percentages among the advanced countries. The OECD’s periodic surveys have found that at the end of compulsory schooling Italian youngsters rank near the bottom in mathematical achievement, having fallen about a year behind students elsewhere. Perhaps this should come as no surprise, considering the decline in the number of mathematics and physics students in universities. Nor do the results in other disciplines provide much consolation. The share of Italian students whose reading comprehension is inadequate is significantly higher than the European average. These unsatisfactory average results are compounded by significant regional disparities, to the disadvantage of students in the South of Italy, and by great variability from school to school. The dispersion of the achievement test results for 15-year-olds is among the highest in the OECD countries. Even in the context of an overwhelmingly public school system, the level of education and income of the student’s family remain decisive. If the quality of schools is differentiated and informational transparency is lacking, only “educated” parents will be able to guide their children to the best classes and the most capable teachers. Our problems do not stem from a shortage of public resources allocated to the school system. Indeed, Italy’s spending on primary and secondary education is higher per student than the OECD average, not because of higher teacher salaries but due to higher teacher/student ratios. Italy has 9.4 teachers for every 100 students in secondary schools and 9.2 in elementary schools, against OECD averages of 7.4 and 6.1 and European averages of 8.5 and 6.8. The higher ratio in Italy depends in part on social policy choices, such as the widespread use of tutors for special students and the local provision of educational services in small and geographically scattered communities. Even taking these factors into account, however, the disparity with the other countries remains substantial, reflecting among other things the fragmentation of the subjects studied, and the difference does not translate into better academic results. Organizational shortcomings and poor motivation of staff are significant factors. The magnitude of the effect that is produced on economic growth by an increase in the average educational level varies with the type of instruction that is promoted. The most effective are those that enhance the occupational mobility of workers and, above all, the spread of new ideas. In the United States the broader diffusion of basic knowledge has fit well with the acceleration in technical progress, helping to increase America’s lead in growth over the countries of continental Europe. Technical and vocational schools with highly specialized courses have long-established roots, notably in Germany, where they have sustained economic and social development since the turn of the twentieth century. They arose in an age in which the definition of skills was much more narrowly circumscribed and more stable than it is now, based as it was on relatively fixed working procedures and standards of knowledge. Today there is a widely perceived need for an extensive revision of the mission of these schools, because there is a greater need for knowledge that can adapt to technological contexts whose boundaries are a good deal less well defined and constantly shifting. Without denying the important role that technical and vocational schools still play in our economic system, schooling could be oriented more to the learning of general skills and aptitudes, which also encourage students to proceed to higher levels of education. This leads us to a brief discussion of universities. In Italy the proportion of people aged between 25 and 34 who have a university degree is still below the average for the main industrial countries, despite the significant increase in recent years following the university reform of 2002. The university drop-out rate is 60 per cent, nearly twice the average for the leading countries. The proportion of graduates who go on to earn a postgraduate qualification is very small, so that Italy is fourth from the bottom in the ranking of OECD countries. The bulk of the recent increase in the number of graduates has consisted of students doing a shorter course. In the last two years matriculants have converged above all on law and the political and social sciences. More generally, by international standards the study courses of Italian university students appear biased towards the humanities and social sciences and away from technical and scientific subjects. Part of the difference is due to the fact that, in contrast with Italy, shorter-course university degrees in other countries are mainly in technical subjects. But another part of the explanation is to be found in the high rents enjoyed by some professions, which distort families’ choices, and in firms’ insufficient demand for high technical and scientific qualifications. Fewer public resources are allocated to higher education in Italy than in many other advanced countries. This is the flip side of the larger volume of resources allocated to primary and secondary education. The basic political choice was to privilege early education to the detriment of investment in advanced knowledge. This is not a far-sighted choice in a world in which innovation is the key to growth. The public resources allocated to higher education in Italy appear even smaller when compared with those made available to Anglo-Saxon university systems, despite their having a great many private institutions. The manner of intervening is different, however: in the United States, for example, it is mainly in the form of direct financing of deserving students and their families through scholarships and personal loans; in Italy, as in the rest of continental Europe, the bulk of funds serve to finance the universities. 4. Looking ahead By now nobody in Italy should have any doubts about the urgent need to revive economic growth. The present lively cyclical upturn is certainly not sufficient to trigger a rapid solution to the structural defects of Italy’s productive system. For the reasons that I have tried to set out here, education is one of the most important aspects of a reform strategy aimed at altering the context in which that system operates. In a modern economy the public sector organizes and regulates the market, produces public goods and corrects externalities. In the case of education, these principles need to be applied taking account of the sector’s specific features and complexity. An effective education policy must reconcile excellence with a fair distribution of the opportunities to go on learning up to the desired level. These two objectives are not in conflict, provided the public sphere seeks to create equal opportunities and chooses operational options that allow the market to play a part in selecting excellence. Scholastic success depends significantly on the conditions of pupils’ families. From this point of view Italy appears to be socially almost immobile. The probability of earning a degree depends on the quality of the preceding education, but if this is sometimes inadequate, as in Italy today, the family’s socio-economic background plays a major role. Too little has changed in this respect since Don Milani raised the same question forty years ago, albeit in another context, in the light of his experience with the children of the school at Barbiana. Giving all young people the same opportunity to succeed in learning, provided they apply themselves, is the key to increasing efficiency and fairness in the field of education. Both these objectives can be pursued in a variety of complementary ways. In primary and secondary education it may be worth increasing the competition between schools, both public and private, through methods of financing that both reward the best schools and transfer resources directly to families in order to give them more choice. The information that guides families in their choice of schools appears insufficient. In addition to the prospect of obtaining a diploma that has the same value for everybody, they should be offered uniform assessment criteria that permit informed choices. It is necessary to eliminate the perverse incentive for families and schools to collude in lowering teaching standards, especially if financing continues to depend exclusively on the number of students enrolled. The first steps towards developing a comprehensive assessment system that have already been incorporated in Italian legislation deserve to be followed by others, not least so as to permit better informed guidance of public action to govern and reform the school system. Somewhat similar considerations apply to universities, essential institutions for an economy that wishes to retain its place among the advanced countries. In recent years important changes have been made to the Italian university system. For the first time an assessment has been made of the quality of research. Notwithstanding all the measurement problems involved, this could shortly be used to guide the public financing of individual universities. It is important that the work done should not turn into a missed opportunity. Transparency and public access to the assessment process help to improve the comparison between universities and permit better informed choices by students, especially those with less access to the channels providing a greater wealth of information. It is to be hoped that this will be the first of a series of measures to stimulate competition among universities, by increasing the incentives to raise standards in research and instruction and in the selection of university teachers. In schools and in higher education, more explicit recognition of merit avoids the mortification of the most talented, provided it is accompanied by measures to support deserving poor students. The recognition of merit is not a guarantee of equity but its absence undoubtedly means society is less fair because it accentuates the discrimination caused by differences in starting conditions; at the same time society is poorer because it wastes its resources. I am convinced we will succeed in renewing the unity of intent that alone can bring an advance in Italian education, the unity that has provided the foundation for the development of the educational system since the Second World War. | bank of italy | 2,006 | 12 |
Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the Annual Congress organised by AIAF ¿ ASSIOM ¿ ATIC FOREX, Turin, 3 February 2007. | Mario Draghi: Growth and stability of the economy and financial markets Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the Annual Congress organised by AIAF - ASSIOM - ATIC FOREX, Turin, 3 February 2007. * * * Growth and stability Against the background of an international expansion that remains strong, the euro area is growing at a rate almost double that of the last five years. In the eight years since the launch of the Economic and Monetary Union monetary policy has created conditions that are conducive to growth and investment. Real short-term interest rates have remained low in all the phases of the cycle, ranging from zero to 2.3 per cent. In the previous two decades they were close to 3 per cent in the countries with a history of monetary stability and to 4 per cent in Italy. Since the end of 2005 the monetary stimulus to the economy has been progressively reduced, with the gradual raising of interest rates. The European Central Bank has acted to tie expectations firmly to the objective of price stability. The credibility of monetary policy has countered the risks of an increase in inflation in connection with the reduction in idle capacity and, until last summer, the rise in the price of oil. In this stable environment, the euro-area economy has benefited from the structural measures taken so far. As we recalled at the last meeting of the ECB Governing Council, since the beginning of monetary union Europe’s economy has created 12 million jobs, helped by labour market reforms and wage moderation. These results clearly indicate the way forward; they call for further progress in eliminating the constraints that still hold down employment, slow growth and exclude too many people from the labour market. In the last ten years a large part of the developing world, which historically had been a debtor, has become a creditor. This shift was made possible by the opening up of international trade and has been accompanied by an extraordinary boom in financial innovation. The dismantling of barriers has also opened the way for investment in illiquid assets, which has risen to unprecedented levels; financial leverage is now used more than ever before. One has the impression that the signals coming from the market may occasionally have been distorted by these changes: the exceptionally low level of risk premiums does not fully reflect creditworthiness; real long-term interest rates also continue to be extremely low, both compared with long-term averages and in relation to the economies’ position in the cycle. Liquidity continues to be abundant, although the monetary policies of the leading countries have been less accommodating for some time. The world economy continues to grow at a rapid pace. It is unrealistic to expect that today’s orderly market conditions will last forever. This is why there has been a call from many quarters for closer international collaboration, not only in order to take steps towards gradually overcoming global imbalances, but above all to strengthen the world financial structure. We do not know where the next crisis will come from but we must do everything in our power to be ready for it. We also need to shun policies that could generate financial instability and cause growth to slow. In particular, we must resist protectionist pressures, such as the measures to obstruct international trade with the emerging Asian economies advocated on many sides. The Italian economy: an opportunity for restructuring and revival The Italian economy continues to benefit from the favourable European and world cycle, although it is growing at a slower pace than the average for Europe. It is estimated that in 2006 output expanded by slightly less than 2 per cent. The improvement in the economic situation compared with previous years is undeniable. But it is not sufficient: the growth achieved so far mainly thanks to the favourable performance of the European economies, and of Germany’s in particular, must be progressively replaced by domestic expansion. If this is to happen a process of strong and lasting growth in total factor productivity, which has stagnated since the middle of the 1990s, must be set in motion. The material and above all human resources, especially young people, that the country possesses in abundance must be brought into play. Positive signs are already visible, mainly among the firms most exposed to international competition, but it is still difficult to distinguish with certainty between the effect of structural changes and that of the factors usually observed during cyclical upturns. Many national labour contracts have now expired or will do so by the end of this year. Hopefully, action by the social partners will lead to an upturn in productivity and growth in employment. One of the first rounds of negotiations, which will evidently have implications for the rest, is for the renewal of the contract governing the public sector, where increases in per capita earnings in recent years have far outpaced those in the private sector without explicit or adequate consideration for the real performance of productivity. Personnel management in the public sector is subject to strict constraints, incentives are few and the independence and accountability of managers are often insufficient. Satisfactory systems of individual evaluation and differentiation need to be introduced. Action must be taken to continue and reinforce policies to promote competition in areas where it is still unsatisfactory. The Government is moving in this direction, as the measures recently adopted also testify. The objectives are commendable. The means must be given careful consideration: liberalizing signifies relying for consumer protection as much as possible on transparency and competition and the oversight of the competent authorities. The structural reform agenda is still a long one and I shall come back to it on another occasion. Let me just say here that it is easier to implement reforms when the economic situation is favourable; the present offers an opportunity that must not be missed. The recovery also creates favourable conditions for continued action to consolidate the public finances. In 2006 these benefited from higher-than-expected revenue, partly due to the good performance of the economy. The temptation to squander this fiscal windfall must be resisted. The public debt, the cumulative result of improvident decisions over a long stretch of time, remains extremely large – the largest in Europe in relation to gross domestic product. The low interest rates obtaining since the introduction of the euro have diminished the public’s perception of the burden this represents for us and for future generations. The size of the debt makes any increase in the return on government securities very costly for the public finances; it is also an obstacle to public investment and the restructuring of public spending; and it hamstrings fiscal policy. If the debt can be cut over the next decade, which will remain fairly favourable in demographic terms, the costs of an ageing population could be tackled more gradually and distributed more equitably. The public debt can be reduced significantly within a short space of time. We must aim to achieve a structurally balanced budget. At the end of the 1990s the public debt represented the same proportion of GDP in Italy and in Belgium, 114 per cent. In Belgium, a virtually balanced budget and greater growth than in Italy by some 6 percentage points over the period allowed the debt ratio to be reduced to less than 90 per cent in 2006. In Italy it currently stands at 107 per cent. This year interest payments in Belgium will be about 1 percentage point of GDP less than in Italy. For the ratio of debt to GDP to be reduced on a lasting basis two conditions must be met: economic growth and the curtailment of expenditure. The level of taxation in Italy is high, imposing a penalty on the firms and households that pay their taxes in full. In the future it needs to be attenuated. The fruits of the fight against tax evasion must be used to lower tax rates. It is estimated that general government revenue increased by about one percentage point of GDP in 2006 and it is forecast to rise further in 2007. Permanent adjustment of the public finances requires structural measures that will hold the rate of increase in outlays in the main areas of expenditure below the potential growth rate of the economy. In 2005 the ratio of primary current expenditure to GDP was the highest since the Second World War, and the figures now available indicate that it remained near that level in 2006. In the field of pensions, it is necessary to ensure, at the same time, tolerable contributions, the financial equilibrium of the system, and the payment of adequate benefits. Italy’s employment rate among persons aged 55 to 64 is scarcely 31 per cent, which is more than ten percentage points lower than the European Union average and nearly twenty points short of the target for 2010 set by the European Council in Lisbon in 2000 with Italy’s accord. What is needed is a collective coming to grips with the situation, similar to the effort that – in the mid-1980s and then with the concertation agreements of 1992-93 – enabled Italy to break the rigid wage-price spiral with hard but farsighted decisions on wage indexation. The transformation of the financial markets A year ago on this occasion I recalled the necessity of pursuing the integration of the European markets and lowering transaction costs. Since then a number of far-reaching transformations have begun in the configuration of Europe’s financial markets. The merger between a leading European and a leading American stock exchange will give rise to a circuit offering competitive liquidity and cost conditions to issuers and investors. The implementation of the Markets In Financial Instruments Directive will heighten competition between regulated markets and the trading platforms operated by major financial institutions or consortia of intermediaries. The greatest impact will be felt in countries, Italy among them, that had previously required all equity trades to be carried out on the official stock exchange. Some significant initiatives are now materializing. A group of international banks have an agreement to construct a platform for trading in equities and a common system for gathering and sharing the equities trading data. The cost of cross-border transactions in Europe is still too high. The initiatives for cooperation undertaken by the main settlement providers have not yet produced satisfactory results, and the Eurosystem central banks are weighing the possibility of directly managing the final phase in the settlement process, in order to lower costs and facilitate the settlement of transactions. The European Commission has recommended a code of conduct for market operators, securities depositories and central counterparties to eliminate barriers to access to the various services, enhance transparency on costs and income, and achieve interoperability. Together, these developments will result in a rapid and significant heightening of competition and concentration at European and world level. The challenge has been issued. Italian banks and the stock exchange must take note and prepare to meet it. The banks will have to make choices, and promptly. The main initiatives already taken in Europe range from stepping up the internal provision of trading services to forming consortia. In Italy the major banks, if they do not consider they have the size and range of business to follow either of these courses, must capitalize on their position as shareholders of the organized markets. Thanks to low prices and the quality of its services, Borsa Italiana has a powerful competitive tool at its command. In addition, it can still benefit from the informational edge deriving from the customary practice, common to all financial marketplaces, of channelling trading in securities, especially in equities, to domestic exchanges. Nevertheless, the spur of growing competition will inevitably make itself felt. In the long run, the significant network externalities and economies of scale that characterize financial markets and the natural gravitation of liquidity to deeper markets threaten to squeeze out exchanges that remain isolated. This is what happened to Italy’s regional bourses. Looking to the future, a failure to exploit scale economies could even undermine the competitiveness of Borsa Italiana’s prices. In the choices it makes, the exchange must succeed in combining the advantage deriving from its roots in the national economy with the benefits of integration. Its shareholders will have a unique opportunity: to make the most of their investment while simultaneously contributing to the development of Italy’s corporate sector. The transposition of the European directive on takeover bids into Italian law is now imminent. The fruit of an unhappy compromise, the directive lays down only minimum harmonization and leaves considerable scope for national law to limit the contestability of control of listed companies. This approach threatens to undo past progress in the protection of minority shareholder rights in countries, such as Italy, where these safeguards are strongest. Transposition must not provide the occasion for overturning the principles established in this respect by the Consolidated Law on Finance. The mandatory nature of the passivity rule has to be confirmed and there must be strict and extremely limited conditions for invoking the reciprocity clause. Finally, considering the importance of shareholder agreements in the control of Italian corporations, the law transposing the directive should confirm shareholders’ right to withdraw from such pacts in the case of a takeover bid. In other countries pension funds, along with other institutional investors, help to ensure the efficiency and the liquidity of the financial markets. They stimulate innovation and competition between intermediaries, they increase the resources available to firms in the form of equity and bond issues, and they exercise continuous monitoring of the strategy of listed companies, to the benefit of the transparency and quality of corporate governance. The relative underdevelopment of pension funds in Italy is an impediment to the growth of the financial system and to the restructuring of the productive economy. Bringing forward the entry into force of the new retirement system rules to this year has been a step in the right direction. Enrolment in supplementary pension plans is low especially among the groups whose public pensions are likely to be smallest – self-employed workers, young people and women, all penalized by the greater variability and discontinuity of their earnings. These workers must be offered pension plans that afford ample freedom in determining contribution flows and facilitate totalization and the portability of contributions, including those paid in different phases of one’s career, from one form of retirement saving to another. The possibility of enjoying the advantages of supplementary pension plans should be extended to public employees. The investment of severance pay in supplementary pension plans can bring substantial benefits for workers. Accumulation over a considerable time horizon is necessary in order to reach pensions of adequate size. On the financial markets investment strategies can be used to obtain, with limited risks, real rates of return in line with or higher than those delivered by the revaluation of severance pay funds. Over long time horizons higher rates of return can be achieved through investment in equities, though at the cost of additional risk. According to recent surveys, workers continue to overestimate the amount of their future pensions by a large measure and are still poorly informed about supplementary pension schemes. It is their right to get clear, regular and complete reports on their accumulated position in their compulsory pension system; the experience of other countries, especially Sweden, is enlightening in this regard. It is necessary to increase workers’ knowledge of supplementary pension schemes; to highlight the flexibility they are given in using the different forms of saving, particularly as regards the right to transfer their accumulated position between schemes and to obtain advances in case of exceptional needs, such as the loss of their job, the purchase of a house or serious illness. The Finance Law included a specific appropriation for information campaigns that will give workers the facts they need to make an informed decision on enrolment in supplementary pension plans. The banking system: efficiency, competition, fairness The number of banks operating in the euro area fell by more than 900 between 2001 and 2005. In the euro-area countries, the average share of total assets held by the top five banks rose by 4 percentage points to 43 per cent. In the same period the degree of concentration of the Italian banking system diminished slightly. Using data referring not to the top five banks but to all the domestic banks in the five largest groups – figures that give a more accurate picture of the Italian banking system – the share declined from 46 to 44 per cent between 2001 of 2005; it rose to 48 per cent last year. Although substantial, the latest consolidation left the overall degree of concentration little changed, owing to the fragmentation that still marks the second tier of banks. Italian banks were at the centre of major crossborder transactions. They are stronger today in Italy and abroad but there is still room for mergers and acquisitions able to create synergies, with benefits for shareholders and customers. The restructuring has been driven by market forces. The Bank of Italy does not promote or guide mergers and acquisitions, neither does it impede them; it does, within the scope of its powers, evaluate the market’s choices, with a view to ensuring conditions of stability serving to protect savers and guarantee the orderly functioning of the financial system. It does not create unjustified barriers to entry for new bank operators. The consolidation of the banking industry can and must produce greater efficiency among intermediaries, not less competition; it must lead to lower prices and better service quality. The groups created by mergers and acquisitions must demonstrate that they are able to reduce the costs for customers significantly and swiftly by accelerating the integration of previously separate organizations. An effective governance structure is one of the necessary conditions for banks to achieve efficiency gains. A rational use of the diversified system of administration and control recently introduced into Italian law can contribute to this. In the two-tier system, the supervisory board, clearly separated from the management board, which is responsible for operating decisions, is interposed between shareholders and managers and performs some of the oversight functions that in the one-tier system are left to the shareholders. Where ownership structures are particularly complicated, the two-tier system can permit more effective control of management’s performance. In the case of recent bank mergers, the initiators have seen the two-tier system as a means of capitalizing on the traditions and experience of the pre-existing institutions. Against this, however, there is the risk of an unclear division of roles and responsibilities, detrimental to efficiency and speed in decision-making. The pros and cons of the choices made will have to be weighed in the light of developments. The two-tier system has facilitated the mergers; it may prove not to be functional in the future, in which case it will be necessary to obviate the shortcomings in a pragmatic spirit. The time has come to revise the governance of cooperative banks, especially the largest, in order to adapt it to the changed competitive conditions. Their contribution to this revision is important. Without prejudice to the core principles of cooperation, it is desirable that Parliament act to increase the room available for outside investors to participate in their capital and decision-making. This must happen in a transparent and open manner; under the legislation now in force, the Bank of Italy can only demand compliance with the letter and the spirit of the existing rules. Protection of the users of banking services is a reference point for the Bank of Italy. A correct relationship between intermediaries and customers is important to banks’ stability itself. Industrial and financial crises, including recent episodes, have exposed banks and the entire financial system to serious legal and reputational risks. Regulatory action to protect customers must be effective and measured. Competition between intermediaries in serving customers must remain the linchpin of regulations governing bank-customer relations. All measures that enhance the transparency of price structures are appropriate. The spontaneous initiative of the banks themselves is the best defence against intrusive regulation, which could rigidify the market and thwart the intended objective of safeguarding the weaker party. Hopefully, legislative proposals for the protection of bank customers with regard to overdraft fees will increase the transparency of banking terms and conditions without turning into a detailed prescription of contractual clauses. In my Concluding Remarks last year I stressed the need to eliminate the costs associated with the closing of current accounts. The statutory provisions recently passed have proved difficult to apply, which may give rise to litigation; the expected benefits risk being annulled. In order to foster the mobility of bank customers and increase competition, the abolition of these costs must be accompanied by simplification of the bureaucratic formalities and the automatic transfer of accountrelated services within a short and definite time limit. This is the message of the European Commission’s recent report on competition in the banking sector. According to the report, the annual management fees for a bank current account in Italy amount to €90, compared with a European average of €14. An earlier survey by the Bank of Italy on a sample of accounts at banks subject to inspection indicated a figure of €163. Naturally, difference between the estimates also reflects the number, type and frequency of use of the services considered. The Markets in Financial Instruments Directive, which I mentioned earlier in connection with its influence on the structure of financial markets, will also inevitably have a significant effect on the relations between banks and customers. A new and clearer definition of the information and conduct requirements applying to banks will increase the transparency of their relations with customers and make the latter’s choices better informed. The new rules, especially those concerning conflicts of interest and inducements, will have a major impact on banks’ operations and organization. Effective protection of customers also requires rapid and economical ways to enforce rights. The law on the protection of savings requires banks to adhere to mechanisms for the out-of-court settlement of disputes. The rules governing the procedures and the composition of the decision-making body will build on the experience gained with the banking ombudsman; they will adopt an approach based on self-regulation by intermediaries and careful consideration of customers’ claims and interests. No formal guarantee can be effective if the persons concerned do not have appropriate instruments for making evaluations. If savers are to be able to find their way among so many different and complex financial products, they will need to have an adequate and up-to-date financial culture. The initiatives undertaken in this field are only a start. The Bank of Italy stands ready to contribute. In my speech to you last year I drew attention to the need to ensure that asset management companies were independent of the banking and insurance groups that control them and distribute their products. This can be achieved by strict corporate governance rules and, if these are insufficient, by measures regarding ownership structures. The present integration between production and distribution of financial products reduces the scope for exploiting the economies of scale present in asset management, attenuates the pressure of competition, increases the risk of conflicts of interest, and ultimately limits the growth of the sector and the protection of investors. Intermediaries, and especially banks, must make asset management companies independent and permit competition in the distribution of products, so as to reduce the costs borne by investors. As in other fields, market initiatives are to be preferred to legislative measures; in their absence legislation or regulation will be inevitable. The competitiveness of Italian funds also requires a review of their tax treatment. It is important that the current revision of the mechanism for taxing financial income take account of the need for a reasonable degree of uniformity across countries as regards how and when taxes are levied and their level. There is room for increased competition and efficiency in the field of payment services as well. Technology now makes it possible to open the market to new participants, such as mobile phone operators and providers of other services. Within the sphere of its regulatory responsibilities the Bank of Italy will introduce the measures needed to permit such developments, while simultaneously ensuring the security of transactions. At European level the creation of a single payments area will require legislative harmonization. The proposals under discussion envisage a new category of specialized European intermediaries that will be able to combine payment transactions with other commercial activities; supervision will be based on the principle of proportionality and prudential requirements related to the risks. This is a development to be encouraged. The integration of markets and the growing role of transnational intermediaries require the harmonization at European level of the rules governing supervision and a strengthening of cooperation among national authorities. This year will see another review of the Lamfalussy process, including its extension to banking and insurance. Convergence of supervisory practices is essential for the efficiency of the European capital market. There are still important differences, such as those in the treatment of hybrid instruments in computing regulatory capital, that must be analyzed and removed. The Bank of Italy will liberalize and simplify the procedures for opening new branches, thereby increasing banks’ independence in shaping their distribution strategies. What is required of the supervisory authority is not so much rigid regulation as the ability to intervene promptly to facilitate and orientate solutions found independently by the market. In applying the highest standards of risk management, the activity of the Bank of Italy and that of banks pursue largely similar objectives. Prudential rules reinforce, do not replace, the practices of sound bank management. Sometimes situations arise in which individual intermediaries perceive the need for corrective action but are reluctant to act independently, because none of them, for fear of suffering a competitive disadvantage, has an incentive to move first. In such cases the initiative of the market is insufficient; the authorities must intervene. Here again, rather than introducing legislative measures it is often preferable to persuade intermediaries to cooperate in the search for solutions. There have recently been some encouraging instances of this internationally. In the derivatives market the problem of order confirmation backlogs has been tackled on the basis of a solution promoted by the financial industry rather than imposed by regulators. But without the latter’s intervention the problem would have remained unsolved, entailing a significant risk for financial stability worldwide. There may be other circumstances in which closer cooperation between regulators and regulated entities is likely to contribute to strengthening the financial system. Innovation has increased the efficiency of risk management enormously. But risk itself has not actually diminished. The growth of the financial services industry allows investors and intermediaries, encouraged by the new forms of diversification, to take on greater and more complex risks than in the past, sometimes without being fully aware of what they are. Often these risks migrate from the balance sheets of banks to other parts of the financial system. This brings new challenges for the supervisory authority responsible for stability and especially for ensuring that the regulatory framework and intermediaries’ management of their operational risks are adequate. Quite often the market is well ahead of regulators in perceiving the existence of problems in collective action, risk management and infrastructure shortcomings. It is essential that intermediaries promptly inform the Bank of Italy. In this way the smooth functioning of markets, the stability of the financial system and the protection of their customers will be maintained. With the meeting of 24 January with some large banking groups we gave new force to a practice of consultation whose primary aim must be to foster such cooperation between the supervisory authority and banks. The principle upon which our action is based is that of a modern and agile supervisory authority ready to listen to the suggestions of the private sector with a view to improving regulation and making it more effective, but at the same time inflexible in working to ensure intermediaries’ competence, fairness and solidity. | bank of italy | 2,007 | 2 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Centro di Economia monetaria e finanziaria "Paolo Baffi", Università Commerciale Luigi Bocconi, Milan, 15 March 2007. | Mario Draghi: Reflections on monetary and financial policy – Governor Baffi’s monetary policy Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Centro di Economia monetaria e finanziaria “Paolo Baffi”, Università Commerciale Luigi Bocconi, Milan, 15 March 2007. * * * The “Paolo Baffi” Centre for Monetary and Financial Economics has invited me to give this talk to revive the custom of the “Reflections on Monetary and Financial Policy” that had been interrupted for a decade. I thought it would be appropriate to start off the new series by exploring the personality and monetary policy of Paolo Baffi, to whom the centre is dedicated. Baffi was Governor of the Bank of Italy during five of the most difficult years this country has known. It is not easy to discuss the problems that beset monetary policy in those years or the decisions that were taken using today’s language. Since then, the conditions of Italy’s economy and politics have changed radically, as have the prevailing opinions on the link between money and economy, the role of the central bank, and its objectives. The lexicon of monetary economics has mutated. The years in which Paolo Baffi was at the helm of the Bank of Italy, a period of exceptional economic and political difficulties, marked the start of the transition towards our present manner of interpreting and conducting monetary policy. Reviewing those years can help us recall the importance of institutional conquests that we now take for granted. Intellectual roots and institutional framework Paolo Baffi was one of the first professional economists to be taken on by the Bank of Italy; it was 1936. He took over the leadership of the Bank in August 1975, just a few days after Guido Carli’s resignation, and was the first Governor to have made his career within the Bank. Many of his writings bear witness to the intellectual evolution and choices of an economist whose outlook embraced equally theoretical interests and policy concerns. In 1935, after Italy invaded Ethiopia, Baffi’s mentor, Giorgio Mortara, carried on a campaign against the international sanctions imposed against Italy from his Giornale degli Economisti. Baffi, twenty-four at the time, came out in favour of international economic cooperation, anxious about the nationalistic illusions entertained by his professor, who retorted with accusations of “internationalistic illusions”. The young man had obviously seen further ahead than the older one, who was soon to suffer the effects of nationalism transformed into anti-Semitism. What interests us here, however, is the fact that Baffi attributed his sound judgement at the time to a “diet of classical texts of economic liberalism”. 1 This left an enduring mark on his training as an economist that was reflected in his subsequent theoretical output, less so in his policies, which were influenced by the formidable constraints existing during his time as Governor. Economic liberalism, according to Luigi Einaudi, was not so much an economic doctrine as a way of reasoning, which takes an apparently simple rule and, through systematic use of theory, derives indirect and distant effects that are often the opposite of their proponents’ intentions. Undoubtedly, one of the main characteristics of Baffi’s thinking was his focus on indirect effects, on the links between the various elements of the economic system. His concern to make plain the relation between real and financial phenomena was at the root of the “national monetary balance sheet” developed in the aftermath of the War, the embryo of today’s financial accounts. In 1953 Baffi was a member of the committee appointed to pronounce on the reform of IRI’s bylaws and its future role. While the majority of the committee favoured the creation of a Ministry for State Holding Companies and an increased role for IRI in promoting economic growth, Baffi and a few others held that the solution lay above all in sound regulation of the market. 2 P. Baffi, “Giorgio Mortara e la Banca d’Italia”, in id., Nuovi studi sulla moneta (Milan: Giuffrè, 1973). Ministero dell’Industria e del Commercio, L’Istituto per la ricostruzione industriale (Turin: Utet, 1955), Vol. II, pp. 575-85. The 1960s and 1970s were, by admission of Baffi’s predecessor, Governor Carli, the period when political power was most closely interwoven with monetary, financial and supervisory policy; it was also the most dangerous time for the repercussions on the performance of the economy, both then and later. 3 In the first half of the 1970s, and particularly between 1973 and 1976, a dense web of constraints and rules developed regarding banks’ portfolios, subsidized credit, interest rates, and capital movements. Baffi never came out openly against this, but his scepticism, rooted in his reading of classical texts on economic liberalism, was no secret to anyone inside the Bank of Italy. To understand the central bank’s modus operandi in those years we must consider the powerful influence exerted by the predominant economic culture. It was not a market culture. Its influence, combined with vested interests, often directed economic policy towards solutions that did not follow the market. In Italy, Keynesianism only acquired a foothold in academia towards the middle of the 1960s and the version that gained credence among policy-makers had a distinctly more dirigiste flavour than that prevailing internationally: not only did economic policies to support demand earn plaudits from politicians and economists, but more generally, above and beyond the actual Keynesian propositions, they saw broad government intervention in economic activity, especially investment, as the means of perpetuating the growth of the 1950s. Development, industrialization and social and distributive conflict were the issues that attracted the best minds and the vision of political leaders. What was asked of monetary policy was to produce growth, capital formation, the narrowing of the gap between Italy and its European partners, and balance-of-payments equilibrium. Price stability was a secondary concern. The autonomy of the central bank was not viewed as essential to stability. In Italy, interest focused on the real economy; the role of money, the causes and effects of inflation were not common subjects of inquiry. Baffi’s studies on money thus constitute a notable exception. The discussions that Franco Modigliani had in 1967 with the top management of the Bank of Italy during the development of the econometric model exemplify the difficulty of describing the problems of monetary policy at that time using today’s language and criteria. In those meetings Governor Carli defined the Bank’s main objective as that of fostering a sufficient level of income to allow investment that would close the distance between Italy and the other members of the European Economic Community. 4 The Governor mentioned price stability only as a subordinate aim, and it was interpreted, moreover, solely as alignment with the level of international prices, that is to say an objective for the defence of competitiveness. The pre-eminence of the objective of price stability did not have formal sanction; it was not shared by public opinion, nor was it comprehended in academic and political circles. Monetary management was increasingly entrusted to administrative controls on credit, namely the ceiling on the growth in bank lending (introduced in 1973) and the requirement that banks invest a part of their portfolios in long-term fixed-income securities. Initially designed for allocative purposes and to support private investment, these instruments were almost immediately employed for macroeconomic purposes and to facilitate the financing of the Treasury. Effective in rapidly curbing aggregate demand, they continued to be used until the end of the 1980s in spite of their allocative cost and the fact that they soon came to be circumvented. Treasury bills were the main instrument for financing the Treasury. At the auctions it was customary for the Bank of Italy to submit a bid guaranteeing that all the securities on offer would be taken up at the floor price. Since this was often set above the levels at which the market would have subscribed the whole quantity issued, this obliged the Bank to make systematic interventions and prevented control of liquidity creation. The interbank market was anaemic and inefficient. Heads of Government and Treasury ministers listened to the Bank of Italy, but the Bank had very limited independence in using the instruments of monetary policy. The discount rate was fixed by the Treasury, albeit on the basis of a proposal from the Governor, and nearly every act of the Bank was formally subject to the Government’s oversight. The prerequisites for autonomy of the central bank comparable to that enjoyed by today’s European System of Central Banks were lacking. G. Carli, Intervista sul capitalismo italiano, edited by E. Scalari (Bari: Laterza, 1977), p. 42. G.M. Rey and P. Peluffo, Dialogo tra un professore e la Banca d’Italia, Vallecchi, Florence, 1995, p. 54. The transition towards a “monetary constitution” In the summer of 1975, when Baffi succeeded Carli, the Italian economy had fallen into the deepest recession since the war, triggered by the oil shock and by the credit tightening that had been agreed with the International Monetary Fund in order to counter the imbalance in the external accounts, the upsurge of inflation and the depreciation of the lira. The shock hit Italy at the height of an expansionary cycle, at a time of extreme weakness of economic policy management. Wages, rising at annual rates of more than 20 per cent, had lost any link with productivity. The devaluation-inflation spiral seemed untamable, not least because of the perverse system of indexation. The Treasury’s deficits, pushed up by increases in public spending that were out of control, had exceeded values compatible with non-inflationary financing. The central bank, unheeded, watched from the sidelines. In the international arena, the prevailing view of the role of monetary policy was changing. The Bundesbank had been announcing money supply targets since 1974, and the Federal Reserve, under Paul Volcker, would adopt quantitative monetary targets in 1979. In the Concluding Remarks that he read on 31 May 1976, Baffi, recalling similar opinions of Einaudi and Carli at dramatic moments, observed that the severe limitations imposed by the institutional framework did not allow the Bank of Italy freedom of action. In times of financial imbalance and wage inflation, he stressed, “control of the money supply has to be abandoned in order to avoid, or at least postpone, worse evils”. However, Baffi did not give up pursuing the fundamental goal: moving Italy towards institutional arrangements in the field of monetary policy that would guarantee monetary stability over the longer run. This process would not actually get under way until the start of the 1980s, with the “divorce” between the Bank of Italy and the Treasury promoted by Treasury Minister Beniamino Andreatta and Governor Carlo Azeglio Ciampi. During the era in which he was governor, Baffi launched a “campaign of persuasion” directed at public opinion and the political forces. It was his conviction that monetary policy, in order to be successful, had to be backed by the consensus of all society on the objectives, including price stability. Italy was still far from such a situation. In Baffi’s view, what prevailed in determining the decisions regarding the public finances and wage trends was an alliance between different political and social groups that fuelled inflation. In the Governor’s view the first requirement for a reform of the monetary constitution was that the principle of safeguarding monetary stability become the linchpin of monetary policy. However, he considered that an insurmountable obstacle to this was the absence within the Italian legal framework of a provision, such as that in Germany, expressly entrusting the central bank with the task of defending the currency. A systematic search was made for arguments in support of assigning the Bank autonomous responsibility for fixing and pursuing monetary base objectives: during internal meetings the possibility was repeatedly raised of calling on the Government to enter into commitments to this effect or of using suggestions of similar import put forward by international institutions such as the European Economic Community or the International Monetary Fund. As one of Baffi’s leading collaborators has recalled, he invited the Bank’s legal experts to delve into every legal nook and cranny in search of the desired precept. 5 The absence of a well-defined institutional framework made it necessary to adopt complicated logical exercises to argue in favour of the defence of the currency: for Baffi the principle of “no taxation without representation”, violated by inflation insofar as it causes arbitrary redistribution, was the one to call upon to give the central bank the task of defending the currency. In this “campaign of persuasion” Baffi frequently discussed monetary policy choices in the press. He believed that announcing monetary objectives was a factor of transparency that would have durably altered central banks’ modus operandi. As he was to say later, “the actions of central banks are no longer cloaked in silence, and perhaps never will be again. Whereas in the past silence was seen as a guarantee of independence, today this is achieved by giving an explicit account of one’s actions”. 6 M. Sarcinelli, “Governor Baffi’s monetary policy”, Banca Nazionale del Lavoro, Quarterly Review, no. 179, December 1991, pp. 513-35. Banca d’Italia, Annual Report for 1978, p.158. Baffi was strongly opposed to the tangle of credit and foreign exchange administrative controls through which monetary policy was conducted. He found it profoundly unsatisfactory “in having to direct central bank action in such a way that it suffocates a system that possesses its own valid parameters and mechanisms; in having to constrain the volume of credit potentially expressed by the flow of monetary base because it is not possible to regulate that flow; in having to channel the flow of credit”. He was convinced that the costs of the distortions produced by administrative controls were substantial and lasting and that the monetary effects were ephemeral: in the long run the aggregates are brought “back into line with basic economic conditions”. Monetary management and the EMS negotiations Baffi did not win the battle against the straitjacket that had been imposed on the market. The emergencies he had to tackle, the exceptionally difficult situation he faced with regard to taxes and wages forced him to continue to use the administrative constraints put in place by his predecessor in earlier years. Monetary policy itself was constrained by the fact that price stability was not explicitly targeted and by his belief that there was no consensus on this in Italy. He was convinced that a monetary rule, however necessary and well formulated, could not replace discipline in the decisions and conduct of society as a whole and that it had to follow, and not precede, the adoption of such discipline. According to the expression used in the Concluding Remarks of the Annual Report for 1975, monetary management in those years was “coming to resemble an economy under siege”. At the beginning of 1976, after political, business, trade union and academic pressure had led to an easing of liquidity conditions, the low level of the official reserves and the opening of a Government crisis triggered a violent attack against the lira, the presages of which had been underestimated up to the end of the previous year, and led to the closing of the foreign exchange market for forty days. The turbulence on foreign exchange markets continued during the year with ups and downs and a succession of restrictive measures that included exchange and credit controls, the reintroduction of the ceiling on loans, an increase in compulsory reserves and rises in the discount rate for a total of nine points. These steps were effective in bringing the external balance back into equilibrium, replenishing the official reserves and repaying foreign loans. The exchange rate fell by about one third; inflation rose to 23 per cent and then slowed to about 12 per cent. Recourse to administrative credit and foreign exchange measures was not avoided. Contemporary documents confirm that Baffi was against using administrative controls but also show that he was convinced their use could not be ruled out given the influence exerted by the state of the market. Late in 1978, the dramatic year that saw the kidnapping and assassination of Aldo Moro and the killing of his escort, negotiations began for Italy’s membership of the European exchange rate mechanism. Not a few considered acceptance of the external constraint as providing powerful support in curbing the factors − rents, wages and public expenditure − that prevented Italy from definitively overcoming an emergency that had lasted too long not to threaten the stability of the country’s institutions. Baffi’s position was cautious: he recognized that belonging to the European Monetary System could help to bring down inflation, but he believed that this should be the result of agreement on domestic policies and that a start should be made before entering into the exchange rate commitment. During the negotiations Baffi advocated a system with a broad fluctuation band of 6 or 8 per cent about the central parity for all the participant countries. This idea was not disagreeable to the Bundesbank, which feared an inflexible exchange rate with partners marked by high inflation and low credibility. Baffi was well aware of the risks of a constraint associated with an exchange rate parity unrelated to the performance of the fundamentals of the economy. He feared that the results Italy had achieved in the three previous years in terms of replenishing the reserves and adjusting the current account of the balance of payments might be jeopardized by participation in a mechanism that would force the lira to appreciate in real terms, to the detriment of exports. Italy did join the EMS, but with a broader fluctuation band than that applying to the rest of the System members. The exchange rate constraint helped to damp down inflation in the first half of the 1980s. Its symbolic value was perceived by the political and social forces as a prerequisite to Italian participation in European integration, and the Bank of Italy was able to implement counter-inflationary monetary policy. Baffi’s caution with regard to the cogency of the exchange rate constraint may have proved excessive, perhaps, but only because System realignments were much more frequent than could have been predicted when the Exchange Rate Mechanism was agreed. At the same time, the availability of the broad fluctuation band, which he had argued for, allowed a degree of freedom for monetary policy and thus limited the risk of the speculative attacks that typify fixed exchange rate regimes. In Baffi’s own words, the mechanism permitted “a soft transition, without the jumps, the discontinuities in market rates that trigger destabilizing speculation and often enable it to reap enormous profits”. 7 The legacy of Paolo Baffi This is not the proper place to recount the well-known judicial affairs that forced Paolo Baffi to resign as Governor on 20 September 1979, only to be totally exonerated from the charges two years later. As he later said, his incrimination obliged him to contend “for two years and more not with bad money but with a justice system that was even worse”. Quite apart from the machinations behind the scenes in his indictment, which had major repercussions on the Bank of Italy, it must be admitted that the institutional architecture of the day – the Director General’s responsibilities included banking supervision but he was also a member of the Board of Directors of IMI – was a weakness, which was later rectified. If the results achieved in the battle against inflation were only partial during Baffi’s governorship, the successes that came in the course of the 1980s and 1990s can be traced to the seeds he had sown with his commitment to a new monetary constitution. During his Governorship the question of separating the responsibilities of government and central bank was posed. The process subsequently set in motion produced first the abandonment and then the prohibition of monetary financing of the Treasury, the assignment to the Bank of Italy of the power to set the discount rate, formal recognition of its independence and, finally, its formal mandate, within the framework of the European System of Central Banks, to work for the objective of price stability. The full achievement of independence nevertheless took another fifteen years, major legislative reform and, lastly, an international treaty. In the 1980s and early 1990s, in a course of reform that was initiated and spurred in part by the Bank of Italy, broader and more efficient money and government securities markets were created. The effectiveness of indirect instruments of monetary control increased. Paolo Baffi as Governor is perhaps best symbolically portrayed as a ferryman of ideas, with all the exertion that such an image implies. His intellectual heritage was liberal, embracing more leavenings of modernity than were to be found in the political and economic culture of the day. But action was fettered by the harshness of the times. These were years, let us not forget, of bitter social conflict, years of terrorism. Paolo Baffi’s awareness of the drama of social problems was painfully acute, as is well known by those who were close to him in those years and could see the signs that a man of his temperament allowed to emerge. Subsequent developments in Italy and in Europe and the consequent advances in economic theory have confirmed that the effectiveness of monetary policy depends above all on appropriate institutional arrangements and on the ability to affect the expectations and the behaviour of the public; and that appropriate institutional arrangements, in turn, are not unrelated to political and social consensus. Institutions comprise the set of written and unwritten rules that guide the conduct of the central bank, formal recognition of its objectives and independence, and suitably designed instruments, ensuring effectiveness of action without interfering in the operation of a market economy. To us Paolo Baffi, who was the very antithesis of the politician, has bequeathed the conviction that the strength of economic policy springs from rigorous conduct and from the consensus it enjoys in the society within which it works its effects. P. Baffi, “Due momenti del negoziato sullo SME: la banda larga e l’adesione del Regno Unito” in Il sistema monetario europeo a dieci anni dal suo atto costitutivo: risultati e prospettive,Atti del convegno promosso dal Ministero degli Affari esteri e dall’IMI (Proceedings of a conference organized by the Italian Ministry of Foreign Affairs and IMI), Rome, December 1988. | bank of italy | 2,007 | 3 |
Remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the Colloquium in honour of Giorgio Gagliani, University of Calabria, Rende, 26 March 2007. | Mario Draghi: Employment and development – the legacy of Giorgio Gagliani Remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the Colloquium in honour of Giorgio Gagliani, University of Calabria, Rende, 26 March 2007. * * * Giorgio Gagliani’s contribution to economic thought Giorgio Gagliani liked to cross interdisciplinary borders, sallying into economic history and sociology. His output was penetrating, original, not voluminous, never complaisant towards passing fashions. His interest in economics lay in the determinants of long-term tendencies, in the factors underlying economic development. The keystone references were the works of Arthur Lewis on development economics and Simon Kuznets on the characteristics of economic growth and its relation with income distribution. In a profound, wide-ranging review-article published in the Annual Review of Sociology, Gagliani critically surveyed thirty years of research on “Kuznets’s inverted U-curve”, the hypothesis that income inequality increases during the transition from an agricultural to an industrial economy and then gradually decreases as society progresses towards more mature stages of development. He concluded that the hypothesis was not borne out by the data, drawing a conclusion that others would reach a decade later or more. His scepticism had immediately led him to discern the fragility of the statistical bases of the studies he was reviewing. This attention, uncommon in the profession, to the quality of statistical data and their comparability over time and space was a hallmark of Gagliani’s research. As with Kuznets, the fulcrum of Gagliani’s analysis was the evolution of the sectoral and occupational structure of employment over the stages of development. At the time Giorgio was writing, Italy had completed the transition from agriculture to industry and was aligned with the other advanced nations. Subsequently, however, the convergence of the Italian economy halted and in some periods even went into reverse. According to OECD estimates, between 1991 and 2004 per capita national income went from 77 per cent to 69 per cent of that of the United States at purchasing power parity, falling back to levels not recorded since the mid-1970s. In the past decade the gap between our economy and the US and other advanced economies has widened. Growth accounting In these years the growth rate of productivity declined and eventually turned negative. A rapid increase in productivity is a prerequisite for the Italian economy’s return to a path of stable growth. The most recent developments – the faster-than-expected growth of output, the expansion of exports in the last year – are promising signs for the future but not yet decisive. Unquestionably, this is the main factor slowing the Italian economy, but it is not the only one. There are two other elements to consider: the labour force participation rate and the demographic structure. In the ten years 1997-2006 per capita GDP grew by 1 per cent per year. Labour productivity gains accounted for 0.5 percentage points of this annual growth and another 0.8 points came from the improvement in the employment rate, i.e. the ratio of the number of people in work to the population aged 15 to 64, while the rise in the demographic dependency rate – the ratio of those under 15 or over 64 to the working-age population – subtracted 0.3 percentage points per year from the growth in output. The repercussions of population ageing have already begun to be felt in our labour market. Deaths have outnumbered births in every year since 1993 except for 2004. The years ahead will see a further sharp contraction in the working-age population, which only immigration flows much larger than those now projected would be able to offset. According to Istat’s latest demographic projections, which assume a net migratory inflow of some 150,000 per year, the Italian population will fall to 56 million in 2050 and only just over half will be of working age. If the labour force participation rates by sex and age group remained unchanged, the labour force would shrink by about 25 per cent compared with today, that is, by more than 6 million people, with an average negative impact on per capita GDP growth of about 0.5 percentage points per year for the next forty years. The need not only to sustain the growth of productivity but also to raise the employment rate is evident. Employment in Italy has increased significantly since the second half of the 1990s, considerably more than could be expected on the basis of the slow growth of output. Between 1996 and 2006 the total number of full-time equivalent workers rose by nearly 10 per cent, or by 2.2 million. An essential boost to employment came from immigrants, who now account for more than 5 per cent of the employed resident population. Despite the recent progress, however, Italy’s employment rate is still one of the lowest in the advanced world. In 2005 it stood at 57.6 per cent, against an EU average of 63.8 per cent; only Hungary, Poland and Malta had lower figures (Figure 1). The gap is especially wide for women (Figure 2). In Italian society, then, there is no lack of unutilized human resources. A comparison of employment levels with the other advanced countries shows that the number of potential workers is a good deal higher than that of persons who on the basis of the rigorous international definitions are classified as “seeking employment” in the official statistics. Especially in the Mezzogiorno and among women, there are many who would be willing to work if they had the opportunity but have ceased looking for jobs because they are discouraged. 1 It is up to economic policy to devise the measures that can mobilize these unutilized human resources, a necessary condition not only for raising the potential rate of GDP growth but also for ensuring a fairer division of resources. Attention must focus above all on female employment, where the disadvantage with respect to the rest of Europe is greatest. Female employment The employment rate has been rising steadily since the mid-1990s for women of all age groups except the youngest, where we see the effects of longer school attendance (Figure 3). Convergence with the European levels is nevertheless still far from accomplished. In 2005, 45.3 per cent of women aged 15 to 64 were employed in Italy, 11 points below the EU average, higher only than Malta’s figure and far short of the 60 per cent target set in the Lisbon Agenda. The gap is due only in part to the different characteristics of the population; in particular, it cannot be ascribed to differences in the level of schooling. The disparity remains very great between the regions of the Centre and North and those of the South and Islands (Figure 4). The failure of women to re-enter the labour market after having children is one of the factors that set Italy apart from many other European countries. In 2005, 41 per cent of Italian women between the ages of 25 and 54 with a child less than seven years old were not in the labour force, compared with the EU average of 35 per cent. The fact that many women do not return to work after giving birth to their first child may reflect the choice to concentrate on caring for their offspring, but it may also stem from the difficulty of reconciling work with maternity. The loss of human resources is plain. About a quarter of Italian women between the ages of 25 and 45 with a secondary schooling do not participate in the labour market, compared with 8 per cent for men. Nor is this lesser presence of women accompanied by a greater propensity to have children: the fertility rate in Italy, together with Spain and Greece, is significantly below the European average. There is a broad consensus that part-time employment opportunities and adequate childcare structures are effective instruments to encourage women to enter and remain in the labour market. Italy is on a par with the most advanced countries in its availability of nursery schools and kindergartens for children between three and six years old, but there is an acute shortage of day nurseries, especially in the South and Islands. The estimates available indicate that increasing the number of places in day nurseries could have a positive effect both on women’s decision to work and on their decision to have children. In the absence of public and private structures for very young children, home care provided by relatives or babysitters becomes essential. An indirect sign of the importance of this form of assistance is given by the positive correlation between the percentage of immigrants in the population at province level and the propensity of better-educated women aged 25 to 45 with pre-school children to participate in the labour market, particularly in the part-time segment. In general, improving the design of policies in support of dependent family members would have the twofold effect of raising female labour force participation and assisting the choice to have children. See A. Brandolini, P. Cipollone and E. Viviano, “Does the ILO definition capture all unemployment?”, Banca d’Italia, Temi di discussione, no. 529, 2004; now in Journal of the European Economic Association, 2006, vol. 4, pp. 153-79. The share of self-employment Gagliani saw women’s low labour force participation as a symptom of Italy’s development delay. He identified a second aspect of this lag in what he called the “considerable anomaly” of the Italian case: the large share of self-employed workers in nonfarm employment. According to the labour force survey, in 2005 self-employment accounted for 27 per cent of total employment, against an EU average of 15 per cent (Figure 5). Among European countries, only Greece had a higher percentage. What are the causes of this disparity? Self-employment is a composite phenomenon. It includes highincome entrepreneurial activities and professions, but also marginal activities comparable to payroll jobs but with lower pay and less protection. Institutional regulation of the product and labour markets influences self-employment in many ways, including by creating barriers that protect rents and generating incentives to evade the rules. Independence and entrepreneurship are significant factors in the choice of many workers to engage in self-employed activities. Often, they are the drivers of the capacity for innovation that has enabled Italian industry to gain and hold a role in important sectors of world trade. In many other cases, however, self-employment is the fruit not of a choice but of the impossibility of finding salaried employment. The anomaly that Gagliani underscored lay in this: the multiplication of formally independent but de facto subordinate employment positions, which he traced to the excessively large social contributions wedge and, more in general, to “administrative inefficiency, the tax regime and broadly political protective acquiescence” (2000, p. 82). In short, he viewed the hypertrophy of selfemployment as an imbalance to be corrected. In 2000 he wrote: “A reversal of trend could come from (a) a strong and efficient public stimulus to innovation; (b) the opening up of retailing to large-scale distribution; and (c) the application to self-employment of effective tax treatment similar to that found in Italy’s partner countries” (2000, p. 90). Gagliani drew this conclusion from a structural analysis of development processes and comparison of the Italian experience with that of the countries that had industrialized earlier. His works did not contain an econometric test, but we can say today that his insight was correct. A comparative analysis on time series for 25 countries and 6 sectors shows that in countries where there is above-average tolerance of tax evasion, high tax and social contributions rates go together with a high share of selfemployment. Furthermore, this share is greater, the more intrusive is product market regulation, especially if it is aimed at maintaining a fragmented supply structure, for example a traditional distribution network. 2 The removal of administrative barriers and restrictions can stimulate better exploitation of economies of scale and the growth of firms, above all in the service sector. Recent studies on the structure of retailing show that these barriers reduce productivity, brake the adoption of the new information technologies and increase profit margins, leading to higher consumer prices. 3 Conclusion As Gagliani suggested, a careful analysis of the composition of employment and comparison with other countries can show us where Italy’s distinctive features constitute a problem and where they are a strength. Creating an environment in which productivity will return to rapid growth and increasing the employment rate are necessities imposed by our country’s demographics if we are to create wealth and avert inequity. They are also the path to stronger social cohesion, because holding a job not only implies income creation but also generates respect and people’s awareness of their role as citizens. Gagliani ended his essay on the relationship between growth and inequality with the following words: Development can only occur via extensive restructuring and relocation of activities and occupations. The faster the process, the lower the proportion of relocations deferred to the next generation, and the higher the number of persons affected during their lifetime who are unable to adjust. These persons are those who are negatively affected by development and who should receive compensation until they find new jobs. Helping them to satisfy their basic needs is a moral duty. See R. Torrini, “Cross-country differences in self-employment rates: the role of institutions”, Banca d’Italia, Temi di discussione, No. 459, 2000; now in Labour Economics, 2005, vol. 12, pp. 661-83. See E. Viviano, “Entry regulations and labour market outcomes: Evidence from the Italian retail trade sector”, Banca d’Italia, Temi di discusione, no. 59, 2006, and F. Schivardi and E. Viviano, “Entry barriers in Italian retail trade”, Banca d’Italia, Temi di discussione, no. 616, 2007. Helping them to bequeath their old jobs to descendants may be harmful to the latter. (1987, pp. 329-30). Gagliani’s conclusion has a more general validity, not limited to the initial phases of development. The evolution of economic systems, changing technological paradigms and the integration of world markets require radical alterations in the structure of production and employment; they impose significant costs on those who will bear the burden of these adjustments. Italy is now going through one such phase. It would be vain to seek to stem the changes under way, and the consequences of such an attempt would be paid by the future generations. The answer lies in implementing instruments that will compensate the “losers” in the process of economic development and enable them to find a place in the new productive system. The context in which Giorgio Gagliani wrote was different, but his conclusions remain just as valid for us today. Writings of Giorgio Gagliani 1971 Disoccupazione involontaria e curva di Phillips. Milan: Giuffrè. 1973 “Note sulle imprese multinazionali e l’occupazione”. Bancaria, vol. 29, no. 9, pp. 1081-89. 1975 “Commercio internazionale e disoccupazione: note di teoria”. Ricerche economiche, no. 4, pp. 334-50. 1977 “Le occupazioni privilegiate nella teoria economica”. Rivista internazionale di scienze sociali, vol. 85, nos. 3-4, pp. 267-305. 1977 “L’andamento della distribuzione del reddito da lavoro dipendente tra salari e stipendi in Francia, Germania, Inghilterra e Italia (1948-1974)”. Note economiche, nos. 5-6, pp. 57-70. 1977 “Wages, Salaries and Female Employment in U.K. Manufacturing” (with P. Antonello). European Economic Review, vol. 9, no. 2, pp. 209-20. 1978 “Osservazioni sulle misure delle disuguaglianze nei redditi tra due gruppi”. Ricerche economiche, no. 1, pp. 97-102. 1980 “Andamento e determinanti della distribuzione del reddito dal lavoro dipendente tra salari e stipendi in alcuni paesi europei”. In Interdipendenza e integrazione nella Comunità economica europa, edited by P. Guerrieri, pp. 159-216. Turin: Einaudi. 1981 “La distribuzione funzionale del reddito nello sviluppo: i problemi delle economie ritardatarie”. Note economiche, no. 4, pp. 18-60. 1981 “How Many Working Classes?”. American Journal of Sociology, vol. 87, no. 2, pp. 259-85. 1985 “Long-Term Changes in the Occupational Structure”. European Sociological Review, vol. 1, no. 3, pp. 183-210. 1987 “Distribuzione personale del reddito, modifiche nella struttura dell’occupazione e sviluppo economico” (with A. Tarsitano). In Strutture economiche e dinamiche dell’occupazione: l’interazione tra fattori di domanda e offerta, edited by C. Cazzola and A. Perrucci, pp. 246-61. Rome: La Nuova Italia Scientifica. 1987 “Income Inequality and Economic Development”. Annual Review of Sociology, vol. 13, pp. 31334. 1992 “Distribuzione del reddito e sviluppo: utilità di un indice di asimmetria a supporto del Gini”. Politica economica, vol. 8, no. 1, pp. 101-28. 1997 “La struttura dell’occupazione nel lungo periodo. Un confronto internazionale”. In Mercato del lavoro: analisi strutturali e comportamenti individuali, edited by R. Brunetta and L. Vitali, pp. 3786. Milan: Angeli. 1999 “L’aritmetica delle modifiche occupazionali nello sviluppo”. In Saggi di politica economica in onore di Federico Caffè, vol. III, edited by N. Acocella, G.M. Rey and M. Tiberi, pp. 315-24. Milan: Angeli. 2000 “Nota su cause e prospettive di un’anomalia italiana: l’occupazione indipendente”. Studi e note di economia, no. 2, pp. 75-92. 2003 “Terziarizzazione precoce e sentieri di sviluppo delle regioni italiane nel secondo dopoguerra: un’ottica internazionale”. Rivista economica del Mezzogiorno, vol. 17, nos. 1-2, pp. 181-208. | bank of italy | 2,007 | 4 |
Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the Ordinary Meeting of Shareholders, Rome, 31 May 2007. | Mario Draghi: Overview of economic and financial developments in Italy Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy, at the Ordinary Meeting of Shareholders, Rome, 31 May 2007. * * * Ladies and Gentlemen, I wish to pay grateful and affectionate tribute to the members of the Directorate who left the Bank in 2006 after decades of dedicated, rigorous and judicious work. They accompanied me in my first steps in this institution, providing the support of their loyalty and experience. Vincenzo Desario, who was appointed Director General in 1994, served the Bank in the exercise of highly sensitive functions, notably in the area of banking supervision. He led the Bank on an interim basis after the resignation of Antonio Fazio. He stamped his mark indelibly on the Bank’s approach to prudential supervision, principles of internal organization and daily administrative practices. The Board of Directors has named him Honorary Director General. Pierluigi Ciocca, who had been Deputy Director General since 1995, gave the Bank the benefit of his profound, original thinking and his vast economic and legal knowledge. He promoted the study of law and economics, inspired research for many years and helped to refine the analysis of the functions of central banking. In 2006 the Directorate acquired new members with expertise and experience, some of it gained abroad. Fabrizio Saccomanni, who as Vice President of the European Bank for Reconstruction and Development was in charge of risk management at that institution for three years, has been Director General since October. Ignazio Visco, Central Manager for Economic Research and previously Chief Economist of the OECD for five years, and Giovanni Carosio, formerly Central Manager for Banking and Financial Supervision, joined Antonio Finocchiaro as Deputy Directors General in December. The Directorate’s new membership combines valuable experience in the international arena with intimate knowledge of the Bank, analytical and research skills with specialization in the area of regulation and central banking. The Bank’s new Statute was approved last year. It modifies the operations of the Bank’s decisionmaking bodies: the Board of Directors, the Board of Auditors and the Directorate. It establishes the principle of collegiality for measures that have external significance. The Bank intends to renew itself, and has already begun to do so. The reorganization taking place affects the functions of the Head Office, the branch network and the representative offices abroad; it provides for the full integration of the Italian Foreign Exchange Office. The aim is to reduce bureaucratic procedures, simplify and rationalize working practices, thus fostering individual responsibility, reallocate resources from the Bank’s internal administration to its institutional functions, and tap into new recruitment channels, as with the forthcoming competitive examination for economists that is open to applicants from abroad. We are on the point of implementing the reorganization of the activities of economic research and international relations, with the objective of structuring their tasks better according to particular needs: to contribute to setting the common monetary policy by monitoring and forecasting short-term economic developments and analyzing monetary strategy and transmission mechanisms; to study the fundamental problems of Italian economic development; to carry out research on the world economy and cooperate with international organizations; to refine economic statistical methodology and disseminate economic and financial statistics. The plan for the reorganization of the supervisory departments is being finalized, to give greater weight to the macroeconomic analysis of risk, the quality of regulation and consumer protection. There will be more interaction between research and supervision, and off-site and on-site supervision will be more closely integrated and have more methods in common. Measures affecting the other functions will follow in due course. The Bank of Italy is also reviewing the principles and procedures for managing its own portfolio of financial assets. The aim is to increase transparency and separate the investment of its own resources more clearly from its other institutional activities. The Bank of Italy has recently introduced numerous innovations in its operating procedures. Since the beginning of 2007 banks have been permitted to include bank loans among eligible collateral for Eurosystem financing operations. Since mid-April the Bank has conducted new very-short-term borrowing transactions on behalf of the Ministry for the Economy and Finance, making treasury management easier and more predictable. On behalf of the same Ministry, it has launched the General Government Transactions Information System, which will enable government entities to evaluate their cash flows in real time and facilitate the adoption of electronic payment procedures. The project for the development of the new TARGET2 platform for settling large-value payments, which is being carried out in conjunction with the Bank of France and the Bundesbank, has reached an advanced stage. TARGET2, which will come into operation in November, centralizes the technical infrastructure of the European payment system, reducing the cost of cross-border interbank transactions. It will allow the ever-growing number of banks with a presence in more than one European country to operate with a single account in central bank money and curb the cost of treasury operations. The branch network will be reorganized on a regional basis in forms that are more appropriate for the present day and without abandoning the Bank’s nationwide presence. Reducing the tasks of selfadministration and increasing those with greater technical content will give branch staff new opportunities for learning and professional growth. Wide-ranging discussions with the trade unions on the organizational changes have been under way for several months. I hope that broad consensus will be reached before long on action to strengthen the Bank’s role and prestige and an agreement concluded on the necessary measures to assist the workers involved. The Bank’s expanding international commitments, the reform of its governance and the new operational initiatives have posed important challenges. The staff have faced them with their customary professionalism and dedication, born of a tradition that has cultivated the spirit of public service, a sense of identification with the institution and merit-based selection in recruitment and promotions. I wish to express my gratitude to all the members of staff . The principles of Community law, primary legislation and the provisions of the Bank’s Statute protect the absolute autonomy of the Bank in the performance of its institutional functions from possible influence by its shareholders. However, the criteria for share ownership appear obsolete and do not ensure a sufficiently broad distribution of shares. The new bill on the reform of the regulatory authorities goes in the right direction, being based on the principles of the independence of the Bank and of a balanced distribution of its share capital. Credibility and independence are essential to the performance of our duties. The autonomy of the central bank, though protected by law, can be fragile unless it is supported not only by authoritative analysis but also by consequent action. The world economy, finance and monetary policy The world economy grew by 5.4 per cent in 2006, the highest rate for more than thirty years. The slowdown in the United States was off set by continued strong expansion in China and the other emerging countries and by the recovery taking place in the euro area and Japan. World trade continued to expand at a rate of over 7 per cent. Economic integration has been an important driving force of the uninterrupted growth of recent years. It is threatened by the resurgence of protectionist tendencies; the signs are visible, most notably in the stalled negotiations on the Doha Round of liberalization measures. The persistent increase in current payments imbalances continues to pose a risk. The current account deficit of the United States reached 6.5 per cent of gross domestic product in 2006, the highest ratio ever recorded; with its counterpart in the growing surpluses of China and other Asian countries and oil producers, it has been financed easily thus far, but the share held by foreign authorities is rising. The financial sector has made a fundamental contribution to economic growth in recent years by permitting unprecedented capital mobility and facilitating efficient capital allocation and by smoothly financing imbalances that in another era would have been disruptive. Financial innovation has enhanced market liquidity and reduced volatility. The expansion in the markets and the continued process of financial innovation are also changing the pattern of risks. The use of derivative instruments has grown further. Their notional value is now equal to ten times world GDP. Alongside instruments serving to hedge market risks, there has been a rapid expansion in those for the transfer of credit risk; the notional value of credit default swaps more than doubled in 2005 and doubled again in 2006. By making it possible to slice up credit risk and evaluate it precisely, allocating it and spreading it among a multitude of market participants, credit derivatives help to raise the productivity of the financial system, just as new production technologies boost that of the real economy. However, they can become a source of instability if intermediaries use them not to hedge existing risks, but to increase the volume of risks they assume. In addition, credit derivatives can modify the modus operandi of the banks that use them. If lenders transfer part of the risk to others, the incentive to evaluate borrowers’ creditworthiness can weaken. A sign of this is to be seen in the rise in sub-prime mortgage defaults in the United States, where the transfer of risk is commonplace. Abundant liquidity and low interest rates have contributed to the vigorous growth of hedge funds and private equity funds. Their role in the functioning of the markets has been positive, but the scale of the phenomenon, the high leverage of hedge funds, the demand from investors and counterparties for greater transparency and the potential risks of instability require the attention of the market and regulators. Supervisors seek to limit systemic risk, relying on market discipline by pressing the intermediaries under their direct supervision to obtain the necessary information from hedge funds and satisfy themselves that procedures are in place for the best management of risk. Risk premiums have now fallen for a broad spectrum of financial instruments and markets. Investors’ perception of risk could suddenly change; an abrupt portfolio adjustment, whatever the cause, would have destabilizing effects on exchange rates and financial markets. Although it is more able than in the past to absorb small and medium-sized shocks, the financial system may have become more vulnerable to “extreme” events that have a low probability of occurring but potentially disruptive effects, due not least to the system’s increasing complexity and the growing interdependence between markets. The development of new instruments and the emergence of new types of intermediary also pose unprecedented challenges for monetary policy. More than ever before, the financial markets are a source of information on trends in economic activity and the expectations of economic agents; central banks’ actions are reflected more rapidly in the prices of financial assets. At the same time, the money and credit aggregates are being increasingly affected by the conduct of non-bank intermediaries; financial innovation is complicating the interpretation of the behaviour of monetary aggregates. From December 2005 onwards the Governing Council of the European Central Bank has gradually moved towards a less accommodating monetary policy stance; it has raised official interest rates by 1.75 percentage points since then. At a time of strengthening economic activity, expanding employment and sharply rising energy and commodity prices, our decisions have kept inflation expectations firmly anchored to the objective of price stability. For the first time a powerful oil shock had no repercussions on inflation. Money and credit continue to grow strongly. Despite the impact of financial innovation on the velocity of circulation, monetary aggregates remain a fundamental element in the strategy of the Eurosystem. In nominal effective terms, the euro appreciated by almost 5 per cent in 2006. One factor in the strength of the single European currency has been the improved economic outlook for the area, in the face of fears of a slowdown in the United States. Monetary policy has remained conducive to growth. Real short-term interest rates are still below the average for the area over the last twenty years. Long-term rates have risen, but by less than in comparable phases of past cycles. The gradualness and careful communication of monetary policy decisions have helped maintain stable conditions in the money and financial markets. Consumer price inflation in the euro area was 2.2 per cent in 2006, just over half the rate recorded in the early nineties. A similar reduction occurred in the industrial countries as a whole, while in the emerging economies inflation fell from 60 per cent to 5 per cent. This remarkable achievement is attributable to the independence of central banks and the clarity of their statutory objectives, and also to the increase in competition triggered by the opening-up of markets. To strengthen growth in Italy The Italian economy has been recovering since the middle of 2005. Growth strengthened during 2006, to an average of nearly 2 per cent, a result that had not been achieved for five years. A similar rate of growth is expected in 2007, despite the slowdown in the first quarter. The recovery has been fuelled by investment and the growth in demand abroad, especially in Germany. Employment has risen substantially, but still largely in the number of temporary jobs. The Italian economy may have shaken off economic stagnation, but its rate of growth is still one of the lowest in the euro area. In the first half of this decade labour productivity fell in every sector, and especially in industry. The disparity in relation to the rest of the euro area indicates slowness in the adaptation of Italian industry to the changes in the technological and competitive environment. The recent improvements in productivity and exports, though still modest and largely cyclical, may nevertheless suggest that a process of restructuring has begun. The restructuring of the industrial sector A survey of more than 4,000 firms carried out in recent months by researchers at the Bank provides initial indications that this is indeed happening. More than half of the industrial firms in the sample have changed strategy in the last five years. The 12 per cent of firms that have shifted their product range towards new sectors earned higher than average profits in 2006. One firm in five, almost double the ratio compared with the beginning of the decade, is adopting some form of internationalization, ranging from cooperation with foreign partners, the preferred solution for small firms, to the outsourcing of manufacturing or marketing. In all the firms the importance of investment in product development, design, brands, and distribution and customer-service networks has increased. Among medium-sized and large companies the use of new technologies for integrated corporate management is becoming more prevalent and the proportion of better-educated staff is rising; corporate profits have benefited as a result. Profits are also inversely correlated with the age of company leaders, a fact of great significance in the country of family capitalism: firms that have tackled generational changeover report higher average profits. Our survey, the many case studies accompanying it and data from other research bodies paint a picture of change, owing partly to a more severe winnowing of firms. According to the Chambers of Commerce, the number of manufacturing firms deleted from the registers has exceeded new registrations by more than 50,000 over the last five years. Confronted with the dual shock of globalization and technological change, the economy is beginning to react. It would be wrong to conclude that the crisis of productivity and competitiveness of the last few years is now behind us. Productivity in industry, which fell by 3 percentage points between 2001 and 2005, rose by just over 1 point last year; in Germany, France and Spain it increased by between 3 and 6 per cent. The divergence of trends in unit labour costs has become more pronounced. We still have a long road ahead of us. Company size remains crucial. Companies must achieve sufficient scale to support the high fixed costs of continuous innovation and an active presence in distant markets; even more than in manufacturing plant, scale matters in developing products, fostering brand recognition and standing, and organizing production. Field surveys reveal obstacles to growth. In our study, 40 per cent of the firms that considered themselves to be too small missed out on opportunities to expand by means of acquisition or merger over the past decade. A gap to close The transformation of the economy is being hampered by an institutional framework that still has major shortcomings, although it must be recognized that progress has been made. The reduction of unemployment, though important, is the only area in which Italy is in step with the timetable envisaged in the Lisbon Agenda. Italy is behind schedule as regards raising the employment rate, especially for women and older workers, education, vocational training, reducing the risk of poverty, innovation, and compliance with environmental constraints; in many cases the lag is greater than the average for the Union as a whole. Last year I pointed to areas where structural measures are of particular importance for the growth of the economy and its enterprises. I would like to revisit some of those issues in the light of developments since then. Education continues to head the list of fields where change is most necessary. The low international ranking of the Italian school system has a geographical aspect that deserves attention. The disparity in levels of scholastic achievement between North and South is significant even in primary school and tends to widen thereafter. One of every five 15-year-olds in the South is “knowledge poor”, which is the prelude to economic poverty; the disparity is even larger if the South’s higher drop-out rate is taken into account. Such a marked geographical difference shows that the problem lies not only in the rules but also in their practical application. The recruitment of teachers, their distribution between regions and different types of school, and their career paths are governed by mechanisms that feature, at different stages, both precariousness and irremovability. Mobility bears little relationship to educational need, merit or capability. Every year more than 150,000 of Italy’s 800,000 teachers change assignments in an arduous progression towards their desired position. Another negative factor is the delay in developing an effective school assessment system, which the experience of other countries suggests is an indispensable complement to school autonomy. Changing the Italian school system must begin with a recognition of the vicious circles that penalize it, demoralize teachers and betray the mission of public education. It is here that the problems originate, and not in a shortage of resources for education per student, which in Italy are actually above the European average. For an advanced economy, an even more direct and immediate contribution to growth comes from the university system. Some important reforms enacted in the past, ranging from financial autonomy to the evaluation of the quality of research, have still not been completed. Priority in the allocation of public resources should be given to financing scholarships for worthy and less welloff students. Universities should be able to compete for students and public funding on the basis of the quality of their teaching and research staff , selected for their academic standing and paid accordingly. The degree of competition in the domestic market in both public and private services affects the growth of firms competing in the international arena. In the countries where the legal and regulatory obstacles to competition in energy, telecommunications, transport and professional services are greater, manufacturing industry grows more slowly. Until a short time ago Italy was – and in some respects still is – among the countries where regulation is most unfavourable to consumers. To date, liberalization in the energy sector has been halting. Although the price of electricity for industrial users in Italy has risen only very slowly in recent years, excluding taxes it is still among the highest in Europe, about 20 per cent above the average. Action to liberalize the market for services, which has been initiated, is essential to regain competitiveness and growth. This objective should also be pursued because of the effects it will have on consumers’ welfare, not least in terms of income distribution. In 2005 more than 15 per cent of the monthly consumer spending of the poorest 20 per cent of the Italian population went for goods and services now the subject of liberalization measures: €140 out of a total of €940, half of which was for energy in various forms. The shortcomings are particularly prevalent in local public services, notably urban public transport and the collection and disposal of waste. The succession of rules enacted in the nineties were designed to separate the management of services, to be awarded by competitive mechanisms, from activities that are natural monopolies, and assigning regulatory powers to local government. These guidelines have been frequently disregarded. The results in terms of the cost and quality of services have been disappointing, with geographical differences depending on the administrative capabilities of local authorities. Liberalization has progressed in other fields. In professional services, where Italian regulations had been the most restrictive among the advanced economies, the initiatives undertaken in 2006 have brought the level of regulation close to the middle of the international range. Action in the retail sector needs to be continued, by establishing not only in law but also in practice the principle that sales outlets should not be rationed geographically except on sound environmental grounds and by guaranteeing the full application of this principle at regional and local level. The failings of the Italian civil justice system are documented in international studies and demonstrated by the inconvenience suffered by individuals and firms. An international comparison of the length of legal proceedings is unforgiving. To take just one example: labour disputes take an average of more than two years to pass through the lower courts in Italy, compared with a year in France and less than six months in Germany. The slowness of justice is due not so much to lack of resources as to organizational weaknesses and defects in the system of incentives. Here too there is a specific Southern problem; an ordinary civil case in lower court takes three times as long in Messina as in Turin, averaging 1,500 days against 500. The universal application of information technology would make proceedings speedier and more efficient and the operation of the various offices transparent; it would also supply the basic information that is indispensable for effective reorganization. Information is vital if inefficiencies are to be eliminated. The quality of the services supplied must become the yardstick for evaluating government departments and the activity of their managers. The objectives must be clear and verifiable. Differentiating earnings partly on the basis of individual productivity, evaluated uniformly and transparently, would help attain them. This is provided for in the Memorandum of Understanding concluded between the Government and the trade unions last January. Infrastructure represents an unresolved problem. The experience of recent years, after the amendment of Title V of the Constitution, has shown that concurrent decision-making between central and regional government is laborious and frequently ineffective. In the general interest, consideration should be given to the possibility that in certain cases it would be advisable, once a certain time has elapsed, to relieve the central government of the obligation to obtain the assent of the regional and local authorities. It must be possible to allow local needs to be expressed without for ever blocking public works that are necessary to the modernization of the country. Sustainable public finances According to Government estimates, net borrowing will come to 2.3 per cent of GDP in 2007, half a percentage point better than the target set at the end of last year. The primary surplus will rise to 2.6 per cent. To ensure the sustainability of the public finances, deficit reduction must continue, with incisive action on the size and composition of the budget. At the end of 2006 Italy’s public debt reached €1,575 billion, or nearly €27,000 per person. For thirty years, from 1964 to 1994, its ratio to GDP rose steadily, from 32 per cent to 121 per cent. It then declined by 18 points by 2004, turning upwards again since then. Without asset disposals and the restructuring of liabilities, the ratio of debt to GDP would be approximately the same today as in 1994. The accumulation of debt has not helped Italy to grow. It has not endowed the country with adequate infrastructure. High debt constrains public policies; it requires higher taxes and reduces the resources available for investment and welfare expenditure. With interest rates rising, albeit by very little so far, interest payments are again tending to increase. They are already equal to the amount spent on public education and to two thirds of that spent on health care. In 2005 there were 42 persons aged 60 or more for every 100 of working age. By 2020 they will have risen to 53 and by 2040 to 83. These trends will affect spending on pensions, health care and social assistance. The choice we face is whether to reduce the debt burden in the next ten years, before the aging of the population becomes more pronounced, or to wait, but in this case accepting major changes in the support that society will be able to provide to its weakest members. The recent improvement in the public finances is due to the sharp increase in revenue. According to the Government’s estimates, the ratio of tax and social security contributions to GDP will rise further this year. It is higher than the European average and close to the peak levels of the last few decades. Among the large European countries, France alone has a higher ratio. Because of tax evasion, which remains high despite signs of a recovery in tax receipts, the difference between Italy and the rest of Europe is greater in terms of the burden on honest taxpayers. The statutory tax rates on both labour and capital are high; the corporate income tax rate is only lower than that in Germany, where the Government recently announced a cut of 9 percentage points. An excessive level of taxation and the variability and complexity of tax rules discourage investment in physical and human capital and raise the cost of compliance. Only by permanently reducing current expenditure can the deficit be curbed and the debt lowered without increasing the tax burden. Since 2000 primary current expenditure has risen by an average of one percentage point more per year than GDP. Its ratio to GDP has reached 40 per cent, comparable to the highest post-war levels. The expenditure mechanisms need to be changed. In 2006 primary current expenditure still grew by 3.6 per cent, compared with the Government’s budget forecast of 1.1 per cent. There is scope for saving in all the major items of the budget; the revision of expenditure programmes that the Government has commenced goes in the right direction. Redistributive policies also need to be subject to a cost-benefit analysis. A lasting adjustment requires action on the pension system. Life expectancy continues to rise and the number of Italians of working age to diminish; meanwhile, the employment rate is the lowest in the euro area. It is necessary to raise the average effective retirement age over time, not least in order to maintain an adequate level of benefit. The architecture of the system introduced in 1995 must be applied. Close correlation between an individual’s pension contributions and benefits reduces the distortions in levies and disparities of treatment between different categories of worker, and permits flexibility in the choice of retirement age. Rigorous and prompt application of the adjustment mechanisms envisaged by the current legislation is essential. But it will not be possible to return the system to a sustainable path and at the same time guarantee workers adequate pensions without a rapid and resolute launch of supplementary pension provision, which is still underdeveloped. The returns on investments in supplementary pension plans are likely to be better than those on severance pay funds, and further advantages derive from the additional contributions from employers and favourable tax treatment. The decision to bring forward the introduction of implied consent for the assignment of accruing severance pay to supplementary pension funds to 2007 and the new forms of flexibility in the use of accumulated savings move in the right direction. However, in many cases enrolment in supplementary funds is being discouraged by the excessive fees charged to savers; little of the benefit of the economies of scale generated by the growth of pension fund assets has materialized so far. Competition must increase; fees are insufficiently transparent and the restrictions on portability are excessive. The limits on the transferability of employers’ contributions need to be reconsidered. Information must be improved: if workers are not fully acquainted with the facts of the public pension that they will receive in the future, they are not in a position to make informed decisions. Supplementary pension plans need to be extended to public employees as soon as possible. Without prejudice to the stability of the public finances, and given that overall contributions to the public pension system equal 33 per cent of wages, by far the highest rate among the major European countries, thought should also be given to permitting individual employees to make voluntary allocations of a limited portion of their public pension contributions to supplementary pension schemes. The financial industry and the capital markets Italian open-end investment funds, which had 17 per cent of Italian households’ savings under management in 1999, now have barely 7 per cent. The outflow of resources, which is still influenced by tax disparities, has gathered pace lately, and in the last three years amounted to almost €100 billion. The presence of foreign funds has grown as a result of distribution agreements with Italian banks, while Italian banking groups have moved part of their operations abroad. Asset management strategies are still subordinated in large part to those of the controlling companies. Reducing the conflict of interest inherent in the cross-shareholdings with banks and insurance companies and the consolidation of asset management companies are vital for the growth of the industry. As I have already had occasion to remark, an open architecture and a clear separation between companies and between owners benefit bank shareholders and fund clients alike. The presence of private equity in Italy is growing, although the volume of transactions remains far below that of the other main European countries. Between 2003 and 2006 the number of Italian management companies rose from 26 to 49 and funds’ financial resources from €3 billion to €6 billion. Above all, the growth is among companies not belonging to banking or insurance groups; in 2006 they accounted for more than half the total resources invested. Intermediaries specializing in the provision of equity capital can foster the growth of small and medium-sized enterprises, contribute to strengthening management, facilitate listing on the stock exchange and accompany generational changeover. Family ownership is a pillar of Italian capitalism; the entrepreneur’s sense of identification with his enterprise is a driving force of growth. Precisely for this reason it is important to have the means of facilitating a changeover when this is necessary. When family owners lose their taste for creative risk, when the wealth invested in the business begins to be seen only as a source of rents or private benefits of control, the immobility of ownership may hold back the growth of the business and set it on a downward path. It is at this juncture that firms have the greatest need of these intermediaries. The potential benefit to all from a changing of the guard is then at its highest, as sometimes is the resistance of the owners. There is a close link between the spread of specialized intermediaries and the growth of the stock exchange. More than a third of the Italian companies that listed between 1995 and 2006 were assisted by private equity firms, thus increasing access to the stock market in Italy, which until now has remained restricted mainly to large firms and has a much lower market capitalization than its counterparts in the other industrial countries. In a rapidly evolving international context, the strategies that Borsa Italiana intends to pursue remain to be defined: its shareholders need to provide clarification. Consolidation between companies managing the international markets is under way; the integration of technical infrastructures has accelerated sharply. This offers excellent growth prospects for those who participate, but raises questions as to the long-term fate of those who remain on the sidelines. Simple ownership structures increase firms’ ability to attract equity investment. An appropriate system of corporate governance satisfies a need for fairness in the treatment of shareholders’ property rights, but also criteria of efficiency. Less-than-transparent systems make it difficult for minority shareholders to provide a stimulus, accentuate the self-referential nature of management and protect the private benefits of the controlling group. Italian listed companies frequently use complex organizational structures. Compared with other methods of separating ownership from control, a pyramid structure may make it more difficult to evaluate intra-group transactions adequately and increase the group’s opaqueness. The complexity of the leading groups has declined in Italy in the last few years. Between 1990 and 2006 the average number of listed companies per group fell from 6.8 to 2.5, the number of layers of control diminished, and the control leverage decreased. Although changes in tax law and in the rules on group transparency played a part, this reduction in complexity was mainly due to market pressure. It is above all the application of the rules on intra-group transactions and the protection of minority shareholders that still needs to be strengthened. In the same period the market value of listed companies controlled under shareholders’ agreements rose from 18 to 22 per cent of the total and their number from 5 to 11 per cent. Banks A year ago Italy’s two largest banks ranked seventh and eighteenth in Europe in terms of stock market capitalization. The top three cooperative banks held 49 per cent of the category’s assets in Italy. Today, if the operations announced by their boards of directors go ahead, the two leading Italian banks will climb to third and eleventh place, and the three largest cooperative banks will account for 73 per cent of the assets of that category. What is happening in Italy is part of the process of banking consolidation that has been under way in Europe for several years. Most of the mergers have originated within individual countries; in some cases they have subsequently evolved into cross-border operations. Where the outcome has been successful, the resulting banks enjoy considerable economies of scale, benefit from greater risk diversification, and are highly capitalized. The lead time before the synergy underlying a merger or acquisition must translate into greater shareholder value and more efficient customer service has been drastically reduced, however. The advent of the single currency, the growth of the financial services industry, and globalization itself have created a European and world market in bank ownership and control. Neither size nor nationalistic defences can safeguard those banks which, although sound, do not constantly seek to increase their value; the market therefore needs to see the fruits of consolidation very soon after the more complex stages of the operation have been completed. Concentration of the supply of banking services must not lead to a lessening of competition: customers must reap the full benefits of economies of scale. Crucially, the governance, corporate structure and organizational arrangements the new banking groups adopt must ensure that they are soundly and prudently managed. In many instances, the banks created by consolidation have introduced new forms of corporate governance, opting for the two-tier system; the activities of the new groups are coordinated by their operational holding company. The two-tier system of governance is effective if it is adopted in a way that ensures a clear division of responsibilities between the various corporate bodies. Overlapping responsibilities are detrimental to efficient decision-making and are considered by shareholders to destroy value; clear lines of responsibility also safeguard stability. Particular attention must be paid to internal controls where a group holding company is formed or its scope is expanded to embrace the entity created by the consolidation. New banking groups must take prompt measures to ensure centralized risk management, particularly with regard to the most vulnerable lines of business. Special emphasis must be placed on reputational risk. Risk assessment models must be adopted and control functions put in place without delay. The acquisition of large corporate shareholdings has become part of the strategy of the leading banking groups. For the banks, this means assuming new types of risk and may give rise to conflicts of interest. By law, such holdings have long been restricted in order to safeguard the stability of credit intermediaries. Developments in risk management techniques and in supervisory best practices now make rigid limits ineffective. Some time ago the Bank submitted a proposal to the Interministerial Committee for Credit and Savings that would allow to reduce administrative constraints by raising the limits on banks’ permissible shareholdings; this is rendered possible by a supervisory system based on precise assessment of all the risks, adequate capital to cover them, the control of conflicts of interest by means of governance and transparency safeguards, and in the future more effective regulation of connected lending. Assessment of the merit of individual mergers is left to the market and the banks’ shareholders, who must be assured full information and adequate opportunities to be heard. They in turn have a duty, particularly in this regard, to be especially active in ensuring that the objective of mergers and acquisitions is to increase value and then in verifying that management decisions are consistent with that aim. This role should be performed in particular by institutional investors, given their fiduciary responsibility towards those who have entrusted them with their savings, and by banking foundations, which manage funds in the interest of the community. The latter’s responsibility is all the more delicate and important for being less clearly defined in formal terms. The present limits on non-financial corporations’ shareholdings in banks and the associated prohibition on their acquisition of controlling interests will also be reviewed in the light of the forthcoming Community legislation. Conditions are now ripe for reform of the legislation governing cooperative banks, to which it is hoped they will make a constructive contribution. A regulatory structure originally designed for small banks is in some respects no longer adequate to cope with the increasingly broad and fragmented ownership that has emerged as a result of consolidation. The legislative proposals to raise the limits on individual shareholdings, strengthen the role of institutional investors and broaden the mechanisms for proxy voting, without destroying the cooperative nature of such banks, are to be welcomed. In 2006 the capital adequacy ratio of Italy’s banking system rose to 10.7 per cent, although that of the leading groups declined slightly. In 2008 all Italian banks will adopt the criteria of the Basel II Accord. Depending on the composition of risk, this may lead to reduced capital requirements; it will certainly result in greater variability between banks. In order to guarantee leeway, the Bank of Italy is working to ensure that banks’ capital ratios, in relation to the degree of risk and the accuracy of risk management methods, remain well above the minimum requirement. Discussions with the banking groups that plan to adopt internal systems for calculating their capital requirements have intensified of late. In recent years cost reductions have contributed to the improvement in the operational efficiency of the leading Italian banking groups, which is now on a par with the average for the major European banks. Despite the progress that has been made, return on equity is lower, however, mainly owing to heavier loan losses; although favourable economic conditions are contributing to an improvement, the quality of Italian banks’ assets is still lower than that of the other leading European banks. The exposure of Italian banks to hedge funds represents less than 3 per cent of their capital. Their exposure to private equity funds is larger; together with loans to the companies in which these funds invest, it amounts to 13 per cent of their capital. Exposures are concentrated among the large banks. In the credit derivatives market the banking system is on average a net buyer of protection. The integration of the European markets brings new challenges for supervisors. The coordination bodies created by the Lamfalussy procedure have helped to harmonize regulation and strengthen cooperation among the authorities of the various countries. In 2006 we took part in coordinated simulations of critical events, so as to be ready to cope with episodes of instability having international effects. The convergence of supervisory practices must be carried further, to make the system less cumbersome, reduce the costs for banks and ensure equal competitive conditions. To simplify the rules while protecting stability and to keep watch over banks’ reputations by increasing the safeguards for customers have been our principles in regulating the banking system. In 2006 and the early months of 2007 the Bank of Italy abolished the requirement to give advance notice of the intention to acquire control of a bank, repealed the rules on maturity transformation and the limits on banks’ medium and long-term lending to firms, simplified the procedures for opening new branches, issued regulations for banks’ covered bonds to create a broad and reliable market, and launched a review of all the supervisory legislation with a view to drastically reducing the number of authorizations. Public confidence remains essential for the soundness of banks. The Bank of Italy verifies compliance with the rules on the transparency of banking and financial transactions and services; the extensive checks it makes at intermediaries help to improve the standard of their dealings with customers. In addition to ensuring contractual correctness, the information banks give to customers must be clear and simple. In order to strengthen the real protection of savers and firms, we plan to review all the legislation on transparency and reduce the bureaucratic formalities. We have launched a new survey on the cost of bank current accounts, among other things to ascertain the importance of structural factors such as the impact of taxation and the excessive use of cash. The recently approved European directive on retail payment services opens the market to new operators, such as large retailers and mobile phone companies; it increases competition, reduces costs, broadens the supply of services and lays the foundations for an integrated payment system in Europe. The Bank of Italy will support an extensive application of the directive, which it is to be hoped will soon be transposed by Parliament. *** Italy has transformed its banking system, begun to put its public finances in order and started to grow again. I have already reported on the progress made by the banking system. The role we played in this regard was neutral, not detached. We indicated the objective, not the actors: to aim for growth, abandoning the parochialism of the past and accepting the challenge of the market. This was where the transformation originated, not in the plans of the authorities. It is now essential that shareholders, households and enterprises clearly discern the benefits, in the shape of stronger banks ready to offer a wider range of services at lower cost. Finally, the conflicts of interest that are ever present in the land of cross-shareholdings have to be resolved. The Bank will follow all of these developments closely. A modern financial system does not tolerate the mixing of politics and banking. Let the separation be clear-cut, and both will be strengthened. For the public finances once again to foster growth and not hamper it, their adjustment must involve less current spending, more investment and lower taxes, and above all it must continue; we have ceased to accumulate debt, we have not begun to reduce it. We must tackle the structural weaknesses of our economy with greater determination. Household consumption, eroded by the extraction of rents and held in check by uncertainty about the outcome of reforms deeply affecting people’s lives, must regain its vigour. Never dealing with the problem of pensions definitively has a cost in terms of lost growth and lower consumption. These are attainable objectives if we all, each according to his own role and without tarrying to lament lost opportunities but drawing strength from awareness of the progress already made, can rediscover that sense of the common good that is essential to the enduring development of the country. | bank of italy | 2,007 | 6 |
Speech by Mr Mario Draghi, Governor of the Bank of Italy, at Session I on Challenges in the World's Financial Markets of the 2007 Money & Banking Conference "Monetary Policy Under Uncertainty", hosted by the CB of Argentina, Buenos Aires, 4 June 2007. | Mario Draghi: Monetary policy and new financial instruments Speech by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, at Session I on Challenges in the World’s Financial Markets of the 2007 Money and Banking Conference "Monetary Policy Under Uncertainty", hosted by the Central Bank of Argentina, Buenos Aires, 4 June 2007. * 1. * * Introduction In my talk on “Monetary Policy and New Financial Instruments” I will first review some of the most important financial innovations we have seen in recent years, and the consequences they have had for financial markets and institutions. Then I’ll discuss some of the implications for financial stability policies, before closing with some thoughts on the implications for monetary policy. 2. The recent wave of financial innovation While there have been many changes in how financial markets function in recent years, perhaps the most striking changes have come in the area of credit risk. Large banks in the developed markets are rapidly moving away from the traditional business of making loans and holding them to maturity. Increasingly they see their business model as originating credit claims (or packaging claims originated by others) and selling them, often in seniority-based tranches, to investors. As a result, the process of disintermediation – which was already well underway in many markets in the 1980s and 1990s – has accelerated. Credit is now something that is largely bought and sold on markets, rather than held for the long term on the balance sheets of financial intermediaries. The increased trading of securitized credit instruments has accompanied, as both cause and effect, the explosive growth in the market for credit derivatives. Meanwhile, derivatives and structured products in other risk categories, such as interest rates, foreign exchange and equities, have also continued to grow in volume and complexity. Rapid innovation in financial instruments has accompanied – again, both as cause and effect – increased activity by non-traditional financial players, notably hedge funds and private equity funds. As institutions, of course, these are not themselves new. But there has been a qualitative shift in the size and scope of their activity. They have gone from being niche players to being key participants and drivers of innovation in a broad range of markets and transactions. The growth of hedge funds is part of an ongoing realignment of the roles of different categories of financial institutions. Hedge funds now account for a large share of trading in many core market segments, and manage a steadily increasing share of the assets of the world’s pension funds and university endowments. At the same time, traditional asset managers have adopted hedge-fund-like strategies, including taking on leverage and adopting short positions. Some hedge funds are taking a prominent role in credit markets, either as direct providers, as investors in the riskiest tranches of funded or synthetic CDOs, and by providing liquidity to the credit derivative market. The rise of standalone CDO vehicles as a channel for credit intermediation in turn has altered and potentially reduced the role of traditional banks in credit markets. Private equity funds have assumed an important role in restructuring corporate assets, with the help of innovative loan structures and financing techniques that rely on hedge funds as traders and investors. And the boundaries between the functions and behaviour of private equity funds and hedge funds have blurred as well. In some respects it’s still too early to forecast the full consequences of these developments. But we can already see some of the changes in financial systems that have resulted. Let me suggest some of the consequences that these changes may have, for financial markets, for financial institutions, and for how we go about fulfilling our responsibilities as central bankers. With respect to markets, the most critical change has been the increased liquidity and transferability of risk. Not only are there ever more instruments and markets in which all kinds of risks can be hedged or traded; there is also a growing pool of counterparties willing to take one or the other side of a risktransfer transaction – as long as the price is right. When analysts talk about the increased liquidity of markets, this is what they’re referring to: in more and more markets, an asset can readily find a buyer at a price that does not command too great a liquidity premium. One reason for this is that many of the new instruments are capital-efficient, meaning that traders do not need to allocate a large amount of up-front capital to adopt the relevant exposure. A second factor helping to increase market liquidity is that more and more players are structurally better at providing it. For example, institutional investors with long investment horizons have now become the largest investors in private equity and hedge funds. Because these investors can agree to lengthier “lock in” periods, in normal times, hedge funds and private equity funds can provide ready liquidity to markets because they themselves do not need to worry about meeting the liquidity needs of their investors. The funds may, however, face liquidity demands from other counterparties, particularly in times of stress – a point I’ll come back to in a moment. The greater diversity of players and instruments, and the increase in liquidity, have had a profound impact on how financial markets function. Volatility and risk premia have fallen steadily over this period of rapid innovation. To a degree, this has reflected reduced real volatility. But, more fundamentally, markets have become structurally more efficient at pricing risks and arbitraging valuation differences across assets. Financial prices are now driven more actively towards fundamentals than before. One consequence of this is that we are moving to a world where financial shocks are more easily absorbed than they used to be, because there is a larger pool of players available who are willing and able to switch quickly from one market to another. As a result, liquidity shortages in one market or financial sector can rapidly be made up by transfers of liquidity from another. This helps ensure that prices for related assets are broadly in line with one another. But at the same time the risk of a broader shock, affecting several markets at once, may have increased. Such a shock could result from a fall in risk appetites of a broad range of participants, perhaps in conjunction with a fall in the liquidity available to hedge funds and other active traders. Hedge funds may be shielded from liquidity demands from their investors, by lock-up periods and withdrawal gates, but they still need liquid funds to meet margin calls on their positions. Those demands are likely to rise most steeply at times when markets are turbulent and the supply of liquidity, whether from other traders or from dealers and prime brokers, is likely to be reduced. If initial price movements trigger counterparty concerns, this could well generate deeper and more broad-based liquidity erosions that can pose risks of a systemic nature. What are the implications of this new environment for financial institutions, particularly the ones that are subject to regulation? One important development is that improved trading and pricing of risks enable financial institutions of all kinds to manage their risks better. For the official sector, this is clearly good news. At the same time, however, competitive pressures from new players and new ways of doing “old business” pose challenges. Greater risk management capacity also means it is easier for participants to take on risks, which can reinforce moral hazard problems. The operating environment has also become riskier, with complex instruments posing risk management and valuation challenges even for the most sophisticated firms. A shock to profitability that reduces the credit standing of one or more large institutions, or leads banks to take on riskier strategies in order to reach a desired level of profits, could have systemic implications that authorities need to be aware of. A critical question for the stability of global financial markets is whether the core intermediaries – the fifteen or twenty large global firms that make markets in the most widely traded derivatives and act as prime brokers to hedge funds – are adequately managing their counterparty and principal-based trading activities. The large dealers firms manage counterparty exposures through a combination of initial margin, variation margin, and allocations of their own capital. So far, these firms seem to be keeping their direct credit exposures to hedge funds and principal trading under control. However, there is evidence that competition for hedge fund business may be putting margining arrangements under pressure. It is also unclear whether firms have adequately protected themselves against indirect exposures to the consequences of greater leveraged activity, such as the risk of a sudden global shock to liquidity as I mentioned a moment ago. Firms are still devising methodologies to model such events and incorporate them in stress tests. But ultimately the best safeguard will be adequate capital and liquidity cushions. 3. Implications for financial stability policy What do these developments mean for financial stability policy? In the new environment, risks seem to be dispersed more widely, but transparency about where risks are located has declined. This reduces the sectoral impact of real and financial shocks, but may also make it harder to anticipate which sectors are vulnerable to a shock. Even more than before, policy needs to move from a reactive orientation, where we intervene in response to problems and threats, to a preventative stance in which systems are made more robust to potential shocks. Certainly it’s not the task of the official sector to stand in the way of innovation or improved efficiency. However, we do need to minimize the moral hazard risks that might come from the increased risk capacity of regulated firms. One way to do this is to redouble our efforts to use regulatory tools – riskbased capital requirements, prudential rules, disclosure that is aimed towards strong market discipline – to align the decisions of regulated firms more closely to market signals. New instruments and trading patterns also call for the expansion or adaptation of the market infrastructure that underpin financial activity. Here, collective action problems among market participants can arise that prevent the market from finding appropriate solutions on its own. Giving the impetus that the markets need to resolve collective action problems is a key task of central banks and financial regulators. We’ve seen some creative examples of this in the last few years, for example the efforts of the Federal Reserve Bank of New York and the Financial Services Authority in London to press large dealers to reduce their backlogs of unconfirmed credit derivatives contracts and to create more resilient settlement arrangements for these transactions. The approach to regulation of hedge funds has been much discussed over the years. After extensive debate following the 1998 LTCM crisis, political and financial authorities agreed an “indirect approach”. This approach relies on the counterparties who provide hedge funds with leverage – largely regulated banks or investment banks – to exercise appropriate discipline in their lending and dealing with hedge funds. Counterparties are expected to impose limits on their exposure to a hedge fund that takes on excessive leverage, is engaged in excessively risky strategies, or is not sufficiently forthcoming with information about their risk exposures. This indirect approach has generally worked well in containing the financial stability risks posed by hedge funds. It is a joint effort, involving first and foremost the exercise of discipline by the private sectors, with supervisors buttressing that discipline when competitive pressures erode it. As markets grow and evolve we need to work constantly to ensure that all of the relevant parties are doing what they need to do. This is the message that came out of the Financial Stability Forum’s recent update of its 2000 report on highly leveraged institutions. In the update we set out five recommendations – addressed to supervisors, hedge fund counterparties, investors, and the hedge fund industry – that FSF members agree are likely to be most effective in financial stability risks related to hedge-funds Three of the recommendations are addressed to supervisors. They are urged to press dealer firms to strengthen counterparty risk measurement and management, especially where instruments are new and complexity is high. They will also work with firms to strengthen their capacity to assess and mitigate their exposures to the market liquidity erosions I mentioned earlier. Lastly, supervisors will evaluate the case for developing more systematic data on core institutions’ global credit exposures to hedge funds. A fourth recommendation calls on counterparties and investors in hedge funds to demand and act upon appropriate information from hedge fund managers, while a fifth urges the hedge fund industry to review and enhance existing sound practice benchmarks for hedge fund managers. I would like to dispel the notion that this indirect approach is a light approach. In particular, for supervisors to be able to judge the adequacy of firms’ risk management processes and to induce more conservatism where this is needed, they must establish – continuously – where the frontier in terms of risk management practices is. And they must then set out expectations about changes that firms individually and collectively must make, and oversee firms’ implementation of necessary changes. An extensive review by the main supervisory authorities of how the largest banks and prime brokers in the world manage their hedge fund related risks is now underway. Separately, the hedge fund industry has begun to take steps to strengthen existing sound practice guidance, notably in the areas of risk management, valuation practices and disclosures to investors and counterparties. We will be following progress in these areas very closely in period ahead. 4. Implications for monetary policy The widespread innovations in the financial markets that I just mentioned – the expansion in the use of marketable instruments, the rise of new players, the development of derivatives and structured products markets – have brought important changes in the way monetary policy is conducted, communicated and transmitted to the economy. First of all, the transmission mechanism is changing. While the effect of monetary policy on the availability and cost of bank credit is decreasing, monetary policy actions have prompter effects on a whole range of financial market yields and asset prices. The latter development may be positive, if our intentions are communicated well and correctly interpreted by investors. It could be detrimental, if it causes more volatility. Our decision-making process is also changing. We have at our disposal a wide range of new information from asset prices, which enables us to gauge market expectations more carefully and take them into account. However, the interpretation of other crucial variables, such as monetary and credit aggregates, is more difficult than in the past, although by no means less important, and calls for renewed research efforts. Let me address some of these issues in turn. 4.1 Monetary policy, asset securitization and the changing role of banks The role of the banking system in the transmission of monetary policy decisions to the economy – the so called “bank lending channel” – was once central. It is now rapidly diminishing. Compared with the traditional way of thinking, this is a sea change. Banks were previously at the centre of the monetary transmission process. The existence of asymmetric information on the quality of borrowers assigned a special role to banks in assessing firms’ creditworthiness and providing external finance; the sensitivity of banks’ checking deposits to interest rate changes gave monetary policy a powerful tool with which to affect banks’ funding and intermediation activity. The development of new financial products and intermediaries is radically reshaping this environment. Banks are taking on a new role in originating, pooling and distributing credit risks outside the banking system. In most markets the securitization of bank loans is booming, and this is affecting the way monetary policy operates. By disseminating information about firms, loan securitization is helping to reduce the spread between the cost of internal and external finance. The possibility to securitize loans and sell them to institutional investors, such as hedge funds, insurance companies and pension funds, eases banks’ funding constraints for new lending. It also allows banks to transfer a substantial part of credit risk and reduce their capital requirements, making possible, other things being equal, a further increase in loans supplied. We are devoting a good deal of research to the implications of securitization on the role of banks in the transmission mechanism. Ongoing research by the Bank of Italy and the ECB (using microdata on 3,000 euro-area banks over the last eight years) 1 finds that banks that make greater use of securitization are more sheltered from the effects of monetary policy changes: in response to increases in official rates, their lending activity shrinks less than does that of other institutions. Securitization therefore appears to reduce the overall effect of monetary policy on loan supply significantly. This finding has important implications on how we assess policy. We can no longer limit ourselves to examining the state of the banking system and its credit risk in order to evaluate the effect of monetary policy on credit conditions and the stability of the financial system. While the banking system may still be the lever by which the entire financial system is controlled, other actors, often located far from where the loans are originated, have an increasing influence on credit supply. The changing distribution of credit risk in the economy may affect the way the transmission mechanism operates, in ways we do not yet completely understand. The resilience of the financial system in the face of larger shocks has yet to be fully tested. Although credit risk will be less concentrated on banks, the financial risks that are being created by the system may actually be greater. It cannot be precluded that episodes of credit risk mispricing may be followed by abrupt adjustments, posing new challenges to the stability of the financial system as a whole. It is too early to tell whether the changes on the financial markets have determined the end of “credit cycles”. Y. Altunbas, L. Gambacorta and D. Marqués, “Securitisation and monetary policy”, mimeo, May 2007. 4.2 Monetary policy and asset markets While the role of banks in monetary policy transmission is diminishing, other channels are gaining in importance. To the extent that financial innovation makes markets more complete and more efficient, actual and expected changes in official interest rates are readily transmitted to a wide range of financial assets. Overall, the effects of policy decisions on financial markets are stronger and faster. A more immediate impact of monetary policy on a wide range of asset prices may have favourable implications, since it provides monetary authorities with a powerful instrument for affecting the economy. Market expectations on future policy intentions move long-term rates and affect financing conditions, even before official interest rates are changed. The modification of asset prices affects consumption and investment decisions. If policy communication is effective, these changes may partly “do the job” for central banks. At the same time, unless we are suitably careful the consequences may be disruptive. Policy actions that diverge from the pace expected by economic agents, which is built into long-term interest rates and other yields as well as into positions taken on the market, may upset markets, increase volatility and, in extreme cases, induce a simultaneous revision in positions, with potentially disorderly effects on liquidity and asset prices. The concern not to destabilize financial markets is one reason why many central banks have striven in recent years to reduce the uncertainty arising from policy decisions. They are paying more attention to proper communication of their objectives, strategies and, with different nuances and practices, future intentions. A trend to greater gradualism in policy action has emerged in all the main industrialized economies (policy moves in excess of 25 basis points are now quite rare for major central banks) partly in response to the greater uncertainty over the impact of rate changes on the financial markets. As the interplay between policy actions and market expectations gathers importance, we should also guard against the risk of what has been described by Alan Blinder as the “dog chasing its tail”. It is fundamental that we to avoid a situation in which financial markets look at the central bank and the central bank looks at financial markets, both losing sight of the underlying factors that determine inflation. In the Eurosystem, we consider it definitely desirable that our policy be predictable in order to reduce uncertainty and volatility in financial markets. However, our actions are ultimately dictated by the economic outlook, not the view of the financial market. In general it is better to avoid surprising the market, but there are times when it cannot be avoided, because we have new information or, more simply, different views from market participants. In these cases, effective communication is even more important. To deliver price stability over the medium term, it is essential that the leadership remain with the monetary authorities. 4.3 Monetary policy and financial market indicators Let me further observe that the development of financial markets and the introduction of new instruments affect not only monetary transmission but also our decision-making process. The availability of a wide range of new products gives us a wealth of information that we jacked even just a few years ago. By contrast, the traditional indicators are now harder to interpret. We have at our disposal a large set of information from derivatives markets (futures, options, swaps) that is key to our decision-making. Prices on these markets allow us to estimate, with a degree of precision that a few years ago would have been unthinkable, the entire distribution of market expectations about crucial variables. We now have indicators of market expectations about inflation, growth and policy decisions, of the uncertainty surrounding those expectations, and even of investors’ attitude towards risk. This helps us to produce better policy decisions: investors’ expectations shape the way the economy is likely to react to our actions and are a source of information on the underlying economic trends. However, the diffusion of new financial instruments is also likely to affect the information content of some of the indicators that central banks regularly monitor and that serve as a basis for policy decisions. The behaviour of money and credit is particularly affected by the emergence of new products and new players. Ten years ago, most of M3 in the euro area was held by households and firms, whose behaviour as money-holders we could understand reasonably well. Only around 6 per cent was held by so-called non-bank intermediaries (which include mutual funds and “financial vehicle corporations” that purchase, pool and repackage bank loans as marketable securities). This percentage is now almost twice as large, and about one fifth of M3 growth is accounted for by these intermediaries. 2 Their demand for money is likely to respond to different motives, and is harder to interpret. Moreover, marketable instruments (such as money market funds) now represent 14 per cent of M3, as against 10 per cent at the beginning of the nineties and only 5 per cent in the mid-eighties. They are held for portfolio purposes and are less directly connected to transactions and spending on goods and services. These developments call for deeper analysis. It would be wrong to conclude, as some commentators seem to have done, that they require a reduction in the role of money in the strategy of central banks, and of the ECB in particular. The dynamics of monetary aggregates still conveys important information on the future evolution of prices, but in order to extract this information it is necessary to process a larger set of monetary data and take account of the significant impact of the recent financial innovations. All the central banks in the Eurosystem are committed to improving their analysis in this direction. Ongoing research at the Bank of Italy is aimed at developing techniques to extract information from the common trend of a large set of monetary indicators (M3, but also its components, the monetary holdings of different sectors of the economy, and the counterparts of M3, including credit developments), using multivariate techniques (dynamic factor analysis) to get rid of noise. Our results indicate that the common trend derived from the various monetary components conveys useful information on the behaviour of inflation a few years down the road. 3 This confirms that the analysis of monetary variables remains essential in the conduct of monetary policy, provided it is based on the assessment of a large information set and sound economic interpretation. This implies that we should not be complacent about the value of our current tools, which are clearly affected by the ongoing change in the euro-area financial landscape. However, playing down the importance of monetary and credit analysis would be a dangerous mistake. In this respect I believe that the “full-information” strategy adopted by the Eurosystem, based on cross-checking the signals derived from real and monetary variables, is probably the best to deal with the challenges posed by a changing environment. 5. Conclusions I have offered a few thoughts on how financial innovation may affect monetary policy. Certainly, I have not exhausted the issues, but sought rather to highlight the key themes and the main lines of current thinking among central banks and other official institutions. We need the experience of a full credit cycle before drawing conclusions. As with any period of rapid innovation, there is a great deal of uncertainty about how critical variables – including credit aggregates, consumption, fixed investment, and inflation – will behave under different scenarios. Policymakers will need to be humble about what they do not know, and to be creative and flexible in dealing with the changes to the traditional relationships that are rapidly taking place. Conferences like this one are of vital importance to foster understanding of these developments and exchange views on what they mean for the tasks we face as central bankers. G. Ferrero, A, Nobili and P. Passiglia, “The sectoral distribution of money supply in the euro area”, Banca d’Italia, Temi di discussione, No. 627, 2006. A. Nobili, “A composite indicator for monetary analysis”, Banca d’Italia, mimeo, May 2007. | bank of italy | 2,007 | 6 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Annual Meeting of the Italian Banking Association, Rome, 11 July 2007. | Mario Draghi: Monetary policy and the banking system Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Annual Meeting of the Italian Banking Association, Rome, 11 July 2007. * * * I wish to thank the Italian Banking Association for extending its traditional invitation to the Governor of the Bank of Italy to take the floor on the occasion of your Annual Meeting. And I should like to convey my special greetings to President Corrado Faissola, who is presiding over the gathering for the first time. Economic and monetary developments The euro-area economy will continue to expand in line with its potential growth rate. The rapid increase in exports should be accompanied by lively internal demand. Industrial production is now at a five-year peak, as is the indicator of business confidence, and consumer confidence continues to improve. In the second quarter of 2007 GDP growth was about 2 per cent on an annual basis. The EuroCOIN coincident indicator calculated by the Bank of Italy has declined slightly since the start of the year but remains at a high level. The Governing Council of the European Central Bank, clearly perceiving the signs of expanding economic activity, has been making its monetary policy progressively less accommodating since the end of 2005. This prompt intervention, in advance of actual pressure on prices, has kept inflation expectations anchored to a stable scenario. Lending conditions for households and firms remain favourable. The money supply and credit in the euro area are still expanding rapidly. M3 growth remains near the highest rates recorded since the start of monetary union. The most liquid components, cash and current accounts, have decelerated. Bank credit to firms is growing at a strong pace, while lending to households has slowed slightly. The deceleration in mortgage lending for house purchase reflects the slackening of property prices and rising interest rates. Since January the rate of inflation has been just under 2 per cent. It may exceed that value temporarily in the months to come as a result of the recent rise in energy prices. The euro has contributed substantially to Italian and European economic growth. Since its introduction, thanks to the Eurosystem’s monetary policy, inflation expectations have remained low and stable, even in the face of sharply rising energy prices. The credibility of the monetary policy stance has kept interest rates significantly lower than in previous decades in every phase of the economic cycle, not just in Italy but in the other euro-area countries. The predictability of monetary policy has helped reduce the volatility of the financial markets. At the launch of the monetary union there were fears that certain structural features would make the Italian economy more vulnerable than others to variations in the official rates. Monetary policy produces its effects on the economy above all by influencing the cost differential between firms’ external and internal finance. Its impact is therefore amplified by information asymmetry concerning the state of the borrower, or by the impossibility for firms of replacing bank loans with market instruments such as bond issues. A situation that is especially common in Italy, where small firms depending on bank credit are prevalent and where private capital markets are still less highly developed than in other large industrial countries. The effect is heightened if the loan market consists mainly of short-term, variablerate loans. Studies conducted by the Eurosystem using a broad range of econometric techniques have nevertheless found that, albeit with modest differences, the economies of all the euro-area countries have so far responded in similar fashion to changes in interest rates. In recent years the exceptionally low level of risk premiums and of interest rates, the abundance of finance in the form of both loans and other financial instruments, and the large volume of firms’ internally generated funds may have softened the effects of structural disparities, which could re-emerge in the presence of less favourable economic and financial conditions. At the same time, however, the structure of the Italian economy is becoming more robust. The consolidation of the credit system has given birth to large banks capable of operating on a range of markets. The improved efficiency of intermediaries and the considerable lengthening of corporate debt maturities have removed earlier weaknesses. The extraordinary development of the euro bond market and the recent opening of the Italian stock exchange to international alliances will also help a system that had lost the market for corporate bonds and where firms’ recourse to the equity market is still limited. Further progress on these fronts is essential if we are to fully exploit the advantages of participating in the Monetary Union. Financial innovation and monetary policy The diffusion of financial innovations, the creation of new products and new intermediaries, and the changing structure of the financial markets alter the importance of the various channels of monetary policy transmission and affect the analysis of money and credit aggregates and their role in monetary management. The role of the banking system in transmitting monetary policy impulses has been diminishing in importance. If the recent changes in the structure of the financial markets prove to be permanent, banks will increasingly be agents that originate loan assets which they then combine and transfer in part to the market. Loan securitizations are booming. In 2006 they were equal to more than one fifth of the increase in lending in the euro area and in Italy. Credit derivatives, though still small in volume, are growing explosively. The transfer of assets to non-bank investors such as pension funds and hedge funds gives banks an alternative channel for procuring liquidity. The transfer of risk by means of derivative instruments can reduce the supervisory capital requirement for a given volume of lending. A study by the Bank of Italy and the ECB on eight years of data from 3,000 intermediaries in the euro area has shown that the banks that make the greatest use of securitization decrease their lending less than others in response to rises in the official interest rates. Other transmission channels are gaining in importance. Innovation has made financial markets more liquid, efficient and complete. The speed with which official rate changes are reflected on a broad range of financial instruments, and hence on saving and investment decisions, has increased. The markets respond to expected moves by the central bank even before its actual moves. The promptness with which markets react to new information increases the risks of instability inherent in unclear communication by central banks. Monetary policy decisions that diverge from the expectations of the market already embodied in financial asset prices can have devastating effects on liquidity and prices in extreme cases. In recent years central banks have augmented the predictability of monetary policy, making objectives and strategies clear and explicit. Central banks take expectations into account, but they do not lose sight of the fundamentals. To avoid surprising the markets is preferable but not always possible. It remains essential for price stability that the authorities’ actions orient the market, not the other way around. The changes in financial structure also affect the information content of the monetary aggregates. Until not many years ago virtually all euro-area M3 consisted of transaction instruments of households and firms, whose behaviour as holders of money was stable enough. In recent years there has been considerable growth both of the portion held by nonbank intermediaries, including investment funds and loan securitization vehicles, and of the portion consisting of negotiable instruments, holdings of which are largely determined by portfolio choices rather than consumer spending. Nevertheless, the money supply is still an essential element in central banks’ assessment of price stability. To extract the full information content, a broad set of aggregates and indicators should be analyzed. The analytical tools need to be adapted, an objective shared by all the central banks of the Eurosystem. The Bank of Italy is developing techniques for the analysis of a set of monetary indicators that includes all the components of money and credit. The transformation of the banking system In the year since your Association’s last annual meeting, three major bank mergers, two of them involving cooperative banks, have been concluded with approval by shareholder meetings. A fourth, passed by the boards of the banks involved, awaits shareholder approval. The Italian banking system has become more robust in terms of the size of institutions. Today the two largest groups both have a significant presence abroad; the conditions exist for competing on a European scale. The other mergers have created banks that are among the largest in Italy. The consolidation of banks is just the starting point. Reorganization can only be said to have been successfully carried through when the gains in efficiency envisaged by the business plans are achieved. The market expects savings from the unification of technological platforms, the integration of distribution channels, the increase in labour productivity. Having a greater number of national-scale banks will increase competition. In order for increased size to engender greater competitiveness, integration synergies must be exploited in full. Past experience shows how complicated it is to integrate different organizations, technologies, networks and corporate cultures. There is a serious risk of heel-dragging and slowness to adapt. A high degree of unity on the part of management and the greatest possible reserve in external communication are of the essence. There is no time to lose. The quality of corporate governance is crucial to the success of integration. Choices must be guided by clear objectives and a rational division of responsibilities. The Bank of Italy is active, attentive. We shall continue to examine the solutions adopted and the way corporate bodies operate, ensuring their proper functioning for purposes of sound and prudent management and intervening whenever necessary. Specific rules on the governance of banks will be issued. It is essential that the new groups organize their system of internal controls as a matter of urgency. The complexity of integration and the rapid expansion of innovative products heighten operational, legal and reputational risks. Clear accountability and the ability of top management to keep control of the key processes are prerequisites for stability even more than efficiency. All the banks involved in the mergers had developed advanced methods of risk measurement to be submitted for supervisory approval as an instrument for calculating capital requirements. In some cases the project will have to be revised to take account of the new situation. In no case is a deterioration of risk control, even a transitory one, permissible. The consolidation of the banking industry will facilitate the reorganization of the asset management industry and the realization of the scale economies that could result if integration synergies are exploited in this field too. Consideration should be given to measures to guarantee the complete independence of the directors of asset management companies. It is commendable that the majorities of the boards of the two largest bankowned asset management companies consist of independent directors. Italian banks have large market shares in the countries of eastern Europe, where lending is expanding rapidly. The loans go above all to households for the purchase of houses, whose prices have risen rapidly. In Slovakia, Poland, Bulgaria and Hungary, where Italian banks’ market share is around one fifth, lending is increasing by more than 20 per cent per year on average. These countries’ external current account deficits are large and persistent. Last year Bulgaria ran a deficit of 16 per cent of GDP. Bank loans, which are mostly indexed to the euro or other foreign currencies, carry lower interest rates than those in domestic currencies. In the short run they are attractive to borrowers but expose them to a severe exchange rate risk, with potential financial and reputational repercussions on the banks. I have repeatedly called attention to the need to complete the reform of the governance of Italy’s cooperative banks. The aim, which I believe is generally shared, is to release the extraordinary potential of these institutions, make sure their corporate bodies are satisfactorily representative, not to question their cooperative mission. To those who want to maintain the present equilibria, I shall not cease to recall the benefits – especially for the largest cooperative banks listed on the stock exchange – of a reform that removes the anomalies of a legal framework tailored to small, local banks. We must ask whether decisionmaking mechanisms in which small minorities have a decisive voice in strategic choices are consistent with the rules of the market. Banking supervision in Europe The concentration of banking systems, the removal of barriers between markets and the transnational nature of the largest groups have given banking supervision a European dimension. These developments have demanded a rethinking of the instruments of supervision that has already had important consequences but is still under way. Harmonization of the rules on banking supervision has reached an advanced stage. There is agreement on the fundamental choices and extensive cooperation among the supervisory authorities, in the first place within the Committee of European Banking Supervisors. For transnational groups supervisory panels are at work, formed by the authorities of all the countries in which a group is present and coordinated by the authority responsible for consolidated supervision. The Bank of Italy chairs the panels for UniCredit and Intesa Sanpaolo and participates in many others. The exchange of information and experience is continual, the climate of cooperation excellent. It is necessary to extend harmonization gradually from supervisory rules to supervisory practices: more effective action, equal conditions of competition, a lighter burden on banks, especially those present in different countries, are the objectives. Further harmonization of the rules on own funds and risk concentration appears urgent. It will also be necessary to design common criteria for stress tests and work for the adoption of a homogeneous prudential statistical reporting format. In the coordination fora the authorities have conducted simulations to prepare for the crisis of a large bank. One learns a great deal from these exercises, and it would be a good thing if they were held more often. Principles and procedures for the allocation of tasks and responsibilities are being defined; the process must be completed rapidly. A strengthening of the role of the CEBS will speed up convergence of supervisory practices and simplify cooperation between authorities. Thought also needs to be given to the possibility of emphasizing the position of the coordinating authority in supervisory panels by giving it the role of lead supervisor, with greater powers on the group’s subsidiaries for purposes of preventing and managing crises. However, the remaining differences between countries in deposit insurance, insolvency procedures and the rules on the transfer of assets between units of the same group could seriously complicate the management of a crisis. Eliminating or attenuating these differences must be placed on the legislative agenda at national and European level. Banks, firms and innovative products Bank’s dealings with firms now embrace not only the provision of loans and payment services, but also the supply of innovative financial services, including risk management products. These can increase the efficiency of the system and be a growth opportunity for banks, provided the customer is given complete information, the seller fully understands the product and the bank’s top management, whose duty it is to appreciate these products in all their complexity, is clearly aware. Banks provide an important service to firms if they assist them in selecting instruments suited to their characteristics. The purpose must be the hedging of risk, not anything else. To encourage customers to assume financial risks rather than hedge them increases counterparty risk, with large possible losses; it creates legal and reputational risks that can undermine the bank’s prospects for growth and even call its stability into question. This is before our eyes in a case now being clarified. An inspection that the Bank of Italy began at a bank in January of this year found that it had sold business customers complex derivative products, highly exposed to an increase in interest rates. Owing to market developments, these derivatives have caused a sudden surge in the indebtedness of the customers who had bought them. The result was an increase in the bank’s exposure to counterparty risk as well as to legal and reputational risks. The Bank of Italy intervened; it is following the case with the utmost attention. Proper conduct, transparency and adequate organization are essential to every bank that alongside its traditional credit operations sells complex products. There must be a clear line of decision-making connecting top management to operating decisions and to customers’ demands. Transparency, proper conduct and the protection of bank customers The Bank of Italy’s supervisory provisions on compliance have been approved and will shortly be published. They lay down general principles, granting banks discretion in selecting the most effective organizational arrangements. Banks’ governing bodies decide the overall design of the compliance function and monitor its actual operation. In all customer relations, transparent and correct information increases the public’s range of choices, fosters competition and prevents legal disputes. Lawmakers and regulators have become more responsive than in the past to the need to ensure correct relations; banks themselves are rapidly becoming aware that the point is not only to defend and enhance the reputation of the industry, but also to gain an important tool of competition. As I have said on other occasions, it is appropriate for regulators to intervene where economic agents and the market are unable by themselves to ensure adequate standards. Self-regulation, if based on agents’ clear determination to pursue its underlying objectives, can be more effective than mandatory rules in many cases. The most powerful tool for pursuing the interest of consumers remains competition, which can function well, however, only if transparent terms and conditions are ensured and the obstacles to customer mobility eliminated. This requires rules at various levels; statutory provisions, administrative regulations, self-regulation and competition are complementary instruments. I therefore take note with favour of the action plan ABI has just adopted to improve relations with customers. The intent to capitalize on cooperation with consumer associations and the authorities is commendable, the declared objectives endorsable: to enhance the transparency and simplicity of relations with customers, to assist customers before and after the sale of financial products, to strengthen their confidence, to eliminate residual barriers to mobility. It is in the system’s interest that customers see concrete progress soon. Self-regulation must benefit competition. The cooperative relationship between the banking system and the Antitrust Authority is positive. In recent times Parliament has intervened on various aspects of the bank-customer relationship, in particular by ordering the abolition of costs for closing current accounts and introducing the customer’s right to extinguish a mortgage loan without a penalty. The Bank of Italy looks with favour on the purposes of these measures, even if it has raised doubts on certain technical aspects and suggested leaving room for secondary legislation and selfregulation. For current accounts, the new rules have given rise to problems of interpretation, and progress has been insufficient: complete portability of accounts is not yet guaranteed. For fixed-rate mortgages, the ban on penalties for early repayment may lead to banks setting higher rates: early repayment is an implicit option in favour of the debtor and thus has a financial cost. Parliament is examining a bill that will prohibit the maximum overdraft fee, a practice not easily defensible and in fact one that some banks have already dropped in a logic of competition. An amendment approved during the bill’s passage through Parliament will, in line with views expressed by the Bank of Italy, allow banks to apply fees for open credit lines, a common practice in other banking systems. The MiFID Directive on Markets in Financial Instruments, which will enter into force in November, will also affect relations between customers and intermediaries. Its more precise description of information requirements, differentiated according to the nature of the customer and the service, will enhance the transparency of the instruments offered. Customers will be in a position to benefit from a larger dataset and make more informed decisions. Fulfilment of the obligation to offer best execution, extended to include factors other than the price, will be entrusted to suitable organizational solutions identified by intermediaries. The Bank of Italy, with the other authorities, is engaged in defining a flexible regulatory arrangement consistent with the need to limit the costs for intermediaries and with the objective of enhancing the attractiveness of the Italian financial marketplace. We have organized training courses for the staff of some of our branches to assist banks in adapting to the new rules. Protection of the parties to bank contracts requires swift-acting, effective and economical dispute resolution instruments. The law now asks intermediaries to subscribe to non-judicial mechanisms. The Bank of Italy, which will have to submit a proposal to the Credit Committee for the regulation of the matter, is about to begin a consultation with intermediaries and customers. The proposal will be based on the experience gained in Italy and elsewhere and on a specific European recommendation; it will ensure that the adjudicating bodies are not only independent but also clearly perceived to be so. The Bank is ready to contribute by taking part in the appointment of disputes resolution panels and providing technical secretariat services. The success of the initiative requires both involvement of the associations of consumers of financial services and convinced participation by the associations of intermediaries, which will also make it possible to draw on the experience of the Banking Ombudsman. No rule on transparency and protection is truly effective if customers lack the means for making informed decisions. With the growing complexity of supply, ensuring the financial education of consumers of banking services has become a matter of crucial importance. The Bank of Italy cooperates with other institutions in projects of financial education, has begun to develop a dedicated section of its own website and, with the Ministry of Education, has launched initiatives targeted at schools. But much remains to be done. The Bank of Italy is committed to preventing and combating money laundering. The planned incorporation of the Italian Foreign Exchange Office into the Bank and the transposition of the new European Anti-Money-Laundering Directive will create the conditions for further progress. The independence of the Financial Intelligence Unit will be confirmed. The rules will be made more incisive, controls increased and new forms of intervention introduced. Loans to households Household debt has risen from 31 to 48 per cent of disposable income since the end of the 1990s. Compared with the situation in the other main industrial countries, both the amount of household debt and the burden of instalments and interest payments are still limited. The debt is largely concentrated with high-income households, which normally are better able to absorb additional costs due to rising interest rates, but its rapid expansion is involving everbroader strata of the population. Financial innovation, more flexible rules and increasing competitive pressures have multiplied the forms of financing available, especially for house purchases. Until not long ago mortgages rarely exceeded 15 years in duration or 50 per cent of the purchase price. Today more than one third of mortgages last more than 25 years and the cover ratio is considerably higher. Access to consumer credit has also become easier. The market in lending to households has expanded and matured. Further progress must be made, however. Both for home mortgages and for consumer credit, the interest rates charged by banks in Italy are higher than the euro-area averages for similar transactions. The recent change in monetary conditions has led to a shift in the demand for mortgages from variable to fixed rate loans; for the latter, the increase in interest rates has exceeded the European average. The new rules on covered bonds will enable banks to expand the range of funding instruments to finance long-term loans and reduce their costs; this will have to be reflected in more favourable conditions for customers. Data harmonized at European level show that Italian banks’ annual percentage rate of charge on consumer credit is still about one percentage point higher than the euro-area average, even though the gap has narrowed in the last few months. Not all of the difference is due to risk factors or to the still limited development of the consumer credit market in Italy. Not even the entry of foreign intermediaries, which now account for more than one third of such lending, has proved a sufficient stimulus to competition. This must be strengthened, especially in distribution channels. According to data gathered pursuant to the law on usury, the interest rates charged by financial companies are higher still. Furthermore, especially where small amounts are involved, rates vary widely even for transactions of the same type, such as personal loans, loans secured by wages and instalment purchases of consumer goods. This probably indicates insufficiently transparent contractual conditions and a pronounced segmentation of the market. The attention banks pay to customers and to their own reputation must be greatest when their contact with the customer is made through outside collaborators. It is necessary to check that each link in the chain leading to bank products charges commensurate fees, to assist in the fight against usury, and to act promptly in cases of suspected unauthorized banking or financial activity. The instruments are not lacking. Brokers’ terms and conditions are subject to transparency requirements. A bank employee who steers someone to an unauthorized person for banking or financial transactions commits a specific crime. Certain characteristics of current account transactions that suggest usury have been made known by the Italian Foreign Exchange Office. The Council of the European Union has reached agreement on a new directive on consumer credit, which will be examined by the European Parliament in the autumn. If approved, the directive will enhance consumer protection by providing for forms of transparency and assistance and new rights. It is in the nature of “maximum harmonization” and will therefore facilitate intermediaries that want to operate in more than one country, thereby stimulating competition. The Government has the commendable intention of anticipating the main points of the directive with ad hoc legislation and introducing, for loan and financial brokers, more detailed regulation and more effective controls, to be entrusted in part to organizations created by trade associations. Payments: lowering costs, improving quality Competition between banks will also be based increasingly on their ability to offer efficient payment services. There is room for improvement in payment completion time, costs and security. Completing a payment by cheque still takes an average of seven days; a legislative amendment facilitating digital transmission of the images would make a significant reduction possible. The creation of the Single Euro Payments Area will provide the occasion for modernizing instruments and infrastructure at national level as well and will be conducive to the specialization of intermediaries and to innovation. The Payment Services Directive has harmonized the European legal framework, strengthened the protection of users and opened the market to new agents competing with banks. But Italy is still considerably behind in the use of electronic payments. Although the diffusion of POS terminals and payment cards is not less than in the rest of Europe, the number of transactions per capita with these instruments is far below the average. The excessive use of cash lowers the efficiency and security of transactions, increases the cost per transaction and hinders the reduction of the prices of payment services. ABI’s commitment in favour of a rapid development of electronic payments is commendable. The results of the survey on the costs of bank current accounts that the Bank of Italy has already begun will be available in the autumn. The stock exchange I cannot conclude these remarks without mentioning the developments involving the stock exchange. A year ago on this occasion, I recalled at some length the essential role that the stock market plays in fostering the growth of the economy. I noted the strong boost to efficiency deriving from the integration of European and world exchanges and the drive to consolidate stock exchanges, including on a federal basis. Just a month has passed since my Concluding Remarks to the annual meeting of the Bank of Italy where I again underscored the growth opportunities that are emerging for exchanges that open to international cooperation and the risks for those that stay on the sidelines. Borsa Italiana has taken steps to capitalize on its strengths – operational efficiency, local roots and its strong presence in some markets – and to reap the benefits of integration in a market of global dimensions. This opening is definitely a positive development. As in other fields, the Bank of Italy points to what it considers the right route. It does not seek to determine any institution’s traveling companions. It notes that the road ahead is still very long and urges that it be traveled resolutely. | bank of italy | 2,007 | 7 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Parliamentary Committee of Inquiry into Mafia-like Criminal Organizations, Rome, 14 June 2007. | Mario Draghi: The prevention and suppression of money laundering Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Parliamentary Committee of Inquiry into Mafia-like Criminal Organizations, Rome, 14 June 2007. * 1. * * The economic aspects of money laundering Money laundering – that is, investing the proceeds of crime in legal economic and financial activities – is the more extensive, the greater the scale of criminal organizations. As these expand, their need to invest their funds and conceal their origins increases. Today, money laundering exploits the development of financial markets and globalization, taking advantage of the same channels that facilitate legitimate transactions, of the greater ease of communication, of technological and financial innovations and also of the fact that the reaction of the authorities is hindered by difficulty in acquiring information and by the costs of international coordination. The possibility of using unwitting intermediaries for illicit transactions makes criminal organizations more dangerous. Loopholes in the rules and blind spots in the control apparatus of various countries enable illegal operators to engage in “regulatory arbitrage” on an international scale. Prevention and suppression may be further undermined by the selfinterested tolerance of some States and the opacity of some off-shore financial centres. Organized crime does not just subvert public order. It also attacks economic and financial stability by altering the proper functioning of market mechanisms to the advantage of dishonest operators. In line with recent European directives, economic crime must be combated by pursuing both the objective of law enforcement and that of economic development. A balanced strategy of prevention and suppression must be founded upon rules that, on the principle of proportionality to the threat, lay down clearly formulated and easily applied obligations; that avoid intrusive instruments and excessively rigid procedures; that do not overburden honest businesses; that institute sound mechanisms of enforcement and sanctions that are swift, effective and proportionate to the seriousness of the infractions; that provide incentives for intermediaries to collaborate with the structures that fight money laundering; and that strengthen domestic and international cooperation among authorities. The States that are most aware of the problem, perceiving that criminal organizations are most vulnerable when they seek to funnel the proceeds of crime into legitimate channels, have long concentrated on the financial system. Given the nature of its activity the financial system can be exploited to launder the proceeds of crime, but at the same time it has proven to be highly effective in cooperating with the law enforcement authorities. The Bank of Italy stands ready to step up its own commitment to the fight against crime, both organizationally and in terms of resources. We are fully aware that money laundering and the financing of terrorism, with their great inherent danger of contagion, now constitute a grave threat to the democratic order. Today I will briefly review the main problems impeding the prevention and suppression of money laundering and suggest possible remedies. The results of action to date are set out in documents annexed to my report. 2. The development of the law on money laundering 2.1 The basic guidelines Italy’s series of legislative measures to coordinate the battle against organized crime began in the early 1980s. In 1982, having perceived the extreme danger of criminal attacks on the legal economy, Parliament introduced the crime of Mafia criminal conspiracy, characterized among other things by the aim of controlling business enterprises and reinvesting the proceeds of crime. Italy’s current legislation on the prevention of money laundering is thus the product of more than two decades of engagement on the part of Parliament and the authorities. It has adopted, and in a number of instances anticipated, the indications of the various international fora. Its development has been consistent with several fundamental choices: the distinction between prevention and suppression; the central management of information and evaluations; and cooperation between intermediaries and law enforcement authorities. The changes made in recent years have incorporated the innovations introduced by international standards and, subsequently, by Community law. The revision of the 40 recommendations of the Financial Action Task Force (FATF) in 2003, the issue of 9 special recommendations to combat the financing of terrorism, and the approval of three Community directives, two of them quite recently 1 , represent the tangible sign of a regulatory framework that is attentive to the changes in criminal techniques. Legislative trends have followed two lines of development. One – found in the Second Directive on Money Laundering (2001/97/EC) – involves extending to additional professional and commercial categories exposed to the risk of laundering the obligation to cooperate actively in prevention and suppression, previously limited to banks and other financial intermediaries. The second – introduced by the Third Directive (2005/60/EC) – makes the stringency of the know-your-customer requirements commensurate with the risk of money laundering as the intermediary infers it from the nature of the counterparty, the type of service requested, and geographical location. This makes the rules more flexible, but it also heightens the responsibilities both for intermediaries, who must institute appropriate procedures, instruments and controls, and for the supervisory and oversight authorities in their duties of governing, promoting and verifying the proper application of the new provisions. Effective oversight presupposes specific knowledge of the risk factors, enabling supervisors to judge the adequacy of intermediaries’ safeguards and, if necessary, to call for suitable correctives. In 2005 the International Monetary Fund recognized that Italy’s rules for the prevention and suppression of money laundering had worked well, and in fact had also served, after 11 September, to block the financing of international terrorism, even though unlike money laundering the latter is defined by the illicit use, not provenance, of the funds. Based on the IMF’s indications, the imminent implementation of the Third Directive on money laundering will offer an opportunity to enhance the efficacy of a body of law that is crucial to the integrity of the national economy. The build-up of successive provisions over the years, the lack of clarity in many rules, and shortcomings in the set of controls nevertheless make a reordering of this legislation necessary. The IMF has expressly called on Italy to produce a consolidated anti-moneylaundering law, which has been envisaged but never drafted. In response the Italian Government has formed a study committee at the Ministry for the Economy and Finance, chaired by Undersecretary Antonio Lettieri with Anti-Mafia Prosecuting Attorney Pierluigi Vigna as coordinator. Directives 91/308/EEC, 2001/97/EC and 2005/60/EC. 2.2 The prevention apparatus The Italian apparatus to combat money laundering originally involved the fragmentation of functions between different bodies and the prevalence of investigation over financial analysis. Reports of suspicious transactions were transmitted directly to law enforcement bodies (the chief of police) at province level. Only afterwards were they sent on to the Special Foreign Exchange Unit of the Finance Police for further analysis. In 1997, in keeping with international experience, which relies on a Financial Intelligence Unit as the heart of the system of prevention and suppression of money laundering, Italy centralized the functions of reception and analysis of the reports within a single body, the Italian Foreign Exchange Office (Ufficio Italiano Cambi, UIC), assigned to inquire solely into the financial aspects. This arrangement was the outcome of a protracted discussion of alternative proposals: the constitution of an administrative authority dedicated exclusively to financial analysis or else of a mixed agency with investigative duties as well, grouping functions deriving from the bodies responsible for financial supervision, the police and the courts. In Italy the latter solution would have been hard to realize and manage, given the high cost of creating and operating such an agency and the difficulty of bringing together qualified resources, removing limits on access to the confidential information held by single administrative units for their own, specific tasks. In the span of just a few years three major legislative changes transformed the UIC’s nature and functions radically: the 1997 law separating the investigative from the financial area, which assigned the Office a key role in combating money laundering; Legislative Decree 319/1998, following the introduction of the European single currency, which restructured the Office and made it an instrumental entity of the Bank of Italy; and Law 388/2000, implementing the principles of an EU Council decision (2000/642/GAI), which formally instituted Italy’s national Financial Intelligence Unit under the UIC. Within the tripartite division of anti-money-laundering functions among the entities assigned respectively to financial analysis, investigation and trial, the UIC receives suspicious transaction reports and examines them further from the financial standpoint, serving as filter between the persons submitting the reports and the investigative bodies and the courts. The FIU receives information not only from the persons subject to the reporting requirement but also from internal and external archives, other government departments and agencies, and its foreign counterparts. The sources of information also include the database now being formed in the framework of the Taxpayers Register (provided for by Decree Law 223/2006, ratified by Law 248/2006), which is the equivalent in some respects of the Register of bank accounts and deposits contemplated by the law since 1991 but never realized. 2 The new rules require banks, other financial intermediaries and Poste Italiane to report to the Taxpayers Register all relations with customers, as determined by an instruction issued by the Director of the Revenue Agency. 3 Law 413/1991, Article 20.4, provided for the establishment of a register of all persons with accounts or deposits with banks and other financial intermediaries. The procedures for its constitution were to be specified in the implementing regulations, which were issued in 2000 by Treasury Decree 269. The decree assigned the operation of the register to the Ministry of the Treasury and also specified the persons allowed access to the data (Article 4). The instruction was issued on 19 January 2007. A circular dated 4 April introduced additional provisions for the formation of the Register. It must contain the personal identifying particulars, including tax number, of the persons with whom the institution has relations from 2005 on. Data on the amount of funds in the accounts, on transactions thereon, or on the amount of assets under management are not to be reported. Access to the Register – reserved to the tax administration, the courts and the investigative bodies expressly specified by the law and solely for the purposes specified – is open also to the UIC, which can use the data for its further inquiry into suspicious transactions. Contacts are under way between the UIC and the tax administration for the prompt institution of a link, which should become operational in the next few months. The tax The FIU, then, is a crucial node in a complex web of relations. Domestically, it engages in intensive dialogue with the persons submitting the reports, with the supervisory authorities, with the investigative bodies and with the courts. Internationally, it forms part of the network of cooperation made up of all its counterpart authorities abroad. 4 The most significant money laundering activity has supranational implications. For effective prevention, therefore, both cooperation between the authorities of the countries involved and uniform rules to prevent distortion and regulatory arbitrage are essential. Accordingly, FIUs take part in the international bodies assigned to the prevention and suppression of money laundering and in bilateral and multilateral initiatives. As the supervisory authority for the credit system, the Bank of Italy is responsible for guaranteeing the sound and prudent management of the individual institutions under its supervision and for the overall stability, efficiency and competitiveness of the financial system. With a view to these purposes the legislation and regulations in force oppose entry into the banking sector of unreliable operators; set integrity and experience requirements for top corporate officers and significant shareholders; subject the owners of intermediaries to controls on personal qualifications and on conflicts of interest; require adequate organization and in particular an effective system of internal controls; and promote transparency and fairness in relations with customers. These are all provisions that help to prevent the exploitation of financial mechanisms for money laundering and that testify to the existence of complementary relations and convergence between the aims of credit and financial supervision and those of the law against money laundering. In order to strengthen the safeguards against the exploitation of intermediaries for purposes of money laundering, the Bank of Italy first issued its “Operating Instructions for identifying suspicious transactions” in 1993. The instructions are intended to assist intermediaries by specifying indicators of anomaly that point to suspicious transactions. The instructions were updated in 2001 to take account of the development of the securities market, the technical advances in the payment system and the spread of new channels for the marketing of financial products. 5 A further update will be effected, as the International Monetary Fund has recommended, after the transposition of the Third Directive into Italian law. 3. Instruments of prevention and suppression The fight against money laundering deploys a sophisticated series of instruments. These include the legal definition of the crime of money laundering itself, the limits on the use of administration is allowed access to the Register exclusively for the purposes of “activities in connection with enforceable tax collection” and for the execution of banking investigations. The European FIUs have constituted a “platform” in the framework of the EU Commission for the detection and resolution of operational problems and for the exchange of experiences and best practices. First of all the instructions lay down organizational rules – consistent with the supervisory regulations – under which intermediaries must know their customers better, which is a first fundamental safeguard against money laundering and the infiltration of criminal organizations into the financial system. Intermediaries are required to take every appropriate action to improve their knowledge of customers and pick up any contradictions between a customer’s economic profile and the services requested. They must procure up-to-date information on the customer’s activities, the economic context in which the customer operates, the financial services requested and any relationships with other intermediaries. The instructions provide a series of illustrative cases of indicators of anomaly of individual transactions in the presence of which the intermediary must determine whether or not to make the suspicious transaction report. The general indicators tend to identify the techniques used to conceal or split transactions and to detect unusual or illogical forms of transaction. The case examples also consider relations that could indicate usury, which can be inferred from transactions on a suspected usurer’s account or the sudden, unexpected appearance of financial resources on the account of customers in difficulty. As a complement to these instructions, the UIC has analyzed the transactions reported by banks for purported usury to provide intermediaries with specific, technical indicators based on the similarities of behaviour observed in these financial operations. cash for payments between private parties, the identification of persons who establish continuous relationships with intermediaries or who effect transactions larger than the legal threshold, the recording of these transactions in special databases, the statistical analysis of financial flows to detect indicators of anomaly, the requirement to report all transactions, regardless of size, that arouse suspicions of being connected with illegal activities. The framework is completed by the application of sanctions and the confiscation of property of criminal origin. 3.1 The definition of the crime Italian penal law has conducted a protracted process of refinement and extension of the legal definition of the crime of money laundering, upon which the detection of illegal conduct depends. In 1978 the crime was defined with reference to funds originating in a small number of particularly grave offences aimed at the appropriation of goods (robbery, extortion, kidnapping). In 1990, as part of the fight against Mafia-style criminal organizations, Law 55 extended the list of “predicate offences” to include drug trafficking. In 1993, Law 328 extended predicate offences to all crimes not of negligence, thereby simplifying the job of the persons called on to detect and report suspicious transactions. 6 Under the present law, “active accomplices in the predicate crime” cannot be charged with money laundering as well (Article 648-bis of the Penal Code). The criminal law approach taken here provides for the illegality of money laundering to be included in that of the predicate offence. Consequently, when it is advantageous for the perpetrators, skilful trial defence based on false confessions of participation in the predicate crime allows defendants to escape conviction for money laundering. The IMF has suggested reconsidering this choice, citing the good results attained by laws against “self-laundering”, i.e. money laundering by the perpetrator of the predicate crime that originates the illegal acquisition of financial resources. 7 The question is now before the Lettieri Committee, which may weigh the need for a better definition of the crime of money laundering focusing on acts serving to conceal the illegal origin of the money or property. 3.2 Limits on the use of cash The rules in Italy prohibiting transfers of significant amounts of funds between private parties in cash or with bearer instruments are aimed at impeding money laundering by obligating Article 648-bis of the Penal Code made punishable “whoever substitutes or transfers money, assets or other benefits deriving from a crime not of negligence, or effects in relation to such money, assets or benefits other transactions such as to conceal their criminal origins”. Article 648-ter makes “whoever invests money, assets or benefits deriving from a crime in economic or financial activities” punishable for illicit use of funds.” The assessment must take into account relations with other crimes, such as the reinvestment of illegal proceeds (Article 648-ter of the Penal Code); criminal conspiracy (Article 416), which is a hallmark of the Italian legal order; assisting and abetting crime (Article 379); and fraudulent transfer of assets for the purpose of facilitating money laundering, under Law 356/1992, Article 12-quinquies. While making “self-laundering” a criminal offence in itself could make it easier to get evidence of complex crimes, it must also be considered that where the predicate crimes are less serious, such an approach could lead to excessively severe punishment. economic agents to use the banking channel for payments. 8 Such rules are not common in legislation within the Community. 9 The number of violations, often involuntary, remains high. The consensus opinion in our country is that the limitations on the use of cash constitute a fundamental bulwark against money laundering; that it should be confirmed and made more efficient by lowering the permitted amount and introducing more stringent monitoring of funds transfers by means of so-called money transfers. The draft legislative decree for the transposition of the Third Directive, on which the Ministry for the Economy opened a consultation in February, clarifies some points regarding the application of the current rules and promotes the spread of registered payment instruments. 10 A significant lowering of the ceiling now set on the use of cash in transactions between private parties is being examined by the Lettieri Committee. Certainly, the increasing integration of payment services affects the efficacy of measures adopted on a purely national basis. In April the European Parliament unanimously approved the Payment Services Directive, which establishes the conditions for providing retail payment services in all the members of the Union and defines pan-European payment schemes (for credit transfers, payment cards and direct debits) and thus contributes to the realization of the Single Euro Payments Area (SEPA) project developed by European banks to promote the use of electronic payment instruments. Measures to reduce costs and taxes 11 could further stimulate the spread of non-cash payment instruments, which are traceable save in marginal cases. 12 By European standards, Italy makes scant use of non-cash payment instruments. In 2006 there were 62 non-cash payments per inhabitant, compared with the euro-area average of 150 in 2004. 13 Cards are the main instrument that permit consumers to limit their holdings of money for transaction purposes. Although Italy’s infrastructure endowment is up to the European standard, payment card transactions numbered no more than 22 per inhabitant in 2006, compared with 46 in the euro area as a whole in 2005. In particular, the rules: a) prohibit transfers between private parties of money and bearer instruments with a total value of more than €12,500; b) require that the personal or corporate name of the beneficiary be indicated and the nontransferability clause be shown on cashier’s cheques and personal cheques larger than that amount; and c) set a €12,500 ceiling on the balance of bearer passbook savings accounts. France alone has provisions comparable to Italy’s. The other member states do not prohibit the use of cash even for large payments, but require economic agents to evaluate the characteristics of the transaction to detect any anomalies. Article 51 of the draft legislative decree expressly prohibits the opening and use of anonymous accounts or savings books. Possible measures concerning costs are pricing incentives for the acquisition of more advanced technology and the reduction of interbank fees, which depends on both payment circuit operators and the Antitrust Authority. As to taxes, the reference is to “stamp tax” on current accounts and the deductibility of the expenses incurred by retailers to equip themselves with electronic payment terminals. These matters are addressed in the Government’s bill, now before the Chamber of Deputies, on “measures in favour of consumers and to facilitate productive and commercial activities and provisions concerning sectors of national importance”. The Community provisions permit exempting non-reloadable electronic money instruments up to €150 and reloadable ones with an annual ceiling of €2,500 from the identification requirements. Nevertheless, identification is mandatory for transactions greater than €1,000. Factors that help to explain these differences include the lower degree of financial deepening of the economy, customers’ concerns about the security, practicality and cost of alternative payment instruments, the fragmentation of retail trade and the size of the underground economy. 3.3 Identification and recording requirements The current legislation requires intermediaries and other specified persons 14 to identify their clients at the time the business relationship is set up or when they carry out transactions in an amount of €12,500 or more. 15 Consequently, every transaction potentially linked to money laundering leaves a trace and can be reconstructed even after the passage of time. As I mentioned, with the implementation of the Third Directive on money laundering the customer identification rules will have to be calibrated so that the strictness of the identification procedure is commensurate with the risk of money laundering, as independently evaluated by every person subject to the requirement. In many cases this will lead to the adoption of less stringent or more stringent procedures than the present ones. The data gathered must be recorded by each person in a database. Transposition of the directive is an opportunity to simplify the rules for keeping electronic databases, so as to facilitate database management by the persons subject to the requirement and consultation during inspections. Aggregated data derived from intermediaries’ archives are the basis of the statistical analyses that the Financial Intelligence Unit uses to conduct studies of individual phenomena or territories, to supplement the examination of suspicious transaction reports, to check on possible failures to transmit reports, and to develop models for automatic detection of anomalies. 16 3.4 Reporting of suspicious transactions The reporting of suspicious transactions is the linchpin of the legislation against money laundering. On the basis of their knowledge of their customers, intermediaries and other persons subject to the requirement identify suspicious cases and send reports to the national FIU. As the authority expert in financial matters, the FIU functions as a filter, analyzing the reports, probing more deeply and condensing the results of its analysis in a summary report that it transmits to the investigative bodies, which evaluate whether to pursue the matter and, possibly, open a formal inquiry. The effectiveness of the FIU’s work is shown by the outcome of the most important money laundering trial, which recently concluded at first level, after ten years, before the Brindisi Court. As this Committee knows, the judgment not only imposed stiff sentences, but also awarded the UIC €3 million in damages, testifying to the important role it performed, as a civil party, in reconstructing the banking transactions under investigation. Among the different systems adopted in Europe, those of Italy and Spain place the greatest burden of assessment on persons required to make reports, who are asked to make an accurate prior evaluation in order to report only truly suspicious cases. In the United Kingdom, where even simple anomalies must be reported, more than 200,000 transaction reports were made in 2006, aggravating the task of the UK’s Financial Intelligence Unit in sifting the transactions for further investigation. France and the Netherlands use more composite methods. Notaries, lawyers, members of the Italian accounting profession, auditors and labour consultants and persons that engage in activities deemed by Decree 374/1999 to be exposed to money laundering (for example, claims recovery, cash handling and transport, gambling casinos, etc.). The law provides for various ways of identifying customers, both in their presence and at a distance. There is the so-called “usury model”, developed together with the Italian Bankers’ Association, to assist intermediaries in detecting and evaluating suspicious transactions potentially related to the crime of usury. The approach chosen in Italy seems preferable, even if it is more onerous for operators. Using the information in their possession, they are required to evaluate the operations of the persons with whom they have relations and to compare transactions’ objective features with customers’ subjective characteristics in order to detect any anomalies. Greater selection at source reduces the number of transaction reports, making them easier to handle for the FIU, which received some 10,000 reports in 2006 and more than 5,400 in the first five months of this year. 17 Since 2000 the FIU has had the power to dismiss reports that lack significance; this enables it to concentrate financial analysis and further inquiry on the cases of real interest. 18 The identity of those who report suspicious transactions must remain confidential for the mechanism to work properly. For some time now the protection of reporting entities and individuals has received attention from the Italian Parliament and the Community institutions. The Third Directive also requires member states to adopt appropriate and effective measures. Efforts must be intensified in this direction. The involvement of individuals cannot be avoided by entrusting the identification of anomalous transactions to computer programs based on predetermined standards. These programs, however sophisticated and technically advanced, can only be an aid; they cannot replace the personal evaluation that is essential to the good performance of the system. Cooperation among all those who are involved, in different capacities, in the fight against money laundering and the financing of terrorism is of crucial importance. Satisfactory results depend on the correct and efficient functioning of the entire chain of actors, each of whom is called upon to contribute actively within his competence to the process. Intermediaries are showing that they are willing to pitch in. Greater cooperation must also meet the need for faster feedback from the investigative bodies on the outcome of reports. This will serve both to refine the evaluation process and to preserve business relations with customers who are found to be in order. 3.5 Sanctions Backing Italy’s legislation against money laundering are penal sanctions whose application in the courts has been limited and administrative sanctions that have proven ineffective. 19 The draft legislative decree to implement the Third Directive reinforces the apparatus of sanctions, above all by empowering the competent authorities (the Bank of Italy, Isvap and Consob) to applying sanctions directly to the persons under their supervision for noncompliance with the provisions on administrative organization and internal control procedures. The Government’s legislative mandate does not allow it to decriminalize the penal offence of non-compliance with the customer-identification and transaction-recording requirements, often caused by mere procedural errors, and to replace it with an administrative sanction. Such a step would be advisable not least to ensure that intermediaries do not abstain from exercising the greater discretion that the directive grants them, for fear of committing a crime. In any event, gross negligence would remain subject to penal prosecution insofar as it abets the perpetration of more serious crimes. A suspicious transaction report does not constitute the “report of a crime” but a form of due cooperation requested of informed persons who are in a position to assist the ascertainment of possible penal offences. This power was introduced by Article 151.2 of Law 388/2000. Reports that have been dismissed are nonetheless forwarded to the investigative bodies, which could have significant additional information on the parties concerned. Legislative Decree 56/2004, implementing the Second Directive to combat money laundering (2001/97/EC), merely introduced some adjustments designed to simplify and rationalize the procedures. Another incongruity is the penal sanction for the failure of the control bodies of legal entities to report even simple organizational irregularities, given that the analogous provisions of the Consolidated Law on Banking and Consolidated Law on Finance provide for administrative sanctions. Altogether, I think a comprehensive reconsideration of the matter is advisable to obtain a closer correspondence between the severity of the offence and that of sanctions, which must be applied effectively. Severe punishment of the most serious violations should be accompanied by a mitigation of the burden placed on the generality of operators. Appropriate remedies could be introduced during the preparation of the Consolidated Anti-MoneyLaundering Law, either by supplementing the Government’s delegated powers or by direct legislative amendment. The decision to enhance the role of the control authorities is certainly endorsable. Their specific competences and the flexibility of their organization can make verification of irregularities and the application of sanctions speedier and more effective. Further steps in this direction would be desirable, aimed at giving the FIU the power to propose sanctions for failure to report suspicious transactions and simplifying the complex sanction procedure for violations of the limits on the use of cash. 20 3.6 Confiscation of property There is increasing awareness that the confiscation of property acquired with the proceeds of criminal activity must be a prime objective of the State in its action to combat crime. Only by attacking their economic power can we stop criminal organizations from being self-fueling and using the illegal proceeds of crime to penetrate the legal economy. “Equivalent confiscation” and “enlarged confiscation” are valid tools for attacking assets of illegal origin. The former makes it possible to seize property of equivalent value to the profit of crime even if not originating from crime, while the latter, inverting the burden of proof, requires the accused to demonstrate the provenance of his assets when they are disproportionate to his declared income or activity. 21 However, the provisions on seizure and confiscation are numerous and not always coordinated. Moreover, they do not take account of the difficulty that confiscation may involve in an advanced economic and financial environment, where it is often necessary to intervene on innovative and complex financial instruments. Furthermore, seized assets that will be confiscated should be managed in a way that will not only preserve them but also generate income and increase their value. The current system does not offer adequate solutions on this point. The experience of other countries, such as the United Kingdom, shows that centralized administration of the assets in ad hoc organizations can ensure economically better results than can be obtained with fragmented management. The provisions therefore need to be rationalized. On more than one occasion the Chairman of the Antimafia Committee of the Italian Parliament, Francesco Forgione, has denounced the shortcomings of the management of Under the current procedure (Legislative Decree 56/2004), the FIU submits an opinion to the Ministry for the Economy, which imposes sanctions after consulting the Commission contemplated by Article 32 of the Consolidated Law on Foreign Exchange. The draft decree implementing the Third Directive eliminates the opinion of the FIU from the procedure. Equivalent confiscation is envisaged by Article 322-ter of the Penal Code when direct confiscation of the profit of crime is impossible because the proceeds have been lost or transferred irrecoverably. Enlarged confiscation was introduced by Article 12-sexies of Decree Law 306/1992. seized assets whose confiscation under criminal law is pending. 22 A committee set up at the Ministry of Justice, on which the Bank of Italy and the UIC are represented, is currently examining this problem, among others. It is necessary to continue on this path of action. 4. The planned changes in the apparatus to combat money laundering As I mentioned, in February the Ministry for the Economy and Finance began a consultation on a draft legislative decree transposing the Third Directive into Italian law. It is certainly right to proceed with a general reordering of the current provisions and to give the competent supervisory authorities a larger role in issuing regulations and verifying compliance. Transposition of the directive has also provided the occasion to propose a rationalization of the tasks of the authorities involved, in various capacities, in the prevention and suppression of money laundering. However, the draft decree, confirming provisions now de facto outdated, continues to entrust the Ministry with powers of “supervision and direction” of the overall activity to prevent money laundering and the financing of terrorism. In addition, it establishes that the Minister may avail himself of the Financial Security Committee, thus extending to money laundering the incisive powers with which that Committee was entrusted by law on a temporary and exceptional basis in order to face the emergency of the fight against international terrorism. The proposed solution raises doubts. In particular, the decision to give the Ministry powers of direction over all the authorities and administrations concerned cannot be endorsed. It conflicts with the internationally recognized autonomy and independence of financial intelligence units. As far back as 1998, the European Central Bank, reviewing a law on the reorganization of the UIC, observed that in light of the need to ensure the UIC’s independence the Ministry’s powers of “supervision” of the fight against money laundering had to be interpreted narrowly, so as not to imply governmental interference in the work of the UIC. The draft decree implementing the directive also conflicts with Senate Bill 1366 presented by the Government on 5 March 2007 concerning, among other matters, the reorganization of the tasks of the authorities responsible for supervising the financial markets. In fact, the bill envisages the incorporation of the UIC into the Bank of Italy and, in that context, specifically regulates the institutional position and the tasks of the organization entrusted with performing the function of financial intelligence unit, observing the guarantees of independence and autonomy required by the international provisions. The bill also takes account of the observations of the International Monetary Fund in its recent evaluation of the measures to prevent money laundering in Italy. The new apparatus contemplated by the Government’s bill also includes a committee, established at the Ministry for the Economy, in which the competent supervisory authorities and the investigative bodies are to coordinate their action on an equal footing. The action proposed in the bill is to be judged positively and could constitute the occasion for relaunching the national Financial Intelligence Unit. I trust that the draft decree that the Ministry is preparing to submit to the Council of Ministers to implement the Third Decree will be brought into line with the approach taken in the bill. In Polìstena in March and, most recently, in Bari at a conference organized by the National Association of Magistrates and the Association of Criminal Lawyers. 5. Conclusions To conclude, with the completion of the long testing period, it appears that the legislation to counter money laundering and the financing of terrorism is proving sufficiently effective. The assessment obviously takes account of the fact that no instruments are capable of definitively rooting out these pathological phenomena, but only measures more or less capable of hindering criminal organizations, reducing their profitability, augmenting their riskiness and increasing their operating costs. There nonetheless remains considerable scope for improving both rules and operating procedures. In the first place all the measures required to encourage the use of electronic means of payment instead of cash and other anonymous instruments must be adopted. At the same time it will be necessary to impose strict controls on all the persons authorized by the directive approved by the European Parliament at the end of April to provide retail payment services in the Internal Market. The coordination of the different authorities making up the anti-money-laundering apparatus can be made more effective by adopting the organizational changes that – as I have recalled – have been proposed by the government as part of the bill on the reform of Italy’s regulatory authorities. In particular, the Financial Intelligence Unit could be strengthened by the planned merger of the UIC into the Bank of Italy. While respecting the separation of roles between the supervisory authority and the unit entrusted with the prevention and repression of money laundering, the UIC merger is likely to bring major synergies in terms of information and controls. In fact the Bank would come to have the powers of control over all the financial intermediaries entered in the general list referred to in Article 106 of the Consolidated Law on Banking and responsibility for keeping the lists of loan and financial brokers. As regards the latter, of which there are about 120,000, I draw attention to the need for a thorough revision of the current legislation in view of the difficulty of cataloguing, managing and controlling them. Increasing the effectiveness of controls means making intermediaries accountable, imposing stricter requirements for access to the activity and entrusting responsibility for keeping the lists to special professional bodies. 23 The changes contained in the Government’s bill should be implemented as rapidly as possible to ensure that the uncertainty inevitably present in periods of reorganization does not hinder or delay the prevention and repression of money laundering. The Bank of Italy undertakes to enhance the activity of the Financial Intelligence Unit and strengthen its operational capacity, in terms not only of human resources but also of its technical and IT endowments. The first objectives to be pursued include shortening the time needed for the financial analysis of suspicious transactions, enhancing the fact-finding process before the start of subsequent investigations, and identifying more streamlined and effective forms of collaboration with judicial and other authorities involved in the fight against crime. As for sanctions, it is necessary to plan a comprehensive reorganization by granting a mandate to the Government with well-defined guidelines for intervention. The Lettieri Committee can address this issue for the purpose of preparing the Consolidated Law on Money Laundering, which should therefore do more than just bring together the existing provisions. It seems better to rely on severe repressive measures, based on ex post control, rather than weigh down all operators indistinctly with excessively onerous obligations. The most common and regulated activity abroad is that of loan brokerage, over which powers of control are normally entrusted to supervisory authorities. These are extremely demanding objectives that all the authorities involved must pursue, collaborating effectively and making the maximum effort to obtain satisfactory results. Annexes Action to prevent money laundering: results 1. Since 1997, in over nine years of activity, the Financial Intelligence Unit has received more than 57,000 reports of suspicious transactions, of which nearly 3,000 in connection with alleged financing of international terrorism; about 2,000 were dismissed directly (see table). Nearly 90 per cent of the reports were made by banks. In 2003 the Bank of Italy ran a campaign to increase the awareness of the banks that had never sent reports. From the responses received, it emerged that the nature of some banks’ operations meant it was unlikely suspicious transactions would be intercepted at them. In particular, the reference here is to small mutual banks located in areas considered not to be at risk, to branches of foreign banks with customers of high standing and to banks with a limited volume of cash transactions. In 2005 an awareness campaign was run aimed at investment firms, asset management companies and non-bank financial intermediaries entered in the special register referred to in Article 107 of the Consolidated Law on Banking. The contribution made by non-financial entities was very small (see table). As for the geographical distribution of the reports received, more than 40 per cent came from regions in the North-West; the remainder were almost equally distributed between regions in the North-East (about 17 per cent), the Centre (more than 20 per cent) and the South and Islands (about 22 per cent) (see table). From when it began operating the Financial Intelligence Unit has suspended 70 reported transactions in view of their seriousness; the transactions in question amounted to about €100 million in total. In all these cases the action taken by the Unit allowed the judicial authorities to sequester the sums involved. The suspension of suspicious transactions clearly has preventive power; closer coordination between the Unit and the judicial authorities might allow this instrument to be used more frequently. On the basis of their findings, since 2001 investigative bodies have dismissed more than 9,300 reports and transmitted nearly 1,400 to the competent judicial authorities (see tables). 2. Analysis of the reports of suspicious transactions concerning organized crime shows a conspicuous use of cash in the building and scrap metal sectors; reports on transactions involving waste disposal are on the increase. These are sectors where the risk of exploitation for the placement of the proceeds of criminal activities is high (see table). A considerable increase occurred in reports on fraud at the expense of the tax authorities concerning VAT, most frequently in the fields of telephony, information technology, and trade in motor vehicles. As regards swindles involving public subsidies, signs have emerged of organized crime’s growing interest in connection with control of the territory. Active collaboration with reporting intermediaries and that with investigative bodies has permitted the discovery of IT fraud, carried out by means of identity theft and phishing, which can only be carried out systematically on an international scale by criminal organizations with cross-border links. Usury and the unauthorized provision of financial services, especially the granting of loans, are activities that have traditionally attracted large volumes of illegal capital. The improper use of pawn tickets, in addition to possibly underlying usury, can be an effective mechanism for the fencing of valuables of illicit origin. The transfer of money abroad is often carried out in an unauthorized manner by persons not entered in the list of financial agents. The remittances of emigrants resident in Italy can also cover flows of funds deriving from illegal trafficking, not least in connection with clandestine immigration. 3. As part of the increasingly intense relationship with the judicial authorities, the UIC, in response to specific requests, has transmitted more than 1,100 reports. Of these about 500 were in connection with the activity of the District Antimafia Directorates and the Organized Crime Investigative Group of the Finance Police, and are therefore potentially linkable to organized crime environments. Since 1997 UIC staff have carried out more than 50 technical advisory engagements for public prosecutors and District Antimafia Directorates, for the most part concerning money laundering and organized crime. In the period 1997-2006 the Financial Intelligence Unit received 2,039 requests for information from its foreign counterparts concerning 5,538 persons; in turn it sent 234 requests concerning 565 persons. The exchange of information with foreign FIUs takes place over special transmission channels. The countries belonging to the Egmont group use the EGMONT SECURE WEB; at European level it is also possible to use the FUNET multilateral European system. These channels have made it possible to identify a large volume of bank balances and financial instruments (in the period 2004-06 more than €270 million and about $28 million) that, reported to the investigative bodies, have been sequestered by the judicial authorities. Between 1997 and the end of 2006 the UIC carried out 430 inspections, which led to 117 reports to the judicial authorities of violations of the rules on intermediaries’ customer identification and data recording. Inspections are used to verify the correctness of the reporting process established by intermediaries subject to the reporting requirement and their compliance with the obligation to identify, record and report suspicious transactions and to submit the aggregate data prescribed by anti-money-laundering legislation. 4. In the same ten years 1997-2006 the Bank of Italy also had intense relations with the judicial authorities and investigative bodies in the broader framework of activity to prevent and counter economic crime. The requests for information and documentation received from the judicial authorities numbered more than 5,000; Bank of Italy employees carried out more than 337 technical advisory engagements, including in connection with money laundering, and gave evidence in penal trials on about 780 occasions. In the same period about 360 reports were submitted to the judicial authorities concerning possible penal offences discovered in the performance of the Bank’s supervisory duties. As part of its ordinary inspections the Bank of Italy verifies the suitability of intermediaries’ organizational arrangements and internal control procedures for anti-money-laundering purposes. This activity led between 1997 and 2006 to the finding of anomalies in the performance of customer identification and data recording obligations at 317 intermediaries out of the 1,940 inspected. The agreements between the Bank of Italy and the National Antimafia Directorate are especially important in that they permit the exchange of information that facilitates the performance of their respective tasks. On the basis of a memorandum of understanding, possible cases of failure to report suspicious transactions found during on-site and prudential controls are transmitted to the UIC for further examination. The Financial Stability Forum’s activity regarding offshore centres Since its establishment in 1999 the Financial Stability Forum (FSF) has been concerned with promoting international financial stability through information exchange and international cooperation among authorities operating in the financial sector. Because the enormous and rapid shifts in capital flows and the opaqueness of the corporate structures of banks and financial companies operating in offshore centres had given rise to financial crises in the 1990s, one of the first FSF working groups was devoted to the analysis of these jurisdictions. In April 2000 it published a report identifying major shortcomings in the regulation of offshore centres and in the cooperation between them and foreign authorities, capable of causing instability in the international financial system and as a remedy proposed stricter compliance by offshore centres with the standards laid down by the international sectoral bodies. The document also proposed that the IMF should launch a procedure for the evaluation of compliance with these standards and outlined a system of incentives, including provision for the supervisory authorities of the industrial countries to take account of offshore centres’ acceptance of international standards when authorizing their intermediaries to operate in such financial centres. Forty-two offshore centres were identified, divided into three groups according to the degree of development of their institutional frameworks and domestic prudential regulation. Between 2000 and 2004 the IMF performed a systematic evaluation in cooperation with the World Bank and other international sectoral bodies (the Basel Committee, the Financial Action Task Force, etc.). On the basis of the results of the assessments, technical assistance initiatives were organized as necessary. In March 2005, after completing the assessments and judging the results favourably, the Forum decided to consider the list of 42 offshore centres to be obsolete and to concentrate its attention on the jurisdictions that still showed shortcomings with regard to the exchange of information and the adequacy of supervisory structures, drawing on the cooperation of the IMF, the international committees responsible for setting supervisory standards, and the countries’ own authorities. At present there are three jurisdictions subject to the activity of the Review Group. Money transfer activity Money transfer has become increasingly important in the panorama of payment services; it consists in offsetting transactions between financial operators linked together in various ways, on a worldwide basis and very rapidly. The business is carried out by way of a series of “virtual passages” involving point-of-sale operators (subagents), agents operating at national level and an international network. Various actors are involved in the business; they can be classified from top to bottom as follows: • the multinationals (or networks) that manage the system; • their agents operating in each country, which in Italy, due to the reserve on financial activity, must be financial intermediaries; • subagents (or locations), which act as points of sale and in Italy are financial agents entered in a register kept by the UIC. More specifically, the general register kept under Article 106 of the Consolidated Law on Banking contains 32 financial intermediaries that belong to international circuits, such as Western Union and Moneygram. To engage in such activities it is therefore necessary to satisfy requirements concerning legal form, minimum capital (€600,000), exclusive corporate purpose, the integrity of shareholders, and the integrity, experience and independence of corporate officers. The UIC has limited powers of control. The business is highly concentrated. The two top-ranking intermediaries (Finint and Angelo Costa, which both belong to the Western Union circuit) and Poste Italiane S.p.A. (for the Moneygram circuit) account for 70 per cent of the value of remittances and 80 per cent of their number. Both in absolute terms and on a per capita basis the remittances sent by Chinese, Filipino and Senegalese customers are much larger than the average and more than proportional to their share of the total immigrant population. The number of financial agents that these intermediaries use is very large owing to the wide mesh of the requirements to enter the market and the possibility of combining the activity with others of a commercial nature (telephony, internet, food shops, supermarkets, etc.). At 31 December 2006 the register kept by the UIC contained 38,200 financial agents, of which 50 per cent operated in the money transfer sector. The financial intermediaries and their agents are subject to the anti-money-laundering provisions. They are required to identify customers, record transactions in the single computerized archive (archivio unico informatico AUI) and report suspicious transactions. Checks on unauthorized money transfer activity and compliance with the anti-moneylaundering obligations are made by the Finance Police, which carried out some 410 investigations in 2006. In particular, 524 suspected violations were reported to the judicial authorities, of which 80 per cent concerned unauthorized agency activity, 10 per cent unauthorized financial activity and the remaining 10 per cent suspected cases of omitted identification. The number of suspicious transactions reported to the UIC was 838 in 2005 and 796 in 2006. A total of 1,801 persons were reported in 2005 and 715 in 2006; the total amounts reported were €86 million in 2005 and €13 million in 2006. Most of the persons reported were Chinese and Senegalese. The total value of emigrants’ remittances in 2006 was about €4,450 million; China and Romania received more than one third of the remittances. The total number of remittances in 2006 was 10.3 million and the average value was €400. The distribution of remittances by Italian province of origin shows Milan and Rome to be out in front with more than 10 per cent each. The statistical data do not permit an analysis of the origins of remittances; a large part probably comes from activities in the underground economy, which lends itself to evasion of tax and labour law and the rules on social security contributions and exchange controls, but also from illegal activities. Some recent investigations by the Finance Police were able to find, for three intermediaries, the source activities of funds making up remittances. | bank of italy | 2,007 | 7 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 16 July 2007. | Mario Draghi: Fact-finding preliminary to the examination of the Economic and Financial Planning Document for the period 2008-2011 Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 16 July 2007. * * * Against the background of a recovery in economic activity, the public finances have improved considerably. However, the structural deficit remains substantial; it does not ensure a rapid reduction in the debt burden enabling Italy to tackle the challenge of population ageing in good time. The Economic and Financial Planning Document envisages a budget for 2008 that does not improve the deficit on a current legislation basis. The budget will nevertheless have to include expenditure-side measures in order to finance outlays deriving from commitments made by the Government or necessary to continue policies under way but not yet embodied in legislation. The corrective measures required to achieve a balanced budget are put off to the three years 2009-11; in particular, about half of the reduction is planned for 2011, the last year of the current legislature. The present favourable phase of the economic cycle would have made it possible to accelerate the budget adjustment. The ratio of taxes and social security contributions to GDP is near the highest levels recorded in recent decades. The commitment to curbing and gradually reducing the fiscal burden is reaffirmed. A plan for significant tax reductions would provide support for the policies designed to increase the potential growth rate of the economy. The Planning Document indicates controlling the quality and quantity of public spending as a priority. Reducing the deficit and containing taxation require a sharp deceleration in the growth of primary current expenditure, which in 2007 is again high and above the original target. The Government is adopting support measures for old people in economic need. Given the projected demographic situation in the decades ahead, only courageous choices that raise the average effective retirement age can make it possible to pay adequate pensions. 1. The state of the public finances The public finances improved in 2006. Excluding cyclical effects and one-off measures, the Government estimates that the deficit fell from 4 per cent of GDP in 2005 to 2.7 per cent last year; the primary surplus rose to 1.9 per cent of GDP. General government net borrowing increased slightly, from 4.2 to 4.4 per cent of GDP. This outcome depended on the extraordinary charges deriving from the cancellation of railway company debt towards the State and from a European Court of Justice ruling on VAT (which together cost nearly 2 percentage points of GDP). The improvement in the accounts in 2006 came from the significant increase in revenue, which benefited from stronger economic growth, some one-off measures and temporary factors, and the success of the measures to extend and recover tax base contained in the budget for 2006 and the supplementary measures enacted last July. The ratio of tax and social security receipts to GDP rose from 40.6 to 42.3 per cent. More than half of the €37.7 billion increase in tax revenue can be attributed to trends in the main tax bases. Another 30 per cent can be ascribed to discretionary measures enacted with the budget for 2006 and the additional measures enacted in July. A further 5 per cent of the increase was due to favourable events during the year, in particular large-scale redemptions of post office savings certificates, which increased receipts from the taxes on interest income, and the return to the usual due dates for the tax on insurance companies’ mathematical reserves. The remainder of the increase, some €6 billion, reflected the reduction of tax evasion and avoidance both as a result of enforcement action and in connection with some structural changes in the Italian economy in recent year (such as the increasingly important role of mass retailing). Despite the acceleration in economic growth, the ratio of primary current expenditure to GDP remained basically constant, near the highest levels of recent decades. The reduction in intermediate consumption was offset by the rapid increase in social benefits. The contraction of public investment spending continued. The deficit was considerably smaller than had been forecast both in drafting the budget and in the course of the year. Both the official estimates and other forecasts underestimated the growth in revenue; for that matter, receipts exceeded expectations in other euro-area countries as well. The general government borrowing requirement decreased by 1.6 percentage points, to 3.7 per cent of GDP. The ratio of debt to GDP rose for the second successive year, reaching 106.8 per cent. For 2007, Italy’s stability programme update of last December indicated a deficit of 2.8 per cent of GDP. In March the Combined Report on the Economy and Public Finances estimated net borrowing at 2.3 per cent. The Planning Document now projects it at 2.1 per cent By comparison with the Combined Report, the revenue projection is revised upwards by more than €2 billion for the year, taking account of the better-than-expected revenues of the first few months. Expenditure is revised downwards by nearly €1 billion, reflecting, among other things, the postponement to 2008 of the renewal of several public-sector labour contracts. The revised estimates for revenue are consistent with the results to date. Excluding the amounts collected in January, which appertained largely to 2006, by the end of June central government tax revenue was 5.1 per cent higher than in the same period of 2006. The Planning Document estimates the annual increase in general government tax revenues at 4.6 per cent for 2007, compared with 3.9 per cent in the Combined Report. The behaviour of the borrowing requirement in the first part of the year is fundamentally consistent with the new estimates of net borrowing for 2007. In the first five months of the year the general government borrowing requirement amounted to €48.7 billion, about €10 billion less than in the same period of 2006. More than half of the improvement in the accounts with respect to the projections in December has now been earmarked by the Government for additional expenditure. In fact, together with the Planning Document, the Government has passed a decree law and a midyear budget revision that according to official estimates will entail additional outlays of 0.4 percentage points of GDP this year and 0.1 points in each of the next two. A good part of the additional expenditure in 2007 represents an adjustment of resources to the necessities of policies already in place; about a fifth reflects new Government initiatives. The increase in outlays connected with Decree Law 81 of 2 July 2007 are estimated at €5.6 billion for this year and €1.6 billion a year when fully phased in. The decree comprises a number of measures. Most of the provisions (worth €2.5 billion) involve central government departments and consist in supplementary appropriations or attenuations of spending constraints enacted in previous budgets. In particular, with an effect valued at €1.5 billion, the decree frees the funds that ministries were obliged to set aside in unavailable reserves under the Finance Law for 2007. It also appropriates funds to increase low pensions (€0.9 billion), for humanitarian aid (€0.3 billion), for current transfers to public enterprises (€0.3 billion), and for short-term substitution of school personnel (€0.2 billion). Finally, it allocates €0.5 billion and €0.7 billion for the modernization of the road and railway networks, respectively. Taking these measures into account, the Planning Document sets the new deficit target for 2007 at 2.5 per cent of GDP (compared with 2.8 per cent in last year’s Document, which was confirmed in the subsequent budget documents). Excluding one-off measures – among which the transfer to INPS of a part of workers’ annual severance pay – the deficit is nearly 3 per cent. The ratio of public debt to GDP is projected to fall from 106.8 to 105.1 per cent. The fiscal burden rises further, by half a percentage point, to 42.8 per cent of GDP. Excluding the severance pay referred to above, the increase comes to 0.1 percentage points. Primary expenditure, excluding the two extraordinary charges for 2006 mentioned earlier, rises from 44 to 44.1 per cent of GDP, reflecting the sharp increase of 19.1 per cent expected in direct investment. Primary current expenditure increases by 4.3 per cent; its ratio to GDP declines slightly (from 39.9 to 39.8 per cent). The growth in expenditure is equal to 4.7 per cent for social benefits, 4.5 per cent for intermediate consumption and 1 per cent for wages and salaries. *** In the last two years Italian budget policy has operated to comply with Italy’s EU commitments to bring the deficit back below 3 per cent of GDP by 2007 and improve the structural budget balance by at least 1.6 percentage points in the two years 2006-07. The groundwork has been laid for ending the excessive deficit procedure against our country. However, the favourable phase of the economic cycle would have made it possible to accelerate the adjustment of the public finances by acting on primary current expenditure. In November 2006, in section II of its Forecasting and Planning Report, the Government planned an increase of 2.4 per cent in primary current expenditure this year. The Planning Document raises that to 4.3 per cent, only slightly less than the projected expansion of nominal GDP but constituting an increase of 2.4 per cent in real terms. If the rate of increase planned in November had been maintained, the incidence of primary current expenditure on GDP in the Document’s macroeconomic planning framework would have decreased by 0.8 percentage points between 2006 and 2007, reducing the deficit to 1.8 per cent. In the five years from 2001 to 2005, the ratio of primary current expenditure to GDP rose in unfavourable cyclical conditions by 2.7 percentage points, to 40 per cent. In 2006-07, in favourable cyclical conditions, it is to be reduced by just 0.2 points. 2. The plan for 2008-2011 2.1. The overall guidelines The priority objective set by the Planning Document is sustaining economic growth, within the constraints set by the need not to jeopardize budgetary equilibrium. Development policies are designed to raise the economy’s potential growth rate, bringing it nearer to the average for the rest of Europe. The actions planned are designed to close the gap in infrastructure, improve the efficiency of government and reduce the tax burden on firms and households. A rationalization of the automatic stabilizers to strengthen the system of incentives is also planned. A strategic role is assigned to measures to foster greater competition in the markets for goods and services and combine environmental protection with a reduction in external energy dependency. There is a commitment to renovating the school and university system, in the light among other things of the relatively poor standing of Italian education in international rankings. The Planning Document states the Government’s intention to tackle the serious problems of the justice system, emphasizing that the shortcomings in this area seriously affect economic activity and the welfare of citizens. Continuing along the lines of last year’s Planning Document, greater support is to be provided to persons in economic difficulty, in particular to low-income families with dependent children, by increasing welfare benefits and renewing housing programmes. The Planning Document maintains the objective set in last year’s Document and reaffirmed in the December stability programme update of balancing the budget and achieving a primary surplus of about 5 per cent of GDP in 2011. From 2008 onwards the deficit targets of the Planning Document are the same as those set in the stability programme, although the latter was based on much less favourable economic projections. The improvement in the baseline projections reduces the corrections necessary by an average of 0.3 percentage points of GDP each year in the four years 2008-2011. For 2008 and 2009 forecast GDP growth has been revised upwards by comparison with the December projections by 0.4 and 0.1 percentage points respectively and the estimates for 2006 and 2007 by 0.3 and 0.7 points. The financial adjustment path traced in the Planning Document envisages only a small reduction in net borrowing in 2008. Subsequently the improvement in the budget balance is projected to average 0.7 percentage points of GDP per year. The ratio of the public debt to GDP is projected to decline by an average of 2.5 percentage points a year from 2008 through 2011 (1.9 points in 2008, 3.3 points in 2011). In 2010, for the first time since 1991, the debt is expected to fall below 100 per cent of GDP. In the December stability programme this result was forecast for 2011. The earlier achievement of this objective depends largely on the faster growth of nominal GDP now forecast for the three years 2007-09 (an average of nearly 1 percentage point more per year). The downward trend in debt also benefits from the assumption that from 2007 onwards the borrowing requirement will be approximately equal to net borrowing. However, excluding the two extraordinary charges included in net borrowing, in 2006 the gap between the two aggregates was equal to 1.2 per cent of GDP. The Planning Document estimates an increase of 0.3 percentage points in the ratio of interest payments to GDP in 2006 and 2007 after it had fallen constantly for a decade. For the subsequent years, according to the planning scenario, the ratio will hold stable at just below 5 per cent, reflecting the expected decline in the debt ratio on the one hand and the progressive rise in interest rates on the other. 2.2 Budgetary policy for 2008 According to the Planning Document, in 2008 the deficit will fall by 0.3 percentage points, to 2.2 per cent of GDP, and the primary surplus rise from 2.3 to 2.7 per cent. Achieving this objective does not require corrective measures with respect to the projections based on the “current legislation” framework (supplemented by the additional spending provided for by the decree law presented together with the Planning Document). Nevertheless, for purposes of greater transparency, the Planning Document observes that the deficit on a current legislation basis excludes some costs that do not derive from obligations under the law but that are very likely to arise. The Planning Document cites three classes of expenditure in decreasing order of obligation: those connected with commitments made by the Government, those bound to established practices such as appropriations for future labour contracts and for the National Road Agency and the State Railways, and lastly those in connection with new initiatives. The Planning Document puts expenditures for commitments already made at €4.1 billion and gives rough estimates of the second and third classes of respectively €l7.2 billion (not counting the resources for the renewal of public employment contracts, still to be determined) and €10 billion. Including the first two classes of outlays for a total of over €11 billion gives an estimate of the deficit projected on an “unchanged policies” basis. This is nearly 2.9 per cent of GDP, excluding the resources for the renewal of public employment contracts. This second method of projection thus highlights the need for corrective measures equal to at least 0.7 per cent of GDP, to which must be added the resources for any new initiatives the Government decides to undertake. The Document stresses that the containment and gradual reduction of the tax burden is a priority commitment. Consequently, additional outlays must be financed by expenditure savings. The Document does not specify how these will be achieved. The Government hopes that the figures indicated for primary expenditure will be a point of reference in the discussion on the planning documents. It expressly requests Parliament, in its resolution on the Planning Document, to give an indication of its own on the level of primary expenditure that should serve as a guideline for the Government in drafting the Finance Bill and for Parliament in the discussion of the budget. According to the projections on a current legislation basis, after growing sharply in 2006 and 2007 revenue will decline slightly in proportion to GDP, mainly as the result of the phasing in of the reduction in the tax wedge on labour enacted with the Finance Law for 2007. 3. Some evaluations Progress has been made in the Planning Document in terms of the quantity and transparency of the information provided. Specifically, estimates are given for expenditures that are very likely to be made but that are not included in the projections based on “current legislation”. These data are essential to the proper evaluation of the present condition of the public finances and the outlook. Hopefully in the future it will be possible to go beyond the indicative estimation of these costs with an explicit and detailed projection of the accounts on an unchanged-policies basis for the entire planning period. In addition, specifying the planning targets for revenue and expenditure as well as the nature of the corrective measures would permit better evaluation of the economic policy guidelines underlying the Planning Document. The part of the Planning Document dedicated to economic development policies examines all the country’s main problems. Its stress on the need for intervention in respect of justice and education, including the university system, is endorsable. Italy would benefit greatly from a more efficient civil justice system and a school and university system up to the standards of the other developed countries. The plans confirm the objective of a balanced budget in the medium term but do not exploit the improvement in the projections to hasten its attainment. For 2008 the Document does not envisage a correction with respect to the balance projected on a current legislation basis. Last December’s stability programme update planned a correction of 0.7 percentage points of GDP to achieve the same objective (a deficit of 2.2 per cent). About half the corrective measures needed to balance the budget are put off to the last year of the planning horizon. Additional initiatives reducing revenue or increasing expenditure (such as revising the law stiffening pension eligibility requirements as of 2008) would increase the size of the measures envisaged for the three years from 2009 through 2011, which the Planning Document now puts at 1.4 percentage points of GDP. In those years too, corrective measures will also have to offset spending commitments not included in the current legislation estimates, such as future labour contract renewals. The experience of the first few years of this decade suggests that the favourable phases of the economic cycle should be exploited for a resolute reduction of the deficit. The risk is having to correct today’s choices in the future, in possibly more difficult cyclical conditions. In the autumn of 2000, after two years in which the public finances had performed better than predicted, the budget for 2001 provided for an increase in the deficit, the first after a number of years. The impact of the measures, for the most part tax reliefs, was estimated at more than 1 percentage point of GDP. The net borrowing target for 2001 was put at 0.8 per cent of GDP; a balanced budget was expected in 2003. As early as mid-2001 the macroeconomic and financial outlook proved to be less favourable, necessitating corrective measures. The budget for 2002 had once again to curb the deficit, with an impact slightly less pronounced and of opposite sign to that of the year before. Finally, in the summer of 2002 further significant adjustment became necessary. The data available today indicate that the deficit amounted to about 3 per cent of GDP in both 2001 and 2002. In the past years budget outturns worse than forecast have entailed repeated slippage of the timetable for adjusting the public finances. The year for budget balance, originally scheduled for 2003 in the Economic and Financial Planning Document released in 1999, has been repeatedly postponed, by nearly a decade now. The achievement of structural budget balance is essential for rapid progress in reducing the public debt. Thanks in part to the consequent decrease in interest payments, debt reduction will make it possible to deal with the problems due to population ageing, increase the amount of resources allocated to productive expenditure and reduce the tax burden, and make room for manoeuvre during cyclical downturns. Belgium has reduced its public debt from 122 per cent of GDP in 1997 to 89 per cent in 2006, with very considerable savings in interest payments. Major factors in the consolidation of the public finances were the introduction of rules making regional and local governments accountable and the institution of an independent authority (including representatives of central and regional governments and the central bank) that sets budgetary targets for all levels of government and reports any overshoots in the course of the year. Finally, by law any extra revenue with respect to forecasts must go entirely to reducing the debt. Other European countries, some with significantly lower public debt than Italy’s, have kept their budgets near balance or in surplus since the establishment of Monetary Union, among other things so as to be in a position to face the problems deriving from the ageing of the population. The Planning Document reaffirms the importance of controlling the quality and quantity of public spending in order to reconcile the adjustment of the public finances with a lowering of the fiscal burden, which is now near the highest levels registered in recent decades. According to the Planning Document’s macroeconomic framework, achieving a balanced budget in 2011 without increasing taxes or decreasing investment with respect to the budget on a current legislation basis requires that the ratio of primary expenditure to GDP fall by nearly 3 percentage points between 2008 and 2011, with an average annual reduction of outlays equal to 0.5 per cent in real terms, in contrast with an average annual increase of 2.3 per cent over the past decade. According to the data provided by the Planning Document, on the basis of current legislation the ratio of primary expenditure to GDP is expected to decline by 0.2 percentage points in 2008. Based on unchanged policies, it would rise by several tenths of a point. Other European countries have managed to reduce their budget deficits in recent years acting on the level and composition of spending. In Germany, for instance, the ratio of primary expenditure to GDP decreased from 45.5 per cent in 2003 to 42.9 per cent in 2006, lower than in Italy. This made it possible to reduce both the deficit, from 4 to 1.7 per cent of GDP, and tax revenue. Assuming unchanged policies, budget balance will be achieved in 2008. The reduction in expenditure has been concentrated in the areas of social benefits, labour incomes and, to a lesser extent, capital grants. It has not involved forgoing the fundamental goals of the welfare state. In the field of pensions, in 2005 Germany introduced a rule limiting the revaluation of pension benefits in periods of a rising ratio of pension beneficiaries to contributors. There is also provision for the gradual raising of the standard retirement age from the current 65 to 67 by 2029. A number of measures have also affected unemployment benefits and active labour market policies, with the aim of rationalizing the assignment of benefits and strengthening the incentives for the unemployed to accept job offers. The financing of the health system has been reformed to redistribute the costs between the public sector and patients, so as to make users more responsible. Public employment costs have been curbed by reducing the number of persons employed by an average of 1.5 per cent per year, and by even more pronounced wage moderation than in the private sector. The proposal for reform of the federal state is designed to increase the degree of financial autonomy of the various levels of government. The Planning Document’s proposal that the related parliamentary resolution indicate a ceiling for primary expenditure is a step in the right direction. This limit should be lower than or at most equal to the level set in the projection on a current legislation basis, and separate caps should be set for current and capital expenditure. In the future these caps should not apply to spending by local authorities, in whose regard the Government last year redrafted the rules of the domestic stability pact, making the crucial criterion not a spending limit but a constraint on the final budget balance, so as to combine spending autonomy with fiscal accountability. It would be consistent with this approach for local authorities themselves to adopt rules on expenditure. Compliance with budget constraints must be based on an appropriate system of incentives and penalties. The limits set at central level should also cover transfers to local government. Special attention must be devoted to the healthcare system, which is the principal component of local government expenditure and has recorded a sharp increase in recent years. Between 1998 and 2006 the ratio of health spending to GDP rose by about 1.5 percentage points, accounting for about 60 per cent of the entire increase in general government primary expenditure. The recent enabling bill for the implementation of Article 119 of the Constitution lays the basis for the gradual abandonment of past spending as the standard for assigning resources to local entities in favour of standardized indicators of costs and requirements. This is the first step towards designing a system of incentives that by combining spending autonomy and financial accountability for local authorities can take full advantage of the efficiency made possible by decentralization. Hopefully the transition to the new legislative framework will be made within a reasonable time frame. International experience, which the Planning Document analyzes extensively, shows that in order to be effective spending caps must be based on a redefinition of the objectives of individual public programmes and on verification of efficient use of the resources allocated. A contribution to more effective control of spending in the drafting of the Finance Bill and in the budget session of Parliament can come from the recently begun revision of the classification of the State budget items and analysis and evaluation of the expenditure of some ministries. Making accounting documents and information more readable permits better measurement of the costs of public programmes and assessment of how well the distribution of resources corresponds to the purposes of public action. In the future, this could enhance the efficiency of public spending, overcoming the great budget rigidity produced by use of past spending as the main yardstick. Choices in the field of pensions are crucial to the lasting consolidation of the public finances in a context in which, by Istat’s estimates, the ratio of the population over 60 to the population of working age will rise from 42 per cent in 2005 to 53 per cent in 2020 and 83 per cent in 2040. The State Accounting Office estimates that expenditure reflecting the ageing of the population will remain substantially constant in proportion to GDP until 2020 and rise thereafter. The increase between 2005 and 2040 will amount to 2.9 percentage points. Increased outlays on pensions (1.7 points) and on long-term care (1.8 points) will be partly offset by savings on education. It is likely that in the absence of intervention these spending items will rise more sharply and sooner. The forecasts for healthcare spending consider only the effects of the changing age structure of the population. They do not take account of other factors such as the rising cost of medical treatment, which has increased health spending significantly in recent decades throughout the industrial world. As for long-term care, the changes in family structure and the increase in female employment could prompt greater demand for public assistance. The estimates of pension spending take account of the effects of current legislation, which includes the revision each decade of the coefficients for converting the contribution base into the annual pension entitlement and the tightening as of 2008 of the minimum pension eligibility requirements by Law 243/2004. According to the State Accounting Office, with no updating of the conversion coefficients (which apply to benefits paid under the defined-contributions scheme introduced in 1995) the ratio of expenditure to GDP would be higher by 0.7 percentage points in 2030, 1.5 points in 2040 and about 2 points in 2050; other conditions being equal, the ratio of the debt to GDP would be some 40 points higher. The measures introduced in 2004 raising the requirements for seniority pensions (which concern workers under the defined-benefit scheme) will reach a maximum restrictive effect on spending equal to 0.7 percentage points of GDP in 2012. This effect will remain broadly stable in the subsequent two decades; it will turn negative in the period 2040-50, when larger pensions will begin to be paid as a consequence of workers having contributed for more years. All else being equal, if the requirements are not tightened the ratio of the debt to GDP in 2050 would be about 20 percentage points higher. The increase in the lowest pensions that the Government has just decided aims at alleviating the situation of economic hardship in which a large number of elderly people live. The payment of adequate pension benefits to a growing number of old people is the challenge that needs to be faced in the coming years. The answers, in Italy as in all the advanced countries, are basically two: gradually raising the age at which people actually retire and developing supplementary pension provision. An incentive to postpone retirement, in line with the lengthening of life expectancy, will derive from full application of the defined-contributions scheme introduced in 1995. Strengthening the link between contributions and benefits improves the system of incentives, reduces the disparities between different categories of workers and permits flexibility in deciding retirement age. The other countries that face demographic problems similar to ours are also moving in this direction. The updating of the conversion coefficients makes it possible to take the lengthening of life expectancy into account, although with considerable delay, and this is essential for long-term equilibrium between the outlays and receipts of the pension system. When expected longevity increases, modification of the coefficients lowers the income replacement rate, maintaining pension wealth unchanged; workers are entitled to a smaller monthly benefit, but receive it for a greater number of years. If the retirement age is flexible, this creates an incentive to prolong one’s working career. As is stressed in the Document, it is necessary to lengthen the time horizon of public action. Reducing the public debt and, I add, ensuring the sustainability of the pension system must constitute the State’s first investment in favour of the country’s young people and future generations. Figures and Tables Figure 1. Primary surplus and temporary effects Figure 2. General government debt in Italy and Belgium Figure 3. Net borrowing in Italy and the euro area Figure 4. Tax revenue and social security contributions and primary expenditure in Italy and the euro area Figure 5. Average cost of the debt, average gross interest rate on BOTs and gross yield of 10-year BTPs Figure 6. 10-year yield differentials with respect to Italy Figure 7. Primary surplus: objectives and outturns Figure 8. Revenue and expenditure in Germany Table 1. Main public finance indicators for general government Table 2. General government revenue Table 3. General government expenditure Table 4. General government borrowing requirement Table 5. Current legislation forecasts and Government targets in the Economic and Financial Planning Document (EFPD) for 2008-11 and 2007-11 | bank of italy | 2,007 | 8 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 10 October 2007. | Mario Draghi: Fact-finding preliminary to the examination of the budget documents for the period 2008-10 Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 10 October 2007. * * * The public finances have steadily improved since 2006 as a result of a sharp increase in tax revenue, attributable in part to progress in reducing tax evasion and avoidance. The ratio of taxes and social security contributions to GDP will be two percentage points higher in 2007 than in 2005. It will remain stable in 2008 at a relatively high level by international standards. During 2007 the unexpected revenue has mostly been used to fund increased spending. Similar choices have been made for the 2008 budget, which increases the deficit in relation to that on a current legislation basis. The progress in reducing the budget imbalances is modest. The measures needed to balance the budget are put off to the three-year period 2009-11. In the two years 2007-08 the ratio of primary current expenditure to GDP will remain constant at the highest levels recorded in recent decades. The key issue for the public finances in Italy is curbing primary current expenditure. A public spending review, budget reform, and strengthening the mechanisms for making local authorities accountable are important ways of improving the use of resources in the public sector. Studies by the Ministry for the Economy and Finance show that there is ample scope for making savings without compromising the achievement of the main policy objectives. The progress made in fighting tax evasion and avoidance means that the levy can be redistributed in a fairer and less distortionary way. It is important that social policy be carefully aimed at achieving objectives of fairness. Funded by reductions in expenditure, vigorous action to reduce the burden of taxes and social security contributions on labour and firms would boost the potential growth rate of the economy. 1. The public finances Between 1997 and 2005 the general government primary surplus fell from 6.6 to 0.3 per cent of GDP. In 2005 net borrowing amounted to 4.2 per cent of GDP and the debt ratio began to rise again. Excluding one-off measures, in the three years 2003-05 net borrowing and the borrowing requirement were about 5 per cent and above 6 per cent of GDP respectively. The increase in the imbalances was influenced by the gap between the strong growth in current expenditure net of interest payments and the modest increase in GDP. In 2006 the accounts improved significantly. Excluding the extraordinary charges deriving from the cancellation of State Railways debt towards the State and from a European Court of Justice decision on VAT (which together cost nearly 2 percentage points of GDP), net borrowing fell to 2.5 per cent of GDP. Excluding the effects of the economic cycle and a broader set of one-off measures, net borrowing fell by 1.5 percentage points to about 3 per cent of GDP. The improvement in the accounts was due to a significant increase in revenue. Taxes and social security contributions rose from 40.6 to 42.3 per cent of GDP. Despite the fairly strong growth in output, the ratio of primary current expenditure to GDP remained basically constant. In 2006 expenditure (net of the extraordinary charges referred to above) and revenue increased by €25.6 billion and €48.5 billion respectively and the deficit was reduced by €23 billion. In 2006 the ratio of debt to GDP rose further, to 106.8 per cent. The improvement in the accounts has continued in 2007. As in 2006, tax revenue forecasts have been increased several times. In September 2006 the Forecasting and Planning Report estimated net borrowing in 2007 would be 2.8 per cent of GDP. In March, the Combined Report on the Economy and Public Finances projected net borrowing on a current legislation basis at 2.3 per cent of GDP. At the end of June, the Economic and Financial Planning Document lowered the projection to 2.1 per cent, mainly as a result of a further upward revision of revenue. At the same time measures were adopted entailing additional expenditure amounting to 0.4 percentage points of GDP; net borrowing for 2007 was therefore estimated at 2.5 per cent. Decree Law 81 of 2 July 2007 provides for an increase in outlays of €5.6 billion in 2007 (a further €0.8 billion comes from the simultaneous revision of the budget) and of €1.6 billion in each of the two following years. Most of the provisions (€2.5 billion) consist in supplementary appropriations or attenuate spending constraints on central government departments. A further €0.9 billion is allocated to finance an increase in low pensions. Resources are made available to modernize the ordinary road and railway network (€0.5 billion and €0.7 billion respectively), for current transfers to public enterprises (€0.3 billion, of which two thirds to the State Railways) and for international peace-keeping missions and humanitarian aid (€0.3 billion). Finally, €0.2 billion is made available for short-term substitution of school personnel and around €0.3 billion for changes to the domestic stability pact. Additional provisions inserted when the decree was ratified have no final effect on net borrowing. The amendments that increase the deficit (the easing of the constraints imposed by the domestic stability pact, the extension of the IRAP relief on labour costs to banks, financial companies and insurance companies, and the attenuation of the rules on sector studies) are offset by new tax measures (changes in the deductibility of expenses for company cars) and by a reduction in current and capital spending. At the end of September, the Forecasting and Planning Report further updated the projections for the public finances on a current legislation basis: revenue was revised upwards by more than €6 billion, while expenditure was reduced by nearly €3 billion. A decree law approved together with the Forecasting and Planning Report allocated the improvement largely to finance a one-off measure for persons with low incomes who are unable to exploit all the income tax reliefs (€1.9 billion, accounted for in the official estimate as a reduction in revenue) and a net increase in expenditure of €5.4 billion. The technical note appended to Decree Law 159 of 1 October 2007 estimates that the measure entails an expenditure increase of €5.9 billion – most of which for the advance payment of charges pertaining to 2008 – and expenditure savings of €0.5 billion. The additional current expenditure amounts to €2.1 billion, excluding the indirect effects on revenue, and the additional capital expenditure to €3.8 billion. The decree’s effects in subsequent years will be negligible. Measures to support the weakest households include the start of a public housing construction programme (€0.6 billion), which will also be used for the modernization of existing dwellings. A further €0.1 billion is allocated for the purchase of property to be leased for social housing. Additional resources are granted for the 2006-07 public employment labour contracts; adjusted for the indirect impact on revenue, the measure will cost around €0.5 billion. Some current transfers to the State Railways (€1.0 billion) and the National Road Agency (€0.2 billion) are also brought forward. A further €1.5 billion is allocated for other capital expenditure, mainly on the metropolitan transport systems of Rome, Naples and Milan (€0.8 billion) and for the MOSE barrier project and other measures to safeguard Venice (€0.2 billion). Finally, expenditure of €0.9 billion is brought forward for development cooperation and assistance, of which €0.4 billion on capital account. A one-off payment of €150 is to be made to taxpayers whose net personal income tax liability for 2006 was nil, plus an additional €150 for each dependent (€1.9 billion). The Report now estimates general government net borrowing for 2007 at 2.4 per cent of GDP. With respect to the forecasts made in the autumn of 2006, which put net borrowing at 2.8 per cent, revenue has been revised upwards by a total of €16.4 billion (1.1 per cent of GDP); excluding the measure in favour of persons with low incomes who are unable to exploit all the income tax reliefs, the increase amounts to €18.3 billion. The estimate for expenditure has been raised by €10.7 billion (0.7 per cent of GDP) mainly as a result of the measures passed in June and September (€11.8 billion). Over half of the revision to the estimate for revenue (€9.3 billion) was made in March 2007 on the basis of the 2006 outturn for receipts. The subsequent revisions have mainly involved direct taxes (€6.4 billion, excluding the effects of the measure in favour of persons with low incomes who are unable to exploit all the income tax reliefs), in connection with the sharp increase in receipts of self-assessed taxes in the four months from June to September compared with the same period of 2006 (31.1 per cent). According to the official estimates, without the above provisions net borrowing in 2007 would be close to 1.5 per cent of GDP. The Report estimates that the ratio of revenue to GDP in 2007 will be 0.6 percentage points higher than in 2006. This increase is largely ascribable to self-assessed taxes paid by enterprises and social security contributions, which include allocations to severance pay provisions. Compared with 2006, the ratio of primary current expenditure to GDP declines by 0.1 percentage points, to 39.8 per cent. This estimate does not include the cost of the measure in favour of persons with low incomes who are unable to exploit all the income tax reliefs, which, as mentioned earlier, is accounted for as a reduction in revenue. Using the consumer price index as a deflator, expenditure in real terms increases by 2.5 per cent, broadly in line with the average for the last ten years (2.3 per cent). The estimates given in the Forecasting and Planning Report show capital expenditure increasing by 12.6 per cent and its ratio to GDP by 0.3 percentage points (excluding for 2006 the extraordinary expenditure connected with the decision on VAT and the cancellation of the debts of the State Railways). The measures passed in the second half of the year to increase and anticipate expenditure, of which more than €5 billion on capital account, should reverse the decline recorded in the first half of the year (-4.1 per cent, according to Istat). The Report estimates that the ratio of public debt to GDP will fall from 106.8 to 105 per cent. The information currently available on the performance of the public accounts basically confirms the estimates contained in the Report. In the first nine months of the year State budget tax revenue grew by 6.4 per cent. In the first seven months the general government borrowing requirement, net of privatization receipts, was €25.8 billion, almost €15 billion less than a year earlier. Its ratio to GDP in 2007 is the lowest of the last ten years. The increase in tax revenue has been driven by receipts from self-assessed taxes, which reflect the upturn in economic activity in 2006, the measures taken to counter evasion and avoidance, and the provisions broadening the tax base to offset the effects of the European Court’s 2006 decision on VAT. Overall revenue from other taxes has also grown faster than GDP: excluding one-off taxes (receipts from which are down from €5.6 billion to €1.2 billion) and receipts from self-assessed taxes, State budget receipts grew by 5.3 per cent in the first nine months of the year. As in 2006, VAT receipts have increased faster than consumption, reflecting the shift in the composition of demand towards goods taxed at a higher rate while consumption of food products has declined, there has been a significant rise in purchases of durables and the measures taken to reduce the scope of tax evasion and avoidance. Revenue from the withholding taxes on income from financial assets has reflected the strong performance of share prices in 2006 and the rise in interest rates. The rapid growth in social security contributions has been influenced both by payments connected with the transfer to INPS of the portions of workers’ severance pay accrued during the year and by the increase in some contribution rates introduced with the Finance Law for 2007. In the first seven months of the year general government debt rose by €44.9 billion. The main contributory factors were: the overall borrowing requirement (€22.3 billion), curbed by the reduction in the share capital of SACE, which led to €3.5 billion in revenue for the Treasury; the increase, of a seasonal nature, in the assets held by the Treasury with the Bank of Italy (€18.7 billion); and the issue of securities at a discount (€4.1 billion). In the two-month period from August to September the above-mentioned assets fell by about €9 billion, slowing the rise in the debt by an equivalent extent. In the last quarter they are likely to fall further; at the end of September they exceeded €32 billion. 2. Forecasts on a current legislation basis and objectives for 2008 and the following years The update of the Economic and Financial Planning Document, presented at the end of September, contained improved public finance forecasts on a current legislation basis for the years 2008-11. Net borrowing on a current legislation basis in 2008 is estimated at 1.8 per cent of GDP, compared with an estimate of 2.2 per cent last June and 2.9 per cent in last year’s Forecasting and Planning Report. However, the objective of 2.2 per cent for net borrowing indicated in the Report is confirmed. Compared with 2007, the planning scenario shows the ratio of tax and social security receipts to GDP unchanged at 43 per cent. Primary current expenditure increases by 0.2 percentage points, to 40 per cent, equal to the peak reached in 2005. Capital expenditure is expected to fall by 0.4 percentage points. The targets for net borrowing indicated in last June’s Economic and Financial Planning Document for the years 2009-11 are substantially confirmed, even though the estimates on a current legislation basis improve by 0.3 percentage points each year. A balanced budget is expected to be achieved in 2011, the last year of the current legislature; the primary surplus should reach 4.9 per cent of GDP. The public debt should fall below GDP in 2010. In the planning scenario of the update of the Economic and Financial Planning Document the budget balance adjusted to take account of the economic cycle and one-off measures improves by 0.2 percentage points of GDP in 2008 and by about 0.7 points in each year of the three subsequent years, going from structural net borrowing of 2.1 per cent of GDP in 2008 to close to balance in 2011. In the official estimates the achievement of these objectives will require yearly interventions to curb net borrowing from 2009-11 of the order of 0.4 percentage points of GDP. This estimate is based on projections on a current legislation basis and therefore excludes some outlays that, while forecast, require the formal adoption of legislative measures (in particular, expenditure for the renewal of public employment contracts, service contracts and contracts for public works). To finance this additional expenditure, the corrective measures will have to be significantly greater than those indicated. 3. The budget for 2008 The budget includes several related provisions that the Government intends to present over the coming weeks. These regard the implementation of the Social Security, Labour and Competitiveness Agreement signed by the Government and the two sides of industry in July, government rationalization measures, and social, family, health, infrastructure and environmental policies. Overall, the budget increases net borrowing in 2008 by €6.5 billion (0.4 percentage points of GDP). It raises resources amounting to €5.4 billion and increases expenditure and introduces tax reliefs amounting to almost €12 billion. Beginning this year, the analysis of the budget measures and documents has been made easier by their organization according to missions and programmes recently introduced for the State budget. 3.1 Expenditure The budget increases public expenditure by €3.9 billion. An expected €4.7 billion in savings is offset by an increase of almost €8.7 billion in expenditure, two thirds of which is current expenditure. The increases in current expenditure principally regard public-sector employment (€2.2 billion) and allocations for the July agreement (€1.3 billion). The resources for public employment serve almost entirely for the renewal of the 2006-07 national contract; together with what was allocated by previous Finance Laws and by the decree law of 1 October, they guarantee an increase in earnings equal to 4.85 per cent beginning in February 2007, as agreed in the spring with the trade unions. Regarding the 2008-09 contract, it should be noted that the accounts on a current legislation basis include: €0.7 billion for an indemnity in 2008 for late signing of the new contract. Other increases in current expenditure regard the ministries (€1 billion), the armed forces (€0.3 billion) and social policies (€0.2 billion). For the first time since 1999, the rules of the domestic stability pact remain substantially unchanged; this contributes to the stability of the legislation and accordingly to its effectiveness. The structure of the pact outlined in the 2007 Finance Law, centred on local government monitoring of balances rather than expenditure, is confirmed. The new structure requires that local entities have significant margins of financial autonomy. Several new provisions, with costs amounting to €0.3 billion, are introduced to resolve problems that emerged in the first year of applying the new rules for local authorities. The objectives set for those that on average recorded a budget surplus in the three years 200305 have been made less demanding; the administrative surplus can be used to finance investment expenses. An adjustment is introduced for the authorities that recorded extraordinary one-off revenue in the period 2003-05, making the objective (calculated on the basis of the results in the same period) less stringent. In the health sector several regions will be granted a thirty-year central government advance of €9.1 billion, to help implement the plans agreed with the Government to eliminate their deficits. While having significant effects on the borrowing requirement and on the debt in view of its financial nature, the measure does not affect net borrowing. Under this transaction the regions’ liabilities will be replaced by government debts (needed to finance the advance granted to the regions). The impact on the borrowing requirement and on the public debt will not be null (it is officially estimated at €3.2 billion) since about one third of the debts to be repaid are of a commercial nature and accordingly are not included in the public debt. The increases in capital expenditure (€2.5 billion) are mainly for ministries and the refinancing of measures to support the economy (€1.2 billion), territorial protection, local transport and infrastructure. More than half of the expenditure savings (€4.7 billion) are on capital account; those on current expenditure (€1.8 billion) are mainly due to a reduction in intermediate consumption. In detail, savings are expected from the shortening from 7 to 3 years of the time limit before extinction of expenditure arrears (€1.6 billion), from ceilings on extraordinary maintenance expenditure for public buildings (€0.5 billion) and from the requirement that social security institutions’ real-estate investments consist exclusively in units of real estate investment funds or shareholdings in real-estate firms (€0.4 billion). Capital grants for business investment are reduced by €0.1 billion. The reduction in the intermediate consumption of central government departments (€0.8 billion) derives from the introduction of expenditure ceilings on ordinary maintenance of public buildings and on rentals (€0.3 billion) and from the rationalization of procurement of goods and services (€0.5 billion). Parameters are introduced to permit more effective management control by the single departments, and the use of a central purchasing system is encouraged. Measures to improve public spending and reorganize general government are expected to yield savings of €0.4 billion. Reorganization will involve military justice, local government and mountain communities. Rules are introduced to speed up the computerization of government. The provisions setting limits on the utilization of some types of tax credit will reduce outlays by €0.3 billion. 3.2 Revenue The budget measures are expected to reduce tax revenue by €2.6 billion, providing for €3.3 billion in tax reliefs and €0.7 billion in tax increases. Tax relief of €2.8 billion is granted to households, mainly in relation to first homes (€2.5 billion), and the structure of taxes on companies is modified. Households will get relief on the municipal property tax (ICI) and income tax relief mainly in connection with house rental. For persons with annual income of €50,000 or less, there is a reduction in the tax on first houses of up to €200, or 1.33 per mille of the tax base, over and above the basic reduction provided for by the central government and others enacted by each municipality. The cost of this measure (€0.8 billion) is charged to the central government, as the revenue loss to municipalities will be made good by central government transfers. In addition, tenants with a registered lease for their first house are allowed a personal income tax credit of €300 if total income does not exceed €15,493.71 and €150 if it is between that figure and €30,987.41. There is an alternative tax credit for young people aged 20 to 30 for the first three years of a registered lease for their first house. The amount is €991.60 for incomes up to €15,493.71 and €495.80 for incomes between that amount and €30,987.41. Persons with incomes so low as not to be taxable will receive an amount equal to the portion of the tax credit they are unable to benefit from; the procedures have yet to be determined. Overall these measures will entail a revenue loss of €1.3 billion. It is provided (at a cost of €0.4 billion) that the imputed income from first houses will no longer count in calculating tax credits for dependents and for labour income, and also that taxpayers with only income from real estate up to €500 will be exempt from income tax. Some other tax reliefs for households are extended, at a total cost of €0.3 billion. Income tax credits for housing renovation expenses are extended to the years 2008-10 (retaining the €48,000 ceiling and the 10 per cent VAT rate). So are the incentives for upgrading the energy-efficiency of buildings (retaining the 55 per cent tax credit and the ceilings already in place, which vary with the type of work performed). Taxes on companies are reorganized on a large scale, with essentially no net impact on the public finances. The measures involve significant simplification. Tax rates are lowered. The rate of corporate income tax (Ires) is reduced from 33 to 27.5 per cent and that of the regional tax on productive activities (IRAP) from 4.25 to 3.9 per cent. Nevertheless, the overall rate of taxation remains higher than in many EU countries, including Germany and the United Kingdom. However, the lowering of the rates will be essentially offset, when the new system is fully in place, by the broadening of the tax bases and by the limits to the use of reliefs granted via tax credits. The Ires tax base is broadened mainly by setting a new limit to the deductibility of interest expenses and abolishing accelerated depreciation. There will be redistributive effects among firms, generally to the benefit of the less heavily indebted. Also, a more favourable treatment for corporate reorganizations is reinstituted. To broaden the corporate income tax base, the treatment of consolidated reporting is also revised. The portion of capital gains enjoying the participation exemption is raised to 95 per cent, as for dividends; this measure tends to shrink the tax base. Consistently with the new treatment of interest expense, the rules on thin capitalization and the pro rata capital tax are abolished, simplifying the system. The tax base for IRAP can now be drawn directly from the company’s income statement without the adjustments required for business income, independently of the rules followed in drawing up the accounts (Italian Civil Code or international accounting standards). This produces not only a simplification of formalities but also greater certainty for firms, by reducing the scope for possible disputes. The restructuring of IRAP is accompanied by the diminution of some tax credits (those for small enterprises and the fixed-amount credit in connection with labour costs); and as for Ires, accelerated depreciation is no longer allowed. For banks and insurance companies the tax base will include 50 per cent of dividends. Sole proprietorships and partnerships will be able to opt, in place of personal income tax, for separate taxation of retained earnings, at the same rate as corporate income tax. For self-employed workers and small enterprises with revenues of less than €30,000 a substitute tax regime is introduced with a tax rate of 20 per cent, exemption from VAT and IRAP, and documentation and accounting simplifications. In addition to the revenue requirement, eligibility for this regime also requires that the taxpayer not have made export sales, not have had any employees during the year, and not have purchased capital goods worth more than €15,000 in the last three years. At present self-employed workers and small enterprises can opt for one of four different, favourable tax regimes, if they comply with a specific set of requirements (involving amount of revenues, start-up of new business, inclusion within sector studies). Of these regimes, the only one that will remain is that for persons who start up new professional or business activities, and only for the tax year in which the business is started up and the following two. Finally, some sectoral tax reliefs are extended to 2008, reducing estimated revenue by €0.7 billion. 4. Some evaluations The Government has said on more than one occasion that the crucial challenge of Italy’s public finances consists in simultaneously bringing down the debt ratio and reducing the fiscal burden on honest taxpayers. To achieve these objectives it is necessary to curb primary current expenditure, which in the past few years has grown at a real rate of between 2 and 2.5 per cent a year, and to “spend better” by improving the effectiveness and efficiency of public-sector operations. Recent fiscal policy decisions do not brake the growth in expenditure. The unexpected additional revenue that has come in this year has gone largely to increasing expenditure. For 2008, the budget will result in a net increase in expenditure of almost €4 billion with respect to the projection on a current legislation basis. This estimate includes the expected effects of an effort to rationalize outlays. However, the spending cuts planned in recent years have not always been carried out in full. Moreover, the recent agreements on pensions will have a significant amplifying impact on expenditure in the medium term. Partly as a consequence of these fiscal policy decisions, the Government’s estimates show primary current expenditure growing by 4.3 per cent both this year and next. In real terms, the increases are close to those registered in the last ten years. These developments are difficult to square with the medium-term objectives set out in the update of the Planning Document. According to this document’s macroeconomic scenario, in order to achieve budget balance in 2011 without increasing taxes or cutting back investment with respect to the levels planned for 2008, the ratio of primary current expenditure to GDP needs to fall by more than 2 percentage points in the three years 2009-11; expenditure would have to decrease slightly in real terms. If it were also intended to bring revenue as a percentage of GDP back down to the 2005 level (44.4 per cent), the ratio of primary current expenditure to GDP would have to fall by more than 4 percentage points in 2009-11, with expenditure contracting in real terms by more than 2 per cent per year. As the “Green Paper” prepared by the Advisory Committee for the Public Finances observes, there is ample scope for achieving savings in all the main expenditure items by reorganizing departments, reviewing priorities, assigning duties more precisely and establishing clear criteria for the evaluation of results. The budget reform and the start of the spending review, implemented at some ministries (Justice, Infrastructure, Interior, Education and Transport), go in the direction of improving the quality of public spending and curbing its level in the medium term. Added to them are the revision of the classification of the State budget, the action begun last year in the health care sector and the proposals for the universities and for the school system. Entrenched practices, the multiplicity of actors, and the inevitable complexity of the rules mean that expenditure reform is a long-term endeavour. However, it is important to achieve results in the short term too. The projected reduction of net borrowing in the two years 2007-08 is slow-paced. Forecast net borrowing this year (2.4 per cent of GDP) is barely lower than last year’s figure (2.5 per cent excluding the extraordinary charges for high-speed rail infrastructure and for the decision on VAT). For 2008 the Government confirms the objective of 2.2 per cent, which had been fixed assuming much less favourable developments in the public finances. Excluding the contributions received in respect of employees’ severance pay, which will have to be returned to workers, net borrowing would be significantly higher in both years. According to the Government’s estimates, net borrowing will decrease by 0.5 percentage points of GDP in 2007, excluding cyclical effects and one-off measures. The improvement would be smaller if the contributions in respect of employees’ severance pay were included among one-off measures. A further improvement of 0.2 points is planned for 2008. The experience of the years 2000-01 suggests it would have been advisable to exploit the positive cyclical phases in order to reduce net borrowing. The decision again to postpone action on the expenditure side increases the budget adjustments needed to achieve a balanced budget in 2011. And there is the risk that cyclical conditions in the future could make the adjustment put off today even more complicated. The jump in revenue is due in part to factors that may not be repeated in the coming years. Revenue has exceeded the forecasts not only in Italy but in other countries too. In some of them, the extra revenue has gone above all to reducing the budget deficit. In Germany it has been used to achieve a budget position that is broadly in balance as early as this year, with a small surplus planned for 2008, while as recently as 2005 net borrowing exceeded 3 per cent of GDP. Furthermore, as part of the reform of the federal structure, the German government has proposed adopting budgetary rules aimed at ensuring budget balance over the entire economic cycle. The official forecasts indicate that in 2008 the ratio of tax and social security receipts to GDP will remain at the same high level of 2007. The taxation of households will be affected above all by the new tax breaks for the taxpayer’s home, largely offset by the automatic increase in taxation due to fiscal drag. Personal income tax (Irpef) has a highly progressive structure that, in the presence of inflation, results every year in households’ tax liability increasing more than their taxable income. A periodic evaluation of the effects of fiscal drag would help to increase the transparency of fiscal policies. The taxation of firms will undergo a series of changes that will ultimately tend to counterbalance each other. Some measures involve an appreciable simplification of formalities and an improvement from the standpoint of the certainty of tax rules. The proposal for the municipal property tax (ICI), a tax that is relatively non-distortionary for economic activity, does not appear to be consistent with the objective, confirmed with the draft enabling law presented in August, of strengthening the tax autonomy of local government bodies. The municipal property tax is the linchpin of local finance in many countries, thanks to the ease of assessing it, the low mobility of its tax base and the latter’s relatively uniform geographical distribution compared with other forms of wealth. The threshold of income below which taxpayers may benefit from the ICI relief, set at €50,000, excludes a limited number of taxpayers. The size of the break for taxpayers who live in a rented home is independent of the number and income of other members of the household and of the zone of residence. The July agreement between the Government and the social partners, which will be incorporated into a bill accompanying the Finance Bill, increases the eligibility requirements for length-of-service pensions, starting in 2008, more gradually than had been established in the 2004 reform. In a context marked by pronounced ageing of the population, it will only be possible to pay adequate pensions by raising the average effective retirement age. The agreement postpones the updating of the coefficients for converting accrued contributions into benefits until 2010. This will be 15 years after the introduction of the coefficients, which, moreover, were based on the 1990 mortality tables. The agreement creates the conditions, after 2010, for the coefficients to be updated more frequently and automatically. Some of the solutions envisaged in the agreement risk moving the system further away from the basic principles of a notional defined-contribution system: equal treatment of workers and a close link between contributions and benefits. The latter improves labour market incentives, in particular making irregular employment less advantageous, and allows greater freedom to be offered in the choice of retirement age. More specifically, the agreement indicates the possibility that the coefficients will no longer be the same for all workers, with distinctions made according to sector of activity. The possibility is also mooted of guaranteeing some workers a minimum income replacement ratio of 60 per cent, independently of the contributions paid, the growth of the economy and demographic developments. The new rules on supplementary pensions, which entered into force on 1 January 2007, have led to a significant increase in the number of persons signed up with private pension funds, but the proportion of workers who have enrolled is still insufficient. According to data collected by Covip, the supervisory authority for pension funds, in the middle of 2007 the workers signed up with some form of supplementary retirement scheme (pre- and post-1993 occupational pension funds, open pension funds, individual pension plans) numbered about 4.3 million (3.3 million at the end of 2006). Counting only privatesector payroll workers, who were affected by the reform of the severance pay system, the number signed up rose between end-2006 and mid-2007 from 1,828,000 to 2,730,000, corresponding to a membership rate of 22 per cent. Members of pre- and post-1993 occupational funds authorized at the end of 2006 numbered 28 per cent of the potential total. The data do not take account of those who were registered for supplementary pension plans via tacit consent (whose number is not yet available). To make sure that future pensioners have adequate incomes, it is necessary to continue the efforts to increase the proportion of workers signing up. In particular, it needs to be increased among young workers and employees of small firms and service businesses. The contribution of persons operating in the asset management field is crucial to ensure that individuals’ retirement saving choices are as appropriate as possible. The resources devoted to advising customers need to be increased; the products offered must be simple and meet workers’ needs. Administrative and management expenses must be kept as low as possible. Competition between funds must be fostered by guaranteeing the maximum transparency and comparability between the different products. Workers should periodically receive clear information on the public and supplementary pensions they can expect to receive. Some measures are intended to counter poverty and social exclusion. They are in addition to the increases in small pensions approved at the end of June and the measures to strengthen unemployment benefits outlined in the July agreement. According to Istat, in 2006 some 11 per cent of Italian households were poor, that is 2.6 million households and 7.5 million individuals. Poverty is especially common among households in the South, those in which the head of the household is unemployed and those with a large number of members, above all children not of legal age. Italy’s poverty rate is high by international standards. It is important to identify instruments that give systematic support to persons in need. A preliminary assessment suggests that some of the measures proposed could be targeted more specifically at the weakest categories. Apart from its temporary nature and the implementation difficulties, the subsidy for persons with low incomes who are unable to exploit all the personal income tax reliefs, introduced only for 2007, might not be very effective in reducing the extension of poverty. In particular, it does not take account of households’ overall economic conditions. * * * The budget for 2008 keeps the main items of the public finances at the levels forecast for this year; it does not take advantage of the good performance of revenue to accelerate the reduction in the public debt; it does not return a significant share of the recent increases in revenue to taxpayers. Over a longer span of time the Forecasting and Planning Report shows that a one percentage point increase in the growth rate of the economy for ten years would reduce the ratio of the public debt to GDP by about 10 percentage points. Fiscal policy can be a major factor in the growth of the economy. A pension system that encourages people to continue to work; a tax system that attenuates the heaviest and most distortionary forms of taxation (the measures on corporate income tax and the regional tax on productive activities are steps in the right direction); an education system that, reformed along the lines of the Government’s White Paper, guarantees higher and more uniform levels of learning across the country; and a system of social assistance carefully targeted to needy citizens these are the pillars of such a fiscal policy. A start has been made on measures to increase the efficiency of public expenditure and improve the organization of the public sector. The challenge is now to achieve a sharp slowdown in primary current expenditure, reduce the burden of taxes and social security contributions on workers and firms, and increase the share of public resources invested in infrastructure and human capital, together with that allocated to the alleviation of poverty. Tables and Figures Table 1. Main indicators of general government finances Table 2. General government revenue Table 3. General government expenditure Table 4. General government borrowing requirement Table 5. General government selected fiscal indicators: government projections – EFPD of June 2007 and September update Table 6. Estimated effects of the budget on the general government consolidated accounts Table 7a. Requirements to qualify for early retirement (July 2007 agreement) Table 7b. Requirements to qualify for early retirement (2004 reform) Figure 1. General government net borrowing, primary surplus and interest payments Figure 2. General government debt level and determinants of its change Figure 3. Tax revenue and social security contributions and primary expenditure in Italy and the euro area Figure 4. Average cost of the debt, average gross interest rate on BOTs and gross yield of 10-year BTPs Figure 5. 10-year yield differentials with respect to Italy Figure 6. Primary surplus: objectives and outturns Figure 7. Primary surplus and temporary effects Figure 8. Budget for 2008: composition and effects on net borrowing | bank of italy | 2,007 | 10 |
Presentation by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, of the new Banca d'Italia-CEPR "Eurocoin" indicator at the CEPR meeting, London, 20 September 2007. | Ignazio Visco: €-coin and the growth outlook for the euro area Presentation by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, of the new Banca d’Italia-CEPR “Eurocoin” indicator at the CEPR meeting on “After a volatile summer, where do we stand? €-coin and the growth outlook for the euro area”, London, 20 September 2007. * 1. * * Nature and history of the project In the eight years since the launch of the Economic and Monetary Union great efforts have been devoted to support the implementation of the common monetary policy. European and national statistical institutions, academia and, naturally, the ECB and national central banks have all worked to provide more timely and reliable data, new instruments of analysis and a deeper knowledge of the euro-area economy. Today, we can base our policy decisions and forecasts on a firmer understanding of the functioning of the euro-area economy as a whole. Thanks to the steady progress in improving the timeliness of publications and the reliability of the statistics, our ability to monitor economic developments has also improved. The Bank of Italy – building on a long tradition of research in macroeconomic forecasting and short-term analysis – contributed actively to the development of innovative tools able to meet these new challenges. Soon after the launch of the EMU, Lucrezia Reichlin, now Director of Research at the ECB (and then CEPR program codirector for International Economics), coordinated a pioneering research project at the Bank of Italy which led to the construction of a new indicator of macroeconomic conditions in the euro area as a whole. This new indicator was called Eurocoin, as it is a “coincident” indicator, i.e. an indicator of current economic conditions. This was the first real-time synthetic indicator of the euro-area economy not based solely on survey data. Built on innovative statistical methods applied to a large data set comprising a variety of statistics related to real, monetary and financial phenomena, it constituted a step forward with respect to traditional indices and provided a timely and broadly based assessment of the economic outlook. Unlike other indicators, Eurocoin is “linked” to GDP growth: each month it gives a quantitative assessment of the conjunctural situation in terms of quarterly GDP growth in the euro area. Since 2002 CEPR has hosted the monthly releases of the indicator on its website. The indicator has been closely monitored ever since, and though its overall performance was satisfactory on the whole, a few problems did emerge. On the basis of this experience and further analytical work, after five years, Eurocoin underwent a substantial overhaul in the Bank of Italy’s Research Department. After a period of continuous scrutiny and testing, we are now ready to publish a new version. This new indicator, €-coin, is what I am presenting today. We believe that it is a useful tool for the research community and for policy makers, as well as for market participants and watchers (see Figure 1). In my talk, I will first briefly summarize the basic ideas behind it. I will then describe the value added of this indicator, show how €-coin can be used for real-time monitoring of the euro-area economy, and compare its performance with that of other commonly used indices, focussing on the advantages of using a large dataset. Finally, I will briefly discuss what we can learn about recent economic developments by looking at the behaviour of €-coin over the last few months. As a last remark I would like to stress the reason why I believe it is important for us to share our indicator with market participants and watchers, and the research community at large. Obviously a central bank is a public institution and making public the results of research that uses considerable resources adds to the available information and provides a “public good”. Furthermore, as Luigi Einaudi, former Governor of the Bank of Italy and President of the Italian Republic, once said, we need “to know in order to be able to deliberate”. We believe that sharing this knowledge helps in forming a common understanding of how our market economy is performing, and in making informed decisions, at both the policy and the market level. Figure 1: The new €-coin indicator 2. €-coin: its value added in monitoring the economy In Figure 1 we can see €-coin and the quarterly GDP growth figures as we now know them (notice that they are not available at the time €-coin is produced). With respect to the previous version the main improvements of €-coin are: i) a more timely signal (at the end of each month we now have an estimate of the underlying GDP growth for that month); ii) lower volatility (a smoother indicator and therefore easier to interpret); iii) a continuous monitoring technique for the data used in the construction of the indicator. These improvements are grounded first of all in a reassessment of the dataset, which now comprises more timely series, a larger amount of international data and is subject to close monitoring every month, to ensure the indicator is always based on the best available data. Secondly, a new method of extracting the common relevant information from the data has been used. This will become clearer when I briefly describe the ideas underlying this aggregate indicator, which attempts to synthesize the information contained in about 200 elementary series. For a detailed description of the methods used, the tests conducted and the results obtained, I refer to the recent paper by Filippo Altissimo, Riccardo Cristadoro, Mario Forni, Marco Lippi and Giovanni Veronese, “New Eurocoin: Tracking economic growth in real time” (CEPR, Discussion Paper No. 5633, April 2006, revised June 2007, and Banca d’Italia, Temi di Discussione No. 631, June 2007). Together with Lucrezia Reichlin, I wish to thank these economists for having devoted so much of their time and knowledge to this project. We can conclude this introduction by noting that €-coin appears to track the underlying trend cycle movements of GDP growth in the euro area remarkably well. But more on this later. 2.1 Monitoring the economy: GDP Let us now turn to what inspired and motivated the construction of €-coin. Ideally, we would like to assess the state of the economy and its outlook using GDP growth, the most comprehensive measure of economic activity. However: i) GDP is published only quarterly and with a rather long delay; ii) it is subject to revisions; iii) most importantly, it is affected by measurement errors and substantial short-run volatility. These factors reduce the potential of GDP releases for gauging the current situation. In fact, I would argue that for short-run policy analysis and decision we are often especially interested in “signal extraction”, that is in removing the “noise” from an estimate of the underlying conditions of the economy. We know that the first quarterly GDP releases are always provisional and that at times important revisions are in order. And, at times, a preliminary but timely and sufficiently robust estimate of what is known as the “trend-cycle” component of the aggregate measure may be especially useful. 2.2 Monitoring the economy: higher frequency data Of course, we do not rely solely on GDP. Our economic outlook is constantly updated by monitoring the inflow of other economic and financial data. Euro-area and national surveys, industrial production and demand indicators are all important pieces of this constantly changing information set. Compared with GDP, these data are more timely and are available at a higher frequency. It is not obvious, though, how to combine potentially contradictory signals coming from so many disparate sources and how to translate these signals into a quantitative assessment of the state of the economy such as that provided by GDP growth (see Figure 2). At the end of the day, “economy watchers” and forecasters rely on their judgment to perform this “weighting task”. Figure 2: High frequency indicators At this point two questions naturally arise i) what is the relationship between monitoring the economy and forecasting? ii) what do we mean here by judgment? In my opinion, forecasting macroeconomic variables for policy purposes requires a framework that helps to make causal dynamic relationships explicit. We can perhaps call this a “structural” model. What we are doing here is a different kind of forecasting, which can perhaps be more properly called “nowcasting”. In fact: i) Structural models are typically built on quarterly variables (though respected annual and monthly “structural” models certainly exist) with a projection horizon of several quarters, often years. It is an acknowledged problem that at the start of the forecasting period we have a wealth of information that is not (yet) captured by quarterly variables, owing both to the publication delays of the national accounts statistics and to the very nature of the information (surveys of consumer confidence, producer intentions, market sentiment, stock market prices, export and import data, and so forth). A satisfactory assessment of the current state of the economy is therefore not only an important element with which to judge the forecasts but also a necessary ingredient of a forecasting exercise, providing the best guess for the “starting condition”. ii) Tools like €-coin are designed to perform this task by extracting, through formal quantitative methods, the information contained in a large dataset. Pooling higher frequency information to obtain an estimate of GDP growth in the current quarter well ahead of official releases can thus be seen as complementary to forecasting. By their nature, indicators based on a large set of monthly or weekly data exploit the information contained in the cross section. In general, however, they are ill-suited to forecasting the variable of interest beyond a very short horizon (i.e. nowcasting, or at most, I would say, one quarter ahead). I believe, with others, that the construction, utilization, evaluation and revision of models for economic forecasting and policy making is a complex “organic social process”, a process in which subjective judgment often plays an important role. In fact: i) Judgment is often a catchword for a rather complicated mixture of experience, use of formal models, statistical tests and intuition. Part of this process can be made more transparent and more rigorous by applying appropriate statistical techniques. ii) Another part of the process, though, is inherently subjective and remains fundamental in deciding which models are really relevant and how results should be interpreted. Judgment is also used in the case of €-coin, for instance in selecting and revising the set of elementary indicators or in deciding the degree of smoothing that the final indicator should have relative to the quarterly GDP figures. iii) It is important, however, in the case we are considering to communicate the reasoning behind the various choices made, both at the methodological level (for instance with the help of technical papers), and at the practical level (making use of appropriate information channels). This is what is being done and will continue to be done in the case of €-coin. 2.3 Monitoring the economy: €-coin in a nutshell The basic ideas behind €-coin are straightforward. What one would like to have is a comprehensive measure of economic activity, like GDP growth, but a measure that is not affected by temporary noise, that is promptly available and that is updated at a higher frequency (say each month) so that it incorporates relevant news without much delay. This is exactly what €-coin delivers. The starting point is the collection of a wide range of data, such as surveys, bond rates, stock market prices or industrial production indices. The information that is relevant to estimate GDP growth is then squeezed out of this large set of monthly and daily statistics and summarized in a few variables, or “common factors”. Through them we can obtain a monthly estimate of the euro-area GDP rate of growth. The method is based on the tendency of macroeconomic data to move together when observed over a sufficiently long time span. This phenomenon implies that, apart from idiosyncratic vagaries, macroeconomic variables are guided by “common” driving forces or a “common” set of few fundamental shocks. These driving forces or shocks can be captured – under very mild assumptions – by a (small) set of common factors computed in the following way: i) pool all the series; ii) find the (linear) combination that captures the greatest part of the trend-cycle movements of these series; iii) regroup the series having “taken out” the first linear combination and search again for the best (second) linear combination defined as above, and so on; iv) choose the number of common factors that, put together in a proper way, provide a sufficient measure of the underlying process characterizing the evolution of aggregate demand (for further details, see the paper by Altissimo et al.). This process can be thought of as a sequence of “cleverly” taken weighted averages of the data, where each average in the sequence is the one that best explains the co-movement of the data at business cycle periodicities given the averages already taken. But how should we read €-coin? €-coin appears to be a very good predictor of current quarterly economic growth. Its aim, however, is to capture the underlying growth momentum in the euro area so that departures of €-coin from actual GDP figures should therefore be seen as transitory and could be interpreted as an over- or under-estimation of actual (underlying) growth rates by official GDP data. 2.4 Monitoring the economy: €-coin in real time The task of €-coin is to monitor in real time the euro-area economy. Let’s then see how it has performed in the recent past. In doing so, its track record will also be compared with that of other well known and widely used indicators. Figures 3a-3d are frames taken from a real time animation. In Figure 3a we are positioning ourselves at the end of 2003. In the upper panel you see the €-coin indicator and the quarterly growth rate of GDP. In the lower panel you see the Ifo business climate, the PMI manufacturing climate, the euro-area industrial production index and, again, the GDP quarterly growth rate. The animation mimics the following: we repeatedly ask ourselves what is our “current” assessment of the true growth momentum in the euro area and month after month we watch what would have been the answer given by €-coin and by the other indicators (one should bear in mind that €-coin also uses the information contained in these competitors, so we are certainly not claiming they are unimportant). Since there is no clear way of translating survey data or the IP index movements into q-o-q GDP growth, they were appropriately rescaled. I would like to direct your attention to two episodes: i) what happened in 2004 (see Figure 3b); ii) the most recent upturn that started in 2005 (see Figure 3c-3d). Figure 3a: Situation at the end of 2003 Figure 3b: Situation at the end of 2004 Figure 3c: Situation in summer 2005 Figure 3d: Situation in February 2007 The case of 2004 is particularly interesting because throughout 2004 many economy watchers, basing their judgment on traditional indicators, repeatedly announced a pick-up in economic activity in the euro area. As it turned out, the signals derived from such indicators were misleading and the recovery in GDP growth did not materialise. Note in particular how the PMI, that will turn out to perform well in the 2005-06 period, wrongly signalled an acceleration in activity for the first few months of 2004. As you see, relying on €-coin would have suggested a more bearish conclusion. In particular, while at any point in time one can always find an indicator that closely follows GDP developments, it is not the case that this happens consistently through time for any single (elementary) indicator. On the other hand €-coin has always performed remarkably well in terms of tracking growth. In the Spring of 2005 the signs of a pick-up started to become evident and this time the acceleration in economic activity was also signalled by €-coin. As you can see, though, moving forward in 2005-06 other indicators show more episodes of what we would call a “false signal” and a tendency either to overshoot or to undershoot GDP. 3. On the use of a large dataset One might wonder what is the advantage of basing our judgment and hence our indicator on a broad range of statistics. We can answer this question in various ways: as we have seen, even focussing just on survey indicators leaves one with the doubt as to which one is the most reliable when faced with possibly contradictory signals. But in order to prove the case today, I will illustrate two advantages of using many series combined together. First, €-coin is an improvement on equally refined methods of constructing a monthly indicator that relies on a limited number of series. One can try different combinations of “cherry picked” series and propose a favourite index, the result will not change: indicators based on a small set of elementary series, even if they are well known and widely used, invariably produce much poorer results in terms of smoothness and reliability than those obtained by carefully constructing the “common factors” as is done with €-coin (see Figure 4). Figure 4: “Cherry picking” The second advantage of using many series in a formal way to construct €-coin is the possibility of assessing in continuous time the impact of the news contained in any of these series on the indicator. This can best be seen by referring to a real episode, such as, for example, the recent turmoil in monetary and financial markets and the surge in uncertainty it has produced. Since most forecasts are typically derived from quarterly macro-econometric models, they are still necessarily based on information gathered to a very large extent ahead of the recent financial crisis. Recent news are typically incorporated in a judgmental way and can usually be reflected in the forecast only as “downside risks”, and even then only rarely with probabilities clearly spelled-out, for instance with the help of a fan-chart. With the information at hand, almost all forecasters have suggested in the last few weeks that the short-term economic outlook for the euro area remains broadly in line with the picture we had before the Summer, i.e. the cyclical expansion will continue in the second half of 2007 at a pace only slightly lower than what was expected in the Spring. However, an issue worth investigating could be whether the initial conditions underlying these projections have changed or not, perhaps reflecting effects from the recent financial developments. What information does €-coin contain in this respect? First of all it confirms the overall positive outlook pointing to an underlying growth rate still between 2.5 and 3 per cent for the euro area as a whole. The modest increase in June and July, that interrupted a weakening trend that started in the first half of the year, was followed in August by a return to a lower growth rate. However, the underlying growth is still higher than what was observed until the first quarter of 2006. To assess the impact of the August news on the state of the euro-area economy, we compared the estimate of €-coin obtained at the end of August with an alternative estimate obtained assuming that we had no August data concerning survey expectations and financial markets, thus replacing the actual data with their forecasts, as it is the case for those components of €-coin that are not yet available when the estimate is finalized (at the end of the month; see Figure 5). Figure 5: The August “surprise” The result shows that with respect to the trends implicit in financial and survey data up to July, the actual turnout in August implied only a minor downward revision. It is still too early to draw definite conclusions but the fall is very modest indeed. While it cannot be excluded that the impact of the August financial turmoil will have only limited repercussions on the underlying macroeconomic conditions of the euro area, it should be noted, on the one hand, that its effects may take time to be fully passed through the economy and, on the other hand, that the turmoil and liquidity strains in the money markets are not over yet. So, a better picture will only be gained with the September and later releases of €-coin. As for September, a very preliminary estimate that does not yet incorporate the information contained in survey data (available only in the second half of the month) points to a further moderation of the underlying rate of growth of GDP (see Figure 6). Note however that the indicator still points to an economic expansion close to potential and above the levels reached at the beginning of 2005. Figure 6: The September “(VERY) preliminary” update 4. The way ahead To conclude, the €-coin indicator will be published at the end of each month on the CEPR (eurocoin.cepr.org) and Bank of Italy (eurocoin.bancaditalia.it) websites. The web pages will contain a graph and a table with the most recent releases of the indicator and a short comment on the interpretation of the signal (note that past releases are treated as “final estimates” and will not be updated). When there are interesting events, the indicator will be further analysed by breaking it into its main determinants (surveys, financial variables and so forth) thus adding some insight in terms of the driving forces of underlying growth. The website will also host a page of invited comments, critiques and suggestions. Links will be provided to related literature and background papers. | bank of italy | 2,007 | 10 |
Keynote speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the Conference "Pension Planning in Italy and the Netherlands ¿ Challenges for Public Policy and Financial Markets', Rome, 25 October 2007. | Ignazio Visco: An ageing population – solutions from financial markets Keynote speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the Conference “Pension Planning in Italy and the Netherlands – Challenges for Public Policy and Financial Markets”, Rome, 25 October 2007. In part this speech reflects views advanced in Visco (2006) and in a report prepared for the Deputies of the Group of Ten in September 2005 by a group of experts that I chaired (Group of Ten, 2005). I have received useful suggestions from Daniele Franco and Fabio Panetta and I would especially like to thank Pietro Tommasino for his assistance and comments. * 1. * * Introduction Italy is an ancient country, rich in history, art and culture. It also has one of the most rapidly ageing populations in the world. We have all heard about the Medici family, whose most illustrious member, Lorenzo the Magnificent, was not only a great politician and statesman, but also a patron of the arts and a poet. To Italians of my generation he is best known for these verses: “Quant’è bella giovinezza, che si fugge tuttavia! Chi vuol esser lieto, sia: di doman non c’è certezza”, that is, in a charming English translation, “Youth is sweet and well, but doth speed away! Let who will be gay, tomorrow, none can tell”. 1 Lorenzo was only twenty years old when he succeeded his father as the dominant force in Florence, embarking on a remarkable political career that would make him the arbiter of the balance of power in Italy. And he was just forty-three when he died, the same year that Columbus discovered America. Today we live much longer lives, but no less uncertain ones: indeed, “tomorrow, none can tell”. Living longer, especially if we are in good health and have the resources to enjoy it, is certainly a positive development. Since in all probability we are not descended from the Medici family, or one of similar wealth, we cannot afford Lorenzo’s hyperbolic discounting, which borders on moral hazard. We must, instead, plan for our future. This is especially so as the demographic changes we are experiencing pose serious challenges for our public finances and the working of labour markets. These certainly include the need for the reform and adaptation of our pension systems. Indeed, the “pay-as-you-go” (PAYG) public pension system that still covers most of the Italian population was devised at a time when life expectancy was lower and fertility rates were higher. While a major reform of the public pillar was made in 1995 and refined over the last decade, the development of private pension saving is now particularly important. The percentage of people enrolled in private pension plans is still low, and the pool of assets managed by pension funds is still very small. 2. Demographic trends The last hundred years or so have seen a spectacular rise in average life expectancy in today’s high-income countries. Very considerable, if less spectacular, progress has also been observed in the rest of the world. For a large part this can be ascribed to the exceptional fall in infant mortality. However, in the last half a century there has also been a remarkable increase in life expectancy at old age. This secular rise in longevity has been accompanied more recently by lower fertility rates, with the result that the world population is now ageing very rapidly. This is not only the case for the OECD countries but for several emerging economies as well, most notably China. From Lorenzo de’ Medici (il “Magnifico”), Trionfo di Bacco e Arianna, 1490 (trans. by Lorna de’ Lucchi in An Anthology of Italian Poems 13th-19th Century, A.A. Knopf, New York, 1922). The unprecedented rise in longevity has affected Italy perhaps even more than other countries and mortality rates at older ages have dropped very sharply. Between the early 1930s and 2004, life expectancy for males has increased by 6.2 years at the age of 60, 4.7 years at the age of 70 and 2.9 years at the age of 80; for women, it has improved even more, by 9.7, 7.6 and 4.6 years. Life expectancy has increased more in absolute terms for the relatively younger ages, so that the shape of the population pyramid is progressively and significantly becoming more “rectangular”. These changes have occurred extremely rapidly in recent decades: about two thirds of the increase in life expectancy of males and about one half that of females took place after 1980. There are reasons to believe that even these striking figures may underestimate the true improvements. For example, life expectancy is usually calculated using the age-specific mortality rates observed today, instead of estimating them on a cohort-by-cohort basis. 2 This may be one of the reasons for the systematic under-prediction of the number of the elderly, especially the oldest old. New and more sophisticated projection methods have been proposed recently. They appear to have produced significant improvements in projection, but life expectancy gains still seem to be somewhat under-predicted. 3 Even if there is consensus that life expectancy will continue to rise in the future (most likely by one to two years per decade), we must therefore acknowledge that there is still a high degree of uncertainty about future longevity. Moreover, lags occur in the production, adoption and disclosure of mortality tables. In particular, cross-country variations in mortality assumptions used by company pension schemes appear at times far larger than the profiles of their members warrant. 4 Indeed, as the 2005 G10 report concluded: “Regulators should promote transparent disclosure of mortality and disability projections and pension actuaries should determine the extent to which these projections reflect actual plan experience and how they model and allow for the uncertainty surrounding these estimates in their funding strategies” (p. 66). Demographic changes may cause systematic deviations in the number of deaths from their expected values. Unlike random variations around a fixed known mortality probability, this is a collective longevity risk that cannot be diversified across the individuals of a given cohort as it affects all of them in the same way. More sophisticated hedging mechanisms are therefore needed, possibly involving the public sector. Indeed, longevity risks are faced not only by company pension schemes but by public programmes as well. In Visco (2006) a rough estimate of the risk facing the Italian pension system was computed by considering the extra pension payments that individuals aged 50 years and older would receive if they lived longer than expected (assuming that most of the cost of reforms to correct this effect would be borne by younger individuals). The same percentage improvements observed in life expectancy between 1990 and 2002 were projected from 2005 forward, with the result that the cost of such a shock would be about 10 per cent of the present value of pension liabilities under the current system. This would amount to 22 per cent of 2005 GDP, with an average annual flow of about half a percentage point of GDP for the next decade, and one percentage point in the 2020s and 2030s. All this clearly points to a need for better and more timely projections. At the same time, because projections are surrounded by a high degree of uncertainty, pension systems should be designed to be robust to uncertainty. They should also be resilient to the economic and political pressures that demographic changes are likely to engender. See also Morcaldo (2007). See Lee and Carter (1992) and Tuljapurkar, Li and Boe (2000). See Cass Business School (2005). As far as public pensions are concerned, the introduction of notional defined contribution (NDC) pension systems in a number of countries, including Italy, goes in this direction. In principle, NDC systems can be designed to calculate pension benefits taking macroeconomic and demographic developments automatically into account. However, regardless of the very long transition period, the Italian pension scheme, in the form it was introduced, differs in some important respects from the prototype of an NDC system. The benefit rules were not designed to be frequently and automatically updated to account for demographic developments and the rate of return on workers’ contributions (equal to the rate of growth of nominal GDP) apparently does not grant the actuarial balance of the system at least in the short-to-medium run. 5 Several changes have been agreed recently between the government and the social partners. While some of the new rules are in line with the NDC philosophy (for example, parameters should be updated every three years instead of every ten and preliminary negotiations with social partners will no longer be needed), others are more difficult to understand (for instance, granting some categories of workers a specific pension benefit-towage ratio). 3. Demographic change and pension systems All pension systems imply a redistribution of real resources from active workers to retirees. While in PAYG systems this is implemented through taxes and social security contributions, in funded systems it is achieved through capital markets, as pensioners use the assets accumulated in their working years to provide for their needs once retired. 6 In both cases, the goods and services consumed by both active workers and retirees are produced by the labour of the former. In a funded system, however, saving and accumulated assets should be greater, leading in principle to a larger amount of resources available. An expected increase in longevity results in higher old age dependency ratios and narrows the range of possible changes to pension system designs, regardless of the institutional arrangements for intergenerational redistribution. Possible measures include: (i) increasing payroll contributions; (ii) reducing pension payments relative to per capita GDP; (iii) raising the retirement age; and (iv) increasing current saving in order to pre-fund greater future pension expenditures. This last would require both an increase in public saving (reducing budget deficits and raising the share of capital expenditure) and an expansion of the private pillar. Some of these options have the normative appeal that the current workforce shares part of the burden with future taxpayers. In particular, policies to raise the age at retirement and increase current savings seem preferable, at least for Italy, given that in the future people will not only live longer but will also be active and healthy longer. 7 Moreover, such policies are likely to increase potential GDP and this will help to alleviate the financial consequences of ageing. Morcaldo (2007). The often overlooked fact that the returns achieved in a funded system depend on demographic developments has been highlighted among others by Mirrlees (1997) and the Pension Commission (2004). See also Visco (2002). Unfortunately, this does not mean that health-related expenditures will be less burdensome. On one hand, scientific and technological progress in the medical field will probably make more disease curable and lead to higher overall expenditures. On the other hand, a large part of medical expenditures is in any case incurred in the very last years of one’s life. All in all, there is a growing consensus among experts and policy-makers that lengthening the average working life and increasing pre-funding are essential to any credible strategy to meet the challenges of ageing. To increase the effective age of retirement, it is important to reduce the disincentives to work embedded in social security rules. PAYG systems are often not neutral with respect to the retirement decision. Indeed, in many social security systems workers’ pension wealth (i.e. the discounted value of future pension payments) decreases with age at retirement, generally because of the weak linkage of benefits to lifetime contributions. The NDC system introduced in Italy in 1995 should offset this distortion, as benefits depend on past contributions and on expected longevity at retirement. However, the new system is being phased-in very slowly. Other potential interventions relate to the labour market, for example offering broader training opportunities to older employees, increasing flexibility in age-earnings profiles and improving on employment arrangements. If we enlarge our framework to account for uncertainty and move beyond the distinction between funded and unfunded pension schemes, a second distinction comes to the fore, namely that between defined contribution (DC) and defined benefit (DB) systems. The two distinctions are independent of one another: unfunded schemes, such as that introduced in Italy in 1995, may well place longevity or even market risks directly on workers; and funded systems may shield workers from risks, placing them on the employer. These two alternative institutional arrangements allocate the risk of unexpected changes in longevity in very different ways, although upon closer examination the differences appear less pronounced. Under a DC system, workers bear the risk that, prior to retirement, an upward revision in the expected longevity of their generation would increase the cost of purchasing an annuity at the moment of retirement. 8 The risk that an individual’s postretirement longevity will turn out to have been underestimated is instead left on those who sell annuities. This risk can be decomposed in two components: (i) the risk that the insured will live longer than the rest of her/his cohort (this is a proper insurance risk, which by its very nature cancels out if the pool of policies is big enough); and (ii) the risk that the average longevity of an entire cohort will prove to have been underestimated (this is an aggregate risk that cannot be easily diversified away). Of course, a large part of the aggregate longevity risk is likely to be shifted back from insurers to workers via (possibly excessively) high annuity prices, and in practice these high prices are a key reason why many people prefer not to annuitize. The result is that, in a fully DC system, the insured must cope with longevity risk on their own. While, in principle, farsighted agents should respond to risk by working longer and/or by saving more, such virtuous responses are often impeded by institutional obstacles (labour market rigidities, financial market incompleteness) and by bounded rationality or myopia. 9 Indeed, the existing private DC schemes are often perceived by households (especially those of slender means) as too risky and too complex (and perhaps too costly). DB schemes, by contrast, are meant to protect workers against aggregate longevity risk, but uncertainty about future improvements in life expectancy would affect these systems too. In fact, an unexpected increase in longevity would necessitate either increasing payroll contributions or the public debt. And in either case the burden would be borne entirely by the younger generations. In other words, high longevity risk would translate into high “political” risk: pension promises might not be honoured, as the intergenerational pact on which they rest might prove socially and economically unsustainable, as well as intrinsically unfair. Of course, even if he/she chooses not to annuitize, there will be an unexpected decrease in the ratio between the level of consumption after retirement and consumption before retirement. As reported by Choi et al. (2001), in a survey of employees 68 per cent of respondents complained that they save too little for retirement, 24 planned to raise their contributions in the future, but only 3 per cent among them actually did so. Occupational DB pension plans are designed to protect employees from longevity (and investment) risks, placing the consequences of any actuarial imbalance on the employer. In this case too, however, workers would be ultimately exposed to longevity risk. The difficulties of recent years are instructive as to possible future developments: questionable investment decisions and adverse financial market developments have opened up a worrisome “funding gap”, increasing the present value of liabilities more than total assets. As a result, many sponsors have closed DB funds to new workers or ceased accepting further contributions from those already enrolled. In some cases, workers have suffered from the default of the plans. To sum up, the great uncertainty surrounding longevity projections creates problems both in DC systems (where individuals and households are left alone to bear longevity as well as market risks) and in DB systems (where entitlements guaranteed by the state and by corporate sponsors might prove unsustainable). The demand for some form of DB pension schemes is nonetheless very strong. 10 This presumably reflects investors’ reluctance to bear longevity risk and investment risk, and suggests that, while it may not be possible to avoid transferring at least part of these risks from the public pension system or employers to workers and households, some form of capital or performance guarantee could significantly stimulate investors’ demand for private pension products – provided that more accurate asset/liability management practices are introduced and supervisory oversight is strengthened. On the supply side, longevity bonds should definitely be encouraged, recent failures notwithstanding. The market for long-dated bonds is also too small relative to the potential demand from institutional investors. The duration of public debt in most countries is quite short (at about 5 years) and the lack of public benchmarks discourages potential private issuers. There is also a shortage of long-term and inflation-linked bonds: the potential demand exceeds supply at least threefold. 11 One could also think of macro-swaps between the pension fund and the health care industries, to exchange their exposure to longevity. Finally, as asymmetric information and market incompleteness cannot be completely eliminated, governments could step in, acting as insurers of last resort at least for the risk of very large unexpected increases in aggregate longevity. This is a further reason for reducing their role as providers of insurance that could be readily purchased in financial markets. 4. The development of private pensions in Italy Since the mid-1990s in Italy the PAYG system has been in a lengthy phase of transition from a standard DB system to a new NDC system. 12 From the very start of the reform process it was clear to policy-makers and experts alike that, in order to achieve an adequate level of retirement benefits, the new public pillar had to be supplemented by a well developed private pillar. The latter consists in two components, occupational and personal pension plans, both voluntary and of the DC type. The development of the private pension pillar witnessed an acceleration in recent years. One of the goals of the system has been to induce workers to divert contributions from the socalled TFR (a severance payment scheme where worker’s contributions are retained by the employer and earn a rate of return of 1.5% plus 75% of the inflation rate) towards private pensions. In order to achieve this objective, the new system includes an automatic enrolment The introduction of “hybrid products”, which share characteristics of both DB and DC schemes, is also often suggested. See Visco (2006). See Franco (2002). provision, whereby workers are enrolled in the pension scheme 6 months after they are hired, unless they explicitly choose to remain in the TFR scheme. It also significantly reduces the tax burden on private pension savings. Starting from January 2007, the end-of-period capital accumulated over contributors’ working lives is subject to a proportional tax rate that is equal to 15 per cent but can go down to 9 per cent depending on the length of the investment period; 13 in comparison, the lowest personal income marginal tax rate is 23 per cent. Our calculations show that the new Italian ETT system (Exempt, Taxed, Taxed) is considerably more favourable than the EET system prevailing abroad. 14 The tax benefits of the new system are particularly valuable for high-income workers – with high marginal personal income tax rates – and for young workers, who can benefit from the favourable tax regime for a longer accumulation period. For example, over a 30-year accumulation period the new tax treatment would allow a low-income worker to increase the value of his/her end-of-period capital by about 24 per cent relative to an otherwise comparable portfolio of financial assets; for high-income workers, the tax benefit would rise to a hefty 70 per cent. 15 Of course, these tax benefits should not be offset by high costs and fees charged to investors. In Italy, these costs vary substantially across funds, but on average they are still relatively high. Recent analyses show that the total yearly costs of occupational funds − which include management fees, administrative costs and the fees paid to the custodian bank − average about 0.60 per cent. For open pension funds and insurance products the total costs and fees are even higher − 1.4 and 2.6 per cent on average, respectively. The expansion of the net asset value of pension funds may well reduce these costs, due to economies of scale. However, the process is likely to be slow and could be insufficient to lower the level of fees significantly. To speed up and reinforce the process, an increase in competition in the asset management industry, fostered by domestic and international competitors, will be necessary. In order to enhance competition, full transparency about fees and other product characteristics is also crucial. This would allow workers to choose the funds and products best matching their needs. In this respect, the fact that employers’ contributions cannot be transferred out of occupational funds limits workers’ mobility and restrains competition in the asset management industry, with potentially significant adverse effects on workers’ welfare. Moreover, to improve governance and reduce agency problems between investors and fund managers, the separation between asset management, auxiliary services, and consulting services should be pursued. The results achieved so far by the new system in terms of participation in private pension funds are fairly encouraging. According to COVIP (the supervisory authority for pension funds), excluding the workers who have adhered to pension plans via tacit consent, in the first six months of 2007 the number of workers participating in some form of supplementary pension scheme rose from 3.3 to 4.3 million. In the same period, the number of participating private sector employees rose from 1.8 to 2.7 million. Longer periods imply lower tax rates. In ETT (Exempt, Taxed, Taxed) systems, workers’ contributions to pension funds are tax-exempt, while the other two components of the pension scheme (the returns earned by the pension funds during the accumulation phase and the end-of-period capital) are taxed. In contrast, in EET systems (Exempt, Exempt, Taxed) the first two components are tax-exempt while the end-of-period capital is taxed. The comparison between the two systems depends crucially on the tax rates applied in each stage. The main advantage of the Italian ETT system is represented by the very low tax rate on the end-of-period capital (see Cesari, Grande and Panetta, 2007). See Cesari, Grande and Panetta (2007). There is nonetheless ample room for improvement, as the percentage of enrolled workers remains relatively low. In fact, at the end of June membership rates were equal to only 22 per cent for private sector employees and 28 per cent for occupational funds. As a result of the low membership rates and the short life of the system, the pool of assets managed by pension funds is still very small: in 2005 it amounted to 3 per cent of GDP, against an OECD average of 88 per cent. Since then it is likely to have increased by only a few percentage points. In the Netherlands, the leading country in Europe, pension fund assets are 125 per cent of GDP. 16 The lag that distinguishes our country primarily reflects insufficient information and awareness about the need to supplement public pensions with private schemes, but it is also due to workers’ low levels of financial education. The lack of solid trust in the functioning of financial markets is also a factor. But how can we stimulate the growth of this sector? One critical issue is information. Despite the efforts recently made by the government, surveys show that Italian workers are still not adequately informed on their future pensions. It is therefore crucial to provide workers with additional information about their accrued and perspective pension rights, both in the public and in the private pillar. An example of the benefits of transparent and clear information on the individual rights stemming from the public system is offered by the Swedish experience, where every year workers receive information on their past contributions and the rates of return granted by the system on such contributions. Valuable additional information could include estimates of the final pension benefits under various macroeconomic and demographic scenarios. Another issue that deserves closer examination is the potential benefit, in a phase of transition of the public pillar towards a DC system, of expanding the different types of guarantees offered on the performance of pension funds. In the current framework, pension funds are required by COVIP to offer an investment line that guarantees the nominal value of invested capital in order to be eligible to collect the contributions of those who have enrolled tacitly. Simulations and developments in the markets show that the costs of offering a broader range of guarantees would not be prohibitive: for example, even with conservative assumptions on market volatility, a capital guarantee in real terms over a 10-year investment horizon would cost 0.7 per cent on a yearly basis. 17 Guarantees that are conditional on particular events (such as long-term unemployment or illness) would imply a significantly lower cost. A low-volatility regime such as the one that has prevailed in recent years would further reduce the cost of guarantees. 18 Yet another way to reduce the costs that workers attach to the shift from the TFR scheme to pension funds would be to allow them to go back to TFR if they changed their mind, although there should be limits on the exercise of such an exit option. Empirical evidence shows that workers’ choices are often backward-looking and are affected by herding behaviour. These two factors could determine excessive movements in and out of different investment vehicles and might lead to an unjustified increase in the costs borne by investors. Customers should not be overloaded with difficult investment choices: the timing and size of contributions and the allocation of assets could be fixed by default rules, allowing a limited menu of options; life-cycle products should be developed to allow portfolio rebalances in line with the changing risk profile of workers as they age. 19 Simplicity and cost-effectiveness are crucial if we want to increase retirement savings among those who most need them. At See OECD (2006). The details of the simulation are reported in Cesari, Grande and Panetta (2007). Although the recent financial turmoil resulted in a marked increase in market volatility, in most markets and asset classes current volatility is still well below the pre-2004 levels. See Boeri et al. (2006) and Merton (2006). present, enrolment is particularly low among younger workers, women, and small business employees. In 2005, the membership ratio of younger workers (aged from 14 to 34) was below 8 per cent; that of women was 11 per cent; that of employees of small businesses (fewer 50 employees) was less than 5 per cent. It is also well known that adverse selection on annuity markets plays a possibly important role in limiting their development. In Italy the fraction of pension capital that is mandatorily transformed into an annuity at retirement is at present equal to 50 per cent of the total capital. An increase in this fraction could perhaps be considered. Finally, we should not overlook the fact that annuities are the classic answer to longevity risk, but by no means the only one. In reality, they make sense for people whose financial wealth is sufficient to buy them a significant income. As it may take time to accumulate sufficient levels of financial wealth until private pension schemes reach maturity, we should remember that real estate is often for households both a currently consumed asset and a major savings vehicle. Since housing wealth constitutes 60 per cent of Italian households total wealth, which is quite high compared with other high-income countries, instruments which help elderly people to extract liquidity from real estate in an efficient manner, such as reverse mortgage contracts, should become more widespread than they are today. 5. Conclusions Several thousands of years after the Age of the Patriarchs and the Bible saying that God had put a limit of 120 years to human lives, we still do not know whether that will be the biological limit to the human life-span. It is clear, however, that we are now approaching it at a very fast pace. It is also clear that in the last decades longevity projections have been systematically downward biased. This has produced an aggregate longevity risk, one that we will most likely continue to live with. Ageing populations require reform efforts at all levels. In Italy, not only has there been a major reform of the dominant public pension system, with a long transition period and many adjustments, but important steps have been taken towards developing an efficient private pension pillar. It will take time for a private system to be an adequate complement to the public system, but the road is clearly indicated and we must continue looking for improvements in information, competition, asset management and supervision. To cope with individual and aggregate longevity risks, it seems inevitable to me that we must aim for a better balance between these two pillars of our pension system. References Boeri, T., L. Bovenberg, B. Coeuré, B. and A. Roberts (2006), Dealing with the new giants: rethinking the role of pension funds, Geneva Reports on the World Economy 8, ICBM-CEPR, Geneva. Cesari, R., G. Grande, and F. Panetta (2007), “La previdenza complementare in Italia: caratteristiche, sviluppo e opportunità per i lavoratori”, Banca d’Italia Occasional Papers, No. 8. Choi, J. J., D. Laibson, B.C. Madrian, and A. Matrick (2001), “Defined contribution pensions: plan rules, participant decisions, and the path of least resistance”, NBER working paper No. 8655. Franco, D. (2002), “Italy: a never-ending pension reform”, in M. Feldstein and H. Siebert (eds.), Social Security Pension Reform in Europe, University of Chicago Press, Chicago. Group of Ten (2005), “Ageing and pension system reform: implications for financial markets and economic policies”, Report prepared for the Deputies of the Group of Ten by a group of experts chaired by I. Visco, in Financial Market Trends, OECD, Paris, November (Supplement 1). Lee, R.D. and Carter, L. (1992), “Modelling and forecasting the time series of US mortality”, Journal of the American Statistical Association, September. Merton R.C. (2006), “Observations on innovation in pension fund management in the impending future”, PREA Quarterly, Winter. Mirrlees, J. (1997), “The economic consequences of ageing populations”, Philosophical transactions of the Royal society, Vol. 352. Morcaldo, G. (2007), “Pensioni: necessità di una nuova riforma”, Banca d’Italia, mimeo. OECD (2006), Pensions markets in focus, No. 3, October. Pensions Commission (2004), Pensions: Challenges and Choices, Stationery Office, London. Tuljapurkar, S., Li, N. and Boe, C. (2000), “Is there a universal pattern of mortality decline? Evidence and forecasts for the G7 countries”, Nature, vol. 405 (789). Visco, I (2002), “Ageing populations: Economic issues and policy challenges”, in H. Siebert (ed.), Economic Policies for Aging Societies, Springer, Berlin. Visco, I. (2006), “Longevity risk and financial markets”, keynote speech to the 26th SUERF Colloquium, Lisbon. | bank of italy | 2,007 | 11 |
Speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the IV Joint High-Level Eurosystem ¿ Bank of Russia Seminar, Moscow, 10-12 October 2007. | Ignazio Visco: Financial deepening and the monetary policy transmission mechanism 1 Speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the IV Joint High-Level Eurosystem – Bank of Russia Seminar, Moscow, 10-12 October 2007. * 1. * * Changes in the financial landscape in the euro area and other industrial countries Since the second half of the 1990s impressive changes have occurred in the financial landscape of industrial countries. The euro area has been no exception: in some regards the pace of change has been even faster than in countries such as the United Kingdom and the United States, traditionally characterised by more developed financial markets. We may define financial deepening as an increase in the size of the financial system and in its role and pervasiveness in the economy. From a monetary policy perspective, the growing diversification of firms’ and households’ portfolios is especially relevant, as they are more and more affected by the developments in financial markets. At least five major changes are worth noticing: • In the last decade gross financial assets have increased very rapidly. Between 1996 and 2006 in the euro area they have risen as a ratio to GDP from 6.6 to 10.5 (compared to 9.8 in the United States and 17.6 in the United Kingdom). As an indication of the funds collected by the private sector, the sum of bank credit to this sector, debt securities outstanding and stock market capitalisation has risen from about 150 per cent to around 240 per cent of GDP in the euro-area (compared to over 300 per cent in the United States and in the United Kingdom; Fig. 1). Fig. 1 - Size of capital markets (ratios to GDP) Bank credit to the private sector Domestic debt securities issued by the private sector Stock market capitalisation United States Euro area Japan United Kingdom 3.5 2.5 1.5 0.5 Sources: IMF International Financial Statistics, BIS, Datastream. • The use of derivatives – futures, options, interest rate swaps and, more recently, credit default swaps together with structured products such as collateralized debt obligations and asset backed securities – has dramatically changed the functioning I would like to thank Pietro Catte and Paolo Del Giovane for assistance and comments. of financial markets. They open to market participants the possibility of unbundling various risk components and allocating them among a multitude of investors; in turn, investors have more scope to hedge against future market movements or, alternatively, to increase portfolio leverage and the volume of risks assumed. The use of derivative instruments has sharply increased in recent years: the total outstanding notional amount of over-the-counter and exchange-traded derivatives has risen from about 94 trillion U.S. dollars at the end of 1998 to around 486 trillions at the end of 2006 (Fig. 2). Fig. 2 - Notional value of over-the-counter and exchange-traded derivatives (outstanding amounts in billions of US dollars; end of year data) 500,000 Exchange-traded OTC Total 400,000 300,000 200,000 100,000 Source: BIS Quarterly Review, September 2007. (1) OTC derivatives include credit default swaps. • As a consequence of the new opportunities opened by financial innovation, the role of banks has been changing. Commercial banks have exploited credit transfer techniques to add to their traditional business a new role of originating, pooling and distributing credit risks outside the banking system. This has allowed them to free capital and enlarge their lending capabilities. In the euro area securitization has developed later than in the United States and the United Kingdom, accelerating only in the more recent years. Between 2000 and 2005 the annual flow of securitized loans has increased from 0.6 to 2.0 per cent of GDP; in the same period it has risen from 2.1 to 8.2 per cent in the United Kingdom and from 4.9 to 14.0 per cent in the United States (Fig. 3). Fig. 3 - Securitized loans (annual flows by country of collateral; percentages of GDP) Euro Area UK USA Sources: European Securitization Forum, Bond Market Association, Eurostat. (1) Euro area figures do not include Pfandbriefe; U.S. data exclude Federal Agency Securities. • New financial market players, such as hedge funds and private equity funds, have emerged; in recent years they have become key drivers of innovation in a broad range of markets and transactions. The hedge fund industry provides a good example of this expansion: according to estimates by Hedge Fund Research it grew from 3,873 funds managing 490 billion U.S. dollars in 2000 to 9,228 funds with around 1.4 trillion U.S. dollars in 2006, corresponding to about 1.2 per cent of global debt and equity outstanding (Fig. 4). Other estimates (by HedgeFund Intelligence) set the assets in global hedge funds at about 2.0 trillion U.S. dollars by the end of 2006, of which nearly 1.5 trillions in U.S. funds, roughly 450 billions in European funds and 150 billions in Asian funds. Fig. 4 - Global hedge fund assets (billions of U.S. dollars) 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Sources: Hedge Fund Research, World Federation of Exchanges (FIBV), Bank for International Settlements (BIS) and Swiss Re Economic Research & Consulting. • An important dimension of the greater diversification of risk has been the increased international financial integration. In the last decade industrial countries’ gross external financial assets and liabilities more than doubled in proportion to GDP, reaching 320 per cent (Fig. 5). Fig. 5 - Gross stocks of foreign financial assets and liabilities (sum of financial assets and liabilities in percent of GDP) Industrial countries Emerging countries Source: IMF (Lane – Milesi-Ferretti database). (1) For each group, weighted average calculated using GDP weights. As a consequence, the range of financing and investment opportunities available to economic agents widened, as reflected in the composition of the balance sheets of firms and households. In particular: • The set of corporate finance instruments used by euro-area firms has broadened. In the first three years after the introduction of the single currency, the net issuance of corporate bonds accelerated dramatically (Fig. 6). The marked deceleration that has been observed in the most recent years reflects, on one side, the impact of corporate scandals, but also, on the other side, the greater availability of bank credit resulting from credit market innovations. Fig. 6 - External financing of euro-area non-financial corporations (net issuance; annual growth rates) Total external financing Bank loans Quoted shares Debt securities Source:ECB. • The market has also broadened, not only in terms of the instruments available but also with respect to the increasing access of a larger number of firms, including those with lower ratings. This increased availability of funds has been extensively used to finance M&A activities. • Between 1995 and 2006 the composition of euro-area households’ financial assets has progressively shifted away from traditional instruments, such as banknotes and deposits, to more sophisticated financial assets whose prices are more sensitive to market movements and credit risk. The share of bonds, equities, insurance products and pension funds has grown from 56 to 67 per cent of total assets, a share that is now closer to those of the United Kingdom and the United States (71 and 83 per cent respectively; Fig. 7). Fig. 7 - Household financial assets, composition by instrument (percentage of total assets; year-end figures) 1.2 1.0 Banknotes and deposits Combined shares of bonds, equities, insurance products and pension funds Other assets 0.8 0.6 0.4 0.2 0.0 1995 2006 Euro area 1995 2006 US 1995 2006 UK 1995 2006 Japan Sources: Eurostat, Flow of Funds Accounts of the United States, Central Statistical Office - UK national accounts, Bank of Japan. • Households have also made an increasing recourse to debt. The increase in euroarea households’ liabilities has been large (from 45 to 62 per cent of GDP) but it has been outpaced by the increase recorded in the United Kingdom and the United States (from about two thirds to around 100 per cent of GDP; Fig. 8). To a large extent, this reflects the rise in mortgage debt, which has been matched by an even larger rise in housing wealth. Fig. 8 - Household financial liabilities (ratios to GDP) 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Euro Area US UK Japan Sources: Eurostat, Flow of Funds Accounts of the United States, Central Statistical Office - UK national accounts, Bank of Japan. 2. Financial market developments and monetary policy transmission The developments described above affect the speed and strength of the channels of monetary policy transmission to the economy. In a nutshell, one may argue that the traditional “interest rate channel”, as well as the transmission via asset prices, have become stronger, while the “credit channel” has become weaker. At a closer look, however, things are less simple. • As financial markets are more liquid and complete, changes in official interest rates are more readily transmitted to the whole term structure and, more generally, to financial asset prices, affecting the economy through the cost of investment financing and the return on saving (as firms can exploit a wider range of financing opportunities and households’ portfolios are more diversified). • As a consequence, the impact of monetary policy through financial market expectations is also more relevant. Central banks can now affect a whole range of asset prices not just by means of their actual decisions on the very short-term interest rates but also by providing signals on their intentions. 2 However, since asset prices also reflect expectations regarding other economic variables, it may be difficult, at times, to identify the specific impact of monetary policy actions and announcements. • A major implication of the increasing weight of financial and non-financial assets in firms and households’ balance sheets is that the effects of monetary policy through changes in asset prices and related wealth effects are likely becoming larger. Indeed, available evidence across OECD countries points to increasing wealth effects over time and to an impact of financial deregulation on these effects. The available empirical studies for the United States estimate long-run propensities to consume in a range of 3 to 7 cents out of each dollar of total wealth increase. The M. Woodford, “Central bank communication and policy effectiveness”, NBER Working Paper No. 11898, December 2005. propensity in the euro area is somewhat lower (3 to 4 cents per dollar of increase in total wealth) according to recent ECB estimates. 3 • The results on the relative importance of changes in financial and housing wealth are not univocal. Importantly, in assessing the relevance of the effects of capital gains and losses we need to keep in mind the relative weights of housing and financial wealth, and the composition of the latter, in the various economies. The volatility of financial and real asset prices also matters, as does the heterogeneity across different categories of households. For example, as rising house values have in general opposite effects on home owners and on tenants who are often saving to buy a house, changes in house prices may have smaller effects. 4 Finally, as international integration of financial portfolios progresses, wealth effects connected to exchange rate movements may take on greater relevance. • Easier access of households to credit has important consequences. Recent research suggests that this is in itself one of the reasons why the effect of house price changes on consumption may have become larger, in particular in the United Kingdom and the United States. Households’ increasing ability to access credit against housing collateral may reinforce the effect of monetary policy through “balance sheet effects”, i.e., through the movements in the price of collateral assets. The growing variety of financial products which became available in recent years, such as home equity loans and mortgage refinancing, allow households to borrow more freely against house collateral; if monetary policy affects house values, this is reflected in consumer spending through the cost and availability of credit. 5 • While speeding up the transmission of policy decisions through the term structure and asset prices, financial innovation weakens the so-called “bank lending channel”. Traditionally, interest rate increases were thought to decrease banks’ credit supply (through a reduced availability of core deposits), which in turn would affect those borrowers that mostly depend on bank credit for external financing. Asset securitisation increases banks’ liquidity and reduces their funding needs in the event of a monetary tightening, while also allowing them to transfer part of credit risk to the markets, thereby easing regulatory capital requirements when needed. 6 Moreover, a wider range of borrowers is now able to make recourse to financial markets as a substitute for banking sources of financing. There are still, however, a number of open questions: • First, is the broad credit channel really weaker? True, the relevance of the “bank lending channel” is affected negatively by loan securitisation and the emergence of non-bank lenders. However, as I have mentioned, the effects that work through the value of collateral and the balance sheets of firms and households (the so-called “ financial accelerator”) are changing, but certainly not losing importance. The conditions at which bank and non-bank lenders are able to attract external funds or F. Altissimo, E. Georgiou, T. Sastre, M.T. Valderrama, G. Sterne, M. Stocker, M. Weth, K. Whelan and A. Willman, “Wealth and asset price effects on economic activity”, ECB Occasional Paper No. 29, June 2005. L. Guiso, M. Paiella and I. Visco (2006), “Do capital gains affect consumption? Estimates of wealth effects from Italian households’ behavior”, in L. R. Klein (ed.), Long run growth and short-run stabilization. Essays in memory of Albert Ando, Edward Elgar, London, 2006. J. Muellbauer, “Housing, credit and consumer expenditure”, paper presented to the Kansas City Federal st st Reserve’s Jackson Hole Symposium, 31 August – 1 September 2007; C. Carroll, M. Otsuka and J. Slacalek, “How large is the housing wealth effect? A new approach”, Johns Hopkins University Economics Working Paper 535, 2006. Y. Altunbas, L. Gambacorta and D. Marqués, “Securitisation and the bank lending channel”, ECB Working Papers Series, forthcoming. to securitize existing loans ultimately depend on their perceived creditworthiness, which is influenced by cyclical developments and also, through the price of collateral, by monetary policy changes. 7 Funding conditions, in turn, will be reflected in the cost and availability of credit to final borrowers. The recent sharp tightening of lending standards to a broad range of U.S. mortgage borrowers is a serious reminder of this possibility. • Second, and more fundamentally, the recent financial turmoil indicates that we need a better understanding of the “originate and distribute” model of financial intermediation and its implications for monetary policy transmission. This model allows greater risk diversification and helps ease credit constraints in normal times. However, it may also induce agents to take on more debt and greater exposure – direct or indirect – to highly complex financial instruments. Furthermore, there is a lack of market-determined prices for certain structured finance products, and the evaluation models used by rating agencies have shown limited reliability in taking into account tail risk. These changes can make the system more vulnerable to sudden increases in uncertainty or shifts in market sentiment, that may result in a widening of credit spreads and possibly in credit rationing. In these circumstances, the effects of monetary policy via the value of collateral can be amplified or become less predictable. • Third, it is important to assess whether household balance sheets in the euro-area are really becoming more similar to those in the United States, where households’ portfolios are traditionally more oriented to risky instruments, mortgage markets are more sophisticated and the recourse to consumer credit and credit cards is much more widespread. The more this were the case, the more the euro-area transmission mechanism would start resembling that of the United States, where monetary policy effects via consumption (and residential construction) have traditionally played a more prominent role than in continental Europe. 3. How is the conduct of monetary policy affected? The above mentioned trends may have important consequences for the way monetary policy is conducted in practice: • Monetary policy is conducted in a world characterised – even more than in the past – by a high degree of financial complexity and widespread non-linearities: while overall risk may be on average lower in normal times, due to greater diversification, it can increase sharply when large systemic shocks occur, that determine a sudden rise in the correlation of asset price movements. An implication is that we should be cautious in using macro-econometric models in circumstances of financial unrest, since they may not adequately capture the role played by large asset price movements. Large price corrections and credit crunches are, in fact, rare and extreme events, and macro-econometric estimates over (relatively) short samples are dominated by “normal time” observations. • The interaction between monetary policy and financial stability issues may become more complex. Indeed, while there is no obvious systematic trade-off between the objectives of price stability and those of financial stability, there might be cases in B. Bernanke, “The financial accelerator and the credit channel”, speech at the Conference “The credit channel of monetary policy in the twenty-first century”, Federal Reserve Bank of Atlanta, Atlanta, GA, 15 June 2007. which a short-term conflict arises. 8 This is particularly the case when financial and credit market turmoil determines systemic tensions in money markets. In these circumstances the distinction between the aims of liquidity provision and the aims of interest rates setting – an easy task under normal circumstances – is more difficult. On the one hand, actions needed to ensure an orderly functioning of the money market may blur monetary policy signals. On the other hand, decisions on interest rates could be interpreted as revealing major information unknown to the market and hinder its normal functioning. • In pursuing price stability, we also need to monitor more closely developments in asset prices that can eventually have an impact on inflation and growth. There are well-known arguments why this is not easy to do: the interactions between asset prices and financial stability are complex, while telling the difference between asset price misalignments and changes in fundamentals is inherently difficult. Nonetheless, there have been cases in the past when asset price developments were clearly hardly related to fundamentals. The assessment of asset price developments is a hard task, but these difficulties do not, in my view, justify an attitude of “benign neglect”. • More generally, this points to the need, for the central bank, to monitor (and respond to) a wider set of indicators, without uniquely focusing on inflation forecasts, as it would be implied by a strict (or even a flexible) inflation targeting approach. There is a large, although not undisputed, body of evidence which suggests that persistently high growth of money and credit aggregates may provide useful “early warnings” of emerging financial imbalances that indeed may also matter for the overall underlying price stability. The greater importance of monetary policy transmission via expectations and asset prices also poses pressing challenges for communication: • If monetary policy communication is effective, market reactions, by affecting the whole yield curve and other asset prices, may partly “do the job” for central banks. However, and for the same reason, communication mistakes can be more costly than in the past, as they may easily destabilise financial markets. Central banks need to insist in their effort to provide proper communication on their objectives, strategies and decisions. • The interaction between monetary policy and financial stability issues also has implications for communication, particularly at times of market stress. In these cases, monetary authorities should not overlook the potential impact, not only of their actions, but also of their communication on the resolution of the financial stability problems. Even advocates of full transparency in the disclosure of future monetary policy intentions agree on the fact that some degree of “constructive ambiguity” may be needed when central banks deal with financial stability issues, to avoid the spreading of fears or, worse, panics. 9 • The importance of an effective policy communication clearly emerged this summer, when a heightened preference for precautionary liquidity by banks following the U.S. sub-prime mortgage market crisis led to strains in the interbank market. The Eurosystem made it clear to market participants that it would intervene to ensure the O. Issing, “Monetary policy and financial stability: is there a Trade-off?”, speech at the Conference on “Monetary Stability, Financial Stability and the Business Cycle”, Bank for International Settlements, Basel, March 2003. A. Cukierman, “The limits of transparency”, paper presented at the Third Banca d’Italia/CEPR Conference on “Money, Banking and Finance: Monetary policy design and communication”, Rome, 27-28 September 2007. orderly functioning of the money market, providing liquidity when needed. It acknowledged the greater uncertainty surrounding its assessment of the outlook for economic activity, while, at the same time, provided guidance to medium term expectations by clearly stating that its monetary policy stance would continue to respond to the evolution of the macroeconomic outlook and to risks to price stability in the medium term. As it was observed by the ECB’s Governing Council, providing an anchor for price stability is all the more important in times of financial market volatility and heightened uncertainty. 4. Some implications for emerging market economies I will now turn briefly to discuss to what extent these trends and the resulting challenges are also shared by emerging market economies. The pace of change in EMEs financial markets and instruments has been even more dramatic than in advanced economies. This has reflected in part a “catch-up” effect following the removal of the main earlier obstacles to financial development – above all, macroeconomic instability, vulnerable external positions and inefficient institutional and regulatory setups. The process has also been supported by a favourable global financial environment. The effects include: • financial system deepening, with strong credit growth and rapid development of bond and equity markets (Fig. 9); • a shift toward more market-based financial systems: local-currency bond markets have been developed, and both investors’ portfolios and sources of financing have become more diversified; • greater international integration, with foreign banks and international investors playing a greater role in domestic financial markets. All in all, EMEs are proceeding faster in these directions than advanced economies did when they were at a comparable stage of development. Fig. 9 - Size of capital markets in advanced and emerging market economies (ratios to GDP) Bank credit to the private sector 3.5 Domestic debt securities issued by the private sector Stock market capitalisation Advanced economies 1 Brazil China India Russia 1996 2006 1996 2006 1996 2006 1996 2006 1996 2006 2.5 1.5 0.5 Sources: IMF International Financial Statistics, BIS, Datastream. (1) Weighted average of United States, Euro area, Japan and United Kingdom, with 2000 GDP weights at PPP exchange rates. These changes in the financial system – together with the fundamental improvement in the macroeconomic and institutional environment – may have important implications for the way monetary policy is transmitted to the economy: (i) as in industrialised countries, transmission may increasingly occur via market prices rather than changes in quantities and the interest rate channel may become more important; (ii) the transmission of monetary policy may be more predictable, thanks largely to the improvement of macroeconomic fundamentals and the stabilisation of inflation expectations; (iii) but financial liberalisation may now make it more difficult to pursue dual objectives in terms of inflation and exchange rates. If EMEs are becoming more similar to industrialised countries, do their central banks face broadly similar challenges? In part, I think they do, in the ways I have just outlined. But they also face other, more specific challenges. Probably the most difficult challenge arises from the need to pursue monetary stability and financial stability in a context characterised by rapid structural change in the real economy and in the financial system. This rapid change is desirable, as it brings with it the modernisation of economic and financial infrastructures. However, it may also show up in very strong credit growth, asset price booms and large capital inflows. For the central bank, it is difficult to tell whether these phenomena are simply the result of a rapid catch-up with more developed economies and stronger fundamentals or, on the contrary, they still reflect underlying distortions, such as unsound lending practices, inadequate regulation and supervision or unrealistic expectations on the part of economic agents. In the latter case, they may be the seeds of future instability. For central banks in emerging economies, developing a sound approach to financial stability and adopting appropriate supervisory tools is at least as essential as a complement to good monetary policy as it is for advanced economies. | bank of italy | 2,007 | 11 |
Remarks by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the High-level Conference on "Looking East, Looking West: Key Challenges Facing the Atlantic Partners", Berlin, 15-16 November 2007. | Ignazio Visco: Panel discussion on "Follow the money – global financial markets” Remarks by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the High-level Conference on “Looking East, Looking West: Key Challenges Facing the Atlantic Partners”, organised by DGAP, American Council on Germany, The Council for United States and Italy, Berlin, 15-16 November 2007. * 1. * * Introduction Over the last decade a new global financial landscape has emerged as a result of substantial changes in market openness, demography and technology. Financial deepening has accompanied a marked increase in economic growth, with the emergence of new economic giants. This has been associated, however, with significant imbalances in current accounts and, as we have seen in the course of this year, a new bout of financial instability. I will briefly consider the main changes in the financial system. As these are not transitory, it is important to inquire into the strengths and weaknesses of what appears to be a new financial paradigm, and assess the main challenges for monetary authorities and financial regulators alike. 2. The new financial landscape: main driving forces 2.1. Economic and financial integration The first, key factor is market integration and financial globalization. This development has several dimensions: • On the trade side, imports and exports of goods and services have accelerated, growing much faster than world GDP. The emerging Asian economies now account for more than a fourth of world exports of manufactured goods, having doubled their share since 1990. The effective entry into the global labour market of significant parts of the populations of China and India is an important element in what we mean by globalisation. This process is still far from complete. • Foreign direct investment has expanded substantially, from less than 10 per cent of world GDP in 1995 to about 25 per cent today; the increase has been similar in advanced and emerging economies. The share of foreign affiliates in world GDP has doubled since the early 1980s, from 5 to 10 per cent. • Financial integration has been very intense in the industrialised countries, where the ratio of gross foreign assets and liabilities to GDP has risen from 140 per cent in 1995 to over 300 per cent today. It is expected to increase sharply in the emerging and developing countries as well, as capital controls are gradually removed. Greater international integration, in these three dimensions, has two main implications. The first is increased interdependence. Shocks are transmitted more rapidly across borders via trade, corporate outsourcing and financial markets. This implies that national policy decisions now have greater potential spillover effects. The second implication – partly a mirror image of the first – is greater risk diversification. Trade shifts part of the repercussions of domestic macroeconomic shocks to the rest of the world. Similarly, investors holding global asset portfolios should be less exposed to country-specific shocks. In spite of the significant increase in integration, however, there seems still to be ample scope for further gains from risk diversification, as domestic saving and investment are still very closely related. 2.2. Population ageing Another major change that is shaping the global economy and financial markets is the ageing of population. A secular rise in longevity has been flanked, more recently, by lower fertility rates, with the result that world population is now ageing very rapidly, not only in industrial countries, but in a number of emerging economies as well, most notably China. In particular: • The steep increase in the old-age dependency ratio observed in many countries has brought a retrenchment in public pensions and a switch to supplementary schemes. These structural changes in pension schemes in turn affect the financial choices of households and have far-reaching effects on financial markets at large. • In order to secure retirement income, households have significantly increased the portion of their financial assets managed by institutional investors, such as pension funds, mutual funds and insurance companies: in the three largest economies of the euro area, in the last decade this share increased on average by 10 percentage points to more than a third. • Due to these demographic and financial changes, households are exposed to considerable financial risk. This reflects the shift in composition of their portfolios in favour of riskier assets, held directly and via institutional investors, and the switch from “defined benefit” to “defined contribution” pension schemes. Together with financial risk, longevity risk has also increased: as people live longer than expected, governments find it difficult to fund public pension schemes and this raises the need for private savings to provide retirement income. 2.3. The new economy and financial innovation A third driving force that has reshaped financial markets over the last decade is the interaction between technical progress and financial innovation. The breakthroughs in information technology and telecommunications have powerfully affected all the building blocks of the financial system: payments infrastructure, intermediaries, markets and instruments. Foremost is the growth of asset securitization, which relies on complex financial instruments and on sophisticated risk management techniques, with several implications: • In the traditional intermediation model, banks raise funds in the form of short-term deposits and invest in longer-term loans that are held to maturity. With the extraordinary growth of securitization, banks have been moving to a new model of intermediation, in which they originate loans and then repackage them for sale to other investors. With this new “originate-to-distribute” (OTD) model, credit risk is not concentrated on banks’ books anymore, but is potentially dispersed among a multitude of investors. • The development of asset backed securities and the vast array of financial instruments built on them (indices, derivatives, etc.), has made bank loans tradable. This has decreased their cost, by reducing the illiquidity premium, and has contributed to the narrowing of spreads and the generally favourable credit conditions we have witnessed in the past few years. Overall, securitization has freed up banks’ capital, which has been used to back new loans. Now that it is possible to trade loans, pent-up demand for credit risk has found an outlet. Thanks to greater financial integration, pension funds, insurance companies, hedge funds and even money market funds have shown an appetite for these products, partly as a form of diversification and partly as the result of intensified search for yield in a world of low interest rates and low volatility. 3. Strengths and weaknesses of the new financial paradigm: a “robust yet fragile” financial system The OTD model has many benefits for banks, investors and the financial system at large: • In the traditional model banks hold credit risk, while other investors cannot get exposure to it. With the new model, banks can sell part of the risk in their loan portfolio and enhance the liquidity of their assets. • At the same time, investors can easily diversify by getting exposure to credit risks; hence, the OTD model is a further step towards complete financial markets. • Credit risk should, at least in principle, be dispersed among a large number of investors with different propensities for risk and different investment objectives and horizons. This variety should reduce the likelihood of large swings of asset prices caused by unidirectional trading strategies, making the financial system more stable. The decrease in financial volatility observed in recent years can be traced, among other things, to the new intermediation model. The bottom line is that the OTD model permits more efficient allocation of credit risk. But it also entails a number of dangers, some of them intrinsic to its mechanism, others more generally related to the greater interdependence of the financial system. 3.1. New sources of risk brought by the OTD model The weaknesses of the OTD model have become evident during the recent financial turmoil: • The pricing of structured finance products (SF) such as ABSs, CDOs and CLOs is complicated. These instruments, constructed by packaging loans, are complex, illiquid and often opaque. Because their valuation depends on data-intensive statistical models and on incomplete data for a host of possible scenarios, they may imply substantial “model risk”. • Rating agencies play a key role, serving as third party certifiers of the quality of SF products, but face technical and incentive problems. Unlike traditional bonds these products are not generally traded in secondary markets, so no public information on their value is available. Conflicts of interest may therefore be more relevant in SF markets than in bond markets: as it is very difficult to verify the quality of the service provided, the standard reputational equilibrium that sustains the agencies’ business model is weakened. • The incentives for banks to act as delegated monitors of their borrowers are weakened substantially, as the bank that originates the loan no longer holds its risk. Whereas in the traditional “buy-to-hold” model banks have an incentive to avoid the deterioration of quality of the loan, so as to prevent default, in the OTD model their interest in monitoring the borrower is greatly diminished. • Risk might be more concentrated than we know. Once SF products are sold, there is no telling where they end up. Risk might be widely spread, which would be beneficial to systemic stability, but it could also be concentrated among a few operators. Unregulated highly-leveraged institutions such as conduits, SIV and hedge funds may pile up substantial credit risk, maturity risk, and liquidity risk, and indeed they have done so. Ultimately, risk may return to banks, which remain the main source of credit. Lacking sufficient information, an adverse event might trigger losses in many dimensions. As has happened since this summer, this could lead to a liquidity squeeze in money markets: banks would not be willing to lend to one another even at short maturity. All in all, OTD is a sophisticated mechanism that, in order to allocate risk efficiently, relies on complex products, liquid markets and a multitude of operators. But products may be opaque, market liquidity may dry up, and some operators may have strong incentives and be accordingly ready to place big bets. So although it is market-based, at least for now the OTD model lacks the main feature of well-functioning financial markets: frequent and abundant trading, which at once requires and produces information and liquidity. As a result, while systemic events may have become less likely thanks to diversification and risk dispersion, their costs may have increased, with the overall increase in leverage and interdependence (more on this later). This suggests that “tail” risk might be larger than is commonly thought; or, in other words, that the probability of extreme events is underestimated. Shocks that would otherwise have been otherwise easy to manage may now become a threat to financial stability if they trigger a chain reaction, as could be the case of a shock to investors with large unbalanced positions or if many investors have similar models and strategies that lead them all to be on the same side of the market. 3.2. Greater interdependence The ongoing process of financial consolidation and the OTD model have produced intermediaries that are closely intertwined with the capital markets. The large, complex financial institutions resulting from consolidation offer a broad range of products – from asset management to corporate finance and prime brokerage services – that rely on wellfunctioning capital markets. Therefore, the OTD model has increased banks’ dependence on capital markets. Today’s global financial system is also far more interconnected than in the past. This has some important consequences for financial stability: • Since banks now sell their loans and offer a range of financial services, an illiquid market would generate substantial risks, such as warehouse risk (i.e. the risk of being unable to find buyers and being stuck with products the bank might not want in the first place) and additional market risks (when assets sold in thin markets would send prices spiralling down, forcing additional sales by leveraged investors and sharply reducing liquidity – something we have seen in recent weeks). To avoid this, at times banks may end up acting as a sort of “lender of last resort to markets”, with all the implicit effects on the availability of credit to other sectors of the economy and on financial stability. • Since the intermediation model increasingly relies on capital markets, market infrastructures are of paramount importance. The quality and reliability of both technical infrastructures – payment, clearing and settlement systems – and the organization of trading in public markets directly affect all players. • A more connected world improves risk diversification and makes markets more resilient. But when contagion is actually set off, an interlinked financial system heightens the risk that it may spread more widely. The very channels that in good times enhance resilience may also propagate, and possibly amplify, shocks. Interdependence thus requires more international coordination of policies for liquidity provision, regulation and supervision of markets and intermediaries. This would help to impede opportunities for regulatory arbitrage and the situations of moral hazard. 4. Challenges for authorities and regulators The recent financial turbulence has posed a number of stiff challenges to monetary authorities and financial regulators. So far, the response has followed a two-pronged strategy: central banks have provided liquidity in order to ensure an orderly functioning of money markets while a number of far-reaching initiatives have been launched in the international fora of cooperation to strengthen the financial system. 4.1. Short-term response to stabilise markets When financial and credit market turmoil produces systemic tensions in money markets, distinguishing between the aims of liquidity provision and the reasons that stand behind the setting of policy interest rates – easy under normal circumstances – becomes more difficult. On the one hand, the actions needed to ensure orderly functioning of the money market may blur monetary policy signals. On the other, decisions on interest rates could be interpreted as revealing major information unknown to the market and hinder its normal functioning. In particular: • Recent events have demonstrated that modern central banks, and the ECB in particular, are well-equipped to deal with these problems, at least as far as shortterm money market rates are concerned. Since August, the major central banks have provided ample liquidity to the interbank system, keeping short-term rates under control. While very short-term rate volatility has increased significantly since, in the euro area the differential between the overnight and the official rate has generally remained very low, in line with pre-crisis levels. • In the United States, the Fed has lowered its target rate twice, for a total of three quarters of a point. In the euro area, meanwhile, the policy rate has been kept unchanged. In neither case has day-to-day liquidity management impaired signalling of the monetary policy stance. • The situation is more problematic on longer money market maturities, where a substantial premium on official rates has emerged. Central bank interventions have been effective in avoiding market disruptions, but they could not address the lack of disclosure underlying these tensions, resolution of which requires additional information of the size and distribution of exposures, an assessment of the impact on banks’ balance sheets, and the completion of the process of risk repricing. All in all, by their prompt interventions the central banks were able to preserve orderly market conditions and avert a liquidity crisis, without endangering the markets’ medium-term expectations in a period of volatility and generalized uncertainty. 4.2. Strengthening the foundations of the financial system The ongoing financial turbulence has not come as a surprise. For some time the supervisory authorities had been emphasizing the increasing strains, stressing the rise in sub-prime mortgage defaults in the United States and warning that investors’ perception of risk might have changed suddenly, leading to abrupt portfolio adjustment and destabilizing effects. But the interaction between the difficulty to value SF products, the evaporation of liquidity and the “rush to exit” to reduce risk exposure could not have been foreseen, and nor could the speed at which the crisis spread across institutions and markets. To tackle the fragilities highlighted by the current turbulence, the financial community has put a number of initiatives in place in recent months. In particular: • At the request of the Group of Seven, the Financial Stability Forum (FSF) is reviewing several important issues such as the management of risks – especially liquidity risk – by the institutions subject to regulation, the appropriateness of capital requirements, the full consolidation of the assets and liabilities currently kept off banks’ balance sheets, and the transparency and valuation of structured financial products. • The EU Finance Ministers have asked the Economic and Financial Committee to examine a number of issues raised by the recent turbulence, analysing them in a way that is complementary to the mandate of the FSF by taking a European perspective and covering slightly different areas, including the implications of the new Capital Requirements Directive, which implements the Basel 2 framework in the European Union. In fact, it was not properly anticipated that commercial banks could be the weak link in the system: other financial institutions, hedge funds first of all, were thought to be more likely candidates to set off a crisis. To some extent, the tensions experienced in recent weeks reflect banks’ attempts to exploit regulatory arbitrage permitted by the Basel 1 framework, transferring outside their balance sheets, to unregulated entities, activities that would have required substantial capital otherwise. Searching for the direction to follow in addressing the issues that have emerged, we can advance the following considerations: • The Basel 2 framework will certainly mitigate the problem, as the risks associated with the innovative, complex activities undertaken by banks in recent years will be easier to capture. With respect to capital requirements, for example, Basel 2 improves on the treatment of mortgage exposures and introduces a capital charge on liquidity lines extended to conduits funded through asset-backed commercial paper. Additional capital will be required to match operational risks in order, for example, to cover legal losses. To enhance market discipline banks will be induced to disclose information about their risk management policies and systems. This will include the risks associated with securitization exposures. As a development of the new regulatory approach, before the turmoil the Basel Committee had begun a review of the existing supervisory approaches to liquidity risk. • While the Basel 2 framework will represent a considerable improvement on the previous discipline of capital requirements, steps need to be taken in other areas to avoid excessive risks and make banks more resilient to shocks. To improve transparency on risk exposures, particular attention must be paid to the obligation to consolidate the accounts of financial vehicles, even if not affiliated, whenever banks exercise substantial control and bear the ultimate risk. To take account of the effective risk for prudential purposes, vehicles that are largely controlled by banks should also be consolidated when capital requirements are established. In order to contain model risk, additional efforts must be directed at refining the methods used to value SF products. Banks’ liquidity management must also be improved, with reference to liabilities no less than assets, to increase our understanding of the relation between market liquidity and banks’ funding liquidity risk. Also, public authorities and market participants should thoroughly review existing incentives in the financial industry at large, to find ways to prevent the accumulation of excessive risks. An additional area of policy intervention that is becoming as important as the regulation and supervision of markets and intermediaries is financial literacy. As individuals become increasingly responsible for their retirement income and the allocation of wealth, so their financial needs are becoming increasingly complex. The financial industry is responding with a wide range of instruments, many of them complex as well. A few remarks on this point are appropriate: • Survey evidence suggests that the majority of consumers lacks financial capability in key areas, even in countries where there is a strong tradition of stock market participation as in the United States or the United Kingdom. For poorer and less educated households the lack of knowledge is greater and has more serious potential consequences. • By improving financial education, policy-makers can affect economic behaviour. Evidence shows a positive correlation between financial literacy and retirement planning abilities, the likelihood of buying risky assets and investing efficiently. • Financial education is helpful but its impact should not be overestimated. Regulations to protect consumers – such as by reducing conflicts of interest for financial advisers, introducing rules of disclosure, and making provision for investment default options – are complementary to financial education. For example, policies to increase the transparency of financial products can improve households’ welfare both on the asset and liability side. Regulation should be designed keeping in mind the trade-off between consumer protection and the inhibition of innovation. 5. Conclusions The increasing complexity and interdependence of the world financial system is channelling resources to the most productive investments, thus supporting efficiency and growth globally. However, the financial system may also become, at times, a source of instability. Policymakers are already adjusting regulation and supervision practices to deal with a rapidly evolving financial system; cooperation to secure a level playing field and to reduce the scope for competition in laxity is required. Coordination when intervening on interlinked markets is necessary. Institutional and retail investors should be made aware of the new set of risks they are facing, in order to make informed decisions. Crises can not always be prevented; as recent events have shown, once they occur swift action can stem the damage and work towards restoring confidence. Again, cooperation and coordination are the only way to deal with systemic events that have the potential to wreck the global financial system. Indeed, while we recognize that an efficient financial market is a fundamental driver of economic growth, we are also aware that financial instability must be limited if it is not to hamper economic activity. | bank of italy | 2,007 | 11 |
Remarks by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the policy panel of the CEDERS - 3rd Meeting on Open Macroeconomics and Development "The Euro Area, the Euro and the World Business Cycle", Aix-en-Provence, 3-4 July 2008. | Ignazio Visco: Divergence in monetary policies across the Atlantic? Remarks by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the policy panel of the CEDERS – 3rd Meeting on Open Macroeconomics and Development “The Euro Area, the Euro and the World Business Cycle”, Aix-en-Provence, 3-4 July 2008. I am grateful to Sergio Nicoletti Altimari for comments and suggestions while remaining solely responsible for the views here expressed. * * * In my remarks, I will first start with the basic question raised to the panel: are there differences in the Fed's and ECB's behaviour? I will then tackle two issues that have probably become more pressing in light of the current financial turmoil: i) are there obvious limitations in the monetary frameworks and how should they be addressed?, and ii) do we need some form of monetary policy coordination? 1. FED – ECB divergences A popular belief is that the dual mandate of the Fed, as opposed to the overriding price stability objective of the ECB, is the major source of policy differences across the Atlantic. In this respect, if we take a medium- to long-term view, and we agree that over those horizons money cannot affect potential output (the Phillips curve is vertical), then the different mandate should not be relevant. Indeed: • The track record of the Fed in the past 20 years, as well as the positions expressed repeatedly by its executives, speak by themselves of the centrality the Fed attributes to the price stability objective (see Figure). • An important difference is of course that, contrary to the ECB, the Fed has not announced a quantitative definition of its goal: this may give the ECB some (slight) advantage in anchoring expectations, as some recent studies appear to suggest, 1 and thus perhaps a more favourable shorter-run trade off. It is at the shorter horizons, in the strategic conduct of monetary policy by the two central banks, that we may more likely find some differences: • A starting point in this respect is the observation that since the start of the euro in 1999 the volatility of policy interest rates in the US has been two times larger than in the euro area (see Figure). 2 • Understanding why this is the case is not easy, as the difference may reflect differences in the conduct of policy, in the structures of the economy, in the size and nature of economic shocks. Indeed, the few analyses that have tried to address the M.J. Beechey, B.K Johannsen and A. Levin (2007), “Are long-run inflation expectations anchored more firmly in the Euro Area than in the United States?”, CEPR Discussion Papers No. 6536. The standard deviation of the (target) Fed fund rate since 1999 is 1,83 percentage points, compared with 0,89 percentage points of the policy rate of the ECB. The average policy rate has been 3,6 for the Fed and 3,1 for the ECB. issue in a systematic way give some hints that all of these factors may have played a role. 3 In particular: o Shocks: Differences in the type and intensity of shocks (especially productivity shocks) have probably played a major role in the last decade. o Structure: Higher wage and price flexibility may explain part of the higher volatility of policy rates in the United States. o Policy: The ECB may have, at least according to some estimates, a higher degree of policy inertia, which may grant it with more leverage on long-term interest rates. There is however no crystal clear evidence of a significantly different response to measures of economic slackness, which may indicate that the different mandates do not impinge too much even in the shorter term. Besides this, we have to be very careful in judgement as we are far from being in a position to state how close to optimal is any of the two policies, given structure and preferences in the two economies. The recent financial turmoil and the different policy responses across the Atlantic have once again spurred a debate (particularly in Europe) on whether the different mandate is the source of divergence (and political calls on the ECB to adopt a Fed-like response). Again it is likely that a combination of factors are at play: • If we compare, for example, the change in the forecasts of the two central banks in the last year, we see that the Fed has changed its forecasts of growth for 2008 by much more than the ECB (-2% vs. -0,5%), while the reverse is true for inflation (+0,4% vs. +0,9%). These changes in the respective outlook go some way towards explaining a different policy response: after all, and notwithstanding the strict financial linkages, we should not forget that the sub-prime crisis originated in the US and it is linked to real economic problems in that country. • The difference in the policy stance may also have accentuated the perception of differences in the liquidity provision policies followed by the two central banks. While some differences were certainly present (in terms of counterparties, instruments and facilities used for open market operations), overall the two banks did not inject more reserves than needed to maintain reference rates near policy rates and net injections were quickly reversed. However, while the ECB had to clearly (and successfully) distinguish liquidity provision from the monetary policy stance, in the Fed case active liquidity provision and more expansionary monetary policy went hand in hand. 2. Financial turmoil and monetary frameworks According to some observers, financial crises are manifesting themselves with increased frequency also because of the success achieved by macro-stabilization policies and the better anchoring of inflation expectations in good and services markets. An aspect of this is that episodes of excess creation of liquidity and credit may fuel asset price bubbles, rather than increase consumption prices. In this respect: See L. Christiano, R. Motto and M. Rostagno (2007), “Shocks, structures or monetary policies? The euro area and US after 2001”, ECB Working Papers No. 774, and J.G. Sahuc and F. Smets (2008), “Differences in interest rate policy at the ECB and the Fed: an investigation with a medium-scale DSGE model”, Journal of Money, Credit and Banking, vol. 40, March-April. • It has been observed that in both the high-tech equity bubble of the late 1990s and in the more recent escalation of real estate prices a “too easy for too long” monetary policy stance may have had some responsibility. • There are also claims that portfolio relocations and abundant liquidity may be causing episodes of bubbles in commodity prices for which future markets exist, with consequences for the prices of other commodities and final consumer prices. By committing itself to closely monitor and to respond, if needed, to developments in monetary and credit aggregates, the ECB has probably made a step towards addressing this issue. Indeed: • Excessive growth in monetary aggregates, credit and leverage may provide useful early signals of the building up of financial imbalances and their potential longer term implications for financial stability, macroeconomic volatility and price stability. 4 • The ECB has also manifested a different attitude towards asset price bubbles, whereas it has not ruled out the possibility of “leaning against the wind” in the face of excessive asset price developments. 5 • We should however acknowledge the enormous difficulties of defining what “excessive” means in this area and of designing a policy that aims at mitigating the risks of imbalances and crises in the financial sector while keeping it consistent with the preservation of price stability. We should probably also avoid asking too much to monetary policy; certainly frameworks and rules in capital markets need to be revised and other policies (regulatory, supervision …) to be involved. In this respect, is the adoption of a fully fledged “flexible inflation targeting” – a framework from which both the Fed and the ECB have differentiated themselves (perhaps for different reasons) – the right way to go? Nowadays flexible inflation targeting is understood as a framework in which the central bank announces (and specifies in quantitative terms) its price stability goal and designs an optimal policy to reach it. But then, one may ask whether this may be too general a framework to provide an actual guidance to monetary policy. 6 Furthermore: • Is there a role for asset prices in flexible inflation targeting (independently of their direct effects on inflation)? • In particular, may asset prices play a role in the anchoring of price expectations that is nowadays recognized by policymakers as a paramount condition for achieving price stability? Anyway, the real issue to me does not lie much in the policy framework, but rather in the limitations of the models we use to interpret economic data and to decide our policy. This is particularly true for how we treat asset prices. Let me just mention two points in this respect. • First, we probably do not know enough about the effects of asset price misalignments and related imbalances in equity, real estate and currency markets, as well as in bank credit and government debt. My reading of the empirical literature is that normally these effects are found to be relatively small and asset price See also, on this issue, the influential BIS view as exemplified for instance in C. Borio and P. Lowe (2002), “Asset prices, financial and monetary stability: exploring the nexus”, BIS Working Papers No. 114. See for example O. Issing (2004), “Financial integration, asset prices and monetary policy”, speech at the Symposium concluding two years of the ECB-CFS research network on “Capital Markets and Financial Integration in Europe”. On this see also my discussion of C. Bean (2003), “Asset prices, financial imbalances and monetary policy: are inflation targets enough?”, BIS Working Papers No. 140. movements are found to play a relatively little role in the transmission of monetary policy. But this conclusion may be seriously biased, as these are often likely to be rare and extreme events. Even if they materialised in strong manner, in macroeconomic estimates they are likely to be dominated over the sample by “normal time” observations and frequently end up to be “dummied out”. • Second, many of the effects associated with asset prices imbalances are likely to be highly non-linear and complex. The implicit monetary policy reaction function would also then be non-linear and complex and likely to depend on asset prices and financial imbalances. 7 Let me just mention some of the weaknesses we need to address in the near future: • Our models do not treat asset prices in any depth; we are unable to appropriately model movements in the risk premia over the cycle. • We are not able to satisfactorily model interactions and feedbacks between the real and the financial sectors; this is particularly true for the non-linearities that emerge during crises. • We lack a deep understanding of the potential link between monetary policy and asset price bubbles; this may, inter alia, require a departure from the rational expectation hypothesis (as recently suggested for example by Sims 8). 3. Coordination of monetary policies The financial turmoil has brought back at the centre of the international debate the issue of monetary policy coordination. In this debate, many feelings and perceptions mix together. At the bottom, there is the argument that the spectacular increase in financial integration implies a progressive decline in the effectiveness of domestic monetary policy. This combines with the perception that central banks may have lost their leverage on longer-term interest rates (see the discussion on the “saving glut”), as is evident from a lower impact of short-term interest rates on the yield curve, a higher correlation of interest rates across countries and a flattening of the Phillips curve caused by globalisation. In this new global environment, it is argued by some, domestic monetary policies can do little in isolation; the only possibility is to join forces. I will structure my remarks on this issue along a few questions. First, does globalisation (increased trade and financial integration) necessarily reduce the effectiveness of monetary policy? • Here, I think worries are probably exaggerated. From a theoretical point of view, we have no reasons to think that because of financial and commercial integration domestic monetary policies should lose control of their statutory goal. 9 As long as domestic currencies continue to be used as means of payments for the internal transactions the ability of monetary policy to control inflation is not affected and domestic inflation remains a domestic monetary phenomenon. 10 See, among others, the example provided in Bordo and Jeanne (2002), “Boom-busts in asset prices, economic instability and monetary policy”, NBER Working Papers No. 8966. C. A. Sims (2008), “Inflation expectations, uncertainty and monetary policy”, manuscript, mimeo. See Woodford (2008), “Globalization and monetary control”, NBER Working Papers No. 13329. Of course, to the extent that globalisation also increases the flexibility of prices and wages, it may hamper monetary policy ability to influence short-run output movements. But, in this case, this ability would not be needed any longer. • A question may however remain whether domestic policies may have become more costly, in terms of their short-run effects on economic activity, due to the increased importance of external spillovers. • Some of the evidence I just referred to (diminished impact of policy rates on longer term rates, flattening of the Phillips curve) may be explained by a higher degree of credibility of central banks, rather than globalization, and indeed we have some evidence that this may be the case. 11 This would reflect an increased, rather than reduced, effectiveness of monetary policy. Second, even if we do not necessarily need to join forces to control domestic inflation, may coordination nevertheless be useful? • Here the answer from theory becomes more blurred. The recent literature based on dynamic general equilibrium models with sticky prices has highlighted the importance of relative prices. Whether there is room for welfare improving monetary policy coordination depends very much on exchange rate pass-through behaviour. Overall, I take from this literature that targeting domestic inflation produces outcomes close to optimal in most cases. 12 • If we add to this the real life complications of getting into (and respecting under changing conditions) formal agreements and the uncertainties surrounding the effects of monetary policy moves (for example on exchange rates), then the case for coordination becomes even more doubtful. Indeed, the experiences of the past (e.g. the Louvre – Plaza agreements) are not particularly encouraging. • In any event, what cannot be compromised is the statutory mandate of our central banks to deliver the assigned objectives. Any formal agreement casting doubts on this principle and causing inflation expectations to slip away would be extremely costing. Considering all this, the road of coordination, understood as entering into formal and binding contingency plan agreements, appears quite narrow. Finally, do we need more cooperation? • The answer in this case is probably positive. Even if we do not necessarily need to coordinate ex ante to attain the final goal, it is quite evident that the increasing interdependencies among the economies complicate the conduct of monetary policies a great deal. In the new environment the case for reinforcing international cooperation is strong. And I do not exclude that particularly for small open economies this may mean a strong incentive to join or to create monetary unions (an extreme form of cooperation). • We are seeing that forms of cooperation are becoming more and more crucial in many fields, such as in liquidity provision policies, in financial institution regulation and supervision, in order to tackle possible systemic crises, avoid regulatory arbitrage, ensure a level-playing field. • In the monetary policy field, there certainly is a high degree of interaction among central bankers, for example through their frequent participation to BIS meetings in Basel. It is indeed essential to ensure a continuous exchange of views, full understanding of each other’s goals, policy intentions and possible spillovers of See, for example, E. Gaiotti (2008), ”Has globalisation changed the Phillips curve? Firm-level evidence on the effect of activity on prices”, Banca d’Italia, Temi di discussione, No. 676. See, for example, M. Obstfeld and K. Rogoff (2002), “Global implications of self-oriented national monetary rules”, Quarterly Journal of Economics, May, and G. Corsetti and P. Pesenti (2005), “International dimensions of optimal monetary policy”, Journal of Monetary Economics, vol. 52 n. 2. different policy options. In some cases this may lead to a common understanding that a particular direction of policy is in the interest of all parties involved. I believe that the situation we are facing nowadays illustrates this case rather well. • We are observing an emergence of strong inflationary pressures around the globe. Monetary policy at the world level appears to be quite expansionary. Short-term real interest rates are negative in the US and are very low or negative in many regions, particularly in emerging economies (for the total of emerging economies’ real shortterm interest rates are close to zero, they are positive for those that have an inflation targeting framework, and significantly negative for the others.) • In many emerging economies, particularly in China, the pegging to the dollar implies importing US monetary policy even if internal conditions, especially domestic demand, are very different. On the one hand, this policy is fuelling liquidity and credit expansion, pushing domestic demand and pushing inflation rates in these economies towards double-digit values. On the other hand, through the increasing pressure on commodity prices (oil and food) it puts pressure to inflation rates also in main industrialised economies. • In advanced economies monetary policy is directed to avoid second-round effects from commodity price increases, but it is unlikely to be able to address the sources of first-round effects (excess demand in large emerging economies), unless it creates so much slack in the advanced economies as to dampen exports and internal demand in emerging economies as well. The need to come to a common understanding of the international situation appears therefore to be particularly pressing at the moment. Getting out of problems may be quite costly if done in sparse order. US PCE Inflation 4.0 Euro Area HICP inflation 3.0 2.0 1.0 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 7.0 ECB Minimum Bid Rate Federal Funds Target Rate 6.0 5.0 4.0 3.0 2.0 1.0 0.0 | bank of italy | 2,008 | 7 |
Text of the Central Bank Whitaker Lecture by Mr Mario Draghi, Governor of the Bank of Italy, Dublin, 18 July 2008. | Mario Draghi: Monetary policy, expectations and financial markets Text of the Central Bank Whitaker Lecture by Mr Mario Draghi, Governor of the Bank of Italy, Dublin, 18 July 2008. * * * How central banks can motivate their decisions and communicate them clearly, completely and effectively is a significant aspect of monetary policy-making. This is not a new issue, but recent developments have raised pressing new policy questions. Communicating monetary policy has become an even more challenging task in the current context of rising inflationary pressures, uncertain economic outlook and fragile financial markets. The expansionary monetary policies adopted in the past, together with severe structural tensions in the oil market, may have played a part in the present difficulties. My aim today is, first, to review the evolution of central bank communication in a longer-term perspective and examine the benefits of transparency, in particular for the euro area. I will then address the implications of the two crucial aspects of monetary policy that we must tackle at the current juncture, namely the interaction between monetary policy, inflation expectations and the surge in oil prices, and the communication and transparency challenges posed by the financial market turmoil. 1. The road to better central bank communication: a historical perspective Until the late 1980s, the conventional wisdom was that to be effective, policy decisions should not be anticipated. An opaque and convoluted language was considered appropriate. Today, that view has been superseded, and openness and clarity in central banks’ communication are now considered mandatory. The change has been radical. Perhaps the key event was the move towards a clear definition of policy goals, which began in the 1970s when a number of central banks adopted explicit monetary targets. Awareness of the importance of policy commitment and good communication in curbing inflationary pressures was an essential ingredient of this strategy. As Paolo Baffi argued when he was Governor of the Bank of Italy, with the advent of monetary targets “the actions of central banks are no longer cloaked in silence, and perhaps never will be again. Whereas in the past silence was seen as a guarantee of independence, today this is achieved by giving an explicit account of one’s actions”. 1 This trend continued with the widespread adoption of quantitative targets for price stability, including, in a number of countries, a specified inflation target. A study by the Bank of England found that in the late 1990s 83 central banks out of 94 surveyed had a definite target, either for the exchange rate, for money supply, or for inflation. 2 Monetary authorities produce and release a vast amount of information: most central banks publish macroeconomic projections and specify the models on which they are based. For example, the ECB publishes the projections prepared by the Eurosystem and ECB staff four times a year. The Federal Reserve has been publishing its FOMC macroeconomic forecasts Banca d’Italia, Annual Report for 1978, 1979, p.158. Fry, M., D. Julius, L. Mahadeva, S. Roger and G. Sterne, “Key issues in the choice of monetary policy framework”, in L. Mahadeva and G. Sterne (eds.), Monetary Policy Frameworks in a Global Context, Routledge, London, 2000, pp. 1-216. for three decades now; it has recently extended the horizon and increased the frequency of the forecasts. Information has also become more timely. Central banks now inform the public as soon as a decision is taken, in press conferences or by releasing the minutes of meetings. The ECB publishes the motivations of the Governing Council’s decisions the day of its policy meeting, and a press conference by the President adds further clarifications. Only a few years ago things were very different. For example, until 1994 the Federal Reserve did not disclose its interest-rate decisions, which investors had to infer from open-market operations. In their statements, most central banks provide commentaries about future policy, although practices differ. Some of them offer only qualitative guidance. From 2000 to 2003 the Fed gave indications of the “balance of risks”; the ECB, when appropriate, gives signals through its communication channels. Other central banks have gone further in this direction, accompanying their macroeconomic projections with an explicit forecast of the future path of policy rates. Not only does transparency on objectives, strategies, analyses and decisions ensure the democratic legitimacy of independent monetary authorities, it improves central banks’ ability to attain their final goals, by shaping price-setters’ expectations and attenuating the cost, in terms of lost output, of keeping inflation in check. It also enhances the effectiveness of monetary policy. Central banks directly control very-short-term interest rates, but most decisions within the economy are affected by longer-term rates, which in turn depend on expectations about monetary policy. As Michael Woodford has observed, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. 3 In the euro area, the need for clear communication is heightened by the multilingual and multicultural environment. Consistent interpretation of the ECB’s decisions by the various national audiences requires the establishment of common terms of reference and their adaptation to the specific national contexts. The national central banks play a key role. However, we should not conclude from this that we now have a common paradigm covering every aspect of central bank communication. In fact, no consensus has yet emerged among academics or central bankers on the ideal communication strategy. On the practice of publishing the projected path for interest rates, for instance, some studies cite the risk that the private sector could give too much weight to central bank information and accordingly under-invest in independent analysis of its own. 4 Research at the Bank of Italy shows that when central banks release their projected path for interest rates, market participants understand well the information it contains. However, central banks seem to communicate effectively even when they disseminate qualitative information only. 5 The existence of different views should not come as a surprise, as the “best practice” is likely to depend in part on the institutional, cultural and economic environment, so that central banks are required to adopt different communication strategies. For example, so far only relatively small countries seem to follow the practice of communicating projected policy rates, possibly because their close dependence on external conditions may make it easier to convey the conditional nature of their projections. As Lucas Papademos pointed out recently, M. Woodford, Interest and Prices, Princeton University Press, 2003. See J.D. Morris and H. S. Shin, “Social Value of Public Information”, 2002, The American Economic Review, and, on the empirical relevance of the argument, L.E. Svensson, “Social Value of Public Information is actually pro transparency”, 2005, NBER working paper 11537. G. Ferrero and A. Secchi, “The Announcement of Future Policy Intentions”, 2008, Bank of Italy, Working Paper Series, forthcoming. there is no single recipe for every detail, 6 although good communication is now an essential component of any central bank’s toolkit. 7 2. Central bank communication, inflation expectations and commodity prices The sweeping changes I have just described, and their lasting effect on the dynamics of inflation, must be taken into account in assessing policy at the current juncture, when, driven primarily by oil and food prices, inflation in the euro area is about 4 per cent, a level unseen since the early 1990s. In the past two decades, innovation in monetary policy design and communication has helped to reduce the level and volatility of inflation, while the low level of real interest rates has stimulated employment and growth. Inflation expectations are better anchored today than in decades past, as both survey data and financial market indicators show. Moreover, long-run expectations appear more firmly anchored in countries where the monetary policy target is specified more clearly. For example in the euro area – where price stability is clearly and quantitatively defined – there is evidence that macro-economic news reports affect shortterm inflation expectations, whereas elsewhere they also affect long-term expectations. 8 Some questions concerning the link between monetary policy, inflation expectations and actual inflation remain open. 9 It would be good to have more information on how aggregate inflation expectations affect pricing behaviour at the micro level. Also, while we have many gauges of the inflation expectations of households, professional economists and financial markets, there is still little information on the expectations of the price-setters themselves (such as businesses). In any case, the short-run trade-off between inflation and the stabilization of real economic activity seems to have improved significantly. Communication has certainly been a key factor. However, a successful communication strategy requires a central bank to be credible. And this, in turn, means matching words with deeds. Our success to date in controlling inflation expectations depends crucially on the lessons we learnt from the oil price shocks of the 1970s. Central banks must now avoid the mistakes that were made then in a number of countries. Indeed, the experience with oil shocks over the last few decades provides a striking demonstration of the benefits of credible monetary policy, even in the current juncture. There is by now ample international evidence that the adverse effects of oil price shocks on the economy are significantly less severe than they were 30 years ago. 10 This result undoubtedly reflects structural changes in the economy, such as greater energy efficiency in production and consumption and more flexible labour markets. The empirical evidence also suggests, however, that the enhanced credibility and the greater transparency of monetary policy have been key in cushioning the inflationary impact of oil shocks. L. Papademos, “Monetary policy communication and effectiveness”, speech at the Annual Meeting of the Allied Social Science Associations, New Orleans, 5 January 2008. A. S. Blinder, “Talking about Monetary Policy: The Virtues (and Vices) of Central Bank Communication”, presented at the 7th BIS Annual Conference, Lucerne, 26-27 June 2008. M.J. Beechey, B.K. Johannsen and A. Levin, “Are Long-run Inflation Expectations Anchored More Firmly in the Euro Area than in the United States?”, CEPR Discussion Paper No. 6536, 2007. See for example B. S. Bernanke (2008), “Outstanding Issues in the Analysis of Inflation”, speech at the Federal Reserve Bank of Boston’s 53rd Annual Economic Conference, Chatham, Massachusetts. See, for example, O. Blanchard and J. Galì, “The Macroeconomic Effects of Oil Prices: Why Are the 2000s so Different from the 1970s?”, NBER Working PaperNo. 13368. Our research shows that even in the past the impact was smaller in countries where the central bank had a clear commitment to price stability and enjoyed high credibility. For example, estimates indicate that in the 1970s and 1980s it was about six times smaller in Germany than in Italy. And in Italy the transmission of oil price shocks to inflation has decreased further since 1999, thanks to the credibility of the Eurosystem monetary strategy. According to recent results, moreover, the diminished impact of oil price shocks on inflation and output is due in part to investors’ better awareness of monetary policy-makers’ antiinflationary orientation or, to put it differently, the credibility of central banks. 11 These considerations underpin the recent decision of the Governing Council of the ECB. Our forecasts indicated that the increase in inflation would be temporary, but it now looks more persistent than we expected a few months ago. Whereas in past months spill-over effects had been modest and underlying inflation had remained subdued, lately the risks have increased. There are signs of an acceleration in internal costs of production, and measures of medium- to longer-term inflation expectations also now indicate tensions. It was to address the increased risk of second-round effects on wage and price setting and to reaffirm a commitment to restoring price stability that the Governing Council decided on 3 July to raise rates to 4.25 per cent. Credibility cannot be taken for granted, a sort of onceand-for-all acquisition. A timely move, instrumental in keeping inflation expectations under control, is certainly preferable to the late, violent corrections many countries experienced decades ago. Indeed, in the days following the rate hike, inflation expectations as derived from the financial markets stopped rising. Policy-makers worldwide need to take good note of these lessons from the past. Expansionary global monetary policies may have accentuated the structural tensions within the oil market. A number of emerging countries are currently experiencing rapid and increasing inflation. In part this reflects the heavy incidence of food in their consumer-price indices, but in many cases it also derives from loose monetary conditions due to such factors as fast growth of money and credit aggregates and the choice of the exchange rate regime. These developments are impacting on inflation at the global level and call for appropriate policy measures. The credibility of monetary policy needs to be preserved in the advanced countries and pursued in the emerging countries, by heightening awareness of the seriously worsening risk of inflation. 3. Lessons from the financial market turmoil The link between monetary policy, communication and the financial markets has also gained importance. Now that financial markets are becoming increasingly efficient and complete, the transmission of monetary policy impulses to the economy is swifter than it was before and has come to depend more heavily on the way the financial markets perceive central bank decisions. Actual and expected changes in official rates are now rapidly transmitted to a wider range of financial assets and on to consumption and investment. The management of expectations is essential, as the release of information that diverges from market views may increase volatility and, in extreme cases, lead to an unwinding of large positions, with potentially disorderly effects on liquidity and asset prices. Against this background, the financial turmoil has raised new issues for monetary policymakers. It is now more difficult to forecast economic developments and to assess the effects of policy decisions and communication on markets, on expectations and, ultimately, on the real economy. See O. Blanchard and J. Galì, cit. The consequences of the recent events for prudential regulation and financial supervision have been examined in the Financial Stability Forum report “Enhancing Market and Institutional Resilience”. I will not dwell on these issues today, but instead focus on the lessons most directly relevant to monetary policy design and communication. A first lesson concerns the role of the monetary authorities in signalling the risks to financial stability. Independent central banks, with their sound reputation, their strong technical skills, and their medium- to long-term perspective, are in the ideal position to assess systemic risks emerging from financial markets and communicate them credibly to the public. Nevertheless, the markets have apparently failed to heed our warnings sufficiently, in this crisis as in past episodes. To many of us, last year’s crisis did not come as a surprise. In June 2007, in a speech at the Central Bank of Argentina, I myself expressed concern that the risk of a broader shock, resulting from a widespread decline in the appetite for risk, had increased. I warned that if the initial price movements were to trigger counterparty concerns, this might easily generate deeper and more broad-based liquidity erosions, posing systemic risks. 12 Other central banks and international institutions had issued analogous warnings, some of them even earlier. 13 Why do markets trust central banks on monetary policy, while they seem to ignore the signals provided repeatedly by monetary authorities on financial stability? One possibility, of course, strictly related to human psychology, is that after a protracted period of favourable macroeconomic conditions investors may become over-optimistic and underestimate risks. But it is equally possible that, as in monetary policy-making, here too effective communication requires words to be followed by deeds. This objective may necessitate wideranging changes in regulations, supervisory practices and central bank responsibilities. The turmoil has shown that international coordination is essential to make private institutions more transparent and avoid the potentially destabilizing effects of the perverse incentives that prevail in some segments of the financial system. As for central banks, it has been maintained that if they are to be as credible when they comment on financial risks as they are in monetary policy, they need to be more closely involved in the task of ensuring financial stability; in some cases this may mean reinforcing their statutory responsibilities. 14 We should also assess carefully whether the instruments currently available to central banks to preserve financial stability – for example by attenuating the pro-cyclical nature of financial markets – are adequate to this formidable task; and whether it might be possible to overcome economic and political resistance to the idea of enlarging the central banks’ role in defending financial stability. But preserving financial stability may also have implications for the conduct of monetary policy. Indeed, the link between monetary policy and financial stability poses a challenge to central bankers. We must seriously reconsider what was until recently a widely held view, namely that monetary policy should play a passive role as financial imbalances are building up and should only intervene after the crash, injecting liquidity to avoid a macroeconomic meltdown (known as mopping up after the event). We should assess whether and how far our policy instruments should also be used to “lean against the wind” to contain financial disequilibria and avoid perverse incentives and an asymmetric expansionary bias in investors’ perception of monetary policy. M. Draghi, “Monetary policy and new financial instruments”, Buenos Aires, 4 June 2007. See, for example, the press release of the Financial Stability Forum’s seventeenth meeting in Frankfurt, 29 March 2007. See, for example, the Report of the Paulson Committee on Capital Market Regulation. Of course, it is extremely difficult to define the meaning of “disequilibria” in this area and to design a policy that will mitigate the risks of financial imbalances and crises while ensuring the preservation of price stability. While we should probably avoid asking too much of monetary policy, we cannot ignore that excessively low interest rates and over-expansion of liquidity and credit can affect the financial industry by encouraging investors’ risk-taking behaviour. This implies that monetary and credit developments should be central in the communication of our strategy. 15 The turmoil has confirmed that the ECB’s strategic emphasis on money and credit developments is appropriate. The second lesson we have drawn from the crisis is that to reap the full benefits of central bank transparency, the financial sector at large – financial institutions, financial instruments, and market behaviour – must also be transparent. First of all, a clear understanding of financial conditions is essential for policy decisions, since variables such as the leverage of the private sector, the distribution of debt and the riskiness of banks affect the transmission of monetary policy. Moreover, when financial instruments are highly complex, the balance sheets of financial institutions may be so opaque that outsiders – central banks, supervisors and even shareholders – may fail to perceive the true degree of risk in the system and so react tardily to financial imbalances. It is even possible that a better predictability of central banks’ actions – concerning the future path of policy rates or their reactions in a crisis – coupled with the perverse incentives for risk prevailing in some segments of the financial system, might encourage risk-taking by private investors. In order to arrive at first-best solutions and improve the system’s stability, progress in central bank transparency must be accompanied by regulatory and supervisory action to make the financial services industry less opaque. Indeed, there is an urgent need for greater transparency in this sector, not only to improve the world financial system’s resilience, but also to ensure that the stance of monetary policy is consistent with both price and financial stability. The FSF Report encourages financial institutions to enhance their transparency already in their 2008 mid-year reports and to improve reporting standards for off-balance-sheet vehicles. The credit rating agencies also play a crucial role in this context, and the Report has indicated several measures to improve their performance. The third lesson we have learnt from the turmoil is that when tensions arise and markets become illiquid, central banks may have to take care in explaining how they intend to act to maintain price stability while preserving orderly conditions on financial markets. This problem is likely to arise in particular on the money market, whose functioning is crucial to the liquidity of securities markets in general. In times of great uncertainty, monetary policy has to be perceived as a stabilizing force, providing a solid anchor to inflation expectations. When there are money-market strains, distinguishing between liquidity provision and the reasons underpinning the setting of policy rates, easy enough in normal circumstances, becomes difficult, but remains nonetheless essential. On the one hand, the actions needed to restore market liquidity may blur monetary policy signals; on the other, decisions on interest rates could be interpreted as revealing information unknown to the market, thus exacerbating tensions. In these circumstances, it is important to make sure that more active liquidity management by the central bank, which is necessary to ease tensions in the money market, is not perceived as a signal of a looser commitment to price stability. See the considerations in O. Issing, “In search of monetary stability: the evolution of monetary policy”, presented at the 7th BIS annual conference, June 2008. During the recent turmoil, the policy actions and the communication of the Eurosystem have carefully distinguished the operations needed to support the money market from genuine monetary policy decisions. Since August 2007, the Eurosystem has repeatedly injected funds into the money market through both MROs and longer-term operations, in order to serve banks’ demand for liquidity. These operations have been accompanied by prompt communication – via press releases or other channels – to reassure the markets that the ECB stood ready to do what was needed to guarantee the orderly functioning of the interbank market and to reduce the volatility of very-short-term rates. At the same time, the Council has emphasized its determination to ensure that risks to price stability over the medium term do not materialize and to keep inflation expectations consistent with price stability. These events have demonstrated that central banks, and the ECB in particular, are wellequipped to handle these problems. Central bank interventions have been effective in avoiding market disruptions, although on longer money-market maturities a substantial premium over official rates has emerged. The turmoil has also shown that in times of stress central banks must be prepared to enhance communication with the markets and to adapt their operational framework to market conditions, taking innovative steps when needed. The recent events have also raised a number of new questions concerning the design of these operations and their communication to the market. First of all, central banks must consider carefully how far they should go in devising new instruments to provide liquidity. In particular, at what conditions should non-deposit-taking institutions be eligible for refinancing operations? Another problem is whether, and to what extent, the tools that are appropriate in emergencies should be announced in advance to the market or even used in normal situations. In order to address this issue, we need to analyse the trade-off between greater disclosure – which would acquaint the central bank’s counterparties with the non-standard procedures, thus facilitating their use in case of need – and the danger of exacerbating moral hazard, encouraging further risk taking. One more issue on which we need to reflect concerns the measures that serve to make recourse to these instruments less likely. For example, recent experience has made it evident that the characteristics of deposit insurance schemes are key to containing the risk of bank runs and liquidity crises. The role of communication and the benefits of full transparency are also crucial in case of crisis. As the events of the past year have shown, the prompt public announcement by the central bank of interventions to support individual institutions may trigger herd behaviour and exacerbate liquidity problems. It is our communication that will induce either stigma or trust. The need to reach a common understanding of these problems is particularly pressing at the moment. The central banks must intensify their cooperation in order to prevent liquidity crises and ensure a level playing field. Enhanced communication and collective monitoring of market developments, with coordinated steps to provide longer-term funds, is of the essence. | bank of italy | 2,008 | 7 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 2 July 2008. | Mario Draghi: Fact-finding preliminary to the examination of the Economic and Financial Planning Document for the years 2009-2013 Testimony of Mr Mario Draghi, Governor of the Bank of Italy, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 2 July 2008. * 1. * * The state of the public finances The public finances improved further in 2007. The ratio of general government net borrowing to GDP diminished by 1.5 percentage points to 1.9 per cent, making it possible for the excessive deficit procedure opened against Italy in 2005 to be abrogated. The primary surplus, almost nil in 2005, exceeded 3 per cent of GDP. After rising for two years, the ratio of debt to GDP fell to 104 per cent. Almost one point of the reduction of 2.5 percentage points in the debt was due to the decline in the Treasury’s assets with the Bank of Italy. The general government borrowing requirement continued to diminish in 2007, falling from 3.7 to 2 per cent of GDP. As in 2006, the improvement in net borrowing was due largely to the increase in the ratio of tax and social security receipts to GDP, which rose back close to the peak recorded in 1997. Primary current expenditure fell slightly in relation to GDP, but still remained close to the postwar peak registered in 2005. About one point of the 1.2 point increase in the ratio of tax and social security receipts to GDP can be ascribed to discretionary measures, including those to widen tax bases and to fight tax evasion and avoidance. Net borrowing is expected to increase in 2008, reflecting lower GDP growth (0.5 per cent, against 1.5 per cent in 2007) and the budget adjustment measures introduced last autumn. In the Economic and Financial Planning Document for 2009-13 the deficit on a current legislation basis is estimated at 2.5 per cent of GDP, compared with the forecast of 2.4 per cent given in the Combined Report on the Economy and Public Finance in March. The primary surplus is expected to fall to 2.5 per cent. The worsening in the expected balance for 2008 compared with the forecast in the Combined Report essentially reflects the reduction in revenue (€1 billion net of the effects of Decree Law 93 issued on 27 May), in connection with the further deterioration in the outlook for growth. In particular, the estimate for indirect tax receipts has been reduced by almost €5 billion, to take account of the slowdown in VAT receipts in the first few months of the year. This downward revision has been largely offset by upward revisions for the other components of revenue. The new estimates on a current legislation basis also take account of the effects of Decree Law 93/2008, which was approved in May and reduced both revenue and expenditure by €2.3 billion. The decree law abolished municipal property tax on primary residences (with a decrease in revenue of €1.7 billion according to the official estimates), reduced the taxation of overtime earnings and productivity bonuses (€0.7 billion), and made numerous cuts in spending appropriations, above all in relation to capital expenditure. Larger transfers from the central government will compensate municipalities for the loss of revenue from municipal property tax. The change to that tax and the suspension, likewise provided for in Decree Law 93/2008, of the power of local government bodies to raise the rates of the taxes within their competence entail a reduction in their degree of fiscal autonomy. The abolition of municipal property tax on primary residences pursuant to Decree Law 93/2008 comes on top of the reliefs already introduced by the Finance Law for 2008. According to the information contained in municipalities’ outturns, about 5 per cent of their total budget revenue came from municipal property tax on primary residences. The impact of the abolition appears to be greater for larger municipalities, for those located in ordinarystatute regions and, among the latter, for those of the Centre and North. The decree law provides that earnings from overtime or deriving from other variable components of compensation are subject to a substitute tax of 10 per cent, up to a maximum of €3,000, and are not included in total income for purposes of personal income tax. The relief is reserved, at least initially, to private-sector employees who in 2007 had payroll earnings of not more than €30,000 and will apply to wages and salary payments received in the second half of 2008. In the second quarter of 2007 about 10 per cent of employees worked overtime, for a number of man-hours equal to 2 per cent of total hours worked. The frequency of overtime work is highest among employees of medium-sized and large industries in the North, males and workers with relatively high educational levels and job qualifications. The expenditure savings derive from the cancellation of numerous appropriations for minor measures (about €1 billion, including €0.4 billion of current expenditure), from the reassignment to the state budget of the funds that Fintecna was to have paid to Stretto di Messina S.p.A. (€0.6 billion) and from cutbacks to INAIL’s real-estate investments (€0.7 billion). Further, the Planning Document’s planning framework also takes account of the decree law approved at the same time as the Document, which increases both revenue and expenditure, leaving net borrowing for 2008 essentially unchanged. On the basis of the official estimates, the decree reduces net borrowing in 2008 by €0.5 billion as a result of additional revenue of €2.2 billion and additional expenditure of €1.7 billion. The former comes from bringing forward to this year the effects of the provisions increasing the taxation of banks − this will affect the second payment on account of corporate income tax and regional tax on productive activities − and of some of the measures that increase the levy on energy companies. Banks’ electronic payment on account of stamp duty and the tax on insurance premiums are increased. Lastly, the decree contains measures to cope with the effects of the increase in the prices of oil products on the competitiveness of the agricultural, fishing and road transport sectors, to be applied subject to the approval of the European Commission and only up to the end of 2008. Almost all of the increase in expenditure concerns current expenditure. About half of the outlays reflect transfers to the municipality of Rome (€0.5 billion) and the decision not to apply the safeguard clause introduced by the Finance Law for 2007 (€0.3 billion), under which budget appropriations for transfers to public entities are to be reduced if expenditure savings are found to fall short of those indicated by that law. The decree also provides for some transfers to the State Railways (€0.3 billion) and increases the operating fund for schools (€0.2 billion). In addition, a solidarity fund is set up for the needier among the population (€0.2 billion), part of which will go to finance a card for purchases of food products and energy services by individuals living in conditions of especially great economic hardship. It is important to procure further resources to support the income of poor households, which are relatively numerous in Italy by European standards and on which the impact of the increase in the prices of essential goods is heavier. Going forward, it is also important to identify instruments that systematically deliver support to persons in economic difficulty. In the planning framework, the ratio of primary current expenditure to GDP is set to rise by 0.7 percentage points, exceeding 40 per cent for the first time; interest payments remain stable at 5 per cent of GDP. The ratio of tax and social security receipts to GDP diminishes by 0.3 percentage points, to 43 per cent. The change in the ratio of fiscal revenue to GDP reflects, on the one hand, the reliefs introduced in 2008 (regarding municipal property tax and personal income tax on primary residences, overtime work and productivity bonuses) and the full phasing in of those established by the budget for 2007 (in particular, the relief regarding the regional tax on productive activities levied on labour costs) and, on the other, the increase in revenue deriving from the measures contained in the June decree law (112/2008). According to the official estimates, structural net borrowing, calculated net of the effects of one-off measures and cyclically adjusted, will increase by 0.6 percentage points of GDP compared with 2007, to 2.3 per cent. The debt is expected to amount to 103.9 per cent of GDP, virtually the same as at the end of 2007. In the first five months of the year the general government borrowing requirement amounted to €38.5 billion, €7.1 billion less than in the corresponding period of 2007. The improvement reflected the significant growth in revenue, to which some extraordinary factors contributed. Tax revenue recorded in the state budget grew by 6.2 per cent (€8.2 billion) in the first five months of 2008 compared with the year-earlier period. Excluding the effects of the abolition of the payment on account by tax collection agents, decided last year, the increase can be estimated at 3 per cent. Receipts from withholding tax on payrolls and pensions increased by 9 per cent (€4.6 billion), reflecting some contract renewals and the associated back pay as well as the high elasticity of revenue to the growth in the tax base. The increase in VAT receipts was particularly small (1.5 per cent); it was probably affected by the complete utilization in 2008 of the changes in the deductibility of VAT on expenses connected with company cars, resulting from the 2006 decision of the European Court of Justice. Social security contributions are rising fast, partly owing to the full effects of the rules governing severance pay accrued by employees who have not adhered to supplementary pension schemes. The available data on self-assessed tax payments in June indicate a reduction in revenue compared with last year, which can be ascribed only in part to changes in legislation. The decrease in receipts caused the state sector surplus to be significantly smaller than in June 2007. 2. The projections based on current legislation and the objectives set in the Planning Document for 2009-13 The Planning Document establishes three guidelines for budgetary action: support for economic growth, stability of the public finances and promotion of social cohesion. The strategy announced by the Government to boost growth is based on the simplification of taxation and compliance for businesses, the strengthening of infrastructure and research, measures to improve the functioning of the labour market, the development of under-utilized areas and the modernization of the public administration. It is to be sustained by a plan of liberalizations, simplifications and privatizations. In the Planning Document net borrowing on a current legislation basis is estimated at 2.6 per cent of GDP in 2009, 2.1 per cent in 2010 and 2 per cent in 2011. The progressive reduction in the deficit is ascribable to the underestimation of expenditure inherent in the current legislation criterion, which does not take into account disbursements which, even if foreseeable or necessary, require the formal passage of legislation (outlays for the renewal of public employment contracts, for service contracts and for the execution of public works). Compared with the estimates published in the Combined Report on the Economy and Public Finance in March, projected net borrowing on a current legislation basis is revised upwards by about half a percentage point in each of the next three years. The new estimates, like those for 2008, factor in the further worsening in the outlook for growth. Excluding the effects of the Decree Law 93/2008, which for 2009 give rise to a decrease in revenue and expenditure of respectively €2.1 billion and €2.4 billion, the increase in net borrowing on a current legislation basis next year with respect to the forecast in the Combined Report derives essentially from an upward revision of primary current expenditure (0.3 percentage points of GDP, or €2.8 billion), relating mainly to social benefits in cash, and of interest payments (0.1 points, €2.1 billion). The significant reduction in the estimate of indirect tax revenue (0.3 points, more than €5 billion) is almost entirely offset by the higher projections for both direct taxes and social security contributions. These changes will also have effects in the subsequent two years. The target for net borrowing is set at 2 per cent of GDP in 2009 (down from 2.5 per cent projected for 2008) and 1 per cent in 2010. For 2011 a budget position basically in balance is planned, confirming the commitments made at European level. Compared with the Combined Report of March, the objective for 2009 is made less stringent (by 0.2 percentage points) and those for the subsequent years are basically confirmed. The primary surplus is forecast to grow progressively, from 2.6 per cent of GDP in 2008 to 4.9 per cent in 2011. The planning framework for the public finances is based on a macroeconomic scenario in which GDP growth is expected to be equal to 0.5 per cent this year and 0.9 per cent in 2009, and is then forecast to increase gradually and to stabilize at 1.5 per cent in 2012. After the deterioration of 0.6 percentage points of GDP expected for the current year, the structural budget balance should improve by about 0.6 points in 2009 and by about 1 point each year in 2010 and 2011 and then stabilize in the following two years. This adjustment path is consistent with the European guidelines for countries that have not yet attained the medium-term objectives. The public debt is expected to remain practically stable this year and to fall to less than GDP in 2011; in fact it is projected to fall from 103.9 per cent in 2008 to 97.2 per cent in 2011. However, the adjustment will be slower than was indicated in March, owing above all to the less favourable estimate of nominal GDP growth. For the entire forecasting horizon the Document projects not only the general government accounts on a current-legislation basis but also the planning targets. The last Planning Document to include a detailed planning framework was that presented in June 1999. A sharp reduction in the ratio of primary expenditure to GDP is planned. For the three years 2009-11 the reduction is projected at 2.2 percentage points. Primary current expenditure will account for 1.4 points of the decrease, owing chiefly to a sharp decline in employee compensation and intermediate consumption; pension expenditure, by contrast, will continue on an upward trend. Capital expenditure is forecast to be reduced by 0.8 points with respect to GDP; according to the Document, in 2011 it will be at its lowest level in recent decades. The above comparison excludes, for 2000, the proceeds from sales of UMTS licences, which were entered in the accounts as a negative component of this aggregate. The planned reduction will involve both gross fixed investment and capital grants. The ratio of public gross fixed investment to GDP, which has been broadly stable at 2.4 per cent for a decade, would thus fall to 2.1 per cent in 2011. The ratio of taxes and social security contributions to GDP will remain unchanged over the five-year planning scenario, after the 0.3-point reduction expected for 2008 to 43 per cent. The increase in direct tax receipts in relation to GDP is seen as being offset by a reduction in social security contributions and indirect taxes. 3. Budgetary policy for 2009-13 For the first time, together with the Economic and Financial Planning Document the Government has specified budgetary measures that according to the official estimates will achieve the Document’s targets for the years covered. This should provide a framework of greater certainty for economic agents and allow budgetary policy to focus on structural reform and measures to stimulate economic growth. Until now, in the Planning Document presented each June the Government had indicated the public finance objectives over the planning horizon and the magnitude of the correction with respect to the current-legislation projection needed to achieve them. The budget was then presented in September, containing the measures necessary to attain the target for the first year. The budget measures consist of four provisions: 1) Decree Law 112 of 25 June 2008, containing measures that will already go into force in the second half of this year to stabilize the public finances; 2) a bill introducing rules that complete the correction needed to achieve the objectives by 2011; 3) a draft enabling act on fiscal federalism; and 4) a draft enabling act for the creation of a local government autonomy code and containing the legal arrangements for Rome as national capital. The last two provisions will be linked to the autumn budget session. To date, only the first of the four has actually been submitted to Parliament. The Document’s planning targets indicate the need for a correction in net borrowing with respect to the current-legislation projection equal to 0.6 percentage points of GDP in 2009, 1.1 points in 2010, and 1.9 points from 2011 onwards. For 2009-11 the correction is almost entirely achieved by the measures contained in the June decree law. The remainder will be implemented with the other provisions that form part of the budget. 3.1 The June decree law The June decree law aims to reduce net borrowing with respect to the current-legislation projection by €9.8 billion in 2009, €17 billion in 2010 and €30.6 billion in 2011. In 2009 the budget correction will consist mainly of revenue increases, which will account for about two thirds of the correction with respect to the figures on a current legislation basis. In the two subsequent years the planned adjustment consists entirely of reductions in expenditure. The revenue measures are aimed in particular at certain high-profit industries. On the expenditure side the measures consist mainly of spending limits; the definition of the means for complying with the limits is left to future provisions. Further, compliance with some of them will depend crucially on measures to increase the effectiveness and efficiency of public structures, which the Government intends to present in a separate bill. The revenue measures are expected to bring additional receipts of more than €7 billion per year starting in 2009, part of which will be offset by the revenue reductions caused by the measures to curb expenditure. The tax increases will involve banks, insurance companies, the energy industry and cooperatives. For banks and insurance companies a limit is set on the deductibility of interest payments, while deductions on account of credit writedowns, allocations to risk provisions and insurance company claim reserves are revised. The entry into force of the new rules on VAT exemption for ancillary services provided by banking groups, which would have increased taxes in 2008, is postponed to 2009. Energy companies are subject to a corporate income surtax of 5.5 per cent and to a substitute tax on the accrued capital gains on their stocks of petroleum products. Extraction royalties are increased. Turning to cooperatives, the withholding tax on interest paid to members is increased, as is the taxable portion of net yearly profit for consumer cooperatives. The favourable treatment of stock options is abrogated, and a capital tax on so-called “family-owned” real estate investment funds is introduced. Under certain conditions the capital gains from the sale of shares reinvested in start-up companies may be exempted. Tax assessments are to be stepped up, with an extraordinary audit plan and rules to combat VAT fraud. In order to simplify taxpayers’ obligations, some notification requirements are eliminated and some of the rules introduced in the past two years to combat evasion are made less stringent. Specifically, the obligation to transmit the list of suppliers and customers is abolished, as is the requirement that professionals have a current account dedicated to their professional activity and that the payments for their services be traceable. The publication of the revised sector studies is moved forward. In addition, the maximum limit for payments in cash and negotiable cheques is moved back up to €12,500 and the obligation to include the tax code of the endorser on endorsed cheques is abrogated. On the expenditure side, the decree-law calls for savings of €10.4 billion in 2009, €17.2 billion in 2010 and €31.2 billion in 2001. In part, these will be offset by increased expenditure of €6.5 billion a year from 2009 onwards. About 60 per cent of the additional spending will be allocated to contract renewals. The resources appropriated for 2009 correspond to just over 2 per cent of total general government staff costs, which implies a significant slowdown in wage increases, which have been particularly large in this sector in recent years. From 2000 to 2007 per capita earnings in the public sector rose at faster rates than in the private sector, bringing the wage differential between them close to the high point recorded in 1990 (nearly 40 per cent). The ban on cumulating pension income with self-employment or payroll income is abolished (€0.4 billion). Public employees with at least 35 years of contributions may request to be suspended from work until they reach retirement age, receiving a monthly allowance equal to half their salary (€0.2 billion starting in 2010). The success of this latter measure depends on the ability of public agencies to identify categories of workers for whom the cost to the State will be less than the benefit of faster personnel turnover. About half the savings will involve central government departments. They derive from cuts to appropriations for the major “missions” into which the budget is divided. The reduction in outlays, which will not involve salaries, pensions, interest payments or other compulsory expenditure, will be equal to 22 per cent in 2009 and reach 41 per cent in 2011. Provided the overall amount of savings on each “mission” is ensured, the individual ministries can choose which spending programmes to downsize, and the Ministry for the Economy and Finance can make further changes during the year acting on a proposal from the ministry concerned. Nearly a third of the expenditure savings will come from local government. The definition of specific measures is deferred to the revision of the Domestic Stability Pact, scheduled for the end of July. Savings on this count are expected to rise from €3.2 billion in 2009 to €9.2 billion in 2011. In the last three years there has been a slowdown in the primary expenditure of local authorities (excluding health spending), reflecting the decrease in capital spending by municipalities in 2005 and 2006 and the slower growth in the regions’ current expenditure in 2007. In recent years there has also been a tendency for the debt of local authorities to increase. The decree prohibits such bodies, for a maximum period of one year, from signing contracts in derivative financial instruments until a regulation governing the matter is issued. According to the Document, outlays in the healthcare sector should be equal to the currentlegislation projection in 2009 and then decrease by €2 billion in 2010 and €3 billion in 2011. The current-legislation projections count the receipts from patient co-payments on specialist health services (€0.8 billion a year), which the 2008 Finance Law abolished only for this year. The measures to achieve the savings target for the healthcare system, without prejudice to the existing deficit reduction plans, are left to the regions, in the framework of an agreement with the central government to be signed by the end of July. In the event of failure to attain the objective, there is provision for an automatic rise in the regional income tax surcharge and IRAP rates. Public employment legislation should enable savings on compensation expenditure to rise from €1.5 billion in 2009 to €4 billion in 2011, financed by a sharp decline in recruitment over the next three years. The measures for 2009 include limiting recruitment to within 10 per cent of the previous year’s terminations, and to within 20 per cent in the two subsequent years. The previous legislation had fixed ceilings on turnover of 20 per cent in 2009, 60 per cent in 2010 and 100 per cent in 2011. The allocations for the stabilization of precarious workers have been reduced with respect to those envisaged by the 2008 Finance Law; resources for second-level collective bargaining have also been cut back. The certification of contract renewals in the public sector by the State Audit Office has been made a necessary prerequisite for their entry into force. The Decree Law in question sets objectives for the pupil-teacher ratio, to be increased from 8.9 to 9.9, and non-teaching staff, to be reduced by 17 per cent. To meet these targets the Ministry of Education, together with the Ministry for the Economy and Finance, will prepare a restructuring plan and the related implementing regulations, which among other things, will include a rationalization of the study schedules and timetables – in particular those of the technical and professional institutes – and of the criteria concerning the size of classes. The current pupil-teacher ratio (8.9) increases only slightly if the calculations exclude backup teachers, a feature of the Italian school system; in the other OECD countries the ratio is on average 16.7 for primary schools and 13.4 for secondary schools. There is scope for improvement in the organization of the school system and a more flexible utilization of the workforce, which could offset the reduction in the number of teachers without affecting the quality of the service. 4. Some evaluations The reintroduction in the Planning Document, after almost a decade, of a multi-year planning scenario for the individual items in the general government consolidated accounts greatly increases the information provided on budgetary policy; it means that Parliament and public opinion can better assess Government policies on the level and composition of public revenue and expenditure. The inclusion of the detailed planning scenario in the Stability Pact will align the information this contains with that provided in the Pacts of the other European countries. Despite the difficult economic climate, the Planning Document confirms the objective of a balanced budget in 2011. It is a sign of Italy’s ongoing commitment to the pledges made to its European partners. The achievement of balance, which is entrusted to an increase in the primary surplus, will guarantee a rapid reduction in the ratio of debt to GDP, a crucial objective in light of the unfavourable demographic outlook in the coming decades. In 2006-07 the structural budget balance improved significantly in many euro-area countries; according to European Commission estimates, the average improvement across the euro area was 1.6 percentage points (2.1 points in Germany). Italy recorded a substantial improvement of 3 points, but is one of the few countries that continue to fall significantly short of budgetary balance. A significant new departure with respect to previous years is the passing, together with the Planning Document, of a decree law that defines what must be done to achieve the objectives set for the next three years. For many areas of expenditure, however, the Decree Law postpones the detailed definition of corrective measures to future legislative and administrative measures. The ratio of tax and social security contributions to GDP envisaged for 2011 is basically unchanged compared with the level expected for the current year, which is high by both historical and international standards. It is important that the progress made in curbing expenditure and the fight against tax evasion be translated as soon as possible into lower tax rates, without compromising the budget balance objectives. If the economy were to perform better than expected, it would be opportune to lighten the tax burden even before 2011. In particular, the fiscal drag should be offset in order to support the disposable income of households. Lower tax rates for workers and firms would reinforce the interventions aimed at supporting growth, reduce the distortions in economic activities and enhance the competitiveness of Italian firms. On the revenue side, the most important interventions aim to raise the taxation of firms operating in sectors that have recorded high earnings in recent years. The heavier fiscal burden for banks could affect the conditions offered to depositors and borrowers and lead to less resources for the banks to allocate to own funds. The fight against tax evasion is being pursued above all by strengthening assessment activity. Significant results in this area will depend on the achievement of greater efficiency by the tax authorities. It is commendable that reducing expenditure plays a major role in the consolidation of the public finances. Most of the reduction in the deficit is expected to be achieved by keeping primary current expenditure basically unchanged in real terms in the three years from 2009 to 2011; in the last decade it grew by more than 2 per cent each year. The reduction in capital expenditure is very large. This must not be allowed to hinder the full development of Italy’s infrastructure, which is needed to boost firms’ competitiveness and support economic growth. Over half of savings concern central government expenditure. The planned reduction of outlays on “missions” and programmes is ambitious. In order to be effective and lasting, this action must be combined with a revision of expenditure centres’ operating procedures and objectives. Compensation of employees is contained through a further tightening of the restrictions on turnover and limits on allocations for contract renewals. Here again the interventions appear sustainable only if accompanied by an incisive overhaul of public employment that raises productivity levels. New staff assessment systems, merit-based promotion and increased accountability, which the Government intends to pursue in an enabling act, all move in this direction. This is the biggest and most difficult challenge with a view to balancing the public finances and supporting economic growth. The Planning Document does not include any measures having a significant impact on pensions. After numerous interventions, this helps provide a stable reference framework for the decisions of workers and firms. In order to curb spending and assure future pensioners receive adequate pensions, the average actual retirement age should nonetheless be raised in the medium to long term. The abolition of the ban on the cumulation of pensions and earnings moves in the direction of increasing the rate of employment of persons aged 60 and over, which in Italy is still relatively low. It is necessary to proceed with the removal of the obstacles and disincentives that keep a large proportion of the less young population out of the workplace. The new rules on supplementary pensions have led to large increases in the workers joining second pillar schemes. It is right to give the new legislative framework time to settle, but adjustments can be considered in this sector as well in the light of the experience matured in recent months. Careful consideration should be given to the possibility of guaranteeing, within specified limits, the reversibility of the choice of allocating severance pay to pension funds. To promote competition between funds, complete mobility of employer contributions could be introduced. Measures designed to increase the efficiency of the life annuities’ market should also be considered. Information on the state pension matured by each worker should be improved, as should that on the costs and characteristics of supplementary pension schemes. Municipalities, provinces and regions are also required to make a substantial contribution to correcting the budget balance. Any considered judgement must await the reform of the Domestic Stability Pact and the bill on federalism, which the Government intends to put before parliament before the end of September. The manner of implementing fiscal federalism will be vital to ensuring the action to contain spending is sustainable and to increase the system’s efficiency and effectiveness. A simplification of the levels of government aimed at exploiting economies of scale and avoiding useless overlaps could help. Decentralization makes it possible to tailor the supply of services to the needs of local communities and at the same time enables the electorate to judge with greater immediacy the quality of public action. To deliver these benefits, decentralization must be based on a system of clear and consistent responsibilities. The fiscal autonomy of local governments, the adequacy and transparency of equalization flows and strict restrictions on borrowing are the key elements of this system. Fiscal autonomy must establish a direct link at the margin between expenditure and taxation. To this end it is advisable that local authorities have sufficient room for manoeuvre on tax rates and bases. The municipal property tax relief granted affects a tax which, owing to the characteristics of property wealth, is the cornerstone of local taxation in many countries. If permanent, the blocking of increases in decentralized taxes also weakens local authorities’ fiscal autonomy. *** The economic slowdown compounds the structural problems of stagnant productivity, the public debt and Southern underdevelopment. Economic policy must now lower the debt and contribute to the recovery of growth, with better public services and a reduction in the fiscal burden. These results require a change in the rules governing the activity of public bodies and their employees. The success of the initiatives outlined in the Planning Document will be essential to making general government more flexible, effective and transparent, reducing its costs, redesigning its structure and removing obstacles to economic activity. | bank of italy | 2,008 | 7 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Italian Banking Association Annual Meeting, Rome, 9 July 2008. | Mario Draghi: An overview of banking in Italy Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Italian Banking Association Annual Meeting, Rome, 9 July 2008. * * * Rising inflation and the outlook for the world economy Expansionary monetary policies together with severe tensions in the market for oil are at the origin of the present international economic and financial difficulties. The protracted monetary expansion in the United States and other countries spread to the main emerging countries because their currencies are pegged to the dollar. The fragilità of the markets originated in the gaps in the regulatory framework and was worsened by perverse incentives that fueled the tumultuous growth of the financial industry. But, as with the weakness of the dollar, the roots can also be found in overly accommodating monetary policies. The massive flight of capital from no longer profitable financial investments and the depreciation of the dollar have contributed to the rise in the price of oil, which is based on the structural tensions underlying this market. The price of crude oil has been rising since the beginning of the decade; in real terms it has already gone beyond its previous all-time peak in 1979-80; it is still rising. The fundamental cause has been the sharp increase in the emerging countries’ demand for energy, with supply struggling to keep up. Demand is inelastic in the short term owing to technical constraints. Supply is even more inelastic because of the increasing cost of discovering and developing new fields, rigidity in refining and transport, and unresolved geopolitical difficulties. But this is not enough to explain the latest price surges. That abundant liquidity worldwide has played a part is confirmed by our estimates, which indicate that the fall in real interest rates since last summer may explain about a quarter of the subsequent rise in world crude oil prices. This not only puts pressure on current and expected inflation, it also poses a threat to world growth itself. The transfer of resources to the oil-producing countries, only offset in part by an increase in their imports, is holding down growth in the industrialized countries. Higher inflation, due also to food prices, is depressing the real value of wages and therefore consumption. International financial markets, influenced by the more uncertain economic outlook and the increases in the price of crude oil, remain fragile. After a return to lower levels in March, risk premiums for corporate bonds and banks’ credit default swaps have begun to rise again. The market for structured credit products has not recovered; money market spreads are still wide. The major international banks have begun to put their balance sheets in order, by reducing their exposure to the riskiest instruments and to a large extent covering their losses by injections of capital. But this capital strengthening is not yet sufficient, it threatens to be hindered by further falls in house and stock market prices. In the United States, rising insolvency rates and the possibility that poor economic conditions could undermine the quality of corporate loans are causes for concern. It is important not to repeat the economic policy errors made in response to the oil shocks of the 1970s. In some countries, an initially expansive monetary policy destabilized inflation expectations; a sharp restriction had to follow. The consequences, partly because of widespread indexation, were persistently high inflation, enormous fluctuations in real interest rates and severe repercussions on economic activity. Compared with thirty years ago, an oil shock has less of an effect on the economies of the consumer countries today, not only thanks to greater energy efficiency and more flexible markets but also because of the credibility that monetary policies have acquired. We estimate that with monetary union the impact of an increase in the price of oil on consumer price inflation in Italy has been reduced fivefold by comparison with the 1980s and 1990s. The credibility of monetary policy has contributed to this achievement. It needs to be preserved in the advanced countries and pursued in the emerging countries, by heightening awareness of the seriousness of the risk of inflation and the growing inadequacy of pegging exchange rates to the dollar. Inflation and monetary policy in Europe The rate of inflation has increased in all the major countries. Although “core” inflation – excluding energy and food products – is lower, the warning signals are growing. Consumer price inflation in the euro area had already reached the highest level since the start of the 1990s in May (3.7 per cent); on the basis of provisional data, it rose to 4 per cent in June. There has been a sharp acceleration in Italy, too. According to Eurosystem forecasts, the rise in inflation in the area will be temporary but more persistent than was predicted several months ago. Inflation is now expected to subside only gradually in the course of 2009, remaining higher than 2 per cent for quite some time. The idea that the rise in inflation is permanent must not take hold. On the eve of the meeting of the Governing Council of the European Central Bank on 3 July, the risks of an increase in inflation appeared to have grown. Albeit in a context of wage moderation, the first signs of an acceleration in costs were visible. Other warning signals were coming from market expectations: inflation expectations measured on the basis of long-term index-linked government bonds were tending to rise; the prices of inflation swaps signaled growing fears of inflation for long-term maturities as well. Against this background, the Governing Council of the ECB decided to raise reference rates by 0.25 percentage points. In the days following the rate hike, inflation expectations derived from the financial markets ceased their upward trend; it appears that they are now beginning to fall back. By taking timely action we intend to help to avert the risk that the rise in the international prices of energy and food products might set off a spiral between expectations and the setting of wages and prices, and to bring inflation gradually back down to levels consistent with price stability in the medium term. Households’ disposable income is defended by combating the rise in inflation, which erodes purchasing power, lowers the real value of financial wealth and is a drag on consumption and growth. We estimate that in Italy the acceleration in prices recorded since last summer has reduced the growth in disposable income by more than one percentage point, by three points if the losses of the real value of financial wealth are also taken into account; it can reduce consumption by more than two points by the end of next year. Average per capita earnings of employees, after tax and social security contributions, are not much higher today in real terms than they were fifteen years ago. Meanwhile, unit labour costs have increased by more than 30 per cent, compared with about 20 per cent in France and practically nil in Germany. This gap between the spending capacity of workers and the competitive capacity of firms reflects the meagre growth in productivity, the persistently high level of taxation and social security contributions, and the effect of inflation; it is at the root of the stagnation of our economy. Price stability is a prerequisite for the resumption of growth. A price-wage spiral would be an illusory remedy and one that monetary policy must oppose. If monetary policy is credible, even if it cannot insulate the economy from the fluctuations of commodity prices, it can cushion their effects on expectations and domestic prices. A prompt monetary adjustment reduces the risk of tardy but violent corrections. Italian banks’ income and capital Excluding capital gains and extraordinary income, the profits of the five largest Italian banking groups fell in the first three months of this year by about a third compared with the same period of 2007; the rate of return on equity fell on an annual basis by nearly five percentage points, to about 9 per cent. The deterioration began in the third quarter of last year. Contributory factors included the decline in fee income, caused mainly by the contraction in asset management activity, the losses on securities trading and portfolio writedowns. In 2007 the tier 1 capital ratio of the largest groups fell slightly, from 6.8 to 6.5 per cent on average, although it remained above the regulatory minimum. Loan quality has remained stable up to now. The ratio of non-performing loans to balance sheet assets for the groups as a whole remains close to 5 per cent; for bad debts alone, the ratio is close to 3 per cent. More than 60 per cent of the nominal value of bad debts is covered by write-downs. The ratio of new bad debts to outstanding loans holds at about 1 per cent for firms and 0.8 per cent for consumer households, levels that can be considered normal. The impact of the international financial turbulence on the accounts of Italian banks has been relatively limited so far. However, income and profitability will continue to be affected if the tensions do not ease. The cost of funding on international markets remains high. The slowdown in economic activity could have an impact on loan growth and quality, weighing on profitability on a risk-adjusted basis. The exposure of Italian firms and households to interest rate risk is particularly large, given the high proportion of loans at short term or indexed to short-term rates: some 90 per cent of the total for firms and more than 70 per cent of mortgage loans to households. The uncertainty of the macroeconomic and financial picture demands that banks adopt a prudent policy of provisioning against future losses. The measure regarding the partial non-deductibility of banks’ interest expense is equivalent to an increase in funding costs of nearly 10 basis points. It is difficult to predict how this cost will be divided: depending on the evolution of market conditions, it could fall on the terms and conditions offered to depositors and borrowers, profits distributed or resources allocated to reserves. Banking supervision The Basel II capital adequacy rules went into force in Italy in January 2007; since the start of this year they have applied to the entire banking system. From 2001 onwards the Bank of Italy had asked the major Italian banking groups to overfulfill the minimum capital requirement, in order to provide for the risks not covered by the Basel I accounting standards. This ensured that the massive process of concentration within the Italian banking industry could take place without jeopardizing balance-sheet soundness. With the new rules of Basel II, however, and in today’s market environment, capital soundness takes on an even more important role, and the banks have been invited to proceed to the necessary strengthening. This autumn intermediaries will also be required to specify the additional capital safeguards to be constituted, where necessary, as part of the obligations laid down under the second pillar of Basel II. It is essential that banks be in a position at all times to evaluate the impact of improbable but devastating events on income and on capital as well as to gauge the possible interactions among different types of risk: credit risk, market risk, liquidity risk and interest rate risk. The Bank of Italy has asked the leading banks to make stress testing a regular practice. The first results, although they are reassuring on the whole, revealed that in some cases the liquidity safeguards against extreme events were not adequate. These banks were asked to restore an adequate level of liquidity without delay. New rules on bank governance came into effect recently; one of their provisions requires that the criteria for the remuneration of bank managers be designed so as to avoid perverse incentives in the matter of risk taking and risk management. With the cooperation of the banks’ compliance units, we shall assess the consistency of incentive schemes with the principles laid down by the new rules. Transparency and information comparability are essential to reducing the uncertainty that weighs on market trends. In accord with the other G7 national supervisory authorities, and in implementation of the recommendations of the Financial Stability Forum, on 16 June we asked Italian banks to include in their mid-year financial statements a detailed treatment of their risks in connection with subprime mortgage loans and structured finance, thus retaining and extending a procedure that had already been instituted in Italy for the annual financial reports for 2007. In line with the indications of the Basel Committee we have asked the leading groups to adopt integrated systems of liquidity risk analysis and control providing for effective liaison between risk management and treasury management. Preparation for critical contingencies continues. In coordination with the other supervisory authorities, we are conducting crisis simulation exercises and specifying the data flows to activate in the event of an emergency. Coordination between the different countries’ authorities and convergence of supervisory practice reduce the cost of supervision over international banks, helping to foster the integration of the European market in banking services. This is another reason for speeding up coordination. At the same time Community directives are progressively harmonizing the regulation of financial markets and products and consumer protection. But there remain significant differences in corporate, commercial and bankruptcy law. Action by European and national legislators is indispensable to strengthen the single market and simplify crisis response. The restructuring of the banking system Our system took full advantage of the opportunity presented by the favourable financial situation of the past years to conceive and carry out major banking mergers, which would be much harder to effect in today’s market conditions. The end-product must be a system that is sounder, more efficient, with a wider range of higher-quality services, and in which banking intermediation is less costly for the economy. Swift execution of planned mergers and continuous verification of the results are essential, especially in the current market situation. Above all, the rapid integration of information systems is a prerequisite not only for efficiency gains but also for risk control, which is increasingly necessary with the growing complexity of business operations and expansion into new markets. It is still early for a full assessment of the impact of mergers on banks and customers. The data available show that at 31 March this year the economic results of the four main groups involved in mergers were substantially in line with their business plans. These indicate, however, that the greater part of the benefits of the mergers carried out in 2007 – estimated at €3.9 billion a year when fully achieved – will not be realized until subsequent years. The extraordinary costs of the mergers, consisting largely of severance benefits for redundant personnel, came to €3.3 billion and were mostly charged to the accounts for 2006 and 2007. In order for customers to benefit from mergers and acquisitions, it is important that the increase in concentration not weaken competitive pressures. In the 1990s, a period marked by intense and growing competition but also by many mergers, the resulting efficiency gains were passed on to customers, albeit with a lag. In the end the banks involved in the concentrations offered their customers more favourable terms both on deposits and on loans. The network economies stemming from mergers enable banks to extend their distribution channels, with a reduction in charges for some kinds of transaction, such as cash withdrawals, and to broaden and rationalize their product range. Concrete progress has already been made. Today, in order to intensify the competitive pressure and enhance customers’ ability to choose, it is especially important to facilitate client mobility. Contributions to this end have come from the rules introduced in recent years on current account closing charges and the early repayment and portability of mortgage loans, from the Bank of Italy’s action on behalf of transparency and fairness in banking products, and from the other authorities’ action in defence of transparency and competition. Local mutual banks continue to have significant weight within the Italian credit system. In recent years over 400 independent mutual banks have expanded the scope of their business within the credit market, especially with firms, exploiting their dense network and a banking model centred on continuity in customer relations. Globalization heightens the need, for mutual banks, like others, to adapt their services to the needs of small and medium-sized enterprises, to increase their operating efficiency and to improve their risk control and management. In other countries mutual banking uses integrated systems to overcome the disadvantages of small size by centralizing production and ancillary services. Italian mutual banks must continue their efforts to work out new organizational solutions that can enhance the integration and efficiency of the network without prejudice to the independence of individual banks. Customer relations I have remarked on other occasions that correct relations with customers, in addition to being a legal obligation, are a strategic factor in the soundness of banks. The most pressing problems concern the portability of mortgages, the maximum-overdraft fee, the transparency of contractual conditions and the regulation of brokers and agents. Regarding mortgages, the legislation introduced in the last few years and the recent initiatives undertaken by the Government and the Italian Banking Association have laid the foundations for the actual convertibility of loan contracts within banks and their external portability. Banks must implement these initiatives without delay, provide the necessary assistance to customers and seize the attendant competitive opportunities. Steps should be taken to replace the maximum-overdraft fee with transparent forms of remuneration commensurate with the size of the loan commitment. I believe that by now banks are fully aware of the need to act promptly and effectively on these two fronts, not least to safeguard the system’s reputation. The present rules on the transparency of contractual conditions for banking customers were instituted by the Bank of Italy in 2003; in recent years they have helped to increase the correctness of banking relations. We will hold a public consultation on a revised set of regulations, which will take account of past experience, the evolution of the market and legislative developments. We are determined to overcome operational rigidities, make informative documentation clearer, simpler and more effective and improve the comparability of the conditions offered by intermediaries. As in the past, consumer associations will be involved in the process. The drying up of wholesale supply channels has led banks to place new issues primarily with retail customers. The more complex and atypical forms of fund-raising are at times associated with scant transparency and high costs: they must be offered to selected customers only, who should be made fully aware of the characteristics and risk profiles of the issues. To avoid legal and reputational risks, banks must adhere scrupulously to this principle; it is essential that the compliance functions initiate their operations. In recent years in Italy, as in the rest of Europe, banks and other intermediaries have turned increasingly to credit brokers and financial services agents, above all to establish initial contacts with potential customers. In some cases this activity can lead to irregular practices and weigh heavily on transaction costs. The correctness and professionalism with which it is performed is crucial for the reputation of intermediaries that use these services; the objective of extending the sales network must go hand in hand with that of providing appropriate services and assuring transparency and economy. We have already drawn the attention of banks to the need to activate all the necessary safeguards. There is, however, an equally pressing need for the adoption of legal measures to raise the standards of professionalism and transparency of brokers and agents, so as to address the considerable rise in their number and avoid any risk of proximity with usury and other illegal activities. Here, the transposition of the European directive on consumer credit represents an opportunity for legislators. Between 2003 and 2007 we completed over 4,000 controls of transparency at branches of banks, financial intermediaries and Banco Posta. Last year these inspections were intensified in frequency (their number increased by over 20 per cent), and in the criteria applied, which focused to an even greater extent on verifying substantive compliance. In addition to imposing the fines for non-compliance, where appropriate the Bank of Italy called on intermediaries to reimburse any charges that had been improperly debited to customers. From 2007 onwards a much more dynamic approach has been adopted to the handling of complaints sent to the Bank of Italy by bank customers who believe they have been treated incorrectly. There are nearly 5,000 such complaints per year. The Banking Supervision Department checks that the banks involved respond promptly and adequately. However, for the protection rules to be fully effective, it is necessary to create the conditions for an increase in bank customers’ knowledge of the characteristics of the financial products in which they invest their savings, the yields they can expect, and the nature and size of the risks they run. Several surveys have shown the existence of gaps to be filled. Recently, authorities, trade associations – including ABI – and consumer associations have taken initiatives in this field. As of last year the Bank of Italy has devoted a section of its website to financial education; in addition, we have launched, in cooperation with the Ministry of Education, a training programme for school teachers, so that economic and financial education can be included in the syllabus. The governance of banks On the basis of the rules the Bank of Italy laid down in March, banks must submit a governance plan and approve the necessary bylaw amendments by June 2009. The Bank of Italy does not prefer one or another of the board models provided for by civil law; it nonetheless takes a firm line in ensuring that, no matter which mode is chosen, the principles of sound and prudent management are complied with in the bylaws and in practice. To the same end, the rules that we have adopted require banks to introduce limits on the positions that their corporate officers can hold on other governing bodies; they also prohibit members of control bodies from having operating responsibilities in other group companies or strategic affiliates. The presence of persons on more than one board of directors is to be considered natural within a group. Responsibility for assessing any competition issues arising from the presence of directors on the boards of more than one company lies with the Antitrust Authority, with which we are ready to cooperate, so as to coordinate interventions in the matters for which we are respectively competent. The prevention of conflicts of interest is also achieved through limits and conditions for banks’ assumption of related party risks. A set of rules has just been submitted to the Interministerial Committee for Credit and Savings. For its part, Consob is drawing up rules, applicable to all listed companies and companies with shares widely distributed among the public, which assign a key role to the independent directors in transactions with related parties. Together with Consob, we shall ensure that the rules are coordinated and limit the compliance burden on intermediaries. Overcoming the asset management crisis The group that we established with asset management companies, and with the participation of the Government and Consob, to propose measures to counter the decline of the Italian asset management industry, is about to complete its work. A first conclusion is that it is necessary to intervene on the tax distortions that penalize Italian investment funds. As is the case elsewhere, they should be taxed on distributed profits and realized capital gains, not on their accrued results. The distortions produced by transparency legislation, which is particularly stringent for investment funds, must be eliminated. It is not a question of reducing the safeguards applicable to investment funds, but of increasing, substantively and not just formally, those applicable to other financial products. In particular, for insurance policies of a financial nature, more information must be disclosed on their liquidity; for bank bonds, customers must be given clearer and more complete information on the costs, risks and liquidity of the investment and on the yield of the instrument compared with that of other securities. The fair value determined by the issuer bank must be reported periodically to the purchasers, especially for unlisted instruments for which the issuer’s commitment to buy them back is the main guarantee of the possibility of liquidating the investment. New rules on fairness and transparency for the distribution of illiquid financial products have been announced by Consob; intermediaries will have to comply with them without delay. The independence of asset management companies is essential. The reduction of conflicts of interest must be furthered by a self-regulatory code of conduct that strengthens this characteristic. It is indispensable that independent directors hold the majority of seats on these companies’ boards. By the autumn, using our powers, we will adopt measures to separate the running of bank-controlled asset management companies more completely from that of the banking group to which they belong, by clarifying the limits and purposes of the parent company’s powers of guidance. Lastly, and I come to the hardest task, it is necessary to upgrade the manner in which financial products are offered to investors, in order to realize in full the principle contained in the Consolidated Law on Finance that intermediaries must act in the customer’s interest. The service of providing financial advice must be defined more sharply and made more professional, promoting competition and transparency. The provision of investment advice must be clearly distinguished from the placement of own products, carried out in the customer’s interest and not be limited to pushing house products. Savers who do not intend to incur the cost of advice must nonetheless be given, in the course of placement activity, a simple but effective explanation of risks, costs and returns, with a check, calibrated to the complexity of products, on their suitability to the characteristics of the customer. An appropriate degree of professional competence must be ensured not only for financial salesmen but also for counter staff. The role of self-regulation is essential in this field, too. New rules are necessary but not sufficient. The renewed growth of the financial industry depends ultimately on the competitiveness of operators, on the promptness with which they grasp the opportunities offered by innovation and respond to the challenge of the everincreasing integration of the sector’s markets and productive structures, including by means of mergers. It is necessary to look far ahead. It has been clear for years that defending a local niche, a captive clientele, is no longer a winning strategy. Today, it is not even an effective means of defence. | bank of italy | 2,008 | 8 |
Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the Aspen Institute Italia International Conference 'Italy, Europe and the US - the transatlantic link and its future', Rome, 1 July 2008. | Mario Draghi: Deep interdependence – the transatlantic economy and its prospects Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the Aspen Institute Italia International Conference “Italy, Europe and the US – the transatlantic link and its future”, Rome, 1 July 2008. * 1. * * Is there still a “transatlantic economy”? How deep is the interdependence between the European and the American economies, actually? Since the preferential transatlantic link was forged with the Marshall Plan sixty and more years ago, the global landscape has been transformed. The economic distress of the European economies, especially in the countries defeated in war, implied the risk of global political instability in the face of the nascent Soviet bloc. The idea for financial aid to Europe was conceived. In December 1947 President Truman had proclaimed that “Our deepest concern with European recovery … is that it is essential to the maintenance of the civilization in which the American way of life is rooted.” For the United States, the Marshall Plan was also an investment in its own security and prosperity. And quite an economical investment at that. The first fifteen months of the Plan’s application cost no more than one month of war. 1 While America offered aid, it called on the Europeans themselves, together, to organize a plan for the reconstruction of an open Europe capable of sustaining its own growth. The American stimulus for Europe’s gradual and multilateral liberalization of foreign trade was crucial. Italy played a special role in transatlantic relations. Through the mid-1960s its trade with the United States was relatively more intense than that of the other large continental countries. America provided 14 per cent of Italy’s imports and took 10 per cent of its exports. For France and Germany these shares were at least five points lower; Germany reached the Italian level only at the end of the period. US leadership in direct industrial investment in Italy was strengthened during the 1950s. In the decades since, more than anything else the transatlantic link has meant cultural fertilization. The United States, for centuries the beneficiary of European culture, found the way to repay this debt, fecundating a war-wracked Old World not only with material aid but above all with the culture of the market, the programme of spreading prosperity to the masses, and innovative entrepreneurial approaches. The Marshall Plan’s Overseas Technical Assistance and Productivity Program was designed to boost productivity by training and the transfer of American industrial practices to western Europe. Even after the end of the Plan, US experts continued their missions to Europe as industrial consultants, and European engineers continued to visit the United States for training. A good number of Italian public administrators took advantage, including the Bank of Italy’s Salvatore Guidotti, who learned “modern” national accounts methods in Washington. A number of management schools on the Harvard pattern were founded in Italy. Two of the leading figures in the Italian industrial renaissance, Vittorio Valletta and Adriano Olivetti, were influenced by this climate. US Department of State, Office of Public Affairs, Current Development Report on European Recovery, no. 3, 1948. Today the European economic community is an established fact, the Soviet adversary has dissolved, Asia has stridden purposefully onto the world stage and other regions too are clamouring for a larger role. The economic supremacy of the United States remains, but now it must come to grips with a series of other economic power centres. How, and how profoundly, have these developments affected the interdependence between the economies on the two sides of the Atlantic? Let us examine the facts. Economic interdependence must be assessed in three respects: the real economy (trade and direct investment); the financial economy; and economic policy (reciprocal influence and cooperation). 2. Trade and foreign direct investment 2.1 On trade. First, a premise: both the US and Europe were and are still relatively “closed” economies. For the United States, foreign trade in goods represents scarcely a fourth of GDP today. The openness of today’s 27-member European Union is of about the same order of magnitude. However, this similarity conceals significant differences in trend. The United States built its internal market much earlier than Europe, in the nineteenth century; and even in the 1950s and 1960s American foreign trade was much more modest than now, accounting for just one tenth of GDP. The dynamics was very different. The US were a closed economy with a predominant internal market until recently. The single countries of Europe were much more open versus the US than vice versa before European integration. As this took off the ground, the internal market replaced external trade. America’s “discovery” of the importance of the world around it is historically recent. It has been fostered by globalization and spurred by the deficit of domestic saving. But the secular dominance of the US domestic market makes American firms and policymakers alike primarily inward-looking. Europe does still consist of sovereign states, but every one has a strong propensity for foreign trade, historically rooted both in corporate strategies and in economic policy philosophy. A good part of that propensity has been channelled into the relatively recent phenomenon of an opening up of national markets to bring them together in one single market. Transatlantic trade nevertheless remains the largest component of both areas’ external economic dealings. In 2007 each side took about a fifth of the other’s exports; the United States supplied 12 per cent of Europe’s imports, Europe 18 per cent of America’s. These shares are still large, but smaller than just a decade ago. They have been lowered by the emergence of major new trading powers outside the Atlantic area. 2.2 In the flow of productive capital too, the once very close interdependence between Europe and the United States has been affected by the emergence of major new countries that both receive and make foreign direct investments. However, the figures on the stock of investment – which reflect the past and not, like flows, only the present – paint a picture of still intense interdependence. Today as thirty years ago, the United States and the European Union are the greatest sources of foreign direct investment in the world, the origin of 70 per cent of the world stock. They have been and still are highly attractive for foreign investment. Despite the competition of the emerging economies, they are host to 60 per cent of the world’s outstanding foreign direct investment. The interdependence between them is evident. The value of American capital in Europe and European capital in America now amounts to nearly one trillion euros. Italy’s overall foreign direct investment has been marginal, with annual flows amounting to just 2 per cent of our GDP on average in the past 10 years, far below the levels recorded in Germany, France or Spain. FDI in Italy have averaged 1 per cent of GDP, as little as in Germany, against over 3 per cent in France and Spain. 3. Finance In the financial sphere, the interdependence between the two sides of the Atlantic is harder to isolate. Certainly, the American model deeply influenced developments in the financial services industry and its legal infrastructure in Europe. But finance is now global, not only transatlantic. In the past 20 years the financial markets of the main advanced and emerging countries have become more and more closely integrated, in response to technological progress and liberalization. Physical production too has played a role. Today, the components of many industrial products are ordinarily made in one country, assembled in another, and then sold throughout the world. This unbundling of production requires high international capital mobility; but the global financial opening has far exceeded that of foreign trade. The co-movement, on a world scale, of national stock exchange indexes and bond yields is empirically significant. Since the 1990s until now, the price variability of a stock has been better explained by the company’s industry than its country. Transatlantic ties are less visible in today’s global financial system than in the past. Good examples are foreign exchange dealing and portfolio investment. The dollar and the euro are still the most heavily traded currencies, being involved in 86 and 37 per cent of the exchange rate transactions, respectively; but the share of the emerging currencies is rapidly rising, and it is now equal to nearly 20 per cent. Europeans still own more than a third of all the US stocks and bonds held by non-residents, but emerging-country investors are moving up rapidly. The portion in Chinese hands has quadrupled since the turn of the decade to almost 10 per cent, owing above all to China’s build-up of foreign currency reserves. That of investors from Latin America has doubled to over 6 per cent. 4. Economic policies Taken all together, the stylized facts I have set out so far make a composite picture. Transatlantic links are still important, but less than in the past, in a globalized and polycentric world. In the field of economic policy, however, they remain today more than ever the centre of international relations. The economic and financial governance of the world rests on a delicate balance between competition and cooperation. The global economy sprang from the success of a model of “democracy and market” that now – admittedly, differing in extent and varying in mix – inspires a growing number of national systems around the world. The first and leading purveyors of this model since World War II have been the United States and Europe. And it is still up to them to set the example of good, fruitful cooperation. Two major questions are on the order of the day: free trade and international monetary and financial stability. 4.1 Free trade is under fire today as it has never been since the 1980s. The 2001 Doha Round of talks for further liberalization has stalled. There is widespread disillusion and alarm over globalization. The task facing governments is not an easy one. The prices of essential goods are rising, the purchasing power of wages and salaries is decreasing, the tranquility of savings is being threatened. And it is true that the fruits of the globalized economy have been distributed unequally among the different social groups. Public opinion is bewildered by a confused world; in the crisis citizens seek reassurance. I understand that governments rediscover the value of protectionist formulas. Freedom of trade may appear a risk, protectionism a form of relief. But problems of income distribution cannot be solved by drying up one of the main sources of income. Both sides of the Atlantic have an interest in preserving a climate propitious to the orderly growth of international trade and investment, based on a set of rules that are above all equitable. The main emerging countries, which have benefited so greatly from global integration, should undertake more substantial commitments to open their markets and accept stricter international rules. Also it is hard to imagine that the transatlantic partners would not be able to find a compromise solution involving a balanced reduction of European import tariff barriers and US farm subsidies. 4.2 In recent months, we have been engaged in assessing the risks and malfunctions of financial innovation and integration. Financial instability has revealed, among other major flaws, serious regulatory inadequacies. Since the onset of the crisis, the G-7 Finance Ministers have asked the Financial Stability Forum to review existing regulation with a view to making the global financial system more resilient to future shocks. The FSF Report was endorsed by the G-7. It addresses the perverse incentives that have produced a level of leverage both excessive and misperceived, and introduces new capital and liquidity requirements. On the foreign exchange front, the dollar, in spite of its present weakness, remains the currency of the world’s largest economy, with deep, open and liquid financial markets and a central bank with a firmly established reputation for independence. Today, however, these same qualities can be claimed by the euro and the area that has adopted it as single currency. Already the euro is widely used internationally for commercial invoices and as currency of denomination of debt instruments. Since 1999, for instance, the share of instruments denominated in euros has risen by more than 10 percentage points to over 30 per cent of the world total; that of the dollar stands at 44 per cent. For the time being the currency is still mainly regional, its use outside the area being largely confined to bordering countries. But the premises would appear to be in place for an extension of its international role in both trade and finance. The transatlantic link is extremely precious and must be cultivated at the policy level. New prospects will open up shortly. To overcome today’s challenges, it will be necessary for objectives to be shared and decision-making to be based on solidarity. The United States and Europe, more closely united, are a guarantee for the world’s stability. | bank of italy | 2,008 | 8 |
Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, 22 August 2008. | Mario Draghi: The current crisis and beyond Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, 22 August 2008. * * * More than a year into the most challenging financial crisis of our times we now face a complex and interlocking combination of rising inflation, declining growth, tightening credit conditions, and widespread liquidity tensions pervading the world financial services industry. Authorities are using a range of tools at their disposal to address these challenges. But this crisis has shown, together with the lack of private sector discipline and weaknesses in the regulatory framework, some novel interrelations that call for action on all these fronts concurrently, and this further complicates our tasks. And yet, as we develop responses to these challenges, we also need to step back and consider how we have arrived at where we are. At a very general level it is now becoming apparent that the transformation undergone by the financial services industry in the last few years has not been fully appreciated in its implications for monetary and regulatory policy making. As was well said by Adrian and Shin in the paper presented this morning, this has been the first post-securitization crisis. Low interest rates and volatility have boosted the size of both regulated and unregulated financial institutions’ balance sheets and their leverage during a long period of time. But of course not all of them were able to withstand a sudden change in financial conditions amplified by the accumulated leverage. Market participants failed to soundly manage, measure and disclose risks, with ignorance, greed or hubris playing their customary roles. But that is where, with the benefit of hindsight, regulators should have stepped in responding to the externalities imposed on the financial system by weak financial institutions, the agency problems that foster excessive risk-taking by financial firms and investors, and the collective action problems in such areas as investment in risk management capacity and infrastructure, in market infrastructures, in the maintenance of market liquidity and, above all, transparency. Still more broadly, reviewing our experience of the past two or three decades, one is struck by the repeated tendency of the financial system to build up risk and leverage over a series of years, then turn and shed risk rapidly and indiscriminately. While the assets and agents involved and the triggering mechanisms differ from one cycle to the next, the cycles have tended to produce significant deadweight costs and distortions in the real economy, both during the upswing and during the subsequent retrenchment, and this is especially significant the more the financial system is leveraged. While we cannot and would not want to eliminate the bouts of optimism and pessimism that are part of human nature, we must address some of the pro-cyclical implications of our own policy making. The conviction of the FSF, called a year ago by the G7 to draft the first report in response to the crisis, is that, due in part to a perverse set of incentives, leverage had reached a level that was both excessive for the risk management capacity of many institutions, and misperceived in its real entity. Therefore, improving the incentives in the system so that risks are appropriately managed and risk control frameworks keep pace with financial innovation; improving the resilience of the system to shocks, whatever their source; and introducing frameworks for dampening the cyclicality of risk-taking, have become the cornerstones of our work plan. Our aim should be to produce a system more immune to the perverse incentives that we have seen, where leverage is lower, and where the sources of leverage and their associated risks are better identified and addressed. Regulatory and supervisory changes will need to go hand-in-hand with enhanced transparency about risk exposures and valuations throughout the system. Let me start with actions to improve incentives. Under the umbrella of the FSF, and in a collaborative effort of national and international regulatory and supervisory authorities, we urged prompt implementation of Basel II, which will align capital requirements more closely to banks’ risks (and I will have more to say about this in a moment). We also recommended strengthening Basel II with respect to capital charges for credit risk in the trading book, for resecuritised assets, and liquidity lines for off-balance-sheet vehicles. We encouraged the Basel Committee to strengthen liquidity management practices and buffers. We have called on financial institutions to align compensation better with long-term, firm-wide profitability, and recommended a range of measures to discipline the practices of credit rating agencies and to reduce regulatory reliance on ratings so that investors engage in proper due diligence rather than relying exclusively on ratings. We also set out several recommendations to enhance transparency and valuation practices. We outlined “leading practices” for disclosures by financial firms, and urged financial institutions to use these as part of their financial reports starting in mid-year 2008. The International Accounting Standards Board, in response to a proposal by the FSF, has initiated a process to develop improved guidance on the valuation of illiquid instruments and related disclosures. We have also called on accounting standards setters to overhaul standards for asset de-recognition and consolidation of off-balance sheet vehicles. And we recommended that securities market regulators address incentives problems in the securitisation chain and work to expand information for investors on securitisation products and their underlying assets. These measures should improve the ability of investors and others to track the risks taken by financial institutions, and thereby increase the effectiveness of market discipline. The progress already achieved testifies to the importance we as financial authorities attach to a stronger framework of regulation. Not only has a consensus been built internationally and cross-sectorally on what is needed, but the process of policy development and implementation is moving forward in coordinated and consistent fashion – and faster than we ever experienced in the past. To illustrate: • Supervisors proposed in July new capital requirements for credit exposures in banks’ and securities firms’ trading books and will set out later this year adjustments to capital requirements for “re-securitisations” and short-term liquidity facilities. • In May, the Basel Committee issued revised guidance on liquidity risk management that materially raises standards for sound liquidity risk management and measurement – including requiring banks to maintain a robust cushion of unencumbered, high quality liquid assets as a safeguard against protracted periods of liquidity stress. • IOSCO and the SEC has set out fundamental changes to its requirements on credit rating agencies to address the quality of ratings, as well as proposals concerning how ratings are used in regulatory guidelines. • Regarding transparency, over this summer, the larger banks have been using our recommended disclosures to provide expanded information on their risk exposures and valuations. • And the IASB is making good progress on new guidance and revised standards for valuations and off-balance sheet entities, which we expect to see in the next few months. There are many other initiatives underway, alongside complementary efforts in the private sector. We welcome the recommendations, along with accountabilities, that have been set out by the Institute of International Finance (the IIF), the Counterparty Risk Management Policy Group, and the American and European Securitization Forums. The key challenge for us as authorities will be to remain engaged in seeing these and other reforms through, particularly given the short-term challenges we face. Regulatory changes will need to be phased in over time to avoid adding to the adjustment challenges the system faces now. But there should be no stretching of timetables for enhancing disclosures, including of off-balance sheet positions, as this is essential to repairing market confidence. Even if we do succeed in rectifying the incentive problems that have tended to generate excesses, our financial system will not be spared risk management failures, shocks and disruptions in the future. This calls for strengthening the system’s resilience, in terms of both a better financial infrastructure and stronger shock absorbers in financial institutions. At the level of the infrastructure, a resilient system is one that is able to withstand the effects of the failure of a large financial institution. By reducing the centrality of any one institution to the system’s stability, stronger infrastructure should also contribute to reducing moral hazard. A critical priority in this area is to address weaknesses in the operational infrastructure of over-the-counter derivatives markets, and the work undertaken by the NY Fed to this extent should be commended by all the jurisdictions. It is also imperative that we strengthen national and cross-border crisis resolution frameworks so that we can allow weakened financial institutions, including large ones, to fail without putting the remainder of the system at risk. In addition to national reform efforts in a number of countries, work is underway in the FSF and the Basel Committee to strengthen cross-border cooperation and contingency planning among authorities in responding to crisis. At the level of individual institutions, improving resilience means ensuring that capital and liquidity buffers are large enough to enable firms to resist external shocks – without mandating buffers at a level that impedes efficiency and encourages regulatory arbitrage. The issue is quite complex, because both the actual and the appropriate size of a buffer shift over time depending on the market and systemic environment. With regard to capital buffers, it is not yet clear how required, desired and actual capital levels will evolve over a full cycle under Basel II, but a framework is now in place for tracking and assessing this. Regulatory minima are one of several inputs into firms’ capital decisions. Banks have made significant efforts to raise new capital to meet anticipated needs relative to regulatory minima as well as to respond to the need to reassure markets. Banks clearly see a benefit to maintaining capital significantly above regulatory minima, and markets (including rating agencies) reward them for healthy capital levels. One reason, among others, that banks maintain this margin is underlying uncertainty over risk exposures, valuations and earnings prospects. When as at present this uncertainty increases, the margin required by the market also rises. To a degree, this is unavoidable. But to reduce the tendency that market reaction lead banks to raise capital (or reduce exposures) to possibly inefficient levels in a systemic crisis, we need a more robust ex ante framework of transparency about risk exposures, along with provisions, margins and reserves for valuation uncertainty, than we have at present. The appropriate size for liquidity buffers is even harder to mandate, or to predict, than for capital buffers, given the unpredictable nature of shocks to market and funding liquidity, and the understandable reluctance of monetary authorities to create perfect certainty about when and how they will provide emergency liquidity. But, as with capital, greater ex ante transparency about banks’ liquidity risk management frameworks, cushions and supporting arrangements should help reassure investors and counterparties and reduce the risk of sudden drains on liquidity, as well as the uncertainty that, over the past year, has led to wide and volatile liquidity premia in interbank funding markets. As we consider how to strengthen buffers, more thought needs to be given to how to promote higher buffers above the regulatory minimum in good times, and more flexibility for the system to make use of these buffers when they are comfortably above regulatory minima. Both the banks themselves and their counterparties should be more confident about the banks’ ability to draw on such buffers in bad times. Banks will only be willing to do this if they do not fear they will be punished by the market – which brings us back to the importance of transparency improvements. If banks can credibly assure markets and their regulators that risks to their asset values and earnings prospects are being soundly managed and contained, then they may be able to survive a temporary decline in capital levels, while still above their regulatory minimum, during cyclical downturns. Authorities will be closely monitoring banking conditions to inform decision on the best timing for introducing tighter capital requirements. We will not unduly burden financial institutions during the adjustment phase, but also not miss the opportunity of the next calm phase in financial markets to strengthen the structure of the financial system. Pacing regulatory changes, but firmly committing to them, will contribute to reducing the potential for cyclicality in the system to be deepened by regulatory capital requirements. There is no shortage of ideas around for how the capital regime might be modified to dampen potential pro-cyclicality. Some have suggested that a regime that adjusts regulatory minima with the cycle could help reinforce the message that buffers need to be built up in good times and are there to be used when a rainy day arrives. To a degree, this is already possible under the second pillar of Basel II. However, too much divergence in national implementation of pillar 2 would raise issues of transparency and consistency in international regulatory arrangements and should therefore be constrained. To be credible, a discretionary system would need to be limited in its scope, fully transparent, and broadly consistent across countries; ad hoc, uncoordinated reductions in required minima could be viewed as forbearance and could give the wrong signal about authorities’ judgement as to the overall strength of the system. It may also be possible to give more attention to the mix of capital instruments supporting banks’ risk exposures. There may be scope to enhance the quality of capital during strong economic conditions. A complementary policy aimed at strengthening buffers could look at mechanisms to automatically increase bank equity levels in bad times, such as reverse convertible debentures proposed by Flannery or the insurance scheme proposed by Kashyap, Rajan and Stein. Although many issues of security design would need to be addressed for these instruments to effectively discipline banks, generate adequate investor demand, and to be reliably collected on when bad states occur, these mechanisms could potentially reduce the bad-signal problems associated both with discretionary changes in minima and with capital-raising efforts by the banks themselves. A necessary complement would be a disclosure framework for risk exposures and valuations that prevents the market taking conversion events or the resort to insurance as a trigger for a broader downgrade of the system’s future prospects. Strengthened capital and liquidity buffers and improved incentives to assess and manage risk should all help reduce the pro-cyclicality of the financial system, and, in the new configuration of the financial services industry more than ever, help monetary policy to attain its traditional objectives. But should monetary policy itself embody in its objective function the health of the financial system? As Chairman Bernanke and others have noted, we cannot afford to ignore the health of financial markets when setting monetary policy. It would be difficult to disagree with this statement, and we should try to make it operational considering however that its application may have different degrees of intensity. We should certainly use the monetary and credit aggregates that give the best projections of financial conditions for a given structure of the financial services industry. But how to go beyond that is a matter of considerable complexity. Though I share the importance of the policy goal, it should be clear that how to define the objective function is not only analytically difficult, but it would also pose serious institutional challenges. For a central bank whose primary mandate is to preserve price stability alone, introducing financial stability as an additional objective could introduce a trade-off where none exists today. Indeed, at times of extraordinary volatility and dramatic risk re-pricing, maintaining price stability could be the best contribution that monetary policy could give to the return to financial stability. The same remains true during peaceful times, when prolonged periods of double digit growth in several credit aggregates should call for action to protect future price stability even if in absence of an immediate danger. Second, I can only point at the difficulty of having a framework that is as clear and measurable as the one we have today for our monetary policies. But where I see the greatest difficulty is in the amount of information that would be needed in order to run a monetary policy having financial stability among its objectives. In other words, we would have to know about both the regulated and the unregulated parts of the financial services industry as much as we know about inflation and output. Of course this would also be the area where, were we to move in this direction, the benefits from enhanced transparency and interactions with regulatory policy would be greatest. In conclusion, the next few years are likely to be ones of low risk-taking and progressively low leverage, as financial institutions and households repair their balance sheets and as internal and external macroeconomic imbalances are resolved. These adjustments will not be painless, and ensuring that they take place in an orderly manner will pose substantial challenges for policymakers: Preserve price stability while supporting growth, and continue injecting liquidity as needed by an industry that is still far from having resolved its problems, at a time of strong inflationary pressures and tightening credit conditions. In such a situation, monetary policy cannot be the only, or even the main tool for reflating the economy and the financial system. Fiscal policy will have a key role to play, in its various configurations. But equally important would be to recreate an environment where banks during this current transitional period were both able and willing to use their buffers to lend, and capital markets were able and willing to fulfil their functions. For this to happen, the uncertainties about risk exposures and asset valuations, about developments in the real economy, about the strength of financial, corporate and household balance sheets need to be adequately addressed. This implies a central role for improved transparency as well as action by the private sector to repair balance sheets and strengthen the functioning of markets. | bank of italy | 2,008 | 9 |
Lecture by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, at the 5th Bundesbank Lecture, Berlin-Brandenburgische Akademie der Wissenschaften, Berlin, 16 September 2008. | Mario Draghi: How to restore financial stability Lecture by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, at the 5th Bundesbank Lecture, Berlin-Brandenburgische Akademie der Wissenschaften, Berlin, 16 September 2008. * * * As this crisis hits its first anniversary, it has evolved into an even more complex combination of rising inflation, declining growth, tightening credit conditions, and widespread liquidity tensions pervading the global financial industry. Banks have raised a significant amount of capital to partly offset writedowns and credit losses. But they are now moving into a phase where credit losses in the banking book will begin to rise. And banks are entering this phase with weakened balance sheets. Alongside a rise in credit related losses, the outlook for bank profitability is poor. The aggregate amount of capital in the system is great enough, under reasonable scenarios, to prevent the system as a whole from falling below regulatory thresholds. But the distribution of that capital obviously matters. And, for larger banks, the capital levels demanded by the market have gone up in response to the greater uncertainty and reduced transparency about their balance sheets. We estimate that banks are likely to need to raise at least once again the amount of capital raised since the crisis began. There are various reasons why some banks will be struggling to reach those levels. That is especially the case for the banks that ran the debt-financed, highly leveraged and maturity mismatched business model that provided steady fee income over the last several years. Now their profitability looks impaired, and their desired deleveraging is likely to be happening through a reduction of new lending. Capital increases are especially difficult in a situation of deteriorating stock markets where falling equity prices nullify the still significant efforts undertaken to delever banks’ balance sheets. This has spurred increasing recourse to hybrid capital instruments, but these may raise in the future concerns about the quality of the capital raised. Let me finally observe that the situation of the banks in the Euro area is so far better than the one we are witnessing in the US and in other jurisdictions. As the crisis unfolds policies are taking a variety of shapes that can be grouped within two broad categories: emergency and structural responses. Until now, the first remained typically national since each crisis was unique to the financial structure of the country and so were the remedies. However, if the crisis were to become systemic – and the past weekend has shown just how sudden and dramatic the turn of events can be – I believe that an internationally coordinated effort will be necessary. On the other hand, it was immediately clear that the structural response that would lay out the foundations for a more resilient financial system in the years to come could not be other than internationally coordinated. It is primarily to this effort that the Financial Stability Forum (FSF) has been called to respond by the G7. The FSF – brought into being by Hans Tietmeyer in 1999 – brings together national financial authorities (central banks, supervisory agencies, and finance ministers) from large international financial centres as well as bodies such as standard setters and international financial institutions, giving it a unique capacity to give impetus to and facilitate coordination among these bodies. Our conviction is that misaligned incentives in several areas of the financial services industry weakened lending and underwriting standards, particularly but not exclusively in the United States. At a more general level, innovation and complexity outstripped banks’ capacity to manage key risks – including funding and liquidity risks, concentration risks, reputational risks, legal risks and warehousing risks. Investor due diligence was poor and reliance on credit ratings unquestioning. Institutions accumulated a level of leverage that was both misperceived and excessive. The initial spark set off by the U.S. subprime downturn fed on these much broader weaknesses, causing the dramatic loss in confidence and liquidity in financial markets that we have seen. This explains why initial losses that might have been insignificant are having such meaningful consequences on the real economy in both Europe and the U.S. The financial system that will emerge from this crisis will be one that operates with less debt and more capital, should be immune to the set of perverse incentives that are at the root of the crisis, and should be such that the risks are better assessed and identified. In the end, while avoiding over-regulation that would stifle innovation, the reform process will re-draw the balance between market discipline and regulation. The FSF report, which was endorsed by the G7 ministers and central bank governors in April this year and has been made public, draws on an extensive body of work by national authorities and the main international supervisory, regulatory, and central bank bodies. A key strength of this report is that it contains recommendations that have been agreed by those that have the authority and commitment to implement. Another key strength is that it aims at correcting the identified weaknesses while preserving a level playing field across countries. A well-defined process is in place for following up on implementation, comprising who does what and by when, and how progress is to be monitored and reported. A comprehensive follow-up report will be presented to the G7 next month. Our recommendations were in the following key areas: • Strengthening the prudential framework for banks, including with regard to capital, liquidity, risk management and market infrastructure; • Strengthening the framework for transparency and valuation; • Changing the role and uses of credit ratings; and • Enhancing the authorities’ responsiveness to risks and our co-operation in dealing with weak banks. Progress in taking forward implementation of these recommendations has been remarkable. To name a few examples: • Supervisors proposed in July new capital requirements for credit exposures in banks’ and securities firms’ trading books and will set out later this year adjustments to capital requirements for “re-securitisations” and the short-term liquidity facilities that funded off-balance sheet conduits. • In May, the Basel Committee issued revised guidance on liquidity risk management that materially raises standards for sound liquidity risk management and measurement – including requiring banks to maintain a robust cushion of unencumbered, high quality liquid assets as a safeguard against protracted periods of liquidity stress. • Over summer, IOSCO and the SEC set out fundamental changes to their requirements on credit rating agencies to address the quality of ratings, to expand the information they provide, as well as proposals concerning how ratings are used in regulatory guidelines. • Regarding transparency, the larger banks have implemented our recommended disclosures to provide expanded information on their risk exposures and valuations of problem assets, on and off the balance sheet. • And the IASB is making good progress on new guidance and revised standards for fair valuations when markets are illiquid, and for consolidation of off-balance sheet entities, which we expect to see in the next few months. On the private sector front we welcome the recommendations that have been set out by the Institute of International Finance (the IIF), the Counterparty Risk Management Policy Group III, and the American and European Securitization Forums. The industry’s involvement in drawing lessons from events has heightened the understanding of market participants of the need to redraw the balance between unfettered markets and regulation. Some of the regulatory changes that I have discussed will need to be phased in over time to avoid adding to the adjustment challenges the system faces now. However, there should be no uncertainty about the authorities’ determination to implement the program of actions that has been internationally agreed. And there should be no stretching of timetables for enhancing disclosures, including of off-balance sheet positions, as this is essential to repairing market confidence. No financial system will be free from crisis whatever the rules of the game. The fundamental task for authorities is therefore to enhance the resilience of the financial system to shocks and disruptions whatever their source, with a view to minimising the knock-on effects elsewhere. At the level of the financial system as a whole, a critical element is the infrastructure of payment and settlement systems, and the body of contract documentation and market practices that underpin financial activity. A resilient infrastructure is one that is capable of withstanding the effects of the failure of a large financial institution. As we speak this objective is being tested by reality. By reducing the centrality of any one institution to the system’s stability, a stronger infrastructure also contributes to reducing moral hazard. A critical priority in this area is to address weaknesses in the operational infrastructure of overthe-counter derivatives markets. The work undertaken by the NY Fed to this end should be commended by all the jurisdictions. The objective of this work is to move the OTC derivatives markets on to a platform where trades can be captured and settled in an orderly way. It is also imperative that we strengthen national and cross-border crisis resolution frameworks so that we can allow weakened financial institutions, including large ones that operate across borders, to be wound down in an orderly manner. This is an area where the mismatch between what we need to have in place, and what is in place, is large. In addition to important national reform efforts in a number of countries, work is underway in the FSF and the Basel Committee to strengthen cross-border cooperation and contingency planning among authorities in responding to crisis. At the level of individual institutions, improving resilience means ensuring that capital and liquidity buffers are large enough to enable firms to resist external shocks – without mandating buffers at a level that impedes efficiency and encourages regulatory arbitrage. The issue is quite complex because both the actual and the appropriate size of a buffer shifts over time depending on the market and systemic environment. Both the markets and regulatory authorities affect the level of capital and liquidity buffers institutions maintain. A key issue, which is particularly relevant in the current period of adjustment, is the ability of banks to use capital levels above the regulatory minimum during adverse conditions. What we have seen is that higher cushions above the regulatory minimum become a new de facto market requirement. Indeed, banks’ efforts to raise new capital in the past year have been not just to meet regulatory minima but also to respond to the need to reassure markets. This is, at least in part, because of festering uncertainty over risk exposures, valuations and earnings prospects. Some of this uncertainty is inevitable – for example, terminal values for securities backed by US housing loans cannot be determined as long as the US market continues to fall. But it is clear that we need a much more robust ex ante framework of transparency to reduce the tendency that market reaction lead banks to raise capital (or reduce exposures) to possibly inefficient levels in a systemic crisis. If banks can credibly assure markets that risks to their asset values and earnings prospects are being soundly managed and contained, then they may be able to survive a temporary decline in capital levels when needed, while still remaining above their regulatory minimum. As the above illustrates, the recent turmoil has raised fundamental questions about the nature of procyclicality, its impact on financial stability, and the feasibility of policies to address it. This brings me to two areas that I believe merit further attention on the part of policymakers going forward: • First, is there a role for the official sector to address procyclicality as a source of financial instability? • And second, should monetary policy embody in its objective function the health of the financial system? Reviewing our experience of the past two or three decades, one is struck by the repeated tendency of financial systems to build up risk and leverage in good times, then shed it rapidly when conditions change. While the assets and agents involved and the triggering mechanisms differ from one cycle to the next, the cycles have tended to produce significant deadweight costs and distortions in the real economy, both during the upswing and during the subsequent retrenchment. This is especially significant the more the financial system is leveraged, as we have seen in the past year. While we cannot and would not want to eliminate the bouts of optimism and pessimism that are part of human nature, we must address some of the pro-cyclical implications of our own policy making. We decided not to address procyclicality per se in our April report (although some of the recommendations touch on it) because of the urgency of making concrete recommendations in other areas. But now it is time for us to return to this topic. As in the areas that I described earlier, the goal will be to strengthen the resilience of the system without hindering the process of market discipline and innovation that are essential to the financial sector’s contribution to economic growth. There is no shortage of ideas around for which aspect of procyclicality is most relevant for financial stability, and for the range of policy options that could help dampen procyclicality. Some of the areas that we in the FSF have decided to look at include: • The capital regime: the Basel II framework ties required capital more directly to the perceived riskiness of an asset, which is likely to increase during downturns and fall during expansions. This is not new, but because Basel II itself is new there is more we need to know on the mechanics – it is not clear yet, in particular, how required, desired and actual capital levels will evolve over a full cycle under Basel II (although a framework is now in place for tracking and assessing this). As we consider how to strengthen the regime, more thought needs to be given to how to promote higher buffers above the regulatory minimum in good times, which can then be dipped into more flexibly during cyclical downturns. To a degree, this is already possible in a discretionary way, although too much divergence in national implementation of Basel II would raise issues of transparency and consistency in international regulatory arrangements and should therefore be constrained. Ad hoc, uncoordinated reductions in required minima could be viewed as forbearance and could give the wrong signal about authorities’ judgement as to the overall strength of the system. How we can best dampen procyclicality in bank capital is an inquiry we are now engaging internationally and in the European context in a coordinated fashion. • A related issue is sound loan-loss provisioning: these are useful tools to counter the effects of procyclicality, especially on new lending. However, our banking systems came into this crisis with historically low levels of provisions. To a degree, this can be attributed to the benign recent default environment. But it also reflects new accounting principles and prudential rules, the effects of which we need to assess in the light of experience. Our aim must be to create scope to promote more throughthe-cycle provisioning techniques that place institutions in a position to absorb losses rather than curtail credit during a downturn. • Compensation issues – these have been much in the public eye recently: do bonusbased pay systems, for both traders and senior and top management of financial firms, reward short-term risk taking with little penalty for the longer-term risks taken to achieve profits? What are the elements of a sound compensation scheme? On this issue, the interests of regulators and shareholders broadly align but banks face a collective action problem. If there is a role for regulators and supervisors in this area, is it ex ante (to adjust risk taking incentives), and/or ex post (to adjust capital to the risks taken)? • Valuation and leverage: the interplay between these has become more important over time for a number of reasons, including more marketable assets (especially credit) that need to be marked to market, more market-based collateralized funding, more leveraged position-taking. But here too there is more we need to know about the mechanics involved. What effects have valuation practices and leverage had on the cyclicality of the financial system? Acting through which channels? Is there a possible or desirable course of action for the official sector? Coming to the issue of monetary policy and financial stability – If the market turbulence tells us anything, it is that the pace of financial innovation in recent years, the volume of transaction in certain markets, the amount of embedded leverage in the system, and the global nature of finance, have transformed the functioning of the international financial system. These transformations were not fully appreciated in their implications for monetary policy making. Central banks are inherently concerned with the health of the financial system. Because of the critical role it performs – that of allocating capital and risk to the economy – a wellfunctioning financial sector is key for the achievement of primary macroeconomic objectives, such as stable prices and sustained growth; for central banks, it is also fundamental for the effective transmission of monetary policy decisions to the real economy. Contributing to the health of the financial system is, in a sense, encoded in the genes of central banks: one of the historical reasons for establishing a central bank was indeed to reinforce financial stability by having an institution that could act as a lender of last resort. The policy followed by the European Central Bank since the start of the turmoil is very much in line with this historical role. The ECB has not remained passive. It has used the tools at his disposal, in particular its liquidity operations, to support the smooth functioning of the money market in periods of acute stress. Its operational framework has proved to be robust and flexible to effectively respond to the challenge posed by the drying-up of market liquidity. However – and this is a crucial aspect of the ECB policy – we have operated under the principle of strict separation between the liquidity provision policy and the stance of monetary policy. Monetary policy, the setting of the level of interest rates by the ECB, has been directed at fulfilling its primary goal: maintaining price stability. This principle is crucial. Charging monetary policy with additional objectives, such as a direct responsibility for financial stability, would risk blurring responsibilities, increasing moral hazard and creating a trade-off where there is none. I fully agree with the remark often made by Otmar Issing that there is no lasting trade-off between price stability and financial stability. 1 Even if, as he acknowledges, some short-term conflicts may occasionally arise, this can be easily accommodated by a monetary policy strategy that focuses on an appropriate medium term horizon, as the one chosen by the ECB. Over such horizons, price stability and financial stability are mutually reinforcing, rather than alternative, goals. We should not forget that some of the most damaging and prolonged periods of financial distress (such as the Great Depression, the Japanese experience in the 90’s and many of the currency crises in O. Issing (2003), “Monetary and financial stability: is there a trade-off?” BIS paper No. 18. emerging markets in the past century) have been associated with – and sometimes aggravated by – the inability to control the inflation process. Relying on a clear separation of roles and a correct assignment of instruments to objectives is particularly important at the current juncture, as we face inflationary pressures combined with weaker economic activity and financial turbulence. It is precisely in these difficult situations that the benefits of a sound monetary framework become apparent. Only by ensuring a return to price stability in a reasonable time frame we will be able to control inflation expectations, reduce uncertainty and risk premia, sustain longer-term financing and purchasing power and thus reinforce the prospects for real activity and financial stability. The risk that a prolonged period of high inflation may destabilize expectations and become entrenched in wage and price setting requires a resolute stance in monetary policy. It is essential that other economic actors too adopt a responsible behaviour. It is also quite obvious that should current financial instability aggravate and threaten to lead to a deflationary situation, monetary policy would have to take this into account. While the role of monetary policy in the current circumstances should be clear, it is nevertheless wise, also in this field, to draw lessons from the recent experience. An important one, which relates to the topic of procyclicality I just mentioned, is on the role that unusually easy global credit conditions over many years had in the build up of the current turmoil. There is a clear asymmetry between the two phases of boom-bust cycles. While the effects of the bust phase are very visible, the building-up of imbalances in the boom phase is not easily detected. This is because there are of course many other factors – not necessarily related to imbalances – that contribute to changes in asset prices and balance sheet positions, and not all booms end up in busts. Central banks are thus easily forced into a situation where they may need to intervene after the crash, injecting liquidity to avoid a financial crisis, or even at times loosening monetary policy to avoid deflation, but remain passive during the previous phase. The problem however is that a monetary policy that limits itself to such a passive role – the so called “mop up after” policy – may increase moral hazard and plant the seeds for further and more acute imbalances in the future. The key challenge is therefore to understand whether monetary policy can or should be more proactive and “lean against the wind” also in periods of growing financial imbalances in a preemptive manner, even in the absence of immediate threats to price stability. This is an open issue on which opinions diverge. I will limit myself to the following observations. First, risk premia in equity, housing, government bonds and corporate debt markets had reached over the past ten years – with different timing – a historical minimum. They had consistently declined since the mid-eighties. There are structural reasons behind this trend: the deepening and broadening of global financial markets; and more stable policy regimes, in particular for monetary policy, leading to lower macroeconomic volatility – and therefore risk – in the last two decades (a phenomenon also known as the Great Moderation). 2 But there have also been transient, and thus less comforting, factors at work: lower volatility in the economy may have been due to “good luck”, i.e. a historically unprecedented decline in the vigour of exogenous shocks. This may have generated a false perception of safety. Most importantly from the point of view of monetary authorities, protracted low interest rates at the global level may have favoured an excessive appetite for risk, reinforcing the flawed incentives in risk management that have played a pivotal role in the recent turmoil. Indeed, the existence of a “risk taking” channel – an impact of monetary policy on either risk perception or risk tolerance – appears to have some ground in both theoretical arguments A detailed exposition of this topic can be found in J.-C. Trichet (2008), “Risk and the macro-economy” keynote address at the conference “The ECB and its watchers X”, Frankfurt am Main, September. and empirical research. 3 Again, all this is not new. From a historical perspective, accomodative monetary policy has been found to be a key factor in many cycles that ended up in crises. 4 The underestimation of risk is particularly worrying when it involves the housing markets, as participants are likely to be on average less informed and less protected against changing conditions than is the case in other markets. Protracted low interest rates associated with asset price booms – especially in housing – very low risk premia and buoyant credit growth should ring a bell to policy makers. Second, the thorough analysis of intermediaries’ balance sheets and monetary and credit developments, which the Bundesbank has championed and is now an essential part of the ECB strategy, is crucial in this field. Besides supporting the assessment on the outlook for price stability, this analysis could be an indispensable ingredient of a monetary policy aiming at a higher symmetry of response to boom-bust cycles, reducing procyclicality and moral hazard in the financial sector. Monetary analysis may be all the more important in situations of potential financial distress when it is necessary to lengthen the horizon of policy, but it is very hard to do so by means of forecasts given the complexities involved. This may be even more true if we allow for the possibility put forward by some observers, that when monetary policy is highly credible, excessive liquidity expansions may find their way first in fuelling asset price and credit booms, rather than in creating inflationary pressures. 5 The analysis of credit and money has also permitted us to form a balanced opinion on the effects the financial turmoil. While we do see a slowdown in credit growth in the euro area, this appears to be in line with the regular impact of slower economic activity and tighter policy conditions. Up to now, we have seen no signs of additional effects coming from financial tensions, and so far the capital position of banks overall in the euro area remains sound. Of course, if the crisis were to become systemic, counterparty risks could always spread all over the world. Third, I do not think that central banks possess a superior knowledge, relative to the private sector, to be able to judge whether a deviation from fundamentals is occurring in the pricing of any individual asset. Having said that, central banks – with their strong technical skills, independent judgement and system-wide, longer-term perspective – are perhaps better placed to assess systemic risks emerging from financial markets. This can prompt informed communication to the financial system and to the wider public and, at times, also monetary policy action. As it is the case in general when confronting low-probability but high-cost events, it may be optimal to choose to err on the side of caution if this helps to reduce the likelihood of future crises. 6 Fourth, as recently recognized by Adrian and Shin among others, in a market based financial system, banking and capital developments have become inseparable. 7 Through the impact it has on capital market conditions, monetary policy may have become more important in influencing the size of financial intermediary balance sheets. In this respect it could play an important role in dampening fluctuations that may lead to potential disorderly unwinding of See, among others, G. Jimenez, S. Ongena, J.L. Peydrò, and J. Saurina (2008), “Hazardous times for monetary policy: what twenty-three million bank loans say about the effects of monetary policy on credit risktaking?”, CEPR discussion paper No. 6514. C. W. Calomiris (2008), “The subprime turmoil: what’s old, what’s new, and what’s next”, paper presented at Federal Reserve Bank of Kansas City’s symposium, Jackson Hole, August 2008; Bordo, M. (2007), “The crisis of 2007: the same old story, only the players have changed”, paper presented at the Federal Reserve Bank of Chicago and International Monetary Fund conference “Globalization and systemic risk”; Chicago. Borio, C. and P. Lowe (2002), Asset prices, financial and monetary stability: exploring the nexus”, BIS working papers, No. 114. Bordo, M. and O. Jeanne (2002), “Monetary policy and asset prices: does “benign neglect” make sense?” International Finance, 5(2). Adrian, T. and H. S. Shin (2008), “Financial intermediaries, financial stability and monetary policy”, paper presented at Federal Reserve Bank of Kansas City’s symposium, Jackson Hole, August 2008. leverage. Given the interlinkages existing in the global system, today this is true not only in the Anglo-Saxon systems, but also in the more bank-oriented European context. Therefore, while monetary policy should continue to focus on delivering price stability, it should aim at a greater symmetry throughout the cycle and cannot afford to neglect the modifications and innovations affecting the structure of the financial system. We should not, however, underestimate the enormous informational challenge we have to confront. We need to improve our analyses and tools to be able to better assess the risks of a systemic crisis, quantify the effects that our actions may have to mitigate those risks and develop a deeper understanding of the two-way linkages between the financial and real sectors. In this respect, a closer interaction between macroeconomic and macroprudential analyses is essential. This requires stronger cooperation and information sharing among authorities both domestically and cross-border. Moreover, greater transparency and improved disclosure practices in the private sector are necessary to be able to fully assess the conditions of the financial system and formulate the appropriate monetary policy. In this sense, monetary policy and policies to achieve financial stability are closely linked. The crisis we are facing is one of the most severe and complex of our times. The challenges will be substantial: restore price stability that would support growth, and ensure that the needed adjustments in bank and households balance sheets and in internal and external macroeconomic imbalances take place in an orderly manner. This will require action on the monetary, fiscal, and regulatory front. It will also require decisive action by the private sector to repair balance sheets, strengthen corporate governance, and improve the functioning of markets. History has repeatedly shown that needed reforms are ignored until a crisis forces action, and that the will to reform quickly dissipates after the crisis has passed. This crisis is no different, and this is an opportunity to strengthen the structure of the financial services industry. | bank of italy | 2,008 | 9 |
Statement by Mr Mario Draghi, Governor of the Bank of Italy, at the Seventy-Eighth Meeting of the Development Committee, Washington DC, 12 October 2008. | Mario Draghi: Challenges now facing the world economy Statement by Mr Mario Draghi, Governor of the Bank of Italy, on behalf of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor Leste at the Seventy-Eighth Meeting of the Development Committee (Joint Ministerial Committee of the Boards of Governors of the Bank and the Fund on the Transfer of Real Resources to Developing Countries), Washington DC, 12 October 2008. * * * Energy and food prices and financial turmoil Today, the economies of both developed and developing nations are faced with high energy and food prices and financial distress, which are severely testing their resilience. Steady leadership, high-quality analysis, and bold answers are needed to overcome the many new challenges that now confront the development process. The World Bank has acted quickly to respond to the emergency situation created in several developing countries as a result of rising food prices, demonstrating that it is indeed able to respond effectively and in a timely manner to rapidly evolving circumstances. However, more must be done. It is now important to strike the appropriate balance between alleviating shortterm needs and longer term development goals and achieve an effective division of tasks in the international donor community. The recent financial turmoil puts an extra premium on the role of both Bretton Woods institutions as providers of financial and advisory services, and as facilitators of international dialogue. As financial authorities worldwide contemplate how to reshape existing regulatory frameworks to prevent and contain financial instability, the Bank must retain its role as a source of assistance in the allocation of limited financial resources to infrastructure and to social safety nets to promote equitable growth. Development and climate change: two complementary economic challenges We welcome the new Strategic Framework on Development and Climate Change for the World Bank Group (WBG). The launch of this strategy is a positive step toward facilitating a more prominent role for the Bank in fighting climate change. Climate change epitomizes the intricacy of development challenges in an increasingly interdependent world. Adaptation and mitigation of its effects entail not only substantial financial costs, but also inter-temporal and spatial tradeoffs in welfare distribution. Though the battle against climate change is often mistakenly viewed as being opposed to economic growth, it is, in fact, an economic and development issue in several respects. • First, climate change will increasingly affect the availability and the relative prices of productive factors, such as land, food, and energy. • Second, the impact on economic activity of unmitigated climate change and its budgetary implications are potentially significant for advanced, emerging, and developing countries alike. • Finally, environmental protection offers an opportunity for growth, not an obstacle to development. This principle should underpin economic policies in advanced and developing countries, as well as development assistance, whether bilateral or multilateral. The role of the World Bank in fighting climate change As an international organization, the World Bank is well-positioned to face the challenges of combating the effects of climate change as they relate to “global public goods.” As a financial institution, it is well suited to address the intergenerational problems that climate change poses. Finally, as a multisectoral development agency, the Bank can make use of its expertise in many policy areas and engage clients in fruitful dialogue, providing an extensive menu of customized policy options. We particularly welcome the emphasis placed by the Strategic Framework on market-based instruments and energy efficiency. In particular, well-functioning and more integrated carbon markets are not only cost-effective environmental tools, they also have the potential to foster a more cooperative stance by developing countries by providing new incentives for them to join mitigation efforts and support innovative technologies. Both Italy and the European Union are leaders in pioneering market-based instruments to address climate change. The European Trading System, while still in its early stages and with ample scope for improvement, is the world’s first trading scheme in operation. Its success has provided a benchmark for the introduction of similar schemes worldwide. The Bank can contribute positively to the promotion of more liquid and integrated carbon markets and help clients reap the gains that will result from an increased demand for environmental protection. As regards energy efficiency, we believe that policy dialogue has the potential to generate benefits for both industrialized and developing countries. The Bank traditionally has a comparative advantage in the area of energy sector reform as it can help clients pursue sustainable energy policies, establish sound regulatory systems that may mobilize additional private sector resources, and ease the financial challenges posed by climate change. Enhancing voice and participation of developing and transition countries We welcome the proposed sequential approach to enhancing “Voice” within the World Bank Group. The proposal of a single package that envisages different milestones will accelerate the Voice reform process, a process that will add to the Bank’s legitimacy and credibility by increasing the representation of its poorest members. We also believe that the World Bank Group will benefit from early adoption of those measures that already meet with broad consensus among its membership. With capital realignment being the most complex issue, we support the proposal to the Board to launch a more comprehensive shareholding structure review, setting the deadline at the 2011 Spring Meetings. We believe that the members’ relative shareholdings in IBRD should be based on the principle of relative weight in the world economy. In this vein, we also favor maintaining a link between the Bank’s shareholding and the outcome of negotiations on IMF quotas. Considering the specific mandate of the Bank, we think that contributions to IDA and Trust Funds cumulated over time should also be included in the criteria for realignment. Additionally, the underlying principle for introducing further criteria should be the preservation of the Bank’s financial soundness. The definition of broader shareholding realignment should also provide stable guidance for future review of shareholder representation. A realignment plan addressing all these issues cannot be arrived at hastily; on the contrary, it must be the result of a thorough and comprehensive process. Finally, fairness and widespread acceptability of the capital realignment plan, as well as the need for a virtuous corporate governance incentive structure, will require that the shareholdings of the most severely underrepresented members be adjusted consistently, irrespective of their classification as developed or developing countries. Conclusion Unprecedented challenges now face the world economy and require a renewed effort on the part of the Bank in the pursuit of its traditional development mission. These challenges also call for a sharper focus by the Bank, within its poverty reduction mandate, on the provision of global public goods. • The current financial turmoil has only added to the distress caused by oil and commodities price increases. At a time when the demand for IBRD loans is likely to increase, it is important that the Bank remain focused on the provision of infrastructure – both social and physical – that can shelter the poorest of this world from the dramatic impact of present and future shocks. In view of this daunting task, IBRD resources are extremely limited, requiring that careful consideration be given to avoid spreading these resources too thinly over too many objectives. A few select priorities should instead emerge from an active policy dialogue with borrowing countries. • Emerging global challenges require that the Bank recognize and clarify its role as a major actor in the protection of global public goods. This calls for a clearly framed and articulated operational strategy that includes detailed assessments of the budget and of the implications for the Bank’s balance sheet of entering these new areas of business. Confronting these unprecedented challenges requires an institution that enjoys strong governance and the full support of its membership. The Voice reform effort aims to ensure that both of these conditions are met. In this endeavor, the Bank, as a truly global institution, needs to reach out to all its members countries – borrowers and donors alike – ensuring equitable representation and a strong capital base. To achieve this goal, the Bank’s governance structure must be aligned with its characterization as a global multilateral financial institution, reassuring capital markets that its commitments are backed by high-grade callable resources and that its products address development needs otherwise unmet. Today, important steps are being taken to meet these conditions, and we trust President Zoellick to successfully steer the institution in the direction that the WBG’s global membership has indicated and endorsed at this meeting. | bank of italy | 2,008 | 10 |
Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the "Europe and the Euro" Conference, NBER-Bocconi University, Milan, 17 October 2008. | Mario Draghi: Financial stability and growth – the role of the euro Speech by Mr Mario Draghi, Governor of the Bank of Italy, at the “Europe and the Euro” Conference, NBER-Bocconi University, Milan, 17 October 2008. * * * To anticipate the thrust of my discussion today, I will concentrate essentially on two themes: 1. First, the euro has proved to be an invaluable asset for our economies. The benefits of the European single currency are crystal clear at the current juncture, while we are facing the most dramatic financial crisis of the last several decades. The common currency has been an essential element of stability. The advantages, however, are not confined to this role: the euro has also been a catalyst for fundamental and positive changes in the real economy, some of which are already very visible. 2. Second, much remains to be done to fully reap the benefits of the single currency. And in my opinion, what is left to be done goes very much in the direction of more – rather than less – integration of our economies. There are measures that may be taken to achieve this goal in many areas and, foremost, in the field of regulation. 1. The euro and the financial crisis To start with, it is quite easy for me to speak of the benefits of the euro in relation with the current crisis. There are several aspects I should like to consider. A first theme relates to the emergency responses to the crisis. As it has been emphasized, in academic publications and in the press, the current turmoil presents both similarities and differences with respect to earlier financial crises, in particular the crisis that led to the Great Depression in the 1930s. As in the past the crisis is marked by a loss of confidence by investors and the public towards key financial institutions and markets. Often in the past, the response of policymakers was marked by uncoordinated actions, and in some case, very serious mistakes, in the provision of liquidity, in the management of exchange rates and trade policies, in the insufficient scale of the interventions needed to support banks. Exchange rate volatility and associated beggar-thyneighbor policies were an important step along the road leading to the Great Depression. Today the situation is clearly different, and we do have some tangible advantages in dealing with the crisis. First, the existence of a common currency in Europe ruled out the possibility of destabilizing movements of intra euro area exchange rates in response to the financial shocks, which would have greatly complicated the response to the crisis. Second, the existence of EMU, by supplying a common currency, a common liquidity policy across Europe, a forum in which the issue of coordinating economic policies can be more effectively discussed and solved, is also crucial. In the immediate aftermath of the crisis, the ECB was quick and flexible to respond to the challenge posed by the drying-up of market liquidity. The Eurosystem’s operational framework has proved adequate to allow rapid and far-reaching decisions and a timely management of the initial stages of the crisis, and flexible enough to deal with the evolving situation, smoothly incorporating any required amendments. We have increased the amount of liquidity provided, lengthened the maturity of operations, set up a facility to offer liquidity in dollars in agreement with the Fed. In the last weeks, we stepped up our effort to normalize the dislocated money market, by deciding some further, and more profound, changes to the operational system. We have narrowed the corridor of monetary policy, shifted to a fixed rate tender with full allotment and enlarged the collateral that can be used by participants. We do not have a counterfactual, but I would argue that some of the pre-EMU national systems would have been put to a hard test by the recent events. The existence of a common liquidity policy proved effective in avoiding that uncoordinated national initiatives open the way to cross-border arbitrage and to undesired spillovers that could have further amplified the turbulence. More generally, in the presence of a systemic crisis and with closely integrated financial markets, the appropriate policy response needed to be coordinated, not only across European borders, but also beyond the euro area. The unprecedented policy move decided jointly by the main central banks of the world on 8 October is a case in point. Coordination on such a scale may have been very hard in the old days. Finally, the worsening of the turmoil since the beginning of September posed new challenges to policy makers of the euro area, calling for prompt action. At first, the severity of the crisis induced some national governments to take autonomous steps to restore confidence, but this proved insufficient, signaling very strongly the need for a coordinated action at the European level. The agreement of October 12 on a concerted European plan of action setting the guidelines for interventions aimed at restoring confidence in financial markets has been a fundamental step in the management of this crisis, not only at the European level, but also globally. Our ten year experience in sharing a single currency and monetary policy proved to be a solid foundation for a common and timely response to the emergency, providing strong support for a coordinated action of governments and central banks. A second theme relates to how we should act to limit the credit crunch. In the current situation the possibility that the tightening of credit conditions and the cyclical downturn reinforce each other in a vicious spiral represents the main risk for the global economy. In this respect, restoring the smooth functioning of the interbank markets globally and within the euro area is a precondition to ensure the stability of credit flows to households and firms, thereby minimizing the real impact of the financial turmoil. The policies adopted so far, including the changes in the operational framework I just mentioned, the lowering of monetary policy interest rates, the efforts of governments to recapitalize distressed institutions have been all essential to avoid a major financial disruption. However, while some progress is visible, their effect on interbank interest rates has so far been limited and slow to build up. Liquidity and counterparty risks continue to be major drivers in money markets, which remain impaired with abnormally high spreads between secured and unsecured lending. In the weeks ahead, an additional support can come from the implementation at the national levels of the decisions agreed at the European level, including the recapitalization of banks and the possibility to make available, for an interim period and on appropriate commercial terms, governments’ guarantee, insurance, or other similar arrangements of new bank senior debt issuance. While some degree of flexibility to adapt to local conditions must be preserved, it is also of the utmost importance that the actual implementation of the new measures proceeds in a coordinated manner, so as to avoid creating any segmentation in markets or uneven conditions for financial institutions across Europe. At the same time, we cannot rule out that further and even bolder steps may be needed in the near future to quickly restore confidence, including actions to strengthen interbank markets. A final theme relates to the efforts to reshape the rules governing the global financial system, in a more structural and medium term perspective. In this field, it was immediately clear since the beginning of the crisis that the structural response had to be internationally coordinated. This was the task assigned by the G7 to the Financial Stability Forum (FSF). The line followed by the FSF is that financial intermediaries in the future will need to have more capital and less debt, be more transparent and be subject to more effective rules. Several important actions are being undertaken at the international and national level – largely following the FSF’s proposals – to reinforce capital requirements and the management of credit and liquidity risk, to improve disclosure policies, valuation practices, accounting standards and the role of rating agencies, and others. Decisive and tangible progress in this area is an essential part of the cure to come out of the emergency. In Europe, I believe we must in particular step up our efforts to quickly overcome existing differences in supervisory practices at the national level, work towards a more harmonized set of rules, make further progress in the cooperation and exchange of information among authorities. Again, I’m confident that the EMU and its institutions will act as a powerful catalyst, helping governments and regulators to redesign the rules for the financial sector, both at the European and at the global level. 2. The euro and the real economy 2.1. Macroeconomic stability Besides helping in confronting the financial crisis, there is ample evidence that EMU has also favoured greater resilience of the euro area economy to adverse real shocks. One crucial aspect in this respect is the high credibility of monetary policy that the ECB inherited from the best traditions of the constituent currencies. A clear cut example is provided by the experience with increases in the prices of energy and raw materials. Blanchard and Galì, among others, have shown that the adverse effects of oil price shocks on the economies have become significantly less severe than it used to be in the past. Recent studies at the Bank of Italy show that after the introduction of the euro the impact of oil price increases on inflation in Italy may have been reduced by ten times compared to the seventies. While there have certainly been other structural changes at work (such as a lower intensity of oil in production and consumption and more flexible labour markets), there is little doubt that the higher credibility of central banks has played a crucial role. The case of Germany is illustrative in this respect: the effects of oil price increases on inflation were very limited already 30 years ago, thanks to the very high credibility the Bundesbank enjoyed at the time. 2.2. International trade One of the reasons for adopting the euro was to facilitate market integration and the completion of the single market, reducing transaction costs connected with the hedging of exchange risks and the variety of currencies used for commercial invoices. The evidence is that expectations have been confirmed in full. Numerous empirical studies concur that monetary union has had a positive effect on the volume of trade within the euro area, although they disagree as to the extent, which is estimated between 5 and 15 per cent. A positive effect has also been observed on commercial flows outside the area; this supports the theory that the adoption of a common currency, unlike preferential liberalizations, does not have distortionary effects on international trade. 2.3. The trend in productivity Is there a visible link between the adoption of the euro and productivity trends in the single currency area? This is a fundamental question on which no consensus has formed yet. From the second half of the 1990s, total factor productivity increased much faster in the United States than in the euro area, where instead its growth slowed sharply. The gap widened with the start of monetary union and has begun to narrow only recently: during the period it has averaged about one percentage point a year. The gap reflects diverging trends in the leading European economies: slower growth in France and Germany and absolute decline in Italy and Spain, although our estimates indicate it has stabilized in Italy in the last two years. The poor performance of total factor productivity accounts for much of the growth gap in labour productivity in the euro area as a whole. The adjustment of capital intensity has also slowed in the area as a result of heavier reliance on labour in the presence of institutional reforms making employment more flexible. To be sure, there are important issues concerning the reliability of statistical measurements. For example, some studies have shown that productivity growth in the United States might have been somewhat overestimated due inter alia to the incorrect measurement of gains in the terms of trade and tariff reductions. In Italy, The Bank of Italy showed that the rate of increase in the export deflator was overestimated in the official statistics. This led to a revision of statistics resulting in an increase of more than 0.5 percentage points per year in productivity growth in manufacturing in the period 1996-2005. But if the correction for statistical error can make Europe’s productivity and growth gap vis-àvis the United States less alarming than it seems on the basis of the original data, they do not annul the gaps. The fact that they have existed for a decade forces us to seek their causes in the structure of our economies. Answering the question on the effects of the euro on productivity is as difficult as any counterfactual exercise. It requires to estimate what trend in productivity would have been without the single currency. However, I believe an answer emerges quite clearly from this conference, at least in two mutually consistent analyses. In a presentation tomorrow, Bugamelli, Schivardi and Zizza will explain how the euro has fostered the restructuring of firms and productive systems, especially in sectors and countries that had relied most heavily in the past on currency depreciation in order to recoup price competitiveness in the short term. And Alesina, Ardagna and Galasso show how the same discipline has pushed governments to carry out significant reforms in the markets for products and services. The findings point to a substantial positive contribution of the euro in terms of productivity. Another case in point is the labor market. Thanks to the reforms of the last ten years, it has been possible to overcome the old image of an immobile European labour market – reflected in high rates of unemployment and a low labour force participation rate – for which the term “Eurosclerosis” was coined. There is empirical evidence of a clear positive association between adoption of the single currency and the increase in employment and decrease in equilibrium unemployment. Finally, Bank of Italy research shows that the reduction of entry barriers in the past decade, thanks to new, less anti-competitive rules, led to an increase in the share of total employment of the sectors where reforms were introduced. Sharper competition has increased incumbents’ productivity and decreased their profit margins, fostered the adoption of ICT and reduced price increases. 3. Conclusions To conclude, I believe that confronting successfully the challenges posed by the current crisis requires that we continue on the road of greater integration and market openness which has been spurred by the adoption of the euro. In difficult times our economic paradigms may change dramatically and the temptation to go in isolation to deal with the most pressing problems may be understandable but may prove to be disruptive. The benefits of having had the euro for the last 10 years speak by themselves. We want to come out of this crisis able to continue enjoying these benefits. | bank of italy | 2,008 | 10 |
Keynote speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the roundtable on "The impact of the payout phase on fin. markets" at the OECD conf. "The payout phase of pensions, annuities & fin. markets", Paris, 12 November 2008. | Ignazio Visco: Retirement saving and the payout phase – how to get there and how to get the most out of it Keynote speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the roundtable on “The impact of the payout phase on financial markets” at the OECD conference “The payout phase of pensions, annuities and financial markets”, Paris, 12 November 2008. I am greatly indebted to Giuseppe Grande and Pietro Tommasino for their help and many useful discussions. * * * The implications of population ageing for financial markets have long been a subject of discussion for public authorities, financial intermediaries and academics. Over time we have become aware that ageing has a deep impact on the structure of financial markets and, at the same time, that this structure strongly affects the way in which demographic trends spread through the real economy. A leading role in this process has been played by the OECD. 1. Times are changing for pension funds Retirement-related saving schemes offered by pension funds and other intermediaries have developed considerably during the 1990s, as workers have relied increasingly on capital markets to sustain their consumption in old age. By the early years of the current decade some issues had reached the forefront of the policy debate, notably the importance of aggregate longevity risk, the transfer of risk from governments and corporations to households, the impact on financial markets of current and prospective reallocations of pension fund portfolios, and the ability of the regulatory and supervisory framework to adapt to the rapid changes in the supply of retirement saving schemes. These issues were comprehensively analysed in a G10 Report on the implications of pension system reform for financial markets, published in 2005. 1 A wide range of policy options were drawn, along the three directions of strengthening the risk management practices of providers of retirement saving, promoting the supply of suitable financial instruments, and raising the standards of investor protection and financial education. Today, those policy conclusions are all the more significant. If anything, the current financial crisis reinforces the need to develop effective ways of protecting retirement saving. However, it may make it harder to adopt appropriate instruments to hedge the risks that may in the long term affect the payout of pension benefits. The severity of recent financial market developments certainly justifies the tendency to concentrate on the short term. The crisis is especially costly for senior workers, whose pension wealth, both inside and outside pension plans, has been dented by the sharp decrease in asset prices. As in previous financial markets downturns, some of these workers may react by postponing retirement. In certain cases this might not be enough, and an argument could be made for public intervention (for instance, in the case of workers near to retirement whose pension benefits would mostly derive from mandatory private pension schemes). This situation also calls, however, for measures to improve the future working of pension systems. The current crisis has only highlighted the urgent need for betterfunctioning markets and better retirement products, if future retirees are to be guaranteed adequate living standards. See Group of Ten (2005). We cannot regard the current events as just one more protracted period of high financial market volatility, to be followed sooner or later by a return of investors’ expectations and risk premia to more comfortable levels. The financial crisis has already proved to be a watershed for the international financial system and it is changing the attitude of public authorities towards banking and capital market regulation. It might also deeply affect the propensity of private investors to take risks. It will not be business as usual anymore. The pension fund industry has already been hit very badly by the crisis. In the four quarters ending in June 2008, in the United States the pool of assets managed by funded private and public pension schemes has declined by more than 9 percentage points, or almost 900 billion dollars. Since then losses have probably doubled, given the collapse of bond and stock prices. Pension funds have also invested a huge amount of resources in troubled assets: according to IMF estimates, potential write downs on US loans and securities range between 125 and 250 billion dollars. 2 The current financial crisis raises several questions about the established practices of the retirement saving industry. Consider, for instance, the major changes concerning credit rating systems, which play a key role in the portfolio management of pension funds in every country; or the uncertain perspectives of the investment banking industry, which provides companies and investors with such essential services as securities underwriting and trading, asset management, and M&A advice; or again the upsurge of counterparty risk on OTC derivatives, which pension fund managers have used increasingly to try to improve portfolio risk management. It is now difficult to figure out how financial intermediaries and markets will adjust to these structural changes. More importantly, the global banking crisis that still engulfs intermediaries and markets threatens to cast a shadow on the very notion that financial markets could be a reliable source of retirement income. More than the never-ending dispute of the pros and cons of equities versus bonds, the focus is increasingly on the ability of financial markets to assure workers a sufficient level of retirement income even over long-term investment periods. Beyond the unresolved issue of aggregate longevity risk, we need to think whether workers should be left alone to deal with financial markets tail risks (i.e. the fact that extreme losses tend to be more frequent than it would be by chance in normal conditions). Even the decision to join a pension fund (where private pension plans are not mandatory) is likely to be seriously affected by the crisis. Investors’ confidence in the soundness of financial intermediaries and markets has been shaken and this may well spread disaffection among workers, notably with respect to pension funds’ defined contribution (DC) schemes. Workers may feel less able than in the past to make difficult decisions about the appropriate level of contributions and dependable asset allocation. The phases of accumulation and decumulation are closely intertwined: the optimal design of the former strongly depends on the latter and vice-versa. I will start from the accumulation phase, because before dealing with the issues posed by the payment of pensions, we have to be sure that workers will actually have something to decumulate when they retire. 2. The importance of pension funds has continued to grow In this decade the pension fund industry has continued to expand relative to the size of the economy, although at a slower pace than in the 1990s (Table 1). At the end of 2006 total OECD funded pension assets (including occupational and personal arrangements) amounted to about 24.6 trillion dollars, or 76 percent of GDP. Asset growth has differed considerably Table 1.1 in IMF (2008). across OECD countries, being stronger in those economies where pension funds are welldeveloped (Figure 1). There has also been a further move from defined benefit (DB) to DC schemes. Generally, the latter have been adopted in countries where private pension schemes have been introduced to complement and compensate the prospective downsizing of public pension systems. However, available data also show that, in countries where DB and DC schemes coexist, the latter have increased further as a share of total assets (Table 2). 3 In particular, DB occupational plans have continued to lose ground in the United States, where they have a long tradition. According to the Employee Benefits Survey of the Department of Labor, the percentage of private industry workers participating in defined contribution plans has increased from 36 percent in 2000 to 43 percent in 2006. In the United Kingdom, too, there is evidence of a further shift from DB to DC schemes, in line with the findings of the Turner Report. 4 Underlying these trends there are well-known structural factors, such as those reviewed in the G10 Report. Ageing populations and the shrinking coverage provided by public pension systems call for an increase in the pool of resources channelled to capital markets to provide for retirement. In several countries changes in labour markets and concerns about future pension liabilities are prompting employers to close DB plans and offer DC plans instead. These profound structural changes in pension systems imply that the sources of retirement income in the future will differ considerably from those of current retirees. This is highlighted by a recent survey of US working-age and retired citizens (Table 3). While only one third of retirees report that they also depend on some kind of retirement savings plan, workers’ expectations regarding the future sources of retirement income show a much greater role of both funded pension schemes (such as 401(k) plans and Individual Retirement Accounts) and other forms of personal saving. This evidence provides further indication that future retirees will depend heavily on savings as a source of retirement income, and specifically on DC pension schemes. 3. Retirement saving should increase further The present crisis creates problems for DB pension plan sponsors (which are the residual risk bearers of the plan) as falling asset prices reduce asset/liability ratios and might ultimately require higher contributions. Partial relief is provided by the increase in yields on corporate bonds, which are used in several countries to discount pension fund liabilities. Several observers have raised concerns about the generalized adoption of market-based, fair value accounting principles. The new accounting standards undoubtedly improve balance sheet transparency and comparability by limiting sponsor companies’ discretion in pension fund accounting practices. However, this may well have intensified the pro-cyclicality of financial market trends, given the importance of pension funds in many countries and their unique role as long-term investors, and may have encouraged pension fund managers to focus on short-term trading. 5 Even more importantly, the crisis may make DC plan members less confident about taking complex decisions. DC plans require workers to make a number of difficult choices, such as whether or not to enrol, how much money to contribute, how to invest it and when to rebalance the portfolio. A serious risk that DC plan members face is not saving enough for This indicator may be partly affected by the higher incidence of risky assets in DC schemes, mainly targeted at young workers. See Pensions Commission (2005) and OECD (2007). See also Annex II.1 in Group of Ten (2005). their old age. Contributions to DC plans tend to be low. 6 Many factors may account for workers’ tendency to under-save: • Left alone to decide how much to contribute, people seem short-sighted and may lack willpower. Recent survey evidence on a representative sample of 51-years old or older US citizens has shown that almost 30 percent of respondents have never thought about a saving plan for retirement. Moreover, only 60 percent of the “planners” were able to stick to the plan. 7 • Workers are also very poorly aware of the degree of coverage provided by their retirement income sources. In Italy, for instance, ten years after three reforms that dramatically reduced the prospective replacement rates of public pension (i.e. the ratio between pension benefit and last pay at retirement) for many workers, adjustment to the new conditions is far from complete and is proving slower for the cohorts and employment groups most affected by the reforms. For example, middleaged and young self-employed workers expect a replacement rate of about 60 percent, which is 20 percentage points higher than the rate consistent with current legislation. 8 This is also true for the funded component of pension wealth, as US surveys tend to find that employees are very poorly aware of the characteristics of the plan they are enrolled in (e.g. whether it is DB, DC, or mixed). 9 • What is worse is the fact that DC plan members are likely not even to consider the problem of setting a target replacement rate for their accumulation plan. This is especially worrying as decisions about contribution rates and asset allocation depend very much on key forward-looking parameters, such as the foreseeable trend of labour income, the planned retirement date, the target pattern of retirement income, and the intensity of the bequest motive. Without a target replacement rate, workers might become aware they have saved too little only when they retire and are no longer in a position to increase the pool of assets available to fund their consumption in old age. The lack of retirement goals may also reflect the poor incentives of selling agents, who have no contractual obligation to deliver any particular fund size on the retirement date 10 : in order to persuade workers to enrol they may allow them to choose contribution rates that are too low. • Finally, it is often argued that another reason why the risk of inadequate savings is serious is that DC plan members tend to choose a fairly conservative asset allocation. In order to accumulate a sufficient pool of funds, they should save relatively more compared with more equity-oriented long-term investors. 11 At the same time equity-oriented portfolios may expose investors to huge investment risks (see below). See, for instance, Choi et al (2004), Pensions Commission (2005), Olsen and Whitman (2007) and Blake, Cairns and Dowd (2008). Lusardi and Mitchell (2006). The level of awareness about public pension provision is low, especially among the self-employed, public sector employees, and younger workers. Presumably this information shortfall also reflects the general uncertainty caused by the protracted reform process, which has made more difficult and burdensome for savers to obtain information on how the new pension system works. See Cesari, Grande and Panetta (2008), updating the estimates in Bottazzi, Jappelli and Padula (2006). Gustman and Steinmeier (2004). Blake, Cairns and Dowd (2008). Choi et al (2004). Two widely used instruments to increase pension fund enrolments and contributions are fiscal incentives and employer-matching contributions. Both are effective means of boosting pension fund returns and greatly increase the convenience of joining a funded retirement scheme. 12 Both have drawbacks, however. Fiscal incentives are usually expensive, regressive, and possibly prone to time inconsistency, especially when tax advantages apply to the payout phase. Employers’ contributions might be offset by a reduction in net wages and not necessarily produce an increase in the worker’s total wealth. Moreover, as they are typically the result of agreements between employers and trade unions, their portability across different retirement schemes may be far from seamless. In any case, workers seem to exploit fiscal incentives and employers’ contributions only partially. For example, a recent study of a sample of DC plan members in the United States finds that each year between 20 and 60 percent of these workers contribute below the threshold (even if they could make penalty-free withdrawals), losing as much as 6 percent of their annual pay – a free lunch left on the table. 13 A factor discouraging workers from increasing pension fund contributions is the relative illiquidity of their net equity in pension funds. DC pension schemes usually grant workers the possibility to withdraw their balances some time before they retire only under special circumstances. Any option to grant higher flexibility of early withdrawals (maybe to those categories of workers, such as young and low-paid workers, that are more likely to be liquidity-constrained) has to be carefully weighted against the risk that short-sighted and time-inconsistent workers might withdraw too much too early, against their own long-term interest. This naturally leads us to underline the importance of providing DC plan members with good investment returns, as this would be the main way to alleviate the relative illiquidity of investments in pension funds and improve the trade-off between liquidity and pension fund returns. In this respect, it is essential to keep total costs to savers low; otherwise, the advantages of pension funds (investing retirement saving in financial instruments as well as enjoying employer contributions and tax incentives) will be seen mainly in the financial accounts of the intermediaries running the funds, rather than in better living standards for pensioners. Indeed, charges may have a major impact on the final balance accrued to workers over an extended period of time. 14 The importance of keeping pension funds’ total costs low has been emphasized, among others, by the Turner Report, which argues that, against reasonable expectations of long-term returns, annual charges of 1.5 percent (not at all uncommon in many countries) are high enough to represent a rational disincentive to According to simulations carried out by Cesari, Grande and Panetta (2008) for Italian DC pension funds, the benefit of the employer’s contribution provided by the recent pension fund law is substantial: over a 30-year accumulation period, even on the most unfavourable assumptions, the return obtained by a pension fund member each year is at least 0.6 percentage points higher, and his final accrued balance more than 6 percent higher, than that obtained by a non-member. Tax advantages are also very large: after 30 contribution years the final balance accrued to a younger worker joining a pension fund would be almost 24 percent greater than that accrued to a worker who invests directly in financial assets; more than half of the advantage would be due to the deductibility of contributions and another third to the preferential taxation of benefits. Choi, Laibson and Madrian (2005). Even small variations in charges lead to big difference in the final balance assigned to workers on retirement. After 30 years, workers who can invest at an annual cost of 0.5 percent per annum could, for the same savings level, enjoy a final accrued balance more than 30 percent higher than that enjoyed by workers facing an annual cost of 1.5 percent. For a detailed analysis of the impact of pension fund costs on workers’ gains from joining a pension fund (based on the parameters of the Italian DC pension funds), see Cesari, Grande and Panetta (2008). voluntary private savings and undermine the case for providing earnings-related pensions in a funded rather than a PAYG form. 15 Cost reductions can come not only from increasing the volume of assets under management, with consequent economies of scale, but also from stimulating competition among pension schemes. This may call for several measures including educating consumers about the effect of charges on pension fund returns; assuring a high degree of transparency and comparability of charges between different schemes; easing the transferability of employer contributions across different schemes, especially for people with term jobs and interrupted careers; and intensifying competition among intermediaries offering pension fund asset management services. Moreover, in all countries public authorities have a powerful (and relatively inexpensive) instrument for boosting pension fund contributions – namely, the provision of information. The better workers are informed, the quicker they revise their expectations and adjust their saving patterns. 16 Workers should be given systematic, timely and clear information to help them make reliable estimates of replacement ratios, taking into account both mandatory retirement programmes and supplementary pension plans. Specifically, for funded defined contribution schemes, either the public authorities or the plan sponsors and financial intermediaries could provide workers with an estimate of the pension scheme’s net benefits, based on reasonable, transparent and standardized assumptions regarding contributions rates, the growth rate of earnings for groups of workers, the growth rate of benefits, the probability of survival, and the expected returns on pension fund assets. Regular assessments should provide an indication of the contribution rates that would be consistent with the updated scenario. The same should be done on a regular basis by the Social Security Department, for the first-pillar pension wealth (as happens, for example, in Sweden). Another powerful instrument in the hands of both employers and policymakers is the design of retirement plans in terms of enrolment, contribution, investment and withdrawal options. In defining default options, there seems to be consensus on a few general criteria such as 17 avoiding opt-in clauses (which imply that the worker is not enrolled unless he or she asks) and relying instead on opt-out clauses or some kind of more active decision-making; offering only a small number of basic investment choices, while being ready to offer a wider choice to those workers that ask for it; and setting employee contribution rates that rise slowly over time. All these solutions are meant to encourage long-lasting changes in behaviour and to overcome inconsistencies in individual decision-making arising due to short-sightedness, inertia, procrastination or lack of willpower. 4. Should we move from unprotected to protected DC schemes? A cursory look at financial market data (Figure 2) shows that over long periods of accumulation higher risks have on average been associated with higher returns. Accumulated returns are lowest for investment strategies that merely track consumer prices, highest for equities, and somewhere in-between for nominal government bond portfolios. However, as we move from the least to most rewarding investment strategy, return variability See the discussion and the international evidence reported in Chapters 1.2, 1.5 and 10.10 by the Pensions Commission (2005). For international evidence on charges as well as policy options, see also Whitehouse (2005). Analysing the effects on household net (real and financial) wealth of the cuts in public pension benefits in Italy, Bottazzi, Jappelli and Padula (2006) find that the impact of pension benefit expectations on saving choices is huge. While for informed workers the offset between private wealth and expected public pension wealth is between -0.4 and -0.8, for poorly informed workers it is much lower, ranging between -0.2 and -0.4. See, for instance, Choi et al (2004), Olsen and Whitman (2007), and references therein. escalates as well, and in certain periods a pure equity strategy may be overtaken by a bond strategy. Moreover, holding period returns clearly indicate that even over long-term accumulation periods the returns from a pure equity strategy may be subject to large drops, as may happen when the holding period includes the first ten months of 2008. This bird’s eye view of financial market returns also shows that by holding a balanced portfolio of stocks and fixed-income instruments, long-term investors may try to increase expected portfolio returns, while keeping return volatility moderate. What I would like to emphasize, however, is that basing asset allocation on the past properties of asset returns may still leave the investor considerably exposed to investment risk, for at least two reasons: • First, past realizations may come from different underlying economic regimes or conceal structural breaks, so that care should be taken when using observed returns to estimate expected returns. 18 It is generally agreed, for example, that around the turn of the century the equity premium declined somewhat; the term premia on longterm interest rates may also have recorded a lasting decrease in this decade. This may again reverse in the near future. • Second, even if expected returns on equities are higher than those on bonds in the long term, actual returns on equities may turn out to be sharply negative. The probability of large drops in asset prices may be substantially higher than it is assumed in standard mean-variance frameworks. Indeed, there is evidence that the distribution of many asset prices has fatter tails than the normal distribution (possibly signalling the unexpected occurrence of very large shocks that may be at odds with standard applications of the central limit theorem). The investment risk can be dealt with, to some extent, by relying on market-based instruments. DC plan members could invest a large share of their funds in risky assets at the beginning of their accumulation period and gradually increase the percentage of cash and government bonds as they approach retirement 19 . One difficulty of this life-cycle investment strategy is that individuals may find it a daunting task to change the asset allocation as they age (as well as to anticipate trends in the prices of risky assets). A solution is provided by accumulation schemes that automatically adjust risk as an investor ages (“life-cycle funds”). This kind of solution has been increasingly adopted for DC pension plans in a number of countries. Financial markets also offer strategies that drastically reduce the exposure to investment risk. One possibility is to restrict portfolio choices to fixed-income instruments, especially index-linked bonds, or to use options. Then there is recourse to rate-of-return guarantees provided by third parties (an insurance company, the sponsor or a central reserve fund). A DC pension fund may also maintain a reserve to smooth returns over time: in good investment years part of the fund’s returns are placed in the reserve, which can be drawn on when they fall below a certain threshold. While financial markets offer different ways of introducing minimum return guarantees, it is clear that the hedging of financial market risks does not come without cost. A higher incidence of fixed-income instruments may take its toll on portfolio returns; the use of derivatives or third-parties guarantees implies the payment of fees. With intertemporal smoothing of returns, good investment years subsidize bad investment periods, with a The very hypothesis of ergodicity of most economic and financial time series has been questioned from time to time (se, for example, Davidson, 1991) and becomes hard to believe in crisis periods. For the long-standing debate on the pros and cons of equities compared with bonds and the asset allocation of long-term investors, see Campbell and Viceira (2002), Siegel (2002), Bodie and Clowes (2003), Merton (2006) and Blake, Cairns and Dowd (2008). potential redistribution of investment income across plan members. Therefore, all these forms of protection from investment risks may result in lower net-of-fees returns. If these are not offset by higher contributions during the accumulation phase, they lead to a lower pension during the decumulation stage – i.e. lower returns imply lower consumption, either during working age or in retirement or both. More importantly, market-based solutions cannot protect investors from strong aggregate shocks hitting several asset classes and economic sectors at the same time. In such an event, aggregate wealth is not only redistributed across individuals and sectors, but it is also destroyed. One might argue that in such exceptional circumstances there is a straightforward solution: a public rescue of pension funds by the government (especially when enrolment is mandatory rather than voluntary). A bail-out of pension fund members would always be an available policy option, provided that it were limited to workers who are close to retirement and unable to take advantage of a possible recovery of asset prices over medium- to long-term horizons. However, a bail-out of pension fund members should always remain the last option for two well-known reasons: it is costly to taxpayers and it may encourage opportunistic behaviour by pension funds in the future. A more sustainable and efficient form of protection could come from some kind of collective inter-generational arrangement. One possibility is that of hybrid pension plans, such as those previously mentioned, in which participants transform their risky claims into guaranteed claims as they become older. 20 In practice, younger workers would partly insure the pension rights of older workers, by accepting to pay higher contributions in periods of adverse financial market shocks. In some countries (for example the Netherlands) these investment vehicles already exist. Another possibility would be a more active role of the State in providing insurance against grave systemic risks. Tail risk in financial markets is similar to what is called aggregate longevity risk, i.e. the risk of a whole cohort living longer than expected. Aggregate longevity risk must be kept distinct from idiosyncratic longevity risk, i.e. the risk of an individual living longer than his or her cohort’s average (a risk that the market can easily insure away). I will elaborate on these risks in the next section. Of course, providing insurance against catastrophic events destroying financial wealth was the reason why PAYG social security systems were introduced, most of them in the aftermath of the Great Depression and of the hyper-inflation following WWII. 21 However, social security systems came under strain in most developed countries for several wellknown reasons. In particular, the sizeable (and largely unexpected) increases in longevity, coupled with a substantial fall in fertility rates, put the financial sustainability of traditional PAYG schemes under question in many countries, unless substantial cuts in benefits and increases in payroll contributions were introduced (and the effective retirement age increased). Yet, there are other ways to provide workers with a collective protection against financial market risks. One example, is the plan put forward by Franco Modigliani and co-authors in various contributions. 22 While it is similar in spirit to inter-generational arrangements, it includes the whole national community in the risk-sharing scheme. Basically, the proposal is to introduce a single funded DC pension scheme which would enter in a swap arrangement See, for example, Boeri et al (2006). Originally, most social security systems were funded. The abrupt destruction of financial wealth due to postWWI and WWII hyper-inflation and asset price collapse led many countries to switch from funded to PAYG schemes (Perotti and Schwienbacher, 2007). See for example Modigliani, Muralidhar and Ceprini (2000), and Modigliani and Muralidhar (2004). with the Treasury each year so that the risky pension fund returns are exchanged with a guaranteed rate of return. With respect to the original proposal, the swap arrangements may involve more than one pension fund, and the swap guarantee may be partial, at a price that in normal times should compensate the Treasury for the risks it undertakes. In this case, it would be especially important to keep pension fund fees and other expenses low, as mentioned earlier. One merit of the Modigliani proposal is that workers with similar characteristics would be granted similar rates of return on their savings. On fairness grounds, it seems disputable that workers with equal pension contributions and in equal in all other relevant respects should end up with very different retirement wealth, due to the evolution of financial markets. Finally, while the feasibility of such a scheme needs to be studied in relation to the various existing national pension systems, it is worth noting not only that it might provide the needed smoothing of pension funds returns, but, more importantly, that the scheme would also put the burden of aggregate financial risks due to events that cannot be hedged at a cohort level within a truly intergenerational exchange framework. Obviously, this would call for the introduction of measures to limit the burden on future generations caused by high and rising levels of public debt. 5. We need cheaper and safer pay-out products An adequate level of pension wealth at retirement is necessary but not sufficient to guarantee adequate living standards during the retirement years. Indeed, it is important to ensure that such wealth is properly decumulated. Therefore, the most important choice is the extent of annuitization. It is difficult not to agree that annuitization of a significant fraction of private pension wealth is highly advisable. It is indeed advisable both for the individual and for the government: • At retirement, workers have to choose the level of consumption for the subsequent years, given the wealth accumulated over their working lives. Without annuities, they would be exposed to longevity risk: if they live longer than expected, they could outlive their resources; if on the contrary their lifespan turns out to be shorter than expected, a fraction of resources would be wasted. By buying an annuity, both risks would be shifted onto the insurance company. • As companies have a wide pool of clients, they can diversify away the idiosyncratic component of the longevity risk. Therefore, they can offer annuities at convenient prices for the investors. However, companies have to bear the aggregate component of the longevity risk, i.e. the risk of unpredicted changes in the average lifespan. To cover this risk, they could ask for a premium that may substantially raise the overall cost of the annuity scheme. • A high degree of annuitization would also work to protect public finances from opportunistic behaviour: individuals may indeed have an incentive to consume resources early after retirement, and to rely on the publicly-financed safety net in the following years. At the moment, annuity markets around the world are rather thin, except in a handful of countries in which private pensions are more developed (such as in the United Kingdom, Switzerland and Chile). This may be due to a wide range of demand and supply factors, such as opaque and inefficient pricing policies by insurance companies, a lack of products which meet the tastes and needs of investors, and the presence of still substantial annuitized benefits provided by public PAYG schemes. 23 However, in a few years’ time the number of pensioners for which annuities or annuity-like products will provide a significant fraction of retirement income is most likely to increase. This is due both to the increased importance of private pensions and to the fact that, in many countries, the law now mandates that a minimum portion of a worker’s pension fund capital should be annuitized at retirement (or it provides strong tax incentives to do so). As the demand for annuity products takes off, an efficient and well-functioning annuity market will become soon a policy priority. Policy action in this field should target two broad goals. First, in order to reduce annuity prices, three main determinants should be addressed: adverse selection costs, which are quite significant according to most existing studies; 24 the premium for the aggregate longevity risk; and a possibly insufficient degree of competition. Second, pay-out products which protect at least in part against the risks which materialize during the decumulation phase should be made more widely available. At the moment, for example, in most countries annuity payments are not indexed to prices. This induces a progressive deterioration of the relative position of pensioners with respect to the rest of the population (as well as an absolute reduction in purchasing power over time). I will now briefly discuss how we can try to achieve these goals. To keep the price of annuities as low as possible, governments and regulators should first of all promote the timely release of accurate mortality tables, as this would help to reduce the aggregate longevity risk. The remarkable increase in life expectancy at older ages that has occurred in the last half a century in industrial countries seems in fact to have been systematically under-predicted by national statistical agencies. The adoption of new and more sophisticated methods might have produced significant improvements in projection but prospective life expectancy gains may still be somewhat under-predicted. Furthermore, lags occur in the production, adoption and disclosure of mortality tables and cross-country variations in mortality assumptions used by company pension schemes appear at times far larger than warranted by their members’ profiles. 25 Moreover, tables for different subgroups in the population should also be made available. This would make it possible to discriminate between annuity buyers, reducing adverse selection costs. In particular, lower prices could be offered to disadvantaged people, with shorter-than-average expected life spans. As good mortality tables are to some extent a “public good”, the role of governments here is significant. See, among others, the contributions in Brown et al (2001) and Fornero and Luciano (2004). Most of the literature measures these costs using the so-called “money’s worth ratio”, defined as the ratio between the net present value of the expected stream of benefits and the amount of money given by the retiree to the insurer (a synthetic indicator of the cost of the annuity). The numerator of the money’s worth ratio can be computed either using survival probabilities for the whole population or probabilities for the sub-group of the annuity purchasers. In the latter case the ratio would turn out to be bigger, as annuitants would on average receive benefits for a longer period. The difference between the two money’s worth ratios is typically considered the most reliable proxy for adverse selection costs. For example, Mitchell et al (1999) provide estimates for the United States respectively equal to 81 and 92 percent. Comparable estimates for Italy are 77 and 87 percent (Guazzarotti and Tommasino, 2008). Of course, these estimates must be taken with caution, as they rely on several assumptions concerning, for example, the future evolution of interest rates. On these issues see the discussion in Visco (2007). With respect to projection methods, particularly popular is the model proposed by Lee and Carter (1992), where the possibility of age-specific patterns in mortality estimates is specifically taken into account. Using this method Tuljapurkar, Li and Boe (2000) produced estimates that show average life expectancy gains for G7 countries by the year 2050 of about 7 years, twice as large as the average gains in official projections. Even this might be a conservative estimate, as it assumes a constant rate of decline in mortality. If the rate of increase in life expectancy registered in the post-war period were to be confirmed for future decades, it would rise by 2050 by more than 10 years. On cross-country variations in mortality assumptions, see Cass Business School (2005). Furthermore, in order to foster competition and keep profit margins low, product prices and characteristics should be as transparent and comparable as possible. To guarantee a higher degree of transparency, both about prices and about product characteristics, it would be advisable to follow the path of countries such as the United Kingdom, where the FSA hosts a web platform in which the different products are compared, or Chile, which has recently adopted a similar system. With reference to the inadequate range of available instruments, governments should first of all remove the obstacles that prevent companies from offering inflation-indexed annuity products. In particular, they could consider providing more inflation-indexed and ultra longterm bonds. The Chilean experience, in which these bonds are issued both by the government and by the corporate sector, is indicative. It also points to the fact that financial innovation and the development of annuity markets are two mutually reinforcing processes. Finally, longevity risk premia could be reduced if companies had access to longevity (or mortality) bonds, allowing better asset-liability management. The issuance of such bonds should then be definitely encouraged, recent failures notwithstanding. 26 The market for reverse mortgages should also be promoted. Reverse mortgages and similar products transform into an annuitized stream of payments a component of the wealth of elderly people which is already significant in many countries where private pension wealth is still small. There is a risk that the crisis, and the sharp drop in house prices, will give a hard blow to these products, which grew significantly in the years of the housing boom (see Figure 3). Better-designed arrangements, in which the risk is shared more equally between the homeowner and the intermediary will also help. The main reason why there is an inadequate supply of instruments for hedging against the risks incurred in annuity provision (longevity risk, inflation risk, financial market risk) is of course the lack of natural issuers, at least in the private sector. Due to their extended timehorizon, governments are a natural candidate to re-insure these risks. However, it is not clear to what extent they could take those risks onto their balance sheets. After all, social security systems are being reformed mainly to spare future workers at least part of the expected costs of population ageing (a concern that is also behind the introduction in several countries of the so-called notional defined contribution schemes for public pensions). One might argue, however, in favour of some limited form of guarantee to annuity providers, to cover only the risk of a “catastrophic” tail event. The use of public resources to provide an insurance against the collective component of longevity risk should then be matched by a more balanced composition of pension pillars that would limit the exposure of the government to the idiosyncratic component of this risk and encourage financial markets, to play a larger role for its insurance, even if with a possible smoothing role by the State along the lines discussed in the previous section. The State could even intervene directly as an annuity provider. This would be likely to reduce administrative costs (thanks to economies of scale) and adverse selection costs (due to a wider pool of clients), and correspondingly reduce prices (mainly because profit mark-ups could be kept to zero). The Swedish experience, in which the government is the monopoly provider of annuities both for individual investors and for pension funds, seems encouraging in this respect, and deserves further attention. See, among others, Group of Ten (2005), Visco (2007), Antolin and Blommestein (2007). I will leave aside the problems connected to the management of duration risk, due to the fact that there might be a mismatch between the duration of companies’ assets and liabilities. Of course, compensation for this risk is also a part of the annuity price. Duration risk seems however more important for DB funds, which provide accumulation vehicles and also pay pensions, than for specialized annuity providers. 6. Conclusions We need to acknowledge that the road to an adequate and stable retirement income is strewn with difficulties and hazards. Many things can go wrong: inadequate contributions and disappointing returns during the accumulation phase could lead to an insufficient amount of resources at the moment of retirement; the lack of inexpensive and safe ways to transform pension wealth into a stream of benefits could lead to insufficient income during the old age, if not immediately, after a certain number of years. The main point of my discussion has been that leaving individuals alone to cope with these risks is inefficient from an economic point of view, given that at least some of them are of a systemic nature. It is not a matter of redistributing a given amount of resources among individuals or across cohorts, but of adverse shocks that reduce the growth potential of the economy (for example in the case of population ageing) or destroy its stock of wealth (as in the case of a disorderly financial market crisis). The solutions that financial markets currently offer cannot effectively address these risks: they should be integrated with collective arrangements involving present and future generations. I believe that it is worth exploring whether such arrangements could take the form of transparent, minimal guarantees provided by the government to pension funds and to annuity providers at prices and with other conditions that compensate the risks. References Antolin, P. and H. Blommestein (2007), “Governments and the market for longevity-indexed bonds”, OECD Working papers on insurance and private pensions, no. 4. Blake, D., A. Cairns, and K. Dowd (2008), “Turning pension plans into pension planes: what investment strategy designers of defined contribution pension plans can learn from commercial aircraft designers”, Pensions Institute discussion paper PI-0806. Bodie Z. and M. Clowes (2003), Worry-free investing: a safe approach to achieving your lifetime financial goals, Financial Times Prentice Hall, London. Boeri, T., L. Bovenberg, B. Coeuré and A. Roberts (2006), Dealing with the new giants: rethinking the role of pension funds, Geneva reports on the world economy, no. 8, ICMBCEPR, Oxford University Press, Oxford. Bottazzi, R., T. Jappelli and M. Padula (2006), “Retirement expectations, pension reforms, and their impact on private wealth accumulation”, Journal of Public Economics, vol. 90, pp. 2187-2212. Brown, J.R., O.S. Mitchell, J.M. Poterba and M.J. Warshawsky (2001), The role of annuity markets in financing retirement, MIT Press, Cambridge, MA. Campbell, J. Y. and L. M. Viceira (2002), Strategic asset allocation: portfolio choice for longterm investors, Oxford University Press, Oxford. Cass Busines School (2005), Mortality assumptions used in the calculations of company pension liabilities in the EU, City of London. Cesari, R., G. Grande and F. Panetta (2008), “Supplementary pension schemes in Italy: features, development and opportunities for workers”, Giornale degli economisti e annali di economia, vol. 67, pp. 21-73. Choi, J. J., D. Laibson and B. M. Madrian (2005), “$100 bills on the sidewalk: suboptimal saving in 401(k) plans”, NBER working paper, no. 11554. Choi, J. J., D. Laibson, B. M. Madrian and A. Metrick (2004) “For better or for worse: default effects and 401(k) savings behavior”, in David Wise (ed.), Perspectives in the economics of aging, University of Chicago Press, Chicago. Davidson, P. (1991), “Is probability theory relevant for uncertainty? A post-keynesian perspective”, Journal of Economic Perspectives, vol. 5, pp. 129-143. Fornero E. and E. Luciano (2004), Developing an annuity market in Europe, Edward Elgar Publishing, Cheltenham. Group of Ten (2005), “Ageing and pension system reform: implications for financial markets and economic policies”, Report prepared for the deputies of the Group of Ten by a group of experts chaired by I. Visco (http://www.bis.org/publ/gten09.htm), also published in OECD, Financial Market Trends, no. 89 (Supplement 1). Guazzarotti, G. and P. Tommasino (2008), “The annuity market in an evolving pension system: lessons from Italy”, CeRP working paper, no.77/08. Gustman, A. and T. Steinmeier (2004), “What people don’t know about their pensions and social security,” in W. Gale, J. Shoven and M. Warshawsky (eds.), Private pensions and public policies, Brookings Institution, Washington DC. IMF (2008), Global financial stability report, October 2008, IMF, Washington DC (http://www.imf.org/external/pubs/ft/gfsr/2008/02/index.htm). Lee, R.D. and L. Carter (1992), “Modelling and forecasting the time series of US mortality”, Journal of the American Statistical Association, vol. 87, pp. 659-675. Lusardi, A. M. and O. S. Mitchell (2006), “Financial literacy and planning: implications for retirement wellbeing”, Pension Research Council working paper, no. 1. Merton R. C. (2006) “Observations on innovation in pension fund management in the impending future”, PREA Quarterly, Winter. Mitchell, O. S., J. M. Poterba, M. J. Warshawsky and J. R. Brown (1999), “New evidence on the money’s worth of individual annuities”, American Economic Review, vol. 89, pp. 12991318. Modigliani, F. and A. Muralidhar (2004), Rethinking pension reform, Cambridge University Press, Cambridge. Modigliani, F., A. Muralidhar and M. Ceprini (2000), “A solution to the social security crisis”, Sloan School of Management, mimeo. OECD (2007), Pensions at a glance, OECD, Paris. Olsen, A. and K. Whitman (2007), “Effective retirement savings programs: design features and financial education”, Social Security Bulletin, vol. 67, no. 3. Pensions Commissions (2005), A new pension settlement for the twenty-first century – The second report of the Pensions commission (www.pensionscommission.org.uk). Perotti E. C. and A. Schwienbacher (2007) “The political origin of pension funding”, CEPR discussion paper, no. 6100. Siegel, J. (2002), Stocks for the long run, third edition, McGraw-Hill, New York. Tuljapurkar, S., N. Li and C. Boe, (2000), “Is there a universal pattern of morality decline? Evidence and forecasts for the G7 countries”, Nature, vol. 405, pp. 789-792. Visco, I. (2007), “Longevity risk and financial markets”, in Balling, M., E. Gnan and F. Lierman (eds.), Money, finance and demography: the consequences of ageing, SUERF colloquium volume 2006, SUERF, Vienna. Whitehouse, E. R. (2005), “Testimony”, Sub-committee on social security reform of the Committee on ways and means, U.S. House of Representatives, 16 June 2005. Table 1. Pension fund assets in percent of GDP (percent) Belgium Canada France Germany Italy Japan Netherlands Sweden Switzerland United Kingdom United States Source: Group of Ten (2005) and OECD (Global Pension Statistics). Reported assets refer to the category “autonomous pension funds”. They may not include all forms of retirement savings plans, in particular those provided by insurance companies. Data for 2003 and 2006 are estimated. Figure 1 Pension funds’ assets/GDP across OECD countries (percent) Change in pension funds' assets/GDP between 2001 and 2006 -10 Pension funds' assets/GDP in 2001 Sources: OECD (Global Pension Statistics). Table 2. Proportion of DC pension plans in selected countries (% share of DC pension plans in autonomous pension funds’ total assets) Canada 7.0 Italy 9.5 80.9 70.5 83.8 Japan 2.4 0.2 4.4 8.2 14.2 United States 46.4 47.2 48.0 48.9 50.2 85.3 51.7 Sources: OECD (Global Pension Statistics); OECD, Pension Markets in Focus. Table 3. Current and expected sources of income in retirement (percent) Workers (Expected) Retirees(Reported) Social Security An employer-sponsored retirement savings plan, such as a 401 (k) Other personal savings or investments An individual retirement account or IRA An employer-provided traditional pension or cash balance plan Source: Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc., 2008 Retirement Confidence Survey. Figure 2 Returns on financial assets: long-term indicators (i) Indexes: 1985=100 (ii) 10-year percentage changes -50 Consumer prices Nominal GDP G7 Gov't Bonds Balanced Portfolio World Stock Markets Sources: IMF, Datastream. Federal Reserve and Thomson Financial 1. Annual data. Consumer prices and nominal GDP relate to advanced economies. The government bond index (Merrill Lynch) and the stock market index (MSCI) also take into account coupons and dividends. “Balanced portfolio” means the index of the weighted portfolio of the stock market and bond indexes, where the stock market weight is equal to the share of corporate equities to total financial assets of the US private pension funds at the end of the previous year. 2. Percentage change over 10 years of the variables described in the previous footnote. Figure 3 Reverse mortgages in the United States (number of federally-insured reverse mortgage loans, fiscal years) Sources: U.S. Department of Housing and Urban Development; U.S. Mortgage Bankers Association. | bank of italy | 2,008 | 12 |
Edited text of remarks by Mr Fabrizio Saccomanni, Director General of the Bank of Italy, at a meeting at the Peterson Institute for International Economics, Washington DC, 11 December 2008. | Fabrizio Saccomanni: Managing international financial stability Edited text of remarks by Mr Fabrizio Saccomanni, Director General of the Bank of Italy, at a meeting at the Peterson Institute for International Economics, Washington DC, 11 December 2008. * * * I am delighted to be here at the Peterson Institute to present my views on international financial instability before such a distinguished audience of eminent scholars and officials, among which I am fortunate to count many old friends. This is my first visit to the Institute since I was invited to join its Advisory Committee and I would like to express my gratitude to Fred Bergsten for the invitation. I am honoured to participate in this important body of the Institute and I look forward to contributing to its activity in the promotion of policy–oriented research in the field of international economics. Instability in the age of globalization International financial instability is a subject that has fascinated and intrigued me since when I was a young economist at the IMF and witnessed with considerable anxiety the collapse of the Bretton Woods system on August 15, 1971. The ensuing decade of instability was mostly attributable to the shock of the downward floating of the dollar and the resulting two oilshocks of 1974 and 1979. After some unsuccessful attempts to rebuild Bretton Woods, the negotiations for the reform of the international monetary system ended in 1976 with the legalization of freely floating exchange rates and that seemed sufficient to fix the problem. A tired US Treasury Secretary, William Simon, commented: “All is well that ends”. At the beginning of the 1980s, following the process of liberalization, deregulation and privatisation set in motion by Margaret Thatcher and Ronald Reagan, it was widely expected that full international capital mobility would interact with floating exchange rates to ensure adjustment of balance of payments disequilibria and a stable financial environment. Instead, these new conditions paved the way for the emergence of a global financial system in which financial innovation and the ICT revolution combined to produce an extraordinary expansion of financial sectors and markets compared with the real sector in both industrialized and emerging countries. The seeds of instability were thus planted on fertile soil. Indeed since the 1980s financial disturbances have occurred with increased frequency and intensity and have entailed major international repercussions. I will not review here the long list of debt crises, currency misalignments, illiquidity in credit markets, asset price bubbles, that have characterized the age of globalization, a subject to which I have devoted considerable attention in the last few years. 1 I would rather quote from a paper written by Michael Bordo, Barry Eichengreen and others in 2001 on “the crisis problem”: since 1973 crisis frequency has been double that of the Bretton Woods and classical gold standard periods and matched only by the crisis-ridden 1920s and 1930s. History thus confirms that there is something different and disturbing about our age. 2 See Saccomanni F. (2008), Managing International Financial Instability. National Tamers versus Global Tigers, Cheltenham, UK and Northampton, Ma: Edward Elgar. See Bordo M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2001), “Is the Crisis Problem Growing more Severe”, Economic Policy, April, pp. 53-82. So, given that the situation has not improved since 2001, what is different and disturbing about the age of globalization? Here are some features that I regard as crucial. What is different • The world economy operates under a “market-led international monetary system” in which market forces determine exchange rates and the international allocation of capital. This is the key point of a paper Tommaso Padoa-Schioppa and I wrote for a conference organized by Fred Bergsten and Peter Kenen at this Institute to celebrate the 50th Anniversary of the Bretton Woods System in 1994. 3 In the paper we underlined the risk that the increased globalization of financial markets could lead to “disturbances that may have an impact on the stability of the financial system”. • Global financial intermediaries operate in a highly competitive environment, but with essentially uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. • Financial innovation (mainly through securitization and derivatives) has greatly enhanced the ability of global players to manage market and credit risks. What is disturbing • There is no stability-oriented anchor for the macroeconomic policies pursued by systemically relevant countries. • Monetary policies targeted exclusively to consumer price inflation are not likely to prevent unsustainable trends in credit flows and in asset prices (equity, real estate, bonds, foreign exchange). • The procyclicality of the financial system has been enhanced by factors leading to excessive credit creation followed by sharp credit contraction. These factors are related to both market dynamics (underpricing of risk, overestimation of market liquidity, uniformity of financial strategies and of risk management models, information asymmetries, herd behaviour) and to financial regulation (capital requirement, fair value accounting). • Perverse incentives and loopholes in the regulatory system have made it possible for financial innovation to transfer credit risks to unregulated entities. • Widespread conflict of interest, between originators of financial products, credit rating agencies and law firms, has facilitated the dissemination of highly complex, risky and opaque instruments among investors with inadequate risk management culture. The response to financial instability The response of the international community to the episodes of instability that have affected the world’s monetary and financial system since the 1980s has been on the whole conducted on a case-by-case basis, with an emphasis on “domestic” factors and circumstances, rather than on “systemic” determinants. This has reflected the prevailing conventional wisdom See Padoa-Schioppa T. and F. Saccomanni (1994), “Managing a market-led global financial system” in P.B. Kenen (ed.), Managing the World Economy. Fifty Years After Bretton Woods, Washington, DC: Institute for International Economics, pp. 235-68. according to which crises are inevitable as they are mostly the result of immutable human factors like greed and gullibility. Crises are also seen as part of a physiological process whereby “unfit” market participants are eliminated and the “fittest” survive and become stronger. In this context, market excesses are tolerated in the conviction that they will selfcorrect in a relatively short time. From a policy point of view, the conventional wisdom recommended the so-called “house-in order-approach”. This assumes that all imbalances have a domestic origin and that, if all countries adopt appropriate policies at home, there would be no systemic problems to cope with and therefore no need for an internationally coordinated response. Obviously, domestic factors do play a role in triggering crisis situations, but they are often amplified and propagated by the operation of global financial markets. Thus a balanced response to crises should ideally address both types of factors. In reality, the policy response has been generally biased towards adjusting the domestic causes of imbalances, such as in the case of IMF financial support packages to emerging countries during the 1990s. Actions targeted to tackle systemic problems have been sporadic or partial in scope. Occasional interventions to correct exchange rate misalignments of major currencies have been conducted by G7 countries, but have been mostly of an “oral” kind in recent years, despite some evidence of success in arresting unsustainable or unwarranted trends, such as the appreciation of the dollar in the mid-1980s, the appreciation of the yen in 1995 or the depreciation of the euro in 2000. Also the much-hyped “reform of the international financial architecture” (IFA), launched by the G7 countries after the Asian-Russian crisis of the 1990s, turned out to be focused essentially on the need to strengthen financial systems in emerging market countries, mostly through the adoption of a series of standards and codes of good conduct. The plan drew criticism from a high level Task Force, set up by the Council on Foreign Relations and led by Morris Goldstein, 4 for not addressing more fundamental issues, like the moral hazard implied by IMF sponsored bail-outs or the overlapping of roles of the IMF and the World Bank in crisis management and resolution. A minority of that Task Force, including Fred Bergsten and Paul Volcker, criticized the plan for ignoring the question of reforming the world’s exchange rate regime, an omission that they equated to “watching Hamlet without the Prince of Denmark”. In the end the IFA reform obliged the IMF to invest a large amount of resources in a Financial Sector Assessment Program (FSAP) which produced reports, highly valuable but not widely read, on almost all its member countries, but with the significant omission of the United States and China. Another main objective of the reform, that of closing loopholes in the financial regulatory regime, again forced the IMF to concentrate mostly on the activity of offshore financial centres based in exotic islands, rather than on hedge funds and other unregulated financial market participants of greater systemic relevance. At a conference on “Reforming the IMF for the 21st Century”, 5 organized in 2006 by this Institute, the mandate of the Fund, its governance and resources, were thoroughly reviewed by an impressive range of academics and officials, including the Managing Director of the Fund. In that context it was recalled that financial sector supervision had led to “a mission creep” in the IMF, diverting resources from its key institutional task of conducting surveillance on macroeconomic and exchange rate policies of member countries. This concern way bluntly underlined by a senior US Treasury official, claiming that the IMF had been “asleep at the wheel of its most fundamental responsibility – exchange rate surveillance”. 6 However, See Goldstein M. (ed.) (1999), Safeguarding Prosperity in a Global Financial System. The Future International Financial Architecture (Goldstein Report), Washington DC: Institute for International Economics. See Truman E. (ed.) (2006), Reforming the IMF for the 21st Century, special report, April, Washington, DC: Institute for International Economics. See Adams, T.D. (2006), “The IMF: back to basics” in E.M. Truman (ed.), Reforming the IMF for the 21st Century, special report 19, April, Washington, DC: Institute for International Economics, pp. 133-8. this unexpected “wake-up call” turned out to be less motivated by global stability considerations, than by more prosaic concerns about the widening bilateral trade gap of the United States with China, entirely attributed to the undervaluation of the renminbi. Ted Truman, who had chaired the conference, concluded that: “The IMF is in eclipse as the preeminent institution of international financial cooperation. Consequently, the world is worse off.” To have permitted this “eclipse” is probably the most crucial flaw in the response of the international community to the challenges of globalization. It led to the perception by the markets, and the public opinion in general, that widening global payments imbalances, exchange rate misalignments, fast growing monetary and credit aggregates, exceptionally low risk premia, were not seen as posing a threat to global financial stability. This perception was reinforced by the recent decision taken by the IMF shareholders to “downsize” the institution because its lending activity to members had shrunk to almost nil in the high tide of international liquidity, as if it had nothing else to do. The international community thus went on to confront the worst economic and financial crisis since the 1930’s with unjustified complacency, ill-prepared, and with its key institution weakened by internal policy disagreements. The response to the current crisis In reviewing the response to the current crisis, I will not address the unprecedented array of immediate crisis management measures undertaken by central banks and national Governments in the major countries to underpin banking and financial systems and to support economic activity. I will rather concentrate on the longer-term work being undertaken in the IMF context, in the G20 and in the Financial Stability Forum (FSF) to reform the international monetary and financial system in order to make it less crisis-prone than the present one and more resilient to shocks. On this more systemic issue, a lively debate has developed involving politicians, academic economists and financial analysts. A recurrent theme in the debate is the call for a “new Bretton Woods” and the recent meeting of the Heads of State and Government of the G20 here in Washington last November was seen by many observers as the starting point of a process that could lead to a fundamental reform of the world’s monetary and financial system. 7 If by a “new Bretton Woods” one means a system built upon the foundations of the “old” one, it may be appropriate to recall how this was shaped. In essence, the Bretton Woods system was based on three main pillars: (i) a stability-oriented anchor for macroeconomic policies, operating through the par-value regime for member currencies in terms of gold and the US dollar; (ii) an obligation to maintain freedom from restrictions for trade and other current international transactions; (iii) the possibility of introducing restrictions on capital movements for restoring equilibrium in the balance of payments. Obviously, in any reform project, these pillars would have to be adapted to the new reality of financial globalization. Leaving aside for a moment the “anchor” question of the first pillar, it must be noted that in the G20 Summit Declaration of November 15, 2008 one can find encouraging language on the issues covered by the two other pillars. As regards free trade, paragraph 13 of the G20 Declaration has strong words on the “importance of rejecting protectionism” and a firm commitment both to “refrain from raising new barriers to investment or to trade in goods and services” and to strive for “a successful conclusion of the WTO’s Doha Development Agenda with an ambitious and balanced See, for example, Eichengreen B. and R. Baldwin (eds) (2008), “What G20 Leaders Must Do to Stabilise our Economy and Fix the Financial System”, London: Centre for Economic Policy Research, a VoxEU.org publication circulated on the web on the eve of the G20 meeting. outcome”. This is a rather non ritual language and it sounds pleasantly out of tune with the widespread feeling that protectionism is on the rise again as a result of the crisis. As regards financial regulation, paragraph 9 of the G20 Declaration broadly outlines an approach that rules out any form of old-time restrictions that would impede or distort the operation of financial markets. This is good, and it should allay the fears of a return to the past. However there is a strong commitment “to ensure that all financial markets, products and participants are regulated or subject to oversight as appropriate to their circumstances”. The G20 further outlined the need to strengthen transparency and accountability, to promote integrity in financial markets and to reinforce international cooperation in the regulatory field, broadly endorsing the program and the division of labour agreed upon in this field by the Managing Director of the IMF and the Chairman of the FSF. The FSF, in the words of Chairman Draghi, is working in particular to ensure that financial systems would have more capital, less leverage and would be subject to more effective regulation. This would imply, inter alia, reducing the procyclicality of the regulatory framework and its reliance on “selfregulation” by market participants, which paves the way to “regulatory capture”. This is a welcome change from the attitude that allowed in the past a growing proportion of markets, products and participants to go unregulated on the grounds that “they have no systemic impact”. This is the attitude that brought to us the “shadow banking system” made up of unregulated SIVs and conduits, distributing opaque structured products containing subprimes and other risky assets with the active marketing of unregulated rating agencies. Obviously, the systemic impact of these G20 commitments will depend on the actual outcome of the negotiations underway in the relevant trade and regulatory bodies. Turning, finally, to the anchor question I must say at the outset that this is the area where little progress has been made so far in official fora. The G20 Declaration mentions the need to reform international financial institutions, but mostly to reflect more adequately “changing economic weights in the world economy in order to increase their legitimacy and effectiveness”. How can we be sure that these steps will ensure that a global crisis such as the present one will not happen again? Pro-cyclicality is an inherent feature of all financial systems and it is likely that a mere rebalancing of power would not achieve significant results in the absence of effective supra-national mechanisms to promote stability-oriented macroeconomic policies at the national level, especially by systemically important countries. Unfortunately, the G20 Declaration has placed insufficient emphasis on measures against the perpetuation of policies that led to unsustainable imbalances at the global level in the recent past. These are difficult problems, but the time has now come, perhaps, to have a fresh look at what are the possible technical solutions. I do not think that the “old Bretton Woods” can offer a viable arrangement for the 21st Century: fixed exchange rates are gone. And yet one must admit that freely floating exchange rates have not really helped the adjustment of global imbalances. Perhaps this is because currencies have now become financial assets that are traded for profit motives with little or no relation to the economic situation or the balance of payments of the issuing country: the exchange rate has thus become more part of the problem than of the solution. From this point of view it would appear more logical to look again at anchors based on a system of target zones for key currencies or to a substitution account that would replace national reserve currencies with the SDR, which I presume is still alive somewhere. But although logical, a revival of these proposals seems hardly promising for reasons that are perhaps more ideological than practical but that are still strongly held. Realistically, the only anchor that one can think of today is an institutional anchor, i.e. an anchor based on institutions endowed with effective multilateral surveillance powers. This, again, is easier said than done. Willem Buiter, with his typical bluntness recently wrote: ”Don’t waste time on multilateral surveillance. The IMF will never have any influence on large member states with strong government budgetary positions and strong external positions”. 8 This is a valid point and indeed so far IMF surveillance has not been very effective despite various attempts to strengthen it. Yet, in my view, a further effort by the international community in this direction is needed. As I argue in my book, the IMF, drawing also from the expertise of the FSF and other relevant international institutions and standard-setting bodies, must be entrusted with the task of identifying unsustainable trends in payment imbalances, credit flows, asset prices, exchange rates, and of formulating specific policy advice to the relevant member countries to promote monetary and financial stability. This is an area where additional research is required and where the IMF could supplement the analytical work conducted by the Bank for International Settlements and in the central banks’ community. Monetary policies and regulatory measures should be designed to complement each other in the context of a “macro prudential approach”, whereby the objectives of fighting inflation and preserving stability in financial systems could be jointly pursued. If the policy indications formulated in the context of IMF multilateral surveillance are not followed, the IMF should make its own assessment known to the public opinion. It is possible that this may create a certain volatility in financial markets, but it will also strengthen the market perception of a two-way risk, thus contributing to brake unidirectional unsustainable market trends that inevitably lead to credit booms (and busts), bubbles, and misalignments. In the end, I think that the gravity of the present crisis requires a strong determination to correct the flaws and the inadequacies of the present market-led international monetary and financial system. In embarking in this difficult effort, the international community should follow the good suggestions that Barry Eichengreen and Richard Baldwin outline in the Introduction to the book I have already quoted: “strengthen existing institutions; start thinking outside the box; do no harm”. 9 See Buiter W. (2008), “Some Suggestions for the G20 on November 15th” in Eichengreen B. and R. Baldwin (eds), op. cit., pp. 17-20. See Eichengreen B. and R. Baldwin (eds), op. cit. pp.1-2. | bank of italy | 2,008 | 12 |
Text of the HKMA Distinguished Lecture by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, Hong Kong, 16 December 2008. | Mario Draghi: Combating the global financial crisis – the role of international cooperation Text of the HKMA Distinguished Lecture by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, Hong Kong, 16 December 2008. * * * Introduction It is an honour and a pleasure to be giving this HKMA distinguished lecture. I thank Joseph Yam for his kind invitation. I also thank Joseph and his colleagues at the HKMA for hosting the FSF Asia-Pacific Regional Meeting that has just concluded. The crisis afflicting the global financial system has now reached a critical stage. On the one hand the combined responses of governments, central banks, regulatory authorities and the private sector have created a base of stability, admittedly still fragile, for the world financial system. On the other hand, the sharp slowdown in global growth will necessarily translate into credit losses that will have a further impact on the banking industry. To mitigate the recession and break this vicious circle a further round of responses – including fiscal, monetary and regulatory policies – is proving necessary. Shortcomings in assessment ahead of the crisis One striking aspect of the crisis is precisely how its unfolding has continued to catch both policy makers and private sector players by surprise. It started with defaults in a marginal segment of the financial services industry, then quickly spread to virtually all assets. From being a US-only event, it has become global, and in fact it is forcing and accelerating the redressing of world macro imbalances that have been with us for 15 years. The current recession is the result. None of these steps had been anticipated in a timely way by the relevant actors. And when I say “in a timely way” I mean with enough lead-time to permit action that could have affected the outcomes. Policies that were reactive, and sometimes even very effective, but never proactive, seem to have been the rule. This is of course not the approach to policy-making that we try to employ when it comes to controlling inflation or meeting other objectives of macroeconomic policy. One reason for this asymmetry is that our knowledge of all the interactions within the financial services industry in a global world was quite superficial at the beginning of the crisis. The private sector has not done any better. The immediate outcome of the private sector’s own shortcomings in assessment has been the sudden death of many businesses and a generalized credit contraction. Our collective understanding of these processes has certainly deepened during the last year but we do not yet have a conscious and fully-fledged view of how the financial sector will look in the years to come. Much of the effort has gone so far into initiatives to address the short-term and medium-weaknesses in the system, but now we may be approaching the time when it will be appropriate to start thinking about reconstruction. To do so, however, we first have to see when and how reality eluded our or the market’s perceptions ahead of the crisis. First, the underlying reason why problems in US subprime loans led to the current broadbased macrofinancial crisis was the global nature of exposures to increasing risk aversion and deleveraging. Risk is now priced and traded at the global level. Over the years preceding the crisis, the overall price of risk fell significantly, and risky, illiquid positions were accumulated in many different national and international markets. When problems emerged in the specific category of US subprime, this started a process which ultimately led to a repricing of risk across all asset classes. As Tim Geithner noted when he delivered this lecture two years ago, this pattern is not a new one: in times of financial crisis, when investors cut risk-taking, they cut it everywhere, and the differing fundamentals of individual markets become irrelevant. Second, many saw risks and leverage increasing, but an optimistic view that overestimated the true degree of risk dispersion and diversification in credit markets had become the conventional wisdom. In particular, even when it became apparent that credit standards had deteriorated, neither capital markets, nor bankers, nor regulators perceived the extent to which the risk exposures generated by securitisation stayed on bank balance sheets. Also we collectively overestimated the ability of the system to absorb, rather than amplify, pressure for de-risking and deleveraging. On another front, it was only once the crisis was underway that the world seems to have discovered the risks inherent in business models that relied excessively on wholesale funding markets, both for specific institutions and for the system. And, given that these risks were misunderstood at the domestic level, all the more so was this the case at the international level, where firms, investors and regulators were farther from the markets where these bad risks were originated. One way to explain this collective blindness is to review those market developments that, in the years leading to the crisis, made both the regulators’ and market’s knowledge suddenly obsolete, while increasing the opacity of the financial system as a whole. Let me give you a few examples. • For the first time in recent years securitization was applied to lower quality mortgages. Monitoring by capital markets of this lower quality was made difficult by the fact that the probability of default did not factor in i) the probability of a drop in real estate prices in the US at the national level, which had not occurred since the Great Depression, ii) the effects of changes in lending standards on probabilities of default in these markets, or iii) the cross correlation across defaults and between defaults and the rest of the economy. • Second, especially after 2004, the massive amount of issuance of collateralized obligations by a few players increased both the market power of these players over the credit rating agencies and their dependence on this source of revenue. • Third, the SEC’s relaxation in 2004 of pre-existing limits on leverage for investment banks vastly increased the complexity of their risk management. For some time neither banks nor regulators seemed to have fully perceived how this decision would radically change the industry. • Finally, the rapid growth of the CDS market, which in ten years went from zero to 44 trillion dollars in notional amounts, created an entirely new definition of counterparty risk that was much more difficult to assess, evaluate and collateralize. With the benefit of hindsight one may be tempted to say that regulators should have probed more deeply, for example, into the risk characteristics of triple-A rated super senior CDO tranches, and should have realised that the risk of a very sharp fall in the credit quality and market value of such instrument was much greater than that of a triple-A rated bond. And, since it is the responsibility of supervisors to be especially attentive to tail risks and extreme events, they should have required banks to make appropriate capital charges against these instruments. This might have been the right thing to do but, as the previous discussion has shown, the knowledge leading to that type of behaviour simply was not there. There are many lessons that one should draw from the current crisis but one especially stands out for its general and all-encompassing character. In the future we will all be much more alert to the systemic implications of both market developments and of our own decisions, and this will have profound implications in many different ways. For one thing, financial innovation will not simply be welcomed for its narrow, specific benefits, as has been the case in the past, but it will be carefully scrutinized for its potential systemic risks. This may well dampen the growth of the financial service industry, while enhancing its survival in the long term. Furthermore, it is no longer true that the threat to let a financial institution fail is the most effective weapon against moral hazard. When implications of defaults are systemic, and in a global world this is the case much more often than in the past, this threat is not credible to say the least. And with this goes our reliance on the financial system’s incentive to credibly regulate itself, unless we can find other mitigants of moral hazard that are immune to systemic implications. Finally, we as regulators have to take a closer look at ourselves, with a view to eliminating everything that contributes to our segmented perception of events in the financial system. Response to the crisis A financial crisis – an event in which the financial system fails at its core tasks, including allocating savings, financing investment, pricing assets, and transferring risk – poses difficult challenges to policy in terms of assessment and the calibration of responses. These tasks are difficult at the domestic level, and still more complex at the global level. A critical set of challenges relate to information gaps. We have made progress in recent years in developing analytical tools and metrics for assessing risks ahead of a crisis. Unfortunately, almost by definition, a crisis involves events and processes that are unexpected. And once problems emerge, their dimensions and implications are impossible to gauge quickly. At the international level, assessment is more challenging still. Cross-border exposures are difficult to assess, and it is especially difficult to anticipate confidence effects, which are often the primary means of cross-border contagion. Also, determining how to calibrate the response is a classic case of decision-making under limited information and uncertainty. There is no way to know either ex ante or ex post whether one made the right choice. A too hasty response in some countries may increase moral hazard in others. But, when we have reached the stage where a forceful response is needed, a delay by some countries in joining the others will dilute the impact of this response and delay prompt resolution. In summary our own vastly imperfect knowledge and its segmented nature would have made a faster and more effective crisis response unlikely, since we were just learning what to do while the crisis unfolded. Under the circumstances, I think governments and central banks have been remarkably flexible and open-minded in developing and implementing creative responses to the conditions that we have faced. We can identify four distinct areas where authorities have needed to act: funding liquidity pressures in interbank markets; solvency risks facing systemically important institutions; medium- and long-term measures to strengthen the system; and the slowdown in the macroeconomy. Each has featured a number of critical information gaps that have had to be overcome, and each has presented its own challenges in terms of international coordination. Liquidity pressures were the primary focus of policymakers in the early stages of the crisis, starting in August 2007, and have remained a concern ever since. Central banks understood at an early stage that they needed to act, and act quickly, given the sudden and rapid rise in the market’s demand for liquid funds, an asset for which they are ultimately the only source of supply. Central banks initially focused on their own markets, but given cross-border confidence effects as well as the need for foreign currency liquidity in many markets, they rapidly developed a number of channels of cooperation, including coordinated policy announcements and foreign currency swap lines. After the collapse of Lehman in September, the systemic nature of the crisis has manifested itself with unprecedented force. In financial markets, we have observed a rapid shift from liquidity to credit risks, from a prevalent recourse to the market and central banks to massive governments’ intervention. Responses have included varying combinations of deposit guarantees, debt guarantees, capital injections, and asset purchases. While these have varied with local conditions, the need for coordination is well understood, and work to make these responses consistent is well underway. What have been the lessons of the experiences of recent months in dealing with the liquidity and solvency problems that have buffeted financial systems? For one thing, we have learned that in this new global risk environment the speed of developments has increased dramatically and correspondingly reduced the time that authorities have for an effective response. This has further increased our reliance on preventative measures ahead of a crisis. Second, we have learned that the international aspects of crisis response have become many times more important than before. The transmission of shocks across borders now happens through more diverse channels than even a few years ago. Given the many international externalities involved in the measures that might be taken by national authorities, the mechanisms for coordinating crisis response need to be in place well in advance. Plans need to be formulated and potential consequences must be thought through. Resolution procedures and bankruptcy arrangements also need to be harmonised better across markets. Strengthening the system From the start of the current crisis, it has been clear that short-term measures to address liquidity and solvency have had to be complemented by actions to strengthen the system in the longer term. Just as there are critical externalities in short-term response measures that call for international coordination, these longer term actions have needed to address the cross-border effects of regulatory policies in order to assure the maintenance of a level playing field. The work to strengthen global systemic resilience is proceeding with a degree of international cooperation and at a speed that would have been unthinkable only one year ago. In developing these initiatives, there has been a broad underlying consensus among authorities that the goal should be to create a financial system that is less leveraged, better capitalised, and more transparent, and that features stronger incentives for all participants in the system. The FSF has proven to be an effective vehicle for coordinating these actions at the international level. Thanks to our broad sectoral membership, which encompasses finance ministries, central banks, top regulators, international institutions, international standardsetting bodies, and expert groupings, we are able to keep one another apprised of the risks facing different sectors and of our respective work programs. Importantly, our membership includes most of the key actors responsible for implementing the actions that we recommend. The willingness of our members to exchange information and views, and to alter and accelerate work programs, has been truly remarkable. However, the crisis has also pointed up the need for us to expand our membership geographically, particularly with respect to the larger emerging economies. This is an issue that we are working on very seriously and on which we expect to make progress soon. A first set of initiatives taken by the FSF has focused on reducing information gaps: in terms of the raw data available to authorities and the market; in terms of the mechanisms, such as credit ratings, through which this information is compiled and used by the market; and in terms of the analytical work we do in the official sector to assess risks and vulnerabilities in the system. Improved international accounting and disclosure practices should help markets and authorities understand risks and exposures better. Accounting standard setters have been taking important steps to address weaknesses in such areas as the valuation of illiquid securities and the treatment of off-balance sheet vehicles. Securities regulators have taken a number of actions intended to improve the role of credit ratings in the system, to clarify their appropriate use by investors and regulators, and to address concerns about conflicts of interest in the ratings process. Closer collaboration between the IMF and FSF is one way that we in the global community hope to improve our ability to stay on top of risks in the future. A second set of initiatives has focused on prudential regulation and oversight. I believe strengthened capital and liquidity frameworks will be seen as a central achievement of the work to enhance systemic resilience. More capital will be required against trading and securitisation risks, and more intense oversight will be applied on liquidity risk management by banks. These improvements will be phased in carefully, so as not to exacerbate situations that are still fragile. Given the importance of preserving a level playing field, this work has necessarily been coordinated internationally. Third, the FSF has initiated different work streams directed at reducing procyclicality in the financial system, i.e. the tendency of the financial system to accumulate excessive risk and leverage in good times and to shed risks excessively in a downturn. Efforts are also underway to improve the incentives created by compensation systems in financial firms. Fourth, supervisors have agreed to cooperate more closely in overseeing internationally active banks, through such vehicles as supervisory colleges. Finally, going forward, it will be crucial to review the perimeter of regulation, in order to reduce gaps and inconsistencies in regulatory regimes and to address potential systemic issues that are present in sectors currently not regulated. New challenges for macroeconomic policies While this structural response is clearly an essential part of the cure, as it helps to renew confidence in the markets, it is also clear that many of the measures we are taking or discussing will only have an impact over the medium term. This is in the very nature of a structural response, which is foremost concentrated on the regulatory framework. Today the immediate challenge we face is to avoid a situation where the recessive forces deepen and combine with the impairment of financial markets in creating a vicious spiral. Over the last few months, the outlook has quickly shifted from slowdown to recession, from supply to demand shock, and from inflation to deflation risks. This new situation requires not only further and bolder actions, but also to step up the level of cooperation and common understanding between policy makers both at the national level and internationally. Let me briefly review the main challenges confronting the conduct of macroeconomic policies looking forward. Monetary policies Monetary policies in response to the drying up of global liquidity have been extremely responsive and fully cooperative. On October 8, coordination in the monetary field reached new heights, with the simultaneous reduction of interest rates in eight major central banks. Since then official interest rates have been reduced in rapid and successive waves across the globe, responding to the deterioration of the economic outlook and the rapid receding of inflation. Today the margins for further action are rapidly shrinking particularly in the US and Japan where policy rates are close to their zero lower bound. Rapidly falling inflation expectations and, in some areas, deflation risks, together with the impossibility of lowering rates below zero, pose the most challenging test for the effectiveness of monetary policies. We know that the inability to maintain sufficiently low real interest rates has aggravated crises in the past. At the start of the Great Depression, for example, short term real interest rates actually increased in the US (up to more than 10 per cent!) until 1933, because of the rapid fall in inflation. In the Japan of the “lost decade” short term real interest rates remained relatively high until 1995. Such developments have been often pointed to as key factors driving these economies into prolonged depression. The list of monetary policy instruments available to central banks to reflate the economy when official rates are close to or at zero is fairly wide. It includes: • a “quantitative easing” policy, i.e. expanding the money base beyond what is strictly needed to keep the official rates at zero, in order to reduce liquidity risks and provide incentives for financial intermediaries to expand their credit (elements of this policy, amply used in Japan until recently, are visible in the exceptional actions of many central banks today); • measures to reduce longer term interest rates, through direct purchase of long term government securities and/or carefully designed communication to influence market expectations (Bank of Japan and the Fed in 2002-03); and • the purchase of a wide range of private assets from securities to equity (as our guest, the HKMA, experienced during the Asian crisis ten years ago). As effective these unconventional monetary policy instruments may be in boosting the economy when price stability is at stake, we have to be aware of their limits and of their broader implications. First, the effects of many such policies are not well-known: the conduct of monetary policy is bound to be surrounded by much more uncertainty than is normally the case. It is for example unclear how far longer term rates, and in particular the risk premia embedded in those rates, can be brought down by liquidity injections in a situation of widespread uncertainty about economic prospects. Well designed communication by central banks may be crucial in this respect. Second, and most importantly, we should always keep in mind that the responsiveness of the economy depends to a large extent on the health of financial intermediaries, in the absence of which even powerful liquidity injections are not greatly effective. Third, there is a risk of introducing distortions in financial prices, and this calls for particular care in designing the measures. Fourth, unconventional measures may have a more direct redistributive impact on specific sectors of the economy or categories in society than normal monetary policy actions. This implies a high degree of common understanding and cooperation between fiscal and monetary authorities, as part of a clear definition of respective responsibilities and fields of action. Fiscal policies As the effectiveness of action in the monetary field becomes less certain, fiscal stimulus becomes more necessary. When financial markets are not working properly and credit constraints are widespread, private spending is more sensitive to current disposable income, and the impact of a fiscal stimulus is therefore greater. To maximize their effectiveness, fiscal actions should not affect the longer term sustainability of public finances, in order to avoid the expectations of higher future taxes; moreover, the stimulus has to be directed where its impact is strongest and fastest. In the current circumstances, the size and quality of international coordination is crucial. Uncoordinated moves create spillovers and relative price or exchange rate movements that can greatly reduce the incentives to implement a fiscal stimulus at the individual country level. On the contrary, with coordinated action taken globally, an individual country’s measures will be more significant with the joint benefit of an increase in foreign demand. The quantitative effects of the spillovers can be quite substantial. Recent simulations conducted at the Bank of Italy find that a coordinated fiscal action at the European level could increase by some 30 per cent the impact of the same measure taken in Italy alone. 1 The results reported by the IMF in its latest World Economic Outlook are also quite telling in this respect. 2 Moreover, in the case of concerted action, country level risk premia may remain more stable than otherwise. But coordination does not imply that every country has to do the same. Starting conditions need to be taken into account. Countries that are net creditors vis-à-vis the rest of the world and with sound public finances, in Asia and Europe, obviously have the possibility to take a frontline position. By doing so they would not only reduce the consequences of the crises for their own economies but also help to contain the weakening of net debtors’ economies and currencies. Moreover, bolstering internal demand in these countries goes in the direction of reducing the large global imbalances accumulated so far and thus may help to set the foundations for a more sustainable growth looking forward. In other countries, where public finances and/or net external positions are less sound, the margins for action are obviously more limited. This does not mean that they are nil. But it implies that medium term growth-enhancing and debt-reducing policies become more crucial. For example, compensating actions may be taken to bolster pension reforms, in order to lighten the burden coming from an aging population and increase participation rates; or to implement deep restructuring measures in the public sector to enhance the efficiency and quality of public spending. If taken with determination, such actions can create room for maneuver in these countries so that they can alleviate the effects of the crisis and improve growth prospects. As fiscal measures are being taken in many countries to counteract the economic contraction, the need to ensure that individual actions come to form a coherent approach is more pressing. In Europe, the European Commission has proposed a plan, currently under discussion, for a concerted action of fiscal authorities, that is very much in line with the principles I have just outlined. In the context of the European single market this is an absolute necessity. But I think that great benefits could derive from adopting a similar approach at the global level. Conclusion The main theme of this conversation is that at the origin of the crisis we find a variety of market developments spurred by financial innovation that were not understood neither by the market actors, banks, and capital markets, nor by regulators. The future challenge lies in producing an environment that is innovation friendly but where knowledge of market participants is adequate. This objective is certainly not realistic for all sorts of financial innovation, for some of the products we discussed, a model taking into account and pricing all risks simply doesn’t exist. In other cases the limits to how much financial innovation will be accepted or allowed may come from the unwillingness of the relevant private sector players to provide all the necessary information. Whatever the case it is likely that the future financial system will have more prudential oversight and more standardisation than in the past. This crisis, as painful as it is, provides all of us with valuable experience that we at the FSF and more generally the supervisory community are building on in designing the future financial system. However the crisis has been remarkable in raising the awareness of all The exercise is conducted using a DSGE model described in L. Forni, A. Gerali and M. Pisani (2008), “The macroeconomics of fiscal consolidations in a monetary union: the case of Italy”, Bank of Italy, forthcoming. See also L. Forni, L. Monteforte and L. Sessa (2008) “The general equilibrium effects of fiscal policy: Estimates for the euro area”, Journal of Public Economics. IMF, “World Economic Outlook, October 2008. authorities about the need to cooperate and coordinate their actions domestically and internationally. Let us hope that the present momentum will stay even when the situation will improve, as I am confident it will. | bank of italy | 2,008 | 12 |
Interview by Mr Mario Draghi, Governor of the Bank of Italy, with CNN, at the World Economic Forum, Davos, 2 February 2009. | Mario Draghi: Interview with CNN Interview by Mr Mario Draghi, Governor of the Bank of Italy, with CNN, at the World Economic Forum, Davos, 2 February 2009. * * * Introduction by Richard Quest: A European country that is struggling in the throes of recession is Italy where business sentiment has fallen in January for the eighth month running. It is now at its lowest level on record. Mario Draghi is the Governor of the Bank of Italy and he is also the Chairman of the Financial Stability Forum. Last week I spoke to him at the World Economic Forum in Davos. It was clear that we had to understand and I needed to understand from him the situation that we face. A I think it’s worthwhile speaking of what ought to be done rather than how the situation stands. I think the first consideration is speed is of the essence. All governments in the world have designed something, have thought about something, but only very few of them have actually done something. So I think the general consensus of …, I mean here, but I should say everywhere, is that fiscal packages that are large, that are lasting, and broad-based are key to the recovery and I think that’s… and they should be speedily implemented. Q Well the problem with what you’ve just said is no-one will disagree with you but it’s taking a very long time to get that activity under way. I’ll give you an example. Subprime was August 07. The freezing of markets was July to September 08. We are January 09 and we have had bailouts but not really much stimulus package yet. A Unfortunately the same thing happened with the Great Depression. The first signs of the Great Depression started a few years, several years before actual fiscal action had been implemented. So we don’t want to repeat that mistake. I think we have reached the stage where I would say most governments are ready to act and overall consensus is there. So it’s time to move now. On the monetary front however, I don’t want to stay only with the fiscal side, on the monetary front I think the response by central banks has been prompt and massive and has certainly been very effective. But it’s clear that now there isn’t much room left to go to have lower interest rates. And also one should keep in mind that monetary policy takes time to produce its effects and it does produce its effects only through the banking sector, which is not in good health. So unless we restore the banking sector’s health, monetary policy action is going to take time. Q We’ve had a partial recapitalization of banks and some say there’s still not enough. We are moving towards the aggregator bank in the US or a good bank/bad bank where the toxic assets … Italy has never really been infected by toxic assets. That probably didn’t … that’s a blessing now. A I mean, let me say something about the banking sector in general. Market place people, public opinion have lost confidence in the banks’ balance sheets. So the prerequisite for any action should be that we have a very significant transparency operation there going on. I think that several of the ideas that have been designed in the last year, like the TARP, the very same bad bank, the idea of segregating toxic assets within banks’ balance sheets are all good ideas that could somehow produce the conditions for doing this transparency operation. But unless that is done, when I say transparency, I mean full recognition of the size of what is toxic; but let me finish, unless that is done no significant private flows will go into the banking industry. Q By saying that you clearly believe that we have not had full transparency yet of the level of toxic assets still outstanding. A Well, let me tell you, let me give you an example. As late as the Fall of 2008 major banks – and I will not name the country where this was happening – were having the same toxic assets posted at figures ranging between 50 and 90 cents per dollar, so that is a good example of lack of transparency. Q I asked Governor Draghi whether he expected ever in his career to have to deal with a crisis like this. He told me, “Frankly no.” | bank of italy | 2,009 | 2 |
Interview by Mr Mario Draghi, Governor of the Bank of Italy, with the Wall Street Journal, at the World Economic Forum, Davos, 2 February 2009. | Mario Draghi: Restoring confidence with more transparency Interview by Mr Mario Draghi, Governor of the Bank of Italy, with the Wall Street Journal, at the World Economic Forum, Davos, 2 February 2009. * * * WSJ: Are there any signs markets are stabilizing or improving and if so, how much should we read into it? Mr. Draghi: There are markets that have started to function again, though at a reduced level. Spreads on the interbank market have narrowed considerably, and the corporate-bond market has shown signs of being alive. There has been a flurry of new issuances in the first few weeks of January. We will get little bits of good news and we can enjoy them. But we shouldn't make too much out of it. WSJ: What is the priority for regulators at the moment? Mr. Draghi: Credit circuits have been clogged now for more than a year. The very first thing to do is restore confidence in the banking sector, because it's clear that until that is done there will be no significant flow of private capital to the banking sector. WSJ: How do you restore that confidence when the market has become so skeptical and skittish? Mr. Draghi: The only thing we can do to help restart the market is to tell the world that there are certain kinds of real products that are simple to understand, easy to price and satisfy certain legal conditions. WSJ: How do you do that beyond emergency measures and into the medium and long term? Mr. Draghi: There needs to be significant progress in developing greater transparency so we can understand what's on banks' balance sheets and what valuations are. WSJ: More specifically? Mr. Draghi: In the future, there is going to be an unavoidable move toward standardization. With standardization, regardless of whether you have regulation, you will have a powerful push toward transparency, because people would understand and price products with full knowledge of them. It is also of primary importance that we create a centralized clearing and settlement process. WSJ: Aren't you afraid that the push for more regulation will put a brake on financial innovation? Mr. Draghi: We want to create a system which doesn't destroy the prospectives of the banking industry. Standardization may well hamper growth of financial innovation, but this growth will be more sustainable through time. WSJ: All things considered, what do you think the banking landscape will look like in the future? Mr. Draghi: What we want is a financial industry, and banking sector especially, where you have more capital, less debt, more rules and much stronger supervision. You can have that only if there is a level playing field and broad endorsement by political leaders. It has to be done in a way that you keep the market alive. That's the art of doing it. WSJ: You talk about engaging political leaders. The G-20 is looking at a variety of changes to the global financial regulatory system. What do you hope will come out of it? Mr. Draghi: I am confident that this group will not only endorse a global response but also contribute to shaping it. WSJ: Is there a sense that we could see political leaders make a coordinated statement about their goals – for instance, increasing transparency – and then leave it to each nation's discretion on how to implement the shared goal? Mr. Draghi: Yes. I think that is exactly the process. There is a great need for political endorsement at the global level. Then implementation is going to be, unavoidably, national. There is a shared sense that one of the great benefits for the financial-services industry was that over the last, say, 20 years, it has became global. Nobody denies this benefit now. We will lose all this if we become protectionist again by taking up initiatives purely at a national level. WSJ: If you achieve all these goals, is the end result a world in which crises become less likely? Mr. Draghi: No. I think crises are part and parcel of the market functioning. Our aim is to make sure you don't amplify normal market oscillations, either by regulation or by individual behavior. That's the ideal regulatory action plan. | bank of italy | 2,009 | 2 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the 15th Congress of the AIAF - ASSIOM - ATIC FOREX, Milan, 21 February 2009. | Mario Draghi: The global recession Address by Mr Mario Draghi, Governor of the Bank of Italy, at the 15th Congress of the AIAF – ASSIOM – ATIC FOREX, Milan, 21 February 2009. * * * The risks to the world economy, which until last summer were only feared, have now materialized. Economic activity is falling sharply in all the main countries. The crisis of confidence is the worst since the Second World War. The forecasts for 2009 have been revised repeatedly downwards. The International Monetary Fund now predicts a contraction of 1.6 per cent in output in the United States, 2 per cent in the euro area and 2.6 per cent in Japan. Recently released GDP data for the last quarter of 2008 and the latest economic indicators presage further downward revisions. The crisis has spread to the emerging economies, which have been affected by the fall-off in global demand and the drying up of net capital inflows. In Europe and in Italy the contraction began in the second quarter. For 2008 as a whole output rose by 0.7 per cent in the euro area; in Italy it fell by almost 1 per cent. The deterioration in exports and investment, and to a lesser extent weak household spending, were contributory factors. For Italy the data on orders, stocks, capacity utilization and the labour market all point to the protraction of the economic downswing in the coming quarters. The repercussions on employment have yet to emerge fully. The indicators available for recent months prefigure a marked deterioration. The fall in output has been accompanied by a sharp increase in recourse to the Wage Supplementation Fund. Businesses expect job losses in the months to come. The contraction in demand can hit society’s poorest and most vulnerable – precarious workers, the young, and low-income households – particularly badly. For more than ten years Italian employment increased at a sustained pace. Between 1995 and 2008 three and a half million jobs were created, thanks above all to wage moderation and greater labour flexibility. Temporary positions have more than doubled. In the third quarter of 2008 fixedterm, temporary and project workers numbered almost three million. Almost four-fifths of these workers’ contracts expire within one year; they are subject to especially severe risk. Economic policy initiatives To break the grip of recession is the task of economic policies. There is general awareness of the need for sweeping interventions at global level, the more closely coordinated the better. Action must focus simultaneously on the three pillars of fiscal, monetary and financial stability policies. The sooner confidence is restored in the prospects for employment and income, a return to balanced growth and the soundness of the financial system, the faster the exit from recession will be. Fiscal policies Fiscal policy has become strongly expansionary in the main countries, with measures to support demand coming on top of those taken to safeguard the banking and financial system. The United States has approved interventions of almost $800 billion, with an aggregate impact on the deficit in 2009-11 of 5 per cent of one year’s GDP. In Japan the measures for 2009-10 amount to 2 per cent of GDP; in Canada, 3 per cent. In Europe, Germany approved a stimulus package amounting to over 3 points of GDP for 2009 and 2010; Spain, a little less than 2 points for one year; the United Kingdom almost 1.5 points; France around 0.75 points. The increases in expenditure and reductions in revenue approved in Italy for countercyclical objectives amount to around 0.5 per cent of GDP, funded by measures of opposite sign. Additional measures are aimed at reassigning already appropriated resources to uses that will effectively stimulate aggregate demand. The structure of the measures reflects the prudence needed in view of the size of the public debt The choice of the forms that public measures in support of demand can take is no less important than their size. While these vary depending on the specific effects of the recession and the state of the public finances, they must support consumption among the weakest sectors and enhance the economy’s capacity for investment growth. The Government has rightly extended temporary eligibility for social benefits to most of the workers who have atypical employment contracts. The funding of these programmes has recently been increased thanks to an agreement between regions and the state. The need remains for a comprehensive reform to cover all workers against the risk of unemployment and facilitate their return to productive activity. Firms’ trade receivables with general government in relation to extensions and delays in payment of goods and services are very large: about 2.5 per cent of GDP, more than 30 per cent of annual general government spending on consumption and investment. Faster payments would help support firms without any structural drag on the public finances. In countries like Italy, where the level of private savings and public debt is high, fast-acting short-term interventions should be offset by structural measures that immediately confer certainty on the rebalancing of the budget in the medium term. It is essential to look further ahead: the long-term sustainability of the public finances is fundamental to ensure the effectiveness of policies in the short term as well. Monetary policies The central banks have made a prompt and coordinated response to the crisis. Official interest rates have been lowered rapidly; in many countries they are near zero. Worrying about getting too close to the lower limit for nominal interest rates cannot be a reason for inaction. The experience of the United States in the 1930s and of Japan in the 1990s suggests that in the initial stages of the crisis it is necessary to counter the tendency of real interest rates to increase. Rapid disinflation must not be allowed to turn into deflation. The ECB has reduced its reference rate by 225 basis points since last October. In the euro area the real short-term rate is now below 1 per cent; if official rates had not been cut, it would have risen considerably because of the fall in inflation. The Governing Council is keeping a close watch on the real cost of money. The main central banks have injected liquidity in unprecedented quantities. They have extended the range of their own instruments for action. In some cases, they have intervened directly by buying corporate debt, reactivating the circulation of credit where it had been blocked, helping to finance the private sector. They can act to influence long-term interest rates. To date, the judgement on the effectiveness of these measures is favourable. 1 When macroeconomic conditions return to normal, the liquidity pumped into the economy should be rapidly drained. The adoption of a strategy to return to normality is premature until See Ben S. Bernanke’s testimony to the Committee on Financial Services, US House of Representatives, Washington, D.C., 10 February 2009. output and employment have stopped falling: but, as with fiscal policy, it is important to provide for it from today to ensure the effectiveness of the monetary expansion, firmly anchoring long-term inflation expectations and countering any speculative bubbles in the prices of financial and real assets. Policies for financial system stability and the revival of credit Reactivating financial intermediation remains essential to get over the recession and return to lasting growth. The surrogate role played by central banks can only be temporary. Interventions in the United States and Europe last autumn (guarantees on deposits and bank securities) affected the liability side of bank balance sheets. They prevented the collapse of the system, reviving some markets. Their usefulness is steadily declining, however; it is now urgent to proceed to new recapitalizations aimed at growth and interventions to support banks’ assets. The International Monetary Fund is now estimating that the losses of the world’s banks and other financial institutions total $2.2 trillion; just five months ago, the estimate was $1.4 trillion. Worldwide, the losses recorded so far by banks come to more than $800 billion; intervention to reconstitute their capital has been approximately equivalent, almost half of it deriving from state funding. It is clear that intermediaries’ capital requirements cannot be satisfied by state intervention alone: the private capital market must be reactivated. The condition for this is the absolute transparency of banks’ assets. Investors and markets remain sceptical about the balance sheets of many financial institutions, and as a consequence the flow of capital into the banking industry has dwindled to a trickle, the level of capital that the market requires of banks has risen, and banks are under pressure to reduce their assets. Internationally coordinated action by supervisors in the principal financial centres is needed to produce uniform valuations of banks’ assets in order to enhance the credibility and reliability of financial statements. The measures announced by various countries in recent weeks, such as ring-fencing the most problematic securities in banks’ balance sheets or transferring them to separate entities (bad banks), are welcome in that they encourage the emergence of the riskiest securities. However, especially in the banking systems that are only marginally burdened by the legacy of the past, the conditions for future growth need to be recreated. Along the lines of what has been done in some countries for existing “toxic” securities, consideration could be given to public guarantees for senior tranches of new credit pools. Retaining part of the risk themselves, the banks could place these securities more readily, reviving a substantial channel of finance that is inactive today. Keeping the markets open Between the third and fourth quarters of 2008 world trade declined, on an annual basis, by around 20 per cent; the IMF forecasts a drop of around 3 per cent this year, the first since 1982. The contraction of trade, which represents one third of the value of global output, has serious repercussions on growth. The siren song of protectionism is powerfully alluring in times of crisis. In the very short term it may bring some benefits and mitigate situations of real social hardship. In the medium term, though, it will certainly prove illusory and destructive, as indeed it did in the 1930s. In November, the G20 countries vowed to keep their markets open, a commitment that was reaffirmed at the meeting of G7 ministers and central bank governors in Rome a few days ago. However, some worrying signs have appeared in recent months. In December, attempts to reach an agreement to conclude the Doha Round of multilateral trade liberalization negotiations failed. Some emerging countries have raised customs duties or initiated anti- dumping actions. So far, such interventions have been limited and for the most part within the range permitted by multilateral regulations. A proliferation of such measures could prove deleterious, setting in motion a cycle of trade reprisals. It is important for the new US Administration to take a firm stand against demands for trade restrictions, and crucial that appeals for free trade should not be contradicted by action within the European Union itself. The European Commission and the ECB are working with the Ecofin Council to draw up agreed policies in the field of financial intermediation and in other sectors receiving government aid. Revising the regulatory framework I have spoken at other gatherings about the progress we have made in revising the global regulatory framework, progress that would have been unthinkable just months ago. Today, I want to mention the work under way in international fora to build a system of macroprudential supervision to flank the traditional oversight of individual institutions. This new perspective carries significant consequences for the extension and application of the regulations. Among these: every financial institution capable of creating systemic risk will be subject to supervision; the authorities will insist on knowing both the correlations between the exposures of the various financial institutions and the way in which risk is transferred over time and space; consideration will be given to the possibility of creating new capital and liquidity buffers that expand in times of growth and contract in the downward phases of the cycle and to the establishment of a leverage ratio that limits the growth in financial leverage; and measures will be taken to reduce the risks attached to OTC products by creating central counterparties. The announcement of banks’ participation in the construction of a central platform for trading in credit default swaps is a step in this direction. The new platform will bring clarity in a market which, because of its size and opacity, is currently regarded as potentially capable of amplifying the crisis. It is envisaged that, at international level, the governance of financial institutions, executive compensation, and the special duties of intermediaries to protect retail investors will be subject to explicit supervision. Further, the formation of supervisory colleges for major international intermediaries will be generalized. Italian banks Eighteen months after the world financial crisis erupted Italy’s banks are in better shape than the largest international banks. They have been protected by a low level of financial leverage, a business model firmly based on traditional lending and rooted in the relationship with household and business customers, and a prudent regulatory framework and system of supervision. In 2008 the major international financial centres were the scene of the sudden collapse of leading institutions and repeated, large-scale government bail-outs. The financial turmoil has affected the financial conditions of our banks, but to a fairly limited extent: from the onset of the phase of financial instability to the third quarter of 2008, the last period for which the consolidated quarterly reports have been released, the leading Italian groups made writedowns of some €4.5 billion as a result of the crisis, a substantial amount but less than for major foreign banks. Profits declined, but were still positive in the first nine months of the year. Overall, capital has remained above minimum requirements. The capital ratios of Italian banking groups are calculated on the basis of stricter prudential criteria than are applied in other systems. Above all, after the collapse of Lehman Brothers the greatest short-term risk for the stability of the international financial system has been the liquidity shortage. Italy has not escaped this. In the unsecured interbank market, turnover fell for all maturities and virtually disappeared for those beyond one week. Risk premiums jumped. At present, liquidity conditions have eased. The spread between unsecured and secured three-month interbank rates, which had widened to 185 basis points on 10 October, has progressively narrowed, reaching 90 basis points in the last few days. Trading in slightly longer maturities has resumed. Some channels of finance that had been clogged appear to be opening up again, even beyond the short term; in January, the corporate bond market showed signs of revival, an important development in a phase when bonds issued by banks in recent years are maturing. But the recovery is fragile and highly uncertain. To provide the banking system with liquidity, so as to prevent any interruption of the flow of credit and payments, has been the principal concern of the authorities for many weeks. Central banks have acted rapidly and in coordinated fashion; the Eurosystem has been one of the key actors. The guarantees introduced by the Italian government and the Bank of Italy have sustained confidence in the banking system and assisted the recovery of the interbank market; we have reported on this on several occasions. On the second of February, in collaboration with the Italian Banking Association and e-MID S.p.A., we launched the Collateralized Interbank Market, which allows banks to trade interbank funds anonymously and with a guarantee against the risks of counterparty illiquidity and insolvency. The interest rates in this market have been lower than those on the uncollateralized market and in the Euribor fixing, reflecting the containment of risk premiums. The Collateralized Interbank Market is open not only to Italian banks but also to other European banks that meet the same requirements, subject to agreement with their home central banks. Complacency about the danger we have avoided so far is of no help, we must look ahead. The recession in Europe will inevitably end up by weighing on the accounts of our banks. Credit risks are emerging both in the traditional sectors of activity and in the emerging economies; our banking system, like those of others, is exposed to deterioration in the latter’s performance. The increase in provisions for loan losses will hurt the banks’ results for this year. The market has discounted this in its valuations. It is necessary to take action to strengthen the prudential defences against the worsening of the cyclical situation and at the same time to create conditions that will guarantee an adequate flow of credit, so as to avoid a downward spiral of tight credit and economic contraction. Beyond the short term, recovery of the real economy is a necessary condition for banks’ solidity. Credit Lending by the Italian banking system, which was still growing fast in the first part of 2008, slowed down over the year; the deceleration became sharp in the last few months. In the fourth quarter the growth in credit to the private sector fell to 4.2 per cent on an annual basis, half as great as in the three previous months. In 2008 the stock grew by 7.4 per cent, a slowdown of more than 3 percentage points compared with 2007. According to the provisional data referring to the sample of banks that provide 10-day reports, the stock of total credit stagnated in January. If this is confirmed, this would imply a fall in just one month of about half a percentage point in the twelve-month rate of growth. The slowdown is common to the other major European countries and has affected all parts of the country and all categories of borrowers. The growth rate was modest particularly for small enterprises and manufacturing industry; construction recorded an especially large slowdown. The fall in production and the uncertain cyclical outlook have depressed the demand for funds for fixed investment and working capital. Households’ demand for loans reflected the fall in housing market activity and purchases of durable goods. In 2008 lending to the sector grew by 6 per cent, compared with increases of more than 10 per cent in the previous years. Personal loans continue to expand at a lively pace. The outcome for credit was also influenced by the more cautious lending policies adopted by banks in response to the increase in the cost of fund-raising, the partial closure of international sources, the deterioration in customers’ creditworthiness and the need to improve capital ratios to cope with the pressure exerted by the markets at a time of pronounced uncertainty. In 2008 resources obtained from foreign banks and money market funds fell by about 10 per cent. They had risen by 20 per cent in 2007 and 34 per cent in 2006, when they had contributed nearly half the growth in fund-raising. Banks have responded to the smaller inflow from abroad by increasing the funds they raise from Italian households, above all with bonds. In 2008 the average cost of total fund-raising rose by 40 basis points compared with the previous year; since October it has started to fall following the reductions in official interest rates and the partial normalization of the interbank market. Loan quality is being affected by the recession. Since the third quarter of last year the flow of new bad debts has been increasing rapidly, and in the last quarter of 2008 the ratio to total outstanding loans was the highest since 1999 (not counting the peak in the fourth quarter of 2003 due to the failure of Parmalat). The deterioration continued in January, when the total debt of newly insolvent customers was 70 per cent greater than in January 2008. The system has a major strength – private-sector debt is considerably lower in Italy than in other countries. Corporate financial debt amounts to 75 per cent of GDP, around 12 points lower than the European average. The leverage of Italian firms is now seven points lower than at the turn of the 1990s, on the eve of the last recession, and the percentage of financial costs covered by internally generated funds is higher. For households, though financial debt is greater than in the past, it is still no more than 49 per cent of disposable income, as against over 90 per cent in the euro area as a whole and 150 per cent in the United Kingdom and the United States. The most recent data indicate that in the third quarter of 2008, allocations to provisions and value adjustments absorbed 30 per cent of the operating profit of Italy’s largest banking groups. This ratio, though still far below the level recorded in the United States, is rising rapidly; it is worth recalling that at the end of the much less severe recession in the 1990s it exceeded 70 per cent. Just as banks have been asked to shed full light on the troubled assets that have been on their books since the onset of the crisis, it is equally important that they conduct a realistic, unflinching estimate of the loan losses that they are bound to incur in the months to come; and that this estimate serve as the basis for conducting balance-sheet management and determining capital injections, dividend policy and executive compensation. Strengthening the banks in order to sustain the economy Guaranteeing a sufficient supply of credit while at the same time maintaining sound and prudent lending standards – this is the challenge that faces the banking system in 2009. A credit squeeze would aggravate the recession; a reduction in prudence could jeopardize the banks’ stability, with serious consequences for their medium-term lending capacity and for the economy. The objective of making funds available to the economy must not be pursued by relaxing standards of creditworthiness but by strengthening the capital base, in order to overcome undue constraints on asset growth. I have had occasion, elsewhere, to remark that the approach to capital strengthening must be pragmatic. Banks must take all necessary measures and seize all opportunities. Some groups have already begun to move by disposing of non-essential assets, retaining earnings and going to the market. With the finalization of the implementing measures, the public funds provided by Law 2/2009 will soon be available. Thanks in part to a fruitful dialogue with the banking system, the instruments offered by the state have been refined, within the limits of EU regulations, to provide a range of flexible possibilities that can be adapted to the needs of the various banks and banking groups. If the funds made available by the state are adequate and the accompanying conditions are reasonable and practical, designed to attain the objective without administrative interference in business decisions, they should be used. It is also desirable to revise the tax treatment of loan losses. In Italy, banks and other financial intermediaries may only deduct loan writedowns up to 0.3 per cent of total lending. Writedowns above that amount are deductible over 18 years. France, Germany and the United Kingdom, by contrast, allow the full and immediate deduction of all value adjustments entered in the accounts. The Italian rules have a procyclical effect: if bad debts increase, the costs to the financial system are aggravated, because the volume of non-deductible losses increases. They are particularly onerous in the present phase of the cycle. Banks’ reputation, an underpinning of stability Always, but especially at times of crisis, a bank’s good name is its most valuable asset, the basis of a solid relationship with customers. Safeguarding and enhancing the banking system’s reputation equally requires irreproachable conduct and rigorous rules. The correctness of banks’ conduct is important for the Bank of Italy because it is a precondition for stability. This is especially true at times like the present, when recourse to customers’ savings has proved essential to enable the banking system to compensate, swiftly and substantially, for the contraction in other sources of funding. Overseeing the transparency and correct conduct of those who offer financial products and investment services is the responsibility of Consob. For typical banking transactions, the law entrusts such supervision to the Bank of Italy. Within a few weeks we will hold a public consultation on new rules, which are being drafted in cooperation with the associations of banks, other intermediaries and consumers. We will make the documents for customers clearer, more concise and comparable. We will use especially incisive instruments for the most widely used products, mortgage loans and current accounts. We will ask that attention to customers’ needs be at the centre of every phase of the production process. Transparency of corporate governance and openness of ownership structures are also preconditions for the good name and efficiency of banks. Formerly, the banking system, constricted by extensive public ownership and a web of rules that conditioned all its activity, had a concentrated and closed ownership structure and its conduct was scarcely competitive. Enormous progress has been made in recent decades. The system of public banks has been dismantled. Consolidation has revolutionized the industry’s ownership structures. Banking foundations, having given up control almost everywhere, have transformed themselves into investors attentive to long-run prospects. The Antitrust Authority recently drew attention to some structural issues concerning the system: concentration of ownership, cross-shareholdings and interlocking directorships. These aspects deserve attention. However, it should be noted that concentration of ownership, a common characteristic of listed Italian companies, is less pronounced for banks than for companies in other sectors. The incidence of cross-shareholdings between the leading banks appears to be lower than in other countries of continental Europe. As regards interlocking directorships, a matter within the competence of the Antitrust Authority insofar as it concerns competition, it is first of all up to the Government and Parliament, to which the Authority addresses its reports, to evaluate whether action is needed and what measures to adopt. * * * When the channels of capital allocation are clogged, the normal operation of the economy becomes jammed and growth is impeded. It is necessary to restore confidence in the financial system, in the solidity of banks and markets. Society expects banks, monetary authorities and governments to offer decisive support in order to come through the storm while not losing sight of the shore. Readiness to act immediately must be accompanied by a strong long-run strategy. Banks are asked to demonstrate clarity and prudence, but also the foresight needed not to withhold credit from deserving customers. The monetary authorities are responsible for ensuring that sufficient liquidity is created and spread through the most suitable channels to the financial systems in which they operate, but they are also charged with firmly anchoring medium-term inflation expectations. Governments are called upon to take prompt, vigorous action to support the economy. It is an opportunity for structural reforms that will enable our country to enjoy faster and better growth in the future. The margins for a countercyclical fiscal policy must be created by intervening resolutely on the basic mechanisms of expenditure, by credibly ensuring the sustainability of the public finances in the long and very long term. At global level, the resources and capabilities of the international financial institutions, especially the IMF and the World Bank, will have to be mobilized. In the European Union, there are the instruments and institutions needed to give concrete support to some neighbouring countries that look to the EU as an anchor of stability. There is no reason to give in to discouragement. Rather, it is an opportunity for the country, all of us, to demonstrate our ability to protect the weakest, to open up new paths for the future. | bank of italy | 2,009 | 2 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, before the Finance Committee of the Chamber of Deputies, Chamber of Deputies, Rome, 17 March 2009. | Mario Draghi: Fact-finding on issues affecting the banking and financial system Testimony of Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Forum, before the Finance Committee of the Chamber of Deputies, Chamber of Deputies, Rome, 17 March 2009. * * * All the main advanced economies recorded a sharp contraction of output in the fourth quarter of 2008. Consumption and investment demand is falling owing to the rapid, generalized deterioration in household and business confidence, the increase in unemployment, the drop in share prices and house values, and tighter access to credit. The recession has passed to the emerging economies, hit by the drop in exports to advanced countries, the decline in raw material prices, and the sudden reversal of capital flows. The countries that depend most heavily on financing from abroad, such as those of Central and Eastern Europe, are especially vulnerable. The International Monetary Fund and other official and professional forecasters have progressively revised their estimates of world economic growth downwards. In January, the IMF projected that world trade would contract by almost 3 per cent in 2009 and that GDP would fall by 1.6 per cent in the United States, 2 per cent in the euro area and 2.6 per cent in Japan. It has already announced that the estimates are being newly revised in the light of more recent data. World GDP growth will probably be negative on average for the year. Economic policymakers have acted promptly to contain the spread of the financial crisis and counter its effects on the real economy. Central banks supplied ample liquidity to the financial system, with interventions of unprecedented size and degree of international coordination. Governments have introduced or strengthened guarantees for bank deposits and securities and have prepared or taken measures to recapitalize financial institutions. These actions have prevented the collapse of the system but they have not yet shed full light on the financial situation of those banks that invested most heavily in “toxic” assets: there is still uncertainty as to the size and distribution of the losses on the balance sheets of what were once the world’s largest banks. Moreover, it is likely that the recession will cause a further deterioration in banks’ assets. The restoration of confidence in financial institutions and properly functioning credit markets is essential, along with support for demand offered by monetary and fiscal policies, in order to restart growth. Official interest rates now stand at minimal levels in the leading economies. There is limited scope for the monetary policy lever to work, although there remains the option of unconventional measures, which are being implemented in part. In some cases, notably the United States, the central bank has put itself in a position to intervene directly in certain segments of the credit market in order to guarantee liquidity to the private sector. The leading governments have introduced fiscal stimulus measures to counteract the contraction in income and employment. The United States has launched a programme of expenditure measures and tax cuts amounting to almost $800 billion, which will have an overall impact on the deficit for the three years 2009-11 of about 5 per cent of annual GDP. The stimulus measures adopted by the European countries and Japan are of a smaller order of magnitude but considerable nonetheless, partly reflecting differences in the initial condition of public finances and in the operation of automatic stabilizers. In China, too, the Government has announced a broad programme of extraordinary expenditure to boost demand. The importance of international cooperation for a return to stable world economic growth and the strengthening of the international financial system was stressed at the meeting of G20 finance ministers and central bank governors in Brighton last weekend. In Italy, as in the rest of the euro area, the recession, which worsened in the middle of 2008, is expected to continue through this year. All the indicators (production, orders and inventories) continue to point to extremely slack activity. GDP is expected to contract in the first quarter of this year, for the fourth consecutive time. The whole of 2009 will probably close with a new, large drop in economic activity, above all in the private sector. The difficulties of the main outlet markets have affected exports, which were the most important source of support for demand in 2006-07. In January, Italian exports to non-EU countries fell to historic low levels. Firms have cut back dramatically on their investment plans owing to the large margins of spare capacity. Consumer price inflation, which has been falling since last autumn, stood at 1.6 per cent in February; it is expected to continue to fall until the summer, mainly thanks to the trend in energy and food prices. Despite the contraction in activity, leading international organizations and professional forecasters do not expect a deflationary spiral to set in. The additional expenditure and reduction in revenue that Italy has approved for countercyclical purposes amounts to about 0.5 percentage points of GDP; these measures are financed by others of opposite sign. In addition, previously allocated resources have been channelled into uses that stimulate aggregate demand more effectively. The decision as to the forms of government intervention to support demand is no less important than the question of its magnitude. They must support the consumption of the weakest categories of citizens and strengthen the economy’s capacity for growth through public investment projects that offer a high rate of return and are shovel-ready. The Government has temporarily extended the possibility of benefiting from social shock absorbers to most categories of atypical workers; further improvements were defined last week. Funding for these measures was recently increased thanks to an agreement between central government and the regions. These provisions are opportune, but there is still the need to tackle a comprehensive reform. The Government has also announced it is examining provisions to facilitate the expansion of residential buildings and to reduce construction charges. The procedures, contents and timetable of any possible measures are not yet known. Simplifying formalities and reducing charges could constitute a stimulus. The complex nature of this subject, concurrent powers between the central and regional governments, and the need to design the intervention so as to preserve the natural environment and balanced town planning make the effects of such action uncertain in the short term, however. The amount of firms’ receivables from general government, connected with deferments and delays in paying for goods and services, is very high: about 2.5 per cent of GDP, more than 30 per cent of annual general government consumption and investment expenditure. Faster payments would support firms without structurally burdening the public finances. In countries like Italy, with high public debt, broad and incisive short-term interventions must be compensated for by structural measures giving immediate assurance of the restoration of budget balance in the medium term. It is essential to look farther ahead: the long-term sustainability of the public finances is fundamental to ensure the effectiveness of short-term policies. Lending and the banks Italian bank lending has decelerated sharply. The annualized three-month growth rate of loans to the private sector, adjusted for the accounting effect of securitizations, fell to 2.3 per cent in January, from 8.6 per cent in September. On the basis of partial data, lending is estimated to have contracted slightly in February with respect to January. The slowdown has affected all categories of debtors. For firms, in January the three-month growth rate was 5.5 per cent, about three points lower than in September; however lending to firms with fewer than 20 employees and to manufacturing industry declined. The fall in production and uncertainty about the future of the economy reduced the demand for credit for investment and for funding inventories and working capital. Lending to households increased by 3.3 per cent in January, against 4.7 per cent last September. The growth in lending to households, which was quite robust a few years ago, had already moderated before the beginning of the financial crisis; the fall in house sales and the drop in spending on durable goods caused a further slowdown. As regards loans for house purchases, which constitute 68 per cent of credit to consumer households, in the fourth quarter of 2008 new loans were down by 20 per cent from a year earlier. Consumer credit for the purchase of goods and services – which accounted for 6 per cent of bank lending to households – slowed sharply. New mortgage loans at fixed rates amounted to €36 billion in 2008 or 64 per cent of the total granted to households, compared with €32 billion (51 per cent) in 2007. The wide gap between Italy and the euro-area average in the cost of new fixed-rate mortgages (one percentage point in June 2007) has now narrowed to nearly nil. In the last few months the share of new fixed-rate loans has fallen slightly, though remaining higher than in the past (55 per cent in January). One factor in this reduction was the fall in interest rates on variable-rate mortgages, making them more attractive to households; on the supply side, difficulties encountered by banks in recent months in obtaining long-term funds may have induced them to limit their supply of fixed-rate mortgages. The stagnation in lending is also due to banks’ adopting a more cautious policy in lending to households and businesses. The Italian banks participating in the Bank Lending Survey reported that in the fourth quarter of 2008 lending conditions tightened somewhat, while firms’ demand for credit was basically stagnant. Between September and December, existing credit lines were reduced by 1 per cent in the face of a virtual standstill in actual lending. The fact that banks are being more cautious in lending reflects difficulties in the funding markets and the deterioration of customers’ creditworthiness. In 2008 fund-raising by Italian banks from non-resident intermediaries fell by almost 10 per cent. As funding from abroad dried up, banks responded by raising funds from households, in particular by selling bonds. This allowed overall fund-raising to continue to expand, but it did not prevent a sharp slowdown; the average growth rate fell from 11 per cent in 2007 to 5 per cent in 2008; in January the latter figure was confirmed. In the same year, lending to the private sector grew more rapidly (7.3 per cent). Lending by large banks, which are more reliant on fund-raising abroad and more exposed to market strains, slowed sharply. Local banks, by contrast, maintained similar credit flows to those before the crisis, thanks in part to a greater inflow of funds. The recession is impinging on the quality of credit. The ratio of new bad debts to total lending to firms is rising rapidly: at the end of 2008 it reached 2 per cent, the highest value since 1999, excluding the spike in 2003 when the Parmalat group collapsed. Preliminary data for the first two months of 2009 show a further increase in the number of customers having bad debts for the first time. The exposure of these customers to the banking system more than doubled compared with the same period in 2008. Although it deteriorated slightly, the quality of credit to households remains high. Private-sector debt is much lower in Italy than in other countries. Although higher than in the past, households’ financial debt is 49 per cent of the sector’s disposable income, as against more than 90 per cent for the euro area and about 150 per cent for the United Kingdom and the United States. Firms’ financial debt is 75 per cent of GDP, compared with a euro-area average that is about 13 percentage points higher and ratios of 77 and 113 per cent respectively for the United States and the United Kingdom. Compared with the years before the 1993 recession, Italian firms appear to be in a sounder financial position today. At the end of 2007 the leverage ratio, calculated on the balance sheets of more than 50,000 firms, was about 50 per cent, 7 percentage points less than at the beginning of the 1990s. Above all the proportion of financial costs covered by internal sources of financing is higher today. In the eighteen months of the crisis the major Italian banks have suffered smaller losses than those of other countries thanks to their limited exposure to toxic assets and strong roots in traditional banking activity, the prudence of the regulatory and supervisory framework, and the less pronounced indebtedness of their customers. For the leading banking groups structured credit instruments are less than two per cent of their balance sheet assets. Investments in the most complex securities are a tiny proportion of the total. The capital of our banks, which, in contrast with developments in nearly all the other leading countries, has not yet benefited from public recapitalizations, remains above the minimum regulatory requirements. The leverage ratio of the leading Italian banking groups – a simple indicator that avoids the complicated risk-weighting of assets required by the Basel 2 rules – is considerably lower than that of the main European banks. The proportion of hybrid capital instruments, the least robust component of tier 1 capital, is small because the Bank of Italy has applied limits that are much more stringent than the relevant international standards. It follows that even when measures of “tangible” capital are adopted, the judgement on the solidity of Italian banks does not change. In line with international practice, the calculation of Italian banks’ regulatory capital excludes the book value of goodwill, an item that in present market conditions is subject to considerable uncertainty. Accordingly, any impairment of this item would not affect banks’ regulatory capital. The market’s assessments nonetheless consider the possibility that a further strengthening of the banking system may be necessary. Banks must prepare to cope with the risks, already materializing, associated with the rapid deterioration in economic conditions. A fundamentally sound model of intermediation has so far sheltered them from the worst effects of the financial crisis; it cannot make them impermeable to the global recession. Capital strengthening, including by means of the instruments made available by the state, is a condition for maintaining the ability of the banking system to provide the economy with credit. In 2009 banks’ gross income will continue to contract, after an estimated fall of about 5 per cent in 2008, despite the still substantial growth on the order of 8 per cent in net interest income. As in the past it is likely that the decline in economic activity and interest rates will have a negative impact on interest income. According to econometric estimates, a one percentage-point reduction in GDP would lead to a 0.7 percentage-point contraction in net interest income; that produced by a one percentage point fall in money-market interest rates would be much larger, on the order of 3.5 percentage points. On the international front, the balance sheets of Italy’s leading banks are weighed down by their exposures to some Central and Eastern European countries, which are suffering from the particularly serious repercussions of macroeconomic imbalances accumulated in the past. According to BIS data, in September 2008 the Italian banking system’s exposure to these countries amounted to just over €150 billion, or 5 per cent of the system’s total assets. More than 70 per cent of the exposure is to five countries (Poland, Croatia, Russia, Hungary and Slovakia). The situation is being carefully monitored by the Bank of Italy. At European level, the political will and the instruments exist for intervention to prevent regional crises if necessary. From the end of September up to yesterday the share prices of the major Italian banks fell on average by more than 50 per cent, in line with the fall recorded by the leading European banks. The share prices of international banks did not benefit from the recapitalization measures adopted abroad. In the same period major Italian banks’ credit default swap premiums, which started from low levels by international standards, rose by about 70 basis points to about 180 basis points, a figure that is analogous to that obtaining yesterday for the corresponding European index. The premiums payable on credit default swaps are influenced by significant variations in the liquidity of these contracts. I have noted on several occasions that from the beginning of the turmoil in summer 2007, the Bank of Italy stressed how essential it was for banks to ensure adequate control of liquidity risk. Enhanced monitoring, moral suasion and specific interventions had a rapid and significant impact; they enabled Italian banks to address the worsening of the financial crisis last September with balanced liquidity conditions, which allowed them to emerge from the most acute phases without incident. Supervisory activity, participation by the Bank of Italy in the collective decisions and actions of the Eurosystem, providing support to the Government and Parliament in the preparation of measures aimed at restoring confidence in the markets – to which I will return shortly – were accompanied by numerous initiatives taken directly by the Bank in the performance of its monetary functions and to alleviate specific difficulties. I have reported on this in detail elsewhere. I wish to recall in particular the swap transactions whereby some of the highest quality securities in the Bank of Italy’s portfolio were made available to banks against securities not eligible as collateral for refinancing, in order to strengthen their ability to access these operations with the Eurosystem at times of tension. The swaps were activated from 16 October onwards. The strong capital base of Italy’s central bank has been of great importance in recent months. It enabled us to plan and implement the interventions we believed necessary to support systemic liquidity promptly and for significant amounts, without jeopardizing the Bank’s balance-sheet. While less tense than a few months ago, conditions on the interbank liquidity market are still far from normal. There continues to be a need for initiatives to rebuild confidence and revive trading. On 2 February trading commenced on the new Collateralized Interbank Market (MIC), a joint initiative by the Bank of Italy, the Italian Banking Association and e-MID SIM S.p.A., the company that operates the e-MID electronic interbank market. Participating banks are given the opportunity to execute transactions with medium-term maturities, in conditions of anonymity and sheltered from credit and liquidity risks. The Bank of Italy evaluates the collateral deposited by the participants and ensures prompt settlement of transactions in the event of default by a counterparty; the banks themselves, which are called on to bear some of the cost of an eventual failure, contribute to the proper functioning of the system on a mutualistic basis. The collateralized market is open not only to Italian banks but also to other European banks that meet the same requirements, subject to an agreement with their home central banks. The volume and prices of trades are satisfactory. Between the first and sixth weeks of activity average daily trades rose from €50 million to €318 million and outstanding deposits reached €2 billion. For maturities of one and two weeks, the most traded by banks, the interest rates on the collateralized market have been consistently lower than those on the uncollateralized market, between 10 and 30 basis points on average per week; on the same contracts the bid-ask spread for the best quotes in the MIC order book have fallen progressively, from 5 basis points to 1 basis point, testifying to increasing market liquidity. In all the main countries the authorities took steps to support the financial system. In Italy the Government and Parliament, with the technical support of the Bank of Italy, adopted a set of measures to protect depositors, support banks’ liquidity and capital, and reinforce their ability to finance economic activity. The provisions, which were adopted under the emergency decree procedure, were ratified by Laws 190/2008 and 2/2009. I believe it is useful to recall their main points. In a first measure (Decree Law 155/2008, ratified by Law 190/2008), retail banking deposits were granted a state guarantee. The guarantee supplements the insurance provided by the previously existing interbank funds. The measure was important to reassure savers when market anxiety levels were most acute. A second set of measures, contained in Decree Law 157/2008, empowered the Ministry for the Economy and Finance to grant a state guarantee on new bank liabilities with a residual maturity of between three months and five years, guarantee entities that offer banks securities eligible for use in refinancing operations with the Eurosystem, and supply government securities to banks in exchange for newly issued liabilities (this is in addition to the Bank of Italy asset swap transactions recalled earlier). All these measures serve to guarantee banks access to a sufficient supply of liquidity, in order to ensure that the normal operation of the lending and payments system is never interrupted, even in conditions of serious turbulence. Together with the interventions by the monetary authorities, the announcement of these measures helped ease tensions on the interbank market in the autumn. Thirdly, to deal with potentially difficult situations, Decree Law 155/2008 authorizes the Treasury to subscribe capital increases of banks facing a situation of capital inadequacy ascertained by the Bank of Italy. The Government shareholding takes the form of non-voting preference shares; such public intervention is subject to the presentation of a restructuring plan assessed by the Bank of Italy. Lastly, Decree Law 185/2008 (ratified by Law 2/2009) authorizes a financial intervention by the state to increase the capital of fundamentally sound banks. In this case it is not a question of rescue operations, but of a measure to strengthen the system and, in a macroeconomic environment that has deteriorated sharply, to avert a perverse spiral between loan defaults and credit restriction. The state intervenes by taking up financial instruments issued by banks. These can be counted for prudential purposes in core tier 1 capital, because both their remuneration and their value depend on the issuer’s profitability and capital adequacy, and they may therefore be used to absorb possible losses in all circumstances. Applicant banks must adopt a code of ethics, including with regard to executive compensation, and undertake to sustain the financing of customers, particularly households and small and medium-sized enterprises. This commitment has been appropriately defined, taking into account the level of the demand for loans and the need to maintain standards of prudent credit allocation. The measure has been made operational by a decree of the Minister for the Economy and Finance. The Bank of Italy has given banks the necessary technical guidance. The economic terms of the issues must comply with the guidelines established by the European Union; several alternative schemes have been defined, partly at the request of the Bank of Italy, to make adherence to the plan more advantageous for banks that intend to redeem their instruments within a relatively short time. The terms of the Italian instruments are in line with those offered by other European countries. I expect banks to make use of them in suitable amounts. The recapitalization law also provides for monitoring the transactions and their effects on the economy and institutes special observatories at prefectures, with the participation of the interested parties. The Bank of Italy will supply the Ministry for the Economy and Finance with data and analyses on the evolution of credit and borrowing costs on a regional basis, as an additional supplement to the ample geographically disaggregated data already released in its publications. The statistical information will allow any specific situations of tension to be identified. It is essential that analysis of credit conditions at local level not stray into a role of pressuring banks, prompting them to relax the standards of sound and prudent management in the selection of borrowers. In my opinion, political and administrative interference in assessments of individual cases of creditworthiness must be avoided. Lending is and must remain an entrepreneurial activity, based on a prudent, professional evaluation of the validity of companies’ plans. Sooner or later, imprudent banks end up in distress and also cease lending. But the test posed by the crisis is severe and requires the ability to be good bankers even when the economy is doing badly. The inevitable deterioration in loan quality due to the recession calls for far-sighted choices: just keeping the accounts straight is not enough. Firm support for creditworthy customers prevents an excessive credit squeeze, which would aggravate the recession, thereby worsening the position of banks’ customers. As I have already said, every opportunity must be taken to strengthen the capital of banks, choosing the most appropriate form in each case: recourse to the market, retained earnings, or the instruments offered by the state. The restoration of confidence in the banking system is a global, not a national question. In my view, four conditions are essential. First, the uncertainty still surrounding the value of the most troubled assets on banks’ balance sheets must be dispelled; this must become an integral part of public interventions in support of the financial system. It is indispensable, especially in Europe, that similar measures be based on common principles, in order to avert competitive disparities between intermediaries of different countries and between banks exposed in differing degrees to the problem of impaired assets. Second, in determining recapitalization objectives, it is vital that the definitions of bank capital be the same at international level. Third, the authorities have made it clear that they intend to protect all systemically important institutions, endow them with the capital needed to face stress conditions, protect depositors and have the shareholders alone bear any losses. To all intents and purposes banks’ other creditors are protected against losses. This must be explained with absolute clarity; it is the only way to drastically reduce the risk premiums that the markets are still demanding on bank liabilities. Fourth, it is time to go beyond dealing with the problems inherited from the past and consider how to ensure the availability of credit from now on. Recapitalizing banks is necessary to this end, but it is not sufficient; there is a need to think about new, even unconventional instruments. This last point is especially pertinent for Italy, where neutralizing the complex financial instruments whose value has plunged is of limited relevance and finding instruments that directly affect the availability of loans for firms and households is more important. One possibility would be the issuing of public guarantees for the senior tranches of pools of new loans, with a view to reviving an important channel of financing, loan securitization, that has completely dried up today. If banks are able to sell part of their loans on an active and liquid secondary market, they can use the liquidity obtained to reactivate the supply of credit. A scheme of this kind would have to be carefully designed in order to ensure its effectiveness in terms of new lending, give banks a correct structure of incentives and minimize the costs to taxpayers. The originator bank should retain some of the risk, thereby still having the incentive to select creditworthy borrowers; it should pay a suitable fee for the issue of the guarantee, commensurate with the quality of the underlying loans. Limiting the public guarantee to the least risky portion of the pool of securitized loans keeps the state from being assigned an inappropriate role in the assessment of creditworthiness. Objective criteria could be established for selecting loans of good quality (for example, mortgages with a loan-tovalue ratio not above a given limit and loans to small and medium-sized firms backed by the Guarantee Fund for Small and Medium-Sized Enterprises), so as to encourage subscription of the entire pool of securitized loans by the market and limit the possible cost to taxpayers. Some features of the tax treatment of banks and other intermediaries in Italy that lack a clear economic logic and produce a competitive disadvantage with respect to other countries should be reconsidered. Value adjustments to loans are deductible from taxable income each year only up to 0.3 per cent of a bank’s total outstanding loans; writedowns exceeding that amount are deducted over a period of eighteen years. The limit and the rules on the writedown period have been tightened repeatedly in recent years. It is difficult to see the economic justification or to find comparable provisions in the other major European countries. In France, Germany and the United Kingdom, value adjustments are tax-deductible on a loan-by-loan basis, in line with those stated in the accounts; in France and Germany, flat-rate allocations to provisions are also allowed. The penalization of Italian banks is pro-cyclical, because the burden is greater during cyclical downturns, when loan losses increase; at present, the mechanism is exerting a disproportionate impact on the credit system. In banks accounts, the limit on the deductibility of value adjustments results in an advance payment of taxes, in essence a tax credit. At the end of 2007 this credit amounted to some €4 billion; for 2008 it comes to €1.4 billion. Writedowns are also non-deductible for the regional tax on productive activities (IRAP) and thus diminish profit. The total impact of these deduction limits on banking profit amounts to some €400 million yearly. A loss always becomes fully deductible when it is realized – if the debtor is in bankruptcy proceedings; otherwise, the revenue agency can object that the loss is not “certain and precise,” with the risk of an ensuing tax dispute. This risk affects the cost and availability of credit. In the present phase, during which loan losses will presumably increase, it would be advisable to diminish, as much as possible, the causes of regulatory uncertainty and hence the tax risks for the system. Starting with 2008, a portion of banks’ interest expenditure (currently 4 per cent) is no longer deductible from corporate income tax or the regional tax on productive activities. The ceiling also applies to transactions on the interbank market, thus constituting a drag on its operations. For a bank, interest expenditure is what the cost of raw materials is for any other business. Neither the United States nor the main European countries have any equivalent rule. Also starting last year, administrative expenses and depreciation are only 90 per cent deductible for purposes of IRAP, while dividends are exempt for 50 per cent of the amount received. These limits are specific to the financial industry and do not apply to other enterprises. Official estimates put the total cost of the non-deductibility of interest expenditure this year at €1.1 billion, a quarter of this due to interbank transactions. This year, the VAT exemption on auxiliary services provided within a banking group is abolished. The exemption reduced the cost to banks of the non-deductibility of VAT on purchases of goods and services and made up for Italy’s lack of the “group VAT” regime, which in many other European countries avoids the application of VAT to intra-group transactions. It is desirable that Italy institute the “group VAT” regime envisaged by the Community directive, thus coming into line with the other main EU member states. Considering that government estimates put the additional cost of the non-deductibility of VAT at €400 million a year, the overall reduction in banks’ net profits due to these specific direct and indirect tax measures will be nearly €2 billion this year. High taxes mean less self-financing, less capital, less lending capacity. A bank’s good name, the basis of a solid relationship with customers, is always a precious asset, and all the more so in times of crisis. Safeguarding and enhancing the banking system’s reputation requires irreproachable conduct in practice, no less than strict rules. Transparent and correct relations with customers protect consumers. They spur competition, ensuring full comparability of products. They are an important part of sound and prudent bank management, because they reduce reputational and legal risks. They safeguard the stability of the system. It is the responsibility of Consob to oversee the transparency and correctness of those who offer financial products and investment services to the public. For typical banking transactions, the law assigns such supervision to the Bank of Italy. This activity has been stepped up in recent years. We have set up a special unit to monitor banks’ relations with customers. We have drafted a radical revision of the regulations under our jurisdiction. Tomorrow, public consultation will begin, using the Internet, on two major proposals: one for the practical institution of the new procedure for out-of-court settlement of disputes between banks and customers; the other for new provisions, designed in part through discussions with associations of banks, other intermediaries and consumers, to make the protections for correctness in dealings with customers more effective. With these new rules we intend to make the documents for customers clearer, more concise and comparable. The instruments governing the most common products, mortgage loans and current accounts, will be especially incisive. For some time now we have intensified our controls. As far as it is within our power, we have directed them to substantial and not merely formal compliance with the rules. In the last three years we have performed checks at 452 intermediaries and more than 2,300 branches. Where we have found specific violations of the rules on notifying the public of the conditions offered, we have initiated sanction procedures (a total of 49, 11 of which have concluded with the levying of sanctions). In 206 cases, though the grounds for formal sanction were lacking, we called upon the intermediary to comply more closely in substance with the rules; we asked for the introduction of organizational arrangements and internal controls to guarantee better customer relations. Where necessary, intermediaries were required to refund sums of money unduly collected from customers and report on this to the Bank of Italy. Recently we have extended our controls to banks’ websites, in order to make sure that on-line customers have protection equivalent to that enjoyed by those using the traditional branch network. Bank customers often write to the Bank of Italy to report what they consider to be incorrect conduct. We receive nearly 6,000 letters a year. In every single case we respond to the writer and ask the bank involved to explain its position, providing a clear answer and reporting it to us. Where necessary, we take the appropriate supervisory measures. On mortgage loans, we have reminded intermediaries of the need to join in the interbank procedures for loan portability. Recent rules changes now allow sanctions for noncompliance. On current accounts, we conduct an annual sample survey of banks’ terms and conditions, whose results will be presented in our Annual Report. *** The crisis has highlighted the need to correct some significant features of the international financial architecture. More robust capital requirements for banks together with measures to counter their pro-cyclical effects; limits on excessive leverage for financial institutions; the extension of prudential rules to segments of financial business that in some countries have largely escaped coverage; strengthening the role of central banks in guaranteeing the macroeconomic aspects of stability – these are the most important elements of a radical and expeditious programme of revision that has been set in motion with a speed and a degree of international cohesion that would have been unthinkable a short time ago. The need for strong global coordination is evident and universally recognized. The major emerging countries have taken a larger role in the governance of the financial system. This is not just a matter of fairness; it is a requisite for effective intervention. I do not intend to dwell on these themes here. But I would like to stress that improved supervisory coordination is essential above all at European level, if we want to preserve the benefits of the single capital market. There is growing support in Europe for bold solutions involving the sharing of some regulatory and supervisory functions. The new European supervisory architecture will not dispense with the wealth of knowledge, expertise, and familiarity with the market built up by national supervisors: it will need to capitalize on these assets within an integrated framework. The experience of the European System of Central Banks shows that this route can be taken successfully. The recent report of the high-level De Larosière Group of experts points in this direction. In particular, I should like to underscore its attention to macroprudential supervision, to be assigned to a central body; the stress on the harmonization of rules and supervisory standards; and the call for Community coordination of the “colleges” that exercise supervision over the large European banking groups. The decision-making processes of the system, the powers and responsibilities of European and national supervisors, have to be designed with care. The European Commission’s intention to proceed with all necessary speed is commendable. | bank of italy | 2,009 | 3 |
Address by Ms Anna Maria Tarantola, Deputy Dir. Gen. of the Bank of Italy, at the Istituto Centrale delle Banche Popolari Ass. Nazionale delle Banche Popolari "Cooperative Banks: Italian and European Aspects", Taormina, 27 February 2009. | Anna Maria Tarantola: Cooperative banks and competition – local vocation and governance issues Address by Ms Anna Maria Tarantola, Deputy Director General of the Bank of Italy, at the Istituto Centrale delle Banche Popolari – Associazione Nazionale delle Banche Popolari “Cooperative Banks: Italian and European Aspects”, Taormina, 27 February 2009. * * * Introduction I would like to thank the organizers for inviting the Bank of Italy to take part in today’s meeting in honour of Professor Giuseppe Muré, a man of great distinction, who combined an academic career with his role as representative of the banking profession, offering a constructive contribution to the complex issues surrounding the business of banking. The role of local banks was a theme that Professor Muré examined on many occasions in the course of work on a broad range of topics, and he was always passionately convinced of their valuable role in supporting SMEs. At a meeting on “Dimensions and Processes of Growth” some twenty years ago, he stressed “the competitive advantage of a bank with a local dimension, which as we all know can adhere to the economic fabric of its place of business” and emphasized that this fundamental resource should not be wasted − indeed, that local banks should preserve their local identity. 1 The value of the business model adopted by Italy’s cooperative “popular banks” (banche popolari) is a very topical issue. It is at the centre of a lively debate concerning the transformations that the category of cooperative banks has undergone, as well as the economic and productive slowdown, both of which draw attention to the relationship between bank and local area. I will begin my talk by looking at how the banche popolari have evolved in the Italian system and how this fits into the European context of cooperative lending before examining their role in supporting the economy and analyzing their main technical characteristics. Finally, I will look at their particular system of governance and consider prospective regulatory developments. In general, the banche popolari have responded to increasing competitive pressure by reviewing and revising their strategies. Large-scale banks have been created, with diversified production, complex group structures, and establishments abroad as well as at home. Small banks of limited operational complexity continue to exist alongside them. While more and more marked differences have emerged within the category, regulations have remained largely the same. We must consider whether this framework is still appropriate to the changed needs of banks, investors and clients and to the aims of the supervisory authority. 1. The role of banche popolari in the development of Italy’s banking system Italy’s banking system has undergone profound changes in the last decade: in size, in manner of operation and in organizational structure. Rapid progress in information and communication technology, financial innovation, growing international openness, and changes in demand for banking and financial services have all led to stronger competition G. Muré, “Dimensioni e processi di crescita”, in Fusioni e acquisizioni delle aziende di credito, Proceedings of the conference held in Modena, 13-14 April 1989. and prompted a far-reaching process of concentration among banking institutions and a rationalization of their productive structures. Mergers have led to an increase in the average size of banks, more complex and structured forms of group organization, and a diversification of customer relation policies and methods. The number of banks has decreased, but the enormous growth of branch networks has kept competition strong in local banking markets. Closer financial integration in Europe has encouraged the market to open up to EU banks, particularly in recent years, and Italian banks to venture abroad. In a rapidly evolving sector, the cooperative banks, for their part, have proved extremely dynamic while evolving in a variety of directions, depending on their different initial situations and the opportunities offered by their local economies. One segment of the cooperative banking sector has consolidated its position in its chosen markets, focusing on internal growth and successfully enacting the role of local bank with close connections with the fabric of small and medium-sized enterprises. The largest banche popolari, on the other hand, have concentrated on external growth, carrying out broad merger programmes, both within their category and outside, by acquiring former savings banks, local banks set up in the form of public limited companies, banche di credito cooperativo (mutual banks) and specialized banks. This has led to the formation of medium and large-sized groups that operate beyond regional borders. In some cases growth has led to changes in ownership structure − and greater market openness − as well as entry into new lines of business. Both growth paths have greatly reinforced the category of cooperative banks as a whole. In the last decade, despite a reduction from 56 to 38 in the number of independent banche popolari and groups headed by banche popolari, their market share in Italy has risen from 16.8 to 21.1 per cent of total bank assets, from 15.9 to 21.6 per cent of lending to residents and from 21.1 to 27.3 per cent of branches. There has been a parallel sharpening of differences within the category. In 1998 the five largest groups headed by banche popolari ran an average of 526 branches, while banche popolari not belonging to groups had 16 each; today those figures are respectively 1,340 and 23. The average value of the top five groups’ total assets was ten times that of the other banche popolari, a ratio that is now close to 25:1. Of the 16 banking groups headed by banche popolari, two are among the top five in Italy in terms of total assets and eight are listed on the stock exchange or have at least one listed member. The leading groups have adopted a more structured organization, for the most part of the multifunctional federal type. 2. Cooperative banks in the European context Cooperative banks are a key component of the cooperative movement in the credit sector, which originated in Europe in the nineteenth century as a response to the problems that small urban and rural businesses had in obtaining credit. From the very first credit unions promoted by Schulze-Delitzsch and Raiffeisen, they adopted an organizational model based on democratic governance and mutualism. In time, this model evolved and differentiated into a multiplicity of institutions with characteristics reflecting the needs of cooperative members on the one hand and the specificities of national legislative frameworks on the other. Today, the cooperative credit sector in Europe embraces systems that are not entirely uniform in terms of legal set-up, size and organization. Some systems are strongly integrated. This is the case in Germany, where the Volksbanken and Raiffeisenbanken are joined in a single trade association and have common central structures (DZ Bank), and in the Netherlands, whose cooperative banks are gathered together in the Rabobank group, one of the country’s largest banking groups. Other systems are more highly diversified, as in France, whose cooperative system includes three of the country’s five largest banking groups (Crédit Agricole, Caisse d’Épargne and Crédit Mutuel) plus the Banques Populaires group consisting of a federal bank and 20 regional banks with more than 3,000 branches. Cooperative banks’ ability to adapt and to grow in highly diverse economic and institutional environments has made them a substantial part of the banking industry in many European countries. Overall, the cooperative banking sector in the European Union counts more than 4,000 local and regional banks, 62,000 branches and 49 million members, with a significant incidence in their national markets. 2 Although comparing international data involves some difficulty, we can put cooperative banks’ market shares in terms of number of branches at about 60 per cent in France, 50 per cent in Austria, 40 per cent in Germany and the Netherlands, and 10 per cent in Spain and Portugal. 3 In Italy, the figure is 39 per cent for the entire cooperative banking sector. In the other European countries, cooperative banks have developed mainly in a context, including the legal and institutional framework, in which central organizations play a driving role. In Italy, by contrast, the movement has been marked by greater differentiation between mutual banks (banche di credito cooperativo) and popular banks (banche popolari), with less integration and autonomous paths of development being preferred. Each model has its strengths and weaknesses. Close coordination at central level can help overcome constraints and inefficiencies due to the small size of individual cooperative banks. On the other hand, in banking as in other industries, entrepreneurial autonomy fosters competition, the quest for innovative solutions, and the ability to adapt to the needs of local economies. 3. Support for the economy The presence of a varied range of intermediaries constitutes an asset for the Italian banking system and has proven invaluable for the country’s economic growth. In particular, thanks to the social and solidaristic concerns inherent in their corporate model, Italy’s cooperative banks not only assist categories of customers at risk of exclusion from the credit market and thus vulnerable to usury, but have also actively sustained specific segments of the market, such as small and medium-sized enterprises. It is on the basis of these premises that Italian legislation has always safeguarded the particular characteristics of cooperative banks in their various forms. Banche popolari are the most important expression of Italy’s cooperative banks in terms of assets. A particularly topical debate today concerns the effects that the rapid expansion of some of these banche popolari may have had on their inclination to support local economies – in particular, the maintenance of close relationships with their reference customers (households, professionals, artisans, SMEs) – and on management’s incentives. The empirical evidence testifies to their close ties with local economies and their role in financing business initiatives. 4 These are reflected in the composition of their lending, with 66 per cent of the total going to firms, against 59 per cent for other banks. Comparing the figures for the five largest banking groups headed by banche popolari with those for major The data are from the European Association of Co-operative Banks, 2007. P. Bongini and G. Ferri, “Governance, Diversification and Performance. The Case of Italy’s Banche Popolari”, paper presented at the conference Corporate Governance in Financial Institutions, organized by SUERF and the Central Bank of Cyprus, Nicosia, 2007. G. Ferri, G. Michetti, C. Pacioni and C. Tondelli, “Banche popolari tra crescita e localismo” in R. de Bruyn and G. Ferri (eds.), Le banche popolari nel localismo dell’economia italiana, Edicred, Rome, 2005. and large banks of comparable size, the gap widens to 10 percentage points (65 against 55 per cent). Strong roots in local economies are a prerequisite for mitigating the difficulties of access to credit even in hard times like these. Excluding bad debts and repos, lending to residents by banche popolari and other banks belonging to their groups grew by 6.8 per cent in 2008, compared with 5.6 per cent for the banking system as a whole. The growth in lending by the five largest banking groups headed by banche popolari was in line with that of the other major and large banks. By contrast, lending growth was much livelier for the smaller banche popolari (13.9 per cent), also by comparison with other banks of comparable size and with similar operational characteristics (7.2 per cent) including the mutual banks (10.4 per cent). The gap between the growth rates of large and small banche popolari is explained in part by the difference in the intensity of their relationship with firms and local communities, since this tends to weaken progressively the more banks grow, open up to the market and expand their range of operations. When there is a significant development of business relationships and areas of activity, including abroad, there can also be a weakening of the control exerted in the form of social pressure and in other ways by the local community (customers and shareholders at one and the same time), so that management’s incentives are less closely aligned with the interests of the community where the bank was originally established. The support for the economy provided by banche popolari, especially the smaller ones, is a major strength of Italy’s banking system. However, there are risks that cannot be ignored. An examination of the banking relationships of a sample of nearly 50,000 firms surveyed by the Company Accounts Data Service shows that the banks that stepped up their lending most sharply in the last year did so in part by significantly increasing their exposure to financially fragile firms. The necessary provision of support to businesses must be accompanied by an objective assessment of the potential of the projects undertaken and the medium-term prospects. Careful and stringent risk management is a sine qua non for credit to continue to flow to where it can safeguard valid business initiatives and contribute to the recovery of productive activity. 4. Technical indicators The banche popolari’s technical indicators – like the main balance-sheet aggregates analyzed above – point to quite considerable diversification in terms of size and market. Capital adequacy ratios show no evidence of any particular difficulty overall. The solvency ratio is in line with that of the banking system as a whole; it is higher for the smaller banche popolari than for the larger, listed ones. Profitability reflects these institutions’ retail specialization, involving broad territorial coverage through a dense branch network. The ratio of operating costs to gross income, which can serve as a proxy for operating efficiency, was 63.8 per cent in June 2008, about one percentage point higher than for banks incorporated as public limited companies. This indicator improves with the size of the bank: it is better for the listed than for the minor banks (63.1 as against 67.9 per cent). ROE is lower for banche popolari than for public limited banks (8 and 10 per cent respectively), and again differs within the cooperative group (8.1 per cent for listed and 7.5 per cent for unlisted institutions). Many cooperative banks, like the others, recorded significantly reduced profits in the first three quarters of 2008, as a result of the financial turmoil. Loan quality is now showing serious effects of the recession, as in the banking system as a whole. The non-performing portion of the cooperative banks’ business loans rose by nearly half in 2008 to 1.9 per cent, compared with 1.3 per cent at the end of 2007. The default rate is rising mostly among the smaller and medium-sized banche popolari and those located in the South. It is hard to compare the technical situation of cooperative banks in Italy and in the other European countries where they play a significant role, as the data are scanty and lacking in uniformity. Table 6 gives some figures; all in all, there does not appear to be any great difference between the state of Italian and other European cooperative banks. Some liquidity problems emerged in conjunction with the tensions in the interbank market. The easing of the strains, the issue of new securities that can be posted as collateral (mainly through self-securitizations), and the Bank of Italy’s emphatic call for the adoption of more sophisticated risk management and liquidity management systems all contributed to a broad improvement in the liquidity profile. Steps still need to be taken to develop sound cash management strategies and to reinforce the organizational machinery, so as to achieve integrated risk management. There are some weak points in organization, according to the Bank of Italy’s periodic examinations. Most of the shortcomings involve the functioning of corporate bodies – compromised, in some instances, by an uneven distribution of tasks and by unsatisfactory internal debate, with repercussions on strategy and coordination – as well as the efficacy of management instruments, the detection and management of risks, and the scope and depth of audits. Risk management – including operational, legal and reputational risks – has not always been adequate to the cooperative banks’ size and complex business. This applies above all to the listed banks, which have been subjected in recent years to growing attention and pressure from the market, particularly as regards the effectiveness of their risk control process. These anomalies are not generalized, however. The need for improvement is found above all where governance systems are not entirely efficient, with rigid, crystallized arrangements and insufficient control over management. Even where they have not yet affected the other profiles, organizational inadequacies always indicate a latent, potential risk. As such, these failings are an important signal that should not be neglected, because they impinge sharply upon growth and competitiveness. Like capital adequacy, organizational adequacy is a safeguard, the precondition for sound and prudent management. 5. Governance The governance of the cooperative banks has been the subject of lively debate in recent years, with strongly differing opinions and points of view. Fundamentally, the question is whether these institutions’ traditional model of governance is still suitable today, capable of serving the needs of banks that have grown through mergers to considerable size, with an increasingly ramified ownership base and open to the capital markets. The main points under debate have been relaxing the limits to individual equity shares, strengthening the role of institutional investors, extending proxy voting, and exploiting the cooperative nature of these intermediaries. The cooperative banking model appears to be subject to strain above all among the larger, listed banks, where ownership that is open to the market and to institutional investors conflicts with rules that, though originally designed to preserve democratic participation, actually make it hard to contest control, limit the representation of the various shareholder components in corporate bodies, and discourage attendance at meetings. On the other hand there is no denying the need to preserve intact the features, peculiar to banche popolari, that favour a development model oriented to sustaining the local community. The proper balance must be struck between the need to preserve the specificity of cooperation and the need for the model of governance to correspond more closely to these institutions’ size and market orientation. Large and complex institutions, interested in nontraditional lines of business, should consider the adoption of a more open and dynamic structure of governance, so as to be able to respond promptly to changes in the business environment and seize new opportunities, design consistent, comprehensive strategies, and ensure effective leadership and coordination. 6. Regulation The legal framework of the cooperative banks in the leading European countries has evolved with the development of the legal and economic context: in Spain there are extensive limits on holdings of capital, including by persons other than cooperative members; in Germany derogations are allowed, in certain circumstances, from the one-person-one-vote rule; in France multiple votes are permitted in proportion to the size of the contribution of capital, albeit within limits laid down in the bylaws. The evolution of the law in Europe has also made it possible to keep up with the development of the competitive context, without significantly altering the essential characteristics of the cooperative model, which is still centred on a democratic structure and mutualistic goals. In Italy the regulation of banche popolari is still marked by the rigorous interpretation of the one-person-one-vote rule, the stringent legal provisions governing the limits to holdings of capital (which can be waived only for some categories of institutional investors), the nonapplication of the solicitation and collection of proxies, by way of derogation from the general rules on listed companies. A balanced and pragmatic evolution of the governance arrangements of banche popolari, in line with the specific features of each one, needs to be carefully assessed and can be implemented by means of self-regulation, especially bylaw innovations to make better and greater use of some options allowed by the applicable company law. An opportunity can be grasped when defining the governance project provided for in the supervisory rules on the organization and corporate governance of banks, which the Bank of Italy issued in March 2008. I am referring to the recommendations aimed at ensuring adequate representation of the various components of the shareholder base and at activating mechanisms that will make it easier for members to take part in meetings. In fact, even in the latest shareholders’ meetings (2008) the presence of members of listed banche popolari and proxies was very low, less than 5 per cent of those entitled to attend except in a few cases. Suitable ways of giving effect to these legal principles include using slate voting systems for the election of minority directors and members of the board of auditors; introducing bylaws that reserve the appointment of a percentage of directors to one or more categories of members; broadening the scope for proxies to attend meetings (in compliance with the Civil Code); distance voting; and introducing bylaw clauses on the possibility of holding meetings in separate locations. Other issues that are the focus of debate cannot be resolved through self-regulation and are the subject of various legislative initiatives: the broadening of the limits on holdings of capital; the assignment of a significant presence of institutional investors in corporate bodies; and the strengthening of participation mechanisms. One of the aims underlying these initiatives is to increase the instruments for strengthening the capital bases of the banche popolari. In the present financial crisis it is essential to remove every potential obstacle to capitalraising measures that should prove necessary. The International Monetary Fund has recently highlighted the risks inherent in the present rules on the limits on the possession of holdings of capital in banche popolari. 5 Members’ participation in meetings must be encouraged with instruments that do not distort the essence of the cooperative form and, at the same time, are in line with the regulatory evolution under way in Europe, partly as a result of the transposition of the directive on shareholders’ rights. 7. Conclusions Overall, the world of the cooperative banks is a vital one and able to support the financial needs of local areas. There are nonetheless broad differences within the category, in terms of size, type of business and openness to the market. The model of governance, which overall has allowed these banks to respond to the solicitations of the competitive environment, may not be entirely suitable for large banks with a broad and highly diversified shareholder base. For such institutions the traditional advantages in terms of customer information and relations deriving from closeness and mutual control performed by member clients are weakened. Without distorting the banca popolare model, organizational and governance arrangements need to be found that will compensate for the loss of that competitive advantage and be more consistent with the increased complexity of such banks’ operations and their growth in size. The financial market crisis that broke out in the summer of 2007 and grew worse after September 2008 has led governments, central banks and international institutions to attempt to analyze its causes and possible remedies, with a view to finding not only immediate solutions but also more far-reaching reforms of the financial markets, regulation and controls. The most authoritative analyses conducted to date − the report of the Financial Stability Forum chaired by Governor Mario Draghi, 6 and the document recently produced by the Group of Thirty 7 − highlight the central role of governance arrangements and risk management systems for the stability of individual institutions and the financial system as a whole. The reforms that legislators and authorities are called upon to carry out, at various supranational and national levels, will be based on common rules and a greater role for organizational and corporate governance variables. In this context the banche popolari, in the same way as the banking system as a whole, must grasp the opportunity to accelerate the process of adaptation of organizational arrangements and internal control systems, remove the problems and enhance these banks’ role and growth potential. The banche popolari should also play a proactive role and demonstrate the ability to evolve towards governance arrangements better suited to the demands of stakeholders and the needs of increasingly competitive markets, while maintaining the spirit of “participative democracy” that underlay the original regulatory framework. This is one way to make it possible to perform the traditional function of the economy even more efficiently, something that is all the more necessary at times of crisis such as the present. International Monetary Fund, “ITALY, Staff Report for the 2008 Art. IV Consultation”, 7 January 2009, p.18; Gutiérrez (2008). Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, April 2008. Group of Thirty, Financial Reform. A Framework for Financial Stability, January 2009. References AGCM (2009), Indagine conoscitiva: la corporate governance di banche e compagnie di assicurazioni. Banca d’Italia (2007), Concluding Remarks, May. 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(1997), Community Links, Co-operative Rules, and the Economic Efficiency of Italy’s Local Co-operative Banks, Proceedings of the European Regional Science Association, 37th Congress, Rome, Italy. Capriglione F. (2004), “Le banche cooperative ed il nuovo diritto societario. Problematiche e prospettive”, in Leo S. Olschky (ed.), Atti del Convegno di studio organizzato dalla Banca di Credito Cooperativo di Cambiano,Florence, 16 October 2004. Cau G., De Bonis R., Farabullini F. and Salvio A. (2005), “Rischiosità dei prestiti ed efficienza allocativa: ci sono differenze tra banche popolari e banche società per azioni?”, in R. De Bruyn and G. Ferri (eds.), Le Banche Popolari nel localismo dell'economia italiana (Rome: Edicred). Carosio G. (2008), Tavola rotonda: Banche e territorio, Centennary of Credito Valtellinese, Sondrio, 12 July 2008. De Bonis R., Manzone R. and Trento S. (1994), “La proprietà cooperativa: teoria, storia e il caso delle banche popolari”, Temi di discussione, 238, Banca d’Italia. Draghi M. (2007), Politica monetaria e sistema bancario, Ordinary General Meeting of ABI, Rome, 11 July 2007. Ferrarini G. (2006), One Share-One Vote: A European Rule?, Working Paper No. 7, Institute for Law and Finance, Johann Wolfgang Goethe-Frankfurt University. Ferri G., Masciandaro D. and Messori M. (2000), “Governo societario ed efficienza delle banche locali di fronte all’unificazione dei mercati finanziari”, in P. Alessandrini (ed.), Il sistema finanziario italiano tra globalizzazione e localismo (Bologna: il Mulino). Ferri G., Michetti G., Pacioni C. and Tondelli C. (2005), “Banche popolari tra crescita e localismo” in R. de Bruyn and G. Ferri (eds.), Le banche popolari nel localismo dell’economia italiana (Rome: Edicred), 172-298. Financial Stability Forum (2008), Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, April. Fonteyne W. (2007), Cooperative Banks in Europe – Policy Issues, IMF Working Paper No. 07/159 (Washington: International Monetary Fund). Fortis M. (ed.) (2008), Banche territoriali, distretti e piccole e medie imprese (Bologna: Il Mulino). Girardone C., Molyneux P. and Gardener E. (2004), “Analyzing the Determinants of Bank Efficiency: The Case of Italian Banks”, Applied Economics, 36, 215-27. Group of Thirty (2009), Financial Reform A Framework for Financial Stability, January. Gutiérrez E. (2008), The Reform of Italian Cooperative Banks: Discussion of Proposals, IMF Working Paper No. 08/74 (Washington: International Monetary Fund). Hesse H. and Cihàk M. (2007), Cooperative Banks and Financial Stability, IMF Working Paper No. 07/2 (Washington: International Monetary Fund). Iannota G., Nocera G. and Sironi A. (2006), Ownership Structure, Risk and Performance in the European Banking Industry, Universitá Commerciale “Luigi Bocconi,” Institute of Financial Markets and Institutions. International Monetary Fund, ITALY, Staff Report for the 2008 Art. IV Consultation, 7 January 2009, 18 ISAE (2007), “Accesso al Credito e Riforma delle Banche Popolari”, extract from Rapporto ISAE, Priorità nazionali. Ambiente Normativo, Imprese, Competitività. Mirone A. (2001), “Le banche popolari negli altri ordinamenti”, in AREL, 1-2/2001, 25-30. Petersen M.A. and Rajan R.G. (1994), “The benefits of lending relationships: evidence from small business data”, Journal of Finance, XLIX/1, 3-37. Pipitone M. (2005), La disciplina giuridica delle Banche Popolari e i modelli alternativi di banca, in R. De Bruyn and G. Ferri (eds.), Le Banche Popolari nel localismo dell'economia italiana, cit. Pipitone M. (ed.) (2008), Gli statuti delle banche popolari (Rome: Edicred). Signorini L.F. (ed.) (1999), “Lo sviluppo locale: un'indagine della Banca d'Italia sui distretti industriali”, Donzelli, Temi di Discussione, 347, March 1999. Turati G. (2004), Are Cooperative Banks and Stock Banks Different Contracts? Empirical Evidence Using a Cost Function Approach, Universitá degli Studi di Torino. Tables Table 1: Summary of data at 31 December 2008 31/12/1998 popolari system Banking groups 31/12/2008 % share popolari of which: including listed banks system % share Banks belonging to groups Banks not belonging to groups Total groups and independent banks 6.9% 5.8% Total banks 11.6% 11.9% Branches 5,545 26,286 21.1% 9,314 34,178 27.3% Loans to residents (bn euros) 15.9% 1,523 21.6% Deposits of residents (bn euros) 19.2% 25.2% 1,416 16.8% 3,196 21.1% Total assets (bn euros) Does not include Cassa depositi e prestiti SpA. – banche popolari. “Popolari” include limited companies belonging to groups headed by Data for 2008 refer to end-November. Table 2: Branches Limited banks and branches of foreign banks 17,968 19,147 19,880 20,098 20,774 20,756 Banche popolari 5,545 6,113 6,871 7,388 7,808 9,314 Banche di credito cooperativo 2,773 2,954 3,192 3,465 3,753 4,108 Total 26,286 28,214 29,943 30,951 32,335 34,178 68.4% 67.9% 66.4% 64.9% 64.2% 60.7% 21.1% 21.7% 22.9% 23.9% 24.1% 27.3% Banche di credito cooperativo 10.5% 10.5% 10.7% 11.2% 11.6% 12.0% Total 100% 100% 100% 100% 100% 100% Limited banks and branches of foreign banks Banche popolari “Popolari” include limited companies belonging to groups headed by banche popolari. Table 3: Breakdown of lending by sector Popolari Top 5 groups Other Other banks Total Large Small and minor Total Firms 65.4% 68.8% 66.3% 55.5% 70.3% 59.1% – of which: up to 20 employees 11.3% 15.6% 12.4% 8.8% 16.4% 10.6% Consumer households 21.9% 24.2% 22.5% 24.6% 21.7% 23.9% Other sectors 12.7% 7.0% 11.2% 19.9% 8.0% 17.0% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% "Popolari” include limited companies belonging to groups headed by banche popolari. medium-size banks following the Bank of Italy’s system of classification. Includes leading, large and Table 4: Lending to firms by size of loan Popolari S.p.A. + foreign branches of which: listed of which: unlisted Credito coop. 0-5m 29.5% 39.0% 37.5% 47.8% 70.1% 5-25m 22.7% 26.5% 26.4% 27.4% 23.1% > 25m 47.8% 34.4% 36.1% 24.8% 6.8% Total 100.0% 100.0% 100.0% 100.0% 100.0% Source: Central Credit Register; data at 31/12/2008. "Popolari” include limited companies belonging to groups headed by banche popolari. Table 5: Twelve-month growth in lending Dec. 2008 Popolari 6.8% – of which: top 5 groups 4.5% other 13.9% Other banks 5.4% – of which: large 4.9% small and minor – of which: BCC Total 7.2% 10.4% 5.6% Percentage changes are net of reclassifications and “Popolari” include limited companies securitizations. belonging to groups headed by banche popolari. Includes leading, large and medium-size banks following the Bank of Italy’s system of classification. (3) Banche di credito cooperativo. Table 6: Technical indicators − an international comparison ROE Cost/ income Tier 1 Total C. Ratio Substandard loans/total lending Crédit Agricole group 10.2% 68% 7.4% 9.6% 4.3% Crédit Mutuel group 11.4% 62% 9.3% 11.0% n.d. Banques Populaires group 5.8% 79% 9.1% 11.1% 3.4% 8.1% 60% 7.0% 9.8% 4.1% 6.9% 69% 7.9% 12.3% n.d. France Italy 8 Banche popolari groups Germany Network of cooperative banks Source: European Association of Cooperative Banks (EACB ) – Consolidated balance sheet at 31/12/07. Table 7: Quality of lending to firms Bad debts/lending 31/12/2007 31/12/2008 1.3% 1.9% – top 5 1.2% 2.0% – other 1.4% 1.7% Other banks 1.4% 2.1% Banche popolari Source: Central Credit Register. Table 8: Income Operating costs/ gross income Net interest income/ gross income ROE BCC* 64.2% 79.2% 9.7% Banche popolari 63.8% 63.9% 8.0% – listed 63.1% 62.7% 8.1% – unlisted 67.9% 69.9% 7.5% 62.7% 61.5% 10.0% S.p.A. Source: Supervisory records – consolidated data at 30/6/08. * Banche di credito cooperativo Table 9: Capital Core Tier 1 ratio Tier 1 ratio Total capital ratio BCC * 14.1% 14.1% 14.8% Banche popolari 6.9% 7.5% 10.4% – listed 6.4% 7.1% 10.1% – un listed 9.6% 9.6% 12.5% 6.2% 6.9% 10.1% S.p.A. Source: Supervisory records – consolidated data at 30/6/08. * Banche di credito cooperativo | bank of italy | 2,009 | 4 |
Commencement address by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the students of the Master in Public Economics at the Faculty of Economics, La Sapienza University, Rome, 4 March 2009. | Ignazio Visco: The financial crisis and economists’ forecasts Commencement address by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the students of the Master in Public Economics at the Faculty of Economics, La Sapienza University, Rome, 4 March 2009. While I alone am responsible for the views put forward in this paper, I wish to thank Fabio Busetti, Michele Caivano, Eugenio Gaiotti, Alberto Locarno, Sergio Nicoletti Altimari, Patrizio Pagano, Fabio Panetta and Stefano Siviero for discussions on its various parts and for their practical assistance. The original speech, which contains various links to the documents mentioned, can be found on the Bank of Italy’s website. * 1. * * Introduction It is perhaps early to draw lessons from the crisis that has hit the global economy. The crisis appears severe and widespread, its effects far-reaching and long-lasting. Measures of various kinds have been taken or are in the process of being taken regarding monetary policy, the use of public resources and the revision of rules and institutions on which the proper functioning of the markets and the operation of financial intermediaries depend. The present is undoubtedly a period of maximum efforts on the part of economic policy and overall political action, efforts that are directly proportional to the seriousness of the crisis. But this is also a moment in which the interpretative models used in analyzing our economies start being reconsidered and attempts are being made at identifying the reasons underlying the failures of markets, economic policies and economists’ forecasts. Besides, this is also necessary in order to better define interventions – global, substantial, focused and lasting – aimed at overcoming the crisis and, as far as possible, preventing, with the design of new rules, new institutions and new policies, such serious instability from occurring again. If overcoming the crisis will be arduous and complex, the process of revising the theoretical and quantitative frameworks of analysis, and the domestic and supranational guidelines and instruments of economic and financial policy will be equally difficult and laborious. To begin, one can and certainly must ask how seriously economic analysis, together with forecasting models, has failed, but also why economic policy, in its various forms, has been so late to respond to the alarms of economists’ analyses and forecasts. This is the subject I should like to address briefly in what follows, while anticipating an obvious answer: if economic policy bears serious responsibilities, economic analysis and forecasting models have also shown important limitations that must be addressed. 2. Origins of the crisis and the economists’ diagnosis Until two years ago the world economy had known an exceptionally long period of rapid expansion, with much smaller GDP growth rate fluctuations than in preceding periods, accompanied by low and stable inflation in practically all the main areas of the globe. Thanks also to the high economic growth rates of large emerging countries, consensus forecasts were for continuing and relatively stable growth. That confidence was gradually eroded by the events that occurred between the summer of 2007 and the autumn of last year and collapsed rapidly in the last few months, giving way to a pronounced and generalized increase in the volatility of markets and economic activity and widespread uncertainty about the future. As is well known, the first signs of the crisis we are passing through were the difficulties encountered by intermediaries that had invested massively in “structured” financial products, linked to the performance of mortgage loans (and hence of the prices of the underlying real estate) granted in the United States to borrowers with low credit ratings (so-called subprime borrowers). The crisis spread rapidly to other segments of the financial market and, in the last few months, to the real economy. The seat of infection was set in fact in a broader context of fragility of the international financial and economic system. The problems that emerged in 2007 in the markets of structured products linked to subprime mortgages triggered the crisis, but the conditions for it to take hold and spread rapidly had gradually accumulated over time. The pre-existent elements of fragility and potential instability had already been partly identified and indicated as possible sources of danger. Economic, demographic and technological changes Great changes have taken place in the last twenty years, in terms of the integration of economies and markets, demographic movements and technological and financial innovation. The growth in world trade of goods and services was extremely rapid, as was that in foreign direct investment. The emerging Asian economies now account for more than a quarter of world exports, twice the level in 1990. In little more than a decade, direct investment rose from 10 per cent of world GDP in 1995 to 25 per cent, with the advanced and emerging economies recording similar increases. Financial integration increased remarkably: in 2007 the ratio of foreign financial assets and liabilities to GDP was equal to 300 per cent in the advanced economies, compared with 140 per cent in 1995, when the prevailing expectations were for rapid growth in both the emerging and developing countries, in conjunction with the progressive removal of the constraints on the mobility of capital. Globalization has obviously brought a large increase in countries’ interdependence and accordingly in the probability of cross-border transmission of real and financial shocks. At the same time the greater risk diversification associated with the increase in the global exposure of financial portfolios should have produced, at least in principle, a smaller exposure to perturbations of a local nature. As regards demography, the very rapid population growth in the developing economies has begun to be matched by a progressive ageing of the population in the industrial countries and in some of the large emerging economies as well (especially China). The increase in life expectancy has gone hand in hand with the reduction in births, causing a sharp rise in oldage dependency ratios (of the elderly in relation to the population of working age), which is set to continue in the coming decades. This has led to a downward trend for public pensions and an increase in supplementary pension schemes offered by pension funds, insurance companies and other institutional investors. In the meantime households’ direct exposure to financial risk has grown: in 2008 in the three largest euro-area countries the proportion of households’ financial assets administered by these intermediaries has reached about one third, up by about 10 percentage points since 1995. Lastly, the development of new information and communication technologies has had a growing impact on every sector of the economy, and society in general. This has had important effects on productivity and economic growth, and on all the building blocks of the financial system, from payment system infrastructure to intermediaries, and from markets to investment instruments. In particular, the securitization of banks’ assets expanded considerably, together with the supply of so-called structured financial instruments (ABSs, CDOs, etc.) whose valuation is generally rather complex. The traditional model of credit intermediation thus gave way, especially in the United States, to a system in which loans granted were rapidly transformed into other financial products having these loans as collateral and sold on the market: the so-called originate-to-distribute model. These instruments – intended in principle to reduce risk, by redistributing it among a multitude of investors, free up capital and hence boost banks’ ability to lend – helped to finance the “new economy”, in parallel with the spread of new technologies. At the same time they made it possible to reduce the cost of loans, above all as a result of the compression of illiquidity premiums. The complexity of structured instruments was coupled, however, with a lack of transparency, in particular as regards their valuation (in which a crucial role was played by rating agencies, without any particular control by regulatory authorities or information providers), by means of statistical models and often carried out on the basis of incomplete and insufficient data. We can now say – unfortunately well into the financial crisis – that opportunistic behaviour by managers, fueled by a distorted system of incentives, especially with reference to executive compensation, led to the creation of unnecessarily complex and opaque financial assets, with the effect of preventing a correct assessment of creditworthiness and often causing excessive risk-taking. The unsustainable growth of external imbalances In this context more and more in recent years the model of growth of the world economy was based on a growing imbalance between a steadily declining US saving rate (negative for the household sector) and highly positive rates for China and other emerging countries (as well as Japan). This led to large external deficits for the United States and huge surpluses for the rapidly growing countries, which served to finance the twin (budget and external current account) deficits of the United States. This was soon recognized since the unsustainability of growing current account imbalances was evident, even though variations in the value of financial assets and liabilities contributed to reducing the explosive expansion of the country’s net external position (Figure 1). The risks associated with such a growth model, in which the rapid expansion of the world’s largest economy was financed with capital from the rest of the world, including, somewhat paradoxically, emerging and developing countries, had been stressed repeatedly and from many sides, although there was no lack of less alarmed observers and analyses suggesting that what appeared to be fundamental imbalances in the external accounts were the result of sustainable developments. At all events, the analyses produced by government and international institutions regularly pointed to the possibility that those imbalances might give rise to rapid and disorderly adjustments, with sudden realignments of the external value of the dollar and abrupt falls in US domestic demand, as the main threat to stable growth of the world economy. In the end, the financial crisis was not provoked by a flight from the dollar but by the slump in the US housing market and the consequent depreciation of structured financial products. This initial spark found ideal tinder in the general vulnerability, and the crisis spread like wildfire, encountering no particular obstacles. For that matter, the US trade deficit was nothing but the counter-item to the insufficiency of saving, above all by American households, over-indebted and holding assets consisting largely of long-overvalued real estate that was itself used as collateral for financial derivatives. The sharp drop in demand in the United States is apparently being accompanied by an effective adjustment of these disequilibria, an exceedingly abrupt correction imposed by the crisis. However, for this adjustment to be carried through and the imbalances definitively rectified, there must be an expansion of final demand, consumer demand in particular, in the countries that are running large external current account surpluses. It is too early to conclude that this will actually be the outcome of the measures now being taken, but economic analysis had correctly discerned the dangers of the disequilibria and the inevitability of an adjustment – the longer postponed, the more traumatic. Although they were discussed in a number of forums for international coordination, the corrective measures needed to remedy matters were never undertaken resolutely enough. The increase in final demand led by the US expansion was accompanied by the extraordinarily rapid growth of economic activity and exports in the large emerging economies (accentuated by policies that impeded exchange rate adjustments) and unprecedented strains in the markets for raw materials. In recent years, given the low price elasticity of energy demand and supply, this resulted in an equally extraordinary rise in energy prices and the steady increase in the trade surplus of oil-producing countries (Figure 1). This was an additional factor of global payments disequilibria and a source of finance for final demand in the United States. Monetary policy and financial and real asset prices In the absence of worrisome inflationary tensions, for over a decade monetary policies were kept very expansive. Low nominal and real interest rates ushered in not only the long period of exceptionally rapid and stable growth of global output but also a powerful expansion of monetary and credit aggregates. This was accompanied by a sharp increase in the liquidity of markets, which in its turn was connected with financial innovation and the strong growth of such institutional investors as pension funds and hedge funds. The upshot was a large, across-the-board reduction in risk premiums, which fell to extremely low levels by historical standards, in all markets (shares, corporate bonds, real estate). The most benevolent interpretations saw this as evidence that the world economy had entered a new phase, the “Great Moderation,” marked by rapid growth without significant fluctuations and by orderly price movements, anchored to low average levels of inflation. The advent of that phase, it was argued, was the result of economic policies effectively oriented to macroeconomic stability, and in particular of monetary policies credibly directed to containing inflationary pressures and preserving the value of money. The result, ran the argument, was a stable, certain outlook, conditions propitious to private initiative and hence to economic growth. This interpretation (based on “good policy”, the standard term used in the literature, as well as on the supposed effects of positive structural changes with the spread of new technologies) was disputed by other analysts. These asserted that the protracted, orderly growth and modest fluctuations was actually the product of exceptionally favourable circumstances, in particular the absence of the sort of violent, repeated, adverse shocks that had marked previous periods (“good luck”). Sooner or later, they argued, in an environment that in a number of ways had not changed radically from the previous decades, this largely expansive monetary policy, by encouraging and in practice financing high risk-taking, would bring about the conditions for abrupt corrections as soon as risk perception and propensity changed. This danger was signalled by a good many observers, and starting in 2004 there were particular warnings that too casual an attitude towards risk-taking might be followed by a disorderly, traumatic reaction in the opposite direction. In the light of events, the optimistic interpretation of world economic trends in recent decades was clearly indulgent. While there is no denying the contribution of good policy, and especially its impact on medium-term inflation expectations, it is now evident that it would probably have been wiser to take greater precautions against the possibility of an erroneous, falsely reassuring reading of events. On a number of occasions the fall in risk premiums pushed bond, stock and real-estate prices up to levels that were clearly unjustified by the fundamentals. The consensus view, in the framework generally known as “flexible inflation targeting” (which authoritative commentators have used, broadly, also to describe the policy of the Federal Reserve), is that monetary policymakers need not worry about countering speculative bubbles in asset prices. What matters is that they take them into account in their forecasts of the variables that are factors in determining the general level of prices, such as inflation expectations and the deviation of final demand from the “potential” level of economic activity (i.e. that corresponding to full use of productive resources). The sole tool at policymakers’ disposal (the interest rate) should accordingly be deployed in order to attain just one objective, namely flexibly preserving the value of money, since it cannot aim simultaneously at curbing the rise in the prices of financial and real assets. Obviously, in memory of lessons from long ago, in order to avoid the depressive effects of the bursting of an asset bubble monetary policy must react swiftly to cut interest rates and expand liquidity. Actually, the impact of asset prices on the spending and investment decisions of households and firms also depends on their relative indebtedness, and all the more so insofar as the latter depends on the collateral represented by their capital goods (for households, mostly residential property). This applies above all to the anglo-saxon economies, and it is a potential factor of non-linear amplification of the effects of changes in real and financial asset values. In this case monetary policy, even under flexible inflation targeting, could be called on directly to counter very large variations in those prices, especially considering that a tightening of bank credit becomes more likely as the level of indebtedness increases. In the long run, holding policy interest rates steady while share or house prices are soaring, in a context of heavy and growing household and corporate debt, could further fuel a speculative bubble that will eventually burst, at a potentially very severe cost to the economy as a whole. Yet this, in practice, was the policy followed for decades by the Fed and the Bank of England, vis-à-vis both the stock market boom of the late 1990s (Figures 2, 3) and the housing boom (Figures 4, 5, 6). Admittedly, in the former case this benign neglect during the boom and the drastic lowering of interest rates during the subsequent market downswing had relatively limited consequences (especially by contrast with Japan’s disheartening “lost decade” of deflation starting in the early 1990s). The case of house prices, however, is seemingly quite different. On the one hand the rise in prices, though strong and sustained (likely exceeding the levels justified by fundamentals), was probably less “explosive” in the United States than in some other countries, such as the United Kingdom and Sweden (but also Spain and the Netherlands) when gauged by the Federal Housing Finance Agency index (but equally so if measured by the Case-Shiller index). 1 On the other hand, however, the devastating repercussions on US financial markets and intermediaries (transmitted worldwide through structured financial products) stemmed precisely from the interaction with the levels of debt of American households, spurred by the possibility that rising house prices offered for mortgage equity withdrawal. In many cases their debt came to exceed their home equity. In this way, the expansion of liquidity and so of credit was accompanied by the ratcheting up of financial leverage, prompted among other things by the emergence of new business models. In his re-examination of the Depression in 1933, Irving Fisher noted: “Easy money is the great cause of overborrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts” (Fisher, 1933, p. 348; emphasis added). In Fisher’s view, that is, depressions stem from excessive debt exposures (inevitably accompanied, one might add, by excessive risk-taking); sooner or later, a correction is inevitable. Once the correction gets under way, the impellent necessity of rapidly reducing excessive leverage exacerbates the fall in asset prices, which is the more violent, the larger the original bubble. And the price collapse, in turn, amplifies financial leverage, making the de-leveraging all the more painful. This danger had long been known to economists. 3. From economists’ diagnosis to pre-crisis policies If economic analysis had effectively pointed out some of the looming dangers, the potential sources of infection and the mechanisms of propagation, then why was economic policy action for so long hesitant, sluggish, lacking in international coordination? To some extent this may have been due to the generic nature of the alarms sounded by economists, their failure to pinpoint the origins and course of development of the crisis, or the very reiteration of warnings when their fears did not materialize, giving policymakers the idea that the risks were vague and remote. But we can also find causes not only in connection with economic analysis but also within the policy decision-making process itself. In the first place, until the crisis was full-blown and the spectre was raised of dramatic, dire developments in the financial markets, there was a lack of international coordination and an inability to take measures to counter the increasingly rapid build-up of balance-of-payments The Case-Shiller index is narrower in geographical coverage than the FHFA index, includes a wider variety of houses (among them, homes bought with subprime mortgages), and excludes the changes in prices estimated at the time of renegotiation. disequilibria and the effects of a disproportionate rise in international liquidity. There was undoubtedly awareness of the paradox of industrialized countries being increasingly financed by the current account surpluses of developing countries. It was clear that for an unusually long time this had determined particularly low levels of interest rates and volatility in the prices of financial instruments. And with US monetary policy maintaining an expansionary stance (too) long after the brief recession of 2001-02, this had transmitted to the Chinese economy, given the prevailing exchange rate system, an impetus whose signs could be seen globally in the spiralling prices of raw materials. All of this was discussed repeatedly at academic conferences, central bank workshops, international consultations and official meetings of ministers and central bank governors. But only the sense of extreme urgency that spread last autumn following the failure of Lehman Brothers made it possible to begin to shape a coordinated response. In the future, it will be necessary to intensify efforts in this direction, including by finding appropriate ways of translating into action, in more binding forms, the interventions decided by the institutions responsible for overseeing the international economy. The reassuring, understandable belief that a new world had emerged – one of Great Moderation – perhaps also led to overestimation of the economy’s ability to absorb shocks. This belief was reinforced by the apparent ease and limited costs with which the global economy overcame the difficulties that loomed large at times in the course of recent years, from the financial crises of the countries of South-East Asia and Russia to the collapse of LTCM, the deflation of the stock market bubble in 2000-01 and the shock caused by the terrorist attacks of 11 September 2001. In particular, the bursting of the so-called dot-com bubble had seemed to be controlled with ease; given the seriousness of the concerns expressed beforehand and looking back on the modest scale of the damage and the remarkable effectiveness of the countermeasures adopted, the conclusion was drawn that the evolution of that crisis had confirmed both the advent of the Great Moderation and the merits of good policy. However, as already observed, there was much debate then, and there still is today, about whether monetary policy should not pay more attention to financial and real asset price trends and to the pro-cyclical growth of credit and leverage, and in some instances respond decisively to seemingly “excessive” movements. Aside from the difficulty of defining what excessive means in practice, it is certainly useful to examine the factors that determine particularly large swings in these prices, just as it is necessary to shed light on the factors that tend to threaten financial stability and disproportionately amplify cyclical fluctuations. Many of these factors probably originate not so much in behaviour as in rules and incentives existing in the markets. In the case, for example, of the mortgage loans that triggered the current crisis due to excessive borrowing, two factors surely played a crucial role: (1) the assumption that the continuous rise in house prices would lower the amount of debt in relation to the value of the underlying asset over time, and (2) the possibility of obtaining mortgages with loan-to-value ratios of 100 per cent and more. In these cases, and as has long been acknowledged (for example, with reference to the sharp rise in house prices in the United Kingdom recorded in the early 2000s), it is obvious that it is necessary to resort not so much to monetary policy but to prudential instruments, with limits on the value of collateral that can be used in taking out a loan. The question is why steps of this kind were not taken, quite apart from the failure to use monetary policy (naturally as a possible second-best instrument). In the same way, it is legitimate to wonder whether confidence in the ability of financial markets to regulate themselves was not excessive. What role was played, in particular, by the waiving of stricter supervision in many sectors of financial intermediation? This, even disregarding the strength of lobbies and instances of excessive proximity between the supervisors and the supervised. In any event, it is clear that the consequences of a change of trend in the perception and concentration of risks were seriously underestimated, notwithstanding the many analyses and signals that had become available in recent years. Excessive deregulation of the financial sphere was also accompanied, as recalled earlier, by an unprecedented development of financial innovation. There was an enormous increase in the supply of complex instruments for hedging risk, structured products often very difficult to value if not using mathematical-statistical techniques whose application presupposed at least three conditions: (1) the availability of the basic information necessary to determine the quality of the products (securities or loans) underlying these instruments (in other words, the likelihood of the loans and bonds being honoured); (2) the validity, essentially over time and in the real world, of the arbitrage principle; and (3) a sufficiently high degree of liquidity in the markets. It is certainly open to doubt whether much thought was given to the soundness of these basic hypotheses, either by the regulators or by bankers and investors. Much remains to be done then, in the process of reviewing the rules and institutions responsible – including at supranational level – for the proper functioning of the markets, the prudent management of financial intermediaries and the valuation of investment and riskhedging instruments. The path of economic and financial development of the modern economies is, however, littered with episodes of excess, speculative bubbles and failures linked to highly imprudent if not criminal practices. If, on one level, the challenge lies in not falling into the opposite excess of exaggerated and obsessive regulation (bearing in mind that the hedging of risk, when properly identified and where possible, is right and proper), on another level I believe we must be aware of our position between the rock of market failures and the whirlpool of policy failures. The thesis I find most convincing is that the area where most errors were made, precisely because there was enough evidence at a macroeconomic level to act in time, was in the lack (beyond the declarations and press releases at G7 meetings), of sufficiently decisive policy reactions to the external imbalances that began to expand rapidly from the second half of the 1990s. Essentially these disequilibria reflected continuous and sustained growth in final demand, especially consumption demand, in the leading economic region of the planet, financed by over-borrowing, primarily from abroad; growth, in short, without the accumulation of savings. To conclude on policies and to support my previous point, I believe that aside from a logical interpretation of what provoked the current crisis, it is useful to propose a chronological reconstruction of the sequence of events that have marked the last ten to fifteen years. I propose the following summary, which admittedly is perhaps a little too USA-centric: 1. The revolution in the new information and communication technologies halted the progressive decline of productivity growth in the United States, which returned to markedly high rates of expansion in the second half of the 1990s. 2. During the same period, following the financial crises that hit the countries of SouthEast Asia and Russia (1997-98) and the collapse of LTCM (autumn 1998), the Federal Reserve’s policy remained essentially accommodating, with a strong expansion of liquidity also to counter the so-called millennium bug. 3. The “new economy” euphoria, beyond being compatible with objective interpretations of the increases in productivity linked to the introduction and spread of the new technologies, was reflected in US household consumption, with a rapid rise in debt and a sustained decline in savings, but with financial positions basically in balance thanks to the increase in net wealth due to capital gains, in part the result of soaring share prices during the dot-com bubble. 4. The powerful expansion in US final demand and imports was gradually accompanied by growth in the exports and output of the major emerging economies such as China and India, which had previously lagged behind, and an upwards trend in US inflation, dealt with by a tightening of monetary policy at the beginning of 2000. 5. Monetary tightening ended by bursting, late, the dot-com bubble in 2000-01. The recessionary effects of this were compounded by those of the severe shock of the September 2001 terrorist attacks. 6. Amid fears of recession and deflationary conditions of the kind that had prevailed in the previous decade in Japan, the Federal Reserve’s response was again very accommodating. A drastic reduction in interest rates was accompanied by a strongly expansionary budgetary policy, which remained in place also in relation to the war operations in the Middle East. 7. Monetary policy also remained expansionary for a long time, facilitating a return to sustained growth in household consumption, not countering the trend towards a zero saving rate, and giving free rein to financial innovation, in conditions of abundant liquidity, especially with the repackaging in 2004-06 of mortgages – in a context of constantly rising house prices – into structured products that opened up new investment possibilities to banks. 8. The growing US current account deficit was accompanied by ever-larger surpluses in emerging countries and Japan, with a significant build-up of official reserves, in a context of a relatively sluggish rise in domestic consumption demand and saving rates even higher than the nonetheless elevated rates of investment. The oilproducing countries also recorded sharply higher trade surpluses, reflecting the rise in oil prices due to the expansion of global demand. 9. The increase in international liquidity connected with the growing payments imbalances and the Fed’s accommodating monetary policy – which contributed, given the limited flexibility of emerging countries’ currencies and the Chinese renminbi in particular, to the global economic expansion – led to a prolonged period, from 2004 to 2007, of low price volatility in financial markets and low nominal yields. This was also due to the large volume of investment in fixed income securities by international investors and countries that had accumulated high levels of reserves by running large and rising current account surpluses. 10. The upshot was the search by investors – including international banks and banks of other countries and financial vehicles they controlled – for investments with higher risk-return profiles and the attendant supply of structured financial instruments backed mainly, although not exclusively, by home mortgages granted with loan-tovalue ratios exceeding even 100 per cent on the false premise that house prices could only increase. 11. The strong expansion of global demand engendered inflationary pressures, to which the monetary policy authorities responded, in part with a view to countering the possible impact on domestic prices of the expansion-driven increases in oil and raw material prices. The rise in interest rates was followed by the progressive deflation of the real-estate bubble, which had a domino effect, particularly on the structured products created using subprime mortgages, with their higher default risk. 12. In the summer of 2007 this triggered the financial crisis, which, despite central banks’ prompt and massive response, has gradually turned into a global crisis affecting whole industries and economies. In this context, a crucial role was played by financial regulation that was behind the curve, indeed entirely absent from some market segments. Speculative behaviour in the markets, the growth in leverage and the various kinds of pro-cyclicality operating at institutional level as well as in the decisions of market participants amplified the centrifugal tendencies. At the root, however, there remain the large trade and current account imbalances that the countries participating in the global economy built up unchecked. 4. Aspects of the forecasting failure Macroeconomic forecasts – whether produced by private-sector analysts or by national and international research and policy institutions – are generally made using econometric statistical models estimated on “time series”, data referring to the past behaviour of economic, financial and demographic variables that, on the basis of theory or statistical experience, are considered relevant for determining the variables of interest. In addition to the constraints suggested by their underlying theory, the different models incorporate to a varying degree the role of institutions, the rules prevailing in markets and the means and procedures of economic policy intervention. Although econometric model specifications often take into account the non-linearities that derive from accounting constraints, the fundamental non-linearities connected with genuine regime changes and that “are not found in the data” have to be addressed in an essentially discretionary manner. Forecasts are therefore conditional exercises conducted for given initial conditions of the endogenous variables “explained” by the model (the data observed at the time the forecast is made), “exogenous” variables (whose behaviour is considered to be basically independent of that of the endogenous variables), assumptions involving future policies and interventions taken to compensate for the basic “linearity” of the approaches used. Examining their performance, we find that errors in forecasting aggregates such as GDP tend to be relatively small, even if not negligible, and to grow with the forecasting horizon. This is shown with reference to Italy in Figure 7, which compares the average errors of several forecasters for the period 19992007. Nevertheless, there is no doubt that forecasts were late to consider the consequences of the financial crisis for economic growth. In the early months of 2008, when strains in the interbank markets had already persisted for six months and were gradually spreading to other segments, the professional forecasters surveyed by Consensus Economics indicated on average that in 2009 GDP would grow by close to 3 per cent in the United States, 2 per cent in the euro area and 1.5 per cent in Italy. In the course of 2008, as negative signals repeatedly came in and the state of the world economy worsened systematically, the estimates were revised downwards, but only very slowly until the autumn; as late as October (the month following the failure of Lehman Brothers), forecasters expected that GDP would expand, even if only modestly, in the United States, the euro area and Italy. Now, at the end of February 2009 and more than a year and a half since the outbreak of the crisis, GDP is expected to contract in 2009 by approximately 2 per cent in all three of those economies. Within the span of one year, the GDP growth forecasts were revised downwards by 4-5 percentage points. These are adjustments of exceptional magnitude (Figures 8 and 9). Looking back at the last 18 months, with the benefit of hindsight we see that the forecastadjustment process was unable to keep pace with events, culpably endorsing, with obstinate short-sightedness until a few months ago, the view there would be a short and relatively mild economic slowdown. Forecasting models have experienced episodes of acute difficulty in the past, especially in the presence of large and unprecedented shocks. Indeed, the effort to overcome the shortcomings that those episodes had revealed has been one of the main factors driving the development of forecasting instruments; aspects and mechanisms that had previously been neglected and whose importance was unexpectedly revealed have been gradually incorporated into successive generations of macroeconomic models. Furthermore, because forecasters are aware that all forecasting instruments are necessarily based on an incomplete and provisional knowledge of a continuously changing world, they have long recognized the advisability of adopting an approach based on a multiplicity of cross-checks. This constitutes a form of self-protection against the risk that the theoretical paradigms underlying the approximation of reality implicit in a model may prove particularly inadequate in certain situations. In addition, employing a battery of different instruments – from the grand econometric models in the tradition of Klein, Ando and Modigliani to the dynamic stochastic general equilibrium (DSGE) models, and including primarily statistical models such as vector autoregression (VAR) systems – makes it possible to filter and interpret more effectively the great mass of partial and fragmentary or even contradictory data that gradually become available. However, to quote Herbert Simon: “Good predictions have two requisites that are often hard to come by. First, they require either a theoretical understanding of the phenomena to be predicted, as a basis for the prediction model, or phenomena that are sufficiently regular that they can simply be extrapolated. Since the latter condition is seldom satisfied by data about human affairs (or even about the weather), our predictions will generally be only as good as our theories” (Simon 1981, p. 170). In effect, for a long time this crisis incubated in an environment that was beyond the ken of macroeconomic models and characterized by widespread opacity as to the actual soundness of the markets and individual participants. It was known that banks’ were holding toxic assets, but the total amount was unknown, let alone the distribution among intermediaries. Although macroeconomic repercussions appeared inevitable, it became possible to assess them more precisely only after the scale of the banking system’s difficulties became clear in the autumn of 2008, generating widespread panic and sudden, generalized increases in risk aversion. The global contours of the crisis also have only become clear relatively recently. At first the general view, with due exceptions, was that the crisis might be confined almost exclusively to the US domestic sphere and that the emerging economies might remain relatively immune (the so-called decoupling hypothesis, long considered plausible by some observers). Only of late has it become completely evident that this is not happening and that the whole world economy is deteriorating badly. Nevertheless, the failure to anticipate the evolution of the crisis under way is undeniable. In my opinion, it primarily reflected limitations and shortcomings in three aspects of modeling and forecasting. In the first place, when there are exceptional developments that constitute a discontinuity with the past, the statistical regularity Simon was referring to no longer obtains. The models, estimated on data plainly belonging to a different population than that involved in the forecast, cease providing a reliable representation of the way the economy works, often without even producing indications serving to identify the adjustments that could lessen the deficiencies. Secondly, in the utilization of forecasts and even more in the way they are remembered, attention inevitably focuses on the numerical value (with its misleading appearance of precision) assigned to the result deemed most likely (the so-called point estimation), while the remarks concerning the forecasting uncertainty, the risks implied by scenarios other than the central scenario, which are nonetheless part of a systematic kit of forecasting analyses, are disregarded or at least rapidly forgotten. Lastly, the current generation of models of the economy has proved deficient above all in representing the aspects that are most important in the transmission of the current crisis, those involving the interrelations between financial markets and the real economy. Regularity and discontinuity As to the first of the three shortcomings I mention, economic systems constantly evolve and transform themselves under the influence of: changes in institutional arrangements, legislative provisions and market regulation; the introduction of new technological paradigms; and the revised objectives, strategies and methods of operation of policy-makers. The changes in the framework in which economic agents (consumers and businesses) make their decisions in turn lead to changes in their behaviour. When there is marked discontinuity with the past, such changes may be far-reaching and the past cease to provide a reliable guide. Models, by definition, reflect historical experience in the values of their parameters – which are estimated for behavioural relations and calibrated for institutional mechanisms – and are therefore reliable when it is “business as usual”, that is, as long as the system they describe is not subjected to unaccustomed pressure. However, in this case it can be argued that their contribution to making right decisions is limited. On the other hand, they become unreliable precisely when, following signs of structural discontinuity, the need to predict the future is most urgent and the benefits of correct forecasting greatest,: yet that very discontinuity casts doubt on the use of models for fundamentally mechanical extrapolation. To a large extent the inability of models to cope with changes in the systems they describe is due to the way in which economic phenomena are represented, that is, using statistical and econometric techniques designed to reproduce, from a necessarily small number of parameters, relations that are sufficiently stable over time. Anomalous observations that do not fit the main mechanisms at work in the historical period used for the econometric estimate are frequently put aside: their information content is neutralized and therefore the model cannot take account of them. And yet those very deviations from the norm could provide precious information about the economy’s behaviour in conditions other than those usually prevailing. On the other hand, episodic observation of exceptional phenomena is inadequate to capture the often complex inter-relations between economic variables; it is only by building up a sufficient number of observations that we can obtain a statistically reliable estimate of a model’s parameters. This limitation reflects a more general characteristic of quantitative analysis of economic phenomena: the difficulty of making statistical inferences from data that are not the result of experiments designed and controlled by the researcher. Exceptional conditions cannot be re-created at will, in the laboratory, for cognitive purposes; our experience will always be limited, partial and episodic. We must therefore make use of information outside the model, refer where possible to historical experience, and intervene on the basis of theory and good sense. Another obstacle to detecting the emergence of stability problems, and thus to taking corrective measures, is the nature of economic information, which is fragmentary, available with varying lags, and often characterized by a marked degree of approximation, which will eventually be reduced, possibly much later. Without accurate, timely and reliable information about what is actually happening, an episode of structural discontinuity may not be recognised as such until long after it first appears. These considerations do not imply, however, that structural forecasting models (i.e. models in which the relations are not just a statistical reflection of the interaction between variables but are a quantitative representation, albeit approximate, of behavioural mechanisms) become completely unusable after a (real or apparent) break in their constituent relations. Anomalies in the relations between variables can only be recognised (and counter-measures taken, adapting and updating available instruments or creating new ones) if we have an instrument that can reliably represent such relations in “normal” conditions. Indeed this is already a very important signalling role. Structural models also allow us to trace the web of causal links between particular variables of interest. Thus, they do not just signal the appearance of discontinuities, they also help to identify which specific behavioural relation in the causal chain described by the models has changed with respect to the past. We can thus circumscribe the area affected by discontinuity, identify the nature of that discontinuity more easily and rapidly, and focus efforts to overcome it more effectively. Finally, once the type of discontinuity has been identified, the actual structure of the model may help to assess the consequences for forecasting by exploiting other relations which remain valid. In the present crisis not all the behavioural relations of the models currently in use have been affected to the same extent. The ones that remain generally reliable could perhaps, pending more systematic and radical solutions, suggest how to correct the answers obtained instead with the relations that have the greatest difficulty adapting to the new situation. In particular, it is worth trying to separate the forecasting errors, or revisions of forecasts, into their main determining factors: assumptions regarding policies (notably fiscal policies, but also market expectations regarding monetary policy); exogenous variables (for example, assumptions about the evolution of oil prices or the trend of world demand, on which, despite possible differences of opinion, the Bank of Italy, like the other national central banks, can only adhere to the evaluations agreed within the Eurosystem); and the changes in “initial conditions” underlined by Simon (see Figures 10 and 11). To assess the importance of the initial conditions we may look at Figure 12, which shows the forecast for GDP growth in the Bank of Italy’s January 2009 Economic Bulletin. As may be recalled, it showed a decline of 2 per cent in 2009 and a return to growth of 0.5 per cent in 2010. The pull exerted by the exceptionally negative estimate for the fourth quarter of 2008 had a considerable effect in this respect. In reality, Italian National Statistical Institute’s figures for the quarter were even more negative, reflecting the underestimation in the model of the performance of world demand. Simply taking “mechanical” account of this and maintaining the gradual but constant exit from the crisis implicit in January’s projections, we move from a 2 to a 2.6 per cent contraction in GDP for this year. The key to tackling the problems created by discontinuity must lie in a better understanding of its nature and so in developing and specifying models in which the relations are based on parameters that remain stable in the long term. Research must therefore aim to identify sufficiently fundamental and reasonably dependable mechanisms that do not change over time. Communicating and exploiting forecasts One area that has shown evident shortcomings in the present crisis lies between the production of forecasts and their utilization: end users (policy-makers, professional forecasters and the public at large) focus on the numbers summarizing the central or “basic” scenario (i.e. the one judged most likely), even though the products of forecasting are often more complex and include an evaluation of the size and direction of the risks surrounding the specific estimate. Such an evaluation usually consists in reporting the results of projections based on alternative hypotheses, thought to be less likely but nonetheless worth examining, particularly considering the often high macroeconomic cost if they were to come about, however unlikely. Virtually all forecasts of recent years have systematically indicated a risk that economic performance might not be as good as outlined in the central projection and that the feared downward adjustments to demand and output might be sudden and dramatic. These dangers were ascribed above all to the unsustainable global imbalances and their tendency to be absorbed suddenly, entailing sharp fluctuations in output in the main economic areas and their reciprocal exchange rates. When repeated warnings are issued about dangers that never seem to materialize, it is almost inevitable that they will eventually be ignored. The consequences of this very natural response may be particularly serious and disruptive, however: the long build-up of tension often culminates in an explosion, which will be all the more violent and dramatic the later it occurs. Perhaps the lesson to be learnt from recent experience is that a forecast should always be given and taken in its entirety: so, not only the central figure, but also the evaluations of the main risks, their size and the likelihood of their realization. When the dangers associated with alternative scenarios are extremely serious, even if not particularly likely, it may be better to adopt less than optimal policies with respect to the case in which the central forecast is realized, but ones that will safeguard against the occurrence of extreme events. When all is quiet, it may be unfortunate to have to renounce, as insurance as it were, part of the benefits of possibly more appropriate actions. But the crisis episodes remind us that the cost of not preparing for the worst may be very high. This means that not only must users of forecasts look more closely at the risk analysis, but that forecasters must learn to communicate their message with more determination and force, adapting their alarm signals to suit. Non-linear interaction between financial and real variables The crisis emerged in correspondence with a particularly weak and underdeveloped problem area in the macroeconomic models in use: the point of interaction between financial variables and the real sector. Simon’s observation regarding the correspondence between a model’s predictive capacity and the quality of the theory it contained is particularly relevant here. What is more, a critical re-examination of history suggests that financial crises – especially when, as at present, they have such a violent impact on the banking sector – have generally had profound and particularly long-lasting consequences for the real economy. While it is reasonable to think that the influence of macroeconomic variables (prices, demand, output) on financial variables is captured sufficiently by the available forecasting tools, our understanding of the reverse effect is much more limited, indeed inadequate. In fact, the impact of financial on macroeconomic variables (i.e. the situation in the present crisis) is only crudely represented in many models. Translating tensions in the interbank markets and banks’ funding problems into an assessment of their presumed impact on corporate investment and household consumption decisions is no easy task given our current state of knowledge. Those who have attempted to quantify the effects of a crisis have immediately run up against the obvious limitations of the available tools: there is no way (or still only a very rudimentary way) to represent the links between loan rationing and changes in the value of assets that can be used as collateral on the one hand, and the real economic variables on the other. This problem can be addressed by adapting the tools we have, of necessity on an ad hoc basis, and this is what has been done to produce the forecast given in Figure 12, in which account is taken of the rapid loss of confidence following the collapse of Lehman Brothers. In particular, it is posited that intermediaries’ greater fundraising costs may be reflected in an increase in average lending rates that is greater than that defined only as a function of policy rates and obtained by estimating the relation between financial operators’ risk exposure gauged by the increase in bond spreads and household and business funding costs. The effect of credit supply-side tensions, such as those emerging from qualitative information derived from the Bank Lending Survey, was taken into account by an equation associating a synthetic index constructed on the basis of the survey results with the forecasting errors of the equation explaining the evolution of investments in machinery and equipment. Obviously, recourse to ad hoc adjustments like this, even if they are necessary and possible using econometric models such as those considered here, cannot be the definitive answer. Many researchers both in research centres and in policy-making institutions have sought to overcome these limitations; and the efforts will multiply in the years to come. Above all there is an urgent need to improve our understanding of how the evolving macroeconomic framework may influence the stability of the financial system and the state of health of banks, especially in the presence of extreme events. Periodic evaluations of this kind have been conducted for years now, some as part of projects coordinated by international organisations; these checks also need to be made more systematic, more intense and more robust. But the serious difficulties encountered by econometric models in forecasting the effects of the financial crisis may necessitate a review of some of the theoretical paradigms related to the role of risk and uncertainty in agents’ decision-making, and not only as regards financial decisions, in particular at times of marked deviations from normal conditions. Obviously this may require discussing very complex problems, such as the possibility of making use, to gauge the probability of a credit crunch (with its non-linear effects on investment and production), of the credit market data themselves. 5. Concluding remarks on models and forecasts The large and, worse, growing imbalances in current payments, the excessively low saving rates, the over-indebtedness of households in America and other countries, and the prolonged and overly buoyant growth of the world economy signalled the unsustainability of global market conditions and a risk of recession that could not be ignored even in the euro area, where the external payments are in balance and monetary conditions are stable. However, the severity of the ensuing crisis has gone far beyond the forecasts and its behaviour has highlighted vast information gaps, particularly as regards the workings of the financial structures and interactions between finance and the economy. Although there has been no lack of deeply pessimistic, and in some cases quite accurate, forecasts and evaluations regarding both the dynamics and the effects of the crisis that began in 2007, almost all of them have been presented – and perhaps it could not have been otherwise – as greater or lesser risks of deviation from a core trend that is certainly negative but not dramatically so. The economic policy response, though rapid in its monetary component, wide-ranging in its revision of the rules and governance of financial markets and institutions, and impressive overall in terms of present and future budgets has nevertheless not yet succeeded in countering a steady loss of confidence that has spread from the financial sector to the real economy. It is too soon though, not only to evaluate the effects of these policies, but even to draw any profound lessons from the features and course of the current global crisis. In any event, there is a fairly high risk that we will only emerge from the crisis slowly and with a basically modest rate of recovery. In general, the effects of economic policy actions are not immediate; on the contrary, they often arrive a considerable time after the decisions are taken. Prudent policy choices can only be made on the basis of evaluations of future conditions and trends. Economic policy necessarily requires models that can produce reasonably reliable forecasts; that can aggregate and organize large, diverse quantities of data; and that can promptly signal any deviation from the behaviour that prevailed in the past. In this regard, I am still convinced that an econometric model, if used intelligently and not mechanically, constitutes a precious tool for making quantitative evaluations. Simply because one forecasting tool proves unreliable, this does not mean that economic policy should no longer make use of models: there is actually no practical alternative to refining those that exist to surmount their shortcomings. This calls for an understanding of the origin and nature of the errors and then developing new ways of interpretation and innovative techniques, which in turn will have to be set aside when, in the future, unprecedented shocks show the limits of the new generation of models. The imperfections of analytical forecasting tools are clear; to some extent the solutions can already be outlined; it is necessary that efforts along the lines indicated be prompt and effective. Economic policy management cannot very long do without reliable quantitative information, especially in troubled and uncertain times; such information can only be obtained using models that have been adjusted on the basis of past experience. Obviously, in order to be useful for economic policy-making, these forecasts, though they may be conditional, must factor in data that are not included in the present models and also allow for judgment based on experience and theory; as I have already said, they must not be “mechanical”. The time has not yet come when we can consider the “economic problem” as a “matter for specialists – like dentistry”, as Keynes, in 1930, would have liked. Unfortunately, that “splendid” time is still to come, as is amply demonstrated by the present crisis, in which economists will manage “to get themselves thought of as humble, competent people, on a level with dentists” (Keynes, 1933 p. 373). References Bean, C. 2003. Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?, BIS Working Papers No. 140, September (with Discussions by I. Visco and S. Whadwani, available at http://www.bis.org/publ/work140.pdf?noframes=1). Borio, C. & Lowe, P. 2002. Asset prices, financial and monetary stability: exploring the nexus, BIS Working Papers No. 114, July (available at http://www.bis.org/publ/work114.pdf?noframes=1). Fisher, I. 1933. The Debt-Deflation Theory of Great Depressions, Econometrica, 1, 4, October. Ferguson, R. W., Hartman, P., Portes, R., & Panetta, F. 2007. International Financial Stability, Geneva Reports on the World Economy, 9, ICMB and CEPR, Geneva. Genberg, H., McCauley, R., Park, Y. C., & Persaud, A. 2005. Official Reserves and Currency Management: Myth, Reality and the Future, Geneva Reports on the World Economy, 7, ICMB and CEPR, Geneva. Keynes, J. M. 1933. Economic Possibilities for Our Grandchildren, in Essays in Persuasion, MacMillan, London (originally in Nation and Atheneum and The Saturday Evening Post, 1930). Obstfeld, M. & Rogoff, K. 2000. Perspectives on OECD Economic Integration: Implications for U.S. Current Account Adjustment (and “Commentary” by I. Visco), in Global Economic Opportunities and Challenges, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August (available at http://www.kc.frb.org/publicat/sympos/2000/sym00prg.htm). Padoa Schioppa, T. 2008. The Crisis in Perspective: the Cost to be Quiet, International Finance, 11, 3, Winter. Portes, R. 2009. Global imbalances, in Macroeconomic Stability and Financial Regulation: Key Issues for the G20, eds. Dewatripont, M., X. Freixas and R. Portes, Vox ebook. (available at http://www.voxeu.org/G20_ebook.pdf). Rajan, R. 2005. “Has Financial Development Made the World Riskier?”, in The Greenspan Era: Lessons for the Future, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August. (available at http://www.kc.frb.org/publicat/sympos/2005/sym05prg.htm). Saccomanni, F. 2008. Managing International Financial Instability: National Tamers versus Global Tigers, Edward Elgar, Cheltenham, UK. Simon, H. 1981. The Sciences of the Artificial, MIT Press, Cambridge, Mass. Siviero S. & Terlizzese, D. 2000. La previsione macroeconomica: alcuni luoghi comuni da sfatare, Rivista italiana degli economisti, V, 2, agosto. Visco, I., 1987. Analisi quantitativa e «guida all’azione» di politica economica, Studi e Informazioni, Banca Toscana, 3. Visco, I. 1991. Politica economica ed econometria: alcune riflessioni critiche, in M. Faliva (ed.), Il ruolo dell’econometria nell’ambito delle scienze economiche, Il Mulino, Bologna. Figure 1: Cumulative current account balances (as a percentage of GDP) Japan Oil-exporting countries (1) China Euro area United States -20 -40 United States -60 Sources: National statistics; IMF, World Economic Outlook 2008; Lane, P. and Milesi-Ferretti, G.M., “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004”, Journal of International Economics, no. 73, 2007. Notes: (1) Cumulative current account balance starting from 1980. – (2) Net external position. – (3) Includes only emerging and developing economies. Figure 2: Stock market indices in real terms (2000 = 100) Japan United States Europe Source: Thomson Financial Datastream. Figure 3: Price/earnings ratio of the US stock market (percentages) average 1980-2008 = 17.4 Source: Thomson Financial Datastream. Figure 4: House prices in real terms (quarterly data; 1996 = 100) United Kingdom Sweden United States (b) United States (a) Japan Sources: Japan: Ministry of Land, Infrastructure, Transport and Tourism; United Kingdom: Nationwide; United States (a): FHFA and (b) Standard and Poor’s Case-Shiller 10-City Home Price Composite Index; and Sweden: Statistics Sweden. Note: Deflated using consumer price indices. Figure 5: House prices in real terms (annual data; 1996 = 100) Spain Netherlands France Italy Germany Sources: France: INSEE; Germany: Deutsche Bundesbank; Netherlands: Nederlandsche Bank; Spain: Ministerio de la Vivienda; and Italy: based on “Il consulente immobiliare” and Istat data. Notes: (1) Deflated using consumer price indices. – (2) For 2008, average of the first three quarters. Figure 6: Difference between observed and theoretical house prices United States United Kingdom 2008Q4 +17% United Kingdom United States 2008Q4 + 7.5% Sources: Based on FHFA, Nationwide and national statistics. For the methodology, see Finicelli, A., “House price developments and fundamentals in the United States, Banca d’Italia, Questioni di Economia e Finanza, no. 7, 2007. Note: (1) Equilibrium level = 100. The theoretical level of house prices is equal to the ratio of rents to the user cost. The latter is given by the sum of interest payments on mortgage loans, maintenance costs and property taxes, net of the expected increase in house prices. Figure 7: Average absolute error in the GDP growth rate in the period 1999-2007: comparison between the main forecasters (percentage points; the transparent histogram refers to the error made in the forecast for 2008) Forecast following year Forecast current year 2.5 1.5 1.15 0.92 0.97 1.13 1.00 0.5 0.30 Bank of Italy 0.34 Prometeia 0.35 0.43 Consensus IMF 0.49 EC Consensus IMF Bank of Prometeia Italy EC Note: Average of the forecasts made in the spring and autumn of each year by the Bank of Italy, Prometeia, Consensus Economics, the International Monetary Fund and the European Commission. Figure 8: Revision of the GDP growth estimates for 2008: Italy and the euro area 2.0 1.8 Italy 1.5 1.5 1.0 Euro area 1.6 1.2 1.2 0.9 0.5 0.6 0.4 0.0 -0.5 -0.5 -1.0 January 2008 April 2008 July 2008 October 2008 January 2009 Source: Consensus Economics. Note: The GDP growth rate in 2008 for Italy was -1 per cent and for the euro area it was 0.7 per cent. Figure 9: Revision of the GDP growth estimates for 2009: Italy and the euro area 2.5 2.0 Italy Euro area 1.5 1.7 1.5 1.0 1.2 1.1 0.5 0.8 0.5 0.0 -0.5 -1.0 -1.5 -1.4 -1.6 -2.0 January 2008 April 2008 July 2008 October 2008 January 2009 Source: Consensus Economics. Figure 10: Breakdown of the GDP forecasting error for Italy in 2008 0.4 Contributions to the error 0.2 Forecasting error 0.0 0.0 -0.1 -0.2 -0.3 -0.4 -0.4 -0.5 -0.6 -0.8 World demand Oil -1.0 Exchange rate, interest rates and other hypotheses Initial conditions -1.2 -1.3 Unexplained part -1.4 Note: Forecast for 2008 published in Banca d’Italia, Economic Bulletin, no. 49, July 2008. Contributions to the forecasting error due to the divergence of the hypotheses regarding the main exogenous variables with respect to the actual results and the revisions of the initial conditions. Figure 11: Contributions to the revision of the 2009 GDP forecast for Italy 1.5 Contributions to the revision 1.0 Total revision 0.5 0.0 0.8 -0.1 -0.5 -0.5 -1.0 -1.2 -1.5 -2.0 -2.5 -1.4 World demand Oil Exchange rate, interest rates and other hypotheses Initial conditions Unexplained part -2.4 -3.0 Note: Forecasts for 2009 published in Banca d’Italia, Economic Bulletin, nos. 49, July 2008 and 51, January 2009. Contributions to the difference of the GDP growth estimate due to the revision of the hypotheses regarding the main exogenous variables and of the initial conditions. Figure 12: Estimates and forecasts of GDP growth rates (annualized quarterly and annual data) 1.4 0.5 -0.6 -0.9 -1 -2.0 -2 -2.6 -3 -4 Bank of Italy Economic Bulletin, January with updated historical data -5 -6 Bank of Italy Economic Bulletin, January Average annual growth (Bank of Italy Economic Bulletin, January with updated Average annual growth (Bank of Italy Economic Bulletin, January) -7 Sources: Banca d'Italia, Economic Bulletin, no. 51, January 2009 and revisions of national accounts data. Note: The GDP growth estimate for 2008 not adjusted for the number of working days is equal to -1 per cent. | bank of italy | 2,009 | 4 |
Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board (previously Financial Stability Forum (FSF)), at the Turner Review Conference, Financial Services Authority (FSA), London, 27 March 2009. | Mario Draghi: The Turner Review rollout Remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board (previously Financial Stability Forum (FSF)), at the Turner Review Conference, Financial Services Authority (FSA), London, 27 March 2009. * * * The past eighteen months of crisis have been a learning experience for all of us. Many had expressed forebodings about the build-up of risks and leverage ahead of the crisis – and I would count both the FSF, BIS and the FSA in that number – but the weaknesses of risk management at major banks were so serious and pervasive as to defy even the more pessimists. Authorities have had to re-examine their fundamental assumptions about how the financial system works, and draw conclusions for how to reshape regulation. Lord Turner’s review does an excellent job at both of these tasks. As we seek solutions to these immediate challenges, from a longer-term perspective we are revising our ideas about what regulation can do, what it cannot do, and what it needs to do. Some say that we should avoid detailing how we will move to a more transparent, better capitalised, less leveraged system in the future and that to do so now would increase the burdens and uncertainties faced by banks in the present. I, and I think Lord Turner as well, would reject this view. To the contrary, as policymakers, while being fully aware about the time scale of implementation of these measures, we need to be as clear as possible right now about how we see the system evolving as we emerge from this crisis, if we are to rebuild confidence in the system among financial institutions, investors and the public at large. Lord Turner’s review lays out a sound, well argued case for revising our approach to financial regulation and placing such revision in an international context. Many of these changes are fully in line with discussions and recommendations that have taken place in the FSF. This shouldn’t come as a surprise, since Lord Turner and Callum McCarthy before him, and more broadly the whole of the FSA have made important contributions to these recommendations. I would especially emphasise: • improving the quantity and quality of bank capital, especially for the trading book; • improved regulation and risk management of liquidity risk; • a risk-based approach to compensation in the financial industry; • counter-cyclical capital buffers; and • incorporating cyclical factors in published accounts. I also applaud Lord Turner’s proposals for enhancing macroprudential analysis – that is, assessing the implications of macroeconomic trends for financial stability, the ability of the financial system to absorb or propagate macroeconomic shocks, and the interlinkages among financial firms. Indeed, it is precisely in this area that we have the most to learn from the experience of this crisis. We need to think hard and carefully about how to put these lessons into practice in formulating policies that incorporate financial stability concerns into traditional macroeconomic policy levers as well as regulatory rules and approaches. Many of these areas for action have an important international dimension. As we implement these new approaches, it is critical to maintain a level playing field internationally as far as possible. We must avoid a situation where national authorities are reluctant to impose tighter regulation for fear that this gives an advantage to banks in other countries. We need internationally consistent rules and standards to support sound international financial activity and mechanisms for supervisors to share information and coordinate supervision of large cross-border institutions. And we must better understand the systemic risks that never respect national borders, as we have repeatedly seen during the past 18 months. This means that we need more effective international cooperation. The FSF contributes to this cooperation by regularly bringing together senior officials responsible for setting financial policy at the national level along with international financial institutions and standard setters. Our dialogue facilitates a common diagnosis of problems, a better understanding of how key policy responsibilities and fields of operation interact, and a more coherent and consistent approach to maintaining a stable and efficient financial system. FSF members share a determination to address the systemic problems that have been at the heart of the crisis and have engaged in an active collaborative effort over the past year and a half to develop and implement measures to strengthen the underpinnings of the financial system. A year ago we published our Report on Enhancing Market and Institutional Resilience, which set out a plan of action for strengthening the system in such areas as prudential regulation, transparency, the role of credit rating agencies, and international cooperation in the supervision of large complex groups. We are also about to issue recommendations and principles in important additional areas: • On procyclicality, the FSF recommends actions that will dampen procyclicality in bank capital, establish more forward-looking loan loss provisions, and mitigate the adverse interaction between the build-up of leverage, maturity mismatching and fair value accounting; • The FSF has also endorsed Principles for Sound Compensation Practices that will better align compensation arrangements in financial firms with prudent risk taking, and make these arrangement subject to supervisory oversight; • Finally, we have endorsed Principles for Cross-border Cooperation on Crisis Management that commit our members to cooperate in preparing for and dealing with financial crises. A significant amount of this work delivers on the G20 Action Plan and will be published as part of the London Summit in the next few days. To be effective and retain legitimacy, the FSF’s international coordination activities need to involve the leading advanced and emerging economies. For this reason, we have recently announced the expansion of our national membership to encompass all of the G20 countries, as well as Spain and the European Commission. The expansion of the FSF’s membership will enhance the FSF’s ability to contribute to ongoing reforms of the international financial system. Countries that are members of the FSF commit to co-operate in promoting financial stability, maintain the openness of the financial sector, endorse and implement international financial standards and to undergo periodic peer reviews of their financial, supervisory and regulatory arrangements. Looking forward, the FSF needs to remain engaged with the most important issues and questions that have been raised by the present crisis. For example, as the Turner Review recognises, regulation needs to focus on the economic substance of financial activities, rather than the legal form assumed by institutions. We have learned that the activities of large, highly leveraged institutions of all kinds have significant systemic impacts and potentially pose critical systemic risks. For this reason, the FSF has initiated work to assess the proper perimeter of regulation – to evaluate which institutions, markets, instruments and activities need to be supervised directly with an eye to their systemic relevance, regardless of their legal form, and what regulatory tools are appropriate. Finally, as authorities we need to improve our ability to recognise, assess and respond effectively to mitigate nascent systemic risks at the global level. This is by no means an easy task – as we have learned from the experience of the present crisis, many critical risks are hidden on and off the balance sheets of large, complex institutions, or in the exposures to complex financial instruments, or in the idiosyncratic characteristics of national markets. No single authority can realistically obtain a complete picture. Yet, looking back on what was said by the FSF, the FSA and others in the leadup to the crisis, it is clear that there was a growing unease with the overall degree of risk-taking, financial institutions’ management of the risks of complex credit products, and with the expectation of many institutions and markets that high, stable levels of market and funding liquidity would continue indefinitely. What the official sector lacked previously was the willingness to dig deeper into these concerns, develop timely strategies to mitigate these risks, and track the effectiveness of our responses over time. For this reason, it is critical that we better pool the analysis and assessments of supervisors and central bankers across the major economies and financial centres and that of the international financial institutions that undertake surveillance of the global financial system. The FSF and the IMF have begun a process to do just this. Second, we need to be more proactive and persistent in how we respond to the risks that we identify. While we will never be able to precisely anticipate the nature and timing of the next financial crisis, there is a great deal we can do to ensure the follow up on the actions of policy-makers to mitigate macrofinancial risks before they become threats to systemic stability, and thereby to ensure that future episodes of financial turbulence remain contained. So let me conclude by once again commending Lord Turner for his timely and well thought report. I hope it will spur all of us, at both the national and international levels, to rethink how and why we regulate, and to make the tough decisions that will be necessary if our financial systems are to resume their primary function in supporting stable economic growth. | bank of italy | 2,009 | 5 |
Statement by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, to the International Monetary and Financial Committee, Washington DC, 25 April 2009. | Mario Draghi: Financial Stability Board – various initiatives Statement by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, to the International Monetary and Financial Committee, Washington DC, 25 April 2009. * * * In the last several weeks we have witnessed a modest revival in market confidence. It appears that the worst scenarios regarding prospects for the global economy and financial system are no longer quite so prominent in the minds of market participants. This offers us a unique window of opportunity both for short-term actions to stabilise institutions and promote credit extension, and for implementing measures to strengthen the system for the longer term. Our main challenge is to break the negative feedback loop between the financial system and the real economy. Repairing the balance sheets of financial institutions is a key part of this, and authorities have taken a range of actions to inject capital into banks, guarantee their liabilities and reduce or remove their exposures to bad assets. The ultimate objective of these measures should be to create an environment in which banks are able to repair their balance sheets through sustainable earnings growth and raise the capital they need from private markets at a relatively low cost. This also means providing enough transparency about risk exposures to allow the market to confidently distinguish strong from weak banks, and reducing market uncertainties on the future treatment of different classes of claimants. Regulatory stress tests are a central part of this process, as are efforts to improve disclosure. Another important part of breaking the feedback loop is to take steps to maintain credit extension to creditworthy borrowers. This has involved, and will continue to involve, a role for public sector balance sheets, including central bank lending and a variety of programmes by fiscal authorities. Steps to restart securitisation markets, with improved transparency and incentive structures building on the lessons of the crisis, can also help to restore credit flows, while enabling banks to clear their warehoused assets. Governments can help here by supporting transparency and standardisation initiatives in the private sector. In the short term, another useful step might be providing guarantees or wraps for the senior tranches of new securitisation issues that conform to strengthened standards of transparency. As we take steps to revive credit markets, we should be especially mindful of the need to maintain an integrated global financial system. Cross-border financial flows have fallen dramatically, among both advanced and emerging economies. This would not be a concern to the extent that it merely reflected a broader process of deleveraging and reduced risktaking. But we should guard against actions that unnecessarily reinforce this trend and reverse the long-term progress towards global financial integration. For example, actions to support banking systems should not distinguish between domestic and foreign-owned institutions, nor should credit be diverted to domestic borrowers through subsidies or inappropriate regulatory incentives. Stabilising the financial sector also includes establishing greater clarity on what the regulatory framework will look like in the longer term. Even as we implement measures to build a stronger, better capitalised financial system, banks and their investors need to be reassured as to their prospects for pursuing profitable business models going forward. This means allowing room for innovation and flexibility, without short-changing fundamental policy goals such as controlling leverage and enhancing consumer protection. Thanks to the work of the Financial Stability Board (FSB) and others, the broad outlines of this future regulatory environment are now much clearer than they were a year ago. The Financial Stability Forum (FSF) – predecessor to the FSB – and its member bodies made several recommendations for strengthening the system over the past year. This represents an enormous effort in terms of international policy development and the priority now must be on national implementation. This work has encompassed actions to: • Strengthen prudential oversight of capital, liquidity and risk management, with key proposals and work underway to strengthen the Basel II framework and enhance supervisory guidance. • Strengthen the operational infrastructure for over-the-counter (OTC) derivatives, with central counterparty clearing for OTC credit derivatives now launched in the United States and in Europe. • Enhance transparency and valuation, with consistent guidance now issued by accounting standards setters in a number of areas. • Improve the role and use of credit ratings, with a revised Code of Conduct Fundamentals for Credit Rating Agencies issued by the International Organization of Securities Commissions (IOSCO) last year and substantial implementation by the rating agencies. • Strengthen information exchange among authorities, with supervisory colleges now established for most global banks. • And finally, actions to strengthen arrangements to deal with financial stress, including through the FSF Principles for Cross-border Cooperation on Crisis Management (published this month), and the new Core Principles for Effective Deposit Insurance Systems, now out for public comment. Work has been also underway to mitigate procyclicality in the financial system, with recommendations issued by the FSF earlier this month covering the bank capital framework, loan loss provisioning practices, and ways of dampening the adverse interaction between leverage and valuation. And the FSF Principles for Sound Compensation Practices, also published this month, will align compensation-related incentives with the long-term profitability of firms. These efforts will help us to avoid similar crises in the future. But the policy agenda is not complete and we must sustain momentum to continue to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability. Indeed, work has not stopped since the London Summit. For instance, there is a substantial work programme underway in the Basel Committee on Banking Supervision on capital and procyclicality, and we are setting in train work with the Bank for International Settlements (BIS) on macroprudential tools. In addition, three areas in which critical work is taking place are (i) accounting and valuation, (ii) hedge funds, and (iii) other systemically relevant entities and products. On accounting issues, the London Summit welcomed the recommendations of the FSF’s procyclicality report, and G20 Leaders called for “accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards.” In this respect, • The International Accounting Standards Board (IASB) decided this week to adopt approaches consistent with the recent guidance on fair value for illiquid markets and fair value disclosure from the US Financial Accounting Standards Board (FASB). While the IASB decided not to implement the FASB staff’s approach to credit loss impairment for available-for-sale debt securities, it did decide to work with the FASB to issue this year a converged proposal to dramatically simplify their standards for financial instruments, which is expected to include a common credit loss impairment approach for loans and debt securities. • The IASB-FASB Financial Crisis Advisory Group has called on both standard setters to work with the FSB and the Basel Committee to address the provisioning and valuation recommendations of the FSB and the G20. A working group to be run by the Basel Committee is being established to develop positions. On hedge funds, the FSB has been tasked with working with national authorities to develop and implement coherent approaches to regulation and oversight of hedge fund managers. We will also be working with IOSCO to develop mechanisms for cooperation and information sharing between relevant authorities on hedge fund exposures. • IOSCO, along with a number of national authorities, is reviewing its approach to oversight of hedge funds. IOSCO released a consultative document on this issue in late March and has held consultative meetings recently. Final policy recommendations are expected in the summer. • The FSB is working to have the hedge fund industry bodies bring forward proposals for high quality global best practice standards for hedge fund managers. These are now expected in May. The various interested bodies will assess their adequacy and report in the fall. Three distinct efforts are underway internationally on other systemically relevant entities and products: • The Joint Forum is advancing its project on the differentiated nature and scope of regulation. It covers four areas: (i) consolidation and group-wide approach, which deals with non-regulated entities within groups; (ii) hedge funds (other funds, such as money market funds, will be considered at a later stage); (iii) mortgage originators and brokers and other intermediaries; and (iv) risk transfer mechanisms, focusing on credit risk transfer instruments and associated markets. • This group is drawing on IOSCO’s work on unregulated markets and products, focused on securitised products and credit derivatives markets – a consultative document in this area will be put out in the next days. • The IMF and the BIS are advancing their work on methodologies to quantify systemic risk and identify systemically relevant institutions and activities. There will be discussion in the weeks ahead on the expectations for joint delivery for the fall. All the above address a few of the areas for actions highlighted during the London Summit. In addition, • On supervisory colleges, the FSB is reviewing progress in the establishment and operation of the colleges. It is expected that colleges for all selected large and complex groups will have been established by June. • On cross-border crisis management, firm-by-firm groups will be established shortly to review contingency planning for the institutions that have FSB supervisory colleges. • The G20 also called on the FSB and standard setters to assess and raise supervisory and regulatory standards and codes, drawing efficiently on existing processes – including the joint IMF/World Bank Financial Sector Assessment Program (FSAP). Three related objectives under this headings include (i) fostering greater adherence to international standards; (ii) helping to identify jurisdictions that lag behind in terms of their implementation of these standards; and (iv) supporting a peer review process among FSB members. The FSB, with its expanded mandate and membership, is well placed to carry through and build on these various initiatives. In all of these areas, the FSB will work to promote better coordination among national authorities, international institutions and standard setting bodies. | bank of italy | 2,009 | 5 |
Statement by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at the Seventy-Ninth Meeting of the Development Committee, Washington DC, 26 April 2009. | Mario Draghi: The financial crisis – impact and responses Statement by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, on behalf of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor Leste, at the Seventy-Ninth Meeting of the Development Committee (Joint Ministerial Committee of the Boards of Governors of the Bank and the Fund on the Transfer of Real Resources to Developing Countries), Washington DC, 26 April 2009. * 1. * * A crisis of growing proportions Since we last convened in Washington for the Bank and the Fund Annual Meetings, six months ago, the crisis has taken a new turn. What was then a crisis affecting most advanced economies is now having severe impact on Developing and Transition Countries (DTC). Several transmission mechanisms have acted adversely over the last semester: financial intermediaries overly exposed to maturity/currency risks have curtailed lending; heightened risk aversion has massively reduced capital flows into emerging economies; export revenues have fallen as a result of declining trade volumes and commodity prices; remittances – normally a countercyclical factor in poor countries – seem to show a reversal in their multiyear upward trend. 2. The Bank response to the crisis The World Bank Group (WBG) has promptly responded to the growing financial needs of its client countries by scaling-up its development assistance and leveraging its own resources with those from other public and private donors. President Zoellick has pledged to bring new IBRD loans from $13bn to $35bn in the current fiscal year and up to $100bn over the period spanning fiscal years 2009 to 2011. Over the same period, IFC plans to fully leverage its capital base by raising its loans to $12bn per year. The WBG response to the financial crisis has also led to the development of the Vulnerability Framework (VF), a well-conceived platform intended to provide donors with an ample choice of multilateral development institutions and facilities to channel development funds. The support to trade finance, as envisaged in the VF, will help timely counteract the sharp contraction in trade volumes that emerged in recent months. The VF is well positioned to play an important countercyclical role, backing countries currently cut off from capital markets with additional finance. At the same time it is important that all new resources falling under the VF umbrella meet standards of accountability, oversight and evaluation as rigorous as those governing the use of WBG funds. More broadly, short-term public budget relief (through fast-disbursing Development Policy Operations) must be strictly and verifiably targeted to restoring fiscal space for essential social needs (Health, Education, Nutrition); a sharp focus on long-term development goals, above all the need to support food security, social safety nets and infrastructure, especially in African countries, must be maintained. We support the envisaged surge in the deployment of IBRD and IFC resources. Lending growth over time under persistent uncertainty on economic and financial conditions warrants continued budgetary discipline and a thorough review of both institutions’ financial sustainability and overall risk exposure. The front-loading of IDA resources and fast implementation procedures such as the Vulnerability Financing Facility, are appropriate measures at this time of crisis. We believe that IDA is well positioned to accelerate its support to low income countries, thanks to the substantial increase of its commitment authority for the next three years under the IDA 15 replenishment. 3. Crisis and climate change: two intertwined challenges The complexity of dealing with climate change reflects the intricacy of development challenges in an increasingly interdependent world. Climate change encompasses, and amplifies, concerns related to natural resource scarcity, food supply and security. It entails substantial financial requirements and distributional tradeoffs that, in turn, pose daunting political economy challenges. However, neither these challenges nor emergencies related to crisis management should undermine the WBG’s commitment to the climate change agenda. Scientists have documented that the window of opportunity to tackle climate change is shrinking fast and that urgent and unprecedented levels of multilateral collaboration are needed. Moreover, the UN Climate Change Conference in Copenhagen in December will shape a new global financial regime providing the World Bank with a unique opportunity to liaise with lead negotiators emphasizing the WBG role in the international debate on climate change. In particular, we expect the WBG to help develop currently existing or proposed financial schemes to support less carbon intensive technologies and to adapt rural and urban environments to the adverse impacts of climate change. 4. Voice We welcome the progress made in implementing the first stage of the reform aimed at enhancing the representation of DTC in the World Bank Group. As agreed at the last Annual Meetings, the shareholding review should consider the evolving weight of all members in the world economy and other Bank-specific criteria consistent with the development mandate of the institution. We invite Management, in close interaction with the Board, to prepare concrete criteria and options for shareholding realignment to be submitted for Governors’ future consideration, with a view to reaching a broad consensus on realignment by the 2010 Spring Meetings. | bank of italy | 2,009 | 5 |
Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at the Ordinary Meeting of Shareholders 2008 - 115th Financial Year, Bank of Italy, Rome 29 May 2009. | Mario Draghi: Overview of economic and financial developments in Italy Concluding remarks by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at the Ordinary Meeting of Shareholders 2008 – 115th Financial Year, Bank of Italy, Rome 29 May 2009. * * * Ladies and Gentlemen, The reorganization of the Bank is going ahead as scheduled. Eighteen branches have already been closed and others will cease operations over the coming months. By the end of this year, 58 of the original 97 branches will still be operational, including 6 specializing in banking and financial supervision and 25 assigned, with a streamlined structure, to the State treasury service and to providing information services to the public. Banknote production will be reorganized, with the agreement of the trade unions, in order to expand output and increase efficiency. Following the absorption of the Italian Foreign Exchange Office, for more than a year the Bank of Italy has had the function of combating money laundering through a Financial Intelligence Unit that operates within the Bank but with special autonomy. It has been endowed with substantial resources and expertise. In carrying out its tasks, the FIU has developed fruitful synergies with the banking and financial supervision area. This benefits the stability and the reputation of the banking system. The Unit cooperates closely with the judiciary and with the Finance Police, to which a constantly growing stream of complaints and reports are submitted. This January Antonio Finocchiaro left the Governing Board to assume the office of chairman of the Pension Fund Supervisory Authority. In the course of a long career, Mr Finocchiaro served the Bank of Italy with rigour and dedication, making important contributions in a diversity of fields ranging from the original development of the Bank’s IT system to the management of human resources and trade union relations, to operational organization and management. Let me offer him my most affectionate and grateful salutation. His place on the Governing Board has been filled by Anna Maria Tarantola, former Managing Director for Banking and Financial Supervision. The Bank’s staff last year faced an extraordinary commitment, commensurate with the difficulties of the economic and financial crisis we are experiencing and the exceptional response required at every level. The earthquake in Abruzzo has posed a painful additional challenge. All are responding with self-sacrifice, putting the great professional and human qualities that distinguish our team to the best possible use. I thank all of them on behalf of the General Council and the Governing Board. The question of the Bank’s ownership structure remains to be dealt with. For over seventy years now the present arrangements have ensured the independence and decision-making autonomy of the central bank. However, the evolution of the structure of the banking system has brought to light a formal anomaly that it is advisable to remove. We are prepared to design, together with our shareholders and with the Government, a solution that will work to the benefit of the entire system. The global crisis Since mid-March tensions in the financial markets have eased and share prices, despite fluctuations, have recovered, returning to the levels recorded at the beginning of the year; the qualitative indicators of the real economy point to a subsidence of recessionary pressures. These are encouraging signs. The likelihood of deflation, in the sense of a protracted decline in the general price level, now appears slight, also because longer-term inflation expectations remain close to 2 per cent. However, in view of their seriousness, the persistent risks to the unfolding economic scenario require that the economy continue to be supported decisively using all available instruments. There is awareness of the need to prepare in advance strategies to reabsorb the large budget deficits and exceptional liquidity creation that characterize the current situation. It is not yet possible to point with certainty to a definitive cyclical inversion: the forecast is for a return to growth in 2010. The general expectation is for falling levels of employment and revenue, accompanied by continuing volatility in the financial markets, with adverse effects on consumption and investment. The task of economic policies is to attenuate the negative spiral of unemployment and consumption. The response has been prompt, vigorous and coordinated at the international level. Up to now there has been no sign of a significant resumption of protectionism. Official interest rates have been cut drastically in all the main economies. Between October 2008 and the beginning of May, the Governing Council of the European Central Bank lowered the rate on main refinancing operations by 3.25 percentage points, to 1 per cent, the lowest level ever reached in the euro-area countries. The reduction was reflected in market rates: the three-month Euribor rate is currently 1.3 per cent, over 4 percentage points lower than in the first ten days of October. Twelve-month interest rates in euro are aligned with those in dollars and slightly lower than the sterling rates. The expansionary measures taken by all the central banks significantly enlarged their balance sheets in ways that reflect differing national financial structures. Bank credit in the euro area is relatively more important than in the United States (around 140 per cent of GDP compared with 60 per cent). Accordingly the Eurosystem has so far focused on banks. The introduction in October last year of a system of bank funding at a fixed rate, limited only by the availability of collateral, was a highly important development; this, along with other measures, enabled banks to meet their liquidity requirements in a situation of money market paralysis. It also provided certainty regarding the rate they would have to pay for a much longer period than in the past: the maturities of longer-term refinancing operations were extended up to six months and, from next June, to twelve months. Against these loans banks can now post as collateral a much broader range of securities than were previously eligible. A global systemic collapse was averted, but neither monetary expansion nor the effect of built-in stabilizers in government budgets could fully counter the fall in aggregate demand and the social costs of the recession. Since last autumn international organizations have been emphasizing the need for decisive discretionary budgetary measures, coordinated internationally and involving all the main countries. The Council of the European Union called for stimulus interventions totalling 1.5 per cent of the euro-area GDP in 2009. In all the industrial countries and in many emerging economies, first and foremost China, the fiscal policy response has been markedly expansive. The size, duration and makeup of the interventions have varied, reflecting in particular the uneven impact of the crisis, the initial state of the public finances and the scale of built-in stabilizers. The simultaneity of the stimulus measures adopted enhances their effectiveness. According to recent estimates by the International Monetary Fund, in 2009 the fiscal deficits of advanced countries will reach almost 9 per cent of GDP, then fall by 1 percentage point in 2010. Between 2008 and 2010 government gross debt is forecast to increase by 27 percentage points of GDP in the United States, to almost 100 per cent, and by 16 percentage points in the euro area, to 85 per cent. The need to place massive volumes of government securities on the market in the next two years puts upward pressure on interest rates; these will intensify with the easing of the recession and attendant rise in demand for private debt securities, checking the recovery of the economies. Once the crisis has passed, the public debt must be reduced sharply. However, history teaches us that without the restoration of the banks to health and without the resumption of credit flows, the recession will be more drawn out and the recovery slower, despite the exceptional expansion of budget deficits. After the failure of Lehman Brothers last September, government interventions to guarantee bank deposits and liabilities and to support recapitalization prevented additional collapses; they were insufficient to avert a contraction of credit. Financial markets are still struggling to become fully functional again. Risk aversion remains high. Worldwide, in the past two years banks have recorded losses of over $1,000 billion in their balance sheets. Just under half of the funds used to rebuild their capital base came from government intervention. Looking ahead, banks’ capital requirements must be met by reactivating the market. This depends on the total transparency of banking assets. The cloud of uncertainty that continues to hang over banks’ balance sheets limits the inflow of private capital, increases the level of capital ratios demanded by the market and makes the incentives to reduce assets more stringent. Action must be taken to re-establish the certainty and credibility of the asset side of bank balance sheets. The measures announced by a number of countries to insure or transfer to separate entities part of their assets can prompt the emergence of the most problematic securities. But to restore confidence in the major international financial institutions, there remains the need for a full, internationally coordinated, consistent, rigorous and transparent stress testing of banks’ balance sheets, which has already been launched in the United States and is being prepared in Europe. Promoting financial stability The crisis is rooted in distortions in the markets’ functioning, regulatory and supervisory shortcomings and the conduct of intermediaries in the world’s leading financial centres. The exceptional liquidity that flowed into those centres as a result of the prolonged disequilibria in savings rates and payments balances contributed to keeping interest rates, volatility and the cost of protection against insolvency at abnormally low levels. This led to a general underestimation of risk with a consequent overvaluation of financial assets and real estate. The defects in regulation and the management of risk by the world’s largest banks were concealed. An accommodating monetary policy contributed to the artificial dilation of financial volumes and permitted the continuation of a situation rendered fundamentally unstable by the distortions and shortcomings mentioned above. The market rejected economic policy interventions despite their timidity; blinded, it lost its diagnostic capacity, its self-correction mechanisms were paralysed. A financial system that combines innovation and solidity, profit and support for households and firms will have to have more rules, more capital and less debt. The global strategy that is emerging is based on three pillars: the international financial institutions, the regulatory authorities and the central banks. The International Monetary Fund has taken on a crucial role; its resources have been more than doubled and its ability to intervene has been enhanced. Today the IMF can support countries in difficulty, especially the emerging economies that are suffering most from the adverse economic cycle; the Fund’s assistance in managing imbalances is preventing the systemic propagation of the crisis. The IMF, together with the Financial Stability Board, has been entrusted with analysing and signalling threats to the stability of the global financial system. It is encouraging that the leading countries have at last accepted periodic IMF examination of the soundness of their financial systems. More rigorous multilateral surveillance than in the past will contribute to the global consistency of national economic policies. But the orderly correction of current account imbalances will have to hinge on a world capital market that is fully functioning and free from defects in regulation and control. This belief underlies the establishment by the G20 Heads of State and Government of the Financial Stability Board. The new body has a broadened membership and mandate by comparison with the Financial Stability Forum; in April 2008 the latter had produced the first report on the steps to be taken to overcome the shortcomings of regulation. The Board is now responsible for monitoring national authorities in the application of those recommendations, coordinating the many committees of regulators and accountants that determine the standards for banks, and proceeding with the establishment of international colleges of supervisors for the largest financial institutions. More rigorous capital and liquidity requirements, the extension of the scope of regulation to non-bank institutions, the completion of Basel II and amendment of the accounting rules in order to reduce their procyclicality, and more demanding supervision and regulation for institutions whose size makes them a systemic risk; these are the measures describing the path of the Financial Stability Board’s work in the coming months. The Italian presidency of the G8 is conducting the work to set global standards for the transparency, propriety and integrity of international economic and financial activity. The crisis has considerably broadened the consensus on the need for central banks to expressly include financial stability among their objectives; restricting their task to taking corrective action after a crisis is no longer deemed sufficient. The idea is gaining ground that the functions of monetary policy and supervision reinforce each other. The debate on these issues is complex and far from over. In Europe the revision of large parts of the system of banking and financial supervision is already under way. The fundamental aspects of this process appear correct; in some points it needs to be strengthened. The assignment of supervisory tasks aimed at systemic stability to a European council is a good idea if it has real powers of intervention and operates in close coordination with the national supervisory authorities. In at least some areas the common supervisory standards should be binding and directly applicable at national level. It is necessary to harmonize deposit guarantee systems and the mechanisms for crisis management. The repercussions of the crisis in Italy According to the latest forecasts, the world crisis will cause GDP to fall in Italy by about 5 per cent this year, after decreasing by one per cent in 2008. The collapse of foreign demand has triggered a sharp contraction in industrial production and investment. The reaction of firms, especially those most exposed to the international cycle, was immediate: the temporary closure of entire factories and production lines; temporary and permanent reductions in the workforce; postponement of purchases of intermediate and capital goods; and unusually long delays in paying suppliers. In the six months from October 2008 to March 2009 GDP fell by more than 7 per cent on an annual basis compared with the previous six months. The recent signs of an easing of the most acute phase of the recession come from the financial markets and opinion surveys, more than from the statistics available to date on the real economy. For a return to sustained growth there must be a stable recovery of the world economy, the weakness of the labour market must not have an even more severe impact on domestic consumption, and the structure of our productive system must be strengthened. Employment and consumption Among the prudential measures that firms have taken to cope with the recession, those involving labour have been of three types: a reorganization of shifts and working hours and a freeze on hiring; recourse to the Wage Supplementation Fund; and non-renewal of fixed-term contracts and layoffs of permanent employees. Nearly all firms have used measures of the first type. Ordinary wage supplementation was also used extensively, quickly reaching the peak levels recorded in the 1992-93 recession; the cover it potentially provides is nonetheless limited − one third of payroll workers in the private sector − and it provides workers with a maximum monthly benefit that is less than half the average gross earnings in industry. It is estimated that two fifths of the industrial and service firms with 20 or more workers will reduce their staff this year; the reduction will probably be most pronounced among the smallest firms. More than 2 million fixed-term workers will see their contracts expire this year; more than 40 per cent work in private services, nearly 20 per cent in the public sector; 38 per cent work in the South. Workers on wage supplementation and job seekers already amount to about 8.5 per cent of the labour force, a share that could rise above 10 per cent. Households’ disposable income and consumption are expected to go on falling, despite the substantial decrease in inflation. The governmental measures in favour of less well-off households and the incentives for the purchase of durable goods are providing temporary support. A first risk of the current cyclical phase is a sharp reduction in domestic consumption, to which firms could react by further restricting their purchases of capital goods and inputs. Firms and the crisis Thanks to the commitment of our regional branches, we have conducted a particularly thorough survey of the state of the Italian economy, the difficulties that firms are encountering and how they are reacting to the crisis. Expectations of a sharp fall in turnover (of more than 20 per cent according to many firms) and great uncertainty as to the duration of the crisis have caused investment plans for this year to be reduced by 12 per cent in industry and services overall and by more than 20 per cent in the manufacturing sector – exceptionally high figures by historical standards. Restructuring in large parts of the economy began in the first half of this decade. Prior to the crisis, some positive results were already visible in terms of productivity and competitive strength on foreign markets, but these difficult times jeopardize the process. According to our survey, about half of the 65,000 industrial and service firms with 20 or more employees are engaged in restructuring. They expect a much smaller than average drop in turnover in 2009. At one extreme, the more financially solid among them are now buffering the impact of the recession by consolidating their technological edge and diversifying their outlet markets. There are a fair number of such firms, we estimate more than five thousand, employing nearly a million people. Some appear ready to take advantage of the crisis by repositioning themselves in the market. At the other extreme lie the firms that, having decided to grow in size and technological intensity, and to open up internationally, had taken on debt. Now, with the crisis, they are faced with the drying up of cash flows, more rigid bank credit, and considerable problems in accessing capital markets. At least six thousand companies, once again with almost a million workers, are affected in this way. The effects of the crisis are being felt above all by firms with fewer than 20 workers. In manufacturing alone there are nearly 500,000 such firms, employing just under two million workers. The very survival of those subcontracting for larger firms that are cutting orders and deferring payments is sometimes at stake. The coming months will be decisive; excessive mortality due to financial strangulation of too many companies that have the potential to prosper after the crisis has passed is a second, serious, risk for the Italian economy. Financing the economy The deterioration of the economy tends to curb bank lending. In April the quarterly rate of growth of credit to non-financial firms was nil; it had been 12 per cent a year earlier. Lending to households has also continued to slow. A part of the deceleration can be explained by a decline in manufacturing and real estate investment and in the consumption of durable goods. But the supply of bank lending has also been curtailed, mainly owing to difficulties in raising medium and long-term funds and to the increase in credit risk. Our survey found that the loan applications of 8 per cent of firms were rejected − the highest figure since the mid-1990s; it was less than 3 per cent a year ago. Over 10 per cent of firms state that since last October they have been asked for early repayment. This happens more frequently in the South of Italy but affects the whole country and even some larger companies. Banks cannot be asked to be less prudent in granting credit; a banking system that risked the integrity of its balance sheets and the confidence of those who entrust their savings to it would not serve the interests of the economy. What can, and must, be asked of our banks is to improve their ability to recognize creditworthiness in the present, exceptional circumstances. Special attention must be paid to the longer-term prospects of the firms that apply for financial assistance. When evaluating and making decisions, banks must take account of technology, organization and the dynamics of firms’ main markets. The Government’s recent initiatives to increase the Guarantee Fund for small and mediumsized firms can strengthen banks’ support to smaller companies. Consideration should also be given to the possibility of making a public loan guarantee scheme available to a broader range of firms, as in other countries, for a limited period of time and with safeguards to reduce distortions in resource allocation. However, it is also important to reactivate the Italian securitization market; if properly structured these instruments will remain a key channel for financing. The less risky tranches backed by portfolios of mainly newly-granted loans could be covered by government guarantee. The State would not be required to make an immediate outlay of funds and its guarantee would be adequately remunerated. Anti-crisis measures Economic policy currently presents more difficulties in Italy than in other countries. Action to bolster demand is restricted by government debt from the past. Measures taken to date to mitigate the social costs of the recession have relied mainly on funds allocated to other purposes. But firm and credible action to set the public finances right within an agreed time frame can provide scope for a more incisive economic policy. The first concern is the danger of a further deterioration of labour market conditions. The crisis has highlighted long-standing deficiencies in our system of social protection, which continues to be fragmented. Otherwise identical workers are treated differently only because they are employed in a craft firm rather than in a larger company. It is estimated that 1.6 million employees and quasi-employees have no right to any assistance if they are dismissed. More than 800,000 full-time workers in the private sector, that is 8 per cent of potential beneficiaries, are entitled to an allowance of less than €500 a month. A good system of social buffers for the unemployed that balances out financially over the economic cycle lifts some anxiety from workers, supports consumption, improves mobility between firms and sectors, and helps redirect individual skills into more productive employment. Well-defined, nondiscretionary assistance, conditional upon engaging actively in a job search – stronger controls being essential here – increases people’s sense of security, gives their life-plans substance, and makes it less necessary to save for a rainy day; it narrows the disparities between workers with and without safeguards. In a welcome move, the Government has already included temporary income support among its anti-crisis measures, including in the case of shutdowns in companies not covered by the Wage Supplementation Fund. It has also made provision for experimental measures in favour of some quasi-employees. The time is ripe for a rigorous, comprehensive reform that will rationalize the current system of social buffers and provide more universal benefits. There is no need to overturn the existing system. It can be re-designed around the two traditional instruments of the ordinary Wage Supplementation Fund and unemployment benefits, suitably adjusted and graduated. These should be accompanied by income support for the cases they do not cover, as happens almost everywhere else in Europe and as proposed in the Government White Paper. A form of tax credit could be considered for those on low wages: this system has been successfully adopted in many countries and could help to regularize informal employment. Among the anti-crisis measures for the productive system, priority must go to action to ease firms’ financial problems, such as the plan of intervention being drawn up with the assistance of Cassa Depositi e Prestiti and SACE, the export credit insurance agency. Additional and more direct support could be provided by cutting payment times for general government trade payables, which amount to about 2.5 per cent of GDP. A further move would be made in this direction by temporarily suspending the requirement to pay into the National Social Security Institute, INPS, the part of contributions to severance pay not allocated to a pension fund, amounting annually to 0.3 percentage points of GDP. While both actions would entail greater recourse to the financial markets, neither would worsen the central government’s net financial position. Measures to stimulate private investment in residential property, which it is hoped will be introduced in suitable form very shortly, will assist the recovery of capital accumulation. Existing building work should be completed at the earliest opportunity and encouragement should be given to local projects, many of which are fairly small and could be launched without delay. The adjustment of the public finances and structural policies The recession is slowly producing an effect on the tax yield: having decelerated for most of 2008, it fell during the last two months. VAT receipts decreased by 1.5 per cent in the year as a whole, compared with an increase of 2.3 per cent in consumption, partly due to the shift towards essential goods carrying a lower rate. In the first four months of this year, VAT receipts were down 10 per cent on the same period of 2008. Revenue from corporate income tax, which dropped by more than 9 per cent in 2008, could fall by a still larger amount this year. Only the revenue from personal income tax is holding up. The action of built-in stabilizers is likely to raise the public deficit by around 2 percentage points this year, to more than 4.5 per cent of GDP. In 2010 the deficit could exceed 5 per cent. Even without additional measures to support the economy, by the end of the crisis the public debt will have increased considerably in terms of GDP, back to the levels of the early 1990s. The ratio of primary current expenditure to GDP, which in 2008 reached the highest value recorded since the Second World War, will rise by 3 percentage points in 2009. Total public expenditure will be well over 50 per cent of GDP, and unless steps are taken it will tend to stay at that level in the years to come. There is a danger that the economy will have to bear the burden of extremely heavy taxation for many years. After the crisis has been overcome, Italy will find itself not only with more public debt but also with an endowment of private capital – physical and human – impoverished by the sharp drop in investment and the rise in unemployment. If we were to do no more than return to a low growth path like that of the past 15 years – starting, moreover, from decidedly worsened conditions – it would be difficult to pay down the debt, while the necessity for restrictive policies to ensure its sustainability would become more stringent. We must aim, immediately, at achieving faster growth in the medium term. It is necessary to act on two fronts: to ensure the consolidation of the public finances and to implement the long-awaited reforms that will enable our economy to be an active partner in the world economic recovery. The measures reducing current expenditure must be introduced into legislation immediately, even if the effects are deferred, not put off to further legislative acts or administrative decisions. In many cases this simply means proceeding more resolutely on the courses already embarked upon. The gradual raising of the average age at retirement will guarantee adequate pensions. A higher employment rate among those between the ages of 55 and 65 will increase both households’ disposable income and the economy’s potential output. In 2008 occupational pension funds recorded negative yields of 6 per cent and open funds lost 14 per cent. These results must not induce us to modify the process launched in the early 1990s to foster the development of a second, funded retirement pillar. In the long run a mixed system is preferable to a straight pay-as-you-go system. Nevertheless, some adjustments and additions may be advisable. It is necessary to encourage the introduction of products that automatically diminish the riskiness of portfolios as retirement nears and to offer securities allowing for better management of risks over the long term. The implementation of fiscal federalism must make a contribution to curbing government expenditure. By strictly linking spending and taxation decisions, without forgoing the principle of solidarity, it can lead to more efficient use of public resources. A crucial feature of the reform enacted by Parliament is the replacement of historical expenditure by standard costs as the criterion for the assignment of resources to local authorities. Until now the reference to historical expenditure has made public budgets more rigid, institutionalizing inertial mechanisms in expenditure trends. Much is expected from the planned reform of the public administration. The breadth of the plan, the emphasis it places on transparency and on the measurement of government performance and the recognition of merit are all important elements of change. The efficacy of the reform will depend on the design of evaluation systems and on the organizational rules adopted. Progress has been made in simplifying and reordering regulations and in reducing red tape, in particular for business start-ups. Yet new regulatory provisions continue to be both complex and opaque. The bureaucratic costs for business activity remain high, with substantial differences from region to region. Regulatory simplification and effective public action are necessary conditions for reducing the incidence of the underground economy, which is estimated to account for more than 15 per cent of overall economic activity in Italy. The concealment of a considerable proportion of the tax base increases the burden on law-abiding taxpayers. It undermines the competitiveness of the majority of firms, creates inequities and disrupts the social fabric. Progress in fighting underground economic activity would make it possible to lower official tax rates, attenuating distortions and unfairness. It is necessary to improve the quality and increase the quantity of human capital and physical infrastructure. Last year on this occasion I dwelt on the urgent need to elevate educational attainment in our schools and universities. The drive for reform in this area must proceed and intensify. Physical infrastructure is a crucial factor in competitiveness. In the last twenty years the gap between Italy’s infrastructural endowment and that of the other leading EU countries has more than tripled. As regards major public works, the failure to set long-term priorities has resulted in discontinuity and the dissipation of funds on a multitude of projects. The list of high-priority strategic infrastructures, originally 21, has now swollen to over 200. The time and the costs for high-speed rail lines and motorway network extensions, and even for short road links and bypasses, are far greater than in other European countries. A kilometre of motorway can cost over twice as much as in France or Spain. The causes are the uncertain attribution of powers and jurisdiction between national and regional government, poor initial cost estimation and shortcomings in reporting and continual project alterations. Regulatory defects limit recourse to project financing. The process of liberalization undertaken in years past must not halt or retreat. In the countries where services are less liberalized, the growth problems of technologically advanced industries are more severe. Local public services are an example of the way in which the absence of regulation entrusted to bodies that are competent and independent of the service providers can engender inefficiency and higher costs for consumers. The crisis and the banks In the recent past the Italian banking system underwent a major transformation, spurred by heightened competition. A large number of mergers and acquisitions, by increasing the average size and efficiency of Italian banks, helped to improve their resilience in the face of the crisis. The crisis caught the Italian banking system at a time when reorganizations were being completed, new forms of governance were being tested and the presence in foreign markets was being expanded. The system remains characterized by the clear prevalence of credit intermediation activity in favour of households and firms, strong local roots and a generally balanced structure of assets and liabilities. The impact of the crisis on the banks has been less traumatic in Italy than in other countries, thanks above all to a limited exposure to structured finance products and lesser reliance on wholesale funding. At the end of 2008 structured credit instruments represented just under 2 per cent of the assets of the main banking groups. Wholesale funding made up 29 per cent of total funding for our system, against an average of 41 per cent in the euro area. A fundamentally sound model of intermediation, together with a particularly prudent regulatory framework and supervisory approach, has shielded Italian banks from the most devastating effects of the market turbulence. Taxpayers have not been saddled with the costs of losses and bankruptcies seen in other countries. The banking system is not immune to the consequences of the crisis, however. Italian banks’ profits contracted sharply in 2008. The return on equity of the largest groups fell by 5 percentage points. Lending rates have come down rapidly since October. The average initial rate on new variable-rate mortgage loans to households declined from 5.6 per cent to stand at 3.7 per cent in March. Interest rates for fixed-rate mortgages have also fallen swiftly; the differential that still existed at the beginning of last year between Italy and the euro-area average has narrowed considerably. For short-term loans to firms, the reduction in rates between October and March averaged about 2 percentage points. But it is also true that the risk and rate differentials between borrowers have widened: the difference between the cost of new loans of limited amount and that of high-value transactions has grown; the disparity in borrowing costs between small and large firms has increased. Those now in greatest need of credit suffer from this. Bad debts and loans classified as “substandard”, that is to say in temporary repayment difficulty, are growing rapidly. The lesson of experience is that the recession will continue to affect loan quality even two or three years after the cyclical upturn. In Italy, unlike other large countries, writedowns to loans are immediately tax deductible only up to 0.3 per cent of the amount of total lending; the portion exceeding that amount is deductible over 18 years. The rule becomes especially stringent in this recessionary phase, in which the pressure to curtail lending in order to satisfy capital requirements is mounting. Banks’ capital Despite the decline in profitability, banks have maintained capital above the minimum standards. The average ratio of capital to risk-weighted assets was 10.4 per cent for the largest groups at the end of last year. The higher ratios found abroad often reflect massive injections of public capital. By international standards, leverage, measured by the ratio of total assets to core capital, is lower in Italy. The Bank of Italy assesses capital adequacy with stringent criteria. Instruments of lesser quality make up 13 per cent of the core capital of the five largest Italian banking groups, compared with 22 per cent for the 15 largest euro-area banking groups. Stress tests, which evaluate resilience in the face of markedly unfavourable economic developments, have become a practice in supervisory action since 2005, when the International Monetary Fund conducted its Financial System Stability Assessment for Italy. We have just completed an aggregated exercise to estimate the impact on banks’ balance sheets of a deterioration in the quality of credit exposures to Italian households and firms in the two years 2009-10 under assumptions of more adverse macroeconomic conditions than those foreseen for Italy by the main international organizations. The results of the exercise indicate our banking system’s ability to hold up, even under more adverse scenarios. But I have already let it be known on several occasions that capital strengthening is a priority for the banking system. It is not only a question of increasing the buffers safeguarding stability. Capital strengthening is essential in order to compete with the leading intermediaries; it is also a necessary although not sufficient condition to maintain the flows of credit to the economy. This is why in the present phase it is also necessary to limit the distribution of profits. Many banks have done so. The sacrifice shareholders are being asked to make today is compensated for by the greater solidity of their investment. The markets have reacted positively. Compared with mid-March, the premiums on the credit default swaps of the largest Italian banks have fallen by more than half, a significantly greater decline than the average reduction recorded in Europe. The effort must continue. The public instruments for capital strengthening envisaged by law are now available. The intervention of the state is temporary; the private shareholders will have to replace the public funds as soon as market conditions permit. *** These concluding remarks were written in the throes of a general crisis that has catapulted the world into perhaps its gravest difficulties since the middle of the last century. The wound that has been inflicted upon the public confidence – confidence in the markets and their protagonists, in the future of millions of people, in the social compact that binds us together – has to be healed. Overcoming the crisis means rebuilding that confidence. Not by means of artifices but with the patient, laborious effort to understand what has happened and what future scenarios are possible; and with the consequent action. Much has been done. It is not the work of a day. Much remains to be done: to create jobs again, to restore vitality to firms, to repair the financial markets, to earn the citizens’ trust. The Bank of Italy, both at home and in international fora, is engaged in improving the regulatory framework and detecting the vulnerabilities and risks of banking and financial business. We shall continue to improve supervision. We must progress in our action to safeguard a system that so far – thanks in part to that action – has withstood the crisis better than others. Every country faces the crisis with its own special strengths and its weaknesses, its own history. There is a national aspect to the response: for Italians, the repercussions will be more or less severe depending on our own choices. In the last twenty years our story has been one of stagnant productivity, low investment, low wages, low consumption and high taxes. We must lift our gaze from the present woes to take the longer view. An effective response to today’s emergency is possible only if it is accompanied by the sort of conduct and reforms that can raise our growth above the low path of recent decades. Italian banks’ balance sheets are not weighed down by a legacy of impaired assets. Let them exploit this advantage over their competitors to face a present and a future that will not be easy; show foresight in assessing their customers’ creditworthiness; follow the example of the bankers who financed the reconstruction and the economic boom of the 1950s and 1960s. Let firms strive to continue the rationalization they began just a few years ago; safeguard the accumulated skills of their workers, which will be invaluable again in what we hope is a not too distant future. The completion of the country’s social buffers, the resumption of public investment and the actions to sustain demand and credit that have been outlined today will have the desired effects if they are coupled with structural reforms – not just in order to be able to tell the markets that the deficit is under control, but because these reforms are the foundation for future growth. Confidence cannot be rebuilt with false hopes. But neither can it be restored without hope. Surely we can emerge from this crisis stronger than before. | bank of italy | 2,009 | 6 |
Keynote speech by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at IOSCOs Annual Conference, Tel Aviv, 10 June 2009. | Mario Draghi: Financial stability in the global environment? Learning the lessons from the market crisis Keynote speech by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at IOSCO’s Annual Conference, Tel Aviv, 10 June 2009. * * * I am pleased to be here today to discuss the emerging financial regulatory landscape that we are building in response to the market crisis. The last few months have been very busy ones in the international regulatory policy field. I will speak to the main thrusts of the reform agenda and the work underway and ahead of us to implement its directions. But before I do so I would like to say a few words about changes to the role that the Financial Stability Board (FSB) will play in future. Over the last year, a broad consensus emerged towards placing the Financial Stability Forum (FSF) on stronger institutional ground, with a view to strengthening its effectiveness as a mechanism for national authorities, standard setting bodies and international financial institutions to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability. A stronger institutional setup will make the FSB more effective in shaping the global response to the present crises and to retaining globally integrated financial markets. To mark these changed objectives, the London Summit re-launched the FSF as the FSB, with an expanded membership and a broadened mandate to promote financial stability. The FSB expanded membership now includes, in addition to the FSF members, the rest of the G20, Spain and the European Commission. These changes will enhance our ability to contribute to ongoing efforts to strengthen the international financial system. New members will add broader perspectives to our deliberations, and increase buy-in and implementation of our output. All members commit to pursue the maintenance of financial stability, maintain the openness and transparency of the financial sector, and implement international financial standards. To this end, members commit to undergo periodic peer reviews – based, among other evidence, on the Financial Sector Assessment Program of the IMF and World Bank. In terms of mandate, alongside the FSF old remit – which was to assess vulnerabilities affecting the financial system, identify and oversee action needed to address these vulnerabilities, and promote coordination and information exchange among authorities responsible for financial stability – the FSB will now also: • monitor and advise on market developments and their implications for regulatory policy, and on best practice in meeting regulatory standards; • we will set guidelines for and support the establishment of supervisory colleges and manage contingency planning for cross-border crisis management, particularly with respect to systemically important firms; • the FSB will strengthen its collaboration with the International Monetary Fund (IMF), including by conducting Early Warning Exercises; • and importantly, we will undertake joint strategic reviews of the policy development work of the international standard setting bodies to ensure their work is timely, coordinated, focused on priorities and addressing gaps. Here there is a strong consensus that the independence of standard setting is essential and must be preserved. Indeed, the value of international standard setting is indispensably linked with their independence. At the same, independent standard setting needs to be complemented with processes for coordination, accountability and governance for standard setters, including regular consultations with stakeholders. As we have seen in the FSB in the last 18 months or so, coordination across standard setting bodies has been essential in crafting a coherent response to this crisis and to creating a more resilient financial sector going forward. The work of IOSCO has been and continues to be of great importance in this regard. To support its functions, the FSB will establish an institutional structure commensurate with its expanded tasks. This will comprise a Steering Committee to take forward to the work of the FSB in between plenary meetings, as well as Standing Committees on Vulnerabilities Assessment, Regulatory and Supervisory Cooperation, and on Standards Implementation. And we will greatly expand its secretariat resources. ** ** ** Moving on to the regulatory reform agenda, the main value of the intense recent period of international policy making has been the broad consensus it has established on the agenda of change needed to build a stronger, less crisis-prone financial system for the future. Let me emphasize the importance of this: without this consensus, the integrated system that has been of such benefits to all of us would be at high risk of fracture. We now need consistent implementation going forward to preserve a level playing field across national financial sectors. To summarise very broadly the thrusts of the agenda, let me begin with a key lesson: the need in future to take a system-wide approach to the assessment of financial system and economic conditions, as well to the system’s regulation, rather than focus alone on the health of individual institutions, markets and products. While individual economies and financial institutions appeared sound to market participants and to us as authorities, we failed to recognise the extent to which savings-investment imbalances, the growth of complex securitised credit intermediation, changing patterns of maturity transformation, rising embedded leverage, a burgeoning shadow banking sector, and rapid credit-fuelled growth, had created large systemic vulnerabilities. In the future, we need – at national and global level – to be in a much better position to understand and address trends in credit growth, in system-wide leverage and maturity transformation, and in the inter-linkages within the financial system, to identify and constrain emerging risks. For this we require additional system-wide prudential as well as other tools. Creating the prudential tools, regulatory set-ups and policy tools required to better constrain system-wide risks, including generating the transparency needed for authorities and markets to be better informed about the risks to the system, is the focus of much of the reform agenda. These changes do of course need to be implemented at national levels. But there is work internationally to generate the tools and policies needed, to promote coherence in implementation and to conduct the monitoring that is required. Let me speak to some of these. One central lesson of this crisis is that the system entered it with too little capital, far too small liquidity buffers, and a capital and valuation regime with significant pro-cyclical consequences. Much work is underway on bank capital and liquidity that will address these issues. The Basel Committee proposed last year changes that by end 2010 will expand Basel II risk capture and very significantly increase trading book capital requirements. And the Committee’s much strengthened liquidity guidelines are in the process of being implemented nationally. Further work is underway to strengthen guidance for and monitoring of liquidity management at large cross-border banks. The FSF and its member bodies also produced a set of recommendations to mitigate procyclicality. These call for (i) regulatory capital requirements to increase the quality and level of capital in the financial system during strong economic conditions so that they can be drawn down during periods of economic and financial stress; (ii) a revision of the market risk framework of Basel II to reduce the reliance on cyclical Value-at-Risk based capital estimates; and (iii) to supplement risk-based capital requirements with a leverage ratio to contain the build up of leverage in the banking system. Regarding provisioning, we – and now G20 Leaders – called on the IASB and FASB to reconsider the incurred loss model by analyzing alternative approaches for recognizing and measuring loan losses that incorporate a broader range of available credit information, including by analysing fair value, expected loss and dynamic provisioning approaches. Policy development in these areas is underway by the IASB and FASB, as well as by the Basel Committee and detailed proposals will be set out by year-end. On accounting more generally, the G20 asked the FSB to monitor progress by accounting standards setters in implementing the G20’s accounting-related recommendations, including efforts to enhance convergence, and improve involvement of prudential regulators and other stakeholders in the IASB’s standards setting process. We welcome the efforts by the IASB to accelerate its work schedule to reduce complexity in accounting for financial instruments, and reduce inconsistencies in standards, a goal that is very close to the FSB’s global mission. Some authorities have raised concerns about the IASB and its approach to certain issues. The FSB has a strong interest in seeing the IASB come through this period in a manner that supports its role as a high-quality independent accounting standard setter that considers constructive input from key stakeholders. As you know, the Financial Stability Forum (FSF; now the FSB), of which the IASB, IOSCO and others are key members, has had a proven record of supporting IFRS as one of the 12 key international standards that promote financial stability, and in providing constructive recommendations that enhance transparency and related IASB standards. Good recent examples of this are the FSF's report on Enhancing Market and Institutional Resilience published in April 2008 as requested by the G7 and the FSF’s procyclicality report in April 2009 which included recommendations developed by a working group co-chaired by Kathy Casey. We have had a positive role in supporting high-quality IFRS and the FSB plans to continue to do so. A second important area in implementing a system-wide approach is to ensure that all systemically relevant institutions, markets and activities are subject to appropriate oversight, transparency requirements and, where needed, resolution mechanisms. In practice, this means that the scope of regulation will be broadened, and that prudential tools and standards, as well as the intensity of oversight, will be recalibrated to better reflect the systemic foot-print of institutions and activities. How to deal with too-big-to-fail institutions and related moral hazard concerns will be an important focus ahead. And we need to establish market infrastructure, including adequate resolution frameworks, to address the problems of interconnectedness and opaqueness in the financial system. A lot of work is underway in these areas: • The BIS and the IMF are setting out methodologies for quantifying systemic risk, identifying systemically relevant institutions and activities, and developing system wide tools for monitoring leverage. • And the Joint Forum is advancing a project on gaps in the scope of regulation, and approaches to addressing them. This covers gaps both in the regulated sector (i.e. gaps such AIG’s holding company), and unregulated markets, products, and entities, where IOSCO has recently set out consultative proposals. • In the area of OTC derivatives, work thus far has focused on establishing central counterparty clearing for the CDS market, but central clearing should be extended to standardized OTC derivatives more generally. • On hedge funds, the US, the EU and other relevant jurisdictions are in the process of articulating registration, regulation and oversight arrangements for hedge fund managers. The FSB, relying on IOSCO, have been tasked with fostering coherent approaches in this area. • The FSF also recently published Principles for Cross-border Cooperation on Crisis Management, to strengthen arrangements for dealing with financial stress at crossborder institutions, and better prepare authorities to manage crisis situations. Another group under the Basel Committee is looking into legal differences across countries and how they can hinder orderly resolution of financial firms. I would like to highlight here the very important work of securities market regulators, working through IOSCO, to restore transparency, market quality and integrity in the securitisation process. The checks and balance within the market failed to address significant moral hazard problems within this chain. For securitization to recover and to play a role consistent with financial stability objectives, these problems need to be addressed. There is balance to be drawn here as to how far regulation should go and how far we can trust market discipline to reassert itself. But one issue we must not lose sight of is that much securitisation product, whether complex or not, whether with their knowledge or not, ultimately ends up in retail investor portfolios. IOSCO is formulating recommendations to address these incentives problems, through conduct and disclosure requirements, retention by issuers of economic exposure to transactions, strengthened due diligence requirements on asset managers, strengthened investor suitability requirements, and not least, reduction of conflicts of interest at credit rating agencies. We look forward to receiving your conclusions at our forthcoming FSB meeting. The above complements other important efforts to strengthen risk management practices and governance at banks and other financial institutions. The lessons of failures in these areas have been set out in reports and guidance by the Senior Supervisors Group (SSG), the Basel Committee, by the IIF and the Counterparty Risk Management Policy Group. One area that politicians, the broad public and supervisory authorities will pay significant attention to is changes to compensation practices at financial institutions. The Principles we have developed cover Effective Governance of Compensation Systems, Effective Alignment of Compensation with prudent risk taking, and Effective Supervisory Oversight and disclosure to and engagement by shareholders. They will be reinforced through supervisory examination and intervention at the national level, as well as by disclosure requirements (on which IOSCO is working). We expect national authorities and firms to implement material parts of the Principles by end of 2009. There is a clear need for supervisors, regulators and other authorities to raise their own game, nationally and internationally. At both levels, authorities need to become more responsive to and more nimble and effective in mitigating emerging risks. Information exchange and co-operation across authorities both nationally and internationally needs to improve. Most countries are reviewing their national arrangements for collaboration amongst relevant national authorities. And at the international level, supervisory colleges have now been established for most global banks. The priority ahead is implementation. This is largely in national hands, but we need coherent approaches across countries and regions. Indeed, the G20 leaders have placed a renewed emphasis on this. The FSB, the standard setting bodies and the IMF/WB have been tasked with assessing implementation to serve three complementary aims: first, to foster greater adherence to international standards; second, to help identify jurisdictions that lag behind in terms of their implementation of selected standards; and third, to support peer review processes, such as those FSB members have committed to as an obligation of membership. ** ** ** I’d like to conclude with a number of principles that guide our actions as we pursue our reform agenda: • First, the guiding principles behind our work is to recreate a financial system that operates with less leverage, is more immune to the set of misaligned incentives at the root of this crisis, where transparency allows better identification and management of risks, where prudential and regulatory oversight is strengthened, and the system is able to let mismanaged institutions fail. • Second, clarity. We are committed to establishing clear expectations about what the future regulatory environment will look like. Establishing stable expectations regarding the future regulatory environment will allow market participants to make forward strategic decisions with a greater degree of confidence. • Third, while the direction is clear, changes will in cases be gradual. Some elements of the reformed system (such as higher capital) will need to be phased in as conditions improve. • Fourth, we must preserve the advantages of open and integrated global financial markets. Given global markets and institutions but national regulatory rules and practices, we must strive for international consistency in standards of regulation to support a level playing field across jurisdictions. At the same time, if open global markets are to be preserved, these standards need to be strengthened to give adequate protections to “innocent bystanders” affected by the indiscriminate risk taking and retrenchment we have observed. • Last, as we develop and apply more assertive regulation and supervision to contain excessive leverage and address market failures, we must resist imposing excessive, stifling levels of regulation. Regulation must not prevent innovation, which is necessary if we are to improve product choices for consumers and an expanded access to credit. But we need to ensure that innovation does not compromise other clearly stated goals, including systemic stability and consumer protection. The challenge for regulators and market participants alike is, as always, to strike the right balance. | bank of italy | 2,009 | 6 |
Paper by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the G20 Workshop on the Global Economy - Macroecon. causes of the crisis: key lessons - Session 2: Did the intern. mon. system contribute to the crisis?, Mumbai, 24-26 May 2009. | Ignazio Visco: The global crisis – the role of policies and the international monetary system Paper by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the G20 Workshop on the Global Economy – Macroeconomic causes of the crisis: key lessons – Session 2: Did the international monetary system contribute to the crisis?, Mumbai, 24-26 May 2009. While I retain full responsibility for the theses presented in this paper, it owes much to exchanges and joint work with Pietro Catte, Pietro Cova, Giorgio Gomel and Patrizio Pagano. For a wider and deeper discussion of the topic, see Catte et al. (2009). * 1. * * Introduction: A macro view If the outbreak of the financial crisis surprised many economists, this was in part because most of them saw the risk of a hard landing for the US economy as originating elsewhere, namely in the unsustainable US current account imbalance, which might have eventually been corrected through a disorderly dollar depreciation. As it turned out, another time bomb, located in the financial system and less visible to most observers, exploded first. But does this imply that the fundamental sources of vulnerability for the world economy had been wrongly identified? Was the time bomb that did explode entirely unconnected to the one that did not? Not only, I think, the answer to both questions is in the negative, but it is worth giving proper consideration to the idea that had the forces that led to global imbalances been removed, the financial turmoil would have had lesser global consequences. A proper counterfactual analysis is beyond the objectives of this short paper, but I believe that the evidence presented here clearly supports such proposition. Both the trigger of the global financial turmoil that started in the summer of 2007 and its proximate causes were essentially financial in nature, and originated in a specific segment of US financial markets. However, when we look at how the crisis spread rapidly across markets and then progressively affected the real economy, not just in the industrialised world but globally, it is immediately clear that only a much broader set of interrelated factors – macroeconomic as well as financial – could have generated a crisis of these proportions. In attempting to disentangle these factors, one should avoid the temptation to look for simple reductionist approach, leading to mono-causal explanations. Distorted incentives, inadequate risk management and lax supervision encouraged the financial sector to take increasingly large, poorly understood risk exposures, financed through high leverage and a growing reliance on wholesale short-term funding. However, it is unlikely that all this would have developed to the same extent had the macroeconomic environment not been characterised by low interest rates, rising asset prices and large saving-investment imbalances in the United States and, with opposite sign, in Asia and the oil producing countries. All this was reflected in growing worldwide external imbalances; while the role of other areas of the world economy should not be ignored, their direct contribution to the imbalances is more difficult to assess. These macroeconomic factors created enormous stress for a US and global financial system in which financial innovation and regulatory failures had progressively introduced serious structural flaws. Moreover, the complacency on the part of risk managers and financial supervisors that allowed the resulting vulnerabilities to grow unchecked owed much to the climate of general optimism that those macro conditions supported. Out of this complex interaction, in this paper I will focus primarily on the role of policies and on how they reacted to the various shocks to the global economy over the past 15-20 years: geopolitical shocks such as the end of the Cold War and the emergence of terrorism; technological shocks like the advent of new information and communications technologies; economic shocks such as the integration of China in the world trading system and financial globalisation. Figure 1 United States: household sector net worth and saving rate (in percent of disposable income) -100 -2 -200 -4 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 Financial assets other than equity Equity Real estate assets of households Financial liabilities Saving rate (right axis) Net worth Other nonfinancial assets Source : Federal Reserve (Flow of Funds) and Bureau of Economic Analysis. Note : Other nonfinancial assets include tangible assets owned by non-profit organizations and consumer durables. Macroeconomic policies and regulatory failures combined and reinforced one another. The results were visible in a number of macro phenomena: • The dramatic fall in US households’ saving rate, from around 7 percent in the early 1990s to close to zero in 2005-2007. This decline in the propensity to save closely matches the rise in household sector net worth (Figure 1), pushed up by successive booms in asset prices. In the 1990s, US households “chose” to reap the anticipated and real (“beyond the hype”) – but partly illusory – benefits of the productivity acceleration related to the New Economy, and incorporated in overblown equity values, in advance, in the form of current consumption; after 2000, they did the same with the rise in housing wealth, and financed their demand through a large increase in indebtedness (Figure 2). Figure 2 US household sector: selected balance sheet ratios (percent; quarterly data) Total debt, ratio to disposable income Net housing equity, ratio to disposable income (1) Leverage (3) (right scale) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source : Federal Reserve and Bureau of Economic Analysis. Notes : (1) disposable income is calculated as a 4-month moving average. (2) Net housing equity is calculated as the difference between real estate wealth and home mortgages. (3) Total debt over total assets. Figure 3 Global measures of liquidity (percent; annual data) Ratio of broad money to GDP - left scale Ratio of bank credit to GDP - left scale Real long-term bond yield - right scale 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source : IMF, World Economic Outlook, October 2008. Notes : (1) Aggregated using GDP weights at PPPs. (2) end of period; weighted average of China, Japan, Euro area, UK and USA. (3) end of period; weighted average of Japan, Euro area, UK, USA and, starting in 1999, China. (4) averages; deflated with CPI inflation; weighetd average of Japan, Euro area, UK and USA. • A very large increase in US and global liquidity (Figure 3). This was largely the consequence of US monetary conditions, which were generally accommodating throughout the 1990s – partly in response to actual or feared shocks to the financial sector (the Asian crisis, LTCM, the millennium bug) – and then were eased dramatically and maintained expansionary for an unusually long period of time following the bursting of the dot.com bubble in the first half of the current decade. It is noteworthy that fiscal conditions also became highly expansionary starting in 2001, dramatically reversing the trend of the second half of the 1990s. • The widening of global imbalances, recognised as unsustainable already in the late 1990s. Starting in 1991, and with a sharp acceleration around 1996, the US current account deficit worsened steadily. Initially its main counterpart was surpluses in Europe and Japan, but after 1997 the surpluses expanded mainly in Asia (in China since 2001-02) and in the oil exporting countries (Figure 4). The US international investment position deteriorated by less than the cumulated deficits would imply, thanks to favourable valuation effects (Figure 5). But these temporary effects masked a clearly unsustainable underlying trend. Figure 4 Current account balances (in percent of world GDP) -1 -2 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 United States Euro area China Em. Asia excl. Japan and China Oil exporters Japan Source : World Economic Outlook, April 2009. Figure 5 Cumulated current account balances (in percent of GDP) 60.00 Japan 40.00 China Oil exporters (1), 20.00 Em. Asia exc. China Euro area 0.00 -20.00 United States United States -40.00 -60.00 Sources : IMF, World Economic Outlook, April 2009; Bureau of Economic Analysis. Notes : (1) Calculated as the cumulated current account balances, starting in 1980. (2) Inludes only emerging and developing economies. (3) Actual net foreign asset position (at market values). Figure 6 Total reserves minus gold (USD billions) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Japan Advanced Economies excl. Japan China, P.R.: Mainland Oil exporters Other Emerging & Developing Economies Source : IMF, International Financial Statistics. • An enormous increase in official reserves (Figure 6). Initially driven by a desire to achieve greater resilience against capital outflows in the aftermath of the Asian crisis, after 2002 the reserve accumulation grew far beyond any reasonable reserve needs. It was largely concentrated in emerging Asia and the oil exporting countries, which pegged their currencies to the US dollar or in any case resisted their appreciation. Figure 7 United States: Fed funds target rate and 10-year Treasury bond yields (percent; monthly data) Federal funds target 10-year Government bond yield 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source : Thomson Reuters Datastream. • Very low levels of global long-term interest rates and asset price volatility after 2003. Long-term interest rates, which had fallen sharply after 2000, remained unusually low even after US policy rates started to be gradually raised in mid-2004 (Figure 7). After the US economy came out of the 2001-2002 recession and the effects of a number of other shocks subsided (Enron-like corporate scandals; September 11 and the start of the global war on terror), credit risk spreads and volatility declined to historically low levels in a broad range of markets (Figures 8 and 9). Figure 8 Implied volatility of selected US financial asset prices (percent; monthly data) 1-year interest rates 10-year interest rates equities (VIX) Source : Thomson Reuters Datastream. Notes : (1) Option-implied volatility on 1 year swap rates. (2) Option-implied volatility on 10 year swap rates. (3) CBOE S&P 500 Volatility Index. Figure 9 Spreads on corporate and sovereign bonds (basis points; daily data) 1,800 1,600 EMBI Global US high-yield corporate 1,400 US high-grade corporate 1,200 1,000 Source : Bloomberg. • A sequence of asset price bubbles, in the United States and globally (Figure 10). The dot.com equity bubble of the late 1990s was essentially driven by overoptimistic expectations, but it was also accommodated by monetary policy. Then, after 2000, the combination of low interest rates, abundant liquidity and investors’ search for yield combined to create extremely easy financial conditions, not only in the United States but globally, which supported and financed an unusually synchronised global housing price boom; by 2007, equity markets too were again at or above earlier peak levels. Figure 10 Global asset prices in real terms (indices 1990=100; quarterly data) Equities - left scale Housing - right scale Sources : Datastream, IMF and OECD. Notes : (1) Deflated with G7 CPI index. (2) MSCI index. (3) Total OECD. The combination of these macroeconomic sources of tension interacted with the financial system flaws to build up very significant, although at least partly hidden, financial fragilities, which were then fully revealed by the outbreak of the crisis. A major role was played by shortcomings in the assessment of risk, especially, but not only, on the part of “large and complex financial institutions”; by the difficulty, if not impossibility, of valuing complex new products of structured finance; by the laxity and gaps of financial regulation. The consequences for the financial system and our market economies will certainly be very substantial and long lasting. But the macroeconomic policy framework and the modus operandi of the international monetary system that led to the imbalances not only exacerbated the impact of the financial flaws but in fact transformed the severe financial turmoil into a fully fledged global economic crisis. 2. The role of policies In my view, then, the lack (beyond the declarations and press releases at G7 meetings and the like) of sufficiently decisive policy reactions to the external imbalances that began to expand rapidly from the second half of the 1990s was crucial. Essentially these disequilibria reflected rapid and sustained growth in final demand, especially consumption demand, in the leading economic region of the planet, financed by over-borrowing, primarily from abroad. Growth, in short, has occurred without savings in the United States and with excess savings in other major economies. If the United States has served as a sort of “consumer of last resort,” other large advanced and emerging economies have implicitly or explicitly followed an export-led growth strategy, that is difficult to maintain indefinitely but also difficult to abandon. The discussion that follows deals chiefly with the inability to respond, in what has come to be called the Bretton Woods II system, to the growing external imbalances. While the surplus economies, in emerging Asia and elsewhere, have not been able to raise domestic demand, a more difficult question concerns the response of the European Union, in particular that of the euro area. For the latter, external positions on the whole have been balanced all throughout its existence (since 1999), and monetary stability has been successfully maintained. Economic growth has been relatively modest, however, and catching up to the US in per capita income has basically halted. My interpretation is that domestic demand has lagged behind not much because of excessive saving but because of limited potential output expansion, the result perhaps of slow and timid structural adjustment. Within the area, the largest economy’s exceptional reliance on exports is also a fact. To show that the role of policies has not been negligible, in what follows I argue that (i) monetary policy in the US was overly expansionary for too long, (ii) exchange rates in several emerging market economies have been too rigidly pegged to the US dollar, and (iii) asset price and financial stability have not been considered a responsibility of the central bank or at best have been assigned a secondary role. These are not original observations, as they have been advanced in various occasions since the late 1990s. However, they have not often been considered jointly and have generally played only a limited part in the policy debate. With the benefit of hindsight, I would venture to say that they are now recognized as most relevant factors in the process that has led to the current global crisis (some relevant references are listed at the end of the paper). To emphasize the role of policies in the onset of the global recession, I believe that it is useful to propose a reconstruction of the sequence of events that have marked the last ten to fifteen years, condensed in the following six statements: • Around the mid-1990s, the acceleration of US productivity and the increase in household net worth determined a first upward shift in private sector propensities to invest and to consume. As the 1990s began, the Cold War was ending. For the previous half-century, America had strengthened its defences and built global alliances to contain Soviet communism, an enemy that now suddenly ceased to exist. My conjecture is that the peace dividend made possible the sudden diffusion of a substantial backlog of originally defence-related technological innovations (in materials, technologies, general know-how) to the civilian economy. In any case, the revolution in the new information and communication technologies (ICT) definitely reversed the trend of productivity in the United States, which returned to markedly high rates of growth in the second half of the 1990s. A large fraction of the productivity pick-up in the United States was due to the diffusion of ICT, which drove overall output growth both directly – through the boost to total factor productivity in the ICT-producing industry itself – and indirectly, via capital deepening in ICT equipment by other sectors (Figure 11). Figure 11 United States: TFP growth by sector (percent per year; period averages) 1.4% 1.2% IT-producing sectors IT-using sectors 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% 1973-1995 1995-2000 2000-2006 Source : Oliner, Sichel, and Stiroh (2007). Expectations of high future productivity and income gains were most likely a factor underlying the decline in saving rates, which may be rationalized in terms of efficient consumption smoothing: US households were simply taking advantage of borrowing opportunities, fostered by financial deregulation, to consume part of their anticipated future income and wealth gains immediately. However, private agents probably overestimated the effects of productivity gains on permanent income and profits. The transmission of the shock to consumption and investment occurred to a large extent via the rise in equity prices. Reasoning in terms of a standard solved-out consumption function, the observed decline in the saving rate is consistent with the hypothesis that consumers perceived the increase in wealth as permanent. In fact, a back-of-the-envelope calculation shows that the decline in the household sector saving rate (by about 6 percentage points from the end of 1992 to the third quarter of 1999) only slightly exceeds what we obtain if we apply the standard propensity to consume out of wealth incorporated in most macroeconometric models, including the Fed’s, to the actual change in household net worth, and compare it to a counterfactual where net worth grew only in line with disposable income. • The US monetary policy stance generally accommodated the hype in the “new economy” in the late 1990s; by historical standards it was particularly easy for a prolonged period after the turn of the century. Following the financial crises that hit the economies of South-East Asia and Russia (199798) and the collapse of LTCM (autumn 1998), the Federal Reserve’s policy remained essentially accommodating; ample liquidity was also provided to counter the risks of the socalled millennium bug. While the ex post fitting of a “Taylor rule” (Figure 12) does not highlight monetary conditions much easier than those that would be implied by a policy responding to output and inflation according to historical standards, it is a fact that they were accommodating what many observers considered to be a bubble in equity prices. In the aftermath of the Asian crisis the output gap reversed but monetary conditions still appeared to be appropriate, as a result of inflation and inflation expectations being contained by a number of supply (as well as external) factors and the credibility, at the time, of the monetary policy regime. But there was some debate over whether the Fed should have started raising rates before the early months of 1999. The rationale for monetary policy at the time was provided by Alan Greenspan’s famous statement at the Federal Reserve Bank of Kansas City Symposium in Jackson Hole in August 1999: “… central banks do not respond to gradually declining asset prices. We do not respond to gradually rising asset prices. We do respond to sharply reduced asset prices, which will create a seizing up of liquidity in the system. But you almost never have the type of 180-dgree version of the seizing up on the up side. If, indeed, such an event occurred, I think that we would respond to it. The actuality is that it almost never occurs, so it appears as though we are asymmetric when, indeed, we are not. The markets are asymmetric; we are not”. In the following months stock prices skyrocketed, especially on Nasdaq, the Fed’s policy moved to a tighter stance, and monetary tightening ended up bursting, late, the dot-com bubble in 2000-01. Figure 12 Actual US short-term interest rate and the Taylor rule (percent; quarterly data) US short-term interest rate Taylor rule 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source : OECD, Economic Outlook No 85; Federal Reserve Bank of Philadelphia and Federal Reserve Board. Notes : Taylor rule formula: r* = 2.85 + π + 0.5•(π - 1.9) + 0.5•(GAP). For the output gap the latest (June 2009) OECD estimates are used. For inflation, oneyear ahead expected CPI inflation from Philadelphia Fed's Survey of Professional Forecasters. The short-term rate is the effective Federal funds rate. The recessionary effects of this were compounded by those of the severe shock of the September 11 terrorist attacks. The Federal Reserve’s response was then very rapid and very accommodating. The drastic reduction in interest rates was accompanied by a strongly expansionary budgetary policy, which remained in place also in relation to the military operations in Afghanistan and Iraq. Monetary policy remained expansionary for a protracted period, facilitating a return to sustained growth in household consumption, not countering the trend towards a zero saving rate. It also gave free rein to financial innovation, in conditions of abundant liquidity, especially with the repackaging in 2004-06 of mortgages − in a context of constantly rising house prices − into structured products that opened up new investment possibilities to banks. The gap relative to historical standards, summarized in the Taylor rule, became very wide and durable. A crucial element motivating this policy was the “deflation scare” of 2002-03, when the Fed became highly concerned that monetary policy risked becoming ineffective in a low-inflation environment. With hindsight, it can be argued that in that period, thanks to the credit and housing channel, US monetary policy had become more powerful than before and that, therefore, the federal funds rate was kept too low for too long. This conclusion would apply a fortiori to the extent that policy should have reacted to rising equity and house prices and to the associated risks to financial stability, given that these were not adequately being offset by regulatory policies and macro-prudential supervision. • As the hype in the “new economy” and the expansionary monetary (and fiscal) stance sustained US domestic demand, they contributed to an unsustainable widening of the external imbalance, compensated by an imbalance of opposite sign that progressively grew in the external positions of major emerging economies. The US current account deficit deteriorated from around 2 percent of GDP in mid-1996 − close to its historical average over the previous twenty years − to almost 6 percent in 2006. For a while in the 1990s the expansion of private sector consumption and investment driven by the “new economy” euphoria was partly offset by a tighter budgetary policy, so the effects on domestic balance (overheating) and external balance (current account deficit) were relatively contained (Figure 13). On the other hand, while fiscal policy turned very expansionary after 2000, it largely offset the sharp increase in corporate net saving as the investment boom ended. Households, which had already turned net borrowers in the late 1990s, ran increasingly larger saving deficits as the housing boom got under way. Figure 13 USA: net lending (-) or borrowing (-) by sector (in percent of GDP; quarterly data) -20 -40 Government -60 Corporates Households -80 Total -100 Source : Federal Reserve, Flow of Funds Accounts. The powerful expansion in US final demand and imports supported the increasingly rapid growth of exports and output for the major emerging economies such as China and India, which had previously lagged behind. The growing US current account deficit was accompanied by ever-larger surpluses in emerging economies and in Japan, with a significant build-up of official reserves, in a context of relatively sluggish growth in domestic demand and, in China, saving rates higher even than the exceptional rates of fixed investment (Figure 14). The oil-producing countries also recorded sharply higher trade surpluses, reflecting the rise in oil prices due to the expansion of global demand. Figure 14 National saving and investment of selected countries and country groups (in percent of GDP) National Saving National Saving National Investment Euro area United States National Investment Japan China National Saving National Investment National Saving National Investment Oil exporters Em. Asia exc. China National Investment National Saving National Saving National Investment Source: IMF, World economic outlook, April 2009. The unsustainability of these growing current account imbalances was already an issue in the late 1990s; afterwards, only a succession of positive variations in the value of net external financial assets contained the otherwise explosive deterioration of the US net debtor position. • A number of countries that pegged their currencies to the US dollar accumulated very substantial official reserves. The investment of these in US Treasury paper contributed to lower long-term interest rates. The financing of the growing US current account deficit did not pose particular problems. Up to 2000 private capital flowed to the United States as returns on financial assets were perceived as being higher than in other advanced countries, due also to faster economic growth. As a result, a self-reinforcing effect set in. The capital inflows to the United States boosted asset prices and returns, thus stimulating additional flows of capital. After the bursting of the dot.com bubble, inflows of private capital diminished substantially, but they were replaced by official flows, coming from countries with limited exchange rate flexibility. The less-than-complete substitution led to a depreciation of the US dollar and of the currencies pegged to it. The accumulation of official reserves accelerated as China and other emerging countries kept pegging their exchange rates to the dollar: of the total increase in foreign exchange reserves between 1998 and 2007 almost 70 percent is to be ascribed to emerging Asian and oil/exporting economies. The large volume of investment in US Treasury securities by foreign official investors contributed to drive their yields lower. The consensus view seems to be that the effect of foreign flows was to lower long-term US rates by slightly less than one percentage point. Much of the fall in yields seems to have reflected a narrowing of term spreads: long rates declined significantly more than the expected future profile of short rates (Figure 15). Figure 15 Long- term US Treasury bond yields and expected short-term rates (percent; daily) 10-year constant maturity Treasury bond yield Expected average 3-month T-bill rate over the next 10 years 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources : Federal Reserve; Federal Reserve bank of Philadelphia, Survey of Professional Forecasters. • Low interest rates triggered a search for yield which, by squeezing risk premiums, tended to make financial conditions even more favourable for a broad range of borrowers. Low perceived risk, abundant liquidity and credit expansion, as well as regulatory failures in some markets, helped feed the house price bubble. Ex-ante real interest rates on 10-year US government bonds fell below 2 percent in 2002, and remained there for several years. One of the consequences was an increasing search by investors − including international banks, banks of other countries and financial vehicles they controlled – for investments with higher risk-return profiles. This stimulated the supply of structured financial instruments backed mainly, although not exclusively, by home mortgages granted with loan-to-value ratios even exceeding 100 per cent, based on the false premise that house prices could only increase. In this context, a crucial role was played by financial regulation that was generally lax, and, in some market segments, non-existent. In this environment, housing finance became cheap and attractive, especially variable rate mortgages, and even more so those with teasers. For 30-year fixed-rate conventional mortgages, rates declined to just above 5 percent in June 2003, with almost 3 percent annual inflation. Housing starts jumped by the end of 2003 and the surge in housing demand spurred housing prices. The increased ability of households to borrow against their home equity was crucial in igniting the spiralling of housing demand and prices. The global housing price rise started in the late 1990s and gradually accelerated after 2000, despite the turn in the economic cycle, supported by lower interest rates. Between 1996 and 2007 real house prices in the OECD area approximately doubled. Although the extent of the increase differed considerably across countries, and a few, such as Japan and Germany were left out for particular reasons (respectively, the earlier experience of an extremely severe boom-bust cycle and the consequences of the reunification process), the cycle was remarkably synchronised for an asset market that is inherently local. The last part of the house price upswing coincided with a new run-up in equity prices; in advanced countries overall market indexes reached levels close to the 2000 peaks in real terms, and in emerging economies exceeded them by far. • Eventually, global supply reached bottlenecks in the form of commodity supply constraints, US monetary policy was gradually tightened, and house prices peaked. At that point, the large risk exposures that had accumulated in the financial system suddenly became apparent, precipitating the turmoil. The strong expansion of global demand was accompanied by a rapid increase in the demand for energy and other commodities, particularly in high-growth emerging economies. Over time, this added to inflationary pressures, and monetary policy in the advanced economies was gradually tightened. By late 2006 the rise in US interest rates had induced first a loss of momentum and then a turnaround in house prices. This triggered a domino effect, starting with the structured products based on subprime mortgages. In the summer of 2007 the world economy entered a period of acute financial turmoil, which, despite central banks’ prompt and massive response, gradually turned into a global crisis affecting whole industries and economies. The earlier rise in leverage and the various kinds of pro-cyclicality that characterise the behaviour of financial systems amplified the rush toward de-leveraging and exacerbated the resulting credit crunch. At the root, however, remain the macroeconomic imbalances that the policies conducted by the systemically important countries had allowed to build up unchecked. The importance of those imbalances, which transformed what could probably have been a manageable episode of financial turmoil into a fully-fledged global economic crisis is evident in the short-lived myth of “decoupling” and the subsequent abrupt plunge in world trade in the last quarter of 2008. The consequences of the crash in the US housing and credit markets and the ensuing recession inevitably spilled over to the global economy: now that the United States has stopped being the consumer of last resort the whole world suffers a lack of aggregate demand exactly because of the unbalanced consumption patterns. Emerging economies have experienced both a dramatic decline in demand due to falling world trade and a sudden stop in capital inflows due to heightened risk aversion. In some sense, this constitutes precisely the disorderly adjustment that a number of observers had been fearing since the manifestation of the global imbalances. 3. Interpretations: the “global savings glut”, “Bretton Woods II”, and the “global asset shortage” Several explanations for the widening of current account imbalances have been suggested. The main strands of this broad literature put some of the mechanisms mentioned above at the centre of the analysis. Namely: (a) the emergence of excess saving outside the United States (global savings glut); (b) the pegging of exchange rates to the US dollar, in many cases at undervalued levels (Bretton Woods II); (c) the investment of the accumulated reserves mainly in US Treasury securities (global asset shortage). Overall, these approaches focus only on some aspects of the narrative that I have sketched out. More fundamentally, to my mind, they downplay macroeconomic policies in the core country and their role in the emergence of bubbles in real and financial assets. The first branch of this literature moves from the reaction of emerging Asian countries to the 1997-98 crisis. The sudden stop in capital flows and the sharp recession forced Asian countries hit by the crisis to reduce their external deficits. Moreover, the crisis induced countries to assign a high priority to the accumulation of large official reserves, as a buffer against possible capital outflows. The rapid improvement of their current account positions was also helped by sharp currency depreciations. In several of these countries the counterpart was a sharp drop in investment. In China, however, which had escaped a currency crisis, there was an exceptional increase in saving after 2002. The formation outside the US of what came to be alternatively termed a “saving glut” and an “investment drought” is seen as consistent with the observation that, approximately in the same years, real long term interest rates at the global level declined to historically low levels and current account imbalances widened dramatically. Overall, the “excess saving” approach does not explain why emerging countries would channel their additional savings into building up portfolios biased towards a few assets (mainly US Treasury paper). This is made explicit in the “Bretton Woods II” analysis, which emphasises the deliberate maintenance of undervalued exchange rates pegged to the US dollar as part of an export-led growth strategy. This second strand of literature too moves from the behaviour of a number of emerging countries (not only in Asia) in the aftermath of the Asian crisis, but focuses primarily on the excessive build-up of foreign exchange reserves. In addition to the emerging economies’ needs to insure against the risk of capital account crises, some other possible explanations of the rapid reserve accumulation have also been mentioned, such as the need to provide investors from advanced economies with some kind of “collateral” against large foreign direct investment or, alternatively, deliberate “mercantilistic” policy strategies aimed at promoting an export-led development model hinging on price competitiveness. An alternative interpretation of the accumulation of reserve assets by emerging economies is provided by a more recent strand of the literature, which focuses on financial globalization, viewed as an ongoing endogenous process of integration between countries at different stages of financial development. According to this view, the United States commands an unrivalled comparative advantage on a global scale in terms of financial market deepness, liquidity and legal infrastructure, and is positioned at the financial core of a rapidly integrating world, while high-growth industrialising economies lack the capability to produce the financial assets necessary to safely store wealth and fully reap their growth dividends. Excess demand for high-quality assets in the periphery translates into a global shortage of assets that pushes the core country, the United States, into a structural equilibrium characterised by persistent current account deficits and low long-term real interest rates. In this story it is not clear, however, what the role of institutional relative to private demand for assets is. Financial repression could explain a demand for investment abroad on the part of private agents, but in practice the role of private capital flows towards the United States diminished sharply after the bursting of the dot.com bubble, and was replaced by official flows. To reconcile the theory with this fact one would have to interpret the official reserve build-up by China and others as being conducted on behalf of private agents. In all these approaches the roots of the current account imbalances lie outside the United States. The focus is on an increasing role of developing countries in providing financing to the United States, although these analyses differ with respect to the issue of the sustainability of current account imbalances. In the global saving glut story the root lies in specific structural distortions in emerging countries that lead them to “save too much” or to “invest too little”. The adjustment of the imbalances thus crucially depends on the correction of such distortions, presumably also via greater exchange rate flexibility in emerging economies. The Bretton Woods II story, on the other hand, focuses more on deliberate policy choices in these countries. Implicitly, it is assumed that those policy choices will be corrected, smoothly, in due time. In the meantime, the US net foreign position would continue to deteriorate, but this is seen as sustainable. Therefore, in both cases, no specific action to correct the imbalances is necessary on the part of advanced countries. Finally, a stark corollary of the global assets shortage story is that, as long as the forces underlying excess saving in the periphery persist and the United States retains its undisputed global financial leadership, (welfare-enhancing) global imbalances should be the norm. None of these stories, by itself, can account for the build-up of financial fragilities, which were then fully revealed by the outbreak of the crisis. To this end, as I noted earlier, the role of macroeconomic policies appears essential. 4. Policy frameworks Two central elements of the story I have sketched out are: (a) an overly expansionary US monetary policy, which permitted a long expansion of consumer spending financed by growing indebtedness; (b) the choice by China and other emerging countries to follow an export-led growth strategy supported by pegging currency to the US dollar, resulting in the accumulation of large official reserves. Both policies were attractive in the short run, but ultimately unsustainable in the long run. This is now clear in retrospect, but even without the benefit of hindsight several signals – the sharp decline in the US household saving rate; the widening global imbalances and the accumulation of huge official reserves; the enduringly low levels of long-term interest rates and risk premiums and implied volatility; the continuous expansion in global credit; the succession of booms in financial and real asset prices – should have alerted policymakers that those policies were feeding a set of disequilibria that could not be sustained indefinitely, but whose correction was nowhere in sight. The question that should be addressed is not so much why those unsustainable policies were undertaken in the first place – in a world of imperfect knowledge, private agents and policymakers make mistakes all the time – but what allowed them to be maintained for such a long time. To address this question, we need to reconsider the conceptual setups that were used to frame and to assess the results of those two policy choices. In addition, we must look to the international monetary system as a whole, and ask why the incentives incorporated in it did not effectively induce the correction of the imbalances and promote policies conducive to the orderly functioning of the world economy. 4.1 Monetary policy It has been argued – in my view, convincingly – that as a result of the success achieved by macro-stabilisation policies and of structural changes in the responsiveness of aggregate supply (also as a result of globalisation), inflation expectations are now much better anchored, and episodes of excess creation of liquidity and credit tend to be reflected primarily in asset price bubbles, rather than in increased consumer price inflation. The task of monetary policy in this context is not necessarily easier. Because asset price cycles tend to be associated with large changes in indebtedness and add to financial vulnerabilities, they can pose significant risks to financial stability. This brings us to the timehonoured question of whether and how monetary policy should react to asset price misalignments and financial imbalances, or more generally whether central banks must (flexibly) target, with just a single policy instrument, more than just consumer price inflation. It has been suggested that to take into account the effects of asset price movements in the context of a flexible inflation-targeting framework central banks may need to look further into the future than is usual. This might work in “normal” times. However, since the precision of forecasts can only decline as we move to more distant time horizons, it is debatable whether trade-offs that depend on forecasts of the distant future and are by their very nature rather uncertain can be stable enough to provide reliable guidance for current policy decisions. Furthermore, one may ask whether this may be too general a framework to provide actual guidance to monetary policy. If allowed to develop, asset price bubbles and the financial instability that usually accompanies them can eventually destabilise expectations about future monetary policy and inflation, especially if authorities follow a practice of always intervening to “clean up” after the bubble has burst, easing policy by as much as is required to offset the effects on the economy. Here the crucial point is that the models we use to interpret economic data and to set policy are particularly lacking in the treatment of asset prices. In this respect: • We probably do not know enough about the effects of asset price misalignments and related imbalances in equity, real estate and currency markets, as well as in bank credit and government debt. These effects are normally found to be relatively small, and asset price movements to play a relatively limited role in the transmission of monetary policy. Even if “extreme events” materialised in powerful fashion, in econometric estimates they are likely to be dominated over the sample by “normal time” observations and frequently end up being “dummied out”. • Many of the effects associated with asset price imbalances are, anyway, likely to be highly non-linear and complex. The implicit monetary policy reaction function would also then be non-linear and complex, and incorporate the effects of asset prices and financial imbalances. But for the reasons previously advanced, the models we use tend to be essentially linear and we often lack the skills, and the memory, to supplement them with well reasoned analysis and robust evidence. Summing up, the difficult question of how much restriction would be needed in the face of rising asset prices calls for more study and experimentation. But, as it has been aptly suggested, it hardly calls for “benign neglect”. 4.2 The international monetary system A key element that allowed the US monetary expansion and China’s exchange rate pegging to be maintained for so long was the fact that they were mutually reinforcing. In a nutshell, demand from US consumers helped sustain China’s (and others countries’) export growth. At the same time, an elastic supply of cheap imports from Asia helped keep inflation low in the United States (and also, by the way, in the other advanced countries), encouraging the Fed to maintain an easy monetary stance. And the investment of emerging economies’ official reserves in US Treasuries contributed to compress long-term yields both in the United States and globally. All this fed global liquidity and rising asset prices. The countries that pegged their currencies to the dollar effectively imported US monetary policy regardless of whether it was appropriate for domestic conditions. This fuelled liquidity and credit expansion, also because of difficulties in sterilizing the effects of the accumulation of official reserves, and tended to feed booms in domestic asset prices and investment. But the high growth experienced by these countries effectively rested on the ultimate support coming from US consumers. This became evident most recently: when it was clear that the financial crisis might involve a massive credit crunch and would require a protracted rebalancing on the part of US households, the fall in demand and world trade was highly synchronised in all advanced and emerging economies. Other surplus countries also had a responsibility in allowing the imbalances to grow. In Japan, long delays in facing up to the structural problems of the financial sector caused a prolonged stagnation of demand. Germany, and other European countries, introduced some structural reforms to the labour market in recent years, but these, in the absence of equally forceful reforms in product markets, have largely translated into stagnating wages and weak domestic demand. The fact that imbalances that were not sustainable persisted for so long shows that no mechanism – market-based or activated by multilateral surveillance – operated effectively to induce a correction. Two closely connected features of the international monetary system seem to have effectively switched off market-based alarm bells: • First, by pegging their currencies to the US dollar, surplus countries managed to avoid pressure to adjust. • Second, the role of the US dollar as the international reserve currency implied that the United States could finance persistent current account deficits without coming under market pressure, as long as the surplus countries were willing to accumulate dollar assets. For the United States, an added benefit of financing deficits in its own currency was that dollar depreciations generated favourable valuation gains on its international investment position. Although it is clear that the international monetary system has not been performing some of its essential functions, it is by no means clear what could replace it. If the key source of its shortcomings is the dollar standard, it is difficult at this stage to identify a realistic alternative. All those that have been mentioned – a supranational currency like the SDR; a tripolar system based on the dollar, the euro and an Asian currency – face very substantial difficulties. Whatever the final goal, the establishment of an SDR-denominated substitution account for existing stocks of official reserves, as recently suggested, may be worth of further consideration as a means to smooth the transition. In this context it may be instructive to recall how we got here. The original Bretton Woods system, as designed by its founders, rested on tight capital account controls. The gradual liberalisation of capital movements helped to exacerbate the tensions within the system, but their roots were deeper. While the system had been designed as a regime of “fixed but adjustable” parities, in actual practice the peripheral countries – both those in deficit and those in surplus – resisted parity realignments, making the system much more rigid. Surplus countries (Germany and Japan) wanted to support export-led growth, while the United Kingdom and France were motivated by a desire to shore up the reputation of their currencies to preserve what was left of their international role. All this could be sustained as long as the pivot country, the United States, was willing to play the n-th country – that is, to accommodate the sum of ex-ante external surpluses and deficits desired by the other n-1 countries – and followed monetary and fiscal policies that were broadly in line with global price stability. This unstable equilibrium became increasingly untenable in the late 1960s and early 1970s, when the United States – then in the midst of the Vietnam war – chose to pursue expansionary policies disregarding their potential inflationary consequences on the global economy. There are some evident parallels between this story and the weaknesses of the current functioning of the international monetary system. Again today, the ultimate source of weakness may be seen as a combination of (a) overly expansionary policies in the centre country that contributed to a massive widening of its external imbalance, and (b) the refusal of peripheral countries to allow exchange rates to move enough to correct their surplus positions. Another interesting parallel between the two periods is the fact that both the early 1970s and the last few years were characterised by a very pronounced and synchronised commodity price cycle, a clear symptom of global inflationary pressures. Underlying all this is the fact that the international monetary system that emerged after the demise of Bretton Woods is a non-system, driven by the revealed exchange rate preferences of the individual countries, with a very weak multilateral surveillance, despite recent attempts to strengthen it. This non-system has never satisfactorily addressed the difficulties connected to the “inconsistent triad” of full capital mobility, fixed exchange rates and the autonomy of national monetary policies. The regime of fixed exchange rate pegs was never replaced by one of generalised free floating, even though the degree of capital mobility continued to increase, but instead gave way to a hybrid system, comprising a great variety of exchange rate arrangements. In practice, throughout the last 35 years, the exchange rate policies of a majority of countries have been marked by widespread “fear of floating”, leading to large foreign exchange intervention. This fear is not at all surprising: in a world that is increasingly integrated economically and financially, large exchange rate fluctuations driven by capital flows can be highly disruptive both to foreign trade and to domestic macroeconomic stability; this, after all, is part of the reason behind Europe’s move to monetary union. 5. Open questions Whatever the shape of the future system, an urgent task – one to address as soon as the economic situation improves – is correcting existing imbalances. The fundamental macroeconomic imbalances that lay at the root of the financial crisis are not being righted by the consequent global recession. At present, the rise in US private sector saving and the sharp fall in investment, partly offset by a larger public sector deficit, appear to have narrowed the US current account deficit from 5.3% of GDP in 2007 to 2.8% in 20092010, as projected by the IMF. However, most of the reduction is due to cyclical, not structural, factors; and the effect of lower oil prices should itself be seen as essentially cyclical. What happens as the world economy comes out of the recession depends largely on what drives the recovery: if it is an expansion of demand in the surplus countries – including not only emerging Asia, but also Japan and some European countries – some real correction of imbalances is possible; but if the world again relies on US consumers as the primary source of demand growth, then imbalances will widen once more. But this calls for potential output in those countries to grow enough to allow for such higher growth in domestic demand, in order not to jeopardize price stability. And this will clearly be a substantial challenge. In any case, if we are to achieve a major rebalancing of world demand, exchange rates will probably have to move as well. But do we have, at present, an effective mechanism to engineer an orderly depreciation of the US dollar against the currencies of surplus countries? So far, since the beginning of the financial turmoil exchange rates have not generally been moving in a direction that favours the correction of imbalances. The dollar has appreciated by 13 percent in effective terms since July 2008 (Figure 16), as the turmoil engendered demand for dollar liquidity and large capital flows out of emerging markets have been seeking a safe haven in US Treasury securities. Those flows may well be reversed as investors’ flight to safety abates and the financial situation normalises. This could trigger disorderly exchange rate movements. Figure 16 Real Effective Exchange Rates (2005 = 100; monthly data) United States Euro area Japan China Source : Bank for International Settlements. Note : increases signal appreciation. This scenario poses a very difficult challenge to the countries that have accumulated large quantities of official reserves, predominantly in US dollars. However, continuing to peg their currencies will only postpone the day of reckoning, while increasing the potential capital losses. This dilemma is exacerbated by the fact that no country can act in isolation, as the present and potential effects on trade flows obviously need to be taken into consideration. Indeed, this is a classic case in which collective action, if feasible, would be welfareimproving. It might take the form of a cooperative agreement among surplus countries for some kind of joint “managed currency appreciation” vis-à-vis the dollar. The appreciation and the boost to domestic demand would have to be large enough to ensure a significant correction of imbalances. But is such collective action feasible? Several practical problems would need to be overcome. Even confining the discussion to Asia, the countries that would have to take part in it differ in many ways: current exchange rate regimes (hard peg, crawling peg, managed floating); degree of capital account liberalisation; stage of financial development; trade specialisation and position in the vertically integrated Asian manufacturing industry. These differences make the determination of how best to achieve the desired result extremely tricky: How large should the appreciation be, and should it be uniform across surplus countries? Is it better to implement it gradually or through one large initial exchange rate realignment? And after that, should exchange rates be managed or allowed to float, to let the market determine the final size of the adjustment? These are difficult questions, to which I do not have an answer. Based on Europe’s long experience of monetary cooperation – which started in the 1970s precisely in order to address the challenges of global currency instability for a group of closely integrated countries – it is worth recalling that progress in such matters often stems from a fruitful tension between a leadership role taken by one or two countries and an unremitting effort to design arrangements and institutions that are balanced (if not always symmetric) and flexible enough to accommodate the needs of all participants. I don’t want to carry the parallel too far, as I am aware of the important differences between Europe and Asia, but I think that large and systemically important countries like China and Japan have a responsibility to exert leadership. At the same time, as the world we live in is truly global, the passage from the current Bretton Woods II non-system to a new international monetary system – more stable, better defined and regulated – must see all the countries affected, especially those of the G-20, as full active participants in its design and ownership. Some references Bean, C. 2003, “Asset prices, financial imbalances and monetary policy: are inflation targets enough?”, BIS Working Papers, 140, September (with “Discussions” by I. Visco and S. Whadwani, available at http://www.bis.org/publ/work140.pdf?noframes=1. Bernanke, B. 2005, “The global saving glut and the U.S. current account deficit”, BIS Review, 16, available at http://www.bis.org/review/r050318d.pdf. Bordo, M. & Jeanne, O. (2002), “Monetary policy and asset prices: does “benign neglect” make sense?”, International Finance, 5, 2. Borio, C. & Lowe, P. 2002, Asset prices, financial and monetary stability: exploring the nexus, BIS Working Papers No. 114, July, available at http://www.bis.org/publ/work114.pdf?noframes=1. Caballero, R., Farhi E., & Gourinchas, P. 2008, “An equilibrium model of “global imbalances” and low interest rates”, American Economic Review, 98, 1. Catte, P., Cova, P., Pagano, P. & Visco, I. 2009, “The role of macroeconomic policies in the global crisis”, mimeo (forthcoming). Craine, R. & Martin, V. 2009, “Interest rate conundrum”, The B.E. Journal of Macroeconomics, 9, (contributions), art. 8, available at http://www.bepress.com/bejm/vol9/iss1/art8. Dooley, M., Folkerts-Landau, D. & Garber, P. 2003, “An essay on the revived Bretton Woods system”, National Bureau of Economic Research Working Paper 9971. Dorrucci, E. 2009, “The macroeconomic dimension of international monetary and financial architecture: analysis and proposals”, ECB, mimeo. Ferguson, R. W., Hartman, P., Portes, R., & Panetta, F. 2007. International financial stability, Geneva Reports on the World Economy, 9, ICMB and CEPR, Geneva. Genberg, H., McCauley, R., Park, Y. C., & Persaud, A. 2005. Official reserves and currency management: myth, reality and the future, Geneva Reports on the World Economy, 7, ICMB and CEPR, Geneva. IMF 2009, “Lessons of the global crisis for macroeconomic policy”, Research Departemnt paper, in consultation with the Fiscal Affairs and the Monetary and Capital Markets Departments, Washington, DC, February 19. Mendoza, E., Rios-Rull, J. & Quadrini, V. 2007. Financial Integration, Financial Deepness and Global Imbalances. National Bureau of Economic Research Working Paper 12909. Obstfeld, M. & Rogoff, K. 2000, “Perspectives on OECD economic integration: implications for U.S. current account adjustment” (and “Commentary” by I. Visco), in Global economic integration: opportunities and challenges, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August, available at http://www.kc.frb.org/publicat/sympos/2000/sym00prg.htm. Obstfeld, M. & Rogoff, K. 2005, “Global current account imbalances and exchange rate adjustments”, Brookings Papers on Economic Activity, 1. OECD, 2001, The New Economy: beyond the hype, Paris. Oliner, S., Sichel, D. & Stiroh K., 2007, “Explaining a Productive Decade”, Brookings Papers on Economic Activity, 1. Padoa Schioppa, T. 2008, “The crisis in perspective: the cost to be quiet”, International Finance, 11, 3. Portes, R. 2009, “Global imbalances”, in M. Dewatripont, X. Freixas & R. Portes, Macroeconomic stability and financial regulation: key issues for the G20, Vox ebook, available at http://www.voxeu.org/G20_ebook.pdf. Rajan, R.G. 2006, “Is there a global shortage of fixed assets?”, remarks at the G-30 meetings in New York, December 1. Saccomanni, F. 2008, Managing international financial instability: national tamers versus global tigers, Edward Elgar, Cheltenham, UK. Taylor, J. 2007, “Housing and Monetary Policy”, in Housing Finance and Monetary Policy, Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August, available at http://www.kansascityfed.org/publicat/sympos/2007/pdf/Taylor_0415.pdf. Visco, I. 2003, “Comments on recent experiences with asset price bubbles”, in W.C. Hunter, G:G: Kaufman & M. Pomerleano, Asset price bubbles, MIT Press, Cambridge, Mass. Visco, I. 2009, “The financial crisis and economists’ forecasts”, BIS Review, 49, available at http://www.bis.org/review/r090423f.pdf. Warnock, F. and Warnock, V. 2006, “International capital flows and US interest rates”, NBER Working Paper No 12560. White, W.R. 2008, “Should monetary policy lean against credit bubbles or clean up afterwards?”, remarks at the Monetary Policy Round table, Bank of England, September 30. Zhou, X. 2009, “Reform of the international monetary system”, People’s Bank of China, speech, March 23, available at http://www.pbc.gov.cn/english//detail.asp?col=6500&ID=178. | bank of italy | 2,009 | 7 |
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Italian Banking Association Annual Meeting, Rome, 8 July 2009. | Mario Draghi: An overview of banking in Italy Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Italian Banking Association Annual Meeting, Rome, 8 July 2009. * * * Credit and the banks Lending to the private sector has slowed further. In April the change over three months turned negative: in May it was equal to an annualized contraction of 0.9 per cent. In the last decade, the average annual rate of growth of lending to the private sector was 9.6 per cent. The contraction involves credit to firms, while that to households continues to expand, although at a significantly slower pace than in recent years. The slowdown in lending by the leading banking groups has been particularly marked. The Governing Council of the ECB has increased its support of banks’ liquidity in exceptional measure. It has also launched a plan to purchase covered bonds issued by intermediaries in the euro area for a total of €60 billion, with the main objective of easing the financing conditions for credit institutions and firms and of encouraging the banks to maintain and increase lending to their customers. The Bank of Italy is participating in these purchases in proportion to its share of the ECB’s capital. Following the reduction in the Eurosystem’s official rates, the interest rates on bank loans to Italian households and firms have fallen to the average level for the area, except for consumer credit rates, which remain higher. The increase in credit risk has translated into a widening of the gap in the cost of credit between small and large firms, with an adverse impact on those that currently have the greatest need for bank financing. The recession is also affecting credit quality. In the first quarter of this year, the ratio of new bad debts to total bank loans outstanding reached 1.6 per cent, the highest level this decade; it had risen to more than 3 per cent following the recession of the early 1990s. The increase in non-performing loans and overdue instalments prefigures a further deterioration. In the South of Italy, borrower risk is on average greater than in the Centre and North, but in March the rate of growth of bank loans in the South exceeded that in the other parts of the country, even though the cost of a loan was 1.7 percentage points higher on average. The deterioration in loan quality is increasingly affecting bank profits. In the first quarter of this year, the loan loss provisions of the main banking groups more than doubled, absorbing half their operating profits. Profits fell overall by 40 per cent; the ROE on ordinary operations halved to 4.5 per cent. The factors that are constraining bank profitability today will become more intense, responding to the recession with the usual lags. The commitment to curbing costs must be intensified and the economies foreseen in business plans must be achieved more quickly. The banks will be decisive in determining whether the crisis we are facing is more or less long-lasting, more or less deep. It is necessary to reconcile prudent management and capital soundness with the need not to deny financial support to firms with good potential for growth and a real ability to weather the crisis. It would be dereliction of duty if the banks and the Bank of Italy were to stray from the path of rigorous evaluation of creditworthiness. A healthy banking system is essential to growth; it safeguards the savings entrusted to banks. However, it is equally important that in deciding on loans banks use all the information available, that they supplement statistical scoring methods which lose some of their predictive power at times of crisis with direct knowledge of customers and their real potential for growth and profitability in the long term. A banking system with local roots is of great value; it needs to be exploited and where it has been lost it must be rebuilt. Banks must take advantage of their grass-roots knowledge of customers and avoid over-reliance on automatic processes. There is ample scope for improvement. Some banks, some of them large ones, are beginning to move in this direction, reviewing their organizational models and their decision-making procedures. What prudential supervision requires of banks Capital Italian banks’ own funds are well above the regulatory minima and have remained so even through the worst of the financial crisis. The capital ratios of the leading banking groups increased in the first three months of this year. I have said, and I say again, that a strengthening is nonetheless necessary. It is not just a question of maintaining strong safeguards for stability; we must compete on an equal footing with the foreign banks which have had to resort to massive injections of public money in recent months; we must be prepared, as of now, to operate with a capital endowment that future regulations will require to be larger than at present. Above all, capital strengthening is indispensable in order to face the deterioration in the macroeconomic situation without neglecting to give firms, households and the economy the support they need. During this phase the Bank of Italy does not allow banks to make early redemptions of capital instruments without a plan for their replacement with resources of equivalent quality and quantity. The quality of the Italian banks’ capital is high by international standards. We are also aware that the rigour with which we evaluate the inclusion of financial instruments in regulatory capital has appeared, in the past, to put Italian banks at a disadvantage with respect to the situation in other countries. We deliberately maintained this policy, even when the market seemed to tolerate particularly high levels of risk. These practices, these evaluation criteria, which have been put to the test in the last two years, have so far brought benefits to banks, the economy, and the public finances. Liquidity The system’s liquidity is still guaranteed by the massive injections of funds from the central banks. The oversight policy we introduced in 2007 has helped Italy’s banking system to weather the severe strains of the last part of 2008 without major shocks. We continue to ask the banks to ensure that foreseeable outflows are covered over a broad range of maturities. The tools of analysis and intervention are being continually improved. The ten leading Italian banking groups were asked to conduct a liquidity stress test, the results of which have shown that the largest groups have a high resistance to stress. In international cooperation fora, work is under way to draw up common safeguards against liquidity risks. The Bank of Italy favours a system based on two instruments: on the one side, the requirement permanently to keep sufficient liquid reserves to ensure that, even in the presence of stress, outflows are covered for an adequate period of time; on the other side, the maintenance of a minimum structural equilibrium between the duration of liabilities and that of assets. Opinion is broadly converging on these positions. The one-year financing operation recently conducted by the Eurosystem has achieved records both in the number of counterparties (1,121) and in the amount allotted (more than €442 billion). The participation of Italian banks amounted to less than 3 per cent of the total. Stress testing bank assets For the quality of loans, and more generally of bank assets, thorough stress testing, performed in a coordinated manner under the guidance of the supervisory authorities, is likewise essential in order to verify the soundness of the single banks and of the system as a whole, to improve the transparency of their balance sheets, and to restore the credit circuit to normal operation. In the United States, in the weeks immediately following the publication of the stress test results the 19 banks concerned were able, in part by selling non-strategic assets, to raise almost $65 billion of new equity capital and issue over $20 billion of bonds without government guarantee. The effect spread to all the US banking sector, which jointly placed almost $90 billion of new shares in the quarter just ended. Ahead of a similar coordinated exercise planned at the European level, in recent weeks we completed a stress test of the Italian banking system by estimating the loan losses that would occur in the period 2009-10 in even more unfavourable macroeconomic conditions than the present ones: the portion of losses not covered by operating profit would equal about one fifth of the system’s end-2008 excess capital; overall, the outcome confirmed banks’ capital adequacy. For the time being, the diversity of intermediaries, methodologies that are still too varied, and difficulties in comparing results make it impracticable to publish the individual results of the stress tests under way at European level. I believe, however, that this objective cannot be deferred for long without delaying the necessary return of banks to the private capital market. Good rules, the right incentives Banks’ governance Rigorous risk management, the safeguarding of banks’ reputations, the verification of correct conduct and compliance with the rules require reliable and effective systems of corporate governance and internal controls: these, even before the Bank of Italy’s supervision, are the first line of defence for the stability of banks and the system as a whole. Last year we issued rules with which banks had to comply by 30 June, where appropriate by amending their bylaws. Bylaws require our approval; the interaction with banks has been intense. While respecting every bank’s autonomy in choosing its own model of governance, we stressed the need for consistent and uniform approaches, clear rules, and a proper balance of power. We called on banks to simplify their governance structures by limiting the number of directors, avoiding overlapping tasks and administrative bodies. We asked that the Chairman act as coordinator and guarantor in a dialectical relationship with top management and laid down the conditions for his correct activity within the executive committee, whenever this was established. For the first time, we requested the inclusion of independent members on the boards of directors of unlisted banks. Owing to the distinctive traits of the shareholder base and governance structures of cooperative banks, we paid special attention to the mechanisms for appointing their governing boards, aiming to maintain their strengths (social responsibility, close ties with households and the productive fabric) and curb the risk of management being excessively self-referential. In keeping with the spirit of mutualism and the egalitarian principle underlying these banks’ structures, we promoted voting mechanisms capable of giving voice to significant minorities among shareholders; favoured an enlargement of proxy voting; and suggested other instruments to enable more effective participation by shareholders. Significant, if uneven, progress has been made; but more remains to be done. Remuneration and incentives One of the lessons to emerge from the crisis is that bad systems for compensating management and those responsible for key functions in banks can favour the excessive accumulation of risks. People paid on the basis of short-term results pursue immediate gain without taking account of the associated risks. The result is a false accounting of profit that generates a deadly risk spiral. Starting last year the Bank of Italy, first among the authorities of the leading countries, introduced specific rules on compensation schemes as part of the rules for banks’ governance. In April this year the Financial Stability Board issued the principles underlying sound compensation practices. First and foremost, provision must be made for an adequate balance between the fixed and variable components of compensation; moreover, pay should be related to actual profits over the longer term, taking the related risks into proper account. Special precautions must be taken to protect the integrity and status of banks’ control function; the governing bodies, and shareholders especially, must be involved in setting compensation policies and in verifying their implementation. The Bank of Italy has formed a task force to assess current compensation schemes and call for correctives when required. The supervisory area is attentive to any international practices that might emerge in applying the principles and recommendations recently issued. The prevention of money laundering Last year the Bank of Italy took over direct responsibility for the anti-money-laundering controls that had previously been carried out by the Ufficio Italiano dei Cambi. Cooperation with the magistracy and the Finance Police is essential to the success of the Financial Intelligence Unit (FIU), to which the Bank of Italy allocates adequate resources for its increasingly demanding tasks. Anti-money-laundering controls have become a regular part of the Bank of Italy’s onsite inspections of financial institutions. In 2008 the Supervision Area and the FIU carried out 191 inspections at banks, investment firms, asset management companies and other intermediaries. A number of recurrent failures to comply fully with the rules were found: insufficient checking of customers, incomplete record-keeping, inadequate assessment of anomalous transactions, poor staff training, and methods of control lacking in incisiveness. Sanctions, reprimands and numerous reports to the law enforcement authorities show that the banks underestimate the need for full compliance with the rules, for strict performance of their obligations. A change of attitude is necessary. Corporate bodies and officers must take responsibility for the proper functioning of the anti-money-laundering systems. The control bodies have specific duties for which they can be called to account, including in the course of inspections. This anti-money-laundering strategy is beginning to produce effects. The number of reports of suspicious transactions that intermediaries transmitted to the FIU increased by 16 per cent to around 14,600 in 2008, and in the first four months of 2009 there was a further sharp rise of about 50 per cent compared with the same period of the previous year. Customer protection The crisis has accentuated the need for continuing action to raise the standards of correctness and transparency in relations with the public, to resolve disputes between banks and customers quickly and to promote the informed use of financial instruments by savers and investors. The stability of the financial system hinges on customer confidence. The Bank of Italy’s new rules on the transparency of banking and financial services represent a thorough overhaul with respect to the past. Customers must be provided with information that is easy to understand and effectively useful for determining whether the transactions proposed are in their interest and for assessing the correctness of the person making the proposal. The rules require intermediaries to institute internal procedures that guarantee correct conduct. The comments received in the course of the public consultation that was completed in May confirmed the validity of the reform, which will be issued this month. As a complement to the civil justice system, a Banking and Financial Arbitrator has been created to give customers an economical and rapid means of obtaining impartial rulings in disputes over banking and financial services. Three boards will be instituted, one for the North of Italy, one for the Centre and one for the South. Bank customers will also be able to appeal to the boards through the branches of the Bank of Italy, which will provide the facilities and technical support for the Arbitrator. I raised the question of the fee charged on a customer’s maximum overdraft at the beginning of 2007, calling on the banks to abandon a practice that is almost indefensible in terms of transparency and efficiency. The law gave the Bank of Italy only the power to make sure that these clauses were applied transparently – not the power to replace them with different contractual provisions. Repeated acts of moral suasion were only effective with the major banking groups. Legislative intervention was necessary, although the reordering of the various provisions governing relations between banks and customers remains desirable and is provided for in the Community law recently passed by Parliament. The banks must now solve the problem at the root. Let them, of their own accord and once and for all, supplant these complex, opaque fees with reasonable commitment fees based on the amount of funds made available. For the rest, everything must be brought back to the transparent application of interest rates. From the beginning of 2010 the threshold rates for anti-usury purposes will include all accessory charges: the maximum overdraft fee, if it is still being charged, commitment fees, mediation fees, and any other costs in connection with the loan. Non-bank intermediation Among more than 1,000 non-bank financial intermediaries registered under Article 106 of the Consolidated Law on Banking and 160,000 financial agents and loan brokers, more than a few are marginal, fragile, of doubtful professionalism and sometimes dubious legality. In the public interest and in the interest of the more responsible, qualified operators, it is urgent to set the situation to rights. We have begun a rigorous selection, intensifying the checks at the time of entry in the registers and those on continuing satisfaction of the minimum standards set by law and compliance with the rules. The Report that we recently submitted to Parliament and the Government gives an account of this. We have struck more than 11,000 financial agents from the register. In cooperation with the Finance Police, we have begun extensive checks in the sectors at greatest risk. Acting on our proposal, the Ministry for the Economy and Finance has deregistered more than 30 financial companies for which significant anomalies were found; many of them had been engaged in providing guarantees and sureties. Controls are being carried out on the intermediaries specialized in granting loans secured by a pledge of one fifth of the borrower’s salary and have already given rise to sanctions. Recent measures of the Ministry for the Economy and Finance and the Bank of Italy have begun to make the criteria for entry in the registers more stringent. But more far-reaching interventions are essential to update obsolete provisions and fill regulatory gaps. We are ready to offer the Government our technical support. Asset management The crisis has exacerbated the longstanding problems of the Italian asset management industry. For years, the Bank of Italy’s watchwords for the industry have been consolidation and independence. A competitive repositioning of the largest asset managers is under way at international level. Some steps towards rationalization are also beginning to be taken in Italy. Recent months have seen spin-offs by banking groups aimed at creating independent operators. Consolidation can yield efficiency gains, which need to be transferred to investors in order to reduce the costs borne by them and fuel the resumption of investment. Management companies’ full autonomy remains essential. We have just begun a consultation on new regulations concerning the management and coordination exerted by bank parent companies on their asset management subsidiaries. Besides clearly defining the strategies they pursue in the sector, banking groups will have to ensure the genuine independence of asset management companies as regards their investment choices and marketing policies. I have repeatedly underscored the disadvantage that derives from the difference between the tax regime for the sector in Italy and abroad. This needs to be revised. The reform of European supervision Supervisory colleges that oversee the consolidated position of international groups, uniform supervisory rules and practices, and a close relationship between the European Central Bank and national supervisory authorities are the three pillars of future European supervision. The proposals put forward by the de Larosière group largely meet these needs but envisage a complex architecture. A European Systemic Risk Board, in which central banks and supervisory authorities will participate, will be responsible for macroprudential analysis and supervision. It is important that it be headed by the president of the ECB, that its activity go beyond merely warning about risks, that it be able to verify implementation of its recommendations and promote the introduction of countercyclical measures. Supervision of all banks, including European groups, will remain a national responsibility. The overall context must change, however. The objective is: common rules, common practices, a common culture, with a single rulebook applicable throughout Europe, and a strong coordinating role for the supervisory colleges. Equally important is the harmonization of depositor-guarantee schemes, of the instruments for intervention in crises, and of the rules for the transfer of liquidity between the units of a banking group. The Bank of Italy is already at the forefront in promoting concrete progress for the groups for which it is home supervisor. Joint and coordinated inspections in the various subsidiaries of a group, conducted together with the host-country authorities, are becoming standard practice. Just a few years ago, such progress was inconceivable. Best practices must be disseminated as supervisory authorities continue to converge. The particularly incisive approach to inspections and supervision that typifies the Italian tradition is a valid reference point. | bank of italy | 2,009 | 7 |
Testimony of Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 21 July 2009. | Mario Draghi: Fact-finding preliminary to the examination of the Economic and Financial Planning Document for the years 2010-2013 Testimony of Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial Stability Board, at the Joint Session of the Fifth Committees of the Italian Senate and Chamber of Deputies, Rome, 21 July 2009. * * * Economic policy is contending with the most severe recession since the Second World War. In 2009 Italy’s GDP will contract by more than 5 per cent. According to the macroeconomic scenario presented in the Economic and Financial Planning Document only in 2013 will economic activity return to its 2007 level. The Government has taken steps to attenuate the effects of the recession on firms and workers. New measures are in the process of being approved. In Italy fiscal action is constrained as far as the deficit is concerned, but not in terms of the composition of the budget, by the high and rising level of the public debt. In view of the sharp drop in revenue, this year’s deficit will exceed 5 per cent of GDP. Public expenditure will reach very high levels. The Planning Document sets the dual objective of strengthening the capacity of the economy to grow and consolidating the public finances. It is important to lay the basis immediately for achieving these results. This would also increase the scope for a more vigorous economic policy. The measures announced for pensions and the plans for reform of general government go in this direction. The manner of implementing fiscal federalism will be crucial for a more effective management of resources. A comprehensive set of reforms must be drawn up with the aim of strengthening the country’s physical and human capital. Tax and social security receipts are still high in relation to GDP, close to the peak values of recent decades. Progress in curbing current expenditure and fighting tax evasion is of fundamental importance to allow labour and corporate tax rates to be reduced in the medium term. 1. The state of the public finances After two favourable years for the public finances, the situation worsened in 2008 After two years of gradual improvement, the situation of the public finances worsened markedly in 2008. Net borrowing began to grow again, rising from 1.5 to 2.7 per cent of GDP. The ratio of the debt to GDP increased by more than 2 points, to 105.7 per cent. The deterioration in the balance was due mainly to tax reliefs, the lapsing of some factors that had sustained tax receipts in the two previous years, and the high rate of growth (4.5 per cent) in primary current expenditure, which accelerated with respect to 2007 and outpaced nominal GDP by a considerable margin. The impact of the business cycle on the accounts was curbed in 2008 by the relatively favourable performance of employment and earnings. The effects of the crisis are expected to be more pronounced this year and in 2010. A further sharp deterioration in the public finances is expected in 2009 According to the estimates in the Economic and Financial Planning Document for 2010-13, this year net borrowing will rise by 2.6 percentage points, to 5.3 per cent of GDP. The public debt is projected to grow by nearly 10 percentage points, to 115.3 per cent. The Planning Document indicates that GDP will decline by 5.2 per cent. These estimates are in line with those included in the forecasts recently presented in the Bank of Italy’s Economic Bulletin. The new estimate of the deficit is 0.7 percentage points higher than the one given in the Combined Report on the Economy and Public Finances in April. The worsening mainly reflects the expectation of a larger contraction in GDP, which was forecast at 4.2 per cent in April, and the increase in the appropriations made with the mid-year budget revision. Structural net borrowing is estimated at 3.1 per cent of GDP. For the first time in 18 years, a primary deficit is projected, equal to 0.4 per cent of GDP. Primary current expenditure is up sharply in relation to GDP Primary current expenditure is expected to increase from 40.4 to 43.4 per cent of GDP, a historic peak around six percentage points higher than the figures recorded at the end of the 1990s. Less than a quarter of the forecast increase this year is due to the expansion of expenditure for income stabilizers and to the effects of the measures to support the economy, which will tend to be reabsorbed in the coming years. Capital expenditure is forecast to show a steep increase in nominal terms of more than 15 per cent (equal to 6.3 per cent for the investment component alone, excluding the increment connected with the repurchase of the properties securitized in 2002). Between 2005 and 2008 capital expenditure had remained broadly stable, while the investment component had fallen by nearly 2 per cent (net of real-estate disposals). The forecast therefore assumes that the pronounced acceleration in outlays estimated by Istat for the first quarter will continue for the rest of the year. The unfavourable cyclical situation is expected to lead to a contraction of 1.2 per cent in revenue, with a more marked drop in tax receipts. Indirect tax receipts are expected to fall by 3.8 per cent and direct tax receipts by 1.5 per cent. Tax and social security receipts are projected to rise by 0.6 percentage points, to 43.4 per cent of GDP. The expected worsening of the public finances is borne out by the interim data currently available. In the first few months of 2009 the borrowing requirement was far larger than in the same period of 2008 Net borrowing amounted to 9.3 per cent of GDP in the first quarter of 2009, compared with 5.7 per cent in the corresponding period of 2008. The worsening of the borrowing requirement reflected the contraction in tax and social security receipts and the significant growth in primary expenditure, which was affected by the Government’s decision to speed up tax refunds in order to assist firms and by the repurchasing of properties that had been disposed of with securitizations in 2002 (€7 billion in total). Tax revenue recorded on a cash basis in the state budget fell by 3.3 per cent in the first six months of the year compared with the same period of 2008, mainly owing to the steep decline in receipts from VAT (-11.3 per cent) and other business taxes (-9.2 per cent). In 2008 VAT receipts had already diminished by 1.5 per cent, against an increase of 2.3 per cent in household consumption, the macroeconomic variable that best approximates the VAT tax base. VAT receipts have continued to fall this year: they were down by 10.2 per cent in the first quarter from a year earlier (and by 12.1 per cent in the second quarter), while consumption fell by 2.6 per cent. Only part of this gap appears to have been due to a shift in the composition of consumption towards essential goods, which are taxed at lower rates. In the first half of 2009 receipts of personal income tax on payroll employment decreased by only 0.7 per cent, benefiting from the relatively favourable performance of per capita earnings. Including receipts recorded in the first half of July, self-assessed taxes can be estimated to have grown by approximately €2 billion with respect to the corresponding period of 2008. The increase reflects the higher-than-expected receipts from the one-off substitute taxes introduced with the Finance Law for 2008 and the anti-crisis decree of last November (more than €6 billion in total). Net of these items, there was a significant fall in corporate income tax. It should be noted that whereas the receipts from the oneoff taxes have basically run their course, the contraction in corporate income tax points to a fall in receipts from the second payment on account at the end of the year. 2. Fiscal policy’s response to the crisis Countries have responded to the severity of the crisis with discretionary policies to sustain the economy The severity of the crisis has created a vast consensus at international level on the need to accompany automatic stabilizers and monetary policy with discretionary countercyclical budgetary policy interventions. In Italy, however, the high level of the public debt limits the scope for increasing the deficit. It remains possible to act through changes in the composition of the budget. It needs to be stressed that the sensitivity of the yields on public debt securities to the conditions of the public finances (deficit and debt) tends to increase in periods of turbulence on the financial markets: the yield differential between ten-year Italian and German government securities widened in the second half of 2008 to more than 150 basis points and is still very considerable, of the order of 100 basis points. In the future, various factors will tend to increase the average cost of the public debt: the substantial recourse to the market by governments to fund measures for supporting the economy, the recovery of economic activity, and fears of a rise in inflation. In Italy, the use of the budget for anti-cyclical purposes has aimed above all, including via administrative channels, to speed up the employment of resources already allocated and direct them in order to support aggregate demand and mitigate the social costs of the recession. The interventions The response to the crisis has consisted primarily in three decree laws, which together appropriated €25 billion of resources for the three years 2009-11 (of which €17 billion funded by increasing revenue), and in the draft mid-year budget revision. Budgetary action came on top of measures aimed at guaranteeing the stability of the financial system and alleviating firms’ liquidity problems. In November 2008 a first package was approved. In addition to several tax reliefs for firms, the package introduced transfer payments to low-income households (known as the family bonus, which supplemented the social card scheme launched during the previous summer); automatic income stabilizers were strengthened for the two years 2009-10 (a measure funded with national and EU funds on the basis of a State-Regions agreement); there were increases in the allocations for investment in public works and in investment grants to the State Railways group (in part to offset previous cutbacks), in conjunction with the adoption of new procedures to speed up the realization of projects included within the National Strategic Reference Framework. A second measure issued last February dealt mainly with incentives for the purchase of cars. At the beginning of July a third decree law introduced tax incentives for investment in machinery between July 2009 and June 2010, through the exclusion from firms’ income of half the expenditure. Tax benefits for new investment had already been introduced in 1994 and 2001. Unlike the more recent measure, these envisaged the exclusion from firms’ income of half the investment in equipment and capital goods made over and above the average for the previous five years (in 2001 it was possible to exclude the year in which most investment was made from the calculation of the average). Only investment in machinery included in division 28 of the ATECO classification qualifies for the new incentive, while previously property and cars were also included. July’s measure also raised the limits set on the deductibility of credit writedowns and allocations to risk provisions for banks. Firms benefited from the introduction of accelerated depreciation for technologically advanced goods; the details of the intervention will be defined in a decree to be issued before the end of the year. The decree law also introduced a series of measures designed to curb the cost of bank commissions, reduce the cost of energy for firms and households, and ensure greater timeliness in the general government payments system. Moreover, the decree law further expanded automatic income stabilizers for the two years 2009-10. In the first quarter of this year, the number of hours worked fell by 3.8 per cent compared with the previous year, a more pronounced decline than that in employment (1 per cent), partly the effect of the slowdown in productive activity and widespread recourse to the Wage Supplementation Fund, which more than tripled overall compared with the first three months of 2008. The number of hours of wage supplementation authorized increased further in the second quarter, by 60 per cent on the previous 8 period. Among those worst hit by the crisis were temporary workers, whose fixed-term or collaboration contracts were not renewed. According to Istat’s survey of the labour force, in the first quarter of 2009 the number of fixedterm, collaboration or project workers was about 260,000 lower than a year earlier, against a slight rise in the number of permanent employees. Finally, the draft mid-year budget revision increases the resources available for general government with the objective of reducing delays in payments to firms. Compared with the budget presented last September allocations on a cash basis increased by €18 billion; those on an accrual basis by about €5 billion. The funding of the anti-crisis measures The expansionary measures contained in the three anti-crisis decrees are all funded within the respective provisions. The costs associated with the November decree are covered by increases in revenue, half of which derive from the introduction of several substitute taxes on voluntary asset revaluations and, to a lesser degree, from a reduction in expenditure; those relating to the measures in the February decree are covered by the revocation of a number of tax reliefs and with increased revenue as a consequence of the growth in demand for durable goods, which the purchasing incentives are expected to deliver. Finally, the costs of the July decree are covered by new legislation to combat tax evasion, the intensification of tax collection activities, the tightening of the requirements for offsetting tax credits, and specific laws on the gaming sector and savings in the pharmaceutical sector. A decree law in favour of the population hit by the earthquake in Abruzzo was ratified in June. The immediate aim of the legislation is to tackle the emergency and in the longer term the objective is to finance reconstruction activity through 2032, by means of grants and state guarantees; compensation for firms is also envisaged. For the part of the plan that is explicitly quantified, the impact on net borrowing in the three years 2009-11 is virtually nil. The funding of the interventions is assured by the increase in revenue deriving from a broadening of the range of gaming activities offered to the public and a tightening of controls in the sector, from further savings in pharmaceutical expenditure and a decrease in the use of the fund for family bonuses. In the two years 2010-11 the interventions will draw mainly on funds set up for other purposes. A rough indication of the level of support to aggregate demand expected from government interventions can be made by comparing the current estimates on expenditure in 2009 and those in last September’s Government Forecasting and Planning Report. In particular, investment expenditure is now expected to increase by 6.3 per cent compared with 2008 (excluding, for uniformity of comparison, repurchases of real estate securitized in the SCIP2 operation in 2002), while in September’s Report it remained unvaried; this revision corresponds to 0.1 percentage points of GDP. For expenditure on intermediate goods the upward revision is around 0.3 percentage points of GDP. The housing plan defined in the agreement reached on 31 March 2008 between the Government, Regions, and local authorities will mobilize private savings and contribute to the recovery of investment. The agreement will be enacted fully in each of the Regions; in several cases draft laws are already in the process of being approved. Amongst other things, the plan allows owners to increase the size of one- and two-family residential buildings by up to 20 per cent, provided these do not already exceed 1,000 cubic metres and excluding unauthorized buildings or those situated in historic centres or in areas subject to a general building ban. The derogations will remain in place for a limited time and in any event not exceed 18 months. Other measures to guarantee the necessary liquidity to small -and medium-sized enterprises Other interventions concerned the Cassa Depositi e Prestiti and SACE, the export credit insurance agency. Although they have no impact on the public finances, these measures increase the liquidity available to firms, especially to small- and medium-sized enterprises. The guarantee fund for these firms was also increased. In particular, the Cassa Depositi e Prestiti will be able to employ up to a maximum of €8 billion in resources derived from postal savings to provide credit to small- and medium-sized enterprises; SACE will be able to provide guarantees to businesses on general government receivables. Last autumn and at the beginning of 2009 steps were also taken to guarantee the stability of the financial system. These made available to the Government a series of instruments aimed at protecting investors and maintaining adequate levels of capitalization and liquidity for banks. There is also a provision for the State to subscribe financial instruments issued by listed banks that are fundamentally sound; these instruments count as regulatory capital; in April 2009 the Combined Report on the Economy and the Public Finances assumed that the resources employed would amount to around €10 billion; to date issues of about €2 billion are nearing completion. A description of the steps taken to support the financial sector is contained in the 2008 Annual Report published on 29 May (see Chapter 19: Supervision). 3. The projections based on current legislation and the objectives set in the Planning Document for 2010-13 The deficit on a current legislation basis is expected to improve in the years 2010-13 In 2010 net borrowing on a current legislation basis is estimated to reach 5 per cent of GDP, slightly lower than in 2009. In 2011 the deficit is forecast to fall to 4.4 per cent and to decline in the following two years, reaching 3.7 per cent in 2013. The outlook for net borrowing takes account of the marked improvement expected in the primary surplus, equal to an annual average of 0.7 percentage points in the four years from 2010-13, only partially offset by the progressive increase in interest payments as a share of GDP (from 5.1 per cent in 2010 to 6 per cent in 2013). The expected improvement in the primary surplus is ascribable to the absence of several costs related to the recession, the effects of the three-year adjustment plan launched in the summer of 2008 and the adoption of the current legislation criterion. This criterion excludes a series of disbursements which, even if foreseeable or necessary, have not yet been the object of formal legislation, such as future public employment contracts, the renewal of service contracts and the execution of public works. Compared with the estimates in the Combined Report, net borrowing on a current legislation basis is revised upwards by 0.4 percentage points in 2010, and by 0.1 per cent in 2011. For 2010, the deterioration in the budget balance with respect to the estimates made in April is mainly due to the decline in revenues, particularly from social security contributions (-0.2 percentage points of GDP or €2.5 billion) and direct taxes (-0.1 points or €1.7 billion), resulting from the reduction of 0.4 percentage points in the expected level of nominal GDP in 2010. The adjustment of interest expense (-0.1 percentage points, equal to about €1 billion) will offset part of the increase in capital expenditure (0.2 percentage points or €2.4 billion). The planning scenario As far as the planning scenario is concerned, the EFPD sets the target for net borrowing in 2010 at the value on a current legislation basis. As explained above, in order to achieve this result it will be necessary to cover the additional expenditure not envisaged in current legislation. In the years that follow, the targets for the deficit are below the values on a current legislation basis, by 0.4 points in 2011 and by around 1.2 points in 2012 and 2013. At the end of the planning period, the target for net borrowing is set at 2.4 per cent of GDP. The primary balance is expected to improve by 0.6 percentage points of GDP in 2010, reaching a surplus of 0.2 points, and by 3.3 points over the following three years. The EFPD does not give details of the planning scenario Unlike the previous EFPD, the present planning scenario does not give information on the level or composition of revenues and expenditure. The Document states that on the revenue side the corrective action will tend to reinforce the measures to combat tax evasion and avoidance. On the expenditure side, the aim will be to ensure that the regional health service deficits are rectified and to introduce more efficient methods of disbursing public services. The lack of information on revenue and expenditure targets makes it difficult to evaluate some critical aspects of the fiscal policy outlined in the EFPD. For example, use of the current legislation basis, among other things, means that the baseline projection indicates a sharp decrease in capital expenditure in 2010. In particular, investment expenditure – after rising by 6.3 per cent in 2009 – is expected to fall by 6.6 per cent (excluding, for 2009, outlays for the repurchase of real estate securitized in 2002), returning to its 2006 value. In a cyclical phase that is likely to remain fragile, this public-sector support of aggregate demand should be maintained. Structural net borrowing, amounting to 3.1 per cent of GDP in 2009, is projected to improve steadily until 2012 (by around 0.3 percentage points per year) and remain virtually stationary in 2013. In 2013 less than a third of the recession-related increase in the debt will have been absorbed The public debt is projected to increase by a further 2.9 percentage points of GDP in 2010 (to 118.2 per cent) before it begins to decline in 2011, reaching 114.1 per cent in 2013. At the end of the planning period, less than a third of the increase in the public debt associated with the recession will have been absorbed. In the future, in implementation of the bill on public accounting and finances now before Parliament, the EFPD will be replaced by the Decision on the public finances as part of a reform that will also affect the timing and content of the documents marking the progress of fiscal policy. The reform should heighten the importance of medium-term considerations in the drafting of fiscal policy. As far as concerns timing, the bill (as approved by the Senate) provides that the Government must submit the Decision on the pubic finances to Parliament by 20 September of each year. By 15 October the Minister for the Economy and Finance must present a bill before Parliament, called the Stability Bill, which replaces the Finance Bill and the Budget Law. The deadline for the introduction in Parliament of the measures linked to the Stability Bill remains 15 November. The time horizons for policy planning and implementation are also brought closer together: the targets set by the Decision on the public finances must relate at least to the next three-year period; budgetary policy must cover three years. 4. Fiscal policy for the years following the recession Two objectives for economic policy The EFPD not only points out the need to maintain the temporary support measures in favour of households and firms, it also assigns fiscal policy two main objectives: ensuring the resumption of progress towards consolidating the public finances, in order to converge towards budgetary balance; and sustaining productivity and economic growth. According to the framework outlined in the EFPD the next years will see large deficits. Measures to restructure the public finances are planned for 2011 and 2012, once the adverse phase of the cycle is past. No corrective action is envisaged, instead, for 2013, beyond what is needed to finance the expenses not included in current legislation. Macroeconomic conditions permitting, it could be a good year in which to press on with the consolidation measures. The legacy of the recession for the public finances: a much larger debt The public debt is expected to diminish in relation to GDP starting in 2011, but – as pointed out earlier – at the end of the planning period less than a third of the increase due to the recession will have been absorbed. The high debt ratio will be one of the most serious consequences of the recession. According to the EFPD forecasts, the debt will stay below the peak recorded in the mid1990s. However, it should be pointed out that the quantity of easily liquidated public assets will also be smaller than it was then. During the decade 1995-2004 asset sales and the restructuring of the bonds assigned to the Bank of Italy in 1994 accounted for about 11 percentage points of the reduction in the debt/GDP ratio. These transactions were not carried out in conjunction with structural measures to curb the growth in current expenditure capable of putting the debt back on a steady downward path. Compared with the 1990s the situation is aggravated by the pressure exerted on the public finances by the ageing of the population: in the mid-1990s the number of over- 65 year-olds was equal to about 25 per cent of the population aged 15 to 64, while in 2010 that proportion will reach 31 per cent, rising to 34 per cent in 2015 and 36 per cent in 2020. The public debt is building up again on the eve of the period in which the large post-war generations retire. The consolidation measures must curb primary current expenditure Given the magnitude of the adjustment needed to put the public debt permanently back on a downward path, it is essential to draw up programmes with medium-to-longterm structural effects as early as possible. Given the present level of taxation and social security contributions – high by both historical and international standards – action to consolidate the public finances must rely, as the EFPD also points out, not only on a significant reduction in tax evasion, but also on the containment and reorganization of current expenditure. The effort to contain outlays must be extremely incisive The achievement of the target set for the deficit in 2013 (2.4 per cent of GDP) requires an average annual reduction in primary current expenditure of about 1 per cent in real terms in the period 2010-13. This estimate assumes that GDP will grow by 2 per cent per year in 2011-13, in line with the macroeconomic framework of the EFPD; that interest expense and revenue will stay at their baseline levels; and that the ratio of capital expenditure to GDP will hold steady at the value forecast for 2010. In order to achieve the deficit target for 2013 without affecting social payments (which in this second scenario will stay at their baseline levels), the other primary current expenditure items will need to decrease on average by around 3 per cent annually in real terms. Efforts to contain outlays in the years to come must therefore be extremely incisive: in the ten years 1999-2008 primary current expenditure recorded an average annual increase of 2.1 per cent in real terms. It should be noted that over the last decade the average growth in expenditure was 1.5 points greater than projected for the following year in the Forecasting and Planning Reports. In the years after 2013 the rapid curtailment of the debt will continue to be a priority. Unless significant progress is made in reducing current spending, and failing a resumption of growth, there can be no doubt that both the public debt and the incidence of taxation and social security contributions will remain extremely high for a long time to come. Given the planning scenario adopted in the EFPD up to 2013, assuming the budget deficit is adjusted by about 0.5 percentage points of GDP each year (leading to balance in 2018) and that GDP grows at an annual rate of 1 per cent in real terms (slightly more than the potential growth indicated in the EFPD for 2013) and of 3 per cent in nominal terms, in 2018 the public debt will still equal 107.6 per cent of GDP. Under this scenario, assuming capital expenditure remains stationary at the level forecast for 2010 and that the average cost of the debt and the ratio of revenue to output stay at the values forecast for 2013, in the five-year period 2014-18 primary current spending should remain virtually stationary in real terms. Assuming that budget balance is achieved in 2015 with GDP growth still at 1 per cent, in 2018 the public debt will amount to 104.5 per cent of GDP. In 2014-15 primary current expenditure will need to decrease on average by around 2 per cent per annum in real terms; in the years after, if budget balance is maintained, there should be scope to increase current spending in real terms or to reduce the incidence of taxation. Finally, assuming budget balance in 2015, but assuming a more favourable rate of GDP growth (2 per cent), in 2018 the public debt should fall to just under 100 per cent of GDP. The average annual reduction in current spending in the two years 2014-15 would be about 1 per cent in real terms. 5. The structural policies for consolidation of the public finances and growth Structural reforms are needed to render the measures efficacious The measures to contain outlays will have to be of a structural nature and will therefore necessitate a reform of the main public services and a reorganization of general government departments. In some cases this will mean continuing on a course already begun. The reform of the budget cycle may improve the control of expenditure The planning and implementation of measures to curb expenditure may benefit from the reform of the budget cycle currently under discussion in Parliament, which might contribute to enhancing the transparency of the public finances and encouraging the adoption of a medium-term approach to fiscal policy. The bill approved by the Senate specifies the information on the public finances that the key documents of the budget cycle must provide. The following are especially important for planning purposes: the information needed to construct the budget on an unchanged policies basis, the data on planned revenue and expenditure, and the economic policy objectives set for the subsectors of general government. In the last ten years the targets for the public finances have frequently been missed and the objective of budgetary balance has been repeatedly postponed. This has entailed heavy costs in the management of the present crisis and reduced the scope for budgetary policy action. Strengthening the rules and procedures of the budget is therefore of great importance. Fiscal federalism must contribute to curbing expenditure The implementation of fiscal federalism offers an opportunity to make the management of public resources more efficient and to rationalize expenditure, while bearing in mind the principle of solidarity. The increase in the proportion of local taxes in the financing of local government expenditure in place of central government transfers and the strengthening of fiscal autonomy by allowing changes to tax rates and bases create a closer link between expenditure and revenue decisions and can lead to greater efficiency. A crucial element of the enabling law passed by Parliament in April is the replacement of the historical cost criterion by that of standard costs and funding requirements for the allocation of resources to local authorities. The calculation of these indicators is subject to technical difficulties that are accentuated by the lack of harmonized budgets at the different levels of government and the large territorial disparities between the levels and quality of public expenditure. The prompt approval of the so-called Local Government Code is also of crucial importance for the implementation of the enabling law on fiscal federalism. The plan for achieving expenditure savings by rationalizing and simplifying the different levels of government, so as to exploit economies of scale and avoid useless overlapping, appears highly commendable. The Local Government Code will specify the division of the functions performed by municipalities and provinces, including the identification of those to be considered fundamental for ensuring fiscal equality, reorganize the network of intermediate local authorities (e.g. mountain communities and consortia of municipalities), rationalize the provinces, reorganize the peripheral offices of the ministries, streamline municipal and provincial councils, and rewrite the Domestic Stability Pact. A significant increase in the average effective retirement age is desirable In the medium term a significant increase in the average effective retirement age is required. Given the sharp rise in life expectancy, a lengthening of working lives is important in order to match the need to curb public expenditure with the need to ensure an adequate income in old age. If accompanied by measures to make older workers’ working hours and earnings more flexible, such a lengthening would also help to increase the labour force participation rate and the economy’s potential growth rate. It would allow more resources to be allocated to other forms of social expenditure. Setting the same retirement age for male and female public-sector workers, which is necessary in order to comply with the judgment of the European Court of Justice, is a step in this direction. Thought will have to be given to completing the reform of the pension system. The Planning Document raises the forecast for the ratio of pension expenditure to GDP in the period 2010-50, basically to take account of the lower estimates of GDP growth. The increase in the relative importance of the liabilities associated with the pension system is another adverse consequence of the recession. According to the Planning Document, in 2010 pension expenditure is likely to be 15.5 per cent of GDP, 1.4 percentage points higher than the official estimates released at the beginning of 2008. In the following years the gap between the two sets of forecasts tends to narrow; in 2050 it is 0.7 percentage points of GDP. The sum of the revisions in the next forty years is about 35 percentage points of GDP. Reduce tax evasion In the budget on a current legislation basis tax and social security receipts exceed 43 per cent of GDP in 2009 and remain close to 43 per cent over the rest of the forecasting horizon. These values put Italy well above the average of the other euro-area countries and are high compared with the past, 43 per cent having been exceeded on only two occasions, in 1997 and 2007. The Planning Document gives great importance to the fight against tax evasion. The large scale of the underground economy increases the burden on law-abiding taxpayers, causes distortions and reduces the competitiveness of the majority of firms. These effects may well be more pronounced in the present phase of economic crisis. As mentioned earlier, a gap has emerged between the rate of growth in VAT receipts and the VAT base. This development needs to be examined with care, not least in view of the reliance some of the measures adopted in the last twelve months have placed on the reduction of tax evasion in order to cover expenditure. In addition to stepping up audits and sanctions, it is necessary to reduce the areas of evasion by lowering in the medium term statutory tax rates, which is to be made possible by curbing expenditure. Stabilizing the legislation on assessments and fostering public intolerance of tax evasion would also help. Reforms for reviving growth It is not sufficient to return to the growth rates of recent years, which were extremely low by international standards. There is a need for structural reforms that will put Italian industry in the best possible position to grasp the opportunities that will be offered by the recovery of the world economy. Once the crisis has been overcome, Italy will find itself with its stock of physical and human capital eroded by the fall in investment and the rise in unemployment. The decline in potential GDP growth that could follow is one of the most worrying consequences of the crisis, as the Planning Document also notes. Increase the efficiency of government departments In Italy the administrative and bureaucratic costs incurred by businesses are high by international standards. The recent measures adopted in relation to setting up businesses are a move in the right direction, but they need to be strengthened and accompanied by further action to improve the efficiency of public offices. The wide gaps between the performances of different public structures are evidence of the scope for large efficiency gains for firms if every office adopted the best practices. The bureaucratic formalities the productive sector must comply with affect many aspects of firms’ competitiveness: their birth, size and productivity. The time consumed and the costs incurred in complying with these formalities show wide territorial variations. According to a survey conducted by the Bank of Italy (on the basis of an international comparison carried out by the World Bank), it takes 12 days on average to set up a company in the “fastest” area and more than 27 in the “slowest” area; the costs range from 13 per cent of per capita income to nearly 30 per cent. The recent reforms have significantly reduced these times, with the greatest improvements taking place in the slowest areas. Large territorial differences were also found in the case of the procedures for obtaining building permits and the transfer of real estate. Improve the quality and effectiveness of government action The recent reform of general government is marked by the scale of the intervention and the importance of the principles upon which it is based: transparency, linking earnings and performance, and benchmarking for the control of results. The effect on the quality of government action will depend, however, on how these principles are applied in practice. Important factors will include the autonomy, organizational and otherwise, of the Assessment Committee and the actual independence of the assessment bodies from the departments they belong to. The major difficulties encountered in measuring the output of the public sector will have to be overcome. Modernize schools and universities It is necessary to continue with the renovation of the school and university systems. Independence and assessment are the key principles. As is also stressed in the annexes to the Planning Document, the strategy for intervention in this field must aim at enhancing the value of human resources, recognizing merit and excellence, and curbing expenditure. Last year saw the inclusion in the Italian middle school final exam of a written exam that is the same across the whole country; it supplements the other tests and teacher assessments. The curricula of high schools have been revised. The reform of the technical institutes which will come fully into force in 2010 will permit a closer interaction between schools and the productive sector, as a result of the increased importance assigned to scientific and technological subjects and English, and the introduction of organizational models that facilitate training carried out in collaboration with firms. At university level, the allocation of resources is made more efficient by implementing the criteria previously announced, which reward the quality of research and teaching. Eliminate the fragmentation of worker protection The Government’s anti-crisis measures have appropriately aimed at preventing the interruption of employment relationships and introduced experimental income-support solutions for some less protected workers. There nonetheless remains a need for a comprehensive reform of Italy’s system of automatic stabilizers. The ISAE survey of manufacturing firms shows some initial signs of a halt in the deterioration of the outlook for employment in the second half of the year. However, without a reversal of the trend of industrial production, which, despite remaining stable in the last three months, is about 25 per cent below the peak reached in April 2008, it is possible that not even recourse to the Wage Supplementation Fund, which has so far been extremely effective, will be able to fend off a fall in employment. A reform of the system of automatic stabilizers for job-seekers that eliminated the present fragmentation of protection provided it is accompanied by a strengthening of the eligibility checks would improve the working of the labour market by fostering the reallocation of workers between sectors and firms. Household consumption would also benefit, not only through direct economic support in the event of the loss of a job but also by reducing the need to save in order to cope with unforeseen events. *** The Italian economy is grappling with a very severe recession, which follows years of modest growth. The period during which economic conditions grew progressively worse appears to have ended; there are some positive signs. Benefiting from the recovery of the world economy, economic activity should start to expand again during 2010. Giving support to industry nonetheless remains a priority objective; a structural weakening of the productive system must be avoided. The exit from the market of a large number of firms would reduce the country’s potential output and would also impose heavy costs in terms of human capital. Budgetary policy must continue in the effort to reallocate resources in favour of labour and firms. The immediate definition of structural measures, capable of curbing expenditure and the public debt in the medium term, would increase the scope for more vigorous action to counter the crisis. A comprehensive strategy of structural reforms, some of which are being implemented and others prepared, can enhance the effectiveness of the action to be taken in the short term, provide certainty to households and firms, and create the conditions for the economy to move to a higher growth path. | bank of italy | 2,009 | 8 |
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