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Closing remarks by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the 2023 Peer-to-Peer Financial Systems Workshop, Rome, 27 September 2023.
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Alessandra Perrazzelli: Closing remarks - 2023 Peer-to-Peer Financial Systems workshop Closing remarks by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the 2023 Peer-to-Peer Financial Systems Workshop, Rome, 26-27 September 2023. *** I am delighted to be here today to close this workshop on Peer-to-Peer Financial Systems. This event - jointly organized by Banca d'Italia, the University College London Centre for Blockchain Technologies and DLT Science Foundation – has provided an opportunity to gather experts with different backgrounds and skills to discuss important topics, to focus on the innovation of the financial system and to strengthen the dialogue among stakeholders. Innovation technology is affecting the entire financial system, reshaping business models, developing services, restructuring the value chains and redesigning the supervisory scope. New technologies, especially when their application is widespread and impactful, as in the financial sector, provide both opportunities and considerable challenges for newcomers and traditional intermediaries and also for regulatory and supervisory authorities. This is the case of the open banking model, which you discussed yesterday. The ongoing technological evolution, favoured by the entry into force of the European Directive on payment services (PSD2), is pushing intermediaries to adopt new business models; they are capable of extending revenue opportunities, improving services but at the same time also of increasing the range of risks (for example, fraud, cyber risk, operational and strategic risks) and the interconnections among the players. In the near future, this effect may be amplified by the introduction of the open finance model, as proposed by the European Commission. Digital innovation also enables public institutions, authorities and regulators to fulfil their mandates, including combating money laundering and terrorism financing and preserving financial and monetary stability: research and development is paramount in order to achieve these goals. Our commitment, with the other European central banks, to CBDCs is an example of this. Regulators thus need to reconcile the promotion of innovation with the need to safeguard consumers and investors, avoid the exclusion of discrimination against less digitalized users, ensure the proper functioning of market infrastructures and payment systems, and preserve the safety and stability of the financial system and the economy as a whole, fostering the 'good innovation' that Mr Tornetta has already discussed with you. The emerging ecosystem features the increasing importance of non-financial risks such as cyber and data protection, while traditional risks are being exacerbated. In this context, deep-dives analysis and research are key to understanding and managing these new complexities. Awareness and clarity are fundamental for both operators and clients to be able to face these challenges, as we are seeing with crypto-assets, and 1/3 BIS - Central bankers' speeches yesterday's panel offered useful insights here. Policy and regulatory attention in the crypto ecosystem has increased in the past year. We have felt the need to provide some useful references for consumers, intermediaries, providers and operators of digital infrastructures, with a dedicated communication in June 2022. Now at European level, we can also rely on MiCAR, which introduces a clear set of rules to deal with crypto-assets. It is part of the EU's Digital Finance Strategy, together with the EU's digital operational resilience act and the DLT pilot regime. MiCAR represents a significant step forward in this field but, as supervisors, we have to continuously monitor the rapidly changing ecosystem. The speed of innovation is a new complexity, requiring an acceleration and a change in the regulation, which, in the new paradigm, should not only follow innovation, but also address it, by adopting a dynamic and modular approach. It is extremely important that operators, supervisors and regulators acquire suitable competencies to understand the risks (IT, operational, reputational, but also in terms of strategic/business model risk) that may arise, to deal with the increasing complexity, to guarantee sustainability and to exploit the opportunities that innovation technologies offer. We need to improve knowledge and awareness of the new ecosystem. The dialogue among regulators, academia, industry players and technology providers is fundamental for steering the potential of innovation in a positive direction, in order to take advantage of the opportunities while at the same time navigating the related risks. Dialogue is vital: encouraging best practices, i.e. defining common standards and principles in order to encourage the development of sound operating models, also with regard to the economic, social and environmental impact, to ensure an adequate level of interoperability between various technological solutions and their overall sustainability, and not only in terms of ESG factors, as the last session highlighted. By leveraging on a constant and constructive dialogue with all the stakeholders involved in the Fintech ecosystem, the Bank of Italy is implementing a clear strategy to support financial institutions and promote the development of sustainable, sound and responsible innovation, thereby ensuring financial stability, financial inclusion and consumer protection. We have set up a complete and integrated system of innovation facilitators to act as a catalyst in the sector: 1. The FinTech Channel is the point of contact through which operators can dialogue easily and informally with the Bank of Italy. They can present projects in the fields of financial services and payments, based on innovative technology, or propose technological solutions designed for banks and financial intermediaries. 2. The regulatory sandbox, in close cooperation with the other two Italian supervisory authorities (IVASS and Consob) and with the involvement of the Ministry of Finance, is a controlled environment where supervised entities and FinTech operators will be able to test technologically innovative products and services in the banking, financial and insurance sectors for a limited period of time. 3. Milano Hub is the innovation centre created by the Bank of Italy to support the digital evolution of the financial market and encourage the attraction of talent and investments. We are completing the second call for DLT projects, and the third one will be announced in the coming months. 2/3 BIS - Central bankers' speeches This is a unique and privileged perspective for monitoring changes and trends in the financial market, also at international level through cooperation and coordination with foreign authorities, institutions and stakeholders. All the information gathered is a great asset for understanding market dynamics and increasing the awareness of operators' needs and strategies, so as to intercept phenomena of interest promptly, and to identify the most appropriate and effective regulatory and supervisory actions to facilitate the development of FinTech, thereby limiting the spread of potential new risks from the outset. These two days of work and debate have provided further value added, giving us and the overall ecosystem interesting empirical, regulatory and policy perspectives and takeaways. In this evolving landscape, the different sessions have provided important scientific contribution on key topics, exploring emerging technologies, their implications for the innovative payments ecosystem, open finance, central bank digital currencies and the potential forms of digital money, closing with their sustainability. As highlighted in the last panel, the interest and the engagement to ensure the greatest compliance with the Sustainable Development Goals is growing among researchers, policymakers and the industry. The discussion embraced all the questions posed by the broader definition of sustainability, encompassing all the social, environmental and economic aspects. Achieving the SDGs is indeed a challenging task, also given the amount of resources needed. The only way forward requires all actors – policymakers, industry and the general public – to do their part. I would like to thank all the organizers, the scientific committee, the participants and the speakers that joined us yesterday and today. 3/3 BIS - Central bankers' speeches
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bank of italy
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Address by Mr Ignazio Visco, Governor of the Bank of Italy, at the 8th Associazione per la Storia Economica (ASE) Annual Meeting, Gianni Toniolo Session, Naples, 29 September 2023.
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bank of italy
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Speech by Mr Paolo Angelini, Deputy Governor of the Bank of Italy, at the Event "Finance and ESG disclosure. System solutions for businesses", organised by Confindustria, Rome, 26 September 2023.
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3ÿ53ÿ723ÿÿ53ÿ41321ÿ 140284 53ÿ 5ÿ23135ÿ5 5ÿ4 408ÿ8453238283ÿ34ÿ5ÿÿ023584 ÿ 1443032ÿ732584 ÿ1234 !"#$%&'!"& ÿ23ÿ3(3753ÿ2ÿ9281ÿ3 8 5893ÿ8 584ÿ23 284 ÿ1584 885ÿ15ÿ85ÿ 1ÿ3ÿ24 ÿ5ÿ04013ÿ5 5ÿ58ÿ813ÿ4 ÿ040324ÿ53ÿ2ÿ2ÿ) 281ÿ052ÿ 04528153ÿ84ÿ023584 ÿÿ524 ÿ71ÿ2ÿ 23532ÿ1584 885ÿ840184 ÿ0 4 3ÿ84ÿ 0417584ÿ 85ÿ4ÿ3 8 584ÿ85ÿ1273ÿ384 ÿ53ÿ ÿ4ÿ58ÿ245ÿ*3ÿ5248584ÿ 7203ÿ7732ÿ8439853ÿ4ÿ85ÿ84993ÿ07 483ÿÿ3932ÿ8+3ÿ,2ÿ53ÿ3ÿ 058985ÿ ÿÿ848045ÿ87 05ÿ4ÿ53ÿ349824345ÿ4ÿ4ÿ1 4ÿ285ÿ1584 885ÿ 2372584 ÿ8ÿ4ÿ872545ÿ5ÿ2ÿ31284 ÿ28ÿ4ÿ38+84 ÿ53ÿ7725148583ÿ2884 ÿ 2ÿ53ÿ5248584ÿ,1253223ÿ 23ÿ07 483ÿ1-305ÿ5ÿ1584 885ÿ23 1 584ÿ 8ÿ534ÿ5ÿ715ÿ723123ÿ4ÿÿ5 5ÿ23ÿ7 25ÿÿ5382ÿ9 13ÿ0 84ÿ5ÿ87293ÿ5382ÿ 1584 885ÿ7322 403ÿ4ÿ72983ÿ2383ÿ 5ÿ,84 ÿ1432ÿ53ÿ723123ÿÿ 3 8 584ÿ17329884ÿ4ÿ0014584 ÿ213ÿ4 408ÿ8453238283ÿ23ÿ3284 ÿ17ÿ5ÿ 8453 253ÿ1584 885ÿ842 584ÿ845ÿ5382ÿ02385ÿ4ÿ7258ÿ 4 3345ÿ78083ÿ *ÿ58ÿ34ÿ53ÿ433ÿ5ÿ4ÿ53ÿ0122345ÿ4ÿ727305893ÿ851 584ÿÿ5382ÿ027253ÿ 0145327 2583ÿ*3ÿ3ÿ5ÿ72983ÿ2383ÿ842 584ÿ8ÿ534ÿ5ÿ3ÿ73203893ÿÿ 23ÿ1584 3ÿ85ÿ783ÿ785893ÿ3305ÿ4ÿ003ÿ5ÿ3(5324 ÿ4 4084 ,03ÿ85ÿ53ÿ34285ÿÿ349824345 ÿ4ÿ08 53ÿ28ÿ4ÿ53ÿ0 34 3ÿÿ 53ÿ5248584ÿ44.4 408ÿ07 483ÿ 4ÿ8453238283ÿ15ÿ845348ÿ151 ÿ 0 2584ÿ1584 885ÿ842 584ÿ8ÿ032584 ÿ4ÿ872545ÿ52584 ÿ7845 /
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Introductory remarks by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the Bank of England – Bank of France – IMF – OECD – Bank of Italy 4th Joint Workshop on international capital flows and financial policies, Rome, 6 October 2023.
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Statement by Mr Ignazio Visco, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 108th 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), Marrakech, 12 October 2023.
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Ignazio Visco: Statement - meeting of the Development Committee Statement by Mr Ignazio Visco, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 108th 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), Marrakech, 12 October 2023. *** The World Bank (WB) and International Monetary Fund (IMF) Annual Meetings come at a poignant time for Northern Africa. The damages and the human toll of the earthquake here in Morocco and the catastrophic floods in Libya bring renewed attention to the need to enhance resilience to extreme natural events. Our most sincere condolences go to the many thousands who have been injured and displaced. We remain inspired by the people of Ukraine, who continue to face the Russian aggression with courage and determination, and we express our steadfast support to the state of Israel and our unequivocal condemnation of Hamas' appalling and vile acts of terrorism. The global macroeconomic outlook is weak and highly uncertain. Global growth will slow markedly in 2023 and 2024 and risks are clearly tilted to the downside, reflecting not only loss of momentum in some areas, but also the possibility that climate shocks and geopolitical tensions could trigger additional food and energy price increases. Meanwhile, inflation is still elevated, though somewhat abating. Most emerging and developing economies remain highly vulnerable to global risks. In this context, the actions of the multilateral system and the international financial institutions are key to providing swift support to the most vulnerable, building inclusive and resilient economies, and generating sustainable growth. We therefore welcome the document "Ending Poverty on a Livable Planet: Report to Governors on World Bank Evolution" and commend management, staff and the Board of Directors for the significant progress made since last April. The direction is clear, the plan ambitious, and the commitment to the reform agenda visibly strong. This needs to continue. We will maintain our support for this work over the coming months with a constructive approach and look forward to further progress by the 2024 Spring Meetings. We agree with the proposed vision and mission, which retain the Twin Goals – eradicating extreme poverty and boosting shared prosperity – while stressing the importance of addressing global challenges. Most importantly, this acknowledges that the fight against extreme poverty and inequality cannot be achieved without addressing the inter-related threats of climate change, pandemics, fragility, and conflict, as well as the pressures related to demographic developments. We note the eight global challenges the WB will focus on in the next few years. We invite the WB to scale up its action on these challenges without losing impetus on key engines of growth like education and institutional quality. We expect the WB to play a greater role in tackling the root causes of irregular migration, drawing on the 2023 World Development Report on Refugees and Migrants to develop innovative and 1/3 BIS - Central bankers' speeches effective solutions. We must recognize that migration is strongly intertwined with the eight global challenges and has significant regional and global spillovers. We also call on the WB to advance our collective efforts on pandemic prevention, preparedness, and response (PPR), as well as other global health-related issues. We cannot lose sight of the increasing development needs of the poorest countries and must work together for a strong IDA21 replenishment. In Africa in particular, old and new challenges have combined to make the most vulnerable dramatically more so, especially young people and women. We urge the WB to develop transformative projects that can help to generate millions of decent jobs for the young. Energy, trade, payment systems, and digitalization should be central to the efforts of the WB and the other multilateral and regional organizations active on the continent. Massive investments in renewable energy will be needed to increase energy access and affordability, export capacity, regional integration and connectivity. In this regard, we also support the Resilient and Inclusive Supply-chain Enhancement (RISE) Partnership, which aims to enhance local value added and promote responsible and sustainable investments in the extraction, processing and recycling of critical minerals fundamental to a clean and just energy transition. Trade is crucial to the African economy, accounting for almost 50 per cent of its GDP and helping ensure access to essential goods like energy and food. Building regional cross-border fast payment systems – including by leveraging technologies available in advanced countries – would shore up economic development through enhanced trade flows and lower remittance costs. Digitalization is a key enabler of all this. In view of the dramatic worsening of fragility and conflicts over the last three years, the WB is adapting its strategy to remain engaged in the most difficult circumstances and to continue to bolster stronger local institutions, while redoubling efforts to promote a solid and competitive local private sector. We welcome this effort to collectively rethink our approach to evolving contexts, particularly through broader analyses of the drivers of social unrest and violent upheavals and a strengthened regional perspective. We commend Management for the continued implementation of the G20 Capital Adequacy Framework (CAF) Review, designed and launched under the Italian G20 Presidency. We note with satisfaction that the CAF measures adopted so far are set to boost the IBRD's lending capacity by more than $100bn over a decade, a figure higher than what the 2018 general capital increase has provided over the corresponding 10year horizon. The increase of IBRD financing power will allow better response to global challenges and traditional development goals. The G20 CAF Review has also spurred IFC and MIGA to put forward equally transformative programs and products. Much can still come from further implementation of the CAF recommendations. We stand ready to evaluate and help devise additional measures and finetune existing instruments, at the Board, with other relevant entities, and in international fora. Private capital mobilization remains crucial to meet the needs and aspirations of developing and emerging countries. We welcome additional efforts to mobilize institutional investors and promote local private sector development. We therefore applaud the launch of the Private Sector Investment Lab and IFC's development of the 2/3 BIS - Central bankers' speeches Warehouse-Enabled Securitization Platform (WESP), renewed diagnostics, targeted government dialogue, and business-enabling policy reforms. We encourage progress on the Global Emerging Markets Risk Database (GEMs) initiative, as part of a larger effort to improve information gathering and knowledge sharing within the larger investment community. The WB should work to maximize domestic resource mobilization, including through the new Public Finance Review (PFR). Envisaging a clear and effective division of labor, we invite the WB to collaborate closely with other partners, in particular the IMF. The ability to put good ideas to good use is just as important as financing. We should therefore focus discussion on promoting innovation, building capacity in client countries, and developing bankable projects. Within the wider agenda of the new WB playbook, we consider three workstreams of utmost importance. First, a strengthened One World Bank approach. This should better integrate policy advice and public sector financing with private sector development and capital mobilization, thereby feeding into a revamped Cascade Approach. Second, stronger partnerships, which should also lead to more effective country platforms. Third, the integration of impact evaluations into WB projects and programs, which requires building capacity in client countries and allows for optimizing design and delivery. Strengthened international cooperation is essential to assisting those in need and enhancing preparedness for future crises in order to prevent their most dramatic impacts. Our constituency firmly supports multilateral institutions and international coordination efforts. As with its 2021 G20 Presidency, Italy enters the 2024 G7 Presidency firmly committed to those efforts. 3/3 BIS - Central bankers' speeches
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Closing remarks by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the 3rd IFC and Bank of Italy Workshop, Rome, 19 October 2023.
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Data Science in Central Banking: Enhancing the access to and sharing of data Closing remarks by Alessandra Perrazzelli Deputy Governor of Bank of Italy 3rd IFC and Bank of Italy Workshop Rome, 19 october 2023 Good afternoon, ladies and gentlemen, I am delighted to see so many distinguished experts gathered here today to conclude this impressive workshop on data science in central banking jointly organized by the Bank of Italy and the Irving Fisher Committee of the Bank for International Settlements. Over the past three days, we have embarked on an educational journey that has enriched our understanding of how data science is reshaping the landscape of the financial industry and of central banking in particular. The knowledge we have shared, the insights we have gained, and the connections we have forged are invaluable, and they will undoubtedly play a central role in the future of our institutions and of the financial sector as a whole. Before I bid farewell to this event, I would like to take this opportunity to express my sincere gratitude to all of the participants, speakers, and organizers for their contributions. Food for thought Over the last three days, we have delved deep into the world of data science, exploring its applications, challenges, and the transformative potential it holds for central banking. We have learned about cutting-edge techniques in data analysis, machine learning (ML), and artificial intelligence (AI) that can be applied to monetary policy, risk management, financial stability, and many other areas that are crucial to central banks’ mandates. Data Science is revolutionizing the banking industry. The presentations of these past few days testify to the special and now important role of data science in crafting central banking operations. The Bank of Italy is committed to being at the forefront of data science innovation in the central banking community. We are constantly seeking better ways to collect and harness new forms of data in order to improve our policy decisions and operational efficiency. In recent years, we have started our journey through Data Science by establishing a multidisciplinary team to consider the benefits and hidden risks of tackling the technological challenges of artificial intelligence and machine learning fuelled by the advances in big data, which continue to evolve at incredible speed. In our competitive world, we are always in search of innovation. The Bank of Italy has shown a knack for technological innovation, realizing its potential for growth and success. In 2021, as a great way to inspire our employees and promote creativity, collaboration, and out-of-the-box thinking, the Bank of Italy sponsored a hackathon, a worldwide competition on applying big data, natural language processing and artificial intelligence techniques to green and sustainable finance, that was jointly organized with the BIS Innovation Hub of Singapore under the Italian G20 Presidency. In 2020, we created Milano Hub, a technological hub supporting the development of innovation and the digital transformation of the Italian financial system. After the great success of the first two calls for proposals, we will launch a third one in the next months In the last few years, we have redesigned our recruitment and hiring process by seeking out new skillsets such as Big Data, Machine Learning and Artificial Intelligence. This is just the beginning. We need to rethink our processes and foster the adoption and development of the right skills. To achieve these goals, we have sponsored special data science training programmes in some Italian universities. The new cohort of hires have already started their journey, which aims to create a flatter organizational structure. In 2020, the total amount of data created, captured, copied, and consumed globally was around 100 zettabytes (an astounding value of 1023 bytes), and it is expected to rapidly increase, reaching 180 zettabytes in 2025.1 The mind-boggling amount of data that is now available to us, provided we are able to analyse it effectively, can give us a better picture of the economy at both the micro and the macro level. The Bank of Italy has constantly striven to be at the cutting edge in developing software and hardware platforms, enabling big data analytics2 for statistical and economic applications. One of the most significant takeaways from this workshop is recognizing that data is not just a resource: it is essential for effective decision-making in central banking. The quality, quantity, and timeliness of data can make all the difference in crafting policies that safeguard our economies and maintain financial stability. By harnessing the power of data science, central banks can enhance their capabilities, anticipate trends, and respond swiftly to emerging challenges. Data taken from https://www.statista.com/statistics/871513/worldwide-data-created/ on September 25 2023. See, for example, ‘Big data processing: Is there a framework suitable for economists and statisticians?’, 2017 IEEE International Conference on Big Data (Big Data), 2017, pp. 2804-2811, doi: 10.1109/ BigData.2017.8258247. ‘Weaving Enterprise Knowledge Graphs: The Case of Company Ownership Graphs. Risks and Precautions in applying Data Science methodology Extreme care is required when employing these new tools. Over the course of the workshop, a number of findings have been highlighted. The ethical dilemmas that institutions and practitioners must wrestle with in order to protect individuals from the consequences of blindly adopting AI-based solutions are numerous and definitely profound. Let me quickly mention some of them. First of all, data science relies on massive amounts of information that leverage large quantities of third-party data, and complex algorithms to generate answers. These methodologies are often opaque and unreliable, an issue that we must address in our work. We should always strive to pick and adopt solutions with sound and accurate explainability. Moreover, the kind of big data we employ typically entails selection bias because of the peculiar characteristics of the population; increasing the number of observations does not reduce the sampling error unless corrected for. Data should be used in a fair and unbiased way, avoiding discrimination or harm to individuals or groups. Second, safety and security: data and systems should be secure to protect against unauthorized access, misuse or abuse. Human oversight is also essential in the development and use of data and new technologies. Third, the availability of much more detailed personal data increases the importance of its integrity, confidentiality and privacy. Providing the right is central to preserving the democratic values of our societies. Furthermore, individuals should exercise full sovereignty over their own data and be able to give or deny consent to their collection and use. This has prompted the development of regulations concerning the treatment of digital data (think of the level of data protection granted under the GDPR in the EU or the CCPA in California). A few years ago, the Bank of Italy started using advanced data security tools to process individual wage data for analysing the gender gap (see ‘Women, labour markets and economic growth’ by F. Carta, M. De Philippis, L. Rizzica and E. Viviano, Banca d’Italia, 2023), a topic recently recognized by the awarding of the 2023 Noble Prize in Economics to Prof. Claudia Goldin ‘for having advanced our understanding of women’s labour market outcomes’. Technologies for processing personal data privately are already available, such as differential privacy, developed in 2006 by Microsoft researchers3, or fully Homomorphic Encryption, in 2009, which has been touted as a possible solution for processing individual data.4 The Bank of Italy has begun experimenting with these technologies. See 'Calibrating noise to sensitivity in private data analysis’, Cynthia Dwork Frank McSherry, Kobbi Nissim, 2006. See ‘A Fully Homomorphic Encryption Scheme’, Craig Gentry, 2009. It is important to note that there is no one-size-fits-all approach to data ethics. The specific ethical considerations will vary depending on the type of data being collected and used, the purpose for which it is being used, and the potential impact on individuals and society. Looking Ahead As we are nearing the conclusion of this workshop, let us bear in mind that our journey with data science in central banking has just begun. The knowledge and skills we have acquired here are tools that we can wield to drive innovation and excellence in our institutions. It is our responsibility to apply what we’ve learned, adapt to the everevolving landscape of technology and data, and lead the way in shaping the future of central banking. I encourage all of you to stay connected, collaborate, and continue the dialogue beyond this workshop. The relationships we have built here can be the foundation for future partnerships and collaborations that will drive progress in our field. The Bank of Italy is firmly committed to carrying out further research on these issues and cooperating with other institutions to strengthen methodologies and applications. Finally, let us not forget the significance of our work. Central banking plays a key role in the stability and prosperity of our countries. Data science can help us navigate the complex waters of modern finance. Together, we can steer our institutions toward greater resilience, transparency, and effectiveness. We have had the privilege of learning from distinguished experts and practitioners in the field, who have shared their knowledge, experiences, and insights. These interactions have enriched our perspectives and deepened our understanding of the intricate relationship between data science and central banking. I would like to extend my heartfelt gratitude to all the speakers, instructors, and organizers who have made this workshop a resounding success. Thank you all for your dedication, your commitment, and your thirst for knowledge. It has been an honour and a privilege for me to be a part of this workshop with you. I wish you all continued success in your endeavours, and may the insights gained here guide us toward a brighter future in our profession.
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Opening address by Mr Ignazio Visco, Governor of the Bank of Italy, at the "SSM Regulation, ten years since" conference, organised by the Bank of Italy in cooperation with the University of Rome "Roma Tre" and the Paolo Ferro-Luzzi "Grandangolo" Research Centre, Rome, 20 October 2023.
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Ignazio Visco: Legal foundations of the Single Supervisory Mechanism - a retrospective look at future challenges Opening address by Mr Ignazio Visco, Governor of the Bank of Italy, at the "SSM Regulation, ten years since" conference, organised by the Bank of Italy in cooperation with the University of Rome "Roma Tre" and the Paolo Ferro-Luzzi "Grandangolo" Research Centre, Rome, 20 October 2023. *** On June 29, 2012, the Heads of State and Government of the euro-area countries issued a statement announcing that the Commission would present a proposal on the basis of Article 127(6) of the Treaty on the Functioning of the European Union (TFEU) for a single supervisory mechanism. This was meant to be a forceful response to the severe stress experienced by the banking sector in the wake of the Global Financial Crisis and the harsh consequences of the sovereign debt crisis that had hit some of the euro-area economies. Just over a year later, that statement was followed by the adoption of the Single Supervisory Mechanism (SSM) Regulation on October 15, 2013. At that juncture, given the urgency, it was decided not to amend the Treaties, but to leverage on the enabling clause of the above mentioned Article 127(6) TFEU, which in any case prescribes a complex and burdensome legislative process, to entrust the European Central Bank (ECB) with extensive and direct micro-prudential supervisory powers over the most important ('significant') banks of the euro area, while at the same time also granting the ECB substantial powers to guide and coordinate the prudential supervision of smaller ('less significant') credit institutions that remained at national level. The Regulation – whose tenth anniversary we are celebrating today – represented a pioneering experiment in the field of EU administrative law, marking a major advance in the EU integration process. While it involved a substantial transfer of national sovereignty to the ECB, the SSM was conceived as a network with no legal autonomous personality, with a Union Institution at its centre – indeed, the ECB – vested for this purpose with considerable direct and intrusive administrative powers visà-vis third parties. The national competent authorities (NCAs) were required to assist the ECB 'in the preparation and implementation' of the acts necessary to perform the supervisory tasks. This included the assessment, on an ongoing basis, of banks' situations, and on-site inspections. The basic principles of a Banking Union were then drawn up over a very short period, especially so if compared with the time that it took to define the framework and the rules at the basis, within the Economic and Monetary Union, of a common monetary policy and a common currency, the euro. Furthermore, and also because of this, the SSM can only operate on the basis of a set of multiple (and at times complex) legal schemes. Ten years ago, the first priority was deemed to be aligning the supervisory practices within the euro area, through a significant but not complete centralisation of administrative powers. At that time, further accelerating the process for harmonising 1/5 BIS - Central bankers' speeches substantive banking law, which had already been under way for years, was not being considered: this is also because, contrary to what the Treaty (Article 140 TFEU) envisages for access to the single currency, primary Union law does not make participation in the single banking supervision conditional on legal convergence. Thus, the time pressure has certainly imposed some trade-offs. I will just recall three of them. The first concerns the decision to concentrate the key administrative powers of microprudential supervision on the ECB, despite the lack of a fully harmonised substantive banking law. The application of different national laws by the ECB and the need to ensure the equality of treatment among the supervised entities has led to a rather peculiar outcome: that of a Union Institution required to apply the national law of each of the (now 20) EU member states belonging to the euro area when implementing the SSM. Accordingly, the SSM's administrative decisions must be adopted on the basis of many different domestic legal frameworks, without at the same time jeopardising the obligation to interpret them in accordance with EU law, given the goal of ensuring equality of treatment for the credit institutions concerned. At the same time, the ECB has the power to issue opinions on draft legislation, including national legislation, in the field of banking supervision. While this is only an advisory role, given that it is also aimed at ensuring harmonised rules, it is certainly significant. The second issue concerns the division of powers between the ECB and the NCAs. A 'political compromise' between the Commission's initial proposal and the significantly divergent stances voiced by the delegations of some Member States was only reached at the end of a complex negotiation. This is reflected in some uncertainty, if not ambiguity, in the SSM Regulation with regard to the exact allocation of powers between the ECB and the NCAs in the matters covered by the Regulation itself. The reason for this essentially lies in the fact that the original text of the Regulation proposed by the Commission envisaged the exclusive competence of the ECB over all the banks in the euro area. Furthermore, the specification of very delicate aspects relating to the allocation of powers, such as day-by-day supervision, had been assigned by the Founding Regulation (i.e. the SSM Regulation)to the NCAs as a task concerning all banks, including the significant ones, whereas under the Framework Regulation (a 'second-level' regulation) it is assigned to the Joint Supervisory Teams chaired by the ECB. Thirdly, the ordinary decision-making process within the SSM has been influenced by the constraints imposed by the Treaties and by the Statute of the ESCB and of the ECB, with the additional complexity coming from the separation between monetary policy and micro-prudential supervision. The set-up of the Supervisory Board as a nondecision-making body that approves complete proposals for supervisory measures and submits them – through a non-objection procedure – to the Governing Council, entitled to raise objections especially on monetary policy issues, is the break-even point. Despite several legal challenges, the SSM has been in many ways a historical achievement. Not least as evidence of the hard balance reached, the text of the SSM 2/5 BIS - Central bankers' speeches Regulation was not deemed as requiring any amendment at the outcome of the two periodic reviews concluded by the Commission on the SSM in 2017 and 2023, pursuant to Article 32 of the same Regulation. There is no doubt that greater uniformity and effectiveness of prudential supervision has been achieved with regard to all the jurisdictions participating in the SSM. The room for arbitrage within the euro area, fuelled by asymmetrical supervisory approaches, has since been considerably reduced. Moreover, the SSM has acted as a catalyst for a significant banking restructuring process, directed at enhancing soundness and capitalisation. The importance of resilient banks for the euro area became evident during the COVID-19 pandemic as well as in the context of the Russian aggression against Ukraine, but it has also been confirmed very recently in connection with the banking crises that occurred in the United States and in the Switzerland. The SSM has certainly benefited from the advantages of a single jurisdiction over all ECB acts and measures: that of the Court of Justice of the European Union. The Bank of Italy is fully aware of the growing role of the case law of the Court in the process of building the Banking Union: so much so that we have set up a periodical publication, in our Legal Research Series (Quaderni di ricerca giuridica), devoted specifically to reporting and providing comments on these judicial developments. The Court of Justice – with its rulings – has first and foremost supported the view of the SSM as a centralised EU mechanism, in which the ECB is acknowledged as the holder of supervisory powers over all the banks in the SSM (regardless of their significant or less-significant classification). Meanwhile, the Court has also affirmed its exclusive jurisdiction over the 'endo-procedural' or 'preparatory' acts adopted by the NCAs, within the perimeter of the common procedures envisaged by the SSM Regulation. It is important that the EU Judge has also provided guidance on the application of national law by the ECB, by making it clear that the ECB – when required to apply national law in transposing directives – must first look to the interpretation provided by the domestic courts. This brings me back to the beginning of these brief opening remarks. The urgency with which the SSM was established has led, inter alia, to the exercising of supervisory powers on all credit institutions that operate in the euro area, in compliance with prudential banking rules that were and continue to be only partially uniform at EU level. This asymmetry is clearly still a source of imbalance. Ten years after the enactment of the founding regulation of the SSM, it is now high time to work towards a much more advanced degree of harmonisation of those rules. From this point of view, it would certainly be desirable to launch a systematic and comprehensive assessment at EU level of the extent to which the current dispersive banking rule directives can be merged into a single comprehensive piece of legislation. It is time to think about a single EU Banking Code, which not only sets out the Pillar 1capital requirements (as is already the case by virtue of the CRR), but also standardises the organisational and governance requirements for credit institutions, with a view to the wide range of activities that banks are authorised to conduct. In addition, the enforcement mechanisms need to be coordinated with the SSM Regulation as much as possible. 3/5 BIS - Central bankers' speeches The significant discrepancies that persist among the various SSM jurisdictions, in the areas of commercial law, corporate law, labour law and administrative law should not be an ideological barrier to such an exercise. The regulation of the qualitative prudential standards to be applied vis-à-vis credit institutions could disregard the corporate models provided under each single jurisdiction, and focus instead on a functional approach. One area, perhaps a minor but not a negligible one, that apparently continues to elude a fully harmonised approach is that of administrative sanctions, as national legislators still retain wide margins of discretion with reference to those who should be sanctioned and, above all, under what conditions. The CRD6 proposal, still under negotiation, seeks to define in a more precise and exhaustive manner the list of infringements that Member States should be obliged to consider when applying sanctions. However, it is still a minimal list, naturally subject to gold plating. Likewise, the precise combination of sanctions against supervised entities on the one hand, and sanctions against their managers, on the other hand, would also seem to remain a matter of domestic law. In the last few years, the European Court of Human Rights as well as the Court of Justice have had a fruitful dialogue with the national judges and drawn up a dense case law on the fundamental procedural principles to be applied to administrative sanctions ('right to be silent', 'ne bis in idem', and so on). We believe that these rulings could form the basis for a fully uniform EU law on sanctions vis-à-vis credit institutions and their management. Again with a view to a level playing field in the sensitive area of enforcement, there should also be some thought on the possibility of harmonising – here at a minimum level, considering the conditions imposed by Article 83(2) TFEU – a very delicate area that is still closely governed by national laws: namely that of the criminal law rules intended to safeguard the exercise of banking supervisory tasks and the general interests underpinning them, within the constitutional framework of the Member States. A mature system such as the SSM should be backed and secured by a hard set of criminal law rules, with their basic features enshrined at EU level. Indeed, any obstruction to the supervisory functions exercised by the ECB or by one of the 20 NCAs ought to be subject to homogeneous criminal sanctioning treatments across the whole SSM area. This would also be true if we refer to an unauthorised exercise of banking activity: with the European dimension of banking supervision, the transnational dimension of such offences does seem to exist per se. My focus today has been on the genesis of the SSM and on possible leverages to remedy some internal weaknesses within the mechanism. The SSM cannot still be deemed a self-contained system, but rather a part – albeit the key one – of that Banking Union which, ten years after the founding regulation of the SSM, has still not been fully completed, especially on the front of crisis management and depositors' protection. It goes without saying that no banking supervision mechanism – no matter how efficient – can extinguish the risk of banking crises, especially when considering the unending transitions to which the advanced banking sectors are subject in the digital era, as the recent collapse of some US regional banks shows. Following the further postponement of the European Deposit Insurance Scheme announced by the Euro group at its meeting of 16 June 2022, the Commission – on the basis of the outcomes of that same meeting – presented a proposal last April for a revision of the Crisis Management and Deposit Insurance framework. 4/5 BIS - Central bankers' speeches On the one hand, the proposal – which takes into account many of the suggestions we voiced in recent years – definitely includes some positive elements that could ease the crisis management for small and medium-sized banks, especially insofar as it enhances the potential for Deposit Guarantee Schemes to intervene to support a transfer of assets and liabilities, both in liquidation or in resolution, and to ensure an orderly exit from the market of failing banks. On the other hand, some critical issues remain: the enlargement of the scope for resolution should be guided by the principle of proportionality, requiring an assessment of the bank's actual capacity to issue Minimum Requirements and Eligible Liabilities, which in the Commission's proposal remains the main source of funding for resolution, and the lack of financial stability exemption for addressing systemic crises, such as the one adopted to solve the recent banking crises in the United States. This is not the time to enter into the details of this very technical debate, but – in my view – it is not possible to outline the perspectives of the SSM without considering the frontiers of crisis management. I leave these thoughts to the eminent panellists of today's conference, which is intended to be an occasion to celebrate a decade in which legal challenges have mostly been successfully overcome, but also to openly discuss the many steps that still await the future generations of colleagues working for and within the EU banking supervision. 5/5 BIS - Central bankers' speeches
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Speech by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the "SSM Regulation, ten years since" conference, organised by the Bank of Italy in cooperation with the University of Rome "Roma Tre" and the Paolo Ferro-Luzzi "Grandangolo" Research Centre, Rome, 20 October 2023.
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Alessandra Perrazzelli: The visionary project of a Single Supervisory Mechanism - where do we stand after 10 years? Speech by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the "SSM Regulation, ten years since" conference, organised by the Bank of Italy in cooperation with the University of Rome "Roma Tre" and the Paolo Ferro-Luzzi "Grandangolo" Research Centre, Rome, 20 October 2023. *** It is a distinct honour to celebrate a remarkable milestone in the European financial landscape – the first ten years of the SSM Regulation. This occasion represents a significant chapter in our financial history, and it is with great pride and enthusiasm that we come together to reflect on the journey, acknowledge our achievements, and chart the course for the future. From its very inception, the Single Supervisory Mechanism was a visionary initiative that forever changed the paradigm of financial supervision in Europe. The path to establishing the SSM was far from simple, as it marked a profound shift from highly fragmented national banking supervision systems, charged with safeguarding their domestic financial institutions, to a unified European approach with a broader perspective. Over the past decade, we experienced a remarkable evolution in our approach, with the goal of crafting a truly European spirit. In fact, the fragmentation of supervisory powers was not fully adequate when it came to addressing cross-border financial challenges and crises. As we have witnessed in recent years, these challenges can take various forms, such as the COVID-19 pandemic, the Russia-Ukraine conflict or the impact of rising interest rates. Had we still been left to address these challenges separately, we would have likely found our financial system less resilient and less able to adapt to rapidly changing circumstances. Today, I would like to focus on the main achievements and challenges that lie ahead in the field of banking supervision. Achievements... First and foremost, the supervisory framework has undergone a profound maturation process. One key point worth highlighting is that the European supervisory framework has emerged as a synthesis of the best national practices. The creation of the SSM allowed us to establish a new standard in supervisory activities, creating a comprehensive framework that ensures fairness, transparency, and accountability. Fairness, as a guiding principle, guarantees that all supervised entities are on a level playing field; this has been achieved by leveraging a powerful benchmarking approach, meaning that each institution is subject to the same rigorous standards thereby preventing any undue advantages or disadvantages. Moreover, the SSM places a strong emphasis on transparency and accountability. It is essential that both the market and the entities under supervision have a clear view of 1/4 BIS - Central bankers' speeches our policy stances and of our supervisory process and its results. This is not only a good practice for financial authorities, it is the backbone of mutual trust and confidence. The SSM has integrated our voices and efforts, in the pursuit of the 'one team spirit', enabling us to leverage different supervisory cultures and diverse operational experiences under a unified SSM methodology. Thus, the SSM has capitalized on the histories of the national supervisory authorities, guided by a shared European vision. However, as we reflect on our accomplishments, we must not rest on our laurels. The global financial landscape is continually evolving, and our European framework must evolve with it. As we chart our path forward, there are specific aspects that warrant our continuous attention and effort. First, there are the differences in national regulatory regimes: while the SSM has made significant strides in harmonizing supervisory practices across Europe, we must remain committed to working on the progressive reduction of disparities between national regulatory regimes in several areas. By the same token, we are still awaiting the completion of the third pillar, the European Deposit Insurance Scheme (EDIS). The puzzle is not yet complete, but we remain confident that we will ultimately get there. Second, the sense of belonging to a single system for our resources: this is an issue that has been at the forefront of discussions, particularly with the initiation of the SSM Integration project. ...and challenges ahead While we take pride in our achievements, it is equally important that we address the challenges and potential vulnerabilities affecting the financial industry, calling for changes in our supervisory approach. One of the critical areas of concern pertains to the SSM's primary focus on supervising banking groups, which constitute just one facet of the broader financial landscape. However, non-bank financial intermediation, encompassing entities such as financial intermediaries, asset management firms, investment funds and payment service providers, has seen significant growth over the past decade and is strongly interconnected with the banking system. While this evolution is a positive development in terms of fostering financial integration and bolstering economic growth, it also introduces heightened risks to the financial system. Increasing competition and potential spill-over effects cannot be disregarded from a supervisory point of view. Another significant challenge is that non-bank financial intermediation, in particular the most innovative ones, often fall outside the traditional regulatory perimeter. This regulatory gap can create a blind spot for supervisors, as non-bank financial entities may engage in activities that could pose systemic risks without adequate oversight. It is vital that we strike a balance between regulating non-bank entities to mitigate risks and allowing them to innovate and provide essential financial services. In this regard, the rise of FinTech companies adds another layer of complexity to this interconnected landscape. FinTech firms often collaborate with banks to offer innovative financial services. Their rapid growth and evolution present regulatory challenges, as 2/4 BIS - Central bankers' speeches they can bridge the gap between traditional banking and non-bank financial intermediation, transforming traditional risks into new or different ones, that are harder to grasp. Therefore, recognizing and addressing these interconnections and the related risks is crucial. However, we cannot wait for the regulatory framework to address this issue. While we recognize the importance of a thorough legislative process in crafting robust and lasting rules, banking supervision often requires proactive measures to stay ahead of evolving market dynamics, as we are presently witnessing. Thus, as we await the establishment of a clearly defined regulatory framework, as supervisors, we are compelled to address the challenge of ensuring thorough and efficient supervision across these interrelated sectors. This responsibility becomes even more critical as we gear up for the implementation of the MiCAR and DORA regulations, which will introduce new dynamics in the financial landscape. The SSM is then tasked with fostering collaboration and information-sharing with other relevant authorities, to ensure a coordinated response and consistent oversight across the financial spectrum. This process will entail adaptability, proactive issue identification and resource allocation to address priorities. It will be crucial to follow the risks wherever they may arise. This will indeed pose a significant challenge for the SSM and the Supervisory Board. In this context, continuing the dialogue with the market will be crucial. The Bank of Italy initiated this process some years ago, developing three integrated channels of dialogue with the market: Milano Hub, the Regulatory Sandbox and the Fintech Channel. It is clear that as we celebrate the first ten years of the SSM Regulation, we stand at a crossroads. In a continuous learning-by-doing process, we are still open to discussing further improvements in our supervisory review and evaluation process, as the last Strategic Retreat meeting held in Rome demonstrated. It is therefore essential that we adapt to these changes, anticipate new challenges while supporting financial innovation, addressing the grey areas of the regulatory/supervisory framework. What's next? The outer reach of AI Currently, banks and supervisors are in the midst of a digital transformation process, a significant shift that has brought about not only heightened traditional risks but also the emergence of entirely new challenges. Amid this ongoing transformation, one topic has particularly captured the spotlight in the realm of innovative tools, and that is Artificial Intelligence. European regulators are actively engaging with the advent of AI, recognizing its far-reaching implications across numerous sectors, including supervised entities and authorities. In particular, the use of technology and artificial intelligence for banks and supervisors is already a strategic issue. Banks could make use of AI in several ways to improve 3/4 BIS - Central bankers' speeches efficiency, such as in credit scoring models, fraud detection, risk management or predictive customer behaviour. As well, AI also has potential application in the realm of banking supervision. AI could help supervisors in assessing banks' compliance with regulatory requirements by analysing vast amounts of data and helping build early warning systems for identifying emerging threats or vulnerabilities. It is imperative that we strategically enhance our competencies, approaches and tools to stay aligned with the rapid evolution of technology and AI. Nevertheless, banks and supervisory bodies must not disregard the ethical considerations posed by AI adoption. AI models have the potential to produce biased decisions and result in discriminatory bank lending. Furthermore, given that banks and supervisors deal with sensitive data, it is imperative that the use of AI aligns with stringent data privacy regulations to mitigate the risk of misuse in the event of data breaches. In conclusion, the advent of artificial intelligence offers substantial opportunities and an expanded toolkit for banks, provided they can effectively manage associated risks. As we embrace the potential of AI, we must be vigilant in our approach to risk management. These new horizons, while promising, also introduce complexities that demand our close attention. We need to safeguard against the appeal of automation and ensure that the role of human expertise remains central in our decision-making processes. We must remember that, no matter how sophisticated and powerful the technology becomes, the ultimate responsibility for decisions cannot be transferred to automated processes. AI can complement and assist, but it cannot replace the judgment and experience of supervisory authorities and a good banker. Conclusions We must be proud of what we have achieved with the SSM. It was indeed a very ambitious undertaking, but we have achieved, in a relatively short span of time, many significant milestones through a common effort aimed at integrating diverse supervisory traditions and incorporating the best national practices into a unified SSM approach. At the same time, we should acknowledge that there is still a long road ahead. Three concepts must remain our guiding stars: a rigorous approach, cooperation and openness to innovation. 4/4 BIS - Central bankers' speeches
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Address by Mr Ignazio Visco, Governor of the Bank of Italy, at the 99th World Savings Day, organised by the Association of Italian Foundations and Savings Banks (ACRI), Rome, 31 October 2023.
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ACRI Association of Italian Savings Banks 2023 World Savings Day Address by the Governor of the Bank of Italy Ignazio Visco Rome, 31 October 2023 Saving, and its natural counterpart, investment, are key factors in a country’s balanced development. At individual level, saving makes it possible to transfer resources over time, ‘putting income aside’ to meet future needs, such as purchasing a house, children’s education and joining a pension fund, to be less vulnerable when times are hard and to look ahead with confidence. The acquisition of adequate financial skills is a form of investment in human capital that can increase the well-being of and the opportunities for people; it is all the more important in light of the large and rapid changes in financial innovation over the last 30 years, as well as the increasing digitalization of the markets. At the same time, it is the first necessary line of defence for savers who are increasingly required to make complex choices and sometimes to deal with high-risk products. The Bank of Italy is aware of the importance of financial literacy and has invested a great deal of resources in order to foster and disseminate it. I have often spoken about this, including in the recent past. Savings are also, however, and perhaps above all a public good that can generate benefits for the community as a whole through the transfer of resources ‘in space’ from households to entrepreneurs and businesses. If they are used well, they make a crucial contribution to a country’s economic growth by financing productive investment in physical, human and technological capital. This creates the economic even more than the legal basis for its protection by the public sector. This protection requires, first and foremost, adequate regulation and supervision of the financial system as a whole, since it plays a key role in bringing together the generation and use of savings and in transferring funds from one place to another and from today to tomorrow, ensuring that they reach those who should receive them by removing liquidity constraints. Nevertheless, the protection of savings goes beyond regulation. Efforts must be made to establish economic and financial conditions such that resources can be used as efficiently as possible, thereby contributing to both the economic development of the country and to the well-being of individual savers. Protecting savings aims to increase the capital accumulated by fuelling a virtuous circle in which the subsequent strengthening of economic activity leads to higher employment and income that in turn makes further savings possible, as well as greater consumption. The economic cycle and monetary policy In the current economic climate, the trend in the household saving rate reflects opposing pressures. On the one hand, it is curbed, via an income effect, by low growth affected by the waning of the post-pandemic recovery in the services sector, the legacies of the energy shock, and the monetary tightening in the main advanced economies. Moreover, the substantial resources set aside during the pandemic allow a larger share of current income to be used for consumption purposes, especially at a time when purchasing power is being affected by high inflation. On the other hand, households’ propensity to save is now tending to rise again as a precautionary response to uncertainty and to the downside risks for growth. It is also stimulated by the gradual increase in real interest rates that, if there are no liquidity constraints, reinforces what economists call the substitution effect. Macroeconomic risks are, however, increasingly affected by geopolitical tensions, exacerbated by the ongoing dramatic events in the Middle East, together with the protracted and tragic conflict in Ukraine. There are also concerns about the evolution and effects of the real estate crisis in China, the risk that inflation will remain high for longer than currently expected, and the greater frequency of extreme weather events, which could lead to further energy and food crises. We are clearly talking about uncertainty and about risks that, since they are ‘external’ to individual euro-area countries and to the European Union in general, cannot be countered by domestic-scale measures, but instead require wide-ranging, shared and coordinated action. Economic policies in the euro area and at national level aim as far as possible to mitigate their potential repercussions on demand and on production activity and to ensure that inflation returns to the target levels fairly quickly. A crucial contribution, though necessarily spread over time, to achieving higher, more balanced and longer-lasting growth rates, as well as to keeping inflation low, has to come from the timely implementation of thorough reforms and decisive structural measures, made even more pressing today by the challenges relating to climate change, the digital transition and demographic change. In the euro area, the economic situation is clearly not satisfactory. The available information suggests that economic growth in the summer months was practically zero. Activity is slack in manufacturing and is weakening in services. The European Commission’s surveys point to a deterioration in consumer confidence, with regard to the short-term outlook for both economic activity and their own financial situation. The labour market continues to hold firm, but the first signs of a slowdown in employment are emerging. Price growth, which to a large extent still reflects external supply factors, is falling sharply. In September, consumer price inflation fell to 4.3 per cent, which is less than half of the peak observed one year ago (10.6 per cent). The recent and more moderate decline in the core component net of food and energy products, which fell to 4.5 per cent in September, confirms that inflationary pressures are gradually subsiding. While wage growth is robust and uneven across countries, it remains in line overall with expectations for the euro area as a whole. These are positive signals, although inflation is still at high levels and changes in all the factors driving inflation need to be carefully monitored. At the same time, the tightening of financing conditions is continuing. Faced with the gradual increase in the cost of loans, which has responded more quickly and more strongly than in the past to monetary tightening, the growth in both loans to firms and loans to households for house purchase was practically zero in the euro area and negative in Italy in September. Moreover, there has recently been a sharp rise in medium- and long-term real interest rates, mainly reflecting an increase in the term premium, coming from the United States in particular. The causes of this rise are still uncertain, but if this external effect is long-lasting, it will contribute to further limiting aggregate demand. With all of this in mind, last Thursday, the ECB Governing Council decided to keep its key interest rates unchanged, having brought them into restrictive territory, with an increase of 4.5 percentage points since July 2022. The ongoing fall in inflation is in line with expectations; concerns about wage-price spirals and a deanchoring of inflation expectations have diminished markedly, as have the possible effects of an increase in demand in excess of the euro area’s production capacity. At the same time, given the lags in the transmission of monetary policy measures, a further reduction in demand can be expected in the coming months, with production remaining subdued and a continuation of the downward trend in inflation. I believe that the Council’s inclination to keep the reference rates at their present levels for a sufficiently long period – i.e. regulating the persistence of our action rather than its intensity – is a wise decision. If there are no new significant shocks on the supply side, this approach strikes the right balance between the risk of doing too much and the risk of not doing enough, at the same time reducing the possible repercussions on the already weak economic activity and the risks to financial stability. In any case, prudence will certainly be required in the coming months, after such a sharp and rapid increase in the key interest rates. The intensity of these interventions can certainly be debated, also given the time it usually takes before their effects are felt in full. Yet there are some who believe that this intensity is due to a possible delay in monetary policy’s countering of inflationary factors already in place since the early months of 2021 when, including and above all thanks to the start of the vaccination campaign, the profound fears associated with the outbreak of the pandemic had already dissipated. Specifically, it is suggested that it was the errors in predicting inflation growth, which were not confined to central bank level, that caused this delay, and that if monetary policy action had been brought forward, the excessive increase in prices over the last two years and the sharp deceleration in economic activity recorded this year would both have been limited. This is not the place to hold this debate, especially given our role; however, I have already said that, up until autumn 2021 and unlike elsewhere, the conditions in the euro area were not suitable for announcing a normalization of monetary conditions, although they were seen as being broadly accommodative. Inflation was still struggling to make a stable return to the 2 per cent target over the medium term, and most of the subsequent forecasting errors were not due to demand factors but to the exceptional growth in energy prices, which was exacerbated by the dramatic events in Ukraine. In light of these observations, I believe that the Council’s reaction to the acceleration in prices, though unprecedently intense, has been in line with the gradual evolution of the situation and that, given a supply shock of this size, it rightly intended to counter the propagation of inflation through successive adjustments of prices, wages and inflation expectations. From this point of view, monetary policy is certainly bearing fruit. The great uncertainty over global economic and geopolitical conditions and the risk of further negative impulses on the terms of trade side have led to confirmation of the intention to pay particular attention to incoming information as it becomes available, but this does not mean that a path has not yet been laid out. The reduction of inflation within the established time frame must be guaranteed; however, at the same time, we must avoid excessive restrictions on money and credit that could generate inappropriate recessionary effects, thereby also helping to fuel uncertainty over the economy and price stability. These two conditions are also crucial for making decisions and for the scope for saving. Savings and finance in Italy Italy’s GDP continued to stagnate in the summer as well. Our surveys and qualitative indicators still signal widespread weakness in manufacturing; despite the good performance of the tourism sector, the strong recovery registered in services after the most acute phase of the pandemic appears to have come to an end. While bearing in mind that in the current challenging environment, point estimates are merely indicative, according to the baseline scenario presented in the Bank of Italy’s Economic Bulletin published in mid-October, GDP is set to grow by 0.7 per cent this year, 0.8 per cent in 2024 and 1.0 per cent in 2025. The risks surrounding these estimates, as well as the estimates for the global economy and the other main euro-area countries, are skewed to the downside, especially because of heightened geopolitical tensions and tighter financing conditions. GDP growth, inflation and rising interest rates are in turn affecting Italian households’ propensity to save, yet the recent developments in savings should be looked at from a broader perspective. Since the mid-1990s, when it exceeded 20 per cent, the ratio of households’ savings to disposable income, which had been historically high by international standards, has decreased considerably, coming down to 10 per cent in 2019, which is below the euro-area average (Figure 1). This decline reflects long-lasting trends, including demographic dynamics and the development of the financial sector, which have increased households’ ability to borrow and to redistribute lifetime consumption, as well as the protracted period of low interest rates, which has made loans less expensive. In 2020, with the dramatic spread of the COVID-19 pandemic and the ensuing social distancing measures both in Italy and internationally, household savings increased exceptionally, by well over 20 per cent in the second quarter of that year. Although the drop in production was broadly mitigated by the household support measures introduced by the Government, consumption expenditure fell sharply. While consumption activity bounced back thanks to the economic recovery, in 2021 households also continued to set aside more resources than they would have done had there not been a public health emergency: after peaking in spring 2022, according to the Bank of Italy’s estimates, total savings accumulated still accounted for 2 per cent of households’ total net financial assets in mid-2023. Since the second half of 2021, as energy costs progressively rose and then soared with Russia’s invasion of Ukraine, inflation started to chip away at households’ purchasing power and at the real value of their savings. Although households still hold substantial excess savings, their financial wealth in real terms is currently slightly below pre-pandemic levels, in line with what has been observed in the euro area on average (Figure 2). Over the same time span, the propensity to save gradually fell again, to below pre-pandemic levels as early as the second half of 2022 and down to 8.5 per cent in the first six months of 2023 on average. Furthermore, with regard to the private sector as a whole, the savings available to the national economy (i.e. including the undistributed profits of non-financial corporations), albeit declining in a long-term perspective, still account for 20 per cent of disposable income (Figure 3). The current composition of households’ financial wealth, which today amounts to around €5,300 billion (four times the disposable income), continues overall to reflect the prolonged period of very accommodative financing conditions, which came to a halt last year. The share of asset management products in total financial assets has been increasing, partly in connection with the broader range of products offered by financial intermediaries, standing at 30 per cent last June. The gap with respect to the euro-area average (around 35 per cent) essentially reflects the underdevelopment of the pension funds sector. Financial wealth is flanked, with a similar amount, by real estate wealth, which has returned to growth following the prolonged weakness under way since the early 2010s. In an environment of high inflation and rising rates, households have recently moved away from sight deposits, which grew substantially in the post-pandemic period, towards more profitable financial instruments. Specifically, in the first half of this year, net purchases of public debt securities exceeded €70 billion, which is very high by historical standards. The share of these securities held directly by households in their total financial assets reached 4.2 per cent, the highest since 2014; that of deposits stood at 26.0 per cent, the lowest since 2008 (Figure 4). If we also consider the public debt securities held indirectly by households through investment funds, their share is estimated to rise to approximately 7 per cent, more than 16 per cent of total outstanding public debt securities. The reallocation of savings has been influenced by the very limited pass-through of the increases in key interest rates to the return on sight deposits, in Italy as in the other euro-area countries. In August, the return on the current accounts held by households, which at the beginning of the monetary policy normalization process was virtually nil in all the main euro-area countries, was 0.3 per cent (against 0.5 per cent in Germany and 0.1 per cent in France and Spain). Conversely, the passthrough to time deposit rates was substantial, mirroring the increase in key interest rates and going from levels close to zero to 3.4 per cent (compared with 3.1 per cent in Germany, 3.6 per cent in France and 2.3 per cent in Spain). In comparison with the return on time deposits or bonds, the very low rates on current accounts reflect, at least in part, their greater liquidity and consequently the fact that they are generally used for transactions rather than as a way to invest savings. Greater returns could be obtained by allocating part of the funds available in the current accounts to deposits with an agreed maturity, which are covered by the same guarantee as the current accounts. Around 60 per cent of households’ financial assets in Italy are invested directly in instruments issued or managed by banks and other financial intermediaries. The soundness and integrity of financial intermediaries therefore help to protect savings while keeping public confidence in the financial system high, without which the stability of the system cannot be ensured. Prudential supervision and regulation are designed to make sure that the risks taken by financial intermediaries are adequately monitored, irrespective of the type of intermediary that has to address and manage them. Similar risks must be matched by similar safeguards, without underestimating the interconnections between the different segments of the system. This is why we sometimes apply stricter requirements than in other jurisdictions, availing of the discretion recognized by EU legislation. Specifically, Italian legislation requires mutual funds that invest more than one fifth of their managed assets in illiquid instruments (such as real estate) to be closed-end; furthermore, financial corporations that provide credit are subject to the same prudential requirements as banks, in order to avoid episodes of contagion. To keep the secondary market for non-performing loans efficient – a key element in the overall stability of the system – we have stepped up our supervision of servicers responsible for the recovery of securitized loans. The stability of the financial system also relies on supervisory authorities scrutinizing the sustainability of the business models of financial intermediaries, their efficiency and the quality of their ownership structures. These tasks have been supplemented in recent years by targeted in-depth analyses aimed at enabling operators to better cope with the cyclical and structural challenges that lie ahead. In the short term, the risks to the financial sector mainly stem from the economic slowdown and the rapidly growing returns on assets, which expose banks to higher credit, interest rate and liquidity risks. Though they should not be underestimated, these risks can still be addressed, given that the starting conditions are satisfactory on the whole. Last June, the CET1 ratio reached 15.6 per cent, the highest level since this capital requirement was introduced. The quality of bank loans, which was perceived as one of the main vulnerabilities of our system for much of the last decade, remains good for now. The flows of new non-performing loans are broadly stable at historically low levels (1.1 per cent), as is their ratio to total loans (1.4 per cent, net of loss provisions). Although liquidity indicators have declined as a result of the repayment of funds borrowed through targeted longer-term refinancing operations, they remain well above the minimum reserve requirements. Central bank-eligible assets are widely available. Finally, in the first half of this year the return on equity stood at exceptionally high levels, partly on account of loan loss provisions still being low. However, future developments in credit quality should continue to be closely monitored, as this is expected to deteriorate towards the end of 2023 according to our projections, which are consistent with the latest macroeconomic scenarios, although the ratio of the stock of non-performing loans to total loans is expected to remain much lower than in the past. Liquidity conditions will also continue to require close monitoring by banks, as the pass-through of monetary policy impulses to yields on bank liabilities remains partial and a considerable amount of the funds borrowed through the targeted longer-term refinancing operations will mature by mid-2024. Banks will therefore have to update their funding plans very frequently, based on the changing market conditions, and to monitor their interest rate risk exposure, while keeping a balanced maturity structure of assets and liabilities. Open-end investment funds also show sound conditions overall and have weathered the rise in yields on financial assets smoothly. In the first six months of the year, net funding was slightly positive; the main indicators of vulnerability to liquidity risk remained low, as did those relating to leverage. Specifically, the systemic importance of alternative investment funds, whose recourse to debt is considerably greater than that of traditional funds, is limited although they have doubled their assets under management over the last decade. In the longer term, savings decisions over the coming years will need to factor in the major structural changes under way. As I have pointed out on many occasions, the digitalization of the economy and finance brings opportunities and risks for both intermediaries and savers. On the one hand, new technologies could reduce the costs of financial intermediation, simplify access to financial services and expand the potential customer base. On the other hand, they increase vulnerability to cyber-attacks, with the consequent risk of sensitive data exposure; they make malfunctions more likely, which may lead to disruptions in the provision of services; and they may result in the improper and discriminatory use of information provided by customers to financial intermediaries. The Bank of Italy’s action on this front is twofold. Efforts to spur financial intermediaries to use new technologies are accompanied by risk management measures. In particular, we are stepping up our action to encourage financial intermediaries to improve their protection against cyber-attacks, to mitigate the risks arising from the outsourcing of some functions to a limited number of operators, and to carefully assess any unwanted consequences of the uptake of artificial intelligence. Finally, informed savings choices may play a key role in achieving the climate transition objectives by helping to reduce carbon emissions. Some signs pointing in this direction come from the growth in open-end mutual funds investing in instruments aimed at financing socially and environmentally sustainable business activities, whose assets under management in Italy have reached almost €500 billion. However, there is a need for reliable data on the carbon footprint of the financed business activities and on the transition plans of non-financial corporations, which must be disclosed properly to the public to boost savers’ confidence in the real usefulness of these instruments, thus increasing their contribution to a greener economy. This brings me to another risk that needs to be addressed: greenwashing. This requires a detailed and shared definition of global and European standards, which we are focusing on and working towards. Public debt As I mentioned earlier, Italian households entrust a not insignificant share of their wealth to the State by buying public debt securities. Like any good debtor, a sovereign issuer also has a duty to make good use of this money and to return it as and when agreed. However, unlike private borrowers, a Government must not only repay its loans. The protection and efficient use of consumer savings require economic policies that ensure balanced financial conditions, smooth out cyclical fluctuations in the economy and improve its growth potential. For highly indebted countries, reducing the debt-to-GDP ratio is a priority: excessive debt relative to growth potential reduces the scope for countercyclical policies, exposes the economy to market stress and raises costs for the government, and ultimately for households and firms. In 2022, the debt-to-GDP ratio in Italy was 141.7 per cent, the highest in the European Union after Greece, although we cannot overlook the significant reduction following a sharp increase during the pandemic: almost 15 of the more than 20 points of increase recorded in 2020 – over half of which due to the mechanical effect of the denominator – will have been absorbed by the end of 2023. However, the Government only expects a marginal decline over the next three years, with debt projected to amount to just under 140 per cent of GDP in 2026. Subsequently, if no action is taken, the ratio risks increasing. Looking ahead, the average cost of debt is set to return to higher levels than the economy’s nominal growth rate and the impact of population ageing on social spending will become more significant. In the 20 years preceding the pandemic, the gap between the average cost of debt and the growth rate was constantly unfavourable, averaging almost two percentage points. The deep recession that hit Italy in 2020 led to it reaching a value close to ten points. On the other hand, the subsequent two years saw exceptionally favourable values for this indicator, as a result of the post-pandemic recovery and, in part, of the strong growth in the GDP deflator: nominal GDP growth was on average more than five percentage points higher than the average cost of debt per year. According to the Update to the Economic and Financial Document published at the end of September, the differential is expected to remain favourable in the current year and in the following two years. However, due to the combined effect of a normalization in the growth rate and the gradual pass-through of higher interest rates, it is expected to narrow over time and to become unfavourable again in 2026, albeit by very little. In the years to come, as the Government acknowledges, further efforts will have to be made both on the fiscal policy front and in terms of measures to raise the economy’s growth potential. Achieving and maintaining adequate primary surpluses is necessary, but fiscal consolidation should not, as it did in the past, undermine the quality of public spending and its ability to support growth. Spending cuts require decisions to be made based on well-defined priorities, with a multi-annual revision of procedures, actions and specific spending programmes. At the same time, revenue increases, which must be credible and are needed to avoid deficit spending, can be phased out as the economy gradually returns to faster growth. The available resources must be directed primarily towards those investments that could not be made by the private sector because of their excessively long time horizon, high risk and inability to absorb their social or environmental impact. This kind of investment, including in human capital, tends to pay off in the long run and ultimately has no adverse impact on the sustainability of public finances. John Maynard Keynes is still quoted, perhaps more than in previous decades, and rightly so, to point out the multiplication effects of deficit spending. Nevertheless, two fundamental aspects are neglected. The first one concerns shortterm conditions. According to Keynes, public resources should be used to smooth out the effects of cyclical fluctuations in the economy in the event of insufficient and unresponsive private demand. In this context, I often recall the words of Lawrence Klein, a Keynesian economist who made the greatest contribution to the use of econometric models for analysing economic fluctuations and stabilization policies: ‘there is nothing in the Keynesian prescriptions to support highly unbalanced policies or excessive reliance on monetary policy to provide economic stabilization’. The second one has a longer-term perspective, whereby, in Keynes’ words, ‘the important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse, but to do those things which at present are not done at all’. The spread between Italian and German ten-year government bond yields has recently widened again, to around 200 basis points, following a marked narrowing last spring. Moreover, it remains notably higher than in other similar European countries, including Spain and Portugal. The higher spread undoubtedly also reflects global, non-country specific factors: monetary policy has raised key interest rates quickly and significantly, and the international geopolitical balances have been disrupted by the conflict in Ukraine and tensions in the Middle East. However, the impact of heightened uncertainty on government bond yields has been greater in Italy than in the other euro-area countries, probably because investors are concerned about Italy’s growth potential and perceive that, for this reason too, the Government budget is still unbalanced. Conclusions With regard to these concerns, we should start by pointing out that the Italian economy has sound fundamentals overall. The availability of private sector savings is high and private debt is low by international standards. Household debt amounts to about 60 per cent of disposable income (40 per cent of GDP), compared with an average of more than 90 per cent in the euro area; corporate debt stands at around 65 per cent of GDP, compared with an average of 100 per cent for the eurozone. Although lagging behind and inefficient in some respects, our production system is vibrant and able to compete on global markets; this is confirmed by Italy’s net international investment position, which turned positive as early as the second half of 2020 and now stands at around 5 per cent of GDP. Rapidly reducing the deficit, while preserving – as I pointed out earlier – the quality of spending, would reinforce the long-term sustainability of our public debt. This is the key contribution that fiscal policy can and must make to protecting Italian households’ savings, and not only those directly invested in government bonds, but the main challenge for Italy is still to make reforms and investments that can lift its growth potential. The problems of our economy are due to structural weaknesses neglected for too long and which cannot be offset by monetary stabilization or fiscal expansion policies. To ensure sustained higher growth, it is essential to remove any obstacles to development, to foster innovation and knowledge, to help firms expand and to modernize our production system. There is ample room for improvement: the employment rates for women and young people are well below the European averages; competition is insufficient in some service sectors; the quality of public services is poor, and low overall, and the effectiveness of public administration is extremely uneven across the country; structural delays in development persist in some areas. Signalling a firm commitment to closing these gaps (including through a good use of European funds) would help to boost investor confidence; this would reduce the yields on public debt. Implementing the projects contained in the National Recovery and Resilience Plan (NRRP) and the reforms that are part of it, which focus on these delays and on jump-starting the green and digital transition of our economy, offer an unprecedented opportunity. Simple, targeted amendments to the NRRP to make it more effective remain possible, though it is essential to proceed with no undue delays. The potential of reforms and the availability of large and innovative investments in Italy’s tangible and intangible infrastructure go beyond their direct effect on aggregate demand; they must and they can provide long-lasting stimulus for private investment by Italian and foreign companies, which is necessary to boost Italy’s potential for economic development. Above all, we must avoid repeating the mistakes we made in the past when our production system was unprepared for the major changes brought about by globalization and the technological revolution. For this reason, investing is essential, not only to close past gaps, but also to be ready to seize the opportunities of the coming climate and digital ‘revolutions’. This is the only way to return to a stable and sustainable growth path with rising employment levels and productivity returning to a sustainable path of stable and balanced growth, which can raise employment levels and push productivity up again. This will also help increase wages and ensure proper work protection, especially for the younger generations, which, incidentally, is the main way to protect savings. In the long run, the return on savings necessarily depends on the medium to long-term economic outlook. The Government is not solely responsible for achieving this goal, as it is a collective effort. However, economic policy must set out the general framework, provide incentives and remove any brakes on production, and improve and maintain the quality of public infrastructure with adequate investment. In their turn, firms and households, assisted by reliable financial intermediaries, must be ready to invest in order to grasp the opportunities offered by the market and new technologies. This is in our common interest and we should all be aware of this; everyone should contribute to this change by looking to acquire new and stronger skills. Achieving sustainable economic and social development, protecting the environment and creating jobs all depend on this undertaking. It is necessary to create the conditions for both domestic and foreign savings to find suitable private investment outlets in Italy; similarly, public sector resources, including those made available through the EU, must be used to lay solid foundations for returning to a stable path of strong growth. To quote Voltaire’s Candide, we must ‘cultivate our garden’ (‘il faut cultiver notre jardin’). However, in the current global environment, in a world that is certainly not ‘the best of all possible worlds’, this is unlikely to be enough. It is hard to understand today all the potential consequences of geopolitical tensions, which show no signs of fading. For some time now, the international balances have been the subject of much needed reflection in the wake of the serious and successive shocks to the world economy over the last fifteen years, as well as of the gradual demographic, economic and political changes in both advanced and emerging countries. The pandemic, the war in Ukraine, and now the dramatic events in the Middle East, risk diverting the course of this rethinking and leading us towards a world increasingly divided into blocs, with fewer movements not only of goods, services and financial capital, but also of technologies and ideas. This is a serious threat, not only because an open world is a tremendous driver of economic growth and for fighting poverty, but also because the major challenges we face cannot be overcome unless there is a growing commitment on the part of all the major political, economic and financial players at global level. It is therefore right to keep our house in order, so as to create the conditions for our economy to make a long-lasting return to higher, balanced rates of growth. However, it is now crucial to contribute, at all levels, to safeguarding international cooperation in any way that is realistically possible, to maintain the multilateral system of trade by reducing its flaws, and to work to share the values and founding principles of peaceful cohabitation between nations as widely as possible. This effort must be made first and foremost in Europe, where we are one of the founding members of the Union. Today, we must do our part to complete its institutional architecture and improve its governance. It is not only a question of making a political or technical contribution in one direction or the other; it is about increasing mutual trust and working together for a truly better world. A stronger and more united Europe, in which we share the responsibility for progress, is the best insurance against the significant geopolitical changes under way, which is an essential precondition for successfully meeting the challenges facing us. Ultimately, the protection of savings, which we are celebrating here today, their effective use in economic activities and the crucial role they play in sustainable and fair development, all rest on this vision and on our commitment to do what we need to do in our country. FIGURES Figure 1 Households’ propensity to save (as a percentage of disposable income) Italy France Germany Spain Euro area Source: Eurostat. Note: Total household saving includes that of consumer and producer households and of non-profit institutions serving households. Figure 2 Households’ net financial assets in real terms (Q4 2019=100) Italy France Germany Spain Euro area Source: Eurostat. Note: Net financial assets in real terms are estimated by deflating nominal financial assets using the household consumption deflator. Figure 3 Private sector saving in Italy (as a percentage of gross national disposable income) Households Private sector Source: Istat. Note: Total household saving includes that of consumer and producer households and of non-profit institutions serving households. The private sector includes households and non-financial corporations. Figure 4 Composition of Italian households’ financial asset portfolios (as a percentage of total financial assets) Deposits and cash Investment funds Other assets Italian government securities Shares and other equity Source: Istat, Financial Accounts. Note: year-end stocks; end-June for 2023. Other debt securities Insurance companies
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Remarks by Mr Paolo Angelini, Deputy Governor of the Bank of Italy, at the event "Promoting Accountability in Times of Crisis", Tenth Annual Meeting of the Working group on financial and economic stability of the The International Organization of Supreme Audit Institutions (INTOSAI), hosted by the Corte dei Conti, Rome, 8 November 2023.
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The banking crises of 2023: some initial reflections Paolo Angelini Deputy Governor of Banca d’Italia remarks at the event “Promoting Accountability in Times of Crisis”, Tenth Annual Meeting of the Working group on financial and economic stability of the The International Organization of Supreme Audit Institutions (INTOSAI), hosted by the Corte dei Conti Rome, 8 November 2023 I am happy to be here at such distinguished event to share some thoughts about the banking crises of last Spring. Such events triggered reflections in the international fora about possible improvements of the current supervisory and regulatory framework on banks and of the existing resolution tools. This is the topic of my remarks today. 1. The recent banking crises In less than two months – from 8 March to 1 May 2023 – four mid-sized US banks (Silicon Valley Bank, Silvergate Bank, Signature Bank, First Republic Bank) and a globally significant Swiss one (Credit Suisse) were shut down, put into receivership, rescued or closed. The event, involving banks with overall total asset exceeding $1,100 billion, was the most significant system-wide banking stress in terms of scale and scope since the Great Financial Crisis. It sent shockwaves throughout the global financial system. In the two weeks following 8 March asset prices worldwide fell, quite sharply for banks’ equities, and the cost of insuring against bank default surged. Wide-scale public support measures were deployed by the US and Swiss authorities to manage the crises and mitigate the impact of the stress, including significant central bank liquidity provision to banks, the activation of FX swap lines, government backstops and guarantees, an extension of deposit guarantee schemes; in the case of Credit Swiss a complete write-off of Additional Tier 1 (AT1) instruments was also effected, a decision which has sparked a lively debate about the legitimacy of the decision as well as on the loss absorption capacity of this class of instruments. Thanks to the effective management by the US and Swiss authorities, the crisis was brought under control. The US S&P 500 and the Eurostoxx 500 indexes in Europe recovered their pre-crisis levels in a few weeks (fig. 1). The impact on the bank component of the indexes has been more intense: in Europe the latter has gradually caught up with the market index, in the US it is still well below. A strong and long-lasting effect was recorded by Figure 1 US and EU stock market indexes (indexes: 8 March 2023=100) Source: Bloomberg. (1) Vertical bars mark the critical dates in the crises of SVB, CS and FRB (in the order, Silicon Valley Bank, Credit Suisse, First Republic Bank). the US regional banks index, which still trades about 40 percent below pre-crisis levels, signalling that problems may still linger.1 As is often the case, it is not possible to trace the crises to few well-identified causes. In the US cases an important role was played by unbalanced business models and inadequate management, rapid growth in assets and deposits, loan and funding concentration, overreliance on uninsured deposits, large unrealized losses on securities held at amortized cost. Also, the fact that the failed banks, like all mid-sized banks in the US, had been partially or fully exempted from Basel requirements likely played an important role.2 The crisis of Credit Suisse had different causes, as it followed a number of difficulties that had emerged over several years. While each bank and each crisis had different characteristics and history, some common elements emerge. First, the proximate common cause of the crises was a rapid loss of confidence by clients and markets, triggered by pre-existing vulnerabilities that in some cases had been known for months or years. While several such vulnerabilities were idiosyncratic, some others were common. In particular, the reports issued by the US and Swiss authorities point out that in all cases the governance and the risk management were inadequate, the business models were unbalanced and the liquidity supervision was not effective. Second, in all cases banks were eventually taken down by large liquidity outflows. An element that sets these crises apart from previous ones was the speed of withdrawals Just last weekend Citizens Bank, another small US regional bank, was closed; the Federal Deposit Insurance Corporation was appointed Receiver and entered into a Purchase and Assumption Agreement with Iowa Trust & Savings Bank. As a consequence of this exemption, the failed banks were subject to less frequent stress tests, were allowed not to reflect in their regulatory capital the unrealised losses on securities booked as “available for sale”, and did not need to compute and respect liquidity ratios. by depositors: while relatively heterogeneous across banks, it was on average very high. Three possible causes of this phenomenon have been considered: changes in technology that enabled faster withdrawals, social media that facilitated information dissemination and coordination among depositors, and uninsured deposits that were concentrated among bank customers with connections to each other.3 Third, authorities resorted to exceptional measures, derogating from the ordinary bank crisis management rules. The US framework envisions the so-called Systemic Risk Exception, which can be triggered when a specific set of conditions are met.4 In the case of SVB, collateral rules were temporarily loosened to accept bonds at par value. Also thanks to ad hoc legislation rapidly approved, the Swiss authorities enforced a dilution of the bank’s shareholders and a write-off of all the AT1 bonds, provided ample liquidity facilities and a second-loss government guarantee to the benefit of the intervening bank (UBS). Remarkably, in both countries authorities decided to extend deposit protection. Especially the decision by the US authorities to adopt unlimited deposit coverage for two of the three banks involved, although on an ad hoc and temporary basis, has reopened a discussion on the optimal level of coverage. Fourth, authorities implemented swift crisis management actions.5 While this is typically the case with bank crises, the speed with which events unfolded in the recent episodes probably represented a particularly stark test. Finally, the shockwave created by the failed banks propagated worldwide, negatively affecting equity prices of firms and intermediaries with no – or very limited – direct links (i.e. bilateral exposures) with these banks. This confirms that dangers for global financial stability can arise not only from very large and highly interconnected banks, but also from the shockwave created even by relatively small intermediaries. The propagation channel is the loss of confidence and the fall in risk appetite of market operators and investors due to news that are perceived to be bad enough. This “contagion by analogy” has nothing to do with direct or indirect relationships between intermediaries, nor with the other factors typically considered when judging the systemic nature of an intermediary.6 See J. Rose, Understanding the Speed and Size of Bank Runs in Historical Comparison, Federal Reserve Bank of St. Louis Economic Synopses n.12, 2023. Rose argues that while technological improvements can explain some of the increase in speed in the recent US cases, they likely had an important effect only for household and small business depositors. Major corporations, which were the predominant source of deposit withdrawals in prior run episodes, could withdraw funds in an automated electronic manner since the late 1970s. On the role of social media see A. Cookson et al., Social media as bank run catalyst, mimeo, 2023. See Congressional Research Center Focus, Bank Failures: The FDIC’s Systemic Risk Exception, April 11, 2023. On the 10th of March the California Department of Financial Protection and Innovation “closed” SVB by appointing the FDIC as liquidator. On the same date, the FDIC announced the transfer of protected deposits (up to $250,000) to a newco (Deposit Insurance National Bank of Santa Clara); the access to protected deposits was guaranteed from Monday 13th March. For Credit Suisse, only a few days passed between the liquidity support of 50 billion granted by the Swiss National Bank (16 March) and the acquisition by UBS (19 March). See L.F. Signorini, Remarks at the Giornata del credito (in Italian), October 2023. These events have been thoroughly described and analysed in a number of reports by standard setters and public authorities.7 The Basel Committee and the Financial Stability Board have started work to draw lessons in the prudential and resolution fields. In what follows I shall largely draw from these documents. 2. On the limits of supervisory action Before moving to the lessons learned and the further reflections, let me sketch some personal considerations on the work of the supervisor. Following a banking crisis, the knee-jerk reaction by observers, even by experts in the field, is to blame supervision. Indeed, supervisors have a central role in ensuring banks’ resilience; their action can occasionally have shortcomings, and in the cases at hand this was indeed openly admitted by the supervisors involved. However, a few considerations are in order. First of all, in virtually every jurisdiction banks are profit maximizing entities that, like any other, respond to their board and senior management, who in turn are accountable to their shareholders. The law says that the responsibility for banks’ soundness primarily lies with these subjects. Indeed, regulation requires banks to have a robust corporate governance as well as internal risk management and controls capable of ensuring informed and prudent risk taking.8 True enough, it is the supervisor’s task to ensure that these desirable features are in place. However, in practice supervisory agencies may face various constraints, including resource constraints.9 With the benefit of hindsight it is easy to see that more attention should have been paid to a certain intermediary, but doing so ex ante may not be so easy. Supervisors adopt a risk-based approach to apportion resources to the various tasks and intermediaries (i.e., they increase resources where they see higher risks), but the exercise is a probabilistic one, which can be defied by reality. Some problems can be detected too late, or not at all. Second, even when the problem is detected at an early stage, it can be difficult for the supervisor to adopt successful remedial actions if the bank is not responsive. Typically, See Federal Deposit Insurance Corporation, FDIC’s supervision of Signature Bank, 28 April 2023; FDIC’s supervision of First Republic Bank, 8 September 2023; Board of Governors of the Federal Reserve System, Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank, 28 April 2023; Government Accountability Office, Bank Regulation: Preliminary Review of Agency Actions Related to March 2023 Bank Failures (GAO-23-106736), 28 April 2023; Basel Committee on Bank Supervision, Report on the 2023 banking turmoil, October 2023; Report of the Expert Group on Banking Stability, The need for reform after the demise of Credit Suisse, 1 September 2023; Swiss National Bank, Financial Stability Report, 2023; P. Hernandez De Cos, Reflections on the 2023 banking turmoil, 14 September 2023. This includes but is not limited to: the composition of the board and the extent to which its members have relevant experience, including banking and financial expertise; the board’s ability to effectively challenge the bank’s management, oversee the bank’s risk profile and steer its strategy; the independence and empowerment of the risk management and internal audit functions; adequate safeguards to identify and eventually mitigate possible conflicts of interest, the enterprise-wide risk culture, including how embedded it is in corporate and business processes; and the incentives provided by senior management compensation schemes. See Board of Governors of the Federal Reserve System, cit.; Report of the Expert Group on Banking Stability, cit. supervisors adopt more and more intrusive measures in a proportionate fashion, gradually increasing pressure as the situation deteriorates. In principle, stark decisions should be taken well before a bank breaches regulatory requirements and reaches the point of non-viability. In its Report on the recent crises, the Government Accountability Office argues that US regulators had been recommended years before to add noncapital triggers to their framework for prompt corrective action, but failed to do so, thus missing a potential opportunity to take early action to address deteriorating conditions at banks. Somewhat similar views are contained in the Report of the Expert Group on Banking Stability for the Credit Swiss case. However, successfully implementing truly pre-emptive measures can be difficult, for at least two reasons. To begin with, if intrusive action is taken too early and based on “unofficial” triggers, the supervisor may be accused of lacking a legal basis for intervention, and therefore be subject to legal challenge. While legal frameworks and practices on this front may differ across jurisdictions, in my experience this happens quite frequently: considering the 40 extraordinary administrative procedures (a typical early intervention measure) of financial intermediaries enforced by the Bank of Italy in the last ten years, in 26 cases our decision was challenged in court by administrators or shareholders; the legal claim was rejected in nearly all cases.10 For a crisis management strategy based on strong early intervention measures to be viable, the supervisor must be able to successfully uphold them in court. But for this to be possible, the legal assumptions on which such interventions are based must be clearly enshrined in the legislation. And indeed, supervisors’ technical discretion needs to be exerted consistently with those legal assumptions. Furthermore, once a bank’s situation begins to deteriorate, it is difficult to engineer a turnaround if the key stakeholders (the shareholders and the management) are not actively cooperating in the effort. A supervisory decision to replace the board can face several obstacles: talented new management may be very hard to attract to a faltering bank; in case the turnaround is unsuccessful the supervisor can be accused of having caused the crisis. In such cases, the authorities may be forced to rely on less robust tools to incentivise banks to address risks, which may prove less effective. The speed of deposit withdrawals and the “confidence effect” that characterized the recent crisis episodes further strengthen the need for the supervisor to act carefully. Summing up, I am not arguing that supervisors should be acquitted without an inquiry. They have their responsibilities, need to be accountable and must constantly search for the optimal point along the trade-off between effectiveness of early intervention and the risk of overstepping their mandate. However, I believe that any balanced ex post assessment of a crisis episode should take the above considerations into account. 3. Lessons learnt for intermediaries, regulators and supervisory authorities The Basel Committee report already identifies several preliminary takeaways for supervisors, including: the importance of supervisors analysing banks’ business models One decision, concerning a bank, was declared void by the Italian Council of State due to procedural matters concerning the powers of the Finance Minister (at the time responsible for the final decision). and assessing a bank’s governance and risk management in light of the crucial role exercised by its governance and risk management bodies; the oversight of liquidity risk; the treatment of interest rate risk in the banking book; the importance of exercising supervisory judgment and reviewing the existing supervisory toolkit; the introduction of a common definition of “internationally active banks”, which would be important to define those that should be fully subjected to Basel Committee’s standards. In what follows I shall focus on the supervisory and regulatory aspects of liquidity risk and on the interest rate risk in the banking book (so-called IRRBB), referring those interested in a broader analysis to the Basel Committee report. In the light of the features of the recent crises, I believe that my choice to discuss liquidity does not need a motivation. On the other hand, the IRRBB is typically a subject for bank analysts. It measures the possible impact of rate variations (under specific hypothetical scenarios) on assets and liabilities in the banking book. In the SVB case, the risk (on the asset leg) measured under the hypothetical scenario of the IRRBB framework began to materialise in 2022 due to the sudden and strong increase in interest rates, since assets were financed mainly by short duration deposits; as a consequence, the market value of long-duration securities declined and unrealised losses materially increased.11 This phenomenon played a key role in the confidence crisis that led to the demise of the bank. It is important also because it has affected to some extent many intermediaries worldwide; not only banks, but also insurance companies, pension funds, etc. Regarding the regulation of liquidity risk, the recent banking crises confirms that prudential requirements, i.e. the so-called Liquidity coverage ratio (LCR) and the Net stable funding ratio (NSFR), would have been able to detect – at least partially – the weaknesses in the liquidity profile of the US regional banks, had the latter been subjected to them.12 At the same time, some areas of the existing regulation, defined after the Great Financial Crisis, may deserve a fresh look in the light of the recent events. Specifically, the calibration of deposit run-off rates embedded in the LCR and NSFR might need to be adjusted to reflect the increased speed of deposit withdrawals. In addition, one could legitimately ask whether deposit concentration (which proved to be a key determinant of massive outflows in the SVB case) should play a role in the formulation of the ratios. Also, the US cases question whether the current regulatory framework is able to capture the risk of excessive maturity mismatch (i.e. that the duration of banks’ funding sources is not properly matched to that of their assets). The NSFR was designed with this risk in mind, but does not cover the entire maturity structure. Specifically, it pools instruments with maturity of one year or more, hence it is unable to differentiate between These securities, based on SVB’s accounting choices, were to be valued at amortised cost, meaning that the bank did not need to record unrealised losses in the balance sheet or in the profit and loss statement (unless it had been forced to sell them). Recall that the failed US banks were not subjected to the Basel standards. Board of Governors of the Federal Reserve System, cit., states that in December 2022 SVB would have reported a breach of the LCR requirement, but not for the NSFR. Similar results are in two posts by G. Feldberg, Lessons from Applying the Liquidity Coverage Ratio to Silicon Valley Bank, Yale School of Management, March 2023, and Silicon Valley Bank’s Liquidity, Part Two: What About the Net Stable Funding Ratio?, April 2023. assets and liabilities with a 18 months (say) maturity vs those with a 10 years maturity, or even longer. Moving to the supervisory aspects, it is worth recalling that the Basel framework requires supervisors to adopt liquidity risk monitoring tools and early warning indicators which should allow them to adopt corrective measures where needed. Indeed, supervisors do collect detailed data on liquidity risks, evaluate the soundness of banks’ liquidity management and can impose additional requirement within the so-called Pillar 2 framework in case they detect shortcomings.13 However, apparently there is little or no harmonization across authorities in the liquidity indicators and, more importantly, in the methodologies to integrate them in the supervisory process. While Pillar 2 add-ons are routinely imposed in the capital framework, add-ons on LCR and NSFR are enforced only occasionally. The cases of SVB and Credit Suisse also show the importance of banks being ready to post collateral to obtain emergency liquidity assistance from the central bank.14 In the Eurozone, the in-house credit assessment systems allow several euro area national central banks to accept loans to non-financial corporations as collateral to grant banks access to refinancing. For the case in which banks do not have sufficient collateral, Switzerland is currently working on legislation to make the state-backed liquidity backstop permanent, after it was introduced as an emergency measure to mitigate the banking crisis. Overall, these areas seem to be promising ones for further work and for higher harmonization, leveraging on best practices where possible. Finally, let me mention that in a world where deposits can take flight in a matter of hours, some sand in the gears might be necessary. This might take the form of a remuneration structure that increases the premium for illiquidity, and therefore penalizes sight deposits.15 Or, fees could be imposed on material withdrawals. The mutual funds industry has been a laboratory for measures of this class. Remuneration of liabilities is an issue that might be worth investigating, by the industry as well as by authorities. Let me come to the IRRBB. The Basel rules cover this issue within the so-called Pillar 2 framework. Also due to this reason, cross-jurisdictional comparison about the standard The Single Supervisory Mechanism (SSM) conducts regular monitoring of liquidity positions of individual banks on a weekly or even daily or intra-daily basis, depending on circumstances. The Banca d’Italia has been routinely monitoring the liquidity position of Italian banks since 2008 on a weekly basis. We are currently refining intraday indicators relying on data from large value payment systems, which are available in real time and can intercept dynamics that cannot be identified from the regular supervisory reporting (cfr. E. Rainone, Identifying deposits' outflows in real-time, Banca d’Italia, Temi di Discussione n. 1319, 2021). Also, liquidity stress test exercises are conducted both on significant and less significant banks. See BCBS, Report on the 2023 banking turmoil, cit., p. 7; Report of the Expert Group on Banking Stability, cit., p. 49. Even if there are no rules explicitly addressing this aspect in the liquidity prudential requirements, the remuneration profile of deposits is to some extent taken into account in the calibration of run-off rates in the LCR. In fact, term deposits with a residual maturity beyond the time horizon of the LCR can be excluded from the calculation of total outflows only if early withdrawal results in a significant penalty for the depositor (i.e. a penalty materially greater that the loss of interest). Where this condition is not verified the deposit must be treated as a sight deposit for LCR purposes. is not easy. The available evidence suggests that its application is not homogeneous.16 In the SVB case, the IRRBB indicators gave some early-warning signals, not heeded by the management: the bank had breached its internal (net) interest rate risk limits on various occasions since 2017, because of a structural mismatch between long-duration securities (especially hit, in terms of unrealised losses, in case of rate increase) and short-duration deposits, without managing the actual risk.17 It remains to be ascertained what the recent events suggest for the IRRBB issue (more intrusive supervision, an enhanced set of tools and indicators, a change in the IRRBB rulebook, greater harmonization). It is worth recalling that the issue of whether to adopt a Pillar 1 approach for the IRRBB was discussed and discarded by the Basel Committee in 2015, after a consultation with the industry.18 Before reopening the debate it would be important to verify how the existing standards are implemented in the various jurisdictions. The supervisory measures of interest rate exposures depend on the time series properties of assets and liabilities. Among the latter, non-maturing items such as sight deposits are especially relevant. While, in principle, sight deposits should be treated as having zero duration, the IRRBB rules allow banks to treat them as if they had a positive duration, and to estimate the latter based on historical data.19 In addition, setting internal limits on maturity transformation might help in preventing the side effect of abrupt interest rate changes as in the SVB case.20 Similar considerations as those made for the calibration of the liquidity ratios apply: the fast deposit outflows observed in the recent banking crises requires a reflection on these methods. Banks should reassess the reliability of historical estimates, exploring to what extent the current environment may have changed customers’ behaviour, adopting discretionary overrides when necessary. Supervisors should be particularly aware of this issue and challenge the soundness of banks’ assumptions and estimates, making use of top down measures when deemed appropriate in order to promptly detect weaknesses and ask for remedial measures. 4. Lessons for crisis management in the EU The recent events have sparked a debate on the adequacy of the regulatory framework for bank crisis management and on the choices made by the US and Swiss authorities. The latter proved to be effective, but they raised questions on the credibility of the resolution For the SSM IRRBB exposures are among the most important inputs of the calibration of the Pillar 2 requirements, which in turn is strongly enforced; the EBA is currently updating and reinforcing the framework. Board of Governors of the Federal Reserve System, cit. Basel Committee on Banking Supervision, Standards. Interest rate risk in the banking book, April 2016. Based on the Basel framework, banks should distinguish between the stable and the non-stable parts of each non-maturing deposit category using observed volume changes over the past 10 years. The stable portion is the one that remains undrawn with a high degree of likelihood. On maturity transformation limits, see P. Bologna, Banks’ maturity transformation: risk, reward, and policy, Banca d’Italia, Temi di Discussione (Working Papers) no. 1159, December 2017. framework. The Financial Stability Board also started work on the facts.21 I shall sketch some reflections for the EU crisis management system. In Europe, the adoption of the Banking Recovery and Resolution Directive (BRRD) and the creation of the Single Resolution Mechanism (SRM) established the basic structure for a harmonized banking crisis management system.22 The reform proposal recently published by the European Commission introduces several improvements in the framework. First, it contains amendments that can facilitate the crisis management of small and medium-sized banks, which has turned out to be a weakness of the system. The possibility for DGS to carry out interventions aiming at preventing the intermediary default, and interventions different from pay out for depositors (so-called preventive and alternative interventions, in the order) paves the way to greater use of business transfer strategies, both in liquidation and in resolution.23 Alternative interventions are also facilitated via the removal of the preferential treatment accorded to deposits that are protected in the insolvency hierarchy (the so-called super-priority), replaced by a uniform treatment of all deposits (the so-called general depositor preference single tier). In principle, this removal increases the cost borne by the DGS in case of depositors’ payout, but in so doing it creates an extra incentive for the DGS to adopt alternative interventions, which typically minimize the cost of banking crises for all the stakeholders involved, arguably including the DGS itself. An increase in the current level of protection would obtain a similar effect. Whereas this measure is not considered in the draft reform, the Bank of Italy has long advocated it. The current protection level of up to 100,000 euros was established in Europe over a decade ago, and does not take into account the decline in deposit coverage in the Eurozone in recent years,24 or the increased speed of deposit withdrawals experienced in the last crisis episodes. In the USA the threshold is set at 250,000 dollars; in Japan unlimited coverage is provided for payment accounts, under specific conditions. Financial Stability Board, 2023 Bank Failures: Preliminary lessons learnt for resolution, 10 October 2023. The SRM, in close cooperation with the SSM, has done strong work on resolution planning, building a relevant buffer of “bail-in-able” liabilities. In 2023 the Single Resolution Fund will reach 1 percent of covered deposits (around €77 billion); together with national deposit guarantee schemes this provides the Banking Union with an overall amount of privately-funded resources. With the ratification of the public backstop to the resolution fund, additional €60 billion will contribute to enhancing ex-ante confidence in the framework. Alternative interventions by the DGS are a key feature of the bank crisis management system in other jurisdictions, e.g. in the US. They allow to avoid piecemeal liquidations, that is the dissolution of the banking company and the gradual distribution of the company’s assets sales revenue to creditors, that represents the worst crisis management option due to its negative impact on public confidence in the banking system, on creditors’ proceeds and on credit relationships. The DGS’ preventive and alternative interventions are subject to the constraint of the least cost criterion, i.e. they must entail a cost for the DGS that is lower than the pay-out of deposits. Compliance with this principle is hindered by the high ranking given to protected deposits in the bankruptcy hierarchy, which makes the pay-out option relatively convenient. A trend that is observed worldwide. See IADI, IADI_Policy_Brief_9.pdf Global trends in deposit insurance coverage ratio, Policy Brief No. 9, October 2023. The upturn in inflation, limited numbers of deposit insurers that have increased nominal coverage levels in the past years, and fast-growing retail deposits during the COVID-19 pandemic may contribute to explaining this decline in coverage ratios. The Commission’s reform proposal still contains weaknesses.25 Leaving aside the conspicuous absence of a European deposit insurance scheme, I would argue that the most important one is the lack of a financial stability exemption to overcome the rigidities of the framework in case exceptional circumstances threaten the EU’s financial stability. As I said above, the US authorities activated such exemption in the recent crises; the Japanese law also provides for extraordinary measures in exceptional cases, assessed by the Prime Minister.26 While the Swiss regulation does not envision a systemic risk exemption, to manage the Credit Swiss crisis the government quickly adopted new legislation with a similar objective. This, in spite of the Swiss Authorities’ own assessment that resolution had been planned for months and would, in principle, have been possible.27 In the light of these events, the absence of some form of escape clause in the new draft EU legislation appears questionable. The strong opposition to the use of public resources, confirmed by the new proposal, represent an additional element of rigidity in this respect.28 A second weakness of the European crisis management framework brought to the fore by recent events is arguably its institutional complexity, which can make it slow. The problem, widely debated when the BRRD was drafted, is likely magnified by the increased speed of the crises. The Commission’s proposal does little to address it. While this problem is partly unavoidable, as it is a reflection of the complexity of the institutional features of the EU,29 some simplifications might be possible in particular for the use of the Single resolution fund, avoiding the involvement of the EU Council and enhancing instead the role of the European Commission. A still unresolved issue concerns the ability of medium and small banks in the EU to respect a challenging MREL requirement in case they were subjected to a resolution strategy. The vast majority of these banks has little or no access to wholesale market for MREL-eligible instruments. To fulfil their MREL requirement they could be faced with a set of bad options: placing subordinated debt with professional investors at prohibitively high costs; placing it with their retail clients, who might be unable to fully appreciate the underlying risk; accepting to deleverage. Unless carefully calibrated, widespread extension of resolution can therefore jeopardize the traditional business models of smaller banks and the biodiversity of the banking system. See Deposit Insurance Corporation of Japan, Annual Report 2021/2022, August 2022. See Report of the Expert Group on Banking Stability, cit, p. 18. For example, even stricter limits to precautionary recapitalization are envisioned (introduction of a quantitative limit, strict time limits for the transfer of the State ownership, with the risk of an automatic declaration of FOLTF). On the other hand, while until recently the prevailing interpretation was that interventions of DGS different from deposit pay out were State aid, this is no longer the case. This interpretation hampered the management of some banking crisis by the Italian DGS, and was challenged by the Italian Authorities. A sentence of the European Court of Justice (the so-called “Tercas” sentence) explained that alternative interventions by the Italian DGS do not represent State aid. This opened the way to synergies in the operation of Supervision, Resolution and DGS in the future. The framework consists of a European Authority (the Single Resolution Board) and of national resolution Authorities. It involves the European Commission and, in the event of use of harmonized financial resources, of the European Council. Moreover, in case of intermediaries with subsidiaries outside the Euro area, the involvement of the respective national Authorities is contemplated. 5. Conclusions The banks and the whole financial system have proven to be more resilient to the March 2023 banking turmoil, compared to the past, thanks to the wide-ranging reforms and enhanced controls implemented after the Great Financial Crisis. The impact on the economy has been probably milder than it could have been. However, the crisis reminded supervisors and regulators about the need to remain alert and to ensure that international prudential standards are quickly implemented and continuously updated. The Basel Committee and the Financial Stability Board are assessing whether the regulatory framework to preserve financial stability may need some changes. Regulation and supervisory practices on liquidity risk are among those requiring attention. Concerning crisis management, the strengthening of the available toolkit and institutional structure in the last years has been relevant. However, bank crisis management remains a challenging task. The recent events clearly show that the concept of systemic bank may change over time depending on several factors (technology, habits), and that we need to wait before concluding for sure that a solution to the long-standing too-big-to-fail problem has been found. Parts of the current European regulation on bank crisis management give pre-eminence to level playing field issues and to the need to contain state aid, relative to the objective of financial stability. A new balance should be found. The CMDI represents the opportunity to achieve this objective. The proposal under discussion contains various improvements, but still present weaknesses, especially for what concerns the crisis of small and medium banks. In the light of what I just said about too-big-to-fail problem, I believe that the new norms should introduce some room for manoeuvre to tackle exceptional events, and preserve the biodiversity of the EU banking system by avoiding to penalize the vast number of small and medium banks not subjected to resolution. Designed by the Printing and Publishing Division of the Bank of Italy
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Opening remarks by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the OECD-Bank of Italy Symposium on "Financial Literacy and Empowerment: Data, Policies and Evaluation", Rome, 17 November 2023.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the Centre for Economic Policy Research (CEPR) - European Central Bank (ECB) Conference "The macroeconomic implications of central bank digital currencies", Frankfurt am Main, 23 November 2023.
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The cost of not issuing a digital euro Speech by Fabio Panetta Governor of Banca d’Italia CEPR-ECB Conference The macroeconomic implications of central bank digital currencies Frankfurt am Main, 23 November 2023 It is a pleasure to be with you today to discuss the implications of central bank digital currencies (CBDCs) from a macroeconomic and policy perspective. I am sure there will be a lot of discussion at the conference about what we can expect if CBDCs are issued. So let me focus on the counterfactual – the consequences of not issuing CBDCs – using the digital euro as a case study. Therefore today I will highlight the costs of not issuing a digital euro.1 Throughout history, monetary transformations have been the result of a dynamic interplay between technological progress, changing human preferences and institutional evolution. In the early Renaissance, commerce and financial innovation flourished in the Italian city-states. The introduction of letters of exchange and correspondent banking freed merchants from the perils of transporting cumbersome gold and silver coins and promoted secure methods of payment which, in turn, facilitated international trade. The substantial wealth of the Italian city-states could then be used as the foundation for the splendour of the Italian Renaissance.2 Today, we are once again at a pivotal point in the evolution of money. The economic landscape is changing in unprecedented ways. Digital innovation has ushered in a new age with the potential to unlock enormous opportunities. These changes inevitably affect payments and money, which are becoming as digital as our economies. Central banks around the world are preparing for this new digital era, recognising both the opportunities and the challenges it brings. They are actively exploring the potential This counterfactual approach was famously employed in the Cecchini report, which made the case for the Single Market by assessing the ‘cost of non-Europe’, defined as the untapped potential of the European internal market due to its incomplete integration. See Cecchini, P., Catinat, M., Jacquemin, A. (1988). ‘The Benefits of a Single Market’, Wildwood House. Ferguson, N. (2009), ‘The Ascent of Money: A Financial History of the World’, 10th Anniversary Edition. of issuing a digital payment instrument alongside cash as a logical next step in the evolution of central bank money. According to a BIS survey3, in 2022, out of a pool of 86 surveyed central banks, 80 (or 93 per cent) engaged in some form of CBDC work, ranging from research and proof of concept to pilots and also live CBDCs. The European Central Bank is one of these, as the Governing Council of the ECB has recently decided to launch the preparation phase of the digital euro project.4 Central banks have long provided reliable means of payment as a public good and an anchor of stability for the financial and monetary system. Why should they not do the same in the digital age and be the only ones not to offer a digital version of their product? But there are sceptics today who claim that issuing CBDCs would be fruitless. Some believe that a digital euro may not be successful enough; many ask what specific benefits it could offer that existing payment methods do not already provide. At the same time, others fear that a digital euro could be too successful and create instability by potentially challenging traditional bank deposits. These opposing concerns deserve close attention, and clear responses. A digital euro would be a digital form of cash that could be used for all digital payments throughout the euro area, free of charge, both online and offline. It would offer the highest level of privacy by default and allow users to settle payments instantly in central bank money. It could be used for person-to-person (P2P), point-of-sale, e-commerce and government payments. No existing digital payment instrument offers all these features. The digital euro would fill this gap. And its design features would prevent its introduction from triggering financial tensions and provide appropriate incentives for all parties involved. It would contribute to financial inclusion while fostering integration, innovation and resilience in the European payments market. But above all, the concerns that are sometimes expressed also tend to overlook a crucial consideration. Assessing the prospective advantages and disadvantages of CBDCs on the assumption that the payments landscape will not change in the future can be misleading. To do so would be to ignore the fact that our 21st century economies are in a state of flux, as evidenced by the multiple technological shocks hitting many sectors of the economy – think of the rise of generative artificial intelligence, to take one recent example. And the financial services sector is certainly not exempt from the inexorable progress of the digital revolution. The use of cash is expected to continue to decline, while large technology companies have already begun to expand into the payments market and are increasingly setting their sights on other financial services, thanks to their very large customer base and global operations. It is against this backdrop that we need to assess the merits of a digital euro. Kosse, A., & Mattei, I. (2023). Making headway-Results of the 2022 BIS survey on central bank digital currencies and crypto. BIS Papers. https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr231018~111a014ae7.en.html. Today I will first examine the most important current shortcomings of the European digital payments market and the risk that these shortcomings will be exacerbated by the quest for dominance of technology platforms in a counterfactual scenario where a digital euro is not issued. I will then argue that the digital euro would offer clear advantages in ensuring a competitive, innovative, open and secure digital payment system, while maintaining the highest standards of privacy protection. I will also discuss how potential risks to the financial sector can be effectively mitigated through the careful design of safeguards. The counterfactual: technology firms’ quest for dominance The rapid digitisation of payments is a prevailing trend that was accelerated by the Covid-19 pandemic. The share of payments made via mobile applications and the share of consumer online payments tripled in the euro area between 2019 and 2022.5 Consumers are clearly embracing the efficiency and convenience of digital payments. However, this transformation is associated with a number of challenges for the European payments market. While pan-European credit transfers and direct debits work thanks to European payment schemes and infrastructures,6 this is not the case for cards and certain types of online payments – whose use is growing disproportionately. This means that, as digitalisation progresses, pan-European payments are in the hands of international players, increasing our dependence on the payment rails they provide. A handful of international companies dominate domestic and cross-border card and online payments. International card schemes operate payment networks that are exclusively compatible with their point-of-sale terminals. This situation raises barriers to entry and expansion and discourages potential competitors from setting up new payment networks. The situation remains largely unchanged despite regulatory initiative and competition law enforcement.7 The decision of European banks to abandon their plans for a continent-wide card scheme is a stark illustration of the dominant position held by these firms.8 It is also striking that the average cost of card payments in the EU has been reported to be higher now than in 2015, when the Interchange Fee Regulation came into force.9 And the scheme fees applied by international card schemes almost doubled between 2016 and 2021 in the EU.10 https://www.ecb.europa.eu/stats/ecb_surveys/space/html/ecb.spacereport202212~783ffdf46e.en.html. SEPA payment instruments – which are the result of a public-private partnership. See Fabio Panetta’s speech at the European Payments Council: https://www.ecb.europa.eu/press/key/date/2022/html/ecb. sp220616~9f8d1e277b.en.html. https://www.nber.org/system/files/working_papers/w26604/w26604.pdf. https://www.finextra.com/newsarticle/39907/epi-abandons-plan-for-visa-and-mastercard-rival-asmember-banks-quit. https://www.eurocommerce.eu/2020/12/benefit-of-interchange-fee-regulation-now-nullified-by-feeincreases/. Rising from around 0.08 per cent to 0.15 per cent. See https://www.bargeldlosblog.de/wp-content/ uploads/CMSPI-Zephyre-Scheme-Fee-Study-V3-1.pdf. As a result, and given the difficulty of using cash in e-commerce, consumers are faced with prevailing payment solutions that work well, but may not be sufficiently tailored to their needs and preferences in terms, for example, of privacy11 and pan-European reach. This situation leads to unnecessary complexity and costs, as consumers are forced to rely on a variety of payment methods depending on the specific transaction and counterpart involved. Surveys show that consumers value the possibility of benefiting from a universally accepted payment method across online and physical stores in Europe.12 In essence, the current state of digital payment markets already justifies the introduction of a truly public and openly accessible payment solution to safeguard competition, better meet user needs and preserve European autonomy. This is likely to become even more critical in the future, as further expansion of large technology companies into payments would make the concerns I have outlined even stronger and more pressing. Three challenges deserve careful consideration. The first is the drive for dominance of technology platforms. These companies are increasingly entering the financial sector and reshaping financial markets. The logic of platforms revolves around bundling various activities, including financial ones, with the aim of expanding their customer base and enhancing network effects. By creating closed ecosystems, or ‘walled gardens’, they reduce competition.13 This is not far-fetched fiction. Concerns about platforms favouring their own products have already been at the forefront of antitrust cases. In as far back as 2010, the landmark European antitrust case known as the ‘browser wars’ exposed the ability of companies to restrict competition. More recently, the European Commission took issue with Apple’s decision to prevent app developers of rival mobile payment wallets from accessing the necessary hardware and software on its devices. This was done to favour its own solution, Apple Pay.14 It is inevitable that technology platforms, armed with their large customer base and big data processing capabilities, will expand their reach into financial services to attract new customers – at the risk of reducing competition. In China, big tech companies such as Payment data are often used for purposes other than those strictly related to payment execution. For example, payment providers may work with private credit scoring companies that inform landlords, creditors and service providers about the individual trust score of their prospective clients. Data obtained from the payment process are also used by merchants in tailoring their offering, using profiling techniques to understand a payer‘s spending capacity or their preferences to increase the effectiveness of certain marketing campaigns. https://edps.europa.eu/data-protection/our-work/publications/techdispatch/ techdispatch-22021-card-based-payments_en. See https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.pr220330~309dbc7098.en.html and https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr230424_1_annex~93abdb80da.en.pdf. By adopting the commercial practices of bundling and price discrimination, suppliers can replicate monopoly pricing and extract consumer surplus from their customers. See Adams, W. and Yellen, J., ‘Commodity bundling and the burden of monopoly’, The Quarterly Journal of Economics, Vol. 90, No. 3 (August 1976). See also Jullien, B. and Sand-Zantman, W., ‘The Economics of Platforms: A Theory Guide for Competition Policy’ (July 2020). CEPR Discussion Paper No. DP15071; Brunnermeier and Payne, 2022 https://economics.princeton.edu/working-papers/platforms-tokens-and-interoperability/. https://ec.europa.eu/commission/presscorner/detail/es/ip_22_2764. AntFinancial and Tencent have overtaken the digital payment and e-commerce sectors, and are expanding into financial intermediation.15 As a result, between 2020 and 2021, big tech credit in China grew at an average annual rate of 37 per cent, outpacing the growth rate of bank credit by more than 20 percentage points.16 Western technology companies are also increasingly challenging financial institutions, seeking to compete with traditional banks as financial service providers.17 In the United States, Apple’s new savings account, linked to its payment solutions, offers interest at more than 10 times the national average rate,18 and has attracted more than 10 billion dollars in user deposits since its launch in April.19 And X (formerly Twitter) is reportedly planning to offer a full range of payment and financial services.20 Amazon offers buy-now-pay-later services to its customers worldwide. This brings us to the second concern about the dominance of technology platforms, that of privacy. Through their involvement in payments, large technology companies have access to extensive customer information – including income, preferences and demand patterns. This information is key to their business model, whether it is based on advertisement revenue, sales of technology-intensive products and services or e-commerce. Their quest for data will only increase with the development of artificial intelligence and big data techniques. Market forces alone will not satisfy the demand for digital money with socially desirable levels of privacy. As I have mentioned above, extensive use of payment data allows big tech companies to price discriminate between customers, cross-sell products and increase margins on their advertisement and commercial services.21 Even if most consumers do not perceive these indirect costs, many have become highly sensitive to the use of their personal data derived from digital payments, as shown by the results of the Eurosystem’s public consultation on a digital euro.22 They are also https://www.bis.org/publ/work947.pdf; Ant Financial’s Yu’e Bao is China’s largest money market fund and one of the largest worldwide, providing on-demand redemptions and close substitutes for bank deposits at higher returns than bank deposits; see also https://pubs.aeaweb.org/doi/pdfplus/10.1257/ pandp.20191012. https://www.bis.org/publ/work1129.pdf. https://www.ecb.europa.eu/stats/ecb_surveys/space/html/ecb.spacereport202212~783ffdf46e.en.html; the share of online payments in consumers’ non-recurring payments increased from 6 per cent in 2019 to 17 per cent in 2022. Mobile phone app payments increased in P2P payments. The share of payments using mobile apps increased threefold between 2019 and 2022. https://www.ft.com/content/bf566eee-9795-4bbb-9494-d55e529316b4. https://www.apple.com/newsroom/2023/08/apple-cards-savings-account-by-goldman-sachs-seesover-10-billion-usd-in-deposits/. https://www.finextra.com/newsarticle/43200/elon-musk-wants-x-to-replace-users-bank-accountswithin-a-year?utm_medium=newsflash&utm_source=2023-10-27&member=144349. https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2662~fa8429a967. en.pdf?4f8b773dd930231c86ed40bb29ff9eca. www.ecb.europa.eu/pub/pdf/other/Eurosystem_report_on_the_public_consultation_on_a_digital_ euro~539fa8cd8d.en.pdf. aware that, in the absence of a digital form of cash, they do not have an attractive and convenient alternative that meets their desired level of privacy. The third concern about the rise of technology platforms is that they may start issuing their own digital payment instruments, posing risks to the functioning of the payment system, monetary sovereignty and financial stability. This is a real possibility, as illustrated by the decision of PayPal – a big-tech-like company with a user base of 450 million – to launch its own dollar-denominated stablecoin. Big Tech issuance of their own currencies will be focused on maximising profits rather than taking responsibility for monetary and financial stability. Depending on the scale of adoption, stablecoins may lead to the fragmentation of the payment system, as they are structured as ‘closed-loop solutions’ that restrict payments to users who adopt a particular payment tool. And, as I have stressed in the past,23 Big Tech would not be concerned about avoiding disruptions to financial intermediation, preventing excessive outflows of bank deposits and ensuring a balanced compensation model, as instead a central bank would be. On the contrary, they would deliberately seek to change the market structure to their advantage. In other words, without policy intervention, the growing role of technology platforms in payments and financial services could have a strong negative impact on the financial sector, disrupting the prevailing financial intermediation process. Digital Euro: Forging a sustainable digital future Regulatory measures can go a long way towards countering the negative effects and preserving the integrity of the digital payment system,24 although tackling the anti-competitive practices in the payment landscape is a highly complex task. It requires a fresh look at the existing toolkit and enhanced international cooperation given the global nature of the phenomenon.25 But it is important to recognise that regulation alone cannot replace the essential role of public money and the confidence it inspires.26 Consider, for example, the introduction of euro banknotes in 2002, when people started counting, paying, contracting, and setting prices in euros. Without the introduction of paper banknotes, the euro might have been perceived as a mere pegging of earlier currencies to a synthetic unit of account, rather than as a fully-fledged currency, backed by strong trust, which is the foundation of Economic and Monetary Union. https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211008~3c37b106cf.en.html. https://www.fsb.org/work-of-the-fsb/financial-innovation-and-structural-change/crypto-assets-andglobal-stablecoins/. https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211008~3c37b106cf.en.html. Brunnermeier and Landau, 2022. Similarly, without the European Central Bank issuing digital money – that would provide a common unit of account and a convertibility anchor underpinning the various forms of private digital money – consumers could lose sight of a visible symbol linking money to the State. This could undermine trust in money and ultimately monetary sovereignty. Moreover, it remains unclear to me why central banks, charged with fulfilling their mandates, should stand idly by in the face of digitalisation. The changes affecting money and payments are at the core of central banks’ responsibilities. In today’s technological landscape, central banks cannot confine themselves to merely providing paper money. They have a responsibility to satisfy people’s needs, which increasingly favour digital payments over physical cash. Issuing a digital euro as a form of digital cash would ensure that public money remains an option available to all, providing a convenient payment instrument with a pan-European reach. And it would provide an alternative payment network to those operated by the dominant card and online payment solution providers, making it easier and cheaper for supervised intermediaries to offer new, pan-European services. The benefits of a digital euro would be amplified in the context of the potential disruption caused by a handful of large technology companies seeking to dominate the payments market. It would play a key role in fostering competition, protecting privacy and enhancing stability. Let me start with competition. A digital euro would be driven by public interest, promoting open standards to create a network that benefits everyone, rather than serving private interests by creating ‘walled gardens’. A digital euro would avoid the creation of closed loops, and instead offer all payment service providers (PSPs) an open platform for innovation, immediately scalable at European level. Nowadays, the novel and advanced payment solutions available in many European countries encounter challenges in achieving a pan-European dimension, with direct costs for European citizens who cannot fully harness their benefits. Unlike digital platforms and e-payment solutions such as PayPal, a digital euro would allow banks to maintain their customer relationships, thereby stimulating innovation within banks. Finally, the reduction of market power would ultimately lead to lower charges for merchants and consumers. A digital euro would ensure that, as the use of cash declines and private companies offering digital payment options gain a larger market share, the benefits do not accrue exclusively to these private companies, but also to consumers and merchants. In addition, it safeguards the role of central bank money, preserving seigniorage – the profit made by the State as the issuer of the currency – for the benefit of taxpayers. The second advantage of a digital euro is its ability to preserve privacy in digital payments. In this respect, it has a notable advantage due to the absence of profit-maximising incentives on the part of its issuer, the ECB. In addition, a specific legal framework would establish strict privacy requirements: for example, the legislative framework proposed by the European Commission would ensure that the ECB has no access to users’ personal data. Furthermore, offline payments would also offer enhanced privacy, as they would not require any third-party validation, relying only on the direct transfer from payer to payee. The third benefit of a digital euro is its potential to contribute to long-term stability. Unlike the potentially disruptive changes expected from large technology firms vying for dominance in digital payments (and, potentially and more broadly in financial services, at a later stage), the issuance of a digital euro will not cause instability in the financial system. On the contrary, it would maintain healthy competition in digital payments, thereby promoting the overall resilience of the financial sector. Crucially, its design features would allow the ECB to maintain a balance between private money, such as commercial bank deposits, and central bank money. Features such as holding limits can be calibrated to avoid any undesirable consequences for monetary policy, financial stability and the allocation of credit to the real economy.27 In all likelihood, the process of digital euro adoption would unfold gradually, as is often the case for new payment methods, reducing the risks of cliff-edge effects on bank deposits. However, to manage the transition well and to mitigate the risk of tensions along the way, the holding limit could be initially set below the intended steady-state level and gradually increased towards it. Ultimately, the limit should neither be so restrictive as to hamper the convenience of the digital euro as a means of payment,28 nor so lax as to ignore the risk of excessive deposit outflows.29 The holding limit will be chosen on the basis of thorough empirical analysis, using models to simulate its effects and alternative transition strategies. Appropriate calibration will also need to ensure robustness to differences between banking markets and supervised intermediaries. And when it comes to the impact of a digital euro on run risks, it is important to remember that depositors do not need digital central bank money to run from a bank. They can already do so by withdrawing cash or digitally, by moving deposits to an account held with another intermediary. In fact, CBDCs could even help mitigate run risks. A digital Adalid, R. et al. (2022), “Central bank digital currency and bank intermediation: Exploring different approaches for assessing the effects of a digital euro on euro area banks”, Occasional Paper Series, No 293, ECB, May; Meller, B. and Soons, O. (2023), “Know your (holding) limits: CBDC, financial stability and central bank reliance”, Occasional Paper Series, No 326, ECB, August; Bindseil, U., Panetta, F. and Terol, I. (2021), “Central Bank Digital Currency: functional scope, pricing and controls”, Occasional Paper Series, No 286, ECB, December. Linking a digital euro wallet with a commercial bank account could reduce the impact of the holding limit on convenience. First, it would always be possible to receive a payment, even if the amount to be received raises the digital euro balance above the holding limit. The excess amount would be transferred automatically to the linked commercial bank account (waterfall functionality). Second, if there are insufficient funds in the digital euro account when making a payment, the shortfall could be transferred immediately from the linked commercial bank account (reverse waterfall functionality). Assenmacher et.al., forthcoming, ‘Managing the transition to central bank digital currency’. euro could provide real-time information on outflows of bank deposits, allowing for a quicker response to incipient runs, which, in turn, would help stabilise expectations by increasing depositors’ confidence.30 Conclusions Let me conclude. I know that the aspects I have raised are difficult to model, but I am also convinced that they are crucial and must be taken into account when analysing the effects of a CBDC on welfare, economic growth and risks. Central banks have a mandate to ensure stability – both monetary and financial – and are therefore naturally inclined to be prudent. But prudence should not mean inaction. The cost of not issuing a digital euro could be significant. Central bank digital currencies would bring considerable benefits to digital payments. As the large technology companies further expand into digital finance, the availability of digital central bank money, together with effective regulation, would become necessary to ensure competition, privacy and the smooth functioning of payments and the financial intermediation process. As forward-looking policymakers, the central banks of the Eurosystem are preparing – including through the possible issuance of a digital euro – to address the risks that the digital revolution poses to monetary and financial stability. Carrying out this complex transition phase to the benefit of the well-being of everyone is the ultimate goal. Thank you for your attention. Keister, T. and Monnet, C. (2020), ‘Central Bank Digital Currency: Stability and Information’, Rutgers University and University of Bern, mimeo. Designed by the Printing and Publishing Division of the Bank of Italy
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Address by Mr Fabio Panetta, Governor of the Bank of Italy, at the conference "The Cooperative Banking Group: opportunities and challenges of a new banking model", organised by the ICCREA Cooperative Banking Group to mark its 60th anniversary, Rome, 30 November 2023.
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Address by Mr Fabio Panetta, Governor of the Bank of Italy, at the conference "Ten years with the euro", Riga, 26 January 2024.
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Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the Vienna University of Economics and Business, Vienna, 24 January 2024.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the 30th Congress of ASSIOM FOREX (the Italian financial markets association), Genoa, 10 February 2024.
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30th ASSIOM FOREX Congress Economic developments and monetary policy in the euro area Speech by the Governor of the Bank of Italy Fabio Panetta Genoa, 10 February 2024 1. Global economic trends and outlook The global economy remains sluggish. World trade stagnated again in the fourth quarter of last year; it is expected to recover moderately this year, but at a much slower pace than in the two decades before the pandemic.1 The simultaneous tightening of monetary policy by the central banks of the leading economies is helping, along with the fall in energy prices, to bring inflation down significantly, but is dampening demand. The exception is the United States, where domestic demand and output continue to grow rapidly. The global outlook is also vulnerable to the uncertainty fuelled by the conflicts in Ukraine and the Middle East, as well as by the economic difficulties in China, where the property crisis continues unabated. Disruptions to the Red Sea shipping route, which handles around 12 per cent of world trade, are forcing vessels from Asia to seek alternative routes. This is delaying deliveries and increasing transport costs, especially for destinations in Europe (Figure A1). In this weak economic context, geopolitical fragmentation is setting back economic integration between countries and regions across the globe. The introduction of trade restrictions, under way for some time, accelerated after the pandemic and the invasion of Ukraine (Figure A2),2 at times taking the form of embargoes on exports of technological products such as microprocessors. This could lead to a rebalancing of trade between countries, as has already occurred for energy products. If this new scenario were to endure, it would have significant medium- and long-term consequences. A decline in the international trade of goods, services, technologies and ideas would reduce productive efficiency and dampen the potential growth of the global World trade is estimated to have grown by 0.6 per cent in 2023. This year, the anticipated trade growth rate is around 2.5 per cent. According to Global Trade Alert, countries have adopted more than 2,000 protectionist measures since 2022; see also WTO, Reports on G20 trade and investment measures (May-October 2023), December 2023. economy, which has been declining for years (Figure A3). Indeed, global value chains are vulnerable to disruptions in the supply of key inputs and have become a source of uncertainty for macroeconomic developments.3 Barriers to capital movements, in turn, reduce investment opportunities and risk diversification across countries. These trends could exacerbate the current downward pressure on the equilibrium interest rate,4 as a result of population ageing, sluggish productivity5 and an increase in the demand for risk-free assets which has outstripped supply. More broadly, commercial and financial fragmentation risks fraying the multilateral order that has underpinned global economic development since the end of the Second World War and fostered peace among the leading powers. The effects of this would extend beyond economics and the financial sphere. Given the openness of the European and Italian economies, geopolitical divisions pose significant risks. It is in our interest to vigorously defend the progress made so far in global integration and in multilateral dialogue. At the same time, a far-sighted and pragmatic approach obliges us to find ways to operate effectively in a less open world, thereby reducing the vulnerabilities stemming from the new global situation. There could be growth opportunities for the least-developed regions in Europe, if they are able to intercept the investment flows in search of market outlets to relocate some stages of the production process. Analyses by the Bank of Italy and other central banks6 suggest that European companies, especially those exposed to the Chinese economy, are reorganizing their production and their supply chains. For Italy, a quantification of the potential losses from specific input shortages due to geopolitical fragmentation is discussed in A. Borin, G. Cariola, E. Gentili, A. Linarello, M. Mancini, T. Padellini, L. Panon and E. Sette, ‘Inputs in geopolitical distress: a risk assessment based on micro data’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 819, 2023. In the language of economists, the long-run equilibrium interest rate is also referred to as ‘natural interest rate’. A. Gerali and S. Neri ‘Natural rates across the Atlantic’, Journal of Macroeconomics, 62, 2019; also published in Banca d’Italia, Temi di discussione (Working Papers), 1140, 2017. M. Bottone, M. Mancini and T. Padellini, ‘Navigating fragmentation risks: China exposure and supply chains reorganization among Italian firms’, Banca d’Italia, mimeo, 2023; M.G. Attinasi, D. Ioannou, L. Lebastard and R. Morris, ‘Global production and supply chain risks: insights from a survey of leading companies’, ECB, Economic Bulletin, 7, 2023, 33-41; Deutsche Bundesbank, ‘The significance of China as a supplier of critical intermediate inputs to German firms’, Monthly Report, 75, 9, 2023, 21-25. While some of the remote regions that have benefited from significant investment from advanced economies in the past are no longer as attractive to investors, countries that can take advantage of low-cost renewable energy and their proximity to European markets may become more so. In a context of tense international relations, being a member of the European Union and of a stable currency area, such as the euro area, as well as of the Atlantic Alliance, has become a competitive advantage. This is a rare opportunity for the Italian Mezzogiorno.7 However, turning opportunities into concrete growth prospects will require active policies to attract capital and to strengthen contextual factors, such as infrastructure, investment in human and social capital, and efficient general government.8 2. The euro-area economy In the euro area, the economy has been stagnating for five quarters now, owing to weak foreign and domestic demand.9 The end of the post-pandemic upswing due to widespread reopenings, the ongoing tightening of monetary policy and the climate of uncertainty are slowing business investment and household spending. Most of the euro-area’s industrial sectors are in recession (Figure A4).10 A country-level analysis shows a sharp decline in industrial production in Germany, hit harder than elsewhere by fewer purchases by China, and by the downturn in energy-intensive sectors and the fragmentation of global manufacturing supply chains. In Europe the cyclical weakness in manufacturing is beginning to affect the service sector. The construction sector has also stalled. The latest information does not point to a significant cyclical recovery in the short term (Figure A5). ‘The economic development of Southern Italy: a national priority’, address by Fabio Panetta at the Foggia branch of the Italian Istituto Poligrafico e Zecca dello Stato (State Mint and Polygraphic Institute), 21 September 2019 (only in Italian). A. Accetturo, G. Albanese and R. Torrini (edited by), ‘The North-South divide: economic development and public intervention’, Banca d’Italia, Seminars and conferences, 25, 2022 (only in Italian); S. Galano, L. Sessa and S. Zuccolalà, ‘The quality of electricity supply: a comparison among Italian regions’, Banca d’Italia, Questioni di economia e finanza (Occasional Papers), 737, 2022 (only in Italian). Total euro-area exports for the third quarter of 2023 were 3 per cent lower than the corresponding year-earlier period, based on national accounts. The pharmaceuticals and electronics sectors are the main exceptions having benefited from, respectively, the surge in vaccine and new drug production, and the strong demand for products needed for remote working. One bright spot in this low-growth scenario is rising employment. Labour demand was initially supported by the post-pandemic surge in manufacturing and then by the shift towards labour intensive processes, made relatively cheaper by rising energy prices. In 2021 and for most of 2022, the number of job vacancies rose. Labour shortages in recent years have spurred businesses to retain workers, even when this means exceeding their staffing needs.11 This has supported employment and consumption. If economic activity remains weak, firms may have to cut their workforce significantly.12 We have already seen signs of a labour market slowdown: the number of vacancies has been falling since its peak in spring 2022 (Figure A6). The fiscal policies of euro-area countries are expected to hold back the economy over the coming months. They are expected to become more restrictive, especially owing to the withdrawal of the stimulus measures introduced in response to the energy crisis. Last December, the European Central Bank revised the 2024 growth projections downward, to 0.8 per cent, leaving those for 2025 unchanged at 1.5 per cent. These estimates are higher than those of private analysts13 and, given the recent data, could prove to be optimistic. In any case, they all point to a modest pace of growth, slower than before the pandemic. However, the problems facing the European economy are not only cyclical. There are structural issues that make the growth model followed by our continent particularly vulnerable to the changes in the world economy that I mentioned previously. A production base integrated into long and complex international value chains, the concentration of exports in areas that are less economically dynamic than before, and the relatively high weight of the industrial sector – which is expanding less than the service sector – are all weaknesses in today’s altered international context. There is a risk that the slow growth of recent years will become rooted in firms’ investment plans, in consumer expectations and, ultimately, in the entire Economists call this phenomenon ‘labour hoarding’. A phenomenon known as ‘labour shedding’. The analysts polled by Consensus Economics in January say that the economy will grow on average by 0.5 per cent in 2024 and by 1.3 per cent in 2025. European production fabric, thereby thwarting future development opportunities and ambitions. In the United States, both GDP and consumption have returned to or even exceeded their pre-pandemic long-term growth paths, but this has not been the case in Europe (Figure 1). Figure 1 Consumption and GDP in real terms in the euro area and the United States (index numbers, Q4 2017=100) Real consumption Real GDP Euro area Euro area: 2014−19 trend USA USA: 2014−19 trend Sources: Based on Bureau of Economic Analysis and Eurostat data. (1) Seasonally adjusted quarterly data. The potential offered by the Single Market is enormous. In order to take advantage of it, we must regain our sense of common purpose, at both the financial and political level, that same sense which enabled us to respond swiftly to the pandemic shock.14 3. Monetary policy in the disinflation phase Over the last two years, the ECB’s monetary policy has shifted sharply from a very expansionary to a very restrictive stance. This change of pace was necessary in response to inflationary shocks of historic proportions caused by bottlenecks in global production chains and energy price increases. ‘Beyond money: the euro’s role in Europe’s strategic future’, address by F. Panetta at the ‘Ten years with the euro’ conference, Riga, 26 January 2024. We could argue about the pace and intensity of monetary policy, but one thing is clear: inflation has not become self-sustaining or endemic. Medium-term inflation expectations have remained anchored at the 2 per cent target (Figure A7), a prerequisite for price stability. This has limited the cost of disinflation, which has so far unfolded without triggering a deep recession. For this to be the end result, for inflation to be permanently eradicated and for the economy to return to a path of growth and stability, the next monetary policy decisions must be consistent with the current macroeconomic picture. In this uncertain environment, any speculation on the exact timing of monetary easing would be a sterile exercise and disrespectful to the ECB Governing Council as a collegiate body. What should be discussed now are the conditions to start monetary easing, while avoiding risks to price stability and unnecessary damage to the real economy. The conditions for starting monetary policy normalization There are three conditions for starting monetary policy normalization. First, the disinflation process must be well under way. Recent data suggest that progress towards price stability has been greater than many were expecting just a few months ago. Inflation fell to 2.8 per cent in January, 8 percentage points below its peak in 2022 (Figure A8). Core inflation, which excludes food and energy, has also fallen rapidly. While varying in intensity, this decline was broad-based across all countries (Figure A9) and across a very large proportion of items in the consumption basket (Figure A10), including products that typically show more persistent price changes. Second, the fall in inflation needs to be sustained. Indicators of short-term and underlying inflation clearly point to ongoing disinflation. Measures of inflation momentum – which are less influenced by past trends and reflect current developments more accurately – are consistently below annual inflation. These are also at low levels for both headline and core inflation, with similar trends for services and industrial goods (Figure 2). The decline in firms’ and households’ inflation expectations, as well as those of market participants, points in the same direction. The latter expect inflation Figure 2 Headline and core inflation in the euro area (12-month percentage changes and annualized 3-month percentage changes) Headline −2 −2 Core Services Non−energy industrial goods −2 −2 12−month 3−month Sources: Based on ECB and Eurostat data. (1) Monthly data. 12-month percentage changes and annualized 3-month percentage changes, calculated using seasonally adjusted data. to return to around 2 per cent as early as this spring. Subsequent downward revisions in the Eurosystem’s projections also signal that disinflation is under way (Figure A11). Another key element is the unwinding of the energy shock. Specifically, gas prices are now close to their mid-2021 level and below the technical assumption used in the latest Eurosystem projections. The third condition for monetary normalization to begin is that the achievement of the inflation target is not jeopardized by a potential interest rate cut. This last requirement depends on several factors: the outlook for economic activity, the transmission of monetary policy to the financial and real sectors, and the risks to future inflation developments. On the first point, I have already outlined the domestic and international factors that are holding back the economy. As regards the transmission of monetary policy, the effects of tightening are proving to be stronger compared with both past experience and the ECB’s previous estimates.15 Moreover, interest rate hikes and the reduction in liquidity supply will continue to weigh on the economy throughout 2024.16 The impact on the credit market has been particularly pronounced, with lending rates to households and firms rising (Figure A12) and real growth rates similar to or lower than during the crises of the past decade (Figure A13). These developments reflect not only the decline in credit demand due to higher lending rates, but also the tightening of credit supply standards at a time when borrowers are expected to become riskier.17 Looking ahead, this tightening may be exacerbated by banks’ lower liquidity buffers (Figure A14) due to the reduction in the size of the Eurosystem’s balance sheet.18 The risks to inflation Turning to the risks to inflation, let me first emphasize that the main concerns raised in the past are proving to be unfounded. I have already mentioned that there has been no upward de-anchoring of inflation expectations; if anything, downside risks are emerging.19 Concerns about the hypothesis of persistently high core inflation have also proven to be groundless: indeed, core inflation has declined in recent months, following the fall in headline inflation, in line with past empirical evidence20 (Figures A15 and A16). ‘Everything everywhere all at once: responding to multiple global shocks’, speech by F. Panetta at The ECB and its Watchers XXIII Conference, Frankfurt, 22 March 2023. ‘The banking channel of monetary policy tightening in the euro area’, speech by P. R. Lane at the NBER Summer Institute 2023 Macro, Money and Financial Frictions Workshop, Cambridge, Massachusetts, 12 July 2023. Empirical evidence suggests that the effects of monetary policy feed into production and price dynamics with an estimated lag of six to eight quarters. See, for example, M. Darracq-Paries, R. Motto, C. Montes-Galdón, A. Ristiniemi, A. Saint Guilhem and S. Zimic, ‘A model-based assessment of the macroeconomic impact of the ECB’s monetary policy tightening since December 2021’, in ECB, Economic Bulletin, 3, 2023, pp. 61-67. The Bank Lending Survey conducted by the Eurosystem suggests that banks’ risk perception and risk aversion were the two key factors behind tighter credit standards for firms and households; see M. Bottero and A. M. Conti, ‘In the thick of it: an interim assessment of monetary policy transmission to credit conditions’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 810, 2023. ‘Disinflation in the euro area and opportunities for the Italian economy’, speech by F. Panetta at the conference ‘Cooperative Banking Group: opportunities and challenges of a new banking model’, Rome, 30 November 2023. Over the past few weeks, inflation expectations five to ten years ahead based on price-indexed financial asset prices have fallen slightly below the 2 per cent target (Figure A7). ‘Getting disinflation right’, speech by F. Panetta, Bocconi University, Milan, 3 August 2023. Similarly, fears that inflation would stop falling after the initial rapid decline – the ‘last mile problem’ – now appear unwarranted: inflation is falling at the same rate or faster than it has risen (Figure A17). The risk remains that still strong nominal wage growth could reignite inflation. This possibility should not be underestimated, but a closer look at the data allays these concerns. Labour is only one production factor, and its share of total costs for firms is much lower than that of intermediate goods and energy (Figure 3).21 Current wage growth, while higher than in 2021 and 2022, is offset by the decline in other costs that has been ongoing for months. Figure 3 Composition of costs for firms in the euro area (per cent of total costs) Industry (excluding construction) Construction Private services Total economy Intermediate goods costs (incl. energy) Labour costs Sources: Based on data from Destatis, Eurostat, Insee and Istat. (1) Estimates based on the data for France, Germany and Italy. The increase in firms’ total production costs – which is the main driver of inflation22 (Figure 4) – has gradually fallen to zero, easing inflationary pressures. In line with these developments, firms do not expect total costs to accelerate in the coming months (Figure A18). Considering only labour and intermediate goods as inputs of production, labour costs account for around 40 per cent of total costs in the economy as a whole. In perfect competition, prices are equal to total marginal costs (see H. R. Varian, ‘Microeconomic analysis’, New York-London, Norton, 1992). In monopolistic competition, firms apply a mark-up to total marginal costs (see A. K. Dixit and J. E. Stiglitz, ‘Monopolistic competition and optimum product diversity’, American Economic Review, 67, 3, 1977, pp. 297-308). Figure 4 Total unit cost, labour unit cost and headline inflation in the euro area (percentage changes on year-earlier period) −4 −4 −4 Labour unit cost −4 Total unit cost Headline inflation Sources: Based on data from Destatis, Eurostat, Insee and Istat. (1) Quarterly data. Percentage changes compared with the year-earlier period. Estimates based on the data for France, Germany and Italy. Unit costs are calculated as the ratio of total costs to total output in real terms. The effects of stagnating total production costs are compounded by those of weak demand for goods and services, which makes firms less likely to pass on wage increases to prices, for fear of losing market share. Therefore, a hypothetical increase in wage growth is currently highly unlikely to trigger a wage-price spiral. Moreover, with inflationary pressures tilted to the downside and corporate profits high, some recovery in the purchasing power of wages, after the recent losses (Figure A19), is to be expected and will support consumption and the economic recovery. Conflicts in the Middle East also pose risks to inflation. However, maritime transport only accounts for a small share of total production costs.23 Here too, low demand and high inventories reduce the likelihood of higher transport costs being passed on to prices to a significant extent. Nonetheless, it cannot be ruled out that the situation will worsen and that tensions will escalate, affecting the supply and prices of energy products. These developments will need to be monitored closely. Transport costs account for around 1 per cent of the euro-area output. Implications for monetary policy Macroeconomic conditions suggest that disinflation is at an advanced stage, and progress towards the 2 per cent target continues to be rapid. The time for a reversal of the monetary policy stance is fast approaching. The March ECB staff projections will provide useful elements for assessing the next monetary policy move. The first step, but also the various options on the way to monetary policy normalization must be carefully weighed. We need to consider the pros and cons of cutting interest rates quickly and gradually, as opposed to later and more aggressively, which could increase volatility in financial markets and economic activity. 4. The economic situation and the Italian banking system In Italy, GDP growth was 0.7 per cent in 202324 and is expected to remain at around that level this year. Inflation, which was 0.9 per cent in January, is expected to remain below 2 per cent in 2024. Industrial production is being affected by stagnation in Germany and by the lower contribution of demand from the other export markets for Italian goods. Growth in value added in services is modest. The exception is the construction sector, where activity is buoyed by incentives that are now being phased out. Despite a generally weak economic environment, some areas of production are showing signs of dynamism. The revision of the national accounts last September raised GDP growth in 2021 by over 1 percentage point, showing an economy that has recovered quickly and resolutely from the pandemic-induced recession. Italian GDP is now 3.6 percentage points higher than at the end of 2019, compared with increases of 1.8 percentage points in France and 0.1 percentage points in Germany. The labour market has also returned to its pre-crisis levels. In 2023, employment increased by 1.9 per cent, reaching its highest point for many years, as did the participation rate. Stable forms of employment have become widespread. The annual figure is based on quarterly data adjusted for seasonal and calendar effects. The forecasts for 2024 released last December, before the release of the figures for last year’s fourth quarter, indicated a 0.6 per cent growth rate. Without factoring in the adjustment for calendar effects, expected GDP growth would be 0.8 per cent (see Banca d’Italia, ‘Macroeconomic projections for the Italian economy – Eurosystem staff macroeconomic projections)’, 15 December 2023. This positive employment trend is bolstering household incomes, especially for less well-off households.25 Consumption grew by 1.4 per cent in the first three quarters of 2023 and we estimate that it will continue to support demand this year. The positive trends that emerged after the pandemic must be consolidated. In recent years, Italy has achieved sizeable trade surpluses and improved its net international creditor position. This testifies to the competitiveness of many Italian firms on the world market, but also signals untapped potential for growth: a positive trade balance is equivalent to a transfer of savings abroad, which in turn indicates that the volume of investment is lower than the capacity to save.26 The recovery in capital accumulation following the pandemic crisis marks a potential breakthrough in this regard. This trend now needs to be reinforced by stimulating investment and channelling it towards improving infrastructure and technology, and firms’ capacity to innovate. In the shorter term, we need to reap the full benefits of implementing the reforms and investment under the National Recovery and Resilience Plan (NRRP), which can boost Italy’s potential growth and make the necessary rebalancing of its public accounts less arduous. The information available for 2023 suggests that the fiscal deficit and public debt as a percentage of GDP have fallen. Over the next few years, despite the expected decline in the deficit, debt should remain broadly stable, largely due to the use of the sizeable building renovation tax credits that have accrued over the past few years. We need to work on several fronts to speed up fiscal consolidation: prudent management of our public finances to achieve an adequate primary surplus has to go hand in hand with reforms and investments that can boost growth. Italian banks The main balance sheet indicators paint a positive picture of the Italian banking system. G. Dachille, M. Paiella, A. Dalla Zuanna and E. Viviano ‘L’impatto distributivo della crescita occupazionale e dell’inflazione: 2018-2021’, Banca d’Italia, Note Covid-19, 31 May 2023 (only in Italian). At the end of September 2023, Italy’s net international investment position stood at €122.7 billion, equal to 6.1 per cent of GDP. This improvement of €17.3 billion compared with late June 2023 can be chiefly attributed to the current account and capital account surplus. Capital rose to 15.8 per cent of risk-weighted assets,27 in line with the other euro-area banks. Non-performing loans as a share of total loans fell to 1.4 per cent,28 completing the recovery process that began almost a decade ago. Liquidity ratios are well above the regulatory requirements. Profitability has also improved: the return on equity is close to 13 per cent,29 a figure not seen since the global financial crisis. Part of this improvement reflects the efficiency gains in costs and in credit risk management, as well as the positive effects of the regulatory reforms and of rigorous supervision. Yet it also reflects exceptional factors. In fact, banks have benefited from the macroeconomic policies adopted to counter the crisis and from the unusual market conditions of the last two years, with ample liquidity and rapidly rising interest rates. The increase in market interest rates has been passed through swiftly to interest income on short-term and variable-rate loans, which account for a large share of total loans in Italy (Figure A20).30 At the same time, abundant liquidity and low demand for credit have limited the increase in the cost of sight deposit funding, which accounts for 40 per cent of total bank funding. The improvement in credit quality also reflects the sound profitability and financial conditions of firms (Figure A21). This in turn partly reflects both the surge in production following the pandemic and the ample liquidity buffers that firms have accumulated in recent years thanks to their access to State-guaranteed loans. Looking ahead, it would be imprudent to rely on the unrealistic assumption that such a positive situation could arise again. And since it is in times of relative calm that the imbalances that emerge in cyclical downturns are built up, we should be thinking today about the risks we may face tomorrow. We need to focus on three areas. The figure refers to Common Equity Tier 1 capital. The ratio of non-performing loans to total loans, net of write-downs. The figure refers to the first nine months of 2023 and is on an annual basis. In Italy, around 80 per cent of the stock of loans to firms and about 35 per cent of loans to households have a variable rate. The corresponding shares in France and Germany are below 40 per cent for loans to firms and equal to around 5 and 15 per cent respectively for those to households. Liquidity and funding Maintaining a balanced maturity structure of assets and liabilities remains a priority. At a time when the Eurosystem is mopping up excess liquidity, banks’ funding plans should be realistic and promptly implemented. It is important to avoid the fallacy of composition: it is unlikely that all banks will be able to turn to the market at the same time and at low cost. Aggregate liquidity will gradually decline, but the ability to raise funds in the market may fluctuate intermittently as banks’ excess reserves diminish or in the event of market turbulence. The US banking crises of March 2023 show that individual lenders’ liquidity strains can rapidly turn into deposit runs, due to the speed with which customers can transfer funds using online banking and to the propagation of information through digital channels. They also confirmed the importance of timely access to liquidity sources, including central bank refinancing. In this regard, the Bank of Italy’s collateral valuation framework permits the rapid collateralization of a wide range of financial instruments, including less liquid ones. Our supervisory function is assessing the accuracy and credibility of banks’ funding plans. Particular attention is paid to banks that have less diversified funding sources and rely on deposit growth. Non-performing loans Past experience suggests that rising interest rates have positive effects on banks’ balance sheets in the short term, but over longer horizons they often have a negative impact on households and firms’ financial conditions, with spillback effects on credit. Bank of Italy estimates suggest that the quality of loans may deteriorate over the next two years. Non-performing loan ratios are expected to remain well below the peaks reached after the sovereign debt crisis, but unexpected events could lead to more adverse scenarios. Banks must be prudent when classifying loans and apply international accounting standards thoroughly, which require them to record expected losses and make appropriate provisions, even when losses have not yet materialized. Where models fail to fully capture the effects of new risk factors on default probabilities, banks are required to make specific adjustments.31 Several banks already do so, but their approaches vary, so the Bank of Italy is conducting research to identify and disseminate best practices in this area. An ecosystem of companies specialized in the management and recovery of non-performing loans has emerged in the wake of the sovereign debt crisis. This activity, which has become an important part of the credit sector, has made considerable progress in recent years.32 But there is still room for improvement. The Bank of Italy is stepping up its supervision of debt collection companies, known as master servicers.33 Some organizational shortcomings have been found, which call for stronger controls and improved risk management and recovery strategies, especially when these are outsourced. The most difficult challenge, and the one with the greatest impact on the real economy, is the management of loans to customers who are struggling but may recover. In order to draw up effective recovery plans for borrowers, companies working in this area need to improve their management, financial and advisory capacities. Capital In light of the risks emerging to their activity, banks must safeguard the soundness of their capital base. Since 2020, the increase in the capital ratios has been driven by the decline in risk-weighted exposures – the denominator of the ratio – mainly as a result of the State-guaranteed loans granted, which are gradually reaching maturity.34 At the same time, the amount of capital has decreased.35 These are called overlays, whose use is encouraged by the supervisory authorities to take account of risks (such as geopolitical, inflation and climate risks), not always adequately captured by ordinary models. See FSB, ‘Peer Review of Italy’, 2024. All supervised servicers perform the guarantee tasks envisaged under Law 130/99 (master servicing tasks). The recovery of securitized loans is almost exclusively left to third-party agencies, which are licenced to do so under Article 115 of the Consolidated Law on Public Security (Testo unico delle leggi di pubblica sicurezza, TULPS) and are not subject to supervision (special servicers). Special servicers have usually already been involved by the investor when due diligence is performed on the securitized portfolios and are responsible for preparing and updating business plans; they are also directly accountable to investors for debt collection scenarios. Around 80 per cent of the State-guaranteed loans to Italian banks will expire by the end of next year. M.A. Aiello, C. Ciancaglioni and G. Manzelli, ‘Risk-weighted assets dynamics for Italian and SSM banks over the last three years’, Banca d’Italia, Notes on Financial Stability and Supervision, 34, 2023. The trends in capital can be reversed by drawing on last year’s exceptional profits, thereby strengthening the banks’ ability to absorb future losses. Aside from the microprudential perspective, macroprudential capital buffers are necessary to enable banks to support the economy in the event of external shocks to the financial system. These can be built up by financial intermediaries using capital in excess of minimum requirements, without raising new capital. With the pandemic emergency behind us, many foreign authorities have increased capital buffers that can be released if adverse events occur. The Basel Committee has welcomed the accumulation of macroprudential reserves, including when cyclical growth is not strong. The ECB has also supported the build-up of such buffers, banks’ capital positions and profitability permitting. The Bank of Italy is examining the macroprudential policy stance in Italy. The results will be announced in the coming weeks. 5. Technology In recent years, the debate on the impact of technology on the financial system has focused on the risk that ‘traditional’ intermediaries could be disintermediated by FinTech companies – young and innovative companies specializing in the application of technology to finance. This risk has not materialized. What can be seen, in Italy and internationally, is that banks have embraced the most promising innovations, adopting the new technologies and in some cases acquiring a controlling stake in FinTechs. These companies currently play a somewhat autonomous role in specific areas of the financial sector, such as retail payments, small loans and asset management. It has become clear that the greatest challenges to the financial system come from global tech giants such as Google, Apple, Facebook, Amazon, Microsoft and several others. These Big Techs enjoy formidable competitive advantages. Their vast financial resources and their position at the forefront of digital innovation are just two of them, and not necessarily the most important when it comes to financial intermediation. The key strengths of Big Techs are their capacity to access and to exploit an impressive wealth of data on hundreds of millions of clients, partly thanks to their client-oriented, rather than product-oriented, business models. Online platforms allow Big Techs to interact simultaneously and cheaply with a large number of intermediaries, firms and consumers via a single channel. For their operators, these platforms are a unique source of real-time data about a given firm’s products, about specific goods and services, and about consumers’ tastes and incomes, and may over time become the main channel for screening customers and for distributing financial and payment services. Financial intermediaries will have to respond to these trends, making greater use of innovative techniques such as digital identity systems, big data and artificial intelligence, in order to realize efficiency gains and provide higherquality services. Above all, they will have to prioritize customer relations. In turn, legislators and supervisors will need to strike the right balance between the goal of stimulating innovation and competition and that of preventing regulatory arbitrage and distortions of competition. Fair competition must be ensured by applying the same rules and controls to the same activities and risks, minimizing the risks engendered by the new players without stifling the development of products that can improve consumer welfare. Central banks are also directly involved as issuers of payment instruments. A central bank digital currency, be it retail or wholesale (in the euro area, respectively, the digital euro and TARGET infrastructure) can provide intermediaries with further instruments to meet the demand from individuals and financial operators for efficient, secure, and low-cost digital financial services. At the same time, widespread access to digital finance raises broader issues, including the defence of monetary sovereignty, financial inclusion, the right to privacy, cyber security, the fight against money laundering and the financing of terrorism, and so on. These matters are being examined by national and international authorities. They are on the Finance Track agenda of the G7, which is chaired by Italy this year. They are also being addressed by the G20, the Financial Stability Board (FSB) and the Committee on Payments and Market Infrastructures (CPMI) in the Bank for International Settlements (BIS). In the coming years, the Bank of Italy will closely follow these issues, which are crucial for the future of the financial system in Italy and in Europe. 6. Conclusions The global economy is being held back by the ongoing monetary tightening in several countries and by the uncertainty raised by ongoing conflicts. Geopolitical fractures are emerging at global level that, if not addressed, could jeopardize development prospects, integration between countries and the multilateral architecture that has supported international relations since the Second World War. In Europe, the economy has not experienced a deep recession so far, but has stagnated for many quarters and there are no signs of a marked acceleration. Inflation is falling rapidly and the risks to price stability have eased. If monetary policy were to take too long to accompany the ongoing disinflation, downside risks to inflation could emerge that would conflict with the symmetrical nature of the objective set by the ECB’s Governing Council. The weakness of the European economy is extending to Italy. To embark on a path of sustained growth, we must act on two fronts. We need to reassure investors about a downward trajectory for public debt; the reduction in the risk premiums that this may entail would make the path easier. We need to stimulate investment that can boost innovation and productivity. Positive signs have emerged in recent years: greater capital accumulation, the strength of the labour market, the ability of many companies to compete in international markets, and the soundness of bank balance sheets. These are key elements that can play an important role in relaunching Italy’s development. APPENDIX Figure A1 Sea freight rates for container shipping on a number of different routes (index numbers, December 2023 average=100) Shanghai − Genoa Shanghai − Los Angeles Shanghai − New York Shanghai − Rotterdam 15 Dec. 2023 1 Jan. 2024 15 Jan. 2024 1 Feb. 2024 Source: Eikon, based on Freightos data. (1) Weekly data. Figure A2 New barriers to trade and foreign direct investment (number of new restrictions) 2,400 Barriers to trade 2,000 Barriers to foreign direct investment 1,600 1,200 Source: Global Trade Alert and UNCTAD. (1) Annual data. – (2) Right-hand scale. Figure A3 Potential GDP growth (per cent) Ar W or ld ge n Au tina st ra l Au ia s Be tria lg iu m Br a C zil an ad a C hi n Fr a a G nce e H rma on n g y Ko ng In Indi do a ne si a N Ja et he pan rla nd s So Ru ut ssi a h So A ut fric h a Ko re a S S U wit pai ni te zer n d l K an U ing d ni te do m d St at es Fo re ig n Ita of de ly Ita ma ly nd (2 ) Source: IMF, World Economic Outlook (October 2007, October 2019 and October 2023). (1) Annual data. Forecasts published in the year indicated in the figure, relating to each country’s long-term GDP growth (5 years forward). – (2) Long-term growth in Italy’s foreign demand is calculated by weighting the long-term GDP growth of each country by the share of Italy’s exports to these economies. Figure A4 Distribution of industrial production across sectors in the euro area based on changes in the indices (as a percentage share of the total number of production sectors) Less than −5% Between −5% and 0% Between 0% and 5% Greater than 5% Source: Based on Eurostat data. (1) Monthly data; 12-month percentage changes. Figure A5 Purchasing managers’ indices (PMIs) in the euro area (diffusion indices) Manufacturing Services Source: S&P Global Market Intelligence. (1) Monthly data. Diffusion indices for economic activity in the manufacturing and service sectors. Values greater than 50 are compatible with expansion in the sector. Figure A6 Forward-looking employment indicators in the euro area (per cent; index numbers, long-term averages = 100) 3.5 3.0 2.5 2.0 Employment expectations Job vacancies 1.5 Sources: European Commission and Eurostat. (1) Quarterly and monthly data. Ratio of job vacancies to total jobs (sum of employment and job vacancies) for the non-farm private sector and employment expectation index. Figure A7 Long-term inflation expectations in the euro area (per cent) 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 Market expectations 0.0 SMA SPF 0.0 Sources: ECB and Bloomberg. (1) Daily, quarterly and sporadic data. Median of the long-term inflation expectations reported by the experts interviewed as part of the Survey of Professional Forecasters (SPF), conducted at the beginning of each quarter, and of the Survey of Monetary Analysts (SMA), conducted around 2 weeks ahead of the ECB Governing Council’s monetary policy meetings. 5-year, 5 years forward inflation-linked swap rates, net of the estimated inflation risk premium. Figure A8 Euro-area inflation (12-month percentage changes) Core Headline Source: Eurostat. (1) Monthly data. For January 2024, preliminary data. Figure A9 Inflation in the main euro-area countries (12-month percentage changes) France Germany Italy Spain Source: Eurostat. (1) Monthly data; For January 2024, preliminary data. Figure A10 Distribution of the components of core inflation in the euro area based on the 3-month annualized change in prices (per cent of total items in the core inflation basket) Developments Historical averages 3−month core inflation −2 Less than 0% Between 0% and 2% Between 2% and 3% Between 3% and 5% 2001−12 2013−19 −2 Between 5% and 10% More than 10% Source: Based on Eurostat data. (1) Monthly data; 12-month changes and annualized changes in the average for the 3 months ending in the reference month compared with the previous 3 months (no overlapping), calculated using seasonally adjusted data for each item in the core inflation basket. – (2) Right-hand scale. Figure A11 Eurosystem inflation projections (per cent) 3.3 3.3 3.0 3.0 2.7 2.7 2.4 2.4 Mar. 2024 June 2024 Sept. 2024 Dec. 2022 Dec. 2024 June 2023 Mar. 2025 Dec. 2023 Source: ECB. (1) Quarterly data. The macroeconomic projections for the euro area are those prepared by experts from the Eurosystem national central banks in the projection exercises carried out in June and December of 2022 and 2023 (Eurosystem staff macroeconomic projections for the euro area). Figure A12 Interest rates on loans (per cent) 6 Households Firms Euro area Italy Source: ECB. (1) Monthly data. Interest rates on new loans to firms and on new mortgage loans to households for house purchase. Figure A13 Credit growth in real terms in the euro area Sovereign debt crisis (12-month percentage changes) Financial crisis −5 −5 Credit to households Credit to firms Sources: Based on ECB and Eurostat data. (1) Monthly data. Credit in real terms is calculated by deflating the nominal figures with the consumer price index. Figure A14 Effects of changes in the Eurosystem balance sheet on banks’ liquidity position and lending (net percentage shares) Targeted longer−term refinancing operations −20 −10 −20 Monetary policy portfolio −10 Effect of changes in the Eurosystem balance sheet on: Banks' liquidity position Lending volumes Source: ECB, Bank Lending Survey. (1) Half-yearly data. A negative net percentage share indicates a negative effect in the reference six-month period. The latest observation refers to the October 2023 survey and incorporates banks’ expectations for the next six-month period (dashed line). Figure A15 Core and headline inflation in the euro area (12-month percentage changes) Core (shifted backward by 6 months) Headline 5.5 4.5 3.5 2.5 1.5 0.5 Source: Based on Eurostat data. (1) Monthly data. The core inflation series was shifted 6 months backward. – (2) Right-hand scale. Figure A16 Inflation for non-energy industrial goods and services and PMIs in the euro area (12-month percentage changes; diffusion indices) 8.0 6.0 5.5 4.5 3.0 3.0 0.5 1.5 Inflation for non−energy industrial goods (shifted backward by 9 months) PMI in manifacturing: output prices −2.0 Inflation for services (shifted backward by 9 months) PMI in services: selling prices 0.0 Sources: Based on Eurostat and S&P Global Market Intelligence data. (1) Monthly data. The inflation series was shifted 9 months backward. Figure A17 The rise and fall of inflation in the euro area, 2021-24 (percentage points; deviation from the 2 per cent target) −14 −12 −10 −8 −6 −4 −2 Months Source: Based on Eurostat data. (1) The peak month for inflation was October 2022 (10.6 per cent on a 12-month basis); the horizontal axis indicates the months before and after this date. Figure A18 Euro-area firms’ expectations of intermediate goods costs and wages (index numbers: expectations of no change=0) 1.5 1.5 Expectations of intermediate goods costs Wage expectations 1.0 1.0 0.5 0.5 0.0 0.0 Source: Based on data from C. Elding, J. Gareis, F. Kuik and R. Morris, ‘Main findings from the ECB’s recent contacts with non-financial companies’, in ECB Economic Bulletin, 5, 2023, pp. 46-48. (1) Quarterly data. Expectations refer to the quarter following the one in which the survey is conducted and are converted into scores that, by construction, vary from -2 to 2. A score equal to zero corresponds to expectations of costs remaining stable; a score greater (lower) than zero signals expectations of an increase (decrease). The value of the score indicates the intensity of the expected change. Figure A19 Employment and hourly wages in real terms in the euro area (index numbers Q4 2019=100) Employment Real hourly wages Source: Based on Eurostat data. (1) Seasonally adjusted quarterly data. Real wages are calculated by deflating nominal wages using the consumer price index. Figure A20 Share of variable-rate bank loans (per cent) 100 Non−financial corporations 100 Households France Germany Italy Spain Sources: Bank of Italy and ECB. (1) The data refer to the end of the year. The figure for firms includes current account overdrafts and excludes non-performing loans; the figure for 2023 refers to September. For households, the figures from countries other than Italy are calculated as 10-year averages of the shares of variable-rate loans in total lending. Figure A21 Ratio of net financial charges to gross operating income for Italian firms (per cent) Sources: Bank of Italy (Financial Accounts) and Istat. (1) The data refer to Q4 for every year up to 2022 and to Q3 for 2023 (latest figure available). Printed on EU-Ecolabel certified paper (registration number FR/011/003) The life-cycle environmental footprint of the paper used was offset by purchasing carbon credits and planting trees in Italy. Designed and printed by the Printing and Publishing Division of the Bank of Italy
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Opening remarks by Mr Fabio Panetta, Governor of the Bank of Italy, at the Symposium in honour of Ignazio Visco "Hard Times": Economic Shocks and Policy Responses since the Global Financial Crisis, Rome, 12 March 2024.
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Fabio Panetta: Honouring Ignazio Visco - a life in economics Opening remarks by Mr Fabio Panetta, Governor of the Bank of Italy, at the Symposium in honour of Ignazio Visco "Hard Times": Economic Shocks and Policy Responses since the Global Financial Crisis, Rome, 12 March 2024. *** It is my pleasure to welcome you today to honour Ignazio Visco, whose term as Governor of Banca d'Italia ended in October last year. It is challenging to sum up Ignazio's career in just a few words. It is even more challenging to do justice to his contributions and his tireless professional dedication. I will avoid the challenge and simply recall – as a friend and as a colleague – some of the episodes that have marked his experience in central banking. As a sign of things to come, Ignazio started thinking about inflation when he was in his early twenties. He studied the topic at the University of Rome, under the supervision of Federico Caffè, and went on to do a doctorate at the University of Pennsylvania, under the supervision of Nobel laureate Lawrence Klein. Ignazio's early research focused on the role of wage indexation in driving inflation in the 1970s. As you all know, the link between wages and inflation is at the heart of the current debate among central bankers in the euro area and beyond. Even as a young man, Ignazio had an instinct for picking critical, policy-relevant issues that lie at the core of central banking. Ignazio joined Banca d'Italia in 1972, just before the oil shock caused by the Yom Kippur War. And when he left Banca d'Italia last year, Europe was dealing with the aftermath of another energy shock caused by the Russian aggression against Ukraine. To an all-round intellectual like him, this must have looked like a vindication of the Italian philosopher Giambattista Vico's idea that history consists of 'recurring cycles' (corsi e ricorsi storici). In fact, between 1972 and 2023, there were many other occasions when Ignazio had to navigate choppy waters, at Banca d'Italia and elsewhere. Hence the title of this conference. In 1992, as Head of the Bank's Research Department, he faced Black Wednesday and the subsequent suspension of the Italian lira from the European Exchange Rate Mechanism. A few years later, while he was Chief Economist at the OECD, the Asian crisis of 1997-98 unfolded, spreading to Russia, Brazil, Argentina and other countries. The Great Moderation of the 1990s and early 2000s provided some respite. But Italy's performance was poor, hampered by low productivity. Ignazio was aware of the scale of the problem, and he initiated and led a major collective effort to identify the reasons for Italy's malaise. The results of this research are well documented and widely accepted today. Ignazio joined the Governing Board of Banca d'Italia in 2007, on the eve of the global financial crisis. And he became Governor in 2011, during the eurozone sovereign debt crisis. 1/3 BIS - Central bankers' speeches Ignazio and I worked together closely during this period. The crisis forced us to talk more about spreads, deficits, and non-performing loans than about productivity. And events moved so quickly that we did not have time to delve into these issues as much as we would have liked. In essence, it was time to act, not speculate. In spite of the pressure, or perhaps because of it, our interactions were always calm, stimulating and productive. Of course I am not in a position to give an impartial view of what we have done together, but I do believe that the work carried out by Banca d'Italia has been extremely valuable in many areas, both domestically and at European level. At the end of 2014, the risk of deflation appeared on the horizon. A broad, persistent price decline put the ECB in a situation it had never faced in its short existence. Nevertheless, the response was swift, creative and effective. I do not want to praise the central bankers in this room too much, but I believe that, on balance, 'unconventional monetary policies' have been a success. As famously stated by Ben Bernanke, these measures do not work in theory, but do work in practice. I am sure that this is a lesson that will remain useful in the future. In 2018, with the risk of deflation and Italy's banking problems largely under control, Ignazio dared to publish 'Difficult Years': a retrospective book wrapped in a thin veil of optimism. Some of his readers were quick to point out that the following years could be even worse. Well, they were not wrong. The last part of Ignazio's mandate saw a truly exotic mix of shocks: the COVID-19 pandemic, the war in Ukraine, the ominous resurgence of long-forgotten geopolitical tensions. Figuring out the inflationary implications of all this required another dose of intellectual heavy lifting, and Ignazio did not shy away from it. Clearly, Ignazio did not get bored during these years. I hope that my mandate will be much more boring. In his 50 years of service, Ignazio was also part of powerful historical processes. Technology and globalization brought tangible improvements in living conditions around the world. The launch of the Economic and Monetary Union and the creation of the euro heralded a new era for Europe. In addition, the Italian economy, despite its structural problems, proved its potential by emerging from the COVID pandemic with an exceptionally strong recovery. These are success stories. They are also stories that none of us should take for granted. Globalization is now in reverse; EMU is still incomplete; and Italy could easily fall back into its low-growth trap. I know how much Ignazio cares about these issues, and I can assure him that Banca d'Italia will continue to work on them with the same passion and rigour that characterized his tenure as Governor. Over his career, between one crisis and the next, Ignazio wrote extensively on a wide range of economic topics, from inflation expectations to education and human capital. He gave thorough, long public speeches on many of these topics. He also spearheaded the development of Banca d'Italia's econometric model. 2/3 BIS - Central bankers' speeches Yet Ignazio left his mark on Banca d'Italia not only as an economist. His knowledge goes far beyond economics, and it includes as many poets, historians and philosophers as economists or statisticians. This combination often proved problematic for our colleagues: they knew that a briefing with the Governor could include any combination of economic arguments, quotes from Dante Alighieri or Søren Kierkegaard, and citations from exoteric econometric papers from the 1970s onward. To make matters worse, Ignazio is notoriously capable of digesting thick background documents without ever losing his concentration, or overlooking a footnote. He also has a sharp eye for spotting typos, and a true dislike for them. And he always doublechecks the double-checks – just in case. In short, he was not an easy client to please. But he was also welcoming and open to debate, especially with junior staff. The fond memories he has left behind among colleagues show that, in the long run, it is this attitude that defines a leader's legacy. I would like to thank the organizers for putting together today's impressive programme. I would also like to thank the keynote speakers, the panellists, the moderator, and all of you for participating in this gathering of friends. Professor Maurice Obstfeld and Professor Hélène Rey will talk about two issues that central banks have to deal with on a regular basis: the elusive neutral interest rate and monetary policy spillovers. Andrew Bailey, Governor of the Bank of England, Agustín Carstens, General Manager of the Bank for International Settlements, and Vítor Constâncio, former vice President of the ECB, know a lot about 'hard times' and financial crises. Professor Beatrice Weder di Mauro has the challenging task of moderating their discussion. I look forward to hearing them all. At the risk of sounding provoking, I would like to conclude by re-quoting Kierkegaard: 'Life can only be understood backwards, but it must be lived forwards.' My wish for Ignazio today is that he will not only continue to look forward, but also to reflect on his experiences, and share his reflections with us and the cohorts of young economists – and potential central bankers – who will follow us. Thank you. 3/3 BIS - Central bankers' speeches
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Speaking notes by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the EMU Lab seminar on "Enhancing fiscal stabilisation in EMU", Villa Schifanoia, Florence, 22 March 2024.
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Luigi Federico Signorini: Fiscal stabilisers, fiscal rules and fiscal union Speaking notes by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the EMU Lab seminar on "Enhancing fiscal stabilisation in EMU", Villa Schifanoia, Florence, 22 March 2024. *** Fiscal stabilisers Fiscal measures1 to stabilise the cycle should be timely, temporary and targeted. In this perspective, automatic stabilisers are preferable to discretionary measures (see e.g. Taylor, 2000). They do not suffer from the lags due to legislative approval and implementation; they do not need explicit action to be terminated. Many of the channels through which they operate inherently benefit those most in need. This largely holds even when a shock is asymmetric, i.e., it selectively affects certain businesses or areas. The literature also points to potential political-economy biases affecting selective discretionary action (see e.g. the survey by Alesina and Passalacqua, 2016). Automatic fiscal stabilisation is explicitly provided by cycle-sensitive budgetary items. Such items are driven by their cyclical macroeconomic bases: unemployment for unemployment benefits, household income for personal taxation, turnover for VAT, profits for corporate taxes. They react promptly to a shock. At the micro level, they go to those that are more directly hit. In a progressive tax system (provided inflation is low) personal income tax revenues also typically decline more than GDP, as some households fall into a lower tax bracket; this supplies an additional short-term boost, (in addition to a redistributive effect). Implicit output stabilisation is also provided by non-cyclical items, especially on the spending side. Most existing government expenditure – such as wages, transfers or intermediate consumption – hardly react to short-run changes in output; thus, they tend to rise as a share of GDP in recessions and decline in booms. The case has been made that, with very large and persistent demand shock, the risk of "hysteresis" effects may justify the recourse to discretionary fiscal measures (see Christiano et al., 2011; De Long and Summers, 2012). However, any discretionary interventions would need to be carefully crafted to avoid unintended distortions, and to provide for appropriate sunset clauses (so that policies, given the usual decision lags, do not end up being out of phase with the cycle, or having an undesirable longer-term impact on the equilibrium of public finances). These conditions are not easy to stick to in practice. An intermediate possibility, of which Professor Blanchard is a proponent, is to make any non-automatic fiscal response to very large shocks not fully discretionary, i.e., to have specific measure triggered by pre-defined exceptional circumstances. The idea is not in fact totally new; it dates back to one of the earliest paper on the subject (Musgrave and Miller, 1948): "The flexibility of the tax system might be 1/5 BIS - Central bankers' speeches increased if provision was made for automatic adjustment in tax rates with changes in income but this could hardly be called built-in flexibility in the usual sense of the term". However, it has been explored more rigorously in recent years (e.g. Eichenbaum, 2019; Blanchard and Summers, 2020 and Boushey et al., 2019). Basically, the idea consists in changing the parameters of fiscal policy (e.g. the generosity of the unemployment benefit scheme or the tax rates) for a period of time, when one or more business-cycle indicators (like the unemployment rate or the output gap) exceed certain thresholds. This approach reduces the distortions and delays typically implied in fully discretionary measures. One can think of several objections. Defining appropriate indicators and thresholds, for instance, may be tricky, both on theoretical and practical grounds. (Professor Blanchard discusses certain key details in his joint 2020 paper). Issues of statistical measurement may arise. The possibility of ex-post tampering with duration and parameters may reintroduce some of the problems inherent in pure discretionary action. Various potential practical pitfalls will have to be taken into account. Still, I understand that an arrangement of this type is actually in place at least in the case the US unemployment benefits scheme. It might be useful to explore the possibility of making use of a similar arrangement in a supranational context, with an open mind and a very pragmatic attitude. Fiscal rules Fiscal rules in a monetary union are needed to ensure the stability of the area by preventing harmful spillovers caused by public-finance tensions in member states. For this reason, members are required to pursue sound forward-looking fiscal strategies to guarantee long-term sustainability. This will make public finances in each country more resilient to negative shocks, thanks both to the fiscal space accumulated in good times, and to the confidence of markets given by credible long-term commitments. While rules originate as a reciprocal guarantee among members of the union, they are also a useful reference for political deliberations in each member state. Pursuing these aims requires careful design. The crux of the matter consists in operationalising the concepts of 'forward looking' and 'long term'. One would like to have rules that are strong enough to ensure that extra fiscal resources are accumulated in good times, but flexible enough to avoid imposing undue pro-cyclical fiscal contractions in bad times. It must be said that the procyclical impact of inflexible fiscal rules can be overstated, especially in a crisis. When a government faces a loss of the market's confidence in the long-term sustainability of its finances, there is no flexibility in formal rules that can spare it the need for forceful action. Still, adequately accounting for the conjunctural situation remains a desirable feature of effective rules. Let me say it once again: this works both ways. Tough rules that require extra prudence and the build-up of fiscal buffers when times permit are a key condition to allow for easier constraints when times so require. 2/5 BIS - Central bankers' speeches Nobody says that devising such rules is an easy task. There is a potentially vast choice of indicators, parameters, procedures and institutional structures, all of which have pros and cons. One has to be prepared to accept second-best solutions, also taking account of the need for reaching tricky political agreements. Europe has long had such rules – and a lively debate about them. This is not the occasion for a retrospective assessment of existing rules, not even from the specific point of view of stabilisation policies. Let me just say that, with all their limits and complications, on balance they are likely to have positively contributed to budget processes, not least by providing reference points and calling for improved domestic procedures – including at the constitutional level. Still, especially after the Covid crisis called for a suspension, there was a consensus that the system had become too complex and unworkable and that a reform was necessary. This process is now coming to a close, following the political agreement reached in February. A positive element of the new framework appears to be its explicit medium-term orientation, entailing a full-fledged debt sustainability analysis performed by the Commission. The reform also provides for more room for bargaining between the European Commission and each Member State. This is good to the extent that it actually increases national 'ownership' of the plans, as the legislators intend, and it does create some useful flexibility. However, it may also imply a highly politicised process, and the way it will work in practice cannot be fully anticipated. A farsighted attitude on all sides will be essential for this approach to succeed. Numerical safeguards are also envisaged. The final compromise includes a minimum structural budget target (1.5 per cent of GDP) and a minimum annual debt reduction target (up to 1 per cent of GDP, depending on the starting point). The role of the 3 per cent deficit threshold has never been questioned. Experience will show how this set of safeguards is actually going to work. (I shall not comment on the details. The choice of parameters and reference levels is always debatable and rather complex, thus undoubtedly detracting from one of the aims of the reform, which was simplification.) Let me just say that, in principle, having safeguards in the procedure is a bit like having output floors and leverage ratios in banking regulation. If the conceptually superior process (risk-sensitive models in banking, well-developed, realistic sustainability models and effective medium-term plans in public finance) works as intended, and if the 'rule-of-thumb' thresholds are well chosen, the latter can be seen as rough 'guardrails', useful to maintain the operations of the main mechanism within reasonable limits. Again, experience will tell. Fiscal union Let me finally make a quick point about fiscal union. 3/5 BIS - Central bankers' speeches If a significant central budget were in place, having simpler rules at the national level would be possible. Any residual procyclical effect could by counteracted by a system of EU-level stabilisers, automatic or (just possibly) semi-automatic (see Romanelli et al, 2022). For common shocks, one key advantage of such an arrangement would be the possibility of simplifying the rules and making them more transparent. For idiosyncratic shocks, it would additionally entail the benefits of mutual insurance (Balassone et al., 2018). National fiscal policies can only spread the effect of a shock on private consumption and GDP over time; a common EU-level stabilising mechanism would also provide a degree of budget insurance against country-specific shocks, i.e., across member countries. (As has been argued, such insurance can also be provided through the capital and credit markets, to the extent that individuals in each country hold a diversified investment portfolio and have access to opportunities to smooth consumption through cross-country lending. In the US, financially-based cross-state insurance has been shown to be even more powerful than that provided by the federal budget (Alcidi et al., 2023). To me, however, this is not necessarily an either/or issue: it is an argument to pursue more financial market integration, as well as more fiscal integration.) No explicit mutual insurance scheme is conceivable without safeguards against moral hazard, opportunistic behaviour or stacked odds. (And of course, in case a more significant common budget is established, safeguard for a sound, forward-looking management at the supranational level will be called for). However, tools can be devised to mitigate moral hazard, equate ex-ante expected benefits (Cioffi et al., 2019; Amato et al., 2023), or put limits on central expenditure or debt. The economic case for a reasonable degree of EU-level fiscal stabilisation, in my opinion, fundamentally stands; the more automatic, the better. In political terms, of course I am under no illusion that this would be an easy or quick route to take. My view is simply that an increased EU-level fiscal capacity with some stabilising effect would be useful. One hopes that it may it become politically feasible in due course. 1 Thanks to Pietro Tommasino and Stefania Zotteri for very valuable input. Opinions are mine.1 Thanks to Pietro Tommasino and Stefania Zotteri for very valuable input. Opinions are mine. REFERENCES Alesina, A. and Passalacqua, A. (2016), "The Political Economy of Government Debt", in: J. B. Taylor and Harald Uhlig (eds), Handbook of Macroeconomics, vol. 2, Elsevier. 4/5 BIS - Central bankers' speeches Amato M., Belloni E., Favero C.A., Gobbi L., Priviero L. (2023), "European Sovereign Debt Risk Management: the Role of an European Debt Agency", Bocconi University, mimeo. Balassone, F., Momigliano, S., Romanelli, M. and Tommasino, P. (2018), "Just Round the Corner? Pros, Cons, and Implementation Issues of a Fiscal Union for the Euro Area", Economia Pubblica, vol. 2018(1), pages 5-34. Blanchard, O. J. and Summers, L. H. (2020), "Automatic Stabilisers in a Low-Rate Environment", AEA Papers and Proceedings, vol. 110, pages 125-130. Boushey, H., Nunn, R. and Shambaugh, J. (2019), Recession Ready: Fiscal policies to stabilize the American economy, Brookings Report. Christiano, C., Eichenbaum, M. and Rebelo, M. (2011), "When Is the Government Spending Multiplier Large?", Journal of Political Economy, vol. 119(1), pp. 78-121. Cioffi, M., Rizza, P., Romanelli, M. and Tommasino, P. (2019), "Outline of a redistribution-free debt redemption fund for the euro area", Questioni di Economia e Finanza (Occasional Papers), n. 479, Bank of Italy. DeLong, J.B., Summers, L. H. (2012), "Fiscal Policy in a Depressed Economy", Brookings Papers on Economic Activity, vol. 43(1), pp. 233-297. Eichenbaum, M. S. (2019), "Rethinking Fiscal Policy in an Era of Low Interest Rates", Macroeconomic Review, April 2019 R. A. Musgrave and M. H. Miller (1948), Built-in Flexibility, American Economic Review, Vol. 38(1), pp. 122-128. Romanelli, M., Tommasino, P. and Vadalà, E. (2022), "The future of European fiscal governance: a comprehensive approach", Questioni di Economia e Finanza, n. 691, Bank of Italy. Taylor, J. B. (2000), "Reassessing Discretionary Fiscal Policy", Journal of Economic Perspectives, vol. 14(3), pp. 21-36. 5/5 BIS - Central bankers' speeches
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Address by Mr Fabio Panetta, Governor of the Bank of Italy, at the ordinary general meeting of shareholders, Rome, 28 March 2024.
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Fabio Panetta: Overview of economic and financial developments in Italy Address by Mr Fabio Panetta, Governor of the Bank of Italy, at the ordinary general meeting of shareholders, Rome, 28 March 2024. *** Ladies and Gentlemen, The global economy remains weak. Sluggish international trade and the uncertainty raised by geopolitical tensions are weighing on economic activity. The restrictive monetary policy of the European Central Bank (ECB) is dampening demand and is contributing, together with falling energy prices, to a fast decline in inflation. Risks to price stability have subsided and the conditions for starting monetary easing are taking shape. As I will explain shortly, the implementation of monetary policy aimed at price stability is reflected in the Bank of Italy's 2023 Annual Accounts, which are submitted to you for approval today, and will continue to affect profitability in the near future. *** I would like to take this opportunity to thank my predecessor Ignazio Visco once again for his service to the Bank of Italy, as we did at the symposium held recently to express our appreciation and to celebrate his two mandates at the helm of the Bank. I would also like to extend my warmest wishes to Piero Cipollone, former Deputy Governor of the Bank of Italy, who was appointed to the ECB's Executive Board last November. He has been replaced on the Bank of Italy's Governing Board by Chiara Scotti, former Senior Vice President and Director of Research at the Federal Reserve Bank of Dallas. Monetary policy and its impact on the Bank's Annual Accounts The Eurosystem central banks have purchased a large amount of securities in recent years in order to ensure that inflation returns to 2 per cent over the medium term. With the rise in inflation, the ECB Governing Council began to tighten its monetary policy in July 2022. It stepped up these efforts in the first nine months of 2023, raising its key interest rates by 200 basis points overall, to 4.5 per cent on the main refinancing operations, 4.75 per cent on the marginal lending facility, and 4 per cent on the deposit facility. The Governing Council has kept the policy rates unchanged since last October. The reinvestment of securities held for monetary policy purposes under the asset purchase programme (APP) was discontinued in July 2023. Maturing securities under the pandemic emergency purchase programme (PEPP) will instead continue to be fully reinvested through the first half of 2024. The ECB Governing Council intends to reduce 1/4 BIS - Central bankers' speeches reinvestments by €7.5 billion per month over the second half of the year, before discontinuing them from the end of 2024. Over the next few months, reinvestments will continue to be made with the flexibility required to counter risks to the monetary policy transmission mechanism. The amount of funding granted to euro-area banks through Eurosystem refinancing operations continued to fall significantly, from €1,324 billion at the end of 2022 to €410 billion at the end of 2023. The decline was mainly due to the repayments of maturing third-series targeted longer-term refinancing operations (TLTRO III), combined with voluntary early repayments driven by the change in funding conditions, which have been less favourable to banks since November 2022. The balance sheet At the end of 2023, the Bank of Italy's balance sheet assets stood at €1,253 billion, down by €223 billion from 2022. The balance sheet reduction is set to continue in the current year as a result of maturing TLTRO III operations and of the ECB Governing Council's decisions to discontinue the reinvestment of maturing securities. On the asset side, just as for the other national central banks of the Eurosystem, the decline was mainly due to refinancing operations, down from €356 billion to €150 billion. Securities held for monetary policy purposes also declined, though to a lesser extent: at the end of 2023, they amounted to €657 billion (€39 billion less than in the previous financial year), with Italian government bonds accounting for around €600 billion. On the liability side, there was a decline both in deposits held by banks, which fell by €57 billion, and above all in the Bank's negative TARGET balance, down from €684 billion to €521 billion. The sizeable reduction in the latter was largely due to net purchases of Italian securities – mostly public sector securities – by foreign investors, and to an expansion in Italian banks' net funding on international markets. These liquidity inflows were partly offset by Italian residents' investment in foreign securities. The disbursement of the third and fourth tranches of Recovery and Resilience Facility funds to the Italian State through the TARGET system contributed to the decrease in the Bank's negative balance. The negative TARGET balance continued to edge down in the first months of 2024, to around €500 billion on average in March. Main drivers of the 2023 net profit and future prospects The Eurosystem's monetary policy is designed and implemented to fulfil the statutory mandate of price stability, even if this leads to a temporary worsening in central banks' profit and loss accounts. Last year, we anticipated that the Bank of Italy would post a sizeable gross loss for 2023, before the release of the general risk provision, largely due to the sharp contraction in net interest income. This has also occurred at the other Eurosystem central banks, some of which recorded a gross loss as early as 2022. The rise in the ECB policy rates led to an increase in the cost of balance sheet liabilities, mainly bank deposits, with no corresponding increase in the yield on monetary policy assets. These assets are actually less sensitive to changes in interest rates, as they consist mainly of fixed-rate securities with medium to long-term maturities. 2/4 BIS - Central bankers' speeches Confirming what had been anticipated last year, the financial result for 2023 before tax and before the release of the general risk provision was €-7.1 billion, against €5.9 billion in 2022. In addition to the €11.4 billion deterioration in net interest income, the reduction in the financial result was explained by the net result of pooling of monetary income, down by €3.5 billion, which was also attributable to the impact of monetary tightening over the last two years. The Bank of Italy is able to absorb these losses thanks to its past capital strengthening policies, based on the principle of prudence. The financial buffers built up over the years to weather the potential materialization of risks are more than sufficient to cover both the loss for 2023 and that estimated for 2024. Based on current monetary policy decisions and the expectations regarding interest rate developments, we expect 2025 to mark a return to profit. As a result, €5.6 billion is released from the general risk provision in the 2023 Annual Accounts. Along with the positive contribution of €2.3 billion from the carryforward of the tax loss – which will enable us to pay lower taxes in the future – releasing this amount means that the Bank can close the year with a net profit of €0.8 billion. We believe that the level of risk coverage remains adequate from a medium-term perspective. In 2023, the risks did, indeed, decrease and they will decrease further in the future as a result of the reduction in the size of the balance sheet. The Bank of Italy – an institution constantly evolving to serve the public When I took office, in a message addressed to the Bank's staff, I called on them to be open to change and innovation, while never losing sight of the values that have underpinned the authority and prestige of the Bank over time. A combination of continuity and innovation must drive organizational planning, working methods and operating procedures. We must seize the opportunities offered by digitalization. We need to carry on with and complete the rationalization of the Bank's offices and processes, keeping the organizational structure aligned with changes in institutional activities and the quest for greater efficiency. We must take special care to use financial resources wisely, to control costs and to maintain a strong balance sheet. I would like to mention two examples that illustrate these principles. To be able to contribute effectively to the Eurosystem's digital euro project – an innovative, secure means of payment, freely available to everyone – we are in the process of adopting an organizational model that brings together all the expertise needed to carry out the required activities in an agile and flexible way. Furthermore, leveraging the experience we have gained with the hybrid work model – which means less need for office space – we have drawn up a plan for reallocating space that will deliver significant savings on building costs. We must then respond to the expectations formed in recent years concerning the size and the activities of the branch network. The Bank's widespread presence throughout 3/4 BIS - Central bankers' speeches Italy is an asset that reflects its historical origins and that strengthens its bonds with civil society, but we must bear in mind that many of the functions traditionally performed locally have been superseded. We are currently evaluating a project to ensure the continued provision of the Bank's services across the country through greater integration with the central offices, making adjustments that do not significantly alter the branch network. The activities that benefit from being conducted locally will be maintained and strengthened further: from relations with local communities to consumer protection, from anti-money laundering to economic analysis and financial education. The local availability of currency circulation services will not be affected. This project and other issues regarding the modernization of our management systems and the improvement of working conditions will certainly form part of future discussions with the trade unions. These talks, when characterized by open, good-faith and constructive debate, are a fundamental prerequisite for the smooth functioning of the Bank. Proposal for the allocation of the net profit Dear shareholders, Pursuant to Article 38 of the Statute, acting on a proposal of the Governing Board and after hearing the opinion of the Board of Auditors, I present for your approval the Board of Directors' proposal for the allocation of the net profit. Under the current dividend policy, the amount paid to the shareholders is kept within a range of €340 million to €380 million, provided that the net profit is sufficient and without prejudice to the Bank's capital adequacy. Amounts outside this range are possible, should the Bank's profitability undergo large shifts, such as occurred in 2023 with the recognition of a gross loss and the consequent need to draw on the general risk provision. Accordingly, from the net profit of €815 million, we propose allocating €200 million as a dividend to the shareholders, €140 million less than that allocated last year. The profit for the State amounts to €615 million, down by €1,061 million. The amount of €140 million is released from the special item for stabilizing dividends to supplement the current dividend allocated to the shareholders. The shareholders will therefore receive a total of €340 million this year too. The remaining balance of the special item – equal to €140 million – would continue to be available should it be necessary to supplement the dividend amount in the future. The total amount effectively allocated to the shareholders over the last five years would therefore be €1,544 million. The total allocated to the State over the same period in the form of profits would amount to €21,629 million, in addition to the current taxes for IRES and IRAP purposes of €4,005 million. 4/4 BIS - Central bankers' speeches
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Welcome address by Ms Chiara Scotti, Deputy Governor of the Bank of Italy, at the 4th Bank of Italy, Bocconi University and CEPR Conference on "Financial Stability and Regulation", Rome, 4 April 2024.
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Welcome address Chiara Scotti Deputy Governor of the Bank of Italy 4th Banca d’Italia, Bocconi University and CEPR Conference on “Financial Stability and Regulation” Rome, 4 April 2024 Opening • It is wonderful to be here today to welcome you to the fourth biennial Financial Stability and Regulation conference organized by the Bank of Italy, the Baffi Centre at Bocconi University, and the CEPR. I wish to thank all the participants – keynote speakers, session chairs, paper presenters and discussants – for their contribution, as well as the scientific and organizing committees for their efforts in putting together this programme and arranging this event. • Research insights are a necessary input to help policymakers address the challenges they face in their work. This is even more so the case when it comes to financial stability and macroprudential policy, an area that needs to be flexible as it grows in response to a fast-evolving financial environment. In my brief remarks today, I would like to share with you some thoughts on the important issues that the conference will address in more detail and depth, specifically on liquidity risk, digitalization, climate risk, and safe assets. Liquidity risk and the 2023 banking distress • One year ago, with the global tightening of monetary policy going on in the background, we witnessed the most notable system-wide banking distress episode since the Global Financial Crisis (GFC). In a matter of weeks, four mid-size US banks failed amidst a loss of confidence by their depositors, and Swiss authorities had to assist with extraordinary measures the acquisition of an ailing globally systemic institution by its main competitor. Despite these tensions, the global banking system showed remarkable resilience, largely thanks to the comprehensive regulatory and supervisory reforms implemented following the GFC. These reforms likely prevented significant economic damage.1 See ‘The banking crises of 2023: Some initial reflections,’ address by Paolo Angelini, Deputy Governor of the Bank of Italy, at the ‘Promoting Accountability in Times of Crisis’ event hosted by the Corte dei Conti, Rome, 8 November 2023. • Nevertheless, the resilience we observed should not make us complacent. The unfolding of the US banking distress last year points to the limits and risks inherent in an unevenly regulated banking system (including when it comes to managing crises), as well as to the need for improving the existing liquidity regulation.2 • Given this, I truly appreciate how the papers that we will discuss today and tomorrow tackle some of these important issues, from very different perspectives. • In particular, over the course of these two days, we will hear about the ongoing secular changes in bank business models – driven, among other things, by the progressive reduction in the number of bank branches and by the decline in the ratio of loans to total assets – and about the consequences of these changes for financial stability, macroprudential policy, and financial regulation.3 • We will delve into the relationship between monetary policy rate changes, maturity mismatch, and financial stability. We will also be presented with evidence from historical data, which offer us new insights into when monetary policy changes could pose concrete risks to financial stability,4 and we will hear suggestions for better policy design through the lenses of rigorous macroeconomic models.5 • We will look at the interaction between liquidity regulation and risk-taking by banks, which is paramount for overcoming the weaknesses in the regulatory architecture that were underscored by the 2023 distress,6 and we will begin to scratch the surface of financial intermediation by non-bank financial institutions,7 which we need to understand in order to improve our regulatory and policy frameworks.8 Digitalization • Another very current issue we will see covered in the programme is the growing digitalization of nearly every aspect of banks’ business models, a development that offers opportunities while posing challenges. The potential impact of digitalization Over recent years the Bank of Italy has been studying ways to further strengthen the crisis management framework and make it more effective, for example through an orderly liquidation framework for smaller banks, in line with the IMF recommendations (see De Aldisio, Aloia, Bentivegna, Gagliano, Giorgiantonio, Lanfranchi, Maltese, August 2019, ‘Towards a framework for orderly liquidation of banks in the EU,’ Banca d’Italia, Notes on Financial Stability and Supervision, 15, and IMF Staff, July 2018, ‘Euro area policies: Financial sector assessment program – Technical note – Bank resolution and crisis management,’ IMF, Country Report). These topics are covered by the keynote speeches by Prof. Strahan and Prof. Seru, as well as by the conference papers by Benmelech, Yang, and Zator (2023) and Kundu, Muir, and Zhang (2024) (mimeo). Conference paper Jiménez, Kushinov, Peydró, and Richter (2023). Conference paper Boissay, Collard, Galì, and Manea (2023). Conference paper Bosshardt, Kakhbod, and Saidi (2023). Conference papers Hinzen (2023) and Giannetti, Jotikasthira, Rapp, and Waibel (2023). See the speech by Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the 54th Credit Day, Rome, 3 November 2022. on households, firms and output is enormous, and we therefore need to understand each and every aspect of this transformation.9 • While initial concerns focused on how Fintech companies could disrupt traditional financial institutions, evidence suggests that banks have adapted to the new technologies and some have even acquired Fintech firms. Still, traditional institutions should continue to innovate in the provision of financial services to guard from other challenges in this field, like those that could come from BigTech companies that can leverage on the combination of a large amount of customer data and advanced technologies.10 • I therefore view the presentations we will hear on the uses and benefits of Big Data for banks as extremely timely. The papers we will discuss today give us a sense of the surplus created by such technologies for borrowers and lenders, and of the scope for technology adoption by banks. This type of research helps regulators and policymakers understand how the ongoing wave of innovations could affect the credit market structure.11 • In turn, policymakers find themselves having to keep pace with innovation in the financial sector. During the course of the conference, we will hear about how supervisors can take advantage of similar innovations – a phenomenon known as SupTech – and what results they can expect.12 Climate risk • The conference also touches upon the financial sector risks associated with climate change, one of the key policy challenges of our times. The transition to a net-zero carbon emission economy requires the introduction of financial disincentives for the use of fossil fuels and the adoption of environmentally sustainable technologies. An effective environmental policy and a sound financial sector go hand-in-hand to Recent works by researchers at the Bank of Italy point to how digitalization was instrumental in the resilience demonstrated by the Italian economy during the pandemic and how it correlates to better bank performance (see Branzoli, Rainone, Supino, 2024). The Bank of Italy also follows this theme closely through different initiatives aimed at interacting with private operators directly, including: the Fintech Channel, the point of contact through which operators can dialogue easily and informally with the Bank of Italy, presenting innovative projects and technological solutions; the Milano Hub, the innovation centre supporting the digital evolution of the financial market and encouraging talent attraction and investment; and the Regulatory Sandbox, which allows supervised entities to test innovative products and services in the banking, financial and insurance sectors for a limited period (see Fintech Channel, the Milano Hub and the Regulatory Sandbox). See ‘Economic developments and monetary policy in the euro area,’ speech by Fabio Panetta, Governor of the Bank of Italy, at the 30th ASSIOM FOREX Congress, Genoa, 10 February 2024, and the lectio magistralis on ‘Digital innovation: Challenges and opportunities for central banks (only in Italian),’ by Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, before the Italian Association of Financial Analysts and Consultants (AIAF), Milan, 15 June 2023. The conference paper Yin (2022). The conference paper Degryse, Huylebroek, and Van Doornik (2024) (mimeo). encourage green investments across all sectors, including brown energy-intensive ones, which must reduce their environmental footprint.13 • Economists have been investigating the interplay between environmental policy, credit supply and green investments14 and, more broadly, the repercussions of climate change for the economic and financial systems.15 As a contribution to this avenue of research, I find empirical analyses on the pricing of transition risk by financial markets in reaction to large-scale environmental policies to be very interesting. They shed light on the interplay between governmental policies, investors’ willingness to finance the green transition and financial stability.16 Safe assets • Last but not least, this conference touches on the key theme of the provision, role, and effects of safe assets in financial markets. Such issues are particularly important in the euro area, where the absence of a European safe asset might hamper the development of a liquid, diversified, and resilient Capital Markets Union.17 • The contributions offered during this conference should help us better understand two specific issues related to safe assets. First, we will discuss the potential financial stability implications of crowding out private safe asset creation through public safe asset supply.18 Second, we will also dig deeper into how satisfying demand for safety leads to long intermediation chains, creating interconnections that can be a source of distress propagation during crises.19 Regarding these issues, the Bank of Italy is putting in relentless effort on multiple fronts. As an investor, the Bank of Italy integrates ESG criteria in the management of portfolios not associated with the conduct of monetary policy, as well as engaging in dialogue with high-emitting firms to enable better evaluation of their transition plans. As a supervisor, the Bank of Italy monitors the exposures of regulated intermediaries to both physical and transition risk, with an eye to combatting greenwashing. In addition, in April 2022, the Bank of Italy published its ‘Supervisory expectations for climate-related and environmental risks,’ with the goal of raising banks’ awareness of climate risk. For these efforts, the Bank of Italy was recognized by the Green Central Banking Scorecard as the second greenest G20 central bank – see ‘Il contributo della Banca d’Italia al dibattito e alle strategie sulla sostenibilità,’ address by Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at Assolombarda, Milan, 15 February 2023 (only in Italian); and the paper on decarbonisation strategies by Deputy Governor Angelini (2024). Contributions from Bank of Italy economists on this topic include Accetturo, Barboni, Cascarano, Garcia-Appendini and Tomasi (2022), Apicella and Fabiani (2023), and Aiello and Angelico (2023). Contributions from Bank of Italy economists on this topic include Alpino, Citino, De Blasio and Zeni (2022). Conference paper Bauer, Offner and Rudebusch (2023) (mimeo). The issuance of joint bonds under the Next Generation EU programme shows that progress towards some form of euro-area public safe asset is possible. Research at the Bank of Italy shows that the gains associated with fiscal diversification would be sizable (Pallara and Renne, 2024). Risk-adjusted redistribution mechanisms could be devised to avoid mutualized debt issuance leading to the systematic transfer of resources to countries with the highest public debt levels (see Cioffi, Rizza, Romanelli and Tommasino, 2019, as well as the reference to this contribution made by Governor Visco in his Concluding Remarks for 2020). Conference paper Altinoglu (2023). Conference paper Farias and Suarez (2023). Conclusion • I conclude by again thanking the keynote speakers, session chairs, presenters, discussants, and all the other participants for being here today. I wish you all two days of very fruitful exchange and discussion.
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Statement by Mr Fabio Panetta, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 109th 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, 19 April 2024.
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Fabio Panetta: Statement - meeting of the Development Committee Statement by Mr Fabio Panetta, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 109th 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, 19 April 2024. *** The global economy has shown remarkable resilience in the face of numerous challenges. Thanks to progress made in the battle against inflation, risks to the outlook are more balanced, and a soft landing is now more likely. However, growth prospects over the medium term remain subdued. An imbalanced recovery and the rise of economic and political fragmentation could worsen the gap between and within nations, hampering income convergence and the welfare of the poorest and most vulnerable economies. Against this backdrop, it is of paramount importance that the multilateral system and international financial institutions make timely and decisive interventions. Opportunities and risks associated with climate change, new technologies, demographic trends, migratory pressures – combined with the need to preserve peace – are global in nature and no country can cope with them alone. The World Bank Group (WBG) is expected to contribute by establishing a new multilateral approach to development. We acknowledge the work done under the WBG Evolution launched in October 2022, and the progress made as described in the Development Committee Paper "From Vision to Impact. Implementing the World Bank Group Evolution." We agree that it is time to work on the Evolution agenda's implementation, focusing on modernizing the operational approach, striving to act as a one WBG, and strengthening the WBG's capacity to measure outcomes, including integrating impact evaluations into projects and programs. Under the recently approved Crisis Preparedness and Response toolkit, we welcome the enhancement of the set of instruments designed to help countries plan in advance and make funds ready for rapid deployment when crises occur. At the same time, we urge the WBG to emphasize the benefits of investing in crisis preparedness and prevention, recognizing that risk mitigation leads to future savings. Likewise, we call on the Bank to continue supporting the analytical work of the G20 Joint Finance Health Task Force (JFHTF), in close cooperation with the WHO, to improve the assessment of social, economic, and health vulnerabilities and risks arising from pandemics, as well as the mapping of financing gaps. We support the WBG's renewed resolve to be a Knowledge Bank, one that is data driven. We highly value knowledge sharing and peer learning and suggest leveraging existing WBG knowledge hubs and building strong strategic partnerships. We reaffirm our commitment to this agenda, recognizing the compelling need to narrow inequities in access to knowledge and new technologies, particularly in Africa. Technical cooperation is fundamental to helping countries build institutions and infrastructures as a precondition for sustainable development. In this vein, Central Banks also play a role. One 1/3 BIS - Central bankers' speeches such infrastructure is a fast payments system (FPS) that measures up to international technical and regulatory standards and is ready to be interlinked with FPS in other jurisdictions. We commend management for the results achieved so far in implementing the G20 Capital Adequacy Framework (CAF) Review, launched under the Italian G20 Presidency, and confirm our commitment to a full and effective adoption of the CAF recommendations. It has already brought an increase in the IBRD's lending headroom to the order of $50 billion over a decade, and there is potential for further expansion. Within the newly approved Framework for Financial Incentives, some shareholders' commitment to providing extra resources through hybrid capital and the portfolio guarantee platform will bring further support to IBRD countries. The work to clarify call and payment procedures of existing callable capital will provide an important layer of assurance to investors and credit rating agencies and create more space for a further reduction of the equity to loan ratio. New resources should also originate from the hybrid capital with private investors and targeted efforts to attract more private capital into development projects. We need to work together on the G20 independent review on the operations of the vertical environmental and climate funds, with the aim to improve access and financial leverage of these funds. We believe that this will be best accomplished with a greater share of resources to be channelled through MDBs. The International Development Association (IDA) must be at the center of the World Bank agenda this year. We must work to ensure a successful IDA21 replenishment, with an optimal mix of donor contributions, efficient use of IDA internal resources, and effective deployment of funds. IDA will be key to putting low-income countries back on a sustainable growth path and fighting extreme poverty on a livable planet. We need to strengthen our focus on the root causes of fragility. Strengthening institutions and developing a pluralistic and competitive local private sector will greatly contribute to mitigating instability and preparing countries to transition out of conflicts and fragility. IDA should deploy its suite of analytical and financing tools for conflict prevention and remain engaged during conflicts. Overall, we reaffirm the recommendations that we have laid down in the non-paper on Fragility, Conflict and Violence in IDA21, together with other donor countries and the Africa, ECA, MENA and LAC (Haiti) borrowers' representatives. Job creation and business development across IDA countries is our North Star in improving local opportunities, especially for the young. This should mitigate the drivers of forced migration, while continuing to improve regional infrastructures, food security, access to energy and health systems and pandemic preparedness. The International Finance Corporation (IFC), working together with IDA, should allocate additional resources to better support local companies and business associations. The most recent CAF measures for IDA allowed us to smooth out the financial implications of earlier frontloading, while also strengthening capital for the next cycles. We look forward to future work to enhancing development impact and further optimizing IDA's balance sheet. 2/3 BIS - Central bankers' speeches Our constituency appreciates the central role of Africa and the partnership built around IDA. Italy has embraced this same spirit with the Mattei Plan, a renewed approach to development cooperation that revolves around the gradual agreement of goals and targets co-designed with African countries. It will be rolled out in synergy with international partners, in the areas of education and training, agriculture, health, energy and water. To embark on a path of sustainable growth, the African continent should also play a stronger role in clean energy products' global supply chains. Italy fully supports the "Resilient and Inclusive Supply-chain Enhancement" (RISE) initiative, launched in October 2023, including with a financial contribution. Italy will work closely with the World Bank to ensure a swift implementation of RISE during its G7 Presidency. Above all, a successful IDA21 replenishment requires a collective effort from all – donors, borrowers and management. The Italian G7 Presidency is actively supporting and coordinating this effort. 3/3 BIS - Central bankers' speeches
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Text of the Lectio Magistralis by Mr Fabio Panetta, Governor of the Bank of Italy, on the occasion of the conferral of an honorary degree in Juridical Sciences in Banking and Finance by the University of Roma Tre, Rome, 23 April 2024.
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Dinner speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the Inaugural Conference of the Research Network on "Challenges for Monetary Policy Transmission in a Changing World" (ChaMP), Frankfurt am Main, 25 April 2024.
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Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the BIS-FINMA-SNB Workshop on "Tackling the risks in systemically relevant banks: lessons from March 2023", Basel, 16 May 2024.
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Luigi Federico Signorini: Lessons from recent crises Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the BIS-FINMA-SNB Workshop on "Tackling the risks in systemically relevant banks: lessons from March 2023", Basel, 16 May 2024. *** Almost a year ago,1 the international financial system experienced the most significant episode of banking turmoil since the Global Financial Crisis (GFC). Four mid-sized U.S. banks and Credit Suisse, a global systemically important bank, encountered severe distress more or less simultaneously. Swift and effective supervisory actions, along with extensive public support measures, enabled the U.S. and Swiss authorities to control the situation. More importantly, the international banking system withstood these events with no major consequences, thanks, at least in part, to the strengthened prudential framework developed in Basel over many years after the GFC. The final Basel III rules marked the conclusion of this regulatory journey. The process involved intense negotiations and some compromises (often reached after difficult discussions), needed to accommodate varying needs and practices. As a member of the Basel Committee for many years, your speaker took part in many of those discussions and contributed in some small way to many of those compromises. By definition, compromises cannot be 100 per cent satisfactory for anyone; I shall come back to certain issues that, in my view, still need fixing. Nonetheless, my opinion is that, on the whole, the outcome of this process was good. Basel III marked decisive progress towards achieving a balanced approach that combines enhanced risk sensitivity with reduced discretionary choices for banks, particularly when using internal models.2 The fact that the financial system has since withstood repeated shocks and (as they say) has been part of the solution rather than part of the problem is, in my view, evidence that these reforms have been useful. Final Basel III implementation The implementation of the final Basel III standards is advancing in most jurisdictions. It is important to maintain momentum and avoid unjustified delays that could lead to fragmentation and loopholes. After more than two years of negotiations, the process is nearing completion in the European Union, with the new rules expected to take effect at the start of next year. The CRR3-CRD6 texts incorporate the Basel standards into the EU rulebook, while accounting for certain specific EU characteristics. Most deviations aim to give banks time to adapt to more stringent requirements, without compromising the Basel spirit. These deviations will be gradually phased out. While the Basel standards primarily target large internationally active banks, the EU applies them to all banks, albeit with some simplifications for smaller and less complex institutions. This approach has been in place since the 2010 Basel III standards were implemented and, I think, is appropriate. The 2023 turmoil showed that threats to financial stability can arise not only from very large banks, but also from smaller 1/5 BIS - Central bankers' speeches intermediaries with specific imbalances, if fears spread on the market that other intermediaries might have similar problems. This phenomenon, which I call 'contagion by analogy', goes beyond the factors currently used to identify systemically important banks, such as size or direct interconnectedness. I have already stressed the importance of a broadly similar and simultaneous application of the final rules in all major jurisdictions. The U.K. and U.S. are also advancing with their national implementation, with rules expected to apply later in 2025. It is to be welcomed that U.S. regulators are thinking about expanding the range of banks subjected to Basel standards. The debate is ongoing; some argue that revising prudential rules and extending Basel rules to smaller banks would hinder credit availability and economic growth. I find this argument unconvincing. First, the Basel Committee's evaluation of Basel III reforms from 2011-21 shows that, as banks increased their capital and liquidity reserves,3 and market-based systemic risk measures improved, the banking sector became more resilient and less vulnerable to distress while maintaining its key functions under stress. The analysis found no evidence of adverse effects on banks' capital costs and lending. In fact, the banks most affected by the reforms saw a reduction in their capital costs. Second, smaller banks matter. The failed U.S. banks were not required to comply with the most rigorous Basel III standards. Despite their assumed 'regional' nature, their crises raised global concerns. While stricter regulatory requirements might not have prevented the crisis (I don't know), at the very least they would have raised a warning about these banks' condition long before their distress. For instance, in the case of SVB, the short-term liquidity requirement would have rung alarm bells in plenty of time. The way forward It is challenging to pinpoint the specific causes behind a crisis. For the U.S. regional banks, several factors contributed: unsustainable business models, poor management, too rapid growth, overreliance on uninsured deposits, and concentration in loans and funding. Credit Suisse's crisis had more complex causes, including large losses from the Archegos and Greensill cases, governance weaknesses, and repeated strategic changes that eroded market confidence. Despite the varying causes, the commonalities reveal potential areas for improving the regulatory framework. In all cases, a rapid loss of client and market confidence occurred. All the banks involved faced substantial liquidity outflows, amplified by social media and facilitated by digital banking. One key area to think about is therefore liquidity regulation. Let me start with a very basic observation. Why are banks subject to regulation and supervision? The banking business has two key features: leverage and maturity/liquidity transformation. Both are necessary for banks to perform their function; both, however, entail a degree of fragility and the risk of spillovers and contagion, with potentially destructive effects that go far beyond the shareholders of individual institutions. Bank regulation is there to limit the system's exposure to such risks, without hampering its fundamental function. 2/5 BIS - Central bankers' speeches This much, I think, is obvious. However, the fact is that, for some reason, international regulatory standards have long concentrated on the first cause of fragility, leverage, by requiring e.g. minimum capital ratios; such requirements have been at the centre of global standards since the start, with the first Basel accord, and have gradually been strengthened over time. The second cause of fragility, maturity transformation (and, relatedly, liquidity), were not covered at all in Basel I or II, and only started to appear in Basel III in the form of liquidity standards and Pillar-2 provisions for the interest rate risk in the banking book (IRRBB). This is strange in a way: it is, after all, common wisdom that bank crises are, more often than not, due to liquidity problems. Basel III thus made progress; but the compromises I mentioned were, in my view, not fully satisfactory in this area. Specifically, there appears to be room for reconsidering the Net Stable Funding Ratio (NSFR). The current NSFR's one-year horizon means that it cannot fully capture a bank's structural exposure to maturity mismatch. In terms of the NSFR, a 366-day maturity is the same as a 30-year maturity. This is not just a theoretical concern. In the case of SVB, despite extreme maturity imbalance in the bank's balance sheet, the NSFR, had it been applied, would not have detected any anomaly. One possible way to address this weakness would be an 'NSFR+', based on a more granular maturity classification of assets and liabilities. Many years ago, the Bank of Italy used to have a rough-and-ready maturity transformation rule to prevent extreme cases. One could build on such experiences. The LCR fared better in the SVB case (as I said, it would have signalled potential distress well in advance)4. However, remote banking and the effect of news spreading at lightning speed on social networks have greatly increased the potential volatility of zero-maturity bank liabilities. This might challenge the current treatment of sight deposits. Concentration (an issue that is related to uninsured deposits) is also a concern. Some further reflection on mandatory pre-positioning of collateral would also be in order. Additionally, two more issues deserve attention. First, the IRRBB. The Basel standards already include principles for measuring and managing it under Pillar 2, but these may not be adequate under all circumstances. One solution might be to put the IRRBB under Pillar 1. In my view, however, given the flexibility needed to tackle interest rate risk under changing market and individual conditions, it would be better to strengthen the current Pillar 2 approach, allowing for tailored requirements, but under a more robust and structured framework. The SSM already adopts such an approach. Second, a reassessment of the rules for deposit insurance would be useful. The inherent trade-off is well-known: a share of uncovered depositors instils market discipline, but their volatile behaviour during crises creates systemic danger. A difficult 3/5 BIS - Central bankers' speeches balance must be struck. Nowadays, as a depositor's flight is just one click of a mouse away, the terms of the trade-off may have changed compared with when the rules were first established. The debate is open. Effective supervision Whenever a bank crisis occurs, everybody is reminded that rules need to be supplemented by effective supervision. Last year's episodes highlighted once again the need for supervisors to understand banks' business models thoroughly and to ensure effective governance and risk management in banks. The recent review of the Basel Core Principles Effective Banking Supervision is therefore very timely and welcome. The matter has been amply discussed in previous interventions in this conference and I shall not pursue it in detail. I concur with other speakers that the use – in a nonmechanical way – of market signals and indicators like a rapid growth of assets is important – and, in fact, already widespread. In general, sharpening supervisors' tools is surely needed. Let me only sound a note of caution on all this. Even with the best principles and tools, supervisors will never be omniscient or omnipotent. With the benefit of hindsight, one can always find a better course of action that the authorities might have taken in a specific case. However, without perfect foresight, and with no waterproof basis in regulatory requirements, it is not always obvious that the authorities would have been in a position to do beforehand, in an analytically and legally robust way, what post factum appears optimal. Supervision must be continuously improved, by all means; but regulation remains fundamental. Further issues for the future Finally, looking beyond microprudential rules for banks, let me mention two further issues that the broader system of financial regulation needs to address-and are, in fact, being actively discussed in international fora. 1. Countercyclical macroprudential rules. Disruptive exogenous shocks (the pandemic was an extreme case) require releasable capital buffers. The Basel Committee has endorsed the concept of using cycle-neutral positive buffers to absorb systemic shocks and avoid procyclicality. Many European countries, including Italy, have introduced this measure with, as far as I can see, minimal costs. 2. Non-bank financial intermediaries (NBFIs): NBFIs' share in financial intermediation, and their interconnections with the banking system, have grown considerably. Credit Suisse's exposure to Archegos and Greensill is just one example of the latter; the Basel Committee's reflections5 on it are a valuable starting point for defining better rules for banks. More generally, the FSB's work on NBFIs' impact on financial stability is proceeding, albeit slowly. To conclude: the 2023 market turmoil has lessons for regulators and supervisors. 4/5 BIS - Central bankers' speeches Banks have proven resilient, but supervisors must remain vigilant. Implementing and updating international standards is crucial to adapting to new challenges. After all, for supervisors there are always 'interesting times' ahead. 1 I wish to thank Francesco Cannata and Fabio Recine for their very valuable input. 2 The role of internal models has been fundamentally revised. For certain risks, such as the Credit valuation adjustment and Operational risks, rather than questing for perfection, the BCBS simply accepted the idea that models cannot provide meaningful estimates. For other risks, such as Credit risk, the new standards constrain the possibility to achieve capital optimisation by imposing input floors as safeguards against overoptimistic assumptions; moreover, the advanced modelling approach can no longer be used for certain portfolios where data are too few and cannot yield statistically robust estimates. For Market risk, the BCBS fundamentally revised the approach to modelling to make it more consistent with the complexities of modern trading activities. An output floor was set as a safeguard against model risk. 3 The weighted average CET1 ratios of the main global banks included in the Basel monitoring exercise sample almost doubled, from around 7 to around 13 per cent, and the leverage ratio almost halved, from around 3.5 to around 6.5 per cent. The liquidity position improved strongly; the LCR and NSFR were always well above their minima during the same period. See the 'Evaluation of the impact and efficacy of the Basel III reforms' Report, published in December 2022. 4 Let me also recall, as the issue of asset valuation is sometimes raised, that in the LCR high-quality liquid assets (HQLA) are marked to market and subject to haircuts. 5 See BCBS, 'Newsletter on bank exposures to non-bank financial intermediaries', December 2022. 5/5 BIS - Central bankers' speeches
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Concluding remarks by Mr Fabio Panetta, Governor of the Bank of Italy, at a meeting for the presentation of the Annual Report 2023 - 130th Financial Year, Rome, 31 May 2024.
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The Governor’s Concluding Remarks Financial Year 130th financial year Annual Report Rome, 31 May 2024 th The Governor’s Concluding Remarks Annual Report 2023 – 130th Financial Year Rome, 31 May 2024 Ladies and Gentlemen, The global economy has continued to expand in recent months, despite the persistently restrictive tenor of monetary policy in many countries and the uncertainty caused by ongoing tensions and conflicts in several regions of the world. The short-term outlook remains weak, however. Global GDP is expected to grow by around 3 per cent in 2024, significantly below the average for the first 20 years of this century. After stalling in 2023, trade is expected to return to growth this year, albeit less so than in the past. Cyclical risks, long tilted to the downside, are becoming more balanced. The ongoing global disinflation suggests that monetary conditions will ease, but will do so at a different pace in each of the major economies. Growth is uneven both among the advanced economies, with the United States proving to be particularly strong, and among emerging and low-income economies. Growth in the latter countries since 2019 has not been enough to narrow welfare gaps vis-à-vis richer countries; high debt servicing costs place many of them in a vulnerable position. The default of one or more of the low-income economies would presumably produce only marginal systemic spillover effects on a global scale,1 though the disorderly management of these crises would have serious consequences for the countries involved and could give rise to geopolitical disputes. In the coming years, the global economy will be impacted by low productivity growth in many areas, by the phasing-out of the fiscal stimuli rolled out to counter the effects of the pandemic and – above all – by the geopolitical tensions that show no signs of easing. According to the International Monetary Fund, global growth is expected to continue at around 3 per cent until the end of the decade. World trade Signs of fragmentation in international trade and financial flows are intensifying. The contentious political and trade relationship between the United States and China has worsened; several areas of the world are plagued by tensions and armed conflicts. It is too soon yet to speak of deglobalization, but it is clear that the process of rapid integration of the world economy has come to a standstill. World trade as a percentage of GDP has remained at 30 per cent over the last 15 years, after having doubled in the previous two decades. Since 2010, foreign direct investment has also stagnated at global level. In recent years, there has been a decline in flows between blocs of politically distant countries and a marginalization of the poorest countries. In the international monetary system, the role of the different currencies and that of the payment and market infrastructures has taken on a strategic importance that goes well beyond the purely economic sphere, particularly after sanctions were imposed on Russia. The dollar and the euro are still the main reserve currencies. The Chinese renminbi is rapidly growing in importance, however, as its increasing use for cross-border payments and commercial transactions shows. Some central banks are also adjusting the composition of their reserves, reducing their holdings of the major currencies in favour of gold, partly in response to sanctions. The future moves on this front by the major economies will need to be assessed in light of the possible repercussions on the global monetary system. International political tensions have heightened the focus on the risks linked to reliance on long and complex global production chains, which had already emerged during the pandemic. The governments of many of the advanced countries have become reluctant to depend economically on countries perceived as unreliable from a geopolitical standpoint. They have taken steps to achieve autonomy in strategic manufacturing sectors and to diversify the supply chains for critical resources such as agricultural, energy and technological goods. These measures have frequently taken the form of protectionist policies: the number of trade restrictions introduced in 2023 was three times higher than in 2019 (Figure 1). Firms are reviewing their strategies, with a view to reorganizing on a national or regional basis the activities that were carried out on a global scale in the past, and to diversifying their sources of supply. Surveys conducted by Banca d’Italia with other central banks show that many European manufacturing firms are replacing their Chinese suppliers with EU-based ones. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA Figure 1 New trade restrictions imposed at global level (number of restrictions) 3,000 3,000 2,000 2,000 1,000 1,000 '09 '10 '11 '12 '13 '14 '15 Investment '16 '17 Goods '18 '19 '20 '21 '22 '23 Services Source: Global Trade Alert. (1) Unilateral changes in the relative treatment of foreign versus domestic commercial interests, with reference to both trade flows and foreign direct investment. We can no longer disregard the need to redress the balance between efficiency and security. At the same time, the negative consequences of severe economic fragmentation and of a return to protectionism should not be underestimated. They are not limited to the countries concerned nor to the purely economic sphere. History teaches us that trade openness and the free movement of goods, capital, ideas and people are powerful drivers of integration and prosperity. In a more challenging environment than in the past, we must therefore protect those principles of international cooperation and the multilateral institutions that have underpinned global economic development and have fostered a lasting peace among the major powers since the end of World War II. Economic fragmentation and technological challenges in Europe today Given how open it is to the rest of the world, the euro area is significantly exposed to the potential risk of global economic fragmentation. Trade with countries outside the euro area was in excess of 55 per cent of GDP in 2023, compared with foreign trade equal to 40 per cent of GDP for China and 25 per cent for the United States.2 Exports contribute to overall demand to a far greater extent than in the United States. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 The euro area is also dependent on foreign supplies of key resources: oil and natural gas, for instance, which account for over half of its total energy needs, originate almost entirely from third countries. These vulnerabilities bear on the ongoing decline in Europe’s international standing. The population of Europe is now only 5.7 per cent of the global population. Over the last two decades, the European Union’s share of global GDP has fallen from 26 to 18 per cent, whereas that of the United States has remained almost unchanged, at 26 per cent, and that of China has quadrupled to 17 per cent (Figure 2). This decline mainly reflects the unsatisfactory growth in productivity, which has fallen behind the United States by 20 percentage points over the same period. Figure 2 Global GDP shares of the world’s main economies (per cent) United States European Union China India 1998 2000 2002 2004 Source: International Monetary Fund. (1) The data refer to current EU Member States. In the current geopolitical environment, Europe must act decisively to become more competitive and bolster its strategic autonomy. This is not in order to set itself against other countries or to retreat within its borders, but to safeguard the future of European citizens, to gain in global authority and to preserve the progress made so far towards a more integrated world. The scale of the challenges ahead of us requires forthright action on different fronts. First of all, the growth model of the past two decades needs redressing by limiting undue reliance on foreign demand. The single market must be optimized and expanded by strengthening integration in such strategic sectors as telecommunications, energy and finance. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA Europe needs to remove the barriers that stand in the way of it achieving the full potential – in terms of economies of scale and number of consumers – of an internal market that compares with that of the United States, also with a view to increasing competition and innovation. Further, because greater competition and innovation entail greater risks, risk-sharing mechanisms also need to be strengthened. I will come back to this matter shortly. The European Union also has to reduce its energy dependency by increasing the generation of renewable energy using its ample store of natural resources. This will contain energy costs and make us more competitive, but it will not free us from our reliance on foreign suppliers of the metals and minerals that are needed for the energy transition. We must therefore establish dependable and mutually beneficial economic and diplomatic ties with the countries that are richest in critical inputs, on the strength of our capacity to provide them with the technologies they need to integrate into global production chains.3 A third area of intervention is the production of advanced technologies, in which Europe currently lacks sufficient specialization. At a time of technological protectionism, it is essential that investments in technology keep pace with those of other advanced countries, focusing on cutting-edge sectors such as robotics, digital and communication infrastructure, space exploration, biotechnology and artificial intelligence. This requires a regulatory environment that favours innovative business initiatives, being mindful that there are some sectors in which competition operates globally, not at European or national level. Artificial intelligence will lead to potentially disruptive changes in the global economy. It will support productivity and growth, albeit with an uneven distribution of costs and benefits across sectors and across society, especially in the short term; it will also involve huge energy consumption. European firms should aim to become involved in developing AI technology. Joint initiatives between players from different countries would make it easier to find the vast amount of financial resources required to compete with foreign producers and create the conditions for building on the outstanding scientific output of researchers working across the EU; they would also make it possible to counter the market power of foreign tech giants. A common response These lines of intervention do not cover all the fields in which the EU is called to act. There is a need for common policies when it comes to the environment, defence, immigration, and education and training, for instance. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 This will require substantial resources: the European Commission estimates that over €800 billion in public and private investment will be needed annually until 2030 to sustain the climate and digital transitions and to raise military spending to 2 per cent of GDP.4 For individual nations to embark on such a vast plan would entail a duplication of spending and sacrificing the achievement of economies of scale. The fiscal capacity of many countries would be a limit and would risk compromising the endeavour, which has to be broad in scope, and would also risk increasing the fragmentation of the single market. Since many of these projects address common public goods such as the environment and external security, insufficient expenditure would be to the detriment of all EU countries and citizens. It is therefore necessary, in everyone’s interest, to act on these initiatives at European level. Completing the European economic architecture The European economic architecture lacks two essential ingredients: a common fiscal policy and an integrated capital market. The banking union remains incomplete. With a fully complete economic architecture, Europe could have been better able to weather the crises of the last fifteen years. There is a pressing need to address these issues in light of the current unstable geopolitical environment and of the huge investments that Europe has to make. The new fiscal framework In a monetary union, a central budget has two main functions: to finance shared public goods and to respond to cyclical fluctuations, both by smoothing out their impact over time – which can also be done at national level, to some extent – and by offsetting the effects of asymmetric shocks across countries. A European budget would allow us to take a fiscal stance that fits the area as a whole, rather than being the mere sum of national policies. It would help us cope better with strong and long-lasting shocks, such as the pandemic or the energy crisis, making fiscal policy consistent with monetary policy. The recent reform of European economic governance has not resulted in significant progress in these directions, nor has it streamlined the rules as necessary. Without any progress towards a common fiscal policy, any reform The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA only tackling national policies risks making European rules appear to privilege austerity over development. However, the new rules introduce innovations that are consistent with growth. They focus on the medium-term sustainability of public debt, rather than on the fine-tuning of fiscal policy, which should pave the way for longer-term planning and realistic paths for fiscal consolidation. They also acknowledge the relationship between the two levers of fiscal sustainability, i.e. fiscal policy and the reforms and investment needed for development. The effects of the new framework will depend on how it is applied: it can reinvigorate the European economy if it combines the required fiscal discipline with the ultimate goal of promoting growth. If the new rules prove effective, cooperation between EU Member States will grow stronger over time, as will public trust in European institutions and, ultimately, in the future of the EU. This would make it possible to move towards a full-fledged fiscal union, which can rely on adequate funding of its own and on debt issuance. Building a European capital market We must not deceive ourselves into believing that the huge investments needed for the competitiveness of the European economy can be funded without a major contribution from private investments and without drawing on the expertise of the financial industry. It is therefore essential to build a European capital market. The euro area has been running a current account surplus for years. As a result, it generates savings that exceed investment and are partly redirected abroad. In order to retain domestic savings and attract international funds, we need an integrated, efficient, liquid, technologically advanced European capital market that can allocate these resources to the most capable entrepreneurs. A single capital market would increase cross-border investment flows and provide households, firms and financial intermediaries with better opportunities for risk diversification, thus mitigating the impact of cyclical fluctuations. Only a quarter of local shocks are estimated to be currently absorbed through the banking and financial channels in the euro area, compared with three quarters in the United States. These are the goals of the European Commission’s Capital Markets Union project, which has been put forward several times over the past decade. Yet European capital markets remain underdeveloped and fragmented, despite efforts to integrate them through EU legislation. In the euro area, the BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 value of corporate bonds as a share of GDP is three times lower than in the United States. Furthermore, although equity is the main source of funding in both jurisdictions, in Europe it is largely unlisted, while in the US most equity is traded on the stock exchange, thereby offering US firms access to a greater pool of potential investors. Today, there are 59 regulated stock markets in Europe, owned by over 30 groups,5 with stock-market infrastructure including 27 central securities depositories (CSDs) and 10 central counterparties (CCPs). In the US there are 24 stock markets, mostly owned by four groups, one CSD and one CCP. The European market’s fragmentation, I believe, has clear disadvantages in terms of operations and liquidity, and creates barriers to entry for investors as well as for businesses. If we want to make progress towards a single European capital market, we need to address two key issues. The first is the lack of a European sovereign safe asset. A common safe asset would allow for better pricing of financial products, such as corporate bonds and derivatives, encouraging their expansion. It would provide a form of collateral that could be used across all market segments, including for cross-border transactions, and it would serve as the basis for foreign central banks’ reserves in euro, strengthening the global role of our currency.6 The securities issued under the NextGenerationEU programme go in this direction. However, one-off placements do not mark a turning point: the scarce liquidity of these bonds discourages their inclusion in benchmarks and is an obstacle to the use of derivative contracts for risk management purposes. The second obstacle to the creation of a European capital market is the fact that the banking union is incomplete. Establishing the Single Supervisory Mechanism and the Single Resolution Mechanism was a major step forward, but it was not enough to create a fully integrated European banking market. The credit sector remains fragmented along national lines: there is no European deposit guarantee fund, the bank crisis management system is incomplete and obstacles to the transfer of banking groups’ capital and liquidity across countries still exist. As banks play a key role in all capital market segments, it is hard to think of an integrated market if they cannot operate effectively across the euro area. The introduction of a European safe asset and the completion of the banking union are preconditions for creating a single capital market, but they are not the only relevant issues. We must not forget the importance of The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA drafting a single European Finance Act, of strengthening central supervision, and of harmonizing corporate crisis management mechanisms. Despite the issues that I have described, I would like to stress the progress that Banca d’Italia and the Eurosystem are making in providing cuttingedge infrastructures for payment, securities and collateral transactions to the European market. Our goal is to ensure its security and efficiency using TARGET services and – looking ahead – through a digital euro and joint collateral management throughout the monetary union. The economic situation and monetary policy in the euro area The real economy The euro-area economy has been stagnating since the end of 2022. Aggregate demand has been affected by tight monetary conditions, the impact of inflation on real household income, and the slowdown in global trade. Manufacturing activity is now down to end-2020 levels. The difficulties in the manufacturing sector were particularly pronounced in Germany, which was hit hardest by the energy price increases and the uncertain performance of the Chinese economy. However, there have been positive signs recently. Euro-area GDP rose by 0.3 per cent in the first quarter of 2024, reflecting better than expected performances in the main economies. Some leading indicators for services and international trade also showed encouraging signs. Against a backdrop of disinflation, the rebound in consumers’ purchasing power as a result of wage growth and the resilience of employment suggests that domestic demand may gain momentum in the months ahead. The projections published by the European Central Bank in March point to recovery firming up this year and GDP growth strengthening to 1.5 per cent over the next two years. These growth prospects are modest and subject to downside risks. Geopolitical tensions could curb the recovery in global trade and lead to higher commodity prices. The restrictive monetary policies implemented in several countries may dampen consumption and investment more than expected. Fiscal policies could become stricter due to a greater than expected consolidation of public finances. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 Inflation Inflation in the euro area stood at 2.4 per cent in April, down by 8 percentage points from its October-2022 peak. The reduction was exceptional in size and speed, just as the earlier increase had been. The ongoing disinflation is confirmed by the slowdown in the core component of the consumer price index, which excludes the typically more volatile energy and food items. Inflation started falling again last month in the service sector too, mitigating fears that this component might dampen disinflation. Price growth is set to decline further in the coming quarters, albeit with some fluctuations. Wage growth is expected to slow, as purchasing power gradually recovers. At the same time, high profitability allows firms to absorb the recent wage increases without raising their selling prices. Moreover, the decline already recorded in energy prices and the expected fall in interest rates will make it less costly for firms to increase their capital per worker. This should result in higher productivity and slower growth in unit labour costs, thereby reducing the inflationary pressures that might stem from wage increases. The ECB’s projections and analysts’ expectations point to a return of inflation to the 2 per cent target in 2025. Monetary policy Monetary policy has operated in a challenging economic environment over the past four years. The pandemic crisis called for highly expansionary measures, some of which were unprecedented. These had to be followed by a rapid normalization and then monetary tightening after the inflationary flare-up. Overall, this process was necessary. The pandemic crisis has been overcome, with the help of fiscal policies, and a financial crisis has been avoided. Supply shocks, production bottlenecks and soaring energy prices have not triggered an inflationary spiral, as they had in the past. Medium- and long-term inflation expectations have remained in check, leading to relatively fast and painless disinflation. But now, we need to prevent monetary policy from becoming excessively tight, pushing inflation below the ECB’s symmetric target. Since last September, when we last increased the interest rates, real short-term rates have risen by almost half a percentage point. Over the coming months, if the incoming data is consistent with the current projections, it will be appropriate to ease monetary conditions. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA This will not stop the action to restore price stability. Even with several cuts in the key interest rates, the monetary policy stance will remain tight: expected real rates implied by the financial markets, which incorporate a cut in the reference rates of 60 basis points in 2024, will remain above any plausible estimate of the natural interest rate for many months (Figure 3).7 Figure 3 Real interest rate and natural interest rate in the euro area (per cent) 2.0 2.0 1.5 1.5 Real interest rate 1.0 Market expectations 1.0 0.5 0.5 Natural interest rate 0.0 0.0 −0.5 −0.5 July '23 Oct. '23 Jan. '24 Apr. '24 July '24 Oct. '24 Jan. '25 Apr. '25 July '25 Oct. '25 Sources: Based on ECB, Bloomberg and LSEG data. (1) The figure shows the actual (solid blue line) and the expected (dashed blue line) one-year real interest rate as measured on 30 May 2024. It also shows estimates of the real natural interest rate: its median (red line) and the 10th-90th percentiles (grey band). For further details, see Chapter 3, Annual Report for 2023, 2024 (only in Italian). The decisions of the US Federal Reserve will be a factor to be taken into account, not a constraint, during monetary easing. A tighter than expected US monetary policy stance could lead to a depreciation of the euro against the dollar and create inflationary pressures. Empirical studies suggest, however, that this effect would be overcome by the negative impact that the US monetary tightening would have on global demand and financial conditions, and therefore on euro-area inflation. When defining the path of policy rate cuts, it should be borne in mind that prompt and gradual action contains macroeconomic volatility better than a tardy and hasty approach. Unlike in the past, the decline in the near future in policy rates will be accompanied by a reduction in the monetary policy portfolios of securities, which will lead to a sharp contraction in outstanding liquidity and a consequent tightening impulse in the credit market. A gradual normalization of the Eurosystem’s balance sheet after the expansion of recent years is certainly appropriate. However, it is essential that this process does not interfere with the monetary policy stance and that the BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 adjustment is carried out without creating liquidity shortages in the system or fragmentation in the transmission of monetary impulses. The review of the monetary policy operational framework was concluded last March. The Governing Council decided that it will continue to implement its monetary policy action through the rate on the deposit facility. Under the new framework, it is essential that liquidity remains abundant to ensure a firm control of short-term market rates. The liquidity needs will be partly met through a structural portfolio of securities and through longerterm refinancing operations. I believe that these components should be given a significant weight in order to ensure a large and stable supply of reserves. The Italian economy The Italian economy has had the lowest per capita GDP growth rate in the euro area for the past 25 years. Labour productivity is at a standstill; investment only returned to above the levels recorded before the global financial crisis in 2023, while total hours worked have not caught up yet. Wage growth reflected the stagnation in productivity: employees’ hourly wages are one fourth lower than in France and Germany (Figure 4). In per capita terms, real household disposable income has been flat since 2000, while it has increased by more than one fifth in France and Germany since then. Figure 4 Hourly wages: spread between Italy and the main European countries (percentage points) −10 −10 −20 −20 −30 −30 Euro area France Germany Spain Source: Based on Eurostat data. (1) A negative spread indicates that hourly wages in the euro area or in a country of comparison are greater than in Italy. Hourly wages refer to payroll employment and are expressed in purchasing power parity. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA A recent recovery, to be consolidated We are not doomed to stagnation, however: the recovery after the pandemic crisis has exceeded expectations and been stronger than in the other large euro-area economies. Unlike in previous crises, recovery has also been robust in the Italian Mezzogiorno. Between 2019 and 2023, a time of great turmoil, Italy’s GDP grew by 3.5 per cent, against 1.5 per cent in France and 0.7 per cent in Germany, and this gap is wider in per capita terms. Employment rose by 2.3 per cent – almost 600,000 people – mainly in permanent contracts. The unemployment rate, though still high, fell by 2.3 percentage points, to 7.7 per cent. The recovery was fuelled by strong investment growth, also supported by tax incentives. Investment grew far more than in the other main European countries on average, not just in construction, which benefited from very generous incentives, but also in machinery and intangibles, which better reflect the technological progress and expectations about future demand (Figure 5). Figure 5 Changes in investment and exports in Italy and in the main euro-area countries (percentage change between 2019 and 2023) (a) Investment in machinery and intangibles −5 (b) Exports of goods Italy Italy France Euro area Euro area Spain Spain Germany Germany France −5 −5 −5 Source: Based on Eurostat data. Exports of goods increased by 9 per cent, more than potential foreign demand, thanks to the improvements in cost competitiveness and quality achieved in recent years and to the diversification by sector and destination market. They remained essentially stable in Germany and decreased in France. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 Once the deterioration in the terms of trade caused by the energy shock had been reabsorbed, the trade balance rapidly turned positive again. Italy is now a net creditor to the rest of the world to the tune of €155 billion, or 7.4 per cent of GDP. Ten years ago, its net foreign position was negative by 23 per cent of GDP and was a source of vulnerability. The Italian economy has certainly long benefited from expansionary monetary and fiscal policies, but also from overhauling its production fabric. The profitability and capital position of firms have improved over the past decade.8 The weight of larger firms has also increased, as they can better reap the benefits of technology and internationalization.9 There has been a significant, though still insufficient rise in productivity in industry and in non-financial private services. If we exclude transport equipment, Italy’s manufacturing industry is the most automated of the main euro-area economies: in 2021, the share of robots per 1,000 workers was 13.4 in Italy, against 12.6 in Germany and 9.2 in France.10 Since 2019, industrial firms have doubled their share of investment in digital technologies, to 17 per cent. Their return to capital accumulation and their ability to succeed in international markets are encouraging signs of strength that need to be consolidated. Looking ahead, the Italian economy will be able to achieve a sustained pace of growth if, on the one hand, it can deal with the consequences of population decline and ageing, and on the other hand speed up productivity significantly. Population decline and labour market responses According to Istat, the number of working age people will fall by 5.4 million between now and 2040, despite a net foreign inflow of 170,000 individuals per year. This decline is expected to cause GDP to fall by around 13 per cent, and by 9 per cent in per capita terms.11 Despite growing over the last decade, labour market participation is still 8 percentage points below the euro-area average, standing at 66.7 per cent. The gap is not large for men, but it widens to 13 points for both young people aged 20 to 34 and for women. Youth employment has been affected by low growth.12 Many have looked for better job prospects abroad: 525,000 young Italians emigrated between 2008 and 2022, and only one third of them came back to Italy. It is graduates above all who have left Italy, attracted by far better pay, employment and The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA career opportunities.13 This out-migration depletes Italy’s human capital, which has traditionally suffered from low levels of education attainment. The female employment rate is still 52.5 per cent. Balancing work and family life in Italy is a challenge. Women leaving the labour force after their first child is born is one of the main reasons for their low labour market participation, and it is good that the National Recovery and Resilience Plan (NRRP) has allocated considerable resources to childcare services.14 Measures to promote a different distribution between in-person and remote working time could help to increase employment, as could a revision of the deductions and cash transfers scheme in order to reduce work disincentives for second earners,15 and policies to encourage the hiring of the long-term inactive. Marked increases in employment rates – up to average euro-area levels – could offset the effects of population decline and keep headcount employment.16 Support for employment may also come from a higher flow of legal immigrants than that expected by Istat. Managing this flow will require coordination with the other European countries, balancing the needs of the production system with social equilibria, and enhancing measures to integrate foreign citizens into the education system and the labour market. However, it is clear that even with increased employment and migration flows, the contribution of labour to economic growth will inevitably be modest. Only productivity can ensure development, job opportunities and higher incomes. Reviving productivity: more investment, more innovation Investment is the main way to spread technological innovation, which accounts for most of the productivity gains. For firms to invest, policies need first of all to ensure a suitable regulatory and competition framework and a stable macroeconomic environment. The positive externalities of investing in innovation warrant targeted public measures, above all when there is a technological lag. The incentives introduced in recent years17 have helped even the smaller firms to adopt new technologies and achieve productivity gains, especially when investment has been combined with a skilled labour force. Technology take-up costs can be limited not only through incentives, but also with an effective network of technology transfer agencies.18 However, we cannot just adopt solutions developed elsewhere; we need to improve our ability to develop new goods, services and technologies.19 BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 The tax credit for research, in force in Italy since 2015, is an important measure, as shown by the great benefits for the entire production system. Over time, however, its effectiveness has been reduced by the numerous changes to the eligibility criteria and to the size of the incentive. The estimated cost of bringing the tax credit rate in line with the average in OECD countries – to 20 per cent, from the current 10 per cent – and making it stable would be less than €1 billion per year, but it could lead firms to increase their research expenditure by more than 15 per cent. Our firms also need to step up their efforts to get the full benefit of the European Union’s initiatives for fostering innovation.20 Lastly, innovation also requires considerable investment in human capital. This is a pressing need in Italy, given the lower availability of highly skilled workers compared with the rest of the euro area. According to our estimates, the changes caused by artificial intelligence would affect two out of three workers in Italy. For most people there would be an increase in productivity and job opportunities, but the latter could be reduced for a significant minority.21 During the transition phase, it will be necessary to guide workers in their vocational retraining or to help them find other jobs, while protecting those who will face higher adaptation costs. Promoting innovative business initiatives There are not many new firms in high-tech sectors in Italy and they have a limited capacity for growth and success. The 2012 law on start-ups introduced simplified rules and tax breaks for creating innovative firms. Nevertheless, the drive of investors who are able to select and finance initiatives that are risky but have high growth potential remains crucial. This is the role of venture capital. In the United States, the top six companies by stock market capitalization, each worth more than $1 trillion, were initially financed by these investors and are now key global players in the digital revolution. In Italy, venture capital activity is underdeveloped, with an annual investment flow of between €0.5 billion and €1.5 billion over the years 2021-23, which is five times lower than in Germany and France. National operators are also few and small in size. The low growth in the sector partly reflects the delay with which this activity began in Italy. It is penalized by the limited development of the stock market and the small average size of firms, which make it difficult to list the The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA companies financed or to sell them to other larger companies once the initial growth phase is completed. Venture capital would benefit if institutional investors were more involved: if the share of assets invested by insurance and pension funds in national funds were equal to that in France, funding would double. Growth can also be fostered by removing legislative barriers. As regards the rules governing smaller fund managers in particular, Banca d’Italia will work to make implementing the enabling law that reforms the Consolidated Law on Finance an opportunity for considering a simplification of the relative obligations. The increase in financing must be matched by greater investment opportunities. In Italy, research work has high productivity and quality ratios, but limited resources.22 Boosting research and having better links with production would make it possible to turn as yet untapped potential into business opportunities. Better public action Public action plays a key role in the functioning of the economy, and not only because of the resources it makes available. Some of the reforms implemented in the last few years have had positive effects on productivity and growth. We must continue along that path: the results are only gradually emerging over time, but they are there.23 The reforms to civil justice and the digitalization of its procedures have made proceedings shorter and halved the number of pending cases compared with 15 years ago. The measures that have simplified market access for some services have made the entry of new firms easier and raised productivity in the sectors concerned. The digitalization of public administration has also increased.24 The NRRP commits Italy to implementing reforms and provides sizeable resources for modernizing its production system and public administration: according to our calculations, they amount to €16 billion for digitalization, €19 billion for research and innovation, €33 billion for transport infrastructures and €17 billion for business investment. It is hard for general government to make the best use of these considerable sums in a limited time frame, but doing so is crucial to reviving the economy’s growth potential. The full implementation of the reforms and investment envisaged in the NRRP – in addition to raising GDP by more than 2 percentage points in the short term – would have lasting effects on growth, BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 due to estimated productivity increases of between 3 and 6 percentage points over a decade.25 The measures I have outlined are not all without a cost, and Italy has a high public debt as a result of the imbalances accumulated in the past. At the end of 2023, it amounted to 137 per cent of GDP, which is quite close to the pre-pandemic figure but higher than in the rest of the euro area. This heavy weight forces us to commit considerable public resources to interest payments every year, taking them away from innovation and development. In order to deal with the debt problem, we need a credible plan to boost growth and productivity, and to gradually and steadily improve the public accounts. This plan will need to put the debt-to-GDP ratio on a firm downward trajectory. The more credible the prospects for debt reduction, the lower the returns that investors will demand for holding it: this in turn will make the adjustment less difficult. Careful choices are needed, especially on the expenditure side, in order to redirect its composition towards development and to cut out inefficiencies. The fight against tax evasion will have to play its part, following the positive results recorded in this field over the last decade.26 We will only be able to break free of the debt burden by combining fiscal prudence and growth. The financial system The Italian banking system The year 2023 was a very positive one for Italian banks. Return on equity exceeded 12 per cent. Profitability benefited from an exceptional market situation, in which the abundant liquidity in circulation curbed the increase in the cost of funding, while the rise in the key interest rates quickly passed through to lending rates, thereby boosting net interest income. Capital rose to 15.6 per cent of risk-weighted assets. The latest data confirm that this positive phase is still underway. Within the Italian banking system, the profitability and capital levels of Italian significant institutions are above the European average (Figure 6). The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA Figure 6 Profitability and capitalization of Italian and European banks (annual data; per cent) (a) Profitability (b) Capital ratio −5 −5 −10 −10 Italian significant banks Italian less significant banks European significant banks Source: Based on supervisory reports. (1) Banks based in European banking union countries. – (2) Return on equity. – (3) Ratio of common equity tier 1 capital to risk-weighted assets. The situation has also improved for the less significant institutions directly supervised by Banca d’Italia. Capital ratios have increased, in part at our behest. This has reflected changes in the risk profiles, above all the risk of a rapid increase in interest rates, which did then materialize. We have stepped up our supervision to prevent and promptly address cases of banks in distress that can be traced back to weaknesses in corporate governance and in internal controls. For the banking system as a whole, the improvements in its income and capital position reflect a multi-year process for restoring efficiency and strengthening balance sheets. The sound condition of banks today is a strong point for the entire Italian economy. Over the past few months, however, I have made it clear that we must not let our guard down. I repeat: we cannot be caught unprepared by tensions that could arise in the future. In April, we asked Italian banks to set up a macroprudential capital buffer of 1.0 per cent of domestic exposures by mid-2025.27 The increase in the requirements will have a negligible impact on credit supply and will make it possible to limit the negative effects of adverse systemic events: if they occur, the Bank could authorize the release of the buffer, thus maintaining the capacity of banks to support the real economy. With regard to the risks linked to the macroeconomic situation, there are two main aspects to consider. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 The first is credit quality. The Italian real estate market is not showing any worrying signs like those emerging in the commercial real estate sector in other countries. However, for total loans, there has been an increase in the share of loans that are performing but have recorded late payments, especially among customers with adjustable-rate loans. It is estimated that for firms, the annual flow of non-performing loans as a percentage of total loans will increase over the next two years by 1 percentage point, from the current 1.7 per cent. Loan loss provisions will remain low as a share of revenues. Looking ahead, it remains crucial for banks to recognize expected losses promptly, by applying accounting standards scrupulously. The second aspect is liquidity. The repayment of targeted longer-term refinancing operations is taking place in an orderly manner. However, careful liability management remains a priority, given that aggregate liquidity will continue to fall, pushing up the cost of funding. The role of technology in the financial system Going forward, technology will play a key role in shaping the activity of financial intermediaries, both banks and non-banks. Payment service providers have improved the products on offer, such as instant payments and digital wallets, and the customer experience. In the asset management sector, several credit funds already use digital platforms to match loan supply and demand more easily. Asset management companies have taken steps to start using distributed ledger technologies, both for the issuance and management of their shares and for investments in digital tokens. These innovations could enable companies to have greater direct access to external sources of funding. Many banks are using technology to replace traditional channels. The resulting efficiency gains are bringing benefits to both banks and their customers. Banks with a greater ability to operate online have higher profitability on average, show improved revenue diversification and increased their share of the lending market. Customers benefit from lower service costs – with charges on online accounts being 60 per cent of what they are for traditional accounts28 – as well as from easier access to banking services. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA The use of technology is being reflected in a reduction in the number of bank branches, which may cause inconvenience for some segments of the population. To prevent financial exclusion and difficulties in accessing cash, we have started a conversation with the relevant ministries and major players. We have also strengthened our commitment to the Eurosystem’s Cash 2030 Strategy and we have helped to design legislation to make it possible to withdraw cash from shops. Investments in innovative technologies made by Italian banks have quadrupled since 2017, but they are still limited.29 For significant banks, they are lower than those of their European competitors. They need to grow: it would be a serious mistake to continue to fall behind in this area. Given the complexity of the projects, we are encouraging intermediaries to strengthen corporate governance systems in order to increase digital skills in the management and control bodies and to improve their ability to manage and aggregate data. Technology is key when it comes to achieving efficiency. However, it must be used to improve the quality of services and ensure that the products offered match the needs of households and businesses. Only this way will banks be able to build a stronger relationship with customers and strengthen their own reputation, which are their most valuable assets. The risks posed by technology The use of technology increases the use of outsourcing and the associated risks. In 2022, financial intermediaries had more than 5,000 agreements in place for the outsourcing of critical functions of their business. Turning to third parties enables efficiency gains but creates operational risks that can eventually affect the entire financial system, when a small number of providers service a large number of financial intermediaries simultaneously. This is the case with tech giants – think of cloud services or the emerging market for AI-based services – but also with companies that provide data-related, administrative or credit services. Outsourcing must not jeopardize the sound and prudent management of financial intermediaries, which remain ultimately responsible for the activities carried out by third parties. In recent months, we have stepped up our efforts, including through on-site inspections, to ensure adequate governance of outsourcing policies. If shortfalls in the activity of these providers are detected, we ask for corrective actions using the information and inspection powers we have under BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 the law. Supervisory authorities’ power to intervene vis-à-vis suppliers, which is currently limited, will be strengthened with the entry into force of the EU regulation on digital operational resilience in the financial sector.30 Together with technology, cyber risks have acquired greater significance, also in connection with geopolitical tensions and the actions of nation state actors. The financial sector is an attractive target, given its dependence on digital data and procedures and its critical role in the economy. Financial intermediaries reported a sharp increase in serious incidents in 2023 (Figure 7). Figure 7 Serious cyber incidents reported by Italian banks (number of incidents) Source: Supervisory reports. The issue of cyber risks is high on the international agenda. As part of the work carried out at G7 level under the Italian Presidency, a second coordination exercise for combating large-scale attacks was held last April. In Europe, under the umbrella of the Single Supervisory Mechanism, the first bank stress test on cyber risks is under way. Its results will then be discussed between banks and supervisors. In Italy, Banca d’Italia and the Italian Banking Association (ABI) created the Computer Emergency Response Team for the Italian financial sector (CERTFin) some years ago with the goal of enhancing the participants’ IT risk management capabilities.31 Banca d’Italia has also established sound working relations with the National Cybersecurity Agency and with the main institutional players operating in the national cybersecurity system.32 Sharing information and leveraging the experience of all the institutions involved is crucial for taking effective collective action to counter cyber threats. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA Conclusions When the single market was launched 30 years ago, the European Commission, chaired by Jacques Delors, published a White Paper on growth, competitiveness and employment. The challenge was to stimulate debate on the future of the EU economy. It is striking that the changes in the global landscape that were being discussed then are the same as those that guide our thinking today: geopolitics, technology, demographics and finance. Of course, the questions then were about the emergence of new competitors on the world stage and the end of the Soviet Union, whereas now they are about global economic fragmentation. At the time, we were facing the first, widespread wave of information technologies, while now it is robotics and artificial intelligence. At that time, the issue was the prospect of an ageing population, but today it is how to organize a society that has already aged and that is struggling to adapt to the changes under way. Then, the growing interdependence of financial markets in a context of free movement of capital was being debated, now we are talking about the strategic importance of currencies in an international financial system that has become part of the geopolitical disputes. While back then the launch of the single market was the culmination of a long integration process, achieved amidst the tragic memories of the devastation of the Second World War, today progress in European integration is the answer to the changes in geopolitical balances and to the risk of irrelevance, to which individual Member States would otherwise be doomed by the sheer power of numbers. Strengthening the capacity for joint action and mobilizing the resources needed to become an active part of the technological, climate and energy transitions is the way to overcome the current static phase. This is true for Europe as a whole, but it is even more so for Italy. We talked a great deal about decline in Italy at the start of this century. In those years, a gap was forming between growth in our economy and that in the rest of Europe, which itself was not doing well compared with the United States. Subsequent crises and shocks have hit the Italian economy hard. Some of the indicators fuelling fears of decline at that time now seem to be telling us that we can reverse the trend. The swift recovery in exports and investment over the last four years points to an overhaul of the production system and a renewed capacity to compete in the international markets. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 Yet we must not delude ourselves: our economy still has serious problems, some of which are deep-rooted and difficult to solve. The economic lag in the Italian Mezzogiorno and the high public debt are inescapable issues for economic policy, as are the competition constraints that create advantages for incumbent firms and limit access for new entrants in many sectors, thus holding back innovation, productivity and employment. We need to open up the economy to competition and give everyone the chance to make the most of their talents. Human capital has a decisive role to play. The skills gap of young people and adults compared with many advanced countries is reflected in employment being tilted towards lower-skilled jobs. Skills and knowledge, which should be nurtured and cultivated throughout our lives, are the cornerstone not only of economic progress, but also and above all of civil progress. It is on the technology front that the battle of the future will be waged, for Italy and for the rest of Europe. We will need to invest in research, support the production system during its transformation, while protecting the most disadvantaged, and create a legislative, economic and financial environment that allows people to take business risks in innovative sectors and limits the monopoly power of a few large players. The agenda is clear and deliverable. It has to be done in order to return to growth and to make our presence count in Europe and, together with Europe, in the world. I cannot believe that a country with our history, our resources and our potential, which together with other countries succeeded in creating a community that has guaranteed development, well-being and peaceful cohabitation for millions of Europeans, is now unable to overcome the difficulties that are there for all to see and on which we all agree. Italy helped to found the European Union: now it can and it must contribute to its progress. We must channel the power of this perspective to look to the future with confidence. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA Note This assessment rests on the limited amount of low income countries’ debt, which stands at 1 per cent of global GDP. Foreign trade is measured by the sum of exports and imports. The objectives laid out in the text can be pursued by promoting partnerships and strengthening supply chains on such terms as those of the Italian government's 'Mattei plan' and of the Resilient and Inclusive Supply-chain Enhancement (RISE) project, backed by the G7 under the Italian Presidency, which is designed to integrate low-income countries into the supply chains for products that are key to the energy transition. Public and private climate-related investment needs stand at an average of €620 billion per year until 2030, according to the European Commission; see European Commission, ‘2023 Strategic Foresight Report. Sustainability and people's wellbeing at the heart of Europe’s Open Strategic Autonomy’, COM (2023), 376, final, 6 July 2023, p.7. A further €125 billion per year will be required for the digital transition and €75 billion to bring defence spending to 2 per cent of GDP, in keeping with NATO commitments. Data for the European Economic Area (which includes the European Union, Iceland, Liechtenstein and Norway). The number of groups includes both regulated markets and multilateral trading facilities; see ESMA, ‘Evolution of EEA share market structure since MiFID II’, 2023. The symbiotic relationship between the existence of sovereign bonds and the development of the capital market is confirmed by many centuries of experience. The wars that ravaged Europe and North America between the end of the 17th century and the 19th century led to a surge in public debt in leading countries such as the United Kingdom, France and the United States. Thanks in part to regulatory innovations that improved the credibility of sovereign issuers, government bonds gradually gained investors’ confidence and were increasingly traded by professional brokers. Over time, this underpinned the development of an ever wider range of financial intermediaries and services, which were able to attract more risk-averse savers and investors and expand the roster of financial market players. The natural interest rate is the theoretical interest rate that is compatible with a level of GDP equal to the potential one and with inflation being in line with the central bank’s target; see K. Wicksell, Geldzins und Güterpreise: eine Studie über die den Tauschwert des Geldes bestimmenden Ursachen, Jena, Fisher, 1898. Over the last decade, Italian firms have increased the ratio of own funds to total financial liabilities by 10 percentage points (i.e. the sum of financial debts and own funds). The share of people employed in firms with 250 or more workers in industry and private nonfinancial services rose to 24.5 per cent in 2022, almost 4 points higher than ten years earlier. For manufacturing as a whole, also including the transport equipment sector, the number of robots employed per 1,000 workers was 16.4 in Italy, against 27.3 and 15.2 respectively in Germany and in France. Automation has grown in recent years, especially in the pharmaceutical, metalworking and food sectors; see the box ‘The use of industrial robots in Italy: an international comparison’, Chapter 6, Annual Report for 2023, 2024. The estimate assumes that labour productivity and the employment rate by gender and age group remain at the same levels as in 2023. The employment rate in the 20-34 age group fell to 49.6 per cent in 2014 and has only recently begun to rise again, reaching 57.8 per cent; it is still below the peak of 62.1 per cent recorded in 2007. The unemployment rate in Italy for graduates aged between 20 and 34 was 12.3 per cent in 2019, more than double the average of the top five destination countries (the United Kingdom, Germany, Switzerland, France and Spain). In 2016, the last year for which the data can be compared, gross hourly wages were about one fifth lower in real terms. Italy has one of the lowest shares of children under the age of two enrolled at childcare facilities in Europe. BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 For example, individual income tax deductions for dependent spouses fall to zero as soon as the spouse’s gross annual income exceeds €2,840. With regard to cash transfers, there are several cases where benefits diminish rapidly if households’ resources increase, and the adjustments are modest for households that become richer when one of its members joins the labour market. In this assessment, employment rates by gender and age group are assumed to catch up with the current euro-area average levels over the next 15 years. See the measures envisaged by the Industry 4.0, Transition 4.0 and now the Transition 5.0 plans. To promote the technological transfer and the digital transformation, there are six different types of set-up in Italy, with more than 400 offices throughout the country. They disseminate information on the potential of investing in advanced technologies and assist firms in measuring their digital maturity, helping them decide on priority areas for action. The current network is widespread but it could benefit from greater specialization in its tasks, given how much roles overlap in the various organizations involved. Private expenditure on research and development accounted for barely 0.8 per cent of GDP in 2022, against 1.4 per cent in France and 2.1 per cent in Germany. The gaps were similar for registered patents. Horizon Europe, the successor of Horizon 2020, is an EU programme that finances research and innovation. Its budget amounts to €95.5 billion for the years 2020-27. The share of funds allocated to Italy by the Horizon programmes is much lower (by around 30 per cent) than its contribution to their funding. It is the same in France and Germany, but both countries spend a much larger share of their own resources on research. By contrast, Member States such as Spain, the Netherlands, Belgium, Sweden, Denmark and Finland receive a share of funds that far exceeds what they contribute (see ‘Executive Summary’, Report on the system of higher training and research, ANVUR, 2023; only in Italian). There is further funding for the Platform for Strategic Technologies for Europe (STEP), which is concentrated in the field of artificial intelligence, robotics and quantum computing. For further details, see the box ‘The potential impact of AI on Italian workers’, Chapter 7, Annual Report for 2023, 2024 (only in Italian). According to Eurostat data, Italy had around 90,000 researchers in research institutes and universities in 2022, compared with 132,000 in France, 187,000 in Germany and 97,000 in Spain. For further details, see Chapter 11, Annual Report for 2023, 2024 (only in Italian). In Italy, the provision of digital public services to citizens and firms has grown by 38 and 43 per cent respectively since 2017. The increases are calculated based on the European Commission’s Digital Economy and Society Index (DESI). For further details, see the box ‘The National Recovery and Resilience Plan’, Chapter 4, Annual Report for 2020, 2021. The 2023 Report on the unobserved economy and on tax and social security contribution evasion and its update in January estimate that the tax gap (i.e. non-compliance with declarations and payments) relative to the main taxes on firms and self-employment (IRAP, IVA, IRES and IRPEF for self-employment and firms) shrank significantly between 2014 and 2021 (by more than one percentage point of GDP, to 4 per cent). With reference to overall tax and social security contribution evasion, the Report shows that both the propensity to evasion and its size in absolute terms declined in the years 2016-21 (the only period for which homogeneous estimates are available), by 6 percentage points and by €24 billion respectively. Or more accurately, the capital buffer is equal to 1.0 per cent of credit and counterparty riskweighted exposures to Italian residents. Half of this target is to be established by the end of this year, and the remaining 0.5 per cent by 30 June 2025. ‘Survey on the cost of bank accounts for 2022’, Banca d’Italia, January 2024 (only in Italian). ‘Fintech Survey of the Italian financial system’, Banca d’Italia, April 2024. The Governor’s Concluding Remarks Annual Report 2023 BANCA D’ITALIA The Digital Operational Resilience Act (DORA). CERTFin’s strategic committee is chaired by Banca d’Italia and ABI and includes the Italian Companies and Stock Exchange Commission (Consob), the Italian Insurance Supervisory Authority (IVASS) and the Italian Association of Insurers (ANIA). Cooperation in the field of cybersecurity has been established with the Ministry of Justice, the Department of Public Security of the Ministry of the Interior, the Carabinieri police force, and the Finance Police (Guardia di Finanza). BANCA D’ITALIA The Governor’s Concluding Remarks Annual Report 2023 Printed by the Printing and Publishing Division of the Bank of Italy Rome, 31 May 2024 Printed on EU-Ecolabel certified paper (registration number FI/011/001)
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Opening remarks by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the G7 Scientific Roundtable, Rome, 3 June 2024.
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Digital POLICY and Data Governance in the age of AI Opening remarks by Luigi Federico Signorini Senior Deputy Governor of the Bank of Italy G7 Scientific Roundtable Rome, 3 June 2024 I am happy to take this opportunity to greet participants in today’s G7 roundtable.1 Digital policy and data governance are bound to imply complex trade-offs. I’d like to highlight three key areas: (i) data localisation; (ii) digital trade; (iii) AI governance. I’ll touch very briefly on each, mentioning issues that are in some way or other connected to today’s papers. There is of course no pretence that the list is exclusive. The number of potential issues is large; personally, I do not even know all the questions, let alone all the answers. What follows is therefore just a set of examples of some important and challenging issues that may relate to today’s discussions. First, data localisation. The key issue here concerns restrictions to cross-border transfers of data. The OECD has shown that cross-border data flows are increasingly regulated.2 Over the last decade, the tally of localisation measures has more than doubled.3 What are we to make of this? Even in liberal democracies and market economies, the regulatory approach to data flows entails some trade-off between liberty, free speech and free trade on the one side, and privacy, intellectual property, crime prevention and national security on the other.4 Balancing such concerns in a fast-changing technological and market environment is a delicate task. Non-free regimes, of course, have other reasons to restrict the flow of data. Thanks are due to Michele Savini Zangrandi and Oscar Borgogno for valuable input. OECD (2023), “Key issues in Digital Trade”, OECD Global Forum on Trade 2023. Ferracane, M. and Ugart, S.G. (2024) “Data localisation: global trends” Working Paper presented at the Bank of Italy’s G7 Roundtable on 3 June 2024. Borgogno, O. and M. Savini Zangrandi (2022), “Data governance: a tale of three subjects”, Journal of Law, Market & Innovation, 1(2), 50-75. In any case, different countries will tackle the issue in different ways. The regulatory web is intricate, and for the time being it is likely to remain so. The regulation of data localisation and data flows generates costs for market players; more so for smaller enterprises, which may lack the resources to cope with a complicated cross-border legal framework.5 Still, the authors of one of today’s papers argue – based on new evidence – that data flow regulation can create benefits for consumers and service providers in terms of increased trust, which might offset any regulatory costs.6 The discussion of the merits and limits of this claim will be interesting. One specific sub-issue concerns the financial sphere. Data flow restrictions affect, among other things, the efficiency and integrity of cross-border transactions and payments.7 The issue of payments belongs to the core of most central banks’ activity, and the Bank of Italy is very active in this field. In many ways, technical and regulatory barriers result in cross-border payments remaining slow and expensive. Surely, safeguards are needed, e.g. for anti-money laundering and counterterrorism purposes. One needs to find a way to reduce costs and increase speed and convenience without compromising on integrity and safety. There are important international initiatives under way. In today’s ‘policy track’ panel, the G7 workstream on Free data flows within a context of trust, initiated under the Japanese presidency with the support of the OECD, will interact with the G20 Roadmap on cross-border payments and the related FSB and CPMI agendas. Let me now turn to my next point: digital trade. Digital trade is booming. According to the OECD, it accounted for 25 per cent of global trade in 2020.8 It presents us with another trade-off, albeit one that is by no means limited to the digital space: trade openness against domestic policy agendas.9 In fact, all over the world fragmentation and barriers are more and more of an issue in the global policy discussion nowadays. Russia’s invasion of Ukraine, heightened strategic J. Jia, G. Zhe Jin and L.Wagman (2021) “The Short-Run Effects of the General Data Protection Regulation on Technology Venture Investment” Marketing Science 40, 4; R. Janßen, R. Kesler, M. E. Kummer, J. Waldfogel (2022) “GDPR and the lost generation of innovative apps” NBER WP Series. Andrenelli, A., Bekkers, E., Lopez-Gonzalez, J., Marceau G. and So, R. (2024) “A song of data flows and trust. A Quantitative Analysis of Cross-border Data Flow Regulation” WTO-OECD Working Paper presented at the Bank of Italy’s G7 Roundtable on 3 June 2024. Financial Stability Board (2022), “Stocktake of International Data Standards Relevant to Cross-Border Payments”. OECD (2023), “Key issues in Digital Trade”, OECD Global Forum on Trade 2023; WTO, OECD, UNCTAD, IMF (2023), “Handbook on Measuring Digital Trade” (2nd edition). Borgogno, O. and M. Savini Zangrandi (2024), “Chinese data governance and trade policy: from cyber sovereignty to the quest for digital hegemony?”, Journal of Contemporary China. rivalries (including about technology), and other tensions that show no sign of abating, have all been factors.10 This trend can touch digital trade. For example, the ongoing Joint initiative on e-commerce at the WTO, which the US had strongly supported, has now seen retrenchment.11 I do not need to underline the importance of global digital trade patterns. The economic rise of some countries (think of India) has been linked, among other things, to their ability to supply technical and professional services remotely. Is this trend going to continue, and how? The topic is not explicitly on today’s agenda, but I believe that it will be in the background of many of your discussions. My third and final point concerns artificial intelligence. Everybody has seen the near-vertical trend in the use of LLMs such as ChatGPT, as well as the surge in AI-related stock valuations. This is not the place even to start discussing the innumerable social, economic, political, technical and philosophical issues that surround AI. Let me just draw your attention to yet another trade-off, which is highlighted by the bubbling, but far from homogeneous, growth in AI regulation. How does one reconcile the protection of privacy, intellectual property and other basic rights (which appears to require more regulation) and the promotion of vibrant innovation (which often appears to require less)? While the legal framework is still evolving, different jurisdictions already seem to be balancing the pros and cons differently. For the moment, there is little hope (or fear?) of a globally homogeneous, consistent regulatory approach to AI. The first of today’s papers12 discusses developments in this area, including the risk that a fragmented global AI market emerges, with isolated regional blocs. Regulation and innovation are also the subject of Professor Aghion’s speech today, and I very much look forward to hearing what he will say. And that, ladies and gentlemen, is all from me. Let me conclude by just thanking all the speakers, discussants, and organisers. There is a lot to discuss about. I wish you a very productive day. ECB - International Relations Committee (2024 Forthcoming) “Navigating a fragmenting global trading system – Some lessons for central banks”. – Governor Panetta has discussed trade issue at length in his recent Final remarks. Burri, M. (2024) “The State of Global Digital Trade Governance” Working Paper presented at the Bank of Italy’s G7 Roundtable on 3 June 2024. Fritz, J. and Giardini; T. (2024) “Emerging Contours of AI Governance and the Three Layers of Regulatory Heterogeneity” Working Paper presented at the Bank of Italy’s G7 Roundtable on 3 June 2024.
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Speech by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the 79th EXCO Week of the International Association of Deposit Insurers (IADI), Rome, 13 June 2024.
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Deposit insurance and crisis management: the current landscape and the way forward Alessandra Perrazzelli Deputy Governor of Bank of Italy 79th EXCO Week of the International Association of Deposit Insurers (IADI) Rome, 13 June 2024 Ladies and gentlemen, good morning. It is a great honour to be here at such a prestigious international event to share some thoughts about the role of deposit guarantee schemes (DGSs) in crisis management, also in the light of changes in the regulatory, operational and technological environment.1 This occasion presents a meaningful opportunity to exchange reflections, experiences and insights from different standpoints, on the milestones reached and possible improvements to the safety net, as well as to promote fruitful dialogue among stakeholders. 1. Main features and the role of DGSs DGSs play a crucial role in the management of bank crises. Robust bank supervision remains the best line of defence against a banking crisis, but a properly designed resolution and an efficient deposit insurance system are important components of a functioning financial safety net. DGSs are essential to curb the likelihood of banking panics and are therefore a key policy feature for ensuring financial stability. Moreover, by collecting funds from the banking industry they help to shift the cost of insurance from the public finances to the banking industry itself. DGS funds are primarily used to prevent bank runs by ensuring that depositors have immediate access to their insured funds in the event of a bank failure, thus acting as an ex ante safe device for depositors (the ‘paybox mandate’). With thanks to Gianluca Aloia, Federico Signore and Marilena Iannicola for their valuable contributions. DGSs may also be called upon to perform one or more additional functions, as they are designed to work as part of a balanced dynamic system and should not be regarded as a static pool of funds. Many DGSs have progressively expanded their mandates to include additional tasks, such as financial support in resolution (the ‘paybox plus mandate’) and have implemented loss and risk minimization strategies.2 Broader mandates enable DGSs to be more committed in banking crisis management. 2. Changes in the crisis management framework As we all know, the framework for dealing with non-viable banks has advanced significantly in the decade following the global financial crisis of 2007-08 and, for the European countries, the subsequent sovereign debt crisis. At the international level, the Financial Stability Board (FSB) focused on systemically important banks and identified best practices for managing their crises. Largely following the international standards set out in the FSB’s ‘Key Attributes of Effective Resolution Regimes’ – which also provide for interaction and cooperation between the resolution authority and DGSs – EU regulators adopted the Bank Recovery and Resolution Directive (BRRD), which introduced a new crisis management regime with a higher degree of harmonization. The aim of the directive was to overcome the too-big-to-fail problem and eliminate the need for bailouts with public funds in the event of bank failures.3 Through the participation of investors and creditors in the failed banks’ losses, the framework also aimed to reduce moral hazard and restore the level playing field for larger and smaller banks. In Europe, the establishment of the Single Resolution Mechanism (SRM), tasked with improving the resolvability standards of significant banks, ensured a consistent approach to crisis prevention and management for the largest banks across the Banking Union. The centralization of duties and responsibilities for bank crisis management at the European level was an essential step towards the completion of the Banking Union and resulted, among other things, in intensive data collection, coordination between authorities and advance planning. For instance, the Deposit Insurance Corporation of Japan (DICJ) has a loss minimization mandate, while the Federal Deposit Insurance Committee (FDIC) in the US adopts a risk minimization model. See IADI, 2022 Annual Survey. Ignazio Visco, introductory remarks at Banca d’Italia’s Workshop ‘The crisis management framework for banks in the EU. How can we deal with the crisis of small and medium-sized banks?’, May 2021. Important progress has been made in improving the willingness of banks to tap capital market in order to issue MREL instruments, in removing obstacles to resolvability, and in implementing tools to intervene early and quickly in an unsound or failing institution. In this environment, DGSs have had a major role to play, as they have been enabled to intervene in the resolution process to preserve the access of covered depositors to their funds, notably in the event of a ‘virtual bail-in’. However, there is still room to improve the regulation of crisis management in small and medium-sized banks – assuming they do not raise concerns for financial stability – which is an important missing piece in the European crisis management framework. 3. The DGSD and DGSs’ interventions beyond payout In addition, in line with the best practices issued by the international standard setters, the Deposit Guarantee Schemes Directive (DGSD) recognized DGSs as fully-fledged participants of the safety net. Under the DGSD, Member States may allow DGSs to perform more than a reimbursement function and use the available financial means to prevent the failure of a credit institution (preventive interventions) and to finance measures in the context of national insolvency proceedings (alternative interventions), subject to certain conditions and limitations (notably the least cost criterion).4 The use of measures other than payout has significant advantages. Not only are they less costly than payout, but from a system-wide perspective they also help to safeguard depositors’ confidence and overall financial stability, mitigating the disruptive effects of piecemeal liquidation.5 Italy’s longstanding experience confirms the central role of DGSs in crisis management. Since the establishment of the two Italian DGSs, 90 interventions out of 93 have been preventive or alternative and only 3 have been payouts.6 Alternative measures proved to be paramount to solve banking crises and a real strategic partnership can be identified among Banca d’Italia and the two Italian DGSs. See Article 11(3) and 11(6) of the DGSD. Piecemeal liquidation is therefore the worst crisis management option, with negative impacts on public confidence and on overall financial stability, while interventions other than payout ensure the continuity of the bank’s borrowing relationships and the preservation of the enterprise value and of the employment level, and a high degree of depositor protection. See ‘The banking crises of 2023: some initial reflection’, speech by Paolo Angelini, Deputy Governor of Banca d’Italia, at the event ‘Promoting Accountability in Times of Crisis’, November 2023; A. De Aldisio, G. Aloia et al., ‘Towards a framework for orderly liquidation of banks in the EU’, Notes on Financial Stability, 15, August 2019; and ‘Protecting depositors and saving money’, Occasional Paper Series, ECB, Frankfurt am Main, June 2023. More specifically, the Interbank Deposit Protection Fund (FITD) has managed 16 interventions since 1987, of which 9 were alternative interventions, 2 were depositor payouts and the remaining 5 were preventive interventions. The Deposit Guarantee Scheme for Cooperative Banks (FGDCC) has carried out 77 interventions since 1997: only one case involved a depositor payout, while the remaining 76 were interventions other than payout (24 alternative interventions and 52 preventive interventions). 4. International experience The key role of DGSs in crisis management is also confirmed in some major non-EU jurisdictions. In the US, for instance, the DGS’s support for the transfer strategies is a pillar in the framework and was successfully used for almost a century, including recently in the early 2023 crises. Between March and May 2023, three large regional banks were closed and resolved with a purchase and assumption (P&A) transaction and with sizeable support from the Federal Deposit Insurance Corporation (FDIC).7 To facilitate the resolution of financial institutions, the Deposit Insurance Corporation of Japan (DICJ) has provided financial assistance in 182 cases and injected capital into 34 financial institutions so far.8 5. Changes in the banking environment The banking environment has changed in recent years. Technological innovation is perhaps the main driver of change. On the one hand, it is leading credit institutions to adapt their business models and rethink the ways they provide banking services, both in response to customers’ new expectations and to changes in product customization and customer service. It is also creating new opportunities in terms of profitability, thanks to efficiency gains and cost reductions.9 On the other hand, it poses challenges. Corporate governance systems should be strengthened in order to increase the digital literacy of management and supervisory bodies. Moreover, technology increases the use of outsourcing (and the associated risks) as well as competition between intermediaries.10 Finally, financial stability concerns may arise. Indeed, the digitalization and internationalization of finance, while providing access to fast payments (including instant bank transfers) and mobile banking, may also lead to the amplification of concerns through social media, causing considerable and unexpected deposit withdrawals and risks of bank runs. Specifically, the FDIC intervened to support the transactions, with a total cost of more than $40 billion (estimated as of 31 December 2023). While one intervention (First Republic Bank) was carried out under the least cost requirement, the systemic risk exception was invoked in the other two cases (Silicon Valley Bank and Signature Bank), so the FDIC could deviate from the least cost principle. See DICJ, Annual Report 2022/2023. Many banks are using technology to replace traditional channels. The resulting efficiency gains are bringing benefits to both banks and their customers. Banks with a greater ability to operate online have higher profitability on average, show improved revenue diversification and increased their share of the lending market. Customers benefit from lower service costs – with charges on online accounts being 60 per cent of what they are for traditional accounts – as well as from easier access to banking services. ‘The Governor’s Concluding Remarks’, Banca d’Italia, May 2024. See also ‘The Governor’s Concluding Remarks’, Banca d’Italia, May 2024. In the new digital world, close cooperation between supervisory and resolution authorities and effective deposit insurance are even more crucial to avoid systemic crises and protect financial stability. The recent turmoil that occurred in the banking sector in the first quarter of 2023 in the US and in Switzerland showed how quickly a risk of contagion can materialize in a digital world and how commercial banks are heavily dependent on a fickle base of depositors. The concentration of large deposits held by firms and individuals connected in virtual communities may contribute to synchronised deposit outflows and cause a massive flight of depositors. Recent crisis episodes have tested assumptions about the appropriateness of the coverage threshold, stimulating discussions on a possible revision of the existing framework with a view to adapting it to changes in the social and economic systems and financial markets. One possible way forward could therefore be to raise the coverage threshold, also in line with the recent international debate.11 In fact, observers with a say on these issues, including IADI, have pointed out the virtuous cycle between increasing the level of depositor protection and reducing the likelihood of bank runs. In our view, a higher insurance threshold would help to stabilize banks’ funding, which tends to be more volatile in the new environment. The possible increase in contributions for the banking system would be more than offset by the increase in its stability and by the perception of greater safety among depositors and other creditors. 6. The EU’s three milestones: CMDI, EDIS and the digital euro Coming back to the EU, let me underline three points. The review of the crisis management and deposit insurance (CMDI) framework in Europe is underway. This project is a unique opportunity to address the shortcomings of the current regulatory landscape. The proposal published by the European Commission in April 2023 introduces improvements but also contains weaknesses.12 It is key that the prominent role of the DGSs in the financial safety net be further strengthened; the effectiveness of the revised framework will depend on two aspects, both related to DGSs. FDIC, ‘Options for deposit insurance reform’; IADI, ‘Uninsured Deposits: Relevance and Evolution Over Time’, Policy Brief No. 8. ‘The banking crises of 2023: some initial reflection’, address by Paolo Angelini, Deputy Governor of Banca d’Italia, at the event ‘Promoting Accountability in Times of Crisis’, Rome, November 2023. Firstly, the use of DGSs to support transfer strategies (both in resolution and in liquidation) should be facilitated, including through a wide and strengthened least cost test. Secondly, the DGSs should be allowed to fill the funding gap efficiently and easily, in order to unlock the resources of the Single Resolution Fund. The wider role of DGSs in resolution and liquidation may raise concerns about the adequacy of their resources and the resulting increased costs for the banking system.13 In this respect, interventions beyond payout typically minimize the cost of banking crises for all the stakeholders involved, arguably including the DGS itself;14 moreover, a wider use of DGS funds would improve the positive outcomes mentioned earlier (in terms of public confidence and financial stability) and may consequently lead to a reduction in banks’ funding costs. Increasing the involvement of DGSs would be even more important with a view to completing the Banking Union through the establishment of the European Deposit Insurance Scheme (EDIS). The creation of a European Fund with the power to support the management of bank failures would mark the transition from a European network of national DGSs to an integrated European mechanism to protect depositors. Indeed, in a broad-based system where responsibilities for supervision and resolution are centralized, depositor insurance should also be mutualized. Only a fully mutualized EDIS that also covers alternative interventions would ensure depositor protection without producing cross-subsidization effects.15 Less ambitious solutions would not deliver the beneficial effects of a fully-fledged mutualization and would transfer the management of crises to the central level while leaving the costs at the national level. From our point of view, it is therefore crucial to ensure consistency between the responsibility of the decision-making process and the funding mechanism. Looking ahead, concerns may arise around the introduction of central bank digital currencies (CBDCs), such as the digital euro. Some observers fear that a digital euro could create instability by potentially challenging the traditional banking business. In this regard, it is crucial to adjust some features of the CBDCs, such as their holding limits, in order to avoid any negative impact on financial stability and to maintain a balance between private money and central bank money. Increased costs may arise from a potential increase in the target level of DGS and from higher contributions paid by banks to replenish the financial resources used. The banking crises of 2023: some initial reflection’, address by Paolo Angelini, Deputy Governor of Banca d’Italia, at the event ‘Promoting Accountability in Times of Crisis’, Rome, November 2023. J. Carmassi, S. Dobkowitz, J. Evrard, L. Parisi, A. Silva and M. Wedow, ‘Completing the Banking Union with a European Deposit Insurance Scheme: who is afraid of cross-subsidisation?’, Occasional Paper Series, ECB, Frankfurt am Main, April 2018. Moreover, a gradual adoption of the digital euro would reduce the risk of cliff-edge effects on bank deposits. It bears repeating that depositors do not need digital central bank money to run on banks. They can already withdraw their funds and move deposits quickly, including through instant bank transfers. On the contrary, CBDCs might even help to mitigate the risk of bank runs. A digital euro could provide real-time information on the outflow of bank deposits, allowing the authorities to react more quickly, which in turn would increase depositors’ confidence.16 7. Conclusion To conclude, recent trends in the banking sector and upcoming changes in regulation could be given due consideration in the ongoing review of the IADI Core Principles, focusing on a well-balanced partnership between stakeholders.17 Developments in the financial sector and technological innovation pose important challenges for authorities and deposit insurers. When market and depositor confidence is lost, they must act in a predictable manner to minimize the risk of bank runs, thus preventing contagion and preserving public confidence. To this end, it is extremely important to learn from past experience and to adapt flexibly to changes in the environment by looking ahead and working closely together. So far, enhancing cooperation in crisis management has been a very ambitious undertaking but many significant milestones have been achieved in a relatively short time span through joint efforts aimed at converging different regulatory traditions and at incorporating the best national practices into a unified approach. Cooperation is key. Banca d’Italia is firmly committed to promoting developments in the field of depositor protection and cooperation. I encourage all of us, regulators, DGSs and supervisors, to stay connected, work together and continue our dialogue, here and in all the appropriate international fora and networks. Today’s meeting provides a great opportunity to discuss all these issues and to explore views and suggestions that will contribute in a constructive way to the debate on how to improve depositor protection and foster a safer financial system. So let me once again thank the organizers for the honour of opening this event, which I am sure will provide us all with inspiring ideas and useful takeaways. ‘The cost of not issuing a digital euro’, address by Fabio Panetta, Governor of Banca d’Italia, at the conference ‘The macroeconomic implications of central bank digital currencies’, Frankfurt am Main, November 2023. The IADI Core Principles for Effective Deposit Insurance Systems were published in 2009 and revised in 2014.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the 3rd Bank of Finland International Monetary Policy Conference "Monetary Policy in Low and High Inflation Environments", Helsinki, 26 June 2024.
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Monetary policy after a perfect storm: festina lente Speech by Fabio Panetta Governor of the Bank of Italy 3rd Bank of Finland International Monetary Policy Conference on ‘Monetary Policy in Low and High Inflation Environments’1 Helsinki, 26 June 2024 Good afternoon ladies and gentlemen. I would like to thank the Bank of Finland for organizing this conference, and Governor Rehn for inviting me. It is a great pleasure to be here. Finland has been crowned the happiest country in the world for the seventh consecutive year in the recently published World Happiness Report:2 I am really happy to be part of that happiness. We are at a turning point in the European monetary policy cycle. In June, the Governing Council decided to cut the key ECB interest rates by 25 basis points after holding them at high levels for nine months. Turning points inevitably attract attention, and the policy debate is now focused on the next steps: ECB watchers are eagerly looking for clues about the pace of the normalization path. I will briefly review what has happened to inflation over the past three years. I will then discuss some of the remaining concerns about the disinflation process, namely price developments in the services sector and the role of profits, input costs and labour costs. After that, I will examine the outlook for inflation and growth from a forward-looking perspective. I will outline my thoughts on the evolution of monetary policy before concluding. My main message is that the disinflation process requires two ingredients. We must keep adjusting policy rates to complete the process and smoothly reach our 2 per cent inflation target in a scenario where our expectations turn out to be broadly correct. But I would like to thank Piergiorgio Alessandri, Marco Bernardini, Francesco Corsello, Alessandro Notarpietro, Marianna Riggi, Alessandro Secchi, Fabrizio Venditti and Eliana Viviano for their contributions and comments. Festina lente – “hasten slowly” – is the Latin motto that epitomised a decisive but calm policy action for Augustus, the first emperor of Rome. The motto was also used in XVI-century Florence by Cosimo I De’ Medici, whose fleet aptly adopted as a symbol a turtle endowed with sails. Helliwell J.F., R. Layard, J.D. Sachs, J.-E. De Neve, L.B. Aknin and S. Wang (eds.), 2024, ‘World Happiness Report’, University of Oxford, Wellbeing Research Centre. we also need to be prudent, and stand ready to adjust our policy in response to shocks that may create upside or downside risks to the current outlook. 1. Genesis and unfolding of a perfect storm After years of low inflation, the euro area experienced an exceptional rise in prices between 2021 and 2023 (Figure 1). Supply constraints, the rebound in consumption and soaring commodity and energy prices created a perfect storm for inflation. The nature of the storm has been debated in countless papers and opinion pieces, and I will not systematically review it again today.3 There are just a few points I would like to emphasize. Figure 1 Euro area headline inflation decomposition (monthly data; per cent and percentage points) Headline y−o−y Energy Food NEIGs Services −2 −2 Source: calculations based on Eurostat data. Notes: the figure reports the year-on-year percentage changes of the euro-zone HICP, decomposed into contributions of its components. The first one is that the conditions for the storm took shape in 2020, when inflation was close to zero. The pandemic disrupted supply chains and caused a structural shift in consumption patterns – including a reallocation from services to goods – that proved to be highly consequential in the following two years. The second point is that, paradoxically, the recovery in the US economy complicated the picture in the euro area. It was fast and strong, underpinned by a generous fiscal stimulus and the excess savings accumulated during the pandemic lockdowns, and it initially involved more goods than services. This led to large swings in relative prices, pushing up headline inflation;4 it also strained supply chains and increased commodity and energy prices on international markets. In a twist of fate, a positive demand shock in the US turned into an additional negative supply shock for Europe. See e.g. Panetta F., 2023, ‘Everything everywhere all at once – responding to multiple global shocks’, speech at ‘The ECB and its Watchers XXIII’ conference, Frankfurt am Main, 22 March. Bernanke B., and O. Blanchard, 2023, ‘What Caused the U.S. Pandemic-Era Inflation?’, Hutchins Center Working Paper 86, June. The Russian invasion of Ukraine in February 2022 radically changed the inflation outlook. On the eve of the invasion, inflation was hovering around 5 per cent, and Eurosystem economists, analysts and investors broadly agreed that price pressures would recede relatively quickly. In the months that followed, an extraordinary series of energy and commodity price shocks doubled headline inflation, unsettling markets and central banks alike.5 In short, we entered into a different world.6 2. Should we (still) worry about services and wages? In response to the rise in inflation, in July 2022 the ECB started an unprecedented series of rate hikes. This decisive response paid off: supply shocks, bottlenecks and soaring energy prices have not triggered an inflationary spiral, as they had in the past, and inflation expectations remained firmly anchored. The disinflation process is now well under way. Inflation fell from a peak of 10.6 per cent in October 2022 to 2.6 per cent in May, and the speed of the decline was unprecedented, as the previous increase. However, inflation has not yet returned to target. Some commentators have pointed to price dynamics in the services sector and the labour market as possible obstacles in the ‘last mile’ of the price stabilization efforts. We should certainly remain vigilant on developments in these areas, but a closer look at the data suggests that the ‘last mile’ may require nothing more than patience and a careful monitoring of the ongoing disinflation process. 2.1. The rise and fall of inflation in the services sector The services sector has attracted attention for two related reasons. First, services inflation seems to be more persistent than goods inflation. Second, services price growth remains above the ECB target. Let me discuss these points in turn. The persistence is only apparent. It reflects the fact that inflation in the services sector started to rise later, peaked later and started to fall later. In turn, this delayed rise and fall depends on the combination of two forces. One is purely coincidental and specifically related to the pandemic episode. Initially, the recovery in consumption was mainly driven by demand for goods, in particular the durable goods that consumers were unable to buy during the first stage of the The shocks had a particularly severe impact on Europe, a net importer of most commodities – unfortunately including Russian gas. The exorbitant energy bills also left European households with far less money to spend on other goods and services than their American counterparts. As this rough summary suggests, and as I have noted on previous occasions, the euro area faced a wave of particularly ‘bad’ inflation. The ‘good’ type is driven by buoyant domestic demand and wage growth consistent with the target; monetary policy should nurture it or mitigate it (depending on the initial level) until the target is reached. The ‘bad’ type reflects negative supply shocks that raise prices and depress economic activity; monetary policy should look through it. There is also an ‘ugly’ type of inflation driven by a de-anchoring of inflation expectations; monetary policy should immediately stamp it out. See Panetta F., 2021, ‘Patient monetary policy amid a rocky recovery’, speech delivered at Sciences Po, Paris, 24 November. lockdowns. The consumption of goods recovered quickly in the euro area; it grew even faster in the US, where it exceeded pre-pandemic levels. Services consumption recovered later and more slowly, especially in the euro area (Figure 2). Figure 2 Diverging consumption paths of goods and services (quarterly data; index numbers, Q4 2019=100) (a) United States (b) euro area 2018 2019 2020 2021 2022 2023 2018 2019 Goods 2020 2021 2022 2023 Services Source: calculations based on US Bureau of Economic Analysis and Eurostat data. Notes: panel (b) is based on euro area countries for which data are available. The second force is structural. Goods and services react differently to exogenous cost-push shocks because they are characterized by different price adjustment mechanisms. In particular, price adjustments are slower for services. One reason for this is that many services are provided directly by the public sector or are subject to administrative and contractual frictions.7 Consider energy price shocks. Estimates based on historical data and standard econometric models show that, following an energy shock, non-energy industrial goods (NEIGs) inflation peaks in about one year and returns to equilibrium within two years; instead, services inflation peaks about six months later and normalizes after almost three years (Figure 3a). In terms of relative magnitude and timing, these estimates are virtually mirror images of the inflation patterns actually observed between 2022 and 2024 (Figure 3b). This remarkable coincidence corroborates the hypothesis that the asymmetric propagation of energy shocks explains a good part of the ‘puzzling’ divergence between the two sectors. The second concern is that services inflation remains higher than goods inflation and above the ECB target. However, this is not surprising: historically, it has almost always been the case. In the euro area, services inflation has been around 1 percentage point higher than goods inflation since the late 1990s; before the great financial crisis, it was also systematically above the ECB target (Figure 4). Whatever the explanation for The a-cyclical, backward-looking ‘latecomer’ items, which include rents and insurances as well as services directly provided by the public sector (health, education, post), played an important role in boosting inflation over the past 12 months (Figure A1). this difference, the data suggest that there is no reason to expect goods and services inflation to coincide in the long run.8 Figure 3 Inflation persistence, services versus non-energy industrial goods (a) Responses to energy shocks in a VAR model (b) Annual inflation rates, 2021-2024 (percentage points) (monthly data; per cent) 0.4 0.4 0.2 0.2 0.0 0.0 −0.2 −0.2 0 1 2 3 4 5 6 7 8 9 10 11 12 NEIGs '24 Services Source: calculations based on Eurostat data. Notes: panel (a) reports impulse-response functions based on a quarterly VAR model over the sample period 1996-2023; the x-axis indicates the number of quarters after the energy shock. Model specification and identification of energy shocks are similar to those presented in Neri S., F. Busetti, C. Conflitti, F. Corsello, D. Delle Monache and A. Tagliabracci, 2023, ‘Energy price shocks and inflation in the euro area’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), n. 792. Panel (b) reports the year-on-year percentage changes of the euro-zone HICP of services and non-energy industrial goods (NEIGs) over the sample period 2021-2024. Figure 4 Inflation levels, services versus non-energy industrial goods (monthly data; per cent) NEIGs Services Source: calculations based on Eurostat data. Notes: the figure reports the year-on-year percentage changes of the euro-zone HICP of services and non-energy industrial goods (NEIGs) over the sample period 1998-2024. Since services are less tradable than goods, the gap may reflect for instance a Balassa-Samuelson effect. According to this theory, if productivity grows faster in the tradable sector than in the nontradable sector (for instance because of international competition), while wages are equalized across sectors in equilibrium, then the relative price of tradables and non-tradables will diverge and the non-tradable sector will experience a higher inflation rate. Productivity growth has traditionally been higher in the goods sector, lending credibility to this interpretation of the data. See Balassa B., 1964, ‘The purchasing-power parity doctrine: a reappraisal’, Journal of Political Economy, 72 (6) 584-596 and Samuelson P.A., 1964, ‘Theoretical notes on trade problems’, Review of Economics and Statistics, 46 145-154. What matters is the convergence of overall headline inflation towards our target, not the behavior of individual components of the price index. The relatively high level of services inflation will be closely monitored in the future, but we have reasons to believe that the stickiness in this sector is not abnormal in any way. 2.2. Wages, costs and profits Wages have been rising gradually to make up for previous losses of purchasing power, and in some countries they may rise further. Concerns that this will reignite inflation are mitigated by three factors. First, intermediate costs have fallen significantly, offsetting the impact of wage increases on the dynamics of total costs. This mechanism is already at play, and it has contributed to a weakening of domestic price pressures: the output deflator decelerated sharply since the end of 2022 (Figure 5). Figure 5 Contribution of costs and profits to year-on-year changes in the output deflator (quarterly data; per cent and percentage points) Output Deflator Unit Cost of Intermediate Inputs Unit Labour Cost Unit Profit '24 Source: calculations based on Destatis, Insee, Istat and Eurostat data. Notes: the figure is based on data for Germany, France and Italy. The three components of the deflator (UCIP, ULC and UP) are obtained dividing, respectively, the cost of intermediate goods, the cost of labour and the gross operating surplus by the real value of production In addition, in recent months firms have not fully passed on the fall in energy and intermediate input costs to final prices. As a result, they have accumulated substantial profits, especially in some sectors; and it is precisely in these profitable sectors that workers are demanding a rapid recovery of past real wage losses.9 This means that, going forward, profits can play a buffering role, limiting the pass-through from wage increases to consumer prices. Finally, since 2021 productivity has been held back by a very intensive use of the labour factor, driven by increases in the costs of other production inputs and the decline in Consider for instance the well-known case of the retail sector in Germany. Wages are expected to rise on average by almost 7 per cent in 2024, but profits have increased by over 40 per cent since 2019, from 110 to 155 billion euros, creating significant shock-absorption capacity. At a more general level, Bank of Italy calculations show that aggregate markups (defined as the ratio between the value of production and total variable costs) are well above their long-term trends in Germany, France and Italy (Figure A2). the real cost of labour. Productivity growth is likely to resume in the coming months, as labour becomes relatively more expensive, leading to an increase in the capital-labour ratio. This will compress growth in unit labour costs and hence consumer prices. 3. The outlook for inflation and growth A careful examination of disaggregated, high-frequency price movements is essential to understand inflation dynamics, but there is a limit to the amount of information that can be gleaned from raw data alone. Monetary policy is forward-looking; as such, it must also rely on an estimate of how inflation is likely to evolve in the medium term. One way of informing this estimate is to use indicators of ‘underlying inflation’ that filter out the noise and cross-sectional heterogeneity in the data and provide a clearer signal on common, medium-term inflation trends. Many available indicators of this kind show that inflation has been firmly on a downward trend since 2023 (Figure 6). The simplest indicator, core inflation, has been on a downward trend too; we should not forget that relatively high services inflation has been accompanied by very low inflation for non-energy industrial goods. Figure 6 Rise and fall of underlying inflation (monthly data; per cent) Core HICPXX PCCI Core '24 UCI Core Source: calculations based on Eurostat and ECB data. Notes: core (HICPX) is the y-o-y inflation rate of the overall HICP excluding energy and food. HICPXX is the y-o-y rate of change of the index that excludes energy, food and also components related to travel and clothing. UCI is a model-based indicator of underlying inflation created by Bank of Italy staff: Aprigliano V. and F. Corsello, ’Underlying Composite Inflation (UCI): a novel indicator to track inflation developments’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), forthcoming. PCCI is the ECB indicator of persistent and common pressures on inflation; Bańbura M. and E. Bobeica, 2020, ‘PCCI – a data-rich measure of underlying inflation in the euro area’, ECB Statistics Paper Series, n. 38. Another strategy is to use model-based projections combined with experts’ judgement. The Eurosystem’s latest projections show inflation gradually returning to target over the medium term, and are thus fully consistent with the underlying inflation indicators. In 2022-2023 inflation forecasts took a battering because they were volatile and (unsurprisingly) subject to large revisions. However, we are no longer in that situation: the projections for 2025 have fluctuated in a narrow range – between 2.0 and 2.2 per cent – for more than a year, and those for 2026 have not changed since last December, standing at 1.9 per cent. While our confidence in the disinflation process has grown steadily over time, the outlook for economic activity remains fragile. The euro-area economy has been mired in stagnation since the end of 2022. The uptick in GDP growth in the first quarter of this year may be less reassuring than it appears, given the disappointing figures for consumption and business investment. Moreover, GDP is projected to grow by an average of 1.5 per cent over the next two years – about half a percentage point less than in the last expansionary phase.10 4. Monetary policy implications So where does all this leave us in terms of monetary policy? The recent cut in interest rates reflects the observed and expected decline in inflation that I have just described. Going forward, the pace of monetary policy normalization will continue to be based on the assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission. There may be sporadic unexpected data points along the way, but the overall course of monetary policy will not change as long as the big picture confirms that we continue to advance towards the target. Two elements need to be borne in mind when assessing this baseline. First, the transmission of the restrictive monetary policy stance adopted so far is still unfolding. Our estimates suggest that the interest rate hikes implemented in 2022-2023 are still working their way through the economy, and that their impact on inflation may be stronger in 2024 than in 2023.11 Second, the effect of any rate cuts is likely to be mitigated by the ongoing contraction of the Eurosystem’s balance sheet. This could make the normalization phase different from the past, for instance by affecting bank funding costs and credit supply. Indeed, the data collected through the Bank Lending Survey (BLS) indicate that the reduction in the monetary policy asset portfolio is already having a tightening effect on bank lending conditions (Figure 7). Most importantly, the baseline – no matter how carefully constructed – is only one of many possible outcomes. The key lesson of the past four years is that policymakers also need to consider alternative scenarios. Allow me therefore to qualify the picture by highlighting the main risks that the euro area may face over the medium term. Between 2013 and 2019, GDP in the euro area grew on average by 1.9 percentage points per year. Weak growth may partly reflect headwinds coming from the credit market: bank funding costs remain onerous, lending rates on new loans are still very high, and loan growth continues to be subdued for both firms and households. Panetta F., 2024, ‘Challenges for monetary policy transmission in a shifting landscape’, speech delivered at the Inaugural Conference of the Research Network on ‘Challenges for Monetary Policy Transmission in a Changing World’, European Central Bank, Frankfurt am Main, 25 April. Figure 7 Impact of the ECB’s monetary policy asset portfolio on credit supply (half-yearly data; net percentage shares) (a) Credit standards (b) Terms and conditions −3 −3 −5 −5 −6 −10 −6 Enterprises Households for house purchase −10 Consumer credit and other lending Source: ECB Bank Lending Survey (BLS). Notes: the figure shows banks’ replies to the BLS question on the impact of the ECB’s monetary policy asset portfolio on their credit standards (panel a) and terms and conditions (panel b) for loans to enterprises and households. A positive net percentage share indicates a tightening impact in the preceding six-month period. The last observation refers to the April 2024 survey and incorporates banks’ expectations for the next six-month period (dashed line). One possible risk is another wave of geopolitical shocks. It is now clear that diplomatic and military confrontations between countries can have dramatic effects on trade, capital flows, growth and prices.12 Given the current state of international relations, we must hope, but certainly not assume, that the global landscape will be more stable in the future than it has been over the past two years. Another risk is an increase in political uncertainty within countries. Some of the world’s largest economies have elected or will elect their leaders in 2024, and political turnover physiologically translates into policy uncertainty: households and investors need to form a view on how incoming governments will handle many critical economic and political decisions. It is hard to imagine how this might affect inflation. Uncertainty can disappear without consequences. It can trigger capital outflows and currency depreciations, creating upward price pressures. But it could also shake confidence and weaken demand, halting or even reversing the fragile recovery we have seen so far. In short, we know that we don’t know. Central banks should be prepared to deal with the consequences of such shocks if and when they materialize. This implies a readiness to use the full range of tools at their disposal to adjust the monetary stance, addressing any threats to price stability, and protect the transmission mechanism of monetary policy. Panetta F., 2024, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, Lectio Magistralis delivered at the University of Roma Tre, 23 April. Lagarde C., 2024, ‘Policymaking in a new risk environment’, Speech at the 30th Dubrovnik Economic Conference, Dubrovnik, 14 June. Reichlin L. and J. Zettelmeyer, 2024, ‘The European Central Bank must adapt to an environment of inflation volatility’, Bruegel Policy Brief, 12 June. 5. Conclusions Let me conclude. The euro area has emerged from a ‘perfect storm’, a violent bout of inflation driven by a series of large and unpredictable supply-side shocks. Inflation is now on a downward path, and many of the issues that we have debated so vigorously in recent months may become less important going forward. The current macroeconomic picture is consistent with a normalization of the monetary stance. The ECB duly started this process a few weeks ago and, in the baseline scenario, it will pursue it gradually and smoothly. In calibrating the normalization we should be data-dependent, taking into account incoming information on the macroeconomic outlook without overweighting temporary blips in the data. We should also be cautious in our communications, avoiding the ‘casual’ forward guidance that can arise from (implicit or explicit) predictions on the timing and sequence of future interest rate cuts. Erratic communication would distract attention from the key determinant of our monetary policy decisions, namely our reaction function. Finally, monetary policy requires a management of risks and tail scenarios, not only baselines. Political and geopolitical risks remain high, and call for awareness, flexibility and state-contingent action plans. Like other central banks, the ECB has been thoroughly tested along these dimensions more than once in the last 15 years. The tests were passed successfully. They were difficult, but also instructive, and they hold promise for how monetary policy will be managed in the future. Based on those experiences, I am confident that – barring new upheavals – we will soon transition from the saga of the ‘last mile’ to the reality of the ‘first smile’ accompanying a full restoration of price stability. Thank you. APPENDIX Figure A1 Role of ‘latecomers’ in service inflation (monthly data; per cent and percentage points) Services y−o−y Accomodation and Transport Restaurants Other Services Latecomers −1 '24 −1 Source: calculations based on Eurostat data. Notes: the figure reports the year-on-year percentage changes of the euro-zone services HICP decomposed into its contributions. Items in the latecomers group include housing rentals, insurance and financial services, health-related services, education, cultural and social services. Figure A2 Markups, recent evolution and long-term trend (quarterly data) 1.290 1.290 1.285 1.285 1.280 1.280 1.275 1.275 Markup '24 Pre−pandemic trend Source: calculations based on Destatis, INSEE, Istat and Eurostat data. Note: estimates based on data for Germany, France and Italy. Markups are defined as the ratios of the value of production over total variable costs. The pre-pandemic trend is calculated over the period 2000-2019. Designed by the Printing and Publishing Division of the Bank of Italy
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Closing remarks by Ms Chiara Scotti, Deputy Governor of the Bank of Italy, at the Conference "The macroeconomic and financial dimensions of the green transition", European University Institute, Fiesole, 28 June 2024.
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Digital and green: twice the transformation, twice the win? Closing remarks by Chiara Scotti Deputy Governor of Banca d’Italia Conference on ‘The macroeconomic and financial dimensions of the green transition’ European University Institute Fiesole, 28 June 2024 Ladies and gentlemen, good afternoon. The conference on ‘The macroeconomic and financial dimensions of the green transition’ is now coming to a close. Let me warmly thank all the participants who have contributed to the success of this initiative, co-organized by Banca d’Italia, the European University Institute, the Euro Area Business Cycle Network and the Centre for Economic Policy Research. The value of this event lies not only in the attempt to shed light on key economic and financial issues linked to the energy transition and the ongoing decarbonization process, but also in gathering together academics and researchers from central banks, other policy institutions and universities in an attempt to foster critical thinking and new collaborations. Needless to say, the analyses of such an outstanding pool of experts are essential in supporting decision-makers in the public and private sectors who have to cope with the multiple challenges of the transition. Yet while the programme has focused on many of the climate-related challenges, in my brief concluding remarks today, I would like to highlight another challenge that I think warrants further investigation: the twin transition, which lies at the intersection of the green and the digital transformations.1 The digital and green twin transitions We are living in a world where the digital transition and the green transition are mostly taking place on parallel tracks, although some commentators have underlined With thanks to Ivan Faiella, Luciano Lavecchia and Juri Marcucci for their valuable contributions. some possible interactions.2 When people think about these transitions, they tend to highlight the negative impact of the digital transition on the climate, and specifically that the expansion in power-hungry digital technologies and services will increase their environmental footprint. Indeed, according to the International Energy Agency (IEA), data centres, cryptocurrencies and Artificial Intelligence (AI) in 2022 accounted for about 2 per cent of global electricity use. The US Energy Information Administration calculates that in 2022, cryptocurrencies alone may have drained more than 2 per cent of the national annual power use.3 A recent study4 shows that, on average, generating an image through AI consumes as much electricity as fully charging a smartphone, and this is on top of the energy used to train the algorithms. This should serve as a warning, as the number of people worldwide using these tools, even for entertainment, is increasing at an incredible rate. There is the dreadful prospect that, in a high-demand scenario, digitalization-related energy needs could even double in 2026.5 Clearly, these developments call for further progress in increasing the share of low-carbon sources in the power mix,6 and for measures to improve the energy efficiency of these digital services.7 Luckily, on the other side, there are also many good things that the digital transition can do for the green transformation. AI tools – such as machine learning and deep learning – can, for example, assist economists, investors, and portfolio managers in improving the use of ESG data to build efficient portfolios8 as well as help scientists in assessing the extent of biodiversity loss,9 map methane leaks10 or water availability.11 In what follows, I would like to mention some practical uses of digital innovation for the green transformation that should be taken into consideration and studied further, On the reinforcing of the green and digital transitions, see Muench, S. et al., 2022. ‘Towards a green and digital future’. EIA (2024). Tracking electricity consumption from U.S. cryptocurrency mining operations. Luccioni, S., Jernite, Y., and Strubell, E. (2023). Power Hungry Processing: Watts Driving the Cost of AI Deployment? Proceedings of the 2024 ACM Conference on Fairness, Accountability, and Transparency. IEA 2024. Electricity 2024. Analysis and forecast to 2026. According to the above mentioned IEA Electricity report, low-carbon electricity generation is set to cover all global demand growth over the period 2024-26. Zhu, H. et al., 2023. Future data center energy-conservation and emission-reduction technologies in the context of smart and low-carbon city construction, Sustainable Cities and Society, Volume 89, February 2023, 104322. Lanza, A.A.G. et al., 2023. Machine Learning, ESG Indicators, and Sustainable Investment, Financial Risk Management and Climate Change Risk, Springer Nature Switzerland. Thompson, T., 2023. How AI can help to save endangered species, Nature, 623, 232-233. O’Donnel, J., 2024. A new satellite will use Google’s AI to map methane leaks from space, MIT Technology review, February 14, 2024. Shaikh, M. and F., Birajdar, 2024. Artificial intelligence in groundwater management: Innovations, challenges, and future prospects, International Journal of Science and Research Archive, 2024, 11(01), 502-512. potentially also among economists like you. Although at the moment these potential positive uses are still overshadowed by the large amount of energy required by digital technologies, this does not mean that researchers should not push the frontier in these areas. I will start by discussing AI-generated energy demand and supply as well as weather forecasts12 and how they can support climate mitigation and adaptation. I will then turn to the use of digital solutions to reinforce the green transition. AI can help with climate transition and adaptation AI solutions can foster the reliability of energy systems, deliver higher living standards, and ensure safety for populations and production. The power of AI possibilities is something we experience directly: nowadays smartphones and digital assistants provide a number of cheap and simple home automation solutions; by coupling the Internet of Things (IoT) with AI techniques, we can monitor and optimize the heating and cooling of our homes. Outside of these day-to-day examples, however, there are many more ways that AI can be seen as a ‘climate game changer’. Our smart-home solutions are just the tip of the iceberg. Gaining a greater understanding of both when power is available and when it is needed is crucial to ensure the efficiency and reliability of the power grid, especially once an increasing share of intermittent renewable sources are integrated. The deployment of smart meters to collect information, and of digital technologies such as machine learning techniques for data analyses can lead to better forecasts of energy demand and supply, leading to improvements in energy efficiency. In addition, by supporting ‘demand response’, technology could minimize discrepancies between demand and supply, reducing ‘peak loads’ and the need to add capacity to manage those peaks, and in turn supporting the resilience and security of the energy infrastructure. In addition to enhancing energy demand and supply forecast and management, AI technologies can help improve weather forecasts as well as the early warning detection of acute climate events, which are essential tools for mitigating the impact of adverse events on populations and assets. Progress in forecasting weather patterns and building climate scenarios could help vulnerable communities and authorities to adapt to climate change13 and could transform climate adaptation strategies in agriculture14 (e.g. through optimized water use, early warning systems on invasions of alien species and selection of resistant crop varieties in response to climate change scenarios) and in the insurance sector15 (e.g. providing vast amounts of data to improve climate risk assessment and the pricing policies for climate-related damage protection). Bi, K. et al., 2023. Accurate medium-range global weather forecasting with 3D neural networks, Nature, 619, 533-538. Lam, R. et al., 2023. Learning skillful medium-range global weather forecasting, Science, 382, 6677, 1416-1421. Kyungmee, K. and Boulanin, V., 2023. Artificial Intelligence for Climate Security. Possibilities and Challenges, Stockholm International Peace Research Institute. De Baerdemaeker, J. et al., 2023. Artificial intelligence in the agri-food sector, Scientific Foresight Unit, European Parliamentary Research Service. McLaughlin, M., 2022. Climate change is a major challenge for insurers, but AI and cloud can help, IBM IBV Blog. Digital solutions can help with climate disclosure and climate-risk identification Other areas in which digital innovation can help with climate transition are the assessment and selection of tools to channel funds towards green and sustainable finance, the progress in sustainability disclosure, the collection of climate-related information, and the evaluation and monitoring of climate-related financial risks, just to name a few important themes. Let me briefly describe some of the efforts in these areas. First, the BIS Innovation Hub and Banca d’Italia launched the G20 TechSprint Initiative in 2021, a global technological competition in the form of a long hackathon designed to show the potential for new technologies, new (big) data, and other innovations to leverage on the potential synergies between digitalization, finance and the energy transition.16 Another initiative in which Banca d’Italia was involved is the 2021 first call for proposals by the Milano Hub, the Banca d’Italia innovation centre located in Milan. Some of the projects developed under this umbrella showed how technology, and particularly AI, can contribute to improving financial services, in terms of ESG data collection and production.17 Second, supply chain partners, financial regulators and financial entities increasingly require that companies, including small and medium enterprises (SMEs), provide some kind of sustainability reporting. Digital platforms could reduce the disclosure burden. Within this context, the United Nations Development Programme (UNDP), the Monetary Authority of Singapore (MAS), and the Global Legal Entity Identifier Foundation (GLEIF) proposed a framework to address SMEs’ sustainability disclosure, harnessing technology and verified data to improve sustainability reporting while lowering costs and barriers to reporting.18 Third, AI – particularly large language models (LLMs) – can help analysts and supervisors in collecting climate-related information from corporates. The BIS Innovation Hub, Banco de España, Deutsche Bundesbank, and European Central Bank launched a project that leverages LLMs to automatically extract climate-related indicators from publicly available corporate reports, thus enabling a widespread and cost-effective analysis of climate-related financial risks.19 Ignazio Visco, G20 TechSprint 2021 – Presentation Event, The G20 TechSprint 2021 on Sustainable Finance, May 2021. One study proposed a method to address the ESG data collection problem by using adaptive AI and natural language processing techniques, showing their effectiveness with real-world documents (Visalli F. et al., 2023. ESG Data Collection with Adaptive AI. In Proceedings of the 25th International Conference on Enterprise Information Systems – Volume 1: ICEIS, ISBN 978-989-758-648-4, SciTePress, pages 468-475. DOI: 10.5220/0011844500003467). Another study used machine learning tools to predict the energy performance certificates (EPCs) of the overall stock of Italian buildings, revealing a discrepancy with the distribution inferred from the national cadaster (SIAPE), thereby having significant implications for policy formulation (Braggiotti F. et al., 2024. Predicting buildings’ EPC in Italy: a machine learning based-approach, Banca d’Italia, Questioni di Economia e Finanza, n. 850). United Nations Development Programme, 2024. White Paper on Project Savannah: Common ESG Metrics for Generating Digital Sustainability Credentials for MSMEs, issued jointly by UNDP, MAS and GLEIF. BIS, 2024. Project Gaia. Enabling climate risk analysis using generative AI. Finally, digital platforms can support sustainable finance by integrating a vast array of regulatory and supervisory data together with market analytics in order to support central banks and financial supervisors to improve their monitoring of climate-related financial risks. In 2022, the BIS Innovation Hub and the Monetary Authority of Singapore launched a climate risk platform exactly for this purpose.20 Conclusions The green and the digital transitions are happening whether we like it or not. We need research to try and understand how they can reinforce each other. One possible area of work is trying to further improve our understanding of which AI tools and other digital developments can be used to support the green transition and improve climate science.21 For example, AI techniques could be exploited to improve the preparation of climate scenarios, replicating the results of conventional models, but taking less computational time and consuming less energy.22 AI solutions could also be used by governments to leverage massive sources of freely available climate-related data (e.g. risk maps, satellite imagery and so on) and to generate tailored insights.23 In addition, some efforts should focus on assessing how some disruptive technologies (such as additive manufacturing in industry, mobility-as-a-service in transportation and AI in buildings) can help to decarbonize hard-to-abate sectors.24 In imagining future decarbonization pathways, researchers should take into account the disruptive impact of digital technologies on energy demand, economic growth and social development.25 Last but not least, another potential area of research is the crucial issue of how to design incentives that could help the two transitions co-evolve and reinforce each other. Historical evidence suggests that twin transitions tend to be lopsided: while we will BIS, 2024. Project Viridis. A climate risk platform for financial authorities. Rylander, Y., 2024. How will artificial intelligence influence climate science?, Stockholm Environment Institute. The conventional physics-based models take weeks to run and are energy-consuming: simulating a century requires the amount of electricity used annually by the average US household. See Wong, C., 2024. How AI is improving climate forecasts, Nature, 628, 710-712. Peixoto, T. C. et al., 2023. Leveraging data and Artificial Intelligence for climate-smart decision-making in government, World Bank Blogs. For example, the Disruptive Digitalization 4 Decarbonization (2D4D) project, funded by the European Research Council under the European Union’s Horizon 2020 research and innovation programme, aims to carry out a comprehensive assessment of the macro-economic implications of the concurrent digitalization and decarbonization pathways. Creutzig, F. et al., 2022. Digitalization and the Anthropocene, Annual Review of Environment and Resources, Volume 47, 479-509. probably experience unceasingly fast progress in the digital world,26 the transition away from fossil fuels will require extended periods of development.27 In this context, how can we maximize the synergies between the two transitions in order to gradually wean future economic growth away from fossil-based energy? We have to consider that green policies also encourage firms’ digitalization; for example, environmental regulation as well as market-based measures (e.g. carbon pricing) promote resource efficiency, and digital solutions are essential in achieving this objective.28 These are just a few examples, of course. What I would like you to take away is that it is really important that the community of academics, central bankers and practitioners put some of these topics on their research agenda so that we can do our best to maximize the benefits in our quest for achieving twice the win in the twin transition. Fouquet, R., and Hippe, R., 2022. Twin transitions of decarbonisation and digitalisation: A historical perspective on energy and information in European economies, Energy Research & Social Science, Volume 91, 102736. “We should not ignore the experience of the past grand energy transition (from traditional biomass energies to fossil fuels) and we should not underestimate the concatenation of challenges presented by practical engineering, material, organizational, social, political, and environmental requirements of the unfolding transition to a fossil carbon-free world”. Smil, V., 2024. Halfway Between Kyoto and 2050. Zero Carbon Is a Highly Unlikely Outcome, Fraser Institute. Fan, J. et al., 2024. Informal environmental regulation and enterprises digital transformation: A study based on the perspective of public environmental concerns, Ecological Indicators, Volume 163.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the Annual Meeting of the Italian Banking Association (ABI), Rome, 9 July 2024.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the 45th Foundation Meeting for Friendship among Peoples, Rimini, 21 August 2024.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the Annual Meeting of the Italian Banking Association (ABI), Rome, 9 July 2024.
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Welcome address by Mr Paolo Angelini, Deputy Governor of the Bank of Italy, at the 7th Bank of Italy and CEPR Conference on "Labour market policies and institutions", Rome, 19 September 2024.
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Welcome address by Paolo Angelini Deputy Governor of the Bank of Italy 7th Bank of Italy-CEPR workshop on labour market policies and institutions Rome, 19 September 2024 Ladies and gentlemen, It is with great pleasure that I welcome you today to the seventh edition of the workshop on labour market policies and institutions, co-organized with the CEPR. The labour market is a key component of our economies, providing the foundation for individual livelihoods and societal well-being. The Covid-19 pandemic and its aftermath have accelerated long-term trends that are reshaping our labour markets: technology adoption and rising inequalities. These two issues are receiving much attention, and rightly so, in my view. They run through the papers that will be presented over the next two days, and will be addressed by our keynote speakers. In my remarks today, I would like to share some thoughts on these two related themes. First, the pandemic accelerated the digitalization of our societies. As a result, the demand for workers with digital skills has risen sharply. While this transformation has created new job opportunities, it has also deepened existing wage inequalities, as it mostly benefited high-paid and highly educated workers.1 Automation and generative AI are an important part of this process. These innovations can potentially improve labour productivity and the quality of work, but they also risk displacing some types of jobs, this time also at the top of the earnings distribution. While the ultimate impact of the new technologies on welfare and inequality is still uncertain, it is clear that it can be potentially large. Therefore, careful monitoring and analysis will be required to guide policy design in areas such as social protection, welfare and education. It is a privilege to have Professor David Autor as our keynote speaker on A. Adams-Prassl, T. Boneva, M. Golin and C. Rauh, “Inequality in the impact of the coronavirus shock: Evidence from real time surveys”, Journal of Public Economics, 2020; O. Aspachs, R. Durante, A. Graziano, J. Mestres, J.G. Montalvo and M. Reynal-Querol, “Real-time inequality and the welfare state in motion: Evidence from COVID-19 in Spain”, Economic Policy, 2022. F. Carta and M. De Philippis, “The impact of the Covid-19 shock on labour income inequality: Evidence from Italy”, Bank of Italy Occasional Papers Series, n. 606, 2021. this important topic. His contributions to the literature on the impact of technology on the labour market and on inequality have set milestones in these fields. While new technologies can affect welfare and inequality, requiring a reaction from labour market institutions and policies, the latter can in turn have an important influence on the adoption of technologies. A few papers in the programme discuss this interplay. One shows that improving the quality of worker-job matching, including through well-designed institutions and labour law reforms, is crucial to unlocking the economic gains of innovation.2 Another paper shows that unions play an important role in technology adoption: their actions reduce the negative effects of technology on workers and can even improve the quality of the technology in which firms invest3 (today’s opening paper, also about unions, confirms that they negotiate over different job characteristics, not just about money).4 Another paper to be presented this morning shows that digital technology can also improve occupational training and skills acquisition, and ultimately promote the adoption of new technology itself.5 Digitalization has also enabled the rapid and massive shift to remote working triggered by the pandemic. Employees benefit from reduced commuting time and costs, more flexible daily schedules, and a better work-life balance. Firms can reap significant cost savings from reduced need for office space, and can achieve better job-matches by potentially recruiting from a larger pool of candidates, as physical proximity is no longer indispensable. But there could be a dark side of these visible benefits: in the medium to long term, the changes in interactions patterns among colleagues brought about by remote working could have unwanted and hard-to-identify effects on productivity, innovation and even mental well-being. Working from home also poses challenges for firms in terms of adapting management practices and incentivising employees.6 Research on these effects is hampered by the relative novelty of the phenomenon, but it will become very relevant to private and public decision-makers as soon as availability of good quality data makes it possible. Let me now turn to the issue of rising inequalities. The pandemic has exacerbated deep-seated inequalities – in income, access to health care, job security, and opportunities. Unequal societies tend to be more prone to economic inefficiencies and political instability, and the two are likely to reinforce each other. Inclusiveness is not only an antidote to inequality, it is also a powerful driver of economic development and resilience. That is why we need to pursue inclusive growth. In labour markets, O. Bandiera, A. Kotia, I. Lindenlaub, C. Moser and A. Prat, “Meritocracy across Countries”, NBER WP No. 32375, 2024. W. Dauth, O. Schlenker and S. Findeisen, “Organized Labor Versus Robots? Evidence from Micro Data”, IZA DP No. 19192, 2024. L. Lagos, “Union Bargaining Power and the Amenity-Wage Tradeoff”, IZA DP No. 17034, 2024. C. Lipowski, A. Salomons and U. Zierahn-Weilage, “Expertise at Work: New Technologies, New Skills, and Worker Impacts”, ZEW DP No. 24-044, 2024. J. M. Barrero, N. Bloom and S. J. Davis, “The evolution of work from home”, Journal of Economic Perspectives, 2023. this means tackling the barriers that have long marginalized certain groups, including migrants and women. The literature has increasingly recognized the important role of immigrants in the economy – in particular their contribution to innovation, labour market fluidity and female participation – and has found that their skills are primarily complementary to those of natives.7 Another important aspect, that has received less attention, is the impact of highskilled immigration on firms. A paper on this topic, to be presented tomorrow, demonstrates the positive impact of high-skilled migration on firm performance and employment.8 Regardless of how important these aspects are, we cannot avoid mentioning the host of challenges posed by the ageing of advanced societies, a particularly pressing concern in Italy. The political debate has often focused on illegal immigration, but awareness is growing that a proper management of migration flows is important to counter the decline in labour force caused by ageing. Another part of the solution to the ageing problem must come from increasing labour force participation. Policies in this area are also essential, and involve, inter alia, promoting female participation in the labour market (another pressing concern in Italy). Regarding the study of gender gaps, we are honoured to have as our second keynote speaker Professor Claudia Olivetti, a leading economist in this important field. Women are less likely to be in top positions within firms, and gender quotas can be of help in this respect. In 2021 the Bank of Italy did its part. We used our regulatory powers to introduce a gender quota for the top management of all Italian banks, following the Italian law on gender balance for listed companies. Let me add another bit of self-promotion. The research department of the Bank has been particularly active in studying gender gaps. Last year we presented and published the results of a major project looking at various aspects of women’s experience in the Italian labour market.9 One of our key findings, to be presented in this workshop, is that gender gaps are already large at the point of entry into the labour market.10 Educational choices, already in high school, are key to explaining much of these gaps. Women tend to avoid STEM subjects, which – also because of the digital revolution – tend to be more remunerative. Let me tell you an anecdote about this. Since 2008, the Bank of Italy has been funding an annual prize for high school students who excel in mathematics and information technology. Students’ participation in the contest is voluntary, and the selection process is entirely conducted by the schools. Over 17 years, the prize has been awarded to 340 students. G. Peri and C. Sparber, “Task Specialization, Immigration, and Wages”, American Economic Journal: Applied Economics, 2009; G. Basso and G. Peri, “Internal Mobility: The Greater Responsiveness of Foreign-Born to Economic Conditions”, Journal of Economic Perspectives, 2020; G. Barone and S. Mocetti, “With a little help from abroad: the effect of low-skilled immigration on the female labour supply”, Labour Economics, 2011. P. Mahajan, N. Morales, K. Shih, A. Brinatti and M. Chen, “The Impact of Immigration on Firms and Workers: Insights from the H-1B Lottery”, IZA DP No. 16917. F. Carta, M. De Philippis, L. Rizzica and E. Viviano, “Women, labour markets and economic growth”, Bank of Italy Workshops and Conferences, 26, 2023. G. Bovini, M. De Philippis and L. Rizzica, “The origins of gender wage gaps: the role of school to work transition”, Bank of Italy Working paper series, forthcoming. The proportion of males has remained fairly constant over the period, averaging 93 per cent. This suggests that in order to better understand the sources of such a deep gender gap, we may need to focus on the secondary school period, possibly even earlier. Let me conclude. The workshop programme is very rich and touches on many other relevant topics that are of great interest to policy makers and to the wider research community. I am sure that each presentation will generate a fruitful discussion and new ideas. I would like to thank the organisers for their efforts, the presenters and the keynote speakers for their contributions, and all of you for being here to participate in the workshop. Designed by the Printing and Publishing Division of the Bank of Italy
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Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy and President of the Insurance Supervisory Authority (IVASS), at the high level conference "Disaster risk financing: the role of insurance in new public-private partnerships", organised by ANIA, Rome, 20 September 2024.
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‘Disaster risk financing: the role of insurance in new public-private partnerships’ Speech by Luigi Federico Signorini President of Ivass ANIA Insurance High Level Conference Rome, 20 September 2024 Ladies and gentlemen, Once again we are seeing dramatic images of floods, damages and losses. The images that we just saw in the walk-in video for this conference are surely older, but could have been taken yesterday. Our hearts and thoughts are with those that have been hit, not just this time but also in the previous months, some repeatedly. We must hope that human life has been spared this time, although I understand that as of this morning some are still missing. This is another reminder of the seriousness of the climate issue. We cannot be in denial. The accelerating change in the Earth’s climate has increased the frequency and intensity of river and coastal floods, landslides, droughts and forest fires worldwide. Europe, in particular, is warming quite fast; according to Copernicus (the European satellite monitoring system), the average temperature for European land in August 2024 was more than 1.5°C above the 1991-2020 average for the same month. In addition to climate-related events, other natural disasters such as earthquakes, tidal waves, volcanic eruptions and bradyseism can have a dramatic impact on the economy and society. The issue of natural disasters and, more generally, catastrophe risks, once confined to scholars of the ‘hard’ sciences, such as physicists and biologists, has become an area of concern for economists, sociologists and lawyers as well. As a consequence, one sees among other things more and more attempts at measuring the economic impact of natural events in a reliable way. The 2023 European State of the Climate Report estimates the direct damage to property generated in 2023 by floods, inundations and fires (disregarding, that is, indirect effects) at more than €13 billion, and the human toll at 151 deaths1. Over the past few years, there has also been a growing attention See the European Centre for Medium-Range Weather Forecasts - ECMWF - 2023 European State of the Climate. in international fora2 to natural disasters as a potential source of systemic financial stability risk. The literature on disaster relief suggests that a purely ex-post approach to damage repair and loss compensation is likely to be sub-optimal. Prevention is of course necessary at various levels. In my speech, as befits the occasion and my role, I shall concentrate on the role a well-regulated insurance industry can play. It is not a minor role. Compensation can be very costly for the public finances when an event occurs. It is also difficult for the private insurance market to provide adequate cover for rare but catastrophic events. Ex-ante risk mitigation and damage prevention and limitation are therefore desirable. Moreover, the nature of catastrophe risk appears to require an appropriate interaction between public relief intervention and private insurance schemes. Certain valuable principles for policy-makers have recently been summarised in a ‘decalogue’ for natural-disaster management,3 drawn up by the OECD and the IAIS, the International Association of Insurance Supervisors, under the auspices of the Italian G7 Presidency – the ‘high-level framework’ that has been repeatedly mentioned this morning. Ivass has actively contributed to this document with technical input. The OECD-IAIS framework states that an effective mechanism for protection against natural catastrophes requires the cooperation of many stakeholders, both public and private. On this point, last year I mentioned the pros and cons of two ways of sharing the costs of a catastrophic event: public intervention and private insurance. I also claimed that an adequate diffusion of insurance cover is not just a question of individual choice, but has elements of a collective issue. Let me add that another factor is the action of charities and volunteers, for whose work we should be deeply grateful. Allow me to recapitulate very briefly the main points I made on that occasion. Public intervention will always be necessary to some extent, because not all risks are effectively insurable and because, in the case of truly catastrophic events, some form of coordination of the reconstruction and its financing is indispensable. Its drawbacks however are, first, that when an event occurs, there is uncertainty about whether compensation will be provided and to what extent, who will be eligible and under what conditions; second, that experience tells us that the implementation of relief measures often comes very late after the event; third, that the distribution of the tax burden being naturally based on pure, discretionary ex-post mutualisation, it can hardly be designed in a way to create the right incentives for ex-ante risk prevention or mitigation. See Radu D., ‘Approaching Disaster Risk Financing in a Structured Way’, European Commission, DG-ECFIN, May 2024; ‘Policy options to reduce the climate insurance protection gap’, ECB-EIOPA Staff Paper, April 2023; and ‘Enhancing the insurance sector’s contribution to climate adaptation’, OECD, Policy Paper, March 2023. ‘High-Level Principles for PPIPs against Natural Hazards’, presented at the end of May in Stresa at the meeting of G7 finance ministers and central bank governors. Private insurance contracts exploit the opportunities of diversification between uncorrelated risks, and can rely on risk transfer and pooling techniques, with benefits ultimately shared between the insurer and the insured. If well designed and implemented, it is certain, prompt and directly commensurate with the damage individually suffered; it can provide powerful incentives for prevention. However, if there are no provisions for mandatory coverage, it is subject to adverse selection. Moreover, it cannot achieve the redistribution goals that public intervention may instead wish to pursue. A recent study made by the Bank of Italy together with the University of Florence4 looks at hydrogeological events that took place in Italy between 2010 and 2018 and their effect on firms survival and performance. In the three years following the event, the affected companies are significantly more likely than others to exit the market; even if they survive, their profitability declines and staff numbers decrease. Insurance can mitigate those effects at the individual level. In addition, the existence of externalities makes underinsurance of such risks also as a matter of public interest. The destruction caused by a natural disaster has consequences that go beyond those directly affected, through the dense network of interdependencies that characterises economies. The swifter availability and granularity of insurance relief compared with that provided by discretionary ex-post public interventions should contribute to reducing these consequences. It is not only insurance that can provide incentives to make businesses and households less fragile and more resilient to disasters. Supervisors, for instance, have been insisting for some time that banks should take physical and other nature-related risk into account when screening the financial merits of projects. Risk mitigation measures should be a factor in setting conditions for loans and other forms of financing. As is well known, Italy is particularly exposed to seismic and hydrogeological risk, including landslides and river floods, as we were sadly reminded yesterday. It also has a 9,000-km coastline, of which 3,400 km, especially in the upper Adriatic Sea, can suffer coastal floods. Yet according to analyses by various research centres and EIOPA5, Italy, along with Greece, shows in Europe the highest protection gap, i.e. the gap between natural-catastrophe (Nat-Cat) risk exposure and insurance protection from such risks. From 1980 to 2022, about 97 per cent of the losses incurred from earthquakes and floods were uninsured, the highest underinsurance level (thus measured) for this type of risk in the European context6. Clò S. et al. ‘The impact of hydrogeological events on firms: evidence from Italy’, Banca d’Italia, Temi di Discussione (Working papers) no. 1451, April 2024. The EIOPA survey considers five risks - earthquakes, floods, coastal floods, wildfires and windstorms. https://www.eiopa.europa.eu/tools-and-data/dashboard-insurance-protection-gap-naturalcatastrophes_en (updated to November 2023). The protection gap arises from both the demand and the supply side of the insurance market. Several aspects can explain the public’s wariness in demanding protection: low awareness of risk and/or of the availability of insurance products; difficulties in understanding complex policies (with regard e.g. to guarantees, benefits, exclusions); high prices. An expectation that public sources will compensate some losses may also indirectly play a role. On the supply side, insuring against catastrophe risks can entail, if and when rare but high-impact events occur, heavy and concentrated losses for insurers. Modelling such tail risk is difficult, especially as climate change is likely to shift the probability distribution of climate-related catastrophic events in ways that are hard to predict. This makes provision of insurance technically challenging and may induce insurance companies to raise the price of cover significantly. Much the same issues arise for reinsurance: in fact, as the effects of climate change become apparent, insurance companies are finding it increasingly difficult to reinsure themselves in the market. These special features of catastrophe risk appear to call for carefully designed measures to improve the framework for Nat-Cat insurance and provide some form of public co-insurance (so to speak), while leaving the market to perform its allocative tasks as efficiently as it can. We therefore welcomed the introduction of a mandatory Nat-Cat insurance scheme for businesses, together with a set of policy support tools, by the 2024 Budget law. In fact, we had been advocating such a move for some time. The law will bring Italy closer to other European countries (including France and Spain) and non-European ones (including the United States and Japan) that have already provided for either mandatory or semi-mandatory models of insurance against natural disasters. The technical details need to be defined by a decree to be issued by the Minister of Economy and Finance and the Minister of Enterprises and Made in Italy, which is now, as you heard, in the process of being finalised. Several points are crucial for a successful implementation. The scheme must be technically sustainable on the insurers’ side and affordable for the insured, so that universal coverage is smoothly achieved. It is also essential that reimbursements are, and are perceived to be, quick and predictable. The extent of the cover offered (and demanded) needs to be adequate. The implementing decree will specify a number of important details, including the events to be covered and the criteria for exclusion. Such elements will largely shape contractual practices concerning e.g. the amounts insured, indemnity limits, deductibles and excesses. The success of the scheme hinges on a careful definition of them. All the main actors concerned should have a voice in discussing the technical details. It is also important to ensure the consistency of the new provision with the existing prudential and supervisory rules for insurance. There are many technical issues, but they can be solved. We must go ahead. We are ready to provide any technical assistance that may be required. The experience gathered from the implementation of the business insurance scheme will also be useful in case an extension of catastrophe risk coverage to households is envisaged. Legislative initiatives in this direction are being considered7 Ladies and gentlemen, Let me conclude by saying that, in general, there are two further key ingredients for reducing Italy’s insurance protection gap: greater awareness of risk (and of the risk-protection tools available) on the public’s side; constantly improving clarity and transparency on the industry side. Citizens and businesses that are well informed on risk will likely be prepared to seek more protection, and to adopt mitigating measures that reduce the risk of loss and at the same time improve the conditions at which insurance can be provided.8 Insurers, for their part, should constantly strive to improve the structure and language of contracts, as well as all aspects of the distribution of policies. Ensuring that contracts are as clear, simple and readable as possible, and that potential customers are in the best position to understand the price and extent of coverage and other conditions, is important not only in the name of fairness, but also in order to guarantee that market competition functions effectively. Insurance education and transparency: at Ivass, we are committed to contributing to both these aims, within our mandate, as best we can.9 See initiatives on the draft framework law on post-disaster reconstruction. See Guiso L. and Jappelli T., ‘Are People Willing to Pay to Prevent Natural Disasters?’ CSEF, working paper no. 723, June 2024. On the domestic front, Ivass participate in the work of the Sustainable Finance Table at the MEF, of which CONSOB, COVIP, MIMIT and MASE are also members. There, among other things, the Bank has promoted the establishment of a Working Group on the Insurance Protection Gap (IPG) to enhance the role of insurance companies as providers of protection for businesses and households against physical risks arising from natural disasters and climate change. At the international level, Ivass is working on the European Commission's project called ‘Technical Support Instrument 2023 - Flagship ESG Risk Management Framework for the Financial Sector’. As part of this project, in-depth studies will be conducted on the causes of low insurance coverage against natural disasters in Italy, and possible prevention measures and policy recommendations will be identified to close our protection gap. Finally, Ivass contributes to the debate on the Insurance Protection Gap taking place in the international insurance and non-insurance cooperation fora of which it is a member: the IAIS, the Network for Greening the Financial System (NGFS), the Sustainable Insurance Forum (SIF) and the Forum for Insurance Transition to Net Zero (FIT).
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Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the scientific workshop on implications of quantum technology for the financial sector, organised by the Bank of Italy, Rome, 24 September 2024.
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Luigi Federico Signorini: Building a quantum-safe financial system what role for authorities and for the private sector? Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the scientific workshop on implications of quantum technology for the financial sector, organised by the Bank of Italy, Rome, 24 September 2024. *** Ladies and Gentlemen, It is my pleasure to open this seminar on the implications of quantum technology for the financial sector. Experts agree that we are on the eve of a very significant technological change: one that will redefine our approach to data and to the tools we use to process them, and may well revolutionise important, even critical, aspects of the way financial institutions operate. Like all significant technological advances, the quantum revolution comes with both promises and threats. Massively enhanced computational power, algorithms that are far more efficient than existing ones, and a much stronger base for artificial intelligence, are expected to offer opportunities for better and cheaper services, but they will also introduce new challenges, not least for financial stability. Central banks and financial institutions have often been early adopters of technological innovations. To preserve trust, institutions should continue to be bold and imaginative, but at the same time fully aware of the risks. Prudent supervisory guidance is needed to preserve the stability, security and integrity of the financial system. Our seminar will be an opportunity to go beyond generalities and explore the most likely concrete challenges and trade-offs we need to face in the quantum era. The Bank of Italy has a tradition of actively and rapidly adapting its policies to changes in the data management landscape. Drawing on our experience, we have long contributed to the action of the European System of Central Banks. We continue to work in partnership with academia and in cooperation with national and international institutions. The most immediate threat most of us currently perceive concerns the protection of the integrity and confidentiality of data. We feel that such a threat calls for a coordinated response, within the G7 and beyond. We shall take the opportunity of this workshop to share our experiences and ongoing work at the Bank of Italy and to present some reallife examples of useful and feasible cooperation at the national, European and global level. We encourage all participants to do the same. Since Peter Shor demonstrated, in 1994, that a quantum computer could theoretically solve problems much faster than traditional ones, he has inspired scientists all over the world to imagine the countless possibilities of this technology, and technologists to look for ways to actually build a functioning machine based on it. Thirty years on, while we 1/3 BIS - Central bankers' speeches still lack a fully functional and reliable quantum computer, we seem to be actually getting closer and closer. As the cybersecurity threat is serious but there are potential ways to fend it off, we cannot afford to wait. Implementing quantum-resistant cryptography tools before quantum computers become practically operational is crucial for data longevity. Sensitive data that are encrypted using today's technology could be stored now by malicious agents and decrypted later, once quantum tools become available; upgrading cryptographic tools as soon as possible is therefore necessary to ensure long-term data security. This is especially relevant for financial institutions. Their core business is ultimately based on the ability to create, manage and use sensitive data, and it is not unlikely that the quantum revolution will hit the financial sector faster and more intensively than other industries. Awareness of the need to act is growing. In the spring of this year, the European Commission published a 'Recommendation on a Coordinated Implementation Roadmap for the transition to Post-Quantum Cryptography'. In the US, the National Institute of Standards and Technology (NIST) officially released its first set of finalised post-quantum cryptography (PQC) algorithms last month. This is a major step forward. In the G7 Finance Track, the Italian presidency identified quantum computing as one of the key strategic cyber issues facing us. It may affect multiple policy areas, including national security, competitiveness, ethics, and skill development. While solutions to achieve quantum security are starting to become available, there are factors that can make market players reluctant to adopt them quickly. These include uncertainty about the actual urgency of the quantum threat, the fact that a common transition approach has not yet emerged, and the fragmentation of investments, responsibilities and regulatory frameworks across jurisdictions. The G7 has launched several technical initiatives to foster coordination among the main stakeholders. With today's workshop, we aim to engage key experts in G7 countries, with a view to developing a shared understanding of the most urgent issues, a potential roadmap to address the transition to quantum resilience and, to the extent possible, an agreed policy agenda. We are fortunate today to have speakers and attendants from a wide range of backgrounds: academia, government institutions (including lawenforcement agencies), central banks, international organisations and the finance industry. This promises to be an ideal opportunity to exchange views, in that it brings together a set of distinguished experts with considerably diverse experience. I encourage all participants to be active, ask questions and share their insights. Ladies and gentlemen, we are also honoured to have Professor Juan Ignacio Cirac Sasturain with us today as a keynote speaker. As many of you will know, our speaker is one of the leading theorists in quantum computation. His contributions range from the physics of quantum computers to quantum algorithms and quantum information theory. Many here will be especially interested in his seminal work on quantum cryptography. Professor Cirac is the Director of the Theory Department at the Max Planck Institute of quantum optics in Garching bei München, Bavaria, and collaborates with many other academic institutions. He has received an impressive number of high-level awards, including the Prince of Asturias Award for Technical and Scientific Research (2006), the 2/3 BIS - Central bankers' speeches BBVA Frontiers of Knowledge Award (2008), the Benjamin Franklin Medal (2010), the Wolf Prize in Physics (2013), the Max Planck Medal (2018), and many others; more are sure to come. The subject of his talk is, very aptly, 'opportunities and challenges of the next generation's computers'. We are certain that his remarks on today's central issue will set the stage for a very productive seminar. Please join me in welcoming Ignacio Cirac to the stage. 3/3 BIS - Central bankers' speeches
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Keynote speech by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the G7 conference on "Building the quantum safe financial system: what role for authorities and for the private sector?", Rome, 24 September 2024.
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Alessandra Perrazzelli: Steering the transition to a quantum-safe world. An internationally coordinated approach Keynote speech by Ms Alessandra Perrazzelli, Deputy Governor of the Bank of Italy, at the G7 conference on "Building the quantum safe financial system: what role for authorities and for the private sector?", Rome, 24 September 2024. *** Introduction Good morning and a very warm welcome to this important workshop on how to build a quantum-safe financial system.* I would like to start by thanking Prof. Cirac Sasturain and all the participants in the panel sessions for their insightful and thought-provoking contributions. Let me extend my gratitude to all the speakers, panellists, and attendees who have travelled from near and far to come here in Rome. Your presence and contributions are vital for the success of this workshop. I am confident that through our collective expertise and collaboration in the remainder of the workshop we will succeed in laying out actionable outcomes for steering the financial system's transition towards a quantum-safe world. Quantum computing, as already noted by many speakers this morning, has the potential to revolutionize the financial system. Thanks to its unparalleled processing power and innovative capabilities, quantum computing can bring about a paradigm shift from the current 'digital economy' to a new era of 'quantum economy'. Such shift encompasses unseen opportunities along with significant challenges for global financial markets, including – in particular – unbalanced access to technology and cybersecurity threats, which we must address with foresight and in a spirit of collaboration. As central banks and financial supervisors, we recognize the importance of striking a balance between steadfastly embracing technological changes on the one hand, and retaining a more cautious approach on the other, in light of the objective of safeguarding the stability, security, and integrity of our financial systems. It is part of our duty to promote and actively participate in the discussion on how to ensure the financial system's transition to the quantum era in the safest possible way, considering the limitations of current technology. Quantum computing, while potentially threatening our system for secure communications, will also be instrumental in developing the solutions to restore resiliency in our financial system. In fact, quantum computing is bound to generate an unprecedented combination of opportunities, risks and uncertainties, which must be managed carefully in order to avoid market inertia and fragmentation, and to sustain an orderly and efficient transition to a quantum-safe world. With today's workshop, we intend to launch a discussion on a possible path for steering the financial system's migration to quantum resilience, within the framework of an internationally coordinated approach involving all the stakeholders: authorities, financial industry, technology providers and academia. 1/5 BIS - Central bankers' speeches 1. The quantum financial system of the future: timeline, opportunities and risks The quantum revolution is already happening, although the exact timeline for its full deployment can hardly be predicted. Innovation in this field is characterized by pivotal and often unexpected transformative breakthroughs leading to sudden acceleration, and sustained by consistent and sizeable public and private investments. The explosion of artificial intelligence technologies, whose interplay with quantum computing holds the potential for both steering and accelerating the development of far-reaching solutions, is making this path even more unpredictable. Against this backdrop of high uncertainty, we expect that the quantum machine capacity necessary to give rise to a significant cybersecurity threat will be achieved in a foreseeable future.1 The financial sector plays a dual role that enables it to look at the quantum phenomenon from two distinct perspectives: firstly, as a user, keen on embracing the capacity of quantum computing for innovation, and secondly, as a highly vulnerable target for quantum-powered cyberattacks. Although the use of quantum computing in the financial sector is still at an immature stage, experimental results already highlight its ability to improve key financial processes, such as risk and portfolio management, payment services and computationally intensive simulation-based tasks (e.g. analyses related to fraud detection and prevention, and anti-money laundering). Exploiting the benefits of quantum computing also presents unique challenges for financial institutions. Like other enabling technologies, quantum computing raises issues related to equitable access and market competitiveness; the full integration of this technology into legacy systems poses significant hurdles. Furthermore, the very nature of quantum computing entails a substantial paradigm shift in how financial services operate. Regulators must carefully navigate the new environment to support the smooth adoption and avoid misuse of these technologies from the private and public sectors. Quantum technologies also bring new risks for the financial sector. In particular, such technologies could be exploited to break the encryption algorithms currently underpinning the security of critical communication systems and digital assets. Critical financial infrastructures are among the main targets of cyberattacks based on quantum computing. They include the financial infrastructures of the future – which will support, for instance, central bank digital currencies and crypto-assets – as the two techniques of key encapsulation and digital signature currently used are both based on asymmetric encryption, which is vulnerable to the quantum threat. It will be of outmost importance to factor in the risks stemming from quantum computing when designing the central bank digital currencies. This risk is already on the table with the practice of 'harvest now, decrypt later' used by malicious actors. Information embedded in contracts currently in force needs to be kept secret for years to come. Even just the possibility that some of it will be exposed – as soon as the technology becomes available – is already a potential blow to trust. 2/5 BIS - Central bankers' speeches 2. The state of the art: one problem, many potential technical approaches As we will see through the lunch session, some solutions to mitigate cyber issues are already available. The heart of cybersecurity lies in cryptography, which – from encrypting data to securing online transactions – is the guardian of our digital world. As the financial industry and governments prepare to protect against quantum threats, it is necessary that they become 'crypto-agile', adopting a multifaceted security strategy that incorporates a range of easily upgradable quantum-resistant solution. The showcase exercise that will be performed in this session will demonstrate that there are two different but complementary approaches that can be used in order to deal with quantum-safe cryptography. On the one hand, we can take advantage of quantum properties to establish secure communication channels between parties, where any attempt to eavesdrop or intercept the exchange of encryption keys is detected. On the other hand, considering that the cryptography involves the use of mathematical algorithms to transform readable data into encrypted data and vice versa, it is possible to replace the current algorithms (unbreakable now, but solvable with quantum computing) with others that are more difficult to solve, even for a quantum computer. Each one of these technologies – or a combination of them – will allow full end-to-end security in our digital communications. At the same time, however, these technologies are all extremely demanding in terms of time and resources. At the current state of the technology, embracing the quantum physics approach is estimated to impose costs of a higher order of magnitude, though it appears to provide a definitive solution to the quantum threat. The showcase exercise will demonstrate how some solutions already available to the market work, leveraging the points I have just mentioned. Clearly, this is not a technological dilemma that can be solved with a black-or-white answer, and what is optimal now may not be optimal in the medium or long term. Migrating the whole financial system toward a quantum-safe setup is a dynamic process requiring a multifaceted approach. Whatever strategy is chosen, though, we need to have interoperable solutions working at all times for the financial industry within a single jurisdiction and between different jurisdictions. 3. Why authorities should act now Numerous public and private initiatives have been launched to develop what are known as 'quantum-safe' solutions. However, some key elements of uncertainty are hampering the market's ability to effectively embrace the migration to quantum-resilient solutions. First, while the implementation timeline for the quantum threat is by no means certain, short-term risk mitigation costs are significant. Second, there is a lack of agreement on a sound migration approach and on suitable interoperable technical standards. Third, the regulatory and capability landscape is fragmented across jurisdictions. These are all obstacles to a timely and orderly transition. 3/5 BIS - Central bankers' speeches Despite growing awareness of the quantum threat, a comprehensive and widely shared action plan in this area remains elusive. The lack of harmonized regulations and of clear international guidelines and standards concerning the transition to a quantum-safe world may induce protracted inertia in the financial system's migration efforts. The global nature of the financial system, the interconnectedness of intermediaries within the financial industry, and between them and the technology providers, call for public authorities to take a whole-of-government approach towards addressing the common threat posed by quantum technology. This includes fostering a dialogue between all relevant public and private stakeholders, aimed at establishing priority areas of intervention and ensuring a common path towards a quantum-safe economy through proactive cooperation and international coordination. A systematic approach involving all international stakeholders is particularly important for financial infrastructures, given their high interconnectedness. We need to protect all links of the chain, especially the weakest. 4. A common path to a quantum-resilient financial system All these elements make the discussion on the migration strategy something that cannot be put off any longer. The importance of preparing the financial system for the transition to quantum computing is at the heart of this workshop. This is the right time to address the challenges of the transition to quantum computing, to agree on the respective roles of public authorities and of the private sector, and to take concrete action. To protect the financial system from the threats posed by quantum computing, the Bank of Italy is proposing – in the context of the ongoing work on risks from emerging technologies affecting the financial system that is being carried out in the G7 Finance Track – that G7 member countries jointly develop a 'common roadmap for quantum resilience', providing a unified policy framework for the actions needed to steer the transition to a quantum-safe financial system through an international cooperation approach. The roadmap should include all initiatives that are essential for a quantum-resilient financial system and could be implemented under the responsibility of different multinational organizations. The monitoring, coordination and governance of the overall roadmap should be undertaken at the highest political level. For example, a shared response at the level of G7 countries would provide a benchmark that could outline the way forward for other jurisdictions so as to cover, eventually, the global financial system. Whichever migration path we decide to adopt, it has to fulfil certain requirements. First, it needs to build on existing regulation in order to capitalize on best practices and, possibly, avoid over-regulation. Second, it will entail the standardization of the approaches taken to risk mitigation across jurisdictions, so as to enable synergies and speed up the transition, as the suppliers of technical solutions will work based on shared guidelines. 4/5 BIS - Central bankers' speeches Third, financial industry players as well as hardware and software providers must participate in the design of the strategy. Their involvement is necessary in order to devise a way forward that hinges on the best and most up-to-date technologies in a field where innovation is characterized by sudden accelerations. Fourth, preservation of interoperability and quality of services must remain the guiding principle of this transition process together with its gradual and safe implementation and with the principle of proportionality, to strike a balance between short-term fixes and long-term solutions. Continuous monitoring of the progress achieved and of the resources absorbed in this endeavour will be important: on this basis, the roadmap commitments can be reassessed along the way, including with respect to the timeline, by accelerating or delaying some milestones as needed. Finally, international coordination is a key aspect. The G7 Cyber Expert Group could be the right forum for operatively managing the quantum resilience migration roadmap, as well as for drafting policy guidelines. Other multinational institutions already involved in the adoption of quantum technologies in the financial system, such as the BIS and the standard setting bodies, could contribute proactively in defining guidelines and standards as cornerstones of the migration. Due to their critical role, financial markets and payment infrastructures, including those that will be supporting the central bank digital currencies, deserve particular attention. The CPMI-IOSCO could be the right organization to lead the work for the quantum resilience of these crucial nodes of the financial system. *** Let me conclude by thanking you all for gathering today to discuss this extremely important topic. Hopefully, the discussion that we initiated today will continue in a fruitful way in the immediate future to deliver as quickly as possible a migration roadmap which can be embraced by all G7 members and possibly also shared with G20 and other countries for wider adoption. * I would like to thank Silvia Vori, Valerio Paolo Vacca, Giuseppe Bruno, Lorenzo Bencivelli, Mauro De Santis, Cristina Andriani, Sabina Marchetti, Antonio Castellucci and Giovanna Piantanida for their contributions to this speech. 1 McKinsey & Company, Quantum Technology Monitor, 2023. 5/5 BIS - Central bankers' speeches
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Statement by Mr Fabio Panetta, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 110th 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, 25 October 2024.
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Fabio Panetta: Statement - meeting of the Development Committee Statement by Mr Fabio Panetta, Governor of the Bank of Italy and Governor of the Constituency of Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste, at the 110th 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, 25 October 2024. *** This year marks the 80th anniversary of the Bretton Woods institutions. In this turbulent time, their mission is more important than ever. Together they must foster growth, create jobs, increase stability, build resilience, fight poverty, and reduce inequalities, all while facing massive global challenges – climate change, fragility, mass migration, pandemics, and the risks stemming from new technologies and demographic trends. We believe that the World Bank Group (WBG), the International Monetary Fund (IMF), and the wider system of multilateral development banks (MDBs) should pursue this complex mission cooperatively, leveraging their respective comparative advantages. In this regard, we greatly appreciate the Development Committee Paper, "A Future-Ready World Bank Group," for its comprehensive report on what has been accomplished under the WBG Evolution, launched in October 2022. We commend the WBG for progress made in improving its operational and financial model to better serve all its clients, with particular attention to the poorest and the most vulnerable. It demonstrates an impressive amount of work that is reshaping and revamping the organization with an eye to strengthening partnership and collaboration within the WBG and with other MDBs. Our constituency continues to advocate for improved monitoring and reporting of the impact of WBG operations, by incorporating better data, impact evaluation, and lessons learned from past experiences. We will continue to ensure that impact and accountability anchor any reforms to operational efficiency and effectiveness. Improved measurement standards in the 22 indicators of the new WBG Scorecard are particularly welcome, and we look forward to further improvements. One of the most important tools the WBG can provide is knowledge. It benefits all countries and is necessary to raise the impact of financial flows on development. To this end, we strongly support the newly envisioned Knowledge Compact and the new Knowledge Hubs, designed to favor the flow of expertise and lessons learned around the globe. We commend management for further achievement in implementing the G20 Capital Adequacy Framework (CAF) Review, launched under the Italian G20 Presidency, which has increased the IBRD's financing capacity by up to $150 billion over the next decade. We congratulate the Bank for the newly adopted IBRD Framework of Restoration Measures, while calling for rapid approval of remaining reforms to ensure its full functionality and alignment with major regional MDBs. 1/4 BIS - Central bankers' speeches We also applaud the work that the MDBs are jointly making to better recognize the value of existing callable capital. While continuing the dialogue with credit rating agencies, we urge management to integrate a part of callable capital into the WB's capital adequacy metrics. We also appreciate the newly established enhanced callable capital, and we call for the most inclusive approach in recognizing the financial leverage of shareholders' voluntary contributions in a way that is consistent with the credit rating agencies' practice. We should be very cautious in designing any reform of IBRD pricing which may have negative impacts on IBRD and IDA financial capacity, which we have been striving to expand. Moreover, we should be aware of any conflicting effects on the newly established Framework for Financial Incentives. We also call for greater analysis of spillovers of price changes for the broader MDBs system, as well as on their implications for the Bank budget anchor and the incentives for country graduation and private sector financing. We urge MDBs to develop effective partnerships with climate and environmental vertical funds so as to maximize scarce concessional resources. MDBs can greatly help improve access to these funds at scale and speed. Thanks to their financial leverage, MDBs can also augment the resources available in vertical funds, by associating programmatic approaches with their parallel subscription of WBG hybrid capital and portfolio guarantees, to strengthen predictability of resources for beneficiary countries. We look forward to continuing work with the WBG to implement the conclusions of the forthcoming G20 Independent High-Level Expert Group Review on the Vertical Climate and Environmental Funds. We appreciate the WBG's new approach to private capital mobilization. Enhanced country diagnostics, stronger country dialogue, and closer collaboration among the WBG institutions are needed to increase the supply of effective projects. The WBG guarantees platform, the publication of GEMs data, the introduction of new products to mitigate foreign exchange risks, and the promotion of policy reforms specifically designed to improve the business environment will all help lower the actual and perceived risks of private investment in developing countries. Project standardization and securitization will contribute to attracting investors and accelerating the WBG's portfolio turnover, thus making capital more efficient. The poorest countries are facing the greatest hardships, and 700 million people worldwide are still trapped in extreme poverty. It is our duty to help them overcome challenges and build a more equitable future. As the largest international development fund in the world, IDA has a major responsibility to help low-income countries return to the path of recovery and sustainable growth, as well as transition out of conflicts, poverty, and deprivation. This year, IDA21 negotiations are creating a new architecture in order to better integrate IDA into a One WBG and strengthen its alignment with the Evolution agenda. IDA must continue to be centered on concessional financing, meaningful policy commitments, and result-oriented targets. 2/4 BIS - Central bankers' speeches At this crucial juncture, we are committed to ensuring that IDA remains the largest and most impactful partnership between borrowers – at different income levels – and donors. Highly concessional resources are a vital source of financing for low-income IDA countries, especially those lacking significant access to capital markets. At a time of heightened debt vulnerabilities, higher interest rates, and lower FDIs, this is even more important. We should collectively deploy all efforts to mobilize adequate concessional finance for IDA21. In this collective effort, the rule-based formula to increase IBRD transfers under better financial conditions and higher incomes – agreed upon in 2018 – is playing a crucial countercyclical role, and it should make shareholders proud of the IBRD's increased role among the key contributors to IDA. The 2018 agreement remains a sign of solidarity and mutual responsibility for a poverty-free world. We also commend the further efforts of IDA itself to stretch its own balance sheet with new CAF measures. These measures allow for more efficient deployment of resources belonging to IDA beneficiaries. We support their full engagements in this decision to best calibrate the appropriate balance between the degree concessionality and volumes, should a trade-off emerge. Our ultimate goal is to spur long-term development through an effective IDA21. The IDA model is well tested in delivering complex and transformative projects in key sectors, based on country ownership. Mission 300, in partnership with the African Development Bank, is an excellent model for using IDA resources through regional multiphase approaches, building partnerships and – together with IFC and MIGA – mobilizing private capital. IDA is also uniquely positioned to deliver infrastructures for regional integration, along with projects and policy reforms to strengthen industrial development and the local private sector. This is especially important in fighting food insecurity, increasing access to healthcare and job opportunities, building sustainable local value chains for critical minerals, and preparing for pandemics. Rising active conflicts and regional instability call on the WBG to renew its approach in addressing the root causes of fragility and maintaining effective engagement in conflict situations. This requires reducing geographical inequalities, promoting broad-based growth, supporting public service delivery in situations of active conflict, and strengthening institutions – including effective and decentralized justice systems and community dispute-resolution mechanisms to mitigate and prevent social conflicts. As part of this effort, the Italian G7 Presidency is working with its partners to ensure a successful replenishment of IDA21, building a solid package that addresses all of these critical issues. IDA must remain relevant to the needs of its clients, particularly Africa and fragile countries. A collective endeavour will be paramount in striking the right balance among donor contributions, internal efficiency, and borrower effort, while broadening the donor base. Africa is a top priority for this constituency, an agenda further advanced during the G7 Italian Presidency. The Mattei Plan, launched by the Italian Government at the Italy- 3/4 BIS - Central bankers' speeches Africa Summit last January, aims to build a renewed relationship with African countries based on equal cooperation, shared interests, and mutual benefits to foster economic growth and social development at the local level. 4/4 BIS - Central bankers' speeches
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Address by Mr Fabio Panetta, Governor of the Bank of Italy, at the 2024 World Savings Day, organised by the Association of Italian Savings Banks (ACRI), Rome, 31 October 2024.
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ACRI Association of Italian Savings Banks 2024 World Savings Day 1924-2024: one hundred years of fostering a savings culture Address by the Governor of Banca d’Italia Fabio Panetta Rome, 31 October 2024 Mr President, Ladies and Gentlemen, World Savings Day was established one hundred years ago, during the celebrations for the foundation of Cassa di Risparmio delle Provincie Lombarde.1 Every year since then, this day has focused on the importance of saving. Saving means transferring resources from the present to the future: people save in order to smooth consumption over the course of their lives; to handle unforeseen events such as job loss or illness; to pay for education, buy a house or start a business. A person’s ability to save depends on their expected lifetime income, although the constraint of current earnings becomes stringent for those who, like many young people, struggle to access credit. The social protection system also plays an important role: a generous pension and an efficient healthcare system attenuate the need to set resources aside. Finally, saving decisions are based on wealth – that which we inherit and that which we plan to leave to our loved ones2 – and on expected returns.3 Savings are an element of stability in the lives of households, yet they are also an important resource for business investment. Savings and economic and social progress are closely linked, as recognized by Article 47 of Italy’s Constitution, which states that ‘The Republic shall foster and protect savings in all forms’. Cassa di Risparmio delle Provincie Lombarde was founded in 1823, but the international conference marking its 100th anniversary was postponed to 1924 for organizational reasons. ‘[V]i sono […] uomini, fortunatamente i più, i quali, mossi da sentimenti diversi, hanno l’istinto della costruzione. […] Il padre non risparmia per sé; ma spera di creare qualcosa che assicuri nell’avvenire la vita della famiglia’, L. Einaudi, Lezioni di politica sociale, Turin, Einaudi, 2004 (c. 1949), p. 191 (There are men who, driven by a wide range of different feelings, have an instinct for construction. The father does not save for his own benefit, but rather hopes to create something that will secure the wellbeing of his family in the future). The higher the return the greater the incentive to save, thereby increasing opportunities for consumption in the future. 1. One hundred years of saving in Italy In 1924, when World Savings Day was established, Italians’ savings had bridged the gap with the other advanced economies,4 thanks to the increase resulting from the economic growth of the Giolittian Era (1901-1914) and the sizeable remittances by Italian emigrants.5 The stock of bank deposits and postal savings books amounted to 27 per cent of GDP.6 Subsequent dramatic historical events – the Great Depression, the Second World War and post-war inflation – decimated the financial wealth of an entire generation: by 1948 the value of bank and postal deposits had plummeted to 10 per cent of GDP. Those painful experiences sharpened the focus of society and of the newly established republican institutions on savings. The protection of savings was even enshrined in our Constitution, a rarity in the international landscape.7 After the Second World War and up to the early 1990s, Italian households were saving one quarter of their income every year on average (Figure 1).8 According to the available statistical reconstructions, Italy’s gross national savings (including the public sector) stood at 9 per cent of GDP in the mid-1920s and, up until the eve of the Second World War, remained on average lower than in Germany and the United States, and higher than in the United Kingdom. M. Gomellini and C. Ó Gráda, ‘Le migrazioni’, in G. Toniolo (ed.), ‘L’Italia e l’economia mondiale: dall’Unità a oggi’, Venice, Marsilio, 2013 (Historical Series of Banca d’Italia - Analysis and Essays Series, XII), pp. 375-421. F. Cotula, T. Raganelli, V. Sannucci, S. Alieri, and E. Cerrito (eds.), ‘I bilanci delle aziende di credito 1890-1936’, Roma-Bari, Laterza, 1996 (Historical Series of Banca d’Italia - Statistics Series, III); R. De Bonis, F. Farabullini, M. Rocchelli and A. Salvio, ‘Nuove serie storiche sull’attività di banche e altre istituzioni finanziarie dal 1861 al 2011: che cosa ci dicono?’, Banca d’Italia, Economic History Working Papers, 26, 2012. C. Pagliarin, ‘Le radici costituzionali della tutela del risparmio’, Banca Impresa Società, 1, 2021, pp. 29-58. The drafters of the Constitution decided to include the safeguarding of savings in the Constitution, although they were aware of the risk that rules similar to Article 47 could turn it into ‘a memorandum and a list’ (Constituent Assembly, session of 19 May 1947, p. 4039). This decision is a testament to the deep wound that the severe monetary disasters of the previous 30 years had inflicted on our economic and social fabric and individual experiences. This flow of savings does not include social security contributions, although in the perspective of the life-cycle theory originally put forward by Richard Brumberg and Franco Modigliani (and then extended by Modigliani and Albert Ando), they are indeed a form of saving, albeit involuntary. See A. Ando and F. Modigliani, ‘The “life cycle” hypothesis of saving: aggregate implications and tests’, American Economic Review, 53, 1, 1963, pp. 55-84. The household saving rate began to decline in the 1980s; it then fell more rapidly after 1992, and eventually stabilized at 10 per cent in this century.9 There are several reasons behind this reduction in the propensity to save. In the 1980s, the presence of a very generous public pension system was an important contributory factor. Later on, household saving was adversely affected by macroeconomic conditions. The 1992 currency crisis and the subsequent fiscal consolidation squeezed disposable income, leading households to save less in order to sustain consumption. On top of that, since the late 1990s, the fall in interest rates brought about by the introduction of the euro and better access to credit have favoured current over future consumption. More recently, savings have been affected by the global financial crisis, the sovereign debt crisis in the euro area, and finally by the pandemic. Demographic factors have also come into play. Population ageing has compounded the fall in the saving rate, with a rising share of elderly people drawing on their assets to fund their expenses, and therefore recording negative savings.10 The resources set aside by younger workers have been very limited, due to their low incomes.11 The rise in the saving rate as a consequence of forced saving during the pandemic was the exception to this general trend. In 1991, for each resident aged 65 or over, there were four people aged between 20 and 64; today that number has become two. For more details, see A. Brandolini and A. Rosolia, ‘Consumi, redditi, risparmi e benessere’, in A. Golini and A. Rosina (eds.), Il secolo degli anziani. Come cambierà l’Italia, Bologna, Il Mulino, 2011, pp. 137-158. With less stable and low-paid jobs, young people are being limited in their ability to save, in spite of the stimulus to make precautionary savings to meet their needs during periods of unemployment. See A. Rosolia, ‘L’evoluzione delle retribuzioni in Italia tra il 1986 e il 2004 secondo i dati dell’archivio WHIP’, Politica economica, 2, 2010, pp. 179-201; A. Rosolia and R. Torrini, ‘The generation gap: a cohort analysis of earnings levels, dispersion and initial labor market conditions in Italy, 1974-2014’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 366, 2016. But households are not the only savers: in this century, corporate savings have grown steadily, accounting for two thirds of private savings in the last decade (Figure 2).12 Overall, the annual flow of private savings now exceeds €400 billion, or one fifth of national income. Only part of it, however, goes towards financing investments in Italy. In the five years before the pandemic, domestic financial resources spent abroad averaged 2.5 per cent of GDP. Had they been used to purchase capital goods, investments would have increased by almost one fifth. 2. A stable, growth-oriented economy Having a robust real economy is the first pillar in the protection of savings. A robust economy is one that grows and invests, generating jobs, income and opportunities to use savings profitably. By contrast, an economy vulnerable to shocks is prone to frequent recessions, which tend to slow the accumulation of savings. The Italian economy has gone through difficult phases in this century. Between 2000 and 2019, Italy’s real GDP per capita declined slightly, against an increase of 25 per cent for the other European countries, although they too were losing ground to the United States. I have already discussed this disappointing trend and its causes in past speeches: low innovation capacity and limited investment, a fragmented production system oriented towards traditional sectors, shortcomings in the public administration and in infrastructure, and low labour market participation. The high level of public debt amplifies these weaknesses, exposing the economy to the vagaries of the markets and limiting our ability to react effectively Corporate savings consist mainly of retained earnings; national saving is the sum of private sector and general government savings, which is the balance between current revenue and current expenditure (not including capital expenditure, which instead contributes to the general government deficit or surplus). to adverse circumstances. Interest expenditure absorbs considerable resources, which could otherwise go into funding education, infrastructure and healthcare.13 In recent years, the Italian economy has shown encouraging signs of improvement. After the crisis of the last decade, the production system has undergone a profound – and painful – overhaul. Firms have come out stronger.14 These changes help explain how the Italian economy has been able to bounce back from recent shocks. Since the end of 2019, Italy’s GDP has grown by 5.5 per cent, against 4.1 per cent for France and 0.2 per cent for Germany.15 The global economy is now in a phase of uncertainty and weakness. According to the latest IMF estimates, global GDP is expected to grow by just over 3 per cent in 2025, below the average for previous decades. The euro-area economy remains weak (Figure 3), partly owing to still high real interest rates and the end of the fiscal stimulus measures introduced in previous years. The Italian economy is suffering as a result. However, it is the longer-term trends that are worrying: ongoing conflicts, the fragmentation of global trade, the division of countries into opposing blocs, and a continent, Europe, which is suffering the effects of population decline, lagging behind and losing influence in international relations. In this context, the European Union and Italy stand in need of far-reaching reforms. Europe needs to revive the sense of common purpose that enabled the adoption of the NextGenerationEU programme and has since waned. The areas in which to take action are numerous:16 we need to realize the full potential of the single market; launch joint projects in innovation and technology, starting with the As I noted recently, Italy is the only euro-area country where interest payments on public debt almost match spending on education; see F. Panetta, ‘If we are not after the essence, then what are we after?’, speech at the 45th Foundation Meeting for Friendship among Peoples, Rimini, 21 August 2024. F. Panetta, ‘The Governor’s Concluding Remarks for 2023’, Rome, 31 May 2024. These figures include preliminary estimates for the third quarter of 2024 released on 30 October. F. Panetta, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, Lectio Magistralis on the occasion of the conferral of an honorary degree in Juridical Sciences in Banking and Finance by the University of Roma Tre, 23 April 2024; F. Panetta, ‘The Governor’s Concluding Remarks for 2023’, Rome, 31 May 2024; M. Draghi, The future of European competitiveness, September 2024. digital and green transitions; reduce foreign dependency in the energy and defence sectors; streamline rules and regulations; create a centralized and autonomous fiscal capacity; and address the demographic challenge. Italy has an important responsibility in lending credibility to the European project, which it can fulfil by carrying out the investments and reforms laid out in the National Recovery and Resilience Plan, reducing the public debt-to-GDP ratio, and decisively tackling the unresolved issues I have mentioned. 3. Monetary stability Monetary stability is the second pillar in the protection of savings. Inflation worsens the allocation of resources and erodes the real value of savings.17 In its first two decades of existence, the monetary union ensured moderate inflation. The pandemic and the energy shock, however, changed this: in 2022, consumer prices grew by 10 per cent in the euro area and by 12 per cent in Italy. The ECB’s monetary tightening actions helped bring inflation down as swiftly as it had risen: today, price growth stands at around 2 per cent for the first time since 2021. The ECB has thus been able to cut its key interest rates in three consecutive Governing Council meetings since June. However, monetary conditions are still tight and new cuts will be necessary. As inflation subsides, our focus should be on the sluggishness of the real economy: without a sustained recovery, inflation risks being pushed well below the target, opening up a scenario that would be difficult for monetary policy to counteract and should therefore be avoided. Tommaso Zerbi opened the Italian Constituent Assembly meeting of 19 May 1947, during which Article 47 of the Constitution was discussed and approved, recalling ‘the cry of millions and millions of small Italian savers, the tragedy – without exaggeration – of our entire generation of small savers, who in the last 30 years or so have seen the purchasing power of the lira fall to one one-hundred-and-fortieth of its value in 1913 or to one thirty-fifth of its value in the period between the First and the Second World War’ (see Constituent Assembly, session of 19 May 1947, p. 4025; only in Italian). 4. Financial stability Financial stability is the third pillar in the protection of savings. Financial crises pose a severe threat to savers because of the destruction of wealth they bring about.18 Banks Over the previous decade, Italy’s banking system suffered the consequences of two recessions within a few years. Between 2008 and 2014, GDP fell by 9 per cent, leading to an increase in business bankruptcies and unemployment.19 Non-performing loans rose to 10 per cent of total loans. Banks suffered sizeable losses, which in many cases resulted in outright banking crises. That is now a distant memory. The banking system is currently well capitalized and profitable. The stock market valuations of the main financial intermediaries exceed their book values (Figure 4), signalling investor confidence in banks’ ability to generate income in the future. These improvements reflect the efficiency gains achieved by financial intermediaries and the strengthening of prudential rules, as well as the favourable conditions of recent years.20 Public aid during the pandemic crisis, including the expansion of state guarantees on loans to small and medium-sized enterprises, played an important In Italy, the global financial crisis of 2007-09 led to a drop in equity prices of almost 70 per cent, followed by a slow and partial recovery. The sovereign debt crisis caused further losses, coupled with a sharp fall in house prices. In that period, yearly bankruptcies doubled to more than 15,000; the unemployment rate rose by over 6 percentage points, to 12.9 per cent. In recent years, the European financial system has been characterized by ample liquidity supply and rapidly rising interest rates. These market conditions have created a particularly favourable environment for banks’ profitability. role. Now that the conditions allow it, the time has come to return to a system of guarantees based on ordinary criteria.21 Looking ahead, the high capital levels and the foreseeable reduction in profitability could push banks towards consolidation, including at cross-border level. Consolidation deals must be made by improving efficiency and creating strong, profitable intermediaries that can better serve the real economy. Greater integration of the banking market at European level would increase the soundness of banks and allow them to operate in multiple countries, diversifying risks and strengthening the provision of services to households and firms. The banking union needs to be completed by establishing a European deposit guarantee scheme and improving the bank crisis management framework. Creating a European capital market is also necessary. The most important – though not the only – condition for achieving this goal is the introduction of a European safe asset,22 which is essential for the operation of financial markets.23 Non-bank financial intermediaries Non-bank intermediaries have become the main financial players, both globally and in the euro area. In Italy, banks continue to predominate, but non-bank intermediaries are growing rapidly (Figure 5). The draft budget law for 2025 reduces the ceiling for guarantees that can be issued by the Italian fund created to improve access to credit for SMEs from €200 billion to €160 billion. This ceiling was €225 billion in 2023. In the five-year period 2015-19, the total guarantees issued by the fund amounted to about €60 billion. In addition to introducing a safe asset, we must draft a consolidated European law on finance, strengthen centralized supervision of non-bank financial intermediaries, and standardize corporate crisis management procedures; see F. Panetta, ‘Europe needs to think bigger to build its capital markets union’, The ECB Blog, 30 August 2023; and F. Panetta, ‘The Governor’s Concluding Remarks for 2023’, Rome, 31 May 2024. A European safe asset would allow for better pricing of financial products, such as corporate bonds and derivatives, encouraging their expansion; it would provide a form of collateral that could be used across all market segments, including for cross-border transactions; and it would serve as the basis for foreign central banks’ reserves in euros, strengthening the global role of our currency. Non-bank finance facilitates the diversification of savings and is a primary source of funding for innovative projects, but it can make the financial system more complex and risky. Banca d’Italia carries out in-depth supervision of about 650 non-bank intermediaries with diverse activities and risks.24 However, strong supervision requires that national efforts be complemented by effective international cooperation. Interaction between different national regulatory and supervisory frameworks is necessary to oversee the activity of financial intermediaries operating on a cross-border basis. This is the case for foreign intermediaries providing financial services in Italy using the single European passport.25 This model offers advantages in terms of competition and freedom of choice for savers, but it assumes that supervision is highly effective everywhere, a condition that is not always met. The supervisory rules and practices for non-bank intermediaries need to be strengthened and harmonized across countries. Banca d’Italia is working towards this goal at both European level and as part of the Financial Stability Board. 5. The role of Banca d’Italia in the protection of savings The protection of savings does not end with the supervision of financial intermediaries. It is also about ensuring the smooth operation and integrity of the financial system as a whole. This means working to improve people’s financial skills,26 and hence their ability to make sound investment decisions. It means offering tools to uphold savers’ Banca d’Italia supervises insurance companies (89 at the end of 2023) through the Italian Insurance Supervisory Authority (IVASS). Other non-bank operators supervised by Banca d’Italia include investment fund managers, investment firms, financial corporations providing loans, crowdfunding service providers, electronic money institutions and payment institutions. The single European passport allows financial intermediaries to freely provide their services in any EU country without the need to establish themselves on their territory. These intermediaries are supervised by their home country authority. As part of its activities in the field of financial education, Banca d’Italia reaches more than 150,000 people each year, including students, small business owners, and socially and economically vulnerable groups at high risk of financial exclusion. rights quickly and inexpensively.27 It means protecting the financial system against money laundering and the financing of terrorism.28 It means taking direct action to counter cyber risks to financial and market infrastructures and making sure that financial intermediaries put the necessary safeguards in place.29 It means ensuring the efficiency and security of the payment system, which is the backbone of the financial system.30 Banca d’Italia performs all these tasks, working with law enforcement and judicial authorities, as well as with other national and foreign supervisory and regulatory bodies. * * * Banca d’Italia reviewed 100,000 complaints from bank customers over the decade 2014-23. The Banking and Financial Ombudsman handled 210,000 complaints, with the assistance of Banca d’Italia’s staff. As a result of the latter and of our supervisory activities, more than €1 billion were returned to customers. The Insurance Ombudsman service will be rolled out over the next few months. Banca d’Italia is responsible for anti-money laundering supervision of financial intermediaries, issues relevant regulations and is involved in setting national and international rules and standards. It carried out about 350 inspections and 1,300 interventions over 2019-23. The Financial Intelligence Unit for Italy (UIF), which works with staff and funding from Banca d’Italia, examines reports of alleged money laundering and terrorist financing (more than 150,000 suspicious transactions were reported in 2023) and carries out its financial analysis. At national level, Banca d’Italia fosters cooperation with various institutional players through its Computer Emergency Response Team (CERT-BI). Together with the Italian Banking Association (ABI), it chairs the Computer Emergency Response Team for the Italian financial sector (CERTFin). At European level, Banca d’Italia is a member of the Euro Cyber Resilience Board for pan-European Financial Infrastructures (ECRB) and the Cyber Information and Intelligence Sharing Initiative (CIISI-EU) for sharing information and cyber intelligence across systemic financial structures. At national and European level, Banca d’Italia monitors cyber risks in order to strengthen the security and business continuity safeguards of intermediaries. It identifies minimum requirements and measures for information system management. Banca d’Italia manages a large number of Italian and European payment infrastructures. For example, at European level, the Bank has been involved in the development and is responsible for the operational management of the Eurosystem’s market infrastructures, consisting of: the T2 system for the real-time gross settlement of large-value transactions in central bank money between financial institutions and with the central bank; the TARGET2-Securites (T2S) platform, which enables securities transactions in central bank money to be settled simultaneously based on the delivery versus payment principle; the TARGET Instant Payment Settlement (TIPS) system for instant payment settlement, which has been processing transactions in Swedish krona, in addition to those in euros, since February 2024. The first two platforms are managed together with the central banks of Germany, France and Spain, while TIPS has been fully developed and is managed autonomously by Banca d’Italia. Saving means looking ahead, at times with uncertainty and concern, more often with confidence and optimism. Adam Smith wrote that ‘the principle which prompts to save, the desire of bettering our condition; a desire which [...] comes with us from the womb, and never leaves us till we go into the grave’.31 Savings are a source of stability and progress for households, as well as an invaluable asset for the economic and civil advancement of a country. The protection of savings, enshrined in our Constitution, is at the heart of Banca d’Italia’s action. Yet it is crucial that all those who manage people’s savings operate with integrity and abide by the highest ethical and professional standards. Only then can we ensure that savings continue to be a driver of prosperity and progress for current and future generations, making it possible to look ahead with foresight and peace of mind. A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, London, Methuen Co., sixth edition, reprinted in 1961, Book II, Chapter III, pp. 362-3. FIGURES Figure 1 GDP and household finances (indices: 1992=1; per cent) 1.50 1.25 1.00 0.75 0.50 0.25 0.00 Household consumption GDP Household disposable income Saving rate Source: Istat’s national accounts. (1) Right-hand scale. Figure 2 Gross saving (billions of euros) −100 −100 General government Firms Source: Istat’s national accounts by institutional sectors. Households Total Figure 3 Euro-area GDP growth rate and contributions of domestic and foreign demand (quarterly data; percentage changes and percentage points) −1 GDP Net foreign demand −1 Domestic demand Source: Based on Eurostat data. (1) Quarterly percentage changes. The data for the third quarter of 2024 are preliminary estimates released on 30 October. Figure 4 Price-to-book ratio of listed banks 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 Italy France Spain Germany United States Source: LSEG. (1) The data refer to the banks included in the Datastream Banks indices of the countries in the key. Figure 5 Financial assets of banks and non-bank financial intermediaries (per cent of GDP) (a) World (b) Euro area (c) Italy Banks Non−bank financial intermediaries Source: Based on FSB data. (1) FSB sample, which includes the 21 largest world economies and the euro area as a whole. Designed and printed by the Printing and Publishing Division of Banca d’Italia
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Speech by Ms Chiara Scotti, Deputy Governor of the Bank of Italy, at the 14th Annual Conference on "Central Bank Business Survey and Liaison Programs", Rome, 30 October 2024.
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Central Bank Business Surveys: Version 2.0 Speech by Chiara Scotti Deputy Governor of Banca d’Italia 14th Annual Conference on ‘Central Bank Business Survey and Liaison Programs’ Centro Convegni Carlo Azeglio Ciampi Rome, 30 October 2024 Ladies and gentlemen, good afternoon. The annual conference on ‘Central Bank Business Survey and Liaison Programs’ is now coming to a close. Let me warmly thank all the participants and speakers who have contributed to the success of this initiative, jointly organized by Banca d’Italia1 and the European Central Bank. The large number of central banks on both sides of the Atlantic participating in this conference reveals the importance of business surveys for policymakers. The usefulness of firm-level surveys has become so clear that an increasing number of central banks have added them to their analytical toolkits in recent years. Indeed, we have many more central banks attending the CBBS conference today than a few years ago, partly thanks to our colleagues at the Atlanta Fed who have pushed for such a larger group.2 This year’s programme brought together insightful methodological and applied papers on various aspects of business surveys. In the remainder of my intervention, I would like to briefly discuss the advantages and limitations of traditional business surveys, and then take advantage of having such an incredible audience in front of me to nudge researchers, both from academic institutions and from central banks, to explore new directions to develop what I defined in the title as business surveys 2.0, to make sure we seize the opportunities presented by new technologies and digitalization. Some advantages and challenges of traditional surveys Sample surveys have been a fundamental tool for capturing policy-relevant heterogeneities among agents, especially firms. Banca d’Italia has a long tradition With thanks to Marco Bottone, Elena Mattevi, Andrea Neri and Concetta Rondinelli for their valuable contributions. Central Bank Business Survey and Liaison Program Group - Federal Reserve Bank of Atlanta. in this field. In the early 1960s, we launched our Survey on Household Income and Wealth,3 and soon after, in 1972, our annual Survey of Industrial and Service Firms (INVIND).4 Over time, we have continued to expand our toolbox: in 1999, we launched the quarterly Survey on Inflation and Growth Expectations,5 which systematically collects firms’ expectations of consumer price inflation at different time horizons, as well as quantitative information on past and expected changes in their own selling prices. More recently, in 2022, we started the biannual Short-Term Survey of Italian Households,6 which tracks household economic conditions over the business cycle. Business surveys remain crucial to this day for providing timely insights into key analytical issues. As shown in many academic papers, they have allowed us to achieve a deeper understanding of expectations7 and their relation with firm-level dynamics,8 of uncertainty9 and other outcomes10 that would have been otherwise unattainable. Because they can provide timely, specific, and flexible information, business surveys have proved to be particularly useful in recent years, which have been marked by large unexpected shocks. During the COVID-19 pandemic, for example, our surveys were crucial to understand the underlying heterogeneity that drove the surge in bank borrowing and deposits.11 More recently, in a world of heightened geopolitical fragmentation, they have been useful to understand the potential impact of supply disruptions from high-risk countries on European regions, sectors, and firms, and, thanks to the coordinated efforts of several central banks, they have allowed researchers to conduct harmonized cross-country analyses.12 ‘Survey on Household Income and Wealth’, Banca d’Italia, Statistics Series. ‘Survey of Industrial and Service Firms’, Banca d’Italia, Statistics Series. ‘Survey on Inflation and Growth Expectations’, Banca d’Italia, Statistics Series. ‘Survey of Italian Households. Short-term Outlook’ (only in Italian), Banca d’Italia, Statistics Series. For example, C.F. Manski, ‘Measuring expectations’, Econometrica, 72, 5, pp. 1329-1376, 2004; L. Bartiloro, M. Bottone and A. Rosolia, ‘The heterogeneity of the inflation expectations of Italian firms along the business cycle’, International Journal of Central Banking, 15, 5, pp. 175-205, 2019. For example, O. Coibion, Y. Gorodnichenko and T. Ropele, ‘Inflation expectations and firm decisions: New causal evidence’, The Quarterly Journal of Economics, 135, 1, pp. 165-219, 2020; A. Rosolia, ‘Do firms act on their inflation expectations? Another look at Italian firms’, Journal of Political Economy Macroeconomics, 2, 4, 2024. For instance, L. Guiso and G. Parigi, ‘Investment and demand uncertainty’, The Quarterly Journal of Economics, 114, 1, pp. 185-227, 2019; D. Altig, J.M. Barrero, N. Bloom, S. Davis, B. Meyer and N. Parker, ‘Surveying business uncertainty’, Journal of Econometrics, 231, 1, pp. 282-303, 2022. For instance, the interpretation of firms about the ECB’s inflation target, see M. Bottone, A. Tagliabracci and G. Zevi, ‘Inflation expectations and the ECB’s perceived inflation objective: Novel evidence from firm-level data’, Journal of Monetary Economics, 129, S15-S34, 2022. M. Bottone, E. Mattevi, L. Modugno, M. Mongardini and A. Neri, ‘Indebitamento e liquidità delle imprese nel 2020: evidenze su microdati di impresa’, (only in Italian), Banca d’Italia, Covid-19 Notes, 21 December 2021. I. Balteanu, M. Bottone, A. Fernandez-Cerezo, D. Ioannou, A. Kutten, M. Mancini and R. Morris, ‘European firms facing geopolitical risk: Evidence from recent Eurosystem surveys’, VoxEU, 18 May 2024; L. Panon, L. Lebastard, M. Mancini, A. Borin, P. Caka, G. Cariola, D. Essers, E. Gentili, A. Linarello, T. Padellini, F. Requena and J. Timini, ‘Inputs in Distress: Geoeconomic Fragmentation and Firms’ Sourcing’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 861, 2024. However, conducting traditional business surveys based on sound methodologies such as probability sampling is becoming increasingly challenging and costly for central banks. Examples of key challenges include the rise in both the item non-response rate − which has tripled to 15 per cent for investment plans since the inception of our INVIND survey − and the unit non-response rate, especially among firms that perceive a high response burden.13 Moreover, the growing awareness and concerns about data privacy and time constraints14 not only complicate the conduct of surveys, but also pose serious risks to data quality and inevitably raise questions about how to use and potentially adapt sample surveys in the future. Where could we go next? The digitalization of information systems, the increasing availability of administrative data, big data, and non-probabilistic and online surveys15 (which may seem like quick, easy, and inexpensive ways to collect data), as well as the rise of artificial intelligence (AI), bring potential opportunities for the development of surveys that must be carefully assessed. I see some promising directions. For example, we should take full advantage of the growing availability of administrative and other unstructured data. Combining these data with methodologically sound and carefully designed sample surveys can greatly enhance the informative value of both. This integration can occur at various levels, such as sample selection, weighting, and streamlined questionnaires. In addition, we should harness the rapid advances in AI and machine learning techniques, which have potential benefits at various stages of the survey process. Let me briefly highlight some avenues for further exploration and research in the latter area. Survey research focuses primarily on the wording of questions and answers in an attempt to gather soft information that it is not readily available in more traditional data, a.k.a. hard information. So it seems natural, at least to me, that a first way to improve traditional surveys is to use large language models (LLMs). In the preparation phase of surveys, for example, LLMs could help create questions, identify inconsistencies and suggest effective response options. In data cleaning and management, LLMs could help detect inconsistent responses and prevent low-quality entries. In the final stage of reporting results, LLMs could help ensure accessible formats, whether in the form of summaries, visualizations, presentations, or written text. M. Bottone, L. Modugno and A. Neri, ‘Response burden and data quality in business’, Journal of Official Statistics, 37, 4, pp. 811-836, 2022. For example, M. Galesic and M. Bosnjak, ‘Effects of questionnaire length on participation and indicators of response quality in a web survey’, The Public Opinion Quarterly, 73, 2, pp. 349-360, 2009. R. Gambacorta, M. Lo Conte, M. Murgia, A. Neri, R. Rizzi and F. Zanichelli, ‘Mind the mode: lessons from a web survey on household finances’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 437, 2018; A. Neri and F. Zanichelli, ‘Principali risultati dell’Indagine Straordinaria sulle Famiglie italiane nel 2020’ (only in Italian), Banca d’Italia, Covid-19 Notes, 26 June 2020; R. Cummings and E. Tedeschi, ‘The effect of online interviews on the University of Michigan Survey of Consumer Sentiment’, Briefing Books, October, 2024. A second way to improve traditional surveys is to use natural language processing and text analysis to quickly extract signals from text. These methods are already widely used in the literature to extract signals on economic variables, such as industrial production from text analysis of survey responses from manufacturing firms,16 or economic activity from earnings calls,17 which are an important channel of communication between market participants and the management of publicly traded companies. In light of these experiences, we might further explore the possibility of extracting information from informal interviews with managers that are traditionally more difficult to interpret, moving away from traditional surveys in which respondents read and select the most appropriate answer. Third, even in the conduct of more formal interviews, surveys could be facilitated by the use of AI-assisted interviewing, which integrates advanced artificial intelligence into the interviewing process, particularly as a tool to assist interviewers in improving data quality (minimizing human error and bias). Such a development would enable more dynamic and responsive interviews that adapt in real time to respondents’ answers, automating routine tasks, providing a more engaging and personalized interaction, possibly leading to higher response rates and greater satisfaction with participation. Fourth, machine learning models could replace current methods for imputing missing data in business surveys, as they are able to capture the complexity in data structures, recognizing non-linear relationships and allowing a large number of predictors to be included.18 Machine learning techniques could also help to detect outliers in surveys, with algorithms that compare responses within the same questionnaire and across waves. Last but not least, LLMs could revolutionize traditional data collection methods. For example, instead of sending out questionnaires, we could provide a programme that firms could adapt to their own databases using LLMs, allowing them to extract the hard information they need, leaving more time for qualitative or soft information, such as plans and assessments. Clearly, the significant benefits of reducing the burden on respondents would have to be carefully weighed against the potential problems of data confidentiality that might discourage firms from participating in the survey. These are just some examples of the potential evolution of business surveys. Understanding whether and how new technologies and tools could be integrated into survey production processes will surely be a challenge, but one that I think is worth taking on. T. Cajner, L.D. Crane, C. Kurz, N. Morin, P.E. Soto and B. Vrankovich, ‘Manufacturing sentiment: Forecasting industrial production with text analysis’, FEDS Finance and Economics Discussion Series, Working Paper No. 2024-26, May 2024. M.A. Gosselin and T. Taskin, ‘What Can Earnings Calls Tell Us About the Output Gap and Inflation in Canada?’, Bank of Canada, Staff Discussion Paper, 29 June 2023; T. Taskin and F.U. Ruch, ‘Global Demand and Supply Sentiment: Evidence from Earnings Calls’ Bank of Canada, Staff Working Paper, 30 June 2023. In this sense, random forests seem to offer some improvements over traditional logistic regression for the complex response model. See T.D. Buskirk and S. Kolenikov, ‘Finding respondents in the forest: A comparison of logistic regression and random forest models for response propensity weighting and stratification’, Survey Methods: Insights from the Field, 2015. Conclusions This conference has provided an excellent opportunity to exchange experiences on methodological and applied issues. It has fostered scientific debate on core topics for monetary and economic policy, facilitated dialogue between institutions, and explored future avenues for research and innovation. Going forward, it is essential to build on the momentum generated here. In an increasingly interconnected world, strengthening our networks and increasing our cooperation could improve the quality and reliability of business surveys and our ability to identify emerging phenomena. Given the busy agenda of this two-day meeting and the growing number of participants, we might consider following up on this event with additional online meetings throughout the year, focusing on specific areas of interest, such as survey design, data collection and data analysis, perhaps with an effort to include the suggestions we have just discussed. Individual institutions often lack the resources to tackle these challenges alone. By working together, we can share lessons learned, best practices, and innovative methodologies to advance the development of business surveys and ensure that they remain a valuable part of our economic toolkits. Designed by the Printing and Publishing Division of the Bank of Italy
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Introductory speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the seminar "The journey to financial well-being through financial inclusion", organised by the Bank of Italy, Rome, 4 November 2024.
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Luigi Federico Signorini: The journey to financial well-being through financial inclusion Introductory speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at the seminar "The journey to financial well-being through financial inclusion", organised by the Bank of Italy, Rome, 4 November 2024. *** Today's event will explore the connection between financial inclusion and financial wellbeing. Why is this important? Financial inclusion has become a widely shared goal of government policies and a topic of interest for central banks and financial authorities at the international level. It has received a lot of attention over the years as an instrument to foster growth, reduce inequalities, increase employment, and alleviate poverty.1 Financial inclusion may help people cope with macroeconomic and idiosyncratic shocks, as it facilitates financial planning and the intertemporal shift of financial resources. From the policymaker's standpoint financial inclusion is important as it improves the individual's economic and financial well-being, whilst having a positive impact on the economy as whole. Studies find that the benefits of financial inclusion can be substantial even in countries with well-developed financial markets, because it can translate into higher wealth accumulation and greater resilience of low-income households. Other studies, focusing on emerging and developing countries, find that increased usage of bank accounts via debit cards has boosted the saving rate significantly because it reduces transaction costs for people to access their money.2 The digitalisation of finance has significantly contributed to promoting financial inclusion through more efficient and effective technologies and through increased competition, which leads to higher quality products and services and to lower costs. Over the last decades, notable progress has been made around the world in increasing access to financial products and services for more individuals, with 76 per cent of people worldwide having a bank or mobile money account in 2021. This represents a significant increase from 2011 when the figure stood at 51 per cent.3 Nonetheless, progress has been uneven across regions, even controlling for income levels. Increased access to digital financial products and services has not translated, in some cases, into higher actual usage of financial products and services. Moreover, in some instances, financial innovation has resulted in the lower financial inclusion of rural households4 or in the worsened financial well-being of individuals, particularly as the result of over-indebtedness and exposure to fraud and scams.5 Possible causes include market failures, lack of competition, inadequate consumer protection rules and an insufficient level of digital and financial literacy.6 Even in advanced countries – where the offer of financial services is regulated and transparent, 1/3 BIS - Central bankers' speeches and consumers are better protected from intermediaries' improper behaviour – authorities continue to consider how to improve the regulatory environment to manage new risks. A specific matter of concern is the exclusion of those who do not possess adequate digital skills for accessing and using the financial services. The data show that the elderly, those with lower education levels, and those living in rural areas suffer from limited access. The shift to digital channels will continue; appropriate actions need to be put into place to ensure that everybody can reap its benefits. It is generally understood that financial inclusion has three dimensions: access, use and quality. The first is the possibility for individuals to access basic financial services and products. The second is the actual ability of individuals to use such services and products in an effective way. The third (and subtler) dimension consists in creating the conditions for financial services and products to work best to improve people's financial well-being. Progress along all three dimensions – access, use and quality – should ideally be simultaneous. Achieving better results on all three fronts is important to ensure the empowerment of consumers, so that markets can actually work in their best interest. The first dimension requires good infrastructures, which are a prerequisite for enabling the efficient and secure provision of financial services. It also requires a competitive environment, to foster higher cost-efficiency, a more diversified offering of financial products and services, and greater consumer choice. The second and third dimensions require consumer protection measures and financial education. Ex ante transparency rules work to ensure that customers are well informed before purchasing a financial product. Ex post rules need to envisage effective recourse if something goes wrong. Conduct supervision monitors the correct implementation of rules. Free and open competition is once again essential to enable consumers to exploit the full potential of transparency and conduct rules. Nothing, however, will work very well unless consumers are endowed with the minimum knowledge that is necessary (1) to make effective use of the information provided, (2) to activate in practice the tools through which services are offered, (3) to compare in a meaningful way the products offered on the market, and (4) to take full advantage of consumer protection rules. Therefore, financial and digital education initiatives are important. Given the growing complexity of financial markets, and the new opportunities offered by digitalisation, the Global Partnership for Financial Inclusion (GPFI) has shifted its focus from simple access to financial services, which was originally its main objective, to fostering the use of financial services and understanding the conditions under which financial inclusion can enhance financial well-being. Last September, Her Majesty Queen Máxima of the Netherlands, Honorary Patron of the GPFI, after having spent 15 years as United Nations Special Advocate for Inclusive 2/3 BIS - Central bankers' speeches Finance for Development was given a new role focusing specifically on financial health (Secretary-General's Special Advocate for Financial Health). This also marks a change in perspective towards the need to focus on the actual outcomes of financial inclusion. Data are useful. The Global Findex database, maintained by the World Bank, is a valuable tool for evaluating progress on access and usage of financial services. More work may be needed on the quality dimension; concepts, statistics and pre-conditions for comparability are all thorny issues, and it is probably appropriate to rely on a set of different indicators rather than concentrate on a single one. Once again: the issue is empowerment, not paternalism – or, as one should perhaps say, parentalism. In all this, there should be no presumption that the regulator, even the best intentioned one, is in a position to take decisions for the consumer. Comprehensive financial education and a robust framework of consumer protection rules are the best tools available to us to enable consumers to make their choices in full awareness of the opportunities and risks. 1 Beck, T. Demirgüç-Kunt, A. and Levine, R. (2007). "Finance, inequality and the poor". Journal of Economic Growth 12:27–49. Sahay, R., ihák M., N'Diaye P., Barajas A., Mitra S., Kyobe A., Mooi Y. and Yousefi R. (2015), "Financial inclusion: Can it meet multiple macroeconomic goals?" IMF Staff Discussion Note 15/17. Banerjee, A., Breza E., Duflo E. and Kinnan C. (2019). "Can Microfinance Unlock a Poverty Trap for Some Entrepreneurs?" NBER Working paper No. w26346. Bettini G., Pigini C., Zazzaro A. (2020) "Financial inclusion and poverty transitions: An empirical analysis for Italy". CSEF, Working Paper No. 577. 2 Célerier C. and Matray A. (2019). "Bank-Branch Supply, Financial Inclusion, and Wealth Accumulation". The Review of Financial Studies, 32(12):4767–4809, 04. Bachas P., Gertler P., Higgins S., and Seira E. (2021), "How debit cards enable the poor to save more", The Journal of Finance, 76(4):1913–1957. 3 Demirgüç-Kunt A., Klapper L., Singer D., and Ansar S. (2022). "Financial Inclusion, Digital Payments, and Resilience in the Age of COVID-19", The World Bank Group. 4 Brunnermeier M.K., Limodio N., and Spadavecchia L. (2023), "Mobile money, interoperability, and financial inclusion", NBER Working Paper Series, (31696), September 2023. Maze R., and Gratz S. (2024), "Fast growth and slow policy: a decade of digital credit in Kenya", Oxford Review of Economic Policy, 40, 82-103. Gubbins, P. and Heyer A. (2022), "The state of financial health in Kenya: Trends, drivers, and implications", FSD Kenya. 5 Cantú C., Frost J., Goel T.,and Prenio J., "From financial inclusion to financial health", BIS Bulletin no. 85. 6 Bianco, M., Marconi, D., Romagnoli A., and Stacchini, M. (2022) "Challenges for financial inclusion: the role for financial education and new direction", Banca d'Italia, Questioni di economia e finanza (Occasional Papers), no. 723. 3/3 BIS - Central bankers' speeches
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Speech by Ms Chiara Scotti, Deputy Governor of the Bank of Italy, at the European Banking Authority Policy Research Workshop, Paris, 6 November 2024.
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Regulator or Researcher Hat? The Interconnectedness Case Speech by Chiara Scotti Deputy Governor of Banca d’Italia EBA Policy Research Workshop Paris, 6 November 2024 A number of remarkable developments have changed the financial landscape over the past decade.1 I am pleased to see that the rich programme of this year’s conference hosted by the European Banking Authority covers some important ones. In my keynote speech today, I will start by looking at three areas of change as conduits to highlight what a difficult job I have got myself into and how I go about disentangling the sometimes conflicting forces and signals that come from wearing different hats: that of a regulator and that of a researcher. First of all, new technologies have been changing the way we do business, shop, pay, etc.2 Technological innovation has made it possible to offer new products and services (e.g. digital assets and services), and to offer old products and services in a different way (e.g. online banking). While technology has become increasingly central to the production function of financial firms, IT services are often provided by a few large third-party providers outside the financial industry (and often outside the regulatory perimeter), with a rise in the potentially systemic linkages within and among the financial, technological, and more traditional sectors. Second, the volume of assets intermediated by non-bank finance has increased over time. If we look at the European Union, an area once characterized by a clearly bank-centred financial system, the total assets of non-bank financial intermediaries (NBFIs) now exceed banks’ total assets. While the expansion of non-bank finance has a This speech was prepared as an introduction to the academic presentation of the paper by C. Brunetti, M. Carl, J. Gerszten, C. Scotti and C. Shin (2024), ‘Interconnectedness in the Corporate Bond Market’, FEDS Working Paper No. 2024-66, August, 2024. I would like to thank A. Pilati, F. Cannata, M. Bofondi and N. Branzoli for their comments on a preliminary draft. See, for example, F. Panetta, ‘The digital euro: our money wherever, whenever we need it’, introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament, 2023; A. Perrazzelli, ‘Technology and regulation: bridging the gap in the collective interest’, keynote speech at Milan Fintech Summit, 2024; and R. De Bonis and G. Ferrero, ‘Technological progress and institutional adaptations: the case of the central bank digital currency’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers) 690, 2022. number of positive effects, it also poses potential risks.3 NBFIs are often less regulated than banks, although they perform similar functions; the rules are not always sufficiently harmonized, both globally and at EU level; and finally, NBFIs are deeply intertwined with banks, and increasingly so with digital players, products, and services.4 Finally, the financial system is facing new material risks stemming from climate change and the transition to a greener economy on a global scale.5 This makes it necessary to define appropriate metrics for measuring climate risk, some of which go beyond the more traditional physical and transition risks and look at the network of weather events.6 I hope that this brief overview has convinced you that the work of financial regulators across the world is complex but also extremely challenging and potentially rewarding, given the contribution that we are required and expected to make to a public good such as financial stability. In response to these changes, financial regulators have already taken a wide range of actions. Focusing on the EU stance, let me just mention some of the most recent regulatory outputs, such as the Market in Crytpo-Assets Regulation (MiCAR),7 the Digital See N. Branzoli, R. Gallo, A. Ilari and D. Portioli, ‘Central banks' corporate asset purchase programmes and risk-taking by bond funds in the aftermath of market stress’, Journal of Financial Stability, 72, 101261, 2024. For a detailed discussion of the opportunities and risks associated with the growth of NBFIs, see L.F. Signorini, ‘Non-Bank Finance: opportunities and risks’, speech at the Euromed Workshop, 2019. See, for example, V.V. Acharya, N. Cetorelli and B. Tuckman, ‘Where Do Banks End and NBFIs Begin?’, NBER Working Papers 32316, 2024; M. Gopal and P. Schnabl, ‘The Rise of Finance Companies and FinTech Lenders in Small Business Lending’, The Review of Financial Studies, Volume 35 (11), pp. 4859–4901, 2022. See P. Angelini, ‘Portfolio decarbonisation strategies: questions and suggestions’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers) 840, 2024; and F. Ferriani, A. Gazzani and F. Natoli, ‘Flight to climatic safety: local natural disasters and global portfolio flows’, Banca d’Italia, Temi di discussione (Working Papers) 1420, 2024. See C. Brunetti, B. Dennis, G. Kotta, C. Norris, C. Shin and I. Zer, ‘Climate Risk Networks and Banks’ Exposures’, mimeo, 2024; and M.A. Aiello, ‘Climate supervisory shocks and bank lending: empirical evidence from microdata’, Banca d’Italia, Temi di discussione (Working Papers) 1465, 2024. The Markets in Crypto-Assets Regulation (MiCAR) introduced a harmonized framework across the European Union for the issuance and offering to the public of crypto-assets and the provision of services involving crypto-assets. It aims to reduce regulatory uncertainty in digital assets markets and foster sustainable innovation in the financial sector by establishing a uniform regulatory environment for the following types of crypto-assets: i) electronic money tokens (e-money tokens - EMTs), which purport to maintain a stable value by referencing the value of one official currency; ii) asset-referenced tokens (ARTs), which purport to maintain a stable value by referencing another value or right or a combination thereof, including one or more official currencies; iii) crypto-assets other than EMTs and ARTs. The rules on the issuance, public offering, and admission to trading of ARTs and EMTs have been in force since 30 June, while the remaining provisions will be fully applicable by the end of this year. Operational Resilience Act (DORA)8 and the review of the Alternative Investment Fund Directive (AIFMD2).9 Much work remains to be done on climate risk, and more generally on ESG issues, including on new forward-looking analytical tools and methodologies for designing sound climate–related stress testing models aimed at assessing the resilience of the financial system over short and very long horizons.10 My North Star in this journey of combining different hats into one is to have clear principles as a regulator and to try to think outside the box as a researcher. And indeed, these two hats have the potential to interact in a smart and effective way, even more so now than in the past, given the challenges I have just mentioned. My main principle as a policymaker is that financial regulation should aim to preserve the benefits of financial intermediation (promoting the efficient allocation of private savings to long-term productive projects by firms, thanks to the maturity transformation services stemming from the combination of deposit-taking and the associated payment services and credit issuance) and those of innovation (as a powerful tool for financial inclusion and socio-economic development), while enhancing the safety and soundness of the financial system. For me, thinking outside the box as a researcher means not being held hostage by entrenched preconceptions and pushing boundaries, running the risk that I might sometimes uncover controversial truths. Let me use interconnectedness as a case in point. Each of the examples I mentioned earlier (technological innovation, NBFIs, climate change) has highlighted the potential risks arising from more interconnected sectors and players. Indeed, interconnectedness The Digital Operational Resilience Act (DORA) introduces harmonized rules aimed at strengthening the digital operational resilience of the financial sector. It seeks to ensure that European financial institutions (including banks, insurance companies, payment institutions, fund management companies, market infrastructures, and ICT service providers) can prevent, manage, and withstand cyberattacks and other IT threats. This will be achieved through the adoption of appropriate measures, such as ICT risk management and incident reporting. The regulation will apply as of 17 January 2025 and is currently being implemented at national level, with numerous Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS) being issued at EU level. The review of the Alternative Investment Fund Managers Directive (AIFMD2), which includes amendments to the UCITS Directive, approved last March, aims to increase the level of harmonization of the rules applicable to fund managers and the degree of integration of the European asset management market, partly to increase the alternative financing channels for the economy, in line with the European Commission's 2020 Action Plan to achieve the Capital Markets Union. The new rules are designed to: introduce a harmonized regime for managers of alternative funds that originate loans and an obligation for asset managers to include liquidity management tools in the UCITS or open-ended AIFs they manage; broaden the activities that fund managers may engage in (e.g. benchmark administration); allow asset managers of alternative investment funds to use depositary services on a cross-border basis, if the domestic depositary market is small and underdeveloped; and generally strengthen and harmonize reporting requirements for asset managers and investment funds. The Directive shall be transposed into Member States’ legislation within 24 months of its entry into force. In this respect, the recent Fit-for-55 stress test (to which the EBA was a key contributor) has been a trailblazing//pioneering exercise that brought together the expertise of the three European Supervisory Authorities (ESAs), the ECB and national competent authorities. is one of the metrics used to define systemic financial institutions,11 as it is usually considered (and has proven time and again, including in the Great Financial Crisis) to be a threat to financial stability and an amplifier of shocks. But is this always the case? With my researcher hat on, my argument today is that if we measure interconnectedness for assets as opposed to entities, then interconnectedness is likely to improve market quality, especially in times of stress, because highly interconnected corporate bonds allow for risk sharing.12 This discussion is related to two very controversial debates. One, as already mentioned, is about the role of interconnectedness in financial stability. The other is about whether the traditional entity-based regulation should be complemented by activity-based regulation. While my paper does not have the ambition to resolve such disputes, it does provide a framework for better assessing systemic risks from an asset-based perspective. Clearly, the jury is still out and more research is needed. As I said in my very first speech earlier this year,13 ‘research insights are a necessary input to help policymakers address the challenges they face in their work. This is even more so the case when it comes to financial stability and macroprudential policy, an area that needs to be flexible as it grows in response to a fast-evolving financial environment’. As I speak to you today, trying to decide which of my hats fits better for the occasion (after all, I am Italian and need to be properly dressed for every occasion), I realize that regulation and research are systemically connected and the two hats are more similar than I thought. Many of the topics we research are driven by issues we need to address as regulators. Thinking outside the box as a researcher is often a response to the problems we face as regulators. I am sure that the discussion fostered by this EBA policy workshop will provide a valuable contribution to our work, and I thank you all for your attention. See Basel Committee on Banking Supervision, ‘Global systemically important banks: revised assessment methodology and the higher loss absorbency requirement‘, 2018. The slides for the paper presented during the 2024 EBA Policy Research Workshop are available here. See C. Scotti, Welcome address at the 4th Banca d’Italia, Bocconi University and CEPR Conference on ‘Financial Stability and Regulation’, 2024. Designed by the Printing and Publishing Division of the Bank of Italy
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Welcome address by Mr Fabio Panetta, Governor of the Bank of Italy, at the 80th anniversary of the Bretton Woods Conference, jointly organised by the Bank of Italy, the Italian Ministry of Economy and Finance and the World Bank Group, Rome, 8 November 2024.
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Fabio Panetta: Italy and the World Bank Group "Partnering for Africa's prosperity" Welcome address by Mr Fabio Panetta, Governor of the Bank of Italy, at the 80th anniversary of the Bretton Woods Conference, jointly organised by the Bank of Italy, the Italian Ministry of Economy and Finance and the World Bank Group, Rome, 8 November 2024. *** Good morning, ladies and gentlemen, It is a pleasure to welcome you to this conference organized jointly by Banca d'Italia, the Italian Ministry of Economy and Finance and the World Bank Group. This year marks the 80th anniversary of the Bretton Woods Conference, a landmark event that laid the foundation for modern global economic cooperation. Since then, the World Bank has played a key role in promoting sustainable development, reducing poverty and driving infrastructure growth around the globe. From post-war reconstruction in Europe to today's support for low-income countries, the World Bank remains a key player in the fight against extreme poverty and inequality. Today, the international community faces new, complex challenges. In recent years, an unprecedented sequence of shocks – from the pandemic to Russia's aggression against Ukraine to the energy crisis – has had a significant economic impact, exacerbating existing protectionist sentiments. Globalization, once seen as unstoppable, is now being challenged by geopolitical conflicts that threaten international trade and the stability of the world economy. As global trade fragments, major countries are increasingly reluctant to rely on trading partners with which they lack stable political, economic or cultural ties. This is fuelling growing fears of a world once again divided into economic, political and even military blocs, challenging the principles of international cooperation and multilateralism that have underpinned global economic progress and kept the peace between the great powers since the Second World War. As we mark this anniversary, we reflect on the vision of the leaders who came together 80 years ago to create a more connected and prosperous world. We reaffirm our commitment to the enduring principles of global cooperation and multilateralism that emerged from Bretton Woods, which today are more important than ever to keep the peace in an increasingly divided world. In this spirit, it is essential that the global community come together again, setting differences aside in order to find shared solutions to the interconnected challenges that affect us all. 1/3 BIS - Central bankers' speeches *** Italy is a long-standing partner of the World Bank Group. Our country joined the International Bank for Reconstruction and Development in 1947 and was one of the first countries to receive a loan to rebuild its economy after the Second World War. Banca d'Italia has been involved from the very beginning. It was one of my predecessors, Donato Menichella, then Governor of Banca d'Italia, who conceived the special Southern Development Fund (Cassa per il Mezzogiorno), which proved to be a powerful instrument for attracting, coordinating and implementing aid in the largest intervention the World Bank had ever made in Europe.1 The World Bank's assistance to Italy from the early 1950s to the mid-1960s had two objectives. First, to finance the aid programme centred on the Cassa per il Mezzogiorno. Second, to cover the additional dollar needs following the programme's adoption without depleting Italy's foreign exchange reserves. Overall, the World Bank's support was instrumental in kick-starting post-war reconstruction and in narrowing the GDP per capita gap between the South and the Centre-North of Italy. The programme proved successful, and in the period 1951-65 Italy's real economic growth averaged 6 per cent per year, while GDP per capita in the South rose from 50 per cent to 60 per cent of that in the Centre-North. In the decades that followed, Italy became a major donor. Its cumulative contribution to the paid-in capital of the World Bank Group amounts to about $1 billion. Since 1960, when the fund for the low-income countries (International Development Association, IDA) was created, Italy has supported all 20 IDA Replenishments with more than $12.4 billion. The World Bank Group adds significant value through its financial leverage and the knowledge it brings to joint high-impact projects and programmes. But Italy's contribution and support to the Group is far more than financial. Italy – and with it Banca d'Italia – actively contributes to the governance of the World Bank through its daily participation in the Board of Executive Directors. The World Bank Rome Office is a key component of this collaboration. Banca d'Italia has proudly supported it over the years, most recently when we offered it a new, larger location. We expect the Rome Office to be a catalyst for fostering collaboration among the various entities within the World Bank Group, and to provide a space for closer engagement with external stakeholders, including partnerships with the Italian authorities. We also expect that the new Rome Office will become a vibrant knowledge hub, bringing its expertise to key development operations in Africa. Africa's development is critical to achieving the World Bank's own goals of poverty eradication and shared prosperity, but it is also essential to a stable global economy and to providing a future for the hundreds of millions of young people who join Africa's 2/3 BIS - Central bankers' speeches workforce each year. Finally, it would also help alleviate the inevitable migratory pressures. Italy's position – at the crossroads of the Mediterranean – makes it uniquely well-placed to play an important role in the development of the African continent. The recently launched 'Piano Mattei' reaffirms Italy's commitment to the common goal of fighting poverty, reducing inequalities and promoting sustainable growth, while addressing pressing global challenges such as climate change, pandemics and migration. It demonstrates Italy's intention to promote high-impact operations in partnership with Africa. Banca d'Italia is ready to work with the World Bank, putting its skills and expertise at the service of promoting development in emerging countries, especially in Africa. *** Today's conference is an important occasion for developing comprehensive and effective engagement with African countries. I would like to thank the organizers for putting together an impressive programme. I would also like to thank the keynote speakers, the panellists, the moderators and all of you for attending. I look forward to hearing from President Banga, Governor Kalyalya and Governor Kganyago. The thematic panels – on energy, jobs and digital infrastructure – will delve into some of the key aspects of any growth process and highlight the strategies needed to stimulate investment in these sectors. If we are to build a more balanced, stable and prosperous global economy, then Africa's challenges cannot but also be the world's challenges. While we will not resolve all the issues on the table today, I am confident that our discussions will help deepen our understanding of the complex matters at stake and identify viable ways forward. Together, through open dialogue and cooperation, we can move closer to fostering a future that benefits not only Africa, but the global community as a whole. 1 The loans granted by the World Bank, subdivided into eight (different) tranches from 1951 to 1965, amounted to about $400 million. The idea of acting on the economy as a whole, and not on single projects – was established on the basis of the 'Big Push' theory, a brainchild of Paul Rosenstein-Rodan, who suggested the adoption of nonfragmented interventions to provide, within a reasonable timeframe, the big push onwards needed in order to kick-start the policies for the development of Southern Italy. 3/3 BIS - Central bankers' speeches
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Keynote speech by Mr Paolo Angelini, Deputy Governor of the Bank of Italy, at "The Many Shades of Climate Change through the Lenses of Dispute Settlement"' conference, organised by the Bank of Italy and the Roma TRE Unidroit Centre, Rome, 8 November 2024.
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Paolo Angelini: The many shades of climate change through the lenses of dispute settlement Keynote speech by Mr Paolo Angelini, Deputy Governor of the Bank of Italy, at "The Many Shades of Climate Change through the Lenses of Dispute Settlement"' conference, organised by the Bank of Italy and the Roma TRE Unidroit Centre, Rome, 8 November 2024. *** 1. Introduction The Bank of Italy has long been a careful observer of themes related to the environment, climate change and sustainability, for four main reasons. First, developments in these fields can have consequences for the economy, and need to be thoroughly understood for conducting monetary policy. Second, the Bank considers climate-related – physical and transition – risks in conducting its supervision and financial stability functions, as these risks feed the classical risk categories to which intermediaries are exposed (credit, market, operational, liquidity). Third, the Bank, while not subjected to the EU climate legislation, is committed to reducing its environmental footprint; it has been publishing an annual Environment report since 2010, and is working towards reaching net zero emissions by 2050. Finally, the Bank owns a relatively large portfolio of assets for non-monetary policyrelated purposes, and is committed to invest it according to sustainability criteria. This attention to environmental themes is shared internationally by over 140 central banks and supevisory authorities that have joined the Network for Greening the Financial System (NGFS). The Network, launched in 2017, has the objective to share analyses, methodologies, experiences and best practices in the environmental field, with a particular focus on climate risks. From this brief overview, it is clear that the theme of today's conference, legal risk stemming from climate change and other environment-related disputes, is fully in scope for the Bank of Italy, and more broadly for the entire community of central banks and supervisors. 1/1 BIS - Central bankers' speeches
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Opening remarks by Mr Fabio Panetta, Governor of the Bank of Italy, at the G7-Seminar on "A fragmenting trading system: where we stand and the implications for policy", Rome, 15 November 2024.
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Beyond fragmentation: economic resilience in a shifting world Opening remarks by Fabio Panetta* Governor of Banca d’Italia G7-Seminar on ‘A fragmenting trading system: where we stand and the implications for policy’ Banca d’Italia Rome, 15 November 2024 Ladies and Gentlemen, It is a great pleasure to welcome you to this G7-seminar on ‘A fragmenting trading system: where we stand and the implications for policy’. We are meeting today just a few hundred metres from Palazzo dei Conservatori, where the Treaties of Rome were signed in 1957. The Treaties laid the foundations for the European Economic Community and the European Atomic Energy Community. They set in motion a vision of cooperation and shared prosperity that still resonates strongly in the world today. Their objectives reflect a set of values that transcend European borders and remain strikingly relevant: to promote the free movement of people, goods, services and capital, and to ensure equal access to essential materials.1 Almost 70 years later, these values are under strain. In my remarks today I will touch on some of the forces that risk pushing the global system towards fragmentation. I will also outline some high-level criteria for tackling the problem. The opening up to international trade, increased economic and financial integration, and closer cooperation between countries are important achievements for the international community after the devastation caused by the Second World War. We must safeguard these achievements to ensure prosperity and peace for future generations. * * * * I wish to thank Alessandro Borin, Michele Mancini, Valentina Memoli, Roberto Piazza and Pietro Rizza for their valuable insights and contributions. Article 52 of the EAEC states that: ‘The supply of ores, source materials, and special fissile materials shall be ensured [...] by means of a common supply policy on the principle of equal access to sources of supply.’ There is perhaps no better way to describe the process of global integration than through the lens of international trade. The ability to trade has always brought countries together. Two centuries ago, the house of Thomas Jefferson, one of the American founding fathers, was filled with wine, furniture and books imported from Europe.2 Since then, global trade integration has increased dramatically and its centre of gravity has shifted. Two hundred years ago, trade was mostly an Atlantic affair.3 Today, trade connects all regions across the world, and its value (imports plus exports) has reached 60 per cent of world GDP. Two main factors have contributed to this expansion. First, falling trade costs. Jefferson could afford to import French wine because he was extremely wealthy. Today, import costs are much lower – for everyone. This is partly because the reduction in international tariffs under the GATT/WTO multilateral agreements has made imported goods cheaper. Indeed, research shows that the increase in import tariffs in the United States in 2018 significantly raised the price of imported goods – tariffs were passed on one-to-one to US consumers.4 Equally important is the fall in international transport costs: by some measures, air transport costs have fallen in real terms from almost $4 per tonne-kilometer in 1955 to $0.3 in 2004.5 Policy certainly matters, but so does technological progress. A second key factor is that global trade now moves through complex global value chains. The furniture in Jefferson’s living room was designed and manufactured entirely in Europe. Today, the material and intellectual inputs for both simple and complex objects come from all over the world. This has led to a spectacular increase in both the interconnectedness and specialization of global economies. Take the iPhone for example. It is designed in the United States, its display comes from South Korea, the memory chips come from Japan, South Korea and Taiwan, and it is all assembled in China.6 Globalization has been accompanied by a dramatic improvement in living standards, especially in China and in other parts of Asia. Hundreds of millions of people have For an account of Jefferson’s private life, see S.N. Randolph, The Domestic Life of Thomas Jefferson, New York, Harper & Brothers, 1871. Some of Jefferson’s furniture can be seen at the official Thomas Jefferson Monticello website. K. Pomeranz, ‘The Great Divergence: China, Europe, and the Making of the Modern World Economy’, Princeton University Press, 2000. M. Amiti, S.J. Redding and D.E. Weinstein, ‘Who’s paying for the US tariffs? A longer-term perspective’, AEA Papers and Proceedings, Volume 110, 2020, pp. 541-546; P.D. Fajgelbaum, P.K. Goldberg, P.J. Kennedy and A.K. Khandelwal, ‘The return to protectionism’, The Quarterly Journal of Economics, Volume 135, 1, 2020, pp. 1-55. D. Hummels, ‘Transportation Costs and International Trade in the Second Era of Globalization’, Journal of Economic Perspectives, Volume 21, 3, 2007, pp. 131-154. F.P. Hochberg, ‘The iPhone Isn’t Made in China: It’s Made Everywhere’, The Wall Street Journal, 31 January 2020. been lifted out of poverty.7 This phenomenon has been so pronounced that between 1980 and 2008 the centre of gravity of global economic activity moved some 5,000 km eastwards.8 This shift in trade has also been accompanied by geopolitical shifts. * * * For all the successes I have listed, we must acknowledge that globalization has also created vulnerabilities. Some have only recently become apparent. Others have been brewing for a long time.9 This brings me directly to the issue of global fragmentation. The COVID-19 pandemic and the geopolitical tensions following Russia’s aggression against Ukraine have highlighted the vulnerabilities associated with over-reliance on single suppliers or regions. These events have shown how specialization can improve efficiency but also lead to excessive concentration, creating bottlenecks in global supply chains. Interdependence is increasingly perceived as a source of risk to national security. Examples include the sudden interruption of Russian gas flows to Europe, or China’s export quotas on gallium. At the same time, several advanced economies have curbed technology exports to non-aligned countries.10 Geopolitical blocs are now considering how to manage specialization and international trade to ensure their supremacy in the race for technology. Companies are already taking note.11 Geopolitical considerations are becoming more important in their foreign direct investment decisions.12 In the European Union (EU), companies have begun to implement de-risking strategies, mainly by replacing Chinese suppliers with EU-based ones.13 Globalization is not over, but the geography of trade is changing.14 At the global level, inequalities have decreased since the 1980s thanks to a reduction in the gaps between countries. See L. Chancel, T. Piketty, E. Saez and G. Zucman (coordinators), World Inequality Report 2022, World Inequality Lab, 2022. D. Quah, ‘The Global Economy’s Shifting Centre of Gravity’, Global Policy, Volume 2, 2011, pp. 3-9. F. Panetta, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, Lectio Magistralis delivered on the occasion of the conferral of an honorary degree in Juridical Sciences in Banking and Finance by the University of Roma Tre, Rome, 23 April 2024. Export quotas on gallium on the one hand, and limitations on technological transfers on the other, are in fact related. See H. Ziady and X. Xu, ‘China hits back in the chip war, imposing export curbs on crucial raw materials’, CNN, 3 July 2023. M. Bottone, M. Mancini, A. Boffelli, D. Pegoraro, A. Kutten, I. Balteanu and J. Quintana, ‘Sourcing governance and de-risking strategies in Europe: a comparative study of Germany, Italy and Spain’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 880, 2024; Centro Studi Confindustria, ‘Catene di fornitura tra nuova globalizzazione e autonomia strategica’, Confindustria Servizi, 2023. IMF, ‘World Economic Outlook. A Rocky Recovery’, April 2023. I. Balteanu, M. Bottone, A. Fernández-Cerezo, D. Ioannou, A. Kutten, M. Mancini, and R. Morris, ‘European firms facing geopolitical risk: Evidence from recent Eurosystem surveys’, VoxEU column, 18 May 2024. F.P. Conteduca, S. Giglioli, C. Giordano, M. Mancini and L. Panon, ‘Trade Fragmentation Unveiled: Five Facts on the Reconfiguration of Global, US and EU Trade’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 881, 2024. Other forces are also pushing towards greater fragmentation. In several advanced countries, critics argue that – by embracing globalization – democratic countries have given up some of their autonomy in implementing national policies that could have offered protection to the most vulnerable workers and citizens.15 Such considerations deserve attention. At the same time, globalization has often been an easy scapegoat. For example, empirical analysis shows that technological progress has a much greater impact on wage inequality than outsourcing or participation in global value chains.16 It has also become increasingly clear that some countries have been able to attract significant volumes of global production thanks to substantial public subsidies.17 For example, the rapid growth of the electric vehicle industry in China has been supported by generous production subsidies.18 Multilateral rules and institutions have not always been effective in addressing these distortions. This has contributed to the erosion of the multilateral system. As a central banker, let me also comment on the state of the international financial system. At global level, the degree of financial integration remains high, and the financial safety net has expanded significantly since the 2008 financial crisis. However, this safety net remains uneven across countries.19 There are signs that the landscape is changing. For instance, there is growing debate about the impact of trade and financial sanctions on the structure of the international payments system. In addition, some central banks are reducing their holdings of major currencies while increasing their gold reserves.20 * * * How should we address the challenges of global fragmentation? Recognizing that this is an extremely complex issue, I will refrain from offering a specific solution. Instead, I will propose a methodological approach and outline some concrete examples of its application. D. Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy, New York-London, W.W. Norton, 2011. R.C. Feenstra and G.H. Hanson, ‘The impact of outsourcing and high-technology capital on wages: estimates for the United States, 1979-1990’, Quarterly Journal of Economics, 114, 3, 1999, pp. 907-940; R.C. Feenstra and G.H. Hanson, ‘Global production sharing and rising inequality: a survey of trade and wages’, in E. K. Choi and J. Harrigan (eds.), Handbook of International Trade, Oxford, Blackwell Publishing, 2003, pp. 146-185; ‘Fostering inclusive growth’, document prepared by IMF staff for the G20 meeting in Hamburg on 7-8 July 2017. L. Rotunno and M. Ruta, ‘Trade Spillovers of Domestic Subsidies’, IMF Working Papers, 41, 2024. European Commission, ‘EU imposes duties on unfairly subsidised electric vehicles from China while discussions on price undertakings continue’, press release, 29 October 2024. The global financial safety net comprises central banks’ FX reserves, central banks’ bilateral swap arrangements (BSAs), Regional Financing Arrangements (RFAs), and the IMF. Its expansion since 2008 was driven mainly by increased coverage from BSAs and RFAs, which however are limited to selected participating countries. The IMF remains the only elements of the global financial safety net that provides universal coverage. See S. Aiyar et al., ‘Geoeconomic Fragmentation and the Future of Multilateralism’, IMF Staff Discussion Notes, 1, 2023. F. Panetta, ‘Beyond money: the euro’s role in Europe’s strategic future’, Speech at the conference for the Ten years with the euro, Riga, 26 January 2024. My basic premise is that we must avoid the illusion that blanket measures erecting protectionist barriers are the solution to our problems. A blanket measure is like a kitchen knife: it is not the right instrument to perform complex surgery. The global economy is extremely complex in its trade, investment and financial interconnections. Attempts to divide the global economy into rival blocs would do more harm than good. An escalation of trade barriers between blocs would lead to severe efficiency and welfare losses for all.21 It would reduce the diversification of our economies and increase the volatility of output and inflation. Indeed, several studies have shown that trade openness and participation in global production networks improve the diversification of sources of supply and demand, thereby reducing exposure to local shocks.22 The weaponization of critical supply chains by commodity-producing countries would severely affect EU manufacturing production, with heterogeneous effects across regions, sectors and firms. For example, value-added in the electrical equipment industry could fall by more than 7 per cent, three times as much as in the textile industry.23 Protectionism would not be as protective as it might seem, as blunt policies would inevitably be circumvented. Key products targeted by bilateral trade restrictions would find indirect routes to opposing blocs through trade with third countries,24 simply turning a bilateral relationship into a three-party trade. This would only add a third trade intermediary, increasing costs and risks and reducing transparency.25 Such unintended consequences would undermine economic efficiency and security. * * * So, how can we pursue a more focused de-risking strategy? In my view, this strategy rests on four main pillars: information, innovation, flexibility and international cooperation. As an example of this approach, I will refer to possible de-risking strategies in the sourcing of critical raw materials. This is a crucial issue for the EU, which accounts for only 0.5 per cent of global production of these inputs.26 See, among others, M.G. Attinasi, L. Boeckelmann and B. Meunier, ‘The economic costs of supply chain decoupling’, ECB Working Papers, 2839, 2023; G. Felbermayr, H. Mahlkow and A. Sandkamp, ‘Cutting through the value chain: The long-run effects of decoupling the East from the West’, Empirica, 50, 2023, pp. 75-108; B. Javorcik, L. Kitzmüller, H. Schweiger and M.A. Yıldırım, ‘Economic costs of friendshoring’, The World Economy, 47, 7, 2024, pp. 2871-2908. A. Borin, M. Mancini and D. Taglioni, ‘Measuring exposure to risk in global value chains’, World Bank, Policy Research Working Papers, 9785, 2021. L. Panon et al., ‘Inputs in distress: geoeconomic fragmentation and firms’ sourcing’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), 861, 2024. For instance, in the case of sanctions imposed on Russia following the invasion of Ukraine, there are signs of a rerouting of EU sanctioned goods through specific third countries. See A. Borin et al., ‘The impact of EU sanctions on Russian imports’, VoxEU, 29 May 2023. F.P. Conteduca, S. Giglioli, C. Giordano, M. Mancini and L. Panon, op. cit., 2024. IEA, ‘World Energy Investment 2024’, 2024; F. Panetta, ‘The heat is on: challenges and opportunities of the energy transition’, Opening remarks at the G7-IEA conference on ‘Ensuring an orderly energy transition’, Rome, 16 September 2024. With better information, we can better identify and monitor vulnerabilities. Many G7 public institutions, including the European Commission and the US Department of Commerce, have developed analytical tools to map critical vulnerabilities in the availability of raw materials.27 However, our understanding of production interdependencies remains limited. More data needs to be collected and pooled, and best practices and tools need to be shared. Innovation is the second pillar. Scientific research and product development can provide us with alternative materials and technologies. This can be financed partly through public-private partnerships for large projects. In addition, multilateral financial institutions such as the European Bank for Reconstruction and Development can finance new supply chains that help diversify sources of critical raw materials. Third, our policies must be flexible enough to adapt to an ever-changing landscape. We cannot predict exactly what future innovations will look like. Nor can we predict geopolitical developments. Nevertheless, we should set long-term goals. Flexibility is all the more important when change takes time.28 The fourth pillar is cooperation. To unlock the greatest gains, we should remain committed to making cooperation truly global. The cost of a fragmented world would in fact be very high. Some research29 suggests that it could exceed 6 percent of global GDP in extreme scenarios.30 But as global cooperation becomes more difficult, there are reasons to at least strengthen cooperation among like-minded countries. The rewards are great: it was a joint US-European supply chain that developed and distributed one of the most R. Arjona, W. Connell García and C. Herghelegiu, ‘An enhanced methodology to monitor the EU’s strategic dependencies and vulnerabilities’, Publications Office of the European Union, Single Market Economy Papers WP/14, 2023; European Commission, ‘Strategic dependencies and capacities’, Commission Staff Working Document, 352, 2021; U.S. Department of Commerce ‘Fact Sheet: Department of Commerce Announces New Actions on Supply Chain Resilience’, 10 September 2024. To understand what this means, consider the production of critical minerals needed for the climate transition. Europe needs a flexible policy mix to significantly reduce its critical dependencies (M. Draghi, ‘The future of European competitiveness’, September 2024). Projects to increase domestic production of critical minerals are under way, for example for lithium. However, uncertainties remain regarding potential yields, especially for rare earths. There is currently no domestic refining capacity for these elements in the EU, so decisions will also have to be made here (L. Gregoir and K. van Acker, ‘Metals for Clean Energy: Pathways to Solving Europe’s Raw Materials Challenge’, KU Leuven, 2022). Some argue that, if technological innovation in recycling advances far enough, Europe could become a net exporter of these minerals in the long term. But, in the short term, we need to step up economic diplomacy to strengthen trade and investment partnerships with a wider group of suppliers, including those in sub-Saharan Africa. The G7 Partnership for Resilient and Inclusive Supply Chain Enhancement is a blueprint for innovative strategies on this front. It can help diversify our supply chains for clean energy products, while providing our partners in low- and middle-income countries with technology transfers that support their economic development. M.G. Attinasi and M. Mancini (coordinators), ‘Navigating a fragmenting global trading system: Insights for central banks’, European Central Bank, Occasional Paper Series, forthcoming. To put this figure into perspective, a 6 percent decline in global output corresponds to the impact of the COVID-19 pandemic on world GDP in 2020. This impact is calculated as the difference between realized world GDP in 2020 and the corresponding value projected by the IMF in its October 2019 ‘World Economic Outlook’. successful vaccines against COVID-19. The EU is already discussing new ways to further coordinate its members’ policies. We also need to work better with our international partners. For instance, we should reinvigorate discussions on trade and investment agreements. On industrial policy, better coordination would at least allow us to avoid costly subsidy wars. * * * Let me conclude by emphasizing that the costs of international fragmentation are not only economic. Much more is at stake: from social progress to international cooperation. And so is freedom – the freedom to trade goods and services, to invest across borders, to share knowledge and ideas. These are the prerequisites for securing prosperity and peace. I very much look forward to the discussions that will emerge from today’s seminar. I am sure it will help raise awareness of the many benefits that only an integrated world can bring.
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the 20th Spain-Italy Dialogue Forum (AREL-CEOE-SBEES), Barcelona, 3 December 2024.
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A European productivity compact Speech by Fabio Panetta* Governor of Banca d’Italia 20th Spain-Italy Dialogue Forum (AREL-CEOE-SBEES) Barcelona, 3 December 2024 Introduction I am delighted to take part in this edition of the Spain-Italy Dialogue Forum which, since 1999, has provided a great opportunity for our two countries to exchange ideas and experiences. Two countries united by the Mediterranean, a sea so enchantingly evoked by the voice of Joan Manuel Serrat. The history of Italy is inextricably linked to that of Spain. The same is true of their economies. Our trade in goods and services totals over €73 billion: Spain is Italy’s fourth largest trading partner, Italy is Spain's third. Spanish direct investment in Italy and Italian direct investment in Spain amount to €14 billion and €46 billion, respectively. Together, our two countries make up a significant part of the euro area. They account for 25 per cent of GDP, 23 per cent of industrial output and 17 per cent of euro-area exports. A staunch commitment to being part of the European endeavour has been a fundamental driver of economic development for both countries – for Italy, which has been a member since the beginning, and for Spain, which has been able to seize the opportunities offered by its more recent accession. However, the European economy is struggling to keep pace with the most dynamic countries, the United States above all (Figure 1.a), mainly because of low productivity growth (Figure 1.b). The fact that the European economy is losing ground is nothing new. The gap with the United States emerged at the end of the last century, with the spread of information and communication technologies, and subsequently widened with the digital revolution and, more recently, artificial intelligence. * My thanks go to Antonella Foglia, Valentina Memoli, Roberto Pisano, Pietro Rizza, Anatoli Segura Vélez, Pietro Tommasino, and Stefania Zotteri for their valuable research and contributions. Figure 1 GDP growth and productivity gaps between the European Union and the United States (a) real GDP (index: 1991=100) (b) GDP per hour worked (index: Q1 1995=100) European Union United States Sources: For panel (a), IMF. For panel (b), Bureau of Labor Statistics and Eurostat. (1) GDP per hour worked in the private sector. These three missed opportunities for Europe are interrelated and are an indication of structural weaknesses. Their effects are visible in Europe’s declining economic position (Figure 2) and, ultimately, in the living conditions of its citizens: if Italy or Spain were US states, they would be in the lowest quintile in terms of GDP per capita, as would the European Union as a whole.1 Figure 2 Global GDP shares of the world’s leading economies (per cent) (a) Shares of global GDP at current prices (b) Shares of global GDP based on purchasing power parity European Union United States China India Source: IMF. The European economic and social model that took shape after the Second World War, based on the principles of freedom, equality and solidarity, as well as international cooperation, has been a marker of civil progress. This model has proven successful in many areas, as shown by the data on life expectancy. It must be preserved, and to do this we need an economy that can grow and generate widespread prosperity. 2023 GDP in terms of purchasing power parity. In the remainder of my speech, I will focus on one goal that I consider to be a priority: putting innovation at the heart of economic policies as a driver of productivity and growth, and mobilizing public and private resources to this end. 1. Innovation, technology and productivity At the root of the European economy’s low productivity lies its insufficient capacity for innovation, which in turn is due to the lack of dynamism in the business sector. In the last decade, investment in research and development by European companies has been about 60 per cent that of US companies, and the gap has been widening over time (Figure 3).2 Figure 3 Private sector R&D expenditure (a) Investment in R&D (billions of euros) (b) Investment in R&D as a share of GDP (per cent) 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 European Union United States China Sources: For the European Union, Eurostat; for China and the United States, OECD. This is compounded by an unfavourable sectoral composition of research activity in Europe, 30 per cent of which is concentrated in mature sectors.3 Over the past two decades, the companies at the top of the research and development investment scoreboard have mostly been in the automotive sector, which is now struggling to keep up with the more radical innovations by its extra-European competitors.4 In the United States, instead, the companies and sectors that spend the most on research and development have changed over time. Twenty years ago it was car manufacturers; The percentage is broadly the same both in terms of purchasing power parity and as a ratio of GDP. The gap is even greater, as shown in Figure 3.a, at current monetary values, which are affected by exchange rate fluctuations and differences in price dynamics. At purchasing power parity, the ratio fell from 62 per cent in 2013 to 50 per cent in 2023. E. Nindl et al., The 2023 EU Industrial R&D Investment Scoreboard, Publications Office of the European Union, 2023. The figures relate to the 2,500 companies that invest the most in research and development worldwide. C. Fuest, D. Gros, P.-L. Mengel, G. Presidente and J. Tirole, EU innovation policy: How to Escape the Middle Technology Trap, EconPol Policy Report, 2024. today it is digital economy and technology-intensive companies, with new players continually emerging that are capable of achieving significant growth and capitalization in a short period of time. There are three main reasons for the predominance of middle technology sectors in Europe. To begin with, the innovation gap that has been building up since the end of the last century, when Europe's production system failed to make the most of the opportunities provided by the spread of the Internet and of information and communication technologies. Then came the US tech giants (Google, Apple, Facebook, Amazon, and Microsoft), whose access to massive datasets, scientific know-how, financial resources, and extensive customer bases, has ensured them a dominant position today as digital service providers and in cutting-edge fields such as artificial intelligence. The European economy’s capacity to innovate is also limited by the fragmentation of research and development activities among firms, universities and research centres based in different countries. This hinders the transfer of knowledge and ideas, and hampers the undertaking of projects with high funding requirements. Finally, the lack of integration between the scientific and business worlds and the rigidity of the EU administrative and regulatory framework stand in the way of transforming research results into competitive products and services for the global marketplace. AI is an eminent case in point.5 Although European research centres have produced highlevel studies in this field, the contribution of European businesses to the development of AI technology is negligible: between 2013 and 2023, private investments in AI amounted to $20 billion in Europe, compared with $100 billion in China and $330 billion in the US.6 Though it remains unclear to what extent AI will increase labour productivity, it is clear that remaining on the sidelines of technological progress – as mere users of innovation developed elsewhere – would be short-sighted. Greater involvement of European companies alongside a handful of global tech giants would not only benefit the economy but also safeguard citizens’ fundamental rights such as personal data protection and pluralism in media and information. 2. The investment we need for a new Europe Over the last ten years, capital investment in Europe has been systematically lower than in the United States; the gap, which had narrowed in the years before the pandemic, is now widening again (Figure 4). Moreover, the trends in investment in research and development point to problems in the quality and composition of spending. Similar considerations apply to many other areas such as robotics, biotechnology and space exploration. N. Maslej et al., Artificial Intelligence Index Report 2024, AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, April 2024. Figure 4 Capital expenditure (per cent of GDP) European Union United States Sources: For the European Union, Eurostat; for the United States, Bureau of Economic Analysis. (1) Capital expenditure is calculated as the difference between gross fixed investment and investment in housing. Europe will need significant resources to achieve sustainable economic growth and to secure its strategic autonomy. According to various analyses,7 a further €800 billion per year will be required in public and private investment until 2030 for the twin green and digital transition and for strengthening its defence capacity.8 This amount, equal to almost 5 per cent of the EU’s GDP every year, 9 does not include all of the expenditure needed to improve our innovation capacity, such as that for upgrading the skills required by emerging technologies. I will not go into the details of these estimates. Rather, I would like to focus on three issues. The first one is the need to implement strategic projects through European initiatives. Their high cost would make investment too burdensome for individual Member States, even for those that are financially sounder.10 Only by joining forces can we improve the functioning of the EU’s single market, exploit economies of scale, avoid duplication F. Panetta, ‘Investing in Europe’s future: The case for a rethink’, speech delivered at the Istituto per gli Studi di Politica Internazionale (ISPI), Milan, 11 November 2022; F. Panetta, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, Lectio Magistralis marking the conferral of an honorary degree in Juridical Sciences in Banking and Finance by the University of Roma Tre, 23 April 2024; O. Bouabdallah, E. Dorrucci, L. Hoendervangers and C. Nerlich, ‘Mind the gap: Europe’s strategic investment needs and how to support them’, The ECB Blog, 27 June 2024; M. Draghi, The future of European competitiveness, 2024. Climate-related investment needs in the EU amount to around €620 billion per year on average (European Commission, 2023 Strategic Foresight Report. Sustainability and people’s wellbeing at the heart of Europe’s Open Strategic Autonomy, COM(2023) 376 final, 6 July 2023, p. 7). This amount must be increased by around €125 billion per year for the digital transition and by around €75 billion per year to bring defence spending to 2 per cent of GDP, in line with NATO commitments. Based on GDP for 2023. For example, recent estimates produced for Germany alone point to around €800 billion additional cumulative investment needs over the period 2025-30; see F. Heilmann et al., ‘Public financing needs for the modernisation of Germany’, Dezernat Zukunft, 2024. resulting from overlapping national initiatives, and stave off the free-rider problems that often occur with public goods.11 The second issue is the source of funds. Such major interventions require joint public and private resources. In the past, four fifths of European capital investment were financed by the private sector and the remainder by the public sector.12 However, it is reasonable to expect that the share of public sector investment will increase in the future, since many projects – such as the production of innovative technologies, the digital transition, energy security and defence – involve European public goods. Furthermore, numerous projects, especially in the early stages, have low returns and uncertain outcomes; this is why the public sector plays such a key role in fostering private sector initiatives. A historic example of this is the DARPA project in the United States, which, since the 1960s, has paved the way for the development of the Internet.13 Last but not least is the need to help European citizens understand that the high investment costs will be offset by equally high rewards. During this transition, it will be essential to protect the most vulnerable segments of the population, which might be more affected by the changes. This approach will be crucial to mitigate any social or political pushback and to strengthen public support for the EU project. 3. The role of public sector resources Europe has been in an anomalous situation for years. On the one hand, some countries have very high levels of public debt – which is a significant problem for Spain and even more so for Italy. On the other hand, the European common debt is very low. The bulk of the EU’s public debt consists of funding for the NextGenerationEU (NGEU) programme. The funds under the Recovery and Resilience Facility, the main instrument of the NGEU, amount to €650 billion; a further €80 billion have been allocated to several existing programmes already included in the EU budget. However, the NGEU programme will end in 2026 and, from 2028 onwards, the outstanding volume of EU bonds will start to decrease, reaching nearly zero over the next three decades. Within a given territory, public goods are non-rivalrous (extending their use to everyone does not require additional costs) and non-excludable (it is not possible to restrict their use to those who have helped finance them). The latter feature is at the root of free-rider problems, i.e., in our case, the incentive for a State to benefit from the efforts of others (e.g. in the environmental field) without making any efforts of its own. M. Draghi, 2024, op. cit. In 1958, the United States founded the Advanced Research Projects Agency (ARPA; later renamed Defense ARPA, or DARPA), with the aim of developing breakthrough military technology. In 1969, they launched ARPAnet, a computer network connecting ARPA to a number of US universities. During the 1970s, the number of universities connected to the network grew and a new protocol was created to streamline and expedite communication between and among network computers, thereby laying the foundations for the development of the Internet as we know it today. DARPA’s activities rely on the interaction between academia, the corporate sector and government agencies. Creating a common fiscal capacity to finance public goods would help Europe overcome this anomaly. To be clear: this proposal does not imply the creation of a ‘fiscal union’, and would require neither an EU finance minister nor mechanisms for systematic transfers between countries.14 The idea, instead, is to set up a common spending programme to finance investments that are indispensable for all European citizens, through a continent-wide productivity compact. To paraphrase Keynes, what matters is not to do better or worse those things which the Member States are already doing, but to do the things that are not being done at all.15 Here is an example that may help illustrate my point. If the EU issued debt securities to fund up to 25 per cent of an investment plan worth €800 billion a year for six years, by 2030 the European common debt would reach 6 per cent of the EU’s GDP. Taking into account NGEU bonds and other programmes managed by the European Commission, it would reach 10 per cent of GDP (Figure 5).16 Let me only mention in passing the other important functions that a common fiscal capacity could perform. As well as mitigating the impact of local shocks that affect only some Member States (a form of mutual insurance), a common fiscal capacity would enable the better management of aggregate demand. This way, the European fiscal policy would no longer be the mere sum of national fiscal stances, but could be made consistent with the cyclical conditions of the euro-area economy as a whole and with the monetary policy stance. ‘The important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all.’ Keynes made the point in his 1926 essay The End of Laissez-faire, referring to the best way to allocate tasks between the public and private sector within a single country (J.M. Keynes, The End of Laissez‑faire, London, Hogarth Press, 1926). The macroeconomic assumptions underlying the simulations are that: the interest rate on the productivity compact will be 3 per cent (equal to the weighted average of the yields on the ten-year bonds of the EU Member States); real GDP growth forecasts up to 2026 are sourced from European Commission, European Economic Forecast. Autumn 2024, Institutional Paper, 296, November 2024; between 2027 and 2030 real growth will align with potential GDP growth (1 per cent), as estimated by the European Commission in 2024 Ageing Report. Economic and Budgetary Projections for the EU Member States (2022‑2070), Institutional Paper, 279, April 2024; from 2031 onwards, the growth forecasts are in line with those made by the European Commission in the same document; from 2027 onwards, inflation remains stable at 2 per cent. Debt ‘excluding NGEU’ means debt relating to the following financial assistance programmes managed by the European Commission: the European instrument for temporary Support to mitigate Unemployment Risks in an Emergency (SURE), the European Financial Stabilisation Mechanism (EFSM), the Balance of Payments (BoP) assistance facility, the Euratom Research and Training Programme, the Macro Financial Assistance (MFA) and Macro Financial Assistance+ (MFA+) programmes, and the loan component of the Ukraine Facility. For SURE, EFSM, BoP, Euratom and MFA the assumption is that the capital will be almost entirely repaid by 2058, as stated in European Commission, Consolidated annual accounts of the European Union for the financial year 2023, COM (2024) 272 final, 2024; for the funds disbursed to Ukraine under the MFA+ programme, the Ukraine facility and the exceptional macrofinancial assistance package adopted by the EU Council on October, the assumption is that they will start to be repaid in 2033. For NGEU, the assumption is that by 2026 all EU Member States will have received the full amount of funds requested and that grant-related borrowings will be repaid linearly between 2028 and 2058 (between 2032 and 2053 for loan-related borrowings). Finally, with regard to the productivity compact, the assumption is that from 2031 onwards, Member States will only repay interest on bonds, whose amount will therefore remain constant in nominal terms. Figure 5 Simulations of the stock of common EU bonds issued to fund the financial assistance programmes managed by the European Commission (per cent of GDP) Excluding NGEU NGEU Productivity compact Sources: For the financial assistance programmes (including NGEU), calculations based on European Commission data; for the simulations, see Footnote 16. The increase in liabilities would be small at central level and used exclusively to boost the productivity of the European economy; 17 it would limit the investment expenditure needs of Member States, which could thus reduce their public debt more quickly. The creation of a liquid secondary market would make it possible to reduce EU bond yields, which are currently penalized by the low liquidity of trading and the absence of derivative instruments to hedge market risks. Based on Banca d’Italia estimates, solving these critical issues could reduce the yields on common EU bonds by over 20 basis points.18 Regular issuances of securities by the EU would also provide us with a European safe asset which, as I will explain, is indispensable for the development of a European capital market. This course of action, however, needs to take into account three important preconditions: the rationalization of the resources already allocated to EU programmes; obtaining the commitment of high-debt Member States to improve their public accounts in order to prevent the EU’s overall debt from rising excessively; and guaranteeing transparent management of EU projects, by ensuring that the resources are actually used to increase productivity and that there is full accountability for all decisions made. A flow of resources, which can conservatively be estimated at around 0.2 per cent of the EU’s GDP for 2031, would be sufficient to repay the additional common debt incurred in the years 2025-30. If, as we could reasonably expect, the plan should lead to higher potential growth, the cost would then fall. K. Pallara, M. Pericoli and P. Tommasino, ‘Issuing European safe assets: how to get the most out of Eurobonds?’, Banca d’Italia, Questioni di Economia e Finanza (Occasional Papers), forthcoming. 4. A European capital market for innovation One of the biggest obstacles when it comes to investing in innovation in Europe is the lack of an efficient capital market that is integrated at EU level and can select the most capable entrepreneurs and support high-risk, high-yield projects from the very outset.19 The investment plan I have described above will require a significant contribution on the part of financial intermediaries and private investors, not only in terms of the resources required, but also to select and monitor the projects. Given the riskiness of the investments, the equity market and other specialized forms of investment – such as private equity and venture capital – will play a fundamental role. Market dynamics may well provide solutions to problems that would otherwise be difficult to solve. However, the conditions must be created for these forces to play out in full. Greater financial integration would make the euro area more attractive to investors, both foreign and domestic. The European economy has been running a balance-of-payments surplus for years. Therefore, it has been generating savings that exceed domestic investment, partly redirecting them abroad. Prior to the pandemic, domestic financial resources invested outside of the euro area averaged over €300 billion per year, or almost 3 per cent of GDP. Had they been directed towards domestic business initiatives, capital investment on our continent would have increased by one fifth. A single capital market would improve the allocation of savings. It would also boost cross-border financial flows between Member States, providing European households, firms and financial intermediaries with better diversification opportunities. This would allow them to mitigate the impact of local shocks and to take part in projects with higher risks and returns. The financial sector currently enables European investors to absorb just one fourth of local GDP shocks, compared with three fourths in the United States. To make progress towards a single capital market in Europe, two fundamental problems must be addressed. The first is the lack of a European safe asset. A common safe asset is essential for the functioning of any developed capital market. The possibility of trading a risk-free benchmark would facilitate the pricing of financial products such as corporate bonds and derivatives, thereby encouraging their development. Furthermore, it would provide a form of collateral that could be used across countries and market segments, facilitating collateralized trading in interbank markets and allowing better risk diversification by financial intermediaries. A safe asset would also attract foreign investment, thereby strengthening the international role of the euro. E. Letta, Much more than a market: speed, security, solidarity. Empowering the Single Market to deliver a sustainable future and prosperity for all EU Citizens, April 2024. The second problem is the lack of a complete banking union, which restricts European banks to operating mainly in national markets. Establishing the Single Supervisory Mechanism and the Single Resolution Mechanism was a major step forward, but it fell short of creating a fully integrated European banking market.20 A sequential, small-steps approach was taken, which has not worked.21 Banks play a crucial role in the major capital markets: from asset management to bond and equity underwriting and placement, and from initial public offerings to financial advisory and market- making services. An integrated capital market requires that banks be fully operational throughout the euro area. The introduction of a European safe asset and the completion of the banking union are the most important preconditions for creating a single capital market, but they are not the only ones. We must not forget the importance of drafting a single European Finance Act, of strengthening central supervision, and of harmonizing corporate crisis management mechanisms. Conclusions Jean Monnet once said: ‘Europe will be forged in crisis’.22 This statement is not only a beacon of hope in hard times, but also a reminder that we must embrace every challenge as an opportunity to transform our continent. Today, we are facing momentous changes: the twin digital and green transition, the deteriorating geopolitical outlook, demographic and migration pressures, and the fragmentation of world trade. These are not temporary crises, but major processes that require appropriate responses. To face them, we need to build an economy that can grow, innovate and generate widespread prosperity. No Member State can do this alone. We need coordinated action at European level: a productivity compact that mobilizes public and private investment in strategic common goods. This endeavour is not just a response to the need to recover lost ground, but also a blueprint for the future. It means strengthening technological sovereignty, creating jobs, improving the quality of life of citizens and protecting such fundamental values as freedom and pluralism. The credit sector remains fragmented along national lines: there is no European deposit guarantee scheme, the bank crisis management framework is incomplete and obstacles to the transfer of banking groups’ capital and liquidity across countries still exist. F. Panetta, ‘Europe’s shared destiny, economics and the law’, Lectio Magistralis by Fabio Panetta, Member of the Executive Board of the ECB, on the occasion of the conferral of an honorary degree in Law by the University of Cassino and Southern Lazio, 6 April 2022. ‘L’Europe se fera dans les crises et elle sera la somme des solutions apportées à ces crises’ (J. Monnet, Mémoires, Paris, Fayard, 1976). To achieve these goals, it is essential that we introduce a European safe asset, complete the banking union, and develop a European capital market that is better able to finance innovative high-risk projects. We must also create a business environment that encourages entrepreneurship and innovation, overcoming regulatory and administrative rigidities that hold back our growth potential. We cannot afford a sequential, small-steps approach. The necessary reforms are interconnected and mutually reinforcing: they must be implemented with determination and vision, building on the recent analyses by Mario Draghi and Enrico Letta. Europe can and must take control of its own destiny. Like Niccolò Machiavelli’s archer, we must aim higher to hit our target.23 Together, Member States can turn challenges into opportunities and build a future of prosperity and progress for all European citizens. ‘It’s like the clever archer who senses that his target is too far off, knows the limitations of his bow, and so aims far higher than he normally would, not because he really wants his arrow to go that high, but to have it fall from a height on to his target’. (N. Machiavelli, The Prince, Chapter VI, 1532, translated by Tim Parks, 2009).
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Speech by Mr Fabio Panetta, Governor of the Bank of Italy, at the meeting "Economy and peace: a possible alliance", organised by the Centesimus Annus Pro Pontifice Foundation, Bologna, 16 January 2025.
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Peace and prosperity in a fragmented world Speech by Fabio Panetta* Governor of Banca d’Italia Economy and Peace: a possible alliance Fondazione Centesimus Annus Pro Pontifice Bologna, Centro San Domenico, 16 January 2025 Today, our world is facing an alarming rise in geopolitical tensions and conflicts. The number of wars, which had decreased after the fall of the Berlin Wall, has turned upward again in the last fifteen years; in 2023 it reached its highest level since World War II (Figure 1). In many regions, war – often fratricidal – is a daily reality.1 Day after day, the news brings us dramatic images, reawakening fears linked to the traumatic experiences of the two world wars. In Western Europe, the debate about significantly increasing defence spending has resurfaced after a long time. But conflicts are not the only cause for concern. The denial of basic needs, which still affects large parts of the world's population, is also a form of violence. After decades of ever stronger international cooperation and economic integration, history now seems to be taking a step backwards. It is a very different world from the days when I started working as a central banker. In many ways, it is a world of greater uncertainty and less hope for the future, although even back then there was no shortage of stark clashes and dramatic tensions.2 * I would like to thank Andrea Brandolini, Patrizio Pagano, Roberto Piazza, Pietro Rizza and Girolamo Rossi for their help in writing this speech, and Valentina Memoli and Roberto Pisano for their editorial support. Most of the ongoing armed conflicts are civil wars. Those in Myanmar, Sudan and Ethiopia are among the bloodiest (Source: ACLED). The war in Sudan is causing a devastating humanitarian crisis: some 25 million Sudanese are suffering from food shortages; 10 million have fled their homes and 2 million have sought refuge abroad. In the 1980s, despite signs of progress and hope – such as the possible rapprochement between the superpowers – there were still geopolitical, social and economic tensions. The Cold War shaped world politics, fuelling fears of an imminent nuclear conflict. In the Middle East, the Iran-Iraq war and the conflict in Afghanistan, with the Soviet invasion, strained international relations. Apartheid in South Africa was a further sign of the persistence of racial segregation dividing societies around the world. In Poland, the Solidarity movement and political tensions under the Communist regime exposed the internal struggles within Eastern Europe. Figure 1 Number of conflicts in the world involving at least one state (number of ongoing conflicts) Internationalized intrastate conflicts Non−internationalized intrastate conflicts Extra−systemic conflicts Interstate conflicts Sources: Uppsala Conflict Data Program (UCDP) and Peace Research Institute Oslo (PRIO), 2024. (1) Intrastate conflict: a conflict between a government and a non-governmental armed group within the territory of a given state, resulting in at least 25 battle-related deaths in one calendar year. If a foreign state is involved, the conflict is defined as ‘internationalized’. If this is not the case, it is defined as ‘non-internationalized’. – (2) Extra-systemic conflict: a conflict between a state and a non-state group outside the state’s own territory, resulting in at least 25 battle-related deaths in one calendar year. – (3) Interstate conflict: a conflict between states, resulting in at least 25 battle-related deaths in one calendar year. It was therefore with great pleasure that I accepted the invitation from the Centro San Domenico and the Centesimus Annus Foundation to reflect, as an economist and with due humility, on such a fundamental issue as the link between peace and prosperity. I welcome this important opportunity to acknowledge the Centro San Domenico’s patronage of Catholic cultural activities for over fifty years. These efforts, like those of the Fondazione Centesimus Annus and above all of the Italian Episcopal Conference, are part of the Catholic Church’s long-standing commitment to addressing social and economic issues, with a particular focus on inequalities and conflicts.3 The first encyclical on economic and social matters – the Rerum novarum, promulgated at the end of the 19th century – was not the origin but the outcome of Catholic engagement on these issues. As far back as the middle of the century, at the height of the industrial revolution, many prominent Catholics were actively analysing the risks of industrial capitalism and of colonialism. At that time, when class conflicts broke out and the Communist Party Manifesto by Engels and Marx was published, important Catholics such as Cardinals De Bonald in Lyon, Manning in Manchester and Gibbons in Baltimore spoke out on the distortions of the capitalist industrial system, while people such as Von Ketteler, a German bishop, engaged with the most important representatives of socialism. Catholic economists and sociologists – from the Italian scholar Giuseppe Toniolo to the Germanic intellectual Carl von Vogelsang – analysed the problems of capitalism and proposed new models of work organization (see O. Köhler, La formazione dei cattolicesimi nella società moderna, in Storia della Chiesa, Vol. IX: La chiesa negli Stati moderni e i movimenti sociali 1878-1914, Milan, Jaca Book, 1982, pp. 234-239, and O. de Dinechin, SJ, Rerum novarum, in ‘Aggiornamenti sociali’, 3, 2019, pp. 258-262). 1. War cannot generate prosperity Humanity cannot thrive without peace, and neither can the economy. In the countries involved in a conflict, war seriously damages the drivers of growth.4 Hostilities destroy productive capital: infrastructure, machinery and raw materials. They claim victims, especially among the young generations, bending learning opportunities and the formation of a skilled workforce to the requirements of war. This reduces the availability and quality of ‘human capital’. Furthermore, wars often erode social capital,5 thereby weakening social cohesion and trust in institutions. The war effort supports aggregate demand and can stimulate innovation, but seriously distorts its purposes. The economic benefits are short-lived and do not remove the need to reconvert the economy once a conflict is over, even in countries that were involved in the conflict but suffered no direct damage to their territory. The high inflation and the steep fall of economic activity that often mark wartime periods are signs of the damage that wars inflict on the economic fabric (Figure 2). The manufacturing of war equipment does not help increase a country’s growth potential.6 Development comes from productive investment, not from arms. That is why, in the 1930s, John Maynard Keynes proposed a massive rise in public investment spending as a solution to economic depression in the United States, suggesting that President Roosevelt’s focus should be on ‘the rehabilitation of the physical condition of the railroads’. 7 Moreover, it is misleading to attribute technological progress to military expenditure. It is scientific research that sparks innovation. Military investment can generate innovation if it is allocated to research.8 However, we do not need to resort to war for this: technologies developed for military purposes only translate into progress when they later find civilian applications. War is therefore a form of ‘development in reverse’9 and cannot bring prosperity. M. Schularick, speech at the ECB Forum on Central Banking, Sintra, 2 July 2024. Research on the importance of social capital for economic development has been influenced by Robert Putnam's work on Italy (see R.D. Putnam, Making democracy work: civic traditions in modern Italy, Princeton, Princeton University Press, 1993). The fact that military spending is not, in and of itself, an instrument of economic development does not mean that it does not play a necessary role in national defence. J.M. Keynes, ‘From Keynes to Roosevelt: our recovery plan assayed’, The New York Times, 31 December 1933. See also G.B. Eggertsson, ‘Great expectations and the end of the depression’, American Economic Review, 98, 4, 2008, pp. 1476-1516. For example, the Manhattan Project, developed in the US during World War II, led to the exploitation of nuclear energy. Similarly, the Defense Advanced Research Projects Agency (DARPA) programme, set up in the 1950s, produced the internet. NASA’s moon landing in the 1960s resulted in aviation and satellite technology advancements, such as GPS. But only military spending dedicated to research can generate long-term economic benefits (see J. Antolin-Diaz and P. Surico, ‘The long-run effects of government spending’, American Economic Review, forthcoming). P. Collier et al., Breaking the conflict trap. Civil war and development policy. A World Bank policy research report, Washington DC, World Bank and Oxford University Press, 2003. Figure 2 Real income and inflation before and after World War II (indices: 1935=100) (a) Real GDP per capita (b) Consumer price index 6,000 6,000 4,000 4,000 2,000 2,000 Italy France Source: Ò. Jordà, M. Schularick and A.M. Taylor, ‘Macrofinancial history and the new business cycle facts’, in M. Eichenbaum and J.A. Parker (eds.), NBER Macroeconomics Annual 2016, Volume 31, 2017, pp. 213-263. 2. Growth and integration as instruments of peace Economic growth, prosperity and peace are instead closely linked.10 To understand this connection, we must recognize that development in modern economies is based on integration and international trade.11 The free movement of goods, capital, people and ideas facilitates the transfer of knowledge and technology, thereby helping to bring peoples together. The idea that open trade and deep integration of production can secure lasting peace inspired the global economic framework that emerged after World War II. The relationship between economic integration and peace is explicitly cited in the Havana Charter, which in 1948 sought to create an international organization for world trade to promote stability and prosperity. The Charter never did enter into force, but the talks led to the General Agreement on Tariffs and Trade (GATT), which was succeeded by the World Trade Organization (WTO) in 1995. For Kant and Montesquieu, economics was the foundation of peace. In Perpetual peace, Kant argued that ‘the commercial spirit cannot co-exist with war’ and that international economic relations must be underpinned by international law ‘based upon a federation of free states’ (I. Kant, Perpetual peace, London, 1795, pp. 157 and 68). Montesquieu, in turn, wrote: ‘L’effet naturel du commerce est de porter à la paix’ (Montesquieu, De l’esprit des lois, 1748, book XX, chapter II, p. 349). The correlation between open trade and growth after World War II has been studied by J. Feyrer, ‘Trade and Income-Exploiting Time Series in Geography’, American Economic Journal: Applied Economics, 11, 4, 2019, pp. 1-35; see also J.A. Frankel and D.H. Romer, ‘Does Trade Cause Growth?’, American Economic Review, 89, 3, 1999, pp. 379-399; D. Rodrik, One Economics, Many Recipes: Globalization, Institutions, and Economic Growth, Princeton and Oxford, Princeton University Press, 2007; M.J. Melitz and S.J. Redding, ‘Trade and Innovation,’ NBER Working Paper Series, 28945, 2021. In 1944, the Bretton Woods Conference established a multilateral system to promote cooperation and trade on a global scale. Other institutions followed over time, such as the World Bank (1944), the International Monetary Fund (1945), the OECD (1961), the G20 (1999) and the Financial Stability Board (2009). The European project itself was conceived as a way of preventing new conflicts between neighbouring countries, following the devastations of World Wars I and II. In the words of Robert Schuman, the economic unification of Europe aimed to make war ‘not merely unthinkable, but materially impossible’.12 These initiatives fuelled the globalization that has taken off since the middle of the last century. The ratio of international trade to GDP rose from 20 per cent in 1950 to 34 per cent in 1975 (Figure 3) and then increased further in the following decades, mainly because of the end of the Cold War and the integration of new countries into the global economy, notably China. In 2019, this ratio reached 60 per cent. Figure 3 International trade developments between 1874 and 2021 (exports plus imports as a percentage of GDP) Industrialization World Wars Bretton Woods era Slow70 balization Liberalization Source: Based on M. Klasing and P. Milionis, ‘Quantifying the evolution of world trade’, 1870-1949, Journal of International Economics, 92, 1, 2014, pp. 185-197. Meanwhile, the global production structure has become increasingly complex and interconnected due to the creation of global supply chains and an increase in trade agreements, from 50 in 1990 to 300 in 2021.13 This open, multilateral trade system has fostered development. The freedom to trade goods and services, to invest across borders, and to share knowledge and ideas has improved economic well-being for much of the world’s population, creating new job opportunities – especially for women – and reducing inequalities between advanced and developing countries (Figure 4). For more information, see the EU website: Schuman declaration May 1950 and F. Panetta, ‘Europe’s shared destiny, economics and the law’, Lectio Magistralis on the occasion of the conferral of an honorary degree in Law by the University of Cassino and Southern Lazio, 6 April 2022. For further information, see the WTO’s website: Regional trade agreements. Figure 4 Inequality between countries: 1950-2020 (index) 0.65 0.65 0.60 0.60 0.55 0.55 0.50 0.50 0.45 0.45 Source: B. Milanovic, ‘Global income inequality by the numbers: in history and now. An Overview’, World Bank, Policy Research Working Paper, 6259, 2012. (1) Inequality between countries is calculated by assuming that all citizens of a given country have the same income. Access to international markets has allowed many emerging economies to grow,14 lifting hundreds of millions of people out of extreme poverty. It is estimated that without the progress made over the last 35 years, 2.4 billion more people would be living in destitution today.15 As the role of international cooperation grew stronger, conflict between states subsided. All this progress led Steven Pinker to consider globalization as one of the reasons for the ‘long peace’ following the end of World War II.16 3. Globalization, its discontents, and geopolitical shifts Globalization has brought indisputable benefits, but there have been unwanted effects too, which have not always been fully understood or properly addressed by governments and international institutions. Although openness to foreign trade has improved living conditions in emerging economies and reduced income inequalities between countries, it has also often exacerbated inequalities within States. Openness to trade has benefited developing countries both directly and indirectly. Direct benefits include access to new production technologies and new markets. Indirect effects include greater competition between businesses and, consequently, higher domestic production efficiency. This openness has also prompted governments to improve the quality of their fiscal and monetary policies (see A. Chari and P.B. Henry, ‘Learning from the doers: developing country lessons for advanced economy growth’, American Economic Review, 104, 5, 2014, pp. 260-265). In 1990, the world population was 5.3 billion, 38 per cent of which lived in extreme poverty (defined by the World Bank as living on less than $2.15 per day, at current prices). Had the share of people in poverty not decreased, today – with a world population of 8.2 billion – there would be 3.1 billion people living in absolute poverty; instead, there are 700 million (see United Nations, World Population Prospects: Summary of Results, New York, July 2024). S. Pinker, The better angels of our nature: why violence has declined, New York, Viking, 2011. In advanced economies – in the absence of reforms in areas such as education, health and social protection – globalization and the relocation of production have contributed to a slowdown in the income dynamics of workers in low-skill and low-paid jobs, but also of many in the middle class. Many low-income countries – in Sub-Saharan Africa especially – have remained trapped in extreme poverty and high debt, in spite of the economic progress afforded by their involvement in the global economy and in spite of aid from multilateral development banks17 and advanced countries. Over 700 million people are suffering from food and water shortages globally, and even more lack access to adequate healthcare.18 Almost 700 million people have no electricity, while 2.3 billion have to rely on using polluting fuels for cooking, posing serious health risks.19 Around 250 million children aged between 6 and 18 are excluded from education,20 with marked gender inequalities.21 Moreover, the increasing economic clout of emerging economies has not been accompanied by corresponding advances in political freedoms. This is partly why leading countries have been reluctant to review the governance of international institutions in order to grant these new economic powers more representation, which has led to dissatisfaction on their part. These factors have caused many to view globalization as an elitist project, whether rightly or wrongly,22 fuelling resentment among large sections of the population. The 2007-08 financial crisis further undermined trust in the ruling classes, eroding confidence in the global Multilateral development banks include the World Bank and regional development banks, foremost among which are the Inter-American Development Bank, the Asian Development Bank and the African Development Bank. In Europe, the European Investment Bank and the European Bank for Reconstruction and Development financed investments in Central and Eastern European countries after the fall of the Berlin Wall. FAO, IFAD, UNICEF, WFP and WHO, The state of food security and Nutrition in the world. Financing to end hunger, food insecurity and malnutrition in all its forms, Rome, 2024. Estimating the number of people without adequate healthcare is a complex issue: according to the World Bank and the World Health Organisation, over half of the world’s population (4.5 billion people) have no access to essential medical services; for more details, see the page on the World Bank’s website: Universal Health Coverage. For more details, see the page on the World Bank’s website: Energy. UNESCO, 251M children and youth still out of school, despite decades of progress (UNESCO report), press release, 31 October 2024. Girls are often unable to attend school because of conflicts and social fragility, and girls are twice as likely as boys to be excluded from school in war-torn countries. See UNICEF, 27 million children out of school in conflict zones, press release, 18 September 2017. Much of the negative effects on the labour market in advanced economies have in fact been driven by technological development and falling transport costs, which have facilitated the offshoring of production to emerging countries. However, in the public debate and according to general perception, these effects are often attributed to globalization. See F. Panetta, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, Lectio Magistralis delivered on the occasion of the conferral of an honorary degree in Juridical Sciences in Banking and Finance by the University of Roma Tre, Rome, 23 April 2024. Moreover, not all countries have complied with WTO rules: for example, industrial development in China has benefited from public subsidies that have outpriced companies and workers in other countries (see European Commission, EU imposes duties on unfairly subsidised electric vehicles from China while discussions on price undertakings continue, press release, 29 October 2024). governance model based on free trade, economic integration, the role of international financial institutions and that of supranational bodies in the resolution of disputes. The world is now evolving in the direction of a multipolar and fragmented system, with rising nationalist and protectionist sentiments and growing competition among opposing blocs of countries. Geopolitical tensions are escalating as a result. On the economic front, these strains have led to trade disputes between the United States and China, to Brexit and to a growing number of vetoes by governments on foreign investments in domestic companies. Global trade is fragmenting and is increasingly being used for strategic purposes, especially in the race for technological dominance. In the next few years, a rise in protectionism can be expected, driven by US policies. Meanwhile, military conflicts are spreading dramatically, and have now come to Europe too. In this context, a growing tendency to reject shared international principles has emerged, even to the point of questioning the efficiency of democratic rules in global competition.23 This raises very serious concerns for the future of international relations. 4. What economic policies are needed for peace? The priority must be to preserve a global economy that remains open to international trade. Severing economic and trade links would lead to a significant loss of well-being for the world’s population, further weakening the multilateral framework that has underpinned global economic development since the end of World War II, with repercussions that would extend beyond the boundaries of economics and finance. I will not dwell on these aspects, as I have discussed them elsewhere.24 That said, it is necessary to correct the imbalances that have emerged over time in order to prevent deprivation and frustration from fuelling tensions and conflicts. To achieve these goals, it is essential to act on several fronts, both domestically and internationally. I will only mention a few key points here, without claiming to be exhaustive. The first step is to combat inequalities, in both poor and advanced countries.25 Reducing gaps in income and opportunities is not only key to building a fairer and more equal society, but is also essential to guarantee social stability. Moreover, it is a prerequisite In the words of the President of the Italian Republic Sergio Mattarella: ‘Our public opinions are instilled with the doubt that democratic power is weak, inefficient, slow, and unfit to govern quick-paced evolutions. Or even that it is a penalizing factor in competing with non-democratic systems.' (speech by the President of the Italian Republic Sergio Mattarella at the Ceremony for the exchange of end-ofyear greetings with representatives of institutions, political forces and civil society, Rome, 17 December 2024). F. Panetta, ‘The future of Europe’s economy amid geopolitical risks and global fragmentation’, 2024, op. cit. and F. Panetta ‘Economic developments and monetary policy in the euro area’, speech at the 30th ASSIOM FOREX Congress, Genoa, 10 February 2024. The Magisterium of the Roman Catholic Church constantly addresses economic inequalities. See, among others, Benedict XVI, Encyclical letter Caritas in veritate, 29 June 2009, no. 42; Francis, Encyclical letter Fratelli tutti, 3 October 2020, no. 116. for development: if a significant part of the population is excluded from economic opportunities, the entire economy suffers. Another step is improving education and training systems. Fair access to education is necessary to break the poverty cycle and build a skilled and productive workforce capable of adapting to market changes and starting new economic activities. Investing in the education of young people, regardless of their initial conditions, means leaving no one behind and making full use of the human capital available. It is also vital to step up social protection and ensure access to efficient health services. This would enable workers to weather difficult times without falling into poverty, encouraging their active participation in the labour market while promoting social cohesion and economic stability. Another priority at international level is managing the external debt of the poorest countries,26 which has reached $1.1 trillion.27 Today, as was the case forty years ago, we must think about how to relieve the burden of this debt, which is hindering productive investment and holding back development in many countries.28 However, the success of current initiatives is challenged by the involvement of new major creditors, such as China, and by current geopolitical tensions.29 Accelerating these efforts would be one concrete step towards finding solutions to improve the living conditions of the populations affected. But that is not all. It is essential to adopt policies that support development, countering the pressure that extreme poverty exerts on migratory flows, making them difficult to control. Investing in the management of these flows is critical to supporting the economies of the migrants’ countries of origin and to responding to the consequences of demographic decline in the destination countries. Additionally, pursuing sustainable The issue of debt of poor countries was raised by Pope John Paul II as early as 1986 in his speech to the United Nations (see CEI, ‘Etica e finanza’, supplement to no. 19, Quaderni della Segreteria CEI, August 2000, pp. 40-42). It was recently revisited by Pope Francis for the 2025 Jubilee (see Francis, Bull of Indiction for the Ordinary Jubilee, Spes non confundit, no. 16, 9 May 2024). The figure refers to the debt held at the end of 2023 by the poorest countries, i.e. those that have access to concessional loans from the World Bank. The long-term external public debt of these countries has reached $780 billion. According to debt sustainability analyses conducted by the IMF and the World Bank, more than half of poor countries are considered as being in ‘debt distress’ or ‘at high risk of debt distress’; the share was less than one quarter ten years ago. We must not repeat the experience of the 1980s, the ‘lost decade’ in the development of many countries, caused by the delay in recognizing the need to reduce their external debt and by the ensuing insolvency crises. The Common Framework for Debt Treatment, signed by the G20 countries in 2020, is the most significant attempt to regulate the debt restructuring processes of low-income countries, expanding the participation in the governance of these processes to non-Paris Club countries, such as China. The Global Sovereign Debt Roundtable, created in 2023 and comprising official bilateral creditors, private creditors and debtor countries, is a useful complement to the Common Framework, focusing on fostering debate on the most important challenges facing restructuring. development models is necessary to ease tensions over access to scarce resources, like water and energy, which often fuel conflicts. Conclusions Globalization has undoubtedly increased integration between countries and created opportunities for economic and social progress in many regions of the world. However, it has also exposed very clear limitations. Current trade and geopolitical tensions are symptoms of a system that has not fully met the expectations and needs of the world’s population. Every day, thousands of people continue to suffer from deprivation and violence, often from seemingly endless fratricidal conflicts. The economy appears to have become globalized without fostering a ‘global consciousness’. Economic integration and international cooperation need to be revived, and their flaws corrected with policies that promote sustainable and inclusive development – policies that combine growth with social justice, environmental protection and the eradication of poverty. Peace and prosperity are closely intertwined. Peace is not merely the absence of conflict; it is also about creating the conditions for every individual to live in dignity, free from fear and poverty. At the same time, any prosperity that does not contribute to widespread well-being will prove fleeting, and risks generating conflicts and instability. As Pope Paul VI stated in his encyclical Populorum progressio, ‘development means peace’.30 Today, these words remind us of the urgent need to work for a future of fairer and more peaceful prosperity. Paul VI, Encyclical letter Populorum progressio, 26 March 1967, no. 87.
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Talk given by the Governor of the Swedish Riskbank, Mr. Urban Bäckström, at the Jackson Hole symposium organised by the Federal Reserve Bank of Kansas City on 29/8/87.
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Mr. Bäckström elucidates the problems Sweden went through in the early 1990s, and considers whether other countries might draw lessons from the Swedish experience Talk given by the Governor of the Swedish Riskbank, Mr. Urban Bäckström, at the Jackson Hole symposium organised by the Federal Reserve Bank of Kansas City on 29/8/87. First a word of thanks to the Federal Reserve Bank of Kansas City for the invitation to discuss the financial problems Sweden went through in the early 1990s. I shall also try to draw some conclusions from our experiences that may be relevant for other countries. Before I came to Sveriges Riksbank I was State Secretary at the Ministry of Finance and involved among other things in the management of Sweden’s financial crisis. While there had, of course, been a good many indications of mounting problems, I was personally made formally aware of the acute and severe financial crisis by a phone call. At the beginning of October 1991, I had been in the job just a few days when I got a call from the head of the Financial Supervisory Authority (banking supervision in Sweden is performed by this authority, not by the central bank). He wanted to inform the Government that a large Swedish bank had more than exhausted its equity capital and would have to go bankrupt if a reconstruction could not be arranged. While working at the Ministry of Finance on the initial problems in the banking sector we started to study historical and international records of financial crises. Irving Fisher’s well-known paper in Econometrica, “The Debt-Deflation Theory of Great Depressions,” from 1933 provided inspiration. We also came across a new volume, “The Risk of Economic Crisis”, edited by Martin Feldstein and containing interesting contributions by, among others, Benjamin Friedman, Paul Krugman, Lawrence Summers and our chairman today, E. Gerald Corrigan. The conclusion from these sources was that a fall in asset prices, such as we had in Sweden, may create problems for private sector balance sheets, affect the supply of credit and result in payment system disturbances. Step by step this may affect spending decisions by households and firms, thereby impinging on general economic activity. A destabilised financial system can bring the economy into what Fisher termed “debt deflation”, that is, a situation where the financial crisis may become very serious and protracted. Thus it was important both to avoid a widespread failure of Swedish banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis. But here first is a brief account of the Swedish crisis. The Swedish crisis - what happened? The economic problems in Sweden in the early 1990s should be seen in their historical context. For several reasons, economic growth in Sweden has been relatively weak ever since about 1970. Following the collapse of the Bretton Woods system the creation of a stable macroeconomic environment turned out to be difficult. Wage formation functioned badly, fiscal policy was unduly weak and this was gradually compounded by structural problems. Credit market deregulation in 1985, necessary in itself, meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, a tax system that favoured borrowing, and remaining exchange controls that restrained investment in foreign assets. In the absence of a more restrictive economic policy to parry all this, the freer credit market led to a rapidly growing stock of debt (see Fig.). In the course of only five years the GDP ratio for private sector debt moved up from 85 to 135 per cent. The credit boom coincided with rising share and real estate prices. During the second half of the 1980s real aggregate asset prices increased by a total of over 125 per cent. A speculative bubble had been generated. The expansion of credit was also associated with increased real economic demand. Private financial saving dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable current-account deficits, accompanied by large outflows of direct-investment and other long-term capital (once exchange control had been finally abandoned in the late 1980s), led to a growing stock of private sector short-term debt in foreign currency. Step by step the Swedish economy became increasingly vulnerable to shocks. During 1990 matters came to a head. Competitiveness had been eroded by the relatively high inflation in the late 1980s, resulting in an overvalued currency. This caused exports to weaken and meant that the fixed exchange rate policy began to be questioned, leading to periods with relatively high nominal interest rates. Moreover, the tax system was reformed in order to reduce its harmful economic effects, but this also contributed to higher post-tax interest rates. Asset prices began to fall and economic activity turned downwards. Between the summers of 1990 and 1993 GDP dropped by a total of 6 per cent. Aggregate unemployment shot up from 3 to 12 per cent of the labour force and the public sector deficit worsened to as much as 12 per cent of GDP. A tidal wave of bankruptcies was a heavy blow to the banking sector, which in this period had to make provisions for loan losses totalling the equivalent of 12 per cent of annual GDP. While this course of events stemmed, as I have indicated, from a variety of factors, it was no doubt the financial vulnerability that helped make it so dramatic. The Swedish economy was steadily approaching a situation that entailed both a banking and a currency crisis. Matters were most acute in the fall of 1992 in conjunction with the European currency unrest. The crisis in banking was triggered, not by a classic bank run but by a loss of international confidence and difficulties with international financing. In many respects the crisis in Sweden resembled what has happened in a number of other countries. By the summer of 1993 the economy was becoming more stable and the problems in banking receded. Fiscal and monetary policy contributed to this and so did a deliberate policy of handling problem banks. The private sector’s financial balance underwent a dramatic change, moving from a deficit of about 8 per cent of GDP in 1990 to a financial surplus of over 11 per cent in 1993. This was a swing of almost 20 percentage points of GDP in the course of only three years. A good deal of the swing no doubt came from private sector adjustments to cope with insufficient solvency. Falling asset prices in conjunction with high debt levels lead to balance-sheet problems in the private sector. The automatic stabilisers in the government budget probably helped to lessen the contraction of GDP. This meant that business profits and household disposable income were sustained relatively well. But it also entailed a massive increase in the budget deficit and this in turn generated new problems. The government debt trend became unsustainable and economic policy’s credibility was weakened. In the early stages of the crisis, monetary policy was directed to maintain the fixed exchange rate. This line had broad support among the general public as well as in the political system. The aim was to establish a low-inflation policy once and for all. But in spite of major efforts, both political and economic, the international currency unrest in November 1992 meant that the fixed exchange rate had to be abandoned. It was replaced by a flexible exchange rate and an explicit inflation target. This resulted in a considerable depreciation of Sweden’s currency, but during 1993 the continued fall in international bond rates meant that Swedish interest rates also moved down to levels that were comparatively low. Together with the Riksbank’s reduction of its instrumental rate, this gave the monetary conditions a stimulatory turn. It also helped to stabilise both the economy and the banking system. Lower market rates eased the fall in asset prices, lightened the burden of servicing private sector debt and mitigated the negative impact on the financial system. Rescuing the banking sector was necessary to avoid a collapse of the real economy. There is no evidence that a credit crunch developed, though anecdotal information did suggest that creditors became more restrictive. I shall be returning shortly and in more detail to how the banking problems were tackled. In 1994, the major budget problems and the expansionary monetary conditions rebounded. Inflation expectations began to move up in many parts of the economy and when interest rates increased worldwide in the spring of 1994, bond rates in Sweden rose much more than in other countries - from just under 7 per cent to over 12 per cent in a few months. This was accompanied by a further weakening of the exchange rate to levels that were appreciably below any reasonable assessment of the real equilibrium rate. The situation called, in other words, for an economic policy realignment -- for what we can call aftercare -- once the acute financial crisis had been checked. A major consolidation of government finance was launched, accompanied by a tightening of the monetary stance which demonstrated that the 2 per cent inflation target was to be taken seriously. In time, this course has enhanced economic policy’s credibility and led to more permanent economic stabilisation. Management of the bank crisis To those of us who were working on the initial banking problems it was soon clear that the crisis in Swedish banking could become very serious. In spring 1992, preparations were therefore made to cope with a variety of conceivable situations. Later we found that our worst-case scenario was on the verge of happening. Looking back, one can see that in the course of the crisis the seven largest banks, with 90 per cent of the market, all suffered heavy losses. In these years their aggregate loan losses amounted to the equivalent of 12 per cent of Sweden’s annual GDP. The stock of non-performing loans was much larger than the banking sector’s total equity capital and five of the seven largest banks were obliged to obtain capital contributions from either the State or their owners. It was thus truly a matter of a systemic crisis. In connection with a serious financial crisis it is important first and foremost to maintain the banking system’s liquidity. It is a matter of preventing large segments of the banking system from failing on account of acute financing problems. In September 1992, the Government and the Opposition jointly announced a general guarantee for the whole of the banking system. The Riksdag, Sweden’s parliament, formally approved the guarantee that December. This broad political consensus was I believe of vital importance and made the prompt handling of the financial crisis possible. The bank guarantee provided protection from losses for all creditors except shareholders. The Government’s mandate from Parliament was not restricted to a specific sum and its hands were also very free in other respects. This necessitated close cooperation with the political opposition in the actual management of the banking problems. The decision was of course troublesome and far-reaching. Besides involving difficult considerations to do, for example, with the cost to the public sector, it raised such questions as the risk of moral hazard. The political system concluded that in the event of widespread failures in the banking system, the national economy would suffer major repercussions. The direct outlays in connection with the capital injection into the banking sector added up to just over 4 per cent of GDP. However, it is now calculated that most of this can be recovered. One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders. A separate authority was set up to administer the bank guarantee and manage the banks that landed in a crisis and faced problems with solvency, though the crucial decisions about the provision of support were ultimately a matter for the Government. A clear separation of roles was achieved between the political level and the authorities, as well as between different authorities. Naturally this did not preclude very close cooperation between the Ministry of Finance, the Bank Support Authority, the Financial Supervisory Authority and the Riksbank. It was up to the Riksbank to supply liquidity on a relatively large scale at normal interest and repayment terms, but not to solve problems of bank solvency. Collateral was not required for the loans to banks, neither intraday nor overnight. The banking system was free to obtain unlimited liquidity by drawing on its accounts with the central bank. The bank guarantee meant that the solvency of the Riksbank was not at risk. In order to offset the loss of foreign credit lines to Swedish banks, during the height of the crisis the Riksbank also lent large amounts in foreign currency. Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries. The Swedish Bank Support Authority had to choose between two alternative strategies. The first method involves deferring the reporting of losses for as long as is legally possible and using the bank’s current income for a gradual write-down of the loss making assets. One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long-run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point. With the other method, an open account of all expected losses and writedowns is presented at an early stage. This clarifies the extent of the problems and the support that is required. Provided the authorities and the banks make it credible that no additional problems have been concealed, this procedure also promotes confidence. It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended. The Swedish authorities opted for the second method: disclose expected loan losses and assign realistic values to real estate and other assets. This method was consistent with other basic principles for the bank support, such as the need to restore confidence. Looking back, it can be said that in general the level of valuation was realistic. Since the acute crisis had been triggered by difficulties in obtaining international finance, great pains were taken to give a transparent picture of how the crisis was being managed, so as to gain the confidence of Sweden’s creditors. This applied both to the account of the magnitude of the banking problems and to the content of the bank guarantee. Various informative projects were arranged for this purpose throughout the world. In Sweden, too, considerable efforts were made to legitimise the measures and their costs. The banking problems did arouse a lively debate in Swedish society, but the work could still be done in broad political consensus, which was a great advantage. The bank guarantee was terminated in 1996 and replaced with a deposit guarantee that is financed entirely by the banks. Conclusions The problems in the Swedish banking system at the beginning of this decade seem to have been more extensive than those which arose in Sweden in the early 1920s. The two periods also differ substantially in the management of the crisis. This may have had a bearing on the very different course of events in these two crises. In the early 1920s, the fall in GDP totalled 18 per cent and the price level dropped 30 per cent in the course of two years. In the 1990s the loss of GDP stopped at around 6 per cent and the price trend did not become really deflationary. Allow me now to summarise what I consider to be the most important lessons from Sweden’s financial crisis: 1. Prevent the conditions for a financial crisis The primary conclusion from our experience of Sweden’s financial crisis is that various steps should be taken to ensure that the conditions for a financial crisis do not arise. - Fundamentally it is a matter of conducting a credible economic policy focused on price stability. This provides the prerequisites for a monetary policy reaction to excessive increases in asset prices and credit stocks that would be liable to boost inflation and create the type of speculative climate that paves the way to a financial crisis. - Looking back, it can be said that if various indicators that commonly form the background to a financial crisis had been followed systematically, then incipient problems could have been detected early on. That in turn could have influenced the conduct of fiscal and monetary policy so that Sweden’s financial crisis was contained or even prevented. In spite of the evident signs, few -- if any -- in the public discussion warned of what might happen. Martin Feldstein offers an interesting explanation in his introduction to “The Risk of Economic Crisis” from 1991. At that time, the industrialised world had not experienced an outright financial crisis since the 1930s. As a result, economists had devoted relatively little work to the analysis of this subject, being more concerned to understand the more normal economic world. This symposium is a positive sign that matters have changed in that respect. The conclusion drawn by the Riksbank is that various indicators must be followed systematically with the aim of detecting any signs of potential financial problems and systemic risks. - In Sweden’s case the supervisory authority was not prepared for the new environment that emerged after credit market deregulation. This meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention. In addition, in many cases the loans were poorly documented. The lesson from this is that much must be required of a supervisor operating in an environment characterised by deregulated markets. 2. If a financial crisis does occur In a sense all major financial crises are unique and therefore difficult to prepare for and avoid. Once a crisis is about to develop there are some important lessons concerning its handling that can be learnt. - If an economy is hit by a financial crisis, the first important step is to maintain liquidity in the banking system and prevent the banking system from collapsing. For the management of Sweden’s banking crisis the political consensus was of major importance for the payment system’s credibility among the Swedish public as well as among the banking system’s creditors throughout the world. The transparent approach to the banking problems and the various projects for spreading information no doubt had a positive effect, too. - The prompt and transparent handling of the banking sector problems is also important. The terms for recapitalisation should be such as to avoid moral hazard problems. - Automatic stabilisers in the government budget and stimulatory monetary conditions can help to mitigate the economy’s depressive tendencies, but they also entail risks. Economic policy has to strike a fine balance so that inflation expectations do not rise, the exchange rate weakens and interest rates move up, which could do more harm than good. In this respect a small, open economy has less freedom of action than a larger economy. - It is important both to avoid a widespread failure of banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis. References Feldstein, M., (ed.), (1991), The Risk of Economic Crisis, NBER Conference Report, University of Chicago Press, Chicago and London. Fisher, I., (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, vol. 1 (October), pp. 337-357. Ingves, S. and Lind, G., (1996), The management of the bank crisis - in retrospect, Quarterly Review, No. I, pp. 5-18, Sveriges Riksbank.
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Remarks by Mr Donald L. Kohn, Governor of the Federal Reserve Bank of Kansas City, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27 August 2005
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Donald L Kohn: Jackson Hole Conference - panel discussion “Financial markets, financial fragility, and central banking” Remarks by Mr Donald L. Kohn, Governor of the Federal Reserve Bank of Kansas City, at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27 August 2005 * * * My perspective on this interesting and stimulating paper by Raghu Rajan has been very much influenced by observing Alan Greenspan's approach to the development of financial systems and their regulation over the past eighteen years.1 I believe that the Greenspan doctrine, if I may call it that, has reflected the Chairman's analysis and deeply held belief that private interest and technological change, interacting in a stable macroeconomic environment, will advance the general economic welfare.2 Chairman Greenspan has welcomed the ability of new technologies in financial markets to reduce transactions costs, to allow the creation of new instruments that enable risk and return to be divided and priced to better meet the needs of borrowers and lenders, to permit previously illiquid obligations to be securitized and traded, and to make obsolete previous divisions among types of financial intermediaries and across the geographical regions in which they operate. At the intersection of market developments and monetary policy, he has led the Federal Reserve's efforts to understand the implications of changing financial technology, such as the growing ease of housing equity extraction, and to use the newly available information about market expectations and the price of risk embodied in market prices. The Greenspan doctrine holds that these developments, on balance, improve the functioning of financial markets and the real economies they support. By allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they do take on, they have made institutions more robust. By making intermediaries more robust and by giving borrowers a greater variety of lenders to tap for funds, these developments have also made the financial system more resilient and flexible - better able to absorb shocks without increasing the effects of such shocks on the real economy. And by facilitating the flow of savings across markets and national boundaries, these developments have contributed to a better allocation of resources and have promoted growth. That is not to say that the Greenspan doctrine holds that private markets always get it right. Prices in these markets are driven by the tendency of human nature to project the recent past - to waves of complacency and gloom - and hence are subject to overshooting. And private parties, left entirely to their own devices, do not always produce a market structure and market relationships consistent with adequate protection of financial stability. However, the actions of private parties to protect themselves - what Chairman Greenspan has called private regulation - are generally quite effective. Government regulation risks undermining private regulation and financial stability itself by distorting incentives through moral hazard and by promising a more effective role in promoting financial stability than it can deliver. In this situation, government regulation has a function but it should be based on clear objectives, narrowly tailored to meet those objectives, and, given the iron law of unintended consequences, it should be clearly superior to private regulation. Regulation can be justified if incentives for private regulation are weak - perhaps because of other government programs, such as deposit insurance - or if market participants are likely to be ineffective, as for example small savers and borrowers. Regulation may also be justified to promote greater flow of accurate information to enable private participants to make better informed decisions. The views are my own and do not necessarily reflect other members of the Board or its staff. I thank Athanasios Orphanides, Matthew Pritsker, Patrick Parkinson, and Vincent Reinhart, of the Board's staff, for valuable comments. Chairman Greenspan has spelled out his views on markets and regulation in many places, and much of what follows is my synthesis of this material. His remarks on "Government Regulation and Derivative Contracts" on February 21, 1997 are an especially valuable source for his approach to government regulation of financial markets New technologies and changing market structures imply that regulation should be constantly under review; at times rolling back regulation - for example, by lifting the Glass-Steagall restrictions on banking organizations - will benefit competition and help the financial sector deliver services more efficiently and effectively. Moreover, regulation itself can benefit from competition. Running regulated and unregulated markets side by side gives people a choice of whether they want protection and helps to constrain regulation. Some of the same purposes can be served by having multiple regulators for the same function; in some circumstances, the possible adverse consequences of competition in laxity may be smaller than the potential for regulatory conformity and regulator risk-aversion to impinge on innovation and change. The Greenspan doctrine has had a perceptible influence on the evolution of markets and the regulatory structure that applies to them. Raghu Rajan voices some concerns about this evolution. In particular, he posits that the shift from depository intermediation to professional asset management has increased tail risk to socially excessive levels and has left the world more vulnerable to rare but potentially very serious tail events; he suggests some ways in which regulation should be increased. In assessing this argument, we might find it useful to separate the question of whether the world is riskier from the question of whether systemic risk has risen. The increased ability to disentangle risk and tailor risk profiles should mean that risk has come to be lodged more in line with investor appetites, a change that has probably tended to reduce the price of risk and encouraged riskier capital projects to be funded. But individual investors at greater risk need not imply increased systemic risk fatter tails and greater potential for losses feeding back on the macroeconomy. In fact, industrial economies have been marked by much less variability in output and inflation over the past twenty years. Many reasons have been given for this so-called great moderation, but developments in financial markets have likely played a role in making the economy more resilient. As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market . The experience of 2001-03 is instructive. Unusually large declines in equity prices and increases in defaults and risk spreads - surely tail events by most definitions - reduced wealth and raised the cost of capital but did not aggravate the downturn by impinging on the flow of funds. Financial intermediaries were not so troubled as to cut off the provision of credit, and in any case, many borrowers had alternative sources of funds. In addition, we have not seen a clear upward trend in volatility of financial asset prices over the past twenty-five years, as one might expect if herding had increased in importance. Judging from options prices, market participants are expecting the volatility of financial asset prices to be damped in the future; they are also requiring lower-term premiums for placing funds for longer terms. I do not share Raghu's nostalgia for the systemic-risk implications of bank-dominated finance. Oldstyle crises involving impaired depository institutions had substantial spillover effects; their repair took time, during which economic activity was affected; and emergency measures to deal with them often involved moral hazard because they were aimed at stabilizing ailing intermediaries. I think we would all agree that the industrial economy that has suffered the greatest systemic strains from problems in the financial sector in the past fifteen years is that of Japan, which remained tied to the commercial bank model Raghu finds safest. The macroeconomic effects of new-style crises involving market liquidity, as in 1998, or outsized movements in asset prices may be more readily cushioned by monetary policies aimed at bolstering the general level of liquidity and reducing interest rates. Such policies also carry less risk of increasing moral hazard. Although investment managers receive substantial funds directly from households, many of their counterparties are sophisticated investors in positions of fiduciary responsibility. In addition, most asset managers are employees of institutions - mutual fund families, bank holding companies - that are in the market for the long haul. It is not in their interest to reach for short-run gains at the expense of longer-term risk, to disguise the degree of risk they are taking for their customers, or otherwise to endanger their reputations. I would expect these counterparties and employers to enforce compensation schemes that foster their objectives. As a consequence, I did not find convincing the discussion of market failure that would require government intervention in compensation. Moreover, compensation regulation is likely to be easily evaded and fraught with risks of untoward consequences. One only has to recall the congressional action of 1993 that, by imposing lessfavorable tax treatment on some forms of executive compensation, fostered the shift to stock options that in turn was thought to have contributed to some of the transparency and corporate governance problems of the late 1990s. Regulatory and supervisory systems do need to evolve to reflect the shift to market-based transactions. As intermediation shifts from depositories, with their specialized knowledge of borrowers, to markets, disclosure and transparency become more important to allow diverse private parties to assess risk properly, exert appropriate discipline, and contribute to the efficient allocation of resources. Greater reliance on markets also elevates the importance of the safety of clearing and settlement systems. Private-sector participants have every incentive to demand these disclosures and to ensure that their trades go through as contracted. But government may need to act in concert with private parties to arrive at collective decisions that strengthen markets and reduce systemic risk but might not be in the interest of individuals acting separately. And with more of the fluctuations in asset prices passing through to a large number and wide variety of households, educating people to make informed choices and protecting retail customers from abusive practices remain key governmental functions. A particularly interesting strand of the debate about excessive risk-taking concerns the interaction of monetary policy and perceptions of risk in financial markets. Some analysts are concerned that several aspects of the conduct of monetary policy in the United States have induced market participants to reduce their expectations about risk too far, setting up the financial markets and the economy for an unpleasant and possibly destabilizing surprise. In this view, the low short-term interest rates that policymakers have thought were required over the past few years to meet macroeconomic objectives are said to have encouraged reaching for yield settling for risk compensation that the investors themselves view as probably inadequate but which they feel compelled to accept, perhaps to achieve targeted levels of real or nominal returns. The tendency of policy to react strongly to sharp declines in key asset prices, and thereby limiting the extent of the decreases, has been thought to induce risk-taking by imparting an asymmetry to asset price movements. Finally, a concern is that the fairly new practice of telling the public about our expectations for the path of the federal funds rate may have given market participants a false sense of security about the future path of policy. These practices have been the result of a monetary policy focused on price and economic stability over the intermediate term interacting with the particular characteristics of the economy. The global decline of inflation and spending induced a global reduction in interest rates to unusually low levels in recent years. Those low rates were, in fact, intended to stimulate risk-taking and investment when private agents pulled back. The tendency for asset prices to fall more quickly than they rise has largely produced the more rapid and noticeable response of stabilizing monetary policy to declines than to increases. And the importance for economic performance of more-accurate expectations about monetary policy, along with the unusually low policy rates, led the Federal Open Market Committee to undertake a more extended discussion of its policy expectations. To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and contain financial crises, risks are genuinely lower, and that development should be reflected in the prices of assets. To the extent that the central bank can convey something useful about its intentions, markets that take account of these intentions will be priced more accurately. The risk is that private agents overestimate the ability or willingness of central banks to damp volatility in asset prices or the economy, or that they fail to appreciate that future policy actions depend on an imperfectly predictable economic outlook. But developments should have partially alleviated some of these concerns. Investors have had an opportunity to observe that policy actions in 1987, 1998, and 2001-03 cushioned the economy, but they did not stop major declines in the prices of equity in 1987 and 2001 or of risky credits in 1998. Short-term rates have risen substantially in the past year, reducing the profitability of "carry trades" without triggering an unwinding that drove long-term interest rates higher or widened risk premiums. And expectations that policy tightening would remain gradual over the near-term have not stopped long-term rates from fluctuating substantially in response to incoming data; the movements of future or forward rates out the yield curve after surprises in data have been at least as large since 2003 as they were before. That is not to say that we have nothing to worry about. As I already noted, Alan Greenspan, himself, has often been concerned about market complacency - as recently as his latest monetary policy testimony. People may well perceive the economy as more stable than it is or central banks with greater power than we have to smooth the economy or to foresee our own actions. Clearly, reminders to the public of the inherent uncertainty in economic developments and policy responses are appropriate and should have some effect. The question is whether these warnings should be supplemented by actions to inject uncertainty into policy pronouncements by saying less than we can or into the economy by shifting our objectives away from seeking the best outcome for the economy over the intermediate term. In my view, such policies would result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.
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Speech by Mr Thomas M Hoenig, President & CEO of the Federal Reserve Bank of Kansas City, at the Central Bank of Argentina 2008 Money & Banking Conference 'Financial turbulence - impact on developed & emerging economies', Buenos Aires, 1 September 2008.
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Thomas M Hoenig: Central banks: changing markets – changing mandates Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, at the Central Bank of Argentina 2008 Money and Banking Conference “Financial turbulence – impact on developed and emerging economies”, Buenos Aires, 1 September 2008. * * * It is a pleasure to be in Buenos Aires today to participate in this high-level conference sponsored by the Central Bank of Argentina. Revolutionary changes in financial markets, combined with events such as the market disruptions associated with the subprime lending debacle, have raised anew questions about the role of central banks in maintaining financial stability. Though central banks have traditionally had some responsibility for financial stability, such responsibility has typically not been placed on par with more explicit mandates for price stability and economic performance, in part perhaps, because of the episodic nature of financial crises. Yet, recent market disruptions in the United States make it very clear that the financial markets, the general public and political authorities will look first and foremost to the Federal Reserve to respond to any significant threats to financial stability. In this context, it may be useful to take a closer look at a central bank’s mandate for financial stability. Today, the Federal Reserve plays a role in “crisis prevention” through its regulation and prudential supervision of banks and bank holding companies. It also plays a role in “crisis management” by providing liquidity to stem financial disruptions and by using monetary policy to reduce the impact of financial disturbances on economic activity. In the current crisis, the Federal Reserve has taken unprecedented steps to manage and contain the crisis. As we examine lessons learned from these events, we will have to decide whether financial stability can be best maintained in the future, as some have suggested, by extending the Federal Reserve’s supervisory and lending authority to a broader part of the financial system. In doing so, we need to examine both the intended and possible unintended consequences of such a decision. Alternatively, if we do not envision a broader role for the Federal Reserve, we need to articulate what other institutional reforms might be needed to avoid a repeat of the recent crisis and to reduce the crisis management burden on central banks going forward. A second issue worthy of further discussion is how a central bank’s mandate for financial stability can be balanced with its other macroeconomic responsibilities. For the Federal Reserve, adding a more explicit financial stability mandate to its existing dual mandate for price stability and economic growth raises important and difficult questions about the compatibility of these responsibilities and the problems that might arise in attempting to achieve them all simultaneously. Let me begin my remarks by examining more closely what is meant by “financial stability” and the Federal Reserve’s current role in maintaining financial stability. Then I will look at the changing structure of the financial system, how the Federal Reserve has responded to the current crisis and the issues surrounding the possible extension of the Federal Reserve’s responsibilities. Finally, I will address some of the possible implications of a broadened financial stability mandate for the Federal Reserve’s other macroeconomic responsibilities. Financial stability and systemic risk As we are all aware, a stable financial system is essential to a growing economy, particularly in terms of providing a sound payments mechanism and efficient, sustainable credit intermediation. Since disruptions to this payments system or credit intermediation process will directly and adversely affect real economic activity, I believe that public policy has an important role to play in mitigating these market breakdowns. One aspect of public policy is to provide a resilient and rational framework within which financial institutions and markets can operate. History, however, suggests that some breakdowns will inevitably occur within any dynamic financial system and economy. Consequently, maintaining financial stability from a public policy perspective does not mean preventing all financial disruptions, but rather mitigating those market and institutional breakdowns that could have a significant impact on aggregate economic activity. A key implication from this perspective is that financial losses or the failure of an individual firm, even a large one, does not warrant governmental intervention unless the outcome poses a substantial threat to the economy. This public policy role is most clearly warranted in addressing systemic risks to the financial system. Systemic risk can be broadly defined as the risk that problems at an individual institution or segment of the market would spread to a wider set of institutions and markets and pose a major threat to economic activity. This type of contagion could occur because of the array of linkages that may exist among institutions and markets through counterparty, payments and other risk exposures. While counterparty exposures at large institutions have constituted the traditional view of systemic risk, I would also extend the definition of systemic risk to include instances where many institutions – and not just the largest – are exposed to a common set of adverse factors, such as during the real estate, energy and agricultural collapses in the United States during the 1980s and early 1990s. Commercial banks have long had a unique role in supporting the economy through their credit intermediation activities and in connecting individuals and businesses to the payments system. These activities have placed banks at the center of policy concerns over systemic risk. However, given the growing role of capital markets and nonbank institutions in the intermediation process, we should begin to ask ourselves whether these broader market segments pose systemic concerns that are independent from those already arising from their linkages to the banking system. The importance of maintaining financial stability and addressing systemic threats to the economy justifies the federal safety net and the need for prudential supervision. We have a long history of using prudential or safety and soundness supervision of the banking system to limit the potential risks to this safety net. The premise behind this approach is that the health of the financial system can be solidified by monitoring and controlling the risks assumed by individual banks and by requiring appropriate levels of capital and liquidity to support their operations. To the extent these supervisory objectives can be met, the risk of serious failures and safety net losses can be reduced. Our changing financial markets, though, are now prompting us to examine how far this framework of prudential supervision and safety net protection can and should be extended. The Federal Reserve’s current role As the central bank for the United States, the Federal Reserve has been assigned a critical role in promoting financial stability and responding to financial crises. This role is inherent in many of its powers including: banking supervision, the provision of liquidity through the discount window and open market operations, and payments system oversight. The Federal Reserve’s responsibilities for banking regulation and prudential supervision are largely aimed at preventing financial crises and protecting the federal safety net. Accordingly, these efforts encompass capital adequacy standards for state member banks and holding companies, consolidated oversight of the risk exposures and risk management practices of these institutions, and corrective enforcement actions to deal with serious problems. The System’s responsibilities for supervising holding companies and state member banks also provide valuable insights on the operation of individual institutions and banking markets. Moreover, with regard to crisis management, this supervisory experience and the information obtained in the supervisory process have been increasingly important in designing appropriate responses to financial disruptions. To deal with or manage potential crises, the Federal Reserve also relies on its authority to inject liquidity into the financial system. Although other regulatory agencies also bear responsibility for helping to ensure financial stability, the Federal Reserve’s authority to supply liquidity gives it a unique role during a financial crisis. This role represents a fundamental purpose behind the creation of the Federal Reserve System and the reason why the Federal Reserve is expected to take the leading role in maintaining financial stability and mitigating breakdowns in the financial markets. The Federal Reserve may inject liquidity through open market operations. To provide liquidity in a more targeted manner, the Federal Reserve may lend through the discount window to any depository institution and may also lend to any individual, partnership or corporation in “unusual and exigent circumstances.” These different ways to inject liquidity thus give the Federal Reserve a choice in how it will supply liquidity to institutions and the overall economy. The new financial structure and the broadening mandate for central banks Traditionally, the Federal Reserve’s supervisory responsibilities and its financial stability concerns have centered on commercial banks. This approach reflects the multifaceted role of banks including: their responsibilities in the payments system, their participation in the credit intermediation process, and their role as a source of liquidity and acting as a counterparty in financial transactions. I think we would all agree, though, that the current market turmoil points out how much the financial system has changed over the past several decades. Recent events illustrate that financial disruptions can arise from outside of the traditional banking channels, while taking on new dimensions and features. As an example, many of the recent problems arose from mortgage-backed securitization activities that not only involved U.S. banking organizations, but also brought in a complex mixture of other firms. Such firms have included investment banks, mortgage originators, credit rating agencies, mortgage servicers, securities issuers, asset managers, investors and financial institutions across many different countries. This experience clearly indicates that more of the credit process is now taking place outside of the banking system and within a much broader global financial marketplace. Investment banks, in particular, are an important segment in this expanding marketplace as they go beyond their traditional focus on underwriting and distribution of securities and private placement activities. Today, we can see that investment banks derive an increasing portion of their business from more sophisticated securities and derivatives activities, mortgage and commercial lending, and the operation of thrift and industrial loan company subsidiaries. The current financial crisis also shows the extensive and complex set of counterparty risks to which major institutions are now exposed and the difficulties such risks may pose in maintaining market confidence and addressing problems at individual institutions. In fact, the collapse of Bear Stearns provides a striking example of how the ramifications of a single nonbank firm’s troubles can extend throughout the financial system, threatening public confidence and complicating any resolution efforts. These developments thus raise a number of issues for managing financial crises. The sheer size of the financial markets, the many different counterparties and the interdependencies among participants suggest that significant disruptions from any portion of the market – bank or nonbank – could “freeze” financial transactions and activities and consequently harm the real economy. Most notably, the growing role that capital markets and nonbank institutions play in the financial intermediation process suggests that systemic concerns can arise independently or in conjunction with the linkages that already exist through the banking system. To deal with the financial breakdowns that have occurred in this expanded financial system, the Federal Reserve has taken several steps that are of a nearly unprecedented nature. These include opening the discount window to primary dealers, taking in a wider range of collateral on loans, lending $30 billion to support the takeover of Bear Stearns, and pledging backup support to Fannie Mae and Freddie Mac. I would note that such steps are taking the Federal Reserve well beyond its traditional policy boundaries and are broadening its financial stability mandate to encompass much more than the banking system and its usual links to the financial marketplace and the overall economy. An apt analogy would be to say that the recent market turmoil has taken us to the other side of the river from where we have traditionally operated. Consequently, we must ask ourselves if we should stop and stay where we are today, continue and go even farther into this uncharted territory, or try to find a way to go back across the river to our previous and wellknown position. More specifically, should the Federal Reserve, as well as other central banks facing the same pressures, seek to formalize this broader role in financial stabilization? If so, a logical step in this process would be for central banks to take on whatever supervisory authority would seem necessary for overseeing the entities operating in this expanding marketplace and for protecting a much wider safety net. Or, alternatively and after the current crisis abates, we could select a path that would take us back to our traditional role and a more carefully defined and contained safety net? Under this approach, many would take steps to strengthen or provide more inherent resiliency to those areas that have suffered the most from recent market breakdowns, which would reflect the positive side of market discipline. What course we choose is of critical importance to the future role of central banks and to their ability to maintain independence in formulating policy. I would like to explore these questions next in terms of two issues: the appropriate use of the federal safety net and the implications for monetary policy under a broadening mandate. Safety net issues and moral hazard concerns The public policy actions directed toward Bear Stearns, primary dealers, and Fannie Mae and Freddie Mac have resulted in a significant expansion of the safety net and the Federal Reserve’s lending practices. Now that more financial activities have gravitated outside of the banking system, more financial stability concerns seem destined to arise. Our lending to support the takeover of Bear Stearns and to provide liquidity to primary dealers, for example, has taken the Federal Reserve well beyond its traditional approach of injecting discount window funds through the commercial banking system. This new financial framework, consequently, leaves us with several distinct choices. Some, for instance, have suggested that we should extend more of a bank-like supervisory and regulatory framework over the major players in this broader financial marketplace in return for their having access to the discount window and other possible forms of public assistance. Others, though, believe that such oversight and safety net responsibilities could lead to a range of problems and an even more fragile marketplace by compounding moral hazard problems and by reducing the role that market discipline could play in strengthening our financial markets and fostering innovation. In general, most recognize that we must think carefully about permanently extending the financial safety net and the Federal Reserve’s lending responsibilities. Using the Federal Reserve’s resources to address breakdowns within a broader financial marketplace will necessarily benefit the assisted institutions, and the particular market segments or financial instruments associated with the problems. Also it is important to keep in mind that many other market participants who have made more prudent decisions will be left at a disadvantage by having to compete without such special favors. For the Federal Reserve and other public authorities, such a role would thus involve a host of difficult decisions during a financial crisis and would potentially put the Federal Reserve in the position of having to pick the winners and losers from a broad range of financial institutions and investors. Moreover, as the Bear Stearns experience shows, these decisions may have to be made in a hurry and with limited information in many cases, and any actions will likely raise questions about why some segments of the economy are protected while others are not. This is a difficult position to find ourselves in and its consequences must be carefully weighed before we choose such a course of action. In providing liquidity or other assistance to market participants who have made unwise decisions, we risk magnifying the moral hazard problems in financial markets. These moral hazard problems will arise as any substantial public assistance works to undermine market outcomes and thereby reduce the incentives that institutions and investors have to manage risk and make sound choices. One need only look to the GSEs Freddie Mac and Fannie Mae to witness the effects such favored treatment has in the marketplace. Perhaps the most prominent example of moral hazard risks is the “too-big-to-fail” problem associated with large commercial banks. As I have noted in prior speeches, this has proven to be a very intractable issue for banking regulators. We all recognize that extending public safety nets, discount window lending and bank-like supervision to a much broader marketplace risks creating a financial system of less inherent stability and an ever larger class of “too-big-to-fail” institutions. Over time it would involve making difficult decisions regarding what segments of the broader financial system should be supervised, how extensively they should be supervised, and whether this supervision would adequately protect the safety net in this new environment. When we consider these consequences it becomes more apparent, to me at least, that we must strive to limit public safety nets and minimize their associated moral hazard problems. There are a number of policy steps we should consider to help markets function in a more orderly fashion and become more resilient to financial crises. To return to my analogy, this means doubling back across the river to a more historical central banking role, and making clear a future crossing would be rare. And we must accept that the credibility of such an assertion will depend critically on how future crises are handled. If we choose to double back, then we must also direct more supervisory focus to the market interdependencies among commercial banks, and we must institute better mechanisms to unwind failing nonbank financial institutions and their counterparty exposures. We should continue to pursue initiatives with the private sector to increase market transparency, enhance corporate governance mechanisms and market incentives, and strengthen settlement systems and trading and securitization markets. And it should be clear that major nonbank financial institutions that seek discount window assistance will immediately come under Federal Reserve oversight. This oversight would be directed toward ascertaining the viability and exposures of such institutions and controlling potential safety net losses. Implications of a broadening mandate for central banks Finally, let me now turn my remarks toward a discussion of the macroeconomic implications of broadening the Federal Reserve’s traditional dual mandate for price stability and maximum employment to include more explicit responsibilities for financial stability. The events of the past year have been especially useful in articulating the challenges that may arise in implementing a tripartite mandate. I would like to focus on the following four questions as particularly important to our understanding of how financial stability fits into a central bank’s portfolio of responsibilities. First, can we define a set of principles to guide a central bank’s mandate for financial stability? This is a key issue for a central bank in determining when it needs to take actions to preserve financial stability or, conversely, when it should refrain from doing so, particularly in situations when political and industry pressures may be calling for a policy response. It is also essential if a central bank is to know when to unwind and remove policy accommodation or special liquidity measures. Defining the principles guiding our financial stability mandate is also important for central banks in communicating with the public and for formulating meaningful debates within the central bank. Second, does a central bank have the ability to effectively pursue a tripartite mandate? That is, does it have enough policy tools, and will these tools be effective in a financial crisis? I think it is fair to say that, at the outset of the current crisis, central banks did not have practiced mechanisms in place to provide liquidity to the institutions and markets most in need of liquidity. Over the past year, the Federal Reserve and other central banks have shown considerable flexibility and ingenuity in addressing these needs. It remains to be seen, of course, whether some of these facilities will be made a more permanent part of the central bank’s policy toolkit. At the same time, it is sometimes the case that the stimulus provided by lowering the policy rate is less effective in a financial crisis because important parts of the policy transmission mechanism are dysfunctional. This difficulty was highlighted in the current crisis where the financial difficulties centered on housing, which is typically a key component of the transmission mechanism. And, it was even more dramatically illustrated in the Japanese banking crisis a few years ago where monetary policy was pushed to its limits with very little effect. As I have indicated on other occasions, care must be taken not to ask too much of monetary policy or we risk adding significant inflationary pressures into an economy. Third, how does a central bank trade off potentially conflicting objectives under a tripartite mandate? Central banks, for instance, may have more to deal with than a financial crisis. In the current situation, we have experienced a severe financial shock coupled with a surge in global inflation. In the face of accelerating inflation, it is important that we not calibrate policy principally to deal with the financial crisis if it involves compromising to an unreasonable extent our ability to achieve our mandate for price stability. In the United States, core PCE inflation has been above most definitions of price stability for the past four years and is poised to move even higher over the near term. The current stance of policy, while understandably calibrated for responding to the immediate financial crisis, will make it difficult to achieve our mandate for price stability over the longer term. Finally, how can a central bank implement a financial stability mandate while maintaining the independence needed to actively pursue its other mandates? As I noted earlier, in the midst of a financial crisis, a central bank will likely be encouraged to take actions that are fiscal in nature or that directly affect the allocation of credit by targeting assistance or liquidity to specific institutions, markets or financial instruments. These actions necessarily affect expectations for similar actions in the future and bring forward political pressures that confirm such expectations for the future. In these circumstances, a central bank must be particularly aware of the difficult trade-offs between its financial stability and price stability mandate, especially where, like the United States, the central bank does not have a formal objective for price stability. Concluding thoughts Let me conclude by emphasizing the broader applicability of the issues that I have discussed today. Although I have focused my remarks mainly on the Federal Reserve, I believe many of the issues raised by this period of financial stress have important implications for other central banks as financial market liberalization and development proceed around the world. Maintaining financial stability in a changing financial system is a difficult task and, realistically, financial crises will occur in the future despite our best efforts to prevent them. Addressing these issues requires a delicate balance between markets and policy intervention and requires recognition of the important macroeconomic implications for central banks. While there can be little doubt that central banks will continue to have responsibility for financial stability going forward, recent events raise important questions about how this mandate should be implemented. Finally, for a market economy to work best, it must to the maximum extent possible find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail. The “Too Big to Fail” issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, to the Peterson-Pew Commission on Budget Reform Policy Forum, Washington DC, 16 February 2010.
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Thomas M Hoenig: Knocking on the central bank’s door Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, to the Peterson-Pew Commission on Budget Reform Policy Forum, Washington DC, 16 February 2010. * * * Thank you for the opportunity to join you today, both to attend and to participate in this event on a topic of some urgency. The United States is moving into an era in which government finance is taking center stage. Fiscal measures taken to bring the economy out of recession, mounting longer-term liabilities for Social Security and Medicare, and other growing demands placed on the federal government have invited a massive buildup of government debt now and over the next several years. Congressional Budget Office (CBO) projections have the federal debt reaching an unsustainable level of two to five times our total national income within the next 50 years, which leads us to an inescapable conclusion – U.S. fiscal policy must focus on reducing this debt buildup and its consequences. In managing our nation’s debt going forward, it strikes me that we have only three options. First, the worst choice for our long-term stability, but perhaps the easiest option in the face of short-term political pressures: We can knock on the central bank’s door and request or demand that it “print” money to buy the swelling amounts of government debt. Second, perhaps more tolerable politically, although damaging to our economy: We can do nothing so long as domestic and foreign markets are willing to fund our borrowing needs at inevitably higher interest rates. Or third, the most difficult and probably the least palatable politically: We can act now to implement programs that reduce spending and increase revenues to a more sustainable level. I recognize that this last option involves hard choices and short-term pain. However, in my view it is the responsible path to sustainable economic growth with price stability. The alternative options inevitably lead to financial crisis and greater long-run losses in national income and wealth. The question of what combination of spending and revenue actions the country might choose is the purview of Congress and the executive branch. As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well. The founders of the Federal Reserve understood this conflict. They understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster. Aware of this danger, they designed our central bank to be responsible for stable prices and long-term growth, and they gave it a degree of independence so that it could carry out this mandate. The goal of policy cannot be to “just get through” the current challenge, but rather to rebuild the foundation of a stable and prosperous economy, looking to our nation’s longterm future. It is in this context that I appreciate this opportunity to address what I see as our emerging fiscal challenges. Lessons from history Throughout history, there are many examples of severe fiscal strains leading to major inflation. It seems inevitable that a government turns to its central bank to bridge budget shortfalls, with the result being too-rapid money creation and eventually, not immediately, high inflation. Such outcomes require either a cooperative central bank or an infringement on its independence. While many, perhaps most, nations assert the importance and benefits of an independent central bank, the pressures of the “immediate” over the goals of the long run makes this principle all too expedient to forgo when budget pressures mount. German hyperinflation is one classic and often-cited example, and with good reason. When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a 500,000 Mark German note. He had been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house. In 1923, it would not even buy a loaf of bread. He said, “I want you to have this note as a reminder. Your duty is to protect the value of the currency.” That note is framed and hanging in my office. Someone recently wrote that I evoked “hyperinflation” for effect. Many say it could never happen here in the U.S. To them I ask, “Would anyone have believed three years ago that the Federal Reserve would have $1¼ trillion in mortgage back securities on its books today?” Not likely. So I ask your indulgence in reminding all that the unthinkable becomes possible when the economy is under severe stress. If German hyperinflation seems an unrealistic example from the distant past, then let’s come forward in time. Many have noted that in the 1960s, the Federal Reserve’s willingness to accommodate fiscal demands and help finance spending on the Great Society and the Vietnam War contributed to a period of accelerating price increases. Although the Federal Reserve was a reluctant participant, it accepted the view that monetary policy should work in the same direction as the Congress and the administration’s goals and help finance at least part of their spending programs. Monetary policy accommodation during this period contributed to an increase in inflation from roughly 1½ percent in 1965 to almost 6 percent in 1970. It also helped set the stage for the Great Inflation of the 1970s as inflation expectations gradually became unanchored. Last Friday, I read that an economist at the IMF raised a question of whether central banks should allow higher rates of inflation during normal times to give them more room to adjust for shocks. While this may sound like a reasonable theory from a credible economist, my concern is that it rationalizes solutions to short-term problems that too often take an economy down the wrong path. The current US fiscal imbalance Today, the United States is benefiting from policies that were established in the 1980s to end the Great Inflation. Confidence in the long-run stability of the U.S. economy and the Federal Reserve’s commitment to price stability have kept the demand for Treasuries relatively strong, allowing the government to borrow at low interest rates from its citizens and the rest of the world. It would be a mistake, however, to take this current ability for granted and to do nothing about the mounting debt. While the last 30 years have been relatively stable – at least until recently – our longer-term history is less reassuring. From World War II to the present, nominal federal debt held by the public has increased over 30 fold. And, supported by steady growth in the money supply, the price level has increased by a factor of 12. That’s a huge increase in the general price level, and it represents a significant reduction in the purchasing power of the dollar over time. These are matters that demand our attention as we make choices involving both fiscal and monetary policy. The immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year – extraordinarily high levels by historical standards. In the entire history of the United States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war. As troubling as these deficits appear, even more disconcerting is the longer-term outlook for the federal debt caused by the accumulation of these deficits over time. The CBO’s long-term debt projections clearly show that current fiscal policies are unsustainable. In one scenario, the liftoff point for federal debt – that is, the time when debt starts rising without any sign of stabilizing – occurs shortly after 2020. By 2035, federal debt held by the public reaches 80 percent of GDP – a level only exceeded during and just after World War II. In another, more pessimistic scenario, the liftoff in debt has already begun, with federal debt held by the public reaching 181 percent of GDP in 2035, easily exceeding the peak debt to GDP ratio of 113 percent that occurred at the end of World War II. A key part of the problem stems from rapid growth in entitlement spending, including spending on Social Security and, especially, Medicare. Over the next 30 years, the Government Accountability Office (GAO) estimates that the present value of future expenditures on all social insurance programs exceeds future revenue by over $50 trillion. That is nearly four times the size of GDP and clearly unsustainable. Adding to my concerns for the nation’s economic prospects is the current level of private indebtedness. As with government debt in the United States, private nonfinancial debt has grown steadily over the post-World War II period, from 40 percent of GDP in 1945 to almost 175 percent in 2009. Every consumer and business that is a net borrower would benefit from lower interest rates. And just as noteworthy, it should not escape our notice that rising inflation would trim the real value of their indebtedness. Thus, high private indebtedness will contribute to the political pressure on the Federal Reserve. Three paths forward Returning to my opening comments, I see just three ways forward in dealing with our current and prospective fiscal imbalances. While each involves considerable pain only the third will resolve the imbalances without eventually causing inflation to accelerate or precipitating a financial and economic crisis. Monetize. One option for dealing with a fiscal imbalance is for the central bank to succumb to political pressure and monetize the debt. As deficits and debt levels within a country rise relative to national income, interest rates tend to rise as well. In this instance the central bank is often pressured to keep rates low and encouraged or required to assist the markets in facilitating the government’s funding needs. If the central bank succumbs to this pressure, its balance sheet will expand, bank reserves will grow, and inevitably the money supply will increase. This process often appears benign at first, but if it goes on unchecked, the outcome is almost always higher levels of inflation and ultimately a loss of confidence in the value of the currency and the economy. Walter Bagehot’s famous dictum about banks holds equally true for governments – once their soundness is questioned, it is too late. At that moment, governments and their citizens are forced to make sizeable, painful fiscal adjustments. An example of both the political pressure that can be exerted on the central bank, as well as the inflationary consequences of debt monetization is currently playing out in Argentina. The president of Argentina recently forced out the Governor of the Central Bank because he would not transfer reserves held at the central bank to repay Argentinean debt. Inflation in Argentina is currently running near 8 percent and will almost certainly increase. Policy Stalemate. The second path forward is a stalemate between the fiscal and monetary authorities. In such a stalemate, the fiscal imbalance grows while an independent central bank maintains its focus on long-run price stability. Although the U.S. government is currently privileged to borrow at favorable rates, the fiscal outlook would inevitably undermine this privilege and its risk premium on debt would increase. Also, as the government competes with private borrowers for funds, the potential exists for the fiscal imbalance to drive up the real cost of borrowing and capital to the private sector as well. Eventually, this combination of large debt, and high cost of borrowing and capital weakens economic growth and undermines confidence in the economy’s long run potential. Slowly, but inevitably, if the fiscal debt goes unaddressed, the currency weakens, as does access to global financial markets. And the cycle worsens, leading ultimately to a financial and economic crisis. An interesting example in this respect is Canada in the first half of the 1990s. During this period, Canadian federal debt increased from about 55 percent of GDP to roughly 70 percent. At the same time, following a joint agreement between the government and the Bank of Canada, the Bank targeted a steady downward path for inflation from 3 percent at the end of 1992 to 2 percent at the end of 1995. With no monetary accommodation from the central bank, unsustainable government deficits and debt caused real interest rates in Canada to climb. While Canadian inflation was below that of the United States throughout this period, Canadians paid a substantial risk premium over U.S. rates to borrow. Moreover, the Canadian dollar came under persistent pressure. Overall economic performance suffered, with GDP growing very sluggishly in the recovery from the 1990–91 recession and unemployment climbing as high as 12 percent. These economic conditions contributed to the election of a new government, which made a credible commitment to balance the budget. In the following years, the federal budget deficit fell dramatically. Revenue increased, and government expenditures were cut sharply. By 1996, Canadian interest rates had fallen below comparable U.S. rates. Inflation remained subdued, real GDP growth picked up, and unemployment fell. Equitable Fiscal Discipline. The Canadian experience in the second half of the 1990s is suggestive of the third – and the only responsible – way to resolve our growing fiscal imbalance: By addressing its source in an environment of price stability. All seem to agree this is the way we would prefer to go, but of course the devil is in the details. At the outset, it requires an institutional framework committed to having an independent central bank. This discourages the fiscal authority from turning to its central bank and should it do so, strengthens the bank’s ability to say “no.” In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation. Knowing inflation is not an acceptable alternative to strong fiscal management, a government faced with rising debt levels must provide a credible long-term plan to reestablish fiscal balance. The plan must be clear, have the force of law and its progress measureable so as to reassure markets and the public that the country has the will and ability to repay its debts in a stable currency. To be broadly accepted, the plan must be seen as fair, in which there is a sense of shared sacrifice across all segments of the economy. Without being specific, these requirements suggest an approach in which we are willing to disappoint a host of special interests. It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors, and resolving our banking problems and the perception that Wall Street is favored over Main Street, all of which would otherwise foster mistrust and cynicism among the public. Leaving these issues unaddressed will undermine the essential popular support required for the tough decisions needed to bring our federal budget into balance. Finally, there are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth. Conclusion As I mentioned in the beginning, the fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis. Eventually, government budgets that are severely out of balance are inevitably reformed – either by force of the markets or, preferably, by choice. Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action. Usually it is at this point that governments reestablish fiscal discipline and renew their commitment to an independent central bank. Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the American Bankers Association Government Relations Summit, Washington DC, 18 March 2010.
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Thomas M Hoenig: Are community banks important? Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the American Bankers Association Government Relations Summit, Washington DC, 18 March 2010. * * * As a Federal Reserve Bank president, I am occasionally asked outrageous questions regarding central banking and commercial banks. “Is the Federal Reserve owned by a European banking cabal?” “How much ownership of the Federal Reserve do the Rockefellers hold?” But over the past few days, the questions have become truly outrageous: “Will the regional and community bank model survive in the future?” Are community banks important? “Shouldn’t the Federal Reserve supervise only the very largest banks and not community banks?” What’s more, it is particularly bothersome to me that these last two questions are most often asked by individuals who have not been in or know what a community bank does. So let me answer the question. Whether you are here today representing JP Morgan or the First State Bank of Hometown, Kansas, the answer is the same. When you cut through the fog, there is no question as to the need for and the importance of community banks in our nation’s financial system. The maps on the screen behind me show that banks with less than $10 billion in total assets hold substantial market share in much of the United States and hold the majority of deposits in 16 states. Bank subsidiaries of bank holding companies with less than $50 billion hold the majority of deposits in 26 states. As you can see from these maps, regional and community banks serve local markets, and in turn, support local economic growth. These banks rely on knowing their customer, and managing those relationships to work with borrowers through good times and bad. Regional and community banks are also typically locally owned and managed, which means they have an immediate and vested interest in the success of their local communities. Yes, regional and community banks also are under pressure from this crisis, and it will be a struggle for them to regain their footing; but, certainly no more so than that for our largest institutions that received significant government support. Commercial real estate will be a drag on earnings for some quarters yet, and there will be bank failures. But this segment of the industry will recover and its model, with its focus on relationship banking, will prosper as the economy recovers and expands. Interestingly, looking at preliminary data, I suspect future analysis of this crisis will find that regional and community banks during the crisis actually may have done a better job of serving their local markets and maintaining lending standards. While this group of banks has a higher concentration of commercial real estate to capital, there is evidence that they are working effectively, and in some instances, more cooperatively than the largest banks with their borrowers to work out or reduce losses, based on their knowledge and active monitoring of customers. Some of our largest banks would be well-served to take a lesson. It is also no coincidence that with breakdowns in other parts of the marketplace, a substantial portion of regional and community banks have increased their loans to businesses. During 2009, 45 percent of the banks with under $1 billion in assets increased their business lending. And while it may make some of the largest banks uncomfortable to hear this, regional and community banks have managed all this while operating at a competitive disadvantage. For it is the largest financial firms that have an implicit, recently made explicit, guarantee that taxpayer dollars will be used to protect them from failure, regardless of what risks they assume. It is only now that we are discussing legislation to address the issue of a special class of the largest firms that we have deemed too-big-to-fail. This is the one item that must be addressed if we are to have any real competitive equity among all financial institutions. What is proposed may need to be strengthened, but it is a start. Let me end my remarks by quickly commenting on the Federal Reserve’s role as a supervisor of regional and community banks, something that will soon come under debate in the Senate and perhaps again in the House. The strong opposition to removing the Federal Reserve from regional and community bank supervision, voiced by myself and others from the Federal Reserve, is not driven by the idea of simply protecting our “turf” or saving Federal Reserve jobs. The record very clearly shows that the Federal Reserve System has made important changes to its operations when such moves benefit the country as a whole regardless of the impact on the Federal Reserve. Most notably, the Federal Reserve was among the strongest supporters of Check 21 legislation, while realizing it would mean the eventual loss of thousands of Federal Reserve check processing jobs. The legislation improved the efficiency of our payments system, and while it was painful for me personally to see the elimination of hundreds of jobs in my District, it was a step we had to take to best serve the nation. In this case, however, serving the best interest of the nation does not mean reducing the Federal Reserve’s supervisory role. Given the importance of 6,800 regional and community banks located in almost as many communities across this country, it is inconceivable to me that the Central Bank of the United States would not have a role in their oversight, through the supervision of state member banks and bank holding companies. The Federal Reserve System was designed by its founders with the goals of it supervising a broad cross section of U.S. banks, assuring equitable access to the Federal Reserve liquidity facilities regardless of institutional size or location, and contributing to the stability of the financial system – not only on Wall Street but on America’s Main Street. It does this job well. In the crisis of the ‘80s, which affected both large and small banks, banks supervised by the Federal Reserve proportionately imposed the least losses on the FDIC when they failed relative to banks supervised by other Federal agencies. In addition, the Federal Reserve’s role in supervision of banks and bank holding companies provides it critical information on local economies in places such as Muskogee, Okla.; Santa Fe, N.M. and Scottsbluff, Neb. And to answer the question: yes, our role in regional and community bank supervision supports our responsibilities as members of the Federal Open Market Committee, by expanding our understanding of local and regional economies. Stripping the Federal Reserve of its responsibility for supervising regional and community banks and bank holding companies should be unacceptable to anyone who cares about equity in the nation’s banking system, largest to smallest bank, and the nation’s regional and local economies. Confining the Federal Reserve’s supervisory role to only the largest firms will, I fear, inadvertently make the Federal Reserve the Central Bank to the largest firms while disenfranchising the other 6800 banks. The map tells the story. When Congress created the Federal Reserve nearly a century ago, it gave us a decentralized system that spanned the continent. The explicit purpose for this structure was to better balance the interest of Main Street against those of Wall Street. Recent experience confirms that this structure is as important today as then, perhaps more so. Community banks are important to the banking system and to the economy, and therefore continue to be important to the Federal Reserve. I have said before but it deserves repeating: It would be a tragic irony if the outcome of this crisis is a gain in power for the largest firms at the expense of the other 6,800 regional and community banks. If so, it would be a win for Wall Street.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Capital Markets Summit: "Getting Main Street Back to Work", US Chamber of Commerce Center for Capital Markets Competitiveness, Washington DC, 24 March 2010.
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Thomas M Hoenig: The financial foundation for Main Street Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Capital Markets Summit: “Getting Main Street Back to Work”, US Chamber of Commerce Center for Capital Markets Competitiveness, Washington DC, 24 March 2010. * * * The views expressed by the author do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. History tells us that for a country to succeed and endure economically it must adhere to a simple set of principles. No matter the market’s complexity, these principles anchor both its financial system and overall economy. And the most fundamental of these principles is a commitment to maintaining the integrity of the institutions within the system. This commitment provides a culture of sound business ethics, a confidence in the rule of law, the reliability of contracts, and a culture of fair play on a level field. How the individual firms compete on this field is up to them. There is almost always a diversity of firms within a highly competitive and appropriately regulated commercial system. Some firms are large, many are small and all are dynamic. Those who relax, resist change, or cheat know that such lapses result in failure, which is determined by the market. If we stray from our core principles of fairness or ignore the rule of law, we distort the playing field and inevitably cultivate a crisis. When the markets are no longer competitive, firms become a monopoly or an oligopoly and it matters more who you know than what you know. Then, the economy loses its ability to innovate and succeed. When the market perceives an unfair advantage of some over others, the very foundation of the economic system is compromised. In these instances, for example, bonuses will far exceed the economic value provided, because the bonus is what we economists call an economic rent. It is not earned, it is only received. The protected will act as if they are protected, they will retain their status independent of performance, and the public will suffer. I like to say, “If you give someone a monopoly, they will act like a monopolist every time.” I open with these comments because our nation today is reacting to a financial crisis and an interruption in the flow of capital. It is also now in the process of addressing its causes in an effort to prevent its recurrence. While calling for action myself, I have been uneasy with what I have seen so far. The attempts to address capital markets and their role as the “Financial Foundation for Main Street,” appear to place a much higher value on rhetoric than on substance and necessary reform. As a nation, we have violated the central tenants of any successful system. We have seen the formation of a powerful group of financial firms. We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences. We must correct these violations. We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law. When we do this, we will not eliminate the small businesses’ need for capital, but we will make access to capital once again earned, as it should be. The inevitable crisis The banking system has gone through an unprecedented era of change starting in the 1980s when lawmakers began removing the roadblocks to interstate banking. This evolution continued to pick up speed in the years that followed through a number of legislative moves that validated the creation of ever larger banks. The scope of activities continued to grow through the 1990s and by the end of the decade we saw the merger between Citicorp and Travelers Group. That merger required the divestiture of certain activities, but this became unnecessary with the passage of the Gramm-Leach-Bliley Act. The legislation allowed a single financial company to engage in commercial banking, investment banking, insurance underwriting and brokerage. This expansion of activities, some argued, created a stronger system overall because the institutions were more diversified. For example, rather than being entirely reliant on a single community or industry, such as real estate, a stronger system was being created because banks were serving a broader nationwide base. A downturn in a single market would be offset by stability in other areas. Although this new era of finance was widely supported, a critical ingredient was missing on the road to expansion and innovation: a framework that would limit dangerous excesses or the development of perverse incentives. Undoubtedly, the most important omission was a way to deal with the larger firms that were using the new growth opportunities to become “too big to fail (TBTF).” Although banking legislation in 1991 specifically tried to limit the Federal Deposit Insurance Corporation’s (FDIC) ability to protect failing banks and their creditors, regulators could make an exception for large institutions whose failure might pose a threat to the economy or to financial stability. As a result, TBTF was embedded in our legal framework. The growth of large institutions has distorted the framework of the financial system in ways other than just TBTF. Larger and more complex institutions have become more difficult to regulate and supervise. In some cases, regulators did not have the resources or authority to keep up with a growing and innovative financial system, particularly during a period when some regulatory rules were being replaced with a risk-focused supervisory system. It has been very difficult for examiners to get large banks to tighten their operations, especially when the banks were generating tremendous profits. These large institutions wield considerable influence. An obvious example of this is the way that Fannie Mae and Freddie Mac were both able to game the political system after their accounting problems and avoid tighter regulation and more realistic leverage constraints. Looking back, one sees that the crisis was inevitable, if for no other reason than that these TBTF firms would push the boundaries until there was a crisis. In a 1999 speech on financial megamergers, I concluded that “To the extent these institutions become “too big to fail,” and … uninsured depositors and other creditors are protected by implicit government guarantees, the consequences can be quite serious. Indeed, the result may be a less stable and a less efficient financial system.” More than a decade later, the only thing I can change about this statement is that the government guarantees are no longer just implicit. Actions during the financial crisis have made this protection quite explicit. The results So, what does this protection mean? TBTF status provides a direct cost advantage to these firms. Without the fear of loss to creditors, these large firms can use higher leverage, which allows them to fund more assets with lower cost debt instead of more expensive equity. As of year-end, the top 20 banking firms held Tier 1 common equity equal to only 5.1 percent of their assets. In contrast, other banking institutions held 6.7 percent equity. If the top 20 firms held the same equity capital levels as other smaller banking institutions, they would require $210 billion in new equity or reduced assets of over $3 trillion, or some combination of both. (See attached charts.) Stated another way, almost one-quarter of the assets held by these large institutions are supported by less equity capital. Furthermore, TBTF reduces the cost of the debt that these firms issue. Due to their implied government support, ratings agencies explicitly increase the debt ratings of the largest banking organizations above the intrinsic rating that would be assigned based on the bank’s condition and the amount of leverage. Not only do these firms get to use more debt, but the debt is cheaper. This framework has failed to serve us well. During the recent financial crisis, losses quickly depleted the capital of these large, over-leveraged companies. As expected, these firms were rescued using government funds from the Troubled Asset Relief Program (TARP). The result was an immediate reduction in lending to Main Street, as the financial institutions tried to rebuild their capital. Although these institutions have raised substantial amounts of new capital, much of it has been used to repay the TARP funds instead of supporting new lending. In other words, I suggest that our economy would be better served by a more diverse financial system. Certainly community and regional banking organizations were hurt by the financial crisis and recession and many of these firms are facing large losses associated with problems in commercial real estate and other lending areas. But despite these problems, many smaller banks have continued to lend. In 2009, 45 percent of banks with assets under $1 billion increased their business lending. Policy changes All of these events bring us to where we are today, talking about the lack of credit availability for Main Street. The good news, such as it is, is that the market is slowly correcting, and credit growth is or will begin flowing to Main Street, providing job growth and economic recovery. However, it will not be rapid or easy. The fact is that Main Street will not prosper without a healthy financial system. We will not have a healthy financial system now or in the future without making fundamental changes that reverse the wrong-headed incentives, change behavior and reinforce the structure of our financial system. These changes must be made so that the largest firms no longer have the incentive to take too much risk and gain a competitive funding advantage over smaller ones. Credit must be allocated efficiently and equitably based on prospective economic value. Without these changes, this crisis will be remembered only in textbooks and then we will go through it all again. As steps toward avoiding this outcome and to assure a more consistent allocation to Main Street, I have three recommendations. First, we must enable capitalism to work and reduce the incentive of our largest financial institutions to take on too much risk by allowing them to fail in an orderly manner. This can be accomplished, but to do so, we must have a credible resolution process that forces shareholders, responsible senior management, and creditors to incur loss if the company takes on excessive risk and becomes insolvent. To be credible, the resolution regime must be independent of the political process and based on the rule of law. Only then, will creditors force these firms to operate with lower leverage. The current legislation in both houses of Congress begins to address this issue. Unfortunately, both still leave considerable room for exception in the hands of the Treasury. This needs more attention. You can find my specific recommendations on how this can be accomplished on the Kansas City Fed’s website. (www.KansasCityFed.org) An often heard statement by many policymakers and financial market experts over the past couple years has been that if a financial firm is too big to fail, then it is too big. I couldn’t agree more. Requiring that the largest financial firms be allowed to fail when they are insolvent and that they must meet at least the same equity capital levels as smaller firms will create a natural limit on the size of firms. It will also do the most for returning our financial system to one that is more efficient and equitable. Second, we must strengthen our supervision of financial firms by returning to simple, wellestablished rules, such as maximum leverage and loan-to-value ratios. In an age of “markets know best” and “growth must be accommodated,” such rules were weakened in statutes and regulations. Today, we are paying the price. Leverage also tends to rise during economic expansions as investors, lenders, and borrowers forget past mistakes or come to believe that “this time it’s different.” We saw this in the years leading up to the current crisis. The acceleration of leverage and increase in loan-to-value ratios reflected a massive miscalculation that risks were low and easily manageable. Third, we must improve the regulatory framework, which may involve reversing some of the deregulation that occurred in the 1990s. Specifically, adopting a version of the proposed Volcker rule would be healthy for long-term stability. It should (1) focus on banning financial holding companies from proprietary trading and investing in or sponsoring hedge funds, and (2) require trading and private equity investment to be housed in separately capitalized subsidiaries subject to strict leverage and concentration limitations. In addition, I strongly support increasing the transparency in financial markets by requiring standardized derivative transactions to be cleared through centralized counterparties, and to the extent feasible, traded on exchanges. Conclusion These reforms will encourage and serve to maintain a diverse and efficient banking system. This means a banking system that includes a healthy mix of community, regional, and large banking companies. The banking system’s diversity allows the United States to have the world’s most innovative and entrepreneurial economy, in large part, because both small and large firms are able to obtain the funding they need. The reforms I propose will promote fairness in our banking system. Fundamental principles are not anti-business. On the contrary, my recommendations are more pro-business than the current regulatory framework. A credible resolution process, simple rules for leverage and loan-to-value limits, and the Volcker rule reforms will allow all banks to compete on an equitable basis. In the end, reinstating these fundamental principles will enhance consumer, business, and Main Street access to that most essential resource – capital.
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Written statement by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the House Financial Services Oversight and Investigations Subcommittee, United States House of Representatives, Kansas City, 6 May 2010.
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Thomas M Hoenig: Leverage – the double-edged sword Written statement by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the House Financial Services Oversight and Investigations Subcommittee, United States House of Representatives, Kansas City, 6 May 2010. * * * Introduction Chairman Moore, ranking member Biggert, and members of the committee. Thank you for the opportunity to testify at this timely hearing. The financial panic of 2008 created the worst recession since the 1930s, sending unemployment soaring to 10 percent and dramatically changing the landscape of our financial system. While many factors were responsible for creating this crisis, there is no doubt that excessive debt and leverage was a major contributor. Leverage, the ability to use debt to build assets as a multiple of a firm’s capital base, is a double-edged sword. Credit is obviously essential to an economy’s growth and prosperity. But when a tower of debt is built on a foundation of weak capital, the inevitable outcome is a collapse and loss of national wealth. Following this most recent crisis, lawmakers and regulators are examining the issues of debt, leverage and financial strength. We are at a crossroads. The country must again review and define an acceptable leverage profile for our economy and specifically for financial institutions. Defining leverage standards too tightly inhibits growth. Defining them too loosely invites excess risk and crisis. My views on this topic are based on 36 years of broad experience in the Federal Reserve. As head of bank supervision for the Federal Reserve Bank of Kansas City in the 1980s, I saw the damage caused nationally and locally by excessive leverage and bank failures – both small and large. As President of our Bank over the past 18 years, I’ve witnessed the anguish of individuals and businesses as they struggled to manage the downside effects of too much leverage. Trends Over the past two decades there has been a systematic increase in debt and leverage within the United States, involving all major sectors of the economy. The charts I have included with my statement show asset-capital and debt-income ratios increasing annually across all sectors, rising to levels well above long-run trend lines. In hindsight most agree this build up was excessive and the markets and the regulators should have seen the crisis coming. But they didn’t. There are three components that we must look at in judging the safety of any level of leverage: the quality of assets, the quality of capital and the amount of capital. While asset quality is important, it is the quality and amount of capital that gets a company through unexpected asset problems encountered during the course of business. For that reason, I will focus my attention here on the quality and amount of capital. Stockholder tangible common equity is the strongest form of capital. It is immediately available to meet creditor obligations and absorb losses. Fundamentally, this is what defines a meaningful measure of leverage. Other measures of capital include different hybrid debt instruments or intangibles that attempt to account for potential value and future earnings. For example, goodwill is an intangible that is not immediately available and evaporates quickly when a firm encounters asset problems. Trust preferred stock is a hybrid-debt instrument that carries cash flow demands over the life of the instrument. Thus, I measure leverage as a firm’s total tangible assets measured against tangible common equity. The leverage at banking organizations has been rising steadily since the mid-1990s. The increase, however, is not immediately obvious because of the different ways capital and leverage can be measured (Chart 1). For example, in 2007 just before the crisis began, leverage for all banking organizations based on total equity capital, which includes common equity, perpetual preferred stock, and goodwill and other intangible assets, was the same as it was in 1993, $13 of assets for each dollar of capital. The story is quite different when you focus on tangible common equity by excluding perpetual preferred stock and goodwill and other intangible assets. Tangible total assets rose from 16 times tangible common equity in 1993 to a multiple of 25 in 2007. The increased reliance on lower quality capital in recent years is clearly seen by the large gap among the various leverage measures in recent years as compared to the early 1990s when all the measures were about the same. Moreover, a closer examination of the distribution of leverage across firms of different sizes shows that almost all of the increase in leverage is due to the largest banking organizations (Chart 2). For the 10 largest banking companies, leverage based on tangible common equity almost doubled from 18 in 1993 to 34 in 2007, and this doesn’t include their off-balance sheet activities. For the rest of the industry, leverage rose from 14 to just 17 (Chart 3). I would also note that for broker-dealers, which are an increasingly important source of credit through the shadow banking system, financial leverage rose from 13 in 1992 to 47 in 2007 (Chart 4). As a result, with twice as much leverage as all other banking organizations, the 10 largest had much riskier balance sheets at the start of the crisis. The much higher leverage and greater risk exposure of the 10 largest firms clearly indicates that they had a significant funding cost advantage over all other organizations, and their creditors believed they had less exposure to losses. This increase in financial sector leverage fueled a significant growth of debt in the non financial sector of the economy and, as it turned out, led to a general excess of credit growth over the past 10 years (Chart 5). Bank lending rose from 39 percent of gross domestic product (GDP) in 2004 to 47 percent by the end of 2007, and that figure excludes the rapid growth in credit from the shadow banking sector and the GSEs, Fannie Mae and Freddie Mac. While bank loans relative to GDP have declined since 2008, it remains well above the long-term trend. The increase in leverage and debt was most prominent in the consumer sector. Consumer debt as a percent of personal income generally has been rising since the 1950s (Chart 6). However, it began a rapid acceleration in 2000, rising from 76 percent to 110 percent by the end of 2007. Non financial business borrowing relative to nominal GDP also has followed an upward trend since the 1950s (Chart 7). During this most recent expansion, it has increased from 77 percent in 2004 to 89 percent at the end of 2007. Finally, and no less importantly, the federal government deficit is at record levels and the current trend is unsustainable (Chart 8). The increase over the past two years is due partly to the automatic stabilizers that come in to use during a recession and to additional fiscal actions taken to restart the economy. These temporary actions will add to an already heavy burden of various programs that have sharpened the upward trend with no obvious end in sight. Effects Given the levels of leverage in the economy, no one should have been surprised at the collapse triggered by the housing bubble bursting in 2006 and the rise in subprime mortgage defaults in 2007. When housing prices fell, many discovered that they had taken on more financial risk than they previously assumed and more than their capital levels could support. The institutions with the highest leverage suffered the most, and, as it turned out, these were some of the largest institutions in the world. Financial panic quickly followed. What started as a Wall Street panic soon created regional distress and finally Main Street suffering. And just like the largest institutions, the regional and community banks that were most leveraged, were most likely to fail. The wave of losses, consumer foreclosures and business failures infected every element of the economy. The deleveraging process commenced as highly-leveraged financial institutions, working with highly-leveraged consumers and business, had insufficient capital to withstand the financial blows. Increasing numbers of homeowners were unable to keep up with their mortgage payments, leading to higher defaults. Mortgage defaults, in turn, sharply lowered the values of mortgage securities held by financial institutions. These losses led banks to attempt to reduce their leverage, which required rebuilding tangible capital and reducing total assets – thus reducing loans. This placed downward pressure on asset values, losses worsened and the vicious cycle of deleveraging worsened. Homes and businesses were lost to foreclosure and liquidation, while unemployment climbed. The large increases in leverage over the past decade have wrecked havoc on our economy and are responsible for the sluggishness of our recovery. Strong economic growth simply cannot occur if consumers and businesses must focus on rebuilding balance sheets instead of on increasing spending, production and hiring of new workers. Once again we have learned that the double edged sword of leverage is a pro-cyclical weapon. Constraining leverage Today, the largest financial firms are showing a solid recovery. Regional and community banks continue to show stress but problems may have peaked as they have worked to reestablish stable capital and leverage levels. The market appears to be correcting and leverage based on high quality capital is returning to more historic norms. In time credit will once again expand and the economy will improve. But it won’t be quick or easy. Therefore, we must now turn to actions that will prevent the impulses of consumers, businesses, and financial institutions from assuming ever more leverage as the expansion becomes a boom. If we take action now, then when the next economic correction occurs there will be less devastation to our economy. If we don’t change policy now, then this crisis will be remembered only in text books and leverage will rise again and lead to another crisis. I strongly support establishing hard leverage rules that are simple, understandable and enforceable and that apply equally to all banks and bank holding companies that operate in the United States. As we saw in the years leading up to the current crisis, leverage tends to rise during economic expansions as investors and lenders forget their past mistakes and believe that prosperity will continue with no end in sight. Straightforward leverage and underwriting rules are not procyclical, so that as the economy expands and heats up, bankers must match increases in assets with increases in capital, which constrains reckless growth. Thus, such rules would serve to limit growth beyond a prudent level by creating a counter-cyclical force that moderates booms and provides a cushion to bank losses when the next recession occurs. For an example of the power of a hard leverage rule, consider the impact on assets and/or equity of restricting bank holding companies to holding no more than $15 of tangible assets for every $1 of tangible equity capital (Chart 9).As I noted, at the end of 2007, the 10 largest bank holding companies held $34 of tangible assets for every $1 of tangible equity capital. If the maximum leverage ratio was 15:1, these companies would have had to reduce their assets by $4.9 trillion (56 percent), increase their tangible common equity by $326 billion (125 percent), or some combination of the two. Simple rules also provide examiners with the tools they need to prevent leverage from rising and underwriting standards from declining. Without hard rules on leverage ratios and lending standards, bank examiners were disadvantaged in taking actions on rising leverage and declining loan-to-value ratios because bankers could correctly claim they were following supervisory guidance on capital levels, and their loan problems were very low, while profits were strong. Finally, the rise in leverage in the last cycle was facilitated by the complexity of international risk-based-capital requirements. In particular, the Basel I risk-based capital standards in place leading up to the crisis provided very crude measures of asset riskiness, which increasingly underestimated risk as asset markets deteriorated. Banks also could arbitrage capital standards and raise their risk-based capital ratios by shifting assets to favorably treated off-balance sheet vehicles or exchanging assets such as prime mortgages for “lower risk” subprime mortgage-backed securities. The Basel II risk-based standards, which we were starting to phase in, would have enabled an even greater amount of leveraging to occur. These standards, which allow banks to use model-based risk estimates for many types of assets, actually suggested banks were holding too much capital in the months leading up to the crisis.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Bartlesville Federal Reserve Forum, hosted by Bartlesville Chamber of Commerce, Bartlesville, Oklahoma, 3 June 2010.
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Thomas M Hoenig: The high cost of exceptionally low rates Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Bartlesville Federal Reserve Forum, hosted by Bartlesville Chamber of Commerce, Bartlesville, Oklahoma, 3 June 2010. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. I appreciate the opportunity to join you here today. Bartlesville plays an especially important role in the history of the Federal Reserve Bank of Kansas City. After Congress passed the Federal Reserve Act nearly a century ago, a special committee was appointed to determine where the nation’s 12 regional Federal Reserve Banks would be located and what regions those banks would serve. When that committee met in Kansas City to discuss business relationships in the central United States, Frank Phillips was among those who attended and spoke in favor of locating our Bank in Kansas City and having it serve Oklahoma. The support from Mr. Phillips and others from Oklahoma was absolutely critical to the eventual decisions that established the Bank in Kansas City and included Oklahoma in the Tenth Federal Reserve District that we serve. A few years after our founding, we opened our Oklahoma City Branch. This morning, the community and business leaders who serve on the Branch’s Board of Directors – including Bartlesville’s own K. Vasudevan – met here in Bartlesville, which seems especially appropriate. This is not the only connection between the Federal Reserve’s founding and Oklahoma. The Senate sponsor of the Federal Reserve Act was one of Oklahoma’s first senators, Robert Owen. Senator Owen, like Mr. Phillips, recognized the importance of having the central bank of the United States tied directly to America’s Main Streets and not isolated in Washington or on Wall Street. That structure is at least as important today as it was a century ago. It is my hope that, after much debate, the regulatory reform legislation now under discussion in Washington will affirm in its final version the importance of these regional responsibilities. It is our job as the regional headquarters of the nation’s central bank to serve as the link between our communities and national policy deliberations. Although these policy issues are always important to our nation, today we find ourselves at a unique and difficult point. We are attempting to support an economic recovery, but in doing so, also avoid fostering the next crisis. It is this challenge that I would like to spend the next few minutes discussing and sharing with you my views. Economic outlook At this point, the U.S. economy appears on the path to recovery. Subject to the risks I will discuss a bit later, the general outlook is good. GDP grew at nearly a 4 percent pace in the second half of last year, after bottoming out last summer. I anticipate growth will be slower this year, coming in between 3 and 3½ percent. What is perhaps most encouraging now is the changing composition of growth that we are seeing. Last fall, a good portion of the GDP growth could be traced to temporary factors related to fiscal stimulus and inventory adjustments by firms that had scaled back during the worst of the recession. At that time, there was considerable uncertainty about what might happen once these temporary factors subsided. However, more recent data suggest that the recovery is more broad-based and self-sustaining, and perhaps even stronger than anticipated. Consumer spending, which makes up more than 70 percent of GDP, has been expanding at a solid pace. While consumers have been cautious about big-ticket purchases, we’re starting to see some signs that this is changing as consumer confidence improves. Manufacturing activity continues its sharp rebound, and nonmanufacturing activity has been expanding as well. With businesses seeing a recovery in demand, business purchases of equipment and software have been robust. Jobs, of course, remain a critical issue. Improvements in labor markets boost household income prospects and enables Americans to take care of themselves and their families and to save for their future. So of course jobs are a crucial component in the transition to selfsustaining growth. We are now seeing clear signs that the process of job creation is taking hold. Payrolls have risen in each of the first four months of this year. In April, payrolls increased by a strong 290,000. The recent uptick in the unemployment rate from 9.7 to 9.9 percent actually reflects an improved outlook, as workers who dropped out of the job market are gaining confidence and beginning to reenter the workforce. Solid job gains in the months ahead will translate into a downward trajectory for the unemployment rate later this year and into next year. Nevertheless, while the economy is improving, recovery in certain sectors will be prolonged. Notably, the construction industry has yet to convincingly turn the corner. The residential housing market received a boost from federal homebuyer tax credits last fall and again this spring, but given the overhang of unsold homes, building activity will remain subdued through most of this year or longer. Nonresidential construction will likely continue to contract this year, due to high vacancy rates in that sector. These are important negatives but by themselves should not derail the recovery. Looking at the economy more broadly, inflation has drifted lower in recent months, which is typical following a recession. While energy prices have kept consumer price inflation around 2 percent, inflation in non-food and non-energy prices – which is core inflation – has been running at rates of around 1 percent. These inflation rates are likely to continue for the next year or so. However, as the economic recovery continues or picks up momentum, I expect inflation to drift higher. As for risks to this outlook, there are several. The fluid situation in Greece and Europe reminds us to be wary. The European debt problems have increased uncertainty and a renewed aversion to risks, and are causing investors to flee riskier assets such as stocks and junk bonds for safer assets such as U.S. Treasury debt. These shifts will have a modest negative net effect on U.S. economic growth in the near term. As an aside, I would note this episode illustrates the longer run danger of running persistent budget deficits – a situation that we must soon address in the United States. Monetary policy It is within the context of this outlook and its longer run implications that the Federal Open Market Committee must balance its objectives of supporting short-run economic growth and long-run stable growth and low inflation. It also is within the context of this outlook and these objectives that policy must be normalized, as reflected in the level of real interest rates and the size and composition of the Federal Reserve’s combined balance sheet. Achieving such multiple objectives requires deft handling. But most certainly, the first step toward a more normal policy is to move policy rates off zero, back toward neutral. In saying this, I have no illusions about the challenges of moving away from zero. But in my judgment, the process should begin sooner to avoid the danger of having to over compensate later, as so often happens in policy. I would begin the normalization of policy by outlining for the public a two-step process: First, the Federal Reserve would continue to unwind its extraordinary policy actions implemented as a response to the financial turmoil that began in the fall of 2008. The market’s need for these facilities has eased and we have closed most of them, returning the discount window to more normal operations. As part of this first step, the FOMC would also eliminate its commitment to maintaining “exceptionally low levels of the federal funds rate for an extended period.” Second, with these steps taken, with the improvements in market conditions and liquidity, and with an improving outlook, the FOMC would be prepared to raise the funds rate target to 1 percent by the end of summer. This would continue the current highly accommodative policy, but would move nominal rates away from zero and real rates to a less negative level. We would then pause, maintaining the funds rate at 1 percent while we assess the economic outlook and emerging financial conditions. This would provide time to judge whether and to what degree further policy adjustments are warranted to assure long-run financial equilibrium and stability. Based on the current outlook consensus, it seems reasonable that the economy would be well-positioned to accept this modest increase in the funds rate. As a reminder, the funds rate target remained between 1 and 2 percent even after the intensification of the crisis in the fall of 2008. It was reduced to its current target range of zero to ¼ percent in mid-December 2008. Relative to the depths of the crisis, conditions today are much improved from where we were 18 months ago. Financial stress is clearly reduced and a sustainable economic recovery appears under way. It is also important to emphasize that the 1 percent fed funds rate target, coupled with the Federal Reserve’s large balance sheet, provides an extraordinarily accommodative monetary policy environment and one that would ensure the economy’s continued progress in the recovery. Setting out such a plan would be a more orderly move toward unwinding the earlier extraordinary actions and would serve to reduce the likelihood of a buildup of new financial imbalances. Let me turn now to the subsequent steps that might be taken to more fully restore policy to a long-run equilibrium policy level. Given the relatively modest expected trajectory of growth and inflation, these added moves will involve some quarters to complete. But the direction should be firmly established now with the timing dependent on the performance of a combination of financial, inflation and growth variables. Experience tells me that a clear commitment now to such action would mitigate the likely need to later tighten beyond our estimate of neutral that so often comes with delay. More specifically, these next steps involve raising the funds rate from 1 to above 3 percent reasonably quickly as we gain confidence that GDP and employment are on a steady path toward potential. The final steps would take rates to between 3.5 and 4.5 percent as economic growth approaches long-run potential. If we are to achieve a steady rate environment, it is also important that the Federal Reserve’s balance sheet be restored to its pre-crisis size and composition. Obviously this requires the careful process of selling the Federal Reserve’s $1.3 trillion portfolio of mortgage-backed securities. Various approaches to this can be identified but most agree that it should be done with the process or time horizon clearly set out for all to see. I also would suggest it begin at least when the fed funds rate rises above 1 percent or sooner if conditions provide the opportunity. Monetary policy and unemployment Finally, I want to spend a few minutes suggesting why it is important to move the federal funds rate off of zero even though the unemployment rate remains above 9 percent. It has been argued, with some supporting evidence, that the Federal Reserve’s commitment to very low interest rates in 2003 and 2004 was too low for too long and contributed to the housing and credit boom and subsequent busts. Between August 2002 and January 2005 – two-and-a-half years – the federal funds rate was below the rate of core inflation. Such low interest rates encourage borrowing and a buildup of debt, sometimes in ways we do not fully appreciate until much later with the benefit of hindsight. In addition, low interest rates – especially with a commitment to keep them low – led banks and investors to feel “safe” in the search for yield, which involves investing in lessliquid and more risky assets. In addition, financial institutions often search for yield by increasing the amount of assets supported by each dollar of net worth – leverage. For example, leverage at securities broker dealers rose dramatically. After averaging just 13-1/4 between 1970 and 2000, leverage climbed to a high of 40 in the third quarter of 2007 – the start of the financial crisis. It was after a period of too-low interest rates, too much credit, too much leverage that the collapse of the housing bubble, the rapid deleveraging and the ensuing financial crisis occurred. And it was after these events that unemployment rose to more than 10 percent and the United States lost 8.4 million jobs. In 2010, we have only gained back 573,000 jobs. In another period, the mid-1970s and early 1980s, low interest rates also triggered an extreme swing in the economic cycle. The real fed funds rate was kept negative for a span of nearly three years, from November 1974 to September 1977. The low interest rate environment led initially to a drop in the unemployment rate. But rising inflation and asset bubbles eventually dictated a restrictive monetary policy implemented by Fed Chairman Paul Volcker and his FOMC colleagues. In the end, the nation paid a high price for the low rates of the 1970s, when unemployment reached 10.8 percent in the recession of the early 1980s. In the drive to achieve price stability and stable growth, monetary policy is a powerful tool. Certainly lowering interest rates is the appropriate monetary policy response to the onset of an economic recession and rising unemployment. But it is also a blunt instrument that has a wide set of intended but also unintended consequences that can and have worsened economic outcomes including misallocation of precious resources, inflation and long-term unemployment. That is why we want to return to a sustainable long-term equilibrium policy rate, starting soon. The economy is improving and policy should reflect that fact, carefully but confidently. Although we find ourselves in a unique environment, history offers us some important lessons. If we do not learn from past mistakes, we will find ourselves repeating them yet again.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Town Hall Meeting, Lincoln, Nebraska, 13 August 2010.
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Thomas M Hoenig: Hard choices Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Town Hall Meeting, Lincoln, Nebraska, 13 August 2010. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. These are trying times for the U.S. economy. The unemployment rate is almost 10 percent, our financial system remains under stress, community bank failures have become weekly news and the central bank is printing money to such an extent that zero interest rates bring little return to those who choose to save. Not in decades has the Federal Reserve seen such challenges in how it conducts monetary policy. With this in mind, this morning I will give you my sense of the issues we face and the hard choices that must be made. I’ll begin by focusing on financial reform legislation, including my observations about where we are with too-big-to-fail. Then I’ll turn to the economy and monetary policy. Regulatory choices On March 6, 2009, I gave a speech in Omaha called “Too Big Has Failed.” I shared my thoughts about the financial crisis and my concern for the long-run effects of bailing out investors of the largest financial institutions. That speech hit a nerve by stating what many considered a simple truth, which is that taxpayers should not subsidize our largest financial firms. With our very important Federal Reserve Branch office in Omaha, I have been in Nebraska many times since then, but this is my first trip back after the passage of financial reform legislation, so it seems an appropriate time to review some of the implications of enacting the 2,300-page law. Overall, important steps were taken in an effort to strengthen and enhance the regulatory framework and accountability of financial institutions. However, the success of this legislation entirely depends on how well regulatory authorities implement the new requirements. There is, for example, a provision called the Volcker Rule, which will limit a large firm’s ability to set up speculative activities. So-called “proprietary” trading and the sponsorship of hedge funds that engage in higher-risk activities must be done outside of commercial banks and bank holding companies, away from direct access to insured funds and the Federal Reserve’s discount window. This is an important provision. However, there are exceptions to the rule and, again, whether it works as intended will depend on how strongly the rules are written, and how well they are interpreted and enforced. The legislation also sets up a new consumer bureau to address the gaps in unregulated and under-regulated financial firms, including mortgage finance companies, payday lenders and credit card issuers. Its success will depend on whether it can appropriately identify those institutions exploiting those gaps and bring them into accepted standards of behavior. If the new bureau merely directs its resources to the already heavily regulated community banks, its beneficial effects will be minor. A targeted implementation program is critical if the consumer is to experience the hoped-for benefits. The legislation primarily hoped to address the public’s concerns about too-big-to-fail institutions – that is, those that are so large and interconnected that they will be bailed out by taxpayers no matter what risks and bad decisions they make because they are too “systemically important” to be allowed to fail. Whether or not too-big-to-fail is addressed by this legislation depends on the leadership at the regulatory agencies when the next crisis occurs. The law now requires that the FDIC take into receivership an institution that is designated as “in default or danger of default” for which the regular bankruptcy process would have systemic consequences. The process for taking this action is complex, requiring multiple regulatory parties to agree, the Treasury Secretary making the final determination with the President’s concurrence, and a court ruling that the action isn’t arbitrary and capricious. This will be an incredible challenge for the regulatory agencies. Recent experience tells us that time is of the essence in a national liquidity crisis. It will be extremely difficult in practice to designate the largest institutions as insolvent, take them over and liquidate. The simple truth is “too-big-to-fail” will not go away easily. Our largest institutions, even after their poor performance during this last crisis, remain financially and politically powerful institutions. It gives me pause, for example, that after the recent devastating experience of the global banking crisis, regulatory authorities are already backing off initial attempts to strengthen international capital requirements for these largest banks and financial firms. The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of 3 percent. This is a 33-to-1 leverage ratio. Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable. As I consider the outlook for financial regulation, I am hopeful but realistic regarding whether next time things will be different. Regulatory agencies have been given a mandate and authority to strengthen oversight of the largest firms. Success will depend on whether we choose to make hard calls and to use the new authority with integrity, fairness and resolve. Monetary choices I want to spend my remaining time on monetary policy. I acknowledge that there are different perspectives on the array of economic data we receive and analyze, and therefore there are legitimate, differing views about what is best for the economy. The Federal Reserve has a dual mandate to pursue stable prices and stable long-term growth. The entire FOMC is committed to pursuing those goals, but there are differing views on the causes and fixes to our current situation. I have been at the Fed through past swings in the business cycle. There is today a familiar theme as I listen to the media, various economists and “market experts.” They say we are entering the era of a “new normal” in which we have to accept high unemployment and low income growth and that interest rates will remain at zero indefinitely. They warn that deflation is a serious risk and that the U.S. could become another Japan, which must be avoided at all costs. Before this week’s FOMC meeting, The Wall Street Journal wrote that the Fed would add more stimulus into the economy – including the purchase of long-term treasuries. It turns out that reporter was remarkably prescient. I share these concerns about our economy. Economic conditions are far from satisfactory, unemployment is simply too high, and we want a stronger recovery. But as much as I want short-term improvement, I am mindful of possible longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to “uncertainty” by taking such actions. Remember, high interest rates did not cause the financial crisis or the recession. Let me summarize four key points that I judge relevant in choosing among monetary policy options. Trend data show modest recovery The recovery is proceeding as many economists earlier this year outlined that it would. It is a modest recovery, with mixed results. Yet, GDP is likely to expand at somewhere around a 3 percent rate through the remainder of the year. Month-to-month data will be mixed, as is typical during recovery. For example, industrial production was down 0.3 percent for April, up 1.3 percent for May, and up 0.1 percent for June. New orders for non-defense capital goods excluding aircraft were down 2.8 percent in April, up 4.7 percent in May, and up 0.6 percent in June. Durable goods orders were up by 2.9 percent in April, down 0.7 percent in May and down 1.2 percent in June. Corporate profits are being reported as consistently strong, month after month. What these data points tell me is that volatile monthly data should not drive policy actions. While monthly data may be mixed, the trend data are consistently positive. Private job growth has been less than hoped for but positive nonetheless. Private payrolls increased 630,000 since January 1. In the first half of the year, private labor income increased in all components: hours worked, employment and wages. Hours worked have risen more rapidly than employment, which is typical for the early stages of an economic recovery. In fact, we are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries. In addition, since the second quarter of 2009, personal income growth has increased 2.8 percent, consumption is up 1.6 percent, investment in equipment and software is up 15 percent, and housing is up 5.3 percent. Year-over-year, industrial production is up 8.2 percent, high tech is up 20 percent and manufacturing is up 8.3 percent. Corporate profits are up 57 percent since the fourth quarter of 2008. While we are not where we want to be, the economy is recovering and, barring specific shocks and bad policy, it should continue to grow over the next several quarters. Corrections take time We are recovering from a horrific set of shocks, and it will take time to “right the ship.” Moreover, the financial and economic shocks we have experienced did not “just happen.” The financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations. In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990–91 and 2001. If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring. Here are some important figures regarding just how out of balance our economy became and what might have contributed to these imbalances between the early ’90s and today: The real fed funds rate averaged 1.6 percent between 1991 and 1995, 0.37 percent between 2001 and 2005 and –1.0 percent from 2008 to the present, hardly a tight policy environment. Gross federal debt increased from 60 percent to 75 percent of nominal GDP Consumer debt increased from 63 percent to 94 percent of nominal GDP Nonfinancial debt increased from 189 percent of nominal GDP at the start of the decade to 234 percent by December 2008. Between 1993 and 2007, the average leverage of the 20-largest financial institutions in the U.S. (total assets-to-tangible equity capital) increased from 18-to-1, to over 25-to-1, reaching as high as 31-to-1. The U.S. increased its debt to the rest of the world dramatically from 4.87 percent to 24.32 percent of nominal GDP. Obviously, the effect of these trends on our economy has been significant and we must accept that they will not be corrected quickly. It is not time for tight policy In my view, maintaining an accommodative monetary policy is necessary at this time, but a clear policy path toward a less highly accommodative policy will encourage a more sustained recovery. Under such a policy, financial deleveraging will evolve slowly and many of the remaining economic imbalances will rebalance. Under such a policy, the economy will expand at a sustainable moderate pace with similar moderate job growth, but job growth that will be stable and resilient. There may be ways to accelerate GDP growth, but in my view, highly expansionary monetary policy is not a good option. To be clear, I am not advocating a tight monetary policy. I am advocating a policy that remains accommodative but slowly firms as the economy itself expands and moves toward more balance. I advocate dropping the “extended period” language from the FOMC’s statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return. The FOMC would announce that its policy rate will move to 1 percent by a certain date, subject to current conditions. At 1 percent, the FOMC would pause to give the economy time to adjust and to gain confidence that the recovery remains on a reasonable growth path. At the appropriate time, rates would be moved further up toward 2 percent, after which the nominal fed funds rate will depend on how well the economy is doing. If such a path were chosen, then how might GDP and important components perform? Let me start with consumption, which for decades amounted to about 63 percent of GDP. During the boom it rose to 70 percent. It seems reasonable that the consumer will most likely return toward more historical levels relative to GDP and then grow in line with income. If so, the consumer will contribute to growth but is unlikely to intensify its contribution to previously unsustainable levels. To view the role of the consumer from another perspective, I would note that personal savings declined from nearly 10 percent of disposable income in 1985 to less than 2 percent in 2007. It is now closer to 6 percent, better in many ways, but still below historical norms. Assuming it stabilizes and personal incomes grows as it has so far this recovery, you get a clearer sense of how consumption will contribute to the economy’s expansion but also why it is unlikely to play a dominant role as it did in this past decade. While businesses need to rebalance as well, they are essential to the strength of the recovery. Fortunately, they are in the early stages of doing just that. Profits are improving and corporate balance sheets for the nonfinancial sector are strengthening and are increasingly able to support investment growth as confidence in the economy rebuilds. Also, although credit supply and demand may be an issue impeding the recovery to some extent, a shortage of monetary stimulus is not the issue. There is enormous liquidity in the market, and it can be accessed as conditions improve. Finally, the federal government needs to rebalance its balance sheet as well. Federal and state budget pressures are enormous, and uncertain tax programs surely are a risk to the recovery. This adds harmful uncertainty upon both businesses and consumers. However, while these burdens are a drag on our outlook, they are not new to the U.S. and, by themselves, should not bring our economy down unless they go unaddressed. I believe the economy has the wherewithal to recover. However, if, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty. A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty. Market motives We were reminded of the critical nature of our financial markets when they locked up during the crisis. We need markets to function smoothly. However, market participants should not direct policy. When mixed data are reported as systematically negative results, and the more positive, long-term growth trends fail to be adequately acknowledged, it is an invitation to hasty actions. Of course the market wants zero rates to continue indefinitely: They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases. The current recovery in its first year saw GDP grow an average of 3.2 percent. The GDP growth rate for the 1991 recovery was 2.61 percent; and for the 2001 recovery, it was 1.92 percent. We would all like to see a stronger recovery, but slow growth is not a decline in growth and we should not react hastily. The summer of 2010 has seemed strikingly familiar to me. I recently went back and looked at news reports for the spring and summer of 2003, just prior to when the FOMC lowered the fed funds rate to 1 percent, where it remained until 2004. I’ll provide just two examples. In June 2003, one prominent economist noted in USA Today: “The Federal Reserve Board recently warned that America faces a risk of [deflation]. Japan has been suffering from it for more than a decade. Europe may be heading toward it. The entire world economy could succumb to it. …This could be the first round in a deflationary cycle. The Commerce Department reports orders to U.S. factories slipped 2.9% in April from March, the largest decline in 17 months. …With fewer jobs and stagnant wages, Americans won’t be able to buy enough to keep the economy going.” Also in June 2003, a Boston Globe columnist noted: “On the surface, one can make the case that the Fed doesn’t have to do anything at all. Interest rates are incredibly low….Still, the Fed will not sit on its hands. Chairman Alan Greenspan and his deputies have done everything but advertise the coming rate cut on the Goodyear blimp. Their motivation is to avoid deflation. …Another rate cut, even a cut of one-half point, doesn’t guarantee that there won’t be an economic collapse. But it makes that collapse less likely – hence the notion of rate cut as insurance policy. As insurance, a rate cut is pretty cheap. Lower rates aren’t going to trigger a burst of inflation, and if they give the economy an extra boost, well, who is going to complain about that?” In the third quarter of 2003, immediately following these and many similar articles, GDP expanded at what turned out to be nearly a 7 percent annual rate, yet rates were left at 1 percent for several months. With the low rates very low for a considerable period, credit began to expand significantly and set the stage for one of the worst economic crisis since the great depression. In my view, it was a very expensive insurance premium. Unemployment today is 9.5 percent. I fully acknowledge that I was on the FOMC at that time. That’s why I believe that zero rates during a period of modest growth are a dangerous gamble. The Great Depression of the 1930s was a traumatic event. We need to be aware of its lessons. We need to avoid its mistakes. For example, the Fed should never again double reserve requirements overnight. However, I urge us not to forget other more-recent lessons from the great inflation and the financial crisis of 2008: Real interest rates that are negative 40 percent of the time create severe consequences. One final note about deflation: The consumer price index was a mere 18 in 1945 but was 172 at the start of this century. Today, despite our most recent crisis, the CPI is over 219. Not once during more than half a century has the index systematically declined. I find no evidence that deflation is the most serious threat to the recovery today. Conclusion I agree that the Federal Reserve needs to keep its policy rate accommodative. For a while longer, it should remain even below the long-run equilibrium rate. However, the economy is improving and is growing at a rate faster than the last two recoveries. Importantly, the recent financial crisis and recession was not caused by high interest rates but by low rates that contributed to excessive debt and leverage among consumers, businesses and government. We need to get off of the emergency rate of zero, move rates up slowly and deliberately. This will align more closely with the economy’s slow, deliberate recovery so that policy does not lag the recovery. Monetary policy is a useful tool, but it cannot solve every problem faced by the United States today. In trying to use policy as a cure-all, we will repeat the cycle of severe recession and unemployment in a few short years by keeping rates too low for too long. I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no short cut.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the National Association of Business Economists Annual Meeting, Denver, 12 October 2010.
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Thomas M Hoenig: The Federal Reserve’s mandate – long run Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the National Association of Business Economists Annual Meeting, Denver, 12 October 2010. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. Introduction and framework Thank you, and it is a pleasure to welcome you to Denver. This is the largest metropolitan area in the Tenth Federal Reserve District and home to one of three branches of the Federal Reserve Bank of Kansas City. The Denver branch serves Colorado, Wyoming and New Mexico – three of the seven states of our region. I appreciate this opportunity to engage and interact with business economists from around the country regarding the policy choices now confronting the nation, especially those confronting the Federal Reserve. In setting out my views, I’ll first spend a minute describing the economy’s performance and then turn to the matter of quantitative easing versus my preferred path of gradual steps to a renormalization of monetary policy. Short-term outlook Currently, a major and necessary rebalancing is taking place within our economy. This includes the deleveraging of consumers, businesses and financial institutions, and it’s during a time that state and local governments are struggling with budgets and mounting debt loads. In this context, a modest recovery with positive overall data trends should be seen as highly encouraging. Following a bounce back from restocking earlier this year, the economy has slowed but it has not faltered. GDP growth has averaged about a 2½ percent annual pace since the first of the year. Industrial production is showing growth of almost 6 percent, and high-tech more than double that. The consumer continues to buy goods, with personal income growing at more than a 3 percent rate, personal consumption expenditures at about 3 percent, and retail sales at more than 4 percent. And the U.S. economy has added more than 850,000 net new private sector jobs since the first of the year. While modest, these are positive trends for the U.S. economy. The issue is, of course, that while private jobs are being added within the economy, it is not enough to bring unemployment down to where we all would like to see it. Unemployment remains stubbornly high at 9.6 percent. With such numbers, there is, understandably, a desire and considerable pressure for the Federal Reserve to “do something, anything” to get the economy back to full employment. And for many, including many economists, this means having the Federal Reserve maintain its zero interest rate policy or further still, engage in a second round of quantitative easing – now called QE2. Some are even suggesting these actions are necessary for the Federal Reserve to comply with its statutory mandate. Interpreting the policy mandate The FOMC’s policy mandate is defined in the Federal Reserve Act, which requires that: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate longterm interest rates”. There is, within the Act, a clear recognition that our policy goals are long-run in nature. In this way, the Act recognizes that monetary policy works with long and variable lags. Thus, the FOMC should focus on fostering maximum employment and stable prices in the timeframe that monetary policy can legitimately affect – the future. The FOMC must be mindful of this fact and be cautious in pursuing elusive short-term goals that have unintended and sometimes disruptive effects. In recent weeks, some have argued that with inflation low and the jobless rate high, the Federal Reserve should provide additional accommodation. Such an action – the purchase of assets by the central bank as a policy easing tool – would mark a second round of quantitative easing. While there are several ways to accomplish this, many suggest that the most likely method would be for the Federal Reserve to purchase additional long-term securities, including U.S. Treasuries. Proponents of QE2 argue that it would provide a near-term boost to the economy by lowering long-term interest rates while raising inflation. These benefits would arise from the purchase of U.S. Treasury securities, which would lead to lower U.S. Treasury and corporate rates. These lower interest rates would then stimulate consumer and business demand in several ways, including encouraging mortgage refinancing that could lead to increased consumer spending, boosting exports through a likely lower exchange rate, and fostering higher equity prices, thereby creating additional wealth. Such a move is said to be consistent with the FOMC’s September 21, 2010 announcement, which stated that it was “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”. Such easing, it is hoped, would bring inflation back up to something closer to 2 percent, a rate that many judge to be consistent with the Federal Reserve’s mandate. In addition, higher inflation would increase demand as consumers move purchases forward to avoid paying higher prices in the future. So, with these purported benefits, why would anyone disagree? New risks and QE2 I believe there are legitimate reasons to be cautious when considering this approach. A meaningful evaluation of QE2 must consider not simply whether benefits actually exist but, if they do, how large they are and whether they are larger than possible costs. Based on recent research and the earlier program of purchasing long-term securities – known as LSAP – I think the benefits are likely to be smaller than the costs. Some estimates suggest that purchasing $500 billion of long-term securities might reduce interest rates by as little as 10 to 25 basis points. The LSAP program was effective, in part, because we were in a crisis. Financial markets were not functioning properly, or at all, during the depths of the financial crisis. In such a situation, it is reasonable that central bank purchases would be useful and effective. However, currently the markets are far calmer than in the fall of 2008. The financial crisis has passed and financial markets are operating more normally. One could argue, in fact, that with markets mostly restored to pre-crisis functioning, the effect of asset purchases could be even smaller than the 10 to 25 basis point estimate. I would also suggest that even if we achieved slightly lower interest rates, the effect on economic activity is likely to be small. Interest rates have systematically been brought down to unprecedented low levels and kept there for an extended period. The economy’s response has been positive but modest. In fact, right now the economy and banking system are awash in liquidity with trillions of dollars lying idle or searching for places to be deployed or, perhaps more recently, going into inflation hedges. Dumping another trillion dollars into the system now will most likely mean they will follow the same path into excess reserves, or government securities, or “safe” asset purchases. The effect on equity prices is likely to be minor as well. There simply is no strong evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption, or cushioning or accelerating the deleveraging that is hopefully winding down. If the purported benefits are small, what are the possible costs? First, without clear terms and goals, quantitative easing becomes an open-ended commitment that leads to maintaining the funds rate too low and the Federal Reserve’s balance sheet too large. The result is a further misallocation of resources, more imbalances and more volatility. There is no working framework that defines how a quantitative easing program would be managed. How long would the program continue, and what would be the ultimate size? Would purchases of long-term assets continue until the unemployment rate is 9 percent or 8 percent or even less? Would purchases continue until inflation rises to 2 percent or 3 percent or more? Would the program aim to reduce the 10-year Treasury rate to 2¼ percent or 2 percent or even less? Without answers to these and other questions, QE2 becomes an open-ended policy that introduces additional uncertainty into markets with few offsetting benefits. As central bank assets expand under quantitative easing, what will be the exit strategy? In the midst of a financial crisis, we may not have the luxury of thinking about the exit strategy. In current circumstances, however, we must define an exit strategy if the objective is to raise inflation but contain interest rate expectations. If history is any indication, without an exit strategy the natural tendency will be to maintain an accommodative policy for too long. While I agree that the tools are available to reduce excess reserves when that becomes appropriate, I do not believe that the Federal Reserve, or anyone else, has the foresight to do it at the right time or right speed. It may work in theory. In practice, however, the Federal Reserve doesn’t have a good track record of withdrawing policy accommodation in a timely manner. Second, we risk undermining Federal Reserve independence. QE2 actions approach fiscal policy actions. Purchasing private assets or long-term Treasury securities shifts risk from investors to the Federal Reserve and, ultimately, to U.S. taxpayers. It also encourages greater attempts to influence what assets the Federal Reserve purchases. When the Federal Reserve buys long-term securities – such as the $1.2 trillion in mortgage backed securities it purchased during the financial crisis – it favors some segments of the market over others. And when the Federal Reserve is a ready buyer of government debt, it becomes a convenient source of cash for fiscal programs. During a crisis this may be justified, but as a policy instrument during normal times it is very dangerous precedent. Third, rather than inflation rising to 2 or 3 percent, and demand rising in a systematic fashion, we have no idea at what level inflation might settle. It could remain where it is or inflation expectations could become unanchored and perhaps increase to 4 or 5 percent. Not knowing what the outcome might be makes quantitative easing a very risky strategy. It amounts to attempting to fine-tune inflation expectations – a variable we cannot precisely or accurately measure – over the next decade. And why might inflation expectations become unanchored? The budget deficit for 2011 is expected to be about $1 trillion. Even if the Federal Reserve were to purchase only $500 billion – and this amount in itself is a source of considerable uncertainty – that would appear to monetize one-half of the 2011 budget deficit. In addition, the size of the Federal Reserve’s balance sheet – now and over the next decade – will influence inflation expectations. Expanding the balance sheet by another $500 billion to $1 trillion over the next year, and perhaps keeping the balance sheet at $3 trillion for the next several years, or increasing it even further, risks undermining the public’s confidence in the Fed’s commitment to long run price stability, a key element of its mandate. While QE2 might work in clean theoretical models, I am less confident it will work in the real world. Again, I will note that the FOMC has never shown itself very good at fine-tuning exercises or in setting and managing inflation and inflation expectations to achieve the desired results. Given the likely size of actions and the time horizon over which QE2 would be in place, inflation expectations might very well increase beyond targeted levels, soon followed by a rise in long-term Treasury rates, thereby negating one of the textbook benefits of the policy. Non-zero rates as an option At this point, with a modest recovery underway and inflation low and stable, I believe the economy would be better served by beginning to normalize monetary policy. If long run stability is the goal, then re-normalizing policy is an important step toward realizing that goal. How might we achieve this goal? First, rather than expand the Federal Reserve’s balance sheet by purchasing additional U.S. Treasury securities, the Fed should consider discontinuing the policy of reinvesting principal payments from agency debt and mortgage-backed securities into Treasury securities. Given where we are, we would need to make such a change slowly but systematically. Allowing maturing mortgage backed securities to roll off, the Federal Reserve’s balance sheet would shrink gradually, with relatively small consequences for financial markets. Second, we should take the first early steps to normalize interest rate policy. This is not a call for high rates but a call for non-zero rates. In 2003 the FOMC delayed our efforts to raise rates. In that period we reduced the federal funds rate to 1 percent and committed to keeping it there for a considerable period. This policy fostered conditions that let to rapid credit growth, financial imbalances and the eventual financial collapse from which we are still recovering. Had we been more forceful in our action to renormalize policy then, it’s likely we might have suffered far less in 2008 through 2010. Also, any effort to renormalize policy would include signaling a clear intention to remove the commitment to maintain the federal funds rate at 0 to ¼ percent “for an extended period”. As the public adjusts to this, we should then turn to determining the pace at which we return the funds rate to 1 percent. Once there, we should pause, assess and determine what additional adjustment might be warranted. A 1 percent federal funds rate is extremely accommodative, but from that point we could better judge the workings of the interbank and lending markets and determine the order of policy actions that would support sustained long-term growth. Other concerns regarding zero rates These are difficult times, no doubt, and it is tempting to think that zero interest rates can spark a quick recovery. However, we should not ignore the possible unintended consequences of such actions. Zero rates distort market functioning, including the interbank money and credit markets; zero rates lead to a search for yield and, ultimately, the mispricing of risk; zero rates subsidize borrowers at the expense of savers. Finally, it is important to note, that business contacts continue to tell me that interest rates are not the pressing issue. Rather, they are concerned with uncertainties around our tax structure; they are desperate to see this matter settled. They need time to work through the recent healthcare changes; and they are quite uncertain about how our unsustainable fiscal policy will be addressed. They are insistent that as these matters are addressed, they will once again invest and hire. QE2 cannot offset the fundamental factors that continue to impede our progress. Conclusion We are recovering from a set of shocks, and it will take time. These shocks did not develop overnight, but came after years of interest rates that were too low, leverage that was too high, and financial supervision that was too lax. If we have learned anything from this crisis, as well as past crises, it is that we must be careful not to repeat the policy patterns we have used in previous recoveries, such as 1990–91 and 2001. If we again leave rates too low for too long out of fear that the recovery is not strong enough, we are almost assured of suffering these same consequences yet again. I am fully committed to the Federal Reserve’s dual maintain to maintain long-run growth so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the National Association of Realtors conference, New Orleans, 5 November 2010.
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Thomas M Hoenig: Reforming US housing finance Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the National Association of Realtors conference, New Orleans, 5 November 2010. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. Introduction My position on the current stance of our nation’s monetary policy is well known, especially to those who closely follow the Federal Reserve. The Federal Open Market Committee has met seven times this year, and at each of those meetings I have cast a dissenting vote against the majority opinion of keeping the federal funds rate target at its current level near zero for an “extended period.” I realize that advocating an interest rate increase is not the best applause line at a Realtors’ conference. However, I believe that moving rates modestly off of zero, where they have been since December 2008, still represents highly accommodative monetary policy. More importantly, such action is necessary if we are to ensure a more stable economy that can thereby foster a more sustainable housing market. How can we revive housing? We have all suffered through the worst collapse in housing prices since the 1930s, and the situation we face will not be easily corrected. The housing collapse can be characterized as a classic asset-price bubble spurred by low interest rates, easily accessible and often-unsound financing, over-optimism about housing price trends, and a high – and difficult to control – level of subsidies that flowed into housing. Although we may have experienced a few exceptional years of housing activity, those years do not come close to making up for the economic recession, foreclosures, erased wealth and slow recovery that we now are experiencing. Given this experience, the question that now confronts us is, “What can we do to create more stable housing markets and lessen the boom-bust cycles in housing?” These cycles have unfortunately become all too familiar over the past few decades. Some argue that our housing and mortgage markets will not recover in a timely fashion without extensive public support. Among the suggested solutions are expanding Federal Housing Administration lending and the role of the Federal Home Loan Banks and allocating whatever funds are needed to bring the two housing agencies, Fannie Mae and Freddie Mac, back to their pre-crisis role for housing. Other ideas include a renewal of tax credits for home purchases and more extensive programs for mortgage restructurings. From the Federal Reserve, some want a continuation of near-zero interest rates for an extended period and greater investments in mortgage instruments. In sharp contrast to that view, others suggest that the financial crisis has exposed a number of critical flaws in our housing policies and mortgage finance system that call for a significant “re-look” at how we finance this industry. For instance, Paul Volcker, who was chairman of the Federal Reserve during a portion of the 1980s real estate crisis, recently described the U.S. mortgage industry as “dysfunctional” and a “creature of the government” that needs reform. The options seem to fall out to either rebuilding a system backed by extensive public support, subsidies and other protections, or build a new framework that returns housing finance to greater reliance on private market forces. I support a policy path that returns the housing industry toward greater market discipline and greater long-run stability. This path requires a greatly reduced role for governmental intervention and public subsidies that have distorted the market over recent decades. The American public, including aspiring homeowners and those of you employed in the housing industry, might be best served, over time, by reducing or removing these subsidies as part of our national policy. There are several factors that argue for making such a change in policy. First, the crisis clearly shows that a mortgage finance system based on expanding the incentives and opportunities to take on more debt with little equity places households at significant financial risk and creates unsustainable trends in housing expansion. Second, such policies create harmful distortions within the economy, and they are enormously expensive in terms of both their explicit and implicit costs, to both taxpayers and homeowners, especially when things go badly. Many of the subsidies directed toward housing have been extremely inefficient, with other parties capturing most of the benefits rather than homeowners. Moreover, with the growing federal budget deficits and the many interests that will be intensely competing for public funds, it is unrealistic to expect that all can be accommodated or that housing can continue to command the same portion of public funds and levels of taxpayer support and exposure. In brief, housing policy is badly flawed, and today’s budget environment requires reform. Fix Freddie and Fannie What specific steps should we take? The first and most obvious step is to reform the two housing finance vehicles of Fannie Mae and Freddie Mac. These two institutions were responsible for more than half of all U.S. mortgages passed through the system at the height of the housing boom. These government-sponsored enterprises were assigned goals around affordable housing that contributed dramatically to the growth in subprime credit and the decline in lending standards that led to the crisis. Fannie and Freddie clearly fit the pattern of what Paul Volcker said we must avoid: “Private when things are going well and public when things are going badly.” Several studies have found that the various subsidies received by Fannie and Freddie have done little to lower mortgage rates. Instead, the vast majority of such benefits accrued to Fannie and Freddie’s stockholders or was used to gain political favor. For example, only two months before Fannie Mae and Freddie Mac were put into conservatorship in September 2008, media accounts detailed how both had made the list of Washington’s top 10 lobbying spenders over the previous decade. Together, they had spent a total of $170 million. 1 At that time, Fannie employed 51 lobbyists and Freddie paid 91, with both counting former members of Congress among their hired guns. This was only two years after the Federal Election Commission levied a $3.8 million penalty against Freddie related to charges it was illegally involved in 85 political fundraisers. Considering the high level of political activism on the part of these GSEs, it should not surprise you to learn that both Fannie and Freddie are considered “heavy hitters” on the Center for Responsive Politics’ website, OpenSecrets.org, which provides a wide range of USA Today, July 17, 2008. data on money’s influence on U.S. elections and policy. That designation means that both are among the biggest donors to federal-level politics since 1989. So, while Fannie and Freddie have spent millions on lobbying and building influence in Washington, their losses could cost taxpayers as much as $363 billion, according to recent estimates – and those are just the direct losses. The overall losses that could be attributed to the GSEs are likely to be several multiples higher when we consider that without their implied “federal guarantee” and related incentives around risk, the markets might have been far more cautious and the financial crisis far less prolific. More stunning perhaps, had these institutions been held to stricter financial standards, far fewer households would have suffered the tragedy of foreclosures, the lost home equity and the loss of personal savings and wealth that today continues to hold back our economic recovery. Given the costs and market distortions these government-supported institutions brought with them, we should be confident that they should not be allowed to operate in the future as they have in the past. We cannot afford to ignore that through their use of implicit government funding guarantees, they held a significant competitive advantage in the marketplace, and that this in turn encouraged excessive risk on their balance sheets, with tragic outcomes. Given past errors, how might we approach the need for some modest support for future financing within the housing industry? I see two basic options. First, if we judge that some public support is needed, we could establish public entities that focus solely on the securitization of conventional, conforming mortgages with strong underwriting standards, tight public oversight and balance sheets limited to holding amounts necessary for warehousing loans to be securitized. This makes the government a conduit only, facilitating the flow of capital but not providing the implicit guarantees on funding and assets held that contributed to this crisis. The market remains the final arbiter of standards and funding. A second option would be to give private entities sole authority to securitize pools of conforming mortgages – similar to what is now done with jumbo mortgages. If the Congress was disposed to provide some favor to housing, a federal guarantee could be given to certain securities backed by mortgages meeting strict conforming loan standards. However, such favored status should be based on some limiting factor, such as need or special purpose. Either of these two options would address many of the problems associated with Fannie and Freddie in this crisis and would create a more transparent and competitive marketplace. The latter option involving privately owned entities would offer the additional benefits of greater market discipline and insulation from political influence and control. Enforce sound lending standards Regardless of these actions, we must as a nation insist on the return to sound real estate lending standards. We know today that countries that avoided the worst of this most recent real estate meltdown did a better and more consistent job in maintaining an effective and consistent set of standards for loan-to-value and debt-to-income ratios. Some countries, such as Canada, even tightened mortgage lending requirements when real estate markets heated up. In the United States, the opposite occurred. While sound credit standards are a key responsibility of individual lenders, public policy also played an important role in the deterioration of loan quality in the United States. This occurred largely through public efforts to promote and subsidize homeownership and increase access to housing credit. During the crisis, politicians, regulators and market participants were singled out for blame. In reality, it was a group effort. In the years leading to this most recent crisis, a common theme emerged at all levels: Households can accommodate more debt relative to income. A report titled The 1994 National Homeownership Strategy: Partners in the American Dream stated: “Financing strategies fueled by the creativity and resources of the private and public sectors should address … financial barriers to homeownership [and] … reduce downpayment requirements and interest costs by making terms more flexible.” In other words, the key to homeownership from a political perspective is to promote more creative and flexible lending standards, or what, in hindsight, we might more correctly call high leverage. This political desire for creative and flexible lending was hardly new in 1994, though. It was also a central fixture in the real estate collapse of the 1980s. A Senate report on a 1982 legislative provision to remove national bank loan-to-value limits on real estate lending provides a powerful insight into the causes of financial crises. According to this report, the purpose of the legislative change was “to provide national banks with the ability to engage in more creative and flexible financing, and to become stronger participants in the home financing market.” Although creative and flexible financing might remain a goal in housing, sound lending standards cannot be ignored if we are to have sustainable housing growth. With this in mind, the Federal Reserve in 2008 revised rules implementing the Home Ownership and Equity Protection Act. These rules simply prohibit lenders from making loans without considering a borrower’s ability to repay the loan from income and assets other than a home’s value. Who would have thought it necessary to write rules that are otherwise nothing but common sense? We should also take a closer look at the loan-to-value guidelines that depository institutions are required to follow in making real estate loans. We should review guidelines to ensure they are adequate, and we should apply them equitably to other lenders. Other lending provisions, subsidies and public policies directed toward the housing sector and home financing also need to be examined. These would include the risk weights for mortgage loans and mortgage-backed securities under the Basel capital requirements, state and federal tax deductions for mortgage interest, reliance on credit rating agencies’ assessments of mortgage-backed securities, and the wide variety of other public policies related to housing. Given current housing conditions and the way a number of subsidies have become embedded in our housing system, some policy reforms would have to be phased in gradually and after markets have recovered. A key point in reviewing U.S. housing finance policies should be to consider whether they encourage homeownership in a cost-effective manner without putting homeowners at unacceptably high financial risk. The 2005 President’s Advisory Panel on Federal Tax Reform, for instance, concluded that the federal tax deduction for mortgage interest provided an “incentive to take on more debt,” involved large subsidies that encouraged “overinvestment in housing” and was “not shared equally among all taxpayers,” with higherincome households receiving “a disproportionate benefit.” Accordingly, the panel recommended replacing the deductions with tax credits and placing a cap on the benefits as a means of distributing the benefits more evenly and limiting the incentives to take on excessive amounts of debt. With regard to promoting housing through interest rate policies, I have many times publicly expressed my views about the dangers of using monetary tools and the Federal Reserve’s balance sheet to pursue low interest rates and fund mortgage-backed securities. The only additional point that I would repeat is that for home financing to follow a path that is sustainable over time, the Federal Open Market Committee must begin taking steps to normalize monetary policy. Conclusion Economists Hyman Minsky, Charles Kindleberger, and, more recently, Carmen Reinhart and Kenneth Rogoff have all written extensively about how high credit growth and the financial imbalances that develop during economic upturns sow the seeds for future financial instability. In a similar manner, a Norwegian economist looked at banking and financial crises in Norway going all the way back to the early 1800s. She found that every major crisis was preceded by a rapid run-up in real housing prices. Consequently, it is apparent that unsustainable trends in housing prices and home financing have been a major contributor to financial crises. The United States stands virtually alone in its use of GSEs and significant subsidies to promote homeownership. Fannie Mae, Freddie Mac and their political supporters have long attempted to justify this system by saying that “American housing finance is the envy of the world.” Few would believe that today. It is time for a significant change. We must move toward a system with fewer subsidies and misdirected incentives. Furthermore, to ensure accountability, any housing subsidies that we decide to keep should be made explicit, voted on transparently and carefully targeted to the intended beneficiaries: potential homeowners most in need and for whom such support will bring success. Many of you might question whether a system with greatly reduced subsidies will work. A partial answer to this question can be found in international comparisons. A recent study, for instance, found that in terms of homeownership rates, the United States ranked only 17th out 26 economically advanced countries. Many countries have achieved higher homeownership rates without – and perhaps because they don’t have – many of the special privileges of U.S. housing finance, such as GSEs, minimal down payments, 30-year fixed-rate loans and mortgage interest tax deductions. To this list, we could also add non-recourse debt instruments, government promotion of “creative and flexible financing,” the ability to prepay loans, affordable housing goals and similar government housing programs. In making these remarks, I am not suggesting we do away with all support for housing. I am saying it is time for change.
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Central Exchange, Kansas City, 5 January 2011.
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Thomas M Hoenig: Monetary policy and the role of dissent Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the Central Exchange, Kansas City, 5 January 2011. * * * My January presentation at the Central Exchange, greater Kansas City’s business women’s association, has become an annual event and an opportunity that I have enjoyed immensely. In particular, I want to recognize the WIN/WIN program initiated by the Central Exchange. I am personally a supporter of this campaign to increase the number of women on boards of directors and in executive positions in greater Kansas City to a level of 20 percent by 2015. More importantly, I am a believer in the business case for gender diversity and am fortunate to have an outstanding leadership team at the Federal Reserve Bank of Kansas City. It happens that 50 percent of those positions are filled by women. Currently the immediate past chairman and current deputy chairman of our Board is Lu Cordova, an entrepreneur’s entrepreneur from Boulder, Colo. She was an outstanding chair during difficult economic and financial times. The Tenth Federal Reserve District, and the entire Federal Reserve System, benefitted from her outstanding leadership. Lu will be speaking here at the Central Exchange in March, and I encourage you to attend that program as well. Today I want to discuss two related topics. First, I will outline my economic outlook for 2011. And since it is because of my outlook for the economy during this past year that I have found myself in the minority view among my colleagues at the Federal Reserve, I will to spend just a few minutes discussing the monetary policy process. The economic outlook As we begin 2011, recent economic data indicate a firmer tone in the outlook, and I am increasingly confident that the recovery is both sustainable and likely to gain strength over the next several quarters. That said, I expect the recovery to be moderate, with real GDP growing about 3 ½ to 4 percent a year over the next couple years. To put this outlook into perspective, it is important to remember that a major and necessary rebalancing – including the deleveraging of consumers, businesses, and financial institutions – is taking place within our economy. Moreover, this is occurring while state and local governments are struggling with budgets and mounting debt loads. With these adjustments, growth necessarily will be more modest than in past recoveries. Under such circumstances, the fact that we can talk about the likelihood of a sustainable recovery is highly encouraging. Before turning to the outlook for this year, let me begin with a brief look back at economic events in 2010. Last year began with solid gains in the first quarter. The nation’s real GDP grew at an annual rate of 3.7 percent and employment rose 261,000. Then the economy hit a soft patch in the middle of the year with growth in output and employment slowing. Fortunately, though, we appear to be coming out of that soft patch with the economy growing at a 2.6 percent rate in the third quarter and expected to accelerate to about a 3 percent rate in the fourth quarter. Over the last few months, we have seen clear signs of improvement. Consumer spending has steadily trended up and is likely to gain further strength as confidence rebounds, personal incomes continue to rise, and the labor market gradually improves. The trend in business spending has been supportive of growth. For example, over the last year, spending on equipment and software increased almost 20 percent. And I expect that strong corporate profits – they grew 26 percent last year – and sales growth will keep business investment a key source of strength going forward. BIS central bankers’ speeches Also, the recently passed fiscal actions, in which Congress and the president extended the Bush-era tax cuts and unemployment insurance, and then also temporarily reduced payroll taxes, will provide a further boost to aggregate demand next year, although not without longer-run risks to the economy. While the consumer and business sectors of the economy are rebounding, the same cannot be said for housing. As you know, housing lost momentum after the end of the homebuyer tax credit, and house prices continue to decline. Moreover, the inventory of unsold homes is exerting downward pressure on house prices and housing activity. As the broader economy continues to grow, though, I expect that we will see a turnaround in housing this year. However, there are many issues tied to the housing crisis that could impede recovery, and much depends on how these issues are addressed in the next several months. Employment is the other issue that seems difficult to understand and solve. Unfortunately, while private jobs are being added to the economy, the pace of job gains is not strong enough to bring unemployment down to where we would all like. In fact, although the United States added over 1 million net new jobs through November, the unemployment rate remained at 9.8 percent. Forward-looking surveys, including our Bank’s manufacturing survey, point to gains in employment over the next six months, and if history is any guide, we should see these increases accelerate over the course of the year. I would also note that our manufacturing survey points to expected gains in production and capital spending, which will contribute to improving job growth. Even so, with the number of people out of work and the growing numbers of new job entrants, it will be some time before we see the unemployment rate well below 9 percent. Given the immediate levels of slack in the economy, core inflation will remain modest in the near term. However, given the degree of monetary and fiscal stimulus in place in the economy currently, inflation should move higher over the medium and longer term, depending on what further steps are taken in these policy areas. Also, the risk of further disinflation or outright deflation is small and, with an improving economy, should only decline further in the coming months. It is also noteworthy that long-run inflation expectations even now remain above 2 percent and should exert upward pressure on inflation during the course of the recovery. There are, of course, risks to the outlook. First, I am concerned about what might happen to the economy if we fail to deal successfully with our long-run fiscal challenges. The budget deficit is the largest we have seen, as a share of GDP, since World War II. With these large budget deficits, total federal debt outstanding is almost $14 trillion, or about 94 percent of GDP. Moreover, projections of deficits and debt show the federal debt will continue to increase, suggesting that fiscal policy is unsustainable and must be changed soon. As we have seen elsewhere, the reaction of interest rates and exchange rates to unsustainable fiscal policy can be sharp and disruptive. While specific recommendations on fiscal policy are not the purview of the Federal Reserve, I would urge serious consideration of proposals that have been offered by several groups, including the Simpson-Bowles deficit reduction plan. These are reasonable starting points for addressing the intractable problem that may have very serious ramifications for future monetary policy. A second concern I have is the consequences that will follow when we combine our current fiscal projections with a highly accommodative monetary policy. In essence, the Federal Open Market Committee (FOMC) has maintained an emergency monetary policy stance in a recovering economy and has continued to ease into the recovery. I believe these actions risk creating a new set of imbalances, or bubbles. Importantly, such actions as they continue are demanding the saving public and those on fixed incomes subsidize the borrowing public. To summarize, I am pleased to be able to say that in my view the economy is in recovery, although at a moderate pace. Over time, barring unexpected surprises, the recovery should gain momentum, which will encourage hiring and slowly bring down the unemployment rate. While we would all like to see the unemployment rate come down more quickly, and in fact should gain momentum, we must also acknowledge that our economy is adjusting to decades of excess consumption, high government debt and spending, and a low domestic savings level. These factors must also adjust, and this will take time as well. The very fact that we are in what appears to be a sustained recovery speaks well of our economy and its flexibility to adjust and regain strength over time. Dissent and monetary policy deliberations My view of the economy’s prospects and the appropriate stance of monetary policy differ from the majority view among my Federal Reserve colleagues. Last year, I was a voting member of the Federal Open Market Committee. Reserve Bank presidents vote in rotation, so I will be a participant rather than a voting member this year. It is a matter of public record that I dissented, or cast a “no” vote in all eight meetings in 2010. Based on audience questions, news coverage and pundit columns throughout the year, it has become obvious to me that the role of dissent in the FOMC is misunderstood and viewed without context. The idea that a dissenting vote is confusing, counterproductive, and generally undesirable is unhealthy. It is also historically inaccurate. In my remaining time today, I will discuss why dissenting views at the FOMC are critical to the success of the Federal Reserve System and that public debate was the intent of its congressional founders. I will also describe how open debate and dissent are fundamental to achieving transparency of FOMC deliberations and to supporting the credibility of the committee in difficult economic times. History When the Congress created the Federal Reserve nearly a century ago, it believed very strongly that the best policy is not made in isolation, but encompasses a wide range of views from all affected interests. A Federal Reserve Bank was established in Kansas City, as well as 11 other major cities across the United States, to make sure the views of communities nationwide had a voice in Federal Reserve policy. The founders knew that such broad-based participation would lead to better decision making. This structure is replicated on the Federal Open Market Committee, which is the body that makes decisions about our nation’s monetary policy through changes in an interest rate known as the federal funds rate, and, over the last couple of years, changes in the size of the Federal Reserve’s balance sheet and the interest rate it pays on excess reserves. The FOMC is made up of 12 members: Seven of them are the Federal Reserve governors who have been appointed by the president and confirmed by the Senate. Governors always have a vote at the FOMC. The other five members are presidents of the regional Federal Reserve Banks who are appointed by their local boards of directors. The New York Bank’s president always has a vote, and the other 11 presidents share the remaining four votes in a set rotation. As a result, while all 12 Reserve Bank presidents are active participants in the FOMC debate, the seven politically appointed governors always have a majority of votes over the five voting Reserve Bank presidents. The regional Bank presidents fill a critical role at the Fed’s policy table. They have the responsibility of representing their respective Federal Reserve Districts in providing their unique perspective on national policy issues. As dictated by the FOMC’s structure, Washington and Wall Street not only participate in all discussions but have a permanent vote. Therefore, it is crucial to have independent voices at the table that regularly interact with Main Street business and community leaders in the rest of the country. In this structure, it is a key point to remember that each member was given a vote, not an advisory role. In FOMC policy votes since 1995 – which is essentially the current era of Fed policy – there was a dissenting vote about one-third of the time. Going back a bit earlier in BIS central bankers’ speeches the 1990s to the ’90–91 recession, there were far more significant levels of dissent for both tighter and less restrictive monetary policy. During the Paul Volcker era, the chairman nearly lost one policy vote. In addition, there were 30 dissenting votes cast in Volcker’s final 30 meetings as Fed chairman. Transparency There are, of course, commonalities between the end of the Volcker era, the 1990–91 recession and today: In each of these periods the economy was poised at a critical juncture and broad disagreement prevailed about the appropriate policy course – and not just around the Fed policy table. By the very nature of our political system, these were also periods of extreme political pressure to provide increased stimulus with an eye toward short-term gains and with a promise to take appropriate steps at some later point to remove that stimulus before inflationary pressures could become a problem. Leaving those issues aside, last year some suggested that dissenting votes confuse the market and that public disagreement among members reduced the effectiveness of Fed policy, including the second round of quantitative easing, known as QE2. As an economist, I cannot be certain that my views are correct. Certainly, a majority of my counterparts on the FOMC last year did not agree with my views. But it is important to recognize that in the face of uncertainty, arriving at the best policy decision is built on divergent opinions and vigorous debate. Because of this, the role of open dissent is at least as critical to FOMC monetary policy decisions as it is to deliberations by the Supreme Court, the United States Congress or any other body with important public responsibilities from the local through the federal level. If you find it unusual to consider the FOMC as being similar to these other deliberative bodies, it is perhaps because many–including some former Federal Reserve officials–tend to speak of Fed policy as being done by a single actor. In 2004, then-Fed Governor Ben Bernanke talked about this issue in a speech where he noted the “diversity of views and opinions likely to exist among the members of a large committee create further challenges of effective communication.” 1 Despite these challenges, he went on to talk about the importance of making these divergent views broadly known: “Although at times it feels cacophonous, the willingness of FOMC members to present their individual perspectives in speeches and other public forums provides the public with useful information about the diversity of views and the balance of opinion on the Committee.” Credibility Some would suggest, of course, that monetary policy is not like a Supreme Court ruling. This line of reasoning comes from an idea that a unanimous FOMC is more likely to foster the confidence that is so critical to the functioning of our economy and financial system. To this line of thinking, dissent becomes even more dangerous in periods of high uncertainty. A deliberative body does not gain credibility by concealing dissent when decision making is most difficult. In fact, credibility is sacrificed as those on the outside realize that unanimity – difficult in any environment – simply may not be a reasonable expectation when the path ahead is the most confounding. The question then becomes: Should the debate that is happening privately remain hidden from the public eye until the meeting minutes or Jan. 3, 2004 transcripts are later released? And in the interim, is the nation somehow better served by giving the public the impression that the entire body is in agreement to the prescribed approach even when that is not the case? In the mid-1980s, after the vote Chairman Volcker nearly lost created a bit of a media circus, Herbert Stein wrote a very interesting column about the issue for The Wall Street Journal. Mr. Stein, who had been chairman of the Council of Economic Advisers under two presidents, wrote that divergent views at the policy table should not be worrisome. It is more important, he wrote, that there are visible principles at work in shaping these views. Stein wrote that in creating the central bank of the United States, “Congress intended diversity (of views) and the Federal Reserve … benefits from the appearance that diversity is at least possible.” 2 To suggest that public support is somehow encouraged by unanimous decisions suggests little appreciation for the public and their understanding about the challenges we face. To me, that fosters a loss of confidence that can be difficult to recover. As a result, the body becomes less able to respond to a crisis and is left more vulnerable to its critics. The Federal Reserve’s founders recognized this a century ago. I hope we continue to recognize its critical importance in the years to come. As for me, I recognize that the committee’s majority might be correct. In fact, I hope that it is. However, I have come to my policy position based on my experience, current data and economic history. If I had failed to express my views with my vote, I would have failed in my duty to you and to the committee. The Wall Street Journal, April 4, 1986 BIS central bankers’ speeches
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Statement by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, before the Senate Committee on Agriculture, Nutrition and Forestry, Washington DC, 17 February 2011.
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Thomas M Hoenig: Recent developments in US agriculture and its role in the US economy Statement by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, before the Senate Committee on Agriculture, Nutrition and Forestry, Washington DC, 17 February 2011. * * * Thank you, Madam Chair. I appreciate the opportunity to discuss recent developments in U.S. agriculture and its role in the U.S. economy. Agriculture remains a vital industry in the expansive region that the Federal Reserve Bank of Kansas City serves and, accordingly, our Bank has a long tradition of focusing significant attention on industry developments. Our observations on agriculture, in turn, have given us useful insight into the U.S. and global economies more broadly. In my remarks this morning, I’ll describe recent developments in the nation’s farm economy and discuss some risks that have my attention. Recent developments in U.S. agriculture Agriculture – broadly defined as farm production and output from related industries – accounts for almost one-sixth of U.S. jobs and economic activity. While the farm share of economic output has declined as other parts of our economy have grown, increased activity in broader agricultural industries – manufacturing, transportation, distribution and food retailing – has opened new job opportunities in both rural and metro communities. A robust agricultural sector cushioned the rural economy in our and other regions across the nation during the recent recession, and the industry’s strength is supporting further improvement in the rural economy today. In 2010, strong demand and tight supplies for most farm commodities contributed to a sharp rebound in farm profits, which then supported sales in farm equipment and other farm-based industries. Strong profits from agriculture also girded important elements of our rural financial system. Commercial banks with large agricultural loan portfolios posted stronger returns than their peers over the past three years. While more than 300 commercial banks failed during this time, only 22 were agricultural banks. Agriculture is also benefitting directly from the rebounding economic strength of China and other emerging market economies, where rapid income growth is driving up food demand. The United States remains a net exporter of agricultural products, shipping more than 40 percent of its wheat, cotton, soybeans and rice crops to foreign countries in 2010. United States crop and meat exports are expected to rise to record highs in 2011. Looking out a little further, economists expect global growth to exceed 4 percent well into 2012, with the developing and emerging market economies remaining in the lead. Rapid income gains in the developing world promise further increases in demand for higher-protein diets. Developing risks in agriculture Despite prospects of sustained farm income growth, U.S. producers must remain alert as they face challenges related to their very success and tied to recent developments in financial markets. Surging commodity prices and low interest rates have translated into increasing farmland values, which have eclipsed their 1980s peaks. In our Bank’s fourth quarter 2010 Survey of Agricultural Credit Conditions, for example, cropland values in Nebraska and Kansas were nearly 20 percent above year-ago levels and more than 75 percent higher than five years ago. BIS central bankers’ speeches This run-up in farmland values has occurred, however, amid financial markets characterized by high levels of liquidity and unusually low interest rates. History has taught us that it is nearly impossible to determine how much of the farmland boom may be an unsustainable bubble driven by financial markets and how much results from fundamental changes in demand and supply conditions. Therefore, it will surprise no one when I say we are watching the market closely, just as we are watching for imbalances emerging elsewhere in the economy. Of particular interest to me is how agriculture might adjust when financial markets return to more-normal interest rate conditions. Rising interest rates often coincide with falling farm revenues and higher capitalization rates, a depressing combination for farmland values. Moreover, even if crop prices remain high but capitalization rates return to their historic average, farmland values could fall by as much as a third, which most certainly would erode the financial health of the farm sector. Fortunately, the industry entered this period with a relatively strong balance sheet. Farm leverage ratios are at historic lows, and agricultural banks are well capitalized. In addition, farm operators and banks have strengthened their risk-management practices, using basic hedging strategies and derivative markets to manage price and balance sheet risk, which contributed to smaller increases in problem assets at agricultural banks than at their peers. Nevertheless, I follow the basic lesson that bad loans are made in good times, and I remain watchful. In closing, I’ll briefly highlight a symposium the Federal Reserve Bank of Kansas City hosted last summer to consider agriculture’s response to the extraordinary shifts occurring in market conditions. There was a marked and, in my view, a very healthy consensus that the industry’s success will lie not in its ability to follow a single path, but in its ability to adapt quickly to shifting economic landscapes and conditions. Still, my nagging concern remains that current distortions in financial markets are increasing the risk that imbalances in asset markets will catch agriculture – and the U.S. economy more generally – by surprise once again. Thank you Madam Chair. BIS central bankers’ speeches Memorandum January 14, 2011 To: Thomas Hoenig, Esther George, Diane Raley, Alan Barkema, Kevin Moore From: Jason Henderson and Brian Briggeman Subject: Farmland Values and Interest Rate Risk Higher crop prices and lower interest rates have fueled a surge in farmland values, raising concerns about a bubble in the agricultural real estate market. Since June, grain prices have doubled, and futures markets suggest that prices could remain elevated through 2014. Still, historically low interest rates and capitalization rates are needed to justify current farmland values. Over the past year, farmland values have posted double-digit gains, with additional gains expected in 2011 (Map 1). By the beginning of 2010, U.S. farmland values had risen more than 15 percent above 2005 levels, lifting the total value of U.S. farmland to almost $2 trillion (Chart 1). While farmers own the majority of U.S. farmland, non-farm investors are buying more land. According to a 2010 Iowa State University report, investors accounted for a quarter of Iowa farmland sales. Low interest rates, which have depressed capitalization rates, contributed to the recent spike in farmland values. Capitalization rates on U.S. farmland have fluctuated over time, falling in periods of negative real interest rates – 1970s and 2000s – and rising during periods of higher real interest rates – 1980s. According to USDA data, Nebraska’s capitalization rate on cropland was 5.1 percent at the beginning of 2010, well below its historical average of 7.5 percent (Chart 2). Despite regional variation, capitalization rates on farmland values have fallen to record lows across the nation, with rates below 5 percent in most states (Map 2). Oklahoma and Texas have lower capitalization rates due to mineral rights inflating farmland values. Given low capitalization rates, farmland values face significant interest rate risk. For example, irrigated cropland in eastern Nebraska is valued at $5,000 per acre. A historically low capitalization rate of 5 percent is needed to rationalize this land value at current corn prices and yields (Table 1). If interest rates would rise and lift capitalization rates to their historical average of 7.5 percent, the capitalized value of irrigated farmland in eastern Nebraska could fall by a third to $3,300 per acre (Chart 3). If capitalization rates would rise to 10 percent as they did during the 1980s farm crisis, land values could drop by half. Additional analysis suggests that other regions face similar interest rate risks. Rising interest rates could also cut farmland values by reducing farm revenues. Higher interest rates tend to raise exchange rates, which limits agricultural exports, in turn depressing commodity prices and farm revenues. In 1981, the spike in real interest rates led to higher exchange rates and contributed to lower agricultural exports. With falling exports, commodity prices and farm revenues dropped, which pushed farmland values to their 1985 lows. If a similar event occurred today, farmland values could fall. For example, if capitalization rates return to their historical average and corn prices drop to $4 per bushel, their 2009 average, irrigated land values in eastern Nebraska could fall almost 50 percent to $2,700 per acre (Chart 4). Other regions face similar risks. In sum, rising interest rates could trigger a sharp decline in farmland values. 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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at Women in Housing and Finance, Washington DC, 23 February 2011.
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Thomas M Hoenig: Financial reform – post crisis? Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at Women in Housing and Finance, Washington DC, 23 February 2011. * * * Thank you for inviting me here today to address this outstanding organization. It is my pleasure to do so. My remarks are entitled “Financial Reform: Post Crisis?” and will address financial regulatory reform and too big to fail. Like most Americans, I am a strong defender of free market capitalism and I’m here today to make an argument that our country should take the difficult steps required to move its financial industry back toward that system. I acknowledge that there is more than one view on this topic. There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes. Today I will describe why I believe that is the case and, more importantly, what must be done to give the United States a financial system that is healthy and competitive, and that supports rather than endangers the economy. There are many villains in the story of the recent crisis and much written to name them, describe them and even curse them. If you want to know how it happened, read “Thirteen Bankers” and “All the Devils Are Here.” If you want to know how to fix the problem, I highly recommend “Regulating Wall Street,” from New York University’s Stern School of Business. If you want to understand why the American public refuses to ignore the injustices associated with executive compensation in bailed out companies versus budget cuts borne by the middle class, read Rolling Stone’s article “Why isn’t Wall Street in Jail?” If you wonder why “no one saw it coming” then I suggest you read up on Brooksley Born or, a decade later, Meredith Whitney. Or, you might even read the remarks of an Iowa-educated bank regulator turned-policy maker in Kansas City. Fifteen years ago, I gave a speech entitled “Rethinking Financial Regulation,” which summarized the major threats facing our financial system. My suggestion then was to take steps to reduce interdependencies among large institutions and to limit them to relatively safe activities if they chose to provide essential banking and payments services and be protected by the federal safety net. I also argued that safety net protection and public assistance should not be extended to large organizations extensively engaged in nontraditional and high-risk activities. A final point of those remarks was that central banks must pursue policies that preserve financial stability. I am going to repeat those suggestions today, and as often as the opportunity allows. History is on my side. Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis. BIS central bankers’ speeches The recent financial crisis The recent financial crisis was one of the world’s worst and most pervasive. Actions taken affecting an array of institutions during the crisis, like each crisis before it, set new precedent and invited new risks going forward. First, during the crisis public safety nets and assistance were stretched far beyond anything that we had done in past crises. Deposit insurance coverage was substantially expanded and public authorities went well beyond this with guarantees of bank debt instruments, asset guarantees at selected institutions, and many other forms of market support. Discount window lending sharply departed from previous practices in terms of nonbanks and special lending programs. Substantial public capital injections were further provided through TARP to the largest financial organizations in the United States and to several hundred other banks on a scale not seen since the Reconstruction Finance Corporation in the 1930s. These steps were similar to those that many other major countries took. Second, at the heart of the financial collapse were some of the largest commercial and investment banks in the country, as well as the markets in which these institutions were key players. The five largest investment banks failed, were forced into mergers, or had to convert to bank holding company ownership to gain the necessary support. Bank of America and CitiGroup both required extensive assistance to pull through this crisis. Special assistance was provided to AIG, the largest insurance company in the United States. In addition, Fannie Mae and Freddie Mac belong in this group because of the influence they exert over the U.S. mortgage market, their enormous losses, and public takeover. It is no coincidence that two principal features of this crisis were heavily bloated safety nets and major financial institutions that were treated as being too big to fail. History shows that these two elements have become more intertwined – the growth of one is linked to growth of the other, in an increasingly pernicious cycle. Andrew Haldane of the Bank of England termed this relationship “Banking on the State” in his excellent speech and paper of the same title. Over time we have experienced a ratcheting process in which public authorities are pressured to widen and deepen their state safety nets after every financial crisis brought on by excessive bank risk taking. This expansion in safety nets then sets the stage for the next crisis by providing even greater incentives for risk taking and further expanding moral hazard problems. As a result, we have become trapped in a repeating game in which participants continue to seek ever higher and more risky returns while “banking” on the State to fund any losses in a crisis. Large organizations, moreover, are the key players in this process as States become more immersed in the perception during a crisis that they must protect any bank regarded as systemically important. We must stop this game if we are to create a more stable financial system and not condemn ourselves to an escalating series of crises with rapidly rising costs. Over the decades of crisis and bailouts there is considerable evidence of increasing levels of banking risk, which includes the long-term declining trend in bank capital and liquidity ratios, higher and much more variable returns on bank equity in recent years, and a link between higher leverage and the expansion in trading assets among large organizations. In the United States, we observe with each crisis and market collapse that policymakers consistently intervene to protect an ever broader group of creditors and investors from loss. This includes the LDC debt crisis, the failure of Continental Illinois, and the thrift industry and stock market collapses of the 1980s. These previous public interventions, though, pale in comparison to what was done recently. Market participants and large financial institutions have little reason to doubt that they will be bailed out again. Let me offer just one staggering example. When Gramm-Leach-Bliley was passed in 1999, the five largest U.S. banking organizations controlled $2.3 trillion in assets, or about 38 percent of all banking industry assets. Currently, Bank of America by itself and in spite of its need for government support during the crisis has the same level of assets – $2.3 trillion – BIS central bankers’ speeches as the top five did in 1999 and the top five now have 52 percent of all banking industry assets. What clearer sign could we find that market discipline no longer exists? Past actions and this growth have given our largest organizations significant competitive advantages over other financial institutions. For example, creditors and uninsured depositors at too-big-to-fail organizations believe that there is almost no chance that they will have to take a loss. This idea is formally acknowledged by the credit rating agencies when they give these organizations separate “support” and “standalone” ratings, which explicitly factor in the government support they likely will receive. The difference in these two ratings thus provides one measure of the funding advantages that too-big-to-fail organizations have over others. Haldane estimated that this funding advantage amounted to about $250 billion in 2009 for 28 of the largest banks in the world. At the Federal Reserve Bank of Kansas City, we estimated the ratings and funding advantage for the five largest U.S. banking organizations during this crisis. In June 2009, these organizations had senior, long-term bank debt that was rated four notches higher on average than it would have been based on just the actual condition of the banks, with one bank given an eight notch upgrade for being too big to fail. Looking at the yield curve, this four-notch advantage translates into more than a 160 basis point savings for debt with two years to maturity and over 360 basis points at seven years to maturity. In a competitive marketplace, where just a few basis points make a difference, these funding advantages are huge and represent a highly distorting influence within financial markets. I’ll name three. They don’t have to sell creditors on the strength of their condition. They have significant advantages in competing for funds. And, they have significant incentives to take on more risk, hold less capital, and book more assets. We should also recognize that the perverse incentives associated with such a system not only can contribute to a crisis, but tend to impede our ability to recover from a crisis. Normally, market forces would steer funds away from institutions having trouble and toward those that are the strongest and most capable of fulfilling their roles as financial intermediaries. However, coming out of this crisis, much the opposite may have occurred. Too many dollars appear stuck in institutions that must restore capital and work through bad asset problems before they can think of pursuing new lending opportunities. One sign that this outcome may have happened is the significant holdings of excess reserves at large institutions and the various strategies they are adopting to use low-cost, short-term funds to go out on the yield curve for Treasuries and other instruments. It is ironic that in the name of preserving free market capitalism in this country, we have undermined it so deeply. The road to a more stable financial system How can we change this game in which some institutions are repeatedly doubling up after taking losses, while public authorities are forced to underwrite the losing streaks? There are a number of options that currently are in the works: more effective regulation and supervision, higher levels of capital, and a resolution policy for too-big-to-fail institutions. However, one additional option used after the Great Depression still needs to be introduced: Glass-Steagell type limitations on the activities of those organizations that are otherwise too big to fail and that so dramatically affect our national and global economies. Let me take a moment to explain my views on each of these options. More effective supervision. The idea of more effective regulation and supervision is a major focus in the Dodd-Frank Act. This act mandates enhanced supervisory standards for all systemically important financial institutions. Such standards are to include provisions for riskbased capital, leverage, liquidity, overall risk management, exposure concentration limits, and resolution plans and living wills. BIS central bankers’ speeches With my supervisory background, I certainly support such efforts. But we should also recognize that supervision alone is not sufficient to address the challenges we face. As an example, two decades ago we were told that supervision based on “prompt corrective action” was the answer to the thrift and banking crisis of the 1980s. This system may have led to more timely supervisory enforcement steps and established a timeframe for the resolution of most institutions. But prompt corrective action, other previous supervisory reforms, and enhanced supervision under Dodd-Frank, still must rely on examiners unfailingly coming up with an accurate picture of a bank’s condition and then being able to act on those findings. In large, complex organizations, this is an exceedingly difficult task and much more so than when I spoke about it 15 years ago. This crisis, in fact, confirms that even the senior management, boards, and financial experts at our largest banks failed to assess adequately the risks they were taking, even though they were involved with such issues on a constant basis and had their reputations at stake. Also, as I previously stated, the substantial incentives that large organizations have to take on more risk, with the government expected to pick up the losses should they incur, unfailingly lead to undue risks throughout the balance sheet. In the hands of any banker, the combination of competitive pressures and perverse incentives are almost certain to result in noticeably higher risk exposures. Against these odds, we cannot expect examiners to have a 100 percent success rate. Factoring in the political power of the largest institutions, we cannot expect even a modest success rate during the upswing in the cycle. Higher capital standards. I also support stronger capital standards, especially in the form of a maximum leverage ratio based on equity capital. Basel III and the Dodd-Frank counter cyclical capital provisions may provide some constraint on excess risk in firms if they are implemented successfully. But again, we must be cautious in what we can expect from this step by itself. Basel I and II were supposed to provide a better means for linking a bank’s capital to the amount of risk it assumed. Along the way, we found that risk was very difficult to measure and that capital needs determined during normal circumstances were not enough for tail events or shocks that create financial crises. It is a fact that the largest financial firms easily met their risk based capital requirements just prior to this crisis. In addition, too big to fail incentives have provided an irresistible motive for large banks to game any capital system, particularly since their uninsured creditors do not count on capital but on a bailout for protection. There were several notable signs of this “gaming” of capital standards leading up to the crisis, including the growth of off-balance sheet activities and the construction of subprime mortgage-backed instruments that marginally met the standards for AAA credit ratings. Even with firmer leverage standards, the incentive is for these organizations to increase balance sheet risks. Resolution policy for too-big-to-fail institutions: A third option is to establish a framework for resolving systemically important institutions. I would add that this framework – to be successful – must convince all market participants that they are fully at risk when dealing with these entities. Most important, this option offers the only direct means to address the incentive issues surrounding too big to fail and, as a result, provides the best opportunity to curtail the repeated game of expanded safety nets and escalating risk. Ending too big to fail in this manner would also bring market discipline back into play as a key force supporting supervision and capital standards. The Dodd-Frank Act provides a framework for resolving systemically important organizations. While it adds to what we already have for closing commercial banks, there are important weaknesses with this framework. In particular, the final decision on solvency is not market driven but rests with different regulatory agencies and finally with the Secretary of the BIS central bankers’ speeches Treasury, which will bring political considerations into what should be a financial determination. So long as we have systemic organizations operating under the government’s protection, we will face the matter of whether we have the will to allow the market and bankruptcy to resolve them. In a major crisis, there will always be an overwhelming impulse to avoid putting such institutions through receivership. Always, it is feared that public confidence will be shattered, creditors or depositors at other institutions will panic, and that there are too many connections that will bring down other institutions. In addition, important services will be lost and the international activities will be too complex to resolve. Many of these fears are likely overstated. I maintain the view that the long-term consequences are much more severe if we fail to take action to end this cycle of repeated crises. In an environment where market participants are truly at risk, they will be much more likely to take steps to protect themselves, thus reducing the side effects of resolutions, and a failed institution’s essential activities can be continued through bridge banks and other means. A recent Moody’s comment further voices a belief that the resolution regime, as outlined in the FDIC’s interim rules, “will not work as planned, posing a contagion risk and most likely forcing the government to provide support in order to avoid a systemic crisis.” Based on this belief, Moody’s intends to continue assuming government support for the eight largest banking organizations, thus helping to carry on the funding advantage these entities have over other market players. Separate risk taking from the safety net. If too big to fail organizations cannot be effectively supervised, capitalized, or resolved – which is exactly where I contend things stand right now – what option remains? For me, the answer is firm: they must be broken up. We must not allow organizations operating under the safety net to pursue high-risk activities and we cannot let large organizations put our financial system at risk. Protected institutions must be limited in their risk activities because there is no end to their appetite for risk and no perceived end to the public purse that protects them. As we have seen in this crisis, size and expanded activities have not led to better and more diversified firms as many once argued, but instead have created very large firms with very similar risk profiles that closely mirror the overall financial system and economy. The serious problems that too-big-to-fail organizations encountered in this crisis provide clear evidence that some have reached a level of complexity and size that defies good management and operational efficiency. A number of financial analysts have even argued that the separate parts of most too-big-to-fail firms would add up to a value much larger than each firm in its entirety. Some have suggested that we should limit the overall size of a banking or financial organization, much like we do now with the 10 percent nationwide deposit cap. There were some failed efforts to include a size or funding cap in Dodd-Frank, but I agree it would be difficult to figure out a good way to restrict size. Having said that, real opportunities were missed to deal with size issues during the crisis. In the heat of the moment, rather than break firms into smaller more manageable firms, even the weakest U.S. organizations were allowed to acquire major entities that failed or needed assistance during the crisis. This compounded the too big to fail problem in an already concentrated financial industry. Instead of taking important steps to restructure these firms or resolving them as failures, regulators were required to turn their attention to such side issues as executive bonuses and how troubled institutions could be forced to lend more. To me the evidence is overwhelming, we should vigorously pursue the restructuring of these firms in a manner that mitigates risk and that would influence the size and complexity of these firms. That is, we must expand the Volcker Rule and carve out business lines that are BIS central bankers’ speeches not essential to the basic business of commercial banking or consistent with public safety nets and then require that these lines be spun off into separate firms. In the excellent book, “Regulating Wall Street,” several of the studies indicate that there are few synergies among financial activities that could lead to economies of scope. The studies also demonstrate that multiple functions in large, complex firms can actually increase systemic risk. Moreover, they suggest that the spun-off activities could thrive without explicit or implied government support. The conclusion in this book is that separating activities in this manner, together with stronger resolution processes and better capital standards, would do much to strengthen our financial system, making it more accountable and stronger. It is time we rethink how the world’s largest firms should operate and what combination of activities should be permissible. For commercial banks operating under the safety net, any additional activities must necessarily be restricted to those regarded as relatively safe and amenable to prudential supervision. We should give more thought and analysis to those activities and their risk implication and impact on the safety net. It is time we ended the cycle of “failure and reward” and return to “failure as failure.” Conclusion In a 2009 article on too big to fail and the problems that resulted from the repeal of GlassSteagall, Martin Mayer gave a very good description of where we currently stand. He stated: “We know now that despite the violence of the shock, both the big banks and the cadre of bank regulators and supervisors – and academics – are shaking off the awful memories of 2008 and are setting up the same pins in the same alleys for the same players to try again. We will have to do this, at least, once more before we even try to get it right.” I share Mayer’s concern that the United States is stuck in much the same game that came out so poorly this last time, but with the prospect for an even greater loss in the next game. We must make sure that large financial organizations are not in position to hold the U.S. economy hostage. But unlike Mayer, I refuse to accept that we must endure yet another crisis before we are willing to finally right the system. BIS central bankers’ speeches
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the London School of Economics, London, 30 March 2011.
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Thomas M Hoenig: Monetary policy and shifting economic risks Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the London School of Economics, London, 30 March 2011. * * * Introduction The past three year period has been a great challenge to policymakers worldwide, including central bankers. Unprecedented steps have been taken to restore stability to the world economy and, just as importantly, to assure a sustained recovery. I certainly support these goals. While I argued for handling the largest financial institutions differently than was done, I supported the Federal Reserve’s massive liquidity injections designed to staunch the financial crisis. After all, central banks exist in part for just that purpose. However, when the crisis is past, it is incumbent upon central banks to return to another of their responsibilities: creating conditions for a sustained economic recovery that requires looking beyond shortterm goals to long-term consequences. For more than a year, I have advocated, not for a tight U.S. monetary policy, but for one that would begin unwinding those policies put in place during the crisis. In January 2010, as the recovery entered its third quarter, I expressed the view that the Federal Open Market Committee should modify its rate guarantee to the market. That is, while agreeing that policy should remain accommodative, I voted against promising “exceptionally low rates for an extended period.” As the recovery continued into the spring, I judged that the Federal Reserve should gradually shrink its enlarged balance sheet with minimal market disruption by disposing of mortgage-backed securities that were trading in the market at a premium. Thus, I voted against replacing maturing MBSs with similar or other securities. Finally, in the fall, I questioned the long-term benefits of further easing monetary policy during a recovery – and I voted against QE2. Today, my view has not changed. The FOMC should gradually allow its $3 trillion balance sheet to shrink toward its pre-crisis level of $1 trillion. It should move the U.S. federal funds rate off of zero and toward 1 percent within a fairly short period of time. Then, after evaluating the effects of those actions, it should be prepared to move the funds rate further toward a level that could be reasonably judged as closer to normal and sustainable. I recognize that these actions are not simple to implement. They would impact different economic sectors differently and to varying degrees. They involve tradeoffs in their effects and uncertainty about the short-term reactions of financial markets and the real economy. However, they are not unreasonable or radical or inconsistent with our experience in dealing with past crises. They are focused on the longer run – reflecting a sharp awareness that policy geared too long toward extensive accommodation undermines market discipline and encourages speculative activities. Put another way, these actions reflect the view that the longer exceptionally accommodative monetary policies remain in place, the greater the danger that resources will be misallocated within and across world economies. Given the wide differences in views around these issues, I want to take time this evening to share my perspective on U.S. monetary policy choices and their effects on economic and financial outcomes. Recovery is under way The financial crisis is over, and the U.S. economy is recovering. GDP growth in the United States averaged 3.0 percent from the third quarter of 2009 through the fourth quarter of 2010. And it is worth noting that for the same period, the International Monetary Fund estimates that global GDP growth averaged 4.9 percent. Also, the United States added BIS central bankers’ speeches 1.5 million jobs into the private sector over the one-year period ending in February of this year. Other parts of the world, especially Asia, have experienced particularly strong growth. While parts of Europe and the U.K. have grown less robustly, the fact remains that the U.S. and much of the world is experiencing sustained economic growth. With the United States and many world economies experiencing such growth and with the U.S. financial crisis over, I would expect to see a change in policy in which stimulus put in place at the height of the crisis would be throttled back. However, this change in policy is on hold in the United States. The reason for the delay is the existence of significant productive capacity that remains unused in many of the developed nations. While the U.S. economy has clearly strengthened, it has not yet returned to pre-crisis output and employment levels. Its unemployment rate, for example, remains near 9 percent. In the U.K., unemployment remains near 8 percent. Thus for many the issue of policy turns on one’s confidence in the long run economic trends and the degree of monetary accommodation needed to ensure that those trends continue. Shifting economic risks The monetary policy being implemented currently within the United States and much of the world is more accommodative now than at the height of the crisis. Policy interest rates remain zero, and the Federal Reserve’s balance sheet continues to expand even as the economy improves. With these actions, the FOMC’s objectives have shifted from that of containing a global crisis to that of more quickly accelerating economic growth. Its components focus on raising inflation expectations, increasing asset values and pushing up growth in aggregate demand, and, as stated in its September 2010 press release, employment. While I agree these are worthy goals, I am concerned that maintaining a crisisoriented policy as the tool to achieve them significantly changes the economic risks. Past success in pursuing this form of policy is mixed at best. Central banks and the long run A Swiss central banker once advised me that the duty of a central banker is to take care of the long run so the short run can take care of itself. In the United States, this simple expression has been codified in its laws. The Federal Reserve Act requires that, “The … Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” These mandates recognize that the factors of production come together in a systematic fashion across economies, sectors within economies and resource availability to create growth. The process is not simple nor does it occur quickly – which is the purpose of putting policy in the context of the long run. It is within this context that policy should acknowledge the improving economic trends and begin to withdraw some degree of accommodation. If this is not done, then the risk of introducing new imbalances and long-term inflationary pressures into an already fragile recovery increase significantly. Short-run actions have consequences In the spring of 2003 there was worldwide concern that the U.S. economy was falling into a “Japanese-like” malaise; the recovery was stalling, deflation was likely to occur and unemployment was too high. This was the prevailing view despite the fact that the U.S. economy was growing at a 3.2 percent annual rate and the global economy’s average growth was nearly 3.6 percent. In addition, the fed funds policy rate was 1 ¼ percent. Although most BIS central bankers’ speeches knew that such a low rate would support an expanding economy, in June 2003 it was lowered further to 1 percent and was left at that rate for nearly a year, as insurance. Following this action, the United States and the world began an extended credit expansion and housing boom. From July 2003 to July 2006, the monetary base in the United States increased at an average annual rate of 4.9 percent, credit increased at an annual rate of 9 percent, and housing prices increased at an annual rate of about 14 percent. The long-term consequences of that policy are now well known. The United States and the world have just suffered one of the worst recessions in decades. The crisis has sometimes been described as a “perfect storm” of unfortunate events that somehow came together and systematically undermined the financial system. Such events included, for example, weak supervision and a misguided national housing policy. While these factors certainly contributed to the severity of the crisis, monetary policy cannot escape its role as a primary contributing factor. In reviewing data from this and earlier economic crises, the fact is that extended periods of accommodative policies are almost inevitably followed by some combination of ballooning asset prices and increasing inflation. I recently compared the movement of real policy interest rates and inflation for four countries: the United States, the U.K., Germany and Korea from 1960 to the present (Chart 1). The relationship between negative rates and high inflation is unmistakable. Also, the relationship between negative rates and housing price busts in advanced economies since 1970 is instructive. In this instance, nearly 50 percent of the housing price busts were preceded by negative real policy rates in the years before the busts (Chart 2). If a housing bust is thought of as a tail-risk event, these percentages are too high. Thus, it is also worth noting that as of this month, the U.S. real federal funds rate has been negative for 11 quarters. These relationships, of course, must be tested more vigorously before final conclusions are drawn; but the data are strongly suggestive and the findings consistent with those of scholars such as Allan Meltzer. Extended periods of accommodative policy, pursued to enhance short-term economic growth, are often highly disruptive in their economic effects. After the easing actions of 2003, unemployment declined from 6.3 percent in June 2003 to 5 percent two years later and to 4.6 percent the following year. However, by late 2009, following the worst of the credit crisis, the unemployment rate was more than 10 percent. The future As in 2003, concerns were voiced this past year that the U.S. economy was facing the prospect of deflation, slow growth and high unemployment. This was the case despite the many actions world economies had taken to remedy the crisis and stimulate growth. For me, it was difficult to conclude that more monetary expansion would assure a sustained recovery, and while there may be events that may slow economic growth, those events are related to other real factors. As the United States continues to ease policy into its recovery, once again there are signs that the world is building new economic imbalances and inflationary impulses. I would suggest also that the longer policy remains as it is, the greater the likelihood these pressures will build and ultimately undermine world growth. In the United States, for example, with very low interest rates, we are beginning to see some assets accelerating in price. Agricultural land prices, for example, are increasing at double-digit rates. High-yield securities in financial markets are demanding price premiums beyond what some would judge reasonable relative to risk. Why? To quote a market participant, “What are my choices?” The world for some time now has been experiencing rapidly rising commodity prices. While some of the increase may reflect global supply and demand conditions, at least some of the increase is driven by highly accommodative monetary policies in the United States and other economies. And, more recently, in the United States there is evidence of accelerating BIS central bankers’ speeches increases in core prices. Over the past four months, core PCE inflation in the United States has increased from a modest rate of 0.7 percent to a rate of 1.5 percent. I understand the U.K. also is experiencing rising prices. While no one can say with certainty whether this will continue, evidence is mounting that it might. I conclude my remarks this evening with the following observation. I tracked the average growth of money and the price levels in the United States from the 19th century to the present (Chart 3). It should surprise no one that there is a striking parallel between the long-run growth of money and the growth in the price-level index. From the end of World War II alone, the price index has increased by a factor of ten. With such a track record, it is hard to accept that deflation should be the world’s dominant concern. Conclusion Central bankers must look to the long run. If current policy remains in place, we almost certainly will stimulate the growth of asset values and inflation. This may temporarily increase GDP and employment, but in the long run, we risk instability, damaging inflation and lost jobs, which is a dear price for middle and lower income citizens to pay. However, the long run is not yet here. We have opportunities to assure greater long-term stability. Moving policy from highly accommodative to merely accommodative would be a step in the right direction. In this way, we can achieve a better long-run outcome than if we delay normalization. BIS central bankers’ speeches BIS central bankers’ speeches
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Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the 29th Annual Monetary and Trade Conference, Global Interdependence Center and Drexel University LeBow College of Business, Philadelphia, Pennsylvania, 24 May 2011.
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Thomas M Hoenig: Back to the business of banking Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City, at the 29th Annual Monetary and Trade Conference, Global Interdependence Center and Drexel University LeBow College of Business, Philadelphia, Pennsylvania, 24 May 2011. * * * Introduction Today’s meeting and sessions are about financial reform, and I congratulate the organizers of this conference for keeping this important topic in the mainstream of discussion. Much remains to be done around reform if we are to ensure a more stable financial system. Topics today will focus on housing, the Dodd-Frank Act, governmentsponsored enterprises (GSEs), the safety net and other reform efforts that necessarily follow the recent financial crisis that has so devastated our national economy. Understandably, major financial interests are lobbying to change and mitigate the impact of Dodd-Frank or influence the reform efforts that will affect the GSEs. One reform effort, for example, that is especially difficult for some interests to accept is the Volcker Rule. This rule will restrict banking organizations from engaging in proprietary trading activities and involvement with hedge and private equity funds. It will affect the largest institutions most directly, confining their risk profile and limiting the advantages of leverage that currently drive behavior among these firms. How it is implemented will influence not only the behavior of these firms in the future but the discussion of other reform efforts yet to be undertaken. I strongly support the Volcker Rule and suggest it should be implemented with resolve and should be strengthened in its reach and impact. Over the next few minutes, I want to outline my reasons for this position. Supporting my remarks this morning is a more extensive white paper prepared with colleagues at the Federal Reserve Bank of Kansas City. This paper is posted on our Bank’s website, www.KansasCityFed.org. A brief history A fundamental characteristic of the United States is that its citizens have an enormous suspicion and distrust of concentrated power – political or financial. For nearly 200 years, state and federal laws placed limits on bank activities and resource concentration, resulting in a relatively open U.S. banking system that has served the country well. In fact, some of the largest institutions in this country started small: The Bank of New York, for example, was founded, in part, by Alexander Hamilton, and the Mellon Bank was founded by a farm boy who built his own financial empire. Thousands of banks, from small community banks to large global players, have operated in this country for most of our 200 years. Banking in the United States thrived under the principles of competition and accountability – as opposed to having a few mega-institutions with the power to allocate a majority of financial resources and decide who wins and who loses. Rather, success followed a structure in which thousands of banks operated; competed; and, in the end, helped build the greatest middle class the world has known. In 1913, when the Federal Reserve was brought into existence, 21,000 commercial banks operated across the country. At that time, the five largest banks controlled assets that we estimate were the equivalent of about 2.6 percent of our gross domestic product (GDP). As late as 1980, the United States had 14,000 commercial banks, and the five BIS central bankers’ speeches largest controlled, in assets, the equivalent of about 14 percent of GDP. Our nation had a lightly concentrated and highly competitive commercial banking and financial system. We saw the ascendancy of the United States as the greatest economic system in the world. And we saw our country change from an agrarian-based economy to a successful agriculture and industrial complex. Today the United States has far fewer banks and a highly concentrated financial industry. We have fewer than 7,000 banks operating across the country. The five largest institutions control assets that are equivalent to almost 60 percent of GDP, and the largest 20 institutions control assets that are the equivalent of 86 percent of GDP. The remaining nearly 7,000 banks control assets the equivalent of only 14 percent of GDP. More noteworthy perhaps is the fact that it was several of the 20 largest institutions that nearly brought down the U.S. economy during this most recent global crisis. We did not get to such a circumstance by accident or a Darwinian “survival of the fittest“ process. We got there through policies that reflected good intentions along the way, but ultimately resulted in bad outcomes. Following earlier crises, such as the 1907 Panic and the Great Depression, we understandably wanted a more resilient system that protected small depositors. So, we first created the Federal Reserve and then the FDIC to provide a safety net of central bank liquidity for solvent banks and limited deposit insurance. During the past 30 years, however, we have expanded the use of the safety net far beyond its original intent. During the crisis of the 1980s and early ‘90s, the government confirmed that some institutions were too systemically important to fail – the largest institutions could put money anywhere, and its creditors would not be held accountable for the risk taken. More striking perhaps in the late 1990s, despite recent experience, Congress repealed the Glass-Steagall Act, which separated activities protected through the safety net from a host of other more-highly risk-oriented and opaque activities. As risks intensified and new crises emerged, this safety net was continually expanded to where the Federal Reserve, the FDIC and the Treasury were empowered to allocate enormous resources to ensure systemically important institutions didn’t bring down the economy. This process inevitably led to the picking of winners and losers – not through competition and performance, but through bureaucracy. The result is increased concentration and, as just proven, less financial stability. Also, as conditions allowed and incentives encouraged, complexity within the financial industry expanded exponentially and so did industry risks. First, the expansion of the safety net enabled and encouraged banks to increase their return on equity by lowering capital levels and increasing leverage. Second, with the elimination of Glass-Steagall, the largest institutions with the greatest ability to leverage their balance sheets increased their risk profile by getting into trading, market making and hedge fund activities, adding ever greater complexity to their balance sheets. Third, perception was reality, as certain complex institutions were bailed out and therefore were in fact the safest places for money to go despite the risk. The market’s ability to discipline was mitigated, and these institutions became so complex that supervision could not control their risk. The conclusion of this experience is that the United States must reform its banking and financial structure if we hope to have a competitive; accountable; and, in the long run, less volatile system. There are good reasons to expand the Volcker Rule and to narrow the scope of activities for institutions operating under the public safety net. The consequence of expanding the safety net to an ever-increasing range of activities is to invite a repeat of our most recent crisis. Yes, with separation of activities, risks will remain in the financial system, but unlike the past decade, this risk will be priced more correctly and failure can be resolved more equitably. BIS central bankers’ speeches Proposal to reduce costs and risks to the safety net and financial system Let me turn briefly to the reforms that I judge necessary if we hope to more successfully manage the risks and costs to the safety net and financial system. First, banking organizations that have access to the safety net should be restricted to the core activities of making loans and taking deposits and to other activities that do not significantly impede the market, bank management and bank supervisors in assessing, monitoring and controlling bank risk-taking. However, these actions alone would provide limited benefits if the newly restricted activities migrate to shadow banks without that sector also being reformed. Thus, we also will need to affect behavior within the shadow banking system through reforms of money market funds and the repo market. Restricting activities of banking organizations The financial activities of commercial, investment and shadow banks can be categorized into the following six groups1: Commercial banking: deposit-taking and lending to individuals and businesses. Investment banking: underwriting securities (stocks and bonds) and advisory services. Asset and wealth management services: managing assets for individuals and institutions. Intermediation as dealers and market makers: securities, repo and over-the-counter (OTC) derivatives. Brokerage services: retail, professional investors and hedge funds (prime brokerage). Proprietary trading: trading for own account, internal hedge funds, private equity funds, and holding unhedged securities and derivatives. Based on the criterion that permissible activities should not significantly impede the market, bank management and the supervisory authorities in assessing, monitoring and controlling bank risk-taking, banking organizations should be allowed to conduct only the following activities: commercial banking, underwriting securities and advisory services, and asset and wealth management services. Underwriting, advisory, and asset and wealth management services are mostly fee-based services that do not put much of a firm’s capital at risk. In addition, asset and wealth management services are similar to the trust services that have always been allowable for banks. In contrast, the other three categories of activities – dealing and market making, brokerage, and proprietary trading – extend the safety net and yet do not have much in common with core banking services. Within the protection of the safety net, they create risks that are difficult to assess, monitor or control. Thus, banking organizations would not be allowed to do trading, either proprietary or for customers, or make markets because such activity requires the ability to do trading. In addition, allowing customer but not proprietary trading would make it easy to game the system by “concealing” proprietary trading as part of the inventory necessary to conduct customer trading. Also, prime brokerage services not only require the ability to conduct trading activities, but also This categorization of financial activities is from Matthew Richardson, Roy Smith and Ingo Walter in Chapter 7 of Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, edited by Viral V. Acharya, Thomas F. Cooley, Matthew Richardson, Ingo Walter, New York University Stern School of Business, John Wiley & Sons, Inc., 2010. BIS central bankers’ speeches essentially allow companies to finance their activities with highly unstable uninsured “deposits.” This combination of factors, as we have recently witnessed, leads to unstable markets and government bailouts. The proposed activity restrictions will enable and require bank management to focus their activities on the traditional banking business and manage their exposure to risks inherent in these activities. Banking is based on a long-term customer relationship where the interests of the bank and customer are more aligned. Both the bank and loan customers benefit if borrowers do well and are able to pay off their loans. In contrast, as shown only too clearly with this recent crisis, trading is an adversarial zero-sum game – the trader’s gains are the losses of the counterparty, who is oftentimes the customer. Also, for those firms with access to the safety net and large amounts of credit, the advantage in the game goes to them. Thus, restricting these activities removes a conflict of interest between a bank and its customers, which encourages a more stable financial environment. In addition, the inherent riskiness of securities trading, dealing and market-making attracts, and in fact requires, people who are predisposed to taking short-term risks rather than lenders with a long-term outlook. The combination of securities and commercial banking activities in a single organization provides opportunities for the senior management and boards of directors to be increasingly influenced by individuals with a short-term perspective. As a result, the increased propensity of these corporate leaders to take high risks for short-term gain leads to more of a short-term-returns culture throughout the organization. Historically, bank investments were restricted to loans and investments in investmentgrade securities. As demonstrated in the financial crisis, the complexity of many assetbacked securities made it very difficult to determine their credit quality. As a result, “complicated” multilayer structured securities should be treated as other non-investment-grade assets are, and commercial banks should be limited or prohibited from holding them. Critics of restricting activities have raised concerns that it would cause problems for U.S. banks because they would face a competitive disadvantage relative to universal banks that are allowed to conduct the full range of activities. They say it would drive U.S. banks and jobs to other countries. If this were accurate, it would be an unfortunate outcome, certainly. However, this conclusion should be considered carefully before it is accepted. First, we have 200 years of banking success in this country that tends to refute that assertion. Second, it seems improbable that any other country should be willing or able to expand its safety net to new large and complex banking organizations. Third, and finally, the U.S. authorities should consider carefully whether it is wise to insure and therefore protect creditors of foreign organizations that operate in this country outside of the U.S.’s prudential standards. Reforming the shadow banking system Critics of restricting the activities of banking organizations also argue that it could worsen the risk of financial instability by pushing even more activities to the unregulated shadow banking system. I agree that focusing solely on the regulated banking industry would not solve the problem and might in fact expand the shadow banking sector that was an integral part of the financial crisis. However, much of the instability in the shadow banking system stemmed from its use of short-term funding for longer-term investment. This source of systemic risk can be significantly reduced by making two changes to the money market. BIS central bankers’ speeches The first change addresses potential disruptions coming from money market funding of shadow banks – money market mutual funds and other investments that are allowed to maintain a fixed net asset value of $1 should be required to have floating net asset values. Shadow banks’ reliance on this source of short-term funding and the associated threat of disruptive runs would be greatly reduced by eliminating the fixed $1 net asset value and requiring share values to float with their market values. The second recommendation addresses potential disruptions stemming from the shortterm repurchase agreement, or repo, financing of shadow banks. Under bankruptcy law, repo lenders receive special treatment as compared to other secured lenders because they are allowed to take possession of the underlying collateral if the borrower defaults. In other words, repo lenders are not subject to the automatic stay that all other creditors are subject to when default occurs. The bankruptcy law also specifies the eligible assets for the automatic stay exemption. One of the changes in the 2005 bankruptcy reform law was to make mortgage-related assets used in repo transactions exempt from the automatic stay. Prior to 2005, only very safe securities were exempt from this stay. The change meant that all of the complicated and often risky mortgage securities could be used as repo collateral just when the securities were growing rapidly and just prior to the bursting of the housing price bubble. One of the sources of instability during the crisis was repo runs, particularly on repo borrowers using subprime mortgage-related assets as collateral. Essentially, these borrowers funded long-term assets of relatively low quality with very short-term liabilities. Therefore, to improve the stability of the shadow banking market, the bankruptcy law for repo collateral should be rolled back to the pre-2005 rules and eliminate the automatic stay exemption for mortgage-related repo collateral. This would discourage such activity and tend to reduce the potential instability that is associated with repo runs. Term wholesale funding would continue to be provided by institutional investors such as mutual funds, pension funds and life insurance companies. Overall, these changes to the rules for money market funds and repo instruments would increase the stability of the shadow banking system because term lending would be less dependent on “demandable “ funding and more reliant on term funding, and the pricing of risk would reflect the actual risk incurred. Conclusion The proposal I am placing before you today will not take all risks out of the financial system. Reasonable risk is, in fact, part of the financial system and essential to our economic success. However, the proposal will improve the stability of the financial system by clarifying where risks reside; improving the pricing of risk; and, thus, enhancing the allocation of resources within our economic system. It also will promote a more competitive financial system, as it levels the playing field for all financial institutions. And finally, it will raise the bar of accountability for actions taken and, to an important degree, reduce the likelihood of future bailouts funded by the American taxpayers. BIS central bankers’ speeches
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Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the Pew Financial Reform Project and New York University Stern School of Business "Dodd-Frank One Year On", Washington DC, 27 June 2011.
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Thomas M Hoenig: Do SIFIs have a future? Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the Pew Financial Reform Project and New York University Stern School of Business “Dodd-Frank One Year On”, Washington DC, 27 June 2011. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. Introduction We are approaching the one-year anniversary of the Dodd-Frank Act. With so much of the Act’s implementation work unfinished, it is not an anniversary that we can celebrate; rather it is an opportunity to take stock. In that vein, I congratulate the organizers of this conference for bringing together such an excellent group of individuals to do just that. In particular, I want to recognize the New York University Stern School of Business and economics faculty for the outstanding research they have done on critical financial reform issues. Their collaborative efforts have produced a series of must-read books that have a combination of rigorous economic analysis and practical policy prescriptions that is rarely seen these days. Much of the Dodd-Frank discussion revolves around the economic distortions and disruptions caused by the largest and most complex financial companies, the so-called systemically important financial institutions, or SIFIs. As we consider the topic of SIFIs, let me ask the following questions: how can one firm of relatively small global significance merit a government bailout? How can a single investment bank on Wall Street bring the world to the brink of financial collapse? How can a single insurance company require billions of dollars of public funds to stay solvent and yet continue to operate as a private institution? How can a relatively small country such as Greece hold Europe financially hostage? These are the questions for which I have found no satisfactory answers. That’s because there are none. It is not acceptable to say that these events occurred because they involved systemically important financial institutions. Because there are no satisfactory answers to these questions, I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril. To more fundamentally address this issue, we must go beyond today’s Dodd-Frank. We must confine the use of the safety net to its original intent. We must reduce the artificial complexity of existing financial structures. The rewards of success must be balanced against the credible consequences of failure. In achieving such goals, we will enhance the stability of the fundamental mechanism through which monetary policy is conducted and the economy depends. The decline in competition and accountability in banking The U.S. economy is the most successful in the history of the world. It achieved this success because it is based on the rules of capitalism, in which private ownership dominates markets and individuals reap the rewards of their success. However, for capitalism to work, businesses, including financial firms, must be allowed, or compelled, to compete freely and BIS central bankers’ speeches openly and must be held accountable for their failures. Only under these conditions do markets objectively allocate credit to those businesses that provide the highest value. For most of our history, the United States held fast to these rules of capitalism. It maintained a relatively open banking and financial system with thousands of banks from small community banks to large global players that allocated credit under this system. As late as 1980, the U.S. banking industry was relatively unconcentrated, with 14,000 commercial banks and the assets of the five largest amounting to 29 percent of total banking organization assets and 14 percent of GDP. Today, we have a far more concentrated and less competitive banking system. There are fewer banks operating across the country, and the five largest institutions control more than half of the industry’s assets, which is equal to almost 60 percent of GDP. The largest 20 institutions control 80 percent of the industry’s assets, which amounts to about 86 percent of GDP. Here’s the irony: this marked increase in concentrated power, and therefore, more concentrated risk, reflects past efforts to assure greater economic stability. This might best be described as “good intentions/bad outcomes” syndrome. For example, the Federal Reserve was founded following the 1907 Banking Panic and was charged with providing liquidity support to solvent banks that were experiencing funding problems. After the Great Depression, the Federal Deposit Insurance Corp. was created to provide limited deposit insurance to protect small depositors and to further increase the resiliency of the financial system. Then, over the past 30 years, this safety net has expanded far beyond its original intent. More recently, Glass-Steagall was repealed, giving high-risk firms almost unlimited access to funds generated through their new access to the safety net. Finally, following a series of crises during the late 1980s and 1990s, the government confirmed that because of systemic impact, some institutions were just too big to fail – the largest institutions could put money in nearly any asset regardless of risk, and their creditors would not be held accountable for the risk taken. Predictably, the industry’s risk profile increased dramatically. The SIFI was born. Is it any wonder then that in the fall of 2008 we experienced the greatest financial crisis since the Great Depression? Financial institutions had again become irresponsible in their lending practices. They had increased their leverage ratios to unprecedented levels. They became “dry kindle” for a financial fire and, with the end of the housing boom, the match was struck. Now, with their bailout costs amounting to billions of taxpayer dollars, SIFIs are larger than ever. Strikingly, they are arguing that they should not be held to stronger capital standards if the United States hopes to remain globally competitive. That assertion is nonsense. The remainder of my remarks today will describe how the United States can achieve a stronger, more stable financial system in order to secure its future as a global economic leader. Proposal to reduce costs and risks to the safety net and financial system Following this financial crisis, Congress and the administration turned to the work of repair and reform. Once again, the American public got the standard remedies – more and increasingly complex regulation and supervision. The Dodd-Frank reforms have all been introduced before, but financial markets skirted them. Supervisory authority existed, but it was used lightly because of political pressure and the misperceptions that free markets, with generous public support, could self-regulate. Dodd-Frank adds new layers of these same tools, but it fails to employ one remedy used in the past to assure a more stable financial system – simplification of our financial structure through Glass-Steagall-type boundaries. To this end, there are two principles that should guide our efforts to restore such boundaries. First, institutions that have access to the safety net should be restricted to certain core activities that the safety net was intended to protect BIS central bankers’ speeches – making loans and taking deposits – and related activities consistent with the presence of the safety net. Second, the shadow banking system should be reformed in its use of money market funds and short-term repurchase agreements – the repo market. This step will better assure that the safety net is not ultimately called upon to bail them out in crisis. Consistent with the first principle, banking organizations with access to the safety net should be generally confined to the following activities: commercial banking, underwriting securities and advisory services, and asset and wealth management services. Underwriting, advisory, and asset and wealth management services are mostly fee-based services that do not put much of a firm’s capital at risk. In addition, asset and wealth management services are similar to the trust services that have always been allowable for banks. Restricting activities of banking organizations In contrast, banking organizations should be expressly prohibited from activities that include dealing and market-making, brokerage, and proprietary trading, which expose the safety net but have little in common with core banking services.1 Thus, banking organizations would not be allowed to do trading, either proprietary or for customers, or make markets because such activity requires the ability to do trading. In addition, allowing Within the protection of the safety net, they create expansive risks that are difficult to assess, monitor or control. Thus, banking organizations would not be allowed to do trading, either proprietary or for customers, or make markets because such activity requires the ability to do trading. In addition, allowing customer but not proprietary trading would make it easy to game the system by “concealing” proprietary trading as part of the inventory necessary to conduct customer trading. Also, prime brokerage services not only require the ability to conduct trading activities but also essentially allow companies to finance their activities with highly unstable uninsured “deposits.” This combination of factors, as we have recently witnessed, leads to unstable markets and government bailouts. Critics of this proposal contend that institutions grow to be large and complex because of economies of scale and scope and they need the size and related complexities to be profitable and to compete globally. They believe firms must have broad, mostly unrestricted access to all financial activities to provide one-stop shopping and compete on a global basis. Arguments also are given that large banks and securities firms are necessary to make efficient markets for securities trading essential for carrying out monetary policy. These arguments are unconvincing and, in fact, mislead. First, yes, it would be unfortunate if restricting activities were to drive U.S. banks and jobs to other countries. However, we have 200 years of banking success in this country to refute that assertion. More recently, under Glass-Steagall, U.S. banks and investment banks were highly competitive and successful as each specialized in lending to or underwriting businesses all over the world. There is considerable evidence that under Glass-Steagall the United States was at no competitive disadvantage to Europe, with its mingled merchant banking system. The United States led the world – because it had strong, prudently run institutions that knew how to manage money in the best interests of the client. This categorization of financial activities is from Matthew Richardson, Roy Smith and Ingo Walter in Chapter 7 of Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, edited by Viral V. Acharya, Thomas F. Cooley, Matthew Richardson, Ingo Walter, New York University Stern School of Business, John Wiley & Sons Inc., 2010. BIS central bankers’ speeches Second, there is no strong evidence of unlimited economies of scale and even less for wide economies of scope. Although both exist, they are captured at an asset size far less than that of SIFIs today. Third, large corporations would have ample convenient access to commercial and traditional investment banking services inside commercial banking. They would have to go to securities dealers to purchase swaps and other derivatives for hedging purposes, something that has been done in the past without difficulty. Finally, it also seems improbable to me that any country should be willing or able to expand its safety net or to expose its taxpayers to the undefined risks of protecting ever-larger and more complex banking organizations. Instead, what countries should be focused on now is getting back to fundamentals aimed at simplifying highly complex and unstable SIFIs. The focus should be on financial stability. Reforming the shadow banking system A legitimate concern of limiting the safety net is that this could worsen the risk of financial instability by pushing activities to the unregulated shadow banking system. Clearly, focusing solely on the regulated banking industry and ignoring the unregulated shadow banking system would not solve the problem and, in fact, might expand the shadow banking sector that was an integral part of the financial crisis. Much of the instability in the shadow banking system stems from its use of short-term funding for longer-term investment. The solution to this instability problem is not to provide a safety net for the shadow banks and regulate them more but, instead, to remove exceptions in which money market instruments are treated essentially as deposits. The current exceptions encourage significant short-term funding of longer-term assets. First, investors in money market mutual and other investment funds that are allowed to maintain a fixed net asset value of $1 have an incentive to run if they think their fund will “break the buck.” Thus, if the fixed $1 net asset value is eliminated and the share values of such funds are required to float with their market values, shadow bank reliance on this source of short-term funding and the associated threat of disruptive runs would be greatly reduced. Second, the potential disruptions to funding stemming from the repo financing of shadow banks should be ended. One of the sources of instability during the crisis was repo runs, particularly on repo borrowers using subprime mortgage-related assets as collateral. Essentially, these borrowers funded long-term assets of relatively low quality with very shortterm liabilities. These practices would be greatly reduced by rolling back the bankruptcy law for repo collateral to the pre-2005 rules. Prior to then, if a repo borrower defaulted, mortgage-related collateral could not be immediately taken and sold by the creditors. Returning to these rules would discourage the use of mortgage-related assets as repo collateral and reduce the potential for repo runs. Term lending through securitization would continue, probably at a smaller scale, with more closely matched term wholesale funding provided by institutional investors such as mutual funds, pension funds and life insurance companies. These changes to the rules for money market funds and repo instruments would increase the stability of the shadow banking system because term lending outside the safety net would be less dependent on “demandable” funding and more reliant on term funding, and the pricing of risk would better reflect the actual risk incurred. A final note: implications for monetary policy Finally, as a member of the Federal Open Market Committee, I realize that we must consider the potential effects of these proposals on the conduct of monetary policy. The impact could BIS central bankers’ speeches be significant because, as currently practiced, monetary policy operations are channeled through a limited number of counterparties called primary dealers. These dealers are required to participate in all auctions of U.S. government debt and represent a key element in the implementation of policy. Currently, there are only 20 primary dealers. They are the largest financial firms operating in the United States, and most are affiliated with commercial banks. It is with this relationship that the changes I propose could affect the conduct of monetary policy. Specifically, given that primary dealers could no longer be affiliated with commercial banks, would this inhibit market-making in securities, including Treasuries, and therefore interfere with the conduct of monetary policy? The answer is “no.” It is not necessary that primary dealers be affiliated with banks. It is only necessary that they be institutions that deal in U.S. Treasuries and participate in auctions of U.S. government debt. Prior to the 1990s merger boom among investment banks and the Gramm-Leach-Bliley Act, it was typical that half or more of the primary dealers were not affiliated with commercial banks. Therefore, the fact that primary dealers are not commercial banks would have little effect on the Federal Reserve’s ability to conduct monetary policy. I would add that although commercial banks could not be primary dealers, they could remain a key part of the monetary policy mechanism. Recently, the Federal Reserve gained experience in using the Term Auction Facility (TAF). The TAF might very successfully be used in conjunction with primary dealer operations to conduct policy well into the future. As you may recall, during the financial crisis, the TAF was an important component of monetary policy. For example, the TAF was introduced in December 2007 with an initial auction of $20 billion. The facility was then ramped up to almost $500 billion by March 2009 – about one-fourth of the assets on the Federal Reserve’s balance sheet. The maturity of TAF loans was generally 28 days or 84 days. By broadening the Federal Reserve’s monetary tools to include the TAF to provide term funds through the banking system in parallel with the primary dealers, we could greatly expand the number of counterparties used in the conduct of monetary policy. Thus, the TAF and primary dealers would provide deep markets for the term portion of policy; primary dealers and traditional open-market operations would continue as the means for managing day-to-day operations and for maintaining the federal funds rate close to the target. With more counterparties, we enhance competition and enable nearly all banks to play a role in the conduct of monetary policy. This would make the largest banks less “SI” and more “FI.” Conclusion The financial system has become far less competitive and far more volatile with the onset of systemically important institutions. Though large firms remain a critical part of our economic system in the United States, they should not become so dominant that they become unaccountable to our capitalistic system. We can make the necessary reforms to end the unique status of the SIFI and, in doing so, restore much of our global competitive vigor. Only from a position of financial strength can the United States remain the global economic leader. BIS central bankers’ speeches
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Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the Rotary Club of Des Moines and the Greater Des Moines Partnership, Des Moines, Iowa, 30 June 2011.
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Thomas M Hoenig: Rebalancing toward sustainable growth Speech by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the Rotary Club of Des Moines and the Greater Des Moines Partnership, Des Moines, Iowa, 30 June 2011. * * * The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives. Introduction The U.S. economic recovery is under way, but it remains more uncertain and volatile than anyone would like. Some believe that the Federal Reserve can speed up the recovery by keeping the federal funds rate near zero, where it has been for nearly two-and-a-half years, and by promising to keep it there for an extended period. If I judged – or if evidence suggested – that a zero rate would solve our country’s unemployment problem or speed up the recovery without causing other adverse consequences, I would support it. However, monetary policy is not a tool that can solve every problem. In today’s remarks, I will outline my current views on the economy, and suggest what alternative options and policies our leaders might consider as we search for ways to build a stronger, more resilient economy. U.S. economic conditions First, it is a testament to the U.S. economic system that even as this nation carries a heavy public and private debt burden, the economy is completing its second year in recovery. The level of activity, as measured by GDP, has now surpassed its pre-recession peak after growing at a nearly 3-percent pace last year. However, I am concerned that in working to offset the effects of this devastating crisis and to restore the economy to health, an extended zero-interest-rate policy is producing new sources of fragility that we need to be aware of and allow for in our future policy choices. Governments, businesses and consumers have made financial choices and allocated resources with an understanding that a zero-interest-rate policy will remain in place indefinitely. The longer we leave interest rates at zero, the more asset values will be defined by these low rates and the greater the negative impact will be once the inevitable move up in rates begins. Complicating the fragility around monetary policy, fiscal policy as a pro-growth policy instrument also appears to be approaching its limit. The government’s stimulus efforts to support the economy, along with lower tax revenues, have resulted in historically large fiscal deficits and a very large debt level. Without a dramatic change, the deficit and the debt will only become more daunting with the rising cost of entitlement programs and likely higher interest rates. For well over a decade, the U.S. consumer has been a principal source of world demand and economic growth. As a result, the United States has incurred consistently large trade deficits, contributing to imbalances in the global economy. As we have painfully learned from the housing bust, growth built on imbalances is ultimately unsustainable. Circumstances require, therefore, that we transition from an economy that relies too heavily on consumption and government spending for growth toward more sustainable sources of BIS central bankers’ speeches demand and economic prosperity. How we undertake this transition will define our economy and country’s economic future. To start, over the next several years, we must change our national savings, consumption and investment habits. Such shifts, though fundamental to long-term economic health, are admittedly difficult to accomplish. They require changes in behavior and expectations. They involve dramatic shifts in resource use, which are not painless as workers are temporarily displaced and industries are disrupted. The pain is immediate, and the payoff comes slowly. However, the gains also can be significant, as more sustainable long-run economic growth is well worth the effort and sacrifice. In a recent visit to Singapore, I witnessed that nation’s commitment to job creation. For example, during the recent crisis and recession, Singapore developed a program to retrain unemployed workers to ensure they would have the skills needed when its manufacturing sector recovered. As is well understood, workforce training matters. I spoke with individuals who described the drive to bring new factories on-line, with the goal of bringing a factory online with minimal delays and, by their description, without compromising safety. Lessons from Germany Other countries have made similar changes out of necessity or during a time of economic distress such as we are experiencing today. Countries have made deliberate choices and not relied on chance to change economic incentives and behavior that served to improve economic performance. I’m not advocating that we pick winners and losers – in fact, that is my biggest argument against too-big-to-fail financial institutions. Rather, I have observed a number of countries that are building and expanding their manufacturing bases – such as Korea, Singapore and China – that have been able to experience strong GDP growth over long periods of time. Germany offers another example of a country having made significant changes to accomplish real employment goals. In the mid-1990s, Germany’s trade deficit was similar to that of the United States. Since then, Germany has moved away from trade deficits to surging surpluses, while the United States has continued to run large trade deficits. Complementing this shift, German levels of employment have made great strides, and its unemployment rate has touched its lowest point in nearly 20 years. I am not suggesting that the United States attempt to be Germany or Singapore, two countries that differ from us in many ways. I am also not advocating that we suddenly strive to achieve a large U.S. trade surplus. This might only create other global imbalances and distortions. However, adjustments in our economy are necessary, and other countries have shown it can be done. Perhaps the most immediate, and obvious, observation is the simplest: We must change our national savings rate. To rebalance the U.S. trade position from deficit to balance requires that the sum of private and public savings match domestic investment. In other words, a country must not produce less than it consumes if it wishes to balance its trade position with the rest of the world. During the 2000s, Germany’s personal savings rate increased and is currently about double the U.S. rate. German households paid down debt and avoided heavily relying on debt, in contrast to the United States and so many other countries’ households. The personal savings rate in the United States has modestly increased since the start of the recession, which is an important positive trend. Unfortunately, this improvement has been more than offset by the dramatic deterioration in public saving reflected in the nation’s fiscal deficits. Though a significant amount of the recent deterioration in public finances is related to the U.S. financial crisis, the fact remains that our national savings crisis has been under way for nearly three decades. Since the early 1980s, our nation has consistently chosen to BIS central bankers’ speeches spend rather than save, as witnessed by the long-term decline in our private savings rate and our tendency toward fiscal deficits. Most importantly, when we look across the more developed countries, we see that those with higher national savings rates tend to have smaller trade deficits and higher domestic production per person. Germany has also benefitted from managing unit labor costs in a manner that keeps its labor force globally competitive. Over the last decade, the German economy experienced relatively modest wage increases and important productivity gains. Both of these factors contributed to keeping unit labor costs in check. However, another important component of its success came in the form of labor policy reforms. In the early 2000s, Germany, with labor and management input, passed a series of labor market enhancements called the “Hartz laws.” These laws modified some of the more generous employee benefits and reduced restrictions on temporary workers and the ability to lay off workers. Germany’s reforms also sought to incentivize unemployed workers to transition to employment by making changes to job training programs for the unemployed and creating targeted subsidies to support some manufacturing job creation. Finally, Germany developed export markets by focusing on meeting the needs of parts of the world experiencing the fastest growth and demonstrating strong demand for capital goods that German manufacturers produce: emerging economies in Asia, Europe and Latin America. The United States is well-positioned to match this kind of performance, if it chooses to do so. For example, since 2000, the share of our exports going to the BRIC countries – Brazil, Russia, India and China – has more than doubled. If we choose to increase our savings rate, if government, labor and management see the mutual advantage of investing in and building a competitive manufacturing environment, then job growth will follow. As the U.S. economy shifts gears to shrink its trade imbalances, many parts of the country will have a role to play. I fully expect Iowa to be an integral participant in this shift. Iowa already possesses a strong manufacturing base that is a key driver of the state economy. By some estimates, about half of the manufacturing firms in the state are small- and mediumsized enterprises, which provide some parallels with Germany’s renowned export powerhouses, known as the Mittelstand. Real solutions versus economic shortcuts Rebalancing our economy and improving our trade position is a necessary development, but unfortunately, it will take time. And as our immediate desire is to rush to improve our economy, I warn against the all-too-common impulse to take shortcuts and suffer their unintended consequences. Here in Iowa, for example, one area where I suspect this tradeoff might be playing out is in the recent rapid run-up in agricultural land prices. Agricultural exports have played a significant role in the rapid rise of land prices. Since 2000, agricultural exports from Iowa have increased by a factor of six. A portion of this growth reflects surging commodity prices due to factors on the supply side – such as extreme weather in parts of the world – and on the demand side, including the well-documented, rapidly growing food demands of emerging economies. In addition to anticipated strong future demand for agricultural commodities, there is another factor affecting these prices: exceptionally low interest rates. As a bank regulator in the 1980s, responsible for financial institutions in Nebraska, Kansas, Oklahoma, Missouri, Wyoming, Colorado and New Mexico, I witnessed the devastating effects of easy credit and leverage in agriculture, real estate and energy. We closed or assisted nearly 350 banks in our region alone. With interest rates near zero and with additional massive liquidity poured into our economy, all interest rates are affected. Therefore, asset values of every kind are also being affected, BIS central bankers’ speeches including land values in Iowa. Loans for land are available at rates well below historical levels – in some instances, 400 basis points below historical averages. The effect on land assets, like any asset, is to artificially boost its value. And there is ample experience that tells us that if rates were to rise quickly, this would affect world demand for commodities and raise the cost of capital on land almost instantly. When – not if – the adjustment occurs, we will see a dramatic drop in values. In the meantime, if operators and speculators have incurred large amounts of debt, then a new crisis will emerge. Finally, we know that a crisis can affect more than one segment of the economy. It nearly always affects the broad economy and employment. Shortcuts don’t work. We need to focus on the real economy. We need to focus on real reform. Conclusion My point today is simply that as powerful as monetary policy is, it sometimes is not enough. It cannot ensure an economy that balances its savings and investing needs. It by itself cannot correct our current account deficit or enhance savings and investment. These will require important changes in our real economy. Providing the right environment in which government can play its role in supporting business and the consumer to save, invest, manufacture and service national and global needs in the end will create real income and wealth. We need to focus on long-term, stable monetary policy and fiscal policy goals that support these broader goals. Having seen the effects of financial crisis after financial crisis as shortterm policies beget short-term policies, we should know that an ever-present short-run focus, even if well intentioned, is the road to ruin. BIS central bankers’ speeches
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Statement by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the House Subcommittee on Domestic Monetary Policy and Technology, United States House of Representatives, Washington DC, 26 July 2011.
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Thomas M Hoenig: Monetary policy cannot solve every problem – concerns with zero rates Statement by Mr Thomas M Hoenig, President and Chief Executive Officer of the Federal Reserve Bank of Kansas City, before the House Subcommittee on Domestic Monetary Policy and Technology, United States House of Representatives, Washington DC, 26 July 2011. * * * Chairman Paul, Ranking Member Clay and members of the subcommittee, thank you for the opportunity to discuss my views on the economy from the perspective of president of the Federal Reserve Bank of Kansas City and as a 20-year member of the Federal Reserve System’s Federal Open Market Committee (FOMC). The Fed’s mandate reads: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The role of a central bank is to provide liquidity in a crisis and to create and foster an environment that supports long-run economic health. For that reason, as the financial crisis took hold in 2008, I supported the FOMC’s cuts to the federal funds rate that pushed the target range to 0 percent to 0.25 percent, as well as the other emergency liquidity actions taken to staunch the crisis. However, though I would support a generally accommodative monetary policy today, I have raised questions regarding the advisability of keeping the emergency monetary policy in place for 32 months with the promise of keeping it there for an extended period. I have several concerns with zero rates. First, a guarantee of zero rates affects the allocation of resources. It is generally accepted that no good, service or transaction trades efficiently at the price of zero. Credit is no exception. Rather, a zero-rate policy increases the risk of misallocating real resources, creating a new set of imbalances or possibly a new set of bubbles. For example, in the Tenth Federal Reserve District, fertile farmland was selling for $6,000 an acre two years ago. That land today is selling for as much as $12,000 an acre, reflecting high commodity prices but also the fact that farmland loans increasingly carry an interest rate of far less than the 7.5 percent historic average for such loans. And with such low rates of return on financial assets, investors are quickly bidding up the price of farmland in search of a marginally better return. I was in the banking supervision area during the banking crisis of the 1980s, when the collapse of a speculative bubble dramatically and negatively affected the agriculture, real estate and energy industries, almost simultaneously. Because of this bubble, in the Federal Reserve Bank of Kansas City’s District alone, I was involved in the closing of nearly 350 regional and community banks. Farms were lost, communities were devastated, and thousands of jobs were lost in the energy and real estate sectors. I am confident that the highly accommodative monetary policy of the decade of the 1970s contributed to this crisis. Another important effect of zero rates is that it redistributes wealth in this country from the saver to debtor by pushing interest rates on deposits and other types of assets below what they would otherwise be. This requires savers and those on fixed incomes to subsidize borrowers. This may be necessary during a crisis in order to avoid even more dire outcomes, but the longer it continues, the more dramatic the redistribution of wealth. In addition, historically low rates affect the incentives of how the largest banks allocate assets. They can borrow for essentially a quarter-point and lend it back to the federal BIS central bankers’ speeches government by purchasing bonds and notes that pay about 3 percent. It provides them a means to generate earnings and restore capital, but it also reflects a subsidy to their operations. It is not the Federal Reserve’s job to pave the yield curve with guaranteed returns for any sector of the economy, and we should not be guaranteeing a return for Wall Street or any special interest groups. Finally, my view is that unemployment is high today, in part, because interest rates were held to an artificially low level during the period of the early 2000s. In 2003, unemployment at 6.5 percent was thought to be too high. The federal funds rate was continuously lowered to a level of 1 percent in an effort to avoid deflation and to lower unemployment. The policy worked in the short term. The full effect, however, was that the U.S. experienced a credit boom with consumers increasing their debt from 80 percent of disposable income to 125 percent. Banks increased their leverage ratios – assets to equity capital – from 15-to-1 to 30-to-1. This very active credit environment persisted over time and contributed to the bubble in the housing market. In just five years, the housing bubble collapsed and asset values have fallen dramatically. The debt levels, however, remain, impeding our ability to recover from this recession. I would argue that the result of our short-run focus in 2003 was to contribute to 10 percent unemployment five years later. That said, I am not advocating for tight monetary policy. I’m advocating that the FOMC carefully move to a non-zero rate. This will allow the market to begin to read credit conditions and allocate resources according to their best use rather than in response to artificial incentives. More than a year ago, I advocated removing the “extended period” language to prepare the markets for a move to 1 percent by the fall of 2010. Then, depending on how the economy performed, I would move rates back toward more historic levels. I want to see people back to work, but I want them back to work with some assurance of stability. I want to see our economy grow in a manner that encourages stable economic growth, stable prices and long-run full employment. If zero interest rates could accomplish this goal, then I would support interest rates at zero. In my written testimony, I have included three speeches that describe in more detail my position on monetary policy. Monetary policy cannot solve every problem. I believe we put the economy at greater risk by attempting to do so. Thank you, Mr. Chairman. I look forward to your questions. BIS central bankers’ speeches
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Presentation by Dr Syahril Sabirin, Governor of Bank Indonesia, at the Banque de France, Paris in March 1999.
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Mr Sabirin discusses recent developments in the Indonesian economy Presentation by Dr Syahril Sabirin, Governor of Bank Indonesia, at the Banque de France, Paris in March 1999. Good evening, ladies and gentlemen. It is a great pleasure for me to be here today at the kind invitation of the Banque de France, and to have an opportunity to share with you the most recent developments in the Indonesian economy. The financial and economic crisis experienced by Indonesia since July 1997 was indeed very dramatic and traumatic. But the many steps we have taken have reversed the situation and established conditions for stabilization and a return to economic growth. We have launched and continue to implement an economic recovery program, designed not only to reverse the situation, but also to establish a stronger foundation for sustainable growth in the future. Let me begin by giving you a brief description of some of the factors which demonstrate that progress has indeed been made and which, as a result, should allow you to make a more positive assessment of the Indonesian economy. First, the value of Indonesia’s currency, the rupiah, is the clearest indicator suggesting that the worst of the crisis is believed to be over. As you may know, from a pre-crisis level of around Rp 2,430 per US$ in early July 1997, the rupiah weakened to reach a low of just under Rp 17,000 in June 1998. This represents a loss of about 85% of the rupiah’s value at its worst point. No economy could survive such a hard blow without serious harmful repercussions. One of our first priorities has therefore been to strengthen and stabilize the value of the rupiah. As a result, the sharp volatility of the rupiah during early 1998 gradually waned due to actions deterring speculative attacks. The monetary authority’s strict discipline and support from the IMF and other international financial institutions played a very important role, pushing up the rate to a range of Rp 7,500–8,000 at end1998. Despite the more recent weakening of the currency associated with the rumors on China’s devaluation, the Brazilian devaluation, and some scattered domestic problems, the rupiah has shown its resilience, signifying the improved confidence on Indonesian economic performance and prospects. From mid-October 1998, the rupiah has moved upward and downward within a range of only around 13%. Indeed, the bank restructuring program, the details and the implementation of which were announced about a week ago, was the latest piece of economic recovery program that contributed to the improved confidence. Now, let me turn to the macroeconomic indicators. GDP suffered a sharp decline in the aftermath of the fall in the rupiah’s value. Indonesia’s gross domestic product, which had grown by over 7% per annum for over a decade until 1997, grew by only 4.9% in 1997 and then contracted by about 14% in 1998. This contraction was due primarily to a sharp decline in production, private investment and lower household consumption due to the steep depreciation of the rupiah and high interest rates that had to be introduced to stop the free fall of our currency. We are confident, however, that the rapid fall in GDP growth has now been checked. For 1999 the economy will still post a negative growth around 2% to 3% year on year, and the economy is estimated to have some positive growth in 2000. Another important indicator, inflation, shows an even more positive trend. During its worst point in early 1998 Indonesia’s inflation rate reached almost 13% in one particular month alone, a dramatic rise from the 1997 level of 10.3% for the whole year. In response, we adopted a tight monetary policy, and work in a very tight discipline to adhere to the preset targets of monetary aggregates on a day-today basis. These efforts, together with the policy actions to secure the supply of basic necessities, have been rewarded. The monthly inflation rate started to decline to a more ‘normal’ level in the last quarter of 1998. We even recorded a negative inflation rate of 0.3% in October. I should also attribute the increased confidence in Bank Indonesia’s anti-inflation policy to the much improved transparency in the conduct of our monetary policy. Beginning the second quarter of 1998 we regularly announce, on a weekly basis, the crucial monetary aggregate data and how they compare to the preset targets. These data, as well as much other information, are available to everybody to access through our website. In June 1998 we recognized the concerns of foreign lenders to the banking system by agreeing to allow these foreign banks the opportunity to exchange loans to Indonesian state and private banks which had already matured or were to mature prior to 1999 into new short- and medium-term loans guaranteed by Bank Indonesia. This measure demonstrated immediately to foreign lenders that the guarantee put in place was operative and the Government’s determination to tackle this problem. At the same time, we recognized that the trade finance arrears that had been built up by some Indonesian banks during the currency and financial turmoil were prejudicing current access by Indonesian entities to trade financing across the entire economy. We agreed to settle these arrears and have paid the due amount. Most recently, in December 1998, we cleared additional arrears. This was, we believe, an important signal to the international banking community. In addition, for those banks that agreed to maintain their trade financing activities in Indonesia, we agreed to guarantee all new trade finance facilities for a year after we received confirmation of these banks’ commitment. Turning again briefly to the corporate sector which had been reluctant to enter discussions with its creditors, we also agreed in June 1998 to set up an agency, the Indonesian Debt Restructuring Agency or INDRA, to provide foreign exchange protection to those borrowers that had renegotiated their debts with their creditors. Strengthening these borrowers by reducing their residual foreign exchange risk improves their creditworthiness, thereby creating an incentive to complete a restructuring. These efforts were followed by the Jakarta Initiative in September 1998 which aimed at setting the right framework and incentives for bilateral debtor/creditor negotiations. These measures combined, and the real money that has been paid to foreign creditors, in particular by Bank Indonesia, show our real determination to resolve the current situation. Indeed our support has been proven with the expenditure of very large sums of our scarce foreign exchange resources reflecting the high priority we give this subject. I would urge you, therefore, not to adopt a reflexive reduction in your activities in Indonesia. Instead, please do focus on the systems in place now and the opportunities open to you within our new strengthened framework. Another very important point I would like to mention here is the high levels of capital-backing required in some jurisdictions on new lending to Indonesia. We believe these levels of provisions are excessive and that they constitute a great hindrance to a resumption of activity in our economy. Let me also take this opportunity to share with you some developments in our banking restructuring program. It is not a secret that the pre-crisis Indonesian financial system was unhealthily fragile and vulnerable to external shocks. We certainly underestimated the vulnerability of our domestic banking system to a crisis in the corporate sector and its potential to paralyze the banking sector; we also probably underestimated the riskiness of many loans in the banks’ portfolios. For our economy to recover, we had to create a strongly capitalized and well managed banking sector in line with international standards. This is our objective. To reach it we have first to address the current situation; that is very low capital base and excessive number of institutions which have not been able to institute the necessary reforms and improvements to their financial conditions, management and operational systems. Clearly, the banking sector has been one of the most seriously affected segments of the economy during the crisis. The effects were transmitted primarily through the following ways. (i) The sharp depreciation of the rupiah suddenly blew up the rupiah value of banks’ liabilities denominated in foreign currencies and put the banks with short position in serious problems; (ii) The economic crisis put banks’ customers (debtors) in problems which depressed the value of banks’ assets; and (iii) The tight monetary policy to stabilize inflation and exchange rates, and the concomitant high interest rates, resulted in negative spreads for the banks. All the factors I cited earlier imply depletions of banks’ capital base. And the longer the problems remain, the sharper the depletion of banks’ capital will be. Indeed, the results of the due diligence being run on the banks in 1998 show how deep the impact of the crisis on the banking sector has been. We fully realize that: (a) the recapitalization program is likely to be costly; (b) the recovery of the economy relies upon the recovery of the banking system, and thus on the recapitalization program; and (c) the failure of the recapitalization program would amount to the very costly delays to economic recovery; then the recapitalization program would have to be designed and implemented very carefully to assure its success. It is for this purpose that our bank recapitalization program carries the following characteristics. (i) The estimates of recapitalization needs are done very realistically, or even conservatively through the due diligence process conducted by international auditing firms on each and every bank. The conservativeness of the estimate would provide some cushion to the changing environment during the process of recapitalization. (ii) The criteria for the banks to be eligible to participate in the Government-supported recapitalization program are made very clear and transparent. (iii) The process of eligibility evaluation is conducted by four layers of committees, each layer works independently of the others, and the meetings of the committees are attended by observers from international financial institutions. This will assure the intensity of the evaluation and add transparency to the whole process. (iv) Among those to be evaluated by the committees, aside from the workability of the business plans, the ‘fit and proper’ of the management and the controlling owners of the banks is a very important and determining aspect. This process will leave out bad managers as well as bad and improper controlling owners from the post-restructuring banking sector of Indonesia. It has been on the basis of the principles I cited earlier that we run our bank recapitalization program to recapitalize those banks that we believe have a viable future together with the decision to liquidate those banks that were not viable. Following an assessment by international auditors of the banking sector, we have classified each bank into one of three categories. So-called category A banks have a capital adequacy ratio of 4% or more. Category B banks are those with a capital adequacy ratio of less than 4% and more than minus 25%. Category C banks are the residual. On 13 March 1999 the Government took a decisive step towards restructuring the private domestic system and bringing it back to financial health: 38 banks – all 17 private category C banks and 21 category B banks – have been closed as they were considered deeply insolvent and as having no prospect of regaining financial viability. Seven large category B banks with extensive branch networks have been taken over by the Government in the public interest to minimize disruption to the payments system. These seven banks will be restructured speedily to improve their financial performance and prepared for later privatization. Nine category B banks have been determined as eligible for recapitalisation by the Government to bring them to the minimum capital requirements. Several committees and international consulting firms have assessed the better financial positions, quality of management and future prospects of these nine banks. Their owners have, however, until April 21, 1999 to inject at least 20% of the banks’ capital requirements, the Government providing the remaining capital in the form of bonds. Finally, 73 category A banks have met Bank Indonesia’s minimum capital adequacy standards and can compete without any public financial assistance. These category A banks will be reviewed regularly to ensure they remain in good financial health and continue to observe all rules and regulations, focusing on three main criteria: their business plans, the ‘fit and proper’ test of their owners, and the nature of any capital injection. With regard to the state banks, all regional development banks will be recapitalized by the Government such that they have a capital adequacy ratio of at least 4%. Mergers between the seven existing state banks will allow us to create some stronger and healthier banks. For instance, four out of the seven state banks will be merged to create Bank Mandiri, which is expected to comprise 30% of banking system deposits in Indonesia. As the restructuring of the state banks takes place, the Government will inject additional capital needed by the banks on a step-by-step basis. The cost of the bank restructuring program will be significant. However, every effort will be taken to minimize this cost and in particular to recover loans from recalcitrant debtors. In terms of the interest cost to the Government in 1999/2000, it is estimated at a total of Rp 34 trillion or Euro 3.5 billion. Of this amount we believe around Rp 16 trillion will be recoverable from sales of assets pledged to IBRA by the owners of the banks. I should like to stress that it is not the intention of the Government to stay forever and dominate the banking sector. The Government’s involvement in the capitalization of the banking sector is only temporary to help the sector recover from the deep problems it is currently experiencing. In three to five years’ time the government’s share in the private banks will be divested, and these banks are expected to be pure privately owned banks once again. Nor is the intention of the Government to be involved in the day-to-day operation of the banks during the three- to five-year period. We only need to make sure that the banks are run properly and efficiently. And the mechanism of the recapitalization program has been designed such as to assure that these ideas are materialized. I can also report to you today that we will continue our efforts in the future to improve the security of our financial system further. We will implement organizational and cultural change in the way we manage bank supervision. We will also review the workings of the amended bankruptcy law and make alterations to ensure that the law works as intended to allow both domestic and international creditors to gain security over the assets of debtors in default. I look forward to reporting our progress in these matters to you in future meetings. Ladies and gentlemen, I hope that I have given you a balanced picture of the current situation in the Indonesian economy, banking system, and of the treatment of the broader financial obligations of the Indonesian private sector.
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Presentation by the Governor of Bank Indonesia, Dr Syrahil Sabirin, at The Indonesian Executive Circle (IEC) Forum in Jakarta on 7 April, 1999.
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Dr. Sabirin talks about efforts to save Indonesian banks Presentation by the Governor of Bank Indonesia, Dr. Syrahil Sabirin, at The Indonesian Executive Circle (IEC) Forum in Jakarta on 7 April, 1999. __________________________________________________________________________________ 1. It is a great honor for me to be here today to speak before this forum, The Indonesian Executive Circle. This afternoon, I would like to share with you some thoughts on the recent developments of the Indonesian banking industry - how the current situation and problems came about, what alternatives were available to deal with them, and how I see the prospect of our banking industry in the coming future. 2. The problems we are currently facing, including the banking problems, came onto the surface after and as a result of the currency crisis beginning in mid 1997. The magnitude of the currency crisis perhaps has not been matched by any other countries in modern time. As you know, from a pre-crisis level of around 2,430 rupiah per US dollar in early July 1997, the rupiah weakened to reach a low of just under 17,000 in June 1998. This represents a loss of about 85% of the rupiah’s value at its worst point. Clearly, no economy could survive such a hard blow without serious harmful repercussions. And it was only to be realized that a crisis of confidence, which was what Indonesia has really been suffering from, could do such a dramatic impact. The sharp decline in national output, massive increase in unemployment, and the deterioration of confidence on Indonesia’s financial institutions, corporations, and economy in general are among the impact. 3. To the banking sector, the currency crisis, and subsequent events, have produced two major repercussions, directly or indirectly, namely: Loss of confidence on banks that resulted in bank runs, loss of deposit base, and liquidity problems. → closing down of 16 banks in November 97. Run down of banks’ capital base. In this case the effects of the crisis were transmitted through the following ways: ½ The sharp depreciation of the Rupiah suddenly blew up the Rupiah value of banks’ liabilities denominated in foreign currencies and put the banks with short position is serious problems; ½ The economic crisis put banks’ customers (debtors) in problems which depressed the value of banks’ assets; and ½ The tight monetary policy to stabilize the exchange rates, and the resulting high interest rates resulted in negative spreads for the banks. Those effects further resulted in many other negative impact on the banks as well as on the economy at large, such as the unwillingness of banks overseas to accept L/C issued by Indonesian banks, credit crunch resulted from the low capital base, etc. And such declining trend in the banking sector reinforced the trend in the real sector, and vise versa. 4. Efforts to remedy the crisis of confidence on banks: Long term; Undoubtedly, this would have to be dealt with by adopting some measures to improve the confidence, both from within the country and from offshore. And, the comprehensive policy package covering economic and non-economic areas was designed for that purpose. However, the recovery of confidence cannot be obtained overnight. It takes time and continues efforts. In the meantime, the economy would have to bear the cost., among other things the high interest rates and/or instability in exchange rates. In this regards, in the short run, we do have a choice, i.e. either to aim at a stronger and more stable exchange rate while bearing the cost of higher interest rate, or aiming at lower interest rate while bearing the cost of weak and unstable exchange rate. Short-term (emergency): the government provides guarantees to all depositors and creditors of locally incorporated banks. This is designed to stabilize the situation so that an orderly work-out of the banking system problems can be carried out. This measure enables banks suffering form lack of liquidity due to massive withdrawals to get liquidity support form the central bank as the lender of the last resort. 5. On the low (mostly negative) capital base. Quite logically, something has to be done. The banks would not be able to do much, to say the least, without anything being done to help recover their capital base. Therefore a re-capitalization program has been introduced, whereby the Government is willing to subscribe to up to 80 percent of the additional capital needs of viable bank. This is likely be a very expensive exercise, although in a longer run there is a chance that the money invested can be largely recovered. The funds that need to be provided for the re-capitalization may exceed 25 percent of GDP. Although the costs of similar restructuring process in other countries do not differ much from what I cited earlier, and in fact the cost in some countries were much higher, the figure itself may raise eyebrows. But, is there any alternative? There is apparently no workable alternative one could think of. One extreme alternative is, of course, not to help the banks with re-capitalization. But, given the blanket guarantee provided by the Government on deposits and other banks’ liabilities, this is certainly much more costly. And it is more so since it will not provide any solution. Many of the banks will likely go bankrupt, and the economy is left with no one to finance. 6. In the meantime, a question often raised to me as well to my colleagues in Bank Indonesia as to why the bank restructuring program came much later in the process to heal the crisis, since – the argument goes - if the condition was dealt with much earlier when the problems in the banking sector were not so deep, it would have been much easier to resolve the problem. The answer is clearly that bank restructuring program would make no sense if the exchange rate is still fluctuating wildly, inflation rates are very high, and interest rates are still producing large negative spreads. So we had to undertake the program of macroeconomic stability first before being able to produce a realistic program on banking sector restructuring. 7. As you know, the comprehensive program for macroeconomic stability, wherein monetary policy played a very important role, has born some fruits. → inflation; exchange rates; interest rates; → conduct of monetary policy → prospect.] We attribute much of the progress made in stabilizing the exchange rate and reducing inflation to the tight monetary policy and consistent set of macroeconomic policies we have implemented. A tight monetary stance was required to control the excess supply of money which entered the economy when Bank Indonesia had to provide extensive liquidity support to commercial banks, particularly in late 1997 and early 1998 when many banks experienced panic withdrawals. We implemented a program under which all sources of central bank money creation were carefully monitored and controlled and the excess liquidity already in the system was reabsorbed through open market operations using Bank Indonesia Certificates (SBIs). Interest rates were by necessity high but the policy has been a success. Since July currency in circulation has been on a declining trend. Confidence in Bank Indonesia’s anti-inflation policy has steadily increased and, with bank deposit rates more attractive, holdings of currency by the public have been increasingly converted into bank deposits. Bank Indonesia’s open market operations have since 29 th July 1998, been conducted by a new system of SBI auctions under which a target amount of SBI instruments are auctioned weekly. Another positive development I can report to you is that as inflation began to contract and the Rupiah strengthened, we have been able to gradually ease our base money target which has allowed interest rates to gradually decline. The one-month SBI auction rate has declined from a high of around 70% in early September to a low of 35% in early January. The rate has now nudged up a bit to around 37% at the last auction, but the overall significant decline in interest rates has provided a much-needed boost to the real economy. 8. I should also attribute the increased confidence in Bank Indonesia’s anti inflation policy to the much-improved transparency in the conduct of our monetary policy. Beginning the second quarter of 1998 we regularly announce, on a weekly basis, the crucial monetary aggregate data and how they compare to the pre-set targets. Mind you, these data, as well as many other information, are available to everybody to access through our website. 9. Turning back to bank restructuring. First on the recapitalization program that was announced on March 13 th . This program had to be designed and implemented very carefully to assure its success, due to the following reasons:: (i) the re-capitalization program is likely to be costly; (ii) the recovery of the economy relies upon the recovery of the banking system, and thus on the re-capitalization program; (iii) the failure of the re-capitalization program would amount to the very costly delays to economic recovery. It was for this purpose that the current re-capitalization program carries the following characteristics. (i) The estimates of re-capitalization needs were done realistically, or perhaps conservatively through due diligence process conducted by international auditing firms. The conservativeness of the estimate will provide some cushion to the changing environment during the process of re-capitalization. (ii) The criteria for the banks to be eligible for re-capitalization were made very clear and transparent. (iii) The process of evaluation was conducted by four layers of committees, each layer to work independently of the others, and the meetings of the committees were attended by observers from international financial institutions. This should assure the intensity of evaluation and add transparency to the whole process. (iv) Among those evaluated by the committees, aside from the workability of the business plans, the “fit and proper” of the management and the controlling owners of the banks is a very important and determining aspect. This process will leave out bad managers as well as bad and improper controlling owners from the post-restructuring banking sector of Indonesia. 10. I would like to reiterate at this juncture that it is not the intention of the Government to stay forever and dominate the banking sector. The Government’s involvement in the capitalization of the banking sector is only temporary to help the sector recover from the deep problems it is currently experiencing. In three to five year time the government’s share in the private banks will be divested, and these banks are expected to be mainly privately owned banks once again. During the three to five year time, it is not the intention of the Government either to be involved in the day-to-day operation of the banks. We only need to make sure that the banks are run properly and efficiently. And, the mechanism of the recapitalization program has been designed as such as to assure that these ideas are materialized. 11. Of course, our work on the banking sector did not stop with the recapitalization. We are still in the middle of the process. Much still needs to be done. We will monitor the development in each individual bank on a day to day basis. We will work with each of them on this, and discuss the way to resolve their problems. For those which may need partners to strengthen their condition, we will function as a match-maker. With regard to prudential regulations, we will continue to monitor their effectiveness, and make adjustments whenever necessary. And, very importantly, we will have to continue to work hard to maintain or improve monetary stability and to ultimately abolish the negative spreads.. 12. I should also stress that, along with banks’ restructuring, companies’ restructuring should also take place at the same time. A number of actions in synergy are being conducted for this purpose. In this regard, the government in June 1998 established the Indonesian Debt Restructuring Agency (INDRA) to provide foreign exchange protection to those borrowers that had renegotiated their debts with their creditors. Strengthening these borrowers by reducing their residual foreign exchange risk improves their creditworthiness, thereby creating an incentive to complete a restructuring. Aside from the INDRA scheme, the Jakarta Initiative was established to help facilitate the meetings between debtors and creditors, and a special task force to help banks restructure their assets was also set up. We should expect that the restructuring of companies will take place along with the restructuring of the banks, and they should be strengthening each other’s progress. 13. As a final remark, bank restructuring formed a complete set of economic recovery program together with: (i) the corporate debt restructuring, (ii) monetary and macroeconomic stability, and (iii) improvement of public and private sector governance. The third point I just mentioned, namely improvement of governance is a very important aspect that needs to be worked out in the near future. The task of restructuring banks and corporations, and improving crucial aspects of governance will be made much easier in a stable macroeconomic environment. So, managing aggregate demand is a crucial task for the government. Here, Bank Indonesia needs to continue to play a very important role. It is believed that as inflation declines, and the Rupiah remains stable, the interest rates will decline gradually, easing the pressure on the corporate and banking sectors. We have seen some encouraging signs. The road ahead may not be that smooth, but we are cautiously optimistic that the crisis has hit its lowest level and we are beginning the climb back to a stable and healthy economy.
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Keynote address by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 33rd Asean Banking Council Meeting, Bali, 10...
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Burhanuddin Abdullah: Globalization, financial stability and regional cooperation Keynote address by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 33rd Asean Banking Council Meeting, Bali, 10 October 2003. * * * Mr. Secretary General, Mr. Chairman, distinguished officers and members of the ASEAN Banking Council, honored guests, ladies and gentlemen, Good morning and Assalamu’alaikum wr.wb It is indeed a great pleasure for me to welcome all of you to this beautiful island of Bali and to open this Meeting today. It is also a most gratifying experience to speak before a large gathering of distinguished representatives of Bankers Association from the 10 ASEAN nations. Your presence here is an opportunity to further enhance cooperation among bankers to promote regional growth in a new global environment. As we all may aware, globalization is a reality and no country in the world is immune to its impact. It has opened up tremendous opportunities, but it has also posed a wide range of challenges and risks. We must therefore strive to maximize the benefits of globalization while endeavouring to minimize the costs. Our experiences in the past crisis has shown that even the most dynamic economies are vulnerable. In spite of the judicious macroeconomic policies that we adopted and the structural adjustments that we carried out, the development gains that we earned over decades could crumble in the span of a few weeks. The severe crisis proved that our banking system had some structural weaknesses. Those weaknesses had led most of the ASEAN countries banking system into deep trouble, reflecting in the mounting amount of non performing loan, serious liquidity problems, huge amount of losses and eventually caused many banks to became insolvent. In the face of these realities, the ASEAN banking industry has rightly responded to restore the solvency and the stability of the banking system, through banking restructuring program, and improvement of banking supervisory and regulatory capability. Ladies and Gentlemen, This crisis may be abating, but greater challenges still lie ahead. The challenges that we are going to faced, first is the heightened competition among banks that requires bankers to make the basic strategic decision. As financial modernization going forward, bankers will be forced to decide what kind of institution they want to be. Bankers need to figure out where they want to be in terms of a whole spectrum of activities whether they want to be a local bank, regional, or global bank. The second is a challenge of effective risk mitigation and risk intermediation. We have to ask how do we keep our risk management skills honed enough to deal with the world of high tech and sophisticated finance. I believe that the nature of the risk is changing. It’s changing because the products and services are also changing in a more sophisticated way; that means the ability to recognize risk, measure risk, manage risk, offset risk, is utmost important for financial institution. The third challenge, obviously, is the process of financial deepening which affected market structures, complicating the task of regulatory oversight in several ways. As financial instrument become more complex; the boundaries between different types of financial market activity (lending, trading, insuring) become blurred; more claims become securitized and were exchanged in markets as traded instruments; and much financial activity became international in nature, blurring boundaries of responsibility among authorities. Now, the question is, what are the implications for bankers and regulators such as central banks? Ladies and Gentlemen, The first implication is that we have to acquire, improved, and further enhance our skills and capabilities. We need to improve our risk management skill considering that the nature of risk is changing very fast with new technology and products. The other is the requirement for us to conduct good corporate governance in the business. The need for transparency and corporate governance in any business including banking is very critical. Banking supervision cannot function well if sound corporate governance is not in place. Supervisory experience underscores the necessity of having the appropriate levels of accountability and checks and balances within each bank. Put plainly, sound corporate governance makes the work of supervisors infinitely easier. Sound corporate governance can contribute to a collaborative working relationship between bank management and bank supervisors. Consequently, central banks or regulator showed, by necessities, to impose market discipline and strengthen risk-based supervision as implied in the Basle Core Principles. Ladies and Gentlemen, In the face of these challenges and implication, ASEAN countries should make every effort to take advantage of the globalization and liberalization of investment and trade, knowing that it is the order of our global economy today. We should therefore actively involved in the many multilateral cooperation and/or institution. To strengthen economic cooperation among ASEAN countries, the leaders of ASEAN has just launched a new series of economies policies and initiatives as mentioned in Bali Concord II during their ninth ASEAN Summit, three days ago. One of the concept in Bali Concord II is the establishment of ASEAN Economic Community. That community envision "a stable, prosperous and highly competitive ASEAN economic region in which there is a free flow of goods, services, investment, labour and a freer flow of capital." The goal is to create a single market and production base by 2020; emulating other regional trade arrangements, particularly of the European Economic Community in the 1960s-1970s. With a population of some 500 million people and a combined GDP of about equal to China’s, ASEAN Economic Community is clearly not an economic lightweight. ASEAN Economic Community should continue to cooperate to make the region more integrated, dynamic, and ultimately prosperous. We should also continue to cooperate in the area of financial sector, among other; to develop the Asian Bond Market that could facilitates Asian savings to be smoothly reinvested in the region, encourage alternative longer term financing through capital market, and formulate the task for the regulatory oversight to deal with the complexities of financial instrument between banks and non banks financial institution. Our ultimate objective is, of course, to establish the financial stability in the region. The role of central banks has to be in conjunction with that of other guardians of financial stability. Complexity, globalisation, and institutional interdependence forcefully argue for close cooperation between central banks, monetary authorities and other standard setters. It is within this sphere that ASEAN swap arrangement could be further strengthened for the benefit of the region. In line with the objective to maintain financial stability, there is an even greater need to promote our common interest and exchange views on regional issues. A major concern to most ASEAN financial sector nowadays is to revive the intermediation function of banking system. Alternatives route toward the recovery of intermediary function should be explored, for example; Indonesia has been trying to improve intermediary function through among others by promoting credit channelling to the micro or small and medium enterprises. There has been quite some success in this area and we are very much willing to share with you the achievement so far. Another concern for ASEAN financial sector is the implementation of Basle Accord II which has raised question of the readiness of the banking system. We should therefore continue strengthening collaboration between central banks, monetary authorities, bankers, and private sector. In this regard, central banks have to provide the infrastructure where financial markets rely on, so that the best practices can be adapted. We also need to harmonized/standardized the financial institution structure, skill, and regulation in the region to face the Accord. Ladies and Gentlemen, On bilateral level, cooperation among bankers in the region is also essential in preparing the system for a more sophisticated and complex banking practice in the globalized era so that the region could still achieving financial stability. This is the challenge for us and also for ASEAN Bankers Association. The ASEAN Bankers Association has played an important role in facilitating the exchange of information and expertise on banking among the staff of the banks in Southeast Asia. There is room for greater cooperation among banks, such as exchange, attachment, and apprenticeship among the staff of the banks in the region, as well as cooperation with other regional groupings and international financial institutions. ASEAN Bankers Association should explore ways to create greater synergies through partnership and cooperation. I believe that the ASEAN Bankers Association will deliberate at length a strategic review of cooperation in Finance, Investment, and Trade; Education; and Inter Regional relation on this meeting. This is an opportunity for the Council to re-examine the relevance of ASEAN Bankers Association roles, and explore ways in which it can better serve its members. ASEAN Bankers Association has to reposition itself to meet the challenges of the new globalized economy. Finally, may I now take a great pleasure in declaring the Meeting open and wishing all of you success in your deliberations. Thank you.
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Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, to the Financial Club, Jakarta, 21 August 2003.
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Burhanuddin Abdullah: Monetary and banking in Indonesia - developments and challenges ahead Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, to the Financial Club, Jakarta, 21 August 2003. * * * Excellencies members of Indonesian Council of World Affairs Distinguished Guests, Colleagues and friends, Good afternoon, and Assalamua’alamualaikum wr wb. It is both a pleasure and an honor for me to be here today to speak before distinguished audience. Let me first thank you for inviting me, to share with you some of my thought regarding our current situation that could probably shape our future. If one ponders on our world today and tries to look back for a while to not too distant past, one may find himself in a bewildering circumstances. It seems that the past is to starkly different than that of today and that has no relevance with the present, let alone the future that we know nothing of. Our very existence at the present is in danger of detachment from our historical root of yesterday. And, yet, we know the passage of time is a continuous events that whatever the dynamic of transition in human endeavour, there is always element of continuity. What is the element of continuity of the economy in transition like the one in our country? Does this element of continuity need to be preserved as such that whatever the social dynamics, it has to be maintained at all cost? Time is the element of continuity for the evolutionary process of nature and macroeconomic stability, in my view, is the element of continuity for the Indonesian economy in transition. The stability is so important that whatever the cost to maintain it, we are ready to pay for it. It is so important simply because we can not imagine what the economy can do without. Macroeconomic stability is the “word” of the day and macroeconomic stability is a regular preaching of central bankers. As a person who has been in the central bank for years, and so get used to the phrase “monetary stability” and/or “macroeconomic stability” that some time questioning the real meaning of these very words. Especially if we look around and see many of our fellow countryman are out of job and many more becoming parasites of our social web. Should we forego some degree of stability in return for employment opening or should we stick to it, and let the other authorities take care of employment issue. The mandate that was given to Bank Indonesia by its constitution is precisely “the maintenance of our monetary stability”. BI is no longer engage in lending activities known as liquidity financing to be extended by our banking sector to a number of the so called “development program”. BI is no longer giving a bridging financing to government. The task of BI is so focused on maintaining stability, that it was granted independence from any policy interference from anybody. BI “has no function in development”, but take care and nurture of the foundation of development, i.e., stability, without which there will be no development at all. Ladies and Gentlemen, It is within this mandate that BI is now trying to perform. In the past several months, we have been quite successful in curbing inflationary pressures. As measured year-over-year, the inflation rate at the end of July fell to 5.79%. This performance was largely due to the appreciation of the rupiah and slow growth in base money, in addition to favorable supply factors. For the year of 2003 as a whole, we are projecting an inflation rate of 5% to 6%, lower than our target of 9%. The strengthened rupiah has a positive impact in capping inflation. During the second quarter, the rupiah appreciated over 4% from the previous quarter. After falling in July 2003 when the Federal Reserve’s last cut US dollar interest rates, the rupiah has traded in a narrow band around Rp8,500. The appreciation of the rupiah during the first half of 2003 was associated with a positive sentiment towards the country, illustrated by higher dollar inflows, related to privatization, the sale of IBRA assets, and the upgrade of Indonesia credit rating by S&P from CCC+ to B-. I should add, however, that, despite the recent strengthening of the rupiah, the foreign exchange rate remains competitive relative to regional competing currencies, including the Thai baht, one of our main export competitors. The drop in inflationary expectations and the appreciation of the rupiah has allowed Bank Indonesia to pursue a monetary policy that is designed to facilitate an accelerated recovery process by guiding interest rates lower. The 1 month SBI rate declined 390 basis points from 12.93% at the end of 2002 to 8.99% on August 20. This has been accomplished while adhering to quantity targeting, whereby Bank Indonesia controls growth in base money within an indicative target range. Throughout the year, the growth of base money has remained within target. This gives us confidence that we will be maintaining the growth in money so that there is sufficient liquidity to satisfy the needs of the real economy, without risking a run-up in inflation. Ladies and Gentlemen, I would now like to turn to the banking sector. Supported by improved macro-monetary conditions, banking sector shows stronger condition. This was reflected in a stronger capital structure, improved NPLs, stronger profitability and recovery in bank intermediation. All banks are now in compliance with the mandatory capital adequacy ratio of 8%. This has allowed the banking sector’s net income to grow as new credits extended have increased in the first half of the year and non-performing loans continue to remain under control with net NPLs reaching only 1.02% in June. Given the improved financial condition of the banking sector, the Government is in position to privatize banks to be owned other than by the government. Among our major accomplishments in this area, have been the sales of BCA, and Bank Niaga, the privatization of Bank Danamon, and the initial public offering of 20% of Bank Mandiri. The Government will press forward with the divestment of the remaining IBRA banks with plans to sell majority stakes in Bank Lippo and Bank Internasionel Indonesia by November of this year, and Bank Permata by February 2004. The Government also plans to sell 20% stake in the state-owned Bank Rakyat Indonesia in September of this year. Ladies and Gentlemen, Despite all these encouraging development in the area of monetary and financial stability, issues, challenges or even problem remains. These problems will remain with us for some time to come. The issues on the monetary front is on the mechanics and the cost of maintaining stability. In the banking front, reluctant intermediation process and maintaining financial stability in the new environment are the most pressing issues that need to be addressed. On a wider circumstances, we are facing credibility issues in light of the upcoming separation from the IMF program. In the monetary front, the challenge is rooted in the slow recovery of bank intermediation function. Bank lending is still limited because of high level of risks and uncertainty and the large number of companies still undergoing restructuring. Credit crunch phenomenon has been evidenced and the response of bank loan rates to the SBI policy interest rate is relatively slow and lagging. With slacking real sector and bank lending, the transmission mechanism of monetary policy to the real economy and inflation faces a number of problems. Since the economy and financial sector are undergoing restructuring, excess liquidity emerges but circulates within the financial markets only, creating a structural breakdown between the real sector and financial system. This problem of excess liquidity, together with market segmentation amongst banks, has put greater risks on exchange rate volatility and difficulties in monetary management. In the condition of excess liquidity in banking sector and non-functioning intermediation, monetary policy is working just like “chasing our own tail”. Banks put their excess liquidity in central bank bills (SBIs) and in return BI has to pay interest on SBIs which means pumping in the liquidity in the banking sector. In the banking sector, one of the main challenges is to recover the intermediation function. In this regards, Bank Indonesia has created the conducive environment by maintaining monetary stability thus providing room for lowering interest rates, thereby delivering positive signals regarding the economic recovery. The positive climate is also an opportunity for the banking sector to re-build its internal condition through credit restructuring and strengthening its capital structure. These will encourage an expansion of bank credits. A decline in interest rates has given businessmen some reason for optimism in the prospects for recovery. Lower interest rates also provided an opportunity for the corporate sector to restructure its financial condition. In the face of limited bank financing, these conditions have provided wider room for reputable corporations to find alternative financing through bond issuance, both domestic and abroad. The Indonesian financial sector is challenged by seemingly possible countermeasure if the Anti Money Laundering Act does not conform to the Financial Action Task Force (FATF) requirements. We believe that the amendment on the Anti Money Laundering Act is an important part in the efforts to maintain confidence in international financial transaction and trade and simultaneously improve good corporate governance especially by increasing transparency of banking transaction. In this regard, Bank Indonesia and Indonesian Financial Transaction Reports and Analysis Centre (PPATK) has been working closely with parliament to pass the amendment. Other issue that needs to be addressed is related with our decision to end the IMF program by the end of 2003. The real issues is not to continue or to stop the IMF program, but more on how we can cover the potential financial gap and credibility gap that might be stemmed from the decision. In addressing the financial gap issue, a number of financing alternatives that have been intensively discussed. However, to find the solution for the potential credibility gap, I must remind all of us that it will take more than just a solid program. Credibility can only be built if we can develop a credible program and at the same time be consistently and strictly adhere to it. Bank Indonesia has been working closely with the Government in developing our own economic program to replace the program currently stated in the IMF Letter of Intent. With the support from all of us, we are confident that we can and we will be able to obediently and consistently implement the program. For monetary policy, we are in the process of preparing the new framework of monetary policy, i.e., inflation targeting framework. This framework provides clarity in our objective and consistency in our monetary policy to pursue price stability, thereby gradually improve credibility. In banking sector, to maintain financial system stability and improve governance in banking sector, Bank Indonesia is currently in the process of preparing Indonesia’s Banking Architecture (API) that can be used as a comprehensive and forward-looking platform for banking policy. The Indonesian Banking Architecture vision is to create a sound, strong and efficient banking system to preserve financial system stability and stimulate national economic development. The new architecture consists of six pillars, as follow: • A sound domestic banking structure with the capacity to meet public needs and to stimulate sustainable national economic development. • A strong banking industry that is highly competitive and has a solid core capable of absorbing shocks. • Good corporate governance as means to strengthen banks’ internal condition • Effective banking supervision and regulations, consistent with the international standards. • A complete infrastructure in supporting sound banking industry, including preparation for more sophisticated technology in line with a more sophisticated financial transaction. • Consumer protection and empowerment. Ladies and Gentlemen, Before closing my remarks, let me figure out the outlook of our economy. Looking forward to 2004, we will continue to strengthen our macroeconomic fundamentals to be the basis for stronger growth in 2004 onward. While monetary policy will remain prudent, as both the inflation rate and the risk premium decline, fiscal policy will stay focused on achieving sustainability. This will require further steps to increase revenue collection and improve access to financing. But as the recovery continues we can begin to look forward to strategic investments to improve the welfare of the people and support the development of the economy. Good macroeconomic management, however, is not enough to sustain high rates of economic growth. High growth requires structural reforms to make the economy more efficient. Such reform programs that the Government is undertaking include the strengthening of legal infrastructure, improving governance and increasing transparency in both public and private sectors. The purpose of the program that we have developed is not reform for reform sake, but to restore investor’s confidence in Indonesia. We fully expect our macroeconomic policy, coupled with the consistent implementation of our structural reform, will allow economic growth to reach 4% this year and will establish the base of real growth of 6% over the medium-term. We do hope our efforts will improve the welfare of our society as a whole. May God bless us. Thank you.
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Address by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 2005 Bankers¿ Dinner, Jakarta, 14 January 2005.
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Burhanuddin Abdullah: Progressing towards a sound, strong banking system for promoting development Address by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 2005 Bankers’ Dinner, Jakarta, 14 January 2005. * * * Fellow Bankers in Indonesia, Senior colleagues at Bank Indonesia, distinguished guests, ladies and gentlemen Assalamu‘alaikum wr.wb, Good evening, and greetings to you all, I. Introduction At the outset, let us first of all express our gratitude to God Almighty that we are still able to gather here this evening in good health to attend the Annual Bankers’ Dinner for the year 2005. For us in the banking community, it has been our tradition to gather together for a moment of reflection and communication among us. Furthermore, on this occasion, allow me, on behalf of the Board of Governors of Bank Indonesia to extend to you our very best wishes for the Year 2005. Ladies and Gentlemen, The year 2004 has just ended. As we reflect on the year 2004, we can say that it was a year that was full of events that had meaning. It was a year full of accomplishments but also a year full of challenge. Perhaps we can say that 2004 was a year where we experienced the peak of political transition and in the process we have successfully conducted the general election in a democratic, peaceful, honest, and fair manner. It was a year where our society has succeeded to recompose itself in an accelerated fashion so that our social life can function in more tranquility. We can also note that the year 2004 was also the year where we achieved macroeconomic stability which would provide a stronger basis on which to base the growth of our economy. Exports and investment are beginning to show signs of vitality in order enabling a more broad-based growth to take place. In our external relations, we can also note that the year 2004 was the year that we have regained our place and our role as member of the international community. We have shown we have achieved maturity as a nation and as a democratic society. We have also shown that we are able to deal with the problems we faced in our own way and with our own program. In short, the year 2004 was a year where we are beginning again to show our own identity as a nation and our determination to stand on our own two feet. With the record achieved in the year 2004 it was natural for us to look to the year 2005 with optimism. However, as we approach the end of the year 2004 a series of serious natural disasters had also occurred that overshadowed the record of accomplishments we achieved. The earthquake in Nabire on the Eastern end of our country and the Tsunami disaster in Aceh and North Sumatera on the Western end of the country had shocked all of us. We have been deeply saddened by the news of the disaster where more than one hundred thousands of lives had been lost as well as property and infrastructure. In the face of the tragic losses of lives and property I wish to extend my deepest sense of gratitude for the concern and commitment that have been shown by the banking community to help our brethrens in Aceh and Sumatera who suffered from the calamities. Assistance for disaster relief from the banking community coordinated by Bank Indonesia has so far reached Rp. 67.8 billion. I also wish to extend my deepest appreciation to those in the banking community who institutionally or individually have organized the relief efforts on their own, and to who had even delivered the assistance directly on the location in the disaster areas. Moreover, may I also take this opportunity to express my great appreciation for the strong commitment of the banking community to restore economic activities in Aceh. In my visit together with the group of the Coordinating Minister last week, I am gratified to note that all banks that have had operation in Aceh have again resumed their normal operation. It is also with great sadness to learn that more than 170 bank employees in Aceh have been reported to have died or are missing in the disaster. More than 120 bank offices have been seriously damaged 1/12 in Aceh. Under such conditions it is heartening to learn that banks have begun their operation on January 3, 2005, one week after the disaster occurred. Bank clearing operation had resumed on January 5 2005. Thus the payments of salaries to civil servants in Aceh have been made according to the normal process prevailing in the rest of the economy. Up to today, it has been reported that of the 13 banks operating in Aceh, 7 have resumed their operation in their premises, 2 in a newly-rented premises, and 4 operating in premises made available by Bank Indonesia. Distinguished guests, fellow officials from Bank Indonesia, ladies and gentlemen, II. Theme: strengthening the banking industry The theme I have chosen for my address this evening is “Progressing Towards a Sound, Strong Banking System for Promoting Development.” This theme has been deliberately chosen based on the facts and urgency of future developments that challenge us to resolve fundamental problems pertaining to the lifeblood of the industry. In recent years, various efforts have been targeted with emphasis on maintaining macroeconomic stability, with Bank Indonesia’s attention drawn more towards resolving economic and monetary issues. Macroeconomic stability, as I frequently explained last year, is an element of continuity, a matter of essentiality for any economy seeking to progress. In this regard, we are thankful that in the midst of a multiplied challenges and tests, we have succeeded in building and sustaining macroeconomic stability. The rupiah has been maintained at an encouraging level, despite coming under pressure around mid-year, and the inflation rate is under relative control at a low 6.4%, with the domestic economy growing at about 5%. With the support of this macroeconomic stability and the fundamental understanding that higher levels of economic growth would require a strong and efficient banking industry, we launched the Indonesian Banking Architecture (API) at the beginning of 2004. This master plan for the future of the banking industry received enthusiastic comments from many quarters. Suggestions, input, and criticisms came from various parties with a concern and interest in our banking industry. All are aware that banking is a key if not the most important industry in turning the wheels of the economy. From that time forth, we have been buoyed with confidence in the ability of our banking industry to proceed with consolidation and institution building by laying down the foundations that will set the course for the banking industry. Having achieved macroeconomic stability, I envisage two important agenda for 2005. The first is to maintain this stability with focus on sustainability, and the second is that it is time for us to devote greater attention to the systems and institutions in the banking industry in order to build strength and deliver results. The hard-won macroeconomic stability should not be frittered away because of the fragile condition of some banks that could endanger the stability of the system as a whole. On the other hand, the banking sector must be capable of building its strength and capacity so that it does not disrupt the stability that we have in hand and can deliver greater benefits to the public. To this end, banking policy in 2005 will be directed towards efforts to strengthen the banking industry with new measures to reinforce policy and concrete actions to accelerate the bank consolidation process. The primary objective of consolidation in the banking sector is to strengthen the banking industry in the face of mounting future competition. It is this ability to face competition that will determine the ability of banks to meet the demands of the public. It is for this reason that Bank Indonesia in the period ahead will pay an increasingly serious attention toward banks which are unable to meet the requirements in the process of consolidation. Bank Indonesia will not hesitate to take a firm policy in order to ensure that the process will succeed. Let it not be that one bad apple spoils the whole barrel. We must not allow the progress we have so far achieved to be endangered by the problem faced by only a handful of banks with problems. The growing momentum of improvements in the banking sector must be safeguarded and supported by continuing corrective efforts. At our gathering this evening, I will present a number of policies that we will pursue throughout 2005 and in the medium to long term. These are specifically the policies that we will institute to accelerate the consolidation process in the banking industry, as I touched on earlier. To elaborate and discuss the theme of my speech this evening, I will first explain the present macroeconomic conditions and outlook and the performance and prospects of the banking industry. This section will be followed by the views of Bank Indonesia on key problems and challenges confronting the industry in 2005 and the medium term. In this section, I will also present the various 2/12 policies that we have developed and now expect to resolve the various problems and challenges and build the Indonesian banking industry as a sound, strong, and efficient banking industry, of benefit to the economy and society. In my closing remarks, I will attempt to present some conclusions by reiterating the key messages that I see as important and deserving of attention from us all. These are points that I expect to become the focus in our efforts to take the development of the banking industry to a new level in support of 7% economic growth in year 2008. Distinguished guests, fellow bankers, ladies and gentlemen, III. The macro environment of the banking industry Before I deal with future policy issues on banking, I wish to take this opportunity to glance at the macro-economic factors that surround the operation of banks. If we examine the development of several key indicators since the crisis, we can note with some satisfaction that they have generally show improvements. Various stabilization efforts undertaken by the Government and Bank Indonesia in the monetary and fiscal fields as well as in bank restructuring have been achieved according to expectation. Having achieved stability which we will continue to safeguard, we are now confident that the time has come to look ahead. After the initial focus of managing the immediate impact of the crisis had been undertaken, we had subsequently began to deal with the process of recovery by focusing on achieving and maintaining stability. Our next phase is to prepare for the longer-run policy requirement to generate the momentum for a higher and more sustained growth. This shift in the evolution of policy can be seen from phasing out of institutions that was directed at dealing with the immediate impact of the crisis. We have exited from the IMF program and the IBRA is now dissolved. Improvements in macroeconomic and monetary situation have ushered a more favorable environment to the economy. Stable inflation and interest rates levels have helped the business sector to obtained cheaper funding through both banking system and the capital market. For the banking system, stable interest rates at the level that was relatively low reduces credit risk of banks and hence progressively facilitate extension of credit to real sector. For the public, gradually decreasing of the level of interest rates, increases their access to bank credits and led to the increase in consumption of durable goods. This in turn had a positive impact on the real sector as reflected in the increase of GDP by 5% during year 2004. Improved macro-economic situation has a salutary impact on the real sector. Although so far growth has been spurt by consumption, it is gratifying to note that investment and exports are begining to show improvements. Growth has taken place across wide spectrum of sectors, with the highest contribution coming from the process industries, trading and transportation. The fact that growth has taken fairly evenly across sectors can also be seen by looking at expenditures when outlays for investments including investment credits have increased. In addition to the domestic factors that has contributed to growth, favorable external situation has also been helpful. The open global economy still provides opportunity for exports and prices of commodities of our interest have been improving. As we enter 2005, we look forward to continued improvement in the Indonesian economy. I am optimistic that macroeconomic stability will be sustained throughout the years to come. The rupiah is set to remain stable with an appreciating trend, while inflation in overall terms will stay well under control despite some expected pressure. The rupiah is forecasted to hold stable while inflation is predicted to stay on track with the government-mandated inflation target of 6%-7%. We predict that the Indonesian economy will grow in the range of 5.0%-6.0% while shifting to healthier balance in sources of growth. The year 2005 will be the year of infrastructure. The government commitment to promoting development projects with added value for the economy, such as toll roads, ports, telecommunications and transportation, and the rail network is a key factor sustaining our optimism for improvement in sources of economic growth and especially investment. Alongside this, non oil-gas exports are predicted to maintain their heartening trend, consistent with the favorable conditions in the international economy, a competitive exchange rate for the Rupiah, and expanding access to international trade financing. Our estimation is that non oil-gas export will continue to be driven by primary products, such as coal, nickel, and rubber, and some manufacturing sectors such as electronics and the food and beverages industry. 3/12 Looking ahead, improvement in export performance will be contingent on none other than improvement in export competitiveness. Global imbalances that could potentially push China towards revaluation of the Yuan will indeed create new opportunities for Indonesian exports through substitution. However, given China’s high productivity and low labor costs, we will be able to avail this opportunity only if we succeed making improvements in productivity and efficiency. The challenges in penetrating export markets will become significantly harder in 2005 with the elimination of textile export quotas, while so far, almost 60% of our textile and textile products have been sold to quota countries such as the United States and the European Union. With the abolition of quotas, China and India, the world’s leading competitors in the textile industry, are predicted to control a 60% share of the global market. Distinguished guests, fellow bankers, ladies and gentlemen IV. Performance of the banking industry Improved macroeconomic condition and stability and growing momentum in growth has had a positive impact on the banking sector. Extension of credits, which is the mainstay of banking activities has gradually increased and it has now reached a significant level. Moreover, what is even more gratifying is the increase in investment credits,which during the crisis had been lagging behind. It is reasonable to expect that bank intermediation will further improve in the years ahead. On the more microeconomic side, the banking industries have achieved some significant progress in many fronts. A number of measures and programs for internal consolidation and restructuring which have been implemented since a few years ago have continued to show satisfactory progress. This can been seen from the strengthening in the capital structure of banks and from the reduction of credit risks as well as increase in profitability. The Capital adequacy ratio of banks [CAR] has arrived at a more satisfactory level, stabilizing at 20%. Problem credits has been under better control as shown by our figures on net non-performing loans (NPL) of 2.1% and gross non-performing loans of 6.7%. Lower NPLs improves profitability of bank. In fact, the banking industry enjoys one of the highest returns to capital. Even more impressive is the progress achieved in syaria banking. Rapid growth in this segment of banking can be seen from the rapid increase in banks undertaking shariah banking, their total asset, as well as the amount financing being extended by shariah banks. It is appropriate to note with satisfaction that the intermediation function performed by shariah banks have been high where their FDR had reached 104%. This level of FRD has placed Indonesian shariah banks high in the ranks among shariah banks in any country in the world. This level of FDR is even higher than the level of conventional bank which only reached 50%. However, with market share still around the 1% mark, sharia banking has not yet reached the point of providing a significant contribution to the economy. Nevertheless, with the record achieved so far shariah banks have demonstrated the viability of alternative financing to the public. However, with the brisk growth achieved in recent years, the sharia banking industry has vividly demonstrated its capacity to offer an alternative avenue for financing to the small and medium-sized enterprises (SMEs). Therefore, it would not be an exageration to anticipate that in the years to come the share of shariah banking will increase significantly, at least comparable to the share in other countries members of the Organization of Islamic Conference. Looking ahead, it is envisaged that sustained macroeconomic stability will pave the way for the banking system to strengthen the bank intermediary function. This is expected to boost lending in 2005 by 20% or about Rp 106.2 trillion. With the continued overliquid condition of the banking system and the moderate 6% increase in deposit funds, this projected growth is seen as achievable. Investment credit, which began to pick up in 2004, is predicted to expand further particularly as infrastructure projects get under way. As I mentioned earlier, the banking system can play a keyfinancing role in the Government plan to accelerate the construction of infrastructure. In this regard, I call on banks to keep a close watch on their funding structure and experience and capacity in project financing. In the consumer sector, credit expansion is predicted to remain strong and will be the first choice for private banks and foreign banks as more banks enter into cooperation with multifinance companies. In the property sector, banks need to exercise greater caution in lending because of the higher risk of default on loans for purchase of apartments and office premises. 4/12 In the SME and microenterprise sector, lending soared in 2004 and this trend can be expected to continue in the years to come. For many banks SMEs would remain one of the preferred areas for the allocation of credits. We need to respond positively to the initiative launched by the UN to declare this year as the International year of micro-credit to help SMEs. With the great potential that are available in the SMEs given banks the opportunity to perform their intermediation function. To extend support to the SMEs, efforts need to be devoted to encourage the Peoples’ Credit Bank (BPR), as the financial institution closest to SMEs in their operation, to enhance their capacity to deal with SMEs. The proximity of BPR to SMEs, both physically and “psychologically”, is part of the strength of these banks that we will continue to build. Looking ahead at the next 1-3 years, Bank Indonesia will pursue measures to promote institutional and capacity building to enhance the capacity of BPR to perform this function and to assume the function of a community bank that would be the spearhead of micro-credit extension. Going forward, the banking industry need to examine and develop innovations to assist the development of SMEs. These innovation could extend the scope of financing to SMEs and at the same time reduce the risks of extending credits to the sector. In this connection, it may be noted that since recent time, we have launched a pilot project in cooperation with local governments and ASKRINDO to explore the possibility of creating a guarantee scheme for credits extended to SMEs. It is our hope that the pilot project could be expanded to more regions if it proves to be effective to reduce the credit risk to SMEs that has hitherto represented a major obstacle to lending by the banking sector. Distinguished guests, ladies and gentlemen V. Problems and challenges As I have mentioned, our goal is to develop a banking industry that would be strong and proactive in order to be able to support a sustained growth of our economy. In the years ahead despite the progress we have achieved, we are fully aware that we will continue to face a series of problems and challenges. Given the dynamic nature of the banking industry, it can only be expected that routine, technical, and operational issues will emerge from time to time as we move forward on our journey. However, we will not be confronting only technical and operational issues. Our lives will not be that easy. The multidimensional crisis we have faced has left some deep scars at the level of the systems, institutions, and individuals. Segments in our society have blamed us, the banking industry, for the misfortunes that they have suffered arising from the crisis. At certain stage the banking industry had suffered a loss of public confidence. This highly abstract but fundamental factor that is central to the banking industry, trust, seemed for a while to have been uprooted from the core of the banking community. There was a feeling at some quarters in the public that the banking industry have failed to provide a sense of security. The reverse also took place. The trauma of debtors defaulting on their loan agreements similarly led to a loss of confidence in the banking system in their debtor customers. Restoring this fundamental building block in the banking business is no easy task. Although we have in general achieved much progress, there are many more things that need to be done in order to regain the trust that had been undermined. We must take steps to regain some of the lost trust by taking steps from the most simple to the most sophisticated. Some the the major challenges we will continue to face and resolve are: First, the problem of relying excessively on short-term fund leading to the predominance of short term credits Although on the average in 2004 deposits experienced a modest increase, the composition of deposits have been dominated by those with maturity of 1 month. In the meantime, deposits with longer maturities have gradually declined. They have been subsequently placed in instruments issued by non bank financial institutions such as bonds and mutual funds. With this composition of deposit funds, the banking system as a whole faces the problem of high volatility of funds. This in turn will hinder the banking system from placing funds in long-term investment financing. The present condition has encouraged banks to seek business in consumption credit or working capital credit carrying relatively short terms in order to avoid difficulties with mismatch between funding sources and placements. 5/12 Second, problems with information concerning the debtor soundness have eroded the confidence of the banking industry in the real sector, hampering the intermediary function We must admit that despite the improvement in the intermediary function over the years, among conventional banks the function is still not operating as it should. This is indicated by the continued high risk premium charged by banks, resulting in the slow decline in lending rates and the tendency of banks to focus their efforts in credit expansion on existing debtors and short-term credit carrying relatively low credit risk. This problem stems primarily from lack of information on the soundness of debtors that would reduce the perception of risk in the banking system regarding prospective borrowers. Within this context, the challenge is how to improve transparency and accuracy on flows of information on debtors/prospective borrowers and economic sectors with potential for lending. This also includes information on the policy direction in the real sector, how to build the understanding and capacity of banks in assessing risk, and how to improve legal certainty in the resolution of problem loans in order to reduce the negative impact of the cost of problem loans on the risk perceptions of banks. On the other hand, banks must be able to understand the wide ranging technical aspects and the economic dynamics operating in the sectors where they intend to market their credits. Excessive concentration of credits in certain sector, in the long term will lead to market saturation, which in turn would increase the risk in extending credit to this sector. Accordingly, bank must be more proactive and constructive in providing opportunity of financing in sectors which are productive and which have not so far being touched optimally. Third, the credibility of the banking system will be contingent on the ability of the banking industry to strengthen good corporate governance, including management of operational risk During 2004, we witnessed a number of cases generally related to the inability of banks to manage operational risks, particularly in regard to fraud committed by bank owners and management. The incidence of fraud points to bad faith on the part of owners and managers who exploit their banks for dishonest personal gain. Failure on the part of individual banks, if allowed to continue, will undermine trust to the banking system. Another matter of fundamental importance and calling for urgent attention is the issue of integrity at all levels, including bank employees. The issue of integrity does not stand in isolation, but comprises part of another, larger problem of the deteriorating credibility of the banking system. In view of these facts, it is time for the focus of our attention to move up to the more advanced level of modern management of the banking industry, the application of good governance principles, and meticulous, scrupulous management of operational risk. Fourth, implementation of deposit insurance scheme requires banks to strengthen market confidence As I elaborated earlier, public confidence in the national banking industry at this time is not fully based on objective considerations. For the public, the Government blanket guarantee is a dominant factor in determining their opinion and confidence toward the banking system. This condition cannot be allowed to persist. Beginning in 2005, the Government blanket guarantee will be phased out and replaced by the Deposit Insurance Agency (LPS). This changeover will place added responsibility on the banking industry to build and maintain public confidence. Without a high level of confidence, the public will quickly move funds from the less trusted banks to sounder banks with stronger capital resources. To prevent this unhelpful phenomenon, the banking industry must be capable of proving that it exists as a secure, sound industry. In order to adequately functional in this environment, going forward banks soundness would be determined not only by its quantitative prudential indicators, but will be much wider to include a more qualitative assessment. Banks must be able to show their ability to strive in situation of fierce competition. In doing this, must be managed by professionals with high integrity who are able to govern between prudence and the management of risks on the one hand, and aggressiveness and creativity in developing new opportunities on the other hand. All transactions must be conducted quickly, promptly, and accurately by means of an extensive office network with optimum utilization of information technology. Banks ability to implement modernization and to adopt best 6/12 practices must become a distinct feature of strategic management that has selling value and can always be transparently monitored by the public. Conversely, banks that are unable to meet the expectation and aspiration of the public as described above would inevitably be abandoned by its customers. Failure to anticipate this means that the banks concerned will inexorably find difficulty in keeping up with normal business, suffer substantial loss or even deteriorating its soundness to the level that may endanger its existence. Fifth, the banking industry is constantly challenged by competition from non-bank products, such as mutual funds, bonds, and insurance As I have mentioned in our bankers’ dinner last year, banks in 2004 would face an increasingly tight competition both among each other and competition arising from other financial institutions. If we compare the banking and non-banking industries, it is obvious that growth in non-bank instruments such as mutual funds has outpaced growth in bank products. Last year, the level of banks deposit has only increase slightly by 4.5% whereas net asset value of mutual funds increased by an impressive 40%. On the other hand, bank credits during 2004 grew only by 20% whereas the Jakarta Composite Index grew more rapidly, especially during the second half of the year, to close 44% higher at year end. The higher return in bullish capital market is also a contributing to a tighter competition faced by banks in mobilizing deposit funds. On one hand, the rate of interest offered on bank funds is limited, being tied to movements in the blanket guarantee scheme rates. On the other hand, mutual funds that comprised of fixed income instruments can offer a fixed and significantly higher return as compared to any bank product. Return from investment in the stock exchange was even higher. Moreover, competition also stemmed from insurance company that also offer hybrids of insurance and investment services, known as unit links. The highly active bonds market in the recent period is expected to escalate in the periods ahead. This in part is attributable to eminent issuance of new bonds by both the government as well as the private sectors in order to finance physical development. The volume of transaction in the bond market is expected to be relatively high would of course influence the decision of the public to place their funds in this instruments. The increasing trend of types of financial instruments offered to public is expected to continue the period ahead. This condition in turn would have an impact in slowing the growth time deposit especially those deposits with maturity longer than 1 month. On the assumption that interest rates would remain relatively stable, it can be expected that the share of this product in the market would continue to decline while the mutual funds that are sold through banks will experience significant increase. It is important to note the increasing role of banking industry in the growth of mutual funds. The extent of the involvement can be attributed to the close relationship between banks with security companies which issued mutual funds. The closeness of this relationship makes it difficult to distinguish between activities of banks from those of other financial institutions. This phenomenon in bank operation of the banking system and the coming strengthening of the regulatory framework for collateralized securities products linked to the banking system appear likely to take bank industry to a new dynamic that would lead toward a more universal characteristics of banking practices. In turn, however, this will aggravate the inherent risks in the banking system and lead to a wider contagious effect. This is because instability in the market for one type of product will quickly spread, affecting the overall stability of the banking industry. It is logical to expect that strategic alliance would continue to develop, as the operation of financial institutions become more integrated and interrelated to one another. Nonetheless, our expectation is that the bank sector would be able to continue to be the driving force in development of these new products. This strategic function can operate directly and indirectly. Directly, banks can serve as the originator of such products. And indirectly, banks can act as selling agent, creditor to financial institutions or as owner of non bank financial institutions such as insurance and security companies. Distinguished guests, fellow bankers, ladies and gentlemen 7/12 VI. Future policy direction Within the banking industry, we have long been aware of these problems and challenges. Responding to this, we have worked together to map out actions and do what is necessary to ensure the sustainability of our banking system. Our desired objective is for the banking system to regain its place as a reliable, trusted industry capable of promoting national economic growth. To accelerate this change and respond to the various problems and challenges that lie before us, we have formulated a number of policy directions for the banking system that we believe will set the course for the future dynamics of the national banking industry. These policy direction include the following: First, accelerate the consolidation process in the banking industry In the Indonesian Banking Architecture (API), Bank Indonesia has laid out a series of measures to build the soundness and strength of the national banking industry. Under this policy, the banking industry consolidation program is a key initiative that sets the course for the future of the national banking industry. Within the next 10-15 years, the national banking industry must become capable of serving as a sound, strong, and dynamic backbone to the economy and of delivering results. However, as I explained earlier, the present situation and challenges and an array of unexpected events in 2004 have compelled us to adopt a shorter time frame for consolidation of the banking industry. In this regard, we must realize that to create a sound, robust, strong, and efficient banking industry, the industry consolidation will not be achieved without first going through a process of consolidation at the level of the individual bank. And, it is this process of individual consolidation that we must strive to complete in 2005. The picture is that an industry putting its house in order and striving for growth must first be sterilized of potential systemic risk that could arise from problems at individual banks. Before the recent launching of the API, Bank Indonesia put together a range of scenarios for the consolidation program for the building of soundness and strengthening of the banking industry as a whole. These scenarios are: • Market driven consolidation • Directives consolidation • Heavy-handed consolidation. These scenarios are in essence of a sequence of action programs that are mutually complementary, should one of the scenarios earlier in the sequence prove ineffective and fail to deliver the desired results. Taking into account the developments that have taken place since the introduction of the API in early 2004, Bank Indonesia is now readying itself to apply the second scenario in the consolidation program, which in essence is an acceleration of the consolidation program scenario set out in the API. The accelerated consolidation cannot be postponed any longer. We all know that pain will continue to afflict us and will be difficult to heal if we persist in concealing a wound. The credo of intensifying competition will sooner or later open up any and every wound suffered by non-competitive banks. For us to restore soundness, we must open the wound and take serious action, including possible amputation. This is the analogy that underlies the thinking on why we must proceed with the consolidation of the banking industry at this time. The choice lies before us, to reduce problems to the minimum and deal with them as early as possible or wait until the condition becomes irreversible. The second choice is clearly undesirable, as it could potentially trigger instability in the overall system. The consolidation scenario that we are considering for implementation in 2005 will begin with a process of identifying the medium and large banks that are currently in very sound shape and have adequate human resources to expand market share without sacrificing prudential banking principles. Our expectation is that these will become the anchor banks capable of stimulating a process of strengthening among other banks whose future ability to compete is reportedly constrained by a range of factors. In conjunction with the process of determining these anchor banks, Bank Indonesia will also identify the banks that have or are thought to have lost competitiveness because of their inability to build stronger resources and especially capital. These banks will then be grouped with other banks in reasonably good condition but which lack competitiveness because of limited market share and are 8/12 experiencing downward trends in both assets and deposit funds. Each group of banks will be offered three options: first, acquisition by an anchor bank; second, merger with other banks in the group; and third, a combination of merger between a number of banks and an anchor bank. In the merger and acquisition process, identification of similarities in operations, market segment, ownership links, and business orientation of the two parties, both the acquiring bank and the bank to be taken over in the acquisition, are key aspects that should form the basis of any decisions taken. It is hoped that with a consolidation mechanism based on the objective condition of each individual bank, the stakeholders will be open and willing to see that the process will benefit all involved. The banking system will be significantly strengthened, because its actors are banks with optimum levels of resilience and competitiveness. The first scenario for accelerated consolidation described above will naturally be reinforced by a variety of supportive measures, such as provision of incentives for acquisitions or mergers and the issuance of special regulations requiring banks meeting certain criteria to proceed immediately with consolidation. By adopting what are regarded as more concrete policy measures for consolidation, the hope is that the national banking industry will be made up of banks that possess the strong commitment and capacity to play an optimum role in the national development process. Bank Indonesia has taken steps to prepare for implementing this consolidation policy through a series of amendments to the Legal Lending Limit provisions, particularly in regard to restrictions on equity participation, and we will announce the new provisions in the near future. Second, reorientation of the working mechanisms and procedures of the national banking industry to more effectively accommodate the needs of the national economy Parallel with the process of institutional consolidations, banks are also required to revitalize their mode of operation. The process of allocating funds that is practiced by banks have been so far relatively passive. Decisions are not based on accurate research information concerning the sectors they are financing. In the years ahead, banks must be able to identified more clearly the various market niches they wish to operate in and must be proactive in seeking the potential clients in those sectors. The human resources in the bank cannot stand by idly, satisfied with their acquired formal education. They must be trained to understand the realities in the market in which they operate. The banking system cannot keep operating only on a conventional basis. The advantage of having complete information on the condition of a certain business or industrial sector will ease the work of the banking system in carrying out its function. The perception of credit risk in the sector will decline and the competitive atmosphere will improve, because any financing activity undertaken by banks will be based on their strengths. The current phenomenon of disintermediation in the banking system will disappear because banks will no longer have doubts about the condition of a sector that it intends to finance. This revitalization process gained added validity when we all agreed that the SME and microenterprise sector would become the future of our future expansion. Financing in this sector literally demands an in-depth understanding for the potential and productivity of the sector to be developed to the full extent. Third, take steps to strengthen the financial system infrastructure A sound, efficient banking system requires adequate infrastructure. In this regard, it is essential to have an adequate financial safety net (FSN). To move towards the establishment of an adequate FSN, Bank Indonesia and the Government have jointly completed the formulation of the policy framework for the FSN that also encompasses the soon-to-be-established Deposit Insurance Agency (LPS). With the establishment of this agency, the responsibilities for management of the guarantee program and resolution of insolvent problem banks will be defined more clearly. To provide assurance of the maintenance of financial system stability in regard to the banking system, implementation of the LPS guarantee will be phased in so that deposit funds will ultimately be guaranteed only to a maximum of Rp 100 million. In addition, Bank Indonesia has worked untiringly to promote the application of Good Corporate Governance (GCG) at all levels of bank management. Bank Indonesia is currently upgrading the provisions relevant to GCG in the banking system and the new GCG regulations pertaining to the functions of the board of commissioners and board of directors should be ready in the near future. At some point in the future, Bank Indonesia will also consider an intensive study of possibilities for changes to the regulations governing ownership of bank shares. 9/12 Because the implementation of GCG requires very strong cooperation and commitment from all parties involved in the banking industry, Bank Indonesia will facilitate the establishment of a banking GCG forum in the near future in cooperation with banking associations and the national committee for GCG. This forum is expected to discuss and set out a regular program for the issues related to governance in the banking system. In this context, I would like to emphasize once again that the responsibility for implementing GCG and management of operational risk does not rest solely with the Compliance Director. All line management and members of the Board of Commissioners must play their part in strengthening and upholding GCG. In the coming year we must also take stronger action against irresponsible parties who have besmirched our image. Prevention of acts of bad faith by bank owners and management clearly requires coordination and cooperation from parties on many sides. I call on all members of the banking system to be critically vigilant of the practices going on within our community, and also provide input and support for the introduction of adequate legal instruments and stronger law enforcement. We are Bank Indonesia have and will continue to build networks of coordination and cooperation with all concerned, ranging from the banks themselves, associations, and other authorities including law enforcement agencies to work systematically and persistently to bring certainty of law enforcement into banking governance in Indonesia. Bank Indonesia is currently working with the Ministry of Finance in drafting a Joint Decree to strengthen coordination between the two institutions for action against fraud possibly committed by banks and other financial institutions. On the other hand, we all know that the banking system will also face mounting operational challenges in the future. Rapid advances in technology will increase the complexity of banking business and lead to the emergence of increasingly innovative products. However, as an industry that has just pulled out of crisis, we must recognize that the banking system faces major limitations in its ability to anticipate risks. For this reason, we need measures for planned and systematic improvement in the quality of risk management. Not long ago, Bank Indonesia issued regulations on risk management that apply to all commercial banks as a minimum standard that banks will soon be required to meet. To build the quality and competence of banking personnel in risk management, Bank Indonesia has introduced the requirement for risk management certification for all levels of bank management. The certification program was launched in 2004 in a program for bank executives, and so far, a total of 252 commercial bank directors have completed their certification. The program will be continued in 2005 for commissioners and also all banking personnel whose work is relevant to the control and operation of risk management. Furthermore, to strengthen the effectiveness of the bank intermediary function, supporting infrastructure is needed that will enable the lending process to operate more quickly and reduce the potential for problem loans. To this end, Bank Indonesia has initiated the establishment of the Credit Bureau set to commence operation in 2005. We have waited long for the Credit Bureau, and a great many have repeatedly asked me when this plan will come to fruition. We fully understand the urgent need of banks for this supporting infrastructure, not only to improve the quality of decision making, but also for increased quantity of lending. We have completed the various preparations and as an initial step to support the operation of the Credit Bureau, we will soon release the Bank Indonesia Regulation on the Debtor Information System. This regulation in essence requires banks to report information on all debtors, and this information will then be available to banks to support their lending needs. Fourth, improving bank prudential aspects and intermediary function In the next few days, as we promised not long ago, Bank Indonesia will issue the “Banking Policy Package” with 3 (three) key objectives that I can mention here: First, promote the operation of the intermediary function and consolidation of the banking system in productive business sectors, as reflected in the Bank Indonesia Regulations on the Legal Lending Limit, the Debtor Information System, and Asset Securitization; Second, promote efforts to build bank capacity in credit risk management, application of prudential principles, and sound banking practices that will ensure sustained financial system stability. This objective is clearly reflected in the regulations on Earning Assets Quality, Legal Lending Limit, Foreign Borrowings, and Asset Securitization; 10/12 Third, measures to improve consumer protection through certainty in the application of standard, secure, and transparent banking services. This objective will be achieved through the issuance of Bank Indonesia Regulations relevant to consumer protection and transparency of banking products. Distinguished guests, ladies and gentlemen Fifth, position the national banking industry on a level playing field It is naturally our hope that all of the policies, commitments, and measures to be pursued during 2005 will bring our banking industry to a condition that will encourage and comfort our hearts. I believe that it is the aspiration of us all for the Indonesian banking community to stand in par with other banking systems in the region. For this reason, we are working as quickly as possible to apply the best practices now established as international standards. With this objective in mind and having held intensive discussions with the banking sector, Bank Indonesia envisages the application of the Basel II working framework as a medium term program that we must strive to achieve within a time frame of 3-5 years. Bank Indonesia plans to launch the application of the Basel II working framework for all commercial banks in 2008. This working framework will be phased in, beginning with the most simple approaches. The policy is expected to influence the behavior of banks in risk management. It is also based on the consideration that the Indonesian banking system, and especially the big banks, have become part of the international banking community, and therefore the application of Basel II can no longer be regarded as merely an option. We believe that the application of the Basel II framework will strengthen the resilience and stability of the banking system and promote better risk management practices. In practice, the application of Basel II framework calls for thorough preparations by Bank Indonesia, the banking industry, and other stakeholders. The scale of comprehensive preparations encompasses effective risk management practices, competent human resources, adequate information technology and databases, and other supporting infrastructure such as accounting standards based on International Accounting Standards (IAS) and credible rating agencies. In view of the scope of all that we will be required to do, it is clear that we face an array of daunting tasks. To this end, over the next 3 years Bank Indonesia will work on the development and implementation of action plans so that each of the crucial agenda that must be undertaken by us all, including Bank Indonesia, the banking system, and other stakeholders, will be focused and directed towards efforts to comply with all the criteria and conditions required under Basel II. Then, having put into place all the prerequisite conditions, we can look forward to having a banking industry at the end of 2010 that will be fully capable of applying best practices and most importantly Basel II. In this process, Bank Indonesia will strive to play a proactive role that is nevertheless proportionate to our mandate. We are strongly committed to continued facilitation of the various needs of the national banking system in response to the problems and challenges that we face in the future. We will keep working to synchronize our banking sector programs with the process of building the resilience and competitiveness of the business sector. Our studies and research will be guided to respond effectively to various problems and challenges. We will make further improvements to the quality of the regulatory framework so that the dynamics of the banking industry will keep moving on the desired course. Our supervisory actions will be more proactive to prevent problems, but will also be given stronger teeth to deal with problems that arise in order to safeguard the resilience and stability of the system. VII. Summary and conclusion We are of course aware of the limitations in undertaking the challenging tasks I have described this evening. That is we in Bank Indonesia are grateful for the support that we have enjoyed from many parties. Indeed, a strong and healthy banking industry is an objective that concerns not only the monetary authority. This aspiration is also shared by the general public, investors and owners and managers of banks. Therefore, ultimately a healthy, strong and proactive banking system is in the interest of all in the society. The various actions, policies, and issues that provide the context as I explained earlier will also inform the recommendations put forward by Bank Indonesia for the drafting of the Amendment to the Banking 11/12 Law, likely to be passed in 2005. To ensure that we all have ownership in this Banking Law, the involvement of all members of the banking community in the drafting process will be essential. I will be looking forward to the contributions and criticisms from the banking industry regarding the draft law that is of such importance to us all. I am deeply gratified that the Government, and in particular, the President of the Republic, has given us full support in the endeavors we are undertaking in Bank Indonesia to strengthen the banking industry. In our meeting with the President, the President had stated that Bank Indonesia should not leave any room for bankers or banks to the disturb the stability of the economy. I am equally gratified to see that members of the banking community have expressed the spirit and intention, as stated in our meetings with Perbanas recently to give stern warning to those bankers for conducts which do not adhere to the principle of prudence and who have violated principles of good corporate governance in at the expense of the broader interest of the banking industry and the public. As I have mentioned earlier, we have so far achieved significant progress in putting in place the foundation for economic stability and financial system more in line with challenges in the years ahead. However we are also aware that in our path toward achieving the objective of a more satisfactory financial and banking sector requires time. We are entering a crucial period in the process of transition toward a better future of banking system. The process of consolidating the national banking industry is an objective that we cannot compromise if the stability and resilience that we desire for the banking system is to be achieved. We must all take note, first of all that the coming years will be no time for complacency. Before us lies only one choice, to work hard to fulfill the commitments and sincere intentions to restructure whatever needs to be put right. We should no longer feel comfortable watching as the various problems unfold within our banking industry. In fact, we as the banking authority see that much remains for us to do to be able to meet this demand. The second point is that in the future, the public will become more discerning and cautious in the selection of banks capable of serving their transaction needs. They will only be willing to deal with banks that provide a sense of security while also offering returns on the funds entrusted to their keeping. They will also select only those banks that understand their needs and are able to provide a wide range of conveniences in their services. These are the criteria that indeed will build and strengthen public confidence. Much work remains to be done. We must do so systematically with clear design. The years ahead will not be without challenges, in fact we will face many more challenges than today. The days ahead will full of struggle but also full of hope. May God almighty gives us the strength and the resolve in our work to achieve a brighter future. Thank you. 12/12
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Keynote speech by Dr Miranda S Goeltom, Senior Deputy Governor of the Bank Indonesia, on the CNBC Strategic Forum, Jakarta, 24 January 2005.
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Miranda S Goeltom: Indonesian macroeconomic developments and policy progressing towards a sound banking system Keynote speech by Dr Miranda S Goeltom, Senior Deputy Governor of the Bank Indonesia, on the CNBC Strategic Forum, Jakarta, 24 January 2005. * * * Distinguished guests and speakers, Ladies and gentlemen, At the outset, let us first of all express our gratitude to God Almighty that we are still able to gather here this evening in good health to attend this forum. It is a pleasure and an honour for me to be here in front of such a distinguished audience. On behalf of Indonesian authorities, I would like also to express our thanks and appreciation to CNBC and related parties for organizing such an important event and gathering most important policy makers and business players in Indonesia. We have just successfully passed the first democratic direct election and is looking forward towards a much brighter future. It is also timely to make a reflection on what we have achieved so far, what structural problems remain and how to make our economy stronger and more resilient in the future. We all also know what had happened in Aceh and in other parts of the world surrounding the Indian Ocean. It was one of the greatest natural disasters in living memory. Now, we should say that after the tragedy in Aceh, Indonesia should, and it will, regain its new spirit, a new resolution, to develop and to create a better life for the people. On this occasion, let me share the recent progress on the Indonesian economy, its challenges and opportunities towards a sound banking system. I will first touch the issue on the macroeconomic and financial developments in 2004, and discuss their outlook for 2005. In the rest of this speech I will also emphasis on the banking sector problems and challenges, as well as future policy directions. Ladies and gentlemen, Macroeconomic and financial developments in 2004 As widely known, throughout the last three years the Indonesia’s economy has been developed favourably. Mutually supportive monetary and fiscal policies have helped maintaining the momentum of economic recovery. Through prudent macro policies, the growth in 2004 is estimated to reach the upper limit of 4.5%-5.0%, higher than in 2003. Investment and exports have also started to rebound since the mid 2004, in line with increased public confidence, improved stability in social political condition and stability in various macro fundamentals. Along with this conducive trend, imports also increased, particularly with regards to raw materials and capital goods in supporting higher capacity utilization. Volume of imports is estimated to grow substantially by 21% relative to only 2.8% in 2003. Exports were also on a positive growth trend, albeit moderate. Oil and gas exports have increased substantially thanks to the positive impact of high oil prices, whereas the increase in exports was partly supported by the non oil and gas sector. As a result, the overall exports and imports is expected to generate US$5.2 billion current account surplus. Ladies and gentlemen, This conducive developments has also facilitated the availability of financing. Credits has grown roughly by 22% throughout 2004 with higher absorption of new credits, particularly by the SMEs. This credit development has led to an improvement in banking sector performance with prudential indicators remaining at sound levels. Banking capital structure continues to exhibits significant improvements. Recent review on each bank indicated that each bank manages to maintain a healthy CAR, reaching around 20% as an average for the banking sector. Key banking indicators such as total loans, total assets and deposit funds, maintained their positive trend. Other indicators such as NIM and LDR subtantially improved, while the figures of NPLs keep setting lower to reach an average banking sector of 6.7% gross, or 2.1% net. The loan expansion was also favored by a declining trend in interest rates. Although showing a stable path since mid 2004 due to tight bias monetary policy, the 3 month SBI rate has declined from 8.15% at the end of 2003 to 7.4% by the end of 2004. This declining trend in the central bank instrument rate led to lower banks’ deposit rate, including credit rates. In line with the declining trend in deposit rates, interest rates for consumption credit, working capital credit, and investment credit continued to move downward. In addition, the spread between deposit and credit interest rates is narrowing further as a result of declining lending rates in contrast to rising deposit rates. The increasing optimism in the money markets was also reflected in the capital markets. The positive investor expectations regarding the Indonesia’s economic prospects has been boosted by controlled inflation, rupiah stability and positive forecasts for economic growth which eventually reflected in the increasing Jakarta stock price index, reaching its peak on December 2004. That higher domestic demand leading to increased imports, as well as some spill over effect due to external factors have also indirectly affected exchange rate fluctuations in 2004, which depreciated around 3.7% to reach on average Rp8.934 per USD in 2004. In line with this, inflation rate went up slowly since January from 4.82% (y-o-y) to 6.4% (y-o-y) at the end of 2004, which is still in the central bank inflation target range of 5.5% +/- 1%. Ladies and gentlemen, Macroeconomic outlook for 2005 The above macroeconomic conditions inevitably underlie the brighter economic performance in the near future. The prospect for growth in 2005 seems to be much stronger along with improvements in the components of GDP. On the demand side, projected growth would be supported by higher investments while a stable trend is projected for private consumption. Export performance is predicted to improve slightly, despite conducive world trade conditions. This favourable development is expected to sustain in line with the improvement of market confidence and optimism in the implementation of the development program set by the new Government. With the competitiveness of the rupiah, GDP growth is forecasted to be around 5.0 – 6.0%. Private consumption is projected to increase by around 5.5%, in line with higher expected disposable income. An increasing trend on both consumer confidence and household expectation is expected to generate higher private expenditures and subsequently higher private consumption. In parallel, total investment, including private investment, is forecasted to grow substantially to around 13.5%. In line with the established democratic government and a more conducive investment climate driven by infrastructure development programs, the private investor confidence is expected to increase. The improvement in risk premium is also considered as an underlying indicator for a better investment climate. In addition, the improved access to the banking sector and the positive trend in equity markets would be expected to play a significant role in boosting investment activities. Macroeconomic stability has provided Bank Indonesia some room to adjust interest rates at stable low levels over the last two years. In addition to increasing bank credits of 20% in 2005, the sources of financing investment activities are predicted to come from the stocks and bond markets. Added to this, FDIs are expected to increase as well. As a result, private investment is predicted to grow by 14%, close to pre-crisis levels, whereas ratio of investment to GDP is forecasted to rise from 19% to 23%. Government consumption growth is predicted to be slower, in line with government efforts to reduce its deficit to GDP ratio. Despite its limited ability to stimulate the economy, the government remains firmly committed to continuously support investment activities through the reallocation of subsidy spending towards capital expenditures. Therefore, the total amount of funds allocated for government investment is estimated to reach Rp199.2 trillion in 2005, or 11.5% higher than the previous year. In addition to domestic financing sources, the 14th Meeting of the Consultative Group on Indonesia (CGI) held in Jakarta last week has pledged to provide assistance a huge assistance, higher that previously expected. On top of this, USD 1.7 billion is provided for the recovery programs in Aceh and North Sumatra. This assistance will support the Government of Indonesia’s medium-term reform program aimed at improving the investment climate, creating jobs, and reducing poverty. Development partners also underscored their commitment to help the Government response to the tsunami-catastrophe in Aceh and Northern Sumatra, with recovery and rehabilitation programs. It is expected that the commitment from the CGI will support the government budget and improve the balance of payments condition, which in turn will support the Rupiah exchange rate. Ladies and gentlemen, With regard to the external balance, favorable global economic activity and high international commodity prices are predicted to strengthen the Indonesia’s balance of payments performance for 2005, especially exports. The surplus continues to spur positive expectation for the availability of foreign currency supply in the domestic market. Supply of foreign currency is also contributed by short-term capital inflows in the form of portfolio investments, which are predicted to remain strong. Potential capital inflows in the form of foreign direct investment are predicted to come gradually in the second semester of 2005, albeit still low. Moreover, non oil-gas exports are predicted to be stronger, consistent with the favorable conditions in the international economy, a competitive exchange rate for the Rupiah, and increasing access to international trade financing. The good progress of Indonesian trade financing is expected to be better in 2005 due to the improvements in macro condition, banking performance, and higher international confidence. This positive progress of trade financing is reflected by increasing number of credit line provided by foreign banks, decreasing cost of trade financing and increasing trade finance facility from domestic banks to private sector. However, the challenges are to be overcome in order to optimize the trade finance facilities from the banking sector. Bank intermediation is yet to be improved in order to maximize the credit line utilization from international banking community. In addition, efforts should be made through assurance of legal certainties and diplomacy to counter the inclusion of Indonesia as country under the Non Cooperative Countries and Territories (NCCTs) list. These positive efforts would eventually lower the trade financing costs. It worth noting that in order to enhance international perception on the more conducive Indonesian business environment, Indonesian authorities have showed the strong commitment and seriousness in building-up anti-money laundering regime in Indonesia. Some progress on the implementation ant-money laundering regime can be described s follows. First, issued new regulation instruments in order to strengthen its supervision function, concerning KYC/AML Supervision Framework, assessment and imposition of sanction on the implementation of KYC, Standard Guidelines on KYC Principles for rural bank, and application of KYC Principles for Money Changers. Second, conducted Socialization and training programs continuously for Bank Indonesia supervisor and examiner, and for banking industry. Third, completed examination programs on 32 commercial banks, consisting of 5 foreign banks, 2 state owned banks, 21 domestic and joint venture banks, 1 regional bank, and 3 Islamic banks. Fourth, conducted seminars/ workshops/MOU for/with law enforcement agencies (National Police, Attorney General’s Office (AGO), Supreme Court and Judges), to promote and foster the effectiveness of the handling of banking and money laundering crime. Fifth, promoted public campaign program on KYC/AML, in cooperation with AusAID. In 2005, we will continue and intensify KYC/AML program, through 2 channels, namely designing and budgeting an Initiative Program, as well as conducting supervision and examinations for all banks to ensure compliance with the KYC/AML regulations. In this regard, designing and budgeting an Initiative Program will be implemented through: (a) Delivering an intensive public campaign program; (b) Reviewing and formulating KYC/AML regulations and references; (c) Building KYC/AML core teams of supervisors and examiners within Bank Indonesia, both in the head office and branches; (d) Arranging training and seminars for the banking industries and public; and (e) Promoting cooperation between Bank Indonesia and other institutions. With the above explored conditions, the exchange rate is estimated to appreciate slightly compared to 2004 with some positive factors would contributed to the recovering of rupiah, including the favourable long-term risk indicators, strong economic fundamentals, and adequate foreign reserves. Inflationary pressures may even be higher considering the likely reduction of oil subsidies in the central government budget. The impact of this policy on inflation will depend on the magnitude of the prices hike, the timing of the implementation and the magnitude of the secondary effects. Central bank estimates have indicated that for each 10% rise in domestic oil prices, overall inflation would at first increase by 0.2%, then leading to a further increase of 0.36%. Taking into account the likelihood of higher oil prices, inflation in 2005 is targeted to be 6% + 1%. Anticipating pressure on inflation, monetary policy would be directed to achieve the medium term inflation target while maintaining the momentum of growth. To enhance the effectiveness of monetary policy, Bank Indonesia is planning to use interest rate as its operational target in mid of 2005. Ladies and gentlemen, Banking industry environment, problems and challenges ahead Looking ahead, it is envisaged that sustained macroeconomic stability will pave the way for the banking system to strengthen the bank intermediary function. Investment credit, which began to pick up in 2004, is predicted to expand further particularly as infrastructure projects get under way. As I mentioned earlier, the banking system can play a key-financing role in the Government plan to accelerate the construction of infrastructure. In this regard, I call on banks to keep a close watch on their funding structure and experience and capacity in project financing. In the consumer sector, credit expansion is predicted to remain strong and will be the first choice for private banks and foreign banks as more banks enter into cooperation with multifinance companies. In the property sector, banks need to exercise greater caution in lending because of the higher risk of default on loans for purchase of apartments and office premises. In the SME and microenterprise sector, lending soared in 2004 and this trend can be expected to continue in the years to come. Going forward, the banking industry need to examine and develop innovations to assist the development of SMEs. These innovation could extend the scope of financing to SMEs and at the same time reduce the risks of extending credits to the sector. In this connection, it may be noted that since recent time, we have launched a pilot project in cooperation with local governments and ASKRINDO to explore the possibility of creating a guarantee scheme for credits extended to SMEs. It is our hope that the pilot project could be expanded to more regions. Ladies and gentlemen, As I have mentioned, our goal is to develop a banking industry that would be strong and proactive in order to be able to support a sustained growth of our economy. In the years ahead despite the progress we have achieved, we are fully aware that we will continue to face a series of problems and challenges. First, we observe the problem of relying excessively on short-term fund leading to the predominance of short term credits. Second, we recognize the exixting problems with information concerning the debtor soundness have eroded the confidence of the banking industry in the real sector, hampering the intermediary function. Third, we also realize that the credibility of the banking system will be contingent on the ability of the banking industry to strengthen good corporate governance, including management of operational risk. Fourth, moreover, we inderstand that the implementation of deposit insurance scheme requires banks to strengthen market confidence. Fifth, and more importantly, the banking industry is constantly challenged by competition from nonbank products, such as mutual funds, bonds, and insurance. Ladies and gentlemen, Future banking policy directions How are we going to respond to these problems and challenges? Within the banking industry, we have long been aware of these problems and challenges. Responding to this, we have worked together to map out actions and do what is necessary to ensure the sustainability of our banking system. Our desired objective is for the banking system to regain its place as a reliable, trusted industry capable of promoting national economic growth. To accelerate this change and respond to the various problems and challenges that lie before us, we have formulated a number of policy directions for the banking system that we believe will set the course for the future dynamics of the national banking industry. These policy directions include the following: First, accelerate the consolidation process in the banking industry; In the Indonesian Banking Architecture (API), Bank Indonesia has laid out a series of measures to build the soundness and strength of the national banking industry. Under this policy, the banking industry consolidation program is a key initiative that sets the course for the future of the national banking industry. Within the next 10-15 years, the national banking industry must become capable of serving as a sound, strong, and dynamic backbone to the economy and of delivering results. However, as I explained earlier, the present situation and challenges and an array of unexpected events in 2004 have compelled us to adopt a shorter time frame for consolidation of the banking industry. In this regard, we must realize that to create a sound, robust, strong, and efficient banking industry, the industry consolidation will not be achieved without first going through a process of consolidation at the level of the individual bank. And, it is this process of individual consolidation that we must strive to complete in 2005. The picture is that an industry putting its house in order and striving for growth must first be sterilized of potential systemic risk that could arise from problems at individual banks. Before the recent launching of the API, Bank Indonesia put together a range of scenarios for the consolidation program for the building of soundness and strengthening of the banking industry as a whole. These scenarios are: • Market driven consolidation • Directives consolidation • Heavy-handed consolidation These scenarios are in essence of a sequence of action programs that are mutually complementary, should one of the scenarios earlier in the sequence prove ineffective and fail to deliver the desired results. Taking into account the developments that have taken place since the introduction of the API in early 2004, Bank Indonesia is now readying itself to apply the second scenario in the consolidation program, which in essence is an acceleration of the consolidation program scenario set out in the API. The consolidation scenario that we are considering for implementation in 2005 will begin with a process of identifying the medium and large banks that are currently in very sound shape and have adequate human resources to expand market share without sacrificing prudential banking principles. Our expectation is that these will become the anchor banks capable of stimulating a process of strengthening among other banks whose future ability to compete is reportedly constrained by a range of factors. In conjunction with the process of determining these anchor banks, Bank Indonesia will also identify the banks that have or are thought to have lost competitiveness because of their inability to build stronger resources and especially capital. These banks will then be grouped with other banks in reasonably good condition but which lack competitiveness because of limited market share and are experiencing downward trends in both assets and deposit funds. Each group of banks will be offered 3 options: first, acquisition by an anchor bank; second, merger with other banks in the group; and third, a combination of merger between a number of banks and an anchor bank. Ladies and gentlemen, In addition to accelerating bank consolidation programs, banking policy directions include other measures, namely: Second, reorientation of the working mechanisms and procedures of the national banking industry to more effectively accommodate the needs of the national economy; Parallel with the process of institutional consolidations, banks are also required to revitalize their mode of operation. The process of allocating funds that is practiced by banks have been so far relatively passive. Decisions are not based on accurate research information concerning the sectors they are financing. In the years ahead, banks must be able to identified more clearly the various market niches they wish to operate in and must be proactive in seeking the potential clients in those sectors. The human resources in the bank cannot stand by idly, satisfied with their acquired formal education. They must be trained to understand the realities in the market in which they operate. Third, implementation of steps to strengthen the financial system infrastructure; A sound, efficient banking system requires adequate infrastructure. In this regard, it is essential to have an adequate Financial Safety Net (FSN). To move towards the establishment of an adequate FSN, Bank Indonesia and the Government have jointly completed the formulation of the policy framework for the FSN that also encompasses the soon-to-be-established Deposit Insurance Agency (LPS). With the establishment of this agency, the responsibilities for management of the guarantee program and resolution of insolvent problem banks will be defined more clearly. In addition, Bank Indonesia has worked untiringly to promote the application of Good Corporate Governance (GCG) at all levels of bank management. Bank Indonesia is currently upgrading the provisions relevant to GCG in the banking system and the new GCG regulations pertaining to the functions of the board of commissioners and board of directors should be ready in the near future. At some point in the future, Bank Indonesia will also consider an intensive study of possibilities for changes to the regulations governing ownership of bank shares. Furthermore, to strengthen the effectiveness of the bank intermediary function, supporting infrastructure is needed that will enable the lending process to operate more quickly and reduce the potential for problem loans. To this end, Bank Indonesia has initiated the establishment of the Credit Bureau set to commence operation in 2005. We have waited long for the Credit Bureau, and a great many have repeatedly asked me when this plan will come to fruition. Fourth, improvement of prudential aspects and bank intermediary function; On January 2005, Bank Indonesia issued the “Prudential Banking Policy Package” with 3 (three) key objectives that I can mention here: First, promote the operation of the intermediary function and consolidation of the banking system in productive business sectors, as reflected in the Bank Indonesia Regulations on the Legal Lending Limit, the Debtor Information System, and Asset Securitization; Second, promote efforts to build bank capacity in credit risk management, application of prudential principles, and sound banking practices that will ensure sustained financial system stability. This objective is clearly reflected in the regulations on Earning Assets Quality, Legal Lending Limit, Foreign Borrowings, and Asset Securitization; Third, measures to improve consumer protection through certainty in the application of standard, secure, and transparent banking services. This objective will be achieved through the issuance of Bank Indonesia Regulations relevant to consumer protection and transparency of banking products. Fifth, bringing the national banking industry to international standard of capital adequacy according to Basel II principles. The adoption of Basel II will commence in 2008 by applying standardized models. By adopting this consolidation policy, we believe that the Indonesian banking system will consist of banks with strong commitments and capacity to play an optimum role in the national development process. Ladies and gentlemen, Financial sector outlook In line with improving economic performance as well as a strong banking performance, bank loans are projected to expand about 20% in 2005 (or about Rp106.2 trillion). Based on our projection, banking sector will have adequate capacity to expand loans as targeted without impeding their capital adequacy and liquidity. With loan growth of 20%- 23% and deposit growth of 6%-7% in the next three years, the CARs of banks are projected to stay at 16% and LDR will be approaching 100%. In addition, higher international commodity prices (especially primary non-oil/gas commodities) resulting from rising demand in export markets would have a positive impact on the domestic business climate, which raise demand for loans. As I have mentioned earlier, we have so far achieved significant progress in putting in place the foundation for economic stability and financial system more in line with challenges in the years ahead. However we are also aware that in our path toward achieving the objective of a more satisfactory financial and banking sector requires time. We are entering a crucial period in the process of transition toward a better future of banking system. The process of consolidating the national banking industry is an objective that we cannot compromise if the stability and resilience that we desire for the banking system is to be achieved. We must all take note, first of all that the coming years will be no time for complacency. Before us lies only one choice, to work hard to fulfill the commitments and sincere intentions to restructure whatever needs to be put right. We should no longer feel comfortable watching as the various problems unfold within our banking industry. In fact, we as the banking authority see that much remains for us to do to be able to meet this demand. The second point is that in the future, the public will become more discerning and cautious in the selection of banks capable of serving their transaction needs. They will only be willing to deal with banks that provide a sense of security while also offering returns on the funds entrusted to their keeping. They will also select only those banks that understand their needs and are able to provide a wide range of conveniences in their services. These are the criteria that indeed will build and strengthen public confidence. Ladies and gentlemen, Today, Indonesia remains attractive to portfolio investors because of the combination of high yield offered, an improving macro-economic position, a diversified economy and stable Rupiah exchange rate expectations. The credit profile is gradually improving. The fiscal deficit appears relatively resilient to varying oil prices, although this issue remains a major question marked by international financial investors. Furthermore, assets sales and privatizations are proceeding forward and Government debt ratios continue to trend down due to the strengthening of the Rupiah and the relatively modest budget deficits. Despite positive recent signs of macroeconomic and political climate in Indonesia, credit agencies point out that the country still faces some credit challenges, namely, high Government debt and overall foreign debt levels, security issues and low levels of investment that limit long-term growth. Looking ahead, I am confident that evidence of continued and timely implementation of reforms by the new government and strong commitment to maintain fiscal consolidation will favourably influence the credit ratings on Indonesia. Much work remains to be done, but we must do so systematically with clear design. The years ahead will not be without challenges, in fact we will face many more challenges than today. In closing, it is my hope that this forum will be able to serve as an arena of information exchange. It takes people from different skills and abilities; authorities, investors, bankers, academics, and others to build a sound business environment and I hope our participation here will serve as a notable step in that effort. Thank you.
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Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the Annual Banker's Dinner 2006, Jakarta, 13 January 2006.
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Burhanuddin Abdullah: Managing the banking industry within the new dynamics of the Indonesian economy Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the Annual Banker’s Dinner 2006, Jakarta, 13 January 2006. * * * Fellow Bankers in Indonesia, Senior colleagues at Bank Indonesia, Distinguished guests, Ladies and Gentlemen Assalamu’alaikum wr.wb, Good evening and greetings to you all, To begin, I would like to invite all of you to join me in expressing praise and thanksgiving to God Almighty for once again extending us the opportunity to meet in this pleasant and congenial setting at the Bankers’ Dinner 2006. For the banking community, the Dinner is an event in which we have established a tradition of taking time to reflect and build our communication with one another, among Bank Indonesia and fellow bankers in Indonesia. An event like this is an opportunity for reflection, to look at ourselves in front of a large mirror and assess our strengths and shortcomings, make the necessary improvements, and move on to the future. We are reminded of a quote from Chairil Anwar, oft cited at the beginning of each year, “Take a look at yourself in the mirror, but not to get ready for partying”. Tonight we shall reflect, self-improve so that we could continue to deliver benefits to the people of Indonesia. In departure from our tradition of hosting this dinner only for bankers, tonight we are privileged to have with us special guests: The Economic Coordinating Minister, The Finance Minister, and The National Development Planning Minister. Also present with us today are members of the Indonesian Parliament, the Chair of the Indonesian Chamber of Commerce and Industry, economic analysts, and leading media figures. Your presence here this evening clearly signifies that monetary and banking issues are of concern to us all. Distinguished Guests, Ladies and Gentlemen: As I start to speak tonight, I am reminded by a night similar to this in early 2005. There, I stood before you ladies and gentlemen as I am now. However, that night was different from tonight as there was a big cloud of worry overshadowing us. By end of 2004, most of us had planned to ring in the coming 2005 with great celebration. To the contrary, at the end of 2004 we saw a massive Tsunami disaster engulf Aceh and Northern Sumatera. We were left aghast and speechless. We all felt sadness. Tens of thousands of our fellow countrymen lost lives and everything they had. We were touched by a sense of shared loss. As the sadness and mourning began to finally ebb, a breeze of hope started to flow. Slowly but surely, optimism towards Indonesia’s economic revival was planted in the chests of the people. And tonight, I would like to ask you to give a momentary look at what we have achieved in 2005, to review our implemented policies and to draw some lessons that can be learned and implemented for the coming years. Subsequently, I would like to convey several steps and thoughts aimed to increase the role of Bank Indonesia and the banking industry in supporting the nation’s economic recovery. We hope this effort is inline with the government’s policies towards economic recovery. In the end, we find that we all have a common goal: to reach an Indonesian society that is just and prosperous. Distinguished Guests, Ladies and Gentlemen: During the first quarter of 2005, optimism ran strong throughout our nation. Economic indicators were on track. Nevertheless, we knew that our economy, having only just pulled out of crisis, still lacked the resilience to withstand external and internal shocks. Excess liquidity, disharmony between strategy and policy implementation, and the lack of economic infrastructure resilience towards external shocks are among the risks potentials our economic stability must face. This vulnerability became apparent in the second semester of 2005. Global financial imbalances, increases in world oil prices, and hikes in domestic fuel prices in October were followed by an increase in inflation (17.11%) in 2005. The Rupiah depreciated by 8.5% and the Balance of Payments showed a deficit of USD 778 million. This contrasts with 2004’s surplus of USD 309 million. The World Economic Forum stated that Indonesia’s competitiveness slipped from 69th position in 2004 to 74th in 2005. This position placed Indonesia in a rung lower than Vietnam. However, despite all the problems, we have to be grateful that our economy was able to maintain a growth of 5.3 – 5.6% in 2005. This growth has helped provide work for only some of those entering the job market and leaving the others adding to the “openly unemployed” statistics. Distinguished Guests, Ladies and Gentlemen: From the policy making point of view, 2005 is a year full of challenges. The macroeconomic stability faced great challenges. Faced with the shocks, Bank Indonesia issued several policies which included tightening of the economy’s liquidity, taking measures to minimize currency speculation, managing demand and supply of state owned enterprise’s foreign currency, and intensifying the commitment to increase provisions of foreign exchange liquidity facilities in order to secure the situation through Bilateral Swap Arrangement mechanisms. These policies proved to be effective in managing the volatile movements of the exchange rate. The exchange rate returned under control and thus remained stable at around Rp9.800 to the US dollar at year’s end. In the midst of these difficult trials and challenges in 2005, we were grateful that the banking industry continued to consistently function well in its service to the public. Credit growth exceeded third party fund growth, with the Loan to Deposit Ratio (LDR) significantly up to 68%. Bank’s financing to prospective economic sectors, such as the consumption sector and the Micro, Small and Medium Enterprises (MSME’s), remains high at levels exceeding 30%. However, a note of caution is in order here as NPL’s tend to move to unfavorable levels. From the money and capital markets, the increase in interest rates in the second semester of 2005 has triggered redemptions from several financial instruments, particularly so for fixed income mutual funds. The mutual funds industry got a bitter taste of large-scale redemptions after times of boom. Distinguished Guests, Ladies and Gentlemen: Based on the 2005 experiences in the economy and banking system, we can ask ourselves what lesson is there to be learned? There are four lessons: • First, in the midst of a highly dynamic global economic, we must be able to recognize problems immediately and make adequate decisions quickly. Our inability to make a timely policy responds to external developments, such as rising world oil prices and global imbalances, have often caused us to lose momentum, which brings a higher cost consequences to be borne by the economy. • Second, the collapse of the mutual fund industry after such rapid growth has become a source of financial system instability. In this regard, early warnings from authorities of the financial sector become necessary to prevent the need for sudden and drastic adjustments in portfolios. We also need to continuously improve the coordination between the capital market authority (Bapepam) and Bank Indonesia. • Third, our relatively thin foreign exchange market that is dominated by large players like Pertamina, is frequently colored by excessive volatility. This relatively high volatility would negatively affect market confidence to the prospects of our macroeconomic stability. This problem would continue if we do not make structural improvements in foreign exchanges liquidity by improving exports performance and capital inflows. • Fourth, the need to think of ways to lessen our dependency on fuel products. In this regard, the development of alternative energy sources and public transportation with low levels of fuel consumption will become a must in the years to come. Distinguished Guests, Ladies and Gentlemen: Stepping into year 2006, it is common that in entering the new year, we would define the expectations we want to achieve as well as identify challenges we hope to overcome within the coming year. In my view, the major challenge we will face in 2006 will be to bring the economy to a new equilibrium. From the external point of view, several international institutions have projected that the growth prospects for the world economy will not change much. It will remain at around 4.3%, with America and China still as the main engine in the global economic growth. Based on those external conditions, we predict that the dynamics of the 2006 economy will largely depend on coordination between monetary, fiscal, and the real sector’s policies. Such coordination needs to be done optimally to manage macro economy stability while promoting economic growth. • From the monetary side, Bank Indonesia will consistently make efforts to reduce the rate of inflation to a single digits in 2006 to allow interest rates to be gradually lowered in order to boost consumption and private sector investment. • From the fiscal side, fiscal stimuli through government consumption and investment would provide a strong jump start towards economic recovery, especially if the government could make use of the unrealized 2005 budgeted spending, carry it forward to 2006 and immediately make it realized within the first quarter of this year. • From the real sector side, economic prospects will be more dynamic if the previously planned infrastructure projects can be realized. If coordination of these policies is able to be conducted coherently, we will see an improved economic growth supported by the needed investment and consumption levels from the second semester of 2006 Overall, Bank Indonesia projects that the 2006 GDP will reach 5.0-5.7%. Growth of that level is predicted to be achievable if investment financing sources from both domestic and abroad can be secured. Aside from stimuli provided by government’s capital expenditures, I expect the banking industry to continue its role in funding long-term investment projects. An optimistic level of economic growth may be achieved if the banking industry at least maintains last year’s level of credit extensions. Foreign sources are also assumed to play a significant role as well. It was noted in 2006 that foreign funding contributed up to approximately 40% of that year’s growth level. These foreign sources comprise of Foreign Direct Investment (FDI), portfolio investments, and foreign corporate loans. Therefore, it is apparent that the steps we must take in improving investment climate becomes the keys of success in achieving the level of growth we strive for. Distinguished Guests, Ladies and Gentlemen: The dynamics of the macro economy in its path to reach a new equilibrium will in itself impact developments in the banking industry. An example could be seen from the credit market. The increase in interest, the increasing burden carried by the real sector, and lowered purchasing power result to predictions of a lower credit demand. From the supply side, the increase of the real sector’s credit risk will cause the banking industry to be increasingly careful in considering the potential debtor’s repayment capacity. From the various discussion forums we have held, we are under the tentative impression and conclusion that the banking industry percieves that there are many risks involved in efforts to rejuvenate the real sector. The banking industry holds doubts regading the real sector. Some of these doubts may have come from, among others, the economy’s level of competitiveness and and that of several commodities which nearly reached nadir levels, the limited information and the banking industry’s limited understanding towards the complexities of particular industries, and unclarity in development direction and development priorities chosen in certain industries in a particular period. All of this exist even though it is understood that clear information regarding to the above issues become a critical navigational tool for banks in allocating their funding. The opposite occurs in the fund market. The amount of third party funds collected by the banking sector has been continuously increasing. The community in general believes that the banking industry is an institution that is able to provide ease and benefits towards their business activities. It is our prediction that the third party fund growth rate continue towards levels similar to those of in 2005. Despite the positive outlook, deposit growth in 2006 demands our deftness and care in management considering risk factors that are increasingly sensitive. As we understand, starting from 2006, guarantee coverage of the Deposit Insurance Corporation will gradually decrease from Rp 5 billion on March 2006 to become Rp 100 million in March 2007. Taking this into regard, the real competition in deposit taking should be in areas of management and service quality, and banks soundness. The ultimate effect of the developments I have elaborated are that profit and capital levels are increasingly pressured. Taking that into consideration, for 2006, we view that a short term pain, while harvesting long term gains business strategies are a good choice. Bank Indonesia views that the longer run perspective, which puts financial system stability on top of short term profits, should become the option. Distinguished Guests, Ladies and Gentlemen: I would now like to convey to you Bank Indonesia’s policy steps in banking. We have divided the policy steps into two according to its completion periods, short term and intermediate to long term policy steps. There are four short term policy steps aimed towards providing banks with bigger room to maneuver in performing its intermediary function in 2006, five intermediate to long term policy steps which basically is an elaboration of Indonesian Banking Architecture (API). As the first short term step, Bank Indonesia will implement temporary adjustment to the regulation regarding the quality of productive assets, while still maintaining the priciples of prudentiality. Regulation 7/2/PBI/2005 issued in 2005 has been successful in bringing about positive changes in the debtor behavior in dealing with banks. With such regulation, debtor’s exposures and performance will be tightly monitored by the bank providing its financing. On the other hand, we also realize that the implementation of this regulation during these challenging times will not be easy. Mounting production costs from higher oil prices and cost of capital following increases in interest rates weakens the corporate balance sheets. The uniform classification requires improvements in the operation of the credit bureau, a key part within the banking industry’s infrastructure that provides debtor information on a symmetric basis to all banks. At this point, the credit bureau is still on the development process, with full operation expected to begin in the next one or two years. Considering the abovementioned aspects, this year, we will be making adjustments to Regulation No. 7/2/PBI/2005. This policy is a temporary measure which in essence is a simplification and phasing in of the regulatory provisions. For this reason, the phasing in of these provisions will begin with syndicated loans, which is already supported by adequate means of communication and later to be followed by bigger debtors and debtors of certain amounts. Second, Bank Indonesia will consider a downward revision in the statutory reserves requirement when the condition of macroeconomic stability permits. The adjustment in statutory reserves requirement will be considered for the first quarter of this year. This consideration is based on the belief that the 2006 macro economy will reach a relatively stable level and thus liquidity of the banking sector can be relaxed. Third, Bank Indonesia will work steadily to improve public access to sharia banking services. We are preparing a regulation that permits branches of conventional banks with a Sharia Unit to also provide sharia transactions through office channeling. By providing office channeling at conventional branches, banks will no longer need to open Sharia Unit branches in numerous locations to offer sharia banking services. Fourth, Bank Indonesia will pursue efforts to expand the coverage of banking services with focus on the Micro, Small, and Medium Enterprises (MSME) sector for more equitable outreach extending to all remote areas. We will take several steps to realize this policy particularly by empowering the role and functions of the banking sector in providing the service truly needed by the MSME. The mapping survey conducted clearly shows that the MSME sector has a high resilience level. Profit levels of this sector is in the range of 10 – 50%, and profit levels of 50% is achieved by 30% of business in the MSME sector. It is clear that the MSME sector is prospective in terms of credit and business management, and more importantly, there is a relatively big portion of this sector that is capable to absorb and conduct healthy principles of economics without the need for subsidies. We will continue the mapping survey in 2006 to identify MSME sectors which truly holds potential and capacity to grow and develop. The results of the mapping process will then be synchronized with the Basel II concepts to accommodate the need to finance the MSME sector. Basel II provides special treatment to the retail portfolio by assigning a lower risk weight, assessments toward debtors in this group on a portfolio basis, and requiring a more flexible criteria towards developments in the economy and accommodate financing issues of small businesses. In this regard, we will make adjustments in Risk Weighted Assets for certain retail business, including Risk Weighted Assets calculations for financing the micro and small sector. We hope that through this step, the banking sector will have a regained sense of enthusiasm and more room to provide financing support to various businesses in this sector. Distinguished guests, ladies and gentlemen: God willing, we will issue regulations regarding to the revision to Bank Indonesia Regulation 7/2/2005. Office Channeling, and MSME this month. Distinguished guests, ladies and gentlemen For the intermediate to long term, we will focus all regulations and policies towards the strengthening of banks operational factors and the implementation of prudential principles. Therefore, as a vision, we may expect to see a more complete picture of the banking industry’s new shape by the end of 2010. It would be a banking industry with greater resilience, higher competitiveness in the global environment, and contributing towards the development of the nation’s economy. To serve these purposes, we will issue the following policies: first, to reinforce capital structures in order to accelerate the consolidation process; second, to expand the role of foreign banks in the economy, third, to build the readiness of the banking system in anticipation of future developments in banking business; fourth, to strengthen bank internal management; and fifth, to improve the banking system infrastructure. First, reinforce capital structures in order to accelerate the consolidation process. During the beginning of 2006, we will conduct an in-depth evaluation of bank business plans through 2008. According to our records, there is at least 27 banks which face an uphill struggle to reach the Rp 80 billion capital requirement by the end of 2007. We view that in order to make the consolidation program effective we will need to focus on the supervision process as follow up steps. By referring to Bank Indonesia Regulation No. 7/15/PBI/2005 regarding to Minimum Tier-1 Capital for Commercial Banks, we will be able to see the effectiveness of the consolidation acceleration process during the first quarter of 2006. This may be done through the evaluation of action plans to be submitted by banks with capital levels under Rp 100 billion. I should emphasize that Bank Indonesia will not hesitate to take necessary actions to ensure that the regulations regarding to limitations in banking activities is upheld should regulation 7/15 cannot be met by a certain bank. These policies are necessary to ensure that the banking industry develops in the desired direction for the future. Second, expand the role of foreign banks in the economy. As we know, during the last three years, we have seen steady expansion in foreign ownership. Foreigners now hold 48.51% ownership of the Indonesian banking industry, comparing to the government’s decreasing stake of the 37.45%. Amongst Indonesia’s 131 banks, 41 are under the ownership control of foreign investors. Bank Indonesia’s policy regarding foreign ownership in banking has been very clear. We have been very open. We realize that with their various strengths, foreign ownership banks have been able to bring added value to the Indonesian banking industry. Their role in channeling capital flows, supporting bonds secondary market activity, supporting international trade, creating product innovations, and transferring knowledge, are decipherable. Foreign banks and foreign ownership of domestic banks has created a positive circumstance for the strengthening of the national banking industry. We convey our sincere thank you for all that have been done. However, we also have hopes that foreign banks, as part of the national banking industry, increase their roles in supporting financing for the development. One of our studies indicates that foreign banks, both foreign bank branches and joint venture banks, have a relatively small role in the intermediation process. In the post-crisis period, foreign and joint venture banks moved relatively slowly in restoring their levels of lending. When other banks embarked on credit expansion in mid-2001, lending by foreign banks on contrary declined and even showed a negative credit expansion during the 2002-2003 period. Going forward, I expect and would like to see foreign banks and joint venture banks to participate more in Indonesia’s economic revival through its financing activities as often said by their officials. With the larger presence of foreign banks in the banking industry, it is understandable that the number of expatriate staffs in Indonesia is on the increase. However, to create greater opportunities for local talents, Bank Indonesia will limit the use of expatriate staff in middle management levels, with the exception for positions that cannot yet be filled by the domestic work force. Bank Indonesia will prepare a policy guideline concerning the development of human resources in the banking sector. This policy will take important notice regarding the presence and role of expatriate staff, which presence should be temporary, and during their stay, they are obliged to conduct transfer of know-how to local staffs through various training processes. Another topic related to foreign banks is regarding to ownership. It may be seen that several foreign banks are owned by the same ultimate shareholder. From the point of view of bank supervision, this is obviously neither effective nor efficient. The same should also hold true for the bank owners themselves. It is not easy to harmonize the business strategy of several banks under their control and avoid unnecessary competition. For this reason, we are looking at the possibility of adopting a single presence policy for banks under foreign ownership control. Under the single presence policy, ultimate shareholders controlling more than one bank in Indonesia will be asked to consolidate their ownership. Third, Bank Indonesia will build the readiness of the banking system in anticipation of future developments in banking business. Regarding to a global trend in the banking industry, it can be said that consolidation is under way between almost all ownership of major banking institutions and other financial industry corporations (such as insurance, money market, securities, mutual funds, and other related derivative activities). Over time, this has rapidly become widespread practice, producing a change in the nature of a bank’s business from conventional operations to the more complex business of universal banking. Universal banking is a development that we must anticipate as part of the future of the national banking industry. Considering the possible consequences, we will be very cautious and selective in the policy to open the possibility to universal banking activities in Indonesia. Fourth, strengthen bank internal management. The fast pace development of information technology requires a level playing field in banking activities to enable the global market to be accessible from all corners of the world. This will force us to realign our operational standards in order to survive and to win in the competitive international banking world. Understanding the importance of this issue, in the coming years, the implementation of best practices in good governance and Basel II should become our focus of attention. It is hoped that when the time comes where the momentum of strengthening shifts to become the momentum of growth, we will be equipped with effective operational capacities which allow us to dynamically move forward in a sustainable manner. Fifth, improve the banking industry infrastructure. We realize that a strong stable financial system, an efficient and effective operating industry, and consumers that fully understand their rights and obligations will only materialize given that the supporting infrastructure is able to facilitate the developing dynamics. It is for that reason that improvements of banking industry must receive top priority. In 2006, Bank Indonesia will improve and strengthen infrastructures in five areas, i.e., improving the Financial Sector Safety Net, the establishment of APEX banks for Rural Banks (BPR’s), Banking Mediation Agency, Bank Research Institutions in various areas of Indonesia, and the regulation of Card Based Payment Facilities. Distinguished Guests, Ladies and Gentlemen: All of this is what I intend to convey to you tonight. It is not hard to imagine the magnitude of problems we must face ahead if we fail to act correctly and quickly. Our economic growth prospect is less than optimal, world oil prices may endure shocks, global imbalances are predicted to rise, and inflation pressure risks remain high. All the while, our time to act is very limited before the effects of those various problems make its way to the banking and financial industry, and ultimately to our daily lives. This gives us great reason not to delay our actions. It is my hope that the several policy steps I mentioned will be able to fix the various problems within the banking sector. To take the steps that I have elaborated, it is obvious that many sacrifices must be made. Therefore, we must continue to work hard and rest only when we reach our goals. The banking sector will continuously improve itself while Bank Indonesia will consistently and with strong discipline guard the steps to take towards the improvements. This nation will also continue to work until all that is aspired, a society that is just and prosperous, is achieved. Once again, I would like to wish you a Happy New Year for 2006. May God Almighty bless us in this new year to take the necessary steps for a better future.
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Paper by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, presented at the South East Asia - Latin America and Caribbean Countries (SEACEN-LAC) Governors Seminar, Kuala Lumpur, 15 September 2006.
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Burhanuddin Abdullah: Monetary and exchange rate policy in a global financial integration – Indonesian experience Paper by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, presented at the South East Asia – Latin America and Caribbean Countries (SEACEN-LAC) Governors Seminar, Kuala Lumpur, 15 September 2006. * * * Introduction First of all, let me thank BNM for hosting the first SEACEN-LAC Governors Seminar with an excellent arrangement. I am both delighted and honored to be here before Fellow Governors from two regions of separate hemisphere, to discuss important issues of common interest. Indeed, the theme of this seminar “Monetary and Exchange Rate Policy and International Financial System” is timely and very relevant for Asian and Latin American economies. We are all aware that over the past two decades, these two regions have undergone daunting challenges in managing monetary and exchange rate, in particular dealing with major external shocks. In spite of our improved resilience in addressing such kind of shocks, thanks to major reforms we have conducted in the aftermath of the late 1990s crises, the downside risks in the global economy could not be dismissed. In fact, under the globalized and integrated financial market, central bankers all over the world, most notably the emerging markets have been confronted with unprecedented potential challenges arising from surges in short term capital flows. Currently, the low interest rates in the international market and concerns over the sustainability of the US twin deficits have been driving factors in pushing capital to flow to emerging markets. At the same time, the high yields on domestic currency-denominated instruments in emerging markets have been the pull factor. As we are all aware, there are distinct characteristics of capital flows during the pre- and post-crisis periods. Before the crisis, capital inflows were mainly associated with efforts by domestic market actors to avail foreign sources of finance through international bank loans and issuance of various global financial instruments. However, since 2003, foreign capital flows have mainly been driven by the flush global liquidity in search of optimum rates of return. The differences between these types of capital inevitably entail different consequences for emerging markets, and as a corollary in monetary and exchange rate policy, which I will briefly elaborate further. Policy on open capital account Dating back to 1970, Indonesia began to seek liberalizing its capital account. Initially, the liberalization started with the removal of compulsory surrender of export proceeds. By 1982, all types of capital controls were dismantled leaving the capital account virtually open. Until the Asian crisis hit in 1997, the existing restriction on capital inflows were only applied to foreign borrowings by banks and companies with government-linked projects and net open foreign exchange position (NOP) on banks as a prudential regulation. Prior to the crisis, this system had contributed to sustained high economic growth, thereby promoting our long term development program. Foreign capital inflows had also fostered the deepening of domestic financial sector by expanding market liquidity. However, the benefits of capital inflows, in particular in the early 1990s, were undermined by financial market imperfection stemming from lax regulation and supervision and moral hazard due to implicit guarantees. These problems were reflected in the inefficient allocation of capital, unhedged foreign liabilities, and inflated asset prices. As market confidence in the prospect of the economy of the emerging market in Asia faltered, reversal of capital outflows could not be arrested, thereby leading to capital account crisis. With the hindsight of the Asian crisis, the Central Bank has sought to strengthen the monitoring on the capital movement and minimize speculative transactions. To this end, in 2001 Bank Indonesia issued a regulation on the non-internationalization of the rupiah. Subsequently, when a wave of capital reversal and speculation against the rupiah triggered by rising world oil prices heightened in 2005, we issued a series of micro policies addressing the imbalances in the demand and supply in the forex market. Furthermore, prudential regulation in the banking sector was also strengthened through a tighter ruling on the NOP and particular transactions in forex trading. Indonesian floating exchange rate regime Needless to say to Fellow Governors that the choice of an exchange rate system depends to a great extent on the condition of a country at a given time. In the current context of Indonesia, under a free capital mobility and limited amount of international reserves, we believe that our floating exchange rate system adopted on August 14, 1997 is an optimal choice. The system, we believe, provides a built-in discipline in a market whereby all other infrastructures are not sufficiently strong. This float will in part create a break on imprudent overseas borrowing, because in doing so market participants will have to factor in the cost of possible movements of rupiah. We are fully aware that in the case of domestic financial markets with imperfections, such as the thin forex market and limited availability of hedging instruments, a floating rate system often leads to high volatility with adverse consequences on stability. Therefore, while in practice we adopt a floating rate system, we are of the view that smoothing of exchange rate movements is necessary. In fact, our measures to reduce volatility are not unique. As posited by Calvo and Reinhart, almost all countries adopting de jure free floating rate system do not rule out interventions to curb volatility in their exchange rates. Such interventions are conducted both through direct intervention on the forex market and through the use of interest rates. Monetary policy framework in a floating exchange rate regime A logical consequence of a flexible exchange rate system is that the exchange rate can no longer serve as a monetary policy anchor. During our stabilization period under the IMF program, Bank Indonesia adopted base money as an anchor. Over the long run, however, we noticed a number of shortcomings in the use of base money as the operating target, such as the difficulties in achieving its target and the poor signal it transmits to the market. Such a poor signal of monetary policy direction and targets obviously fails to meet the need to maintain market expectations on the future exchange rate movement. In view of those factors, Bank Indonesia adopted a fully-fledged inflation targeting framework in July 2005. The framework at least consists of three primary characteristics. First, monetary policy is directed towards achievement an inflation target explicitly announced to the public for a specified time horizon. In this regard, under the new Central Bank Law the inflation target is set by the Government. Second, monetary policy must be implemented on a forward-looking basis, responding to future developments in inflation. On the operational level, Bank Indonesia uses the BI Rate as policy rate to respond to the future trend in inflation. In formulating monetary policy, the Taylor-type rule is used as a benchmark. Thus in essence, interest rates used as monetary policy instruments are adjusted in such manner so as to respond to deviations in the inflation gap and output gap. Obviously, rules like these are not to be applied mechanically. A balance between rule and discretion, or constrained discretion, as I see it, is especially necessary when monetary policy must be pursued within an increasingly globalized and complex financial environment. We must always be alert of market developments, whether the money market or markets for goods, and a number of other signals and indicators reflecting domestic and global economic developments. We should also keep in mind that while inflation is the sole objective of a central bank, the public also pursues its own objectives, such as job creation and improvement of incomes. For this reason, the inflation targeting framework retains the fundamental monetary policy paradigm of striking the optimum balance between inflation and output. Apparently, when a central bank faces a dilemma of choosing between inflation and growth, inflation remains the priority. An example of this can be seen in the problems we faced last year, when world oil prices almost doubled. This disturbing trend became highly problematic for monetary policy because not only did it boost inflationary pressure, but also inhibit economic growth. Many suggested that the central bank did not need to respond to this temporary surge in inflation. However, our view at the time was that despite the temporary nature of the disturbance, the inflationary impact emanating from the higher oil prices through increased price for other goods and services, such as transport and wages, would drive up core inflation. In this situation, the tight policy was necessary to prevent sustained escalation in public inflation expectations. The third characteristic of the ITF is that monetary policy is implemented on a transparent basis with measured accountability. In my view, with elements like these, inflation targeting is more than a mere framework for monetary policy. Inflation targeting promotes the good governance of a central bank. By announcing the inflation target to the public, the central bank commits itself to its achievement. Uncertainty over future inflation will ease because public inflation expectations have a point of reference, and thus economic costs arising from uncertainty will also be reduced. Communication to the public on the future monetary policy direction is also vital so that the public can anticipate the central bank monetary policy and to avoid ‘surprises’ that could trigger volatility in the money market. To strengthen policy effectiveness in this present age of disclosure, the central bank must also carry out a process of educating the public on what the monetary policy objectives are, the strategy for achieving these objectives, and what lies behind the decisions taken. One example involves the communication of the monetary policy response to soaring oil prices and risks from global imbalances at a time of weak conditions in the real sector and high unemployment. Communications between the central bank and market players are also necessary, especially when financial markets are experiencing turbulence. In financial markets fraught with asymmetric information, the wealth of information held by the central bank is frequently of great benefit in mitigating this issue and thus preventing panic and herding by investors. In this regard, the credibility of the central bank is crucial. Concluding remarks Under the environment of financial integration, the task of a central bank in maintaining both monetary and financial system stability has become more challenging. To navigate under this changing environment, in my view a central bank should have at least three critical tools at its discretion. First is the flexible exchange rate system, which provides for autonomy of monetary policy. Second is a monetary policy framework which is consistent, credible, and transparent so as to provide a monetary policy anchor within the flexible exchange rate system. Third is a strong banking system capable of absorbing the various risks created by financial globalization. The mounting risks and uncertainties emerging within the financial globalization process also underscore the importance of the central bank role in guiding public expectations. Within this context, the credibility of the central bank is crucial. To this end, transparency, accountability, and effective communication must be integral to the entire monetary management process. In short, communication may serve as an additional “instrument” that a central bank should use at its disposal to complement other monetary instruments for monetary policy to operate effectively. Thank you.
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Speech by Dr Burhanuddin Abdullah, Governor of Bank Indonesia, at the Annual Bankers' Dinner 2007, Jakarta, 12 January 2007.
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Burhanuddin Abdullah: Capitalizing on stability for sustained growth Speech by Dr Burhanuddin Abdullah, Governor of Bank Indonesia, at the Annual Bankers’ Dinner 2007, Jakarta, 12 January 2007. * * * Assalamu’alaikum wr. wb, Good evening and greetings to you all, I. Introduction In commencing my speech, I would like to invite you to join me in expressing thanks and praise to God Almighty who has again blessed us with the chance to meet in this pleasant and congenial setting at the Annual Bankers’ Dinner 2007. On this wonderful opportunity and on behalf of the Board of Governors of Bank Indonesia, please allow me to wish you all a Happy New Year for 2007. May we all be blessed in every step that we take. Tonight marks the fourth time I stand at this prominent forum, in the presence of you, distinguished ladies and gentlemen, to deliver the Governor of Bank Indonesia’s start-of-year briefing. This also suggests that it has been almost 4 (four) years since I was appointed to the position of Governor of Bank Indonesia. Despite some shortcomings as well as successes, I would like to thank you all for your support and cooperation that has been so forthcoming over the years. II. Reflection of 2006 economic dynamics A. Year 2006 - the year to restore stability Distinguished guests, The year 2006, which only passed a few days ago, was replete with splendid colours which I found most impressive. To policymakers in Government, Parliament, and also Bank Indonesia, 2006 was a year which finally provided some breathing space, albeit with several footnotes. To entrepreneurs, 2006 was a year of mixed achievements. Enterprises in the real sector, in the manufacturing industry in particular, found 2006 a constrictive year. Competition pressures from more efficient and productive countries were enormous. Notwithstanding, 2006 was a year that generated much profit for participants in extractive industries, as reflected by the surging export level to countries that are our primary trading partners. Nonetheless, to the majority of the general public, 2006 was a truly trying year. It was a test of resilience and patience as a result of high inflation, which were direct and indirect effects of fuel price hikes in the previous year. With all these episodes, phenomena and dynamics, 2006 was a year we should nevertheless be thankful for. For that reason, at the beginning of my speech tonight, I would like to invite you all, distinguished ladies and gentlemen, to compare notes and ask imperative questions regarding the intentions, motivation, steps and achievements for the year that has just passed us by. What have we achieved so far? What must we persevere within the coming year? What are our problems? Is it lack of hard work? Sincerity? Determination? Or is it something else? We are asking such questions while looking throughout the country and wondering where are we in the race to seek prosperity for all of our people? Could we be left behind by our neighbouring countries? In the following section I will explicate the targets, hopes and dreams we must knit together this coming year, 2007. Inevitably, deep observation and sharp analysis are required on the numerous predicaments and on the social and cultural order of society, which will become the foundation of growth and development in our economy. Subsequently, towards the end of my speech I will present some messages, follow-up steps and policy measures that will take place this coming year, under one common goal, that is to make our economy a more prosperous one. Distinguished guests, The transition from 2005 is still fresh in our minds. We left 2005 full of hopes and concerns, because we were convinced that at the earlier part of 2006 we would still see some difficulties as a result of adverse external shocks, particularly the soaring global oil price. Nevertheless, hopes abounded during the early part of 2006. We were optimistic, firstly, that macro economic stability would be restored to its proper path and be maintained so that economic enthusiasm would return to where it should be. Secondly, we also strived to achieve the first goals in order to quickly minimize the rigidities and structural inefficiencies in our economy. We should be grateful because we were able to maintain macroeconomic and financial system stability during 2006. Numerous indicators which endured pressures in 2005 have shown positive improvement in 2006. Relatively high inflationary pressures at the beginning of 2006 have gradually dissipated throughout 2006. By the end of 2006, the inflation rate was recorded at 6.6% (y-o-y); below the targeted rate of 8±1% set by the Government and Bank Indonesia. Success in controlling inflation in 2006 also reveals that monetary policy was able to mitigate the second round effects of soaring global oil prices at the end of 2005 on inflation expectations (See Graph 1)1. Inflation stabilization in 2006 and relatively good performance in the balance of payments, with a surplus of 3.7% of GDP, also contributed towards a stable rupiah exchange rate throughout 2006, after significant depreciation in 2005. Entering 2006, exchange rate volatility had also decreased. The year 2006 was also an important one as we settled our outstanding obligations to the IMF without triggering significant turbulence in the market. With the debt now cleared, we are now a ‘regular’ member of the IMF. Even though the outstanding obligations have been paid, our foreign exchange reserves position was maintained at an acceptable level. This improved the confidence of market players in the foreign exchange markets. Throughout 2006, the rupiah to US dollar exchange rate tended to be stable at a level of Rp.9,100 – 9,400 per USD with relatively lower volatility than the previous year (See Graph 2). If we look a little further back, the outlier period, as a result of significant price changes in the economy, is generally beyond the control of monetary policy. On average, CPI inflation from 2003-2006 was recorded at 6% y-o-y outside its outlier in 2005, which was recorded at 17%. Towards the end of 2006, uncertainty regarding shocks in regional financial markets emerged as a result of the Bank of Thailand’s policy aimed at stemming the flow of short-term capital into its financial system. Fortunately such fears never materialized. Although the rupiah fluctuated momentarily, it soon stabilised in line with its external balance. The policy taken by Thailand was based on its domestic considerations and economic interests. We also have our own considerations in formulating policies that match our own particular circumstances and interests. In this case, Bank Indonesia believes that the liberal capital account regime that has been implemented for many years remains congruent to our wider national interests. The economic theory of Kydland and Prescott regarding time inconsistency in employing a policy seems a relevant reference point with respect to the choice of policy regime which we have instituted ex-ante. We cannot simply alter our capital account regime to become more closed without precipitating a loss of credibility. Credibility, which we have strived painfully to achieve over the years, should not be thrown away merely due to the temptation of temporary benefits. With the above positive developments, Bank Indonesia found the opportunity to gradually reduce the BI Rate during 2006. Throughout 2006, Bank Indonesia trimmed the BI Rate by 300 basis points, which by end of 2006 was recorded below 2 (two) digits, namely 9.75%. Such reductions were taken to preserve the positive market perceptions and support a more conducive business climate, while safeguarding stability in the financial markets amid capital inflows for portfolio placements. The regained macroeconomic stability provided opportunity for a broad-based economic recovery. National economic expansion became visible in the second half of 2006, particularly in the growth of production indicators, although insufficiently balanced due to a less-than-conducive investment climate and the high-cost economy. Investment slowed compared to the previous year, and therefore made exports and private consumption the primary base of economic growth. Furthermore, beginning in the second half of 2006 we witnessed an upswing in credit growth, which was followed by acceleration in government spending, and thus helping to boost economic growth. At the end of 2006, economic growth was recorded at 5.5% y-o-y2 . The national banking industry has achieved a gradual marked improvement over the last three years. Quantitatively, there has been a significant upswing across various financial performance indicators and banking industry activity. This was underpinned by growth in total assets, which was bolstered by a build-up in earning assets, including credit (See Graph 3). As of November, total assets in the banking industry had risen to Rp.1,635 trillion, whereas credit portfolio rose by Rp.78,2 trillion (10.7%). This was funded by growth in deposits to the tune of Rp.123 trillion (10.9%). Banking capital was also Bank Indonesia’s estimation. maintained at a level deemed more than adequate, as reflected by the Capital Adequacy Ratio (CAR) which was maintained at the relatively high level of 20%. Meanwhile, the level of Non-Performing Loans (NPL) in the industry has taken a significant dive, which indicates that, essentially, the prevailing condition of the banking industry has experienced a marked and continual improvement. It should be noted that the current level of NPL in the banking industry is heavily influenced by the NPL of state-owned banks, which still carry some long-standing problems from the past. Qualitatively, the health and resilience of the banking industry over the last few years have also witnessed significant improvements. The human resources capacity within the banking industry has increased, along with the enhanced understanding of prudential concepts and risk management throughout the banks’ organization hierarchies. The management information system, internal control system, risk-management system, good governance and all operational procedures that follow; have generally strengthened. The quality of the banking service is also a crucial factor for which progress is managed through the creation of a trusted customer protection system. In the capital markets, the price of bank shares experienced a rather significant hike before finally stabilizing. Bank issued bonds also received a positive response from the market at an acceptable price. Deposits at banks steadily accrued year by year reaching 10% annually despite a continuous fall in the savings’ interest rate, following cuts in the BI Rate. This could be considered as a strong indication that public confidence in the banking industry has recovered and even grown. Alterations to the Bank Deposit Guarantee Scheme, implemented in the latter part of last year, were performed smoothly and without triggering turbulence that could threaten overall financial system stability. Concerns regarding flight-to-safety and flight-to-quality from the customers of small banks, as a result of changes in the blanket guarantee scheme to a limited guarantee scheme instituted by the Deposit Insurance Corporation (LPS) have proved not to materialise, or at least minimised. Meanwhile, the Rural Bank (BPR) industry has also shown growth. This industry plays an important role in developing Small and Micro Enterprises (Graph 4), and communities of villages and suburbs. There are currently 1,935 Rural Banks with 3,157 bank offices with a credit portfolio reaching Rp.16,9 trillion (Table 1). As the nominal amount of credit is usually small, to reach a particular amount of credits extended, Rural Banks will have a much higher client ratio compared to that of Commercial Banks. Table 1. Performance of Rural Banks Ladies and Gentlemen, Speaking about the development of the financial industry, and the banking industry to be more specific, four years ago, we clearly realized that banking industry supervision and regulation must be based on a long-term vision in its achievement strategy, and such a vision must be approached through systematic and measurable efforts. Therefore, at the beginning of 2004, Bank Indonesia issued Indonesian Banking Architecture (API), a blueprint of upcoming banking industry guidelines, and the kind of vision, direction and form to be achieved. The holistic policies that Bank Indonesia issue to achieve such goals up until the end of 2010 are included as part of the API policy structure. Since then, as our distinguished guests may observe, Bank Indonesia has continuously strived to manage and improve all aspects of banking activities. Each regulation, from strategic ones to the technical guidelines of operational courses of action, was designed to be a torch to light the darkness and lead the way. Steadily, albeit sometimes slowly, the national banking industry has achieved good progress and alleviated many of its problems. The pillars set forth in the Indonesian Banking Architecture have begun to transform into pillars of banking industry strengths, promoting greater stability. Through the implementation of good corporate governance (GCG), the most recent Bank Indonesia survey suggested that nearly all banks have conducted self-assessments. The results of the self-assessments concluded that approximately 98% of banks in Indonesia have applied a minimum of 50% of the GCG principles, as mandated by PBI 8/4/PBI/2006 regarding GCG Implementation for Commercial Banks. Management information systems, internal control systems, risk management systems, and all operational procedures that follow, have generally progressed, however, there remains room for improvement. As another step to greater ensure that good governance in the banking industry is upheld, in 2006 we took a step which we deem to be strategic. A step that we believe may help rebuild a good image and erase any negative perceptions that abound within the Indonesian financial system which can be exploited for illegal activities, such as money laundering. The step taken is the cooperation with various law enforcement authorities – The Indonesian Police, the Attorney General, The Indonesian Financial Transaction Reports and Analysis Centre (PPATK) – and most recently the Corruption Eradication Commission (KPK). The aforementioned cooperation between Bank Indonesia and the various law enforcement institutions is hoped to be able to clear any misperceptions regarding to coordination efforts in handling various banking crimes, including corruption. Perception, understanding, competence and the work ethic in dealing with multiple banking problems will be settled through a performance structure that is prompt, objective and proportionate. Therefore, it is expected that public confidence, as the foundation of banking business, can be safeguarded and continually improved since it is guaranteed by a trustworthy law enforcement system. As a result of our relentless endeavours, the dark cloud that has overshadowed the national banking industry for so long has begun to disperse little by little. We should also reinforce our pledge and commitment, as well as find the faith that we will, in time, accomplish our ultimate goal: “the establishment of a sound, strong, beneficial and rewarding national banking industry”. B. Several problems in 2006 Ladies and Gentlemen, Based on my previous comments, it would not be excessive to say that there have been numerous successes achieved during 2006. We have successfully enticed our economic machines back on the proper track. We have reduced the cost of financing, which was the direct result of high inflation. We have reiterated that the economic management of our country will only succeed if it is us, ladies and gentlemen, who do it. However, against this backdrop, we also comprehend how serious our perennial carry-over problems have become, which we have shouldered year after year. That is the structural rigidities within our economy, which in turn has paved the way for inefficiency, squandering time and resources in the form of excess liquidity and unemployment, and abject poverty that continues to worsen. Meanwhile, the condition of the real sector, which forms the spine of the country, is faced with an inevitable paradoxical phenomenon. The growth and expansion of economic capacity that took place over the last few years tended to favour capital intensive sectors rather than labour intensive ones. Unemployment continues to grow despite a prospective economy. Lately, we have also observed the exacerbation of poverty. Graphs 5 and 6 provide an illustration of the paradox of growth phenomenon. There is a suggestion that such paradox of growth occurs due to structural imbalances in the Indonesian economy. Distortions caused by imperfect market structure and the presence of oligopolystic industries, which were legacies of Indonesia’s economy history, have caused the economy to work only sub-optimally and restrain the market’s ability to allocate resources efficiently. Such distortions limit access and broader participation in economic activities. This situation has been present for too long and thus making it easy for us to forget to address it. We must now immediately open the doors of access and invite broader participation in the economy through improvements in investment climate, licence process simplifications, and other improvements. I believe that we all understand that it is only through these means we can achieve high quality growth, which in turn will resolve the large income gap issue. From this argument, it is clear that improving investment climate, opening easier access and broader participation in the economy are important factors in post-crisis economic recovery. Meanwhile, it has been found by non-governmental institutions such as LPEM UI and ADB that there remain many constraints to investment. The development of these constraints in the recent year hints us that the investment climate has yet to improve on a general level. Moreover, referring to the most recent survey results, illustrated on Graph 7, some of the constraints have followed an increasing trend, such as uncertainty surrounding economic policies and regulations; corruption; taxation related matters; the skills and education of human resources; infrastructure, particularly electricity and public transport; a poor legal system and protracted conflict resolution; as well as cost of financing. In connection to these survey results, we can also observe that the revision of Taxation Law; Labour Law; Customs Law; Investment Law; infrastructure improvement and future energy security; legal certainty; and the harmonisation of regulations between central and regional governments, were regarded by both domestic as well as international investors as constraints to investment activities in 2006. As a result of the above, investors and the banking industry; be they domestic or international, perceive the presence of high micro-structural risks in our real sectors. This is why only minimal interest abounds in long-term investments, as shown by the low growth of Foreign Direct Investment (FDI) to Indonesia in the post-crisis era, despite the very high FDI potential of other countries in the Asian region at the moment. Compared to other countries in the Asian region, the micro risk and distortions prevalent in the real sector have contributed to lower efficiency and productivity in the Indonesian economy. IMD survey results published in the World Competitiveness Report 2006 show that, based on economic performance, government efficiency, business environment efficiency and the infrastructure in Indonesia, our country is positioned at 60th out of 61 countries (See Table 2). Meanwhile, a World Bank survey on investment supporting factors shows that Indonesia has dropped to 135th place in 2006; from 131st in the previous year. The tribulations I have just mentioned, compounded by the passage of time, have caused a slower accumulation of capital, reflected by a stagnant investment growth, and a contraction in the share of investment in GDP (See Graph 8a), as well as a significant reduction in the quality of capital in the economy (See Graph 8b). The downside of such low accumulation and quality of capital is reflected by the phenomenon of supply side rigidity in the post-crisis economy. Such a case is illustrated in Graph 9, which shows a steeper slope in the dynamics of price and output in Indonesia in the post-crisis era. The supply side rigidity in the post-crisis economy has in turn triggered the low absorption of labour and reduced the speed of economic growth (See Graph 10). These last two aspects clearly pave the way to wide-reaching social and economic effects: Our poverty level has risen along with widening socio-economic inequalities (See Table 3). From a different perspective, micro risk and economic distortions, which curb investment, are also reflected by the decoupling of the financial and real sectors. Banks become reluctant to distribute funds to the real sector and tend to place their funds in low risk financial instruments, such as SBI and SUN. Bank funding to the real sector significantly drops and we are then left facing a liquidity overhang in the form of outstanding SBI, which currently amounts to slightly above Rp.200 trillion, forcing an imbalanced economic growth. Our economy only grows with one engine. We are flying with only one engine! The real sector tends to move slowly since micro-structural risk impedes on banking intermediation, whereas the financial sector continues to expand due to the constancy of funds invested into it. Such conditions are very unhealthy to our economic system as a whole if they persist. In addition, micro risk and the structural distortions in the economy, which trigger supply side rigidity, have caused the economy to be more vulnerable to external shocks and inflationary pressures. Our core inflation rate has remained persistent. This constraint has surely affected the funding interest rate in the economy as a whole, which tends to be relatively high. This series of events have caused collective suffering for all. By looking deeper to see who will suffer the most from such situation, we can all agree that it is not morally justified. My whole argument is to reaffirm that corrections to structural distortions and improvements in investment climate are the primary determining factors of the interest rate’s ability to slide naturally, whilst maintaining stability. It is through these means that a sustainable development may be realized. Distinguished guests, Prevailing conditions combined with our turbulent economy, noted or not, will continue to aggravate other problems in social, political and cultural life. I have noted some of the disarray in public social life that tends to prioritize the interests of a limited group compared to broader national interests. Consensus and commitment, which we have all agreed upon, are barely felt. Many of us move towards self-interest fulfilment and it is, therefore, very difficult to connect with one another to achieve our national interests. More than ever we require a common thread that can unite us as a unified country. In terms of global relations, upon seeing other countries marching forward, concern, powerlessness and a sense of alienation abound. We praise and study their successes, nevertheless we remain unable to match their lead. Meanwhile, violent culture, self-centred social conduct, regressive ideas, extremism, intolerance and a terrible work ethic are becoming the bread and butter of this nation. Political developments in the post-crisis era have only provided a minimal level of valid rewards that could possibly affect public prosperity. Democracy, which we have adopted as the cornerstone of development, remains primarily out of reach and unable to optimise the greater interest of our nation. These inauspicious events, which I have briefly outlined today, unfortunately have been made even worse, marked by a series of natural disasters that ripped at the heart of our beloved country. Another disaster seems to strike and rub salt in our wounds while we are still mourning and trying to recover from the one before. Earthquakes, tsunamis, long droughts, bush fires, a mud volcano, and the most recent floods and landslides, all struck in succession at different regions of the nation. The economy of the victims in the disaster areas is extremely constricted despite all the aid that has poured in. We at Bank Indonesia have asked the banking industry to provide special allowance for credits to business enterprises throughout the nation that are affected by the disaster. We hope that this will further assist them with the establishment and reconstruction of their business ventures. Regrettably, this step remains far from adequate. Against this abhorrent backdrop, the public urgently requires a united front from all of the nation’s components to share concern and hope. We all feel troubled by the crises we are facing. We need a political and cultural strategy to restore the nation’s consensus and commitment, awaken the sense of importance, eliminate the feeling of being alienated, and become more receptive towards hope. For this reason, we, distinguished ladies and gentlemen, should be able to demonstrate to the public that we are performing to our fullest capacity, be it as the regulatory authority, banking, the business world, mass media, or any other key role, all in the interest of the affected masses. We must unite, help one another, and work much harder to overcome our economic pitfalls. Only by doing so will the very real hope of improvements in all aspects of our nation’s life be established. Regarding to economic issues we face, I am sure that we can all agree that coordination and cooperation with various other institutions which have the authority, expertise, and appropriate policy instruments will be instrumental in resolving those issues. It is clear that monetary and banking policies cannot resolve various structural problems related with unfavourable investment climate and distortions in the goods and services market which in turn cause high costs in the economy. Bank Indonesia, as the monetary and banking authority, has limitations in its tasks and its policy instrument’s scope of reach. In accordance with the mandate given by the Law, Bank Indonesia can only contribute to the nation through its efforts in maintaining macroeconomic and financial system stability. Still, the achievement of such a mandate will largely depend on coordination with other authorities, cooperation with various parties, and the help and support of various stakeholders. We do realize that there remain many weaknesses in the area of banking supervision, even though today’s banking industry is much sounder, stronger and more profitable compared to several years ago. III. Economic outlook for 2007 A. 2007 - a defining moment Ladies and Gentlemen, With respect to the overall condition and dynamics of the economy in 2006, it would not be excessive to say that 2007 is a defining moment: the year when capitalizing on macroeconomic stability to generate greater optimism for the lasting recovery of our nation’s economy becomes essential. In this defining moment, the journey of development for our country is entering a critical phase. Everything that we achieved back in 2006 has led us towards the middle of a bridge of hope, which we should immediately cross by expending our every effort and wholeheartedness but while exercising caution at all times. If we are able to keep pacing forward and safely across that bridge, then the hope of a better future will open wide before us. However, if we are forced to halt because of our uncertainty or loss of direction, then the proverbial bridge will crumble beneath us due to the excessive burden that we carry. We would drop back to square one and would, in fact, then face an even higher mountain to climb. Entering 2007 means that we are entering the 10th (tenth) year since we were hit by the multidimensional crisis that so devastated all aspects of our nation’s life. 10 (ten) years is a lengthy period of time for a nation to recover. We need to tell ourselves that enough is enough! Delay will only continue to marginalise and alienate our great nation in the ever increasing pace of globalization era; filled with stiffer competition between countries. Delay will crush us in time. There’s only one way for us to resolve our problems. If you want to have a prosperous life, work hard! There’s no substitute for a hard work. Hard work towards self-improvement is a sufficient condition on the road to better future. Therefore, 2007 is the perfect time for us to work harder with better focus and greater commitment. It is now time to act because inaction can be fatal! In the midst of World War II, under extreme pressure, Sir Winston Churchill once said “We shall prevail”. This phrase is relevant to our condition at the moment. There will not be any chance of losing sight of the prize if we grab tightly with both hands our spirit, faith and hope. The crisis ten years ago may have almost severed most of our life lines, but it could not extinguish our hopes for the future of our nation. Never have we surrendered to any predicament in the history of our nation. We have always risen from the depths to fight for our dignity and pride as a sovereign nation. From Bank Indonesia’s perspective, the macroeconomic condition in 2007 is expected to remain stable and will become the primary foundation to achieve higher growth, provided that micro risk factors and distortions in the real sector can be minimized and the investment climate improves significantly. Economic growth in 2007 is projected to reach 6.0% (within a range of 5.7%-6.3%), which surpasses economic growth in 2005 and 2006. In the first semester of 2007, the main thrust of economic growth will stem from consumption with some assistance from private investment. Such a rise in consumption will be fostered by an upswing in public purchasing power as a result of the plan to raise the salary of civil servants and the regional minimum wage early in the first semester of 2007 and to maintain inflation at a low targeted rate. Economic growth is projected to be even more robust in the second semester of 2007 along with significant improvements in private investment and greater government capital expenditure. The expected increase in private investment will be encouraged by greater confidence among economic agents regarding improved economic prospects, but also by the positive effects brought about by a slide in both the inflation and interest rates, on top of a stable exchange rate. Externally, exports are projected to grow steadily but remain stunted due to global economic growth, which is not as buoyant as during 2006. On the other hand, imports of goods and services are projected to rise along with a surge in domestic demand. Judging by the most recent export growth figures, which are primarily attributable to natural resource commodities, the falling trend in the prices of global commodities is projected to be offset by export of manufactured goods, as investment climate improves. A number of commodities are expected to provide the largest contribution; including textiles, electrical appliances, chemical products and machinery. The balance of payments in 2007 is expected to record a surplus, although not as large as the surplus in 2006 (See Table 4). The smaller surplus is attributable to an increase in import demand along with a boost in economic activities. According to our projection, the current account balance for 2007 will reach a surplus of 1,87% of GDP. As per the projected balance of payments, foreign exchange reserves in 2007 are expected to be around US$47 billion. The surplus in the balance of payments, the increase in foreign exchange reserves and market confidence in the quality of macroeconomic policy management will, in turn, support the stability of the rupiah exchange rate in 2007, which is projected to move in line with the external balance. Greater economic activity in 2007 is not expected to add excessive pressure on prices, in general, so that CPI inflation is expected to remain within the target range set forth by the government, namely 6% ±1%. The growth in demand is expected to be offset by improvements in supply as investment climate improves and, as such, is not anticipated to heap more pressure onto core inflation. Projected CPI inflation in 2007 is also supported by the preserved inflation expectations of market players (See consensus forecast in Graph 11) and low upward pressure on administered prices along with the scrapped government plan to hike the prices of strategic administered groups of goods. In addition, inflationary pressure on the volatile foods group is estimated to be low thanks to government commitment to ensure the smooth supply of food, particularly basic necessities. Nevertheless, I must underline some factors that may affect the economy in 2007. Economic growth in 2007 has the potential to surpass expectations provided that some crucial facets of the government’s agenda for 2007 are implemented immediately; such as improving the investment climate; reducing economic distortions; bolstering infrastructure development, particularly energy, public transport; and, modernization of industrial machineries. Against this backdrop, Bank Indonesia predicts that economic growth may reach 6.3% with private investment as the primary driver as well as consumption Conversely, the opposite may also be true in the form of sluggish economic growth; reaching just 5.7%, if various constraints and downside risks are unable to be mitigated. The constraints are related to production capacity flexibility in balancing the mounting demand, primarily stemming from an unchanged and unfavourable investment climate and the high-cost economy. Furthermore, economic projections for 2007 will also be influenced by the ability of the domestic economy to absorb the risks that may emerge in 2007, in particular those related to global financial flows. Whichever scenario that would actually take place in the process, the ever increasing support role of banks to provide funding will also be a critical factor if the projections are to be realised. In 2007, credit growth is expected to reach 15%-18% with a focus on infrastructure and labor intensive - low import content sectors, such as the agricultural sector and its respective sub-sectors. To this end, the hitherto constricted capacity and capability of particular banks to distribute funds, due to the prevailing high NPL value, should be resolved post-haste. Presently, we can witness how an array of accelerated infrastructure projects desperately require bank funding, particularly state-owned banks. If this is undertaken with proper sequencing and at a measurable pace so as not to induce macroeconomic instability, the success of these projects is predicted to generate significant multiplier effects on the dynamics of other sectors. If the projections I have mentioned come to fruition, it is expected that the liquidity overhang and value of un-disbursed loans, which are currently rather large in the banking industry, will fall in 2007. Moreover, funding from outside the banking sector, which recently saw a rise, is expected to continue to bolster the recovery of a broad-based economy. In relation to this, the banking industry is faced with the threat of even tighter competition, be it between the actors within the banking industry or even from actors outside of the banking industry in funding provision. This requires players in the industry to look more introspectively, to judge if they can weather the storm of such stiff competition. Each actor is obliged to improve their operational efficiency, which is currently deemed as insufficient, particularly for domestic banks. Thus, a constrictive interest rate environment would immediately be followed by a fall in the banking credit interest rate, which has been suggested is rigid throughout the adjustment process. Over time, this would, in turn, boost the competitiveness of the banking industry, and the actors could enjoy a lower interest rate. B. Direction of economic policy in 2007 With respect to the projections that I have been discussing, I would like to reiterate that distortions and the unfavourable investment climate are the primary constraints faced that could retard a balanced economic recovery in 2007. From Bank Indonesia’s perspective, all of the limitations I have mentioned could hamper the array of measures taken by Bank Indonesia to achieve and preserve macroeconomic stability. The economy will become more vulnerable and less able to mitigate the range of domestic and external shocks. Our monetary policy stance would tend to be particularly cautious, especially when unexpected shocks occur that may trigger risk to price stability. In terms of the wider national interest, it will not be possible to permanently and continuously alleviate poverty and reduce unemployment without structural improvements that slash the high-cost economy and enhance the investment climate. I therefore see the benefits of the following policy strategy : 1. From the monetary policy side: the implementation of inflation targeting framework (ITF), within the wider structure of macroeconomic policy, is a strategic step that must continually be taken by Bank Indonesia to maintain market confidence on macroeconomic stability and overall financial system stability. A number of issues related to capital flows, exchange rates and the interest rate within a liberal capital account regime and a floating exchange rate environment should be placed in the context of global economic adjustments and the kind of macro-monetary policy response that would be appropriate to deal with them. In this context, policies that provide incentives for long-term capital flows should be prioritized over policies that punish short-term capital flows. In addition, to support the financial market development and to improve monetary policy effectiveness, we also see the need to improve the operational structure of monetary policy. 2. In terms of financial sector policy: Bank Indonesia acknowledges the importance of bolstering the financial market development to mitigate economic shocks. To this end, and by observing numerous potential shocks in the global and domestic markets over the next 1-3 years, some policies to expand and deepen the domestic financial sector need to be instituted without delay in 2007. This requires a coordinated and collaborative effort involving Bank Indonesia, government institutions and banking institutions – as the primary component of the financial sector – as well as non-bank financial institutions. 3. From the banking policy side: Bank Indonesia sees the need to promote indirect banking intermediation through diverse efforts to foster universal banking without jeopardizing the ongoing banking sector consolidation. We must also direct such endeavours to encourage financial market deepening. 4. From the government’s side: the implementation of sharper government policies to reduce micro risk in the real sector through thorough improvement of the investment climate is critical in 2007, including to expedite infrastructure development and the provision of a sustainable energy supply. It is also necessary to eliminate the range of distortions in the goods and services markets expeditiously so that the high-cost economy may be suppressed immediately. Moreover, 2007 would be a great year to develop sectoral focus in the strategy and implementation of long-term national development, with more weight given to labour-intensive sectors with high local input. On that last note over the economic outlook for 2007, allow me next to elaborate some of my thoughts on the essence of the problems and challenges that national banking needs to address this coming year. IV. The essence of the problems and challenges facing banking in 2007 Distinguished guests, Before profoundly focusing on the forward direction of banking industry policy, please allow me to centre our view on a broader illustration of the problem. This evening, I will not venture too deep in emphasizing the micro technical problems confronting the banking industry; something I have normally done in my speeches over the last three years. On this blessed occasion, I will try to guide your thoughts and views to participate in figuring out how the role and purpose of the banking industry are supposed to be placed in achieving the goal of national economic development. In my understanding, our ultimate target of economic development that we strive to achieve is the establishment of “Perpetually Higher and Better Economic Development”. Only with higher economic growth with a better quality of economic development can we, together, alleviate poverty and overcome unemployment problems. To achieve our target will require cooperation and hard work from various parties, including the national banking industry. The role of banking has become incredibly strategic in accelerating our national economy. This is the reason why we need a healthy and robust banking system which significantly contributes to funding the economy. Such banking system will strengthen the capacity of the financial system in particular, and the economy in general in confronting multiple shocks amidst a national economy that is becoming increasingly internationalized and integrated with the global economy. The aim of strengthening banking institutions on the one side, and optimising the banking intermediation function on the other are not two separable or debatable things; they are not dichotomous. They both resemble two sides that make up one coin as a whole. Only through strong banking, which is able to execute its intermediary role properly, can we achieve financial system stability and ensure the usefulness of banking to the general public. Throughout the past three years, Bank Indonesia has undertaken numerous measures to fortify our regulation as well as supervision of; to persist with the restructuring of individual banks; to establish sound banking industry infrastructure Throughout 2004-2006, we have personally experienced activities which should have been concluded expeditiously but ended up protracted. Conversely, there have been activities that we thought would take a long time which were concluded swiftly. This is why we make adjustments to our policy. However, in the process of determining policy, the overarching goal, which is to build a solid and beneficial banking system, is something that we must consistently strive to achieve. In the process, policy instruments may require adjustment depending on the prevalent situation. This restructuring process to me is a continuous and dialectic social process, which we can all dynamically comprehend and participate in. We have overcome numerous troubles and challenges, but there are even more that we must address, since it is true that “Life is a game of improvement, not a game of perfection”. Therefore, it is quite ordinary if adjustments occur in a policy, especially when the conditions and dynamics of our environment demand so. There is, however, a contemplation that we rely on as the monetary and banking authority: we will only consider adjustments to micro policy on condition that adjustments are taken measurably and cautiously, without sacrificing macroeconomic stability as a whole and consistent in the context of the overarching goal. In entering this defining moment, it also critical to note that in order to achieve such continuous economic growth, we require the presence of a robust formal sector which able to perform optimally. Emphasis on the informal and micro, small and medium enterprise sectors, albeit with significant growth, should be considered as a temporary supporting pillar. It is true that we must push these two sectors to become a formal sector that is thriving, large, reliable and not merely serving as a social pillar. We must also encourage the expansion of the formal industry sector so that it can absorb more of the available unemployed human resources. Regrettably, since the dynamic and developing crisis, this sector has remained insufficiently significant to achieve the desired growth. Investment in this sector is limited compared to the amount required for noteworthy growth. Perhaps we should remain patient and wait for investment to come to this country. After all, we all are aware that the government has strong commitment and is working hard to overcome the numerous obstacles in the investment climate. However, while waiting for the investors to arrive, there is one thing that worries many parties: the snail-like pace of the banking intermediation function. Anxiety stabs at our hearts and pierces our thoughts. Why would the banking industry hesitate to utilize the available potential: while banking industry restructuring has shown its success; while infrastructure has been equipped by the presence of the Deposit Insurance Corporation and the Credit Bureau; while banking institutions have been bolstered; and amidst improving macroeconomic conditions? The pattern of banking operations still contradicts funding the consumption sector and the allocation of funds in financial markets. The latter issue reflects an unproductive, and thus unsustainable, operational pattern. Such limited operations are also, in essence, skewed away from our commonly agreed banking industry goal, namely to ensure an effective, efficient and significant banking industry for the good of the Indonesian economy. This issue requires serious attention and immediate resolution. The banking industry would like to avoid being deemed as indifferent, insensitive and not serious in comprehending the national complexity. Apart from the existence of unresolved problems in the real sector, this condition should not be used as an excuse for banks to stagnate and cease trying to stimulate activity in the sector. Moreover, the banking industry is the most anticipated catalyst to create a breakthrough, to lure investments that will kindle corporate industry activity and take over the role of consumption that has been the spine of economic growth for the last 5 years. These hopes are not excessive considering all the efforts expended to provide us with the confidence in banks’ capabilities as the primary engine driving the rise of the Indonesian economy. The banking industry must take the reins immediately through its role in intermediation. Banking has to be able to redirect its operations from financing consumption credits and placements in financial sectors which has been representing its principal weapon for more than the past 9 years; towards a more productive way of funding working capital and investment credits. We even believe that if banks are able to raise their productive funding to Rp.150 trillion in 2007, especially towards ventures with low imports and which are highly labour intensive, then the economy will be able to expand above and beyond current projections. To this end, banking is required to be able and willing to open up and look for new opportunities in terms of funding. Current economic demand dictates that extra effort from the banking industry is required to communicate and to better recognize the characteristics of the surrounding business world. With better recognition, I believe that the perception of banks to a high level of risk exposure in the domestic business environment can drastically be reduced. There are abundant industries out there that are waiting for assistance from banking. To name a few, there are the aquaculture industry, agriculture, plantations, mining and other industries that have always perceived banking to not be on their side. In addition, I also demand that the banking industry seek innovations in its funding products. The problem with infrastructure funding is that requires a great amount of finance, albeit vital in stimulating economic activity. I am confident, however, that it can be dealt with through the innovation of funding products by the banks themselves. A credit consortium and syndicate represent another choice for bank in reduce their risk exposure that has to be born in funding projects of relatively high value. Therefore, in 2007 I expect bankers to work harder, be more innovative and more creative in packaging credit as well as bear credit risk exposure together. Bank Indonesia will assist all of you, with policy support, through the steps necessary, which I will elaborate on in my briefing this evening. V. Direction of banking policy in 2007 Ladies and Gentleman, With the desire and spirit to rise above the existing problems, allow me this evening to deliver my thoughts and views concerning measures that can be undertaken by Bank Indonesia to support national economic growth. My views comprise of 8 (eight) leading principles of policy direction and strategy, which will be enacted in the coming years. Firstly, Bank Indonesia will more actively function as a catalyst in the process of increasing bank intermediation function towards the real sector. In facilitating bank disbursals in the financing process, Bank Indonesia will seek and dominate information as well as thoroughly observe the dynamics of the real sector, as an inseparable part of studying macroeconomic indicators. Various movements and dynamics in this sector will be analyzed, studied and monitored routinely by Bank Indonesia, since this sector can influence macro indicators. For me, Bank Indonesia’s understanding of real sector conditions, which has always been sought through research, studies and surveys as well as direct participation to observe actual conditions, need to be utilized by other parties, particularly banking institutions. BI will promote itself as the National Economic Database as well as the Information Centre of Economic Studies that is available to all parties. Against this backdrop and in addition to propagating the fruits of its labour, BI will service the requirements of its stakeholders by conducting researches and studies on various business sectors and industries, including micro, small and medium enterprises (MSME), both independently and in collaboration with the banking industry. Initiatives to establish the research subject in the various business sectors is offered to parties in need rather than by BI itself; as has been tradition. Within this framework, it would be acceptable for me to say that the banking industry is the industry most likely to fully utilize Bank Indonesia’s endeavours. In the recent decentralization era, Bank Indonesia feels the need to take a critical role in encouraging provincial business movement. Having 37 offices in provincial capital cities and other major cities in Indonesia, physical proximity between Bank Indonesia and people throughout Indonesia will be narrowed through the improvement of its role and function, as well as supporting regional economic research in order to satisfy public needs wherever we are. For that reason, we have formulated an initiative to adjust the overall BI organization, including the initiative to revitalize the function and role of Bank Indonesia branch offices (KBI), and the possibility of opening new offices in areas whose development requires KBI support. The ability of KBI to participate as the extension of Bank Indonesia in communicating the results of research and studies on the business environment will be greatly improved. Apart from taking part in this generic role, the potential of KBI will also be sharpened in order to comprehend specific issues faced in its locale; being more active in providing advices to regional government and economic actors/agents; resolving existing issues; and providing a useful source of information to participants of the regional economy. Through the realisation of this measure, Bank Indonesia is constantly ready to serve and utilize its significant resources. Skills, competency, data, information as well as the infrastructure held by Bank Indonesia is, in essence, nationally owned and has to be accessible for development purposes. We are also ready to place researchers from Bank Indonesia on various research projects or helping with the preparation of development policy throughout the nation. With these numerous collaborations efforts, it is hoped that the outcomes of Bank Indonesia work will be seen to support national issue resolution and directly deliver the needs of its stakeholders. We realize that the decentralization phenomenon present amidst the pace of globalization and economic democratization requires advanced economic management. Currently, without questioning their readiness, regions have been directly faced with global competition. For instance, the tourism industry in Bali directly competes with Phuket in Thailand. The dried fruits industry in East Java has to jockey with the same industry in Cebu Philippines. Without adequate knowledge regarding the state of the competition and various upcoming challenges, as well as guidance in confronting those obstacles, it is possible that regional industries will experience uncertainty or even make unfeasible moves that can weaken their competitiveness in international trade. To this end, Bank Indonesia will participate and conduct real sector studies from the perspective of regional uniqueness and niches. The second strategy and direction of policy which will be taken in the coming year is to collaborate and coordinate with the government in order to reorganize the national banking industry through the revitalization of existing banks and their role, especially state-owned banks. We fully support and openly welcome the policy steps taken by government to improve the performance of state-owned banks. In our view, the rejuvenation of state-owned banks is a step that needs to be taken immediately, especially due to their strategic role and position in the national banking industry. At present, the total assets of state-owned banks amount to 37% of the total assets of the banking industry with share of credits at almost the same level of around 36%. We have a high expectation that state-owned banks are capable of taking the lead in endorsing the bank intermediary function, which is currently sub-optimal. Furthermore, we also rely on their power and competence to fund various development projects that are in the interest of many people. However from recent progress, we have notice that competition within the banking industry for potential customers with good track records is becoming very heated; it is neck and neck. What is noteworthy is the participation of foreign-owned banks, including joint-venture banks, adding to the competition with their readiness and strength of service. Competition challenges from foreign-owned banks will gradually become an important factor that must be noted by domestic banks, particularly state-owned banks within the same peer group. Looking at the data, it appears that the credit allocated by foreign-owned banks is showing improvement. One of the key strengths of foreign-owned banks in penetrating the markets is their higher efficiency level compared to state-owned banks. The efficiency of foreign-owned banks is clearly reflected by their low ratio of overhead costs to operational costs, such that they are capable of offering credit at a lower interest rate without sacrificing profit (See Graph 12 and 13). This efficiency is also supported by excellent credibility and image, so that foreign-owned banks are able to incur relatively lower costs of funds. On the other hand, the efficiency level of state-owned banks, which is relatively low at present, is associated with expenses and operational costs that must be covered. Consequently, the interest rates offered by state-owned banks are relatively higher and difficult to reduce since this would mean taking a cut in revenue. With this in mind, there is a clear gap in level of playing field between the two, which will widen if not controlled immediately. There is no other alternative for state-owned banks other than to try to keep pace with the efficiency level of foreign-owned banks. Clear policy direction and strategy has to be set without delay. Various issues that have caused soaring overhead costs in state-owned banks have to be resolved immediately. The problem of high NPL has to be rectified without delay as this represents the primary source of the higher costs in terms of the provision for bad assets. Improvements in human resource productivity as well as efficiency in utilizing information technology and other resources have to be made continually in order to attain and even surpass the efficiency level of foreign-owned banks. Furthermore, ladies and gentlemen, the size of the bank also determines the level of efficiency achieved. First of all, in general, a larger bank is able to obtain funds at a cheaper price than the smaller banks. Secondly, larger banks are able to efficiently utilize economies of scale which allow them to split their operational costs over a larger unit. Obviously, foreign-owned banks, which mostly form part of the multinational banking industry, can optimise this advantage. In this context, banking consolidation, which began in 2005, has become critical and must be accelerated further. We should focus our attention on the options laid out in the Single Presence Policy. We hope that an accurate choice of policy and strategy will allow existing state-owned banks to expand and become healthier, more robust and powerful that are able to serve as Indonesian banking’s flag carriers and compete with the global banking industry. Meanwhile, where state-owned banks are expected to support the execution of development programs, these banks must be able to seek and discover market niches that reflect their strengths. Existing state-owned banks must have an edge in expertise, so that their very existence is felt and all elements of the community can be proud. With regards to the consolidation process, which began three years ago, the third step that we are going to take in 2007 is to attempt to facilitate the merger process between banks that we deem in need of assistance. In October 2006, we issued PBI that contains a number of incentives to be distributed in the merger and consolidation process. These incentives represent our greatest endeavours in the form of banking industry initiatives to facilitate mergers, which can immediately reap concrete results. However, if it becomes clear that in 2007 our efforts to support mergers, particularly those aimed at reducing the number of banks with systemic risk, still lack the necessary positive response, Bank Indonesia will have to become more decisively involved. The matchmaking process, which seeks compatible partners among problematic banks, needs to be facilitated in a more direct and concise way. From our data and information, both quantitative and qualitative, we will try to establish stronger, sounder and more profitable banking institutions that are the result of a useful merger. Matching business patterns, characteristics, targets and market segments are all aspects that are thoroughly considered in this process. However, this is not the case in terms of the majority shareholders’ or bank owners’ interests. We will exercise extreme caution in accommodating their needs. The balance of needs between one party and another is the result of an agreement that absolutely must be reached in the process. Those parties must be willing to accept and provide deal options that are mutually beneficial. This is where Bank Indonesia will try to take a role in the negotiations, which will head towards the principles of honest brokering; namely neutral, proper and optimal. The process in its entirety will involve our role as supervisor and also as regulator of the banking industry. The supervisors in Bank Indonesia will commence work as soon as possible. Therefore, as bank owners, it would be appreciated if you could kindly be more susceptible to cooperation and coordination to achieve the results that we all strive for. Moving on, the fourth step that we will take in 2007 is directed towards facilitating a smooth banking intermediary function, which has become the focal point of the problems faced by our banking industry recently. In my calculation, no fewer than seven Bank Indonesia Regulations have been issued in the past two years to provide breathing space for the banking industry in performing its primary role. I believe it is our role, distinguished ladies and gentlemen, to maintain monetary and banking stability. On the one side, we strive to be sensitive towards a plethora of difficulties faced by the banking industry in its efforts to fund development. On the other side however, we also do not wish to see the privileges and dispensation that we have granted destroy our accomplishments. Naturally, the banking industry is a risky industry, and is therefore prone to experience difficulties if not managed carefully. With respect to these well-known industry characteristics, we strive to ensure that every policy measure taken can strike the optimal balance between the potential risk and rewards gained. For that reason, the policy we have taken this time to foster the intermediary function is not fully relaxed in nature. It is more a policy to facilitate. One effort that can be immediately done is to study the possibility for banks to finance some specific sectors such as agriculture which until currently is still lacking of banks attention. Banks credit to this sector is still relatively small, only around 5.3% of total banks credit portfolio. Without special regulation, the agriculture sector would still find it difficult to grow, even though Indonesia has been internationally known as the agriculture nation. Even now, we still have 10 commodities which outperform other countries in the international market, providing good living to the people and generating adequate foreign exchange reserves. In this respect, focus upon agriculture sector is of relevance, at least for the time being before we can move to wider aspects of agriculture industry. We also need to consider developing agriculture sector within the context of backward and forward linkage. That is why developing partnership between small farmer and medium/large farmer along with the established agriculture corporations will serve as one major condition in developing the sector, so the efforts will not only aiming at increasing production but will also involve technical assistance, marketing as well as to improve small farmers eligibility in accessing banks’ credit. Of the policies that we will issue presently, there will be one to amend the content of a particular PBI, and one will purely be a confirmation letter on the interpretation on some regulations that we have promulgated in the past. We feel that there are numerous regulations that require commonality in interpreting and understanding the substance they are trying to achieve. Some of the regulations, for which the content we shall adjust and/or clarify include: 1. 2. Regulation concerning guidelines to evaluate credit collectibility. Currently, the guideline to evaluate earning assets over Rp.500 million is based on three criterion pillars, namely prospects, debtor performance and the promptness of payment. There are also some conditions in the evaluation, such as: the obligation to submit an audit report conducted by a public accountant. As such, companies that record losses must be classified as unhealthy. Shortly, we are going to review these regulations and conditions and make the following adjustments: a. The assessment of earning assets of up to Rp.5 billion can be conducted by referring to 1 of the 3 pillars, namely the promptness of payment. The main purpose of this policy is to ease banking in the distribution of credit to potential customers of micro, small and medium enterprises, who still require the support of banking to build and develop their ventures further. To the banking industry itself, this evaluation would improve the condition of debtor collectibility; classified as unhealthy by the three pillars. The improvement in collectibility is attributable to the relaxing of this criterion, which would also reduce the burden of the provision for assets associated with the presence of NPL. Banking costs could also be minimized which would precipitate a drop in the credit interest rate offered. To the pubic, we predict that micro, small and medium enterprises make up the sector that can directly make use of this privilege. However, we need to bear in mind that all existing privileges must not influence the implementation of risk management and prudential principles that must be exercised when allocating credit. Integrity, professionalism and good governance from banking industry actors fully reflect the quality and competence of you, distinguished guests here this evening, in undertaking your responsibilities. We all realize that this is the toughness and robustness that the banking industry stands on. b. An exception to the three pillars is granted for financing of debtors/projects that have obtained government assurance as regulated by PBI No 7/2/PBI 2005 regarding Quality Evaluation of Commercial Banks. With this exception, development projects guaranteed by the government can easily obtain financing from the banking industry. Even a consortium to grant this syndicated credit would be simpler to assemble since the risk signals are concise and measurable. c. Pressures on the risk-management ability of banks in credit allocation and evaluation are comparable to the compliance of various secondary qualifications. Some of the collectibility evaluation conditions that are currently deemed as burdensome to banking will be bypassed, as long as the banking industry understands the risk exposure and is prepared with an assortment of mitigation measures as required. Adjustments to the regulations related to prudential principles will be as follows: d. Raising the limit for earning asset value through uniform classification from the current value of Rp.500 million to Rp.5 billion; which is sufficient for the top 50 bank debtors. e. Including additional types of collateral that can be used to reduce the provision for bad assets. With respect to ongoing dynamics and prevailing conditions, the types of collateral currently regulated will be widened by including equipment and warehouse receipts, as stated in established laws and regulations. f. Confirming the Legal Lending Limit (LLL) at 30% of capital for state-owned enterprises that reside in the various development sectors. Currently, the banking industry gives the impression that state-owned enterprises eligible for a 30% LLL are only those related to infrastructure. In the future, a 30% LLL will be applicable not only to infrastructure related state-owned enterprises but also state-owned enterprises in other sectors. g. Stressing and re-explaining to related parties within LLL regarding the joint financing of some companies (including banks) on a common project. It must be understood that the financial relations of companies involved in joint financing does not restrict their relationship. Therefore, the relationships between the joint financed companies are not classified as interrelated as long as there is no other relationship restriction. h. Reiterating that it is possible to allocate credit to problematic debtors providing that the debtors maintain good intentions and that the credit only became bad due to reasons beyond the control of the debtor. It will be possible for such debtors to be eligible for new credit but only after thorough analysis and under close supervision. The amalgamation of the adjustment and confirmation steps I have just described to you, ladies and gentlemen, is expected to underpin the intermediary function of the banking industry, which has been constrained for many years. A holistic, thorough and accurate understanding of valid regulations should form the foundation of every strategic step we take, backed up by a legitimate argument, without over-regulating to maintain stability. To this end, we internally at Bank Indonesia will also strive to build the capacity of our supervisors in terms of seeing, comprehending and interpreting the existing risk exposure. This way the gap between the supervisor and supervisee of perception and comprehension, utilizing prudential signs when reviewing potential credit, can be eliminated. The hopes rested on the banking sector to improve the intermediary function are also applicable to foreign-owned banks. Since 2006, this challenge seems to have been addressed positively by the foreign-owned banks. Therefore, the burgeoning credit allocation to productive sectors by foreignowned banks is very encouraging to see. To maintain the continuity of this wonderful momentum, our fifth step in the coming year is to provide guidance to foreign banks to contribute more optimally to the development of the Indonesian economy. It is about time that foreign banks in Indonesia be better focused on more productive and useful endeavours to their host country, especially in their respective position that has dominated the ownership of banks in Indonesia. It is not excessive for us to expect foreign-owned banks to improve their commitment and compliance to support the funding of national development. Furthermore, the escalating number of foreign-owned banks in Indonesia raises concerns regarding the work opportunities of the domestic professional workforce. The current soaring unemployment rate in Indonesia urges us to ask foreign banks to think about and cooperate to overcome this situation. Concerns of a lull in work opportunities for the local workforce are escalating along with the rising number of foreigners in the Indonesian banking industry. As per what we promised back in 2006, this problem will have to be addressed through a special policy aimed at limiting the number of foreign workers at the middle management level; which is two levels below the director, except in fields that have proven to be beyond the capabilities of local workers due their rare nature or scarce expertise. Such tenures are limited to a maximum of three years. Using this time frame will force banks that utilize foreign workers in middle management to transfer the knowledge and technology to local employees. The sixth strategic step that will be taken in the near future is to more proactively develop the financial market as well as financial instruments. As I briefly mentioned earlier, our economic recovery in the future calls for a sound, healthy and deep national financial sector that can effectively mitigate the negative effects of shocks in the global financial market. There are currently other implications of a shallow financial market, especially amidst high micro risk. The implications include the constriction of economic funding for long-term investment and less effective monetary policy transmission mechanisms. The limited numbers of financial products with various durations, as well as primary and secondary markets that support trading, have triggered excess funds to the SBI market and short-term portfolio placements. This has pushed the real sector of the economy to rely on consumption stemming from the wealth effect in the financial sector. Meanwhile, the liquidity overhang in the financial sector, particularly in the banking sector, has reached an alarming level as banking only focuses on short-term financial activities, particularly the short-term deposit market and SBI market, without distributing credit for investment. To address the issues above, I am convinced that the policy to deepen the domestic financial market, as well as to develop innovative financial products, can be a strategic step that will support investment in real sector, which, in turn, may reduce the liquidity overhang. Efforts that can be made to deepen the domestic financial market and widen its products range include issuing SPN and fostering SBI of the longer term durations; providing an effective regulatory environment for financial product development that covers medium-term notes, corporate bonds and commercial papers; and providing a greater opportunity for activities related to asset securitization, universal banking and the growth of sharia-based financial instruments. These steps clearly require collaborative efforts from Bank Indonesia, the government as well as banking and non-bank financial institutions. In relation to this, Bank Indonesia will incorporate the issue of financial market development in the Banking Law. The seventh strategic step concerns policy and strategy related to the expansion of sharia banking. Witnessing the rapid growth of the sharia banking industry in our nation, Bank Indonesia believes that it is necessary to expedite such growth in order for the public to reap even greater benefits. We estimate that the total assets of sharia banking, which currently account for about 1.5% of total banking assets, to increase to at least 5% by the end of 2008. Consequently, we will conduct an accelerated program of sharia banking, which will be effectively carried out beginning in 2007. The program to accelerate the expansion of Indonesian sharia banking will be undertaken through three key measures: First, through more intensive societal education regarding sharia banking. This measure will be taken to improve public understanding and awareness of sharia financing and banking. Second, we will stress a review of sharia products, sharia financing services, and encourage the expansion of service outlets to boost the accessibility of sharia banks in line with the public requirement. And third, Bank Indonesia will actively participate in supporting incoming foreign investment through sharia financial instruments. Through these three measures, we hope to make sharia banking the pride of its followers. Sharia banking is not a flash-in-the-pan but something truly monumental, with comparable quality and reach to conventional banking. Sharia banking products and services have to be attractive and formulated in line with public demand. In essence, better realization and understanding from society precipitates greater, real and effective, demand from the public. In this context I would like to invite you all, distinguished ladies and gentlemen, to actively participate and work hard together to improve integrity, so that the existence of higher quality and more useful sharia banking can be established in society. A unified vision from all stakeholders is crucial when establishing a sound and efficient sharia banking system, considering how sharia banking can position itself as a solution provider. In turn, such circumstances will create a sense of belonging in the community towards sharia banking. Last but not least, the policy to be implemented in 2007 is associated with the existence of a rural banking industry and its relation to the livelihoods of rural people who are involved in the informal business sector. We cannot hide the truth that the informal business sector exists and, in fact, supports most of our people’s livelihoods. I would even like to note that this sector is indeed a form of social safety net which allows our people to have dreams, hopes and optimism to survive in their, often difficult, journey through life. Small-scale farmers in villages, traders in traditional markets, cigarette sellers, small-scale grocery vendors and many other agricultural labourers are marginalized by the situation and indeed make up the largest segment of our society. If we want to alleviate the drudgery and improve the quality of life of our people, this is the sector which we must focus our attention. These people are currently in furthermost row; however it is time to now put them on the forefront in our policies. Putting the last first. Understanding the dynamics of rural people’s lives should be redefined within the context of their relationship with rural banks. Due to the size and specific criteria of commercial banks it is almost impossible for them to finance the informal business sector. We have noticed that credit disbursement to informal sectors requires a particular approach and strategy that are specific to the conditions of these particular sectors, without ignoring the significance of the risk-management system. Prudential principles must reflect market characteristics for which they serve. If a commercial bank client’s track record is obtained through standard mechanisms, then the track record of clients or potential clients of BPRs may be sought through the social system established in the society. A supporting empirical fact to this is that BPRs are located within proximity to their clients, furthermore, the BPR’s employees are recruited from the banks immediate surrounding. From the very beginning, we have to realize that the relatively small business size of rural banks which located in a specific and limited social environment; are the rural banks’ competitive advantage over commercial banks. Advanced rural banks do not existentially have to operate like commercial banks. Therefore, going forward, we will review regulations concerning the development of BPRs in increasing its role and contribution as a Micro Finance Agent (LKM). It is hoped that BPRs will be able to maintain the interest of the Small and Medium Enterprises (SME) and the village community and be as agile as other LKM’s in meeting the public’s needs. Good functioning BPRs and LKMs must be able to distribute themselves across the country. Indonesia has more than 60.000 villages, however formal banking services have only reached less than 10.000 locations. Therefore, expansion in BPR and LKM’s reach is a concrete answer to the SME and village community’s need in general. One of the efforts Bank Indonesia has implemented to support BPR growth is the Linkage Program. The Program entails the channeling of credits to Micro, Small, and Medium Enterprises from Commercial Banks or from Syariah Commercial Banks to BPRs or Syariah BPRs. Without compromising prudential principles, efficiencies and synergies are created from these relationships. Against this backdrop, the policy direction applied by Bank Indonesia is to redirect the role, function and operational design of rural banks to their fundamental purpose, that is, to serve the common people, particularly those in informal sectors and living in remote areas. The role of rural banks, which was initially to satisfy the financial needs of the common people and in the past primarily meant the informal financial sector, has to be reutilized. The relationship between rural banks and the informal financial sector has to become complementary, looking for assistance and complementing each other to best serve ordinary people. Meanwhile, as we see the BPRs develop, another issue will need to earn our attention. This is the prevalence of other forms of Micro Finance Institutions (LKMs) which behave very similar to a bank in the sense that they mobilize public funds. Examples include Savings & Loans Cooperations (KSP), Baitul Maal Tamwiil (BMT), Community Credit Institutions (BKD), and Community Funding Body (LPD). The number of the aforementioned institutions reaches not less than 10.000. On the one hand such prevalence provides an array of variations of non-bank financial institutions which add to Micro and Small Enterprises and communities in villages funding alternatives. Its unique characteristics and closeness to the village community enables various LKM’s to continue to exist in various communities. However, on the other hand, such LKM’s come with its problems, such as lack of clarity as to their various types, forms, and its supervisory authority. Such condition creates situations whereby protection for LKM’s stakeholders and the LKM itself are weak. This issue should receive our attention here, ladies and gentlemen. Moving forward, regulation towards various LKMs need to be strengthened. With that as a background, and also taking into consideration that two years ago was the Year of Micro Credit, we must move quickly and complete initiatives started in 2001 and finalize the Draft for the Law on LKM to become the Law on LKM. I feel that this is worthy of your and our support. VI. Conclusion Ladies and Gentlemen, Fellow bankers, This is what I can convey this evening. While reviewing the set of problems and challenges we face, we all realize that the years to come will not necessarily be any easier than the years that have passed us by. An array of measures to achieve policy success, both from the government and Bank Indonesia, require your unrelenting support and cooperation throughout their execution. Therefore, we are always open to suggestions and recommendations regarding any of the policies that we have promulgated. We now have time, be it through this informal forum, breakfast meetings with bankers, or chief editors meeting with the mass media; to discuss the various issues raised here this evening. I expect that the existence of such avenues of discussion will minimize any potential arguments and differences that seem to be picked up by and dominate the mass media, which, in turn, do nothing but confuse the general public. I would also like to take this opportunity to express that in confronting future challenges, we need the involvement and participation of all public elements, including the press. The complexity of our problems requires agents and institutions that never cease worrying or reminding us about them. This is where the role and contribution of the press becomes crucial. The press have the concerns of the common man at heart and therefore always ask questions. The press play a strategic role in building social infrastructure and democracy by remaining impartial and sensitive, always paying attention and constantly reminding us all about the importance of common principals and goals in establishing public prosperity. An inspiring press core is crucial for the people, especially to us as the policymakers. Constructive reviews from press agents regarding the choices laid bare before us, with their accurate and objective explanations, will make it easier for society as a whole to face the challenges that obstruct the journey ahead. For that reason, I would like to express my appreciation to the press core that has helped us glean enlightened information throughout the years. I hope that the press remain constant in fighting for the establishment of public prosperity. I hope that constructive cooperation may endure into the future between us all. Finally, let us all work harder and collectively to shoulder this nation, which is currently at a crossroads, towards a new and better horizon. This is an example of how our attitudes must be in terms of progressing into the New Year. We should keep striving to resolve national problems. National banking, on the one side, will continue to clean house and reorganise itself to re-establish its role as a significant intermediary institution. On the other side, Bank Indonesia will strive to consistently steer the required improvements in a disciplined manner. Once again, Happy New Year for 2007. May Allah SWT bless us all and help illuminate our steps towards a better future. Thank you. Wassalamu’alaikum wr. wb.
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Speech by Dr Burhanuddin Abdullah, Governor of Bank Indonesia, at the International Symposium "Ten Years After the Asian Currency Crisis: Future Challenges for the Asian Economies and Financial Markets", Tokyo, 22 January 2007.
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Burhanuddin Abdullah: Reflections on the changes in the region a decade after the Asian crisis Speech by Dr Burhanuddin Abdullah, Governor of Bank Indonesia, at the International Symposium “Ten Years After the Asian Currency Crisis: Future Challenges for the Asian Economies and Financial Markets”, hosted by the Center for Monetary Cooperation in Asia (CeMCoA), Bank of Japan, Tokyo, 22 January 2007. * * * Honorable Governor of Bank of Japan, Mr. Toshihiko Fukui, Honorable Managing Director of the IMF, Mr. Rodrigo de Rato, Fellow Governors, Ladies and Gentlemen, Good morning. First I wish to join others to express our appreciation to thank the Bank of Japan for organizing this important event. It is indeed an opportune time to reflect on the recent developments and progress that we have achieved following the crisis. I believe that through a frank and candid discussion we can share from each others’ experience during this symposium in the spirit of cooperation especially on how we have fared through the turbulence period of unprecedented economic crisis of the late nineties. We expect that we can capitalize on the recent progress and cope with the future challenges for the benefit of our economies. In this session, allow me to briefly express my reflection on the changes in the region a decade after the Asian crisis to identify factors that would influence the economic dynamism and prospects of East Asia in general and ASEAN in particular. Fellow Governors, In my observation, I notice that a number of remarkable changes have occurred in the region. First is the heightened regional cooperation with the objective of establishing a regional self-help. Unlike most of their counterparts in other parts of the world, the latest financial crisis, among other factors, provides strong impetus for the monetary and financial cooperation in East Asia. The initiative to create a set of Bilateral Swap Arrangement, to develop Asian bond markets, and to conduct regional surveillance are our collective means to maintaining greater stability in the region, particularly in the face of highly volatile flows. I surely hope that this kind of cooperation will continue and be widened in the future so as to positively affect the economic dynamism in East Asia. Second, in the aftermath of the Asian crisis, countries in East Asia have become more conscious in protecting their own national interests and of strengthening their sense of security amidst greater global economic uncertainties. This is shown by the fact that countries in East Asia have accumulated the bulk of the world's foreign-exchange reserves. In the past year China added more than $250 billion to its stash, breaking the USD1 trillion record level. By November last year, ten East-Asian countries plus India have amassed some USD3 trillion of foreign-exchange reserve. Such a huge accumulation of international reserves certainly entails opportunity cost and exchange rate risk especially amid the looming global imbalances. However, the build-up of these reserves in a way also provides cushion against unanticipated reversal of capital flows given the openness of the foreign exchange regime and financial market the integration. In connection to this, more and more countries have settled their obligations to the Fund. Indonesia, one of the crisis-hit-countries, closed the final chapter of the Asian crisis following the last prepayment of its obligation in October last year. Such a prepayment reflects the strength of economic recovery and the balance of payments positions of the crisis hit countries, which in a way provide an evidence of the Fund’s success in Asia. Yet it may also suggest that countries tend to prefer executing their own self-formulated programs when conducting reforms. In addition, Indonesia’s recent experience with the Fund during the crisis suggests that turning back to the Fund in case of another crisis will be politically much more difficult than in the past. Third, while Asian economies have fully recovered from crisis, investments as percentage of GDP have been well below the pre-crisis level. Other non-crisis Asian economies except China also exhibited a slowdown in the growth of their investments. After showing a slight recovery in 2004, the ratios moderated in 2005. The slump in investment in Asia mainly reflected a sharp fall in private investment. Many economists shared the view that the low level of investment cannot be explained by changes in fundamentals. With the exception of China, aggregate saving has been stable over more than 10 years. Among key factors responsible for the slump include investor’s perceptions that the investment environment is riskier. I would appreciate it if fellow Governors would share their experience on this issue. Finally, many emerging countries in Asia were forced to abandon their traditional dollar-peg system and to allow their exchange rates to float in the summer of 1997 amidst intense currency attacks by speculators. After a period of sharp depreciation accompanied by high volatility, exchange rates in these countries bottomed out against the US dollar in the autumn of 1998, thanks to a return of confidence in the economic prospects of these countries. However, simply turning to flexible exchange rate regime and more liberal capital account policies do not solve all the exchange rate problems. Despite the sound policies in place, we frequently witness sharp volatility which is due to speculative capital flows and not justified by its fundamentals. At the same time we have progressed quite liberally in terms of our capital and current account policies. The adoption of these policies was endorsed by multilateral agencies, including the IMF, during the height of the Asian crisis. It is therefore my hope that all of us in this symposium come up with a set of viable policy options to address this issue of speculative flows in Asia. In particular, I would appreciate views from the IMF. Fellow Governors, On that final note I would like to end my speech. Those developments in the aftermath of the crisis that I have mentioned will certainly influence the economic dynamism and prospects of East Asia in general and ASEAN in particular. I am looking forward to fruitful discussions in this symposium. Going forward, it is my hope that we can engage in greater policy cooperation and coordination in East Asia.
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Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 2008 Annual Bankers¿ Dinner, Jakarta, 18 January 2008.
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Burhanuddin Abdullah: Opening the path to stability, safeguarding the nation’s economic development Speech by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, at the 2008 Annual Bankers’ Dinner, Jakarta, 18 January 2008. *** Assalamu’alaikum wr.wb, Good evening and may I wish you all a triumphant year ahead, I. Introduction To open my speech here today held in such salubrious settings, I would like to invite you all to join me in expressing thanks and praise to God Almighty who has again blessed us with the chance to congregate here for the 2008 Annual Bankers’ Dinner. Taking advantage of such a wonderful opportunity and on behalf of the Board of Governors of Bank Indonesia, please allow me to wish you a very happy and prosperous year ahead in 2008. May you be blessed in every step that you take. Ladies and Gentlemen, In distinction from previous years, tonight is an exceptional one for me. Tonight marks the fifth time I stand here in the presence of you, distinguished ladies and gentlemen, to deliver my annual address. The five years has flown by. Unsuspectingly, this year is the final year of my tenure as the Governor of Bank Indonesia. Together we have traveled far on our arduous journey. We have faced numerous trials and tribulations one after another. Some brought immense satisfaction, while others yielded grave disappointment. Together we have come to understand that the wide ranging and compelling changes in the global and national constellation over the past ten years have delivered new challenges in terms of managing national economic stability. Fluctuations and uncertainty seem to be a constant that incessantly shadows us along with the prevailing shifts and changes. Nevertheless, we should be grateful. Solid collaboration and close coordination, based on common understanding, have become fundamental elements in establishing and maintaining monetary, banking and payment system stability by Bank Indonesia. Therefore, prior to delivering the main substance of my annual address this evening, please allow me to express my sincere appreciation to the banking community who has been so incredibly supportive of Bank Indonesia’s policy measures in terms of reinforcing and driving the banking industry’s performance in general. I would also like to offer praise and my highest admiration to all elements of the Central and Local Government, the Parliament, business community, academics, observers, the media and all other parties that I am, unfortunately, unable to acknowledge individually, who have provided technical and strategic support to Bank Indonesia in fulfilling its duties. Ladies and Gentlemen, It was ten years ago when our nation started to march towards the rise of a new democratic community in Asia. It is from early this year we witness the rise of Indonesia as a new economic star in Asia. We thank God that our beloved country has finally closed the final chapter of the painful Asian crisis. We pray that, God willing, it is closed for good. We have now entered a new era, one that will be better than the past. Early on we are witness of several encouraging economic achievements. Our economy has started to gain speed using both its engine – its stability engine and growth engine – It is no surprise that many passengers aboard and bystanders outside are surprised by the acceleration taking place. For the first time since the Asian Economic Crisis, economic growth in Indonesia has surpassed 6% annually. Meanwhile, in the past five years, we have been witness to bold macro economic developments despite the various encounters of hardships. The financial system resilience and stability are now in much better shape than that of pre-crisis. We now can make note that the national banking industry has withstood and even held back impacts of significant shocks. We are thus able to say that stronger resilience is within our national economy. Ladies and Gentlemen, The new Indonesia of the 21st century holds many hopes and opportunities. As such, the eyes of the world are steadily focused on us as we take steps to our future. All that we have achieved by deconstructing institutions of the past, and constructing new ones, and doing this in the midst of a true democracy, is definitely not something to be given only light regard. We have now become a reference for countries of the third world on how democracy and positive achievements in the economy go hand in hand. Our country’s history and surrounding polity has never, until now, traveled this road before. The early years following the 1945 Proclamation of Independence have actually seen democratic life, as the one we see today. The period after the 1945 Proclamation of Independence to the mid 1950’s are penned in our national history as the time in which political openness and democracy were part of this nation’s everyday lives. A multiparty political system was in close harmony with strong spirits of civility. Life within our nation then was filled with dialogues, arguments on the nation’s ideals, and exchange of thoughts amongst first class intellectuals which were political elites revered for their wide horizons in the era they were in. It was during this era that our Nation and its Founding Fathers were Asia’s ray of lights, which later scripted in gold as what sparked the Asia-Africa spirit. However, we must admittedly write in our books that the period of openness, democracy, and civility did not last long as there was a lack of seriousness in planning and implementing economic development for the benefits of the society in general. Political freedom was emphasized over economic development which resulted into a free, open, and democratic country, but one with no real improvements towards the welfare of the people. This oversight led us to the 1960’s which was marked by the deterioration in nation’s social, political, and economic life. It is during the next era that history writes about the positive dynamics of the New Order development. From the end of the 1970s, we had been able to come closer to fulfilling our promise of independence with the quality of life improvements and economic prosperity for the people. In the next decade until the mid 1990s, the world was witness to the contributions of Indonesia as one of the Tigers in Asia’s economic-political arena. However, it was also during the three decades of the New Order era that the urgency to develop open and democratic political system was lost. This oversight eventually led us to a severe economic and political crisis. In that journey through our labyrinth of collective memory, we find many contradictions regarding who should take role as captain of our nation ship. “The economy as captain or politics as captain” is the coffee shop debate that has kept us amused for some time. However, something very different has arisen in the last five years. In our minds and hearts, we perceive a fundamental change in the life in our nation-state which represents a break from the past. The difference lies in the fact that, over the last five years, there has been a consolidation of political life in a free and open democracy taking place alongside an increasingly solid economic consolidation. On one side we are once again living in a free and open democratic society. We have also implemented regional autonomy and economic decentralization. We have elected the president and head of regions through direct election, while the press enjoys greater freedom and is maturing at noticeable pace. Alongside, the economy continues to grow while economic stability is maintained. We even have formulated and implemented economic policies without the guidance and interference of foreign parties, such as the IMF, whose interest often lie incongruously with that of the people of Indonesia. The period we were in IMF’s Extended Fund Facility until the completion of the Post-Program Monitoring represents a trying time in our nation’s history. During that era, we were not able to formulate and implement adjustment policies with a scope and pace which were in complete agreement with the interests of and needs of the Indonesian people. Many compromises were demanded and many of them did not fully benefit our nation’s interest, but rather, only the interest of various other parties. The hand below is never the hand of dignity. Never again do we to live in an era in which our people and nation-state were reduced in dignity. Democracy, openness, freedom, and the courage for sovereignty in public policy have made us become our true selves, with many opportunities to achieve prosperity for all Indonesians. This brings proof of validity to what our Founding Fathers have believed in all along. We must always maintain the right view and attitude in fulfilling the promise of freedom and independence – something for which our Founding Fathers have fought dearly. Admittedly, if we only look at the figures, at this point, what we have achieved is far from dramatic. However, behind such developments emerge a strategic shift. We have gradually strengthened our state institutions, which has enabled us to take continuous steps forward towards more sustainable improvements, and thus reducing ad-hoc actions. Various institutions, Bank Indonesia included, have taken gradual steps towards improvements, which will then continue to take place in all essential fields. In almost the same context with Muhammad Hatta’s view regarding Indonesia’s 1945 Revolution, our ability to put democracy parallel with prosperity becomes “a link of a long chain of fundamental and significant changes” in the life of people in other developing countries in Asia and Africa in the future. Therefore, we should be uplifted by such an extraordinary achievement; one that was achieved by our own initiatives and hard work. We are also thankful to God for giving us such a rare opportunity. As one of only a handful of democratic developing economies and one of the largest republic in Asia, it is appropriate that in the future we continue to strive towards further identifying our strengths and abilities to autonomously determine our own choices and take unerring decisions in the interest of our nation. It has been our belief since the 1945 Proclamation of Independence that the sustainability of the Republic will be better guaranteed if democracy is upheld. Such was the case during the past five years. It also befalls on us to use the success thus far achieved as priceless capital to prepare our future steps and answer the challenges of the 21st century. Founding Fathers of this nation, Sutan Sjahrir, Soekarno and Muhammad Hatta, once said that the independence of Indonesia as a nation-state in 1945 is but a vehicle to achieve the independence of the people of Indonesia. However, 62 years after the 1945 Proclamation of Independence, a great many of the people find themselves longing for an order which allows them to gain their independence. Such would be from a nation-state which provides prosperity and educates the majority, and not minority, of the people. Such longing is our biggest challenge and is also a call of history to us all. Ladies and Gentlemen, For me personally, my journey in leading Bank Indonesia, a state institution mandated by the public to maintain national economic stability, is an extremely precious experience. The experience has bestowed upon me a deeper understanding of our economic dynamics, current and upcoming challenges and opportunities, as well as the means to accomplish the aspirations of the general public, namely improved welfare for all Indonesians. And of course as a citizen of this great nation myself, the mandate has also provided great honor and opportunity for me to pay homage to our nation and all Indonesians. This evening, the time has come for me to reflect on what Bank Indonesia has achieved in my five years of leadership. It would not be excessive to say that I would like to make this a part of my moral responsibility to the stakeholders of Bank Indonesia. Tonight, I will also present views regarding the economic prospects and challenges to be faced over the next five years and their implications on Bank Indonesia. I genuinely hope that the future perspective I plan to present here this evening can serve as a contribution for us all in determining some common measures to achieve a better national economic future. The theme of my oration this evening is “Opening the Path to Stability, Safeguarding the Nation’s Economic Development”. As for the systematic of my presentation, at the beginning I would like to reopen pages of my work log and take you all on the journey of Bank Indonesia in fulfilling its constitutional mission over the last five years. Some of the questions my comments are based upon include: What policy initiatives have been adopted and what are their considering factors? How far has progress been achieved in its implementation? What has it contributed to the overall process of economic growth in the post crisis era? In the subsequent part, I would like to address future economic prospects and challenges, as well as measures that need to be taken by Bank Indonesia to ensure that the institution remains an integral part of the solution to the nation’s economic woes. Several of the challenges are not totally new since they have persisted for some time and continue to persist to this day. In the future, however, such challenges could intensify further, and therefore the urgency of our preparedness will become critical. Finally, prior to concluding my address here this evening, I would like to present some views on possible follow-up measures and policies that I believe need to be taken over the next five years; giving 2008 new momentum for the establishment of Bank Indonesia that is more relevant for the prosperity of all Indonesians. II. A recap of Bank Indonesia task implementation 2003-2007 1. National economic achievements Ladies and Gentlemen, At the beginning of 2007 we had restored macroeconomic stability following the global oil price hikes towards the end of 2005 and minimized their effects on the exchange rate, inflation and interest rate up to mid 2006. Then, you may recall, on this very same occasion last year, I likened our economic condition in 2006 to an airplane flying on just a single engine. On one side we had succeeded in restoring macroeconomic conditions back on track. However, due to intricate micro and structural challenges in the economy, the pace and quality of economic growth was still below expectations. Furthermore, productive business activity in the real sector was quite sluggish. At the beginning of 2008, we should all be grateful for closing 2007 behind satisfactory accomplishments as evident by primary economic indicators (Table 1). As such, maintaining our airplane analogy, our economic airplane has started to soar with both engines running. Consequently, it should not be completely unexpected that many of its passengers are shocked by the new found acceleration. Allow me to briefly present several salient economic achievements up to the end of 2007. Regarding economic growth, for the first time since the Asian Economic Crisis, economic growth in Indonesia has surpassed 6% annually, reaching 6.3% in 2007. The growth is characterized by a balance between demand and supply, as reflected by the resilience of consumption expenditure followed by favorable growth in investment. The realization of Gross Fixed Capital Formation (GFCF) through 2007 increased by 8.37%, while private investment grew 7.18% from last year’s level. Such growth caused the investment to GDP ratio to rise from 19.5% in 2003 to 23% in 2007. Widespread diversification is also evident in the economy. Therefore, despite a manufacturing sector that has not yet fully recovered, many other sectors have developed and consequently supported wealth creation in our economy throughout 2007. Such diversification is verified by expansion in the mining, trade, telecommunications, transportation, utilities, construction and services sectors. All the improvements gained in the real sector have provided strong initial indications that structural constraints stemming from the microeconomic side (supply side constraints) are improving. Table 1. Main Economic Indicators Indicators 5.68 17.11 5.48 6.60 6.3 6.59 86,995 103,514 69,462 73,868 45,12 35,28 34,724 42,586 9.713 9.167 118,937 86,354 31,3 56,900 9.140 Government Finance Revenue (Billion Rp) 298,605 341,396 403,367 495,224 637,796 Spending (Billion Rp) 322,180 376,505 427,177 509,632 670,591 Budget Deficit/Surplus (%of GDP) -1.3 -1.7 -1.0 -0.5 -1.0 -1.1 Macro GDP (% - yoy) Inflation (% - yoy) 4.38 10.03 4.72 5.06 5.03 6.40 External Export (Billion USD) Import (Billion USD) Debt to GDP ratio (%) Foreign Reserve (Billion USD) Exchange Rate 59,165 64,109 35,652 39,546 65,71 57,01 32,039 36,296 8.950 8.570 70,767 50,615 53,40 36,320 8.948 Financial Market Yield Global SUN (%)** JSX Index 6.08 4.72 3.71 1,000 4.92 1,163 5.93 1,806 2007* 5.89 2,746 Net: * Position as of December (estimation) **Since 2006 using global bond due in 2014 Externally, the Indonesian balance of payments (BoP) has run a surplus for four years consecutively. At the end of 2007, the BoP surplus was 3.1% of GDP, giving a surplus for the past three years of 2.4% of GDP. Net capital inflows to the financial markets, direct capital investment, net exports, and the net remittance from Indonesian migrant workers have all contributed to positive BoP performance. In this respect we can observe that Indonesian non oil and gas exports remained high amidst a slowing global economy. This shows that the destination countries for our exports have become more diversified, negating some of the adverse effects of the economic slowdown in developed countries, which has also been compensated by exports to countries with high economic growth such as China and India. Impressive BoP performance over the past four years has provided room for us to fund development activities, service our foreign debt without triggering significant fluctuations in the foreign exchange market, strengthen our position through additional foreign exchange reserves, and most importantly, through the contribution of net remittance inflows from migrant workers, the resilience of domestic demand in the national economy has been maintained. Regarding foreign exchanges reserves, I would like to announce that by the end of 2007, our foreign exchange reserves had reached USD 56.9 billion; equal to 5.7 months of imports and servicing of the government’s foreign debt. Strong BoP performance has also provided the opportunity for us to expedite servicing the debt to IMF in 2006. This was taken through careful calculations in the spirit of public policy independence and confidence in future economic performance. Payments due over the next 3.5 years were serviced on 12th October 2006. Consequently, Indonesia no longer has to comply with the programs in the IMF Letter of Intent. Although debt repayments to IMF were finalized, financial market conditions remain stable and foreign exchange reserves have continued to grow. More balanced economic growth, a balance of payments surplus, and a healthy foreign exchange reserve position have largely assisted efforts to preserve rupiah stability, especially over the mid to long term. Over the past five years, with the exception of 2005 which was marked by severe global oil price hikes, headline inflation, measured by the Consumer Price Index, and core inflation recorded 6.19% and 6.28% annually, compared to an annual average during the pre-crisis era of 8.21% and 9.13% respectively. Meanwhile, ignoring exchange rate fluctuations in 2005, the rupiah exchange rate in the past five years appears to have been well maintained within a range conducive to maintaining the internal and external balance of our macro economy. Furthermore, rupiah exchange volatility is currently far below that of the early years following the crisis. Overall, this provides greater certainty to business players in the real and the financial sector regarding the average exchange rate in the long run. Therefore, I would like to state that the positive developments occurring in the inflation and exchange rates have subsequently supported the management of expectations regarding macroeconomic stability and underpinned the competitiveness of exports in the mid to long term . If we observe the progress made by banks, at least since the beginning of 2004, it would be a fair assessment to assert that the current growth in banking indicators is satisfactory (Table 2). Growth in total bank assets has increased sharply by 60%, from Rp737.85 trillion (63.7%) to Rp1,895 trillion in November 2007. Meanwhile, credit has expanded by Rp529.6 trillion; more than twice its level in 2004 to Rp1,004.6 trillion at the end of last year. The expansion in credit extension was supported by a rise in deposits by Rp551 trillion or 62% compared to its level in 2004 and thereby making the level of deposits Rp1,437.5 trillion in November 2007. Table 2. Perkembangan Indikator Utama Perbankan Indicators Credit (T Rp) Third Party Deposits (T Rp) NPL Gross (% ) NPL Nett (% ) Interest (Work. Cap.) (% )* Interest (Investment) (% ) * Interest (Consumption) (% )* Number of Banks* * Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 410.3 835.8 8.1 2.1 18.3 17.8 20.2 477.2 888.6 8.2 3.0 15.1 15.7 18.7 138.0 595.1 963.1 5.8 1.7 13.4 14.1 16.6 133.0 730.2 1,127.9 8.3 4.8 16.2 15.7 16.8 131.0 832.9 1,287.0 7.0 3.6 15.1 15.1 17.6 130.0 Nov 2007 1.004.6 1,437.5 5.4 2.3 13.2 13.3 16.3 128.0 *) As of October 2007 **) As of the above date there are16 banks with capital below Rp. 80 bill. Throughout 2007, supported by a decline in the BI rate along with macroeconomic stability, credit grew according to the targets set by banks at the beginning of the year and recorded growth of 24.3%. The recent noteworthy credit growth indicates that banks have returned to contributing significantly to the funding of overall national development. One aspect that requires attention in regards to bank performance up to the end of 2007 is that bank stability in the post-crisis era already far exceeds that of the pre-crisis era. Nowadays, the majority of banks maintain their capital adequacy at a high level, with an average CAR in the range of 19.5%. Total assets have experienced a substantial increase of 11.9% to Rp1,845 trillion. Regarding profitability, bank ROA has risen from 2.6% to 2.8%, which generally stems from improvements in the efficiency of operational banking activities. Meanwhile, bank NPL has performed satisfactorily, improving from 6.98% (gross) and 3.63% (net) to 5.41% and 2.29% respectively. This is primarily attributable to the implementation of government legislation, namely PP No. 33, 2006, by government-owned banks. Moreover, banks have also been able to absorb the numerous substantial fluctuations in the economy such as oil price hikes and their follow-through effects on the exchange rate, inflation and the interest rate, as well as the contagion effects of the subprime mortgage crisis in the US. This resilience is tightly enshrined in our ever improving bank risk management capability and prudential principles that are strictly enforced throughout the national banking industry. Ladies and Gentlemen, Maintained macroeconomic stability coupled with a sounder and more resilient banking industry has restored investor confidence regarding the future prospects of the Indonesian economy. This is strongly reflected by the improvement in Indonesia’s rating awarded by international ratings agencies. Currently Indonesia is approaching investment grade and closing in on the pre-crisis level (Graph 1). Notwithstanding, along with strong corporate profits and positive future expectations, investor confidence is also high due to the resurgent global excess liquidity inflows to Indonesian financial markets, making the JSX Composite one of the best performing indices in the world (Graph 2). Several sub-sectors that support the improvement of the JSX Composite confirm the existence of diversification in the sources of wealth creation in the economy. Graph 2. JSX Indices Graph 1. Rating of Indonesia The above achievements will surely come as some relief to many as they endured amidst many trials and fluctuations stemming from domestic issues such as the natural disasters that struck one after the other, and globally from oil price fluctuations and the subprime mortgage crisis. It is therefore understandable if we then declare that our national macro economy is sufficiently resilient to face unpredictable fluctuations. Graph 3. Fiscal Consolidation We can also observe that such achievements represent the fruits of collaboration amongst all elements of public policymakers in espousing national economic recovery. Policy aimed towards fiscal consolidation during the early post-crisis era followed by a more expansive fiscal policy over the past two years has stimulated economic activity without triggering price or exchange rate instability, thus preserving economic expansion. The fiscal authority has also succeeded in periodically trimming the foreign debt liability, from above 100% at the beginning of the crisis, to around 35% in 2007. This will further strengthen the prospects of future fiscal sustainability (Graph 3). Furthermore, with respect to fiscal resilience, the policy to reduce fuel subsidies in line with oil price fluctuations in 2005 represent concrete steps to further reinforce our fiscal posture over the mid to long term. Such policy has also helped reduce uncertainty in the foreign exchange market in response to oil price hikes at the end of 2007. As regards policies relating to the improvement of social indicators and the investment climate, we have also witnessed some gratifying developments. The drop in abject poverty is something we can all be pleased about. The poverty rate, measured by the percentage of people living below the poverty line, dropped from 17.75% in 2006 to 16.6% in 2007; a decline in absolute terms of 1.88 million people. The progress of the program to end poverty is supported, in many aspects, by the increase in economic growth and macroeconomic stability. No less important are the social programs implemented to assist the underprivileged to survive amidst fluctuations and natural disasters. The decline in poverty has improved the achievement indicators of Indonesia’s Millennium Development Goals (MDGs). Of the eight MDGs, Indonesia managed to record its most progress in the program to end poverty. A World Bank report (November 2007) states that the percentage of the population living on an income of less than US$1 per day is 8.5% lower than the 2015 MDG target, namely 10.3%. Other MDG indicators have also shown improvements, as illustrated by the high number of students enrolled in primary education; the low child mortality rate of under-5 year olds; and significantly improved public access to clean water. In addition, the World Bank noted that in nearly all aspects, the achievement of MDGs in Indonesia has progressed according to appropriate targets. To promote investment activity incentives, the government has also strived to improve the investment climate through the issuance of an integrated economic policy package (Inpres No. 6 – July 2007) which covers the renewal of three previous packages, namely the investment improvement package, the infrastructure acceleration package, as well as the financial sector reform and small medium enterprise (SME) sector empowerment policy package. In improving investment, the new policy package also includes government legislation concerning the implementation of capital investment and reducing the time taken to process investment permit applications in Indonesia. Meanwhile, in terms of infrastructure, banks have actively participated in providing funding access. This has been supported by a credit insurance program and an investment scheme through a Public Private Partnership (PPP) mechanism. Relating to the domestic investment climate I have already mentioned, we have also seen satisfactory achievements towards regional autonomy. Currently, a group of progressive regional governments have arisen whose regional development performance exceeds that of others. These success stories are demonstrated through the ability of the bureaucracy in progressive areas to unfurl the benefits to all people in the regions. A survey conducted by The Committee for the Monitoring of Regional Autonomy Implementation (KPPOD) indicates that important achievements in progressive areas are tightly related to improvements in the national investment climate, such as the rising human development index, better service efficiency and quality from the regional governments, completion of infrastructure networks, and improved governance in the government. These all represent positive developments in terms of addressing the supply side constraints in our economy over the long run. We now have a far greater hope that in the future, given the support of all elements, a critical mass of progressive regional governments can be achieved, and thus resulting in a faster paced economic growth that is higher in quality and better balanced. 2. Contribution of the financial sector 2.1. Strengthening the three pillars of stability Ladies and Gentlemen, Numerous achievements in 2007, in relation to economic performance as a whole and the advancement of several public policies, have been undertaken collaboratively by all policymakers. Such collaboration has also been actively supported by the diligence of all economic players in the business community and by the general public. I would also like to reiterate that we should be pleased of these achievements since many policies to catalyze economic growth over the past five years have been taken amidst a free democracy and policy independence. With the same pride and faith in national faculty to live in an autonomous polity, I would like to acknowledge that public policymakers in the financial sector and all business players in their respective industries have provided tangible contributions in encouraging public policy independence, and furthermore Bank Indonesia welcomes each and every current economic achievement. Like other public policy-making institutions, Bank Indonesia has its own niche in public policy continuum in the country. Bank Indonesia is one of the primary institutions that provide the three pillars of stability which support and represent the elements of continuity for sustainable economic development. The three pillars of stability include: (a) stability of the rupiah value; (b) a healthy and resilient financial industry to support financial system stability; and (c) a modern and efficient payment system to support economic transactions. Mirroring humankind’s need for air to breathe, the presence of the three pillars of stability is in constant demand, and hence appropriate for the People to underline them as the constitutional mandate of Bank Indonesia through legislation for the central bank ratified by the Parliament. Looking back at Bank Indonesia’s tumultuous journey over the past five years, I feel confident to announce that efforts to meet the various aspirations set forth in the mandate have yielded significant results, which have maintained the momentum of sustainable national economic development and improved its future prospects. The results have been obtained in the spirit of autonomous policy making in line with the interest of our economy as a whole, and without interference from foreign parties. For that reason I would like to take this opportunity to extend my sincere appreciation to all my staff at Bank Indonesia who, over the last five years, have given their all and shown exceptional quality as first-rate professionals, thinking independently and consistently taking decisions that prioritize our nation’s interests. Ladies and Gentlemen, A key achievement for our economy in the past five years has been the availability of a more stable national financial system, compared to the pre-crisis period, that supports economic resilience. The stability of the financial system is evidenced by the fact that our financial system is clearly better prepared to resist and absorb the numerous shocks arising from both the global and/or domestic economy. In addition, the national financial system has shown greater efficiency and effectiveness in allocating funds through intermediation and risk management, and continued to expand its role in supporting economic transactions. The establishment and maintenance of a more stable financial system has been supported by various achievements made in the three pillars of stability that have become the elements of continuity in national economic development. The most salient achievements can be summarized as follows: – The rise in confidence of international and domestic economic players towards the ability of the monetary authority to maintain macroeconomic stability and support the quality of national macroeconomic policy management. – A more effective banking industry to buttress financial system stability as a whole and galvanize national economic growth, as well as being more prepared to face the challenges associated with globalization. – A more modern payment system infrastructure that is supporting and lowering the costs of transaction activity throughout the nation. The establishment of a more stable and useful financial system, along with the reinforcement of the three pillars of stability, has provided breathing space for public policymakers in other sectors to implement various micro-structural policies to precipitate the restoration of the post-crisis economic growth dynamic to its original position. With more space, structural improvements in the real sector are better managed in terms of complexity, direction and pace. Furthermore, structural improvements are no longer disrupted by other issues related to instability in the monetary system, financial system or payment system 2.2. Strategic policy initiatives regarding the three pillars of stability The achievements made for the three pillars of stability that I have already discussed, in many aspects relate to strategic policies instituted by Bank Indonesia as the monetary, banking and national payment system authority. Permit me now to present some of the strategic initiatives taken. 2.2.1. Initiatives in the monetary sector Ladies and Gentlemen, Regarding monetary policy, strategic initiatives taken include the implicit implementation of the Inflation Targeting Framework (ITF) since 2003, and the full-fledged ITF since 2005. This measure represents an effort to ensure monetary policy is more effective in stabilizing the rupiah amid shocks in global financial markets, as well as maintaining stability when conditions are calm. Effectiveness is very much required in the era of global financial market maturity, especially as we adopt a free foreign exchange regime with a free-floating exchange rate regime. Shocks emanating from global financial markets can quickly spread to our financial markets even in the absence of any additional shocks stemming from fundamental conditions in the domestic economy. Such contagion is rapidly reflected in the foreign exchange market in the form of exchange rate shocks, which can eventually adversely affect inflation and macroeconomic stability. Such shocks require mitigation as exchange rate and inflation instability intensifies the market risk borne by our financial system as a whole. Since its implementation, I can declare that the ITF has provided concrete results in the form of maintained macroeconomic stability over the last five years, despite significant shocks to our economy. Along with ITF implementation, headline inflation has remained within the inflation target set by the Government. Full-fledged ITF implementation since July 2005 has been marked by the use of the BI rate as the operational target for monetary policy, replacing previously used base money. The change in instruments enabled monetary policy implementation to be well monitored by market participants. The use of the BI rate has also ensured expeditious monetary policy response to influence market expectations amidst shocks; therefore, monetary policy has been more effective as a stabilization tool. Two events have epitomized this stability, namely the fuel price shocks in 2005 and the US subprime mortgage crisis mid 2007. The global oil price shock that violently shook price stability in 2005 signified a tremendous shock. Its direct effect was evidenced by headline inflation rising to 17.1% in 2005 and the exchange rate depreciated significantly. However, a strong combination of fiscal and monetary policies at that time to correct negative market expectations towards fiscal resilience in the long run and to suppress the second-round effects of fuel price shocks and exchange rate depreciation on inflation through ITF, brought macroeconomic stability back on track in 2006. Macroeconomic stabilization subsequent to the 2005 fuel price shock has also yielded positive results, where amidst escalating volatility in the financial markets, our economy expanded by 5.5% in 2006. In addition, amidst the subprime mortgage crisis last year, BI rate policy in the context of ITF also helped maintain market expectations towards macroeconomic stability in the mid to long term. With further support from the fact that our banking industry was sufficiently resilient to confront market risk and the subprime mortgage crisis, macroeconomic and financial system stability was maintained despite strong contagion at the time. Taken as a whole, this helped us maintain sustainable economic growth in 2007; surpassing 6%. In the context of preserving macroeconomic stability over the mid to long term, one advantage of ITF is that the BI rate is set in a forward looking manner and, therefore, is anticipative towards economic prospects, both in terms of price and economic growth development. This helps the central bank to periodically build upon its reputation and credibility in the market regarding its commitment to maintain macroeconomic stability. With a strong reputation and good credibility the costs that arise in maintaining economic stability are reduced and policy is more effective in achieving its target. To this end, I would like to acknowledge that the macroeconomic stability and boost in economic growth we currently enjoy is a reflection of the gain in credibility as a result of stabilization policies taken in recent years. Such a gain in credibility constitutes very precious capital to further reinforce economic stability and increase economic resilience going forward. In the context of wider macroeconomic stability, although we follow a floating exchange rate system, smoothing exchange rate fluctuations, including through supply and demand adjustments in the foreign exchange market, is still pertinent. Efforts to minimize volatility are not something that uniquely occur on our side, but are also a global phenomenon. Nearly all countries that have adopted a de jure floating exchange rate system, in practice, intervene to overcome volatility in the exchange rate, either through direct intervention in the foreign exchange market or by using open market operation instruments. Therefore, at certain times, Bank Indonesia has always maintained a presence in the foreign exchange market, especially when conditions could potentially trigger an imbalance. These measures have been able to suppress volatility, avoiding potential exchange rate instability attributable to speculative activity. In order to further reinforce its ability to overcome shocks in the financial market, Bank Indonesia over the past five years has strengthened the national foreign exchange reserve position. This step is taken as insurance against future macroeconomic instability amidst uncertainty with respect to the correction of global imbalances and resurgent cross-border capital flows. Although we follow a floating exchange rate system and free foreign exchange regime, a sufficient first line of defense is needed to help absorb shocks and thus maintain macroeconomic stability. In implementing such policy, we must ascertain that the increase of outstanding SBIs, which is the cost of strengthening foreign reserves, remains at a level Bank Indonesia’s budget can accommodate. Observation on various central banks in the region, such as the Bank of Korea, Bank of Thailand, and People’s Bank of China suggests which have taken similar steps suggests that outstanding central bank bills can decrease in due time as economic activity improves in the medium term. Table 3. Outstanding Central Bank Bills in Select Countries Bank of Thailand Bank of Korea People Bank of China Bank Indonesia CB Bills 593.5 Billion Baht 158,390 Billion Won 3,230 Billion Renmimbi 207.4 Trillion Rupiah % of GDP 8% 19% 7% 6% *) As of 2006 (except Thailand 2005) Source: CEIC,central bank web sites Meanwhile, as a second line of defense, a bilateral swap arrangement with Japan, Korea, and China was signed by Bank Indonesia under the ASEAN+3 Chiang Mai Initiatives framework. Bank Indonesia was given the responsibility to do so by the Indonesian government. This regional self-help initiative is a strategic step taken by the Ministers of Finance of the ASEAN and three industrial countries in order to maintain regional economic and financial stability. From Indonesia’s viewpoint, such arrangement could provide encouragement to terminate IMF’s Post-Program Monitoring and ensure that autonomous policy-making is maintained. 2.2.2. Initiatives in the banking sector Ladies and Gentlemen, Moving on I would like to talk from the point of view of bank policy. As in other emerging countries, the banking sector is the main sub-system of the financial system as a whole. Currently, the share of our banks within the financial system remains above 80% of total assets in the financial system. Therefore, the banks form a strategic industry with the significant role of supporting the dynamics of national economic development and growth. Until today, the intermediation function of the banking industry remains a dominant source of funding for businesses in productive sectors. Learning from past experiences, banking system stability is a primary aspect that must be maintained to ensure sustainable national economic growth. Volatility in one bank can quickly spread and affect public confidence in the banking system itself and also the economic system as a whole. Therefore, it is not excessive to say that efforts to guarantee the maintenance of banking system stability represent a serious policy priority that requires consistency in its implementation. Generally speaking, satisfactory achievements made by the banks up to the end of 2007 are not independent of strategic policies summarized in the initiatives to prevent bank crises from reoccurring and resolution initiatives should such crises reoccur. With respect to the former, two primary strategic policy initiatives include the implementation of Indonesian Banking Architecture since 2004 and the preparation towards Basel II in 2008. Meanwhile, with the respect the latter, Bank Indonesia along with the Ministry of Finance and other related institutions continues to strengthen initiatives within the national Financial System Safety Net. A. Indonesian banking architecture Ladies and Gentlemen, A few days ago was the fourth anniversary of the launch of the Indonesian Banking Architecture (API) program. Undoubtedly API has produced numerous tangible benefits in the post-crisis economy. Our national banks are currently a part of the solution for other national economic development issues. In other words, our national banking industry that was previously a hindrance to national economic development has become obsolete. Strengthening banks through the API framework has aggressively bulwarked the economy as banks currently constitute the main safeguard of financial system stability. The Indonesian financial system that has, hitherto, been dominated by banks strengthens my view that the role of banks in crisis prevention as well as maintaining macroeconomic stability remains particularly apposite. Through its six pillars, API has complemented the banking sector and its authority with instruments expected to form deep and strong foundations for further bank reinforcement and development. From the beginning it has been clear that the constraints faced by each API pillar are different, however in general, I am pleased to see that API program development has progressed according to plan and the banking industry is showing numerous signs of seriousness in supporting our reinforcement efforts. Let me briefly outline several of the most prominent achievements related to API. Banking consolidation, which began since the launch of Pillar I of API, has reached its final stage of preparation, the stage where some banks have determined their strategic future direction. As we are all aware, 2008 is the year when all commercial banks must maintain a minimum capital requirement of Rp80 billion to uphold its status as a fully-operational commercial bank. From the 128 banks in the industry, currently all of them have met the above capital requirement. We will follow-up twenty of these banks with an examination regarding to their capital addition. However, under the assumption of the banks’ good intentions, we can say that all banks have been able to meet the minimum capital requirement, and will also be able to meet the Rp100 billion capital requirement by the end of 2010. It is important for me to acknowledge this achievement as, at least to this point, the banking industry’s resilience in absorbing risks in general has increased. This is basically one of the aims of Pillar I of API. The year 2008 will also be when banks determine their future strategic steps regarding ownership of more than one bank in Indonesia under the Single Presence Policy. Consequently, I expect that the affected banks will be able to realize those steps according to the determined time line. The year 2010 will see a banking industry comprising of banks that are not only stronger in their capital structure, but also with greater focus regarding their direction and strategies. In this regard, I would also like to state that there are several followup steps that need to be and are being taken by state-owned banks. The complexity of banks whose owners are the government requires the government to make several strategic adjustments. This obviously requires time. And as such, in accordance to the issued regulation, additional time may be provided for banks with issues which are high in its complexity to ensure that the benefits obtained from the implementation the policy is optimal. Several dynamics and realities in global and national economic condition; the yet to be established tax incentives for mergers; as well as cultural differences among banks should not hinder steps to consolidation considering that this is for the greater good of the Indonesian banking industry when confronting future challenges in the era of financial globalization. Bank consolidation will create banks with greater capacity and potential to operate on a larger scale to penetrate new markets that have previously been off-limits to our national banks, such as the foreign markets of regional Asia and farther a field. In addition, large, sound banks as a result of consolidation will provide greater contributions to the country, both in the form of dividends (for government owned banks) or tax income (for all banks). It is important to note that various tax incentives implemented to promote the consolidation process will be compensated many fold by the higher income derived by the state through taxes. Higher state income could, in turn, promote the realization of numerous infrastructure projects where, again, Indonesian banks would be able to play a substantial role considering their increased capacity. The purpose of Pillar 2 of API is to enhance the quality of bank regulations and has succeeded in establishing Regional Banking Research Institutions (LPRD) in a number of chosen regions. As of now, LPRD have been established in collaboration with four regional universities, namely Andalas University in Padang, Brawijaya University in Malang, Hasanuddin University in Makassar, and the North Sumatera University in Medan. The resultant 16 research papers comprise of studies that address the necessities of each specific region. Research topics are quite varied, covering the potential of establishing new banks, customer cover, as well as the perception and the attitude of the Santri people towards sharia banks. Considering the substantial role of MSMEs in driving the economy both at a central and regional level, it is hardly surprising that each LPRD has its own research topics related to the funding and development of micro and small enterprises. To balance and anticipate the future increasing complexity in the banking world and to address the demands made by stakeholders regarding enhancing Bank Indonesia’s performance quality, some improvements in bank oversight have been undertaken. The related improvement programs, incorporated in Pillar 3 of API, are aimed at creating effective supervision and regulation referring to international standards. In order to enhance the effectiveness of bank supervision and regulation, Bank Indonesia has taken steps to intensify coordination with other supervisory institutions, reorganizing the banking sector within Bank Indonesia, refining bank supervision infrastructure support, refining the implementation of a risk-based bank supervision system, and improving the effectiveness of supervision enforcement. The form of the new Bank Indonesia supervisory organization will further support the implementation of risk-based supervision (RBS). The RBS approach demands the supervisor thoroughly and comprehensively understand the conditions and problems faced by a bank, which is then followed by another set of actions and criteria utilizing a swift and accurate process. The new shape of the Bank Indonesia supervisory organization is also designed to support the implementation of consolidated supervision enabling the supervisor to see a bank’s problem not only as a single entity but also see the existing relationships from that bank’s business group. Therefore, we have provisioned our supervisors with relevant knowledge through a continual education program for bank supervisors. Meanwhile, Pillar 4 of API which encompasses improvements to management quality and bank operations has been implemented through a risk-management certification program for bankers designed to authenticate the risk-management ability of an independent institution. Certification is based on internationally recognized standards and is crucial for Indonesian banks. Other than to standardize the ability of the Indonesian banking society, these efforts also represent one way to address the strong current of globalization. Basel II has made the banking world more convergent so that the risk management of human resources in Indonesian banks must be equal to their overseas counterparts. The enhancement of local bankers’ capabilities is also critical in welcoming the 2015 ASEAN Economic Community. Currently, over 19,000 certificates from various levels have been bestowed upon bankers who have graduated the program. However, I feel it important to remind you that no certificate can act as a substitute for a competence and integrity. This certificate is a vehicle for a banker to improve his or herself and each banker must continuously strive to prove that they deserve their certificate. Under Pillar 4 of API, Bank Indonesia has also set forth standards for Good Corporate Governance (GCG) through Bank Indonesia Regulation 2006. Due to diverse bank conditions, we have so far tolerated and given substantial leniency to banks during the early stages of policy implementation. However, beginning in 2008 it is expected that all banks have fully applied GCG principles. 2008 is the new anchor year for bank transparency to the public. This year, all banks are required to submit a self-assessment report pertaining to GCG implementation. With such transparency, it is expected that public social controls will be formed. The public will have full access to a bank’s performance and GCG implementation, which will assist them in determining which bank to entrust their savings and fund management to. I hope that the public will already be able to access a bank’s GCG report from the respective bank’s website by the middle of this year. To complete the existing bank infrastructure and contribute to improving bank risk management, Bank Indonesia is refining the Credit Information Bureau (BIK). BIK is part of Pillar 5 of API. The Credit Information Bureau was established to overcome problems of asymmetric information that often hinders the effectiveness and efficiency of bank intermediation. From a creditor’s point of view, BIK is expected to expedite the analysis process and decision-making of credit approval, help lower the risks inherent with non-performing loans, and reduce the dependency of creditors on conventional collateral as creditors are able to assess the credit reputation of their candidate debtor. From a debtor’s point of view, BIK will accelerate the time taken to obtain credit approval. Information sharing will address the problems of asymmetric information which, in turn, will significantly improve the efficiency and effectiveness of financial institution intermediation. Other than the benefits of BIK implementation I have already mentioned, BIK is also expected to trigger a positive change in debtor attitude. By accurately and thoroughly monitoring credit exposure, debtors should be motivated to service their debt more promptly to avoid damaging their personal credit history. In the future, with greater awareness on the benefits and consequences of credit history, the public should become more motivated to build a good credit history in order to help them in case they wish to apply for a loan one day. This practice has been witnessed in many countries where the credit bureau infrastructure has been around for a prolonged period. Finally, with regards to Pillar 6 of API, a program to improve customer protection and empowerment has been implemented since 2005. In improving such customer protection and empowerment, regulations have been promulgated to govern product information transparency, the use of a customer’s private data, a mechanism to address customer complaints, and provisions for alternative dispute settlement between a customer and a bank. The three regulations were issued as a Bank Indonesia response to numerous complaints and problems faced by customers in utilizing bank products and services. However, it has always been known that the dissemination of the above three regulations would not actually resolve the root of the real problem, namely the low level of public understanding regarding the characteristics of bank products and services, especially those related to risks and costs. In response to the circumstances I have outlined, Bank Indonesia launched a public education program in banking. This activity is expected to minimize the problems faced by the public related to banks. We also hope that this program can contribute in enhancing the ability of the public to better plan for their future by utilizing bank products and services accurately in the current financial globalization era. We would like public education in banking to move away from being limited by time and become a continuous national-scale program. If previously Bank Indonesia has tended to focus on establishing bank and financial system stability enabling the public to conduct business and receive an income to support their quality of life, then the current focus will provide greater attention on how the public should plan and manage their finances. Public education on bank products is also in line with efforts of financial deepening, where the public will be faced with a growing variety of investment products. Sound public understanding regarding the characteristics, use and risk of bank products and services is becoming increasingly crucial. With the above background, we have launched an education program called “Ayo ke Bank” (Let’s Go to the Bank) which will continue to 2008. We will see that the slogan does not become a meaningless catchphrase, but rather, represent the banking community’s commitment to increase the larger community’s participation in national development through the understanding and utilization of various banking products. B. Preparation for Basel II implementation Ladies and Gentlemen, Still within the context of crisis prevention, to maintain stability and improve the strength of the Indonesian bank system, four years ago Bank Indonesia set a strategic policy to adopt Basel II commencing in 2008 using the simplest approaches possible. In harmony with the Basel II implementation roadmap, the completed work program is expected to provide the foundations for effective implementation of the chosen approach in the calculation of bank capital adequacy according to Basel II. The work program comprises of Pillar 1 regarding the minimum capital requirement, Pillar 2 regarding the supervision review process, and Pillar 3 regarding market discipline under the framework of Basel II, which will be actualized through intensive discussion by the Basel II Working Group, including communication and socialization with the banking industry. Some of the achievements regarding Road Map towards Basel II are as follow. Regarding Pillar 1, in preparing regulation towards using internal model by bank in calculating capital charge for market risk, regulation has been issued regarding the Capital Adequacy Ratio (CAR) of Commercial Banks by Calculating Market Risk. In terms of credit risk, the preparation of the regulations have also been discussed by stakeholders, including the government. Some crucial issues included in Basel II that require follow-up coordination between Bank Indonesia and the government, include: (i) better defining small and medium enterprises (SME), which can be used to define retail debtors and small medium entities (SME); and (ii) a list of state-owned enterprise (BUMN) supported by the government that can be categorized as public sector entities (PSE). Still in the confines of credit risk, Bank Indonesia has also begun the recognition process for domestic ranking agencies namely PT Pefindo, PT Moody’s Indonesia and PT Fitch Rating Indonesia by applying several parameters that comprise of six detailed eligibility criteria according to Basel II. A similar process has also been applied for the preparation of regulations regarding capital charge calculations for operational risk. Further descriptions of gross income definitions and profit/loss items included in gross income have also been discussed by the working group. Pillar 2 is more oriented towards internal Bank Indonesia preparation. The work program translates into the 4 principles of Pillar 2, namely internal capital adequacy assessment process (ICAAP), supervisory review evaluation and process (SREP), CAR above minimum and early intervention into the bank supervisory system constellation. Risk-based supervision is expected to support effective and efficient Pillar 2 application. In time, Bank Indonesia will comprehensively issue consultative papers relevant to the implementation of Pillar 2. The Pillar 3 work program is aimed at enhancing the framework of bank publications and reporting according to international standards, namely international accounting standards – IAS. For this purpose, Bank Indonesia has adopted IAS 32 and IAS 39 in the form of PSAK 50 and PSAK 55 followed by the compilation of PAPI. There is also the need to enhance bank reporting, namely the commercial bank monthly report (LBU), by facilitating additional data and information required by Basel II. It is important to note that based on the quantitative impact study – QIS on systemically important banks, Bank Indonesia accepts that, generally speaking, our banks are ready to adopt BASEL II using the simplest approaches. However, we also see that eventually, Basel II implementation will not only require the readiness of the banking industry to implement better risk management including improving the quality of the capital and information system, but also require Bank Indonesia readiness to improve the quality of regulation, supervisors, the information system and practices, as well as follow-up on bank supervision. Other than the common achievements made to date, I see that in order to reach enhance banks through Basel II implementation, our attention often deviates by the perceptions or information that are not always entirely accurate regarding Basel II implementation, which in turn could be detrimental. One of the common misconceptions is that Basel II implementation for commercial banks in Indonesia will heavily burden the banks. Here I feel it necessary to reiterate the achievement for Indonesian banks in adopting Basel II is to use the simplest approach. Therefore, other than the inclusion of operational risk in their capital calculation, there is no material difference with Basel I as been practiced for some time. Another common fallacy is applied to the preparation of Basel II implementation support infrastructure. Considering the approach that must be used is the simplest one, such minimal requirements in terms of infrastructure remain well within the reach of Indonesian banks. By minimizing and separating some of the current erroneousness, we will be able to see the actual requirements of Basel II much easier. It can be said that the spirit of Basel II is the effort to continuously improve quality and the effectiveness of risk management – from banks and supervisors alike – to strengthen the overall banking system. How to achieve this Basel II spirit should have received a greater attention. Generally speaking, improving bank riskmanagement quality requires collaboration between banks and Bank Indonesia to improve the risk-management practiced by banks, improve the effectiveness of risk-based supervision by Bank Indonesia, and improve the quality of constructive dialog between the two. Such cooperation will breed a thought pattern and culture which continuously minimizes the potential of bank failures through better risk management. Therefore, we should focus our energy and minds not only on achieving tangible items, such as using various approaches to measure market, credit or operational risk, but it is more important to achieve the intangibles, such as adopting a mindset or risk-management culture that supports the spirit of Basel II. Our achievements to date are reasonably satisfying; let us now complement these achievements by nurturing an appropriate culture and mindset to fully enjoy the fruits of Basel II implementation. C. Refining coordination in line with crisis resolution Ladies and Gentlemen, Concerning crisis resolution, allow me to explain the background that led to this initiative. The economic crisis that struck Indonesia in 1997 was extremely expensive from a financial point of view and in terms of the lessons learnt. To this end, there are three primary policy responses from Bank Indonesia, namely first, efforts to recover banks and the economic system post crisis through restructuring banks; second, preventing crises in the future through strengthening the banking system, namely through IBA and Basel II implementation; and third, resolution should a crisis reoccur. To create a crisis resolution mechanism, the government established the Financial Sector Safety Net (FSSN) where Bank Indonesia is one key element. FSSN is a mechanism formed under the macro-prudential framework and has the mandate of establishing and maintaining financial system stability as well as protecting the interests of financial services users. Considering that the financial system comprises of many industries, FSSN coverage not only includes banks but also non-bank financial institutions, the capital market and payment system. For FSSN to run effectively, tight regulations and high supervision quality, a sufficient lender-of-last-resort facility, an adequate customer deposit insurance program, and concise financial crisis management procedures all play critical roles. Solid regulations and close supervision represent the first lines of defence. Coordination between all institutions involved (Bank Indonesia, Ministry of Finance and the Deposit Insurance Corporation) is a crucial factor of FSSN. Therefore, through the Financial System Stability Forum (FSSK) established last year, Bank Indonesia has and will continue to tighten coordination with all related parties. 2.2.3. Initiatives in the payment system Ladies and Gentlemen, Within the national payment system, Bank Indonesia has implemented various strategic policies to develop payment system infrastructure to become more reliable, fast, accurate, secure and effective in supporting all transactions nationwide. Such a developed payment system can contribute significantly to the maintenance of payment system stability as a whole. Failure to settle by one payment system participant could lead to serious risk, however, and disrupt the smoothness of the payment system. Such failure may also trigger contagion risk and trigger systemic disruption in the financial system, including serious disruptions to macroeconomic stability. For that reason, in managing and maintaining the smoothness of the payment system, Bank Indonesia has tried and will always endeavor to reduce various risks in the national payment system and improve its efficiency. In relation to the large value of the payment system, Bank Indonesia has continuously improved the quality of the BI-Real Time Gross Settlement (RTGS) system; implemented at year end 2000. In 2007, the BI-RTGS system, which is a real-time payment and transaction settlement system, processed an average of 33,000 transactions per day with an average daily value of Rp172 trillion Realizing the importance of the BI-RTGS system in supporting smooth payment transactions, as a systemically important payment system, we at Bank Indonesia have always strived to enhance the BI-RTGS, referring to The Core Principles for Systemically Important Payment System (CP-SIPS) issued by the Bank for International Settlements. We have also improved operational security and the reliability of the BI-RTGS system by enhancing security instruments and the overall information technology used in implementation, including improving the back-up quality and instituting a business continuity plan in case of natural disasters. Subsequently, as part of the efforts to realize an efficient, fast, secure and reliable payment system, Bank Indonesia has improved the quality of the clearing process through the development of the Bank Indonesia National Clearing System (SKNBI). SKNBI, which was implemented in July 2005, processed an average of 318,000 transactions per day in 2007 with an average daily value of Rp5.5 trillion Since SKNBI implementation, the use of credit notes to transfer funds between banks through clearing, which was deemed inefficient particularly with regard to the printing fee and processing procedure, has become obsolete and is now paperless. The implementation of paperless clearing is national, which allows participants to transfer credit to any bank office throughout Indonesia. Regarding customer protection principles, Bank Indonesia has set forth the duties and responsibilities of banks when sending transfer instructions and receiving transfers through BI-RTGS and SKNBI. The regulation principally attempts to protect the interest of the customer who sends or receives a transfer instruction, therefore the efficiency and security of the payment system is felt by the general public. The development of a non-cash payment system, especially card based payments, prompted Bank Indonesia to issue PBI No. 7/52/PBI/2005 on 28th December 2005 regarding the Implementation of a Card-based Payment System as well as several External Circulars regarding the procedures, Customer Protection and Prudential Principles, improved security, as well as supervision. In order to support the establishment of a healthy credit card industry, Bank Indonesia actively encourages the formation of a self-regulating organization (SRO) able to set the standards to be adopted in the credit card industry in Indonesia. Through the SRO, the standards set will be able to safeguard the security of credit card instruments and maintain healthy competition. In the meantime, to anticipate the public requirement for non-cash payment instruments, Bank Indonesia continues to facilitate electronic payments (e-money) and is preparing relevant policy and regulations to manage the implementation of e-money ensuring efficiency and security. Bank Indonesia is aware of the importance of developing micro-scale non-cash payment instruments to complement the existing high value and low/retail value instruments. The micro-payment instrument would be designed to serve extremely low value, high frequency payments in an expeditious manner. The must suitable micro-payment instrument to satisfy this requirement is e-money. E-money is a micro-payment instrument that constitutes a stored value facility instrument. A benefit of E-money is its ease of use; it can be recharged through various facilities provided by the issuer, such that e-money is capable of reaching all strata of the public, including those without access to the usual non-cash payment instruments offered by banks. In December 2007, as the government’s cashier administrating various government income and expense accounts, Bank Indonesia implemented the “Bank Indonesia Government – electronic Banking (BIG-eB) System” in order to provide a better service to the Government. The BIG-eB system is provided by Bank Indonesia to the Department of Finance to facilitate information exchange as well as to perform electronic and online transactions on Government Accounts which are administrated in Bank Indonesia. The facility is expected to serve the government’s treasury single account requirement and simplify the management of the government’s accounts. 2.2.4 Initiatives in the real sector Ladies and Gentlemen, Since I began speaking at forums such as this evening’s there have been several fundamental issues that represent the primary focus of Bank Indonesia in fulfilling its duty as a state institution and central bank. One thing that is institutionally cemented to nearly all central banks in the world is the vital function of maintaining national macroeconomic stability. This function provides operational room for the central bank but is limited by the instruments it has at its disposal. A central bank cannot directly move beyond these borders since it lacks the necessary instruments and also because it has no intention of doing so. However, real sector performance remains the key focus of a central bank, especially since unhealthy growth in the real sector can disrupt economic stability, which is the focus of a central bank. Therefore, to continuously follow the performance of all economic sectors in Indonesia is an integral part of the central bank’s duty. Furthermore, the central bank must, from time to time, provide appropriate signals regarding upcoming issues to be aware of, and also contribute to micro-structural efforts to improve real sector conditions. This is necessary considering that each time the central bank institutes a policy to maintain national economic stability all sectors are affected by that policy, either directly or indirectly. Thus, it would be unwise for the central bank not to take a more sensitive approach to ongoing economic and social developments that may trigger widespread effects on the longterm stability of our economy. As such, it would be imprudent for the central bank to be mechanical and bureaucratic in its approach to developments in the economy. Consequently, Bank Indonesia has taken direct steps to invigorate the real sector without violating its mandate as the guardian of stability, not only in advancing Bank Indonesia’s role in policy advisory but also facilitating role to strengthen bank’s intermediation function. In terms of policy advisory, in the middle of last year, Bank Indonesia launched a multi-year work program, namely Bank Indonesia Regional Office Reorientation. This step was taken to allow Bank Indonesia’s regional offices (KBI) to be more proactive in observing economic and social development throughout the nation, as well as building strategic partnerships with local governments. Meanwhile, as a facilitator to expedite economic development Bank Indonesia has initiated Small Medium Scale Enterprise (SMSE) cluster pilot project program and established a task force, named “Tim Fasilitasi Percepatan Pemberdayaan Ekonomi Daerah” (TFPPED), that provides technical assistance to SMSE. The team was formed to help expedite regional “grass root” economic development by improving the commercial bank’s intermediation function. In time, this Task Force will unify with the duties of Bank Indonesia’s regional offices. The team members consist of heads of local government, Bank Indonesia (central and regional), banks, associations and institutions or other related institutions. As a pilot project, TFPPED has been established in eight Bank Indonesia’ regional offices: Bandung, Medan, Manado, Cirebon, Pontianak, Jambi, Kupang and Purwokerto. Another initiative taken to facilitate bank intermediation includes the implementation of Indonesian Business Information Data (DIBI). DIBI has been introduced to reduce asymmetric information between banks and the real sector, which we suspect as one of several causes of the sub-optimal bank intermediation function. The design of information architecture developed in DIBI is expected to serve the information requirement of banks and MSME economic players in many regions of Indonesia. For MSME economic players, we expect DIBI to broaden their knowledge range not only to generate new ideas for business opportunities but also to serve the needs of business expansion. Whereas for banks, DIBI is expected to encourage creativity in credit extension. To begin, the design of the information architecture in DIBI was adjusted to the information resources currently available in Bank Indonesia, including regional economic reviews which are conducted periodically. We strive to ensure that the macro and micro information presented strongly correlates and is germane with the needs MSME economic players, either directly or indirectly. According to its purpose, future DIBI development will be directed towards presenting more micro-business related data and information. On top of rolling out initiatives as part of its future routine duties, Bank Indonesia has also taken a comprehensive range of strategic measures together with the Government in directing the activities of Bank Indonesia’s subsidiary companies that must be divested prior to 2009. Through the Askrindo divestment, Bank Indonesia’s stake in the company has declined from 55% to about 25% following a capital deposit by the Government of Rp850 billion. The capital deposit by the Government to Askrindo has substantially helped overcome the constraints associated with the prevailing high business risk perceived by the banking community. With such additional capital, Askrindo’s ability to insure credit extended by banks has increased. On 5 November 2007, the Government launched a credit program for activities of the poor (KUR), which is distributed through banks and insured by Askrindo. PT Bahana Pembinaan Usaha Indonesia (BPUI) continues to contribute significantly in terms of providing financing and business opportunities to MSMEs. Through its subsidiary company, PT Bahana Artha Ventura (BAV), there are currently over 90 thousand MSME players that receive financing and assistance. Despite the constraints connected with the limited capital currently faced by BPUI due to the delay in converting the government’s Investment Fund Account debt into capital, the latest BAV business plan includes arrangements to continue extending business financing to MSMEs, which is projected could potentially reach about 275 thousands MSMEs by 2012. This credit extension to MSMEs is projected to create around 2,5 million new jobs. III. Future economic challenges and prospects 1. Future economic challenges Ladies and Gentlemen, The strategic initiatives introduced by Bank Indonesia since 2003 and up to the end of 2007, as I have discussed so far are far from complete. We still have much outstanding homework left to attend to further strengthen financial system resilience to confront the challenges of tomorrow. Some of the challenges I have addressed that we face imminently will continue over the next five years with higher intensity. In addition, further challenges loom on the horizon, which require anticipative measures to be taken post-haste. In the context of such challenges I would like to reiterate that we cannot and should not take for granted continues financial system stability into the future. Such an assumption could leave us vulnerable in a comfort zone that shatters our ability to adapt and anticipate problems. Therefore, allow me to continue this discussion by outlining my views on the challenges facing our economy and financial system, which require the diligence of all relevant parties to anticipate and subsequently further strengthen financial system stability and ensure the continuation of economic achievements into 2008 and beyond. 1.1. Changes in the global financial market Ladies and Gentlemen, An increasingly imminent challenge which lies before us is the changes taking place in the world financial system. If we fail to respond to these changes by strengthening our efforts in maintaining financial system stability, the potential of a crisis reoccurring will increase. These changes have taken place since at least the 1980s but are increasing in their intensity with the rapid development of information technology. We can now witness very rapid changes in derivative instruments and structured finance instruments. The innovations and developments of such instruments increase the complexity and financial transactional links. Such changes are also supported by increasing levels of excess liquidity in the global financial market and the increased demand for variations in financial instruments, given different consumers’ risk profiles. Consequently, there is a blurring of financial intermediation roles between the traditional banks and non-bank market players. It is observed that the banking industry tends to distant itself from relationship lending practices and lean towards asset securitization strategies in its efforts to transfer risks by trading instruments repackaged to be traded in the secondary market. We also see tighter integration between international financial markets, which is reflected by a higher volume of cross-border financial flows. Greater integration between the markets is supported by the emergence of new players, that operate across borders and are owned privately, such as hedge funds, or those that are the subsidiary company of state-owned institutions, such as sovereign wealth funds. Other factors adding to cross-border financial flows include asset portfolio management by pension companies as well as insurance companies from large nations, and the re-emergence of leveraged buy-outs by private equity companies. Changes in the global financial market have swelled global excess liquidity, exacerbated by more varied sources of liquidity for funding, cheaper financing cost as a result of a permanent decline in global inflation over the last decade, and the emergence of new growth centers that support wealth creation of the growing middle-class (“new money”) in the global economy, especially in emerging countries. With its free foreign exchange regime, changes in the global financial system and increased global excess liquidity have made our domestic financial system appear shallow, with instruments limited to mainly shares, SUN and SBI. Problems then arise as, despite its lack of depth, our financial market in the past few years have provided yields that attract shortterm investors. In the stock market, such attractive yields are supported by increasing corporate profit prospects, IPOs, and macroeconomic stability. Meanwhile, differences in productivity between developed countries and us have created a spread in interest rates. Such spreads tend to attract portfolio investments into our financial market through carry trades in stocks or risk free instruments, such as SUN and SBI. Although short-term capital inflows are useful to meet the short-term national financial requirement, they are also very volatile and vulnerable to sudden reversal. This is because they are sensitive to the changes in expectations and are often associated with irrational behaviour. Sensitivity to expectations is currently clearly evidenced by the sensitivity of the rupiah towards changes in the risk appetite of global investors towards US-Dollar denominated debt instruments issued by developed countries, including Indonesia, through the global financial market. In the last two years, we have observed an improving positive relationship between the value of the rupiah and EMBIG spread fluctuations (Graph 4). This is a challenge in itself for the management of rupiah stability by Bank Indonesia. Meanwhile, short-term capital inflows can also send the wrong signals about the fundamental condition of the rupiah. As a result the exchange rate can suffer serious misalignment that attracts speculation if not addressed appropriately. Graph 4. Rupiah Sensitivity to EMBIG Spread It would seem obvious that what I have outlined so far implies that maintaining macroeconomic stability is clearly one of the supporting pillars of overall financial system stability. High uncertainty has made the task of monetary policy more complex. Meanwhile, although preferred by speculators, exchange rate volatility could trigger adverse effects on inflation expectation through pass-through effects. Excessive exchange rate volatility also can affect the balance sheet of corporations and financial institutions, especially when outstanding liabilities in foreign denomination are not hedged. Furthermore, exchange rate volatility can disrupt international trade activity due to capacity limitations affecting either the exporter or importer when adjusting to changes in the exchange rate. Additionally, when the Government also has foreign-denominated liabilities, for example in Indonesia, exchange rate volatility can disrupt market valuation for SUN as well as fiscal sustainability. Therefore, from a macroeconomic management point of view, our exchange rate policy in the overall framework of monetary policy requires special attention. We at Bank Indonesia accept that the measured intervention policies we take to smooth exchange rate volatility, without imposing a specific level, is consistent with our focus on rupiah stability in the mid to long term. I would like to restate that Bank Indonesia policy for exchange rate volatility, be it through a measured intervention policy, BI rate interest rate policy, or prudential banking policy, to date remains effective. However in future, Bank Indonesia is aware of the need to improve the OMO mechanism and short-term money market infrastructure, which will improve the contour of the yield curve in our financial system. I will revisit this topic at the end of my speech this evening. As for the resilience of the banking system as the other pillar of financial system stability, I can say that extensive stress testing performed by Bank Indonesia has categorically shown that our banks are able to overcome market risk related to macro instability. However, we need to further reinforce the resilience of the banking industry because bank overconfidence can easily overstretch activity. Bank Indonesia would like to avoid this in the future. 1.2. Changes in the global commodities market Ladies and Gentlemen, Another challenge that will shape the Indonesian economy of the future is more severe turbulence in the commodities market, which also stems from the external sector. Three important factors require cautious observation, namely structural changes in the global energy market, international food prices and the effects of global warming. These three factors are inter-connected and, if not carefully addressed, could have an adverse impact on domestic economic growth. In the last few years, commodity prices, especially the global oil price, has experienced a significant surge. Fundamentally, oil price hikes reflect a rise in demand amidst contracted production. Although demand for fossil-based fuels from OECD countries, such as the US, Europe and Japan has tended to be lower due to the warmer winter in the northern hemisphere as a result of global warming, we have observed a structural change in the energy market. The changes have arisen because of the significant rise in demand from China, India and other developing countries, along with the rise in their economic activity. Conversely, global oil production has tended to stagnate. The global race to provide alternative energy sources has triggered soaring international food prices. In the first eight months of 2007, average international food prices – especially corn, wheat and soybean – rose by up to 10.5%. Biofuel production has been blamed as one of the reasons for the price hikes. Biofuel has raised the demand for corn and soybean. The global oil price hikes have provided the impetus for biofuel production. In emerging countries, the rise in global food prices could have serious negative impacts and trigger a direct or indirect rise in the cost of living through inflation of non-food prices. The transmission of food price hikes to non-food prices will be more significantly felt in emerging countries than the developed world because of the high portion the food basket holds in the household expenses of families in emerging countries. Moreover, the effect of extreme weather changes related to global warming is also promoting a rise in international food prices. To illustrate my point, the 2006 drought in Australia decimated wheat production by up to 60%. Experts predict that the effects of global warming will not only place additional pressures global food production but also threaten global harmony, such as by rising sea levels due to the melting polar caps, changes in sea currents and worsening droughts in many countries. For us in developing countries, these threats are extremely serious because they directly relate to the ability of underprivileged peoples to deal with shocks and natural disaster. We are aware that global warming is a reflection of global externality where the negative impacts do not stem from current trends but from an accumulation of past and future events. As a result, it is our future generations that will feel the full brunt of the negative impacts brought about by global warming. 1.3. Social-economic exclusion Ladies and Gentlemen, If we reflect back on the economic crisis we endured 10 years ago, it would be fair to claim that the crisis caused significant social-economic exclusion for many Indonesians. The exclusion occurred due to income redistribution and, of course, a sudden redistribution of economic-political power as the crisis hit. The exclusion faced by those who were already poor and those who became poor as a direct result of the crisis is not theatrical but extremely real. The ultimate effects of this redistribution still suffocate the lower strata of the socialeconomic pyramid to this day. Widening income disparity, decreasing human development quality and increasing informality combined with no social protection in the labor market, when compared to the precrisis era, are Asian crisis excesses for which improvements we continue to strive. Therefore, Bank Indonesia gratefully welcomes the current efforts being undertaken to expedite improvements in all forms of public social-economic prosperity. This acceleration is indeed necessary. In the present economic globalization era, rapid resolution of the social exclusion problems is demanded by our human worth. Social exclusion causes asymmetry to both groups in the social economic pyramid when addressing economic shocks. Meanwhile, as I mentioned earlier, our economy in the future will also face greater volatility regarding the exchange rate as a result of cross-border capital flows and rising food supply prices due to structural changes in the global economy. Vulnerability to shocks is compounding the already difficult situation the underprivileged find themselves in, whereas wealthier members of society are lucky to have a cushion and can therefore adjust better. This kind of gap disrupts our human worth. Such a contrasting gap eventually has the potential to provide negative feed-back on the continuity of our current economic achievements. The negative feed-back may arise mainly due to the poverty trap and a trickle up economy. In other words, the potential exists for the emergence of rogue elements in our economy. This would certainly restrict our process in continuing the many positive achievements made to the end of 2007. Meanwhile, a burgeoning socio-economic gap will also impede our attempts to confront the already very real challenges ahead, namely the establishment of 2015 ASEAN Economic Society. Lackluster public socio-economic prosperity could trigger adverse follow-through effects for our nation in the era of economic integration. The competitiveness of our economy will drop below that of its peer-group due to incomparable production factor total productivity, a contracted domestic market and a lack of interest from the business community to expand production capacity. We will then become less compatible for other countries to establish joint collaboration, therefore, on the one side we fail to take any benefits of globalization and on the other side we only receive the negative effects. The views I am trying to put across to you all this evening imply the importance of adjusting the way we view our priority scale to improve the various positive achievements already made. Amidst an external environment that could trigger serious challenges and a domestic environment that is becoming more integrated in line with globalization, numerous issues related to economic competitiveness should motivate us to redouble our existing achievements. However, in improving our economic competitiveness, we must not neglect the social inclusion of all our nation’s citizens. Any established competitiveness will be unsustainable without such empathy, as competitiveness does not provide any meaning to the social contract that we base our lives upon. Ladies and Gentlemen, In relation to the social exclusion issue as I have mentioned, we are challenged to improve the social-economic condition of small farmers and laborers in the agricultural sector, which make up the majority of workers in our economy. The agricultural sector has not been able to bring prosperity for the small farmers and can bring the whole economy into a prolonged stagnation. Meanwhile, from the perspective of national resilience, the agricultural sector cannot support sustainability in food supply and also cannot be expected to absorb employment. Externalities in the form of potential poverty traps and persistent inflation in food prices are felt in rural areas as well as cities. This is a concern for Bank Indonesia. Aside of that, we are faced with the paradox of growth phenomenon. Such phenomenon exists as there is a tendency of businesses to utilize more capital than labor. The preferences of these businesses are rational. National and global excess liquidity has brought the cost of capital to relatively low levels while much challenge remains within the labor market. Taken from a global perspective, such phenomena is one of global capitalism and free competition which requires businesses to increase their competitiveness to capture market share. A method to achieve efficiency is by exchanging low skilled workers with capital-intensive machinery or capital. Such technology switching will become more common in the future with increasingly sophisticated innovations in production technology. For us in an emerging country, this phenomenon requires greater attention, especially since growth in the manufacturing sector has slowed in the post-crisis era compared to pre crisis. Manufacturing sector growth in the pre-crisis era was 11.7% on average (1994-1997), whereas post crisis it has dropped to 5.2% (2003-2007). A downturn in the manufacturing industry has increased the role of the non-tradables sector. However, growth in the nontradables sector is currently supported by lower added-value activities. Despite the positive impact of such growth in the form of less exchange-rate pass-through to inflation, the negative impacts include lower added-value for the economy as a whole. The negative effects have also slowed growth in public income on average in the post-crisis era and reduced private consumption growth to a level below that of the pre-crisis period. To address this paradox of growth we need to ensure that the emerging added-value emanating from technological advancement does not focus on a select portion of the population. We will also have to be more sensitive to the requirement for a transparent, efficient and accurate redistributive income policy, which ensures that the benefits are shared with those considered left behind socio-economically. Moreover, policy incentives to develop and strengthen the growth of labor-intensive micro, small and medium enterprise, particularly in the non-farm sectors in rural villages, need to be considered. This will provide a safety net for the public should shocks undermine the economy. 1.4. Persistent inflation Ladies and Gentlemen, Another challenge we face together is the rigidity of our inflation rate, which seems to begrudge a decline. Many reasons exist to motivate us to immediately address this challenge with unbroken commitment. One of them is that with permanently lower and more congruent inflation towards the inflation rates of trading partners, our macroeconomic fundamentals and balance of payments will improve. However for Bank Indonesia the drive towards permanently lower inflation is to dissipate pressures stemming from social exclusion. Low inflation will preserve the continuity of purchasing power, especially for the underprivileged, whose numbers are immense in our country, while also helping to achieve better quality of economic development for everybody. We know that a rise in the number of the poor can be attributable to a rise in inflation because a rise in inflation signals an erosion of public purchasing power, given the low growth in nominal income. Nevertheless, high inflation will also widen the income disparity gap due to asymmetries between the rich and poor when addressing price inflation. Graph 5. Inflation Indicators I must add, however, that to permanently lower inflation is not a trivial task by any stretch of the imagination, especially in Indonesia. Our headline inflation rate is highly affected by volatile food inflation, which is persistent in nature. Persistent in this regards means that every time a shock occurs, inflation of this group tends to take a long time to return to its initial rate. As I have shown in Graph 5, it can be seen that although headline inflation has returned to “normal” subsequent to the 2005 shocks, volatile food inflation remains persistently high. Many hypotheses have been proffered regarding the source of such persistence. One that is often put forward is that the persistence arises because of inefficiencies due to imperfections in the food commodity distribution market. Several hypothetical factors have been offered that could trigger these imperfections such as the underdevelopment of markets in relation to: (a) provision of logistics, transport and transportation infrastructure for food; (b) the management of perishable goods by the producers; and (c) the supply of symmetrical information for the suppliers, middlemen and retailers. Another hypothesis often suggested are distortions triggered by policies that favour certain market players so that oligopsony and oligopolistic practices as well as rent-seeking activity arise in the distribution market. If we assume that these hypotheses are valid, then the persistence of food price inflation is a microeconomic phenomenon. This implicates the relevancy of monetary policy as a direct control instrument for food inflation, and suggests the importance of a deeper microeconomic review with regards the food distribution market nationwide, so as to enable us to formulate and implement more effective policies. We should also be motivated by the fact that over the last four years disparity has appeared in regional headline inflation. As illustrated in Graph 6, over the last four years 34 cities out of the 45 surveyed by BPS show a headline inflation rate above the national rate. Graph 6. Regional Disparity of CPI Inflation Our headline inflation rate also seems to follow a long-term trend, or core inflation, that is rigid and difficult to bring down (sticky inflation). Data shows that since 1990, our lowest inflation ever recorded was 5% during a brief period before the crisis, namely between Quarter III/1996 and Quarter II/1997, and then also between Quarter IV/2003 and Quarter I/2004. Meanwhile, our research shows that during the current post-crisis era inflation has remained persistently high at around 5% annually. This situation beckons the next question of what is the lowest inflation rate we can expect to achieve over the mid to long term? Is it possible to achieve permanent inflation in the rage of 2% to 3% annually such as our trading partner countries? Are there any specific characteristics of our economy that keep our inflation rate permanently higher than that of our primary trading partners? I believe that the steep difference between our inflation and that of our trading partners is closely related to the formation of public expectations that tends to look to the past at a time when our inflation rate never fell permanently below 5% on average. There are yet more hypotheses that can explain this. First is that monetary policy still has room to further increase its credibility. Since ITF implementation there have been signs that the average core inflation rate, whose movement is highly affected by monetary policy credibility, has shown a declining average since 2003, towards a rate significantly below pre-crisis levels. A linear trend of core inflation since 2003 is recorded at 7% annually; meanwhile the similar trend from 1992-1997 is recorded at 8.50%. This means that since ITF implementation there has been long-term declining trend in core inflation of 1.5 percentage points. I feel certain that in future consistent ITF implementation will improve monetary policy credibility further and subsequently bring down the long-term trend of core inflation permanently. Second, the reduction of core inflation is hindered by the abundant room for improvements in the productivity and efficiency of the economy as a whole. Improvements will affect microeconomic aspects that form the core inflation rate, especially improvements to economic capacity in terms of product supply and services. Through continuous capacity improvements, demand pressure on products and services will be absorbed avoiding inflationary pressures on the economy. Market players that deal with the supply and distribution of products and services on a daily basis will rapidly observe such improvements and apportion them in their future price adjustment plans. The resultant positive expectations will further help reduce core inflation to a level that is permanently lower. The close relationship between the inflation rate and economic productivity and efficiency implies that a disinflation policy needs to be implemented by consistently complying with the principles of gradualism and balance. Overly tight monetary policy amidst rather low economic productivity and inefficiency can lead to recession. Meanwhile, too loose monetary policy amidst low productivity and inefficiency can turn the economy inflationary and not propoor. The subsequent inflation will erode the purchasing power of the poor, which will widen the socio-economic gap. Meanwhile, the tight correlation between the inflation rate and structural aspects implies that to successfully undertake a credible disinflation process requires thorough and integrated coordination between all institutions in the Government including Bank Indonesia. Generally speaking, such coordination can be conducted by dividing policy direction into three major parts. First is to continuously maintain internal and external rupiah stability through preemptive and prudential monetary principles as well as policies for the money market, banks and the payment system that strive to buttress financial system stability. This first policy direction is the responsibility of Bank Indonesia and is aimed at dissipating instability risk in the financial sector that can disrupt rupiah stability. Second is to maintain fiscal resiliency and sustainability in the long run to prevent the emergence of fiscal domination that could adversely impact the expectations of SUN investors towards the prospects of future inflation. This then can disrupt and hamper monetary policy effectiveness in maintaining macroeconomic stability as a whole. Third is to improve the structure and infrastructure of the food distribution market and increase the efficiency and productivity of the economy as a whole. 1.5. Regional competitiveness in the era of regional autonomy and globalization Ladies and Gentlemen, Yet another future challenge we face is regional competitiveness in the era of regional autonomy and globalization. The World Economic Forum (WEF) reported in their 2006-2007 “Global Competitiveness Report” that Indonesian competitiveness ranks 50th out of 125 countries; compared to 69th out of 107 countries in the previous year. Despite the obvious improvement that has taken place, Indonesia is still considered among the least competitive countries in the Asian region. Indonesian competitiveness continues to languish behind Singapore (ranked 5th), Japan (7th), Malaysia (26th), Thailand (35th) and India (43rd). Meanwhile, based on an International Institute for Management Development (IMD) report in the World Competitiveness Yearbook 2007, Indonesian competitiveness was ranked among the two lowest countries surveyed, namely Indonesia ranked 54th, whereas Venezuela ranked 55th out of the 55 countries sampled. As appears to be common knowledge, increasing economic globalization has made competition amongst countries even tighter. On top of this, tighter global competition directly affects the regional economy, especially in the era of regional autonomy and fiscal decentralization. Consequently, the need has arisen for each region in Indonesia to improve their competitiveness. Furthermore, tight competition among the regions of Indonesia forms the “spear head” for the improvement of national competitiveness amidst the growing desire to compete globally. This has left me wondering about the overall picture of competitiveness in each region in the country today. We can observe that based on overall competitiveness, about 65% of municipalities in Indonesia remain below the national average, whereas only 17% have actually exceeded the national average. This indicates a significant distortion in economic growth in municipalities across Indonesia. The regional economy still requires improvements in primary infrastructure quality, as well as business expansion to absorb excess labor and improve labor quality. Meanwhile, regions struggling with low competitiveness are often characterized by an agricultural sector that does not relate to the region’s primary economic sector, as well as insignificant private sector funding. As a result, we currently face the challenge of improving regional economic competitiveness. To confront this challenge we must not neglect the escalating political-economic relevance of the ever emerging local governments, which tend to be highly location specific. This provides insight that the uniform engineering of economic and social growth on a national scale is irrelevant at the local level. We therefore need to formulate methods to solve the national problem based on the idiosyncrasies of local wisdom buried in heterogeneity. This is a challenge in its own right for a nation that has always thought in terms of monolithic uniformity. Such an objective fact sends a message to all policymakers to deconstruct and then reconstruct the meaning and role of overall national growth. 1.6. Preserving cultural capital in the globalization era Ladies and Gentlemen, With regards to our efforts to adapt to globalization, we are also required to seek and build an appropriate cultural spirit for economic growth from the diversity of our nation. Economic growth is merely a reflection and consequence of the cultural spirit entrenched in a country. The continuity of our cultural spirit to address the variety and multi-faceted socio-cultural aspects of our economic regions will determine our achievements in economic growth and the restoration of competitiveness in the future. It is necessary to comprehend that development through the transformation of the economy, social and political, in its entirety is very much affected by human factors and cultural richness. In the lesser context of economic growth, over two decades ago Soedjatmoko informed us that economic growth demands not merely the presence of formal institutions and technocratic skills but also cultural factors such as certain norms and social capital that support economic development. However, in a wider context of development, diversity in culture plays a fundamental role in developing good for humankind. In every culture lies the collective memory of a nation. Upon entering the labyrinth of that collective memory each individual will remember, forget, reconstruct, redefine his views and even build a new view for the continuity of common cultural advancement. In that process, cultural diversity can become the instrument that opens the door to world-view enrichment. Such enrichment through exchange can result in not only abstract matters such as world views and philosophical speculation, but also practical matters such as the discovery of traditional medicines that have been discovered through local wisdom for centuries. This goes to show the importance of cultural work to ensure our nationality continues to possess a rich and colorful cultural mosaic. However, confronting the upcoming challenges will be immense, especially due to the strong undercurrent of global culture homogenization that tends to form a uniform world view, i.e. the world of commercial consumer based on the most fleeting of cultures in the west. The challenge for us becomes one that is daunting as the homogenization process appears seductive to our subliminal perceptions with its impacts to the local culture being gradual at best. Without us knowing, we have become part of a huge market comprising of those who are very consumptive and dominated by industrialization. 2. Future economic prospects Ladies and Gentlemen, The panoply of future challenges does not inherently imply that our prospective economic achievements will lose their passion. I believe that the current trend of optimism, where the economy is running on both engines, can be maintained into the future. To me a vital reason for this optimism is that our democracy is already consolidated, therefore, we have confidence in the effectiveness of our government in delivering results. Furthermore, our bureaucratic tools will be even more effective despite us hosting one of the largest democratic events in Asia next year, namely the 2009 Indonesian direct election. I have also witnessed myself that the ongoing efforts to address the remaining structural constraints in our economy have been up-scaled. This represents a rational step for our incumbent government since it nurtures even greater tangible benefits for the people that support a free and open democratic system. The second reason for my optimism is the availability of stable economic condition and robust macroeconomic resilience currently within our grasp. This resilience is briefly illustrated in Table 5 and will become the trigger of better and sustainable economic expansion over the next two years despite strong external challenges in the financial market and global commodity market in the form of oil price hikes and soaring global food prices. On the whole, projections of future economic growth compiled by Bank Indonesia are as follows. We expect economic growth to continue to rise through 2009 and will gradually reach 7% annually. Economic growth will primarily be supported by an increase in economic capacity in line with the BoP surplus, a stable exchange rate, and a reduction in inflation. Strong BoP performance will be supported by several factors. From a current account perspective, the performance of our non oil and gas exports will remain strong due to diversification in export destination countries and strong global demand for primary commodities relating to alternative energy. In terms of the capital account, portfolio investment flows, especially for equities, will remain robust along with numerous IPOs and high expectations for corporate profits in Indonesia. Several prominent facts that I have gleaned from the global financial community also indicate a large global investor appetite for capital investment in Asian emerging market countries, especially due to prevailing high global excess liquidity. Regarding the net remittance from Indonesian migrant laborers, I expect that in the future income transfer will remain strong and steady, representing substantial capital inflows to Indonesia. BoP performance, taken as a whole, will support Bank Indonesia in taking the necessary steps to maintain rupiah stability. We will continue our ongoing measured foreign exchange intervention policies to smooth out volatility in the exchange rate, without imposing a specific level. We are also aware that our policy to maintain adequate foreign exchange reserves must remain consistent by maintaining macroeconomic stability in the long run. We at Bank Indonesia are clear that maintaining a stable exchange rate and nurturing a favorable climate so as to strike a balance between internal and external balance are pre-requisites to further reduce price sensitivity to exchange rate fluctuations. By lowering the exchange rate passthrough effects, core inflation, which is the mid to long term trend of headline inflation, will be preserved at a consistent rate approaching the inflation targets. We see that the ex-ante inflation targets up to 2010 are not impossible to achieve, namely 5 +1% in 2008, 4.5 +1% in 2009, and 4 +1% in 2010. This disinflation trend will further bring our inflation rate closer to that of our trading partners, which on average is within the range of 2-3% annually. The achievement of inflation targets will be supported by the following policy mix. On the fiscal side, the fiscal authority will continuously strive to improve fiscal sustainability amidst the oil price shocks and future global uncertainty. To this end, the 9 steps announced to safeguard the budget formulated last year will constitute the initial guidelines for market players regarding fiscal resilience. Meanwhile, as part of a thorough anti-inflation policy, all government ministries and agencies related to the control of food inflation will take measures to lower its rate and ease its persistence. Table 4. Indicators of Financial System and Macroeconomic Resiliency Indicators Forecast: 2008 Macroeconomy Macroeconomic condition in 2007 was more resilient than that in 2006, with CPI inflation kept in check, stable rupiah exchange rate, increased foreign reserves, lower debt ratio and maintained fiscal sustainability CPI Inflation Rupiah Exchange Rate Foreign Reserves Debt to GDP Short-term debt to foreign reservesratio Primary Balance 6.6% yoy Appreciated by 5.96%, with volatility of 3.79% 6.6% yoy 5% + 1% Appreciated by 0.29%, with volatility of Rupiah exchange rate slightly 1.37% depreciates asa result of rising import in tandem with increasing economic activities Dec‘ 06 = USD42.6 Billi on, equivalent to Dec‘ 07 = USD57 Billion, equivalent to 5.7 USD 72.9 Billion 4.5 monthsof import and government monthsof import andgovernment foreign foreign debt repayment debt repayment 35.3% Oct 2007 = 33% 70.1% 52.4% Surplus: 1.4% of GDP Surplus: 0.7% of GDP Banking Industry Banking industry’s resiliency strengthened, demonstrated by increase in capital, improvement in quality of credit, rise in profit a enhancement of risk management Main indicatorsof performance CAR= 20.47%, NPL Gross= 6.98% (NPL Net = 3.63%), ROA = 2.60% Credit growth 14,1% with LDRof 64.7% CAR= 19.82%, NPL Gross= 5.63% (NPL Net = 2.49%), ROA = 2.80% (Oct 2007) 23.1% with LDRof 69.0% (Oct 2007) NPL Gross : 5.11% 24% with LDR of 72.0% Capital Market Capital Market’sresiliency improved, asmarket capitalization, volume and frequencyof transaction continued to grow Liquidi ty in Capital Market Market Capitalization = 45% of GDP Avg. vol of Bond Trading = IDR3.3 trillion a day, freq. of bond trading= 146.7 times NAV of mutual fund = IDR50.87 trillion Market capitalization = 49% of GDP Avg. vol of Bond Trading = IDR5.8 trillion a day, freq. of bond trading= 253.4 times NAV of mutual fund = IDR90.4 trillion Monetary policy will contribute significantly through the preservation of exchange rate stability, which is to become a key policy. Moreover, through the BI rate policy under the inflation targeting framework, Bank Indonesia will continually maintain a consistent monetary policy stance to achieve the inflation targets set ex-ante. From time to time, we will compare how far the BI rate stance complies with the forward-looking expectations that we form through Bank Indonesia projections and surveys of inflation expectations. We will also take policy steps to reinforce financial system stability in order to reduce the potential of global financial market shocks affecting the domestic foreign exchange market. To strengthen the financial system Bank Indonesia will take strategic steps, for example through domestic financial market deepening, and further improve the performance and resilience of the banking industry. I will elaborate on these steps further in the final part of my speech this evening. The proposed low inflation rate will help support the development of permanent income, therefore strengthening purchasing power, especially in the middle to low income group. Supported by further improvements in MDG indicators, stronger purchasing power will become more permanent in nature and subsequently broaden the consumption base of the domestic economy. Provisions and improvements to primary infrastructure, bank credit, adequate energy supply and wider access to entrepreneurship will boost domestic market capacity. This will then become a catalyst for national production capacity expansion through FDI and domestic investment in both the corporate and MSME sectors. A rise in continuous investment will further push Indonesia towards investment grade status. IV. Strengthening stability, safeguarding development Ladies and Gentlemen, All of the predictions I have just outlined are highly dependent on the assumption that financial system stability as a whole is maintained over the next two years. This assumption in many cases is reliant on policy initiatives instituted by Bank Indonesia relating to the three pillars of stability. Therefore, in the following section, allow me to present several views on the steps that need to be taken by Bank Indonesia to strengthen stability and subsequently safeguard our current economic progress. The realization of three robust pillars of stability in the national economy requires knowledge and patience in making adjustments, which in the long term will improve the effectiveness of various policy initiatives and programs. Adjustments made in the short term sometimes encourage our stakeholders to question the credibility, and even the continuity of policy initiatives we introduce ex-ante. There are a few gloomy moments on our path towards stability, however, there are also many bright days where the stakeholders finally comprehend that ex-post adjustments do not mean a lack of commitment to achieve what we have announced ex-ante. To characterize Bank Indonesia’s policy initiative management over the last five years I would use two keywords: gradualism and balancing. Within the two keywords, there is an understanding that the management of policy initiatives and programs cannot merely be rulebased. It is sometimes necessary to be discretionary when changes in the strategic environment and in the economic constraints occur. Nevertheless, when implementing discretionary policy, we do not entirely abandon the merit of being guided by some rules so as to ensure we stay congruent with our mandates to strengthen the three pillars of stability. Against this backdrop, our freedom and creativity in implementing policy adjustments will always be a measured discretion. I feel this needs to be reiterated to banish any doubt in Bank Indonesia’s commitment to continually provide three pillars of stability that form the preconditions and elements of continuity for sustainable economic development. Therefore, in the short term we will continue and complete, post haste, our outstanding homework. However, in anticipation of the numerous future constraints we face, there are several new policy initiatives that I deem necessary to be taken in the monetary sector as well as banks, the payment system and the real sector. 1. Initiatives in the monetary sector Ladies and Gentlemen, In the monetary sector, Bank Indonesia will introduce initiatives to mitigate the challenges thrown on us by financial globalization, while preparing monetary policy to conform to AEC 2015. The initiatives are divided into three key groups: initiatives to develop the domestic financial market, initiatives to strengthen monetary policy effectiveness, and initiatives to improve policy tools for AEC 2015. 1.1. Domestic financial market development Currently we can see that the domestic financial market has developed very rapidly, particularly the Government Debt Instrument (SUN) market. In future, the role of the domestic financial market will become more significant, in ensuring monetary policy effectiveness as well as maintaining economic stability in a broader sense. If we look further, challenges related to financial globalization, as I mentioned before, have a greater potential to disrupt our domestic economy. This has been very discernible lately with respect to the global financial market crisis stemming from the collapse of the low-quality household sector, or subprime mortgages, in the US. Although to this point the impact on our domestic financial market remains contained, this crisis proves the importance of a stronger, deeper and more liquid financial market so that potential disturbances emanating from external factors can be minimized. Considering these factors, it is important that we enrich the instruments and types of transaction used in implementing monetary policy. This includes reactivating repo transactions with underlying SUN, reactivating longer tenure SBI (6, 9 and 12-month SBI), and foreign exchange swap transactions. Reactivation of SUN repo transactions through liquidity management will also improve activity and liquidity in the SUN market. As a result the SUN market will be more efficient and more resilient to shocks. Meanwhile, FX Swap transactions will synchronize and harmonize steps to manage liquidity and maintain rupiah market stability with the domestic foreign exchange market. We expect these steps to support various efforts to deepen the financial market as a whole (financial market deepening). Still related to our effort to expedite financial market deepening, we have also looked at the significance of expediting the development of the sharia financial industry. Developing the sharia financial industry will broaden the types of instruments available to the public in managing their financial assets portfolio. This will greatly assist the domestic financial market to absorb shocks. Besides, developing the sharia financial industry will also allow sharia banks to grow more rapidly. This mutually beneficial interaction will expand the share of sharia banks in our national banking industry. The global excess liquidity phenomenon that principally stems from the middle-east leaving the US market after the implementation of the Patriot Act will help develop the sharia financial industry further. Many other countries such as Qatar, United Arab Emirates, Malaysia, Japan and Singapore have also taken strategic steps and have been successful in attracting the excess liquidity. Malaysia and Singapore have even used Indonesia as a source of funds through attractive sharia instruments. However, in the case of Indonesia, much more needs to be done in the near future, especially when considering that Indonesia is believed to hold great potential in the global sharia financial industry due to its large Moslem population; the largest Moslem population in the world. In the future, in line with the upcoming implementation of the AEC 2015, competition in the sharia financial industry will be tougher. Many constraints to the growth of the domestic sharia financial industry, such as tax issues, still impede the common efforts currently underway. In addition, the development and improvement of the national sharia financial industry competitiveness still requires the support of infrastructure: institutions, regulations, a sound legal framework, human resources and market infrastructure. To fill this void solid coordination is required by us all. In support of such coordination Bank Indonesia will formulate a grand strategy for national sharia financial industry development, through collaboration with other related institutions. Bank Indonesia will also review various aspects related to the strategy and implementation of monetary policy in our economy that uses a double financial system, namely conventional and sharia. 1.2 Strengthening monetary policy effectiveness Ladies and Gentlemen, There have been many sections of my talk here this evening that emphasize how rapid the changes are happening around us. To survive amidst such conditions there is no other option but to adapt by making the necessary improvements to mitigate our problems and weaknesses. In the monetary sector, one of the policy strategies we consider necessary for continuous review and improvement is the effectiveness of ITF implementation. From the assessment results of ITF implementation over the past three years, the opportunities to optimize existing strategy effectiveness remain wide open. This is primarily due to liquidity management, predominantly performed through 1-month SBI issuance that still triggers fluctuations in available liquidity in daily money market, high interest rate volatility and a steep short-term yield curve in the money market. These factors do not effectively promote portfolio management efficiency in financial institutions and further encourage them to seek profit by utilizing the difference in the shortterm interest rate. High fluctuations in the money market interest rate also exacerbate the uncertainty surrounding the liquidity of financial institutions that invest their funds in longer term assets than the source of funds. In other words, the cost of being temporarily illiquid becomes expensive. Market players tend to be short-term orientated which, in turn, distorts monetary policy transmission and is also inefficient in promoting the role of the financial market in the economy. Steps to improve monetary policy effectiveness that we envisage are basically tactical move deemed necessary to optimize the effectiveness of monetary policy implementation under ITF. In its implementation, this tactical move will be focused on efforts to maintain interest rate stability in the short-term inter-bank money market (PUAB), especially the overnight rate, as a transmission tool of monetary policy, while also serving as a mechanism to generate a more reasonable short-term yield curve. In a wider context, the move will also aim at improving asset pricing efficiency in the financial market and bank products. Therefore, steps to introduce SBI issuance over a longer maturity period is a precondition that must also be met. This is to absorb excess structural liquidity through the auction mechanism. The amount of SBI issued for various time periods will be based on projections of the bank liquidity requirement. Simultaneously, Bank Indonesia will continue to monitor liquidity and the PUAB O/N daily interest rate as well as responding to deviations within certain limits, through Fine Tuning Operations. In principle this will ensure that there will be sufficient daily liquidity to settle bank transactions and, therefore, the PUAB O/N interest rate will remain steady. If Bank Indonesia needs to add or remove liquidity temporarily then repo transactions can be introduced, either by issuing SBI or SUN, or FX Swap transactions. With a genuine short-term yield curve market players no longer focus on profit taking with a short horizon in the money market. This will encourage them to be more active in seeking profit through fund investment and management over a longer horizon. This policy initiative is expected to maintain the overnight PUAB interest rate at a consistent level that reflects the direction of Bank Indonesia monetary policy, namely the BI rate level. These policies, in turn will also promote banks and other financial market players to use asset and liabilities management (ALMA) more professionally, including risk management. Money market interest rate stability will reduce the risk of long-term investment liquidity risk while also improving financial market infrastructure, therefore, it is more efficient in promoting quality and sustainable economic growth. 1.3 Strengthening analytical tools for In anticipation of ASEAN economic community Ladies and Gentlemen, The third initiative in the monetary sector is strengthening policy analysis related to AEC 2015. The ASEAN Charter in Singapore on 20th November 2007 witnessed the introduction of the ASEAN economic integration program that is no longer up for negotiation. The AEC 2015 intra ASEAN free-trade agenda is nearly complete and will usher in a significant change in the movement of the production factor. The effect of free movement in the production factor is the establishment of a new configuration of intra ASEAN economic production distribution. It is therefore imperative for a central bank to understand the determinants of this new configuration. We need to project new characteristics and determinants of economic production distribution. As we are discussing something that will take place in the future, we do not have any data that can be interpreted through empirical study. Therefore, Bank Indonesia will initiate several theoretical and analytical research programs. Also, to investigate in more detail the effects of trade constraints (tariffs and non tariffs) on the export performance and public welfare of every ASEAN country, multiyear research is necessary involving enthusiastic, competent and highly dedicated parties. To this end we will develop a modelling technique based on Computable General Equilibrium (CGE) using the database of the Global Trade Analysis Project (GTAP) and Financial-Social Accounting Matrix (FSAM). To my knowledge, to date there are few public institutions in the country that have conducted this very important research agenda. If we reflect together, future Indonesian success in AEC is not independent of our competitiveness relative to the competitiveness of the other nine ASEAN member countries. I believe that competitiveness has three dimensions, namely (1) basic necessities, which include institutions, infrastructure, macroeconomic stability, primary education and health; efficiency determinants, which include follow-up education and workshops, an efficient products and services market, financial market development, technological readiness and market measurements; and (3) innovation and sophistication, which include advancement determinants and the level of innovation. Therefore, research that can map the competitiveness of ASEAN countries and reveal where Indonesia’s competitiveness can be improved is a vital input, which should be followed up immediately by all elements of the nation, including Bank Indonesia. Finally we also need to understand the role of the monetary authority amidst AEC 2015 implementation. We need to see whether our prudent monetary policy, which targets low inflation and macroeconomic stability, remains in our nation’s best interest. Up until now we have been convinced that prudent anti-inflationary monetary policy is pro-poor domestically. 2. Banking sector initiatives 2.1 Direction of follow-up policy in the context of restructuring the national banking industry Ladies and Gentlemen, Moving on I would like to discuss my thoughts on the future direction of banks. Since Indonesian Banking Architecture was launched at the beginning of 2004 we should be grateful for the strength and resilience of the banking industry when confronting the various risks and shocks that have increased gradually over time. Industry performance has also improved slowly. Bank profits are steadily increasing in line with the expansion of the intermediation function and efficiency improvements, as well as effective risk management. Although much has been accomplished, a lot more still remains to do. In this current globalization era, the speed of change often impresses. Our achievements today do not guarantee success tomorrow. Only the fundamentals are not prone to rapid change. We have always utilized this awareness as the foundation of IBA formulation for banking industry policy. The achievement of six fundamentals, namely the pillars of IBA, represent, in essence, a transformation process; from the chaos that came from the crisis, to a solid industry resilient to shocks that can compete globally and benefit all strata of society. This process requires an implementation strategy that ensures every initiative and program introduced can succeed and become a fundamental strength in the future. Therefore, every step needs to be carefully and cautiously calculated. It is imperative that we remain always sensitive when addressing the changes and dynamics of this process. We also have to be able to calculate the implications of each step on all related dimensions, prioritize policy, and maintain a good balance in the implementation to avoid unnecessary shocks. One endeavor undertaken to achieve the fundamental goals of API, with its lengthy complexity, is the restructuring of the banking industry as set forth in API Pillar 1. This objective requires the fulfillment of many preconditions in the strategic environment, including the banking industry, and also the support and participation of all parties. Clearly, within in the implementation of this policy, Bank Indonesia cannot progress single-handedly. Support from all stakeholders, particularly the banking community, Government, and People’s Representative Council, is the key to successfully achieving the ultimate goal. From our journey is an important note that requires attention, namely that a sound and robust banking industry is capable of playing its role optimally. Realizing this, steps to strengthen bank resilience, as part of the strategy to restructure the banking industry, do not always have to be taken sequentially with steps to optimize the function of the industry. Both can be performed simultaneously, filling in and complementing one another depending upon the prevailing economic priority. Therefore, in the face of a range of problems and limitations in policy implementation, it would not be taboo to adjust our strategy. We know that in the market economic system we currently follow, regulation can only be effective and no disrupt stability if the strategies and mechanisms adopted follow the guidelines and principles of the market system. As I have previously mentioned, many steps to support this process have already been instituted. By mapping the strengths as well as the weaknesses and directing them into the operational scheme of each bank, we have been able to line up a bank consolidation program, a capital adequacy requirement, and a single presence policy. On the other hand, we must also continue reviewing the conditions and potential of the public economy through expanding the role of Bank Indonesia branch offices, rolling out programs that support real sector growth and improving information quality as well as data, business and economic analysis. Furthermore, we must upgrade the information system to enable banks to access information more thoroughly and accurately regarding conditions in the public economy throughout Indonesia. Such policies have to be followed by consultative and persuasive steps for each bank manager to position oneself to fill every structural layer of the industry. Based on my thoughts, I would like to take this opportunity to outline three key strategies that I suggest to use as a reference when continuing banking policy over the next five years. First is follow-up policy direction in terms of restructuring the national banking industry. Within this policy scope, I have placed three initiatives aimed at solidifying the consolidation process according to projections of economic growth against what I consider to be a bank’s role in the future, namely: a) Determining the possibility of re-establishing banking policy dedicated to support the funding of long-term development projects. b) Broadening operational opportunities for universal banking by banks deemed capable and worthy of running it. c) Optimizing the bank’s role in funding development, especially for foreign-owned banks. Second is the direction of rural bank development, which represents one pillar of the local economy, considering the potential of the local economy and the welfare of the public. Third is to catalyze the growth of Sharia Banking. Allow me to elaborate further on the backdrop of my thoughts and offer some initiative ideas we can take to materialize them. A. Investigating the possibility of re-establishing a policy bank dedicated to support the funding of long-term development projects Ladies and Gentlemen, At the 2007 bankers’ dinner, I elaborated upon supply side rigidity in response to demand, which hinders the smoothness of our economic growth. I also stated that one of the causes of such a phenomenon is low investment growth by both foreign and domestic parties as well as in other strategic and long-term productive business activities. In the past 10 years since the crisis, the accumulation and quality of capital has been slow and its proportion to GDP has not recovered to pre-crisis levels. Clearly I do not need to repeat what I covered last year. I imagine we can all recall and explain the many constraints undermining strategic investment to our economy. However, our explanations are no longer viable if we then take no further action. What is far more important and urgent is how we can direct our efforts, strength and hard work to immediately succeed in overcoming this impasse in investment. We all know that the Government and other related parties have continued to strive for reform in many sectors and tried many ways to prevail over the numerous existing investment constraints. Nonetheless, we also know that such efforts are problematic because the issues we face are incredibly structural and complex, and often inter-related. From the abundant investment constraints we have identified, one is the limitation or absence of physical infrastructure. It is all too commonplace to see or feel much of our physical infrastructure is malfunctioning, obsolete or insufficient in capacity. Developing facilities and infrastructure such as electricity, roads, seaports, storage, manufacturing sites, dams, irrigation and many others is relatively still limited. Even for routine public economic activity, such infrastructure is no longer worthy of attracting new investment. In my view, this is due to at least three factors. First, in the first few years during and after the crisis, our economy contracted. Against this backdrop, fund sources for development purposes became limited and priority was allotted to the payment of short-term liabilities. Second, despite economic improvements over the past few years the majority of the state budget has gone to regional areas, for which the use of development funds is highly dependent on the ability of the local governments. From existing data it is clear that local government absorption of the state budget remains sub-optimal. As a result, development funds have mutated into short-term funds, which only circulate in the financial sector. Third, infrastructure projects of national interest require substantial budget allocation that cannot be fully covered by the state budget. Other commercial sources of funding are required, such as from banks or the capital market. Unfortunately, bank funding is still dominated by short-term fund sources; therefore, the funding of long-term infrastructure projects is relatively limited. We cannot allow this to persist. Appropriate infrastructure is dearly needed if we want our economy to expand further in a more balanced and prosperous way. Regarding the challenge of persistent inflation that I mentioned earlier, improvements and the expansion of infrastructure nationwide is crucial. Good quality infrastructure will counter product supply distribution constraints and lower costs on the supply side, thus making the economy more efficient. Consequently, better efficiency will enable the supply side to be more responsive to demand, alleviating the susceptibility of our economy to inflation. In the longer term, better infrastructure will also support economic productivity, which will provide the opportunity for more permanent disinflation. We must thoroughly address these three development constraints collectively. This evening I am advocating an idea that is actually not totally new to us but is now extremely pertinent and urgent. The idea is the re-establishment of a special bank policy to fund long-term development projects. This Policy Bank, in essence, is an extension of the Government’s desire to seek long-term funding through numerous methods and mechanisms. Other than direct public funding, banks must focus on long-term funding from the financial market by issuing bonds, and seek overseas loans from multilateral institutions. Funds gathered through this bank policy are subsequently distributed to long-term projects and development programs, particularly infrastructure, to complement development funding allocated through the state budget. Operational activity will be focused as an investment bank to provide support and facilitate the Government, including regional development banks (BPD), in issuing bonds in the capital market, both conventional banks and sharia. In the context of strategic policy and growth management, the bank policy represents the primary motor and drive for the Government to build a collaborative framework for effective and efficient funding of public and private partnerships. To facilitate this policy direction, Bank Indonesia will continue to undertake numerous reviews and preparation policy steps, including the initiative to expand universal banking which I would like to expand upon shortly. After in-depth reviews and detailed preparations, the Government could establish such a bank through the consolidation of banks or financial institutions that have this bank policy, or by establishing a brand new bank. The ownership of such a bank can subsequently be diversified to many parties, such as the general public, other state-owned banks, stateowned enterprises, foreign private parties or domestic international institutions, provided that the Government remains the majority shareholder and controller. It is important to note the implications of establishing a government bank to administrate this special duty. With the existence of this bank, other government banks will be required to adjust their role, function and strategy to avoid any unnecessary competition. Each government-owned bank will have its own function and role to support the growth process by optimally providing services to the public according to its own market share. With the adjustment in focus and business strategy of the government banks, I expect each government-owned to compete with other banks according to their vision and mission as well as their competitive strengths. For Bank Indonesia, this policy measure will generate significant results in terms of reinforcing the bank consolidation program, while also serving as an integral part of national bank restructuring as a whole. B. Expanding operational opportunities concerning universal banking for suitable banks Ladies and Gentlemen, Recently, Bank Indonesia presented a plan to the public regarding the possibility of adopting universal banking to substitute our current commercial banking approach. We have adjusted legislation to serve as a legal foundation for our banks. Action to adopt this universal system is basically a response to our position amidst financial sector globalization that is becoming more real in our daily lives. In practice, to improve the banks’ function and role in mobilizing public funds, current global bank development direction is innovative. This enables the integrated packaging of a bank’s products with other financial industry products. In terms of the banking industry, this is undertaken to achieve several objectives simultaneously, more specifically to hasten fund flows managed by banks, as well as expand the operational base to be capable of increasing the income margin and reducing risk exposure. From a public policy management standpoint, the adoption of universal banking into the Indonesian banking system will also support financial market deepening, which will eventually contribute to financial stability and economic growth. Broader bank product variety may also be instrumental in maintaining financial stability as it provides investment diversification for the public. Without concentrating placements in only one or several types of product, it is expected that the economy will become more resilient when confronting shocks. In this case, a deeper financial market is often identified as a more resilient and stable financial market. Financial intermediation that is required to drive an economy will also be assisted by the growing number of available financial products. Integration of bank activities and products in the form of asset securitization, mutual funds, and derivative transactions will obviously increase risk exposure, not only for the institutions involved, but also the financial system as a whole. Consequently, we will have to be prepared to meet the various supporting conditions to continuously maintain stability. Banks involved in universal banking are required to have capable human resources, solid financial and operational power, as well as the ability to manage risk effectively before commencing such activity. In fact, it is clear that our banks currently have indeed undertaken de facto universal banking activities through collaboration with other financial institutions or subsidiary companies. To avoid any unwelcome surprises that may lead to fluctuations, the relevant authorities will inevitably have to announce their determination in observing the overall operational dimension so far undertaken by banks. It is imperative that management of the banking financial industry is complementary and compatible by clearly detailing each stakeholder’s responsibility and authority. This has to be followed up by close collaboration and coordination among the relevant authorities to protect overall system stability. To this end, consolidated risk-based supervision implemented by Bank Indonesia will be improved by observing the relationships between banks and other financial companies. Once we have finished formulating the management of universal banking, we will offer several options to banks permitted to operate in this sector: 1. Merge with their subsidiary company, especially those that operate in securities. 2. Maintain the subsidiary company in the financial sector but declare all of its activities within the business activity of the principle bank. In this context, we will collaborate with the applicable authorities to compile prudential principles and a set of uniform operational data and information standards for each product or activity categorized as a universal product. 3. Choose to execute a vision, mission and business activity strategy focused on investment activity (investment bank). 4. As a consequence of the options on offer, Bank Indonesia will determine the portion of activity related to universal banking within differing definitive limits. The differences relate to the three options I just outlined and are based on the results of Bank Indonesia research regarding the ability of each bank in undertaking this activity. From the viewpoint of Bank Indonesia, universal banking embodies a hope that our banks can position themselves internationally within our banking industry structure. Such banks will have to be adequately equipped to compete globally. If consensus can be reached on this matter then we must scramble to prepare ourselves immediately. The demands of the global financial market render it impossible for us to freely and leisurely set our own schedule. AEC 2015 is just around the corner with its various implications on various socio-economic aspects of our nation. The main key to begin stepping towards our destined place is already in our hands. As we realize that the adoption of the universal banking pattern will entail much preparation, we can see that the many aspects of the banking industry enhanced by API are starting points from which we start. The banking consolidation program, enhancements in bank’s financial and operational aspects such as capital, risk management, and efforts in consumer education are programs which we must complete according to the set schedule. As we move forward, the enhancements conducted by API are increasingly showing its merits. The adoption of universal banking is only one possibility made possible by API. As such, we would be amiss to think that the final structure of API will be completed in 2010; that year is only the starting point for the industry’s further enhancements. C. Optimising the role of banks in development funding, especially foreign-owned banks Ladies and Gentlemen, From Bank Indonesia’s point of view, the process of reinforcing the banking industry, which we began shortly after the Asian Crisis, has yielded essential changes in the banking industry constellation in Indonesia. Currently, there are 49 commercial banks that are majority owned by foreign parties, totalling 46% of total national bank industry assets. Providing we can maintain financial system stability and policy direction, Bank Indonesia estimates that the acquisition process of domestic private banks by foreign parties will continue. From the point of view as an authority, the change in industry constellation is multidimensional and must be followed and monitored in terms of the function and role of banks in the economy in future. I often ask myself what implications will arise as a result of the change in structure. In addition, I regularly discuss this matter with a variety of stakeholders, both domestic and foreign, who can assist me with the answers to my questions. Obviously, there are many countries in the world where their banking industry is dominated by foreign stakeholders. However, Indonesia is different. The change in constellation has prompted many questions, such as will we as a nation be able to reap the benefits of a banking industry dominated by foreign parties? What policy response must Bank Indonesia take to address this, primarily in order for Indonesian banks to contribute optimally to the growth process? From my investigation, I have come to a temporary conclusion that such questions are perennial and will continue to shadow us all, especially us at Bank Indonesia. The answers will very much depend on numerous factors concerning the banking industry itself. We all know that one crucial factor that can affect the optimization of the function and role of foreign banks in Indonesian economic growth lies in the response and policy direction taken by the authorities. Realizing this, I feel the need to propose some basic principles to determine the direction of Indonesian banking policy to address our concerns as a nation in overcoming and benefiting from the change in ownership constellation. I would like to bring our thoughts and views in line to see the opportunities available for banks to be the motor and director of economic activity. This principle is known as “banks leading the development.” This basic principle is contrary to the general principle commonly used as the cornerstone of banking activity in an economy, namely “banks follow the trade”. How have I come to the conclusion that banks should be the motor and director of the economy? The answer returns me to the future economic challenges I have already discussed here this evening. The challenges implicate the importance of the contribution made by the banking sector in joint efforts to address the challenges of social exclusion. Therefore, we require banks to utilize the public economy (a socially inclusive banking sector) and open access to assets at the grass-root level to improve the quality of economic growth and support domestic market growth. We are all aware that bank activity is commercial, which obviously is mandated with maximizing profit. There is nothing wrong with this; however, it is important to understand that sustainable banks in the long term also demand a developing domestic market. Fund mobilization that is not followed by growth in productive assets at the grass-root level to augment the permanent purchasing power of middle to working-class citizens that represent the majority of producers and consumers in the country, will slowly bring banks into a race to the bottom. Therefore, I would like to encourage foreign banks in Indonesia to jointly empower and expand their customer base because this is where the future expected returns lie. The efficiency you have gained, which shows your professionalism as bankers, is capital to build your customer base to further ensure your business resilience in the future. I fully understand that in many ways what you are experiencing in terms of your competitive environment is similar to what is known as a prisoner’s dilemma. Individually, the benefits you enjoy as initiators of a more prosperous customer base are not necessarily followed by a constructive tit-for-tat strategy by all participants. The absence of this coordination mechanism has become our concern because such circumstances could eventually trigger “stagnation” that disrupts the expediency of all participants in the banking industry. Consequently, Bank Indonesia will provide equal incentives for all and will be a fair mediator to ensure that no one plays outside of the rules commonly made and agreed upon. In line with this, I would like to propose three policy programs to constitute guidelines in optimizing the role of banks in addressing the numerous economic challenges we currently face. These policy programs are primarily targeted at foreign-owned commercial banks, which continue to direct most of their credit extension to the consumptive sector. However, implementation does not imply that other domestic banks are exempt from enjoying the benefits of this policy. Bank Indonesia will institute this affirmative policy for the greater good of all banks; differentiating the weight of liability according to the portfolio conditions of each bank. First is the responsibility of every bank to nurture entrepreneurs of productive ventures in certain regions or sectors who have always had potential but never been properly developed. This nurturing process is in line with the extension of business loans, in the form of working or investment capital, the amount of which is tailored to the prospects and ability of the business. The ratio or portion of total credit to each debtor in meeting this liability will be calculated referring to several indicators. One crucial indicator to be used is the relative comparison of the amount of existing consumption credit on a bank’s portfolio. The costs involved in this process to be borne by the banks can be calculated as the cost of funds acceptable to the debtor, or as part of the operational (overheads) costs of a bank. Second is the obligation to extend credit to the productive MSME sector at a given ratio or portion of total credit distributed by each bank. This policy is not completely new. Before the crisis, Bank Indonesia once implemented this policy in the national banking industry to promote MSME growth. By taking into account past experiences, a refined version of this policy is being considered for implementation. Third is the duty to implement a Corporate Social Responsibility program in every bank at a ratio to be commonly agreed upon. I take the view that a bank’s CSR program should be directed towards the strategic efforts to shape our nation’s future. One of the strategic fields in this respect is education. I hope that banks can substantially contribute to education through innovation and creativity to provide better opportunities for our children to achieve their dream of a brighter future. Fourth are Bank Indonesia measures to immediately finalize reviewing the possibility of reducing the calculation for risk-weighted assets (ATMR) on credit for activities of the poor (KUR). Based on a thorough review, the opportunity has arisen to reduce the ATMR of such credit, considering that it has been re-insured by Askrindo, which is a state-owned enterprise itself. In practice, the current portion of KUR distribution not covered by Askrindo and therefore the responsibility of banks is 30%. Taking into account current ATMR calculation regulations, where credits insured by state-owned enterprises have a risk weighting of 50%, then we project that we will immediately adjust the ATMR calculation for KUR to around 30 to 40%. Hopefully in the near future we can promulgate new regulations pertaining to this credit. There is also the possibility of a new ATMR calculation for MSME credit guaranteed by insurance companies other than Askrindo, as long as the respective insurance company can meet a set of conditions to be determined. As usual we will fully cooperate with all of you in the formulation process to discuss the best measures we can achieve jointly together. I believe that the three policy steps I have outline can act as the trigger to establishing strategic national assets for our future, including the banking industry. Good communication needs to be maintained and improved in quality. The banking community does not have to hesitate in presenting the many concerns that require an appropriate response from Bank Indonesia, but should do so without creating unnecessary noise in the public domain. We must agree that the future of this nation does not only lie in the big cities dominated by non-tradable sector activity. This nation should rely on the potential and power of its resources, which remain overlooked in many rural areas. Therefore, if we in the banking community wish to survive and continue generating profit in the long run, the existing potential must be developed and realized in order to achieve growth. 2.2. Development direction of rural banks as a support of local economic strength Ladies and Gentlemen, I would like to now turn my thoughts to rural banks. As I mentioned in my guidelines last year, rural banks need to be redefined in the context of serving the range of dynamics in the lives of the underprivileged. When we see many rural banks in suburbs or even the city, it beckons the question of whether it is a true rural bank that is actually serving the Poor. What is so wrong with our villages that rural banks hesitate to go there? Or maybe we approach this from the opposite point of view, what is wrong with the rural banks that they choose to enter the cities? Finding answers to these questions is hardly a difficult task. We have to admit that the economic condition of many people in the villages is still a concern. On the other hand, by following the current trend of approaching the matter as a commercial business venture, rural banks take short cuts by operating as commercial banks seeking to generate a profit. However, the original concept based the placement of rural banks in the national banking industry to operate specifically to serve a particular public segment, which require special treatment. From our standpoint as the monetary authority, rural banks are not banks that issue checks, debit cards and wire transfers or electronic money; therefore, from the outset we have not placed rural banks under monetary policy transmission. This exclusiveness is intended to allow rural banks to be more flexible when penetrating rural areas in order to serve underprivileged people, which is indeed the purpose of their existence. Having almost 10 times more premises than commercial banks, rural banks should be able to spread throughout the country without having to concentrate on entering the large cities or operating like commercial banks. From the point of view of the banking authority, rural banks do not have systemic impact in the case of a problem. However, if many rural banks fail to compete with commercial banks due to their inability to utilize their exclusivity, the breakdown will significantly burden the banking system. Against this backdrop, it is normal for Bank Indonesia to deem a review of existing policy and a subsequent response necessary, according to the basic concept and principles we jointly agreed upon. I would like to reiterate that rural banks are required to become more efficient in performing their role and function to serve the public in rural areas. Rural banks must to return to their mandate of supporting the local economies, which are the target and focus of their business activity. Economic localities which grow and stem from local people’s socioculture values should form the backbone of rural banks. The fundamental difference between rural banks and commercial banks is the ability of rural banks to enter and become part of norms and dynamics of their surrounding community. Thus, the approach and operational activity of rural banks must reflect the habits, traditions and culture of the public being served, therefore, they feel comfortable and safe with the respective rural bank. Consequently, the operational structure of rural banks must be customized according to its target market. Realizing the need to redefine and redirect the policy direction of rural banks in the future, I would like to highlight several initiatives we can take over the next five years. 1. Thoroughly conduct research studies and reviews concerning local economic strengths that would be more relevantly served by rural banks instead of commercial banks. From the results of the study, rural banks should be able to formulate and prepare an operational structure suitable to local conditions, and therefore exploit the niche opportunities to generate profit. 2. As a starting point, Bank Indonesia is currently preparing the internal establishment of the Centre for Micro Finance Study. This study centre will be established together with many parties; including international institutions with extensive experience and deep knowledge on micro funding like GTZ, Swisscontact and IFC. The study centre is expected to sharpen numerous efforts taken by the Government and other parties to support the development and utilization of poor public economies in various rural areas and villages. 3. Compile a blueprint for future rural bank policy direction involving various stakeholders, particularly the local government, in order to synergize the function and role of rural banks in supporting the provision of region/village development funding, together with other micro financial institutions that currently exist. Under this initiative, numerous policy options will be reviewed to reorganize the rural bank industry according to the socio-economic potential of the local cultures where rural banks are deemed to have strong development possibilities. 4. Discover the most suitable form of supervision and management to be adopted by rural banks. In line with the variety present in the operational structure of rural banks Bank Indonesia’s role as the authority must also adjust to maintain the health and strength of rural banks without constraining the operational structure of each individual rural bank. Under such circumstances, a one-size-fits-all principle is no longer relevant. Therefore, the opportunity has presented itself, in the management and supervision of rural banks, that Bank Indonesia will include other stakeholders that genuinely understand rural bank conditions in each region, such as the local government, LSM, consultants and other stakeholders. The function and role of Bank Indonesia in future will focus more on providing guidelines, prudential signs as well as illustrating the overall industry conditions and dynamics. 2.3. Measures to expedite sharia banking expansion Ladies and Gentlemen, My final thought for the banking sector concerns sharia banking. In an effort to support sharia industry growth, this year, we have targeted 5% of overall bank assets to be owned by sharia banking. Furthermore, up to 2015, we expect this share to increase to 15%. This is certainly an ambitious target but definitely attainable. We need to garner all banking industry stakeholders and other related parties to work harder and be more innovative to achieve this target. Based on our observations and by monitoring the performance of sharia banking worldwide, we believe that the potential strength and competitiveness of sharia banking in Indonesia will grow and develop substantially. We will also see that sharia banking is a financial product and service whose universal values are fair, beneficial and practical for everybody served. Referring to current conditions, the target of 5% of total bank assets may still be considered a huge challenge for sharia banking. Therefore, besides efforts from the sharia industry itself, common goals and close collaboration between industry players, Bank Indonesia, the Government, as well as other related parties are needed. Moreover, the development of sharia banking has to be shifted from being an issue of Bank Indonesia and other related parties to a national issue. Each stakeholder has their own role to perform optimally, referring to the mutually agreed upon agenda to realize their objectives. As a national agenda, sharia banking development can be achieved through the following steps: i. Offer incentives, simplicity and facilities to attract new investors. ii. Conduct intensive sharia banking socialization to provide knowledge and also encourage the public at all groups/segments/strata to use financial services / products offered by sharia banking. iii. Foster MSEs and create an Account Officer for Sharia Banks to improve the real sector which is expected to strengthen sharia banking funding from the demand side. iv. Expand the involvement of sharia banking in government projects. v. Complete the promulgation or amendment of several favorable laws to catalyze sharia banking development. For example, amend taxation laws, complete the sharia banking law, and Sukuk Law. Meanwhile, over the next few years, Bank Indonesia will continue to apportion greater attention to three key matters to support sharia banking growth. First is capital. Strong capital is important to maintain rapid and prudential sharia banking growth. Bank expansion and rapid deposit growth need to be balanced against capital; therefore, growth in sharia banks will remain sustainable and prudential. Second is human resources. As a budding industry, the quality of sharia banking human resources is a critical element in its success to serve the sharia needs of the Indonesian public. Professional and competent human resources are required, at least on a par with those in conventional banking. This will provide evidence to the public that sharia banking is a highly professional industry that can offer many benefits and has strong potential. Third is service coverage. Expansion of service coverage through “office channeling” has helped the public to place their savings in proven sharia banks. Strong interest from the public will subsequently broaden office channeling coverage to serve not only the public requirement to place funds, but also serve the public’s needs related to financing. We have also noticed that demand for exemplary service quality has enabled sharia banking to absorb the very best employees available in banking. 3. Initiatives in the national payment system Ladies and Gentlemen, In terms of the payment system, some future measures that I personally consider important to support financial system stability include making the national payment system more useful for the public as well as complying further with international best practices. Implementation of the Bank Indonesia Government – Electronic Banking system (BIG-eB), which was officially launched at the end of last year, will be improved in quality and service coverage. Better service quality and coverage is expected to boost the effectiveness and efficiency of monitoring and national government financial transactions, and thus support overall efforts to stimulate national economic growth. I also acknowledge the importance of improving the efficiency of the BI-RTGS system. The plan to launch BI-RTGS Version 2.0 is an important step in our efforts to build a more reliable national payment system. In the coming five years, Bank Indonesia will continue to maintain the adequacy of good quality bank notes and to improve the efficiency of its distribution to Indonesia’s border regions. The provision of sufficient amounts of high quality bank notes is a means of strengthening the presence of our state’s symbols in those remote areas, and thereby the territorial integrity of the Unitary State of the Republic of Indonesia. 4. Initiatives in real sector Ladies and Gentlemen, Beginning this 21st century, we are still faced with the issue of social exclusion that I mentioned earlier this evening. When a group in society is systematically overlooked socio- economically they feel a great desire to improve their rights and welfare, or what Amartya Sen coined social deprivation. Then, at that point poverty exists as an ontological entity. Amidst unlimited supply of labor, social exclusion is shaking the very meaning of the social contract in our country. Those confined to the lower echelons of the socio-economic pyramid feel that their world is not protected by the social contract they are engaged in. A sort of insecurity and existential concern exist in their mind. The most logical explanation about their situation is limited access to upward social mobility and such limitations create a thirst for more opened doors. In response to that challenge the KBI Reorientation Program, launched mid 2007, will be intensified in its implementation. The role of Bank Indonesia branch offices in stimulating economic growth in rural areas will be strengthened, so as to ensure a more sociallyinclusive Indonesia that is also better prepared to join the AEC 2015. Included in this program is the establishment of branch offices in regions with progressive achievements in all sectors of growth – political, economic, social and cultural – and have the potential to become new growth centers in Indonesia. As part of the first phase, we will soon be opening branch offices in Banten and Gorontalo Province, and reopen branch offices in Tegal and Pematang Siantar. I would now quickly like to present several salient points of the work program in future, which we will be implemented gradually, as follows: First is to improve the coverage and quality of regional economic statistical data owned by KBI and integrate the reporting of regional economic statistics, so as to improve the effectiveness of KBI’s policy advisory role. The information is to be compiled in DIBI, which can be accessed by all elements of the nation who require it. Second is to conduct strategic regional economic research concerning the opportunities and potential of the regional economy, preparedness in welcoming AEC 2015, MDG achievements, the effect of climate change on the economy and the welfare of the people, the production and distribution network, the structure-conduct-performance of industries, as well as the development of cultural and social capital. Third is to improve the facilitation role in KBI regarding banking intermediation to the microsmall-medium enterprise group using DIBI and information held by BIK. Fourth is to analyze thoroughly the sources of regional inflation, develop an early detection system for regional inflation, coordinate with the local governments regarding the stabilization of regional inflation, and facilitate the establishment of a Regional Inflation Stabilization Team. Fifth is to improve the quality and utilization of the libraries in KBI as well as making the library a learning & cultural centre for the public of the respective region. As part of its role as a learning centre, the KBI libraries will provide reference sources for entrepreneurs and potential entrepreneurs in the regional areas. The availability of an adequate business library in this globalization era, in addition to widening the public’s skills in adapting to this era, can also open opportunities for those who are creative, innovative and independent to look for their own solution and therefore mobilize upwards. With its function as a cultural centre, KBI libraries will become a place where cultural diversity and local wisdom is read, stored, studied and celebrated. V. Conclusion Ladies and Gentlemen, This has been what I could present to you here this evening regarding the strategic initiatives to be taken by Bank Indonesia this year. Allow me to conclude, if you will, by delivering some footnotes as follows. The past five years in the journey of post-crisis economic growth has been a transitional period from the clutches of a multidimensional crisis to reconsolidation of economic growth that strengthens the key foundations of our economy. The results of this reconsolidation are beginning to appear and now, therefore, comes the time for us to move away from policies focused on initially centring efforts towards economic recovery and restoring the social fabric of a society decimated by a serious emergency, towards solidifying this social fabric. Therefore, in the upcoming periods the time has come to gradually reduce our attention on rescue operations and refocus on restructuring efforts that provide long-term fundamental improvements. In the future, we want the establishment of an economic life that can compete globally, increase the prosperity of the public and adapt to the best practices in the world. Establishment of such an economic life requires consistence, patience and persistence in taking appropriate improvement measures whenever the chance presents itself, no matter how small that step is. Even the longest journey begins with the first step… In line with the process to become more anticipative, a new aspect will affect us all in the near future that requires all of our attention, namely the commitment among governments of ASEAN countries to implement economic integration in the ASEAN region in 2015. Formally, this commitment, written into a binding agreement, will open up the economies of ASEAN countries in the form of a free trade area. Irrespective of the final form, national economic policy will need to be adjusted to fit with this new trend. Thoughts and anticipative measure have to be prepared as soon as possible because formally the market opening process has been agreed to be in effect by 2015. With such wide-reaching developments the banking community is also required to prepare a number of changes and improvements institutionally, procedurally, technically, technologically and in terms of human resources development and capital. We have run tread this path together periodically and continue to apply international best practices, which have already been implemented around the world. The widespread growth I have mentioned also has internal implications for Bank Indonesia as one of the state institutions that plays a special role in the life of Indonesia. Many internal adjustments also need to be taken considering the upcoming challenges. This includes paying attention to the operational and organizational implications on Bank Indonesia branch offices around the country. Ladies and Gentlemen, In the last five years we have faced many fundamental changes in the dynamics of the economy, which in many aspects are the results of the great tide of economic globalization. In terms of progress as a civilization, there is not a single country in the world that could resist and close itself away from globalization, let alone reverse such a process. It seems that the global economy is undergoing a rapid transition to become one large market, which will produce excess. The excess we have already felt is global warming due to a waste of production activity that is growing too fast compared to the Earth’s capacity to absorb it. The effects of such an excess for us in a developing country cannot be ignored. Global warming has triggered climate change that has recently disrupted our efforts to expedite economic growth. We must surely take this matter seriously since for the majority of our people the effect of climate change is the dimmed hope of a better life, which subsequently causes existential concerns. We also need to ensure that as a country and part of humankind, we do not fail to take care of the environment that is part of the crucial solution to climate change. Transition of the global economy into a global market also yields a wide effect on human behavior as “homo economicus”. We have experienced changes in preference and vision of economic players on the life that they are living. In an analytic structure, these changes seem to be shaking the validity of casualty relationships between economic factors. A number of theories we previously took for granted, that policymakers could base their important decisions on, are gradually changing into myths. This phenomenon may cause confusion even for those with vast experience in public policy, especially since addressing this phenomenon requires the policymaker to continuously deconstruct and reconstruct assumptions they base their analysis tools upon. Such an exercise possesses many risks, particularly as the decision of public policy does not allow the luxury of repeatable experiments. Therefore, any mistakes in choosing which assumptions are the most accurate when formulating policy can have wide-reaching effects on the public’s welfare. In the end, public policy is an art form in grouping assumptions with policy considerations, for which the process requires wisdom, maturity and most importantly: guts and intuition. Ladies and Gentlemen, Globalization has also alerted us to the importance of continuously ensuring that Indonesia is possibility that is not absurd. When this republic was established we knew that there was only a handful of people that did not question the possibility of Indonesia as an “imagined community”. We have realized, and our nation’s forefathers also knew, that not many countries have an objective chance to remain intact as a modern, democratic and open country amidst the mosaic of diversity and contrast. Therefore, to borrow from an Indonesianist at Cornell University, Indonesia as an imagined community is a common project that we need to strive for with positive achievements in all aspects of life. Ten years following the crisis is a perfect time for us to strengthen the viability of this great country that is endowed with many vital foundations for the advancement of humankind. The advice offered by Muhammad Hatta over 60 years ago remains pertinent to us at the beginning of the 21st century: “With struggle comes progress! We should take advantage of the current transition we are facing to plant good seeds for the future of our country. This is a crucial moment that will determine our fate as a nation for centuries.” Finally, before I conclude, please allow me to offer my sincerest appreciation to my senior, who represents the generation before me, namely Mr. Rachmat Saleh, former Governor of Bank Indonesia, who because of his visionary leadership built Bank Indonesia and the Indonesian banking industry as crucial economic institutions. Mr. Rachmat Saleh was the Governor of Bank Indonesia who purposefully promoted efforts to strengthen the institution and provide opportunities for Bank Indonesia staff to improve their professional knowledge and expertise. A successful leader is one who has created as many successors as possible, and that is exactly what Mr. Rachmat Saleh did. He also frequently reminded us to always maintain the unity of Bank Indonesia, as a strategic institution that plays a decisive public role in our republic, and to always make our institution better in fulfilling its function as a public servant. I would like to offer our most heartfelt gratitude and respect from all Bank Indonesia staff, including the leadership, to Mr. Rachmat Saleh. If you still remember 15 years back when I was talking with you at Bethesda-Maryland, I told you that you are ”the living legend”. Tonight I would like to reiterate my statement that you will always be ”the living legend” in Bank Indonesia’s history. May you be blessed with good health and continue to contribute to the progress of Bank Indonesia and our economy. Finally, Happy New Year 2008. Let us all keep working hard together. We believe that God will always be with us to bless and enlighten our path towards a better future. Thank you. Wassalamu’alaikum wr. Wb.
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Keynote speech by Prof Dr Boediono, Governor of Bank Indonesia, at Bank Indonesia's Annual International Seminar on 'Macroeconomic impact of climate change - opportunities and challenges', Nusa Dua, Bali, 1-2 August 2008.
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Boediono: Macroeconomic impact of climate change – opportunities and challenges (Keynote speech) Keynote speech by Prof Dr Boediono, Governor of Bank Indonesia, at Bank Indonesia’s Annual International Seminar on “Macroeconomic impact of climate change – opportunities and challenges”, Nusa Dua, Bali, 1-2 August 2008. * * * Fellow Governors, Distinguished Speakers and Scholars, Ladies and gentlemen, Good morning! It is indeed a pleasure and an honor for me to welcome all of you to Bank Indonesia’s Annual International Seminar in this beautiful and majestic island of Bali. This seminar has become one of Bank Indonesia’s annual traditions, and this year’s event marks its 6th “anniversary”. It is truly heartwarming to see the presence of distinguished guests in the audience – fellow Governors, deputy governors distinguished speakers and scholars from various world leading universities. We are truly delighted by your attendance. We are looking forward to having lively discussions and hearing your valuable insights. Having this good mix of participants we can surely hope for richer policy perspective on global warming and climate change. In this same island last year, during the 2007 UN Climate Change Conference, 187 nations have acknowledged the unequivocal evidence of global warming and risks of severe climate change impacts. The Bali Road Map produced by that conference was a significant milestone in the global drive to address the issues arising from global warming and climate change. The Inter-governmental Panel on Climate Change (IPPC) concluded that global warming could cause significant change to biological and physical systems, such as an increase in tropical cyclone intensity, changes in precipitation pattern, salinity of the sea, wind patterns, the reproductive period of animals and plants, species distribution and population, epidemics, and also influence various ecosystems in high latitude (including the Arctic and Antarctic), high altitude locations, as well as coastal ecosystems. Some of these effects will only be felt in the long run, some in the not too long run and some, such as the rise in the frequency and intensity of extreme weather with all of its consequences, are already evident now. However, we need to recognize the fact that there is an asymmetry in the capability of citizens and governments in the developing and developed countries in coping and mitigating the crises’ adverse impacts. It is now agreed that to effectively respond to such a global challenge, we need a global and coordinated agenda of actions. In developing such an agenda, we ought to bear in mind that for governments in the developing world, unfavorable global climatic trend generally coupled by the lack of sufficient technology, human capacity and fiscal space may further limit the scope of policy requirements that could be extended to them. Our coordinated and shared response to climate change must entail a systematic re-profiling and redirecting of global expenditures by both governments and businesses to the developing world. Let me remind the audience that the Bali Road Map emphasizes the provision of financial and other incentives to, scale up the transfer of clean energy technologies from the developed to the developing world. Nations have also agreed to develop programs designed to scale up investment that will lead to the transfer of technologies to developing economies. While the government is going to be important even critical in dealing with climate change, an even more difficult task involves changing the incentives of the billions of individual consumers and companies in the private sector. Consumers will need to reduce the use of carbon intense products and businesses motivated to develop alternatives. Getting these incentives right and unleashing private sector innovation has to be a big part of the response. In that respect, if properly coordinated, climate change mitigation and growth can both be pursued at the same time. Capturing the needs of countries to mitigate the impacts of climate change, new industries are already rapidly developing. The countries that get the incentives right by creating an environment for the development of these technologies designed are on the right path to becoming economic winners in the next great technological revolution. Let us also not forget the most important aspect of any program in mitigating climate change, namely not to leave behind the world poor while countries develop and implement marketbased solutions to mitigate climate change risks. Mechanisms for adaptation fund to help poor countries cope with climate change should be part of our partnerships for development. To properly define our role, as central bankers, in such a global effect, we need to spell out as precisely as we can the ramification of the macroeconomic impact of global climate change. As we gather in this room today, the world out there is struggling to deal with a crisis not, in my view, unrelated with the problem of global climate change: the unprecedented food and fuel price surge. Unfortunately, it happens as the world finance is also in turmoil. The market consequences of all that have kept central bankers across the globe awake at night from time to time. Fellow Governors, ladies and gentlemen, Before I conclude my remarks, let me reiterate that we live in a truly challenging time. Viewed from a policy maker in a developing economy, I must also say that the threat of climate change may go beyond the usual welfare statistics. If left unresolved climate change and the accompanying twin crises may, in due time, put our shared vision of a free, open and democratic globe at risk. Let me now end my opening remarks with an expression of confidence that discussions in Bank Indonesia’s 6th Annual International Seminar will certainly be prolific and enrich our understanding of the macroeconomic impact of climate change. I am looking forward to this seminar’s policy recommendations. Lastly, enjoy your stay in Bali! I do hope your stay in this warm and hospitable island of gods fashions you with lasting pleasant memories of Indonesia. Thank you.
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Closing remarks by Prof Dr Miranda S Goeltom, Senior Deputy Governor of Bank Indonesia, at Bank Indonesia's Annual International Seminar on 'Macroeconomic impact of climate change - opportunities and challenges', Nusa Dua, Bali, 1-2 August 2008.
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Miranda S Goeltom: Macroeconomic impact of climate change – opportunities and challenges (Closing remarks) Closing remarks by Prof Dr Miranda S Goeltom, Senior Deputy Governor of Bank Indonesia, at Bank Indonesia’s Annual International Seminar on “Macroeconomic impact of climate change – opportunities and challenges”, Nusa Dua, Bali, 1-2 August 2008. * * * Fellow Governors, Distinguished speakers and chairpersons, Honorable guests, Ladies & Gentlemen, On behalf of Bank Indonesia, I would like to express our most sincere thanks to all of you for the honor that you have just bestowed upon my invitation to participate in the annual international seminar of Bank Indonesia in our island of gods, Bali. Also, I would like to thank all honorable guest speakers, chairpersons, and participants for your valuable presentations and fruitful discussions during this one and a half day seminar held in such salubrious settings. In my belief, the sharing of views and experiences among central bankers, commercial bankers, academicians, bureaucrats, and the business community will enhance more productive policies with regards to global climate change phenomenon, to support sustainable growth in the long-run, as well as maintaining financial stability and alleviating poverty. My Dear Colleagues, Distinguished participants , We have just completed an invigorating and very productive discussion. For the past oneand-a half day we have deliberated on a wide range of global issues related to climate change impact, in which all of them are import ant, some of them are crucial to the life of human being and the planet. We have been through the rigorous deliberations, and energetic but always friendly discussion. We also have summoned the spirit of this seminar and drawn inspiration to contribute within our own justification a better macroeconomic and financial stability in conjunction of global climate change. The evidence of global warming has become apparent as the consequence of human activities. We have learnt that it is not fiction or propaganda, but it is a fact and real. The costs of policies to address climate change can be contained by ensuring that mitigation policies are well designed. It will be crucial to aim at a framework that is sustainable and provides incentives for country participation. We have made just another step in the long journey of our inspirations to mitigate the global climate change impact. Indeed, as has always happened, after every seminar that we convene such as this, we grow more unified in our thoughts, more coordinated in our actions, and more effective in participation in international decision-making. As a result of these efforts, we keep in step with rapid march of history. We have also thoroughly examined our options and arrived at a broad common understanding (platform) over critical issues on the global climate change impact to macroeconomic, financial stability, and poverty eradication. Climate change is predicted to have some impacts in spreading disease, earlier spring arrival, plant and animal range shifts and population changes, coral reef bleaching, downpours, heavy snowfalls and flooding, drought and fires, and other natural catastrophes. The revolution and transformation of natural changes has brought significant far-reaching effects on human well-being, particularly to the sustainable economic development and poverty alleviation. This condition would, unfortunately, generate greater risks on business and economic activities that should be addressed. Ladies and Gentlemen, Now, as we are approaching to the end of our seminar, please allow me to close with several salient points and comments made by distinguished guest speakers at this forum. Let me start with strong message brought to us by his Excellency the Governor of Bank Indonesia, Mr. Boediono, during his opening remarks. He stated that the threat of climate change may go beyond the usual welfare statistics and if left unresolved, climate change and the accompanying twin crises may, in due time, put our shared vision of a free, open and democratic g lobe at risk. He argued that to effectively respond to such a global challenge, we need a global and coordinated agenda of actions. I, indeed, share his view as expressed in my paper on the Macroeconomic Policy and Climate Change in the session of economic consequences of climate change and policies option. In this regard, I believe that there are a number of key messages we need to take away today; emphasizing that the policies should be integrated in different sectors and not be instituted to sacrifice the achievement of long-term social welfare. All countries need to agree that climate change and development goals can and should be pursued jointly. International frameworks should recognize the right of nations to increase their living standards, and the common but differentiated responsibilities of developed and developing countries in mitigating the effects of climate change. For this, countries need to pursue effective mitigation at the lowest cost. In this regard, not only unequivocal political leadership of developed countries, but also strong commitment from all countries to engage on climate change, is amongst the fundamental pillars to promote global welfare. Meanwhile, Dr. Hans Timmer emphasized that developing countries are taking center stage in the climate change issues. This conviction relies on the fact that (i) growth in developing world is much faster than expected during the 1990s and the cheapest mitigation options are in developing countries, (ii) developing countries are most vulnerable to climate impact and it has come earlier than expected, and (iii) current analysis includes distributional impacts within countries and poor are hit hardest. For that reason, climate change policies must be integrated into development strategy , and developing countries have to become key players in those policies. Prof. Iwan Jaya Azis on his presentation, “exploring economy-wide impacts of climate change in a resource-rich country” shared with us his finding from his analysis on these issues using recursive dynamic computable financial general equilibrium (CFGE) model. His research was empirically based on resource-rich country, such as Indonesia, with a concentration on the area that the country faces substantial challenges in terms of declining productivities due to climate change, such as food, mining, forestry and fisheries. One of his finding is that optimizing the innovative approaches on developing Indonesia’s enormous biological potential seems to be able to avoid a trade-off between mitigating climate change and maintaining macroeconomic stability. It was also pointed out that the appropriate policies of mitigation that lead to productivity improvements do not always involve a trade-off between income growth and poverty reduction. Furthermore, he showed us his support on carbon credit scheme, but raised issues as to whom the financial revenue should go to. Ladies and Gentlemen, The second session discussed whether there is a role for central bank in climate change adaptation. We started with two issues from the viewpoints of central bankers as brought up by the first speaker, Hernán Lacunza, namely how will climate change impact on the macro economy and what is the best way for monetary policy to deal with it. Lacunza argued that monetary policy by itself can not do a particularly efficient job of controlling or mitigating the factors that lead to climate change. Instead, monetary policy can devote efforts to adapt to climate change so that its contribution to macroeconomic stability is not jeopardized. The key here is to be flexible, in particular, the standard inflation targeting approach could be modified as necessary, in order to deal with persistent supply shocks – through the use of countercyclical policies as reserve accumulation, exchange rate management, and a more extensive use of informed judgment than before. Meanwhile, Prof. Peter J. Sinclair argued that consumption of nature’s capital calls for taxation so that there would be rewards for depleting natural capital more slowly. Regarding t he terminology of “Green GDP”, Prof. Sinclair argued that it is a misnomer in that it focuses on gross income, and not on income net of depreciation in any sense. So it is fiscal policy that is centre stage in this regard, not monetary policy. He has showed that the trend of ad valorem fossil fuel taxation can have important consequences, even if inter-temporal issues imply that its level may be irrelevant. Nevertheless, global warming has important implication for monetary policy, through its long run impact on rates of real interest and growth, and its short run repercussions on the level of prices of fossil fuels, which may react quite strongly to changing perceptions of the character and extent of the global warming phenomenon. At the last of this session, Dr. Junggun Oh identified impacts of climate change which might be a decrease in the potential capacity of growth, a rise in the inflation rate, a decrease in capital flows, and deterioration of exports, and thus a slowdown of global economic growth followed by changes in market interest rate. Thus the tough challenges faced by the central bank is how to keep the commitment to price stability on the one hand and how much to take the possible worsening economic growth and employment into account. As wit h Lacunza, Dr. Oh argued that climate change are largely supply shock, yet the central bank should set the optimal target rate of inflation based on studies on the impact of climate change and inflation rate. Distinguished guests, Ladies and Gentlemen, Session three of this seminar was designed to discuss the role of fiscal policy in promoting environmental friendly growth and development. Fiscal stimulus among other policy measures, could encourage a market in developing green investment and production towards sustainable economic growth. As the first speaker of this session, Prof. Emil Salim highlighted the fact that market failure has locked conventional market economy in an unsustainable pattern of development with no environmental values. This has caused a subsidized growth of economy, followed by bursting energy and food crisis comparable to what we are seeing now. At the global level market failure is perpetuated by the absence of independent global institutions to develop market corrections, while a t the national level, market failure prevails with subsidized energy in conventional growth without any considerations on pollution costs. In this regard, green fiscal policy come at the forefront to correct market failure. Several existing policies were mentioned such as palm-oil pollution tax in Malaysia, wind-energy subsidy in Japan, palm-oil export tax in Indonesia, and clean development mechanism, which are already adopted by several countries. He also reiterated the basic notion of green fiscal policy is to get the market price of environmental services right. To do so, the Government need to focus on long term development goal rather than the short one. Further, Ms. Teresa Ter-Minassian, suggested that impact of climate change to public finance should be responded by fiscal measures to mitigate and to adapt its consequences. Aimed at raising the price of pollution, mitigation measures can be implemented through carbon tax, cap-and trade schemes, and reduction of fossil fuel subsidies. Despite of its obstacles, countries in the world should encourage international cooperation in mitigation measures by adopting minimum rates of carbon taxes, border tax adjustments, possible sectoral agreement, and establishing positive incentives for avoiding deforestation. At minimum, it is important to know new public investments can be climate-proofed, and the associated country level cost. More work is also needed on how financial mechanisms can be used for market-based insurance against climate change risks. The third speaker in this session, Mr. Chalongphob Sussangkarn, argued that policy officials at Ministry of Finance (MOF) should have an understanding on environmental and climate change issues because many key policy instruments are under the jurisdiction of the Ministry of Finance, and most of them are market based instruments such as taxes. Without the understanding and support of Ministry of Finance, whether at ministerial or bureaucratic level, it would be very difficult to introduce environmental friendly market based fiscal measures. The fourth speaker in this session, Dr. Stephen Specks used the concept of an environmental fiscal reform (EFR) to address multiple policy objectives (those are environment, fiscal, and poverty reduction). He argued that environ mental reforms are a key instrument of raising fiscal revenues and fighting poverty through generating or freeing up budgetary resources to be used for pro-poor investments, while furthering environmental goals. Options of instruments of an EFR package should encompass a broad range of taxes, pricing instruments and reforming subsidies. In EFR concept, he allocates revenue in some ways such as: revenue allocated to priority spending areas; revenues are used for reduction in other taxes – tax shifting exercise; or revenues are earmarked for environmental/pro poor investment programs. He also finds evidences that EFR can increase the efficiency of the economy. EFR can be a powerful tool for mobilizing revenues, while simultaneously promoting environmental objectives and supporting poverty eradication measures – but EFR is not a “panacea”. With the concept proposed, Dr. Specks offers an important part of a development policy tool kit complementing and strengthening regulatory and other approaches to fiscal and environmental management – not only in developed but also in developing countries. My dear colleagues, The fourth session in this morning covered issues in financial system adaptation and innovation arising from climate change. Vast impact of climate change on production and consumption has led to the need for financing and market structure adjustment. There is room for banking and other financial institution to transform into green banking/financial institution and for them to be innovative and to create new financial instruments as part of adaptation effort. Ms Kathleen Robbins in this session outlined the problem of imbalances in trade and production subsidy between developed and non-developed countries. This is one of the reasons that can keep the poor t rapped living in poverty. In this regard, “Pyramid Protocol” can be a way to help the poor and alleviate poverty and raise the real income of the poor. It is suggested that the only way to help the poor and alleviate property is to raise the real income o f the poor. On the other hand, giving chance for the poor to get financial support to start small business is one way to help the poor graduate from poverty. Hence, financial returns, social benefits, and environmental benefits, are the need to be considered when designing responses to climate change. The question of whether climate change is a big deal for financial system was addressed by our fellow from bank of Thailand, Dr. Bandid Nijathaworn. He strongly agrees that climate change is indeed a big deal for the financial system through increasing risk exposure from macroeconomic impact, risk and new business opportunities with economic transformation, and financial system role as an agent for change. However, progress in Asia is in fact much less. Nevertheless, he finds that there are several key policy principles for moving the issue forward, such as clear global rule of the market beyond 2012, market infrastructure and incentive structure provided by the government, market-mechanism should be the key driver to deal with this new paradigm, and financial regulation should be neutral. He argued that there is substantial opportunity for the financial system, especially in supporting green technology and carbon trading market. He proposed the following action s to start-up emerging markets includes establishing the country’s overall strategy on carbon trading, reducing searching cost, educating all market players, and providing tax incentive to build up the market. Moreover, Barry Eichengreen shared his views that climate change is a clear case where financial market and instruments can be part of the solution. They offer coping strategies for firms, farmers, and governments struggling with the consequences, although both of markets and instruments find obstacle to progress. There are financial-market-like variants of cap-and trade offering cheaper ways than mandates of limiting emissions. On the other hand, there is a spirited debate between the advocates of carbon taxation and cap-and trade. Of course, both approaches require political will. On the other hand, Preety Bhandari on her remarkable presentation, described that the estimated investment and financial flows needed in 2030 is large compared with the funding currently available under the Convention and its Kyoto Protocol, but small in relation to estimated GDP and global investment in 2030. Hence, she urged the need for a clever financial architecture by exploring potential new international sources. In order to solve these matters, she proposed an optimal combination of mechanisms, such as the carbon markets, the financial mechanism of the Convention, ODA, national polices and new sources of finance are needed. The entities that make the investment decisions are different in each sector and the policy and/or financial incentives needed, will vary. Ladies and gentlemen, The final session, included four enlightening presentations, elaborated issues on adapting poverty eradication strategies to climate change. As the first speaker in this session, Mr. Danny Leipziger of World Bank argued that poorer households will be the most affected by climate change. He also raised the issue that systemic impacts will also threaten inclusive growth. This is so because changes in relative prices will affect poverty and distribution, rising fiscal pressures will strain poverty and investment budgets, and stress over natural resources can elevate conflict risk. He proposed several actions to be done in addressing climate change and poverty reduction. They are mitigation policies to adopt less GreenHouse Gas intensive technologies, adaptation strategy integrated with national poverty reduction strategies, economic adjustment impacts of global climate policies and impacts that lead to rising commodity prices and changes in trade flow. However, he also stressed that mitigation must proceed on a win-win basis with sensitivity to the needs of the poor. Finally he quoted important message from Schelling (1992) that the best defense for developing countries against climate change may be their own continued development!. Meanwhile, Hakan Bjorkman shared the other half story of the climate change, that is beyond the issue of deforestation and rising contribution to the green houses gas. Bjorkman conveyed key messages from a UNDP report, whereby climate change threatens to undermine Indonesia's effort in poverty alleviation. The impact is intensifying the risk and vulnerabilities facing by the poor people, placing further stress on already over-stretched over coping mechanism. So far global attention has been focused on mitigation and principally effort to reduce emission and carbon dioxide. These measures are important but for the poorest community the most pressing issue how to adapt. On the other hand, HS Dillon reiterated that developing countries dependent upon agriculture will be particularly harmed by global warming. HS Dillon also point out that the food security does not only come from impact of climate change and the lack of speed in food production to catch the rising demand, but also point the development and trade policies practiced that caused depressed agricultural prices leading to stagnant agricultural productivity in many places as well as the rapacious institutional investors playing in the commodity futures markets. Any solution, therefore, should not only be directed at cutting emissions but also enhancing the capacity of those who stand to suffer most. As part of the global solution, Dillon suggested that we focus on improving the quality of our institutions, providing more quality extension and easier access to credit and other resources so that even the small farmers can adapt, and adopting sound agricultural practices which allow preserving wildlife and developing rural communities at the same time in a sustainable manner. Finally Dr. Erna Witoelar shared her important messages that climate change is often recognized as a global equity issue. It’s the world’s poorest of the poor who contributed least to the atmospheric buildup of greenhouse gases, which are being hardest hit. It is also about countries and sections of populations who are the least equipped to deal with the harm they face, both for lack of economic resources and as a result of being geographically located in higher vulnerability areas. Meanwhile wealthier nations and populations, which have contributed the most to the atmospheric changes linked to global warming, are experiencing fewer effects and are also better able to withstand them. She highlighted three important approaches that need to be taken into account namely: a holistic approach at all levels of governance, from local to national to global; build synergies to upscale pilot projects and good practices to reach more regions, especially remote areas and multi-stakeholder approach where governments, private sector and civil society need to jointly engage, scale up and harmonized efforts to enable all least developed regions to achieve their MDGs. Lastly she believes that climate change mitigation and adaptation are far more than technology and infrastructure. It is about people’s resilience and building partnerships for everybody’s informed participation in climate change mitigation and adaptation together with efforts to achieve other MDGs. Ladies and gentlemen, We have taken another step forward in shaping a common position for mitigating the global climate change impact toward a better life of human beings. Following the Bali Roadmap on December 2007, and again through this seminar, the issues concerning the action of adaptation and mitigation of climate change will be discussed more comprehensively in searching for an effective and efficient global resolution. Having done all these and more, I do believe that we have not only completed some part of our preparations for the world actions in mitigating negative global climate change impact, but also advanced our broad inspirations for the building of macroeconomic and financial stability, for the long lasting prosperity of human being. Considering the multitude of points of view and the speakers and participants arguments, some of them conflicting with each other, on the various global climate changes impact that we have addressed, it is remarkable that we have accomplished as much as we discussed. I can only attribute this productiveness to your diligence and dedication and, above all, your will to accommodate and compromise in order to arrive at a common ground. For we all know that the stakes are exceedingly high, that the quality of life of future generations depends on the efficacy of our present efforts. We know that human welfare is indivisible and that has given us a strong sense of common purpose which is the unmistakable evidence that in all of us the spirit of Bali is vibrantly alive. Indeed, we have not merely paid lip service to history. Through our exertions during yesterday, through what we have accomplished in this seminar, we have endeavored to pay proper homage to the first generation of world leaders who met in this island last year. My dear Colleagues, Distinguished Participants, In this meeting you have all generously contributed your valuable thoughts and your power of articulation you have also given much of yourselves, many of you working until the small hours of the morning in order to fulfill this demanding seminar’s agenda. For that I cannot thank you enough. Also, I would like to thank IMF, ADB, GTZ, UNDP, and USAID for their valuable, partial financing of this one-and-a half day seminar. Last but not least, I would like to extend my heartfelt appreciation to the organizing committee and all support staffs, who have ensured the success of this year’s seminar. Before I close this remark, let me bring up an interesting note about Bali. The water found here on this paradise island is extremely addictive; once you tried it you will succumb to the island’s exotic wonders and return time and time again. So, once is never enough. I urge you to make the most of your visit and explore the magnificent sights, tastes and sounds of the island, with the hope that the memories that you make will be great, unforgettable ones. And finally, may God Almighty bless your journey home, and those taking the green tour this afternoon, I know you will have a great time!
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Speech by Prof Dr Boediono, Governor of Bank Indonesia, at the Bankers' Dinner 2009, Jakarta, 30 January 2009.
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Boediono: Living in a global economic crisis Speech by Prof Dr Boediono, Governor of Bank Indonesia, at the Bankers’ Dinner 2009, Jakarta, 30 January 2009. * * * Ministers of Indonesia’s United Cabinet, Members of the People’s Representative Council, Prominent Bankers, Ladies and Gentlemen, Assalamu‘alaikum wr.wb, Good evening and may God bless us all, Introduction To open my speech here this evening, I would like to invite us all to jointly extend our prayers and gratitude to God Almighty for this fantastic opportunity to gather together in such salubrious settings at the Annual Bankers’ Dinner 2009. To the banking community, this event represents a tradition as a moment of reflection and information exchange between us all. I would quickly like to take this great opportunity, if not slightly belated, on behalf of all members of the Board of Governors of Bank Indonesia, to wish everyone a Happy New Year 2009. The upcoming year of 2009 will be beset with challenges, however, we continue to be blessed with strength and guidance from God Almighty in all our endeavors. Distinguished guests, ladies and gentlemen, It is already extremely clear that numerous challenges and tests of our proverbial character will bedevil 2009. We are currently riding upon the crest of a great wave that represents the deepest global economic crisis since the Great Depression befell the world in 1929. Dominating the thoughts of economic policymakers and players worldwide is how to weat her this “perfect” maelstrom successfully. We have all entered “survival mode”. To the majority of us here in Indonesia, the salvo that heralded the onset of a global economic crisis was heard during the first months of the second semester 2007. At which time it was disclosed that a number of banks and financial institutions in the U.S and U.K were suffering financial hardship. The reason was attributed to sub-standard quality mortgages, or subprime mortgages, that began to perform poorly. In hindsight, the subprime mortgage debacle was merely the tip of the iceberg and was immediately followed by rapid escalation. The impact of the crisis spread like wildfire and deepened further. What began its life as a mortgage crisis quickly became a global credit crisis within a matter of months. The risk perceived by economic players increased almost exponentially. Credit flow for normal activities was severely disrupted as investors switched their savings to cash or gold instead of extending loans. Banks and financial institutions stretching across all corners of the globe faced their toughest time and some of them, including those with a global reach, filed for bankruptcy. The governments of several countries were forced to provide bailout and rescue packages to inject liquidity into the economy in previously unheard of amounts. To this day banks and financial institutions remain in a state of financial distress and credit flows are far from normal. ”The financial sector is broken”, remarked Paul Volcker. What has deeply concerned economic players worldwide, and is to be avoided almost at all costs, is the vicious downward spiral between the financial sector and real sector. In other words, the financial sector fails to function effectively, thus exacerbating the real sector, which subsequently undermines financial sector performance and so on, hence the downward spiral. The governments and central banks of many countries have taken any measures necessary, including unconventional steps to save the situation. In order to stop the downward spiral that I mentioned, the monetary authorities, particularly of the major economies, poured in vast amounts of liquidity. In addition, almost all governments have rolled out fiscal stimulus packages. To save their respective financial sectors, the governments of several countries have intervened, including through the implementation of blanket guarantee schemes for savings held at banks, insuring or taking over disputed assets, injecting capital into financial institutions and even buying out such institutions. If I portray a gloomy picture of the global economy, I certainly do not wish for us to be pessimistic, particularly regarding our own domestic economy. Objectively speaking, the current situation, and indeed the outlook, of the global economy is dreary at best. It is important that we view our problems objectively and as such we can take appropriate actions to really deal concisely with the problems. Actually, I would like to encourage you all to be more positive. I believe that with mutual determination and measurable steps we can traverse this challenging path safely and soundly, and God Willing, we will emerge stronger on the other side. At a global level, I foresee a bright spot. At the epicenter of this crisis, the United States, new hope is dawning in the form of a new government with their new economic team, who have pledged to take prompt and forceful actions in order to deal with the crisis. The willingness of major countries to coordinate their policies has also strengthened. I have also observed that some components of previously taken actions have demonstrated favorable results, despite remaining relatively minor as the scale of the crisis has mushroomed. Meanwhile, amidst such inauspicious surroundings, Indonesia is certainly not in the worst position compared to other countries. In general, our macro posture, including economic growth, is not bad. Our banking industry also remains robust. Indonesia can be considered lucky as its banks’ and financial institutions’ exposure to subprime mortgages is minimal. However, we are certainly not immune to the impacts of the crisis. As global credit crunch reached its pinnacle following the bankruptcy of Lehman Brothers, which dealt a psychological blow to the domestic market, in November 2008 the Government took over Bank Century in order to maintain national banking stability. Moreover, Indonesian banks are not immune from the problem of derivative products, and the scale being relatively smaller compared to several other developing countries, and significantly less than in developed countries. Meanwhile, some have expressed that our delay in integrating our financial sector with the global financial network is really a blessing in disguise, as it has saved us from more serious crisis fallout. I tend to agree with this view. In my opinion, it serves as a lesson for us not to be over enthusiastic to advance or be considered advanced before we truly understand the inherent risks and before we are ready with the required tools to manage such risks. Later I will return to this subject on the lessons learned from the ongoing crisis. A current issue we face today is the waning access of corporations and banks to sources of foreign financing. The exodus of funds from developing countries, including Indonesia, has been stemmed. Furthermore, the signs of capital inflows to Indonesia are yet to materialize, except on a small scale. The return to a normal flow of funds has not yet transpired but, as I have mentioned, there is reason to be optimistic. We have all witnessed how developed countries have gone all out when taking measures to normalize the supply and flow of credit to their own countries in order to stem the tide of deteriorating economic activities. Once credit flows in such countries have returned to normal, fund flows to developing countries will gradually return to normal too. Indonesia must position itself among other developing countries so that we can be among the first to benefit from the global financial awakening. In my view, the key lies in positioning Indonesia to be considered as a safe and convenient place to conduct business and investment. We have to assure investors that our macro economy is properly managed and sustainable, and that our financial sector, particularly the banking sector, is robust. This is our joint responsibility. Another issue of concern is the domestic interbank money market that has not operated normally in terms of daily transaction volume, in particular from the aspect of access by medium and small banks to this fund source. For your information, this issue regarding the interbank money market has been experienced by numerous countries and each country has responded differently. In general, the response is one or a combination of three steps: guarantee provision by the government; an insurance program with government support; and an expansion of the liquidity facility provided by the central bank to banks. Hitherto, Indonesia has relied primarily on the third option, namely by expanding the liquidity facility to banks. Over the past several months, Bank Indonesia has taken several steps towards this common end. It is important to admit that these steps have not resolved all of the outstanding problems, particularly in terms of access by medium and small banks that do not have adequate secondary reserves. Expansion of the central bank’s facility, such as through the short-term funding facility (FPJP), is not a perfect substitute for an optimal interbank market. Bank Indonesia expects national banks to jointly take initiatives and play a more active role in jumpstarting the domestic interbank market. We at Bank Indonesia always welcome further discussion with banks on this issue. Meanwhile, during the past two quarters, as has been evident in all countries, Indonesia is no exception; the global financial turmoil has crushed economic activities in general. This is a dangerous stage that requires forceful and effective steps to bring it to an end. Countries’ experiences have shown that a structural financial crisis such as is occurring now will have lasting impacts on the real sector. Sluggish economic growth will continue for several periods despite liquidity returning to normal. Consequently, I would like to reiterate the importance of strategies with clear targets. I will mention three targets that we must strive towards together: (a) to pass safely through this period of global credit crunch; (b) to ensure that national economic activity does not deteriorate in the short term; and (c) to promote conducive conditions so that the subsequent domestic economy is on a track to sustainable economic growth. Fiscal stimuli are a key step in preventing the further deterioration of economic activities in the short term. Furthermore, the expeditious implementation of the 2009 National Budget is required and it also has to succeed. However, as Ben Bernanke often reminds us; to emancipate ourselves from the shackles of this crisis, fiscal stimuli have to be introduced concomitantly with financial sector strengthening. Fiscal stimuli are basically a way to prime the pumps. They will not catalyze sustainable economic growth if not buttressed by a reawakening of private and business sector activities. Furthermore, the private sector will only be roused if supported by a fully functioning financial sector. As such, measures to repair and reinforce our financial sector must be taken along with the introduction of fiscal stimuli. In our great nation, banks remain a reliable source of financing for the business sector, and thus, tidying up and strengthening our banking sector must remain a priority for continuous implementation. Within its authority but constrained by capacity limits, Bank Indonesia will take any and all measures required to attain this target. For a developing country such as Indonesia, I would like to add one more ingredient to Bernanke’s recipe; that is we also have to perform structural reforms to remove the obstacles to business activity. Lessons learned Distinguished guests, Experience is the best teacher in life. The ongoing global crisis provides valuable lessons for our future endeavors. Allow me to highlight a few. A simple lesson learned from this crisis is the importance of going back to basics. Let us view the reason. The current crisis can be seen as a consequence of financial sector development that is detached from its roots, which is real economic activity. Expansive development of the financial sector in many countries for over a decade has stemmed from financial product innovation as well as the great strides made in financial institutions. Such innovative growth has been made possible by the revolution in information technology and global financial liberalization. The financial sector in many countries has attracted many people, including the best and the brightest, as it is often a fast track to wealth and riches. Those who are skillful, innovative and dare to take risk can receive a befitting reward. Financial products that have become more varied, more sophisticated and more complex have a fatal side effect, namely that the inherent risks are more difficult to assess. Financial instruments are becoming separated from underlying transactions that should form their base and have developed into bubbles. Due to their internal dynamics, the bubbles are swelling and many have finally burst, which precipitated this crisis. In short, the ongoing crisis is basically a consequence of failed risk management, both at the micro and macro levels. Back to basics applies to all financial institutions, particularly banks. The main role of banks is to facilitate and finance activities associated with the supply of goods and services to the people; more specifically “real” activities. Banks perform their function through financial intermediation; that is to collect funds from their owners and distribute it to borrowers. However, banks can act as more than just intermediaries. Banks can create additional liquidity through demand deposits. Such bank activities inherently contain risks, either to the bank itself, to savers, to the banking system or to the economy. These risks have to be properly mitigated by the banks, which is their primary responsibility and requires the full attention from bank management, above and beyond a full-time job. Banks play a role in financing activities with clear underlying transactions, which have to be based on clear risk assessment. Dabbling with speculative instruments is not the domain of bankers. Banks should avoid activities that contain bubbles. If such activities cannot be avoided, effective risk management must be applied. Bank Indonesia, as a regulator, has an interest in encouraging banks to apply prudential principles. In the future, we will strengthen the protocols required to accomplish this objective. The current crisis has also provided concrete proof that the concept of universal banking is not a crisis-durable model. We should reconsider this concept thoroughly and with caution. Policies taken to further develop the industry towards more advanced concepts must be followed by various strengthening measures and the preparation of resolute risk management. Meanwhile, we can conclude that the narrow-bank concept is more befitting the banking domain and has been proven to endure during a crisis. The selection of a bank business model determines the resilience of the banking sector. During the current crisis and the catastrophic crisis of 11 (eleven) years ago, we can clearly observe that banking sector resilience is the main line of national defense against financial turbulence. Allow me briefly to draw one more important lesson from the ongoing crisis. The lesson is that the basic principles of conventional macro management have been proven to be relevant in conditioning an economy against turbulence. Countries that observe and protect their basic indicators, such as the national budget deficit, current account deficit, ratio of debt to repayment capacity, foreign reserves, inflation rate, liquidity growth and exchange rate under a framework of sustainable economic growth, in general, are in a better position to confront a crisis. Conventional wisdom prevails even (or especially) during a storm. With reference to macro equilibrium management, I believe that this crisis has brought a more structural lesson. Using experience gleaned from the current crisis, we need to consider some more basic questions; questions that will help guide us when positioning Indonesia during this era of globalization. For instance, what is the best equilibrium for our economy: between the domestic market and export market, between the financial sector and real sector, between the outward orientation and inward orientation of our financial sector, particularly our banks, between relying on domestic financing or foreign financing. Such questions require a fair, thorough and in-depth thought process. It is imperative to answer these questions if we want to develop a more resilient national economy to future turbulence. Prospects and challenges in 2009 Distinguished guests, Allow me to further explain the horizon we face in 2009. One issue that can be considered undeniable is that all countries around the world face an economic downturn. Indonesia is no exception. For us, the effects of the crisis began to be felt during the last quarter of 2008. The economic slowdown will be more obvious in 2009, particularly during the first semester. Estimations we ran at end of 2008 projected that our domestic economy in 2009 will grow in the range of 4%-5%. Certainly not too bad when compared with the projections of many other countries. However, observing the current global trend, the downside risk will increase. In line with efforts to protect economic growth, the key here is how to maximize domestic market potential to bolster domestic economic activities. The foremost element of this policy is to expedite the implementation of a fiscal incentive package and the 2009 national budget. Well-controlled inflation as well as government, political party and public expenditure for the upcoming General Election, will also help underpin public purchasing power. In addition, certain policies that must be intensified include measures to improve the business climate and reduced domestic business costs. The implementation of such policy should not require any additional funding, however, more focused and determined actions to detangle the knots are necessary. We hope that during this year of the general election, such policies can be continued and even intensified. Meanwhile, along with tumbling commodity and fuel prices as well as solid rice production, the interest rate in 2009 is expected to decline, in the range of 5.0-7.0%. If current developments persist, however, the lower limit of this range is expected. Questions often arise on the prospect of our Balance of Payments this upcoming year. Based on detailed calculations performed at the end of last year, we estimate that the Current Account will run a deficit of around 0.11% of GDP in 2009. Global fund flows are estimated to return to normal in 2009. However, there is one particular note for Indonesia. If the experience of the 2004 General Election reoccurs this year, namely a safe General Election that results in the formation of credible cabinet, then during the fourth quarter there will be relatively large inflows of funds. The majority of such funds belong to our nation’s citizens, temporarily placed abroad while awaiting confirmation of the domestic political situation. Based on our calculations, foreign reserves by the end of 2009 are estimated at USD51 billion; adequate to finance 4.7 months of imports and government foreign debt repayments. In the banking sector, stress tests indicate that the resilience of our domestic banking industry is sufficient. In 2009, the capital adequacy ratio (CAR) is estimated to decrease slightly from 16% in 2008 to 14%. From regulatory capital point of view, this ratio is still well above its minimum limit. However, from the economic capital view, this development should be anticipated in a timely fashion. A declining capital adequacy ratio indicates the reduced ability of banks to absorb various risks and expand credit. Therefore, I would like to see efforts to reinforce bank capital remain as our primary focus in the future. Bank Indonesia will continue to closely monitor the development of capital at each bank. We are all aware that without safe and adequate capital, the bank intermediary function will not run optimally, and industry resilience to inauspicious conditions, such as now for example, will be undermined. Based on current capital strength and contradictory to credit growth in developed countries such as in the European Union and United States, where a downturn was experienced in 2008 and perhaps negative growth will prevail in 2009, credit growth in Indonesia in 2009 is estimated to remain in the range of 18%-20%. Yet the downside risks are relatively large. Meanwhile, slow economic growth will precipitate a rise in NPL to around 5% in 2009, which is still considered within safe boundaries. It is important to be aware that liquidity in our banking system is currently adequate. This is evidenced by large placements in Bank Indonesia Certificates by Indonesian residents; now totaling Rp200 trillion, and undisbursed loans of Rp253 trillion (November 2008). This large liquidity pool indicates that our economy is not suffering from a liquidity shortfall. Our challenge is how to utilize this liquidity to finance economic development and business sector activities. Direction of monetary and banking policy in 2009 Distinguished guests, Under the all-encompassing blanket of the current global crisis, we are fully aware of the importance of monetary policy that supports the real sector. However, policy must be consistently implemented in the context of sustainable economic growth, supported by economic stability in the mid-long term. Monetary policy must strike a balance amongst stimulating the real sector, maintaining price stability, maintaining financial market harmony and ensuring financial system integrity. Monetary and liquidity loosening will be complemented with thorough surveillance and assessment by Bank Indonesia on indicators associated with these targets. Distinguished guests, We are aware that the various obstacles emanating from the global financial crisis in 2009 require concrete steps by the relevant authorities to maintain the performance of business players in productive sectors. To this end, policy should be directed to ensure that the bank intermediary function can be performed optimally. Meanwhile, we also expect that the extension of Rural Business Loans and MSME loans will experience relatively strong growth. Such credit is vital to rural people and those in remote areas in order to enable them not only to survive but also expand their businesses during difficult periods such as we expect in 2009. Several policy measures have already been taken and will continue to be taken in the future to facilitate credit flow. This evening, I do not wish or have the time to convey in any detail the regulations that will be promulgated. I opine that during this difficult period filled with uncertainty, the policies of Bank Indonesia will continue unabated, following economic dynamics that require appropriate responses as well as anticipatory measures. However, generally speaking, I would like to disclose that Bank Indonesia recently issued regulations aimed at providing freedom of action for banks to extend credit. The regulations cover several issues that constitute areas of concern for most of you present here this evening, such as: extending the transition period for Basel II implementation with reference to the capital cost of operational risk calculations; procedure simplification for opening a branch office, including sharia banks; adjustment of risk-weighted assets for Small Enterprise Loans with a guarantee scheme; adjustment of the credit assessment method for specified amounts; providing USD repurchase agreement (repo) facility between banks and Bank Indonesia; as well as reducing liabilities regarding the provisions for losses of nonearning asset (abandoned assets). In the very near future, in-depth regulatory steps to improve bank transparency, as well as strengthen the effectiveness of liquidity risk management and derivative products will complement these regulations farther. Under such a policy, all players in the banking industry, including shariah, is expected to have sufficient space to maintain its intermediary function, as well as continue the implementation of prudential principles and risk management as a priority. Distinguished guests, As I mentioned earlier, the cornerstone of our defense against a crisis is the banking sector. The economy is crisis resistant if its banking sector is crisis resistant. The banking sector I allude to is based on two pillars, namely good governance and good supervision. Regarding good governance, I would like to stress one pivotal aspect. With the circumstances found pervading our financial and banking sectors lately, I am even more assured that human integrity and character, above all else, are determining factors. We can adopt a sophisticated risk management system and put in place a good supervision system, however, in the end the result is subject to the integrity and character of the administrators. No matter how good a system is it will not work if the administrators seek loopholes to abuse and exploit. In the future, Bank Indonesia will strengthen its screening process based on the character and integrity of our bankers, and certainly, our supervisors. Bank Indonesia will also impose strict sanctions for those who abuse their authority. PSP and bank management must take full responsibility, bound by prevailing laws and regulations, for incidents that occur at their respective banks. Improvements to bank resilience closely correspond to the quality of bank supervision. With this in mind, I am happy to report that Bank Indonesia is currently undertaking steps to augment bank supervision. The repositioning and revitalization of personnel is currently underway. Supervisory procedures and methods are constantly reviewed to focus on issues that determine the wellbeing of a bank. In 2009, we plan to boost the effectiveness of bank supervision through two key measures. The first is to complete the risk-based supervision framework by improving the risk assessment process, oversight, auditing and system surveillance. Ameliorating the quality of risk management, particularly liquidity management and control over new products and bank activity, represents the mainstay of ongoing endeavors. This is considered sufficiently urgent to be handled during the current financial turmoil. Second is to improve the function and organization of supervision both at head office and all branch offices of Bank Indonesia. We will continue to strengthen the correlation between findings and actions; between audit results and management steps. We will form a panel team to improve audit quality and managerial steps. This year, we will also increase our budget for training. These measures are expected to secure our pathway through this crisis period as well as also build more solid foundations for better bank supervision in the mid term. Closing Distinguished guests, This brings me to the end of my speech here this evening. The ship that represents our national economy is currently navigating a tempestuous ocean. The ship itself is relatively robust, certainly stronger than the ship we sailed eleven years ago. However, the current weather front dwarfs that of eleven years ago. Notwithstanding, I am convinced we can weather the storm. The key is that the ship’s crew and passengers are unified and open to help one another based on trust. I am confident that this is our joint resolution, as the alternative is too expensive for our country, as transpired eleven years ago. I sincerely wish you all a productive year ahead and once again, Happy New Year for 2009. Hopefully during this New Year, God Almighty will bless us and light our way towards a better and more prosperous future. Thank you. Wassalamu’alaikum wr. wb.
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Keynote speech by Prof Dr Miranda S Goeltom, Acting Governor of Bank Indonesia, at the Intern. Seminar on Islamic Finance & Banking "Opportunities for Indonesian Investment through Sharia Financing - Experiences & Challenges", New York, 17 July 2009.
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Miranda S Goeltom: Opportunities for Indonesian investment through sharia financing – experiences and challenges Keynote speech by Prof Dr Miranda S Goeltom, Acting Governor of Bank Indonesia, at the International Seminar on Islamic Finance and Banking “Opportunities for Indonesian Investment through Sharia Financing – Experiences and Challenges”, New York, 17 July 2009. * * * Distinguished speakers and participants, Ladies and Gentlemen, May I ask you to join me in thanking God the Beneficent and Merciful for His unbounded grace that has enabled us to gather here today on such an important occasion, the International Seminar on Islamic Finance and Banking, entitled “Opportunities for Indonesian Investment through Sharia Financing: Experiences and Challenges”. I am thrilled to see so many distinguished speakers and participants, all prepared to contribute with their insightful experience and expertise. In my opinion, this seminar is of paramount importance in the midst of our efforts to discuss alternative solutions to avoid a repeat of the current economic and global financial crises. In such a deep global crisis we must seek ways to survive and, subsequently, return to our previously hard-earned growth and stability. This is precisely the time when collective action is required most, in order for us all to survive this global financial tsunami and emerge the other side stronger and wiser. Given the depth and systemic nature of the crisis, a wait-andsee approach or simply hoping that recovery will take place on its own is utterly unacceptable. The crisis and the current global financial system Ladies and Gentlemen, A number of analyses argue that the ongoing global financial crisis is inseparable from the effects of the global financial system. In the past decade, financial products have become more diverse, advanced and complex. This is attributable to the effect of innovative development in terms of information and technology, deregulation of supporting financial systems and a favorable global macroeconomic environment, including a low real interest rate. BIS data shows that global financial assets stock increased sharply from about 100% of global GDP in 1980 to over 300% in 2005. This development was further accompanied by expansive growth in the amount and scope of derivatives and financial instruments. The position of interest rate swap and other derivatives reached USD600 trillion at the end of 2007 (11 times annual global GDP) compared to USD75 trillion in 1997 (2.5 times global GDP). The position of Credit Default Swap (CDS) also reached five times that of global corporate bonds in 2007, which is a very different picture when compared to conditions in 2004, where the share of CDS was just 85% of corporate bonds. On the other hand, however, such developments also carried fatal side effects. Financial instruments have become more independent from their underlying transactions that should serve as the foundation. Risk assessment on the types of asset owned has also become more difficult and complex. We have further witnessed that the phenomenon of escalating activity in the global financial market turned out not to be permanent. As we have noticed, bubbles have burst and brought terrible impacts on the global economy since mid 2007. The most commonly used adjective to describe the current financial crisis is “unprecedented”. It is unprecedented in terms of the speed at which events unfolded and triggered a series of domino effects; the scale of the impact that has become global; and it is truly unprecedented in terms of the panoply of unconventional measures taken by authorities around the world. This is clear for all to see in the policy responses taken to overcome the crisis, which is incredibly complex and certainly costly. The IMF projected that global economic growth would contract from 3.2% in 2008 to -1.3% in 2009, whereas economic growth in developed countries is expected to be even worse, shrinking by -3.8%. IMF also predicted that total losses due to the current global financial crisis will top US$4 trillion, twothirds of which stem from the banking sector. The crisis and the sharia financial system Ladies and Gentlemen, The lesson we can glean from this crisis is that a sound and resilient economy is not based on speculative activity. Furthermore, financial sector activity must be founded on business activities that produce real benefits to the public. This condition, in my opinion, implies that the behavior of the current financial system needs to be reset; going back to basics (khittah) as intermediary institutions that distribute funds from surplus units to deficit units. One alternative that has the potential to bolster back-to-basics principles would be to expand the role of the sharia financial system. This relates to the structural advantage of the sharia economic system, which does not permit speculative transactions or products without a real underlying transactions. A traditional sharia financial system focuses on conservative products and avoids exposure to high-risk financial instruments. Consequently, the dependence on financial instruments is comparatively low because investment in each financial instrument must be identified clearly and accurately. The key characteristics of the sharia financing system also aligns the role of banks to be consistent with their primary function, namely to collect funds from their owners and distribute it to borrowers. To be more precise, the main function of banks is to facilitate and finance activities associated with the supply of goods and services to the people; more specifically “real” activities. Therefore, financing activities through sharia banking are closely linked to real sector development. Moreover, speculation and gambling, the main culprits behind the on-going crisis, are not tolerated. Thus, by design, the Islamic financial system can instill greater stability in an economy. And, if implemented correctly, the Islamic financial system can provide an optimal risk management system. Sharia financial system performance Ladies and Gentlemen, The potential role of sharia financial institutions in the economy has been discussed on numerous occasions. According to The Banker magazine in 2007, sharia-compliant assets worldwide have grown by almost 30% per annum in recent years. Such growth outstrips most other business segments in financial services. In 2008, sharia financial assets worldwide reached $643 billion and are expected to exceed $1 trillion by 2010. In fact, there are currently more than 400 financial institutions offering sharia compliant products globally, including Sukuk, which has created significant demand in the market over the last five years. Countries like United Arab Emirates, Saudi Arabia and Malaysia are competing to become centers of Islamic finance. In such a competitive environment, Indonesia also has a great opportunity to advance itself as the center of Islamic finance. As the most populace Muslim country on the planet, with a population of more than 237 million, Indonesia is undoubtedly a promising market. Since the establishment of its first Islamic bank in 1992, the sharia industry in Indonesia has exhibited relatively robust growth. Sharia banking is in its infancy since the establishment of the first Islamic bank in 1992, however, has demonstrated strong and steady growth. Business volume has grown expansively, exceeding the growth rate of the banking industry as a whole. Currently in Indonesia there are three full Islamic banks (FIBs), 19 Islamic Banking Units at Conventional Banks (IBUs), and 92 Islamic Rural Banks. As a whole, the industry is supported by 531 Islamic bank offices currently operating throughout Indonesia (288 FIBs, 121 IBUs and 92 rural banks). The sharia banking industry has amassed total assets amounting to Rp50 trillion (USD 4.2 billion), or 2.1% of all bank assets in Indonesia. This share has increased steadily from previous years: 1.4% in 2005, 1.6% in 2006, 1.8% in 2007 and 2.14% in 2008. With 1,470 branch offices spread over the country, the amount of financing provided by the industry has grown from a mere Rp 5.5 trillion (USD 458 million) in 2003 to Rp 28 trillion (USD 2.3 billion) in 2007 and Rp 38 trillion (USD 3.2 billion) in 2008. The industry has also shown its commitment to support micro and small-scale businesses with microcredit financing (KUR). By the end of 2008, total microcredit extended by sharia banks reached Rp 326 billion (USD 27 million). As a whole, the Islamic banking sector has grown at a compounded annual growth rate (CAGR) of over 46% in the last five years. Notwithstanding, the Industry is expected to acquire a 15% market share of the total national banking system by 2015. With reference to the capital market, the first corporate sukuk was issued in early 2002, followed by tens of corporate sukuk issued over the subsequent years. Islamic capital market development was marked by its inclusion in the National Master Plan in 2005. As of December 2008, there were 22 corporate Islamic bonds issued under mudharabah and ijarah contracts totaling Rp 4.78 trillion (equivalent to USD 434.5 million), or approximately 2.7% of total bonds issued. Furthermore, there are currently 36 issuers of Islamic Mutual Funds, consisting of equity funds, fixed income funds and balanced funds. Net Asset Value (NAV) totals Rp1.8 trillion (USD163.64 million), approximately 3.5% of total NAV for mutual funds. Those promising sharia financial institutions are inextricably tied to strong political will from the stakeholders. In June 2008, the Islamic banking industry in Indonesia gained new momentum as Parliament passed a new Islamic Banking Act. In April of the same year, Parliament also enacted a new bill concerning Islamic Bonds. The promulgation of these two laws has provided a firm legal foundation for Islamic banking in the country, thus promoting the advancement of Islamic banking and finance. In August last year the Government successfully issued state sukuk and then in February of this year retail state sukuk were issued. Surely, this has contributed significantly to further catalyze the development of a wide-based retail secondary market for investment products that adhere to Islamic rules. Meanwhile, a bill to tax sharia transactions is being drafted, which we expect will be passed shortly. We hope that it will provide fairer tax treatment for sharia financial activities, thus making sharia products more competitive. Concerning the current global financial crisis, Indonesia’s sharia banking industry has remained relatively stable and insignificant affected. This fact is positively contribured by low exposure to international investment and foreign exchange transactions in Indonesia’s sharia banks. It is approximately just 5% of total assets and liabilities. Annual growth in assets, deposits and sharia banking financing remains high, at 29.5%, 27.1% and 26.08% respectively in May 2009. Stable sharia bank performance is also clearly evidenced by low industry-wide Non-Performing Financing (NPF) at just 6.19% in May 2009, despite a slight increase in March and April 2009. NPF has remained relatively steady compared to NPF in 2007 and 2008 at 6.62% and 5.75% respectively. With regards to capital, Tier-1 capital position also increased to Rp2.48 trillion, compared to its 2008 position of Rp2.19 trillion. However, we are aware that a lot of homework and groundwork still remains to be done. There are issues regarding the basic structure of sharia products, both for asset finance and fund raising or liability products. These products require further clarification and clearer guidance not only from the banks but also from the authorities. Another set of challenges that lie ahead in terms of further nurturing sharia finance is how to effectively introduce and sell related products to this potentially huge market. Sharia financing and Indonesia’s economic outlook Ladies and Gentlemen, We believe that the potential of sharia financing in Indonesia will continue to grow in the future. In a country with such a large Muslim population the potential for sharia product expansion is great. Currently, the number of sharia users is relatively still limited, namely 3.3 million fund account holders and 525 thousand financing account holders. The outlook for sharia financing in Indonesia is keep promising thanks to robust economic outlook. Indonesia’s economy, in fact, has outperformed many other countries in the region and peer group. Economic activities have been sustained by relatively strong domestic demand, capable of absorbing domestic production and preventing the market from falling deeper off the precipice of recession. In the first quarter, the economy recorded 4.4% growth, which far exceeds international economic growth. Whereas, economic growth in Quarter II2009 is projected at between 3.7% and 4.0%, buoyed by consumption, which is projected to exceed 5%. Holistically, Bank Indonesia expects the economy to grow between 3.5% and 4.0% in 2009. Inflation in 2009 is projected to be lower than our initial forecast, possibly below 5%. This is affected by, among others, improving inflation expectations and sustainable food supply and distribution. However, Bank Indonesia continues to monitor potential inflationary pressures expected in 2010, including rising global commodity prices. In this context, future monetary policy is designed to strike an optimal balance between stimulating the domestic economy and maintaining macroeconomic and financial system stability in the mid term. We also believe that Indonesia’s growth prospects are supported by sustainable financial system stability. In the financial sector, CAR remains high at 17.3% and NPL is still in the safe zone; below 5%. Meanwhile, bank liquidity, including liquidity in the interbank money market, is improving and deposits have increased. Despite the limited response by bank interest rates and credit disbursements that are far slower than expected, the bank credit extension plan has shown indications of quicker expansion in the near future. Ladies and Gentlemen, Let me conclude my brief remarks by expressing that, from the point of view of a central bank in an emerging economy, the winds of change are indeed blowing. Dealing with the global financial crisis is paramount. Many of our working assumptions are constantly being challenged by this new reality, which requires creative and sound policy on our part and, more importantly, courage to implement bold, often unprecedented, measures. In this respect, we at Bank Indonesia believe that sharia financial institutions show great promise as one of cornerstone of future sustainable economic activity. Finally, I am sure that this Seminar will generate valuable insight and new ideas in terms of dealing with the global financial crisis. Bank Indonesia, as the monetary and banking authority in Indonesia, is ready to fully support the continued development of sharia finance in the country. We invite and warmly welcome all of you who wish to join with us and develop sharia finance. May God bless all of us with His mercy.
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Opening address by Dr. S. Budi Rochadi, Deputy Governor of Bank Indonesia, at the SEACEN Seminar on Currency Operations and Management, Bali, 12 August 2009.
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S Budi Rochadi: Currency operations and management Opening address by Dr. S. Budi Rochadi, Deputy Governor of Bank Indonesia, at the SEACEN Seminar on Currency Operations and Management, Bali, 12 August 2009. * * * Distinguished Speakers, Honourable Guests, Respected Participants, Ladies and Gentlemen, Assalamu’alaikum wr. wb.and Good Morning. I am delighted to be here this morning to welcome all of you to the SEACEN seminar on Currency Operations and Management on this beautiful island of Bali. Before I begin, I would like to ask you all to join our hands together and thank the Almighty because it is only due to His blessings that we could gather here to attend the seminar in good health and excellent condition. This Seminar is intended to further enhance knowledge sharing among SEACEN members as well as between central bankers and industry in all pertinent issues of currency operation and management. Ladies and Gentlemen As we are all aware, the very traditional responsibility of a central bank is to issue and distribute currency to serve the country’s economy. It is hardly imaginable a modern economy could function smoothly without any cash transaction. Regardless of our achievement in advancing non-cash payment system, cash still remains a critical payment instrument. Fulfilling this responsibility is indeed not a simple thing. There are so many challenges in assuring that the society’s need of adequate currency in terms of quantity and quality for every denomination is met. This only can be achieved if we have an accurate demand for currency forecasting, a smooth currency procurement, and a reliable currency distribution system, which can cater any geographical condition and public preference for the currency. I am quite sure that all of the issuing authorities from SEACEN members are facing difficulties in conducting this task. Even though the problems could vary between countries, there is one thing among others that we share in common that is the accompanying problem with the rise in the number of population. In our case, this task is not made any easier by the fact that the Indonesia’s estimated population of around 240 million at the end of 2008 is spreading in almost a thousand inhibited islands. Another important issue that the central bank and issuing authority have to deal with considering its severe impact on the economy is the counterfeiting activity. Nowadays counterfeiters are becoming more advanced. To cope with that the central bank needs to increase their vigilance by continuously improving the security features of the currency to give protection and assurance to the public holding the currency. Ladies and Gentlemen, To achieve the goals mentioned above, the cooperation among issuing authorities and currency industries should be further deepened. This cooperation will provide safeguard to the proprietary techniques solely used to produce national currencies amidst the development of many security features and printing techniques today. Therefore, governments and security businesses involved, must constantly adjust their whole range of currency operation and management system from design, production, distribution, and destruction process. In this dynamic situation, communication and information sharing will help all members of the currency community to better understand and respond to the ever changing environment. Communication brings knowledge, which in turn means greater understanding for the community as a whole. However, communication does not necessarily mean revealing information that should be kept confidential nor does it mean disclosing commercial secrets or proprietary information. Ladies and Gentlemen, In this spirit of communication, I believe that the presence of our fellows from banknote security industry and other related institutions in this seminar will provide us an opportunity to obtain more valuable information that can broaden our perspective. In addition, information sharing among central bankers regarding experiences in managing our respective currencies could help each of us to improve efficiency and effectiveness in our daily job. Finally, may I now take a great pleasure in declaring the Seminar open and wishing this event a great success. Have a pleasant stay in Bali. Wassalamu’alaikum wr. Wb. Thank you.
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Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Banker Association for Risk Management (BARa) seminar on "Managing Risks in an Uncertain World", Jakarta, 26 October 2009.
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Budi Mulya: Managing risk in the new landscape Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Banker Association for Risk Management (BARa) seminar on “Managing Risks in an Uncertain World”, Jakarta, 26 October 2009. * * * Chairman, Board members and members of the Indonesian Bankers Association and Banker Association and Risk Management, Distinguished Speakers, Ladies and Gentlemen, It is such a great honore to be here today, especially to join in a dialog amongst experts and practitioners, on risk management. The risk management topic, has become an important subject to be seriously addressed, considering on what we have observed during the most recent global financial crisis. The impact of the crisis that emerged back in September 2008, has spread deeply and widely through, both financial market and real economic, in particular passing through international trade channel. Since then, we all have witnessed that over the past year, there has been dramatic change, in many aspects of the economy and financial market globally. The magnitude impact of the crisis into individual country differs, depending on how, and to what extent the economy of individual country, and its financial institutions is linked into the global market. Yet, there is no single country immune from the recent turbulence. This is mostly because at the first stage the financial turmoil which started in the US financial market has triggered panic amongst financial market players, in face with high uncertainty, and this behavior was spreading almost instantly worldwide. To that respect I would like to emphasize, that such market behavior has much to do with risk management, more specifically in the weakness, of its implementation in the real world. Thus, the recent crisis shows somewhat in contrast of the fact that during the last decade risk management has become one important topic in discussion. As a management tool, the practice of risk management so far, has failed to change human being behavior that tends to be easily trapped in complacency. That is, a tendency of not assessing risk properly in good time, partly covered by expected high return, but then reacting so extremely in reverse when thing goes in the opposite direction. However, as we observed from the ongoing public debate with regard to the cause of the recent turmoil, the similar phenomenon can be found within the authority’s or regulator’s perspective. In particular, on how they perceived risk in setting policy and in regulating financial industry. More specifically on the assumption that market discipline will always work properly. One highlight that we can derive from what has been happening so far, is that the financial industry must always be closely linked with the real sector activities, the fundamental economic. The Indonesian economy and financial industry during turmoil As in some emerging economies, Indonesia essentially has quite a strong fundamental, and much better compare to what was during 1997/98 Asian crisis. However, as I previously mentioned the crises that caused global economic growth slump and the international trade volume squeeze, as well as a high degree of uncertainty that surrounded the international financial market has also weakened the domestic economic activities. Yet, the economy is still able to expand. The Indonesia’s economy grew at 6.1% in 2008. The Indonesian economic growth reached the bottom in quarter II 2009 at 4%, a 0.4% drop from previous quarter of 4.4%. We expect that the Indonesian economy will grow at 4.0 to 4.5% in 2009, higher than previously estimated. The domestic economic growth is mainly supported by domestic demand which contribute more than 60% of GDP and natural resources export. In 2010, we expect the economy will grow at 5% to 5.5%. Along with declining domestic economic activities in 2009, inflation rate has also descended. As of September 2009, the year to date inflation rate is 2.28%. Inflation is expected back to its normal pattern in 2010 at 5 +/-1 % as economic activities start accelerating. In addition, the domestic banking industry is also in relatively sound condition and well capitalized. The average capital adequacy ratio (CAR) is around 17% and the gross nonperforming loan (NPL) ratio is below 5%. Those facts show that the Indonesian economy is relatively sheltered from the biggest turbulence since the world’s war II. However, foreign investors tend to undermine those facts, and perceived risks exaggeratedly on the Indonesian economic fundamental. Despite that, it was true that the crisis caused panic and lost of confidence, in particular post Lehman Brothers collapsed on 15 September 2008, which led to the phenomenon of holding cash alike and safe haven assets, it has put significant pressure on Indonesian economy and increasing volatility in the domestic financial market. Risk perception on the Indonesian financial market has been so high as shown in the hike of CDS spread, that reach a peak of around 1000 bps in October 2008, the highest spread amongst countries within the region. Further, the exodus from emerging market financial assets, led the government bond (SUN) price index (IDMA index) to fall to its lowest level ever at 67.11 in October 2008, which mean that across the board yield of SUN, has hike to above 15%. The IDR exchange rate again US Dollar, has also weakened dramatically from around 9.200 levels, to reach its peak at 12.000 levels in November 2008. However, the above symptoms of increasing counterparty and credit risk also could be observed in domestic market. The inter-bank money market indicators also revealed similar shape, to those found in global market during the crisis. The spread of JIBOR 1 month over BI Rate for instance, has widened significantly to around 250 bps, despite that the interest rate was in a declining trend, while in normal condition it is always below 50 bps. Further, there was also a tendency that banks prefer to hold their reserve, in shorter maturity of Bank Indonesia’s OMO instruments (FASBI and short-term deposit collection, the so-called FTK). These, along with nervous as observed in the banking industry with regard to its funding source, public or third parties deposit that led to unhealthy competition amongst banks, has showed that, there was some potential liquidity risk in the domestic banking sector. To cope with the above mention situation, the Government and Bank Indonesia took some necessary measures to safeguard the domestic economy. Government has provided fiscal stimulus to secure the real sector activities, as well as to prevent the deterioration purchasing power of the poor. Meanwhile, the monetary policy stimulus, took form in accommodative stance, as inflation has fallen, by reducing BI Rate 300 bps since November 2008, from 9.5% to 6.5%. In addition, from the operational level, Bank Indonesia has also undertaken some measures aimed at addressing market liquidity concern, by providing and ensuring the supply of liquidity in cash money market, both in US Dollar and in Rupiah. In US Dollar market, Bank Indonesia reduced the required reserve ratio, from 3% to 1%, lengthening the maturity of swap operation, and ensuring the US Dollar liquidity need for domestic corporations via banks, by providing window for rediscounting export underlying instrument. Meanwhile, in the rupiah money market, Bank Indonesia took similar measure, such as providing window for “repo” transaction, using underlying assets of government bonds, and certificate of Bank Indonesia (“SBI”), for various maturity, recently up to 3 months, through an auction mechanism. The auction mechanism is also aimed at averting, the negative “stigma” from banks’ perspective in dealing with the central bank to obtain temporary liquidity in fair market price. All those measures, which in essence is similar to those taken by major authorities globally, even though differ in scale and instrument variety, has so far help the Indonesian economy and financial sector, in passing by the most challenging episode during the crisis. Along with improvement in global economy and financial market, those indicators have move back to their more normal level. The spread of JIBOR 1 month over BI Rate, for instance, has decline significantly at around 15 bps. Yield of SUN has declined to 10%-11% for the 10 years SUN and longer maturity. The CDS spread has also dropped to below crisis level of below 200 bps, close to the pre crisis level. Meanwhile, the IDR exchange rate has also recovered and hover around 9,400 recently, despite still at higher volatility compare to the pre crisis period. However, the policy transmission into the real sector has been slowing down as uncertainties remain. The banks’ lending, needed to support the economic growth, is still quite slow. The year to date banks’ lending growth up to September 2009 is still below 5%. In addition, the lending rate also does not decline as expected. Despite that, this is sensible, in face with the declining economic slowdown and uncertainty, but is also closely linked with the way banking implement risk management. For some extent, this reflects, that they tend to avoid risk rather than, properly identifying and manage risk accordingly. We also observe that the way financial investors globally, do not show any change in their behavior, as mainly reflected in the high volatility of stock market. They tend to over react on every single news and data announcement, which indicates their eagerness, to try to recover their lost during the crisis, and nervousness of potential lost. This behavior, is potentially threatening the sustaining economic recovery. The risks and challenge ahead There are now more signs of global economic recovery and improvement in the prospect of financial market. However it is still too early to conclude, that the recovery path will be smooth and sustainable, since as I previously mention, the lag of policy transmission tend to lengthen and uncertainty remains. In addition, issues concerning the implication of extraordinary measures, that has been taken by major authorities, such as the widening of fiscal deficit in major countries, and the “exit policy” of quantitative easing taken to fight deflationary pressure in those countries has started to emerge. To cope with this issue, authorities have intensified their policy communication, to convince that all needed measures and tools have been prepared. Yet, it seems that all of those are not convincing enough, as at this stage, the political involvement in every country tends to increase. With the above background, we have to keep optimistic, but still have to be cautious. From the risk management perspective, the challenge in the period ahead, is in identifying the potential risk appropriately, which is the key in risk management. The recent turbulence has changed the global economy and financial market landscape. Consequently the standard indicators, both in financial market and real economic, might have also changed, and we cannot rely on their empirical behavior. In face with this situation, we all have to widen the indicators to be considered, including qualitative indicators. The recent development has also lead the authority, to adjust and shift their paradigm and approach in setting the macroeconomic policy, and supervising as well as regulating financial sector. In addition, authorities globally have been challenged, with a more serious dilemma. On one side, their need to maintain sustainable economic recovery process, which means need to be expansionary or accommodative. While on the other side, they need to maintain financial system stability, mainly by strengthening regulation and supervision and improve the balance sheet structure of financial industry, banking in particular, and its risk management as well as to avoid the potential inflation in the medium to long term horizon. Striking the optimal balance between these two situations will be challenging and dynamic. The situation we have in Indonesia is considerably better than those faced by developed countries, but we have to always be aware, that we are in an integrated world, and that there is structural changes. Hence, more prone to external shock. In this regard, Bank Indonesia always commit, in achieving a balance between financial stability and monetary stability, in order to maintain low and stable inflation needed to safeguard a healthier and sustainable economic growth. The situation I just described, should always be taken into account in conducting business in a more challenging period ahead, more specifically in the risk management practice. For banking industries, considering their important role in the economy, and the severe impact in the society when they fail, I hope there will be more professional, and more proper implementation of risk management, and in particular a more efficient asset and liabilities management. From today’s seminar, I hope we will have a better insight in risk management area and a fruitful discussion to enhance our understanding and more importantly to increase confidence in implementing it. Thank you.
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Remarks by Mr Budi Mulya, Deputy Governor of Bank Indonesia, in the 6th Executives' Meeting of East Asia-Pacific Central Banks (EMEAP) Monetary and Financial Stability Committee (MFSC) Meeting, Chiang Mai, Thailand, 14 November 2009.
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Budi Mulya: Exit strategy in advanced countries and their implications for the EMEAP region Remarks by Mr Budi Mulya, Deputy Governor of Bank Indonesia, in the 6th Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) Monetary and Financial Stability Committee (MFSC) Meeting, Chiang Mai, Thailand, 14 November 2009. * * * Let me start by commending Dr. Krishna Srinivasan and Dr. Eli Remolona for the excellent presentations on this very timely and important issue. A vast discussion on exit strategy has been hovering around us recently, which involve so many ways and aspects. However, today, I will focus on three main aspects; first, the strategy itself; second, the implications it will bring; and third, the challenges it will leaves us with. The strategy for exit Let me begin with the first part: the strategy for exit. The biggest challenge is determining the timing to exit. On this issue, I believe we share the same understanding that it will depend on the state of the economy and the financial system of a country. Nonetheless, given the still uncertain and fragile global economic recovery, especially those of the advanced economies, I have a conviction that we should err on the side of further supporting demand and financial repairs. Accordingly, the exact answer would be don’t rush. In relation to this, it is always relevant to ask about the authorities’ commitment, especially the Fed, to err on the side of being too late, rather than too early, in starting their tightening cycle. The next issue is the sequence of exit. In this respect, the complexities lie on the interaction between fiscal vs. monetary, and conventional vs. unconventional policy. It is relevant for us to ask which one will come first. Should credible commitments to mediumterm fiscal consolidation precede monetary tightening? Would withdrawal of current extraordinary liquidity support and deposit guarantee accelerate or offset monetary tightening? Similarly, should central banks raise interest rates before they unwind unconventional monetary policies, or the other way around? In this respect, let me recall that the G20 recommends that central banks can raise interest rates before they dry up liquidity. However, let me also balance this view with the fact that abundant liquidity inside the system tends to impede any central banks attempt to raise short term interest rate, like the one occuring in the US. Thus, credibility would be the issue. How to exit is another issue. In this respect, unwinding the central bank’s elevated balance sheet amidst slowly adjusted potential output, will always be economically difficult and politically complicated. Of course, there are several options to take, e.g. whether utilize either reverse repo, issuing central bank bill, or start to explicitly declare medium to longer term inflation target. But different consequences may arise from the way those factors are decided and implemented. To begin with, it is important to distinguish between the long term risk and the short term consequences. As I pointed out earlier, the extent to which exit strategies take place is not an easy issue and involving vast complexities as these strategies will always be contradicted with the pace of the recovery itself. Problems exist when the perceptions about the exit builds up and feeds up the tail risk where market players are irrationally exuberant in responding the way the recovery runs. First, the perception that the authorities in advanced economies, mainly the Fed, will maintain their loosening stance in an extended period has become a sort of long-run certainty. Second, the perception that market mechanism will efficiently make automatic correction against shortrun dynamics. As a result, risky asset prices have risen too much, too soon, and too fast compared with macroeconomic fundamental. Simply to say, asset price bubbles fueled by this too enthusiastic retort is and will always be our main short-run implication of the speculation builds up around the exit strategy issues. The implications and policy dilemma The impact of major economies’ exit policy to EMEAP countries will depend on the degree of openness of a country from the point of view of both trade and financial account. In Indonesia, for instance, this financial account channel has become substantial as short term cross border flows has been sizable in domestic financial market. In addition to economic openness of a country, two other aspects that should be taken into account are economic characteristic and policy regime being implemented. In terms of the latent economic characteristics, the nature of the role of each economic sector to GDP, the level of exchange rate pass-through, the role of expectation in inflation formation which would provide unique level of shock absorber specific for each country from global shock. Nonetheless, I do believe that the EMEAP economies are facing similar immediate problem, i.e. how best manage the increasing volatile short-term capital flows stemming from asymmetry in economic recovery between advanced vis-à-vis emerging economies and the policy responses that go with it. Thus, our policy effectiveness will be confined by the pace of recovery and the exit strategy in advance economies, mainly in the US. In the wake of US dollar weakening, letting the domestic currency to appreciate implies inflating the bubbles. On the other side, sterilizing the appreciation to offset the spillovers will also mean putting additional liquidity flush to the financial market, and thus keeping short-term rates lower than is desirable. Yet, tightening monetary policy will also be a hard choice since it will elevate the appreciation trend as well as complicate central bank communication on the back of recovery. Directly limit capital inflows through regulatory approach is also a hard option. A consensus view on this is that it will only be effective as long as there is a policy uniformity across countries, which is in my view far from doable, since countries with closely aligned agendas – i.e. supporting the recovery – are unable or unwilling to take bold steps in terms of coordinating exchange rate policies. That is primarily because the overriding objective of nearly all parties involved is to maintain some level of exchange rate competitiveness, and that is simply not possible. The same concern was also brought forward in the recent G20 meeting. The challenges for EMEAP Amidst of all of the complexities around the exit strategy issue we face, we still have to end up with best options. Simply to say, in the current state of the global financial landscape, it is a big challenge for central banks, mainly in emerging economies, to shape their policies. We cannot put the exit policy merely as a long run issue. Rather, current development on this leads me to believe that we have already dealt with its implication since it shapes market perception. Therefore, on the absence of ideal policy, it is always relevant for us to find a better escape clause. And on this respect, the way we communicate to the market plays a big role in shaping the right incentives to them while maintaining the pace of the recovery. As a good measure to risk awareness, it is also beneficial for us to always consider the probability of odds scenario to happen. In this respect, let me suggest that regional coordination and cooperation is a key word. While there is much rhetoric on the need for a coordinated exit strategy, such an outcome will be challenging to be delivered given the different recovery rates both in Asia particularly EMEAP countries, and the rest of the world. In the mean time, EMEAP countries should get ready to receive the impact of exit policies in advance economy which will differ in term of speed and magnitude, depending on each country’s specific economic character. Given this, a faulty exit strategy of the advanced economies could easily spill over into smaller economies, swamping our efforts to deal with the slowdown. Managing an exit from the current policy settings as growth recovers poses another test for EMEAP central banks to that hard-won credibility. With inflation in the process of bottoming out and the recent data flow in EMEAP countries suggesting a clear recovery in economic activity, we all find ourselves pondering the risk that the economic stimulus provided by fiscal and monetary policy makers might be withdrawn earlier compared to advance economy. In this regard, I believe that monetary policy credibility is particularly crucial to the countries’ growth risk premium, which is judged by historical inflation volatilities. For some countries, given the inflation volatilities are historically high, a more pre-emptive monetary policy response is warranted in order to anchor inflation expectations. Provided that improving balance of payment positions, for countries which historically have strong pass-through from exchange rate changes to inflation expectations such as in Indonesia, stronger exchange rates will also be important to keep inflation expectations well-anchored without necessitating to aggressively increase interest rates and hurting the growth recovery. In other words, a strong exchange rate can serve as an effective anchor to inflation expectations. This will be important throughout as higher global commodity prices in 2010 could begin to translate into higher inflation expectations. Finally, every country has a stake in the sequencing and magnitude of the strategies of the large economies. The impact of global exit on smaller economies could manifest in a return of recessionary tendencies as well as balance of payments (BoP) problems, which have generally not been a significant feature so far. IMF programs have conventionally been oriented to dealing with BoP crises. In the current scenario, the larger resource base may have to be deployed with much more flexibility to help particularly smaller economies to deal with the potentially recessionary impact of exit — a kind of global macroeconomic safety net. Some operating guidelines for such a program need to be quickly developed. Thank you.
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Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at Japan International Cooperation Agencys (JICA) seminar on "The Challenge in Developing Indonesia's Financial Market", Jakarta, 11 December 2009.
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Budi Mulya: The need to strengthen Indonesian financial market Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at Japan International Cooperation Agency’s (JICA) seminar on “The Challenge in Developing Indonesia’s Financial Market”, Jakarta, 11 December 2009. * * * Distinguished speakers, ladies and gentlemen, It is such a great pleasure to join in today’s seminar, which will address Indonesia’s financial market and its further development. This particular topic, I believe, become more relevant and crucial for Indonesian economy. In the last couple of decades, we all have been witnessing on the role of the financial market in many economies. Yet, within the last two years, we also have observed on how financial market malfunction has severely impacted the real economy, a very hard lesson to learn. Many aspects of this phenomenon have been written and discussed, both from policy makers’ perspective as well as analysts’. All of these analyses are intended to search for the most possible cause of the crisis, in order to prevent a repeating occurrence in the future. On that respect, I would like to highlight one important aspect from the most recent global financial turmoil, as background of my speech today and as one alternative reference of the approach in discussing the future development of Indonesia’s financial market, that most fit with Indonesian economic characteristic. In general, if we look back to the mid 2007, it can be reasonably seen that the crisis emerged in the debt market, particularly with regard to its derivative product, which reached its peak in September 2008 when Lehman Brothers collapsed. The financial market transaction and instrument development moved too far, beyond the need to serve the economic financing in a healthy way. The value of financial market instruments have been much higher, compared to their fundamentals value and their inherent risk. This is also closely related to the fact that the financial institution involved has also not been supported by adequate resource buffer to absorb potential capital loss. They tended to operate with very high leverage, depending their funding from money market, as well as debt market. On this regard, the liquidity of those markets is a crucial key, since in high leverage circumstance, counterparty risk could easily jump. As a consequence, when there is a serious disruption in money market, as we observed during financial crisis, funding becomes more difficult for those institutions. They had to undertake force sale of their assets, experienced big losses, and some of them even collapsed or had to be bailed-out by the government. Some argued that those behaviors were closely related, or as consequences of the low interest rate policy, particularly in early 2000s, as well as the relatively loose financial institution regulation and supervision by authorities in major countries. Now, we are also again witnessing low interest rate environment in major countries, as one of the main parts of the crisis policy respond. However, there is now an increasing discussion on how to enhance the effectiveness of the financial regulation and supervision, to prevent, that what happened in the past will not be repeated. In addition, there is also an increasing attention, put in the risk taking behaviors of financial market players, such as we find in the Leaders’ Statement of the G20 Summit in Pittsburgh last September. This risk taking behavior is believed, affecting monetary policy transmission through their significant distortion in financial stability. Hence, in turn it reduces the effectiveness of monetary policy. This issue, known as risk taking channel, is also relevant to today’s discussion, but I will not discuss further this aspect in my speech this morning. With the above background, I would like to emphasize my speech on the liquidity aspect of the banking and money market, as well as in the financial market. This liquidity aspect, along with the availability of related “infrastructure” is a crucial foundation, to ensure the soundness of financial institutions and to develop healthy financial market. The Indonesian banking, money market and financial market In contrast to those observed in major financial market, the Indonesian financial market can be considered as still in an early stage of its development, despite significant progresses achieved in the last couple of years. Also, from the type of transaction and instrument variety, as well as from their funding type of financial institution, the Indonesian financial market could be viewed as too traditional or too conventional. Yet, these facts became such a “blessing in disguise” and help sheltered the domestic financial market and the economy from the adverse impact of the recent global crisis. Before I elaborate on the aspects that need to be improved in our domestic financial market, I would like to briefly discuss the characteristics of the Indonesian banking, money market and financial market as a background. Banking The Indonesia’s banking industry is actually operating in a new stage in post 1997/98 crisis and 1999 banks recapitalization era, as compared to the previous period. There are two factors that characterized the current Indonesian banking sector in general. First, they are operating in structural excess liquidity in the inter-bank money market. In this regard, I refer the term liquidity as central bank’s reserve money. This is also reflected in the volume of Bank Indonesia’s open market operation – banks’ liquidity that Bank Indonesia absorb, as part of Bank Indonesia’s monetary policy implementation to maintain short-term money market (overnight PUAB) stable around BI Rate. This is cash alike in banks’ assets. This is actually a rather common phenomenon in countries that experienced financial crisis and had to bail-out the financial industry. For example, in the US, the central bank balance sheet has ballooned from around USD 800 billion before crises into around USD 2.2 trillion recently. This data also reflected in the US commercial banks or other financial institutions’ placement – usually in overnight basis as excess reserve and now remunerated at 25 bps – in the Federal Reserve. Thus, in essence similar to bank placement in Bank Indonesia’s OMO instrument (SBIs. FASBI, FTK). The situation I just described was needed to facilitate the domestic banking sector consolidation process in the post 1997/98 crisis. However, if this continue to exist too long, will lead to a mislead incentives. It will not encourage banks to have a more efficient asset and liabilities management. Also, banks will tend to be less aware to liquidity risk, as there will be a perception that there will always be a huge supply of liquidity in inter-bank money market. This can be seen during the peak of global financial turmoil at the end quarter of last year, where our domestic money market also experienced a significant “perception” of tightening liquidity, despite that there was a large number of liquidity stock in the money market. There was more than Rp. 150 trillion of banks’ cash, placed into Bank Indonesia’s OMO instruments. Yet, the inter-bank money market indicators showed that the flow of liquidity in inter-bank money market has squeezed. The volume of inter-bank money market has declined from its normal level of around Rp. 10 trillion to below Rp. 5 trillion. The interest rate spread has also widened significantly. The JIBOR 1 month spread over BI Rate jumped from its normal level of around 50 bps to around 220 bps. Further, there was also indication of unhealthy competition among banks, to maintain third party’s fund by offering higher deposit rate. Second, there is large number of government bonds (SUN) in banks’ balance sheet, which mostly originated from banks’ recapitalization in 1999. Recently, banks hold around 50% of outstanding SUN of Rp. 570 trillion. This type of asset is risk free hence no bad debt provision is needed. It helps banks in maintaining a strong capital, but with result a lower yield compare to other earning assets. However, on the other side, this result in banks being more expose into market risk, as has been showed when the SUN prices (IDMA Index) dropped to their lowest level of 67.11 in 29 October 2008. Under excess liquidity condition, banks’ attention on the liquidness of this type of assets is relatively low. In this regards, I refer liquidity as an easiness of SUN to be traded, or exchange into cash without significantly impact their price. Banks tend to practically borrow in unsecured money market, rather than undertake repo transaction to serve their short-term liquidity need. This could be seen, that despite Bank Indonesia has actually facilitated market participants to establish a standard repo agreement (MRA) since June 2005 as one infrastructure to increase the liquidity of SUN market, but in reality their respond is quite marginal. Money market and financial market The Indonesian money market is basically inter-bank money market, as it mostly involves only banking. So far, the transaction in the inter-bank money market is dominated by unsecured lending/borrowing (PUAB), and mostly in a very short term maturity. Around 60% of inter-bank transaction is overnight. There may be some short-term debt instrument in OTC (over the counter market), but I believe in a very small numbers and not actively traded amongst bank. There is also perhaps, an interest rate swap (IRS) or overnight index swap (OIS) in OTC market, as there is sometime a quotation in Bloomberg or Reuters. But, it seems not quite regular and the transaction is supposed to be in a very small number. Thus, in general, money market is not yet considered to better serve banks’ portfolio management. Meanwhile, in the foreign exchange market, the transaction is also still dominated by spot transaction. The daily volume of inter-bank spot transaction is about 1.5 – 2 billion US Dollar in the last two years. In addition, swap transaction is around 300 million US Dollar in 2009, a bit lower compare to around 500 million US Dollar last year. Further, the financial market is dominated by government debt instrument. The development of Indonesian financial market actually took place from the post 1997/98 period. The SUN market begun in 2002 when banks were started to be allowed to gradually trade their recap bond holding. The development in government bond market then triggered the development of corporate bonds as government bond serve as a risk free benchmark in debt market. However, the transaction in SUN market is, so far, dominated by outright transaction. The repo market is not yet active, partly for the reasons as I have previously described, which lead to a perception of bank that undertake repo is in a desperate liquidity need situation, hence will be punished with higher interest rate. The relatively less liquid domestic financial market can be seen from the SUN turnover. Recently, the daily outright trading volume of SUN is just around Rp 6.5 trillion and 300 transaction within the last two years. Thus, just around 1% of SUN outstanding. While the repo transaction is much lower, below Rp. 1 trillion daily, but not always occurring every day. Why we need to further develop Indonesia’s financial market? From the above description, basically, I have just explained the main reasons, the need to further develop the Indonesian financial market. First, to increase the resiliency of domestic financial market, including the banking sector, from possible liquidity shock. Second, to increase the efficiency of financial portfolio management and to strengthen liquidity risk management, which in turn it will increase the effectiveness of monetary policy from Bank Indonesia’s perspective. And third, given the increasingly importance of financial market in the economy, it is crucial to have a strong, efficient and healthy financial market to avoid any possible distortion, including from inefficient practice that will add more cost in economic financing. However, the development should be undertaken in gradual manner, and again, should always be linked closely with the need of the real economy. I will now highlight some issues that I believe should be firstly considered as a starting point to develop our domestic financial market. The development of repo market can be considered as a starting point to increase financial market liquidity. This will increase efficient banking liquidity and portfolio management, as well as government financing. In this regard, as financial transaction is mostly in essence a legal contract, thus having a commonly accepted standard repo agreement is a key. In this area, Bank Indonesia and the Government Debt Management Office, has again encouraged market participants to establish a standardized repo agreement that complies with international standard. In line with this, the progress of the commitment from major market players in debt market (HIMDASUN) signed in 20 August 2009 has to be monitored closely. On the other side, Bank Indonesia will also continue to promote the use of repo transaction by enhancing the strategy adopted in Bank Indonesia’s liquidity management operation. In addition, the need to have a commonly accepted standardized transaction among market participants is also valid for transaction in foreign exchange market. It is also important to encourage the establishment of broader self regulatory organization (SRO) in domestic financial market that covers all segments in the market, to provide convention for various market transactions, and to assist in monitoring OTC market, as well as a counterpart for the authorities and regulators. However, it is important to note that coordination among authorities, and the continued dialog with market participants, is a key element in developing financial market that most fit with the need of the economy. Ladies and Gentlemen, I hope today’s seminar produces fruitful discussion for all of us, as well as exchange perspectives from expertise speakers to enrich our understanding on developing the Indonesian financial market. Thank you.
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Speech by Dr Darmin Nasution, Acting Governor of Bank Indonesia, at the Bankers' Dinner 2010, Jakarta, 22 January 2010.
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Darmin Nasution: Strengthening Indonesian banking, embracing global recovery Speech by Dr Darmin Nasution, Acting Governor of Bank Indonesia, at the Bankers’ Dinner 2010, Jakarta, 22 January 2010. * * * We have successfully navigated 2009 with a number of achievements that would make anyone proud. Our economic resilience to the global economy remains relatively high. Economic growth in 2009 reached 4.3%, which includes our economy in the exclusive group of countries that achieved positive growth. Meanwhile, our accommodative monetary policy stance throughout 2009 bolstered economic performance and this policy was further buttressed by several operational measures, for example strengthening open market operations as well as refining the interest rate structure. In future, monetary policy will be directed towards maintaining low and stable inflation in the 5%±1% range for 2010; and continuing its declining trend until it is as low as neighbouring countries at around 3%. Efforts to bring medium-term inflation down to a lower level are relevant in terms of maintaining the competitiveness of the domestic economy, especially in view of the upcoming ASEAN Economic Community in 2015. In addition to sustaining economic conditions, financial sector stability was also maintained, which is inseparable from a number of policy measures instituted by the Government and Bank Indonesia to overcome the effects of the global crisis in the final quarter of 2008, followed by additional measures implemented in 2009. The financial sector, which was placed under significant pressure in November 2008 with the Financial Stability Index (FSI) peaking at 2.43, gradually recovered in December 2009 with FSI dropping to 1.91; below the critical indicative level of 2.0. Direction of banking policy Learning from our extensive experience with crises, Bank Indonesia introduced four incentive and disincentive based policies in 2010. 1. Strengthening the resilience of the banking system by underpinning a number of regulations, reinforcing the bank supervision system, restructuring the banking industry in Indonesia, as well as deepening the financial market. a. The applicable regulations include capital regulations in order to buttress the resilience of banks against risk, transparent financial reporting, improving the quality of good corporate governance, as well as improving the effectiveness of risk management. b. Policy to shore up the bank supervision system will be achieved by strengthening risk-based supervision, enhancing operational bank supervision, feasibility and compliance testing, as well as improving collaboration among supervisory authorities domestically and abroad. c. Policy to reorganize competition in the domestic banking industry will be achieved through bank restructuring in harmony with the appropriate business scale and capital requirement, as well as increasing the capacity to absorb business risk. In addition, several regulations will cover, among others, mergers, consolidation, sources of funds for bank acquisition, the terms for bank acquisitions, the role of individual/family owners, as well as the terms and conditions of business development. d. Policy to deepen the financial market will encourage the development of financial products that can be used as an alternative by banks for productive channelling and placements to the real sector, especially infrastructure financing. Therefore, the financial market is expected to become more liquid with banks becoming less dependent on BI instruments. 2. Improving the bank intermediation function through refined regulations and greater availability of supporting infrastructure. The regulations in question include the Statutory Reserve Requirement, optimizing the efficiency of bank operations and simplifying the terms and conditions governing foreign exchange in order to stimulate credit allocation. BI will also help form an institution to supply credit basis data per sector, per region to assist banks asses risk. 3. Expanding the role played by sharia banks in the national economy and bolstering resilience. Sharia banking policy will become more intensive to raise capital, facilitate the development of sharia business units and facilitate the requirement for competent sharia human resources. 4. Improving the role of rural banks in terms of micro finance and strengthening resilience. This policy will become more intensive, among others, to raise capital and facilitate the requirement for competent human resources, as well as assert the position of rural banks as community banks. A need will arise after the global crisis for a systemic regulator that can monitor the soundness and stability of the financial system as a whole. The role of such an institution will be to collate, analyze and report information regarding significant interactions on the markets and inter-institutional risk; investigate whether an institution is exposing the financial system to systemic risk; design and implement regulations; and coordinate with other regulatory institutions, including the fiscal authority, to resolve systemic crises that may emerge. There are three reasons why the central bank may take the role of systemic regulator. First, the central bank has daily contact with market players in its function of implementing monetary policy. Second, the responsibility of maintaining macro-economic stability corresponds closely with guaranteeing financial system stability. History has shown that economic crises around the world are always linked to financial crises; therefore, the central bank naturally has to consider interactions between the financial sector and monetary policy. Third, the central bank has the function of lender of last resort. Therefore, the central bank must utilise its resources to supply short-term emergency funds during a crisis. Bankers are expected the shift their business strategy away from merely surviving the crisis to exploiting the opportunities presented by the global economic recovery. Strengthening the banking industry does not imply that its soundness is in doubt, however, it will lead to more efficient banks and a more optimal intermediation function.
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bank indonesia
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Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the New York Society of Security Analysts (NYSSA) seminar, New York, 15 April 2010.
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Budi Mulya: Investment opportunity in Indonesia – looking toward a better future Keynote speech by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the New York Society of Security Analysts (NYSSA) seminar, New York, 15 April 2010. * * * Let us start by expressing our gratefulness to the God almighty. I’m very proud and honor to be here today and have all the opportunity to share with you. For that reason, let me deliver my sincere gratitude to my fellows NYSSA, speakers, my colleagues in Indonesian Embassy and Bank Indonesia Representative Office, as well as to you all of being here today and make this happen. Distinguished guest, ladies and gentlemen Indonesia is a rich country and proven to earn a strategic position and potentials across the region and the world. Shares borders with Malaysia, Papua New Guinea, East Timor, Singapore, Malaysia, Philippines, and Australia, Indonesia is a big archipelago with 17,508 islands scattered over the length of 741,050 sq mi or almost at the same distance between California to Maine. Indonesia’s size, tropical climate and archipelagic geography offer rich and extensive natural resources and support the world’s second highest level of biodiversity right after Brazil. Indonesia also records as the world’s fourth most populous country as well as a huge consumption base as the population reaches around 231 million people by 2009 and is expected to grow to almost 300 million by 2050. Almost 45 percent from almost 114 million workforces are in agriculture sector, with the remaining employed in the expanding manufacturing industry, mining, and services. Indonesia is also the largest economy in Southeast Asia and a member of the G-20. In 2009, Indonesia’s nominal GDP reach almost US$515 billion with nominal per capita GDP was US$2,590, and per capita GDP PPP was US$4,150. All together, the tertiary sector is the economy largest and accounts for about 45% of GDP proving the strong character of a domestic driven economy. Major industries include petroleum and natural gas, textiles, apparel, and mining while major agricultural products include palm oil, rice, tea, coffee, spices, and rubber. Indonesia is also an open economy with a sizable trade surplus in 2009, consisting of export revenues of almost US$120 billion and import expenditure of about US$84 billion with Japan, United States, Singapore, and China as our main trading partners. Nonetheless the story is not always wonderful. After enjoying a period of high economic growth, the 1997–98 financial crises brought out structural consequences in the domestic financial system and governance, damping investment, and private sector development. As a result, the average annual growth 4–5% since the 1997–98 crises is not sufficient to significantly increase per capita income, accommodate the increasing number of new entrants in the labor market, and reduce poverty. Similarly, the current investment share of about 25% of GDP is still too far to achieve the pre-crisis growth average of 7–8% when investment shares were more than 30%. On that account, creating new jobs by encouraging investment is very essential for us. This is a daunting challenge, given the many structural impediments concerning the macro fundamentals, governance and institutions, and infrastructure in the economy. All of these lessons emphasize us the urgent need for an improvement in the overall investment climate. Measures have been taken and significant progress has been achieved in the last five years. The recent World Investment Prospect 2009–2011, UNCTAD, for instance, reported Indonesia ranks number 9 of 15 countries as the most prospective investment destination by foreign investors. A number of key factors of Indonesia’s attractiveness for investments include growth prospects and market size, access to natural resources, and relatively competitive labor costs. Distinguished guest, ladies and gentlemen Today, Indonesia has emerged a very different country compared with a decade ago. It has embarked upon a far-reaching institutional transformation and has become one of the region’s most vibrant democracies. The first stage of this transformation, from 1998 to 2003, was a period of political and economic change, characterized by democratization and decentralization of government. Indonesia’s almost 500 provincial, district and city governments now undertake nearly 40 percent of public spending. Despite obstacles it brought, decentralization contributed to the consoling of regional conflicts and promotes political stability as well as offers an emerging more vibrant spatial geographic distribution of economic development throughout the country. The second stage, from 2004 was a period of democratic institutions consolidation as well as returning to political and macroeconomic stability, most notable in Indonesia’s first direct presidential elections and in its debt levels falling to below 35% of GDP . Among others, the Government has taken steps to address different aspects of the investment climate through policy reform packages covering key areas of concern of private investors, such as taxes, customs, investment frameworks, and the financial sector. On the institutional transformation, the Government is working to set up the institutional framework, coordinating mechanisms and enhancing governance. On the provincial side, a number of sub-national governments have undertaken major reforms of their public sector systems, introducing among others performance-based budgeting and one-stop public services. The legal arrangement is also directed to improve investment climate, both directly by promulgating Investment Law No. 25 of 2007 and indirectly by imposing open capital account through promulgating Law No. 24 of 1999. The later is set up to improve the financial infrastructure to support capital inflows, both for direct investment and portfolios. To enhance macroeconomic stability, government and so does the monetary authority works hand in hand and commits to enhance fiscal and monetary discipline as well as strengthening the financial architectures. Learning from the failure of 1997–1998 crises, our policies were focused on enhancing policy transmission, improving financial market efficiency through prudential practices and financial market deepening. To this point forward, the Government was improving their capacity on fiscal budgeting, to be more specific, the adoption of active debt and cash management. They are also fully committed to improve fiscal sustainability by reducing debt to GDP ratio. Steps were also taken in the area of monetary policy framework. Since 1999, Bank Indonesia was mandated to achieve single objective of price stability, both in terms of inflation and the exchange rate and at the same time was given independency on our policy conduct. In 2005, Bank Indonesia has fully adopted Inflation Targeting Framework marked by the introduction of BI Rate as the policy rate to increase the policy effectiveness in achieving the inflation target set by the Government. In 2008, further enhancement has been done in the area of monetary policy implementation by the introduction of overnight interbank rate as our operational target to improve the effectiveness of the monetary policy. Institutional reform in the financial sector has been done by improving the soundness and efficiency of the financial market through the combination of imposing prudential practices and enhancing market deepening. Financial sector reforms are crucial to raising Indonesia’s growth rate and enhancing the economy’s resilience. In banking industry, reform is conducted by strengthening bank’s capital, introducing risk management practices and World Bank, Investing in Indonesia’s Institutions for Inclusive and Sustainable Development, 2008. governance, and not to mention improving supervisory capabilities. These were done by adopting Basel core principles and promoting mergers and acquisitions. The same reforms have conducted in the capital market, debt market, as well as non-bank financial institution. One of the most important breakthroughs can be observed in the development of the debt market following the issuance of marketable government bond in 2002, which is not only useful to deepen the financial market but also significantly reduced the need for foreign financing and thus increase the economic resiliency. Distinguished guest, ladies and gentlemen Strong commitment to reforms has yielded a progressive and more resilient fundamental performance, especially in the last five years. Indonesia resumed higher levels of growth and has re-emerged as a confident middle-income country as well as increasing regional and global standing as the world’s strongest economic performers close to those of India and China. Indonesia’s economic growth accelerated to a 10-year high and proven to be robust during the wake of the 2008–2009 global economic crisis. Real GDP has been growing at 5 to 6 percent annually since 2002 and, in 2009 per-capita real GDP exceeded the level reached in 1997, immediately prior to the Asian crisis. The legacy of Government’s prudent fiscal management and a strategy of fiscal consolidation have contributed to the significant reduction in government debt levels, which are estimated to fall to 31.5% by end-2009. Investment share to GDP is improving though is still below pre-crisis levels. In 2009, Indonesia’s was 23% of GDP, or significantly improves from 19 percent of GDP in 2002 signaling a structural improvement on the business climate. Increasing efficiency on the institutional framework as well as strong fiscal and monetary discipline has also been able to reduce inflation markedly and so does the exchange rate. In the financial sector, the banking sector, which account for about 80% of the financial industry’s assets, is in sound shape and is relatively unexposed to developments in troubled financial markets elsewhere. Indonesia has a well-developed and well-regulated banking sector and has made major advances over the past five years in establishing a sound legal and administrative framework for the modernization of public financial management in line with good international practice. On the last April 2nd, 2010, OECD upgrades Country Risk Classification (CRC) ranks of Indonesia from the previous level of 5 to 4. Indonesia was the only country of the 161 countries, given the CRC upgrade in the latest OECD committee meeting session on April 2010. The main factor supporting the upgrades is Indonesian impressive macroeconomic indicators as the economy is one of the most resilient amid the global financial crises and Indonesia is one of the few countries that experienced positive economic growth in 2009. Improvement in macroeconomic performance and economic stability is the result of a combination of good and forward looking economic policy, ongoing structural reforms, as well as good debt management. Prior to this upgrade, on March 12, 2010, Standard and Poor’s also upgraded Indonesia long-term foreign currency rating to BB (from BB–) and long-term local currency rating stays at BB+. Outlook for both are “positive”. The upgrade was also observe in the rank of global competitiveness as publicized by the World Economic Forum. On the 2009–2010 Global Competitiveness Index, Indonesia rank was increasing to 54 from previously 72 in 2003. The upgrade would certainly put Indonesia in a better position before its creditors in negotiating, particularly export credit creditors. During the 2008–2009 worldwide contraction, Indonesian economy still enjoyed a positive growth of 6.0% in 2008 and 4.5% in 2009 and held by high and inclusive growth of domestic demand, particularly consumption. Indonesia is less exposed to external shocks than other economies in the region as its trade share to GDP is relatively small at about 50 percent of GDP. Inflation is moderated and achieved year-on-year increases of only 3.4% in March 2010 held by adequate supply responses and rupiah exchange rate appreciation. As a result, the unemployment rate fell back from 11% in 2005 to 7.9% in 2009. This development supports the fall of the poverty rate that has fallen by about one percentage point per year since 2003 and reached 15 percent in 2009. On the external balance, balance of payments is strong and achieved a current account surplus of US$10.5 billion and capital account surplus of US$2.3 billion in 2009. This has contributed to a sizeable accumulation of official international reserves, which to date approached US$71.8 billion in March 2010, providing Indonesia with a cushion against external shocks. Strong fundamentals have been proven as the key cushion to the adverse impact of global economic downturn and quickly revive market risk appetite toward Indonesian asset classes. The exchange rate has been appreciated about 24% at Rp9090 per US$ by the end of March 2010 from its weakest level of Rp12,020 per US$ in February 2009 on the back of net foreign capital inflows. Constraint on liquidity following the recent global credit squeezing has been recovered as the counterparty risk revived quickly and the market spreads narrowed. Indonesia’s economic outlook is favorable. Growth is projected to reach the upper level of 5.5–6.0 percent range in 2010, rise to 6.0–6.5 percent in 2011 and is expected to gradually returning to trend growth rates approaching 7.0 percent thereafter, on the back of the upturns in export growth following ongoing global economic recovery as well as investment acceleration. Investment is expected to grow 9 percent in 2010 and rise even faster by 11 percent in 2011 on the back of higher public capital spending on infrastructure that driven better private investment and lower risk premium. On the fiscal side, Indonesia has been able, through prudent fiscal policy, to bring its public debt to GDP ratio lower. Projections indicate that this trend is likely to continue. Inflation will continue to moderate and is likely to be at the lower end of its target range of 5%±1% in 2010 and 2011 as the output gap is still wide enough to response to the acceleration in demand side and supported by stable rupiah exchange rate. In the medium term, inflation is expected to converge to its regional average at 3.5–4.0%. On the external side, current account and capital account is expected to continue in surplus of US$5 billion and US$ 8 billion consecutively, support the continuingly surplus balance of payments and drive to higher international reserve. Favorable development on the fundamental sides along with ample market liquidity will maintain stability on the financial market especially in banking industry i.e credit will grow of 17–20% in 2010, along with high CAR around 19% and subdued NPLs below 5%. Well maintained macroeconomic fundamentals, strengthening external liquidity position, gradually declining government debt ratio, supported by prudent fiscal policy and smooth implementation of structural reforms, is expected to sustain higher economic growth in the coming years to keep the positive momentum for further rating improvement. Distinguished guest, ladies and gentlemen Despite these achievements, new challenges are waiting in front of us and hence much progress is still needed. The main constraint for Indonesia’s economic development is to translate the available resources into better outcomes. Delivering better development outcomes now depends largely on improving government effectiveness through strengthening accountability and capacity at all levels, as well as ensuring that much of future growth is driven by private sector development . There are much to be done in the area of resource allocation, incentives system, and transparency. Investment rates are improving, but are still below pre-crisis levels. The Government has taken steps to address different aspects of the investment climate through policy reform packages but several challenges remain. Institutional capture is a major obstacle in this area, with many reforms still to be implemented effectively and evenly on the ground. Improving the quality of Indonesia’s infrastructure is another essential aspect of strengthening Indonesia’s competitiveness and we are still work on it with full commitment. As far as recent development and prospect of the economy, challenge emerge as the global World Bank, Investing in Indonesia’s Institutions for Inclusive and Sustainable Development, 2008 recovery process makes is still highly uncertain and will determine the degree to which Indonesia’s growth accelerates in 2010 and beyond. I believe that the future success will depend on improving the policy conduct and quality of our institutions, particularly the public sector. Our top priority is to maintain stability as well as increase the resiliency of domestic financial market from possible liquidity shock. Our policy will always be directed consistently on achieving medium term inflation target and thus promote macroeconomic stability. For sustainable growth, Indonesia will have to ensure effective implementation of key reforms to the investment climate to both permits the private sector to drive growth and to increase public institutions capacity. On my view, access to financial services should be enhanced through a well-functioning and deep financial market. The later is needed to facilitate and promote longer term investment, maintain markets confidence especially on short-term investment, and thus prevent the economy from sudden reversal. This can be done by improving market efficiency through prudent practices of the market players, existence of liquid market, strong liquidity risk management, and wider-range financial instruments including hedging instruments. The presence of credible credit information system is also needed to lessen credit risks and lowers borrowing costs. Against this backdrop, we are committed to improve regulatory quality, the rule of law, and good governance through accountability and enhancing institutional capacity. Distinguished guest, ladies and gentlemen Building on its existing economic and political fundamentals, Indonesia today has the opportunity to create this virtuous cycle of sustainable and inclusive growth. Overall, Indonesia has a strong willingness to improve the condition. I am very optimistic to the direction of Indonesian economy ahead and expect you all would share the same few. Before I end up my remarks, I would like to deliver my sincere gratitude to all distinguished speaker Mr. John Chambers, Dr. Richard Clarida, and Mr. Russell King, who has dedicated their valuable time to share with us today, and for that reason, let’s us proceed to the Seminar and have a fruitful discussion. God bless you all. Indonesia 2005‐2011 ‐ Key Macroeconomic Indicators and Projections Actual Projection Indicators 2005 2006 2007 2008 2009 2010 2011 Real GDP Growth (% annual, yoy) 5.7 5.5 6.3 6.0 4.5 5.6 6.0 Export (US$ bn) 87.0 103.5 118.0 139.6 119.6 140.0 151.9 Imports (US$ bn) 69.5 73.9 85.3 116.7 84.4 106.6 121.4 Current Account Balance (US$ bn) 0.3 10.9 10.5 0.1 10.5 5.1 ‐0.4 Budget Deficit (% of GDP) ‐0.5 ‐0.9 ‐1.7 ‐0.1 ‐1.6 ‐2.1 ‐1.9* Inflation (% change, yoy) 17.11 6.60 6.59 11.68 2.78 4.80 5.50 * Bank Indonesia Assumption Source: Central Bureau Statistics and Bank Indonesia Projections Indonesia’s external debt 2005–2009 ST Debt to Total Debt Ratio 17.7% 15.6% 19.5% 19.0% 18.3% ST Debt to Reserve Ratio 68.6% 48.5% 48.3% 57.1% 47.9% Debt Service Ratio 17.3% 24.8% 19.4% 18.1% 22.7% Debt to Export Ratio 124.3% 107.2% 100.3% 93.5% 121.4% Debt to GDP Ratio 46.5% 35.9% 32.2% 30.1% 31.5% ST MATURITY (in USD million) 23,838 20,641 27,493 29,512 31,666 TOTAL DEBT (in USD million) 1/ 134,504 132,633 141,180 155,080 172,871 RESERVE(in USD million) 34,724 42,586 56,920 51,639 66,105 NET DISBURSEMENT (in USD million) 2/ 1,042 (6,724) 1,817 5,962 10,356 DSP (PRINCIPAL + INTEREST) (in USD million) 18,709 30,675 27,319 30,013 32,293 References Badan Koordinasi Penamanan Modal (BKPM), Investment Policies Statement, June 2009. Badan Pusat Statistik (BPS – Statistic Indonesia), several official press release and publications. International Monetary Fund, World Economic Outlook, 2009. Joint Asian Development Bank-World Bank Report, Improving the Investment Climate in Indonesia, May 2005. Moccero, Diego. Improving The Business And Investment Climate In Indonesia, Economics Department Working Paper No. 638, OECD, September 2008. Mulya, Budi. The Need Strenghten Indonesian Financial Market, Delivered at JICA’s Seminar on “The Challenge in Developing Indonesia’s Financial Market”, held in Nikko Hotel, Jakarta, 11 December 2009. Raldi Hendro Koestoer, Promoting Regulatory Reform for Investment in Indonesia, Office of Coordinating Ministry for Economic Affairs, Republic of Indonesia (CMEA-RI), presented at APEC High Level Conference on Structural Reform, 8–9, September 2004, Tokyo, Japan. World Bank, Global Competitiveness Report, 2000 edition up to 2009–2010 editions. World Investment Prospect 2009–2011, UNCTAD. World Population Prospects (2008) http://esa.un.org/unpp/ United Nations. World Bank, Investing in Indonesia’s Institutions for Inclusive and Sustainable Development, Country Partnership Strategy For Indonesia Fy2009–2012, 2008.
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Address by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Deutsche Bank Access Asia Conference, Singapore, 12 May 2010.
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Budi Mulya: Indonesia – pursuing a better shape of the economy Address by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Deutsche Bank Access Asia Conference, Singapore, 12 May 2010. * * * It is such a great pleasure to be here today, to share and exchange view with all of you. I would like to thanks Deutsche Bank for the invitation to join at this important event where, various investors, business leaders and senior government officers gather to have a constructive dialogue. It is increasingly recognized that intensive communication, such as what we have today, becomes more important both from the authorities’ perspective as well as from investors’ point of view. In particular, in the periods where despite signs of a growing global economic recovery, some uncertainties remain. The most recent concern on global recovery is on the sustainability path of the recovery and the further possible impact of the most recent sovereign debt crisis that just emerged in the Euro area. As we just observed a couple of days ago, the global financial market was again shocked by a “semi-panic” behavior brought about by the uncertainty with regard to the rescue package on the Greece debt crises, and sort of “safety net” provided for some peripheral countries in the Euro area. Thus, having a more convergence view from various parties, with regards to the stage of the particular economy and various government measures will help to avoid unnecessary distortion into the recovery process. With that background, I will start today with briefly describing what Indonesia has been through during the crisis and then on how Indonesia has changed within the last decade, before I discuss the prospect of Indonesian economy and its challenge ahead. Indonesia during the recent global crisis During the most recent global crisis, which we all knew as one of the worst global crises in history, the Indonesian economy has demonstrated to be fairly resilience. Despite some negative impacts on the economy, particularly in the domestic financial market, the Indonesian economy was still experiencing a positive growth of 6.0% in 2008 and 4.5% in 2009. That achievement was mainly sustained by high and inclusive growth of domestic demand, in particular consumption. Indonesia is relatively less exposed to external shocks than other economies in the region as its trade share to GDP is relatively small at around 50 percent of GDP, with its export is still dominated by natural resource commodities. Accordingly, the unemployment rate fell back from 9.1% in 2007 to 7.9% in 2009. On inflation, while it has experienced an increase in 2008 of 11.68% year-on year, is now back in a significant declining trend of 2.78% in 2009 and 3.91% in April 2010. This development is mainly supported by rupiah exchange rate appreciation trend and adequate supply side responses. The balance of payments is also well maintained. The current account and capital account still record a surplus, contributed to a sizeable reserves accumulation of around US$78 billion in April 2010, in line with the exchange rate appreciation trend. Meanwhile, the banking industry and the domestic financial market also showed a sound performance despite, as I previously mentioned, some pressures during the peak of the crisis brought about mainly by liquidity scarcity perception, and as an impact of flight to safety phenomenon. Those pressures in the Indonesian financial market was caused by an increasing money market interest rate spread, high exchange rate volatility, as well as the increase of government bonds yield along the curve. All of those indicators have recently returned to their normal pattern. What Indonesia has achieved so far shows that various measures taken by the Indonesian authorities can be reasonably considered effective. The fiscal and monetary stimulus employed in measured manner has helped the economy to endure from external shock. The various policies were mainly aimed at maintaining confidence to cope with panic and fear of scarce liquidity, and preserving domestic purchasing power. However, we noticed that there were some doubts, in particular from foreign investor, with regard to the strength of the economy and the efficacy of the policy that has been taken. This clearly shows from the significant increase of credit default swap (CDS) during the peak of the crisis. That perception was somewhat understandable since the situation was extremely uncertain, such that there was unclear on how the impact of the crisis would be into any particular country. From those experiences, there are at least two important lesson learned. Firstly, it has highlighted the more crucial role of transparency with regard to the economic fundamental information and macroeconomic policy rationality. Secondly, it is important to preserve the consistency of prudent macroeconomic policy. On the later, it will be very challenging recently as the policy trade-off has significantly increased. With regard on how Indonesia was dealing with the recent global crisis, Indonesia has actually employed all that has been learned from a painful 1998 crisis. Ever since, the 1998 crisis has brought structural changes in Indonesian economy and financial system, and more importantly in political structure. Indonesia was transformed into one of the largest democratic country in the world. Indonesia after more than a decade from 1998 crisis As I just mentioned, Indonesia is now structurally different with what was in a decade ago. This is as a result of more than ten years of consolidation and dynamic transition in almost all sectors. The extensive transformation measures became a continuing agenda with full commitment. In the last ten years, we have embarked upon a far-reaching transformation measures, especially in the area of improving our institutional capacity. During this process, the Government has taken steps to improve our economic efficiency through policy reform packages covering key areas of concern, such as taxes, customs, legal frameworks, and the financial sector. So to speak, one of the most notable steps are the introduction of open capital account through promulgating Law No. 24 of 1999 and increasing the investment flexibility by stipulating Investment Law No. 25 of 2007 to encourage offshore financing for the economy. The Government and Bank Indonesia, as a central bank, are always committed to consistently undertake fiscal and monetary discipline, as well as strengthening domestic financial market resiliency. Learning from the failure of 1998 crises, our policies were focused on enhancing policy transmission, improving financial market efficiency through prudential practices and financial market deepening. The Government is also improving their capacity on fiscal budgeting by adopting a better debt and cash management. Prudent fiscal policy can partly be observed by gradually reducing the debt to GDP ratio, in particular the foreign debt. The debt to GDP ratio has declined significantly within the last couple of years, from 77% in 2000 to around 30% recently. From a monetary policy perspective, Bank Indonesia has consistently pursued Rupiah stability as mandated by the new Bank Indonesia law that was first introduced in 1999. In practice this has been manifested in an effort to focus on achieving the medium term (three years) inflation target set by the government and avoiding excessive exchange rate volatility consistent with the free exchange rate regime adopted since 1998. On this regard, Bank Indonesia has increased the transparency and clarity of its monetary policy stance by introducing “the BI Rate” as a policy rate since June 2005. Further improvement has also been undertaken in mid of 2008 by translating the BI Rate as a short-term money market interest rate target (known as PUAB overnight target). Thus, PUAB overnight has been used as an operational target in executing the monetary policy decision through Bank Indonesia’s domestic market operation. The main reason behind this enhancement is based on two reasons. First, the increasingly importance of agents’ expectation in forming inflation along with the development of domestic financial market, in particular, the government bond market. Second, the need to increase the efficiency of domestic money market, which in turn benefits to enhance and to further strengthen banks’ liquidity management. Steps were also taken in the area of improving the capacity of financial institution, as well as improving financial market efficiency. Banks are encouraged to strengthen their capital and compel to conduct best practices, especially in the area of risk management. On the other hand, we are also bounded to increase our supervisory capacity to ensure a prudent banking practice. Years of strong commitment on reform has resulted in a resilient economic fundamental, at least, in the last five years. The economic growth accelerated to a 10-year high. Fiscal consolidation significantly reduces government debt, a proof of commitment of fiscal discipline. Prudent macroeconomic management has also led to the declining trend of inflation and exchange rate volatility as well. In the financial sector, the banking sector is well capitalized and in a better balance sheet structure. Strong macroeconomic fundamentals and resilient microeconomics structures lead to better risk perception, or a more accurate valuation from my point of view, as reflected by the recent rating upgrade. But to be frank, I feel that from the sovereign risk assessment, Indonesia is still somewhat “undervalued”. It is perhaps that major rating agencies tend to be too conservative in assessing Indonesia’s risk profile. This might possibly be a reflection of the “traumatic” view relate to the 1998 crisis. However, the recent update from some rating agencies has become a promising recognition into the fundamental transformation process in Indonesia. Following Standard and Poor’s, Fitch, and Moody’s, OECD has also upgraded Indonesia’s Country Risk Classification ranks from 5 to 4 on early April 2010. Similar progress also came from the ranking upgrade of our global competitiveness index from 72 in 2003 to 54 recently. Prospect and challenge ahead Global recovery coupled with favorable risk perceptions support our optimism toward the outlook in 2010 and 2011. We are quite confident that the Indonesian economy will grow at around 6.0% in 2010 and to 6.0–6.5% range in 2011. This is mainly supported by the upturn on export and increasing investment. For the next periods, we expect that the economy will keep growing in an upward trend given the proven strong commitment from the Government to implement reform measures on infrastructure projects and investment climate. On the later, it is important to note that the public check and balance mechanism, to ensure a more efficient bureaucracy and to improve business climate, has been increasing significantly compare to a decade ago. Meanwhile, the continuing prudent fiscal policy by maintaining public debt at the manageable level will ensure fiscal sustainability, to sustain economic growth commitment. We expect that inflation will continue to be moderate at the lower middle of the target of 5% +/-1% in 2010, as there is still “room” from the output gap to support the increase domestic demand. On this regard, the central bank’s monetary policy will always commit to ensure the low and stable inflation going forward. While on the external side, current account and capital account are expected to continue reasonably strong. Overall balance of payment is expected to strengthen, partly supported by an increasing trend of foreign direct investment. Stronger macroeconomic outlook and ample domestic liquidity will maintain financial stability, especially in banking industry. Bank’s loan is expected to grow at around 20% in 2010, held by strong capital adequacy ratio of around 19%, recently. While, banks’ non-performing loans (NPL) is expected to be maintained at to below 5% level (gross). However, we are fully aware that despite growing positive signs of the economic prospect, yet many domestic agendas are still required to ensure their implementation. I am optimistic on this prospect, but of course it is more in a consistent step by step progress, rather than in an instant change. In addition, to ensure for a sustainable and strong economic growth, Indonesia will also have to ensure that access to financial services should be enhanced through a well-functioning and deep financial market. The later is needed to facilitate and to promote longer term investment, maintain markets confidence, especially on short-term investment, and thus to prevent from the unnecessary external shocked. This can be done, partly by improving market efficiency through enhance financial market liquidity and wider-range of financial instruments as well as better financial market infrastructure. As part of those concerns, Bank Indonesia will consistently improve its liquidity management strategy. On the global economic recovery, as I previously mentioned, the risk is still quite challenging. It will much depend on the solution prospect of Euro zone debt threat. Yet, considering the Euro area authorities measures such as what they took during this weekend, and their coordination with other authorities in other region, I do hope that there will be a promising solution. To conclude, I am very cautiously optimistic to the prospect and the direction of the Indonesian economy ahead. I do hope that you would share the same view. Thank you. References Badan Koordinasi Penamanan Modal (BKPM), Investment Policies Statement, June 2009. Badan Pusat Statistik (BPS – Statistic Indonesia), several Press Releases and publications. Bank Indonesia, various Monetary Policy Review, Quarterly Monetary Report and Press Releases. International Monetary Fund, World Economic Outlook, 2009. Joint Asian Development Bank–World Bank Report, Improving the Investment Climate in Indonesia, May 2005. Moccero, Diego. Improving The Business And Investment Climate In Indonesia, Economics Department Working Paper No. 638, OECD, September 2008. Mulya, Budi. The Need To Strengthen Indonesian Financial Market, Delivered at JICA’s Seminar on “The Challenge in Developing Indonesia’s Financial Market”, held in Nikko Hotel, Jakarta, 11 December 2009. Raldi Hendro Koestoer, Promoting Regulatory Reform for Investment in Indonesia, Office of Coordinating Ministry for Economic Affairs, Republic of Indonesia (CMEA-RI), presented at APEC High Level Conference on Structural Reform, 8–9, September 2004, Tokyo, Japan. World Bank, Global Competitiveness Report, 2000 edition up to 2009–2010 editions. World Investment Prospect 2009–2011, UNCTAD. World Bank, Investing in Indonesia’s Institutions for Inclusive and Sustainable Development, Country Partnership Strategy For Indonesia Fiscal Year 2009–2012, 2008.
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Address by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Oversea-Chinese Banking Corporation (OCBC) Global Treasury Economic and Business Forum, Singapore, 9 July 2010.
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Budi Mulya: Indonesian economy – recent developments and challenges Address by Mr Budi Mulya, Deputy Governor of Bank Indonesia, at the Oversea-Chinese Banking Corporation (OCBC) Global Treasury Economic and Business Forum, Singapore, 9 July 2010. * * * First of all, I would like to thank OCBC Bank for the invitation to join in today’s global business community forum. The event like what we have today, become more important recently since authorities as well as business leaders worldwide, have been faced with one of the most challenging episodes post 2008 and 2009 global crises. Authorities are facing high uncertain environment and have to deal with more delicate policy dilemmas to ensure the sustainability of global economic recovery process. Hence, it is always a benefit to exchange view with market and business leaders to obtain a more convergence perception with regard to the stage of the economy and authority’s policy responds. This is because communication, such as through dialogue we have today, in particular with regard to the nature, the scope and the objective of policies taken by authorities, become more crucial to maintain market confidence and hence, to reduce uncertainty. Market confidence poses an important factor to ensure the efficacy of various policies taken by authorities. It could be obtained when the rationality of the policies taken are well understood as intended. Hence, it will gain in a convinced behavior with regard to the policy implementation. Further, maintaining market confidence is even more imperative in the aftermath of the onset of Euro zone crisis early this year, where coordination among authorities globally has been at the most challenging stage. This is because country specific factor, including political involvement, become increasingly materialize. Yet, from various international coordination forums, such as the latest G-20 meeting in Toronto last month, we all observe that the nation leaders’ awareness with regard of policy coordination is held firmly. The agreement to together pursue a sustain path of global economic recovery and to achieve a more balance global growth as reflected in “growth friendly fiscal consolidation plans”, is a strong evidence to that. One thing that I would like to highlight, with regard to the communication aspect as I have mentioned, is that the demand for policy clarity and transparency – without delay – is increasing, including the demand for very details macro economic data or statistic. This fact has also been one of Bank Indonesia’s concerns to always improve the policy transparency communication. With that background I would like to briefly share what Indonesia has been through and the macroeconomic strategy to ensure the sustainability of Indonesia’s economic performance in a very challenging and still fragile global economy and financial market environment. Recent economic development I will start my brief description on the development of the Indonesian economy by emphasizing that what Indonesia has been through and achieved, particularly during the most recent global turmoil, is mostly as a result of years of “post 1998 crisis” transformation process. Indonesia is now transformed into one of the world largest democratic and structurally different with what it was a decade ago. This is as a result of more than ten years of consolidation and dynamic transition in almost all sectors. The extensive transformation measures that became a continuing agenda with full commitment, despite its challenging process, have provided a more resilience foundation into the Indonesian economic development. Of course, there are still many agendas to be executed to improve and to increase the efficiency of the whole business and economic activities. But, the progress so far, particularly the consistent prudent practice of macroeconomic management, has proven to contribute to shelter the domestic economy from further adverse impact of the most recent global crisis. Among few countries in the region, Indonesia was still experiencing a positive growth of 6.0% in 2008 and 4.5% in 2009. While, in the first half of 2010, supported by a better than expected global the economic recovery is expected to grow at 6%, which is higher than previously estimated of 5.7%. In 2010, the Indonesian economy is expected to grow at 6% and slightly higher in 2011 and 2012. These were mainly sustained by high and inclusive growth of domestic demand, in particular consumption. Yet, export performance and investment has also showed a slight increase and expected to sustain their upward trend. Inflation has also moderated at 5.05 % (year-on-year) in June 2010, held by adequate supply responses and rupiah exchange rate appreciation, despite that there was a hike in volatile price component. Hence, the June inflation is slightly higher than previously estimated. However the recent increase of the volatile food price is expected to be temporary and inflation is expected to be maintained within target range of 5% +/– 1% in 2010 and 2011. The core inflation figure is also supportive to Bank Indonesia inflation assessment. To this respect, the latest monetary policy decision to keep BI Rate at 6.50%, is considered as adequate to ensure the inflation expectation within the target range and supportive to maintain the growth momentum, as well as to encourage bank lending. Meanwhile, the balance of payment figure shows a strong indication of improvement, brought about by strong domestic economic fundamental and conducive global economy. The current account balance in the second quarter this year to be higher than previously estimated and expected to be around USD 1.7 billion surplus. While, overall balance surplus will also improve to be at around USD 4.3 billion, higher than previous estimation. These developments have contributed to the increase of the foreign exchange reserve which now amounted to USD 76.3 billion. The current foreign exchange reserve level is equivalent to approximately 7.4 months of imported good, higher than what is observed in the peer group countries. Those progresses have contributed to the IDR, which continue in an appreciation trend, despite some corrections in May with moderate volatility caused by market concern with regards to the rescue package in Euro zone. Since early this year, IDR has been appreciated at around 4% with a lower volatility in the second quarter this year. On this respect, Bank Indonesia’s policy, consistent with the free floating system, is to ensure that IDR fluctuates in line with the economic fundamental and to avoid excessive volatility. The IDR movement recently is considered still adequate into external sector while supportive into anchoring inflation expectation. In addition, I would like to convince you that in dealing with the mounting recent debate on short term capital flows which always have such a “double edge sword” into small open economy like Indonesia, the approach taken is consistent with the free capital mobility regime as stated in the foreign capital system law (The Law No.24/1999). However, to prevent from the negative impact of “hot money” flows, Bank Indonesia emphasize on the banking prudential and financial market deepening measures, as well as directed to encourage longer term investment. The six measures as in the latest Bank Indonesia’s policy package launched at June this year is also in view of this balance approach. Further, the banking industry and the domestic financial market also show a continued sound performance and maintained in well capitalized condition. In general, domestic financial market has recovered well from pressures observed during the peak of the crisis, which mainly triggered by liquidity scarcity perception and impact of flight to safety panic phenomenon. All money market indicators have recently returned to their normal pattern. The banking intermediation has also been showing an improvement. In the first half of this year, bank lending grew at around 19% and for 2010 is expected to grow at 22%–24% range which will ensure the economic growth. While non-performing loans (NPL) is well maintained at low around 3% (gross) and capital adequacy ratio (CAR) in average at level of 18%. On the fiscal side, the government also showed a strong consistent effort in budget management efficiency and discipline. The fiscal deficit keeps low level of below 3% of GDP, which this year is expected to be 2.1%, and will be in a declining trend for years ahead. While, at the same time various measures are taken to continually improve its spending mechanism. Prudent fiscal policy has resulted in a significant decline in the debt to GDP ratio from 77% in 2000 to at below 30% recently. The economic performance I have just described is an evidence that consistent prudent macroeconomic policies taken by the Indonesian authorities, as part of the more than a decade transformation process within the very dynamic political democratic development, has provided a stronger foundation to sustain the further economic development. Those achievements has partly also been reflected in a better investor risk perception as shown in the decline of credit default swap (CDS) spread, which is now stable at around 180 bps for 5 years CDS, and recent sovereign rating improvement from major rating agencies. Yet, with regard to the later, I believe that rating agencies still tend to be too conservative in assessing Indonesia’s risk profile. Hence, it is not yet fully reflects the result of the significant transformation progress that Indonesia have been through within more than a decade, while they still more in “traumatic” view relate to the 1998 crisis. Outlook and challenge ahead We are quite confident that the Indonesian economy is on track. The economy will move on a faster pace compare with our previous belief and will be around 7% growth within the next couple of years, given the already proven domestic resilience so far. Economic growth will also be boosted by the upturn on export and investment. Improving external demand and better risk perception toward domestic fundamental economy will also keep the current account and financial account in a good shape, and contribute to the increase of foreign exchange reserve. However, there is of course a risk that has to be taken into account and monitored closely with regard to global financial market and economic development. Despite the still ongoing Euro zone crisis, in particular with respect to its banking sector and global financial market is also still fragile, global economy has shown a quite significant improvement. Yet, we expect that the risk will be moderate given strong world leaders commitment as I have previously mentioned. One thing that also ensures the prospect of domestic economy is a continuous strong commitment of the Government to implement infrastructure projects, especially in transportation and energy sectors, and reform measures in investment climate. With respect to the later, it is important for us to note that the public check and balance mechanism in ensuring more efficient bureaucracy and improving business climate, has been increasing significantly compare to a decade ago. While on inflation, we are quite confident to maintain within the target range of 5% +/– 1% up to 2011 and expect a declining trend ahead. In this regard, monetary policy will be consistently directed toward achieving low and stable inflation set by the Government. To achieve this low and stable inflation, which is now become more a common concerns, the Government and Bank Indonesia have taken measures to strengthen relevant policy coordination to better monitor and control inflation. I would like to convince you that our agenda is priorities on how to ensure that the economy always move on the right track, despite some risk factors to take into account as I have mentioned above. Also, I am optimistic in our strong commitment to implement, step by step, some agendas to improve the environment to facilitate a sustainable growth and a better quality of economic development. Before I conclude, I would like to also share that with regard to the global agenda on the financial sector reform and strengthening banking industry capital and risk management, as well as to encourage market disclosure and the adoption of a more convergence international accounting standard, Indonesia as a member of G-20 countries, also take step in the same spirit. Yet, the implementation will of course consider the stage and the structure of domestic financial market and banking industry. This is as partly can be observed in Indonesia participation in financial sector assessment program (FSAP). To conclude, I am optimistic into the prospect and the direction of the Indonesian economy ahead. I do hope that you will share the same optimistic view. Thank you. References Bank Indonesia, “Economic Report on Indonesia 2009”. Available at www.bi.go.id. Bank Indonesia, “Press Release No.12/31/PSHM/Humas, 5 July 2010”. Available at www.bi.go.id. Bank Indonesia, “Press Release No.12/28/PSHM/humas, 16 June 2010”. Available at www.bi.go.id. Bank for International Statements (BIS), “General Manager’s statement”. Statement by Mr. Jaime Caruana, General Manager of the BIS, at the BIS press conference on the occasion of the Bank’s Annual General Meeting, Basel, 28 June 2010. www.bis.org. G-20, “The G-20 Toronto Summit Declaration”, June 26–27, 2010.
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Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers' Dinner 2011, Jakarta, 21 January 2011.
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Darmin Nasution: Strengthening stability towards sustainable growth – a transformation challenge Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers’ Dinner 2011, Jakarta, 21 January 2011. * * * Honorable Ministers and Members of Parliament, Prominent Bankers, Distinguished Guests, Ladies and Gentlemen, Assalamu’alaikum Wr. Wb, Good evening and may God bless us all, 1. In this beautiful evening, I would like to invite all of us to jointly extend our gratitude to God Almighty for the opportunity to meet in such wonderful settings at the Annual Bankers’ Dinner 2011. 2. Although slightly belated, please allow me on behalf of all members of the Board of Governors of Bank Indonesia, to wish you a Happy New Year 2011. We hope this new year will be the year of our great achievement. Distinguished guests, ladies, and gentlemen, 3. We have just passed the global economic crisis 2008/2009 and if I may construe our economy in the period of 2010–2011 will be in the stage of transformation to a new era, shifting from a recovery phase towards a sustainable growth. Our journey during the course of transformation stage, however, would not be an easy one. 4. As the first line of defence, Bank Indonesia always puts a prudent and consistent management of monetary and banking policies as a priority. Nevertheless, this prudence and carefulness would not be enough. It seems that the risks and challenges after the crash of 2008/2009 will be as tough as what we have pursued in the midst of crisis. The risks and challenges ahead are much more diverse and complex with global economic policy constellation tending to escalate. 5. Thus, our transformation process towards a sustainable growth inevitably needs a new mindset and approach. To put things in the context, let me recite Einstein’s observation that “The whole of science is nothing more than a refinement of everyday thinking.” This statement seems to apply to our state of affairs. The effectiveness of a particular policy will always diminish and render obsolete along the way, and therefore it should be evaluated, aligned and even modified without sacrificing its main principles. 6. In a very dynamic world and in the face of uncertainty with all of its possible risks, our creativity and ability to explore possibilities through simulation will be tested. Indeed, policy makers cannot rely on a single policy instrument, they have to create a multi-front policy and formulate an accurate mix which could provide an optimum trade-off. Decisive actions and top-down approach sometimes are required when complexity and uncertainty are on the rise. Distinguished guests, ladies, and gentlemen, 7. In the beginning of 2011, we should be gratitude that we have gone through all of the challenges in 2010 with a number of noted achievements. Nevertheless, a series of concerns which has bearing on economic and financial performance remains. BIS central bankers’ speeches 8. In the past two years Indonesia was among a few Asian countries which consistently reached positive economic growth. In the midst of financial crisis, Indonesia was able to grow 4.5% in 2009, and in 2010 our economy has expanded even higher by achieving a 6.0% growth. 9. The structure of growth is now relatively more broad-based. Although the contribution of private consumption is still dominant, the contribution of investment to growth began to pick up by 2.0%. The performance of export was also significant, contributing a 5.7% growth. 10. On the other hand, CPI inflation reached 6.96% in 2010, predominantly pushed by the high pressure of food prices at year end. Such increase of food prices is a global phenomenon, and it has generated inflation pressures in a number of countries. Nevertheless, the pressure on core inflation was still manageable, recorded at 4.28%, due to rupiah appreciation and vigorous economic capacity to respond to rising consumption pressure. 11. We also recognized that the upward trend of consumption and investment has brought on high rate of import activities. The rise of import activities was still met by adequate export revenues hence could keep a net surplus on Indonesia’s current account balance amounting to USD 6.2 billion or 0.9% of GDP. Distinguished guests, ladies, and gentlemen, 12. We have all witnessed how many countries have undergone severe circumstances during 2008/2009 crisis and we have all witnessed how our economy has remarkable resilience during the crisis. Apparently, it has inspired global portfolio managers of a new economic power in Asia aside from China and India which has a huge market potential, solid economic fundamental, and attractive yields and capital gains. 13. Indonesian financial market was perceived as a magnet which attracted abundant global liquidity. We saw the surge of capital inflows into the country, mainly to several portfolio instruments such as government debt securities (SUN), Bank Indonesia Certificate (SBI), and equities. In total, inflow of portfolio investment to Indonesia has reached USD 15.2 billions during 2010. 14. A better prospect and resilience of our economy also attracted foreign direct investors, though still limited to resource-based sectors such as mining. This was evident from the foreign direct investment which reached USD 12.6 billions, increasing threefold from 2009 which was recorded at USD 4.9 billions. 15. Indonesia’s balance of payments reached a surplus of around USD 30 billions in 2010. International reserves also posted an increase as it reached USD 96.2 billions or grew 45.5% higher than 2009, equivalent to 7.1 months of import and the repayment of short-term government debts due. 16. A solid balance of payments and increased international reserves has put Indonesia’s external liquidity position on a stronger footing. Furthermore, a decreasing ratio of government debt to GDP (29.5% of GDP as of October 2010) provides further contribution to the robustness of Indonesia’s external sector. 17. We believe that stronger performance and resilience of the external sector was among the reason behind the recent improvement of our sovereign ratings. I am optimistic that now we are on the way to investment grade. The primary obstacles to achieve investment grade mainly relates to infrastructure development, which I believe is a task that must be resolved together. Issues on infrastructure development have been discussed numerously and policy recommendations have been formulated as well. It is time now to consistently implement them. BIS central bankers’ speeches 18. A surplus balance of payments was also reflected by a relatively stable rupiah. In 2010, rupiah strengthened 4.2%, in a range that we view is quite ideal and consistent with the macroeconomic and business environment. 19. Increased economic activity during the course of 2010 was also supported by the performance of banking sector which was reflected in improving intermediation function and stability of the sector. This was evident from several aspects such as credit expansion which reached 22.8% in 2010, a relatively high capital adequacy ratio (CAR), and a steady low gross non-performing loan (NPL) which was kept under 5%. Overall, resilience of domestic financial market was improving. The escalated debt crisis in Europe which peaked in May and November 2010 only put temporary pressure on the domestic market. Distinguished guests, ladies, and gentlemen, 20. All of the achievements which I have mentioned are the fruits of our hard work, including the banking community. Those achievements are much more appreciated and cherished since they were achieved in the midst of global uncertainty and calamity. 21. In this opportunity, allow me to address Bank Indonesia’s policy responses in 2010 in preserving macroeconomic and financial system stability. In accordance with tonight’s theme, I believe that strengthened stability will support the transformation process of our economy in the aftermath of the global financial crisis from a recovery stage to a more sustainable growth. 22. The way Bank Indonesia formulates policy responses is indeed a meticulous process involving deep internal discussion. This was undeniable since the threats and challenges in 2010 was so diverse and unpredictable creating complexity in the policy making process. 23. In general, there are three challenges in 2010 which will persist in the future. First, the challenge of global economic imbalance. Two years after the crisis, the global economy underwent two speeds of recovery in which the recovery in emerging markets is more rapid than that in advanced economies. To ensure durability of recovery, policy makers in developed countries rely on accommodative policies. On the other hand, policy makers in emerging markets have to deal with economic overheating. We may say that almost all emerging markets have undergone policy normalization in 2010, some countries even have shifted to tightening mode. 24. Second, challenges associated with global capital mobility and currency war. The differences of economic cycles and policy stances between developed countries and emerging markets unfortunately have led to unfavorable consequences for emerging market. This is evident in the context of tidal wave of capital inflows into emerging markets including Indonesia. The surge of capital inflows bring about complexities of macroeconomic policy management to emerging market, including Indonesia, since it has bearing on currency appreciation pressure, asset bubble risks, and financial fragility following capital reversal. 25. Policy responses by way of foreign exchange intervention and managing capital flows in several emerging market have generated different appreciation pressures among countries. In the mean time, since keeping large stock of international reserves is deemed too costly, emerging markets tend to put their reserves in other emerging markets. This situation indeed entails a significant negative externality in the emerging markets region. Hence, a policy coordination in the multilateral level is necessary to avoid negative externality of individual country policy response. 26. Third, challenges related to domestic demand and inflationary pressure. Global financial crisis 2008/2009 has deteriorated inter and intra-regional trade which prompted many countries to focus on promoting domestic demand. However, in the BIS central bankers’ speeches context of Indonesia, relying solely on domestic demand has two significant implications. 27. Firstly, a high domestic demand may generate inflation since supply side is quite less flexible to respond to accelerated demand. Secondly, a high domestic demand may accelerate import even faster since import content in our industry is still perceived high. This situation will bring about decreasing current account surplus or even a deficit. Since the ratio of short-term capital to total capital inflows is quite high, the risk of current account deficit should be monitored closely. Distinguished guests, ladies, and gentlemen, 28. On that note, a number of policy mix of monetary and macroprudential instruments have been implemented during 2010 to mitigate the global and domestic risks. In the midst of surging capital inflows and abundant excess liquidity, efforts to combat inflationary pressure cannot solely rely on conventional policy instruments such as the interest rate. Increasing interest rate may attract even more capital inflows. It is for this reason, a mix of policy instruments is needed. 29. The policy mix implemented is intended to address the challenge of maintaining external and internal economic stability. Achieving external stability means, maintaining strong and sustainable balance of payment, meanwhile internal stability implies attaining low and stable inflation to support sustainable economic growth. 30. To maintain external stability, a policy mix is aimed at exchange rate stabilization and capital flows management through macro prudential policies. In the midst of surging capital inflows and appreciation pressures, exchange rate stabilization policy through intervention is maintained to minimize the exchange rate volatility, taking into consideration the direction and movement of exchange rates in the region. Given the complexity of relying only on intervention, macroprudential policies are also pursued. Since June 2010, Bank Indonesia has started to implement macroprudential policies with the imposing of the one-month-holding-period (OMHP) for SBI buyers. This regulation requires SBI buyers to hold their holdings for one month before selling them to other parties. I view this policy very useful in preventing large and sudden capital outflows originating from SBI transactions such that it can manage to reduce exchange rate volatility. The scope, timing and sequencing of the policy mix are based on the consistency of the exchange rate to macroeconomic target and the impact of excess liquidity resulting from exchange rate stabilization on monetary operation. 31. Meanwhile, to sustain internal stability a policy mix is introduced to maintain price stability and appropriately manage domestic demand. Measures taken include among others imposing a level of interest rate in combination with macroprudential measure to manage excess liquidity. This is done through increasing Minimum Reserve Requirement. The scope, sequencing and timing of the policy mix took into consideration inflation and macroeconomic projections, the current excess liquidity (including the impact of foreign exchange intervention and fiscal expansion), and the cost of monetary operation. 32. We continue to calibrate the mix of policy measures taken to strike an optimal trade off between various macroeconomic targets. Bank Indonesia also maintains on going coordination with the government especially to minimize the impact of volatile foods and administered prices inflation on the economy. Distinguished guests, ladies, and gentlemen, 33. In the short run, I believe the opportunity for higher economic growth is still very much wide open. Bank Indonesia projects economic growth in 2011 to reach the range of 6.0%–6.5%, and increasing to 6,1%–6,6% in 2012. Investment which BIS central bankers’ speeches began to improve since 2010 is expected to continue its growth hence creating a more balanced economic growth structure. 34. Higher growth in 2011 is also supported by solid performance of the external sector. Exports is expected to be more diversified and grow stronger while the fast growing imports is in line with robust investment and consumption. 35. The portion of foreign direct investment as a composition of capital inflows is estimated to expand. Overall, the 2011 balance of payment is projected to reach a surplus of USD16.4 billion, and the foreign reserves to reach USD112.6 billion by the end of the year. This is equivalent to 7.5 months of imports and short-term government debt repayment. The sizable foreign reserves will strengthen sustainability of the Indonesian economy in mitigating various external shocks (a self insurance mechanism). Distinguished guests, ladies, and gentlemen, 36. We observe stronger economic growth in 2011 is expected to be accompanied with rising inflationary pressure. We are well aware of the number of sources of inflationary pressure, especially those coming from increase food prices as well as possible adjustment of administered prices. The rise in inflation expectation due to the impact of food price increase on the perception and dynamics of the domestic financial market recently, is also a special concern to us. 37. In this context, Bank Indonesia together with the government will continuously coordinate to fine tune various programs to increase supply and improve distribution of staple goods. Bank Indonesia has high hopes and is certain that the Government will thoughtfully address this issue. The synergy between an appropriate policy mix and a well-built coordination will undoubtedly bring inflation to its target of 5%±1% in 2011 and 4,5%±1% in 2012. 38. In my capacity as a monetary authority, I would like to reemphasize that Bank Indonesia is still very much committed to direct the BI rate to reach the medium term inflation target which is in the range of 3.5%. The setting of the BI rate is formulated with excise measurement so that inflation and expected inflation will move towards the corresponding target without sacrificing economic growth. 39. I have strong believe that by the official establishment of the ASEAN Economic Community by 2015, we can achieve the medium term inflation target hence bring our inflation rate to the level of neighbouring countries in the region. A low and stable inflation accompanied with improvements to various structural impediments will support the Indonesian economy which is estimated to grow by 7.5% by 2015. Distinguished guests, ladies, and gentlemen, 40. The picture of our state of economy which I have just portrayed is still prone to a number of global and domestic risks. The global economy will continue to move dynamically in its search for equilibrium. However, this process may well be described as an indefinite search within a dark and never ending tunnel. 41. An imbalanced global economic recovery, a persistent debt crisis in the peripheral European area, signs of economic overheating in emerging markets, and extreme climate change and its impact on food prices are still considered as risks that may affect the stability of the global financial market in years to come. The dynamics of the global financial market can have an immediate impact to Indonesia as we currently have a relatively open financial market. Our first challenge is how, on the one hand, we can strengthen our domestic financial system while, on the other hand, reap the benefits of this relatively open market, including efforts to deepen our market. BIS central bankers’ speeches 42. Based on my observation, efforts to deepen our financial market are moving on a relatively slow track. In this context, the strengthening of the domestic investor base must be a priority so that the dynamics of our financial market is not solely dependent on changing global investor risk appetite. Furthermore, we may no longer have to fear the risk of capital reversal. In this opportunity, I welcome efforts made by the Ministry of Finance and the Ministry of State Owned Enterprises on their cooperation to maintain the stability of the government debt securities. Distinguished guests, ladies, and gentlemen, 43. A number of domestic issues in 2010 are still pending and must be resolved. In this context, our second challenge is how to transform the Indonesian economy into a more sustained economy supported by sustainable growth. Despite its relatively more stable growth compared to most other countries in the region, the structure of the domestic demand of the Indonesian economy must be further boosted to be an investment-driven demand. For example, the high economic growth of China and India are supported by a share of investment to GDP of 45% and 33%, respectively. This is compared to Indonesia with a 24% investment to GDP ratio. 44. Indonesia still lags in attracting FDI compared to the two countries. Despite its increasing trend in 2010, according to the United Nation’s World Investment report, the ratio of the stock of incoming investments to GDP for Indonesia is only 13.5%, far below Thailand (37.5%) or Malaysia (39%). 45. The dynamics of our economic growth structure in terms of sector must also be put to our attention. Labour intensive sectors which facilitate transfer of technology, especially the manufacturing industry, are contributing less and less to the economy. On the other hand, an accelerating growth is depicted in small value added, resource-based industry and non-tradable sectors such as telecommunication. If left unattended, this problem may lead to deindustrialization that may cause reduction in the value added of the national industry. 46. Our domestic manufacturing industry is also heavily dependent on imports. As a consequence, economic growth is followed by rising imports which causes the current account surplus to decline. Such a trend is actually already happening. In 2009, our current account recorded a surplus of USD 10.7 billion (2.0% of GDP), and in 2010 in line with strengthening consumption and investment, it fell to USD 6.2 billion (0.87% of GDP). Distinguished guests, ladies, and gentlemen, 47. The third challenge is how to direct inflation to a low and stable level in line with the set target. Recently, market perception on inflation is based more on short term phenomena or cyclical factors. 48. In the last ten years, Indonesian inflation on average reached 8.2% and is on a declining trend. This rate is well above regional average during the same time period. However, there has been significant progress as the inflation gap during this period is declining. In fact, compared to the BRIC countries, all having an investment grade rating, the inflation rate in Indonesia is relatively close to the level of the rate in Russia and Brazil, and even lower than in India. Regardless its improving inflation profile, Indonesia needs structural reforms in order to further lower inflation to be in line with neighbouring countries. 49. The fourth challenge is reaping the benefits of incoming capital flows. Foreign investors’ appetite for domestic financial market should ideally be directed to facilitate domestic financial market deepening and corporate financing. In this context, we need to find breakthroughs on how to provide incentives to boost initial/secondary public offering or even bond issuance. Also, imperative measure BIS central bankers’ speeches needed to provide assurance to foreign investors is the strengthening of infrastructure, which includes institutional aspects, regulation, and market efficiency. Distinguished guests, ladies, and gentlemen, 50. 51. I am certain that through commitment, active participation, and strings of coordination among affiliated parties, we are able to face the various risks and challenges mentioned. To direct inflation towards its target, policy taken by Bank Indonesia during 2011 will take the form of stronger monetary and macro prudential policy mix that have been implemented in 2010. This effort is done by taking into consideration all available instruments to be optimally calibrated. These instruments include: a) BI rate is directed to be consistent with announced inflation targets, 5%±1% and 4,5%±1% for 2011 and 2012, respectively, while keeping in mind the increasing inflationary pressure. b) Foreign exchange policy is aimed at achieving inflation target while keeping consistence with other macroeconomic targets and providing certainty to the business world. The possible trinity solution Bank Indonesia has opted for will be the optimal configuration of foreign exchange stability, management of capital flows, and interest rate response. In other words, taking into consideration the various complexities, Bank Indonesia’s strategy to go around the impossible trinity is by choosing middle ground solution instead of corner solution. c) Monetary operation and macroprudential policy to manage domestic liquidity are directed to be consistent and supportive of the interest rate policy in achieving the inflation target and managing domestic demand. d) Macroprudential policy on capital flows is aimed at supporting foreign exchange policy and preventing excessive impact on domestic liquidity. Two policy packages announced in December 2010, an increase in reserve requirement in foreign currency and reinstatement of the limit of daily short term foreign debt position, fall into the category of macroprudential instruments directed to manage capital flow. In the midst of capital inflows, such increase in reserve requirement in foreign currency will strengthen banking liquidity management. Meanwhile, the limit of daily short term foreign debt position will increase prudence in managing banking short term foreign debt. In the formulation and implementation of the policy mix, it is important to keep in mind linkages between monetary and financial stability. Bank Indonesia will continue to calibrate various measures so that the policy mix taken will bring optimal trade off between monetary stability, financial system stability, and sustainable economic growth. Distinguished guests, ladies, and gentlemen, 52. In line with the macroeconomic development, allow me to give explanation on Indonesia’s banking condition, much of which certainly needs to be encouraged and dealt with. To this end, I will underscore principal aspects that I believe require closer attention. 53. I would like to begin with financial system stability and the positive banking performance in 2010. In general, financial system stability is reasonably maintained as indicated by the Financial Stability Index of 1.75, much lower than the 2.43 figure recorded during the 2007/2008 crisis. The performance of the banking industry, as I mentioned before is also quite satisfying. The intermediation function is enhanced BIS central bankers’ speeches although still leaving room for growth, the credit risk is maintained, and the capital is adequate with the support from ample liquidity which I believe is more than enough. 54. The indication of excess liquidity in the banking sector is reflected by the size of the liquid instruments as of 15 December 2010 including SBI amounting to Rp 494.5 trillion and Government Debt Securities amounting to Rp 229.9 trillion. The banking undisbursed loan amounting to Rp 556.8 trillion also indicated the presence of excess liquidity. This highlights that our economy is not short of liquidity. The challenge is in how to channel that liquidity to finance productive business sector and economic development as a whole. 55. I see a serious issue here, where in a condition of excess liquidity, the role of banks in promoting economic growth is still small. The ratio of credit to GDP in 2010 is only 26.1%, just a slight increase from 25.7% in 2009. This low figure is caused by the impact of the 1997/1998 crisis which has pushed Indonesia into a low leverage economy. In this condition, deleveraging process in the corporate sector occurred for quite a long period. Not surprisingly, during that period, credit to the corporate sector grew at a low pace. I indeed hope that banks have the courage to take bigger role in reviving the corporate sector, off course with high quality service and efficient cost. 56. In my opinion, banks need to take a closer look at non-bank sources of financing which have developed to be more competitive. To illustrate, in 2010 financing through equity and bond market reached Rp 280.6 trillion or 4.4% of GDP, compared to 3.7% of GDP in 2009. The number of issuers increased from 57 to 74 (2010). This condition should be able to encourage banks to increase their efficiency so as to maintain sound competitiveness. 57. Apart form the above matter, I see a potential opportunity for SMEs to become an engine for the economy. Data as of end 2010 showed that the share of SME credit have reached 53.32%, growing 25.17%. These figures indicated the dominance of SME to the total credit. Furthermore, the 2.65% non-performing SME loan is lower than that of the non-SME (3.51%). 58. On top of that, there is room for improvement for the SME sector. The lending rate for this sector is still higher than for the other corporate sector. This is a challenge for us together, because if the interest rate for SME can be lowered further, the benefit will be high for the economic activity. 59. Regional wide, our banking competitiveness in terms of efficiency, capital and asset is still lower compared to other countries in the region. Based on data from Bank Indonesia and Bank Scope as of end 2009, our ratio of operational expenses to operational income (OEOI) and net interest margin (NIM) are 81.6% and 5.8%, respectively. Meanwhile, Singapore, Malaysia, Thailand and the Philippines charted OEOI of 32.7%–73.1% and NIM 2.3%–4.5%. This fact indicates how Indonesian banking efficiency is the lowest among ASEAN-5. This is ironic to the other fact that the average increase in bank equity price in Indonesia is very fantastic. To this end, I request banks to catch up in terms of efficiency. 60. Moreover, the challenge ahead that we should confront together is how to reach an equal footing for our banking competitiveness as we are heading toward the ASEAN Economic Community (AEC). The banking sector liberalization under the AEC will be effective in 2020. Like the saying: “9 years a short period of time, the future will be here before we know it,” we all have to be ready for the challenge. Therefore, banks are demanded to have the capability to compete while enhancing their resilience individually, among others through capital accumulation for sound expansion of assets. BIS central bankers’ speeches 61. At the global level, as a highly regulated industry, banks cannot disregard international standards, all the more with Indonesia being a member of the Group of 20 (G-20), Financial Stability Board (FSB), Bank for International Settlements (BIS) and Islamic Financial Services Board (IFSB). By implementing various agreed commitments, it is expected that Indonesian banking sector keeps growing healthy in the corridor of international prudential standard. 62. Considering the various global concessions in maintaining the financial system stability, I notice that the capital and liquidity aspects need to be reviewed. Meanwhile, crisis resolutions for the possible systemic impact of failing financial institutions also need to be strengthened. All these challenges pose serious concerns and adopted by Bank Indonesia as the basis for strengthening the program of the Indonesian Banking Architecture (API). 63. By the end of 2010, Indonesia has completed the Financial Sector Assessment Program (FSAP) as part of its commitment as the member in G-20 global community. FSAP assesses the extent of resistance, and compliance with international standards of financial sector. The results of FSAP are encouraging. The level of Indonesian banking sector resilience is deemed robust and sound. The stress tests indicate that the resilience of our domestic banking industry is sufficient in time of a crisis. Furthermore, the level of Indonesian compliance with the main principles of effective bank supervision is considered to be sound. Therefore, let me extend our appreciation to distinguished ladies and gentlemen for this achievement. Distinguished guests, ladies, and gentlemen, 64. Albeit those various issues to be addressed, I have faith the macro economic outlook for 2011 still provide hope for banking industries to grow. The industry should see credit growth in the range of 20%–23% in 2011. However, this growth is vulnerable to the potential risk of commodity price increases and inflationary pressures, as well as the increased role of non-bank financing. In return, those factors might potentially surpress credit growth in the range of 19%–21%. 65. To encourage the growth of micro-, small- and medium-scale business credit (UMKM), Bank Indonesia requires banks to include micro-, small- and mediumscale business financing scheme in their business plan. Let me take this opportunity to thank all stakeholders who have supported the initiative of synergy through the commercial banks – rural banks linkage program, and the initiative of using guarantee schemes as one of risk mitigation efforts. 66. To increase the role of rural banks in micro-, small- and medium-scale business credit sector and the communities in their vicinities, particularly lower and middle class society, adjustments in the asset quality rules are applied to obtain a more encouraging atmosphere, hitherto creating an agile rural bank sectors without neglecting the prudential credit principles. Likewise, redesigning the rural banks efficiency, specifically on how to substantially reduce lending rates, is profoundly necessary. 67. To strengthen the regional economic development, BPD Regional Champion program is launched to help boosting up the role of Regional Development Banks (BPDs). The program is aimed to improve the viability and competitiveness of regional development banks; hence they can effectively perform their function as agents of development in the regions. 68. Related efforts in improving the quality of national Islamic banking industry, I view that there are 3 respective aspects to take into consideration: (i) improving the professionalism and the quantity of manpower in the industry, (ii) providing robust and sound incentives, especially in the form of conducive regulatory environment, BIS central bankers’ speeches and (iii) strengthening product innovation and infrastructure in Islamic banking industries. Distinguished guests, ladies and gentlemen, 69. Of various opportunities and problems arising in 2010, Bank Indonesia has issued the December 2010 Policy Package. Its main objective is to strengthen and improve macroeconomic stability as well as banking resilience and intermediation. 70. An improved bank intermediation policy seeks to ensure the availability of supplies through the deepening of the market (Home Ownership Loans (KPR) securitization provisions), to create competitive loan costs (provision of transparency base rate loans), to adjust credit risk weighting of retail and KMK (provision RWA) as well as to reduce asymmetric information with the provision of credit information data (private credit bureau requirements). In addition, to extend the scope and depth of intermediation, enormous efforts through expanded access to financial institutions (financial inclusion) and BPD Regional Championship program are continuously carried out. 71. An improved resilience of banking industry policy seeks to sustain the banking industry growth, to strengthen competitiveness and to mitigate the crisis surprises. To achieve these goals, banking industries are required to strengthen their qualitative and quantitative improvement aspects, which is attained through the existing sets of rules in fit and proper test, increased compliance of commercial banks, risk based balance asset (ATMR) and associated effective risk management in business cooperation Bancassurance. 72. Policies related to institutional empowerment, competitiveness and the resilience of rural banks and Islamic banks are aimed to create an equal playing field with conventional banks. These efforts will be endorsed by sets of rules and regulations in earning assets quality rating, bank financing and sharia unit restructuring, the maximum limit of funds for rural banks (RB) sharia financing, and changes in licensing change from conventional banks into Islamic banks. 73. Through this policy package, Bank Indonesia attempted to strengthen the effectiveness of banking supervision, particularly through the creation and implementation of early warning system and macro prudential supervision. These efforts will be in line with the refinement of rules and regulation in risk-based banking supervision, improvement in bank entry and exit policies, and adoption of risk-based supervision and consolidated supervision. Distinguished guests, ladies and gentlemen, 74. Let me also seize this opportunity to propose my ideas on Indonesia’s policies and guidelines for desirable future to cope with economic turbulence ahead. These are generally basics but in my humble opinion these issues are critically important as steps to be taken in order to transform the post-economic conditions of economic and banking crisis today, towards sustainable economic growth. 75. First, I recognize that the sustainable supply of Indonesian foreign exchange is crucial to sustain macroeconomic stability, particularly in maintaining exchange rate stability. We need to think thoroughly how the foreign exchange, particularly from export, can comprehensively cover import and financing needs, in addition to its contribution to financial deepening. 76. Second, I believe the strengthening of banking supervision system and the deepening of the banking industry through consolidation remains vital to determine the success for overcoming a crisis amid the global competition. Banking capital might be sufficient to boost up the national economy pillars progressively; however I develop a feeling this is not sufficient to face the incoming potential crisis. Lessons BIS central bankers’ speeches learned from the crises in 1997/1998 and 2007/2008 have taught us to understand an important message that the fragility of banking industries would inflict harms on the nation, the central bank and eventually bring misery and misfortune upon the citizens. 77. Bail-out may be necessary in time of crisis, but past experience shows that such measure might create another new turbulence in terms of economic, political and legal complications. We need to develop preventive steps and an overall soundness and strong capital defence. This paradigm has been intensively discussed among regulators and practitioners in banking industries by replacing the paradigm of bailout with bail-in. It means the banks themselves should have a buffer to absorb risks and mitigate shocks in establishing the proper crisis protocol. 78. This concern has reinforced my conviction that consolidation, both in the capital as well as in the institutional dimensions, needs to be accelerated. Thereby, it is necessary to evaluate alternatives for the improved soundness and higher efficiency in implementing consolidation based on the more interesting incentives and disincentives regulation scheme, either in the areas of merger, acquisition, or any other corporate actions. The robust and sound banking capital is also beneficial for developing competitiveness such as in the development of information technology and business scale. This endeavour is required to meet MEA implementation prerequisites, since the average capital level of Indonesian banks is the lowest among those in ASEAN-5. 79. Third, I extremely emphasize the magnitude importance of efficiency; hence expect banking industries to promote a lower and efficient NIM. In my modest opinion, efficiency is the key to untie the knots of the extricable intermediary complexity, therefore increasing credit and is expected to stimulate further economic growth. Efficiency as well encourages the banks behaviours in providing prudential, selective, productive and prospective credit. Such behaviours in the long run will accelerate the prudential banking practices, which is the prerequisite of financial stability. This provides evidence that banking efficiency bear fruitful growth and stability as well in banking industries. 80. Efforts to increase banking efficiency have been initiated. We certainly still recall an agreement setting a fixed deposit rate more than a year ago. This is then followed by endeavours to review the spread of interest rate led to the implementation of prime lending rate. Bank Indonesia, needless to say, will continue to analyse further measures, including those related in providing gifts to customers, and benchmarking between banks. 81. Fourth, to be better prepared in the era of economic integration, facilitate the flows of banking transaction and boost the national economy, the policies for the development of the payment system are aimed to make the system more efficient, reliable, simple and secure. The focus is on the development of system and infrastructure, as well as on strengthening the regulatory basis. 82. Starting 2011, Bank Indonesia will enhance the existing systems, including BI-RTGS, BI-SSSS G-II, Direct Debit-SKNBI, Retail Payment Interconnectivity, and ATM chip standardization. Efficiency in the payment system will also be increased with the plan to ingrate the existing payment system network through National Payment Gateway (NPG), the further promotion of financial inclusion through payment system by retail agent, and the proposal of rupiah redenomination program which is currently in the phase of coordination with the government. 83. Fifth, my view is that the Indonesian Banking Architecture should not only elaborate the ideal condition of banking industry with all the important pillars as its components. Two other dimensions should be covered. First, how should we place each of different types of banks in Indonesia on its deserved position, based on its BIS central bankers’ speeches reason of existence. This should include the consideration on the positions of conventional bank vs. syariah bank, general bank vs. people’s credit bank, local bank vs. foreign bank, and national bank vs. rural development bank. Moreover, it should also be studied how to produce synergy among those. 84. Second, the Indonesian banking architecture should contain a roadmap that can guide us from the present situation to the ideal condition architectured. Indonesian banking architecture should not be a static snapshot, but a dynamic roadmap. Such roadmap should include the implementation of best practices in the banking industry covering many dimensions, including business model, standard setting, information system, and ownership. 85. Sixth, there are many lessons learned since the 2008 global crisis which contribute to a new framework of thinking. Despite the repetitive nature of crisis, we cannot rely on yesterday logic, or solely relying on conventional macro policy to resolve current issues. The introduction of the macroprudential policy strengthens the effectiveness of conventional policy and brings new hope to the crisis recovery. Such a policy requires a more collaboration, coordination, interaction and integration between micro supervisory function and macro monetary function in maintaining financial stability. The challenge ahead is securing a comprehensive policy framework and I myself hope that it can be maintained and further continued in the future. 86. Seventh, I would like to invite all banking sector colleagues to utilize Indonesia’s demographic potentials with its large population and still relatively limited access to financial sector. Bank Indonesia, hand in hand, with the government is currently formulating a financial inclusion national strategy. This national strategy will serve as a framework consisting of strategic actions to open the access of unfinanced persons as well as unbanked persons to the financial sector. 87. Lastly, to promote good governance, I am of the view that excessive risk taking which can potentially induce moral hazard as witnessed during the 2008 crisis needs to be prevented. On that note, compensation or remuneration structure of bank executives conducive to the development of professionalism and integration is needed. Distinguished guests, ladies and gentlemen, 88. In addition to the policy direction I have described, we must also formulate medium to long term strategies. My view is that capital accumulation, both in the form of physical and human capital, and productivity improvement is key to boosting a balanced aggregate supply and aggregate demand. It is hoped that this ideal condition will lead to higher GDP and lower inflation which will in turn be followed with an increase in GDP per capita. 89. Different speed of convergence to levels of developed countries is seen in the development of income per capita of several main Asian countries. Singapore has out-achieved developed countries since the 1990s decade, while Korea is converging to Japan following the 1997–1998 Asia crisis. To illustrate, for the case of Indonesia, the ratio of Japan’s income per capita to Indonesia’s income per capita is on a gradual decline since the 1990s decade, with a slight interruption during the Asia crisis. This means that Indonesia’s income per capita is catching up to Japan’s income per capita. 90. According to the October 2010 IMF’s projection, the ratio is estimated to further decline until 2015 and may continue onwards. However, further analysis shows that the speed of convergence to match developed countries is not yet sufficient. 91. Bank Indonesia study shows that in addition to low capital accumulation and productivity, the non optimal speed of convergence is also caused by most binding constraints in the economy. Should these constraints be untangled, a more BIS central bankers’ speeches accelerated economic growth through increasing investment could be achieved. The five most binding constraints are: 1) insufficient innovation through research and development; 2) a low standard quality of education and health; 3) insufficient possession of information and communication technology; 4) inadequate transportation and distribution infrastructure; and 5) unsustainable supply of energy (for example electricity). Undoubtedly, the role of the state is needed to resolve such binding constraints. 92. In my view, there is a key policy that should be a priority, namely human capital reforms. This would be a crucial precondition to elevate Indonesian economy to knowledge based-economy of 21st century. Human capital reforms could be initiate by a simple yet fundamental initiative on health and education. 93. Furthermore, by focusing on human capital reform, Indonesia could avoid middleincome trap, a phenomenon in which a developing country (as defined as middle income country group) is unable to move up to higher level of income. I believe that all of us have the same vision that in 2050 Indonesia will be free from poverty and could achieve an inclusive growth with notable surplus in key areas, including agriculture. Distinguished guests, ladies and gentlemen, 94. I hereby invite bankers to shift the mindset of business from “opportunities capture mode” in respect of the recovery after the crisis to the “sustainable growth plan” as the global economic crisis begins to fade. I am certain the resilient solidity we have demonstrated in the previous economic thunderstorm has momentously motivated us to go forward in creating a sustainable and robust banking and economic growth 95. Let us all join hands in unity and walk confidently towards a better tomorrow. And once again, Happy New Year 2011. May God Almighty give our work His blessing; strengthen our purpose in achieving a more developed and prosperous Indonesia. God bless us all. Wassalamu’alaikum Wr. Wb. BIS central bankers’ speeches
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Speech by Dr Halim Alamsyah, Deputy Governor of Bank Indonesia, presented in the opening keynote session of the 2nd Annual World Islamic Banking Conference: Asia Summit, Singapore, 8-9 June 2011.
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Halim Alamsyah: Some critical issues concerning the sustainability of Islamic finance development – Indonesia perspective Speech by Dr Halim Alamsyah, Deputy Governor of Bank Indonesia, presented in the opening keynote session of the 2nd Annual World Islamic Banking Conference: Asia Summit, Singapore, 8–9 June 2011. * * * Bismillahir Rahmanir Rahim H. E. Lim Hng Kiang, Minister for Trade and Industry, Republic of Singapore and Deputy Chairman, Monetary Authority of Singapore H. E. Mohd. Rosli Sabtu, Managing Director, Monetary Authority of Brunei Darussalam Tan Sri Zarinah Anwar, Chairman of Securities Commission Malaysia Distinguished Speakers, CEOs, Islamic bankers, academics and practitioners, Ladies and Gentlemen Assalamu’alaikum warahmatullahi wabarakaatuh and very good morning It is an honor for me to deliver speech in this 2nd Annual World Islamic Banking Conference in Singapore, as a platform to discuss issues and efforts required to enhance cross-border connectivity of Islamic finance. As we have seen now, development of Islamic finance are growing very fast in the world, particularly in Asian countries such as Malaysia, Indonesia, Pakistan, and Brunei, as well as in Middle East countries such as United Arab Emirates (UAE), Saudi Arabia, Bahrain, Qatar, and in European countries such as UK and Luxemburg. Hence, collaboration between countries in those regions would potentially very important to boost the expansion of Islamic finance in the world. Ladies and Gentlemen, Islamic finance has gained a significant global exposure and experienced a phenomenal growth in the last three decades. From only US$137 billion of the total assets in 1996, it expanded to reach US$895 billion in 2010. 1 In the near future (2015), the amount will be expected to be US$5 trillion. 2 With such a progressive development, certainly it needs further commitment especially among countries having Islamic finance industries to maintain and foster their sustainable growth. Countries in Asia, which I mentioned before, are keen to tap such promising industries and want to become the center of Islamic finance in their region. Many Islamic financial institutions have been established by both foreign and local players and expanded their products and services to cover Islamic finance growing market. As such, in Malaysia, the share of Islamic finance has reached 22% of the total banking industry; Pakistan plans to capture share 12% market share of Islamic banking by 2012 and Indonesia targets 15%–20% market share of total banking industry in the next ten years. On the other hand, in the Middle East countries, especially Gulf Cooperation Council (GCC) countries, the market share of Islamic finance has expanded to go beyond 15% headed by UAE, Bahrain, Saudi Arabia and Kuwait. Even, some of the local Islamic banks have had overseas branches such as Kuwait Financial House, Al Rajhi Banks, HSBC Amanah, etc. It The Financial Express, Bangladesh (23 May 2011) Moody’s Investors Service BIS central bankers’ speeches reveals that the expansion of Islamic banks is underway and right now countries like Singapore, Hong Kong, China and Japan have prepared themselves to establish the Islamic finance industry. These are very interesting facts which could further enlarge the number of countries having Islamic finance industries. With greater economic interdependency and convergency together with more open financial system and capital account regimes in many countries, the new financial system (Islamic finance) have flourished and may become an important catalyst for growth and stability in many countries. For example, Indonesia as a country with the biggest moslem population in the world has only started its Islamic banking industry since 1992. With a liberal banking system regime and regulation, Islamic banking industry has grown very fast and right now it has eleven Islamic banks and 23 Islamic windows including Islamic foreign banks such as HSBC Amanah, Maybank Islamic, and CIMB Niaga Islamic. Although its share currently is still trivial (around 3%) compared with the conventional banks, the industry has shown its resiliency. Furthermore, our research has shown that it has also positively contributed to the expansion of Islamic banking and financial services throughout the country, and enabling more multiplier for future Islamic financial development in the country. Excellencies, Ladies and Gentlemen, Besides the growing trend of Islamic banks, another promising industry is the Islamic capital market, notable Sukuk market. It emerges in various countries in the Middle East and Asian countries. The recent global Sukuk market has crossed USD134 billion in issuances and Malaysia leads this market with 65% market share followed by Middle East countries with 26% market share and the rest of the world. However, the tenor of the world Sukuk market is dominated by short term Sukuk tenor which is 55%, while the long term tenor (for example more than 10 years tenor) is only 20%. The Sukuk market in Indonesia is also progressing, with a nominal amount of USD6.2 billion (as of May 2011) and annual growth of 9.3% (2010). In the near future, I strongly believe that Sukuk will grow significantly as it can be developed to have various forms of contracts with attractive features offering competitive returns and liquidity. In addition, the existences of excess liquidity from surplus savings in Asia and oil revenues countries across Middle East become a potential demand for Sukuk. This opportunity can be used by the government or private companies to issue Sukuk as an alternative financing source. The current positive trend of issuing Sukuk for financing government’s infrastructure projects provides a good signal of support from the government that should be maintained. Ladies and Gentlemen, Through this summit, where the meeting of regulators, practitioners, academics, potential investors and industry experts are possible, it is hoped that the potential of the Islamic banking and finance will be maximized to further improve the current swift development of the industry. In the future, it is expected that Asia will grow to be the next Islamic finance hub, in addition to Middle East. Bridging these two potential markets for developing Islamic financial industry will also contribute to the increase of economic growth in respective regions. Despite all those success stories and potential growth of Islamic finance, we believe that the road ahead remains challenging. I would like to point out four main issues that can be further discussed in this summit. Firstly, concerning the Islamic financial products. In terms of product development, Islamic financial institutions should develop innovative products that can bring up the uniqueness of Sharia components. Instead of emulating conventional products or adopting Islamic dressing to existing products, industry should move towards creating pure or genuine Sharia products that seek to bridge the financial sector with real sector. BIS central bankers’ speeches I believe the strength as well as the uniqueness of Islamic transactions lies within the profitloss sharing mechanism, provision of underlying assets and commitment to promote real sector. However, in general, the record of Profit-Loss Sharing (PLS) transactions in Islamic banking industries across countries are still relatively low. I strongly believe that increasing portion of profit-loss sharing transactions, such as mudharabah and musyarakah, will be beneficial for both the financial sector and the real side of the economy and will eliminate decoupling or detachment effect between two sectors, a situation that was behind the recent global financial crisis. Another issue related to product development is about product codification. At the moment, as you all know, there are different acceptations or agreements of fatwas concerning the approval of certain products. In other word, there are still some unresolved issues in fiqh muammalah for certain sharia products. While such differences are well understood and in Islamic tradition are well accepted, we still need to step up our efforts to make product codification as an international efforts as it will certainly have very positive benefits in promoting and facilitating sharia product developments and innovations. Product codification provided by international institutions will reduce the gap and promote products harmonization among the countries. Excellencies, Ladies and Gentlemen, Secondly, concerning the legal infrastructure and regulatory standard for Islamic finance. As mentioned above, product structured based on Islamic principles is, by nature, different from its conventional counterparts. Hence, it requires a dedicated legal framework confirming with Sharia principles. The existing law is not sufficient in solving disputes concerning the Sharia transactions. The availability of an appropriate legal infrastructure is particularly important for the development of Islamic financial institutions, especially in creating a more conducive environment for sharia transactions to grow efficiently. Perhaps, legal framework is one of the most important challenges in developing Islamic finance since so far only a limited number of countries have issued specific laws governing Islamic finance and dispute settlement, including cross border resolutions. In addition to the availability of legal framework, development of Islamic finance also needs global regulations and standards. The existence of global regulations and standards is essential to promote cross-border transactions and foreign participations in the development of Islamic Finance in Asia and other regions. Currently, we already have several international institutions, such as IFSB and AAOIFI which have authority to issue regulations and standards. The role of those institutions should be enforced and improved. Moreover, it would be better if every country that develops Islamic finance voluntarily adopt those regulations and standards. For instance, Islamic finance regulator in each country is encouraged to adopt voluntarily risks management standard released by IFSB. Again, due to its uniqueness, we should not apply the same approach of assessing risks in Islamic finance in a similar way with conventional institution. For example, profit-loss sharing portfolio may expose the bank from the loss incurred by the third party. Hence, Islamic financial institutions should adopt suitable global regulations and standards. It will create regulations uniformity that will spur harmonization and further integration of global Islamic finance. My third point will be about Islamic Financial Stability. If we, who are part of Islamic finance community, work together in developing financial products which truly confirms to Sharia principles, complemented by appropriate legal framework, regulations and standards, Insya Allah, this creation of “genuine” Islamic financial system would be able to reduce systemic risks and continue to become resilient to any financial shocks. As mentioned earlier that increasing portion of profit-loss sharing transaction will reduce the potential bubble in the economy and decoupling problem between financial sector and real sector. The fourth point is about “real rate of return” references. Besides beneficial in creating and maintaining stability, we also believe that profit-loss sharing, the spirit of Islamic finance, BIS central bankers’ speeches would give more fair return to all parties (funds owner, financial institution, and borrower). The return distributed to all parties should be a real result of business activities in the economy. However, at the moment, Islamic financial institutions seemingly tend to refer their rate of return to conventional rate of return (interest rates). Conceptually they should refer to the real rate of return in the economy. Unfortunately, currently there is no valid reference available about the real rate of return. Therefore, international Islamic institutions and countries regulator need to collaborate to study about the real rate of return that will become a reference for Islamic financial institutions in determining return, instead of referring to conventional interest rates. Ladies and Gentlemen, Beside those four main issues, I would like also raise two additional challenges regarding liquidity and human resources. Most of us aware that currently Islamic financial markets have limited instruments and restricted access to short-term funding options in raising liquidity as compared to conventional markets. We should think of methods to enhance Islamic liquidity market based on contracts consistent with Sharia principles. A caveat for such initiative will be, to carefully identify and structure the instrument for the purpose of raising liquidity only and not for the tools for speculation. The emergence of global money market will reduce the reliant of Islamic financial institutions in mirroring the techniques regularly use by conventional banks that are still within the grey area and debatable in terms of its Sharia compliancy. Hence, Islamic finance can maintain its reputation as the sector linking financial intermediary and real sector and slowly close the door to a heavy use of leverage that once led to Global Financial Crisis. Related to human resources issues, we understand that the fast growth of Islamic financial institutions so far isn’t followed by sufficient supply of human resources. In Indonesia context, the tremendous acceleration of Islamic finance industry has created human resources supply gap of more than 30.000 people recently. I believe the same phenomenon can also be observed in many countries. In order to fill the gap of human resources supply, establishing international efforts to tackle the issues and involving more formal and informal institutions teaching Islamic finance can be one possible solution. Moreover, the well-trained and wellexperienced pool of talents in more developed Islamic markets should open for learning exchange program facilitated by other countries with a strong international cooperation and engagement, more widespread supply of well-versed and skilled human resources will further foster the market growth given the rising demand for Islamic products and services. Excellencies, Ladies and Gentlemen, Let me close my speech by highlighting that Asia has bright prospects in Islamic banking and finance industry. In order to escalate the existing growth and trajectory to a next level, I sincerely hope that all parties, from the region and overseas to jointly explore new growth opportunities in Islamic banking and finance in this region. I wish you all to have an enriching and fruitful discussion and hope that we can contribute to the development and multiply the growth of the industry. May Allah Almighty bestow us the strength and patient to persevere in fulfilling our duty for a better future. Thank you for your kind attention, Wassalamu’alaikum warahmatullahi wabarakaatuh Dr. Halim Alamsyah BIS central bankers’ speeches
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Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers' Dinner, Jakarta, 9 December 2011.
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Darmin Nasution: Building efficient equilibrium towards sustainable growth Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers’ Dinner, Jakarta, 9 December 2011. * * * Respectable Members of Parliament, Prominent Bankers, Businessmen and Dignitaries, Distinguished Guests, Ladies and Gentlemen, Assalamu’alaikum Wr. Wb, Good Evening and May God Bless Us All, To open my speech here today held in such salubrious settings, I would like to invite you all to join me in expressing thanks and praise to God Almighty who has blessed us again with the opportunity to congregate here for the Bankers’ Dinner at the end of 2011. In distinction from the previous Bankers’ Dinner’s tradition usually held in the opening of a new year, this 2011, we have decided to organize this annual event at the closing of the year. By doing so, it is sincerely hoped that we have ample time to reflect on the success and failure over the past year as well as to discuss our expectations, risks and challenges to draw commitments ahead of time. Distinguished Guests, Ladies, and Gentlemen, It has come to our common understanding that changes in the constellation of the global economy since the global financial crisis of 2008 and its aftermath had left a profound and widespread fright. Against the backdrop of lingering effects from the global financial crisis, significant challenges in managing an increasingly complex macroeconomic stability has risen considerably. External shock and uncertainty seem becoming a constant dimension that incessantly shadows us along with the prevailing shifts and changes. In this current era of globalization, every formulation and implementation would be surrounded by some degree of uncertainty. However, it is believed that every open economy such as Indonesia will be constantly challenged by different external shocks over time. The problem is we do not know when, how big and through which channel the shock will happen. Nevertheless, we should be grateful. Despite the uncertainties, our economy has shown stronger performance this year compared to last year. Solid collaboration and close coordination, based on common understanding, have become fundamental elements in achieving and maintaining the successful management of our economy. Therefore, prior to delivering the main substance of my annual address this evening, please allow me to express my sincere appreciation and thanks to the banking community, all elements of the Central and Local Government, the Parliament, business community, academics, observers, the media and all other parties that I am, unfortunately, unable to acknowledge individually, who have been so incredibly supportive of Bank Indonesia in fulfilling its duties. For me personally, my journey in leading Bank Indonesia, a state institution with legal mandate to maintain national macroeconomic stability, is extremely precious and cherished experience. The experience in this arduous journey through labyrinths of trials and tribulations, has bestowed upon me a deeper understanding of our economic dynamics. Hence, as citizen of this great nation myself, the mandate has also provided great honor and opportunity for me to pay homage to our nation and all Indonesians by always giving my best. BIS central bankers’ speeches This evening, the time has come for me to reflect on what Bank Indonesia has achieved during the years of my leadership and communicate the plans and strategies beforehand by presenting my views regarding the economic prospects and challenges to be faced in the years to come and their implications on Bank Indonesia. I genuinely hope that the future perspective I plan to present here this evening can serve as a contribution for us all in determining some common measures to achieve a better national economic future. For that reason, the theme of my speech this evening is “Building Efficient Equilibrium towards Sustainable Growth.” Distinguished Guests, Ladies, and Gentlemen, By the theme, I would like to bring your thoughts and views to meditate over the question on how we suppose to place the function and role of banking industries in achieving economic development goals. In particular, I am asking all of us here to contemplate on how to heal from inefficiency disease that has hindered our economy from growing higher and more sustainable. Only by such sustaining growth, then the problem of poverty and unemployment can be solved altogether. It is technically believed that high and sustainable growth often refers to potential economic growth. Based on our estimate, the potential growth of Indonesian economy is around 7%, provided that investment could grow by 12% per year. However, to achieve sustainable economic growth, two conditions have to be satisfied. First, there should be a continuous condusive macroeconomic environment. Second, capital accumulation and total factor productivity should grow so that economic capacity and competitiveness would steadily increase. Capital accumulation can be achieved through investment in the form of machinery, plants, research and development and human capital. The sustainability of investment is influenced by multiple factors, such as profit expectation, investment climate, and not less important, the availability of financing. For Indonesian economy, the scarcity of financing is among the most binding constraints of investment activity. This has been reflected in the latest surveys on sectoral mapping and on business condition. More specifically, the surveys pointed to financing constraint suffered by business players, particularly difficulties in accessing bank loan, resulting from too high lending rate, too demanding collateral obligation, and too complicated administrative requirement. Reflecting on the survey results, I would like to invite all of us to retrospect on the place and role of banking industry. There is no doubt that banking industry has its strategic role in our national economic chain. Looking back into its evolution through innumerable crises and elongated learning curve, it would not be excessive to say that our banking industry should have been transformed itself into better banking industry as expected by the public. The public craves for banking industry that is not only sound and robust, but also capable to effectively and efficiently participate in financing the economy. The establishment of sound and robust banking industry on the one hand, and its successful in performing their intermediation function effectively and efficiently on the other hand, are two things that cannot stand apart. It’s like two sides of a coin. It is possibly there is a trade-off between the two, but we can certainly find the optimum point between the two. We cannot remain silent, static and satisfied too soon, believing that our banking industry has reached a good equilibrium, while we know that banking industries in other Asian countries continue to pursue improvement and transform for the better to attain the real equilibrium of sound, robust, and efficient banking industries. If it is the bad equilibrium that prevails, then we will face difficulties and hardships in coping up with the imminent challenges laid bare before us in welcoming The ASEAN Economic Community (AEC) by 2015. When we do not have the capability to compete in the globalization era, we become less compatible with other nations. Consequently, we become less able to benefit from globalization and only accept-induced harm. BIS central bankers’ speeches Distinguished Guests, Ladies, and Gentlemen, Amidst the increasingly strong currents of globalization, I see 2011 as a fascinating and worthy of note year. Throughout 2011, we have booked numerous successful achievements which bring immense satisfaction. Yet, the year is also full of dynamics and mounting challenges that have transformed us to become a relatively more matured entity in managing our national economic stability. In managing our national economy during the year 2011, global fluctuations and uncertainty seem to be a constant threat looming incessantly over us. The uncertainty of European mechanism for sovereign debt crisis resolution and widespread fears of the lingering global recession have become two epicenters triggering turbulence and unrest in the global financial markets during 2011. In closely following up the European debt crisis, we experience an infinite uncertainty of walking into dark abyss. We do not know yet how profound and how much longer the European debt crisis will continue to last because the dimension of the crisis is significantly extensive and complex. At present, there are negative events producing more negative events in a reinforcing vicious cycle (adverse feedback loop) as reflected in the government debt crisis, worsening fragility of banking industries, and the simultaneous slowdown in economic activity which in turn escalates the crisis into precipitous and prolonged crisis. Meanwhile, the U.S. economic recovery appears to remain stagnant due to the restricted maneuverability in fiscal policy to stimulate economic activity. The combination of a relatively constrained fiscal policy and economic slowdown has naturally compelled them to pin their hopes on their central bank as the savior of the economy. However, the diminishing room to cut interest rate has coerced central banks like The Federal Reserve to invent creative policies to stimulate economy through “quantitative easing”. As an emerging market country, we, too, suffer the blows of such measure in the form of two-way cross border capital flows. Retrospect to these highlights, it is not my intention to discourage us into a pessimist in looking up to the future. Quite the opposite, these highlights are presented to make us continue to be vigilant and devise stretched policy frameworks to withstand large adverse shocks in anticipation of global imbalances and uncertainty in the coming year that is predicted to be no much better than the current condition. We are also required to make adjustments and re-alignment over the prevailing forecasts. Distinguished Guests, Ladies, and Gentlemen, We should be grateful, in the midst of unrelenting global turmoil; the resilience of financial sector and national economy has been increasingly demonstrated robustness. At least, during 2011 the Indonesian economy has managed to insulate itself from the spillover effects of European debt crisis through trade channel due to its robust basis of largely domestic demand-driven economy within our economic structure. Despite having successfully safe-guarded our financial system integrity, we believe that its spillover effects through financial markets channel had been felt ever since the start of the Greece’s fiscal crisis in mid 2010. In early 2011, a period in which optimism over the global economic recovery flourished, massive capital inflow flooded our market, thus rupiah was greatly appreciated. However, this optimism faded instantly in April and May 2011 following the credit rating downgrades for Portugal and Greece by Fitch. In early September 2011, the scale of the crisis pressure escalated to Italy and Spain, prompting investors to reassess (repricing) the investment risk profiling and reposition the portfolio in emerging market assets, including in Indonesia. We have witnessed how rupiah has been considerably under pressure in the last three months amidst foreign currency excess demand situation. BIS central bankers’ speeches Amidst imbalances of foreign exchange supply and demand within these last three months, Bank Indonesia has maintained a steady pace of rupiah depreciation in a relatively measured scale against regional currencies. The obtained range of fluctuations in exchange rates aligns consistently with the internal and external macroeconomic balance that create conducive atmosphere in providing greater certainty for business players in the real and financial sectors regarding the average exchange rate in the long run. Distinguished Guests, Ladies, and Gentlemen, We have been closely monitoring that amidst massive pressures on global financial markets, our economy had bred strong resilient forces that make it more apt to mitigate external turbulences. This heartening situation has provided us some space to direct various macroeconomic indicators into the right track (on-track). Domestic household consumption expenditure remains strong, while investment and exports continue to rise. In spite of this, the inconsequential realization of fiscal capital spending has led to situation in which multiplier effects of fiscal operations towards limited Gross Domestic Product (GDP) is still inadequate. With the ever-increasing investment, the investment ratio to GDP rose to 31.3% compared to 23.6% in 2005. The increased investment was also reflected in increased imports of capital goods mainly in the form of machinery, the high growth in investment lending, and the expansion of Foreign Direct Investment. The increasing role of investment and export has paved the way to the well-maintained of a balanced economic growth in 2011. For 2011, the Indonesian economics is projected to grow 6.5%, surpassing the achievements of 2010 at 6.1%. Corresponding to the increased investment, manufacturing industry is projected to grow by 6.1% (yoy), offsetting the growth in the extractive sectors such as mining. It is heartening to note that the expansion of manufacturing industry has boosted absorption of workforce in formal sector. Consequently, unemployment rate fell to 6.6% in August 2011 from 7.1% in August 2010. Portrayal of our success in maintaining exceptionally high economic growth even during the recent global downturn is deemed satisfactory with the Consumer Price Index (IHK) inflation remained under control. The IHK inflation is forecasted reached only 3.9% (yoy). Meanwhile, core inflation remains steady in these past three-years at around 4.0% which indicates that the economy is yet operating below its potential growth. This occurs because an increased production capacity is simultaneously correspond with increased investment. I perceive this trend as a good start because it means capital accumulation process is on the lead to buttress the effectiveness of the productive capacity expansion of the economy. Our latest assessment on the phenomena of supply side constraint points to the fact that the sensitivity of price increase (core inflation) to growth increase has declined during the last 5 year, particularly compared to early 2000s. Distinguished Guests, Ladies, and Gentlemen, In the midst of sluggish economic recovery in developed countries and commodity price correction within global market, Indonesia’s exports performance remains solid. Exports grew 28.2% during 2011. We can take advantage of the increased intra-regional trade in Asia; so that adverse effects of the economic slowdown in developed countries can be compensated by increased exports to Asian countries having high economic growth such as China and India. In the meantime, imports continued to grow rapidly (30.4%) as a consequence of accelerated economic activity. I conclude that the rising imports performance is still within a relatively safe and healthy outlook because it is likely associated with the imported raw materials and capital goods to spur increased production capacity. Meanwhile, the quality of capital inflow structure is significantly improving with the increased foreign direct investment (FDI) exceeded portfolio investments. Overall, in 2011, the balance BIS central bankers’ speeches of payments booked surplus of USD 12.6 billion and foreign reserves rose to USD 111.0 (December 7, 2011). Distinguished guests, ladies, and gentlemen, The financial system stability preserved in the midst of global turbulence is also attributable to the resilience of our banking industry, which is increasingly able to absorb instability risks while maintaining its intermediation function. Improvement in capital and consistent implementation of bank prudential principles appear to be effective in avoiding drastic deterioration in the industry. This is reflected in the low gross non-performing loan (NPL) ratio, reaching only 2.7%, far below the indicative threshold of 5%, while capital adequacy ratio (CAR) was recorded at 17.2% at end of October 2011. Despite pressures on domestic foreign exchange market, the rupiah liquidity condition in the interbank money market (PUAB) remains unaffected, while banking liquidity also continues to be adequate. Third party fund (DPK) in 2011 (up the October) grew 19,0% yoy, while ratio of liquid assets to non-core deposits was kept above 100% (182.0%) as of October 2011. The banking intermediation function is managed to run as planned. In 2011 credit growth reached 25.7% (yoy), while loan to deposit ratio (LDR) rose to 81.4% as of October 2011 from 75.5% at end 2010. The quality of the credit growth escalates as credit to productive sectors increases reflected by growth of investment credit that reached 31% as of October 2011. In addition to the enhanced ability to absorb risks, our banking industry is also able to gain large amount of profit, in fact the largest among ASEAN countries. In October 2011, return on assets (ROA) of the banking industry stood at 3.11%, far above ASEAN average of 1.14%. Meanwhile, for Islamic banking, based on a survey conducted by BMB Islamic Finance, Islamic business and management consultancy based in London, Indonesia Islamic financial industry occupied the 4th position in the world after Iran, Malaysia and Saudi Arabia. Indeed, this is a very satisfactory achievement. In September 2011, total assets of Islamic banking has reached Rp 126, 6 trillion or 3.8% of total national banking assets, grew by 47.8% (yoy) and the highest in the last 3 years. The average CAR of Islamic Banks (BUS) and Sharia Unit (UUS) grew at 16%, while the average Capital adequacy Ratio (CAR ) of Islamic Rural Bank (BPRS) 24.7% . In the rural banks group, in late October 2011 a year on year assets grew by 20.56%, credit 20.96%, third party fund (DPK) 21.31%, and the number of deposit accounts grew 9.72%, while Capital adequacy Ratio (CAR), in late October 2011 grew 28 , 58%. Distinguished guests, ladies, and gentlemen, I view the positive achievement of the national economy in 2011 as a result of hard work and strong cooperation among stakeholders, which is supported actively by the banking community, business agents and the general public. In this opportunity, I would like to highlight several policy actions taken by Bank Indonesia in confronting the national economy dynamics during 2011. On the monetary side, Bank Indonesia’s policy in 2011 is basically a strengthening of previous year’s policy mix, but further calibrated to the dynamics and challenges of the economy during 2011. Interest rate policy throughout 2011 is directed to be consistent with the predetermined inflation target of 5%±1% and 4,5%±1% in 2011 and 2012, respectively. In February 2011 Bank Indonesia increased BI Rate by 25 bps to 6.75% as a response to intensifying inflation expectation, which is attributable to high volatile food inflation. Since September 2011, the monetary stance is turned to an easing phase, by decreasing the lower limit of interbank money market interest rate corridor. Further in October and November 2011, Bank Indonesia lowered BI rate by 25 bps and 50 bps, respectively to arrive BIS central bankers’ speeches at the 6.0% level. The decision to lower BI Rate is indeed quite delicate since it has to be taken in the middle of ongoing turmoil in the global financial market and against the market mainstream. However, we have strong belief supported by highly fundamental consideration. Since mid 2011, we have been convinced that CPI inflation would move down, possibly even reaching below the 5±1% target. On the other hand, we need to lay stronger basis for domestic demand in anticipation of global economic slowdown. It can be noted that this year Bank Indonesia is ahead of the curve by being the first central bank in Asia to lower policy interest rate. We view that the national economy should also be ring-fenced from instability sources such as short term capital flows. In addition, the structure of capital flows needs to be amended by shifting it to longer instruments. Therefore, on 13 May 2011, the SBI’s holding period is extended to 6 months from previously 1 month. This policy proves to be effective in halting capital inflows into SBI and shift foreign capital investment to government securities market. Distinguished guests, ladies, and gentlemen, Experience demonstrates that crisis management often bears extremely high economic and social cost and involves long recovery. Against this background, Bank Indonesia also implemented Crisis Management Protocol (CMP). However, the CMP needs to be equipped with proper guidance and legal basis which regulate crisis prevention and resolution process in a systematic and integrated way on a national scale, through Financial Safety Net Law. Financial crisis generally starts with liquidity squeeze in the interbank market, market interest rate hike, and exchange rate pressure. For that reason, we intensify monitoring on financial market transactions, especially to scrutinize vulnerabilities that would lead to financial crisis. Through the developed monitoring system, we wish to ensure the adequacy of rupiah and foreign exchange liquidity in the financial market, as well as to maintain exchange rate stability. Therefore, we conduct a combination of intervention in the foreign exchange market and acquisition of government securities (SBN) in the secondary market. This policy is quite effective in stabilizing the exchange rate and SBN price, while also increase SBN accumulation in Bank Indonesia for monetary operation purpose (Reverse Repo). In order to maintain the stability of the exchange rate, we also need to seek long-term policy breakthrough by ensuring sustainable supply of foreign exchange. Against this background, at end September 2011, we took the initiative to issue a regulation to obligate export proceed and proceed from external debt to be deposited in domestic banking system. This policy can be considered soft compared to those in Thailand and Malaysia, who has regulated tightly foreign exchange flows related to exports and imports since decades ago. We have been taken hostage for too long by market mechanism, which in fact lead to market imperfection, and we need to correct it. Considering the significant role of inflation from the supply side problem, Bank Indonesia has been in close coordination with the government to preserve price stability, particularly resulting from volatile nature of commodities prices and government’s decision on administered prices. Bank Indonesia has taken steps to increase the role of Inflation Control Teams, both in national and regional levels. Additionally, Bank Indonesia regional representative offices have also routinely published Regional Economic Study which serves as outlets of various aspects of the regional economy. Distinguished guests, ladies, and gentlemen, On the banking area, within 2011 bank Indonesia has pursued several policies framed by four pillars, namely: BIS central bankers’ speeches a. Policy to boost banking intermediation role, to enable more efficient and transparent intermediation, as well as to open access of low-income community to financial services. Included in this policy is the policy on Transparency of Information on Primary Lending Rate and the continuation of financial inclusion program. I put strong attention this strengthening of banking transparency, which is expected to lead up to efficiency. First, a transparent banking industry would encourage healthy competition through better market discipline. Second, it would increase banks’ ability in identifying aspects that influence cost structure such that higher efficiency level can be achieved. b. Policy to enhance banking resilience, so that banks remain strong and sound in confronting competition, through more transparent management that refers to good governance principles. This policy includes improvement in the calculation of capital to suit better with risks, and obligate banks to implement anti fraud strategy, prudential principles in outsourcing and risk management in delivering services to prime customers. c. Policy to strengthen supervisory function, aiming at increasing the effectiveness of bank supervision, especially in terms of the quality of early warning system. Consequently, we apply improvements to the regulation for bank reporting to Bank Indonesia.. Meanwhile, to enhance the effectiveness of resolution to banking problems, we impose deadline for every bank supervision status through the regulation of “Determination of Status and Follow-Up Supervision.” d. Strengthening of macroprudential policy. This policy is aimed to strengthen financial system stability through better implementation of macroprudential surveillance. Included in this policy is increase in foreign exchange reserve requirement and LDRreserve requirement. In the mean time, policy on syariah banking in 2011 continues to be pursued in terms harmonization of regulation with conventional banking, relaxation of regulation, and implementation of Law No.21 Year 2008 on Syariah Banking. Among the issued regulation is regulation on asset quality for syariah commercial bank, syariah business unit, and syariah rural banks, financing restructurization, and risk management for syariah commercial; bank and syariah business unit. We also support research, training and facilitation of SMEs though policy and strategy to “Enhance SME’s Access to Banks” and “Encourage Banks to finance SMEs”. This policy is aimed to enable SMEs to enhance its eligibility and capability so that they can meet banks requirements (bankable), while also boosting regional economy capacity. With intensifying payment transactions through means of payment such as credit card, ATM/debit card, and e-money, we pursue a number of policies to ensure the establishment of safe and efficient payment system. This policy includes among others standardization of chip-based ATM/Debit Card, establishment of national payment gateway and standardization of electronic money. Distinguished guests, ladies, and gentlemen, It is important for me to say that we cannot and may not assume that our macro stability will definitely continue in the future. This assumption can lead us to comfort zone that would reduce our ability to anticipate future challenges early on. For that reason, allow me in this part to highlight views on the challenges confronted by our economy, which requires hard works from all of us to anticipate and address them in 2012. The increasingly difficult external challenge is related to vulnerability and recovery of the global economic recovery, which may be worse than predicted (downside risk). This is considering the complexity of European debt trap which definitely will affect global economy. IMF has just revised 2012 global growth from 4,0% to only 2,0%. BIS central bankers’ speeches On the one hand, with the dismal global picture, national economic machinery will depends on effectivity of domestic absorption and the ability to benefit from local markets. In connection to that, the capacity to preserve growth momentum will be limited should banking intermediary and fiscal expenditure absorption are sub-optimal. On the other hand, combination among global economic deterioration, low interest rate, dan global excess liquidity, tends to shift global portfolio allocation. Such situation is a source of instability which challenges emerging markets’ authorities in sustaining its financial stability. As a domestic challenge, we have a lot of homework to finish. Some of them are old issues we never solve and thus have created inefficiency in the economy. In financial sector, national banking industry after 1998 has been more vigilant. However, its contribution for economic development is still in the margin. If we look at the statistic, Indonesian banking asset to GDP ratio has reached 47,2% in September 2011. However, credit to GDP ratio is only 29,0%. As comparisons, credit to GDP ratios in the region vary, with Malaysia, Thailand and China recorded 111,4%, 117,0%, and 131.0%. Opinions of business players provided a similar picture. From Bank Indonesia recent survey on “how to finance your company”, the proportion of bank loan in total financing is very low, that is only 25% for working capital, and only 21% for investment. On the contrary, intental financing has been the main source of financing, 48% for working capital and 61% for investment. In other words, it seems that the large asset size in banking industry is not followed by high contribution to the economy. This is also because there is a substantial portion of banking assets that are not productive from macroeconomic point of view. Those are ones in the forms of monetary instruments (Fasbi, TD, SBI) and government debts (SBN). The size of banks placement in monetary instruments and government debt securities are Rp 415.48 trillion and Rp 245.97 trillion, respectively, as of end of October 2011. In total, they constitute 31.4% of the total credit of Rp 2,106.2 trillion. About 60% of Bank Indonesia monetary instruments are currently held by the 10 biggest banks. Moreover, it seems that to preserve high probability, banks charge high lending rates to customers, partly also to compensate for the generally lower rate from placement in monetary instruments and government securities. The low efficiency of banking industry has also contributed to high lending rate. This is reflected by operational cost to operational revenue ratio (BOPO) of 86.44% as of October 2011. For comparison, the same ratios for ASEAN countries are 40%–60%. Although intermediation function somehow works, operational inefficiency generate high cost financing, resulting in low economic competitiveness. Such high financing cost can be illustrated by lending rate of working capital loan, investment loan dan consumption loan, which are 12.09%, 11.66%, and 13.40%, respectively, as of October 2011. This is despite BI rate having reached the lowest ever level of 6.0%. For comparison, with 3.0% policy rate in Malaysia and 4.5% in the Philippines, bank lending rates in Malaysia and the Philippines are only 6.5% and5.7%, respectively (October 2011). The current structural problems which give rise to false equilibrium in the banking industry can not be solved by market mechanism alone. There is a need to put a corrective policy in place to bring the system back towards its real equilibrium. On the real sector side, inefficiency still dominates the conduct of the economy following the weakness of market microstructure, which eventually hindered market capacity to efficient allocation of resources. This feature has significant impact on inflation rate particularly on foodstuff category which tends to be volatile and uneasy to subdued. The fragile microstructure of staple food markets has significant bearing on two fronts, namely production and distribution process. On the production front, the less effective development strategy in the agricultural sector, for instance, gives rise to imbalances between supply and consumption of rice which BIS central bankers’ speeches unfortunately has taken place for a long period of time. The recent increase of rice supply resulted from rice import, seen as a mere short cut solution to the problem. On the distribution front, the weakness of the market microstructure revolves around (i) the availability of logistics services, transportation, and transportation infrastructure related to foodstuff, (ii) the availability of a symmetric market information for suppliers, wholesalers, and retailers, and (iii) the presence of policy that favors particular market players which eventually create oligopolistic behavior in the distribution market, as well as rent-seeking activities. The weakness of the microstructure in the distribution market has caused rising prices in the consumer level, but not in the producer level. Distinguished Guests, Ladies and Gentlemen, The magnitude of challenges we face in the coming years should not discourage our optimism towards the prospect of the economy. In the future, we must strive to maintain a high sense of hope and optimism, macroeconomic stability and a strong economic growth momentum. Amidst the global economic slowdown, we expect the domestic economy to grow 6.3%–6.7% in 2012, or slightly lower than in 2011 due to sluggish growth of export. For that reason, we are able to maintain stronger economic momentum provided that the foundation of domestic economic growth is strengthened. We are confident that the lowering of the BI rate since October 2011 will revive domestic financing, particularly from the banking sector. An economic growth rate of 6.3%–6.7% will require financing (including credit channelling) amounting to Rp 598 trillion, or equivalent to a credit growth rate of 26,9% (yoy). Investment growth rate which reached 7.7% in 2011 is expected to grow even higher in 2012 at 9.7%–10.1%. Vigorous investment will eventually buttressed purchasing power hence supporting household consumption growth in 2012 which is projected to reach 4.7%–5.1%. Meanwhile, the role of fiscal stimulus is projected to be limited in line with the conservative fiscal deficit target (1,5% of GDP) along with the still significant budget allocation for subsidies. CPI inflation in 2012 is projected to be consistent with the target of 4,5 percent ± 1 percent in 2012–2013 and is expected to be stable at around the level of 4,5%. Distinguished Guests, Ladies and Gentlemen, Considering that the management of the macroeconomy is still prone to global risk as well as the complexity of the domestic predicament, Bank Indonesia policy direction in 2012 will stay focused towards the following: a. Optimizing the role of monetary policy in supporting economic capacity as well as in mitigating the risk of global crisis. b. Increasing the efficiency of banks in optimizing their contribution to the economy, while strengthening banking resilience. c. Increasing the efficiency and competitiveness of the payment systems in servicing national payments as well as international payments. d. Strengthening the resilience of macroeconomic condition by enhancing coordination in the management of crisis prevention and resolution. e. Supporting real sector empowerment including initiatives to broaden banking access to a wide-array of community (financial inclusion). In 2012, policy mix of instruments will be strengthened and calibrated. Policy rate response will be anchored so as to be consistent with the CPI inflation target of 4,5 percent ± 1 percent in 2012 and 2013, while at the same time maintain the momentum toward economic BIS central bankers’ speeches strengthening and mitigate the risk of global economic slowdown. This interest rate policy will also be complemented with macro-prudential policy to mitigate the risk of vulnerabilities in the consumptive sectors which is seen unsustainable or potentially prone to asset bubble risk. The monetary operation policy strategy will be directed to maintaining interest rate stability in the rupiah money market and to supporting exchange rate stability in the forex market. I am of the view that this kind of stability is needed to provide a broader leeway for domestic financial market deepening. Therefore, monetary operation will be based on instruments which can directly stimulate transactions in the money market such as in the rupiah interbank money market (PUAB), Repurchase Agreement (Repo), and the swap market. This approach, I believe, will be able to encourage more efficient and sound liquidity management of banks, and lessen dependence on placement in monetary instrument. I also observe the need to continue the re-alignment process of interest rate structure in the financial market by refining mechanism of the open market operation. Bank Indonesia policies on exchange rate will be centered on maintaining exchange rate stability while preserving external and internal balance of the economy, and providing certainty for all economic agents. Since January 2012, policy on exchange rate stability will be supported by the implementation of the regulation on export proceeds and foreign debt withdrawal through domestic banks. Bank Indonesia is also reviewing some regulations to enrich forex market instruments in order to revitalize hedging transactions. To curb regional inflation, we will optimize the functions of Bank Indonesia Regional Offices (KBI) as facilitator and catalyst for the acceleration of development in the region, particularly in eastern Indonesia where growth is still having immense disparity. KBI will be encouraged to carry out its functions effectively by strengthening coordination and cooperation as well as synergizing with local government. In the future, Task Force for Regional Inflation Control Team (TPID) should be sustained by strategic consumer goods information systems primarily encompassing information on national production and stock. To achieve this target, strong commitment and support from a wide variety of parties, including from relevant ministries such as Ministry of Agriculture, Ministry of Commerce, as well as Local Government is significantly needed. Distinguished Guests, Ladies and Gentlemen, On the banking sector front, policy will be directed to maintain a proper balance between improving competitiveness and strengthening banks’ resilience, as well as encouraging banks’ intermediation function including broadening access to low cost banking services for the rural community. In order to improve banks’ competitiveness, kebijakan Suku Bunga Dasar Kredit (SBDK) will be carried on to ensure a well-functioning market mechanism so as policy targets could be achieved. From banking supervision perspective, we will continue to enhance enforcement of policy by requiring banks to include an appropriate level of targets on efficiency improvement and credit rates lowering in their business plan. Bank Indonesia is also looking into the practice of interest rate setting for third party above the level set by the Indonesia Deposit Insurance, as well as limiting the conduct of prize or gift offering to banks’ customers. Policy to strengthen banks’ resilience will be conducted through improving banks’ capital structure. It is hoped that such policy can reinforce bank in anticipating potential risk specifically amidst global economic uncertainty. I see that policies on consumer protection and governance also need special attention. Following several act of banking frauds during the course of 2011, policy in these two aspects needs to be reviewed. For that reason, in 2012 we will continue to refine several aspects related to customers and potential customers protection. BIS central bankers’ speeches Furthermore, to improve banks’ governance, several regulations on financial report transparency would be reviewed particularly in relation to published financial report and regulation pertaining to appointment of public accountant by banks. We also will examine policy on banks’ ownership and multi-licensing following the increased complexity of banks’ activities. Distinguished Guests, Ladies and Gentlemen, We view that the strengthening of central bank’s role as a systemic regulator following the enactment of the law on Otoritas Jasa Keuangan (OJK) is timely as the role of banking regulation and supervision will be handed over from Bank Indonesia to OJK at the end of 2013. Going forward, Bank Indonesia will continue to escort banking industry in the context of financial stability system. For this purpose, Bank Indonesia will conduct surveillance both on banks and non banks, examine banks in the context of macro-prudential, and will coordinate closely in the context of crisis prevention and resolution. The function and the role of Bank Indonesia to achieve financial system stability is an important part of Bank Indonesia Law’s amendment which was scheduled under 2012 National Legislation Program. Distinguished Guests, Ladies and Gentlemen Aside from bank competitiveness and resilience, we will encourage the process of banking intermediation through several measures: a. By continuing the initiatives to broaden the community access to banks (financial inclusion), particularly low cost banking services for rural community, including improving “My Saving” program (Tabunganku), developing program on financial education, implementation of Financial Identity Number and conducting survey on financial literacy. b. Working together with government agencies, facilitating intermediation to support financing in several potential economic sectors. We will also assess any potential barriers in the financing of those sectors with relatively low credit growth. With regards to financing needs of particular sectors which are commercially unviable for banks but possessing strategic roles for the economy, Bank Indonesia together with the Government, will develop a special financing scheme. Initiative to increase competitiveness and governance is also center in the policy direction for sharia banking particularly sharia rural banks. In addition, we will also encourage the development of products and activities of sharia banking. Going forward, strategy to develop sharia rural banks will be directed in accordance with the characteristics of sharia rural banks as a community bank with a sound, robust, and productive feature with special focus on providing financial services for SMEs and rural community. Similar to the banking sector, financial services sector will also be encouraged to lowering economic costs. This sector includes cash and non-cash payment systems as well as transaction settlements. Bank Indonesia determines to take a lead in setting policy orientation for payment services development in the future. In this context, policy coordination among institutions and authorities is imperative, especially since the development of payment services will also involve many parties beyond the central bank. Going forward, the development of payment services industry will be performed by the following initiatives: a. First, improving security and reliability of payment services providers by implementing risk mitigation including leveraging on technology advancement, strengthening legal framework, strengthening supervision, and improving the role of national payment services providers; BIS central bankers’ speeches b. Second, improving efficiency of national payment services providers, including encouraging the setting-up of interoperability and interconnection among services providers. c. Third, improving consumers’ protection by enhancing transparency of services providers and strengthening regulation on consumers’ protection. Those abovementioned programs on payment services development are stipulated in an integrated blueprint which serves as a guideline to establish an efficient, secure, and reliable payment system. Distinguished Guests, Ladies and Gentlemen, This brings me to the end of my speech this evening. A thoughtful ponders on the challenges ahead lead us to an understanding that the years ahead will not be easier than previous years. Our commitment to carry out policies and measures as already presented will definitely call for support and cooperation from all of you. As closing remarks, I would like to invite all of you “to release our nation from any traps of inefficiency, otherwise, we will be crushed by modernization and globalization”. May Allah Almighty always be with us, bless us and lighten our way towards a better future. Thank you. BIS central bankers’ speeches
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Keynote speech by Dr Darmin Nasution, Governor of Bank Indonesia, at a seminar, Jakarta, 13 February 2012.
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Darmin Nasution: Indonesia – sustaining growth during global volatility Keynote speech by Dr Darmin Nasution, Governor of Bank Indonesia, at a seminar, Jakarta, 13 February 2012. * * * Fellow Speakers, Distinguished Guests, Ladies and Gentlemen: Assalamu alaikum Wr. Wb. Good morning and May God Bless Us All, To open my speech here today, I would like to invite you all to join me in expressing thanks and praise to God Almighty who has blessed us again with the opportunity to come together here for this seminar. This seminar is held to have a better understanding on the improvement of macroeconomic management and banking regulation that Indonesia has achieved following Asian crisis in 1997–98, as documented in the new IMF book titled “Indonesia: Sustaining Growth during Global Volatility”. Distinguished Guests, Ladies and Gentlemen It has come to our common understanding that changes in the constellation of the global economy since the global financial crisis of 2008 and its aftermath had left a profound and widespread consequence. Against the backdrop of lingering effects from the global crisis, significant challenges in managing an increasingly complex macroeconomic stability has risen considerably. External shock and uncertainties seem becoming a constant dimension that continually shadows us in the process of policy formulation and implementation. The problem is we do not know when, how big and through which channel the shock will happen. As we might be aware, the unprecedented global financial turmoil from 2007 to 2009 was a big shock to the global economy, and represented the deepest deterioration since the 1930s. Thus far, Indonesia’s economy has weathered the global storm well. Indonesia has continued to record strong macroeconomic performance with sustained high economic growth. Provided that many economies had negative growth in 2009, Indonesian economy in that year still grew by 4%, which was one of the highest in the region. In the following years Indonesian economy continued improving with well-maintained macroeconomic and financial system stability. Economic growth in 2011 was recorded at 6.5%, increased from the growth in 2010 at 6.1%. This strong growth was supported by strong private consumption and investment along with good export performance. Looking forward in 2012, we believe Indonesian economy would expand in the range of 6.3%–6.7%. The main source of the growth is expected to come from domestic demand as investment activity gains momentum, owing to stronger economic fundamentals and improved business climate. The recent upgrades of Indonesia’s rating by Fitch and Moody’s will help boost growth up to its potential level, as long as it is accompanied by efforts to utilize our large potential and address various structural issues. We believe that the upgrade may lead to a wider investor base not only to government bond market, but also to corporate bond and equity markets. This will eventually lower borrowing cost for the country in a more structural manner, complementing the growing stream of FDI inflows to investment activities. Looking at inflation, although historically Indonesian inflation rates were relatively higher compared to other emerging countries in the region, in recent years Indonesia has successfully reduced inflation to single digits. Last year Indonesia’s inflation rate was recorded at only 3.79% (yoy). And the declining trend in inflation still continues, in which inflation in January 2012 was only 3.65% (yoy). BIS central bankers’ speeches The achievement of the low inflation rate was supported by policies to bring down core inflation as well as inflation of volatile food prices and administered prices. For 2012, we expect that inflation pressure will still be manageable within the range of inflation target 4.5%+1%, even taking into account the impact of limitation on fuel subsidy or rise in administered prices. The coordination between Bank Indonesia and the government in controlling inflation will certainly play an important role to bring down inflation. Thus far, this coordination is carried out, among others, through inflation control taskforce at national level (TPI) and regional level (TPID). Distinguished Guests, Ladies, and Gentlemen The performance of Indonesia’s external sector also shows resiliency. Amidst escalated global economic uncertainty, Indonesia’s balance of payments in 2011 continued recording a considerable surplus. The composition of capital account has further improved as reflected by FDI flows surpassing net portfolio flows beginning in the second half of 2011. This change in the nature of inflow to more long-term flows will definitely enhance the resilience of the economy. In line with the development in balance of payment, the international reserves has increased significantly in recent years. International reserves at the end of January 2011 reached USD112 billion. Indeed, the reserves have been depleted compared to mid 2011, but remain adequate to cover 6.3 month of imports and short-term government debt repayment. This depletion merely reflects the process of recycling the international reserves in response to the depreciating pressure on rupiah during the last several months of 2011 triggered by mounting European debt crisis. As policy response to preserve macro and financial system stability, Bank Indonesia also implemented dual intervention strategy in the FX and government bond markets simultaneously. This strategy had stabilized both the currency and government bond price from further drop, while also increase the stock of government bond in Bank Indonesia portfolio for monetary operation purpose such as Reverse Repo. Currently, we hold around Rp 70 trillions of government bond. On the financial sector, our financial system stability has been well-preserved during the recent global turbulences. This goes back to more than a decade of repairs and improvement since the ASIAN crisis 1997/1998 which has made our financial system, including the banking sector, more resilient and able to absorb instability risk as big as the 2008 and 2011 turmoil. The banking industry has been more resilient, as indicated by secure level of capital adequacy ratio (CAR) above the minimum level, reaching 16.0% at the end of 2011 and gross non-performing loans (NPLs) managed at comfortably safe level of 3.0%. Nevertheless, I believe the role of Indonesian banking sector and its efficiencies can still be further strengthen in supporting the economic development. Last year, bank lending grew by 25% dominated by productive loan such as investment loan (36%) and working capital loan (24%). Despite this encouraging progress, the ratio of bank credits to GDP in Indonesia is still very low, only standing at 30%, well below other countries such as Malaysia, Thailand and China, which ratio has reached above 100%. This is in line with BI survey which indicated limited role of banking as companies still rely more on internal fund. At the end, this condition reflects the remaining large potential for business expansion. Distinguished Guests, Ladies, and Gentlemen, The prevalent opinion points toward the improvement of macroeconomic management where Indonesia has implemented a program of wide-ranging policy reforms, particularly since the 1997–98 Asian financial crisis. As pointed out above, the source of Indonesia’s resilience includes a prudent monetary and fiscal policy, a sound banking system, a large stock of international reserves, and a more flexible exchange rate. BIS central bankers’ speeches These underlying strengths allowed Bank Indonesia and the government to respond with standard “countercyclical” monetary and fiscal policies to mitigate the adverse impact of the global economic crisis. Yesterday, at the board meeting we decided to cut BI Rate further down by 25 bps to 5,75%. This kind of policy reaction contrasts sharply with past episodes such as the 1997–98 Asian crisis, 2005 mini-crisis, and 2008 global financial crisis when Indonesia responded “procyclically” by raising interest rates and tightening fiscal policies. This edited volume prepared by IMF staff, entitled Indonesia: Sustaining Growth during Global Volatility, elaborates the substantial improvement in the quality of macroeconomic management and banking regulation that Indonesia has achieved in the midst of a volatile global environment. In addition, this book also highlights the most binding constraints that need to be addressed to sustain and increase economic growth as well as to further lower vulnerability going forward. Overall, this book provides a deep and balanced perspective on the Indonesian economy that might help to further enrich the framework of macroeconomic management in Indonesia. We appreciate the thorough analysis of IMF staff on various issues regarding Indonesia’s economy. This in-depth and balanced analysis benefited from candid discussions between the Indonesian authorities and IMF staff during the Article IV consultations. Their analysis has provided insight to our policy discussions which should contribute to improving Indonesia’s economic performance. I sincerely hope that publication of this book will help to better understand the progress made by Indonesia in macroeconomic management and policy that can be used to further strengthening not only Indonesian economy but also other economies. Distinguished Guests, Ladies, and Gentlemen Needless to say, we cannot and may not assume that our macro stability will definitely continue in the future. This assumption can lead us to comfort zone that would reduce our ability to anticipate future challenges early on. I believe this seminar will be the right place to discuss both global and domestic challenges and how we should deal with them. At the global perspective, the immediate policy challenges is certainly how to mitigate the impacts of global economic slowdown and uncertainties. Meanwhile, at the domestic front, a lot of domestic unfinished issues to be addressed which most of them are structural issues we never solve and thus have created inefficiencies both in the financial and real sectors. I hope this seminar will give us various perspectives on how to strengthen Indonesian economy amidst those global and domestic challenges. May Allah Almighty always be with us, bless us and lighten our way towards a better future. Thank you. BIS central bankers’ speeches
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Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers' Dinner, Jakarta, 23 November 2012.
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Darmin Nasution: Towards sustainable and inclusive growth – challenges amidst the global turbulence Speech by Dr Darmin Nasution, Governor of Bank Indonesia, at the Bankers’ Dinner, Jakarta, 23 November 2012. * * * Respectable Leaders and Members of Parliament, Honorable Ministers and Heads of Institutions, Prominent Bankers, Distinguished Guests, Ladies and Gentlemen, Assalamu’alaikum Wr. Wb, Good evening and may God bless us all, Commencing our respectable gathering this evening, I would like to invite all of you to join me in extending praise and gratitude to God Almighty who has blessed us once again with the opportunity to meet here for the Bankers’ Dinner 2012. In this very appropriate time, please allow me on behalf of Bank Indonesia’s Board of Governors to express our deepest gratitude and appreciation to the banking community as well as the government, the parliament, businesspeople, academics, experts, press and other stakeholders for supporting Bank Indonesia in performing its mandates. Distinguished guests, ladies and gentlemen, 1. During last year’s Bankers’ Dinner on December 9, 2011, at this very same room, I caught the glimpse of optimism surrounding all of us. We were optimistic that 2012 would be the year of hopes and opportunities for all of us to continue safeguarding the economy with a strong and sustainable growth. 2. It was indeed not an overly sanguine expectation considering that 2011 had seen a steady domestic expansion accompanied by impressive macro stability. Furthermore, since early 2011 the US economy had shown signs of bottoming out from its severe crisis in 2008. 3. However, by mid 2012 we came to realize that the global crisis has not subsided. The multi dimensional crisis that depressed the European economy has brought a global impact of great magnitude during 2012. 4. Up to this moment, the European region has been confronted by unavoidable debt trap, tightened fiscal space, squeezed monetary room, mounting unemployment level, fragile financial sector, and decaying market confidence. All of these combined has manifested into a vicious circle that is weakening Europe’s ability to escape from the prolonged crisis. 5. As the global inter-linkages strengthened, the dynamics of emerging economies cannot be entirely decoupled from what happens in the advanced economies. Since mid-2012, we have seen some big developing countries, particularly China, began to lose its endurance. Distinguished guests, ladies and gentlemen, 6. The depth and scope of crisis originated from US sub-prime bubble burst coupled with European debt problem have shifted backward the structural capacity of advanced economies. In the following years, advanced economies will have to accept a low-growth new equilibrium. BIS central bankers’ speeches 7. Economists have called this equilibrium “the new normal.” It represents an era resulted from significant post-bubble correction following “the great moderation” spanning from 2000 to 2007. During this tranquil episode, global economy grew high in a relatively long period of time, supported by rapid technological advancement, low level of interest rate and inflation, but accompanied by the accumulation of leverage in the household sector as well as excessive risk taking and engineering in the financial sector. The bubble has finally burst at the end of 2008, culminated with the episode of “Lehman Collapse.” Distinguished guests, ladies and gentlemen, 8. While the advanced countries started the opening decade of this new millennium with the golden era of “great moderation” and closed it with the gloomy “new normal”, the exact opposite happened in Indonesia. We started in thorny path resulted from the aftershock of economic stabilization program post the 1997/1998 crisis, and landed successfully inside a transition period of an economy categorized as middle income country. 9. Indonesia’s per capita income by the end of 2011 has reached approximately USD 3,000, six-fold increase from the figure in the Asian crisis of 1997/1998. If our economy continues to grow while the macroeconomic and financial stability can be maintained, it is only a matter of time before Indonesia move into the upper middle income countries category with per capita income reaching USD 4,000. 10. We also manage to close the early decade of the new millennium with phenomena of an increasing group of society experiencing higher standard of living, the so-called middle class. At present and in the future, this group will become an important transitional strength to influence our entire aspects of life, be it politics, economy, social as well as culture. 11. We have optimism that with the rapid increase in the productive-age population as a demographic bonus within the population pyramid, the growing middle class will continue to expand until at least the next 20 years. Distinguished guests, ladies and gentlemen, 12. In the midst of prolonged sluggishness within the advanced economies, the expanding middle-class population has strengthened and enriched the diversity of base demand of goods and services in the domestic market, thereby steadfastly supporting the economic expansion. In the last eight years, we manage to successfully maintain a continuous economic growth of around 6.1–6.2% per year (figure 5), one of the highest in the world. 13. In addition to the expanding middle class population, the resilience of the domestic economy is also sustained by the stable and conducive macro and financial environment, therefore providing space for a broad-based economic expansion. In my view, this achievement is inseparable from the solid and well-coordinated fiscal, monetary, and banking policies that are built based on prudence and discipline. 14. The Economist, in its November 10, 2012 issue, presented an interesting analysis describing the new era of Great Moderation in Asia. The magazine applauded Indonesia for having the most stable economic growth within the last twenty quarters in world economy. 15. The magazine also acknowledged Indonesia as a pioneer in implementing monetary and macro prudential policy mix. Through an effective policy mix, Indonesia is deemed capable of mitigating credit risks and preventing capital outflows without having to raise interest rate. BIS central bankers’ speeches 16. The central bank’s policy of preemptive easing, according to the magazine, has significantly contributed to maintain economic growth stability. Since October 2011, Bank Indonesia has become the first central bank in Asia to lower its policy rate. 17. In my view, this magazine’s review has revealed a fresh reference on the fact that macro management relying solely on prudence and discipline is insufficient. At the end of the day, it remains true that the policy is more of an art rather than a science. Distinguished ladies and gentlemen, 18. While growth can be maintained at a high level, the inflation rate in recent years has in fact shown a downward trend towards the medium-term target of 4.0 percent. Likewise, the rupiah in the past three years have also been moving in line with the fundamental condition. 19. On the one hand, the achievement of a low inflation and stable exchange rate has created conducive climate for the resilience of the banking industry. On the other hand, the well-proven resilience of our banking industry is able to become a shock absorber for the economy. This is supported by adequate capital strength to absorb various risks, as well as effective regulation and supervision. 20. With improved resiliency, the banking intermediation is on the right track. This is reflected in the relatively strong growth of productive loan, while keeping the non-performing at a low level. The increase in credit expansion is also inseparable from BI’s policy a few years ago which linked the Minimum Reserve Requirement to Loan-to-Deposit Ratio. 21. With the declining macro risks and the proven financial stability, the saving-investment dynamic grow more robust and contributive to strengthen the structural foundation of the economy. Investors begin to feel confident developing their production capacity. This is reflected in an increased ratio of investment to GDP, even surpassing the pre-crisis level of 1997/1998. Distinguished guests, ladies and gentlemen, 22. Based on some notes I have underlined earlier, it is not an overstatement to say that in the midst of the turbulent global economy and financial markets, we have recorded numerous successes in 2012. Nevertheless, a series of concerns which has bearing on economic and financial performance still needs to be addressed. 23. In my view, the biggest challenge today is on how best we can manage economic resources and allocate them in the most efficient way possible and right on target. It is also essentially important how we manage to improve the innovation capacity and technology readiness. 24. At this point, I believe the speed in addressing the two challenges will affect our ability to maintain the sustainability of our economic growth in a balanced manner. I would define these equilibriums as internal balance, i.e. the balance of growth and inflation, and external balance which include the balance of payment. 25. We can illustrate internal balance and external balance as two interconnected containers. Imbalances of both or even one of the two could cause the economy to quickly exhaust its power. 26. We experienced external imbalance in 2005 and 2008 because the domestic demand was not supported by efficient and well-targeted allocation of resources. I would like to relate this to the importance of re-composing fiscal expenditure to make it better targeted, especially to address the infrastructure gap. 27. It is true that the structure of fiscal expenditure which prioritizes subsidy and routine spending contributes to the resilience of domestic demand, such that economic growth can remain equally stable across the whole regional territories. Nonetheless, BIS central bankers’ speeches the resulting price distortion has encouraged excessive fuel price consumption, leading to pressure on the balance of payment. 28. A valuable lesson learned has certainly been obtained from the mini crisis of 2005. The sluggish response to the accumulated problem in the form of delays in adjusting fuel prices had resulted in excessive policy implementation. This led to a steep rise in inflation up to 17% and a sharp decline in purchasing power. 29. Therefore, in 2012 Bank Indonesia continues to endeavor for the balance of payment to be well managed. Notwithstanding, maintaining proper balance of payment is not a matter of interest rate, exchange rate, or macro prudential policy per se. 30. Fundamentally, the balance of payment dynamic correlates more to how our industries own competitive ability and become independent in developing innovative capacity and technological readiness, as well as how economic resources are allocated in an efficient and well-targeted manner. 31. In the middle of the currently expanding economy, the diverse challenges at the end require our ability to direct the economy toward more productive activities and to provide larger and more sustainable supporting capacity for the economy. Among the needed abilities is to avoid the potential vulnerability in the economy such as asset price bubble. 32. Our observation shows that since September 2011, mortgage and auto loan grew faster than the average growth of aggregate credit. At that time, the mortgage loan expanded up to 43% with motorcycle credit reaching 62%, while credit growth in aggregate term only arrived at 24%. This potential risk of asset price bubble could trigger financial instability if not mitigated immediately. Distinguished ladies and gentlemen, 33. In addition to the above macro challenges, another significant test relates to how the financial sector contributes to economic development through effective and efficient financing. The Banking Act No.7 Year 1992 as amended by Act No.10 Year 1998 clearly stipulates the banking industry to play intermediary role for the economy in an effective and efficient manner. 34. Since last year we have initiated a number of preliminary steps to improve banking efficiency. We launched a policy requiring banks to publish their Prime Lending Rate. 35. The result has been reflected in the gradually declining lending rate, although this can be improved further. Some SMEs still have to deal with micro credit interest rate of around 30%. 36. In my point of view, to improve banking efficiency, efforts needs to be conducted comprehensively taking into account various constraints involved. As an illustration, around 91% of our banking financing source relies heavily on third party funds which concentrated in short term deposits. 37. From those third party funds, 44% is in the form of term deposits of which 50% is beyond the deposit guarantee scheme. The sizable amount of third party funds outside the guarantee scheme resulting from the unhealthy structure of the funding market as price (interest rate) is greatly influenced by the oligopolistic power of some big depositors. 38. This micro constraint has given rise to the rigidity of deposit rate within the banking sector in responding to the downward central bank’s policy rate. 39. In terms of fund management, only 4% of banks’ asset is placed in the interbank money market. With the number of banks currently reaching 120, segmentation of BIS central bankers’ speeches the banking industry structure is evident as reflected in the small amount of placement in the interbank money market. 40. Excess liquidity is heavily concentrated only in a few banks whereas other banks must compete to obtain third party fund, leading to high deposit rate. Distinguished ladies and gentlemen, 41. Segmentation in the area of banking capacity is also found. A great number of banks are operating in contrast to their capacity, and even below their level of economies of scale, hence creating inefficiency. 42. According to Bank Indonesia study, a bank must at least have Rp1 trillion of core capital in order to start operate efficiently. Core capital requirement must increase to at least Rp5 trillion to enable banks to operate at a level of optimal efficiency. 43. This explains why in general the level of our banking efficiency has not been satisfactory. However, I welcome achievements in efficiency improvement as reflected in the lowering of the operation expense to operation income ratio of the industry, reaching 74% in September 2012. However, several banks are still reporting efficiency ratio of above 90% and even some above 100%. Distinguished ladies and gentlemen, 44. Various problems and challenges in the economy which I have just elaborated have initiated Bank Indonesia to take a number of policy measures during 2012. 45. The formulation of monetary policy was made by strengthening the calibration of a mix of monetary, exchange rate, and macroprudential policy with good dose flexibility. Such blend is required as we must simultaneously respond to two challenges. First, we must prevent the effect of global slowdown to the economy through counter-cyclical policy measures. Second, we must preserve macroeconomic and financial stability through carefully calibrated combination of instruments. 46. Entering the year of 2012, our monetary policy was confronted with deteriorating global economic outlook due to the escalation of the European crisis. On February 9, 2012, we decided to lower the BI rate by 25 basis points to 5.75%. 47. However, the continuity of the counter-cyclical policy response was faced with the challenge of stronger inflation expectation in the midst of the uncertainty of the fuel price adjustment. 48. On that background, since March 2012, the BI rate was maintained at the level of 5.75%. As policy maneuver, we have made a number of adjustments to the overnight interest rate corridor. Strengthening the monetary operation framework for liquidity management was also implemented by optimalizing the reverse-repo-government securities transactions. Distinguished ladies and gentlemen, 49. The increasing challenge in formulating monetary policy in 2012 arises from the increasing pressure on the Rupiah. In the vulnerable global financial markets as of today, we perceive exchange rate stability as the first line of defense in maintaining macroeconomic and financial stability as a whole. For that reason, it is critically important to maintain the exchange rate stability. 50. In keeping exchange rate volatility in check, we continue to thrive for balance between supply and demand in the foreign exchange market. To strengthen the supply structure, since June 2012, Bank Indonesia regularly conducts the USD term deposit auction. BIS central bankers’ speeches 51. The opening of the USD term deposit auction is expected to address scarcity of instrument in the domestic interbank money market, and to optimize foreign exchange received from export proceeds. 52. To strengthen the supply structure for reserves emanating from Export Proceed Reserves, including oil EPRs, Bank Indonesia will release trustee regulation shortly. This regulation is intended to provide solid legal grounds for trustee activities for banks managing reserves and assets under custody. Distinguished ladies and gentlemen, 53. As we retain the policy rate to maintain its consistency with inflation target and mitigate the adverse impact of weakening global economy, we optimize the use of macro prudential instruments, in particular a maximum loan to value ratio and a minimum loan down payment effective March 2012. 54. In general, we observe that calibration of our macro prudential and monetary policies have started to produce positive outcome in our economy. Our economy growth, despite slightly slowing down due to global factor, stays strong sustained by solid domestic growth. At the same time, inflation stays controllable at low level. Distinguished ladies and gentlemen, 55. Driven by various problematic issues surrounding financial and banking systems as I have previously explained, in 2012 Bank Indonesia formulates conventional and Islamic-based banking policy frameworks within 3 complimentary corridors. These corridors are (i) safeguarding macro economy and financial system stability, (ii) bolstering resiliency and competitiveness of banks, and (3) bolstering intermediation. 56. Our policy responses in the first corridor, safeguarding macro and financial stability, are manifested by macro prudential regulation. As I have explained earlier, as part of our policy mix, we have made effective Housing Loan to Value Auto Loan Down Payment regulations applied for conventional banks. 57. The LTV is intended to mitigate financial system instability emanating from rapid credit growth in consumptive sectors, particularly in housing and automotive. To mitigate regulatory arbitrage, in near future we will release LTV and DP applied for Islamic banks and Islamic unit of conventional banks. 58. To anticipate the impact of the global economic issues that could destabilize the financial system and the banking sector, Bank Indonesia will soon revise regulation on Minimum Capital Adequacy Requirements of Commercial Banks, offering an approach to a more comprehensive risks-based capital calculation. 59. In essence, banks will be required to provide the minimum capital in compliance with their risk profile ranging from 8% to 14%. This amount can be set higher if based on Bank Indonesia existing minimum capital requirement, the amount is not adequate to anticipate risks. 60. The statute applies similarly for foreign bank branches operating in Indonesia. Within the framework of the financial system stability, foreign bank branches operating in Indonesia are required to maintain Capital Equivalency Maintained Assets (CEMA). CEMA serves as compulsory capital allocation fund in the form of business capital deposited in certain amount of financial assets that should also meet certain requirements. CEMA will help foreign bank branches bank to immediately anticipate and mitigate the risks. Therefore, risks on financial system can be properly maintained. 61. To safeguard financial stability, Bank Indonesia has enhanced the crisis management protocol related to exchange rates and banking, including integration BIS central bankers’ speeches with the national crisis management protocol and improvement of short-term funding facilities. To make crisis management effective for systemic crisis prevention, this MoU needs to be sheltered under the protection of upcoming Financial Sector Safety Net Act. Distinguished ladies and gentlemen, 62. In the second corridor, strengthening resiliency and competitiveness of banks, Bank Indonesia implements policies to structure bank ownership and regulate activities and bank network expansion on the basis of capital (the so-called multi-licensing regime). 63. Structuring bank ownership, of which regulation was issued under Bank Indonesia regulation number 14/8/PBI/2012, has spirit and philosophy to enhance good governance and bank soundness ratings. Therefore, banks whose soundness ratings and governance are deemed to be strong will be exempted from this regulation as long as they successfully maintain strong governance and ratings. 64. In the meantime, regulations on bank operational activities and network expansion are very important in endeavours to foster competitiveness of banks. Therefore, Bank Indonesia will soon release regulation concerning “Banking Activities and Network Expansion based on Capital.” 65. On the basis of this regulation, commercial banks will be categorized into four buckets depending upon their Tier 1 size. In other words, the bigger the Tier 1, the wider the scope of the activities and network outreach of the banks. Each bucket will have clear definition of scope of activities as well as network outreach. Lower buckets will permit banks to have basic banking services, whereas higher buckets will permit banks to have wider scope and more complex activities. 66. Banks will be stimulated to foster inclusive finance to support economy development in the region currently underserved. Therefore, regulation on bank activities will be linked to regulation on the mechanism for opening bank office networks. 67. This regulation provides incentive and disincentive mechanisms for banks to expand their activities and branch office networks depending upon their allocation of Tier 1, regionalization, and level of efficiency. Incentives and disincentives are provided through allocation of core capital (Tier 1) required differently for different types of branch networks to be opened by banks (full branch, sub branch, and cash payment points) depending upon the zone considering efficiency level of the bank. Under this regime, core capital required for banks opening office networks in zone with high bank density will be higher than those with lower density. 68. Enhanced regulatory regime for banking activities and distribution expansion will be launched in the same package with amendment of Single Presence Policy (SPP). 69. The amendment will be undertaken by reopening the option to establish holding company. With this option, strategic investors currently holding positions as controlling shareholders in a particular bank will be permitted to become controlling shareholders in other banks without obligations to exercise merger and consolidation of banks under their controls. 70. In the third corridor, we will strive to ensure that bank intermediation is on the right track. Therefore, each bank will be mandated to meet target of productive lending determined for each operational bucket. To stimulate inclusive economy growth, inclusive in the productive lending target is micro, small, and medium enterprises lending at minimum of 20%. The regulation on this productive lending target will be made public shortly. BIS central bankers’ speeches Distinguished ladies and gentlemen, 71. Safe, robust, and efficient payment systems are vital conduits supporting sustainable economy expansion and efficient transactions in the banking sector. During the course of 2012, Bank Indonesia has collaborated with banking industry to develop the payment system. 72. Key steps completed in 2012 include standardizing chips for ATM and debit cards, fostering synergies amongst ATM networks, and developing electronic credit transfer system for rural bank customers embedded in the National Clearing System. 73. Besides, to mitigate default risk in the credit card segment, in the beginning of 2012 Bank Indonesia released regulation concerning limitation of the number of credit card issuer that is commensurate to financial capacity of customer. Distinguished ladies and gentlemen, 74. Before we focus on the policy outlook that Bank Indonesia will pursue, allow me to shed some lights on the forthcoming challenges in wider perspective. 75. In 2013, global economy will step into the new normal. In this stance, we need to remain vigilant over two substantial risks, which unless well-mitigated, will amplify complexities in managing our macroeconomic policies. 76. First, risk from the continued uncertainty surrounding the European crisis, and second, risk from the US fiscal cliff, inevitable tax increase and the automatic budget cut in the US, in early 2013. 77. In its October 2012 publication, the IMF warned that failure to address the dual global risk combination will drag developed economies into a whirlwind of recession and the global economy will only grow by 2.0%, far from the baseline scenario of 3.6%. 78. With such bleak portrait, we can obviously see the daunting challenge we face in the future. On that note, backed by supportive demographic structure as our capital base, we are challenged to immediately take a number of structural adjustments. 79. We have been called upon to immediately make efficient every aspect of the economy in order to be more competitive. The development of a more efficient and reliable domestic connectivity, improvement in the ease of doing business, harmonization of regulation and reforms of bureaucracy are important aspects which we must address. 80. I feel troubled if we continue to dally while we still have time; we will remain trapped in the current natural resources-based economic model. By the year 2020, our demographic bonuses we now enjoy will start to diminish. 81. However, if we succeed, I believe we would be able to bring changes in our economic models, from resource-driven growth to efficiency-based growth. 82. In spite of this, we cannot simply rely on efficiency alone. In the future, the Asian region is expected to enter a new era as pioneer of global growth. Asia will grow as basis for consumption, production, and technological progress. 83. Asia’s position as technology-intensive production base is increasingly taken into account. For example, the mobile gadget iPhone, labelled as “Made in USA,” in fact has its major components supplied by Asian countries. 84. The reduction of various impediments to every policy aspects will move us from a resource-driven growth economy to an efficiency-based growth economy. However, relying solely on efficiency is not enough since going forward the Asian region is BIS central bankers’ speeches projected to become the new growth frontier as the basis of production, consumption, and technological advancement. 85. The establishment of these three bases are supported by growing intra-regional trade. In this regard, we are faced with both challenges as well as opportunities: “Will Indonesia reap the enormous potential benefit from Asia by becoming a part of the regional production chain, or will Indonesia stand still and continue as a resource-based economy and only become the market of other countries?” 86. To become an acknowledged player in the Asian production chain, we must become an innovation-driven economy. For that matter, the strengthening of scientific and technological infrastructure as well as human capital to support technological readiness and increase private innovation capacity are considered as strategical aspects which must simultaneously be the focus of our attention. 87. If we are able to bring our economy to become more efficient and innovative, based on technology and human capital, it is without a doubt that Indonesia in time will become an excellent production hub in Asia. That is where we must be heading, with the spirit, commitment, and courage for self-reform. Measures of reforms which we must take to reach this destination will equip our economy with extra energy, independence, and flexibility to face the challenges of globalization. Distinguished ladies and gentlemen, 88. In our effort to develop an efficient and innovative economy with sustainable growth, we must not neglect the need for equal access of opportunities for every layer of the society (inclusiveness). Based on such economic and objective rationale, inclusive growth is more sustainable and optimal for the economy. 89. However, the transition of our society into a middle class category has some transitional impact to economic gap. Looking deeper into the problem, the transition will result in human capital productivity gap in our domestic economy. 90. The two pillars of productivity will make total economic productivity less optimal and the economy will lose its economic thrust. Ceteris paribus, such economy will be more prone to external as well as internal shocks, and this condition will negatively affect our ability to preserve macroeconomic and financial stability. This will in turn put our effort to eradicate poverty and reach better income distribution at risk. 91. For that matter, an inclusive growth is not just merely an empty term. In reality, more than half Indonesian population still do not have access to the formal financial channel (2010 World Bank Survey). 92. This fact also shows that the market is still largely open to banking industry. Furthermore, data shows that the ratio of credit to GDP is still around 31%. It is with respect to this inclusive growth that Bank Indonesia views the significance of “inclusive financial program.” Distinguished ladies and gentlemen, 93. Based on this line of thinking, it is in my view that the future economic policy direction is to answer to the challenge of achieving a sustainable and inclusive growth of the Indonesian economy. 94. If we are able to address the number of structural impediments which have been previously identified, we can hope that the economy will be able to grow on a higher path, and at the same time benefits can be inclusively reaped by every layer of the society. 95. Taking into consideration that macroeconomic management going forward will still be exposed to global risk and the wide complexity of the domestic problems, Bank BIS central bankers’ speeches Indonesia will continue to calibrate a policy mix composed of interest rate, exchange rate, and macroprudential aspects. 96. To support exchange rate, market interest rate, and overall financial stability, the monetary policy implementation will continue to be enhanced with a more integrated operational framework, with the emphasis in using government securities in monetary operation. In my view, however, this form of stability should not encourage moral hazard behaviour of economic players and the market in general which may expect the authority to constantly intervene to maintain stability at all costs. Such form of stability should in fact give room for the process of financial market deepening. 97. A deep financial sector will extremely help in making effective monetary policy transmission, providing a more variety of instruments for risk mitigation (hedging) and facilitating effective and efficient economic financing, including those provided by our banking industry. Distinguished ladies and gentlemen, 98. In my view, our banking industry must continue to be encouraged to improve resilience, efficiency and its role in intermediation. Broadening of the public’s access to an affordable banking service through the financial inclusive program is included as part of strengthening intermediation function. 99. Going forward, the financial inclusion program must be implemented through the supply and the demand sides. From the supply side, broadening of an affordable banking services access, and making available banking products meeting the need of the lower income society must be carried out. 100. In this regard, going forward, we plan to broaden banking service access by way of a non-conventional measure through the use of information technology, telecommunication, and agent cooperation or familiarly known as branchless banking or mobile payment. Through this strategy, banking services will reach every layer of the society without having to physically present the bank office. Distinguished ladies and gentlemen, 101. In this regard, branchless banking must be implemented in phase with due consideration on potential risks that may occur, including its impact to the financial stability. On that account, in early 2013 Bank Indonesia will issue guidelines on the implementation of branchless banking which will be followed by the issuance of a number of supporting regulations. 102. Recognizing the increasing strength of the Indonesian middle class, Bank Indonesia also views the need to optimize such new strengths through the acceleration of generating new business ventures. For that, Bank Indonesia will continue its cooperation with universities and the private sector by preparing a business training program for college students and former Indonesian workers abroad. 103. Currently being prepared is a start-up loan for business start-ups. This skim will involve technical agencies and other agents in coaching, consulting, guaranteeing and providing eligible credit collateral, such as land certification. 104. The major obstacles of the community’s lower economic level in accessing credits for productive purposes are not only the lack of eligible credit collateral availability but also the high levels of lending rate for the micro segment. As such, I view that the fruits of national banking efficiency improvements should be felt by those in the lower economic level. Having said that, we will promote healthy competition in the micro segment through, among others, the publication of Micro Credit Lending Rates. BIS central bankers’ speeches Distinguished ladies and gentlemen, 105. Aside supporting the development of inclusive finance, the policy direction for the payment system of the future will focus on several very specific dimensions. 106. First, to increase the community’s trust in using payment system instruments, we will continue to improve the security of features in using non-cash payment instruments and support ways to make non-cash transactions more affordable and the services safe, prompt, and widely accepted. 107. Second, to increase the efficiency and convenience of payment system users, we will promote interoperability between payment systems. This will be achieved through the implementation of standards for the payment instrument or infrastructure. 108. Third, we will strengthen the legal framework, both for the providers and the users of payment system. The rapid development of payment system supported by technological development needs to be supported by more stringent laws in the form of a payment system act. Distinguished ladies and gentlemen, 109. To conclude my speech tonight, please allow me to present economic outlook of 2013. As we view the prospects ahead, we will not be able to release ourselves from the reality that the Indonesian economy is situated within a very challenging global environment. 110. However, the width and depth of such global atmosphere does not mean that our economy’s outlook is devoid of any optimism. We should remain optimistic as we have a stable economy, proven and acknowledged, a domestic demand based on growing middle class, and adequate policy spaces to absorb global risks. 111. Such three basis of economic strength will continue to support the growth of confidence and as such can serve as a driving force in the continuation of physical and human capital accumulation process. Several latest indicators show the continuous accumulation of capital for the development of production capacity from both domestic and abroad. 112. With such prognosis and also the support of increasing government capital expenditure, we see the 2012 growth of investment around 10.7%, and we expect that it will continue to increase to 11.6%–12% in 2013. 113. With increasing investment, in due time, purchasing power will be sustained, thus household consumption growth in 2013 can be maintained at 5.0%–5.4%. 114. The economic expansion also gains impetus from export performance which is estimated to improve in line with improved commodity price. For 2013, total exports are estimated to grow by 5.4%–5.8%. 115. With solid growth centres, we believe that the national economy’s momentum can still be maintained and even be enhanced. As such, we are optimistic that the national economy in 2013 will grow by 6.3%–6.7%. 116. I firmly believe that growth will reach the upper end of the range if structural issues mentioned earlier can be addressed. 117. Even though growth will continue to be on the upside, the 2013 inflation is forecasted to remain under control within the expected target range of 4.5 ± 1 percent. Distinguished ladies and gentlemen, 118. This is, in effect, what I have to share with you tonight. Looking at the challenges we are facing, I think we agree that the years to come will be no easier than the BIS central bankers’ speeches episodes that have passed. However, we should embrace an optimistic attitude. The potential and opportunities within our nation remains strong and vast, and it is our duties to unlock them. 119. We trust that God Almighty will always be with us and give His blessings and ease our steps towards a better future. Thank you. Wassalamu’alaikum Wr. Wb. BIS central bankers’ speeches
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Address by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at the Annual Bankers' Dinner, Jakarta, 14 November 2013.
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Agus D W Martowardojo: Managing stability, promoting transformation for sustained economic growth Address by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at the Annual Bankers’ Dinner, Jakarta, 14 November 2013. * * * Honorable , Leaders and Members of House of Representatives, Supreme Court, People’s Consultative Assembly, Regional Representative Council, and Supreme Audit Board, Ministers of United Indonesia Cabinet II, Chairman of Indonesia Financial Services Authority, Leaders of Non-Government Institutions, International Institutions, and Prominent Bankers, Former Governors of Bank Indonesia, Enterpreneurs, Economists and Scholars, Distinguished Guests, Ladies and Gentlemen, Assalamu‘alaikum Wr. Wb., Good Evening and May God Bless Us All, 1. I would like to commence our respectable event by praising and thanking God Almighty who has blessed us with the opportunity to gather here in the occasion of Governor’s Address and Annual Bankers’ Dinner 2013. 2. I am delighted to have the opportunity to meet all of you on my initial appearance in our strategic forum this evening. On this momentous occasion, I would like to emphasize that this event is an important platform to harmonize our views on current economic condition, emerging challenges, and efforts to strengthening the measures. 3. Your presence provides additional support for Bank Indonesia in undertaking its mandates, and is essential for us to further enhance economic resilience in dealing with greater challenges ahead. In this regard, allow me to express my humble gratitude for your participation. Distinguished Guests, Ladies and Gentlemen, [Economic Development 2013] 4. Since I took my position in Bank Indonesia, I have personally experienced formidable economic challenges [TABLE 1]. I initially joined Bank Indonesia on May 24th, 2013, just only two days after Chairman of the Federal Reserve indicated its plan to start tapering its monetary stimulus. A very brief signal from the Chairman, yet it has world-wide negative impacts. From that moment until end of August 2013, massive foreign capital flew out from our economy which eventually led to sharp depreciation of the rupiah. 5. However, we observe that global issues overshadowing our economy are much broader than the issue of the Fed’s tapering itself. We view that there are, at least, three main global issues which have created uncertainties and put more pressures on our economy in 2013. 6. First, uncertainty of the speed of global recovery. The global economic recovery process is not as expected, and even slower than previously estimated. The global environment becomes more uncertain because of the shifting of global economic landscape. I still remember, two years ago, we have had a discussion about the two-speed world recovery, i.e. slow recovery in advanced economies, and much faster recovery in emerging BIS central bankers’ speeches economies. Now, the situation has turned around. The United States’ economy has strengthened, the European economy has shown signs of escaping the crisis, while emerging economies have slowed down. In other words, the phenomenon of a three-speed world recovery has emerged [GRAPH 1]. Table 1 Revision of global growth forecast 2013 Graph 1 A three speed world recovery 7. Second, the wide-spread uncertainties as consequences of the US policy’s indecisiveness, not only related to the withdrawal of ultra-accommodative monetary stimulus but also the debt ceiling crisis and the US government shutdown. These prolonged unfavorable circumstances have triggered global investors to re-evaluate risks and caused excessive reactions, which have led to turmoil in the global financial markets, including in Indonesia [GRAPH 2]. BIS central bankers’ speeches Graph 2. Capital flows & the IDR/USD exchange rate 8. Third, the uncertainty of global commodity prices. In line with the sluggish global economic growth and heightened volatility in the global financial markets, commodity prices have continued its downward trend, confirming the end of commodities super-cycle era [GRAPH 3]. Graph 3 Global commodity prices Distinguished Guests, Ladies and Gentlemen, 9. The three main global issues I mentioned previously have inevitably affected the performance of Indonesia’s economy. Amidst the robust domestic demand, intense global pressures have put more burden on the current account. BIS central bankers’ speeches 10. The current account deficits have occurred since the fourth quarter of 2011 [GRAPH 4]. Furthermore, sliding commodity prices which have started since the beginning of 2012 have affected exports that finally led to growing current account deficits. Graph 4 The current account 11. These substantial current account deficits are not only caused by trade balance deficits but also overburdened by prolonged services and income balance deficits [GRAPH 5]. On the other hand, foreign portfolio investment flows have fluctuated associated with changes in sentiment, known as risk-on and risk-off behavior in global financial markets. Together with the issues of current account deficits, turbulence in domestic financial market creates deterioration of the Indonesia balance of payment posture. Graph 5 The net services and income account 12. Economic adjustments are eventually unavoidable. Yet, we argue that these economic adjustments are needed as part of rebalancing process toward a more balanced economy which is aligned with its economic fundamentals. BIS central bankers’ speeches 13. In line with the deterioration in the balance of payment, rupiah has demonstrated a weakening trend. Moreover, the hike of inflation caused by the reduction in fuel subsidy is also part of the delayed adjustment process. These conditions have finally led to a lower economic growth. Distinguished Guests, Ladies and Gentlemen, [Policy Responses and Current Economic Condition] 14. The Government and Bank Indonesia have taken various policy responses to safeguard economic adjustments. These policies are intended to maintain economic stability to ensure the process of short term adjustments remain in place. In particular, the policy responses are aiming to ensure a stable inflation, maintain exchange rate of rupiah in line with its fundamentals, and reduce current account deficits toward a more robust level. 15. Within these policy directions, Bank Indonesia attempts to further strengthen the policy mix ranging from: (i) Increasing Bank Indonesia Rate by 175 bps to the level of 7,50%, from June to November 2013; (ii) Reinforcing monetary operation; (iii) Stabilizing rupiah exchange rate; (iv) Strengthening macro-prudential policies; (v) Promoting monetary and financial system stability policy cooperation with other central banks; and (vi) Enhancing policy coordination with the Government. 16. On behalf of Bank Indonesia, I would like to extend our sincere appreciation to the Government for its policy responses. The decision to raise the subsidized fuel prices in the end of June 2013 has reduced pressures on fiscal sustainability, although this effort is inadequate to further improve current account posture. In addition, we are of the view that the Government has already taken initial positive steps by introducing the policy packages in August and October 2013. Respected Audience, Table 2 INDONESIA balance of payments – quarterly 17. Without intending to be complacent, it is worthy to mention that the policy responses have demonstrated positive contributions. Various indicators reflect that economic BIS central bankers’ speeches adjustment process remain under control. The trade deficits have started to decline in the third quarter of 2013. The foreign capital inflows has also intensified [TABLE 2]. 18. Positive developments on the balance of payment have supported the stability of rupiah since the end of September 2013. At the same time, the micro structure of foreign exchange market shows improvement as indicated by the increase in the volume of interbank transactions and a more healthy price discovery in the forex market. A lower off-shore non-deliverable forward rate (NDF) compared to the spot rate indicates a more liquid market [GRAPH 6]. Graph 6 Foreign exchange market 19. The high level of inflation following the hike of subsidized fuel prices has returned to its historical pattern [GRAPH 7]. This development suggests that the second round impacts of the hike of subsidized fuel prices were restrained. Although the administered and volatile food prices have significantly increased, core inflation remains below 5,0%. The inflation has surpassed its target of 4,5±1%, yet we forecast inflation in 2013 will slightly fall below 9,0%. Graph 7 Inflation BIS central bankers’ speeches 20. We expect our economy will expand by 5,7% in 2013. Although lower than its growth in 2012 that was recorded at 6,2%, the figure is still above the estimated average growth rate of its peer countries of 3,6% [GRAPH 8]. Graph 8 INDONESIA economic growth vis a vis peers 21. The adjustment process of the Indonesia’s economy is also supported by the stability of financial and payment system, as well as sound foreign debt level. Through a consistent policy, excessive pressures stemming from economic adjustments could be avoided [GRAPH 9]. Graph 9 Banking indicators Distinguished Guests, Ladies and Gentlemen, [Economic Challenges and Opportunities Ahead] 22. Ahead, the current challenges are not about to recede very soon. At the present juncture when the economy is in the adjustment process to a soft landing, I see a number challenges, BIS central bankers’ speeches both global and domestic, remain at the fore. The challenges are not only those that are cyclical in nature but also those that are structural, and therefore demand our collective attention. 23. Along this line, we need to remain vigilant of the global economic growth dynamic. While the global economy in 2014 is projected to expand at around 3.5%, the shift in the world economic landscape is anticipated to continue [TABLE 3]. The average growth of the US and Europe, which only arrived at 2.2% and 1.4% respectively within the last two decades, is expected to rise to 3.1% and 1.6% in the next five years. On the contrary, China’s economy in the subsequent five years will have to accept a new normal growth of around 7%, after expanding at an average 10.25% in the last two decades. Similar pattern is expected to occur in other emerging markets’ economic path. Table 3 The shift in global economic landscape 24. What becomes a concern for us is the risk that the shift in the global landscape will reverse the direction of portfolio flows to advanced countries, particularly the US [GRAPH 10]. Undeniably, the delay in the reduction of US monetary policy stimulus has provided “temporary breathing space” for us at this moment. Nonetheless, the tapering off of the US monetary stimulus is indeed an unquestionable event that will occur in the near future. As a matter of fact, several recent indicators have started to reflect a strengthening of the US economy. 25. Against the background of the above global challenges, equally daunting challenges arise in the domestic front [FIGURE 1]. The first challenge relates to our financial market that needs to be restructured. One of the issues pertains to the fragmentation of rupiah excess liquidity in the banking sector. This calls for attention as it would increase the complexities of monetary operation and disturb the stability of the financial system. BIS central bankers’ speeches Graph 10 Global capital flows Figure 1 Structural challenges to monetary policy implementation 26. Another challenge concerning the financial market is its lack of depth and liquidity. In the rupiah market, this is reflected in the low turnover and the anomaly of price formation in the repo market [GRAPH 11]. The collateralized market does not appeal to many market participants and is more expensive compared to the uncollateralized interbank money market. In the meantime, the foreign exchange market is characterized by low volume and inactive hedging transactions. With such micro structure, the exchange rate is easily under pressure even when the demand for foreign exchange experiences a small upsurge. BIS central bankers’ speeches Graph 11 Domestic money market condition 27. The second challenge deals with structural weaknesses that will inhibit our attempt to boost the economy to a higher level. Today, Indonesia has firmed up its position as a middle income country and is in transformation from lower middle income to upper middle income [GRAPH 12]. This implies that the middle class expansion in the last decade will continue and correspondingly our domestic market will enlarge. The structure of demand for goods and services will also be getting more diverse with increasingly complex characteristics [GRAPH 13]. Graph 12 Income per capita BIS central bankers’ speeches Graph 13 Expanding middle class 28. Notwithstanding, amid the changing structure of aggregate demand, I view that the economy has expanded too rapidly and is susceptible to correction [FIGURE 2]. The Economic expansion is also followed by a weakening posture of the current account. Consequently, the pace of economic growth to a higher path is hindered. Figure 2 Structural challenges BIS central bankers’ speeches 29. I view the above impediment to economic growth as a reflection of the existing imbalance between the structure of aggregate demand and the capability of the supply side. In the supply side, the production structure that took shape within the last decade has been gradually felt to be obsolete. 30. This is actually a sensible development [GRAPH 14]. The existing production structure reflects the comparative advantage that we used to utilize to take Indonesia transforming from low to middle income country. The abundant natural resources heritage outside Java and the human resources surplus in Java have become the primary assets that lifted a large part of our society out of the poverty trap. These primary resources have enabled us to build an industrial order dominated by export industries that are intensive in human and natural resources such as coal mining and crude palm oil industry. Graph 14 Net exports of natural resources and low tech industry 31. Nevertheless, when Indonesia finally stepped up to become a middle income country with a growing middle class, such industrial order is no longer sufficient. The typical characteristic of a middle class society is having the desire and simultaneously the capability to purchase goods with higher quality and value added. In line with the increased complexities of the demanded goods, greater basis for comparative advantage and industrial capability are undoubtedly needed. 32. This gap between demand and supply is increasingly fulfilled by imports, primarily goods produced by middle and high technology industry [GRAPH 15]. The net imports of goods in this category have grown larger since Indonesia stepped into a middle income country category in 2014. This technology deficit in the supply side is felt across the nation. Nonetheless, the stronger industrial capacity in Java has not sufficed in accommodating the substantial changes in the structure of national demand. BIS central bankers’ speeches Graph 15 Spatial profile of trade balance in Nusantara 33. I believe this condition does not stay apart from the impact of several aspects that are inadequate and need to be improved. First, the availability of infrastructure for connectivity both digitally and physically. Second, the management of domestic energy. The energy management aspect has acquired growing attention as the augmenting demand for energy has to be fulfilled by imports, which eventually aggravates the ongoing problem of current account deficit. Third, several aspects related to business climate that are under the close watch of businesses, including ease of starting up a business, legal certainty, registration of personal proprietary right, insolvency settlement, and enforcing contract. 34. Overall, the above domestic structural challenges demand our increased attention as our integration with the ASEAN Economic Community (AEC) is looming near in 2015. The question for us is “Are we able to gain the benefit of AEC and develop to be part of the global value chain, or merely become a target market?” Distinguished Guests, Ladies and Gentlemen, [General Policy Direction] Figure 3 Policy direction BIS central bankers’ speeches 35. In the spirit of determination and thrust to respond to the challenges and strengthen the stepping stone toward sustainable growth, allow me to convey Bank Indonesia’s policy direction ahead and a number thoughts concerning the structural reformation that we need to pursue together with the Government [FIGURE 3]. 36. Let me underline that in our policy direction ahead, including in the period of political transition in 2014, Bank Indonesia will consistently preserve the stability of the economy and the financial system. Stability needs to be prioritized in order to create a more balanced and sound economic structure, therefore becoming a strong foundation for economic transformation in the future. 37. The economic balance that I am referring here is economic growth that is supported by a sustainable posture of the current account. On the one hand, sustainable can be interpreted as a condition where exports have high value added and industries are capable of producing intermediate goods and services that so far still rely on imports. On the other hand, the financing of current account should derive from more permanent sources, i.e. Foreign Direct Investments that will propel the growth and development of advanced and globally competitive industry sector. 38. With the complexities of the confronted challenges, BI’s policy direction is measured in terms both goal and time dimensions. As regard the goal dimension, BI is not simply committed to manage inflation to be between its target range, but more broadly, is also directed to manage current account toward a sustainable path, while preserving the stability of the financial system. 39. The effort to attain low inflation is not negotiable as it becomes a pre-condition for the sustainability of the economy. Notwithstanding, the Asian and global crisis demonstrate that low inflation is not sufficient to warrant sustainable economic growth. 40. The journey of our economy post 97/98 Asian shows that we need to remain vigilant even when inflation rate remains low, because it may well be a delayed inflation which will be accompanied by increasing current account deficit. The inflation phenomenon was indeed delayed since the risk of rising inflation was temporarily absorbed by government subsidies such as fuel and energy subsidies. Inflation rate was also subdued owing to decreased pressure from imports as the prices of global commodities declined. 41. From the time dimension, Bank Indonesia’s policy stance will consistently be adopted in a time-consistent manner until the economic condition becomes more balanced. This dimension is in line with the structural challenges which will take quite a long time to be resolved. 42. In sum, Bank Indonesia’s policy direction is implemented through a policy mix in the monetary, macropudential and payment system area. Distinguished Guests, Ladies and Gentlemen, [Monetary Policy Direction] 43. In the area of monetary policy, the BI Rate will be consistently directed towards controlling inflation to be within its target. Furthermore, the monetary policy stance is taken to support efforts in reducing the current account deficit to achieve a sustainable level and to maintain a robust financial system stability. 44. The exchange rate policy is aimed at guiding the exchange rate to move within its fundamental value acting as shock absorber instrument of the economy and not as shock amplifier. In this context, a deep and liquid foreign exchange market is needed to support a more efficient creation of the exchange rate. 45. The monetary policy is strengthened with a number of monetary operation strategies. In the area of rupiah liquidity management, the monetary operation strategy will be to continue to absorb structural excess liquidity in a guided and measured manner. This is conducted BIS central bankers’ speeches among others by extending the open market operation tenor through the introduction of the 1 year or longer SBI tenor and the Medium Term Notes. 46. Furthermore, Bank Indonesia will continue to strengthen the development of the rupiah and the forex money market and the deepening of the financial market. As an initial step, the facilitation of the “mini” Master Repo Agreement initiative for a number of pilotbanks is seen as a meaningful step and will contribute to the implementation of a larger scale initiative which is the General Master Repo Agreement. In addition, Bank Indonesia will also issue a number of money market regulation and several funding instruments for financial institution liquidity management such as the revision of the commercial paper regulation and the inter bank repo transaction based on syariah principle. We will also undergo policy harmonization and increase dissemination and education to the market player. 47. One policy which we will continue to take to improve external endurance is the strengthening of the second line of defence through financial cooperation with other central banks and financial authorities in the region. We view these types of cooperation should be continuously strengthened to anticipate against uncertainty of risk of the global economic condition that can instantly weakened the external sector performance. Distinguished Guests, Ladies and Gentlemen, [Macroprudential Policy Direction] 48. In an effort to strengthen external sector endurance, we will also adopt macroprudential policy through supervisory action. The macroprudential policy is aimed at strengthening credit composition extended to productive sectors with export orientation and which provide import substitute goods and support efforts to increase economic capacity. 49. Bank Indonesia will also buttress the implementation of its new function and authority as the macroprudential authority. In this context, macroprudential policy will be directed towards systemic risk management, including credit risk, liquidity risk, market risk, as well as strengthening the capital structure [FIGURE 4]. Figure 4 Macroprudential policy mix BIS central bankers’ speeches 50. In managing liquidity risk, we will improve the syariah minimum reserve requirement and introduce a staged Liquidity Coverage Ratio (LCR) instrument starting from January 1, 2015. As the time for its implementation is nearing, I urge banks to include the LCR target in their respective 2014 Bank Business Plan. In the area of capital buffer, the calculation of bank capital will be enhanced by the incorporation of more complex and comprehensive risk elements, such as the economic cycle and assessment of banks with systemic impact. 51. In the area of strengthening financial system stability, I view the enhancing of a macromicro coordination between Bank Indonesia and OJK to be important. I have initiated the macro-micro coordination effort by the signing of the Joint Decree (SKB) on October 18, 2013. In principle, the Joint Decree includes commitment to ensure the smooth transition of the bank microprudential supervision and the effective implementation of the task, function, and authority of each institution. 52. Enhancement of macro and microprudential coordination is important to prevent any increase in regulatory cost, discourage regulatory arbitrage, and improve the quality of the Crisis Management Protocol (CMP). In the area of financial sector policy, I am confident that OJK will preserve consistency of the banking regulation and supervision and continue the policies/commitments agreed thus far with the banking industry. 53. Nevertheless, I view coordination between the two authorities can be further strengthened with coordination and cooperation between institutions in the context of crisis prevention and resolution. Such coordination is necessary to provide legal certainty basis in terms of crisis prevention and resolution. On that note, I am hopeful that the financial system safety net law can be introduced soon to serve as an umbrella for a better cooperation between relevant authorities. 54. Strengthening the financial system, specifically the banking sector, becomes more critical in response to the implementation of the AEC in the financial services sector in the year 2020. It is in my view that improving perseverance and competitiveness as key factors to a healthy competition. Banks must escalate their business scale in order to achieve a higher level of economic of scale and concurrently an improved governance. 55. It is in this context that I wish to remind banks undergoing corporate actions or holding an unfavorable governance rating and bank soundness level by the end of 2013, to adjust their ownership composition to be in line with the threshold established. Such adjustment should also follow the existing regulation in place and the transfer of ownership share to other parties must gain clearance from the authority. I wish to avoid the buying and selling of business permit since in principle business permit granted are merely facilities provided by the state and cannot be transferred without prior approval from the rightful authority. 56. The same principle also applies to the transfer of bank ownership share to foreign investors. In principle, these investors can play a role in the national banking industry. However, it must be carried out in a proportional and reciprocal manner and delivering benefits to the economy. In this context, authorities agreement and commitment between countries is necessary to ensure equality in terms of market access as well as national treatment and an adequate cross-border supervision. 57. The development of syariah financing is also a priority in strengthening financial system stability. The relatively rapid development of legal and institutional infrastructure, as well as syariah financial market and its supporting instruments since 2008 will continue to be broaden to boost syariah principle based economic contribution to the national economic growth. Within this framework, existing syariah education program will be enhanced to become an economic movement, the so called Syariah Economic Movement which is expected to commence in the near future. Distinguished Guest, Ladies and Gentlemen, [Payment System Policy Direction] BIS central bankers’ speeches 58. In the area of payment system policy, Bank Indonesia will remain to be the rightful authority to regulate, develop, monitor and grant payment system operation license. In this capacity, we will develop a more efficient domestic payment system industry through the improvement of payment system architecture and broadening access to payment services. Such policy is taken to anticipate rising public needs for non cash instrument payment. We will also reinforce regulatory and payment system monitoring aspect through the improvement of capacity, including improvement of the Bank Indonesia human resource competency in the area of fund transfer operation and foreign exchange merchant [FIGURE 5]. Figure 5 Payment system policy 59. In its implementation, the payment system policy will be based on three main strategies as follows: (1) strengthening the domestic industrial structure, (2) technical and mechanism standardization to improve efficiency, and (3) expansion of access to payment services. The first strategy is implemented through the development of the National Payment Gateway [FIGURE 6]. This initiative can increase domestic industry efficiency in terms of cost reduction – cost of transaction, mitigate systemic risk on settlement activities and broaden payment access. Figure 6 National payment gateway timeframe BIS central bankers’ speeches 60. The second strategy will be carried out by developing standardization aspect in the national payment system industry. Such strategy will create a safe and smooth functioning of the system, preserve a healthy competition and will not create any economic rent. Furthermore, we will also promote the standardization of Government routine expenditure through non cash mechanism. 61. The third strategy will be conducted as an integral part of the financial inclusion policy supported by education program and consumer protection. This is done by making use of innovation and information technology, specifically through the simplification of know your customer, while maintaining its reliability in the implementation of the know your customer principles. To further promote non cash payment system we will explore cooperation with the Government for the possibility of providing fiscal incentive for non cash transactions. Distinguished Guests, Ladies and Gentlemen, [Financial Inclusion and SMEs Policy Direction] 62. In addition to the monetary, macroprudential, and payment system policy, Bank Indonesia will also strengthen its policy in relation to financial inclusion and SMEs [FIGURE 7]. The two policies have roles in promoting banking intermediation and efficiency hence contributing to the strengthening of the financial system stability and supporting policy in the payment system area. Figure 7 The scope of financial inclusion & SMEs policy 63. The financial inclusion policy is focused on five main strategies. First, enhancing financial education as an effort to alter financial management behaviour, especially to the low income part of society. Second, improving financial access supported by the firming up of the payment system infrastructure, utilizing information technology and innovation, as well as local economic unit network. Third, consumer protection to ensure the public’s rights when using financial access and the payment system. Fourth, reduction of asymmetric information by providing financial profile data of the public currently untouched by the banking sector and commodity information data. Fifth, introduction of regulation under the financial system stability framework as well as providing policy recommendation to relevant authorities BIS central bankers’ speeches [FIGURE 8]. Meanwhile, the policy on SMEs in principle adopts a similar strategy to the financial inclusion and further complemented with the improvement of SMEs capacity. Figure 8 The principles of financial inclusion & SMEs policy Distinguished guests, <Coordination with Government> 64. Efforts in responding to economic challenges necessitate coordination with the Government, especially on issues related to structural challenges. Within the scope of cyclical challenges, Bank Indonesia once again appreciates the steps taken by Government in controlling the 2014 Budget deficit at 1,7% of GDP. That target reflects our similar perspective in prioritizing efforts for economic stabilization. Nevertheless, persistent strength in demand for subsidized fuel remains as our common challenge. Figure 9 A global race to prosperity BIS central bankers’ speeches 65. In addressing the dimension of structural challenges, it is noteworthy for us to improve the quality and speed in implementing public policy in order not to lag behind competitors in the global strategic environment [FIGURE 9]. In this regard, a need for acceleration in various policies to improve the quantity and quality of infrastructure, strengthening the management of domestic energy, including speeding up the development of a clean and renewable alternative energy, and ameliorating every aspect related to ease of doing business in Indonesia such as law and regulation. I believe that the strengthening of every elementary aspect in our competitiveness will lessen our technology deficit and improve our industry capabilities. 66. Within the same context, Indonesia needs to strengthen its investment strategy in promoting the development of upstream industry for intermediate goods with high valueadded. Therefore, the presence of manufacturing FDI by global manufacturers of quality and who are market leaders within their respective industries must become the complementary part of our national investment policy in the future. In the same sense, Indonesia will also benefit by the downstreaming of natural resources extractive activity. Distinguished guests, Ladies and gentlemen, 67. I am aware completely that everything that I have conveyed regarding improvement of production structure on the supply side could not be materialized in the near term. Nonetheless, I hold the view that not much time is available to keep postponing steps in materializing them. 68. Indonesia’s position as a middle income country which is progressing to become a high income country requires us to rethink the relevance of economic growth model that we have always been implementing. Indonesia as a middle income country could no longer rely only on cheap labor wages and extractive activities. It is about time for us to switch towards a growth model that emphasizes increased industrial capabilities. 69. Also within that context, the whole efforts in overcoming the structural deficit in the supply side need to be mounted as a joint effort in building an innovation ecosystem across Indonesia, as a “New Growth Model”. In that ecosystem, diffusion of technology, R&D and innovation activities, intellectual property rights, risk capital and education activities, interact with each other without barrier and supported by the availability of reliable connectivity both physical and digital. 70. Encompassing all of those, we can expect that the national economy will transform to become more reliable, efficient, and globally competitive, with sustainable economic growth in a stable economic environment. Respected audience, [Economic Prospect 2014] 71. Considering those economic challenges and the policy direction which will be taken by Bank Indonesia and Government, it can be expected that our economy in 2014 will be in a consolidation phase [FIGURE 10]. BIS central bankers’ speeches Figure 10 Cyclical economic forecast 72. This consolidation is tied to the still unfinished economic correction process in rectifying our current account deficit, which is expected to decrease in 2014. Imports which are increasingly manageable, along with the recovery process within the domestic economy are expected to support the improvement of the current account balance. 73. Economic growth in 2014 is expected to improve within the range of 5,8–6,2%. This prospect is supported by improvement in export along the improvement of global economy and domestic demands. However, projection of current account balance and potential downside risk in economic growth will require attention considering that the process of slowing global economy is still ongoing. The prospect could change direction if the process of global economic recovery is stopped, as happened in 2013. 74. From the perspective of price, we project that inflation in 2014 will be back under control, within the target range of 4,5±1%. This is influenced by the positive impacts from various policies taken by the Government and Bank Indonesia. Inflation of foods and inflation of administered prices are expected to be stabilized, supported by expectation of improvement in the supply and distribution of food, assuming there will be no more policy of price increases that is of strategic nature. Core inflation is expected to remain controlled due to the preservation of supply availability, stable Rupiah exchange rate, and manageable inflation expectation. 75. For the prospect of banking in 2014, potentially fragile economy and interest rates increases need to be anticipated. In this sense, we forecast that credit growth from banking in 2014 will be within the range of 15–17%, supported by growth in Deposits along the same pace. In our assessment, that pace of credit growth is consistent with our efforts in balancing the economy. Therefore, I expect the active involvement of the banking sector to adjust the target of credit growth in each respective Bank Business Plan for 2014 to be more consistent with our effort in managing the economy towards a healthier direction. Respected ladies and gentlemen, <Medium-term prospects> 76. In the medium-term perspectives of 2015–2018, global economy is expected to grow at an average rate of 3,9%, driven by expected improvement of economic activities within the United States. Prices of non-oil and gas commodities are expected to increase, albeit limited. Nevertheless, prospect of global oil price needs to be carefully monitored because it can potentially increase due to ongoing global economic recovery. BIS central bankers’ speeches 77. Indonesian economic growth is expected to reach 6,5% in 2018, if all transformation policies in the economy proceed according to expectation [FIGURE 11]. I take the view that those policies can improve the structural balance between demand and supply, while also easing the problem of current account balance structure. Along the same line, economic growth could be stuck at 6% if the transformation process does not proceed according to expectation. Figure 11 Medium-term economic prospect Distinguished ladies and gentlemen <Vision, Mission and Strategic Values of BI > 78. In order to achieve those important targets, Bank Indonesia is transforming itself. We have launched our vision until 2024, which is to become a central bank that is to be a credible institution and the best central bank in the region. 79. We strive to be the best in the implementation of policy mix, macroprudential development, management of capital flow, initiative policies for the creation of Regional Financial Safety Net, financial inclusion and SMEs, and the development of digital financial services. All those will proceed along the stage of restructuring, enhancing, and shaping the end state, for the achievement of low inflation and stable exchange rate. 80. To support the achievement of our vision, we want to ensure that all potential resources within our control are functioning more effectively. Therefore, our new strategic values, which comprise (1) upholding trust and integrity, (2) promoting professionalism, (3) seeking perfect performance, (4) prioritizing public interest, and (5) strengthening coordination and teamwork, will be continually strengthened to support the achievement of that vision. Distinguished ladies and gentlemen, <Closing/Epilogue> 81. Looking at the issues and challenges that we currently face, it is not difficult for us to imagine the bigger problem that is waiting for us in the future if we fail to act quickly and appropriately. We have not achieved an optimal economic growth, while being faced with the challenge of restoring our current account balance, and simultaneously we must also continuously improve to advance the economic transformation towards the direction that we aspire to. 82. In that regard, we have to commonly develop a work ethic and we will not rest until those goals are achieved. Before concluding tonight remarks, please kindly allow me to quote a known philosopher from the 4th century BC, Cicero: “within the character of the citizen, lies BIS central bankers’ speeches the welfare of the nation.” That the development of a nation cannot be separated from the work ethic and character of the nation itself. 83. Allow me to conclude my remarks tonight. May God Almighty bless and lighten our steps forward. That will be all and thank you. Wassalamu’alaikum Wr. Wb. BIS central bankers’ speeches
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Keynote speech by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at the Fitch Ratings Credit Briefing on Indonesia, Jakarta, 13 March 2014.
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Agus D W Martowardojo: Maintaining balance for sustainable growth Keynote speech by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at the Fitch Ratings Credit Briefing on Indonesia, Jakarta, 13 March 2014. * * * Accompanying charts can be found at the end of the speech. Honorable Speakers, Distinguished Guests, Ladies and Gentlemen, Good Morning to you all. 1. First of all, allow me to congratulate the organizer of this event, the Fitch Ratings Indonesia, for successfully arranging this forum. It gives me a warm feeling to see such of a good crowd of committed and distinguished business people attending this forum. I hope this gathering will give the opportunity of a healthy exchange of views to ensure better understanding of each others’ visions for the future. 2. With that spirit, I find this event provides a great time to take a fresh look at the opportunities in Indonesia at this challenging juncture. To give you the background, I will share my view from the perspective of the central bank on “how Indonesia thus far successfully navigates throughout the global storm and our optimism to deliver a sustainable growth”. Indonesia in a challenging time Ladies and Gentlemen, 3. The year of 2013 was, without doubt, a challenging time for Indonesia’s economy. A combination of unfavorable elements in global environment such as slowing economic growth, declining commodity prices, and global liquidity shift from emerging to advanced economies, has generated considerable pressures on the country’s economy and financial market through both trade and financial channel. 4. A combination of a slowdown of China’s growth – as the main Indonesia’s trading partners – and the deteriorating trend of commodity prices continues trimming down the Indonesia exports. Simultaneously, as the economy gained traction and grow with the speed more than 6%, in nature it would need sufficient support of imported goods, in particular, capital and intermediate goods. By 3rd quarter of 2013, as we all noticed, current account deficit widened. Meanwhile the inflation escalated as a consequence of the fiscal policy adjustment to reduce fuel subsidies. 5. We have also been through the most challenging time since the mid-2013 when the scale of the global financial shockwaves hitting Indonesia triggered by the announcement of the Fed tapering, followed with a massive portfolio out flows. During June 2013 alone, portfolio investment registered net outflows of $4.0 billion. 6. Since then, Indonesian rupiah have come under significant pressure and fall by 26% throughout 2013. I should accept the fact that the magnitude of pressure was exacerbated by thin forex liquidity in the domestic market. In the midst of heightening pressure stemming from capital outflows and strong depreciation, natural suppliers of dollars (exporters) have been on the sidelines which contributed to the low market volume. 7. The widespread ramifications of global factors to our economy should serve as an important “wake up call”. It is a strong reminder that we have a number of home-grown structural problems as well, among others are reliance on primary resources commodities in our export, and high dependency on import for energy and food supply. On top of that, we have underdeveloped financial markets that often add complication to the existing problems. BIS central bankers’ speeches 8. Responding to the challenges, Bank Indonesia focused its policy to drive inflation back to its target corridor. The policies were also aimed at narrowing current account deficit to a healthier level to support the sustainability of the economic growth. This was performed in a pre-emptive way and therefore demonstrated our bold, decisive actions in preserving macroeconomic stability. Bank Indonesia also pursued an intensive coordination with the Government to ensure an optimal mix of monetary and fiscal policies. We realized that coordination is paramount in such challenging-time. Indonesian economy is on the right track Ladies and Gentlemen, 9. We proudly share that the recent development particularly since the final quarter of 2013 revealed that the pre-emptive and decisive policy action carried out by Bank Indonesia and the Government has successfully steered the economy to the right track. In the last two months inflation remains under control and expect could be brought back to its target corridor of 4.5%±1% in 2014 (Graph 1). Meanwhile, the economic growth for 2013 have been maintained at reasonably high 5.76% with a more balanced structure as a result of stronger real exports and moderation of domestic demand (Graph 2) 10. Current account deficit is moving towards a healthier and a more sustainable level. It decreased sharply during the final quarter of 2013, amounting to just USD 4 billion or 1.98% of GDP, which is well below the 3.85% of GDP reported in the 3rd quarter of 2013 (Graph 3). On the other hand, capital and financial account recorded an increasing surplus buttressed by a massive inflows both in terms of FDI and portfolio investment. After three quarters of deficit, BoP finally returned to positive territory by posting USD4,4 billion surplus in Q4 2013. 11. Better economic fundamentals braced by pro-active policy has bolstered market confidence, hence pushed foreign portfolio flows back to domestic financial market (Graph 4). As a result, since early January 2014, the Indonesian Rupiah gained 6,0% as of 7 March 2014 or as the strongest currency among Emerging Market currencies (Table 1). Likewise, the credit default swap premium dropped from 233 bps in December 2013 to 177 bps in 7 March 2014, suggesting a better appetite on the Indonesian financial asset (Table 2) 12. There also a mark positive in the microstructure of domestic foreign exchange market. Interbank forex liquidity is now easier with a greater interbank trading volume in the range of USD 1,5–1,8 billion a day, compared to only USD 200–500 million average during mid-2013 (Graph 5). Moreover, there is a greater transparency in the forex price discovery and the market seems to take the JISDOR onshore fix as positive. 13. This positive development in the forex market microstructure certainly help alleviate the past perception where the central bank was perceived as the sole main supplier of US dollar. As a result, the international reserve have been back on the rise and reached USD 102,6 billion at the end of February 2014 (Graph 6). Our next step is to implement the Code of Conduct to strengthen the credibility of domestic foreign exchange market. 14. Once considered a “fragile five currencies”, Rupiah now set itself apart as a result of careful and coordinated policy actions. In short, the policy mix pursued jointly by Bank Indonesia and the Government has managed to allow for an orderly adjustment in the economy without sacrificing too much growth. Indonesia’s economy is now running on the right track. Lesson learned Ladies and Gentlemen, 15. The dynamics in the economy throughout 2013 has brought home a lesson about the importance of having an optimal balance on external and internal sector. A sustainable economic growth requires not only a low and stable inflation, but also a healthy posture in BIS central bankers’ speeches current account. In addition, such balance must also be attained in the dynamics between the goods market (ie. inflation) and the financial markets (ie. asset price). 16. This lesson has a few policy implications. First, we need a discipline, forward looking, and bold macroeconomic policy from both monetary and fiscal authorities to achieve the desired optimal balance in the economy in the medium term. 17. Second, the role of financial system stability cannot be undermined. It is critical to have a well-functioning financial system through which money would go to support productive economic activities. In this context, we have pursued various macroprudential policies to help navigate economic uncertainties in 2013. 18. Third, macroeconomic policies alone are not sufficient. The dynamics in 2013 also taught an important lesson about the role of structural reform in sustaining economic growth. Without effective structural policy, an external shock would always require substantial adjustment in the demand side that will only intensify boom-and-bust cycle in the economy. Economic outlook and risk Ladies and Gentlemen, 19. Despite lingering uncertainties, we believe the economy will be more stable and balanced in 2014. Domestic demand will continue to moderate but exports are expected to perform more favourably in line with the global economic recovery. Therefore, growth in 2014 is projected to hit the lower end of the 5.8–6.2% range. 20. Bank Indonesia expects the balance of payments to continue improving in 2014, supported by shrinking current account deficit and growing surplus in the capital and financial account. We estimate the current account deficit will be below 3% in 2014. Bank Indonesia asserts that inflation will remain under control and within its target corridor of 4.5±1% in 2014. Credit is projected to grow at 15–17% range which is consistent with the effort to bring the economy to a healthier and more balanced level. 21. Going ahead, challenges remain. We have to prepare ourselves to face a rocky and bumpy road ahead. Global uncertainties concerning the Fed normalization policy as well as the risk of an economic slowdown in China are among the critical risk factors that we have to anticipate. These risks could rekindle similar environment that have put our economy in jeopardy last year. Policy direction and further agenda Ladies and Gentlemen, 22. For that reason, at no time we should be complacent. The bumpy road ahead necessitates a wide ranging policy initiatives to enable a smooth ride for the Indonesian economy. 23. Bank Indonesia will continue to pursue monetary policy that is consistently directed towards reducing current account deficit to healthier level and controlling inflation within its target corridor of 4.5±1% in 2014 and 4.0±1% in 2015. We do not tolerate inflation move beyond the upper bound of the target range. Bank Indonesia will also strengthen policy coordination with the Government to manage domestic demand. 24. But again, as I mentioned before about lesson from 2013 experience, a sound macroeconomic policy is not sufficient to sustain economic growth. It is imperative to augment it with structural reform. We have to address our reliance on the export of primary commodities given the boom of commodity prices is over. At the same time, efforts should be made to address our heavy reliance on energy and food imports. BIS central bankers’ speeches 25. In the financial sector, financial market reform is also imperative. We, in Bank Indonesia, with close collaboration with OJK, have committed to boost financial market deepening initiatives. This includes elements such as well-functioning securities and money market, seamless payment system, and well developed long-term financing. A nation in transition Ladies and Gentlemen, 26. The year of 2014 is rather special. With the general election at our doorstep, maintaining macroeconomic stability is a key. Macroeconomic stability, in our view, is the element of continuity for the Indonesian economy in transition. In this regard, I would like reiterate our commitment to maintain the stability of our economy. 27. I would also like to emphasize here the remarkable progress in the nation’s journey to democracy. Less than two decades ago, if we recall, there was an imminent risk of “balkanisation” following a devastating financial crisis and an abrupt regime change. But now we are viewed as a strong and stable democracy, supported by institutional reforms in both private and public spheres. 28. With more than 500 elected offices throughout the archipelago, election and peaceful transition of power actually occur almost every day in this country. I am confident that the upcoming parliament and presidential elections will be no different. And it will be a testament to the strength of our democracy and its ability to support economic development. Closing Ladies and Gentlemen, 29. Before concluding this remark, I would like to remind us that Fitch Rating is the first rating agency to award investment grade to Indonesia after losing the credential due to 97/98 financial crisis. We believe that such decision was taken after an elaborate assessment on the country’s economic and financial data. And as we all have witnessed in 2013, it turned out to be an accurate assessment. Indonesia’s economy is indeed resilient and is able to withstand challenges that may have come to its way. 30. I am confident that Fitch Rating will continue to have faith in the prospect of the Indonesia’s economy on the ground of careful and comprehensive analysis. In fact, we all need to believe in the ability of our economy to move forward despite challenges and doubts. 31. I am closing my speech today with a relevant quote from Franklin D. Roosevelt – former US President. “The only limit to our realization of tomorrow will be our doubts of today. Let us move forward with strong and active faith.” Thank you and I wish you a fruitful discussion in the rest of the conference. Governor of Bank Indonesia Agus D.W. Martowardojo BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Keynote address by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at "Managing ASEAN Risk", American Indonesia Chamber of Commerce, New York, 14 April 2014.
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Agus D W Martowardojo: Making headway towards sustainable growth – challenges in a volatile world Keynote address by Mr Agus D W Martowardojo, Governor of Bank Indonesia, at “Managing ASEAN Risk”, American Indonesia Chamber of Commerce, New York, 14 April 2014. * * * Good morning, Distinguished guests, Ladies and Gentlemen 1. It is a distinct pleasure to be here, on my way back to Indonesia after attending the World Bank/IMF meeting in Washington DC. I would like to thank American Indonesian Chamber of Commerce for the invitation. 2. I also like to say that this event-theme namely “Managing ASIAN Risk” is timely and appealing. Since last couple weeks, you must have already heard many interesting discussions about the parliamentary and presidential election in Indonesia. 3. And, here, I would like to reaffirm that given the political transitions is underway, Indonesian economy remain offering causes for optimism. Ladies and Gentlemen 4. I am pleased to share that the recent development particularly since the final quarter of 2013 showed that the preemptive and decisive policy measures carried out by Bank Indonesia and the Government has effectively steered the economy to the right track. 5. Despite unfavorable weather condition, in the last three months inflation remains under control and back to its normal path. Current account deficit is moving towards a healthier and a more sustainable level. It decreased sharply during the final quarter of 2013, amounting to just 1.98% of GDP, which is well below the 3.85% of GDP reported in the third quarter of 2013. 6. Since I took the office in May 2013, I was in the view that the policy shift is needed to lower the current account deficit gradually to a sustainable level. It’s my firm believe that any delay in responding to economic imbalance often cause us to lose momentum, which carries a harmful consequences on the economy as a whole. As well, a sustainable economic growth requires not only a low and stable inflation, but also a healthy posture in current account. 7. For that reason, we (Bank Indonesia and Government) geared policy mix to put priority on the stabilization over the growth, and commit to safeguard the adjustment process to be a soft landing one. Given saw moderation in domestic demand, we have managed to allow for an orderly adjustment in the economy, without sacrificing too much growth. Last year, economic growth stood at 5,8% which reasonably high compared to our peers countries. 8. The dynamics in the economy throughout 2013 has also brought home a lesson that in order to achieve the desired optimal balance in the economy we need a discipline, forward looking, and bold macroeconomic policy. In fact, improved economic fundamentals supported by strong policy have bolstered confidence among global investor, hence attracted foreign portfolio flows back to domestic financial market. 9. Since early January until April 4, 2014, the influx of global portfolio flows into Indonesia’s financial market reached US$6.9 billion. As a result, the Indonesian Rupiah gained 7,0%, become the strongest currency among Emerging Market currencies. Once considered a “fragile five currencies”, the Indonesia rupiah now set itself apart as a result of preemptive and strong policy actions. BIS central bankers’ speeches 10. This picture is contrast against the event in mid-2013 at the time I jointed Bank Indonesia where the changing market’s enthusiastic reactions to Federal Reserve’s signal of so-called “QE tapering” led to a sell-off of emerging market debt and equities, and reversal of foreign capital flows. 11. There is also a mark positive in the microstructure of onshore foreign exchange market. Foreign exchange liquidity in onshore market is currently ampler with a greater interbank trading volume, thus buffering the IDR exchange rate against unwanted volatility due to the sudden surge in dollar demand. With a greater market volume certainly help alleviate the past perception where the central bank was perceived as the sole main supplier of US dollar. 12. Likewise, there is a greater transparency in the foreign exchange price discovery and JISDOR (Jakarta Interbank Spot Dollar Rate) has been well accepted by the market, including by the ABS Singapore formally as spot reference for NDF market in last February 2014. Managing short term volatility Ladies and Gentlemen 11. Indeed, in the recent months, turbulence in the global financial markets seems to have somewhat been moderated. This possibly reflects the fact that much of future risk of the Fed tapering has been priced in during the second half of 2013 outflow episodes. 12. This is, however, not to say that short-term volatilities are no longer with us. In these uncertain times and with all the increased interconnectedness of the world economy, volatility and short-term fickleness of marketplace are unavoidable. 13. The interplay between market players’ expectations, their self-fulfilling nature and spillover effects frequently paves the way for market exuberance in response to a trigger event. Therefore, we should realize that we are definitely not out of the woods and it’s not going to be an easy task to be sustained. 14. Beside, emerging market like Indonesia still has to prepare to face a rocky and bumpy road ahead. The G20/IMF meeting last week raise concern that the balance of risks to global growth has improved, but that some hurdles along the way remain. These include the potential risk for reversal in capital flows from emerging markets to advanced economies as risk averse investors seek relatively more attractive advanced economies’ assets. 15. And there is a risk of renewed bouts of market volatility with the expected normalization to a more neutral monetary policy stance in the United States. In either case, the result could likely lead to financial turmoil and difficult adjustments in some emerging markets, with a risk of contagion. 16. These risks if not well-managed could reawaken similar environment that have put many emerging market economy in jeopardy last year. Hence, the challenges going forward for policymakers are, not only to have the right set of “firm policy responses in place” to deal with these short-term volatilities, but also to assure that all the market participants are well prepared for the scenarios that could be expected. 17. In this regard, I have frequently encouraged the business sector at home to manage their foreign exchange risk. In this context, Bank Indonesia has taken many steps to promote the use of hedging instrument including by relaxing the foreign exchange regulation. I believe, in these uncertain times where information and confidence are very important in influencing market actions, protection against the foreign exchange risks should be viewed as the foremost strategy. BIS central bankers’ speeches Upgrading of the supply slide Ladies and Gentlemen 18. Although short-term volatility has often caught us by surprise, there is a pressing need to consider longer-term issues. And to support long-term perspective, Bank Indonesia has set macroeconomic and financial environment to support such goal. Indeed, sound macroeconomic have been instrumental in safeguarding economic stability and for some extend helping Indonesia weather through numerous shocks that have come its way. 19. But, we should also not be under the illusion that sound macroeconomic practices can be taken for granted. It would be a mistake to be soothed into complacency by the success of short-term volatility management. 20. In particular, there remain important long-term challenges to the sustainability of growth in Indonesia. As we all aware, in many emerging market including Indonesia most policy responses have been focused on demand-side management through monetary or fiscal policy. After all, pursuing demand management policies alone can only take us so far – somewhat akin to stepping on the gas pedal without “upgrading” or modifying the car we drive. 21. Thus, from domestic backdrop, Bank Indonesia give serious consideration on the need to address structural issues to be very pressing since the real lift of potential growth of the economy must essentially come from supply-side progress. Without effective structural policy, an external shock would always require substantial adjustment in the demand side that will only intensify boom-and-bust cycle in the economy. 22. Indeed, the task is not going to be easy. Reorienting the economic growth strategy to focus more on skills development, innovation, and productivity involves deliberate planning over relatively long stretch of time. Two principles are of the essence: consistency and continuity. Due to the long-term nature of structural readjustments, continuity of policy implementation is required for the policy measures to take meaningful effect on the economy. 23. The good news is that some of the infrastructure projects in Indonesia have already been in progress and will continue move on regardless of “the political regime shift”. Last month, the construction of double tract railways just completed, connecting Jakarta and Surabaya, as the biggest and second biggest city respectively. Meanwhile, the other many ongoing projects remain the responsibility of the next administration to ensure adequate infrastructure in the medium term. 24. To be sure, in Indonesia, democracy is a continuous process since its conception fourteen years ago rather than a fixed state of bliss to be attained. The process is shaped by voices of the people, under an institutional setup that provides checks and balances. With more than 500 elected offices throughout the archipelago, election and peaceful transition of power actually occur almost every day in Indonesia. I am confident that the upcoming presidential elections will be no different. And it will be a testament to the strength of our democracy and its ability to support economic development. It’s my firm believe that the next administration will ensure quality public policy that can enhance the country’s competitiveness and sustain long-term growth. Outlook 2014 Ladies and Gentlemen 25. Against the background of quite an unpredictable external environment, I believe that the Indonesian economy would be more stable, balanced, and growth at reasonable rate in the range of 5,5–5,9%. Many of the supporting factors remain in place, including stronger export and improving business confidence which should provide an enabling environment for growth. BIS central bankers’ speeches 26. Bank credit is projected to grow at 15–17% range which is reliable with the effort to bring the current account to a healthier. That being said, we expect the current account deficit to continue shrinking below 3,0%. Indeed, latest trade figure already pointed to an upbeat-sign as shown by the surplus of trade balance in February and March 2014. 27. Inflation will remain under control and within its target corridor of 4.5%±1% in 2014. With many uncertainties ahead, it is wise to keep the inflation rate low to ensure that the economy remains competitive and to minimize pockets of instability, whether through excessive growth of bank credits or asset price bubbles. Closing Distinguished guests, Ladies and Gentlemen 28. I would like to end my talk this morning by stressing that despite many roles that Bank Indonesia plays in ensuring economic and financial stability, Bank Indonesia’s policy alone cannot ensure sustainable economic growth. 29. A sustainable growth requires a structural reform for having a reliable infrastructure, – in terms of physical, financial, institutions, and human capital – as an enabler for Indonesia to grow and break into the high-income level bracket. 30. If infrastructure development is unable to keep up with expanding economy and growing demand of the population, the economic growth is constantly constrained to achieve its full potential. Encouragingly, in Indonesia, progress has been observed in many projects although room for improvement remains. 31. I believe the next administration remain placing emphasize on the structural reform, while Bank Indonesia will continue to ensure a stable financial and economic environment, so that businesses can continue to thrive and individuals can enjoy better standards of living on a sustainable basis. Thank you. BIS central bankers’ speeches
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Speech by Mr Perry Warjiyo, Deputy Governor of Bank Indonesia, at the NBER 25th Annual East Asian Seminar on Economics, Tokyo, 20-21 June 2014.
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Perry Warjiyo: US monetary policy normalization and EME policy mix – the Indonesian experience Speech by Mr Perry Warjiyo, Deputy Governor of Bank Indonesia, at the NBER 25th Annual East Asian Seminar on Economics, Tokyo, 20–21 June 2014. * I. * * Introduction Indonesia is weathering relatively well this year the spillovers from the US monetary policy normalization process. In fact, over the past two months portfolio inflows are increasing, equity prices are rebounding, bond yield is decreasing, and exchange rate is appreciating (Graph 1-4). This is evidence that strengthening domestic macroeconomic fundamentals and financial system stability plays crucial role for minimizing the spillovers. The aggressive and bold measures of monetary and macroprudential policy mix since June 2013 have resulted in streams of positive news of benign inflation, faster than expected decline in current account deficit, and better than expected GDP growth to the markets. This note draws Indonesian experience on the transmission mechanism and policy responses to global monetary factors, with a focus on the recent episode following the Fed announcement of planned tapering in May 2013. In particular, three main issues will be discussed. First, the setting of interest rate supported by exchange rate flexibility and capital flows management in responding to policy trilema arises from global monetary factors. Second, the efficacy of macroprudential measures in reinforcing lending channel of monetary transmission mechanism at the back of volatile capital flows and underdeveloped financial market. And third, the important of financial market deepening in smoothing out the transmission of global monetary factors to domestic monetary and financial system stability. II. Making possible the policy trilemma The UMP and its normalization process give rise to policy trilemma of the optimal setting on interest rate response, exchange rate flexibility, and some forms of capital flows management. Interest rate policy needs to be geared toward maintaining price stability, taking into account the impacts of global interest rate and some rooms of exchange rate flexibility as shock absorber. But market over-reaction and structural rigidities may cause unnecessary exchange rate overshooting and volatility that may hamper growth as well as overall monetary and financial system stability. Volatility in the capital flows is also complicating the optimal monetary policy response for achieving domestic economic objectives. For Indonesian case, we cope with this policy trilemma through a monetary and macroprudential policy mix, consisting of interest rate response complemented by some exchange rate flexibility, capital flow management, and macroprudential measures. Clear communication, policy coordination with the government on inflation, fiscal and structural reforms, as well as central bank cooperation on strengthening regional financial arrangements also play crucial role. The interest rate policy, as in other inflation targeting countries, is the main instrument to anchor inflation expectation and forecast going forward to fall within the targeted range. Exchange rate policy is geared toward maintaining the stability along its fundamental path. Some forms of capital flows management are implemented to dampen its short-term excessive volatility. Macroprudential measures are targeted to manage procyclicality and excessive lending in some specific sectors. Overall, the policy mix is intended to reinforce the effectiveness of all monetary transmission channels (interest rate, exchange rate, money and lending, asset prices, as well as expectation channels) to better withstand the spillover impacts of global monetary factors. BIS central bankers’ speeches Interest rate policy Indonesia is among the first central bank that ahead of the curve raised its policy rate in the aftermath of Fed announcement on planned tapering in May 2013. We started to raise the BI policy rate by 25 bps in June 2013. We then aggressively raised the policy rate by 50 bps in July, another 50 bps in August, and 25 bps in September 2013. After pausing in October, we raised again the policy rate by 25 bps in November 2013. In total, the policy rate was increased by 175 bps to 7.50% within six months. We hold the policy rate since then and maintain our tight monetary policy stance. The primary objective of this aggressive interest rate policy is to preemptively anchor inflation expectation that initially arose from food price shocks. Subsequently, the increase in policy rate is to contain the second round impact of fuel price hike that caused CPI inflation to reach its peak at 9.0% in July 2013. The large increase in policy rate is also to help in slowing down the domestic demand to dampen the current account deficit that rose to a peak of 4.4% of GDP in Q2-2013. The timing of the aggressive increases in policy rate is also important as they help in responding to the capital reversals and increasing interest rate and risks in the global financial market following the Fed announcement of planned tapering. We believe bold and aggressive response in interest rate is a key to send a strong and clear signal to the market in our monetary policy deliberation. Higher consideration is given to domestic factors, even though global monetary conditions and trends are always taken into account. The bold response in interest rate has succeeded in containing the inflation pressures and helped in reducing current account deficit faster than initially forecasted. The CPI inflation returned to its normal path since September and downed to 8.3% in December 2013, much lower than our earlier forecast of 9.0%–9.8% (Graph 5). The inflation decelerated further to 7.3% in May 2014 and we believe it will down to 5.3% at the end of 2014, and thus falls within our targeted range of 4.5%±1% (Graph 6). Trade balance turns into surplus and current account deficit is falling much faster than expected from 4.4% of GDP in Q2-2013 to 1.9% of GDP in Q4-2013 and 2.0% of GDP in Q1-2014 (Graph 7–8). We are aiming to lower the current account deficit from 3.3% of GDP in 2013 to below 3% of GDP in 2014 and around 2% of GDP in 2015. We believe this level of current account deficit is more sustainable in the longer term for Indonesia. The good news is that these price and external stability can be achieved with better than expected economic growth. GDP growth recorded at 5.8% in 2013 and it is forecasted to moderate to 5.1%–5.5% in 2014 following the stabilization policies (Graph 9). The interest rate transmission mechanism is working even though it is yet to complete. Following the 175 bps increase in policy rate, bank deposit rate rose by 240 bps as liquidity is tightened and competition among banks in raising funds is increasing (Graph 10). But interest rate on lending increased only by less than 50 bps due to a combination of factors, e.g. time lag in interest rate setting, excess liquidity and aggressive lending in some banks, and shallowness of domestic financial market. Aggregate liquidity and monetary aggregates have already declined substantially, e.g. M1 growth downed from around 22% in January 2013 to 9% in April 2014 (Graph 11), even though liquidity is not evenly distributed among banks. Bank lending growth declined more gradually from 23.5% to 19.0% during the same period even though it accounts for 16.1% if excludes exchange rate depreciation (Graph 12). Going forward, even though the policy rate is held constant, continuous monetary tightening will bring about further decline in lending growth to about 15–17% at end of 2014. Exchange rate policy Even though increases in policy rate have succeeded in anchoring inflation expectation and helped in slowing down the domestic demand, it could not left alone to play all the burdens of economic adjustments, including in further reducing current account deficit and mitigating the spillover effects from the UMP normalization process. It would need excessive increases in policy interest rate to do all the adjustments. Some room for exchange rate flexibility helps in BIS central bankers’ speeches facilitating the reduction of current account deficit and the transmission of global monetary normalization. For Indonesia, exchange rate policy is geared toward maintaining the stability of exchange rate movements that is consistent with its fundamental path. The path is calibrated through some methodology of determining the fundamental exchange rate and then inputted to be consistent with macroeconomic forecasting and simulation when determining the policy interest rate. Real Effective Exchange Rate (REER) is one approach to check the consistency of exchange rate movements to the fundamental (Graph 13). To achieve this objective, symmetric intervention in the foreign exchange market is conducted to smooth out the short-term volatility of day to day exchange rate movements in the market with the path that is consistent with the fundamental equilibrium exercises. The objective is not to achieve a certain level or range of exchange rates, but merely to avoid too excessive volatility that may give rise to panics and disruptions in the smooth functioning of foreign exchange market. Introducing greater exchange rate flexibility is not always easy when facing shallow domestic foreign exchange market, however. This is what we are facing in Indonesia in the aftermath of Fed announcement on planned tapering last year. The markets were not ready to adjust to our new policy of greater exchange rate flexibility to facilitate the spillover impacts of Fed tapering and the adjustments on current account deficit, especially during the period of June to August 2013. There was large divergence of exchange rate determination among the banks that accompanied increasing volatility and depreciation of exchange rate movements during this period (Graph 14). Frequent and close communication with market participants is important to adjust their behavior to the new policy direction. The smooth functioning of domestic foreign exchange market has resumed since September 2013. Capital flows management Volatile capital flows, especially those of short-term and speculative natures, increase the risks of instability to both monetary and financial system stability. The carry trade flows often give rise to excessive volatility in the exchange rate movements beyond implied by fundamentals. Dual intervention is one of strategy to smooth out volatility. But in some cases, measures of capital flows management are needed. For Indonesia, the policy on capital flows management is guided with three principles. First, the objective is to help mitigate the negative impacts of short-term volatility in capital flows to instability in exchange rate as well as overall monetary and financial system. Second, they are targeted to short-term and speculative capital flows since we welcome those flows that are medium-longer term that benefits the economy. And third, the measures are consistent with our broad principle of maintaining free foreign exchange system. They are temporary, i.e. the measures are strengthened when too much capital inflows and relaxed when too much capital outflows, and do not differentiated to both domestic and international investors. Followings provide clear examples. During heavy capital inflows from the UMP easing, in 2010 we introduced six month holding period for transactions in the central bank bills and imposed a maximum of 30% capital to the short-term off-shore borrowings of the banks. But following the Fed announcement of planned tapering in 2013 we relaxed the holding period for central bank bills to one month and expanded a number of transactions that are excluded from the calculation on off-shore borrowing of the banks. We view that these measures help in dampening the short-term and volatile capital flows, and thus are consistent with the objective of managing financial stability. III. Assessing the macroprudential measures As underlined before, the interest rate transmission mechanism of monetary policy is not always smooth and fully effective in a country where financial market is not yet developed such as Indonesia. Other channels of monetary transmissions must be deployed, including BIS central bankers’ speeches the lending channel. This is where macroprudential measures play key role, including in smoothing out the procyclicality nature of bank lending behavior. Thus, both the objectives of maintaining monetary and financial system stability are taken into account when we design macroprudential measures. In Indonesia, the formulation of macroprudential measures is done as follows. We develop some methodologies to assess some sort of optimal lending growth of the banks, including what we call non-accelerating inflation lending growth model. We apply the model to aggregate lending growth as well as lending growth to each bank, certain types of lending (consumption, working capital, and investment) and per economic sectors. By comparing these optimal vs. actual lending growth, we have some idea where excessive lending occurs and thus some instruments of macroprudential measures are justified and can be applied. This is the approach that we applied when introducing loan-to-value (LTV) ratio to lending to automotive and property sectors in 2012. We then strengthen the LTV ratio to lending to property sectors in 2013, especially to mortgages for the second, third, and so on purchases of certain types of housing and apartments. The measures are also complemented by supervisory actions to banks that we viewed exhibit excessive lending behavior. We note that the formulation and implementation of macroprudential measures require a much detail and complex analysis and calibration, as well as the need for clear communication to the banks and business community. Our experience shows that the macroprudential measures and supervisory actions help in reinforcing the effectiveness of monetary transmission mechanism and supporting the financial system stability. Even though lending growths increased in the period prior the implementation of these measures, probably banks and their customers wanted to utilize the interim period, they declined substantially in relatively short-period in the subsequent episode. The growth of mortgage on housing for less than 21 M2, for instance, declined from more than 100% to the negative growth during the period of June to September 2012 (Graph 16). Likewise, the growth of mortgage on apartment less than 21 M2 dropped from more than 300% to less than 10% during the period of January to November 2013 (Graph 17). It should be noted that the automotive and property sectors contain substantially large import content, and thus managing lending growths to these two sectors help in reducing the current account deficit. IV. Financial market deepening The stage and depth of domestic financial market influence the transmission mechanism and policy response to global monetary factors, in both the UMP easing period as well as the normalization process. Preceding discussions clearly show the challenges that we face in Indonesia. Interest rate transmission is lagging in the absence of domestic money and fixed income markets that provide efficient mechanism interest rate and term-structure determination. The shallowness of domestic foreign exchange market often causes excessive volatility and overshooting of exchange rate movements in responding to global monetary and financial shocks. This is the rationale for our focus and priority on financial market deepening, as an integral part of our policy responses to the normalization process of the UMP in the advanced countries. In addition to strengthening the economic fundamentals, sound macroeconomic and financial system stability, the best defense for withstanding the spillover effects of such global monetary and financial factors is to make our financial market more conducive and resilience to swings in the international investor preferences. We embark on a series of policy initiatives to deepen our financial market, especially domestic money and foreign exchange markets. In the foreign exchange market, we succeeded in establishing the Jakarta Interbank Spot Dollar Rate (JISDOR), reflecting the actual transacted exchange rates, as a reliable reference for the market. Recently, the Association Banks of Singapore (ABS) recommends their members to use JISDOR as BIS central bankers’ speeches reference rate in fixing their NDF transactions. We also introduce FX swap transactions with the banks both bilaterally and weekly auctions. Further relaxation on regulations regarding underlying transactions for forward and swap as hedging instruments has been issued, and we are now campaigning to the banks and corporates to use more hedging instruments in managing their increasing exchange rate risks. We also make significant progress in deepening domestic money market, especially those of collateralized transactions. We use more reverse repo with government bonds in our monetary operations. We have succeeded in developing interbank repo using government bonds as underlying transactions. Within less than three months, the size of transactions increases substantially from almost nonexistence to equivalent of USD3 billion. The number of banks participate in this interbank repo enlarges from only 8 to 65 banks, and more will follow. We believe this progress of financial deepening play important role in supporting our policy mix of monetary and macroprudential measures in responding to the spillover effects from the normalization process of the Fed monetary policy. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Opening remarks by Dr Halim Alamsyah, Deputy Governor of Bank Indonesia, at the 3rd International Conference on Inclusive Islamic Financial Sector Development, Jakarta, 28 August 2014.
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Halim Alamsyah: Inclusive Islamic financial sector development Opening remarks by Dr Halim Alamsyah, Deputy Governor of Bank Indonesia, at the 3rd International Conference on Inclusive Islamic Financial Sector Development, Jakarta, 28 August 2014. * * * His Excellency: Prof. Dr. Didin Hafiduddin, CEO of National Zakat Authority; Representative of IRTI-IDB: Prof. Dr. Abdul Ghafar Ismail; His Excellency: Associate Prof. Dr. Ahmad Zaki Hj Abd Latiff, Director of Institut Kajian Zakat Malaysia; Prominent speakers; and, All participants, Assalamualaikum Wr. Wb, and good morning to all of you. It is a great pleasure for me to welcome you in this conference on Islamic financial sector development in Jakarta and welcome to Bank Indonesia’s building. I am pleased to see that the development of Islamic financial industry could take place in many frontiers including asset size, products and services, and also financial sectors. This conference proves the industry’s ability to move towards better quality in servicing the market. Supported by internationally qualified experts, it is not overdo if I expect at the end of the session, this conference will produce strategic initiatives and measures to give the Islamic Finance a greater and significant role in the economic development. Distinguished Guests, Ladies and Gentlemen, The 2007/2008 Global Financial Crisis (GFC) has taught us a valuable lesson that merely depending on monetary policy alone is insufficient to achieve macroeconomic and also financial system stability. We learned that the source of crisis has shifted from macro side (fiscal and monetary) to micro side (financial agents). Therefore, it is necessary to complement monetary policy with microprudential policy and macroprudential policy. Indonesia has a specific experience on this matter, as we have also been a severe economic crisis in 1997/1998 that brought a wide-range impact with an expensive cost to the economy, social and politics. At the time, we had to do a very tough effort to regain credibility and resources to pursue our target of social welfare and prosperity. This experience has fortunately brought us to be more alert to financial disturbances, leading us to come through the GFC relatively unscathed. Considering those facts, we are very grateful that, as a mandate from G-20 summit, the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) and other standard-setting bodies are now working hand-in-hand to design a better institutional arrangement, tools and instruments to promote effective monetary and macro-prudential policy. In line with that, it is also agreeable that the High Level Committee of the Islamic Financial Services Board (IFSB) members called for the Islamic Financial System to strengthen regulatory and liquidity infrastructures as well as building a healthy and beneficial linkage to the real sectors. BIS central bankers’ speeches Excellencies, Ladies and Gentlemen, Besides all the advances in monetary and macro-prudential policies to strengthen financial stability, we are at the stance that structural policies is also crucial in supporting financial system resillience. Lesson from the 1997/1998 crises, we learned that micro and small enterprises were relatively resistant to economic shocks, giving significant contribution to financial and economy recovery. Hence, structural policies need to be promoted to advance wealth distribution to more people, particularly low-income class. In regard to this concept, Islamic social sector that covers Zakat and Awqaf systems can play very important role in accelerating economic development and supporting financial stability. In Indonesia, as studied by Bank Indonesia’s researchers in 2012, total of all zakat potential from various sources is approximately Rp217 trillion or equivalent to USD22.6 billion. This number is equal to 3.4% of Indonesia’s 2010 Gross Domestic Product (GDP). However, the realisation of those potential zakat is still below our expectation. Recent data recorded only Rp2.7 trillion or 1.2% of total zakat potential has been received. This is our home-work to explore ways to boost this number. Unlike the other commercial sources of fund, the zakat funds would never cause unnecessary burden to the economy since the type of the funds is not commercially claimable, and hence, no excessive social cost will occur. The same also goes to the Awqaf sector where, as a matter of fact, more people are endowed with low cost assets. Again, potential benefits from those assets has not been materialized yet, because most of the assets are still poorly managed. Based on data from Indonesian Awqaf Board, Awqaf land has now reached not less than four billions of meter square, a very significant source if we can optimized them. With this huge potential of Zakat and Awqaf land, we can expect a significant drive to economic development. I personally believe that these ideas are in-line with those of the governments, as well as multilateral development banks (MDBs). For this reason, it is not surprising if central banks and other regulatory bodies put their attention to enhance zakat and awqaf system. One of the areas to be improved is the regulatory aspect, which includes zakat core principles to provide reference for the establishment of zakat system in the OIC member countries. Financial deepening program in many countries should also promote product innovation and enhancement to give a wider access to broader segments of people, which is in line with the program of Islamic Development Bank, African Development Bank, Asian Development Bank and the World Bank. This in turn will bring substantial benefits to support national poverty alleciation program. Distinguished Guests, Ladies and Gentlemen, Please allow me to close my speech by expressing my appreciation and sincere gratitude to all speakers and participants for the willingness to join this event. I also would like wish you all a fruitful discussion and deliberation in this important event. As I mentioned before, I believe that with the support of internationally reputable academics and market players, we can reach significant outcomes to promote zakat and awqaf system. Finally, I am delighted to officially open “the 3rd International Conference on Inclusive Islamic Financial Sector Development”, enjoy the discussion and the rest of session at Bank Indonesia Museum in the evening. Thank you very much, wassalamualaykum warahmatullah wabarakatuh. BIS central bankers’ speeches
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Speech by Mr Ronald Waas, Deputy Governor of Bank Indonesia, at the signing of the working guidelines between Bank Indonesia and the National Police, as a follow-up action to the Memorandum of Understanding (MOU) "Cooperation to support task implementation and the authority of Bank Indonesia and the National Police of the Republic of Indonesia", Jakarta, 24 September 2014.
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Ronald Waas: Handling alleged payment system and currency exchange crime Speech by Mr Ronald Waas, Deputy Governor of Bank Indonesia, at the signing of the working guidelines between Bank Indonesia and the National Police, as a follow-up action to the Memorandum of Understanding (MOU) “Cooperation to support task implementation and the authority of Bank Indonesia and the National Police of the Republic of Indonesia”, Jakarta, 24 September 2014. * * * Honourable, Chief of the Criminal Investigation Agency, Commissioner General Suhardi Alius, M.H.; Leaders of MABES POLRI: KADIVKUM, KADIVHUMAS, DIRTIPIDEKUS, DIRTIPIKOR; Leaders of Bank Indonesia as well as all other attendees and invitees. Assalamu’alaikum warahmatullahi wabarakatuh, good morning to you all. • First, let us praise God Almighty that we may gather here today to witness the signing of working guidelines between Bank Indonesia the National Police, in this case the Criminal Investigation Agency, concerning “The Handling of Alleged Payment System and Currency Exchange Crime.” • The signing of the working guidelines represents a follow-up action to the Memorandum of Understanding (MoU) signed between Bank Indonesia and the National Police on 1st September 2014 regarding “Cooperation to Support Task Implementation and Institutional Authority.” • Pursuant to the Memorandum of Understanding (MoU) signed by the Governor of Bank Indonesia and Police Chief, the following tasks will be spotlighted for synergised implementation: – Data and/or information exchange; – Security and escorts; – Supervision; – Law enforcement; – Enhanced human resources; – Socialisation. Concerning law enforcement, one aspect that will be synergised through cooperation between Bank Indonesia and the National Police is the handling of alleged payment system and currency exchange crime, otherwise known as money changers. • Law enforcement in the area of currency exchange is essential considering its susceptibility to abuse by unauthorised parties, including money laundering and terrorism funding, the narcotics trade as well as trafficking disguised as currency exchange activity. • In order to prevent various forms of criminality in the currency exchange business, Bank Indonesia recently promulgated Bank Indonesia Regulation (PBI) Number 16/15/PBI/2014, dated 11th September 2014, concerning Non-Bank Currency Exchange Activity. The regulation fosters stronger and more refined non-bank currency exchange activity that must be licensed by Bank Indonesia. The recent BIS central bankers’ speeches regulation will help mitigate potential risk in the form of misuse and crime linked to currency exchange. Ladies and Gentlemen: • In accordance with its mandate, Bank Indonesia is the monetary and payment system authority. As the monetary authority, the mission of Bank Indonesia is to maintain rupiah stability and preserve effective monetary policy transmission. Currency exchange, as a supporting sector of the financial industry, plays a strategic role in terms of achieving rupiah stability. • Meanwhile, the mission of Bank Indonesia as the payment system authority is to create secure, effective and uninterrupted cash and non-cash payment systems. • One vision of Bank Indonesia regarding the non-cash payment system is to advocate and promote a less cash society through greater public utilisation of non-cash payment instruments. The realisation of a less cash society is important to nurture a more efficient economy, in addition to fostering good governance in terms of financial management by the public, business players as well as government institutions. • A crucial stepping-stone towards the realisation of a less cash society is that all parties feel secure when performing non-cash transactions, namely feeling protected from the threat of criminal activity by unauthorised parties. A survey conducted by Bank Indonesia confirmed that security when performing non-cash transactions is the overarching concern of the public, followed by convenience and interoperability amongst the providers of financial transaction services. • In order to combat potential criminality in the payment system and currency exchange industry, more intensive handling of alleged payment system and currency exchange crime is required. Furthermore, the imposition of strict sanctions pursuant to prevailing regulations should act as a deterrent to potential criminals. • It is necessary to include tight coordination and cooperation in a clear and transparent mechanism, in accordance with the tasks and authority of Bank Indonesia and the National Police, referring to prevailing laws and regulations with due consideration paid to the principles of justice, utility and legal assurance. • We warmly welcome the signing of these working guidelines concerning the handling of payment system and currency exchange crime, which also represent a part of the Memorandum of Understanding (MoU) signed previously. Implementation of the working guidelines will be complemented through cooperation between Bank Indonesia Representative Offices and local police departments. Ladies and Gentlemen: • Through the working guidelines, we are confident that efforts to handle payment system and currency exchange crime will be more effective moving forward, hence realising the common objective of protecting the public through the creation of a sound and secure payment system and currency exchange industry. • The working guidelines are expected to become a form of good communication, intensive coordination and synergetic collaboration between Bank Indonesia and the National Police, related ministries, law enforcement officers and other stakeholders. • That concludes my opening remarks with the belief that God Almighty will always bless us and light out way towards a better future. Wassalamu’alaikum wR. wB. Thank you. BIS central bankers’ speeches
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Speech by Mr Ronald Waas, Deputy Governor of Bank Indonesia, at the Signing Ceremony for Cooperation between the Bank Indonesia Representative Office and Police Department in Riau Islands Province concerning "Coordinated Handling of Payment System and Currency Exchange Crime", Batam, 22 October 2014.
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Ronald Waas: Coordinated handling of payment system and currency exchange crime Speech by Mr Ronald Waas, Deputy Governor of Bank Indonesia, at the Signing Ceremony for Cooperation between the Bank Indonesia Representative Office and Police Department in Riau Islands Province concerning “Coordinated Handling of Payment System and Currency Exchange Crime”, Batam, 22 October 2014. * * * Honourable, • Deputy Governor of Riau Islands Province; Dr Soerya Respationo, SH, MH; • Chief of the Criminal Investigation Agency of the Republic of Indonesia, Suhardi Alius; • Leaders of the National Police • – WaDir. TIPIDEKSUS, Kombes Rohmat Sunanto; – Kasubdit Upal, Kombes Agus Nugroho; – Kabag Kerjasama antar Lembaga – Divkum Polri, Kombes Syahri Gunawan; – Kapolda KepRi; Brigjen Polisi Drs. Arman Depari; Leaders of Bank Indonesia Representative Offices and Departments – Head of the Bank Indonesia Representative Office in Area VIII, Mahdi Mahmudy; – Head of the Bank Indonesia Representative Office in Riau Islands Provice, Gusto Rizal Eka; – Executive Director of the Payment System Supervision and Policy Department; – Executive Director of the Money Management Department; – Executive Director of the Legal Affairs Department; – Executive Director of the Communication Department; – Expert Staff of the Board of Governors, Hari Utomo; • Members of the Riau Islands Leaders’ Communication Forum; • Mayor of Batam, H. Ahmad Dahlan, MH; • As well as all those in attendance. Good morning to you all, 1. First, let us praise God Almighty for blessing us here in attendance at such a salubrious setting to witness the signing of an agreement between the Bank Indonesia Representative Office and the Police Department here in Riau Islands concerning “Coordinated Handling of Payment System and Currency Exchange Crime”, also known as money changers. 2. Such activity represents an integral part of institutional coordination between Bank Indonesia and the National Police, formalised in a Memorandum of Understanding (MoU) concerning “Cooperation to Support Task Implementation and Institutional Authority” signed by the Governor of Bank Indonesia and the Chief of Police on 1st September 2014. BIS central bankers’ speeches 3. That Memorandum of Understanding (MoU) was followed by the signing of Working Guidelines between Bank Indonesia and the Criminal Investigation Agency regarding the “Handling of Alleged Payment System and Currency Exchange Crime”. The working guidelines provide impetus for further similar cooperation at all Bank Indonesia Representative Offices and Local Police Departments throughout the Indonesian archipelago. Ladies and Gentlemen; 4. 5. Coordinated handling of alleged payment system and currency exchange crime represents synergic institutional efforts between Bank Indonesia and the Police, particularly in the area of law enforcement. In broad terms, the scope of coordination entails the following: • Information and/or data exchange; • Security and escorts; • Supervision; • Enhanced human capital; and • Socialisation. There remains substantial cooperation that must be completed and refined as an inseparable element of the agreement signed here today. In addition to the arrangement concerning law enforcement in the payment system and currency exchange industry, Bank Indonesia and the Police will immediately initiate a number of other working guidelines as follows: • Working guidelines concerning coordinated security (offices and personnel) as well as escorting valuable state-owned property; • Working guidelines concerning coordinated development, licensing and supervision of security companies that secure the transportation of money and are responsible for rupiah management; and • Working guidelines concerning coordinated prevention and handling of alleged rupiah currency crime. 6. In the case of the working guidelines concerning coordinated prevention and handling of alleged rupiah currency crime, this represents a tangible follow-up to our previous discussions at the seminar on the Mandatory Use of the Rupiah Domestically. As I mentioned at that seminar, there are three dimensions to the compulsory use of the rupiah. 7. First is the Legal Dimension. A number of regulations, including the Currency Act and the Foreign Exchange Act as well as Bank Indonesia regulations concerning rupiah entering and leaving Indonesia and Ministry of Trade regulations regarding labelling the prices of goods and services all serve to strengthen the legal basis for using rupiah in the archipelago. The variety of aforementioned regulations directly and indirectly reinforces the mandatory use of the rupiah for all cash and non-cash transactions settled in the territory of the Republic of Indonesia. 8. Second is the National Dimension. The rupiah is a symbol of sovereignty of the Republic of Indonesia. Therefore, using the rupiah for all transactions settled in the territory of the Republic of Indonesia is the duty of all citizens. That is the only way the rupiah will become the “host” of its own nation. 9. And third is the Economic/Business Dimension. Hitherto, foreign currency transactions in Indonesia have, amongst others, triggered greater domestic demand for foreign currencies. The large foreign currency requirement for domestic BIS central bankers’ speeches transactions has left the economy vulnerable to economic shocks. Domestic and international confidence in the rupiah will bolster economic resilience, providing the rupiah gravitas at home and abroad. Ladies and Gentlemen, 10. Law enforcement in the area of currency exchange is critical, especially considering that the currency exchange business is vulnerable to abuse in the form of money laundering and terrorist funding, the narcotics trade as well as smuggling under the guise of currency exchange. 11. The city of Batam is a hub of currency exchange activity, evidenced by the number of licensed non-bank money changers in the city, totalling 122, which is the second largest in Indonesia along with Denpasar. In terms of transaction volume, up to September of this year, Batam placed fourth after Jakarta, Denpasar and Bandung, with a contribution equivalent to Rp683 billion (4.58%). 12. Meanwhile, in terms of discovering counterfeit banknotes, based on records of Bank Indonesia and the National Police, as many as 549 counterfeit banknotes were discovered on the Riau Islands up to September 2014, which is far lower than the amount seized last year totalling 1,666 banknotes. Counterfeit banknotes in Riau Islands Province accounted for 0.66% of the national total or around 10% of the total on Sumatra, placing Riau Islands third after the provinces of North Sumatra and Bandar Lampung. 13. In order to prevent currency exchange crime, Bank Indonesia promulgated Bank Indonesia Regulation No. 16/15/PBI/2014, dated 11th September 2014, concerning Non-Bank Currency Exchange Activity. The regulation reinforces and refines all aspects of currency exchange activity that must be licensed by Bank Indonesia. Furthermore, the regulation is also expected to mitigate potential risk in the form of currency exchange crime. Ladies and Gentlemen, 14. Pursuant to the Bank Indonesia Act, Bank Indonesia is the monetary and payment system authority. As the monetary authority, the mission of Bank Indonesia is to create and maintain rupiah stability. Currency exchange activity, as a supporting industry of the financial sector, plays a strategic role in terms of underpinning rupiah stability. 15. Meanwhile, the mission of Bank Indonesia, as the payment system authority, is to create a secure, efficient and uninterrupted cash and non-cash payment system. In terms of the non-cash payment system, Bank Indonesia tireless strives towards a Less Cash Society (LCS), namely encouraging the general public towards a proclivity for non-cash payment instruments. To that end, Bank Indonesia recently launched a National Non-Cash Movement in order to expedite the proliferation of non-cash transactions. 16. Payment (retail) transactions in Indonesia are currently dominated by cash-based transactions. Weak public understanding concerning the existence and use of non-cash payment methods, coupled with limited quality infrastructure, forces the public to favour cash-based transactions for their daily activity. 17. A survey conducted by McKinsey & Company (2013) revealed that in comparison to its peer countries, the use of cash for retail transactions in Indonesia remains dominant at 99.4%. The dominant use of cash is a consequence of risk and rupiah management costs. Statistics show that each year the amount of currency in circulation grows by around 15%, far exceeding population growth at around 2–3% and GDP growth of around 5–6%. A less cash society is expected to precipitate BIS central bankers’ speeches more balanced growth with more widespread use of non-cash payment instruments amongst the public. 18. The National Non-Cash Movement is critical to hasten the realisation of a more efficient economy as well as better governance in terms of financial management amongst the public, business players and government institutions. To ensure a more effective programme, the National Non-Cash Movement is run in synergy with various ministerial and provincial government programmes through the application of e-Government and e-Payment. Ladies and gentlemen; 19. A key determinant of a less cash society is a sense of security for all stakeholders when conducting non-cash transactions, in particular protection from criminality by unauthorised parties. This was confirmed by a Bank Indonesia survey, which found that security when conducting non-cash transactions is the main factor cited by the general public, followed by convenience and interoperability amongst financial service providers. 20. In order to combat potential criminality, the intensive handling of suspected crimes is paramount. Solid coordination and consolidation between the relevant authorities and law enforcement is expected to prevent and minimise various payment system and currency exchange crimes. Furthermore, the imposition of stringent sanctions will act as a deterrent to potential criminals. 21. Sound coordination and cooperation is required in the form of a clear and transparent mechanism pursuant to the respective task and authority of Bank Indonesia and the Police at the central and regional levels referring to prevailing laws and regulations as well as paying due regard to principles of justice, mutual benefit and law. 22. I warmly welcome the signing of this agreement on handling alleged payment system and currency exchange crime as an integral part of our combined efforts to combat various crimes. Ladies and gentlemen; 23. Through the signing of this document, we are sure that the future handling of alleged payment system and currency exchange crime will be more effective, thereby bolstering efforts to protect the general public through the creation of a sound and secure payment system and currency exchange industry. 24. The working guidelines will help combine effective communication, intensive coordination and synergic collaboration between Bank Indonesia, the Police and the Government and the central and local levels, whilst ensuring all stakeholders maintain effective law enforcement in the payment system and currency exchange industry. 25. In closing, with the confidence that God is always by our side, may He bless our endeavours towards a brighter future. Thank you. BIS central bankers’ speeches
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